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UNITED STATES
SECURITIES AND EXCHANGE COMMISSION Washington, DC 20549
   FORM 10  Q QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d)
OF THE SECURITIES EXCHANGE ACT OF 1934 For the quarterly period ended March 31, 2005 Commission File Number 0-11630   TeraForce Technology Corporation  Delaware
    
    76-0471342(State or Other Jurisdiction of
    
    (I.R.S. EmployerIncorporation or Organization)
    
    Identification No.)1240 East Campbell Road, Richardson, Texas
    
    75081(Address of Principal Executive Offices)
    
    (Zip Code)
 469-330-4960
(Registrants Telephone Number, Including Area Code)   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 þ No o Indicate by check mark whether the registrant is an accelerated filer (as defined in Rule 12b-2 of
the Exchange Act). Yes o No þ There were 134,175,824 shares of Common Stock outstanding as of April 30, 2005.




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TERAFORCE TECHNOLOGY CORPORATION AND SUBSIDIARIES INDEX PagePart I
    
    Financial InformationItem 1
    
    Financial StatementsConsolidated Balance Sheets of the Company
at March 31, 2005 (unaudited) and December 31, 2004
    
    
    2Consolidated Statements of Operations of the Company
(unaudited) for the three months ended March 31, 2005 and 2004
    
    
    3Consolidated Statements of Cash Flows of the Company
(unaudited) for the three months ended March 31, 2005 and 2004
    
    
    4Notes to Consolidated Financial Statements
    
    
    5Item 2
    
    Managements Discussion and Analysis of Financial
Condition and Results of Operations
    
    
    10Item 3
    
    Quantitative and Qualitative Disclosures About Market Risk
    
    
    13Item 4
    
    Controls and Procedures
    
    
    14Part II
    
    Other InformationItem 1
    
    Legal Proceedings
    
    
    15Item 2
    
    Unregistered Sales of Equity Securities and Use of Proceeds
    
    
    15Item 6
    
    Exhibits
    
    
    16Certificate of the CEO Pursuant to Section 302Certificate of the CFO Pursuant to Section 302Certification Pursuant to Section 906




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PART I  FINANCIAL INFORMATION 
 ITEM 1  FINANCIAL STATEMENTS TERAFORCE TECHNOLOGY CORPORATION AND SUBSIDIARIES 
   March 31,
    
    
    December 31,2005
    
    
    2004(unaudited)AssetsCurrent assets:Cash and cash equivalents
    
    $
    1
    
    
    $
    3Accounts receivable
    
    
    372
    
    
    
    150Inventories
    
    
    1,193
    
    
    
    854Prepaid expenses and other current assets
    
    
    101
    
    
    
    516Total current assets
    
    
    1,667
    
    
    
    1,523Property and equipment, net
    
    
    290
    
    
    
    335Investment in affiliate
    
    
    100
    
    
    
    100Other assets
    
    
    2,537
    
    
    
    1,086$
    4,594
    
    
    $
    3,044Liabilities and Stockholders DeficitCurrent liabilities:Current portion of notes payable
    
    $
    9,806
    
    
    $
    6,634Accrued liabilities
    
    
    2,797
    
    
    
    2,670Accounts payable
    
    
    644
    
    
    
    584Deferred revenue
    
    
    100
    
    
    
    100Total current liabilities
    
    
    13,347
    
    
    
    9,988Long-term notes payable
    
    
    
    
    
    
    1,364Stockholders deficit:Common Stock, $.01 par value; authorized 250,000,000 shares;
134,765,401 and 133,561,425 shares issued in 2005 and
2004, respectively
    
    
    1,338
    
    
    
    1,336Additional paid-in capital
    
    
    192,260
    
    
    
    190,525Accumulated deficit
    
    
    (200,764
    )
    
    
    (198,582
    )(7,166
    )
    
    
    (6,721
    )Less 400,474 shares of common stock in treasury at cost
    
    
    (1,587
    )
    
    
    (1,587
    )Total stockholders deficit
    
    
    (8,753
    )
    
    
    (8,308
    )$
    4,594
    
    
    $
    3,044
 See accompanying notes to consolidated condensed financial statements. 2




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TERAFORCE TECHNOLOGY CORPORATION AND SUBSIDIARIES 
   Three Months EndedMarch 31,2005
    
    
    2004(unaudited)Net revenue
    
    $
    379
    
    
    $
    4,607Cost of revenue
    
    
    392
    
    
    
    881Gross profit (loss)
    
    
    (13
    )
    
    
    3,726Expenses:Engineering and development
    
    
    542
    
    
    
    501Selling and administrative
    
    
    1,080
    
    
    
    1,3031,622
    
    
    
    1,804Operating profit (loss)
    
    
    (1,635
    )
    
    
    1,922Other income (expense):Interest expense
    
    
    (555
    )
    
    
    (335
    )Other
    
    
    8
    
    
    
    (547
    )
    
    
    (335
    )Net income (loss)
    
    $
    (2,182
    )
    
    $
    1,587Basic and diluted income (loss) per share
    
    $
    (.02
    )
    
    $
    .01Weighted average number of common shares
outstanding (thousands):Basic
    
    
    133,184
    
    
    
    130,603Diluted
    
    
    133,184
    
    
    
    147,300
 See accompanying notes to consolidated condensed financial statements. 3




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TERAFORCE TECHNOLOGY CORPORATION AND SUBSIDIARIES 
   Three Months Ended March 31,2005
    
    
    2004(unaudited)Cash flows from operating activities:Net income (loss)
    
    $
    (2,182
    )
    
    $
    1,587Adjustments to reconcile net income (loss) to
net cash used in operating activities:Depreciation and amortization
    
    
    57
    
    
    
    55Amortization of deferred financing costs
    
    
    389
    
    
    
    201Other
    
    
    424
    
    
    
    (20
    )Changes in operating assets and liabilities:Accounts receivable
    
    
    (222
    )
    
    
    (387
    )Inventories
    
    
    (339
    )
    
    
    148Deferred revenue
    
    
    
    
    
    
    (1,200
    )Accounts payable and accrued liabilities
    
    
    187
    
    
    
    (513
    )Net cash used in operating activities
    
    
    (1,686
    )
    
    
    (129
    )Cash flows from investing activities:Capital expenditures
    
    
    (5
    )
    
    
    (21
    )Software development costs
    
    
    
    
    
    
    (8
    )Net cash provided by (used in) investing activities
    
    
    (5
    )
    
    
    (29
    )Cash flows from financing activities:Proceeds from issuance of notes payable
    
    
    3,739
    
    
    
    Principal payments on notes payable
    
    
    (2,050
    )
    
    
    Proceeds from issuance of common stock
    
    
    
    
    
    
    5Net cash provided by financing activities
    
    
    1,689
    
    
    
    5Net decrease in cash and cash equivalents
    
    
    (2
    )
    
    
    (153
    )Cash and cash equivalents, beginning of period
    
    
    3
    
    
    
    165Cash and cash equivalents, end of period
    
    $
    1
    
    
    $
    12
 See accompanying notes to consolidated condensed financial statements. 4




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TERAFORCE TECHNOLOGY CORPORATION 
    Basis of Presentation The accompanying consolidated financial statements have been prepared by the Company without
audit in accordance with accounting principles generally accepted in the United States of America
for interim financial statements and with instructions to Form 10-Q and Rule 10-01 of Regulation
S-X. In the opinion of management, all adjustments (consisting only of normal recurring accruals)
considered necessary for a fair presentation have been included. The accompanying consolidated financial statements do not include certain footnotes and
financial presentations normally required under accounting principles generally accepted in the
United States of America and, therefore, should be read in conjunction with the audited financial
statements included in the Companys Annual Report on Form 10-K for the year ended December 31,
2004. The Company incurred significant operating losses during the first quarter of 2005 as well as
in 2004, 2003 and 2002; however, the amount of these losses decreased in each of those years.
These losses were funded with the proceeds from the sale of debt and equity securities, proceeds
from borrowings, proceeds from the sale of assets and, in 2002, with proceeds from the settlement
of certain litigation. The Company has approximately $10 million in debt obligations that are due within one year or
less. The Company has been negotiating with the holders of certain of these debt obligations to
restructure or otherwise extend the maturity of the obligations. These negotiations have not been
concluded and there is no assurance that they can be under acceptable terms. Should the Company not generate sufficient cash from operating activities the Company will
require additional capital. The Company believes that it will be able to raise additional capital
through either the issuance of new equity securities, the incurrence of new debt or the
modification of the terms of its existing debt obligations. There can be no assurance that the
Company can accomplish these matters, or can do so under acceptable terms. These financial
statements do not include any adjustments that might result from the outcome of this uncertainty. 5




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TERAFORCE TECHNOLOGY CORPORATION
Notes to Consolidated Condensed Financial Statements
(Unaudited)
March 31, 2005 Inventories The components of inventories are as follows: March 31,
    
    
    December 31,2005
    
    
    2004($ Thousands)Raw materials
    
    $
    808
    
    
    $
    554Work in process
    
    
    101
    
    
    
    7Finished goods
    
    
    284
    
    
    
    293Total
    
    $
    1,193
    
    
    $
    854
 Segments of Business The Company currently operates in one business segment, defense electronics, and all of the
Companys net revenue has been generated by the defense electronics business. Income Taxes For the three months ended March 31, 2005, the Companys effective income tax rate differed
from the federal statutory rate due to taxable losses incurred for which no benefit was provided.
For the three months ended March 31, 2004, the Companys effective income tax rate differed from
the federal statutory rate due to current period tax expense offset by an offsetting decrease in
the valuation allowance for the same amount. Stock Option Plan The Company accounts for its stock option plan in accordance with the provisions of Accounting
Principles Board (APB) Opinion No. 25, Accounting for Stock Issued to Employees, and related
interpretations. As such, compensation expense is recorded only if the current market price of the
underlying stock on the date of grant exceeded the exercise price. In December 2004, the Financial
Accounting Standards Board issued a revision of Financial Accounting Standards No. 123, Accounting
for Stock-Based Compensation(SFAS No. 123R). SFAS No. 123R supercedes APB Opinion No. 25 and
requires a public entity to measure the cost of employee services received in exchange for an award
of equity instruments based on the grant-date fair value of the award, and recognize that cost over
the related service period. In the Companys case SFAS No. 123R is effective for the fiscal period
beginning after December 15, 2005 and the Company will begin recognizing option expense January 1,
2006. 6




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TERAFORCE TECHNOLOGY CORPORATION
Notes to Consolidated Condensed Financial Statements
(Unaudited)
March 31, 2005 The following table illustrates the effect on net income and earnings per share if the Company
had applied the fair value recognition provisions of SFAS No. 123 to stock-based employee
compensation, as well as the expected effect of adopting SFAS No. 123R: Three Months EndedMarch 31,2005
    
    
    2004($ Thousands)Net income (loss) allocable to
common stockholders:As reported
    
    $
    (2,182
    )
    
    $
    1,587Additional compensation
expense
    
    
    (127
    )
    
    
    133Pro forma
    
    $
    (2,309
    )
    
    $
    1,454Income (loss) per share:As reported
    
    $
    (.02
    )
    
    $
    .01Pro forma
    
    $
    (.02
    )
    
    $
    .01
 Earnings Per Share Basic and diluted earnings or loss per share are the same for the three month periods ended
March 31, 2005 and 2004 because all potential common shares were anti-dilutive in 2005 and
potential common shares did not have a material effect in 2004. For the three-month periods ended
March 31, 2005 and 2004 approximately 101,000,000 and 59,000,000 potential common shares,
respectively, were anti-dilutive and were excluded from the computation of earnings per share. Notes Payable Notes payable consist of the following (in thousands): March 31,
    
    
    December 31,2005
    
    
    2004Guarantied Bank Facility (A)
    
    $
    3,900
    
    
    $
    3,90012% Convertible Subordinate Notes (B)
    
    
    2,835
    
    
    
    2,860Subsidiary revolving credit facility(C)
    
    
    2,396
    
    
    
    1,175Convertible Note (D)
    
    
    500
    
    
    
    Other (E)
    
    
    289
    
    
    
    2899,920
    
    
    
    8,224Amount due within one year
    
    
    (9,806
    )
    
    
    (6,634
    )Unamortized discount
    
    
    (114
    )
    
    
    (226
    )Amount due after one year
    
    $
    
    
    
    $
    1,364
    The Company believes it has reached an agreement in principle to extend the maturity of the
facility to April 30, 2006 under certain conditions, including a reduction of the amount
outstanding and restructuring of the Companys other debt obligations that are due in 2005.
In April 2005 the maturity 7




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TERAFORCE TECHNOLOGY CORPORATION
Notes to Consolidated Condensed Financial Statements
(Unaudited)
March 31, 2005 of this note and the supporting letter of credit were extended to
June 15, 2005 in order to allow for the completion of such matters and the extension to April 30, 2006. There
is no assurance that the predicate conditions can be met or that these arrangements can be
completed before the scheduled maturity date. (B) These notes currently mature June 30, 2005. The Company has had discussions with the
holders of a significant portion of these notes regarding a proposal to extend the maturity of
the notes to June 30, 2006 and to provide for the payment of
interest due June 30, 2005 in shares of the Companys common stock, at the option of the Company. In return the Company has
proposed to provide additional warrants to the holders of the notes. These negotiations have
not been completed and there can be no assurance that they will be completed prior to the
maturity of the notes on June 30, 2005. (C) In March 2005 the Companys wholly-owned subsidiary, DNA Computing Solutions, Inc.
(DCS) entered into a $2,750,000 revolving credit facility with Encore Bank (Encore).
Initial proceeds of $1,725,000 were used to repay amounts outstanding under similar credit
facilities with FirstCapital Bank (FirstCapital). Borrowings under the facility bear
interest at prime plus 50 basis points, payable monthly. All amounts outstanding under the
facility are due March 14, 2006. The facility is secured by the assets of DCS, the guaranty
of the Company, the stock of DCS and by limited guaranties provided by the same seven private
investors involved in the FirstCapital transactions. The loan agreement with Encore places
certain restrictions on DCS including restrictions related to the sale of assets, the
incurrence of debt, the granting of liens and changes in management. In addition, the bank
may accelerate the maturity of amounts outstanding under the agreement in certain
circumstances, including the insolvency of DCS, the Company or one of the guarantors, the
death of one of the guarantors, the default of other debt of the Company or the guarantors or
the imposition of a judgment in excess of $50,000 against any of the parties. In connection with providing the guaranties for the Encore arrangements, the Company and DCS
have entered into a Reimbursement Agreement with the private investors. Under the new
Reimbursement Agreement all the prior reimbursement agreements related to the FirstCapital
facilities were terminated. Accordingly, prior conversion rights for the purchase of
9,965,278 shares of common stock were cancelled and previously issued warrants for the
purchase of 15,937,500 shares of common stock were cancelled. Pursuant to the new
Reimbursement Agreement the Company and DCS have agreed to reimburse the guarantors for any
amounts they may incur related to the guaranties. Any such obligations are due 30 days after
demand and bear interest at prime plus 2%. The Company has also agreed to use its best
efforts in arranging for the guarantors to acquire the note and collateral held by Encore in
the event of a default under the Encore agreement. As consideration for providing the
guaranties the Company granted to the private investors conversion rights to purchase
13,750,000 shares of our common stock for $2,750,000 in cash. The proceeds from this
conversion must be used to repay amounts outstanding under the Encore facility and to retire
or reduce the amount available under the facility and therefore subject to the guaranties. In
addition the Company has issued to the private investors warrants to purchase 27,500,000
shares of our common stock. The warrants have an exercise price of $0.10 and may be exercised
any time through March 31, 2010. The Company has estimated the value of these conversion
rights and warrants at approximately $2,100,000 using the Black-Scholes pricing model. This
amount has been recorded as a deferred financing cost and is being amortized over the term of
the Encore debt. A default by the Company in payment on the Guarantied Bank Facility or the 12% Convertible
Subordinated Notes would result in a default pursuant to the Encore facility. 8




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TERAFORCE TECHNOLOGY CORPORATION
Notes to Consolidated Condensed Financial Statements
(Unaudited)
March 31, 2005 (D) Concurrently with the Encore transaction, the Company entered into a $500,000 convertible
note agreement with a private investor. The terms of this agreement are substantially
identical to the Encore agreement, except that the Company rather than DCS is the borrower.
The $500,000 note may be converted into 2,500,000 shares of our common stock at the option of
the holder, the same conversion rate as in the Reimbursement Agreement discussed above. In
addition, the Company has issued a warrant to this investor for the purchase of 5,000,000
shares of our common stock. The warrant has terms essentially identical to the warrants
issued pursuant to the Reimbursement Agreement. The Company has estimated the value of these
warrants at approximately $385,000 using the Black-Scholes pricing model. This amount has
been recorded as a deferred financing cost and is being amortized over the term of the
convertible note. The Company has entered into Registration Rights Agreements with the private investors under
the Encore transaction and the Convertible Note. Under these agreements the Company has
agreed to file a registration statement for the resale of the common stock to be issued upon
exercise of the conversion rights and the warrants, no later than May 31, 2005, and to use its
best efforts to have the registration statement declared effective by the SEC as soon as
practicable thereafter. (E) Consists of the following:  
    $100,000 note payable to an officer and director, a related party, under a
demand note. This note may be converted into common stock at the option of
the holder at the rate of $1.00 per share.
    $189,000 payable to Zurich American Insurance Company. Supplemental Disclosure of Cash Flow Information Three Months EndedMarch 31,2005
    
    
    2004($ Thousands)Cash paid during the period for:Interest
    
    $
    74
    
    
    $
    39
 9




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ITEM 2  MANAGEMENTS DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS FOR
THE PERIOD ENDED MARCH 31, 2004 Forward Looking Statements The statements in this Quarterly Report on Form 10-Q of TeraForce Technology Corporation (the
Company) regarding future financial and operating performance and results, and other statements
that are not historical facts, are forward-looking statements, as defined in Section 27A of the
Securities Act of 1933, as amended, and Section 21E of the Securities Exchange Act of 1934, as
amended. We use the words may, expect, anticipate, believe, continue, estimate,
project, intend, designed or other similar expressions to identify forward-looking
statements. You should read statements that contain such words carefully because they discuss
future expectations, contain projections of results of operations or of our financial condition,
and/or state other forward-looking information. These statements also involve risks and
uncertainties, including, but not limited to:  
    events, conditions and financial trends that may affect the Companys future plans and
business strategy,
    results of expectations and estimates as to prospective events, and
    circumstances about which the Company can give no firm assurance. Examples of types of forward-looking statements include statements on future levels of net
revenue and cash flow, new product development, strategic plans and financing. These
forward-looking statements involve risks and uncertainties that could cause actual results to
differ materially from those projected or anticipated. Factors that might cause a difference
include, but are not limited to:  
    general economic conditions in the markets in which the Company operates;
    success in the development and market acceptance of new and existing products;
    dependence on suppliers, third party manufacturers and channels of distribution;
    customer and product concentration;
    fluctuations in customer demand;
    the ability to obtain and maintain access to external sources of capital;
    the ability to control costs;
    U. S. Government budget, procurement and contracting trends;
    overall management of the Companys expansion; and
    other risk factors detailed from time to time in the Companys filings with the
Securities and Exchange Commission. We believe it is important to communicate our expectations of future performance to our
investors. However, events may occur in the future that we are unable to accurately predict, or
that we cannot control. Any forward-looking statement speaks only as of the date the statement was
made, and the Company undertakes no obligation to update any forward-looking statement to reflect
events or circumstances after the date the statement was made. Because it is not possible to
predict every new factor that may emerge, forward-looking statements should not be relied upon as a
prediction of actual future financial condition or results. When considering our forward-looking
statements, keep in mind the risk factors and other cautionary statements in our Annual Report on
Form 10-K for the year ended December 31, 2004 and other filings with the Securities and Exchange
Commission. Risk factors provide examples of risks, uncertainties and events that may cause our
actual results to differ materially from those contained in any forward-looking statement. If one
or more of these risks or uncertainties materialize, or if underlying assumptions prove incorrect,
actual outcomes may vary materially from those forward-looking statements included in this
Quarterly Report on Form 10-Q. The terms we, our and us and similar terms refer to the
Company and its consolidated subsidiaries, not to any individual or group of individuals. 10




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Comparison of Three Months Ended March 31, 2005 toThree Months Ended March 31, 2004
 Net Revenue Net revenues were derived from the following sources: Three Months EndedMarch 31,2005
    
    
    2004($ Thousands)Product sales and services
    
    $
    379
    
    
    $
    1,657License fees
    
    
    
    
    
    
    2,950Net revenues
    
    $
    379
    
    
    $
    4,607
 Product sales decreased in the first quarter of 2005 as compared to the first quarter of 2004
due primarily to the suspension of orders related to three programs beginning in the last half of
2004. We received orders related to two of these programs late in the first quarter of 2005 and
expect to ship the related products in the second quarter. We expect net revenue in the second
quarter of 2005 to increase significantly from the first quarter of 2005 and to continue at this
higher level throughout 2005, but there can be no assurance as to the amount of the increase, if
any. We learned in April 2005 that a particular program related to an intelligence gathering
application had been cancelled by our customers customer. We had expected this program to produce
significant net revenue in 2005. License fees are attributable to our technology licensing and marketing agreement with VISTA
Controls, Inc. (VISTA). As of March 31, 2004 we had met substantially all of our delivery
requirements under the agreement. We have received, and recognized as revenue a total of
$3,400,000 of the $3,500,000 in license fees called for under the agreement. We believe we have
satisfied the criteria necessary for the receipt of the remaining $100,000 and are engaged in
discussions with VISTA regarding the payment of this amount which has not been included in our net
revenue as the collection of the amount is uncertain. Gross Profit Gross profit declined in the first quarter of 2005 as compared to the first quarter of 2004
due to the decline in product sales and the absence of license fees described above. As product
sales increase, we expect gross profit as a percent of those sales to increase due to the effect of
fixed costs which are included as cost of revenue. Engineering and Development Expense Engineering and development expenses increased slightly in the first quarter of 2005 as
compared to the first quarter of 2004 due to increased outsourced services in the 2005 period.
Engineering and development expenses have been relatively constant over the past several quarters
and we do not expect them to increase or decrease materially over the balance of 2005. 11




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Selling and Administrative Expense Selling and administrative expense decreased by $223,000 in the first quarter of 2005 as
compared to the same period in 2004. The decrease related primarily to decreased sales and
marketing expenses, particularly decreased sales commissions resulting from the lower net revenue.
We generally expect these expenses to increase as net revenues increase in the future. Interest Expense Interest expense increased in the first quarter of 2005 as compared to the first quarter of
2004 due to increased borrowing levels and costs related to recent financing transactions.
Interest expense for the first quarter of 2005 includes approximately $389,000, versus
approximately $201,000 in the first quarter of 2004 related to the amortization of the value of
warrants issued in connection with various debt transactions and beneficial conversion features
related to convertible debt obligations. Liquidity and Capital Resources
 As of March 31, 2005, our working capital deficit amounted to $11,680,000, which included
$9,806,000 of notes payable due within one year. Of these notes payable approximately $3,900,000
is due June 15, 2005 and approximately $2,785,000 is due June 30, 2005. We have been engaged in
discussions with the holders of this debt, and the parties that provide security for some of the
debt, regarding extensions of the maturity of the debt. We have not reached definitive
arrangements with these parties and there can be no assurance that we will be successful in
restructuring or extending the maturities of our indebtedness or that any such transactions would
be on terms favorable to us. If we are not able to arrange extensions of the maturities of these
debt agreements it is highly unlikely that we will be able repay these amounts as they mature, as a
result of which the holders of the secured debt could exercise their security interests in
substantially all of our assets. The exercise of these security interests would leave insufficient
assets to continue our operations. These events would have a material adverse effect on our
business, financial condition and results of operations. In addition, failure to make payments
when due on any debt agreement would result in an event of default under that agreement, which in
term would result in an event of default under our other debt agreements. If this occurs we may be
forced to seek protection under the federal bankruptcy laws. Operating Activities Net cash used in operations for the three months ended March 31, 2005 amounted to $1,686,000.
This amount arose primarily from the net loss of $2,182,000, offset by non-cash charges. In the
second quarter of 2005 we received inventories valued at approximately $300,000 in partial
settlement of our dispute with LaBarge (See Part II, Item 1 Legal Proceedings). This resulted in
an increase in inventory and a decrease in other assets of approximately $300,000. Investing Activities For the three months ended March 31, 2005, investing activities used cash in the amount of
$5,000, primarily for capital expenditures for computer equipment. We expect capital expenditures
to remain near this level for the balance of 2005. Financing Activities In January 2005 we expanded our revolving credit arrangements with FirstCapital Bank
(FirstCapital), bringing the total amount outstanding under those arrangements to $1,725,000. In
March 2005 we entered into a new $2,750,000 revolving credit facility with Encore Bank (Encore).
The initial proceeds from the new Encore facility were used to repay all amounts outstanding under
the FirstCapital facilities. As of April 30, 2005 essentially all amounts available under the
Encore facility were outstanding. Also in March 2005 we issued a $500,000 convertible note to a
private investor. The proceeds from the 12




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Encore facility, after repayment of the amounts to FirstCapital, and from the convertible note were
used for general working capital. In the first quarter of 2005 approximately $27,000 in principal balance and accrued interest
of our 12% convertible subordinated notes was converted into 203,976 shares of our common stock.
In April 2005 approximately an additional $55,000 in principal balance and accrued interest was
converted into 410,423 shares of our common stock. Outlook The fall-off in orders in the last half of 2004 and the resulting decline in net revenues in
the fourth quarter of 2004 and the first quarter of 2005 have led to a significant decline in our
liquidity. As of April 30, 2005 we have used substantially all of borrowing capacity under the
revolving credit facilities we entered into in March 2005. Our shipments of product and net
revenues have begun to increase in the second quarter of 2005 and, as discussed above, we expect
net revenues to increase in the second quarter of 2005. There can be no assurance however that the
increase in net revenues will be sufficient to produce positive cash flow from operations in the
second quarter of 2005 or beyond. We believe that we will be able to optain additional capital to fund any shortfall in near term operating cash
flow, but there is no assurance that we can accomplish this or that it can be accomplished as funds
are needed. If we are not able to raise additional liquidity there could be a material adverse
effect on our ability to complete orders for our products or to accept new orders. The terms and
conditions that accompany any increase in our borrowings could have a material adverse effect on
the value of our common stock. We believe that our financial condition is having a material adverse effect on our ability to
secure additional orders for our products because of customers concerns over our financial
viability. Essentially all of our assets have been pledged to secure our existing credit
facilities and we have approximately 2,000,000 shares of common stock authorized to be issued which
have not been reserved for issuance in connection with our previous financing transactions.
Therefore, our ability to raise additional capital or to restructure our existing debt obligations
is extremely limited. Our inability to raise additional capital or restructure our existing debt
obligations could reduce our working capital to a level insufficient to enable us to continue our
operations, which would have a material adverse effect on our business, financial condition and
results of operations. We believe that the most viable option available to us under these circumstances is to enter
into a strategic transaction with another, larger entity within our industry. A number of such
entities have expressed an interest in such an arrangement and we are engaged in discussions with
certain of these parties. Such a transaction could take a number of forms including, but not
limited to, a licensing arrangement, a sale of the stock of DNA or a sale of all or some of the
assets of DNA. There can be no certainty as to the proceeds that we may derive from such a
transaction. A substantial portion, if not all, of any proceeds will likely be required to satisfy
our outstanding debt obligations. It may be necessary to file for protection under the federal
bankruptcy laws in order to effect any such transaction. Such actions could have a material
adverse effect on the value of our common stock. Contingent Liabilities We have been in the past and could be in the future exposed to contingent liabilities that, if
resolved adversely to us, could have a material adverse effect on our liquidity, our results of
operations and our financial position. 
 ITEM 3  QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK We have outstanding debt at March 31, 2005 amounting to approximately $6,800,000 that bears
interest at variable interest rates, such as prime or LIBOR, and subjects us to interest rate risk.
For example, 13




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an increase of 50 basis points in these rates would result in an increase in our annual interest
expense of approximately $34,000. 
 ITEM 4  CONTROLS AND PROCEDURES The term disclosure controls and procedures is defined in Rules 13a-15(e) and 15(d)-15(e) of
the Securities Exchange Act of 1934, or the Exchange Act. This term refers to the controls and
procedures of a company that are designed to ensure that information required to be disclosed by a
company in the reports that it files under the Exchange Act is recorded, processed, summarized and
reported within the time periods specified by the Securities and Exchange Commission. Our
management, including our Chief Executive Officer and our Chief Financial Officer, has evaluated
the effectiveness of our disclosure controls and procedures as of the end of the period covered by
this quarterly report. Based upon that evaluation, our Chief Executive Officer and Chief Financial
Officer have concluded that our disclosure controls and procedures were effective as of the end of
the period covered by this quarterly report. There were no changes to our internal control over financial reporting during our last fiscal
quarter that have materially affected, or are reasonably likely to materially affect, our internal
control over financial reporting. 14




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PART II  OTHER INFORMATION 
 ITEM 1  LEGAL PROCEEDINGS In March 2002, we entered into an agreement with LaBarge, Inc. (LaBarge) for the development
and manufacture of a conduction cooled version of a certain model of our VQG4 product. In
February 2003, we terminated the contract because we believe LaBarge did not fully perform under
the contract and defaulted. Subsequent to February 2003, we engaged in a series of discussions
with LaBarge regarding the settlement of outstanding issues, including claims of monies owed. We
were unable to resolve these issues and in October 2003 litigation was brought by LaBarge against
the Company in the Circuit Court of the County of St. Louis in the State of Missouri. In these
proceedings LaBarge alleged that we improperly terminated the contract and sought recovery of costs
and lost profits amounting to approximately $700,000. We filed counter claims alleging that
LaBarge breached the contract and sought recovery of amounts previously paid to LaBarge, costs
incurred resulting from the breach and lost profits. Such items aggregated in excess of
$1,000,000. In February 2005 we reached a settlement of the LaBarge matters. Pursuant to the settlement
agreement LaBarge paid us $100,000 in cash and delivered to us component inventory that had been
acquired in connection with the contract. The original cost of these components aggregated
approximately $336,000. 
 ITEM 2  UNREGISTERED SALES OF EQUITY SECURITIES AND USE OF PROCEEDS In March 2005 the Company and its wholly-owned subsidiary, DNA Computing Solutions, Inc.
entered into a $2,750,000 revolving credit facility with Encore Bank. The facility is secured, in
part, by limited guaranties provided by a group of private investors. As consideration for
providing the guaranties, we entered into a Reimbursement Agreement with the guarantors. Pursuant
to the Reimbursement Agreement, the guarantors have the right to purchase up to 13,750,000 shares
of our common stock for $2,750,000 in cash. The guarantors also received warrants to purchase
27,500,000 shares of our common stock. The warrants have an exercise price of $0.10 per share and
may be exercised at any time from their issuance through March 31, 2010. Also pursuant to the
Reimbursement Agreement, previously issued rights to purchase 9,965,278 shares of common stock and
warrants for the purchase of 15,937,500 shares of common stock were cancelled. Also in March 2005 the Company issued a $500,000 convertible note to a private investor. The
note has terms essentially identical to the Encore Bank facility. The convertible note may be
converted into 2,500,000 shares of common stock at the option of the holder. The Company also
issued to the private investor warrants for the purchase of 5,000,000 share of our common stock.
The terms of the warrants are identical to those issued pursuant to the Reimbursement Agreement in
all material respects. We have agreed to file a registration statement by May 31, 2005 for the resale of the shares
of our common stock to be issued upon the exercise of the conversion rights and warrants described
above. The issuance of the conversion rights and warrants was exempt from registration pursuant to
Section 4(2) of the Securities Act of 1933, as amended, in that the transactions did not involve a
public offering. During the first quarter of 2005 certain holders of our 12% convertible subordinated notes
elected to convert these notes into common stock. Notes with a principal amount of $25,000 and
accrued interest in the amount of approximately $2,000 were converted, resulting in the issuance of
203,976 shares of common stock. The shares of common stock issued upon conversion of the notes
constituted exempt securities under Section 3(a)(9) of the Securities Act of 1933, as amended. 15




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ITEM 6  EXHIBITS Listed below are all Exhibits filed as part of this report. Exhibit
    
    Description of Exhibit31.1
    
    Certificate of the Chief Executive Officer pursuant to Section 302 of
the Sarbanes-Oxley Act of 2002.31.2
    
    Certificate of the Chief Financial Officer pursuant to Section 302 of
the Sarbanes-Oxley Act of 2002.32.1
    
    Certification pursuant to Section 906 of the Sarbanes-Oxley Act of 2002.
 16




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SIGNATURES Pursuant to the requirements 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. TERAFORCE TECHNOLOGY CORPORATION
(Registrant) Date: May 16, 2005
    /s/ ROBERT P. CAPPSRobert P. CappsChief Financial Officer(Principal Financial and Accounting Officer) Date: May 16, 2005
    /s/ HERMAN M. FRIETSCHHerman M. FrietschChief Executive Officer and Director
   (Principal Executive Officer) 17