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                      SECURITIES AND EXCHANGE COMMISSION
                            Washington, D.C. 20549

                               ----------------

                                   FORM 10-K
(Mark One)
[X] ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE
    ACT OF 1934 FOR THE FISCAL YEAR ENDED DECEMBER 31, 2000

                                       OR

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

                       Commission file number: 000-30005

                               ----------------

                         NUMERICAL TECHNOLOGIES, INC.
            (Exact Name of Registrant as Specified in Its Charter)

<TABLE>
 <S>                              <C>
            Delaware                                94-3232104
 (State or Other Jurisdiction of                 (I.R.S. Employer
 Incorporation or Organization)               Identification Number)
</TABLE>

<TABLE>
<S>                                            <C>
           70 West Plumeria Drive
            San Jose, California                                 95134-2134
  (Address of Principal Executive Offices)                       (Zip Code)
</TABLE>

              Registrant's Telephone Number, Including Area Code:
                                (408) 919-1910

          Securities registered pursuant to Section 12(g) of the Act:
                  Common Stock, par value $0.0001 per share.

                               ----------------

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

   Indicate by check mark if disclosure of delinquent filers pursuant to Item
405 of Regulation S-K is not contained herein, and will not be contained, to
the best of registrant's knowledge, in definitive proxy or information
statements incorporated by reference in Part III of this Form 10-K or any
amendment to this Form 10-K. [X]

   Aggregate market value of the voting common stock held by nonaffiliates of
the registrant as of March 1, 2001: $319,722,632

   Number of shares outstanding of the registrant's common stock, $0.0001 par
value, as of March 1, 2001: 32,921,337

                      DOCUMENTS INCORPORATED BY REFERENCE

   Portions of the definitive Proxy Statement for Numerical Technologies,
Inc.'s Annual Meeting of Stockholders to be held on June 13, 2001 are
incorporated by reference into Part III of this Form 10-K.

   Certain exhibits filed in connection with Numerical Technologies, Inc.'s
Registration Statement on Form S-1, dated April 6, 2000, are incorporated by
reference into Part IV of this Form 10-K.

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<PAGE>

   Certain information contained or incorporated by reference in this Annual
Report on Form 10-K is forward-looking in nature. All statements included or
incorporated by reference in this Annual Report on Form 10-K or made by
management of Numerical Technologies, Inc. and its subsidiaries (collectively,
"Numerical", except as otherwise set forth herein), other than statements of
historical fact, are forward-looking statements. Examples of forward-looking
statements include statements regarding Numerical's future financial results,
operating results, business strategies, projected costs, products, competitive
positions and plans and objectives of management for future operations. In
some cases, forward-looking statements can be identified by terminology such
as "may," "will," "should," "would," "expects," "plans," "anticipates,"
"believes," "estimates," "predicts," "potential," "continue," or the negative
of these terms or other comparable terminology. Any expectations based on
these forward-looking statements are subject to risks and uncertainties and
other important factors, including without limitation those discussed in the
section entitled "Item 7: Management's Discussion and Analysis of Financial
Conditions and Results of Operations--Trends, Risks and Uncertainties". These
and many other factors could affect Numerical's future financial and operating
results, and could cause actual results to differ materially from current
expectations.

                                    PART I

Item 1: Business

   We are a leading commercial provider of proprietary technologies and
software products that enable the design and manufacture of subwavelength
semiconductors. We offer a comprehensive solution that enables the production
of smaller, faster and cheaper semiconductors using existing equipment. This
solution enables our customers and industry partners to realize increased
return-on-investment, and deliver new high-performance semiconductors more
quickly.

   Our patented phase-shifting technology, combined with our proprietary
optical proximity correction ("OPC") and process modeling technologies form
the foundation of our subwavelength solution. Our comprehensive subwavelength
solution integrates these technologies into each key stage of semiconductor
manufacturing to form an integrated design-to-silicon flow. We believe that
our technology leadership and relationships with leading companies within the
semiconductor industry will drive the adoption of our solutions as the
industry standard.

   We have currently licensed our proprietary technologies for production use
to Motorola, Texas Instruments and United Microelectronics Corporation
("UMC"). MIT Lincoln Laboratories ("MIT"), a research facility, has
demonstrated the future potential of our proprietary technologies by producing
0.025-micron features. Our other industry partners and customers include
Applied Materials, KLA-Tencor, Canon, Nikon, DuPont Photomask, Dai Nippon
Printing, Photronics, Cadence and Taiwan Semiconductor Manufacturing Company
("TSMC").

Industry Background

   Businesses and individuals increasingly rely on electronic products and
systems powered by semiconductors. These products and systems include desktop
and portable personal computers, mobile phones, Internet appliances, video
game consoles, and high-speed networking and communications products that
serve as the backbone of the Internet. Growing recognition of the benefits of
advances in electronics, including enhanced productivity and communications
capability, drives demand for higher performance, lower cost, smaller and more
power efficient products with greater functionality. To meet this demand,
manufacturers of electronic products and systems require an increasing supply
of faster, cheaper and more power efficient semiconductors. The Semiconductor
Industry Association estimated, in its June 2000 report, that the worldwide
market for semiconductors will grow from $195 billion in 2000 to $312 billion
in 2003, or 60%. Delivering these advanced semiconductors will require rapid
advances in integrated circuit ("IC") design and manufacturing technologies.

                                       2
<PAGE>

 The Historical March to Smaller Feature Sizes and Systems-on-a-Chip

   The ability to produce advanced ICs depends on developing technology that
enables the design and manufacture of semiconductors with smaller feature
sizes. A semiconductor's "feature size" relates to the size of circuit
components in the device and is measured in microns, or millionths of a meter.
Advanced semiconductors today have feature sizes of 0.10 to 0.18 micron. To
illustrate how small these features are, when placed side by side, one
thousand 0.10 micron transistors can fit within the width of a single human
hair. Smaller feature sizes significantly increase performance while
decreasing the size, cost and power consumption of semiconductors. Smaller
feature sizes also allow multiple components, such as microprocessors, memory,
analog components and digital signal processors, to be integrated into a
single semiconductor.

   The resulting complex semiconductor, commonly referred to as system-on-a-
chip, offers significant performance, cost, power and reliability benefits
over systems that require multiple semiconductors to perform the same tasks.

   Advances in semiconductor design and manufacturing technologies enabled
reductions in feature sizes from 3.0 micron in 1980 to 0.13 micron and smaller
in today's advanced production fabrication facilities. These advances led to
significant improvements in electronic systems and products. For example,
today's cellular phones compared to those of a few years ago have a battery
life of days instead of hours, weigh ounces instead of pounds and can be
produced at a fraction of the price. In addition, today's cellular phones have
many times the computing power of the most advanced personal computer in 1980.

   To date, the semiconductor industry relied upon advances in semiconductor
equipment to produce smaller feature sizes on semiconductors. However, to
fully realize the benefits of smaller feature sizes, significant advances have
also been required in each of the following key stages of the semiconductor
design-to-silicon flow:

  .  Semiconductor Design Tools. A variety of complex software programs used
     to design, simulate and verify semiconductor designs.

  .  Photomasks. Templates used to transfer images of electronic circuits to
     silicon wafers.

  .  Semiconductor Equipment. Sophisticated equipment used to manufacture
     semiconductors.

  .  Semiconductor Manufacturing. Complex processes required to create
     semiconductors on silicon.

   Historically, leading semiconductor companies designed, manufactured and
tested their semiconductors in their own facilities using internally developed
tools. The growing complexity of the design and manufacturing processes and
the escalating cost of manufacturing facilities resulted in a disaggregation
of the semiconductor industry into companies separately focusing on each
individual stage of the design-to-silicon flow. This disaggregation is fueling
the rapid growth of "fabless" semiconductor companies, which do not own or
operate their own semiconductor fabrication facilities, design tool vendors,
semiconductor equipment manufacturers and third-party semiconductor
manufacturers, or foundries. Each of these industry markets faces significant
challenges as feature sizes continue to decrease.

 The Subwavelength Challenge

   Semiconductor manufacturing equipment transmits light at a specific
wavelength through a photomask to create images of IC patterns on a
semiconductor. This process is referred to as photolithography or optical
lithography. At feature sizes below 0.25 micron, the semiconductor industry
reached a critical technology transition. At and above 0.25 micron, the
wavelength of light used is smaller than the IC features. However, at 0.18
micron and below, the wavelength of light used in production semiconductor
manufacturing equipment is significantly larger than the IC features,
resulting in image quality that degrades rapidly. This is like trying to paint
a one-inch line with a four-inch paint brush. This growing disparity between
feature sizes and wavelength of light is referred to as the "subwavelength
gap." As a result, manufacturers in the industry cannot produce semiconductors
with feature sizes of 0.18 micron and smaller with acceptable yield levels
using traditional

                                       3
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technologies. Furthermore, as the demand for reduced feature sizes continues
to outpace the reduction in wavelengths used by available equipment, this
subwavelength gap will widen.

                             [GRAPH APPEARS HERE]

   In its 2000 International Technology Roadmap, the Semiconductor Industry
Association predicted that the semiconductor industry would introduce
microprocessors with 0.10 micron feature sizes for semiconductors by the end
of 2001 and 0.10 micron random access memory chips, or DRAM, by the end of
2005. Advances in manufacturing equipment technology alone can no longer
enable the progression to smaller feature sizes and we do not expect
alternative non-optical manufacturing processes to be commercially viable for
many years. As a result, the semiconductor industry must develop and integrate
new subwavelength solutions into all aspects of the design-to-silicon flow.

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Our Solution

   We are a leading commercial provider of proprietary technologies and
software products that enable the design and manufacture of subwavelength
semiconductors using existing design tools and semiconductor equipment. We
have accelerated the semiconductor technology roadmap by at least two years,
enabling the production of semiconductors with feature sizes of 0.09 micron.
Our comprehensive solution addresses each key stage of the design-to-silicon
flow, including physical design, design verification, manufacturing data
preparation, photomask manufacturing inspection and photolithography. By
offering a subwavelength solution that is used in every stage of the
semiconductor design and manufacturing process, we integrate the entire
design-to-silicon flow for subwavelength ICs.

                           [FLOW CHART APPEARS HERE]

   Our patented phase shifting and proprietary OPC and process modeling
technologies serve as the foundation for our subwavelength solution. Our
subwavelength solution leverages our expertise in semiconductor and photomask
manufacturing processes, semiconductor equipment, IC design, software
development and subwavelength technologies.

   Our proprietary technologies and software products are designed to offer
the following key benefits:

   Proven Path to Smaller, Faster, Cheaper and Power Efficient Devices. Our
industry partners and customers demonstrate the success of our proprietary
technologies and software products. For example, Motorola used our phase
shifting technology and software to enable its 0.18 micron wafer fabrication
facilities to produce 0.10 micron features. In December 2000, UMC licensed our
patented phase shifting technology in order to deliver 0.07 micron features on
their 0.13 micron process. Further, in May 2000, MIT, a research facility,
demonstrated the future potential of our technologies and products by
successfully creating 0.025 micron features. MIT used our phase shifting
technology and standard 0.25 micron semiconductor manufacturing equipment.

   Accelerate Time to Market. In today's economy, semiconductor manufacturers
can achieve a significant market advantage by being the first to introduce
more advanced semiconductors. Introducing next generation semiconductors has
historically required the semiconductor industry to install new equipment or
to construct new manufacturing facilities, which may take up to three years to
complete. Our phase shifting technology and

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software products enable companies to use existing equipment to produce
smaller, faster and more power efficient semiconductors, thereby enabling them
to introduce new products more rapidly.

   Increase Return on Capital Equipment Investment. We design our proprietary
technologies and software products to enable existing semiconductor
manufacturing equipment to produce subwavelength ICs. Using our technologies
and products, semiconductor manufacturers will not be required to spend
billions of dollars to produce ICs with smaller and smaller feature sizes. As
a result, these semiconductor manufacturers can significantly increase their
return on invested capital. Furthermore, we believe that the use of our
proprietary technologies and software products results in higher manufacturing
yields.

   Integrate the Key Stages of the Design-to-Silicon Flow. We design our
proprietary technologies and software products on a common platform and
architecture and to be implemented in key stages of the design-to-silicon
flow. Our software products utilize a common process modeling and simulation
technique that allows the tools and equipment used in subsequent stages to
understand and process the results generated by each of the prior stages. For
example, the separate tools and equipment used to design, verify and
manufacture semiconductors can coordinate with each other to ensure an
accurate design-to-silicon flow. This coordination is increasingly critical as
the semiconductor industry disaggregates into different companies that
specialize in separate key stages of the design-to-silicon flow. We believe
this coordination is necessary to the successful production of subwavelength
semiconductors.

Our Strategy

   Our objective is to establish our proprietary technologies and software
products as the industry standard for the design and manufacture of
subwavelength semiconductors. Key elements of our strategy include:

  .  Drive Continued Adoption of Our Subwavelength Solution

  .  Expand Relationships with Our Industry Partners

  .  Leverage Our Comprehensive Platform

  .  Leverage Our Market Position in Manufacturing Data Preparation Products

  .  Integrate Subwavelength Technology into the Design Automation Flow

  .  Extend Technology Leadership Position

  .  Maintain Time-Based Software and Intellectual Property Licensing Models

   Drive Continued Adoption of Our Subwavelength Solution. We seek to
proliferate our proprietary technologies and software products as the solution
to the subwavelength gap problem. As part of this strategy, we intend to
continue to expand our relationships with leading integrated device
manufacturers, or IDMs, such as Motorola and Texas Instruments, and leading
foundries such as TSMC and UMC. Due to the increasing proportion of
semiconductors manufactured at foundries, we intend to increasingly focus our
efforts on establishing our patented phase shifting technologies as the
standard at TSMC, UMC and other foundries to further drive the adoption of our
subwavelength solution by each of the other participants in the design-to-
silicon flow. We believe that semiconductor manufacturers, including IDMs and
foundries, must first adopt our proprietary technologies in order to drive
adoption of our technologies by the other participants within the design-to-
silicon flow. If these manufacturers do not perceive our proprietary
technologies and software products as a viable solution to the subwavelength
gap problem, our technologies and products may become more difficult to
license to such manufacturers and this may limit the adoption of our
subwavelength solution by the other participants in the design-to-silicon
flow.

   Expand Relationships with Our Industry Partners. We intend to strengthen
and expand our industry partner relationships with the leading companies
within each stage of the design-to-silicon flow. To date, we have developed
relationships with semiconductor design tool vendors such as Cadence,
photomask manufacturers such

                                       6
<PAGE>

as Dupont Photomask, Dai Nippon Printing and Photronics, and semiconductor
equipment manufacturers such as Applied Materials, Zygo and KLA-Tencor. We
believe that these broad-based industry relationships will help to proliferate
our proprietary technologies and software products as the industry standard.
We must expend significant management, sales and our other limited resources
in order to expand and strengthen these relationships. Our ability to
successfully do so is dependent upon our industry partners not developing
their own solutions to the subwavelength gap problem, or our competitors
offering better terms or pricing conditions to our industry partners.

   Leverage Our Comprehensive Platform. We intend to leverage the common
platform of our proprietary technologies and software products to aggressively
market our products to each key market in the semiconductor industry. This
common platform enables data and information regarding subwavelength designs
to be shared by participants in each key stage of the design-to-silicon flow.
Because our proprietary technologies and software products ensure the accurate
and consistent communication of subwavelength design and process data, each
participant in the design-to-silicon flow benefits from their use. In order
for us to be successful in aggressively marketing our technologies and
products to each key market of the design-to-silicon flow, we must continue to
ensure that we design such technologies and products so that each key market
can work efficiently with the other markets.

   Leverage Our Market Position in Manufacturing Data Preparation
Products. The vast majority of semiconductor, photomask and semiconductor
equipment manufacturers and foundries use our manufacturing data preparation
software as the essential link between the design and production stages of the
design-to-silicon flow. We intend to build on this market position in
manufacturing data preparation to market our subwavelength proprietary
technologies and software products to these customers. Our manufacturing data
preparation software competes with current and future products in this stage
of the design-to-silicon flow. We may need to take various steps, including
without limitation reducing prices, in order to remain competitive in the
market for mask data preparation software.

   Integrate Our Subwavelength Technologies into the Design Automation
Flow. Through our acquisition of Cadabra Design, we acquired one of the most
widely-used solutions for the automated creation of the fundamental building
blocks ("cells") required for IC design. These cells communicate process
information to automated design tools. We intend to integrate our proprietary
technologies into the Cadabra solution in order to offer design teams fast
access to the processes that incorporate our subwavelength technologies. In
order to be successful in integrating our proprietary technologies with the
Cadabra solution, we must focus our research and development efforts in order
for the integrated solution to function correctly and efficiently. We must
also focus our sales and marketing efforts to emphasize to semiconductor
manufacturers the benefits of purchasing this integrated solution.

   Extend Technology Leadership Position. We believe we were among the first
to recognize that the subwavelength gap would represent a significant
challenge to continued advances in semiconductor technology. To capitalize on
this business opportunity, we engaged in significant research and development
activities over the past five years, pioneering manufacturable phase shifting
technologies that we believe are the key to bridging the subwavelength gap. We
assembled a strong team of subwavelength experts, more than half of which have
graduate technical degrees, and we intend to continue expanding our research
and development efforts to further enhance our proprietary technologies.

   Maintain Time-Based Software and Intellectual Property Licensing
Models. Our business model allows us to build on the sales and marketing
efforts of our industry partners, which resell, market and promote our
technologies and products. We seek to generate the majority of our future
revenue through time-based license fees, intellectual property licensing
agreements and other innovative, ongoing agreements with IDMs, foundries and
reseller licensees. Our ability to generate this revenue depends on industry
acceptance of such agreements and licensing models as well as our ability to
protect our proprietary technologies.

                                       7
<PAGE>

Technology

   As feature sizes decreased to dimensions smaller than the wavelength of
light used in optical lithography equipment, phase shifting and OPC
technologies became critical to the continued growth of the semiconductor
industry. Widespread deployment of subwavelength technologies requires the
industry to create an efficient and integrated IC design and manufacturing
process and introduce new technologies into several stages of the design-to-
silicon flow. Our proprietary technologies and software products allow IC
designers, as well as manufacturers of photomasks, semiconductor equipment and
semiconductor devices, to successfully deploy phase shifting and OPC
technologies. We believe we are the only company exclusively focused on
delivering a comprehensive solution that enables the design and manufacture of
subwavelength ICs.

 Phase Shifting

   The foundation of our subwavelength process technologies lies in our phase
shifting technology, which manipulates light waves to produce high-resolution
images of subwavelength IC features. Our phase shifting technology sequences
positive and negative light wave patterns to prevent interfering waves from
causing the image on silicon to blur or disappear entirely. This enables
designers and manufacturers to create IC features that are less than half the
size of those that can be produced using conventional optical lithography
techniques. Our phase shifting technology also dramatically reduces
sensitivity to variations in the manufacturing process such as focus
deviations and lens imperfections, significantly improving manufacturing
yields. We developed the industry's first production-worthy, commercial phase
shifting technology by combining the multidisciplinary expertise of our
scientists and engineers and investing significantly in joint research and
development activities with leading photomask and semiconductor manufacturers.

                             [CHART APPEARS HERE]

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 Optical Proximity Correction

   Our OPC technologies embed corrective features in the IC design and
photomask to reduce image distortions caused by interfering light waves. We
developed these technologies in close collaboration with photomask and
semiconductor manufacturers to improve photomask manufacturability without
sacrificing performance. Our OPC technologies focus on correcting distortions
in semiconductor features that would most affect the semiconductor's
performance. OPC makes it possible to obtain an IC pattern that more closely
resembles the original desired design. However, as feature sizes continue to
decrease, OPC is no longer sufficient to ensure acceptable manufacturing
yields. At these smaller feature sizes, semiconductor manufacturers will
employ both OPC and phase shifting process technologies.

                            [4 CHARTS APPEAR HERE]

 Process Modeling and Simulation

   Historically, the designed layout of a semiconductor, its representation on
the photomask and the corresponding features on the semiconductor were
essentially identical. At subwavelength feature sizes, this relationship no
longer exists. As a result of distortions created during the manufacturing
process and the application of phase shifting and OPC, the design of a
semiconductor, its representation on the photomask and the pattern transferred
to the semiconductor all look different. We developed proprietary process
modeling and simulation technologies that recharacterize the relationship
between device design, photomask pattern and semiconductor features. This
recharacterized relationship allows designers and manufacturers to accurately
translate designs and photomasks to final semiconductors. Semiconductor
manufacturers can calibrate our process models to accurately characterize
their specific processes and use them in our software products throughout the
design-to-silicon flow. Manufacturers can use a common process model
throughout the design-to-silicon flow to facilitate consistency in the
communication of process and design data.

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 Automated Transistor Layout ("ATL")

   In the process of designing ICs, it is very important to effectively and
automatically communicate process requirements into the IC design flow.
Traditionally, this has been done through a "library" of cells for IC designs.
These libraries have, in the past, been created through an intensive, manual
process. With the advent of subwavelength processes, however, the design of
libraries becomes much more complex. Phase shifting information and OPC
effects must be considered in the library design process. Through our
acquisition of Cadabra, we offer technology that automates the creation of
these cells, saving both time and engineering resources.

 Implementation Technologies

   We developed or acquired several technologies necessary to implement the
mainstream design and manufacturing use of phase shifting and OPC
technologies. These include:

  .  design automation algorithms for phase shifting and OPC;

  .  hierarchical design data management technologies;

  .  subwavelength design verification technologies;

  .  photomask defect analysis technologies;

  .  high-performance process simulation algorithms and process model
     calibration technologies;

  .  algorithms for manufacturing data preparation; and

  .  algorithms to automatically create and optimize the cells required for
     IC design.

Products

   We offer technology products, software products and services that together
provide a comprehensive subwavelength design-to-silicon solution.

Technology Products

   Phase Shift Technology. Our phase shifting technology licenses allow the
licensee to produce subwavelength semiconductor devices using our proprietary
technology. We offer limited use research and development licenses that allow
the licensee to use our proprietary technology for pre-production purposes. We
also offer production licenses of our phase shifting technology that are time
based, or are licensed per fabrication facility or per device produced.

   Subwavelength Process Development. We offer a comprehensive implementation
package that includes a development plan, calibration and test photomasks and
on-site customer assistance to develop advanced subwavelength manufacturing
processes using our phase shifting and OPC technologies and software products.
Our engineers and scientists work on-site at our customers' fabrication
facilities to develop these processes and generate design rules, calibrated
models and associated design-to-silicon flows.

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Software Products

   We offer a comprehensive suite of complex, tightly integrated software
products that all of the key markets within the semiconductor industry can
use. These markets use our software products independently or integrate them
with IC design tools, and photomask and semiconductor manufacturing equipment.
Our products address the needs of subwavelength design and manufacture in four
key sectors of the design-to-silicon flow:

<TABLE>
<CAPTION>
             Sector                   Products               Applications
   --------------------------- ---------------------- -------------------------
   <C>                         <C>                    <S>
   Physical Design and         iNPhase                .  Ensure compatibility
   Post-Layout Data Processing TROPiC                    of semiconductor
                                                         designs with
                                                         subwavelength
                                                         processes
                               iMagic                 .  Create phase shifted
                               SiVL                      and OPC device design
                                                         layout
                               Cadabra Design/Classic .  Verify silicon
                                                         performance of designs
                                                      .  Automate the creation
                                                         and optimization of
                                                         the cells used for IC
                                                         design

   Manufacturing Data          CATS                   .  Process design data
   Preparation and             iNMask                    required to fabricate
                                                         and inspect photomasks
   Photomask Manufacturing     iNMask-MRC             .  Verify input data,
                                                         manufacturing data
                                                         processing and
                                                         photomask layout
                                                      .  Convert photomask
                                                         design data to formats
                                                         required by specific
                                                         photomask
                                                         manufacturing
                                                         equipment
                                                      .  Verify photomask and
                                                         wafer
                                                         manufacturability

   Photomask Inspection and    Virtual Stepper        .  Characterize located
                                                         photomask defects
   Measurement                 iNSpect                .  Transcribe and
                                                         transfer design data
                                                         to photomask and wafer
                                                         inspection and
                                                         measurement equipment

   IC Fabrication and          IC Workbench           .  Optimize fabrication
   Process Development         ModelCal                  process parameters
                               RuleGen                .  Generate calibrated
                               CheckIt                   process models and
                                                         design rules for phase
                                                         shift and OPC
                                                         processes and our
                                                         products
                                                      .  Verify silicon
                                                         performance of designs
</TABLE>

   Each of these products is described below.

Physical Design and Post-Layout Data Processing Products

   iNPhase. Our iNPhase product automates and integrates the design,
verification and OPC functions of our phase shifting technology. iNPhase also
verifies that the semiconductor design is free of "phase conflicts," or design
configurations that could result in manufacturing failures.

   TROPiC. This integrated product automatically corrects designs for process-
induced distortions of subwavelength features. TROPiC implements our OPC
technologies that control photomask complexity to lower photomask cost without
sacrificing semiconductor performance.

   iMagic. Our process simulation software product uses process models that
are calibrated to individual semiconductor manufacturers' processes. iMagic is
used by designers to simulate the final IC features that correspond to their
designs.

   SiVL. Our silicon-versus-layout product utilizes our proprietary process
simulation technologies to verify that conventional, phase shifting and OPC
designs produce printed IC patterns within specified tolerances. By

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accurately predicting "silicon level" failures, SiVL reduces or eliminates the
need to repeat the design and manufacturing process. SiVL integrates with
tools used to verify that the IC patterns are within specified tolerances.

   Cadabra Design/Classic. Our Cadabra Design/Classic product line automates
the creation and optimization of cells used in IC design. These cells act as
the communication vehicle for manufacturing process requirements to design
tools. These products allow us to integrate our proprietary subwavelength
technologies into the design flow in a manner that is transparent to
designers.

Manufacturing Data Preparation and Photomask Manufacturing Products

   CATS. This family of products includes products that automatically create
different photomask layers by sizing and combining design layers. Our CATS
products allow users to view the input and output data of the manufacturing
data preparation process and verify photomask design accuracy using a
combination of graphical algorithmic and query analyses.

   iNMask. Our iNMask formatting product automatically transcribes photomask
layout data into input data formats optimized for specific photomask
manufacturing equipment. iNMask supports leading photomask equipment
manufacturers, including Etec, Hitachi and Leica.

   iNMask-MRC. This product verifies that the photomask data files produce
manufacturable photomasks and wafers. The data is checked for variations from
manufacturing requirements, including minimum widths, spacing and layer to
layer errors.

Photomask Inspection and Metrology Products

   Virtual Stepper. This product allows photomask manufacturers to accurately
assess the impact of photomask defects on the silicon wafer. Photomask
manufacturers using Virtual Stepper can quickly determine photomask quality,
improving their productivity and yield. The Virtual Stepper takes direct input
from defect inspection and review equipment manufactured by leading equipment
companies including Applied Materials, KLA-Tencor and Zygo.

   iNSpect. Our iNSpect product automatically transcribes photomask layout
data into input data formats optimized for specific photomask and wafer
inspection equipment. iNSpect also identifies measurement locations for
photomask and wafer measurement equipment. This product supports leading
equipment manufacturers, including Applied Materials, KLA-Tencor, Leica and
Zygo.

Semiconductor Fabrication and Process Development

   IC Workbench. IC Workbench is an interactive process simulation, analysis
and optimization tool. This product includes a powerful graphical user
interface, design data viewer and editor with real-time simulation feedback.
This allows users to rapidly evaluate the impact of design and process
parameters on the final silicon results while optimizing subwavelength
processes.

   ModelCal. This product enables users to automatically calibrate process
models using empirical measurement data from specific semiconductor
manufacturers' processes. ModelCal implements our proprietary model
calibration technology to produce extremely accurate process models using our
calibration photomask designs for both phase shifting and OPC applications.

   RuleGen. This product automatically generates design rules and parameters
for phase shifting and OPC processes using our calibrated process models. The
output of RuleGen is fully compatible with the input requirements of iNPhase
and TROPiC.

                                      12
<PAGE>

   CheckIt. This product performs accurate, exhaustive, silicon-level
verification for phase shifting and OPC designs prior to IC production.
CheckIt accurately predicts potential failures in the manufacture of semi-
conductors and marginal locations on phase shifting and OPC designs.

Services

   Design Services. We assist our industry partners and customers with
semiconductor designs that use our phase shifting and OPC technologies. Our
design services include creating phase shifted designs, applying OPC
technology to designs and verifying the final design layout. Our design
services help industry partners and customers rapidly adopt our technologies.

   Technology Integration Services. We offer technology integration services
to allow our industry partners to integrate our software products with their
products for marketing to their customers. We develop software interfaces to
semiconductor design tools and equipment to enable the necessary data
communication to integrate the operation of the combined products.

 Customers and Industry Partners

   We license our proprietary technologies and software products to companies
in key markets within the semiconductor industry. Our customers include
licensees of our phase shifting technology and software, manufacturing data
preparation, silicon verification, photomask verification and automated cell
generation software. Our industry partners integrate our technologies and
software into their products and act as resellers. The following customers
accounted for annual license, maintenance and technical service revenue of at
least $250,000 in either 2000, 1999 or 1998:

<TABLE>
       <S>                                             <C>
       IDMs and Foundries                              Design Tool Vendors
       ------------------                              -------------------
       Intel                                           Cadence Design Systems
       Infineon
       IBM                                             Semiconductor Equipment
       Macronix                                        Manufacturers
                                                       -------------
       Matsushita                                      Applied Materials
       Motorola                                        KLA-Tencor
       National Semiconductor                          Leica Micro
       ST Microelectronics                             Zygo
       Texas Instruments
       Toshiba                                         Photomask Manufacturers
                                                       -----------------------
       TSMC                                            DuPont Photomask
       UMC                                             Photronics
       VLSI Technology                                 Toppan
</TABLE>

   Cadence represented 24% of our total revenue for 2000. KLA-Tencor, Zygo and
Cadence represented 23%, 17% and 16% of our total revenue for 1999,
respectively. Zygo, National Semiconductor, and Toshiba represented 52%, 37%
and 14% of our revenue for 1998, respectively. No other customer accounted for
10% or more of our revenue in 2000, 1999 or 1998.

Research and Development

   Our future success will depend to a large extent on our ability to rapidly
develop and introduce new proprietary technologies and software products and
enhancements to our existing products. We have made and expect to continue to
make substantial investments in research and development. We invested $12.6
million (54% of revenue) in 2000 in R&D for product development and
engineering programs to improve or sustain existing product lines. The
complexity of phase shifting and OPC technologies requires expertise in
physical IC design

                                      13
<PAGE>

and layout, photomask manufacturing, optical lithography, numerical algorithms
and software development. We believe that the multidisciplinary expertise of
our team of scientists and engineers will continue to advance our market and
technological leadership. Our ability to advance our market and technological
leadership is dependant upon our ability to retain our current team of
scientists and engineers, as well as recruit new scientists and engineers with
the requisite skill set to advance our proprietary technologies and software
products. We must compete for some of these individuals in the very
competitive Silicon Valley market, where our headquarters are located.

   As of December 31, 2000, our engineering group consisted of 101 employees.
These employees are focused on the following objectives:

     Product Development. Our product development group is organized in teams
  around the different products we offer. A separate team within this group
  develops our common core technology and ensures that each product fits into
  this common architecture.

     Advanced Research. Our advanced research group works independently from
  our product development group to assess and develop new technologies that
  meet the evolving needs of subwavelength design and manufacturing.

     Product Engineering. Our product engineering group is primarily focused
  on product release, platform support, quality assurance and product
  documentation.

Sales and Marketing

   We rely on our direct sales force and on our industry partner relationships
to penetrate each key market of the semiconductor industry. Domestically, our
direct sales force operates primarily out of our headquarters in California.
We also employ sales personnel in Oregon, Virginia, Maine, Minnesota and
Texas. In addition, we have subsidiaries in Korea, Japan, Taiwan and The
Netherlands who work closely with resellers and partners. We intend to
continue to expand our sales and support personnel both domestically and
internationally. In order to do so, we must compete for some of our personnel
in the very competitive Silicon Valley market where our headquarters are
located. As of December 31, 2000, we had 53 employees involved in sales and
marketing.

   Our marketing personnel focus on developing our relationships with industry
partners. Our industry partners include leading semiconductor equipment
manufacturers, such as Applied Materials and KLA-Tencor, and design tool
companies, such as Cadence. We also entered into joint-marketing relationships
with leading photomask manufacturers, such Dupont Photomask and Photronics.
Our direct sales efforts have focused primarily on licensing to foundries and
IDMs. To date, we have concentrated our sales and marketing efforts on selling
research and development licenses and to a lesser extent, production licenses.
We have already entered into production licenses with leading semiconductor
manufacturers. We expect to extend these efforts to generate production
licenses as semiconductor manufacturers move into production of subwavelength
ICs. However, in order to further extend our research and development licenses
to production licenses, we must expend significant marketing resources, with
no guarantee of success.

   See Note 9 to the Consolidated Financial Statements and "Management's
Discussion and Analysis of Financial Condition and Results of Operations" for
information regarding the geographic distribution of our revenue for 2000,
1999 and 1998. We are subject to risks associated with economic and political
instability in certain foreign countries.

Competition

   The semiconductor industry is highly competitive and characterized by
rapidly changing design and process technologies. The market for phase
shifting and OPC solutions is rapidly evolving and we expect competition to
continue to increase. We face direct competition from other providers of phase
shifting, OPC, manufacturing

                                      14
<PAGE>

data preparation and automated cell generation solutions, including Avant!,
Mentor Graphics and Prolific, Inc. We also compete with companies that have
developed or have the ability to develop their own proprietary phase shifting
and OPC enabling solutions, such as IBM. Many of these companies are larger
than we are, have greater financial or other resources than we do and
therefore can withstand adverse market or economic conditions more readily
than we can. We may also face competition from alternatives to current
photolithography systems. In addition, commercially viable manufacturing
processes that provide alternatives to our subwavelength solution may be
developed in the future by existing or potential competitors. We believe that
the principal competitive factors in our market include technology viability,
product availability, performance, reliability, functionality, cost and
customer service. We believe we compete favorably with respect to each of
these factors. Our phase shifting, OPC, manufacturing data preparation and
automated cell generation software products compete with existing and future
products in the semiconductor manufacturing market. We have recently
experienced an increase in the competitive product offerings for data
preparation software. We may continue to take various steps, including without
limitation reducing prices, in order to remain competitive in the market for
data preparation software.

Business Combinations

   On January 1, 2000, we acquired Transcription Enterprises Ltd.
("Transcription"), a company incorporated in California. Under the terms of
the acquisition, we issued approximately 3,810,000 shares of Series E
Convertible Preferred Stock and $40.0 million in notes payable for all of the
outstanding stock of Transcription. The total purchase price was approximately
$86.0 million, including acquisition costs of approximately $250,000. The
Transcription acquisition was accounted for under the purchase method of
accounting.

   On October 27, 2000, we acquired Cadabra Design Automatic, Inc ("Cadabra"),
a Nova Scotia limited liability company. Under the terms of the acquisition,
we issued approximately 3,200,000 shares of our common stock and options to
purchase our common stock for all of the outstanding stock and options of
Cadabra, of which approximately 2,641,000 shares are actually exchangeable
shares. The exchangeable shares are exchangeable for shares of our common
stock, on a one-for-one basis, at the option of the holder thereof. Such
shares will, generally, automatically convert to our common stock on October
27, 2005. The total purchase price was approximately $110.6 million, including
acquisition costs of approximately $3.0 million. The Cadabra acquisition was
accounted for using the purchase method of accounting.

   For further details of Transcription and Cadabra business combinations, see
Note 2 to Consolidated Financial Statements.

Intellectual Property

   Our future success and competitive position depend upon our continued
ability to develop and protect proprietary technologies. We rely significantly
on a combination of patents, copyrights, trademarks and trade secrets to
protect our proprietary technologies and prevent competitors from using our
technologies in their products. In the future, we may seek additional patent
protection when we feel it is necessary.

   Our existing or future patents may be circumvented, blocked, licensed to
others or challenged as to inventorship, ownership, scope, validity or
enforceability. Third parties have advised us of literature which they believe
to be relevant to our patents. It is possible that this literature or
literature we may be advised of in the future could negatively affect the
scope or enforceability of either our present or future patents. We may not
receive competitive advantages from the rights granted under our patents. In
addition, our future patent applications may not be issued with the scope of
the claims sought by us, if at all. Furthermore, others may develop
technologies that are similar or superior to our proprietary technologies,
duplicate our proprietary technologies or design around the patents owned or
licensed by us. We are aware of and are evaluating certain patents with which
our products, patents or patent applications may conflict. If any of these
patents are found to be valid, and we are unable to license such patents on
reasonable terms, or if our products, patents or patent applications are found
to conflict with these patents, we could be prevented from selling our
products, our patents may be declared invalid or our patent applications may
not result in issued patents. Additionally, changes in the

                                      15
<PAGE>

patent laws, including the interpretation or enforcement of patents, may
adversely affect the scope, validity or enforceability of our patents. In
addition, in foreign countries, we may not receive effective patent and
trademark protection. We cannot be sure that steps we take to protect our
proprietary technologies will prevent misappropriation of our technologies.

   In addition, we generally enter into confidentiality agreements with our
employees, industry partners and customers, as well as generally control
access to and distribution of our documentation and other proprietary
information. Despite this protection, unauthorized parties may copy aspects of
our current or future software products or obtain and use information that we
regard as proprietary.

   The semiconductor industry is characterized by vigorous protection and
pursuit of intellectual property rights or positions. There are also numerous
patents in the semiconductor industry and new patents are being issued at a
rapid rate. This often results in significant and often protracted and
expensive litigation. From time to time third parties may notify us of
intellectual property infringement claims. If it is necessary or desirable, we
may seek licenses under these third party patents or intellectual property
rights. However, we cannot be sure that third parties will offer licenses to
us or that we accept the terms of any offered licenses.

   If we fail to obtain a license from a third party for proprietary
technologies that we use, we could incur substantial liabilities, or suspend
sales of our software products or our use of processes requiring the
technologies. Litigation could cause us to incur significant expenses, harm
our sales of the challenged technologies or software products and divert the
efforts of our technical and management personnel, whether or not a court
decides the litigation is in our favor. In the event we receive an adverse
result in any litigation, we could be required to pay substantial damages,
cease sale of infringing products, expend significant resources to develop or
acquire non-infringing technology and discontinue the use of processes
requiring the infringing technology or obtain licenses to the infringing
technology. We may not be successful in the development or acquisition of
intellectual property, or the necessary licenses may not be available under
reasonable terms, and any development, acquisition or license could require us
to expend a substantial amount of time and other resources. Any of these
developments would harm our business.

Employees

   As of December 31, 2000, we employed 191 employees worldwide, of which 128
individuals were located in the United States and 47 individuals were located
in Canada. In the Silicon Valley, where our headquarters are located,
competition for highly skilled employees is intense. We believe that our
future success is highly dependent upon our continued ability to attract and
retain qualified employees. We must also deal internationally with labor and
employment laws with which we are not familiar. None of our employees is
represented by a labor union or is subject to a collective bargaining
agreement. We believe that our relationship with our employees is good.

                                      16
<PAGE>

                      EXECUTIVE OFFICERS OF THE REGISTRANT

   The following table and notes set forth information about our executive
officers as of March 1, 2001:

<TABLE>
<CAPTION>
   Name                     Age                            Position
   ----                     ---                            --------
   <S>                      <C> <C>
   Y. C. (Buno) Pati.......  37 President and Chief Executive Officer

   Yao-Ting Wang...........  37 Senior Vice President Engineering and Chief Technology Officer

   Richard Mora............  54 Chief Financial Officer

   Atul Sharan.............  41 Senior Vice President, Marketing and Business Development

   Kevin MacLean...........  38 Senior Vice President and General Manager, Transcription

   Faysal Sohail...........  37 Senior Vice President, Worldwide Field Operations
</TABLE>

   Dr. Y. C. (Buno) Pati has served as our President and Chief Executive
Officer since he co-founded our company in October 1995. From October 1995 to
December 1996, Dr. Pati served as an assistant professor of electrical
engineering and computer science at Harvard University. From October 1992 to
October 1995, Dr. Pati conducted research efforts in computational and system
sciences applied to integrated circuit manufacturing at Stanford University.
Dr. Pati has published numerous articles in signal processing, communications,
fast lithography simulations and automated phase shifting photomask design. Dr.
Pati received a B.S., an M.S. and a Ph.D. in electrical engineering from the
University of Maryland at College Park.

   Dr. Yao-Ting Wang has served as our Senior Vice President Engineering and
Chief Technology Officer since October 2000. Since he co-founded our company in
October 1995 to October 2000, Dr. Wang served as Chief Technology Officer. Dr.
Wang's doctoral dissertation research was on automated design of phase shifting
photomasks using fast algorithms and signal processing techniques. Dr. Wang is
active in the areas of fast lithography simulations and automated advanced
photomask designs, with specific interests in communications, signal processing
and lithographic techniques. Dr. Wang received a B.S. degree from National
Taiwan University and a Ph.D. in Electrical Engineering from Stanford
University.

   Richard Mora has served as our Chief Financial Officer since October 2000.
From May 1999 to October 2000, Mr. Mora served as our Chief Financial Officer
and Vice President, Operations. From August 1994 to April 1999, Mr. Mora was
Chief Financial Officer and Vice President of Finance at Mattson Technologies,
Inc., a semiconductor equipment manufacturer. From June 1998 to May 1999, Mr.
Mora was also Vice President and General Manager of the High Temp Products
Division at Mattson. From September 1988 to August 1994, Mr. Mora served as
Chief Financial Officer and Vice President of Finance at Actel Corporation, a
semiconductor manufacturer. From June 1985 to August 1988, Mr. Mora was Chief
Financial Officer and Vice President of Finance at HHB Systems. Mr. Mora
received a B.S. in Accounting from Santa Clara University and is a Certified
Public Accountant.

   Atul Sharan has served as our Senior Vice President, Marketing and Business
Development since October 2000. From October 1998 to October 2000, Mr. Sharan
served as our Vice President, Marketing and Business Development. From April
1997 to October 1998, Mr. Sharan was director of strategic business development
at Ambit Design Systems where he helped establish and manage key partner
relationships with LSI Logic and Cadence. From May 1991 to March 1997, Mr.
Sharan held senior sales and marketing management positions at Compass Design
Automation. While at Compass as General Manager-Compass India Operations, Mr.
Sharan helped establish a software development center in India. From December
1984 to May 1991, Mr. Sharan worked in semiconductor manufacturing operations
at VLSI Technology and Integrated Device Technology. While at IDT, Mr. Sharan
helped initiate the company's first overseas test and assembly plant in Penang,
Malaysia. Mr. Sharan received an M.B.A. from the University of California at
Berkeley, an M.S. in engineering from the University of Houston, Texas and a
B.Tech. degree in Engineering from the Indian Institute of Technology in
Kanpur, India.

                                       17
<PAGE>

   Kevin MacLean has served as our Senior Vice President and General Manager,
Transcription since October 2000. From January 2000 to October 2000, Mr.
MacLean served as our Vice President and General Manager, Transcription. In
June 1986, Mr. MacLean co-founded Transcription Enterprises Limited, where he
served as Vice President until we acquired the company in January 2000. Mr.
MacLean received a B.S. in Mechanical Engineering from Cornell University.

   Faysal Sohail has served as our Senior Vice President of Worldwide Field
Operations since October 2000. In June 1999, Mr. Sohail joined Cadabra Design
Automation Inc. where he served as President and Chief Executive Officer until
we acquired the company in October 2000. From April 1995 to June 1999, Mr.
Sohail held various management positions with Synopsys Inc., including Senior
Vice President of Corporate Strategic Planning from June 1998 to June 1999 and
Senior Vice President and General Manager of Design Architects group from
April 1997 until June 1998. In October 1990, Mr. Sohail co-founded Silicon
Architects Inc., a silicon design intellectual property company, where he
served as Director of Marketing until the company was acquired by Synopsys
Inc. in April 1995. From January 1987 until October 1990, Mr. Sohail held
various positions with Actel Corporation, including Manager of Field
Applications. Mr. Sohail received a B. S. in Computer Engineering from the
University of Illinois, Urbana-Champaign.

Item 2: Properties

   Our executive offices and principal operations are currently located in
approximately 39,300 square feet of office space in San Jose, California under
a lease that expires in May 2004. We also lease approximately 2,400 square
feet of office space in Los Gatos, California under a lease that expires in
February 2006 and 15,200 square feet of office space in Canada under a lease
that expires in February 2002. In addition, we lease approximately 11,000
square feet of office space in San Jose, California, which is currently
unoccupied, under a lease which expires in December 2004. We intend to
sublease this facility.

   We lease office space for sales and customer support offices in six
locations throughout the world: two in North America, three in Asia and one in
The Netherlands.

   We consider the above facilities suitable to meet our requirements.

Item 3: Legal Proceedings

   None.

Item 4: Submission of Matters to a Vote of Security Holders in Fourth Quarter
ended 2000.

   No matters were submitted to a vote of security holders of the registrant
during the fourth quarter of the year ended December 31, 2000.

                                      18
<PAGE>

                                    PART II

Item 5. Market for Registrant's Common Equity and Related Stockholder Matters

   Our common stock is traded on the Nasdaq National Market System under the
symbol of NMTC. The following table sets forth, for the periods indicated, the
low and high bid prices per share for our common stock as reported by the
Nasdaq National Market.

<TABLE>
<CAPTION>
                                                                   Low    High
                                                                  ------ ------
   <S>                                                            <C>    <C>
   Year Ended December 31, 2000
   Second Quarter (beginning April 7, 2000)...................... $22.00 $56.25
   Third Quarter.................................................  26.75  67.31
   Fourth Quarter................................................   9.13  35.25
</TABLE>

   As of March 1, 2001, there were approximately 5,000 holders of record of
our common stock.

   No dividends have been paid on the common stock in 2000 and 1999. We
currently intend to retain all future earnings, if any, for use in our
business and do not anticipate paying any cash dividends on our common stock
in the foreseeable future.

Recent Sales of Unregistered Securities

   None.

Use of Proceeds

   In April 2000, we sold a total of 6,364,100 shares of common stock (the
total amount registered) at $14.00 per share through our initial public
offering pursuant to a registration statement on Form S-1 declared effective
by the Securities and Exchange Commission on April 6, 2000 (333-95695). The
initial public offering commenced on April 7, 2000 and the net proceeds, after
underwriters' commission and fees and other costs of $7.9 million associated
with the offering, totaled approximately $81.2 million.

   Since April 12, 2000 (the closing date of the initial public offering), we
have used an estimated $24.7 million of the net proceeds from the initial
public offering to fund operating expenses and increase working capital, $1.6
million to purchase and install machinery and equipment, and $30.2 million to
pay the balance of principal and accrued interest under the notes payable
issued in connection with the acquisition of Transcription. We have placed
approximately $24.7 million in short-term, interest-bearing, investment grade
securities pending future use.

   No payments constituted direct or indirect payments to directors, officers,
general partners of the issuer or their associates, or to persons owning ten
percent or more of any class of equity securities of the issuer or to
affiliates of the issuer.

                                      19
<PAGE>

Item 6. Selected Consolidated Financial Data

   The following selected consolidated financial data should be read in
conjunction with, and are qualified by reference to, the consolidated
financial statements and related notes and "Management's Discussion and
Analysis of Financial Condition and Results of Operations" appearing elsewhere
in this Form 10-K. The consolidated statements of operations data for the
years ended December 31, 2000, 1999 and 1998, and the consolidated balance
sheet data at December 31, 2000 and 1999 are derived from our audited
consolidated financial statements included in this Form 10-K. The consolidated
statements of operations data for the years ended December 31, 1997 and 1996,
and the consolidated balance sheet data at December 31, 1998, 1997 and 1996
are derived from our audited consolidated financial statements not included in
this Form 10-K. The historical results are not necessarily indicative of
future results.

<TABLE>
<CAPTION>
                                           Year Ended December 31,
                                   -------------------------------------------
                                   2000(1)(2)  1999     1998     1997    1996
                                   ---------- -------  -------  ------  ------
   <S>                             <C>        <C>      <C>      <C>     <C>
   Consolidated Statement of
    Operations Data:
     Revenue.....................   $ 23,340  $ 5,492  $   736  $  620  $   51
     Depreciation and
      amortization...............     24,820      340       99      24      10
     Acquired in-process research
      and development............      1,930      --       --      --      --
     Amortization of deferred
      stock compensation.........     18,766    3,990      862     --      --
     Total costs and expenses....     73,965   14,693    7,469   1,239     225
     Loss from operations........    (50,625)  (9,201)  (6,733)   (619)   (174)
     Net loss....................    (48,811)  (8,828)  (6,551)   (584)   (169)
     Loss per share, basic and
      dilutive(3)................   $  (2.27) $ (1.26) $ (0.89) $(0.08) $(0.04)
     Shares used in per share
      calculation, basic and
      dilutive(3)................     21,827    7,019    7,373   7,397   4,722
<CAPTION>
                                               At December 31,
                                   -------------------------------------------
                                   2000(1)(2)  1999     1998     1997    1996
                                   ---------- -------  -------  ------  ------
   <S>                             <C>        <C>      <C>      <C>     <C>
   Consolidated Balance Sheet
    Data:
     Cash and cash equivalents...   $ 30,607  $13,486  $ 4,973  $  656  $  615
     Working capital.............     47,912   10,499    2,320     377     309
     Total assets................    240,974   17,605    6,611   1,081     647
     Total stockholders' equity..    219,134   12,405    2,815     474     340
</TABLE>

(1) We acquired Transcription Enterprises, Inc. (Transcription) on January 1,
    2000 in a transaction accounted for as a purchase. The consolidated
    statement of operations and other data for the year ended December 31,
    2000 and the consolidated balance sheet data as of December 31, 2000
    include the results of operations subsequent to January 1, 2000 and
    financial position, respectively, of Transcription.

(2) We acquired Cadabra Design Automation, Inc. (Cadabra) on October 27, 2000
    in a transaction accounted for as a purchase. The consolidated statement
    of operations and other data for the year ended December 31, 2000 and the
    consolidated balance sheet data as of December 31, 2000 include the
    results of operations subsequent to October 27, 2000 and financial
    position, respectively, of Cadabra.

(3) Share and per share amounts for all historical periods have been restated
    to reflect the three-for-two stock split for stockholders of record as of
    April 6, 2000.

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

   The following commentary should be read in conjunction with the
consolidated financial statements and related footnotes that appear beginning
on page 38.

                                      20
<PAGE>

Overview

   We develop and market proprietary technologies and software products that
enable the design and manufacture of semiconductors with subwavelength feature
sizes. We derive revenue from intellectual property and software licenses,
maintenance and related technical services. To date, we have derived a
significant portion of our revenue from research and development licenses to
integrated device manufacturers, or IDMs, and foundries of our phase shifting
attendant subwavelength technologies and software licenses, as well as
licenses of photomask verification software to semiconductor equipment
resellers. To date we have entered into production licenses with two
semiconductor manufacturers. We expect to enter into additional production
licenses as semiconductor manufacturers adopt our proprietary technologies for
production. Production licenses grant licensees the right to use our phase
shifting intellectual property and software to design and manufacture
subwavelength integrated circuits, or ICs. In order for semiconductor
manufacturers to enter into production licenses with us, these manufacturers
must continue to embrace our proprietary technologies and software products
and not enter into agreements with our competitors in this regard. We must
also expend significant sales and marketing resources on these manufacturers
with no guarantee of success.

   In January 2000, we acquired Transcription Enterprises Ltd.
("Transcription") for approximately $45.7 million in Series E preferred stock,
$40.0 million in notes payable and $250,000 in acquisition costs, resulting in
goodwill and other intangible assets of $91.9 million which is being amortized
on a straight-line basis over two to five years. We have accounted for the
acquisition under the purchase method of accounting and, as a result, our
historical results of operations do not include the results of operations of
Transcription prior to January 1, 2000.

   On October 27, 2000, we completed the acquisition of Cadabra Design
Automation, Inc. ("Cadabra"). Under the terms of the acquisition, we issued
approximately 3.2 million shares and options to purchase our common stock for
all of the outstanding stock and options of Cadabra. The stock issued and the
options assumed had an aggregate fair market value of approximately $120
million. In addition, we incurred approximately $3.0 million in acquisition
costs. The acquisition was accounted for under the purchase method of
accounting and accordingly the purchase price was allocated to the acquired
assets, in-process technology, which had not yet reached the stage of
technical feasibility, goodwill and other intangibles and recorded in the
fourth quarter of 2000. A one-time non-cash charge for in-process research and
development, non-cash charges for deferred compensation and the amortization
of goodwill and other intangibles were recorded in the fourth quarter of 2000.
These recurring amortization charges will have a negative impact on future
results of operations.

   The following table presents the pro forma combined, consolidated financial
information of Numerical, Transcription, and Cadabra as if our acquisitions
had taken place on January 1, 1999:

<TABLE>
<CAPTION>
                                                               Year Ended
                                                              December 31,
                                                            ------------------
                                                              2000      1999
                                                            --------  --------
                                                             (In thousands,
                                                            except per share
                                                                amounts)
   <S>                                                      <C>       <C>
   Net sales............................................... $ 26,829  $ 23,142
   Net loss allocable to common stockholders............... $(83,430) $(57,754)
   Loss per share.......................................... $  (3.54) $  (6.30)
</TABLE>

   The charges for purchased in-process research and development of $300,000
and $1,630,000 related to the Transcription and Cadabra acquisitions,
respectively, have not been included in the pro forma results above, because
such charges are non-recurring and directly related to the acquisitions.

   Because of the significance of these acquisitions, we do not believe the
discussion and analysis of our historical financial condition and results of
operations set forth below are indicative, nor should they be relied upon as
an indicator, of our future performance.

   In April 2000, we sold a total of 6,364,100 shares of common stock at
$14.00 per share through our initial public offering. The net proceeds, after
underwriters' commission and fees and other costs associated with the

                                      21
<PAGE>

offering, totaled approximately $81.2 million. In April 2000, we paid the
balance of principal and accrued interest under the notes payables issued in
connection with our January 2000 acquisition of Transcription with a portion
of the net proceeds. The remaining proceeds have been and will continue to be
used for working capital and general corporate purposes. We may use a portion
of the net proceeds to acquire businesses, products and technologies that are
complementary to our business. Pending these uses, we have invested the net
proceeds from this offering in short-term, interest-bearing, investment grade
securities.

   We recognize revenue in accordance with the provisions of Statement of
Position 97-2 ("SOP 97-2"), "Software Revenue Recognition", as amended by SOP
98-4 and 98-9. Our revenue is derived from intellectual property and software
licenses and maintenance and technical services. Revenue is recognized for the
various contract elements based upon vendor-specific objective evidence
("VSOE") of fair value of each element. If VSOE of fair value does not exist
but post-contract customer services ("PCS") is the only undelivered element,
we recognized the fee, including up-front payments for licenses, under the
arrangement ratably over the contractual PCS period. To date, we have not
established VSOE for the service or annual maintenance elements of many of our
products. License revenue, including up-front fees, is recognized when
persuasive evidence of an arrangement exists, the product has been delivered,
no significant post-delivery obligations remain, the license fee is fixed or
determinable and collection of the fee is probable. Revenue for technical
services is recognized as the services are performed or on a percentage-of-
completion method of accounting, depending on the nature of the project. Under
the percentage-of-completion method, revenue recognized is that portion of the
total contract price equal to the ratio of costs expended to date to the
anticipated final total costs, based on current estimates of the costs to
complete the project. If the total estimated costs to complete a project
exceed the total contract amount, indicating a loss, the entire anticipated
loss would be recognized currently. Maintenance services are typically priced
based on a percentage of the license fee and have a one-year term, renewable
annually. Services provided to customers under maintenance agreements include
technical product support and unspecified product upgrades. Deferred revenue
includes billings in excess of recognized revenue and payments received in
advance of revenue recognition.

   In December 1999, the Securities and Exchange Commission issued Staff
Accounting Bulletin: No. 101 "Revenue Recognition in Financial Statements"
(SAB 101). SAB 101 summarizes certain of the Staff's views in applying
generally accepted accounting principles to revenue recognition in financial
statements. We implemented the guidelines of SAB 101 effective January 1,
2000. The adoption of SAB 101 did not have a material effect on our financial
statements.

   We have adopted SFAS No. 131, "Disclosures about Segments of an Enterprise
and Related Information." This statement requires enterprises to report
information about operating segments in annual financial statements and
selected information about reportable segments in interim financial reports.
It also establishes standards for related disclosures about products,
geographic areas and major customers. The method for determining what
information to report is based upon the "management" approach, which requires
us to report certain financial information related to continuing operations
that is provided to our chief operating decision-maker for the purpose of
evaluating financial performance and resource allocation. Our chief operating
decision-maker reviews revenue by both geography and customer. We are not
organized into business units nor do we capture expenses or allocate resources
based on segmentation of our business. Therefore, we believe that we operate
in a single segment.

Results of Operations

   Revenue. Revenue was $23.3 million for 2000, compared to $5.5 million and
$736,000 in 1999 and 1998, respectively, representing increases of 325% and
646% for the respective periods. Approximately 80% of our 2000 revenue
increase was due to our acquisitions of Transcription and Cadabra in 2000 and
the remaining 20% was from the continued adoption of our software and
proprietary technology solution by companies throughout the design-to-silicon
flow. The increase in 1999 compared to 1998 was primarily due to increased
research and development licenses to foundries and IDMs and increased reseller
sales.

                                      22
<PAGE>

   The breakdown of revenue by geographic regions in which our proprietary
technologies and software products and services are delivered, as a percentage
of our total revenue, is as follows:

<TABLE>
<CAPTION>
                                                                   Year ended
                                                                  December 31,
                                                                 ----------------
                                                                 2000  1999  1998
                                                                 ----  ----  ----
   <S>                                                           <C>   <C>   <C>
   North America................................................  57%   78%   85%
   Asia.........................................................  33    22    14
   Europe.......................................................   9   --      1
   Other........................................................   1   --    --
                                                                 ---   ---   ---
                                                                 100%  100%  100%
                                                                 ===   ===   ===
</TABLE>

   The increase of revenue to Asia and Europe as a percentage of total revenue
is primarily a result of our acquisition of Transcription which led to
increased access to international markets and customers for our products.

   We expect that revenue will continue to increase due to the continued
adoption of our technologies and expanded product offerings. Our actual
revenue is substantially dependent on, among other factors, the adoption by
semiconductor manufacturers, and other participants in the design-to-silicon
flow, of our proprietary technologies and software products, and not those of
our competitors or those developed internally. Our revenue is also subject to
the impact of economic conditions in various geographic regions.

Costs and Expenses

   Cost of revenue. Cost of revenue includes primarily salary and related
costs for engineers associated with maintenance and technical services. Cost
of revenue was $2.2 million for 2000 compared to $307,000 and $127,000 for
1999 and 1998, respectively. The increase in 2000 was primarily due to
increased cost for engineers associated with maintenance and technical
services, which resulted from an increased customer base related to our
acquisitions of Transcription in January 2000 and Cadabra in October 2000. The
increase in 1999 was primarily due to an increase in the time spent on service
and integration efforts by our engineering personnel. As a percent of revenue,
cost of revenue was 9% for 2000 compared to 6% and 17% for 1999 and 1998,
respectively. We anticipate that cost of revenue will increase in dollar
amount as we support our increasing number of industry partners and customers,
including those acquired through acquisitions, and assist our research and
development licensees to transition into production. Our cost of revenue is
dependent in part on our revenue. To the extent our revenue increases or
decreases due to, among other factors, those described above, our cost of
revenue may increase or decrease.

   Research and development. Research and development expenses consist
primarily of salaries and related costs for personnel engaged in research and
development activities. Research and development expenses were $12.6 million
for 2000 compared to $4.6 million and $2.7 million in 1999 and 1998,
respectively. The increase in 2000 was primarily due to increased costs
associated with additional personnel in our expanding research and development
efforts and, to a lesser degree, to cost of personnel added as a result of our
acquisitions. The increase in 1999 was primarily due to additional personnel-
related costs resulting from additional engineers engaged in the enhancement
of existing applications and development of new products. As a percent of
revenue, research and development expenses were 54% in 2000 compared to 84%
and 363% for 1999 and 1998, respectively. We anticipate that we will continue
to commit substantial resources to research and development in the future and
expect that research and development expenses will continue to increase in
dollar amounts to support increased research and development efforts, but
decline as a percentage of revenue in the long term. Our research and
development expenses, as a percentage of revenue, are dependent in part on our
revenue. To the extent our revenue increases or decreases due to, among other
factors, those described above, our research and development expenses as a
percentage of revenue may increase or decrease.

                                      23
<PAGE>

   Sales and marketing. Sales and marketing expenses consist primarily of
salaries and related costs for sales and marketing personnel, sales
commissions, tradeshows and other marketing activities. Sales and marketing
expenses were $9.2 million for 2000 compared to $4.2 million and $1.4 million
for 1999 and 1998, respectively. The increases in 2000 and in 1999 were
primarily due to additional sales and marketing personnel, increased sales
commissions and higher tradeshow expenses, and to a lesser degree in 2000 to
cost of personnel added as a result of our acquisitions. As a percent of
revenue, sales and marketing expenses decreased to 39% for 2000 compared to
76% and 191% for 1999 and 1998, respectively. We expect that sales and
marketing expenses will increase in dollar amounts to support increased sales
efforts, but decline as a percentage of revenue in the long term. Our sales
and marketing expenses, as a percentage of revenue, are dependent in part on
our revenue. To the extent our revenue increases or decreases due to, among
other factors, those described above, our sales and marketing expenses as a
percentage of revenue may increase or decrease.

   General and administrative. General and administrative expenses consist
primarily of salaries and related costs for operations and finance employees
and legal and accounting services. General and administrative expenses were
$4.5 million for 2000 compared to $1.3 million and $2.3 million for 1999 and
1998, respectively. The increase in 2000 was primarily the result of increased
spending in personnel, personnel-related costs and professional fees and to a
lesser degree to cost of personnel added as a result of our acquisitions.
General and administrative expenses in 1998 included a $1.4 million bonus to a
founder and officer. Exclusive of the bonus, general and administrative
expenses increased by $300,000 in 1999 primarily as a result of increased
spending in personnel and professional fees. As a percent of revenue, general
and administrative expenses were 19% for 2000 compared to 23% and 313% for
1999 and 1998, respectively. We expect that general and administrative
expenses will increase in dollar amounts to support increased administrative
efforts, but decline as a percentage of revenue in the long term. Our general
and administrative expenses, as a percentage of revenue, are dependent in part
on our revenue. To the extent our revenue increases or decreases due to, among
other factors, those described above, our general and administrative expenses,
as a percentage of revenue may increase or decrease.

   Depreciation and amortization. Depreciation and amortization expense
consists of depreciation of property and equipment and amortization of
acquired intangible assets. In 2000, our acquisitions of Transcription and
Cadabra generated approximately $199 million in identified intangibles and
goodwill, and are currently being amortized over periods ranging from three to
five years. Depreciation and amortization expenses were $24.8 million in 2000
compared to $340,000 and $99,000 for 1999 and 1998, respectively. The increase
in 2000 was primarily the result of amortization of acquired intangibles
associated with the acquisitions of Transcription in January 2000, and Cadabra
in October 2000. The increase in 1999 was the result of increased levels of
property and equipment. We expect amortization and depreciation expense to be
approximately $49 million in 2001. Amortization and depreciation expense could
increase due to other acquisitions or impairment of existing identified
intangible assets and goodwill in future periods.

   In Process Research and Development. In 2000, we recorded charges of $1.9
million or 8% of revenue, of which $1.6 million was recorded in the fourth
quarter of 2000, for acquired in-process research and development primarily
resulting from the acquisition of Cadabra (see Note 2 of Notes to Consolidated
Financial Statements). This amount was expensed on the acquisition date
because the acquired technology had not yet reached technological feasibility
and had no future alternative uses.

   The value assigned to developed technology and acquired in-process research
and development was determined through extensive interviews, analysis of data
provided by Cadabra concerning developmental products, their stage of
development, the time and resources needed to complete them and, if
applicable, their expected income generating ability, target markets and
associated risks. The Income Approach, which includes an analysis of the
markets, cash flows and risks associated with achieving such cash flows, was
the primary technique utilized in valuing the developed technology and in-
process research and development.

   The in-process research and development acquired from Cadabra in the
transaction consists primarily of technology related to replacement and
enhancement of Cadabra's core technology, principally cell layout design
tools.

                                      24
<PAGE>

   The projects identified as in-process technology are those that were
underway at the time of the Cadabra acquisition and at the date of the
acquisition required additional effort to establish technological feasibility.
These projects have identifiable technological risk factors which indicate
that, even though successful completion is expected, it is not assured. If an
identified project is not successfully completed, there is no alternative
future use for the project and the expected future income will not be
realized.

   Amortization of deferred stock compensation. Amortization of deferred stock
compensation represents the amount of amortization related to the difference
between the exercise price of options granted and the estimated fair market
value of the underlying common stock on the date of the grant. We recognized
stock-based compensation of $18.8 million for 2000 compared to $4.0 million
and $862,000 for 1999 and 1998, respectively. We are amortizing deferred stock
compensation over the vesting periods of the applicable options, using the
multiple option method. We expect amortization of deferred compensation to be
approximately $19 million in 2001. Amortization of deferred stock compensation
could increase or decrease in future periods as a result of future grants or
cancellations of options whose exercise prices are less than estimated fair
market value on the date of grant.

   Interest expense. Interest expense was $893,000 for 2000 compared to $0 for
1999 and 1998. Interest expense relates to the notes payable associated with
the acquisition of Transcription in January 2000. In April 2000, we paid the
remaining principal and interest due under these notes with proceeds from our
initial public offering.

   Interest income. Interest income was $3.0 million for 2000 compared to
$373,000 and $182,000 for the same periods in 1999 and 1998, respectively. The
increase in 2000 was primarily due to higher average cash and short-term
investment balances as a result of proceeds from our initial public offering
in April 2000. The increase in interest income in 1999 was primarily the
result of higher investment balances. We expect interest income to decrease in
2001 due to lower interest rates. Interest income could increase or decrease
in future periods as a result of future changes in interest rates or changes
in levels of investment balances.

   Provision for income taxes. Provision for income taxes was $253,000 for
2000 compared to $0 for 1999 and 1998. The increase in 2000 was due to
provisions for foreign taxes associated with foreign subsidiaries established
in 2000.

   We expect our tax rate for 2001 to be approximately 36%, excluding the
impact of amortization of goodwill and other intangible assets from our
acquisitions and amortization of deferred stock compensation. This estimate is
based on current tax law, our current estimate of earnings and our expected
distribution of income among various tax jurisdictions, all of which are
subject to change.

Liquidity and Capital Resources

   As of December 31, 2000, we had cash and cash equivalents and short-term
investments of $53.9 million. As of the same date, we had working capital of
$47.9 million, including deferred revenue of $6.3 million. Deferred revenue
represents the excess of amounts billed from licensees over revenue recognized
on license and maintenance contracts.

   Net cash used in operating activities was $4.8 million during 2000,
compared with $4.4 million used in 1999. Net cash used in 2000 primarily
reflects a net loss of $48.8 million, increases in prepaid and other of
$1.1 million and reductions in accrued expenses of $0.7 million and accounts
payable of $1.3 million, offset by amortization and depreciation expenses of
$24.8 million, amortization of deferred stock compensation of $18.8 million,
write-off of in-process research and development of $1.9 million and increases
in deferred revenue of $1.9 million.

   Net cash used in investing activities was $21.5 million during 2000,
compared with $1.5 million in 1999. Net cash used in 2000 consisted of net
purchases of $23.3 million in short-term investments and $2.0 million in

                                      25
<PAGE>

purchases of computer hardware and software and office furniture and
equipment. Our acquisition of Cadabra provided $3.7 million of cash.

   Net cash provided by financing activities was $43.5 million during 2000,
compared with $14.4 million in 1999. Net cash provided in 2000 primarily
consisted of a $81.2 million net proceeds from our initial public offering and
$1.5 million of net proceeds from common stock option activity, partly offset
by the payment of the $40.0 million principal outstanding under the notes
issued in connection with the acquisition of Transcription described below.

   On January 1, 2000, we acquired Transcription. In connection with the
acquisition, we issued $40.0 million in promissory notes. Shortly after
issuance of the notes, we repaid $5.0 million of the principal, leaving a
balance of $35.0 million outstanding under the notes. The remaining principal
amount, plus interest at 8.0% per annum, was payable in 16 equal quarterly
payments of $2.2 million, plus interest commencing on April 1, 2000. In April
2000, we paid these notes in full with a portion for the net proceeds from our
initial public offering.

   We are subject to various legal proceedings and claims, asserted and
unasserted, that arise in the ordinary course of business. In addition, on
March 14, 2000, ASML MaskTools, Inc. filed a complaint alleging we infringe
two U.S. patents and have committed unfair or fraudulent business practice
under the California Business and Professions Code. We are currently
investigating the patents and allegations. Litigation is inherently uncertain,
and an adverse decision could limit our ability to offer some features of our
OPC product. Were an unfavorable ruling to occur, there exists the possibility
of a material impact on the net income of the period in which the ruling
occurs and thereafter. The parties have stipulated to a number of delays to
the litigation and no trial date has been set.

   We expect to experience significant growth in our operating expenses,
particularly research and development and sales and marketing expenses, for
the foreseeable future in order to execute our business strategy. As a result,
we anticipate that such operating expenses, as well as planned capital
expenditures, will constitute a material use of our cash resources. Our
expenses are dependent in part on our level of revenue. In addition, we may
utilize cash resources to fund acquisitions of, or investments in,
complementary businesses, technologies or product lines. We believe the
existing cash will be sufficient to meet our working capital and capital
expenditure requirements for at least the next 12 months. Thereafter, we may
find it necessary to obtain additional equity or debt financing. In the event
additional financing is required, we may not be able to raise it on acceptable
terms or at all.

   In June 1998, the FASB issued Statement of Financial Accounting Standards
No. 133, or SFAS 133, Accounting for Derivative Instruments and Hedging
Activities. SFAS 133 establishes new standards of accounting and reporting for
derivative instruments and hedging activities. SFAS 133 requires that all
derivatives be recognized at fair value in the statement of financial
position, and that the corresponding gains or losses be reported either in the
statement of operations or as a component of comprehensive income, depending
on the type of hedging relationship that exists. The effective date for SFAS
No. 133 for us is January 1, 2001. At the current time, we do not have any
derivative instruments, nor have we engaged in hedging activities to date.

   In March 2000, the Financial Accounting Statements Board issued
Interpretation No. 44 (FIN 44) Accounting for Certain Transactions involving
Stock Compensation, an interpretation of APB Opinion No. 25. FIN 44 clarifies
the application of Opinion 25 for (a) the definition of employee for purposes
of applying Opinion 25, (b) the criteria for determining whether a plan
qualifies as a noncompensatory plan, (c) the accounting consequences of
various modifications to terms of a previously fixed stock option or award,
and (d) the accounting for an exchange of stock compensation awards in a
business combination. FIN 44 is effective July 1, 2000, but certain
conclusions cover specific events that occur after either December 15, 1998,
or January 12, 2000. The adoption of FIN 44 did not have a material impact on
the consolidated financial statements.

   Our future results of operations and the other forward-looking statements
contained in this section, in particular the statements regarding our goals
and strategies, revenue, costs of revenue, capital spending,

                                      26
<PAGE>

depreciation and amortization, research and development expenses, sales and
marketing expenses and general and administrative expenses, interest income,
the tax rate and pending legal proceedings, involve a number of risks and
uncertainties. Our future revenue, expenses and operating results are all
influenced by a number of factors, including those discussed above and those
below, all of which are inherently difficult to forecast.

Trends, Risks and Uncertainties

Additional Factors Which May Affect Our Future Results

If key markets within the semiconductor industry, especially semiconductor
manufacturers, do not adopt our proprietary technologies and software
products, we may be unable to generate sales of our products.

   If the four key markets within the semiconductor industry, which we believe
are semiconductor manufacturing, semiconductor equipment manufacturing,
photomask manufacturers and design, do not adopt our proprietary technologies
and software products, our revenue could decline. We believe we design our
technologies and products so that each key market within the semiconductor
industry can work efficiently with the other markets. For example, if
designers do not adopt our technologies and products, it will be more
difficult for them to design semiconductors which are understood and processed
efficiently by mask manufacturers that do adopt our technologies and products.
In addition, we believe semiconductor manufacturers need to adopt our
proprietary technologies and software products first in order to drive
adoption by the other three markets. Semiconductor manufacturers define and
develop the manufacturing process. While designers, mask manufacturers and
equipment manufacturers are not required to adopt our technologies and
products in order to work with semiconductor manufacturers that do adopt them,
we believe the efficiency of the manufacturing process with respect to such
designers, mask manufacturers and equipment manufacturers is diminished if
they do not. If each key market of the semiconductor industry does not
perceive our proprietary technologies and software products as the industry
standard, our technologies and products could become less valuable and more
difficult to license. Factors that may limit adoption of our subwavelength
solution within the markets include:

  .  our current and potential industry partners and customers may fail to
     adopt our technologies and products;

  .  the semiconductor industry may not need subwavelength processes if there
     is a slowdown in semiconductor manufacturing or a decrease in the demand
     for smaller semiconductor feature sizes; and

  .  the industry may develop alternative methods to produce subwavelength
     features with existing capital equipment due to a rapidly evolving
     market and the likely emergence of new technologies.

We depend on the growth of the semiconductor industry and the current economic
slowdown in this industry may cause a decrease in the demand for our
proprietary technologies and software products and revenue.

   We are dependent upon the general economic cycles of the semiconductor
industry. Our ability to increase or even maintain our current revenue is
largely dependent upon the continued demand by semiconductor manufacturers and
each other key market within the semiconductor industry for ICs and IC-related
technologies. The semiconductor industry has from time to time experienced
economic downturns characterized by decreased product demand, production over-
capacity, price erosion, work slowdowns and layoffs. We believe the
semiconductor industry is currently experiencing such an economic downturn
and, as a result, the sales of proprietary technologies and software products
may decrease.

In order for potential industry partners and customers to adopt, and expend
their own resources to implement, our technologies and products, we must
expend significant marketing resources, with no guarantee of success.

   Our proprietary technologies and software products involve a new approach
to the subwavelength gap problem. As a result, we must employ intensive and
sophisticated marketing and sales efforts to educate

                                      27
<PAGE>

prospective industry partners and customers about the benefits of our
technologies and products. Our sales and marketing expenses increased to $9.2
million in 2000 from $4.2 million in 1999. In addition, even if our industry
partners and customers adopt our proprietary technologies and software
products, they must devote the resources necessary to fully integrate our
technologies and products into their operations. This is especially true for
our industry partners so that they can begin to resell and market our solution
to their customers. If they do not make these expenditures, establishing our
technologies and products as the industry standard to the subwavelength gap
problem will be difficult.

Our limited operating history and dependence on new technologies make it
difficult to evaluate our future prospects.

   We only have a limited operating history on which you can base your
valuation of our business. We face a number of risks as an emerging company in
a new market. For example, the key markets within the semiconductor industry
may fail to adopt our proprietary technologies and software products, or we
may not be able to establish distribution channels. Our company incorporated
in October 1995. In February 1997, we shipped our initial software product, IC
Workbench. We have only recently begun to expand our operations significantly.
For example, we grew from 105 employees as of January 1, 2000 to 191 employees
as of December 31, 2000.

We have a history of losses, we expect to incur losses in the future and we
may be unable to achieve profitability.

   We may not achieve profitability if our revenue increases more slowly than
we expect or not at all. In addition, our operating expenses are largely
fixed, and any shortfall in anticipated revenue in any given period could
cause our operating results to decrease. We have not been profitable in any
quarter, and our accumulated deficit was approximately $65.8 million as of
December 31, 2000. We expect to continue to incur significant operating
expenses in connection with increased funding for research and development and
expansion of our sales and marketing efforts. In addition, we expect to incur
additional noncash charges relating to amortization of intangibles and
deferred stock compensation. As a result, we will need to generate significant
revenue to achieve and maintain profitability. If we do achieve profitability,
we may be unable to sustain or increase profitability on a quarterly or annual
basis.

We recently acquired Cadabra Design Automation Inc. If we are not successful
in integrating Cadabra's products and operations with ours, our revenue and
operating results could decline.

   Our acquisition of Cadabra Design Automation Inc. will only be successful
if we are able to integrate its operations with ours, which could
substantially divert management's attention from the day-to-day operations of
the combined company. If we encounter any difficulties in the transition
process, the revenue and operating results of our company could decline. We
must successfully integrate Cadabra's products with ours. One of the elements
of our strategy is to integrate our subwavelength solution with the Cadabra
solution in order to offer design teams fast access to the processes that
incorporate our subwavelength technologies. We must also focus our research
and development and sales and marketing efforts to realize the technological
benefits of this combination. If we are not able to integrate these solutions
effectively or successfully, research and development and sales and marketing
expenses could increase with no corresponding increase in revenue and our
reputation could be harmed.

   In addition, the process of combining our company with Cadabra could
interrupt the activities of any or all of the companies' businesses. It is
possible that we will not be able to retain Cadabra's key management,
technical and sales personnel. The acquisition of Cadabra could also cause our
industry partners and customers to be uncertain about our ability to support
the combined companies' products and technologies and the direction of the
combined companies' development efforts. In particular, semiconductor
manufacturers, which have previously relied on and endorsed the Cadabra
solution, must continue to rely on and endorse this solution under our
combined company. As a result, these semiconductor manufacturers, as well as
our other industry partners and customers, may delay or cancel these orders,
which could significantly decrease our revenue and limit our ability to
implement our combined business strategy.

                                      28
<PAGE>

Our acquisition of Transcription Enterprises Limited may increase the focus of
the semiconductor industry on the manufacturing data preparation market, which
could lead to a rapid and substantial increase in competition.

   Our acquisition of Transcription may increase the semiconductor industry's
awareness of the market for manufacturing data preparation software, which
could lead to a substantial increase in the number of start-up companies that
focus on software solutions for data preparation. Manufacturing data
preparation software translates semiconductor designs into instructions that
control manufacturing equipment. Potential competitors could pursue and
execute partnership agreements with key industry partners we intend to pursue,
which could make it difficult or impossible for us to develop relationships
with these potential industry partners. In addition, some of our current
competitors may increase their own research and development budgets relating
to data preparation, or may more aggressively market competing solutions.

If we do not continue to introduce new technologies and software products or
product enhancements ahead of rapid technological change in the market for
subwavelength solutions, our operating results could decline and we could lose
our competitive position.

   We must continually devote significant engineering resources to enable us
to introduce new technologies and software products or product enhancements to
address the evolving needs of key markets within the semiconductor industry in
solving the subwavelength gap problem. We must introduce these innovations and
the key markets within the semiconductor industry must adopt them before
changes in the semiconductor industry, such as the introduction by our current
and potential competitors of more advanced products or the emergence of
alternative technologies, render the innovations obsolete, which could cause
us to lose our competitive position. These innovations are inherently complex,
require long development cycles and a substantial investment before we can
determine their commercial viability. Moreover, designers, mask manufacturers
and equipment manufacturers must each respond to the demand of the market to
design and manufacture masks and equipment for increasingly smaller and
complex semiconductors. Our innovations must be viable and meet the needs of
these key markets within the semiconductor industry before the consumer market
demands even smaller semiconductors, rendering the innovations obsolete. We
may not have the financial resources necessary to fund any future innovations.
In addition, any revenue that we receive from enhancements or new generations
of our proprietary technologies and software products may be less than the
costs of development.

We rely on Cadence for a substantial amount of our revenue, and if our
contracts with Cadence were terminated or not extended or renewed, or if the
fees we are to receive are reduced, we would need to replace this revenue
through other sources.

   We have two agreements with Cadence with initial two-year terms that run
through 2002 to 2003, respectively. If these contracts were to be terminated
or not extended or renewed, or if the fees we are to receive are reduced, we
could lose a material portion of our revenue. We would need to replace this
revenue with revenue from other customers by increasing the sale of our
proprietary technologies and software products to our current customers and
industry partners, or by entering into new contracts with new customers either
of which would result in an unexpected diversion of management efforts and
possible increases to operating expenses, with no immediate increase in
revenue. For 2000, Cadence was responsible for approximately 24% of our total
revenue.

Fluctuations in our quarterly operating results may cause our stock price to
decline.

   It is likely that our future quarterly operating results may fluctuate from
time to time and may not meet the expectations of securities analysts and
investors in some future period. As a result, the price of our common stock
could decline. Historically, our quarterly operating results have fluctuated.
We may experience significant fluctuations in future quarterly operating
results. The following factors may cause these fluctuations:

  .  our recent acquisition of Transcription and Cadabra, as well as future
     potential acquisitions by us;

  .  the timing and structure of our product license agreements; and

  .  changes in the level of our operating expenses to support our projected
     growth.

                                      29
<PAGE>

The accounting rules regarding revenue recognition may cause fluctuations in
our revenue independent of our booking position.

   The accounting rules we are required to follow require us to recognize
revenue only when certain criteria are met. As a result, for a given quarter
it is possible for us to fall short in our revenue and/or earnings estimates
even though total orders are according to our plan or, conversely, to meet our
revenue and/or earnings estimates even though total orders fall short of our
plan, due to revenue produced by deferred revenue. Orders for software support
and professional services yield revenue over multiple quarters, often
extending beyond the current fiscal year, or upon completion of performance
rather than at the time of sale. The specific terms agreed to with a customer
and/or any changes to the rules interpreting such terms may have the effect of
requiring deferral of product revenue in whole or in part or, alternatively,
of requiring us to accelerate the recognition of such revenue for products to
be used over multiple years.

We intend to pursue new, and maintain our current, industry partner
relationships, which could substantially divert management attention and
resources, with no guarantee of success.

   We expect to derive significant benefits, including increased revenue and
customer awareness, from our current and potential industry partner
relationships. In our pursuit to maintain and establish partner relationships
within each of the key markets in the semiconductor industry, we could expend
significant management attention, resources and sales personnel efforts, with
no guarantee of success. To establish and maintain our partner relationships,
we expend our limited financial resources on increasing our sales and business
development personnel, trade shows and marketing within trade publications. If
we did not have to pursue potential industry partners, we could focus these
resources exclusively on direct sales to our customers. In addition, through
our partner relationships, our partners resell, market, either jointly with us
or unilaterally, and promote our technologies and products. If these
relationships terminate, such as due to our material breach of the contracts
or the partners' election to cancel the contract, which generally is
permissible with prior notice to us, we would have to increase our own limited
marketing and sales resources for these activities. Further, we may be unable
to enter into new industry partner relationships if any of the following
occur:

  .  current or potential industry partners develop their own solutions to
     the subwavelength gap problem; or

  .  our current or potential competitors establish relationships with
     industry partners with which we seek to establish a relationship.

   We have only recently entered into many of our current partner
relationships. These relationships may not continue or they may not be
successful. We also may be unable to find additional suitable industry
partners.

Many of our current competitors have longer operating histories and
significantly greater financial, technical, marketing and other resources than
we do and as a result, they may acquire a significant market share before we
do.

   Our current competitors, or alliances among these competitors, may rapidly
acquire significant market share. These competitors may have greater name
recognition and more customers which they could use to gain market share to
our detriment. We encounter direct competition from other direct providers of
phase shifting, OPC, manufacturing data and automated cell generation
technologies. These competitors include such companies as Avant!, Mentor
Graphics and Prolific, Inc. We also compete with companies that have developed
or have the ability to develop their own proprietary phase shifting and OPC
solutions, such as IBM. These companies may wish to promote their internally
developed products and may be reluctant to purchase products from us or other
independent vendors. Our competitors may offer a wider range of products than
we do and thus may be able to respond more quickly to new or changing
opportunities, technologies and customer requirements. These competitors may
also be able to undertake more extensive promotional activities, offer more
attractive terms to customers than we do and adopt more aggressive pricing
policies. Moreover, our competitors may establish relationships among
themselves or with industry partners to enhance their services, including
industry partners with which we may desire to establish a relationship.

                                      30
<PAGE>

The market for software solutions that address the subwavelength gap problem
is new and rapidly evolving. We expect competition to intensify in the future,
which could slow our ability to grow or execute our strategy.

   We believe that the demand for solutions to the subwavelength gap problem
may encourage many competitors to enter into our market. As the market for
software solutions to the subwavelength gap problem proliferates, if our
competitors are able to attract industry partners or customers on a more
accelerated pace than we can and retain them more effectively, we would not be
able to grow and execute our strategy as quickly. In addition, if customer
preferences shift away from our technologies and software products as a result
of the increase in competition, we must develop new proprietary technologies
and software products to address these new customer demands. This could result
in the diversion of management attention or our development of new
technologies and products may be blocked by other companies' patents. We must
offer better products, customer support, prices and response time, or a
combination of these factors, than those of our potential competitors.

We are growing rapidly and must effectively manage and support our growth in
order for our business strategy to succeed.

   We have grown rapidly and will need to continue to grow in all areas of
operation. If we are unable to successfully integrate and support our existing
and new employees, including those employees added as a result of our
acquisition of Cadabra, into our operations, we may be unable to implement our
business strategy in the time frame we anticipate, or at all. In addition,
building and managing the support necessary for our growth places significant
demands on our management as well as our limited revenue. These demands have,
and may continue to, divert these resources away from the continued growth of
our business and implementation of our business strategy. Further, we must
adequately train our new personnel, especially our technical support
personnel, to adequately, and accurately, respond to and support our industry
partners and customers. If we fail to do this, it could lead to
dissatisfaction among our partners or customers, which could slow our growth.

We must continually attract and retain engineering personnel or we will be
unable to execute our business strategy.

   We have experienced, and we expect to continue to experience, difficulty in
hiring and retaining highly skilled engineers with appropriate qualifications
to support our rapid growth and expansion. We must continually enhance and
introduce new generations of our phase shifting and OPC technologies. As a
result, our future success depends in part on our ability to identify,
attract, retain and motivate qualified engineering personnel with the
requisite educational background and industry experience. If we lose the
services of a significant number of our engineers, it could disrupt our
ability to implement our business strategy. Competition for qualified
engineers is intense, especially in the Silicon Valley where our headquarters
are located.

Our chief executive officer and chief technology officer, as well as the co-
founders of Transcription and the key executive officers of Cadabra, are
critical to our business and they may not remain with us in the future.

   Our future success will depend to a significant extent on the continued
services of Y. C. (Buno) Pati, our President and Chief Executive Officer; Yao-
Ting Wang, our Chief Technology Officer and Senior Vice President of
Engineering; Roger Sturgeon, one of our directors and a senior executive of
Transcription; Kevin MacLean, Senior Vice President and General Manager of
Transcription; Faysal Sohail, a Senior Vice President of Worldwide Field
Operation and Martin Lefebrve, a member of our Office of Technology and senior
executive of Cadabra. If we lose the services of any of these key executives,
it could slow our product development processes and searching for their
replacements could divert our other senior management's time and increase our
operating expenses. In addition, our industry partners and customers could
become concerned about our future operations, which could injure our
reputation. We do not have long-term employment agreements with these
executives and we do not maintain any key person life insurance policies on
their lives.


                                      31
<PAGE>

If we fail to protect our intellectual property rights, competitors may be
able to use our technologies which could weaken our competitive position,
reduce our revenue or increase our costs.

   Our success depends heavily upon proprietary technologies, specifically our
patent portfolio. The rights granted under our patents and patent applications
may not provide competitive advantages to us. In addition, litigation may be
necessary to enforce our intellectual property rights or to determine the
validity and scope of the proprietary rights of others. As a result of any
such litigation, we could lose our proprietary rights and incur substantial
unexpected operating costs. Litigation could also divert our resources,
including our managerial and engineering resources. We rely primarily on a
combination of patents, copyrights, trademarks and trade secrets to protect
our proprietary rights and prevent competitors from using our proprietary
technologies in their products. These laws and procedures provide only limited
protection. Our pending patent applications may not result in issued patents,
and our existing and future patents may not be sufficiently broad to protect
our proprietary technologies. Also, patent protection in foreign countries may
be limited or unavailable where we have filed for and need such protection.
Furthermore, if we fail to adequately protect our trademark rights, this could
impair our brand identity and ability to compete effectively. If we do not
successfully protect our trademark rights, this could force us to incur costs
to re-establish our name or our product names, including significant marketing
activities.

If third parties assert that our proprietary technologies and software
products infringe their intellectual property rights, this could injure our
reputation and limit our ability to license or sell our proprietary
technologies or software products.

   Third parties, for competitive or other reasons, could assert that our
proprietary technologies and software products infringe their intellectual
property rights. These claims could injure our reputation and decrease or
block our ability to license or sell our software products. For example, on
March 14, 2000, ASML MaskTools, Inc. filed a complaint alleging we infringe
two U.S. patents and have committed unfair or fraudulent business practice
under the California Business and Professions Code. We are currently
investigating the patents and allegations. The defense of these claims could
divert management's attention from the day to day operations of our company,
as well as divert resources from current planned uses, such as hiring and
supporting additional engineering personnel. Litigation is inherently
uncertain, and an adverse decision could limit our ability to offer some
features in our OPC product. In addition, third parties have advised us of
literature which they believe to be relevant to our patents. It is possible
that this literature or literature we may be advised of in the future could
negatively affect the scope or enforceability of our present or future patents
and/or result in costly litigation. In addition, we are aware of and are
evaluating certain patents with which our products, patents or patent
applications may conflict. If any of these patents are found to be valid, and
we are unable to license such patents on reasonable terms, or if our products,
patents, or patent applications are found to conflict with these patents, we
could be prevented from selling our products, our patents may be declared
invalid or our patent applications may not result in issued patents. In
addition, a company could invite us to take a patent license. If we do not
take the license, the requesting company could contact our industry partners
or customers and suggest that they not use our software products because we
are not licensed under their patents. This action by the requesting company
could affect our relationships with these industry partners and customers and
may prevent future industry partners and customers from licensing our software
products. The intensely competitive nature of our industry and the important
nature of our technologies to our competitors' businesses may contribute to
the likelihood of being subject to third party claims of this nature.

Any potential dispute involving our patents or other intellectual property
could include our industry partners and customers, which could trigger our
indemnification obligations with them and result in substantial expense to us.

   In any potential dispute involving our patents or other intellectual
property, our licensees could also become the target of litigation. This could
trigger our technical support and indemnification obligations in some of our
license agreements which could result in substantial expense to us. In
addition to the time and expense required

                                      32
<PAGE>

for us to supply such support or indemnification to our licensees, any such
litigation could severely disrupt or shut down the business of our licensees,
which in turn could hurt our relations with our customers and cause the sale
of our proprietary technologies and software products to decrease.

Defects in our proprietary technologies and software products could decrease
our revenue and our competitive market share.

   If our industry partners and customers discover any defects after they
implement our proprietary technologies and software products, these defects
could significantly decrease the market acceptance and sales of our software
products, which could decrease our competitive market share. Any actual or
perceived defects with our proprietary technologies and software products may
also hinder our ability to attract or retain industry partners or customers,
leading to a decrease in our revenue. These defects are frequently found
during the period following introduction of new products or enhancements to
existing products. Despite testing prior to introduction, our software
products may contain software errors not discovered until after customer
implementation. If our software products contain errors or defects, it could
require us to expend significant resources to alleviate these problems, which
could result in the diversion of technical and other resources from our other
development efforts.

We face operational and financial risks associated with international
operations.

   We derive an increasingly significant portion of our revenue from
international sales. In 2000, compared to 1999, the breakdown of our revenue
by geographic region, as a percentage of our total revenue, was North America,
57% and 78%, Asia, 33% and 22%, Europe, 9% and 0%, and other, 1% and 0%,
respectively. In addition, as a result of our acquisition of Cadabra, a Nova
Scotia limited liability company, in October 2000, 47 of our 191 employees as
of December 31, 2000 were located in Ontario, Canada. We have only limited
experience in developing, marketing, selling and supporting our proprietary
technologies and software products, and managing our employees and operations,
internationally. We may not succeed in maintaining or expanding our
international operations, which could slow our revenue growth. We are subject
to risks inherent in doing business in international markets. These risks
include:

  .  fluctuations in exchange rates which may negatively affect our operating
     results;

  .  export controls which could prevent us from shipping our software
     products into and from some markets;

  .  changes in import/export duties and quotas could affect the competitive
     pricing of our software products and reduce our market share in some
     countries;

  .  compliance with and unexpected changes in a wide variety of foreign laws
     and regulatory environments with which we are not familiar;

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

  .  economic or political instability.

   We may be unable to continue to market our proprietary technologies and
software products successfully in international markets.

Our operations are primarily located in California and, as a result, are
subject to power loss and other natural disasters.

   Our business operations depend on our ability to maintain and protect our
facilities, computer systems and personnel, which are primarily located in or
near our principal headquarters in San Jose, California. California is
currently experiencing power outages due to a shortage in the supply of power
within the state. In the event of an acute power shortage, California has on
some occasions implemented, and may in the future continue to

                                      33
<PAGE>

implement, rolling blackouts throughout California. We currently do not have
backup generators or alternate sources of power in the event of a blackout,
and our current insurance does not provide coverage for any damages we or our
customers or industry partners may suffer as a result of any interruption in
our power supply. If blackouts interrupt our power supply, we would be
temporarily unable to continue operations at our facilities. Any such
interruption in our ability to continue operations at our facilities could
damage our reputation, harm our ability to retain existing customers and
industry partners, or obtain new customers or industry partners, and could
result in loss of revenue. Furthermore, the deregulation of the energy
industry in California has caused power prices to increase. If wholesale
prices continue to increase, our operating expenses will likely increase. In
addition, San Jose exists on or near a known earthquake fault zone. Our
facilities are susceptible to damage from earthquakes and other natural
disasters, such as fires, floods and similar events. Although we maintain
general business insurance against fires and some general business
interruptions, there can be no assurance that the amount of coverage will be
adequate in any particular case.

We may need to raise additional funds to support our growth or execute our
strategy and if we are unable to do so, we may be unable to develop or enhance
our proprietary technologies and software products, respond to competitive
pressures or acquire desired businesses or technologies.

   We currently anticipate that our available cash resources will be
sufficient to meet our presently anticipated working capital and capital
expenditure requirements for at least the next 12 months. However, we may need
to raise additional funds in order to:

  .  support more rapid expansion;

  .  develop new or enhanced products;

  .  respond to competitive pressures; or

  .  acquire complementary businesses or technologies.

   These factors will impact our future capital requirements and the adequacy
of our available funds. We may need to raise additional funds through public
or private financings, strategic relationships or other arrangements.

We may be unable to consummate other potential acquisitions or investments or
successfully integrate them with our business, which may slow our ability to
expand the range of our proprietary technologies and software products.

   To expand the range of our proprietary technologies and software products,
we recently acquired Transcription and Cadabra, and we may acquire or make
investments in additional complementary businesses, technologies or products
if appropriate opportunities arise. We may be unable to identify suitable
acquisition or investment candidates at reasonable prices or on reasonable
terms, or consummate future acquisitions or investments, each of which could
slow our growth strategy. If we do acquire additional companies or make other
types of acquisitions, we may have difficulty integrating the acquired
products, personnel or technologies. These difficulties could disrupt our
ongoing business, distract our management and employees and increase our
expenses.

The market price of our common stock has been and may continue to be volatile
and could decline.

   The market price of our common stock has fluctuated in response to factors,
some of which are beyond our control, including:

  .  changes in market valuations of other technology companies;

  .  conditions or trends in the semiconductor industry;

  .  actual or anticipated fluctuations in our operating results;

  .  any deviations in net revenue or in losses from levels expected by
     securities analysts;

  .  announcements by us or our competitors of significant technical
     innovations, contracts, acquisitions or partnerships;

                                      34
<PAGE>

  .  volume fluctuations, which are particularly common among highly volatile
     securities of technology related companies; and

  .  departures of key personnel.

   General political or economic conditions, such as recession or interest
rate or currency rate fluctuations in the United States or abroad, also could
cause the market price of our common stock to decline.

The fluctuations in our stock price could result in securities class action
litigation, which could result in substantial costs and diversion of our
resources.

   Volatility in the market price of our common stock could result in
securities class action litigation. Any litigation would likely result in
substantial costs and a diversion of management's attention and resources. The
share prices of technology companies' stocks have been highly volatile and
have recorded lows well below their historical highs. As a result, investors
in these companies often buy the stock at high prices only to see the price
drop a short time later, resulting in a drop in value in the stock holdings of
these investors. Our stock may not trade at the same levels as other
technology stocks, or at its historical prices.

Item 7a: Quantitative and Qualitative Disclosures about Market Risk

   Our exposure to market risk for changes in interest rates relate primarily
to our investment portfolio. We do not use derivative financial instruments
for speculative or trading purposes. We place our investments in instruments
that meet high credit quality standards, as specified in our investment
policy. The policy also limits the amount of credit exposure to any one issuer
and type of instrument. We do not expect any material loss with respect to our
investment portfolio.

Item 8: Financial Statements and Supplementary Data

   The consolidated financial statements and supplementary data required by
this Item 8 are listed in Item 14(a)(1) and begin at page 38 of this Annual
Report on Form 10-K.

Item 9: Changes in and Disagreements with Accountants on Accounting and
Financial Disclosure

   None.

                                      35
<PAGE>

                                   PART III

   Pursuant to Paragraph (3) of the General Instructions to Form 10-K, the
information required by Part III of this Form 10-K are incorporated by
reference from the registrant's Proxy Statement to be filed with the
Securities and Exchange Commission in connection with the 2001 Annual Meeting
of Stockholders ("the Proxy Statement"). The Proxy Statement is anticipated to
be filed within 120 days after the end of our fiscal year ended December 31,
2000.

Item 10: Directors and Executive Officers of the Registrant

   (a) Information with respect to directors of the registrant appears in the
registrant's Proxy Statement under "Election of Directors." This portion of
the Proxy Statement is incorporated herein by reference. Information with
respect to executive officers appears in Part I of this Form 10-K.

   (b) Information with respect to compliance with Section 16(a) of the
Exchange Act appears in the registrant's Proxy Statement under "Section 16(a)
Beneficial Ownership Reporting Compliance." This portion of the Proxy
Statement is incorporated herein by reference.

Item 11: Executive Compensation

   Information with respect to executive compensation appears in the
registrant's Proxy Statement under "Executive Compensation." This portion of
the Proxy Statement is incorporated herein by reference.

Item 12: Security Ownership of Certain Beneficial Owners and Management

   Information with respect to certain beneficial owners and management of the
registrant appears in the registrant's Proxy Statement, under "Share Ownership
by Principal Stockholders and Management." This portion of the Proxy Statement
is incorporated herein by reference.

Item 13: Certain Relationships and Related Transactions

   Information with respect to certain relationships and related transactions
appears in the registrant's Proxy Statement under "Related Party
Transactions." This portion of the Proxy Statement is incorporated herein by
reference.

                                      36
<PAGE>

                                    PART IV

Item 14: Exhibits, Financial Statement Schedules, and Reports on Form 8-K

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

  (1) Financial Statements:

    Report of Independent Accountants

    Consolidated Balance Sheets at December 31, 2000 and December 31, 1999

    Consolidated Statements of Operations for each of the three years in
    the period ended December 31, 2000

    Consolidated Statements of Stockholders' Equity and Comprehensive Loss
    for each of the three years in the period ended December 31, 2000

    Consolidated Statements of Cash Flows for each of the three years in
    the period ended December 31, 2000

    Notes to Consolidated Financial Statements

  (2) Financial Statement Schedules:

    Financial Statement Schedules have been omitted as the information
    required to be set forth therein is not applicable or is readily
    available in the financial statements or notes thereto.

  (3) Exhibits:

    The exhibits listed in the accompanying Index to Exhibits are filed or
    incorporated by reference as part of this Form 10-K.

  (b) Reports on Form 8-K:

   On November 2, 2000, the registrant filed on Form 8-K with the Securities
and Exchange Commission announcing the closing of the acquisition by the
registrant of Cadabra Design Automation Inc. On December 22, 2000, the
registrant filed a Form 8-K/A to its November 2, 2000 Form 8-K filing to
include the financial statements of Cadabra Design Automation Inc. and the pro
forma financial information of the registrant required by the November 2, 2000
Form 8-K.

                                      37
<PAGE>

                       REPORT OF INDEPENDENT ACCOUNTANTS

To the Board of Directors and Stockholders of Numerical Technologies, Inc.

   In our opinion, the consolidated financial statements listed in the
accompanying index appearing under Item 14(a)(1) on page 37 present fairly, in
all material respects, the financial position of Numerical Technologies, Inc.
and its subsidiaries at December 31, 2000 and December 31, 1999, 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 of America. 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 of these statements in accordance with
auditing standards generally accepted in the United States of America, which
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, assessing the accounting principles
used and significant estimates made by management, and evaluating the overall
financial statement presentation. We believe that our audits provide a
reasonable basis for our opinion.

/s/ PricewaterhouseCoopers LLP

San Jose, California
January 17, 2001

                                      38
<PAGE>

                          NUMERICAL TECHNOLOGIES, INC.

                          CONSOLIDATED BALANCE SHEETS
                     (in thousands, except per share data)

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

Current assets:
  Cash and cash equivalents................................ $ 30,607  $ 13,486
  Short-term investments...................................   23,281       --
  Accounts receivable......................................    4,983     1,819
  Prepaid and other........................................    3,177       394
                                                            --------  --------
    Total current assets...................................   62,048    15,699
Property and equipment, net................................    3,209     1,613
Goodwill and other intangible assets.......................  175,402       --
Other assets...............................................      315       293
                                                            --------  --------
                                                            $240,974  $ 17,605
                                                            ========  ========

           LIABILITIES AND STOCKHOLDERS' EQUITY
           ------------------------------------

Current liabilities:
  Accounts payable......................................... $  3,208  $    613
  Accrued expenses and other liabilities...................    4,608     1,945
  Deferred revenue.........................................    6,320     2,642
                                                            --------  --------
    Total current liabilities..............................   14,136     5,200
                                                            --------  --------
Deferred tax liability.....................................    7,704       --
                                                            --------  --------
Commitments (See Note 4)

Stockholders' equity:
  Convertible preferred stock, $0.0001 par value:
   Authorized: 5,000 shares;
   Issued and outstanding: none and 8,103 shares in 2000
    and 1999, respectively.................................      --          1
  Common stock, $0.0001 par value:
   Authorized: 100,000 shares;
   Issued and outstanding: 32,834 and 9,570 shares in 2000
    and 1999, respectively.................................        3         1
Additional paid in capital.................................  319,541    50,100
Receivable from stockholders...............................   (4,050)     (315)
Deferred stock compensation................................  (30,572)  (21,220)
Accumulated deficit........................................  (65,751)  (16,162)
Accumluated other comprehensive loss.......................      (37)      --
                                                            --------  --------
    Total stockholders' equity.............................  219,134    12,405
                                                            --------  --------
                                                            $240,974  $ 17,605
                                                            ========  ========
</TABLE>


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

                                       39
<PAGE>

                          NUMERICAL TECHNOLOGIES, INC.

                     CONSOLIDATED STATEMENTS OF OPERATIONS
                     (in thousands, except per share data)

<TABLE>
<CAPTION>
                                                   Year Ended December 31,
                                                   --------------------------
                                                     2000     1999     1998
                                                   --------  -------  -------
<S>                                                <C>       <C>      <C>
Revenue........................................... $ 23,340  $ 5,492  $   736
                                                   --------  -------  -------
Costs and expenses:
  Cost of revenue.................................    2,167      307      127
  Research and development........................   12,627    4,627    2,671
  Sales and marketing.............................    9,161    4,163    1,404
  General and administrative......................    4,494    1,266    2,306
  Depreciation and amortization...................   24,820      340       99
  Acquired in-process research and development....    1,930      --       --
  Amortization of deferred stock compensation
   (*)............................................   18,766    3,990      862
                                                   --------  -------  -------
    Total costs and expenses......................   73,965   14,693    7,469
                                                   --------  -------  -------
Loss from operations..............................  (50,625)  (9,201)  (6,733)
Interest expense..................................     (893)     --       --
Interest income...................................    2,960      373      182
                                                   --------  -------  -------
Loss before provision for income taxes............  (48,558)  (8,828)  (6,551)
Provision for income taxes........................      253      --       --
                                                   --------  -------  -------
Net loss..........................................  (48,811)  (8,828)  (6,551)
Deemed dividend related to beneficial conversion
 of Series C preferred stock warrants.............      778      --       --
                                                   --------  -------  -------
Net loss allocable to common stockholders......... $(49,589) $(8,828) $(6,551)
                                                   ========  =======  =======
Net loss per common share, basic and diluted...... $  (2.27) $ (1.26) $ (0.89)
                                                   ========  =======  =======
Weighted average common shares, basic and
 diluted..........................................   21,827    7,019    7,373
                                                   ========  =======  =======

(*) Amortization of Deferred Stock Compensation:
  Cost of revenue................................. $    863  $   118  $    22
  Research and development........................    8,776    1,836      465
  Sales and marketing.............................    3,619    1,444      361
  General and administrative......................    5,508      592       14
                                                   --------  -------  -------
                                                   $ 18,766  $ 3,990  $   862
                                                   ========  =======  =======
</TABLE>

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

                                       40
<PAGE>

                         NUMERICAL TECHNOLOGIES, INC.

    CONSOLIDATED STATEMENTS OF STOCKHOLDERS' EQUITY AND COMPREHENSIVE LOSS
             For the Years Ended December 31, 2000, 1999 and 1998
                                (in thousands)

<TABLE>
<CAPTION>
                    Convertible
                     Preferred                                                                      Accumlated
                       Stock        Common Stock   Additional  Receivable    Deferred                  Other
                   ---------------  --------------  Paid in       from        Stock     Accumlated Comprehensive
                   Shares   Amount  Shares  Amount  Capital   Stockholders Compensation  Deficit       Loss       Total
                   -------  ------  ------  ------ ---------- ------------ ------------ ---------- ------------- --------
<S>                <C>      <C>     <C>     <C>    <C>        <C>          <C>          <C>        <C>           <C>
Balance at
December 31,
1997.............    3,300  $ --     7,930   $  1   $  1,307    $   (50)     $    --     $   (783)     $ --      $    475
Exercise of
common stock
options..........      --     --       825    --          61         (5)          --          --         --            56
Return of common
stock............      --     --      (525)   --         --         --            --          --         --           --
Repurchase of
common stock.....      --     --      (503)   --          (2)       --            --          --         --            (2)
Issuance of
Series C
preferred stock
and warrants, net
of issuance costs
of $47...........    2,445      1      --     --       7,924        --            --          --         --         7,925
Repayment of note
receivable.......      --     --       --     --         --          50           --          --         --            50
Deferred stock
compensation
related to grants
of stock.........      --     --       --     --       2,800        --         (2,800)        --         --           --
Amortization of
deferred stock
compensation.....      --     --       --     --         --         --            862         --         --           862
Net loss.........      --     --       --     --         --         --            --       (6,551)       --        (6,551)
                   -------  -----   ------   ----   --------    -------      --------    --------      -----     --------
Balance at
December 31,
1998.............    5,745      1    7,727      1     12,090         (5)       (1,938)     (7,334)       --         2,815
Exercise of
common stock
options..........      --     --     2,001    --       1,333       (315)          --          --         --         1,018
Repurchase of
common stock.....      --     --      (158)   --         (20)       --            --          --         --           (20)
Issuance of
Series D
preferred stock,
net of issuance
costs of $455....    2,358    --       --     --      13,425        --            --          --         --        13,425
Repayment of note
receivable.......      --     --       --     --         --           5           --          --         --             5
Deferred stock
compensation
related to grants
of stock options
and issuance of
common stock.....      --     --       --     --      23,272        --        (23,272)        --         --           --
Amortization of
deferred stock
compensation.....      --     --       --     --         --         --          3,990         --         --         3,990
Net loss.........      --     --       --     --         --         --            --       (8,828)       --        (8,828)
                   -------  -----   ------   ----   --------    -------      --------    --------      -----     --------
Balance at
December 31,
1999.............    8,103      1    9,570      1     50,100       (315)      (21,220)    (16,162)       --        12,405
Stock and options
issued in
connection with
acquisitions.....    3,810    --     2,671    --     165,942        --        (12,594)        --         --       153,348
Exercise of
common stock
options..........      --     --     2,411    --       5,290     (3,772)          --          --         --         1,518
Repurchase of
common stock.....      --     --      (287)   --        (237)       --            --          --         --          (237)
Repayment of
notes
receivable.......      --     --       --     --         --          37           --          --         --            37
Common stock
issued in
connection with
initial public
offering.........      --     --     6,364      1     81,162        --            --          --         --        81,163
Exercise of
preferred stock
warrants,
including deemed
dividend.........      109    --       --     --         778        --            --         (778)       --           --
Conversion of
preferred stock..  (12,022)    (1)  12,022      1        --         --            --          --         --           --
Deferred stock
compensation
related to grants
of stock options
and issuance of
common stock.....      --     --       --     --      21,109        --        (21,109)        --         --           --
Amortization of
deferred stock
compensation.....      --     --       --     --         --         --         18,766         --         --        18,766
Deferred stock
compensation
related to
cancellation of
stock options....      --     --       --     --      (5,585)       --          5,585         --         --           --
Shares issued
under employee
stock purchase
plan.............      --     --        83    --         982        --            --          --         --           982

Net loss.........      --     --       --     --         --         --            --      (48,811)       --       (48,811)
Foreign currency
translation
adjustment.......      --     --       --     --         --         --            --          --         (37)         (37)
                                                                                                                 --------
Comprehensive
loss.............      --     --       --     --         --         --            --          --         --       (48,848)
                   -------  -----   ------   ----   --------    -------      --------    --------      -----     --------
Balance at
December 31,
2000.............      --   $ --    32,834   $  3   $319,541    $(4,050)     $(30,572)   $(65,751)     $ (37)    $219,134
                   =======  =====   ======   ====   ========    =======      ========    ========      =====     ========
</TABLE>

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

                                       41
<PAGE>

                          NUMERICAL TECHNOLOGIES, INC.

                     CONSOLIDATED STATEMENTS OF CASH FLOWS
                                 (in thousands)

<TABLE>
<CAPTION>
                                                    Year Ended December 31,
                                                   ---------------------------
                                                     2000      1999     1998
                                                   ---------  -------  -------
<S>                                                <C>        <C>      <C>
Cash flows from operating activities:
Net loss.......................................... $ (48,811) $(8,828) $(6,551)
Adjustments to reconcile net loss to cash used in
 operating activities:
  Depreciation....................................     1,156      340       99
  Amortization of acquired intangibles............    23,664      --       --
  Acquired in-process research and development....     1,930      --       --
  Amortization of deferred stock compensation.....    18,766    3,990      862
  Changes in assets and liabilities:
    Accounts receivable...........................      (225)    (736)    (758)
    Prepaid and other.............................    (1,107)    (334)     (67)
    Other assets..................................       (22)    (254)     (31)
    Accounts payable..............................    (1,273)     374      111
    Accrued expenses and other liabilities........      (712)     604    1,244
    Deferred revenue..............................     1,863      426    1,834
                                                   ---------  -------  -------
      Net cash used in operating activities.......    (4,771)  (4,418)  (3,257)
                                                   ---------  -------  -------
Cash flows from investing activities:
  Proceeds from sales of short-term investments...    13,210      --       --
  Purchases of short-term investments.............   (36,491)     --       --
  Purchases of property and equipment.............    (1,957)  (1,497)    (455)
  Cash received in acquisition of Cadabra.........     3,704      --       --
                                                   ---------  -------  -------
      Net cash used in investing activities.......   (21,534)  (1,497)    (455)
                                                   ---------  -------  -------
Cash flows from financing activities:
  Proceeds from initial public offering...........    81,163      --       --
  Repayment of notes payable......................   (40,000)     --       --
  Proceeds from exercise of common stock options..     1,518    1,018       56
  Proceeds from issuance of preferred stock.......       --    13,425    7,925
  Proceeds from employee stock purchase plan......       982      --       --
  Repurchase of common stock......................      (237)     (20)      (2)
  Repayment of notes receivable for preferred and
   common stock...................................        37        5       50
  Proceeds from related party loan................       --       --       250
  Repayment of related party loan.................       --       --      (250)
                                                   ---------  -------  -------
      Net cash provided by financing activities...    43,463   14,428    8,029
                                                   ---------  -------  -------
Effect of foreign currency translation on cash
 flows............................................       (37)     --       --
                                                   ---------  -------  -------
Net increase in cash and cash equivalents.........    17,121    8,513    4,317
Cash and cash equivalents at beginning of year....    13,486    4,973      656
                                                   ---------  -------  -------
Cash and cash equivalents at end of year.......... $  30,607  $13,486  $ 4,973
                                                   =========  =======  =======
Supplemental cash flow disclosures:
  Stockholder notes receivable exchanged for
   common stock or preferred stock................ $   3,772  $   315  $     5
  Interest paid...................................       893      --       --
  Deemed dividend on preferred stock..............       778      --       --
  Stock and options issued in connection with
   acquisitions...................................   153,348      --       --
</TABLE>

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

                                       42
<PAGE>

                         NUMERICAL TECHNOLOGIES, INC.

                  NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

NOTE 1--Business and Summary of Significant Accounting Policies

Nature of business

   Numerical Technologies, Inc. (the "Company") designs and develops
proprietary technologies and software products that enable the design and
manufacture of integrated circuits with subwavelength feature sizes. The
Company markets and sells its products and services to semiconductor
manufacturers, resellers and original equipment manufacturers primarily in
North America, Europe, and Asia.

Reincorporation

   In January 2000, the Company's Board of Directors authorized the
reincorporation of the Company in the State of Delaware. As a result of the
reincorporation, the Company is authorized to issue 100,000,000 shares of
$0.0001 par value common stock and 5,000,000 shares of $0.0001 par value
preferred stock.

Stock Split

   In January 2000, the Company's Board of Directors approved a three-for-two
share split of the Company's preferred stock and common stock. The share split
was effective upon the closing of the Company's April 2000 initial public
offering. All share and per share information have been adjusted to reflect
the reincorporation and the share split.

Initial Public Offering

   In April 2000, the Company completed its initial public offering (IPO) of
6,364,000 shares of common stock (including 830,000 shares purchased by the
underwriters over-allotment option) at $14.00 per share. Net proceeds totaled
$81.2 million, net of issuance costs. At the closing of the offering, all of
the then issued and outstanding shares of preferred stock were converted into
shares of common stock.

Principles of consolidation

   The consolidated financial statements include the accounts of the Company
and its subsidiaries. All intercompany accounts and transactions have been
eliminated in consolidation.

Certain risks and concentrations

   Financial instruments that potentially subject the Company to a
concentration of credit risk consist of cash, cash equivalents, investments
and accounts receivable. Cash, cash equivalents and investments are deposited
with financial institutions that management believes to be creditworthy.

   The Company performs ongoing credit evaluations of its customers' financial
condition and, generally, requires no collateral from its customers. The
Company had amounts receivable from two customers representing 23% of accounts
receivable and from one customer representing 86% at December 31, 2000 and
1999, respectively. The Company has experienced no losses and does not
consider allowance for doubtful accounts necessary at December 31, 2000 and
1999.

   In 2000, one customer accounted for 24% of total revenue. In 1999, three
customers accounted for 23%, 17%, and 16% of total revenue. In 1998, three
customers accounted for 52%, 37% and 14% of total revenue.

                                      43
<PAGE>

                         NUMERICAL TECHNOLOGIES, INC.

            NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(Continued)


Use of estimates

   The preparation of financial statements in conformity with generally
accepted accounting principles requires management to make estimates and
assumptions that affect the 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 revenue and expenses during the
reporting period. Actual results could differ from those estimates.

Financial instruments

   The carrying amount of the Company's financial instruments, including cash
and cash equivalents, short- term investments, accounts receivable, accounts
payable and accrued expenses, approximate fair value due to their short
maturities.

   In June 1998, the FASB issued Statement of Financial Accounting Standards
No. 133, or SFAS 133, Accounting for Derivative Instruments and Hedging
Activities. SFAS 133 establishes new standards of accounting and reporting for
derivative instruments and hedging activities. SFAS 133 requires that all
derivatives be recognized at fair value in the statement of financial
position, and that the corresponding gains or losses be reported either in the
statement of operations or as a component of comprehensive income, depending
on the type of hedging relationship that exists. The effective date for SFAS
No. 133 for the Company is January 1, 2001. At the current time, the Company
does not have any derivative instruments, nor has it engaged in hedging
activities to date.

Cash, cash equivalents and short-term investments

   Management determines the appropriate classification of marketable
securities at the time of purchase and evaluates such designation as of each
balance sheet date. To date, all marketable securities have had contractual
maturities of one year or less and have been classified as held-to-maturity.
Interest, dividends and realized gains and losses are included in interest
income. Realized gains and losses are recognized based on the specific
identification method.

   The Company considers all highly liquid investments with maturities of
three months or less at the time of purchase and money market funds to be cash
equivalents.

Property and equipment

   Property and equipment are stated at cost less accumulated depreciation.
Property and equipment are depreciated on a straight-line basis over their
estimated useful lives of 2 to 5 years. When assets are sold or retired, the
cost and related accumulated depreciation is removed from the accounts and the
resulting gains or losses are included in the statement of operations.
Expenditures for repair and maintenance are charged to expense as incurred.

Goodwill And Other Intangible Assets

   Intangible assets represent purchased intangible assets and the excess
acquisition cost over the fair value of tangible and identified intangible net
assets of businesses acquired (goodwill). Purchased intangible assets include
developed technology, trade names, assembled workforces, covenants-not-to-
compete and customer bases. Intangible assets are being amortized using the
straight-line method over estimated useful lives ranging from 2 to 5 years.

                                      44
<PAGE>

                         NUMERICAL TECHNOLOGIES, INC.

            NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(Continued)


Long-lived assets

   Long-lived assets, such as goodwill, other intangibles and property and
equipment are periodically evaluated for impairment when events or changes in
circumstances indicate that the carrying amount of the assets may not be
recoverable through the estimated undiscounted future cash flows resulting
from the use of the assets. When any such impairment exists, the related
assets will be written down to fair value. No impairment losses were incurred
in the periods presented.

Software development costs

   Software development costs incurred in the research and development of new
products and enhancements to existing products are charged to expense as
incurred. Software development costs are capitalized after technological
feasibility has been established. The period between achievement of
technological feasibility, which the Company defines as the establishment of a
working model, until the general availability of such software to customers,
has been short, and software development costs qualifying for capitalization
have been insignificant. Accordingly, the Company has not capitalized any
software development costs since its inception.

Income taxes

   Deferred income tax assets and liabilities are computed annually for
differences between the financial statement and tax bases of assets and
liabilities that will result in taxable or deductible amounts in the future
based on enacted tax laws and rates applicable to the periods in which the
differences are expected to affect taxable income. Valuation allowances are
established when necessary to reduce deferred tax assets to the amount
expected to be realized.

Revenue recognition

   The Company recognizes revenue in accordance with the provisions of
Statement of Position 97-2 ("SOP 97-2"), "Software Revenue Recognition", as
amended by SOP 98-4 and 98-9. The Company's revenue is derived from
intellectual property, software licenses and maintenance and technical
services. Revenue is recognized for the various contract elements based upon
vendor-specific objective evidence ("VSOE") of fair value of each element. If
VSOE of fair value does not exist but postcontract customer services ("PCS")
is the only undelivered element, the Company recognizes the fee including up-
front payments for licenses, under the arrangement ratably over the
contractual PCS period. To date, the Company has not established VSOE for the
service or annual maintenance elements of many of its products. License
revenue, including up-front fees, is recognized when persuasive evidence of an
arrangement exists, the product has been delivered, no significant post-
delivery obligations remain, the license fee is fixed or determinable and
collection of the fee is probable. Revenue for technical services is
recognized as the services are performed or on a percentage-of-completion
method of accounting, depending on the nature of the project. Under the
percentage-of-completion method, revenue recognized is that portion of the
total contract price equal to the ratio of costs expended to date to the
anticipated final total costs, based on current estimates of the costs to
complete the project. If the total estimated costs to complete a project
exceed the total contract amount, indicating a loss, the entire anticipated
loss would be recognized currently. Maintenance services are typically priced
based on a percentage of the license fee and have a one-year term, renewable
annually. Services provided to customers under maintenance agreements include
technical product support and unspecified product upgrades. Deferred revenues
includes billings in excess of recognized revenue and payments received in
advance of revenue recognition.

   In December 1999, the Securities and Exchange Commission issued Staff
Accounting Bulletin: No. 101 ("SAB 101") "Revenue Recognition in Financial
Statements". SAB 101 summarizes certain of the Staff's views in applying
generally accepted accounting principles to revenue recognition in financial
statements. We

                                      45
<PAGE>

                         NUMERICAL TECHNOLOGIES, INC.

            NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(Continued)

implemented the guidelines of SAB 101 effective January 1, 2000. The adoption
of SAB 101 did not have a material effect on our consolidated financial
statements.

Stock-based compensation

   The Company accounts for its stock-based compensation in accordance with
the provisions of Accounting Principles Board Opinion No. 25 ("APB No. 25"),
"Accounting for Stock Issued to Employees" and complies with the disclosure
provisions of Statement of Financial Accounting Standard No. 123 ("SFAS No.
123"). Deferred compensation recognized under APB No. 25 is amortized over the
vesting period on an accelerated basis using the model presented in Financial
Accounting Standards Board Interpretation No. 28 ("FIN No. 28"), "Accounting
for Stock Appreciation Rights and Other Variable Stock Option or Award Plans".
Accordingly, the percentages of the deferred compensation amortized in the
first, second, third and fourth years following the option grant date are
approximately 52%, 27%, 15% and 6%, respectively, for options with a four-year
vesting period.

   In March 2000, the Financial Accounting Statements Board issued
Interpretation No. 44 ("FIN No. 44") "Accounting for Certain Transactions
involving Stock Compensation, an interpretation of APB Opinion No. 25." FIN
No. 44 clarifies the application of Opinion 25 for (a) the definition of
employee for purposes of applying Opinion 25, (b) the criteria for determining
whether a plan qualifies as a noncompensatory plan, (c) the accounting
consequences of various modifications to terms of a previously fixed stock
option or award, and (d) the accounting for an exchange of stock compensation
awards in a business combination. FIN 44 is effective July 1, 2000, but
certain conclusions cover specific events that occur after either December 15,
1998, or January 12, 2000. The adoption of provisions of FIN No. 44 did not
have a material effect on the Company's Consolidated Financial statements.

Net loss per share

   The basic net loss per share is computed by dividing the net loss
attributable to common stockholders for the period by the weighted average
number of the common shares outstanding during the period. The diluted net
loss per share is the same as the basic net loss per share for the periods
presented because common equivalent shares, composed of common shares subject
to repurchase and common shares issuable upon the exercise of stock options
and warrants and upon conversion of convertible preferred shares, are only
considered when their effect would be dilutive. In 2000, 1999 and 1998,
8,125,000, 11,976,000, and 7,580,000, respectively, antidilutive securities,
including options, warrants and convertible preferred stock, were excluded
from the net loss per share computation.

Comprehensive income

   The Company adopted Statement of Financial Accounting Standards No. 130,
("FAS 130") "Reporting Comprehensive Income". FAS 130 establishes standards
for reporting comprehensive income and its components in a full set of
general-purpose financial statements. Comprehensive income includes net
earnings and other comprehensive income. Other comprehensive income includes
accumulated translation adjustments. Total comprehensive income and the
components of accumulated other comprehensive income are presented in the
accompanying Consolidated Statements of Stockholders' Equity and Comprehensive
Loss. Total accumulated other comprehensive income is displayed as a separate
component of stockholders' equity in the accompanying Consolidated Balance
Sheets.

                                      46
<PAGE>

                         NUMERICAL TECHNOLOGIES, INC.

            NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(Continued)


NOTE 2--Acquisitions

   On January 1, 2000, the Company acquired Transcription Enterprises Ltd.
("Transcription"), a company incorporated in California. Under the terms of
the acquisition, the Company issued approximately 3,810,000 shares of Series E
Convertible Preferred Stock and $40.0 million in notes payable for all of the
outstanding stock of Transcription. The total purchase price was approximately
$86.0 million, including acquisition costs of approximately $250,000. The
transaction was accounted for under the purchase method of accounting.

   On October 27, 2000, the Company acquired Cadabra Design Automation Inc.
(Cadabra), a limited liability company incorporated in Nova Scotia, Canada.
Under the terms of the acquisition, the Company issued approximately
2,671,000 shares and 528,000 options to purchase the Company's common stock in
exchange for all of the outstanding stock and as replacement of all the
outstanding options of Cadabra. The total purchase price was approximately
$110.6 million, including acquisition costs of approximately $3.0 million. The
acquisition was accounted for using the purchase method of accounting.

   The allocations of the purchase prices are as follows (in thousands, except
useful life):

<TABLE>
<CAPTION>
                                                                         Useful
                                                                         Life in
                                                  Transcription Cadabra   Years
                                                  ------------- -------- -------
   <S>                                            <C>           <C>      <C>
   Net tangible assets...........................    $   244    $  1,964   N/A
   In process research and development...........        300       1,630   N/A
   Developed technology..........................      7,400         660   4-5
   Customer base.................................     14,300       5,040   4-5
   Covenants not to compete......................      2,700       2,290   2-3
   Work force....................................      1,500       1,800   2-4
   Trade name....................................        200         --      5
   Deferred tax liabilities, net.................     (6,454)        --    N/A
   Goodwill......................................     65,780      97,244   4-5
                                                     -------    --------
     Total consideration.........................     85,970     110,628
   Deferred stock compensation...................        --       12,594
                                                     -------    --------
     Total.......................................    $85,970    $123,222
                                                     =======    ========
</TABLE>

   The purchase price was allocated to the identifiable assets acquired and
the liabilities assumed based upon the fair market value on the acquisition
date. The value assigned to developed technology and acquired in-process
research and development was determined through interviews, analysis of data
provided by management of the acquired company concerning developmental
products, their stage of development, the time and resources needed to
complete them, if applicable, their expected income generating ability, target
markets and associated risks. The Income Approach, which includes an analysis
of the markets, cash flows and risks associated with achieving such cash
flows, was the primary technique utilized in valuing the developed technology
and in-process research and development. Because the in-process technology had
not reached the stage of technological feasibility at the acquisition date and
had no alternative future use, the amount was immediately charged to
operations. The amounts allocated to indentifiable intangible assets are
amortized over their estimated useful lifes. The excess amount of the purchase
price over the fair market value of the identifiable assets acquired is
accounted for as goodwill and is being amortized over the estimated useful
life of four to five years. The valuation for the intangible assets has been
determined using management's assumptions and the report from an independent
appraiser.


                                      47
<PAGE>

                         NUMERICAL TECHNOLOGIES, INC.

            NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(Continued)


   The value of deferred compensation of approximately $12.6 million was
derived using the guidance of FIN No. 44, the intrinsic value of unvested
options and employment escrow shares, and the remaining vesting periods of
unvested options and the employment escrow shares. The deferred compensation
is being amortized on a graded basis using the multiple options method over
the remaining estimated lives of the options and the escrow period of the
employment escrow shares.

   The projects identified as in-process technology are those that were
underway at the time of the acquisitions and at the date of the acquisition
required additional effort to establish technological feasibility. These
projects have identifiable technological risk factors which indicate that even
though successful completion is expected, it is not assured. If an identified
project is not successfully completed, there is no alternative future use for
the project and the expected future income will not be realized.

 Unaudited Pro Forma Information

   The following unaudited pro forma summary presents the consolidated results
of operations of the Company, excluding charges for acquired in-process
research and development, as if the acquisitions of Transcription and Cadabra
had occurred on January 1, 1999 and does not purport to be indicative of what
would have occurred had the acquisitions been made as of January 1, 1999 or of
results which may occur in the future.

<TABLE>
<CAPTION>
                                                               Year Ended
                                                              December 31,
                                                            ------------------
                                                              2000      1999
                                                            --------  --------
                                                             (In thousands,
                                                            except per share
                                                                amounts)
   <S>                                                      <C>       <C>
   Net sales............................................... $ 26,829  $ 23,142
   Net loss allocable to common stockholders............... $(83,430) $(57,754)
   Loss per share.......................................... $  (3.54) $  (6.30)
</TABLE>

NOTE 3--Balance Sheet Detail

<TABLE>
<CAPTION>
                                                                 December 31,
                                                                ---------------
                                                                 2000     1999
                                                                -------  ------
   <S>                                                          <C>      <C>
   Prepaid and other current assets:
     Employee and officer notes receivable..................... $ 1,367  $   58
     Deferred tax asset........................................   1,250     --
     Other prepaids and current assets.........................     560     336
                                                                -------  ------
                                                                $ 3,177  $  394
                                                                =======  ======
   Property and equipment:
     Computer equipment........................................ $ 3,268  $1,362
     Furniture and equipment...................................   1,034     490
     Computer software.........................................     537     234
                                                                -------  ------
                                                                  4,839   2,086
   Less accumulated depreciation...............................  (1,630)   (473)
                                                                -------  ------
                                                                $ 3,209  $1,613
                                                                =======  ======
   Accrued expenses:
     Payroll and related expenses.............................. $ 3,293  $1,204
     Other accrued expenses....................................   1,315     741
                                                                -------  ------
                                                                $ 4,608  $1,945
                                                                =======  ======
</TABLE>

                                      48
<PAGE>

                         NUMERICAL TECHNOLOGIES, INC.

            NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(Continued)


NOTE 4--Commitments

Operating leases

   The Company leases its facilities, primarily in California and Canada,
under noncancelable operating leases which expire at various dates through
January 2006. The lease for the Company's San Jose, California headquarters
contains a three-year renewal option and requires a security deposit of
$272,000 in the form of cash and a letter of credit. The letter of credit is
secured by a $204,000 certificate of deposit, which was considered restricted
cash at December 31, 2000. The terms of certain of the Company's leases
provide for rental payments on a graduated scale. The Company recognizes rent
expense on a straight-line basis over the periods, and has accrued for rent
expense incurred but not paid. The Company is responsible for maintenance,
insurance and taxes under its leases.

   Minimum lease payments as of December 31, 2000 for noncancelable operating
leases are as follows:

<TABLE>
<CAPTION>
   Year                                                           Lease Payments
   ----                                                           --------------
                                                                  (in thousands)
   <S>                                                            <C>
   2001..........................................................     $1,452
   2002..........................................................      1,317
   2003..........................................................      1,338
   2004..........................................................      1,041
   2005..........................................................        189
   Thereafter....................................................         16
                                                                      ------
                                                                      $5,353
                                                                      ======
</TABLE>

   Rent expense was $963,000, $474,000 and $229,000 for 2000, 1999 and 1998,
respectively.

NOTE 5--Capital Stock

Preferred Stock

   Effective April 2000, the stockholders of the Company approved an amendment
to the Company's certificate of incorporation authorizing 5,000,000 shares of
preferred stock. The Board of Directors has the authority to issue the
preferred stock in one or more series and to fix its rights, preferences,
privileges, and restrictions, including dividend rights, dividend rates,
conversion rights, voting rights, terms of redemption, redemption prices,
liquidation preferences, and the number of shares constituting any series or
designation of the series.

Exchangeable Shares of Cadabra Design Automation, Inc.

   On October 27, 2000, in connection with the acquisition of Cadabra, the
Company caused to be issued 2,641,000 exchangeable shares in the capital of
Cadabra Design Automation Inc. (Numerical Canada), a newly-formed, wholly-
owned subsidiary of the Company. Each holder of such exchangeable shares has
the right, at any time, to exchange such shares on a one-to-one basis into
common stock of the Company. All outstanding exchangeable shares will be
automatically converted into shares of common stock of the Company no later
than October 27, 2005. The exchangeable shares have voting rights and
characteristics equivalent in economic effect to the rights of the holders of
common stock of the Company.

Stock Option Plans

   On January 24, 2000, the Company approved the 2000 Stock Option/Stock
Issuance Plan (the "2000 Plan"), under which all remaining shares available
for grant under the Company's 1997 Stock Option Plan (the "1997

                                      49
<PAGE>

                         NUMERICAL TECHNOLOGIES, INC.

            NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(Continued)

Plan") and 3,000,000 additional shares of the Company's common stock were
authorized for issuance. The 2000 Plan is intended to serve as a successor to
the 1997 Plan. As of December 31, 2000, the Company had reserved approximately
653,000 shares of common stock for future issuance to employees and directors
under the 2000 Plan. At December 31, 2000, no options were available for
further grant under the 1997 Plan and the other various plans the Company
assumed during the year as a result of the Cadabra acquisition.

   Under the 1997 Plan and the 2000 Plan, the Board of Directors has the
authority to determine the type of option and the number of shares subject to
option. The exercise price is generally equal to fair value of the underlining
stock at the date of grant. Options generally become exercisable over a four-
year period and, if not exercised, expire ten years from the date of grant.

   Options granted under the 1997 Plan were eligible for exercise in whole or
in part prior to vesting. Certain options granted under the 2000 Plan, subject
to approval by the Board of Directors, are also eligible for exercise in whole
or in part prior to vesting. Exercised but unvested shares are subject to
repurchase by the Company at the initial exercise price. At December 31, 2000,
2,985,000 shares were subject to repurchase at an average price of $1.75.

   Under the 2000 Plan, the Board of Directors has the discretion to grant
options to nonemployee directors. Each nonemployee director who first becomes
a Board member after the date of the initial public offering may be granted
options for up to 30,000 shares. In addition, each nonemployee director may be
granted options for up to 7,500 shares annually.

   The following table summarizes option activity through December 31, 2000:

<TABLE>
<CAPTION>
                                                        Outstanding Shares
                                                   -----------------------------
                                          Shares   Number     Price     Average
                                         Available   of        Per      Exercise
                                         for Grant Shares     Share      Price
                                         --------- ------  ------------ --------
                                            (In thousands, except per share
                                                        amounts)
<S>                                      <C>       <C>     <C>          <C>
Balances at December 31, 1997...........     202       57     $0.07      $0.07
Increase in authorized shares...........   1,591
Options granted.........................  (1,236)   1,236  $0.03-$ 0.17  $0.17
Options exercised.......................             (825) $0.03-$ 0.17  $0.33
Shares repurchased......................      35           $0.03-$ 0.17  $0.05
Options cancelled.......................      47      (47)    $0.33      $0.08
                                          ------   ------
Balances at December 31, 1998...........     639      421     $0.33      $0.33
Increase in authorized shares...........   3,498
Options granted.........................  (3,019)   3,019  $0.33-$ 1.00  $0.81
Options exercised.......................           (2,001) $0.03-$ 1.00  $0.67
Shares repurchased......................     158           $0.03-$ 0.33  $0.12
Options cancelled.......................      31      (31)    $0.33      $0.33
                                          ------   ------
Balances at December 31, 1999...........   1,307    1,408  $0.33-$ 1.00  $0.88
Increase in authorized shares...........   3,528
Options granted.........................  (4,811)   4,811  $0.00-$44.88  $7.75
Options exercised.......................           (2,411) $0.33-$12.00  $2.20
Shares repurchased......................     288           $0.07-$ 1.00  $0.82
Options cancelled.......................     341     (353) $0.33-$30.38  $2.60
                                          ------   ------
Balance at December 31, 2000............     653    3,455  $0.00-$44.88  $9.34
                                          ======   ======
</TABLE>

                                      50
<PAGE>

                         NUMERICAL TECHNOLOGIES, INC.

            NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(Continued)


   The following table summarizes information about options outstanding at
December 31, 2000:

<TABLE>
<CAPTION>
                                  Options Outstanding          Options Exercisable
                         ------------------------------------- --------------------
                                     Weighted Average Weighted             Weighted
                                        Remaining     Average              Average
                           Number    Contractual Life Exercise   Number    Exercise
Range of Exercise Price  Outstanding    (In Years)     Price   Exercisable  Price
-----------------------  ----------- ---------------- -------- ----------- --------
                                  (In thousands, except per share amounts)
<S>                      <C>         <C>              <C>      <C>         <C>
$ 0.00-$ 1.00...........      765          9.07        $ 0.67       765     $ 0.67
$ 1.24-$ 4.77...........      319          8.10          2.72       315       2.69
$ 7.15-$ 8.03...........      351          8.44          7.81        79       7.80
$12.00..................      396          9.22         12.00         2      12.00
$12.50..................    1,481          9.93         12.50       --         --
$19.08-$44.88...........      143          9.56         34.19       --         --
                            -----          ----        ------     -----     ------
                            3,455          9.32        $ 9.34     1,161     $ 1.73
                            =====                                 =====
</TABLE>

2000 Employee Stock Purchase Plan

   On January 24, 2000, the Company approved the Company's 2000 Employee Stock
Purchase Plan (the "ESPP") and authorized 300,000 shares to be issued under
the ESPP. Under the ESPP, employees are granted the right to purchase shares
of common stock at a price per share that is 85% of the lesser of: the fair
market value of the shares at (i) the beginning of a rolling twenty-four month
offering period, or (ii) the end of each semi-annual purchase period. The ESPP
was effective upon the effective date of the Company's April 2000 initial
public offering.

Deferred Stock Compensation

   During 2000, 1999 and 1998, the Company generally issued stock options
under the 1997 Plan and the 2000 Plan at exercise prices deemed by the Board
of Directors at the date of grant to be the fair value. In anticipation of the
Company's IPO, the Company subsequently determined that, for financial
statement purposes, the estimated value of its common stock for certain stock
options granted prior to the IPO was in excess of the exercise prices.
Accordingly, the Company has recorded deferred compensation for the difference
between the purchase price of common stock issued to employees under stock
options and the fair market value of the Company's common stock at the date of
grant. This deferred compensation is amortized to expense over the period
during which the Company's right to repurchase the common stock lapses or
options become exercisable, generally four years. At December 31, 2000, the
Company had recorded deferred compensation related to these options in the
total amount, net of cancellations, of $37.6 million.

   In conjunction with the acquisition of Cadabra in October 2000, the Company
issued stock options to officers of Cadabra to purchase 200,000 shares of the
Company's common stock at a value that was less than market value. In
addition, the Company assumed the existing option plans of Cadabra and issued
528,000 options as replacements for all existing options under the assumed
plans. The Company recognized deferred compensation of $6.0 million associated
with these options which is being amortized over the vesting periods of these
options.

   The Company issued 528,000 shares of the Company's common stock to officers
of Cadabra in connection with the October 2000 acquisition which are being
held in employment escrow accounts. These shares will be released in
accordance with a three-year vesting schedule, contingent upon the continued
employment of the officers. Accordingly, the Company has recognized deferred
compensation of approximately $10.6 million which is being amortized over the
three-year vesting periods of the shares. No such shares had vested as of
December 31, 2000.

                                      51
<PAGE>

                         NUMERICAL TECHNOLOGIES, INC.

            NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(Continued)


   The Company had charges for amortization of deferred compensation related
to equity transactions of $18,766,000, $3,990,000 and $862,000 during 2000,
1999 and 1998, respectively.

Pro forma stock-based compensation

   Pro forma information regarding net income and earnings per share is
required by SFAS No. 123. This information is required to be determined as if
the Company had accounted for its employee stock under the fair value method
of that statement. The fair value of options granted in 2000, 1999, and 1998
reported below has been estimated at the date of grant using a Black-Scholes
option pricing model with the following weighted average assumptions:

<TABLE>
<CAPTION>
                                                                         Stock
                                                      Stock Option      Purchase
                                                          Plans           Plan
                                                     -----------------  --------
                                                     2000   1999  1998    2000
                                                     -----  ----  ----  --------
   <S>                                               <C>    <C>   <C>   <C>
   Risk-free interest rate..........................   6.0% 5.8%  5.5%     5.0%
   Expected life (years)............................     5    5     5      0.5
   Volatility Factor................................ 222.5% 0.0%  0.0%   222.5%
   Expected Dividend Yield..........................   0.0% 0.0%  0.0%     0.0%
</TABLE>

   The Black-Scholes option valuation 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 valuation models require the
input of highly subjective assumptions, including the expected stock price
volatility. Because the Company's options 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 the
opinion of management, the existing models do not necessarily provide a
reliable single measure of the fair value of its options. A total of
approximately 4,811,000 options, including options assumed through
acquisitions, were granted during 2000 with a weighted-average exercise price
and weighted-average fair value of $7.75 and $14.06, respectively. The
weighted-average exercise price and weighted-average fair value of stock
options granted during 1999 was $.81 and $11.85 per share, respectively. The
weighted average exercise price and weighted average fair value of stock
options granted during 1998 was $0.17 and $3.45, respectively.

   Had compensation expense for the stock option and stock purchase plans been
determined based on the fair value at the grant date for options granted in
2000, 1999 and 1998 consistent with the provisions of SFAS No. 123, the
Company's net loss and net loss per share would have been increased to the pro
forma amounts indicated below:

<TABLE>
<CAPTION>
                                                    Year Ended December 31,
                                                    --------------------------
                                                      2000     1999     1998
                                                    --------  -------  -------
                                                     (in thousands, except
                                                        per share data)
   <S>                                              <C>       <C>      <C>
   Net loss allocable to common stockholders
     As reported................................... $(49,589) $(8,828) $(6,551)
                                                    ========  =======  =======
     Pro forma..................................... $(62,235) $(8,946) $(6,558)
                                                    ========  =======  =======
   Net loss per common share, basic and diluted
     As reported................................... $  (2.27) $ (1.26) $ (0.89)
                                                    ========  =======  =======
     Pro forma..................................... $  (2.85) $ (1.26) $ (0.89)
                                                    ========  =======  =======
</TABLE>

   The increases in the pro forma amounts above reflect the incremental fair
value over the intrinsic value recognized as part of deferred stock
compensation.

                                      52
<PAGE>

                         NUMERICAL TECHNOLOGIES, INC.

            NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(Continued)


 Warrants

   In June 1998, in connection with the issuance of Series C preferred stock,
the Company issued immediately exercisable warrants to purchase 150,000 shares
of the Company's Series C preferred stock at an exercise price of $3.26 per
share. The warrants were exercised and the preferred stock exchanged for
common stock as part of the April 2000 initial public offering. As a result,
$778,000 in deemed dividends on the preferred stock conversion was incurred in
2000.

 Notes receivable from Stockholders

   During 2000 and 1999, officers of the Company exercised stock options in
exchange for notes receivable totaling $3,772,000 and $315,000, respectively.
The notes, which are secured by the underlying shares of common stock, accrue
interest at rates ranging from 4.9% to 8.0% per annum, and are payable, with
principal, in 2001 through 2002.

NOTE 6--Income Taxes

   The provision for income taxes consisted of (in thousands):

<TABLE>
<CAPTION>
                                                 Year Ended December 31,
                                                 ---------------------------
                                                  2000      1999      1998
                                                 -------   -------   -------
   <S>                                           <C>       <C>       <C>
   State:
     Current.................................... $     2   $    --   $    --
   Foreign:
     Current....................................     251        --        --
                                                 -------   -------   -------
   Total provision for income taxes............. $   253   $    --   $    --
                                                 =======   =======   =======

   The provision for income taxes is different than the amount computed using
the applicable statutory federal income tax rate with the differences for the
years summarized below:

<CAPTION>
                                                 Year Ended December 31,
                                                 ---------------------------
                                                  2000      1999      1998
                                                 -------   -------   -------
   <S>                                           <C>       <C>       <C>
   Income taxes (benefit) computed at federal
    statutory rate .............................   (34.0)%   (34.0)%   (34.0)%
   State taxes, net of federal benefit..........    (1.2)     (3.2)     (3.2)
   Non-deductible acquired in-process research
    and development.............................     1.3       --        --
   Non-deductible amortization of goodwill......    11.7       --        --
   Non-deductible amortization of deferred
    compensation................................    13.1      15.4       4.5
   No benefit from net losses of foreign
    subsidiaries................................     0.8       --        --
   Tax credits..................................    (2.4)     (1.7)     (0.8)
   Change in valuation allowance................     8.0      28.4      30.5
   Other........................................     3.2      (4.9)      3.0
                                                 -------   -------   -------
   Income tax expense...........................     0.5 %     0.0 %     0.0 %
                                                 =======   =======   =======
</TABLE>

                                      53
<PAGE>

                         NUMERICAL TECHNOLOGIES, INC.

            NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(Continued)


   The components of the net deferred tax assets and liabilities are presented
below (in thousands):

<TABLE>
<CAPTION>
                                                         December 31,
                                                   --------------------------
                                                     2000     1999     1998
                                                   --------  -------  -------
   <S>                                             <C>       <C>      <C>
   Deferred tax assets:
   Net operating loss carryforwards............... $  5,183  $ 2,675  $ 1,323
   Research and development tax credit
    carryforwards.................................    1,625      382      222
   Foreign tax credit carryover...................      233
   Capitalized research and development costs.....      857      --       --
   Accruals.......................................      310    1,444      450
                                                   --------  -------  -------
   Total deferred tax assets......................    8,208    4,501    1,995
   Valuation allowance............................   (2,945)  (4,501)  (1,995)
                                                   --------  -------  -------
   Net deferred tax assets........................    5,263      --       --
                                                   --------  -------  -------
   Deferred tax liabilities:
   Acquisition related items......................  (11,717)     --       --
                                                   --------  -------  -------
   Total deferred tax liabilities.................  (11,717)     --       --
                                                   --------  -------  -------
     Total net deferred tax liabilities........... $ (6,454) $   --   $   --
                                                   ========  =======  =======
</TABLE>

   The Company has established a valuation allowance against certain of its
deferred tax assets due to the uncertainty surrounding the realization of such
assets. Annually, management evaluates the recoverability of the deferred tax
assets and the level of the valuation allowance. At such time as it is
determined that it is more likely than not that deferred tax assets are
realizable the valuation allowance is reduced.

   In 2000, the Company completed the acquisitions of Transcription and
Cadabra. These acquisitions were accounted for under the purchase method of
accounting. The purchase price of these companies was in excess of the
carryover tax basis of the assets acquired, resulting in the recognition of a
deferred tax liability. Since the Company may elect to file consolidated
returns on an ongoing basis, the future taxable differences may be offset by
the Company's future deductible differences, primarily net operating loss
carryforwards. As a result, a valuation allowance was no longer required
against certain of the Company's deferred tax assets and accordingly was
released, reducing the goodwill resulting from the acquisitions.

   The Company had the following carryforwards and credits at December 31,
2000:

<TABLE>
<CAPTION>
                                                  Expiration Date     Amount
                                                  --------------- --------------
                                                                  (in thousands)
   <S>                                            <C>             <C>
   Net operating loss carryforwards
     Federal.....................................    2010-2020       $11,265
     State.......................................    2003-2005         5,505
   Research and development credits
     Federal.....................................         2005       $   845
     State.......................................   Indefinite           528
</TABLE>

   The Tax Reform Act of 1986 limits the use of net operating loss and tax
credit carryforwards in certain situations where changes occur in the stock
ownership. In the event the Company has a change in ownership, utilization of
the carryforwards could be restricted.

                                      54
<PAGE>

                         NUMERICAL TECHNOLOGIES, INC.

            NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(Continued)


NOTE 7--Related Party Transactions

   In November 2000, a loan was granted to an officer and stockholder of the
Company for $1.1 million. The loan, which is secured by the assets of the
officer and stockholder, is non-interest bearing and is payable in full in May
2001.

   During 1998, the Chairman and Chief Executive Officer of the Company loaned
the Company $250,000 for a period of two months at an annual interest rate of
8%. The loan was repaid in 1998.

NOTE 8--Employee Benefit Plan

   The Company sponsors the Numerical Technologies, Inc. 401(k) Retirement
Plan (the "401(k) Plan"). The 401(k) Plan provides for tax deferred automatic
salary deductions. Under the terms of the 401(k) Plan, employees over the age
of 21 are eligible to participate after completing three months of employment.
The Company is permitted to make contributions to the 401(k) Plan as
determined by the Board of Directors. No Company contributions were made to
the 401(k) Plan in 2000, 1999 or 1998.

NOTE 9--Operating Segments

   The Company has adopted SFAS No. 131, "Disclosures about Segments of an
Enterprise and Related Information." This statement requires enterprises to
report information about operating segments in annual financial statements and
selected information about reportable segments in interim financial reports.
It also establishes standards for related disclosures about products,
geographic areas and major customers. The method for determining what
information to report is based upon the "management" approach, which requires
the Company to report certain financial information related to continuing
operations that is provided to the Company's chief operating decision-maker
for the purpose of evaluating financial performance and resource allocation.
The Company's chief operating decision-maker reviews revenue by both geography
and customer. The Company is not organized into business units nor does it
capture expenses or allocate resources based on segmentation of its business.
Therefore, the Company believes that it operates in a single segment.

   The following is a summary of the Company's revenue attributed to the
geographic regions in which the technology and services are delivered:

<TABLE>
<CAPTION>
                                                            Year Ended December
                                                                    31,
                                                            -------------------
                                                             2000    1999  1998
                                                            ------- ------ ----
   <S>                                                      <C>     <C>    <C>
   North America (primarily the United States)............. $13,321 $4,300 $626
   Japan...................................................   4,250    516  105
   Asia, excluding Japan...................................   3,539    675  --
   Europe..................................................   1,991      1    5
   Other...................................................     239    --   --
                                                            ------- ------ ----
     Total................................................. $23,340 $5,492 $736
                                                            ======= ====== ====
</TABLE>

   The Company has no material long-lived assets outside North America in any
of the years presented.

                                      55
<PAGE>

NOTE 10--Quarterly Summary (Unaudited)

<TABLE>
<CAPTION>
                                                       Quarters Ended
                          ------------------------------------------------------------------------------
                          March 31, June 30,  Sept. 30, Dec. 31  March 31,  June 30,   Sept.    Dec. 31,
                            1999      1999      1999     1999      2000       2000    30, 2000    2000
                          --------- --------  --------- -------  ---------  --------  --------  --------
                                            (In thousands, except per share data)
<S>                       <C>       <C>       <C>       <C>      <C>        <C>       <C>       <C>
Statements of Operations
 Data:
Revenue.................   $1,892   $ 1,089    $   635  $ 1,876  $  3,456   $  4,742  $  6,636  $  8,506
Cost of revenue.........       22        41         70      174       334        296       591       946
Research and
 development............      743       924      1,309    1,651     2,592      3,257     3,386     3,392
Sales and marketing.....      929       886      1,014    1,334     1,798      2,134     2,432     2,797
General and
 administrative.........      187       251        322      506       885      1,204     1,277     1,128
Depreciation and
 amortization...........       70        69        109       92     4,712      4,748     4,811    10,549
Acquired in-process
 research and
 development............      --        --         --       --        300        --        --      1,630
Amortization of deferred
 stock compensation.....      434       714        909    1,933     5,217      5,524     4,865     3,160
Total costs and
 expenses...............    2,385     2,885      3,733    5,690    15,838     17,163    17,362    23,602
Loss from operations....     (493)   (1,796)    (3,098)  (3,814)  (12,382)   (12,421)  (10,726)  (15,096)
Net loss................     (467)   (1,755)    (2,956)  (3,650)  (12,939)   (11,739)   (9,891)  (14,242)
Net loss per share,
 basic and diluted......   $(0.07)  $ (0.25)   $ (0.41) $ (0.50) $  (1.71)  $  (0.50) $  (0.37) $  (0.50)
</TABLE>

                                       56
<PAGE>

                               INDEX TO EXHIBITS

   These Exhibits are numbered in accordance with the Exhibit Table of Item 601
of Regulation S-K:

<TABLE>
<CAPTION>
 Exhibit No. Description
 ----------- -----------
 <C>         <S>
     2.1     Agreement and Plan of Reorganization, dated as of December 21,
              1999, between the registrant, Transcription Enterprises Limited,
              Transcription Enterprises, Inc., Kevin MacLean and Roger
              Sturgeon.*

     2.2     Agreement and Plan of Merger between the registrant and Numerical
              Technologies, Inc., a Delaware corporation.*

     2.3     Agreement and Plan of Amalgamation, dated as of September 5, 2000,
              by and among Numerical Technologies, Inc., Numerical Nova Scotia
              Company, Numerical Acquisition Limited, 3047725 Nova Scotia
              Limited, Cadabra Design Automation Inc., Martin Lefebvre, and Fay
              Sohail.**

     3.2     Amended and Restated Certificate of Incorporation of registrant.*

     3.3     Bylaws of registrant.*

     4.1     Form of registrant's Common Stock certificate.*

     4.2     1999 Second Amended and Restated Shareholders Rights Agreement,
              dated January 1, 2000, between the registrant and the parties
              named therein, as amended on January 14, 2000.*

    10.1     Form of Indemnification Agreement entered into by registrant with
              each of its directors and executive officers.*

    10.2     2000 Stock Plan and related agreements.*

    10.3     1997 Stock Plan and related agreements.*

    10.4     2000 Employee Stock Purchase Plan and related agreements.*

    10.5     Lease Agreement, dated June 15, 1999, by and between the
              registrant and CarrAmerica Realty Corporation.*

    10.6     Lease Agreement, dated May 10, 1999, between Transcription
              Enterprises, Inc. and Los Gatos Business Park.*

    10.7     Employment Agreement, dated January 1, 2000, by and between
              Transcription Enterprises, Inc. and Roger Sturgeon.*

    10.8     Employment Agreement, dated January 1, 2000, by and between
              Transcription Enterprises, Inc. and Kevin MacLean.*

    10.9     Non-Competition Agreement, dated January 1, 2000, by and between
              Numerical Technologies, Inc., Transcription Enterprises, Inc.,
              Transcription Enterprises Limited and Roger Sturgeon.*

    10.10    Non-Competition Agreement, dated January 1, 2000, by and between
              Numerical Technologies, Inc., Transcription Enterprises, Inc.,
              Transcription Enterprises Limited and Kevin MacLean.*

    10.11    Stock Option Agreement--Early Exercise, dated November 2, 1999, by
              and between the registrant and William Davidow.*

    10.12    Stock Option Agreement--Early Exercise, dated May 26, 1999, by and
              between the registrant and Richard Mora.*

    10.13    Stock Option Agreement--Early Exercise, dated December 27, 1999,
              by and between the registrant and Richard Mora.*
</TABLE>

                                       57
<PAGE>

<TABLE>
 <C>   <S>
 10.14 Stock Option Agreement--Early Exercise, dated March 31, 1999, by and
        between the registrant and Atul Sharan.*

 10.15 Stock Option Agreement--Early Exercise, dated December 27, 1999, by and
        between the registrant and Atul Sharan.*

 10.16 Stock Option Agreement--Early Exercise, dated February 3, 1999, by and
        between the registrant and Lars Herlitz.*

 10.17 Stock Option Agreement--Early Exercise, dated December 27, 1999, by and
        between the registrant and Lars Herlitz.*

 10.18 Stock Option Agreement--Early Exercise, dated November 17, 1999, by and
        between the registrant and John Traub.*

 10.19 Stock Option Agreement--Early Exercise, dated December 27, 1999, by and
        between the registrant and John Traub.*

 10.20 Stock Option Agreement--Early Exercise, dated July 15, 1998, between the
        registrant and Harvey Jones.*

 10.21 License Agreement, dated as of October 1, 1999, between registrant and
        Cadence Design Systems, Inc.*+

 10.22 OEM Software License Agreement, dated December 31, 1997, between
        registrant and Zygo Corporation (fka Technical Instrument Company).*+

 10.23 Addendum to OEM Software License Agreement, dated March 25, 1999,
        between registrant and Zygo Corporation.*

 10.24 Software Production and Distribution Agreement, dated January 9, 1998,
        between registrant and KLS-Tencor Corporation.*+

 10.26 Development and Distribution Agreement, dated October 1, 19991, between
        Transcription Enterprises Limited and KLA Instruments Corporation.*+

 10.27 Addendum Number One to Development and Distribution Agreement, dated
        December 27, 1999, between Transcription Enterprises Limited and KLA
        Instruments Corporation.*+

 10.28 Stock Option Agreement--Early Exercise, dated February 1, 2000, by and
        between the registrant and Roger Sturgeon.*

 10.29 Stock Option Agreement--Early Exercise, dated February 1, 2000, by and
        between the registrant and Kevin MacLean.*

 10.30 Stock Option Agreement--Early Exercise, dated February 10, 2000, by and
        between the registrant and Y.C. (Buno) Pati.*

 10.31 Stock Option Agreement--Early Exercise, dated February 10, 2000, by and
        between the registrant and Yao-Ting Wang.*

 10.32 Stock Option Agreement--Early Exercise, dated October 23, 1998, by and
        between the registrant and Atul Sharan.*

 10.33 Amendment No. 1 to Lars Herlitz' Stock Option Agreement dated February
        3, 1999 and December 27, 1999, dated as of January 24, 2000, by and
        between the registrant and Lars Herlitz.*

 10.34 Amendment No. 1 to Atul Sharan's Stock Option Agreements dated October
        23, 1998, March 31, 1999 and December 27, 1999, dated as of January 24,
        2000, by and between the registrant and Atul Sharan.*

 10.35 Amendment No. 1 to John Traub's Stock Option Agreements dated November
        17, 1999 and December 27, 1999, dated as of January 24, 2000, by and
        between the registrant and John Traub.*
</TABLE>

                                       58
<PAGE>


<TABLE>
 <C>   <S>
 10.36 Stock Option Agreement--Early Exercise, dated February 10, 2000, by and
        between the registrant and Naren Gupta.*

 10.37 PSM Software Development and License Agreement, dated as of March 10,
        2000, by and between registrant and Cadence Design Systems, Inc.*+

 10.38 License Agreement, dated March 1, 2000, between registrant and Motorola,
        Inc.***+

 10.39 Production License Agreement, dated December 31, 2000, between
        registrant and United Microelectronics Corporation.+

 21.1  Subsidiaries of the registrant.

 23.1  Consent of Independent Accountants.
</TABLE>
--------
*   Incorporated by reference to the registrant's Registration Statement on
    Form S-1 as declared effective by the Securities and Exchange Commission
    on April 6, 2000.

**  Incorporated by reference to the registrant's current report on Form 8-K
    as filed with the Securities and Exchange Commission on September 15,
    2000.

*** Incorporated by reference to the registrant's Quarterly Report on Form 10-
    Q as filed with the Securities and Exchange Commission on May 12, 2000.

+   Confidential treatment has been requested with respect to certain portions
    of this exhibit. Omitted portions have been filed separately with the
    Securities and Exchange Commission.

                                      59
<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.

                                          NUMERICAL TECHNOLOGIES, INC.

                                                /s/ Yagyensh C. Pati
Dated: March 26, 2001                     By: _________________________________
                                                    Yagyensh C. Pati
                                              President and Chief Executive
                                                         Officer

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

<TABLE>
<CAPTION>
             Signature                           Title                  Date
             ---------                           -----                  ----


<S>                                  <C>                           <C>
      /s/ Yagyensh C. Pati           President, Chief Executive    March 26, 2001
____________________________________  Officer and Director
          Yagyensh C. Pati


      /s/ Richard S. Mora            Chief Financial Officer       March 26, 2001
____________________________________
          Richard S. Mora

     /s/ William H. Davidow          Chairman of the Board         March 26, 2001
____________________________________
         William H. Davidow

       /s/ Yao-Ting Wang             Director                      March 26, 2001
____________________________________
           Yao-Ting Wang

       /s/ Thomas Kailath            Director                      March 26, 2001
 ____________________________________
           Thomas Kailath

        /s/ Harvey Jones             Director                      March 26, 2001
____________________________________
            Harvey Jones

       /s/ Naren K. Gupta            Director                      March 26, 2001
____________________________________
           Naren K. Gupta

</TABLE>


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