**UNITED STATESSECURITIES AND EXCHANGE COMMISSION**

**Washington,D.C. 20549**

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

 

**Forthe Fiscal Year December 31, 2004, or**
| **o** | ** ** | **TRANSITION REPORT PURSUANT TO SECTION 13 OR  15(d) OF THE SECURITIES EXCHANGE ACT OF 1934** |
|-------|------------|---------------------------------------------------------------------------------------------------------|

 

**Commissionfile number: 000-32929**

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MONOLITHIC SYSTEM TECHNOLOGY, INC.

(Exact name of registrantas specified in its charter)

| **Delaware**                                                    | ** ** | **77-0291941**                       |
|-----------------------------------------------------------------|------------|--------------------------------------|
| (State or other jurisdiction of  incorporation or organization) |       | (IRS Employer Identification Number) |

 

**1020 Stewart DriveSunnyvale, California 94085**

(Address of principalexecutive offices)

**(408) 731-1800**

(Registrant’s telephonenumber, including area code)

Securities registeredpursuant to Section 12(b) of the Act:

| Title of each class | ** ** | **Name of each exchange on which registered** |
|---------------------|------------|-----------------------------------------------|
| None                |       | None                                          |

 

Securities registeredpursuant to Section 12(g) of the Act:

**Common Stock, par value$0.01 per shareSeries AA Preferred Stock, par value $0.01 per share**

(Title of Class)

Indicate by check markwhether the registrant (1) has filed all reports required to be filed by Section 13or 15(d) of the Securities Exchange Act of 1934 during the preceding12 months (or for such shorter period that the registrant was required tofile such reports), and (2) has been subject to such filing requirementsfor the past 90 days. Yes x  No o

Indicate by check mark ifdisclosure of delinquent filers pursuant to Item 405 of Regulation S-K isnot contained herein, and will not be contained, to the best of registrant’sknowledge, in definitive proxy or information statements incorporated byreference in Part III of this Form 10-K or any amendment tothis Form 10-K. x

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

The aggregate market valueof the common stock held by non-affiliates of the Registrant, as of June 30,2004 was approximately $167,923,000 based upon the last sale price reported forsuch date on the Nasdaq National Market. For purposes of this disclosure,shares of common stock held by persons who beneficially own more than 5% of theoutstanding shares of common stock and shares held by officers and directors ofthe Registrant have been excluded because such persons may be deemed to beaffiliates. This determination is not necessarily conclusive.

As of February 23,2005, 30,456,212 shares of the registrant’s common stock, $0.01 per value, wereoutstanding.

**DOCUMENTS INCORPORATED BYREFERENCE**

 

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**TABLE OF CONTENTS**
| **Part I**   |
|-------------------|
| Item 1.           |   | Business |   | 3 |
| Item 2.           |   | Properties |   | 26 |
| Item 3.           |   | Legal Proceedings |   | 26 |
| Item 4.           |   | Submission of Matters to a Vote of  Security Holders |   | 27 |
| **Part II**  |
| Item 5.           |   | Market for Registrant’s Common  Equity and Related Stockholder Matters |   | 28 |
| Item 6.           |   | Selected Financial Data |   | 29 |
| Item 7.           |   | Management’s  Discussion and Analysis of Financial Condition and Results of Operations |   | 30 |
| Item  7A.         |   | Quantitative and Qualitative Discussion  of Market Interest Rate Risk |   | 40 |
| Item 8.           |   | Financial Statements and  Supplementary Data |   | 41 |
| Item  9.          |   | Changes in and Disagreements with Accountants on  Accounting and Financial Disclosure |   | 42 |
| Item 9A.          |   | Controls and Procedures |   | 42 |
| Item  9B.         |   | Other Information |   | 43 |
| **Part III** |
| Item  10.         |   | Directors and Executive Officers  of the Registrant |   | 44 |
| Item  11.         |   | Executive Compensation |   | 44 |
| Item  12.         |   | Security Ownership of Certain  Beneficial Owners and Management |   | 44 |
| Item  13.         |   | Certain Relationships and Related  Transactions |   | 44 |
| Item  14.         |   | Principal Accountant Fees and  Services |   | 44 |
| **Part IV**  |
| Item  15.         |   | Exhibits, Financial Statement  Schedules, and Reports on Form 8-K |   | 45 |
|              |   | Signatures |   | 47 |

 

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**Part I**

*This Annual Report on Form 10-K and the documentsincorporated herein by reference contain forward-looking statementswithin the meaning of Section 27A of the Securities Act of 1933 and Section 21Eof the Securities Exchange Act of 1934, which include, without limitation,statements about the market for our technology, our strategy, competition,expected financial performance and other aspects of our business identified inthis Annual Report, as well as other reports that we file from time to time withthe Securities and Exchange Commission. Any statements about our business,financial results, financial condition and operations contained in this AnnualReport that are not statements of historical fact may be deemed to be forward-lookingstatements. Without limiting the foregoing, the words “believes,” “anticipates,”“expects,” “intends,” “plans”, “projects,” or similar expressions are intendedto identify forward-looking statements. Our actual results could differmaterially from those expressed or implied by these forward-lookingstatements as a result of various factors, including the risk factors describedin Part I., Item1, “Business—Risk Factors,” and elsewhere in this report.We undertake no obligation to update publicly any forward-looking statementsfor any reason, except as required by law, even as new information becomesavailable or other events occur in the future.*

MoSys®, MultiBank® and1T-SRAM® are our trademarks. Product names, trade names and trademarks of othercompanies are also referred to in this report.

***Item 1. Busines***s

**Company Overview**

We design, develop,license and market memory technologies used by the semiconductor industry andelectronic product manufacturers. We have developed a series of patentedsemiconductor memory technologies, called 1T- SRAM technologies, thatoffer a combination of high density, low power consumption and high speed atperformance and cost levels that other available memory technologies do notmatch. We license this technology to companies that incorporate, or embed,memory on complex integrated circuits. We generate revenue from intellectualproperty licensing, which consists of licensing and royalty revenues. We havein the past also sold memory chips based on our 1T-SRAM technologies.

Using elements of ourexisting memory technology as a foundation, we completed development of ourfirst memory chips incorporating our 1T-SRAM technologies in the fourth quarterof 1998. Through the second quarter of 2001, almost all of our revenue wasgenerated by product sales of our memory chips. Since then, however, licensingand royalty revenues have represented the majority of our revenues. Ourlicensing revenue consists of fees paid for engineering development andengineering support services. We are entitled to receive royalties under eachof our licensing agreements when our licensees manufacture or sell productsthat incorporate our technology.

We signed our firstlicense agreement related to our 1T-SRAM technology at the end of the fourthquarter of 1998 and first recognized revenue from licensing our 1T-SRAMtechnology in the first quarter of 2000. In 2001, we introduced enhancements tothe original technology with 1T-SRAM-M, a lower power version and 1T-SRAM-R, aversion offering improved quality and reliability features. In 2002, weintroduced 1T-SRAM-Q, which offers twice the density of our originaltechnology.

As of December 31,2004, we had signed license agreements related to our 1T-SRAM technologies with48 companies. Our licensing sales cycle is lengthy. Generally, we expect theperiod from our initial discussion with a prospective licensee to a signedagreement to last from three to six months. Once our customer signs a licenseagreement, we generally will recognize revenue from fees for developing and delivering1T-SRAM designs to the customer over a period of 6 to 18 months. If thecustomer subsequently uses our 1T-SRAM design in production, we would notexpect to receive any royalty payments until 18 to 24 months after thecommencement of the project.

To complement our existinghigh-density, low-power 1T-SRAM technologies, we announced the availability ofour low power 6T-SRAM-R compilers in early 2004. The 6T-SRAM-R compilers incorporate the sametechnologies that deliver the quality and low-power advantages offered by our 

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1T-SRAM technologies for large memories and canextend these benefits to small memories of less than one megabit in size, forsystem-on-chip, or SoC designers. To date we have not licensed these compilersto any customers.

In 2004, we phased out ofselling our proprietary IT-SRAM memory chips. Currently, our product salesconsist of selling existing inventory. We do not expect to make and sell memorychips in the future.

**Industry Background**

*Trends in the Semiconductor Industry*

Electronic products playan increasingly important role in our lives, as evidenced by the growth of thepersonal computer, wireless communications, networking equipment and consumerelectronics markets. These markets are characterized by intensifyingcompetition, rapid innovation, increasing performance requirements andcontinuing cost pressures. To manufacture electronic products that achieveoptimal performance and cost levels, semiconductor companies must produceintegrated circuits that offer higher performance, greater functionality andlower cost.

Two important measures ofperformance are speed and power consumption. Higher-speed integratedcircuits can allow electronic products to operate faster, enabling theperformance of more functions. Reducing the power consumption of integratedcircuits contributes to increased battery life and reduced heat generation inelectronic products. Reduced power consumption also enables integrated circuitdesigners to overcome costly design hurdles, such as meeting the thermal limitationsof low-cost packaging materials.

In addition to offeringhigh-performance products, semiconductor companies must produce integratedcircuits that are cost effective. High-density integrated circuits require lesssilicon, thus reducing their size and cost. Cost reductions also can beachieved by simplifying the integrated circuit’s manufacturing process andimproving the manufacturing yield.

To avoid the high cost ofsubstantial redesign, semiconductor companies typically use technology that isscalable, which means it can be readily incorporated into multiple generationsof manufacturing process technologies. Process technology generations aredistinguished in terms of the dimension of the integrated circuit’s smallesttopographical features, as measured in microns (one millionth of a meter). Thesemiconductor industry has continuously developed advanced process technologiesthat enable the reduction of silicon area on integrated circuits andconsequently lower costs. The industry is predominantly using 0.25-micron,0.18-micron and 0.15-micron manufacturing process technology. However, currentdesigns are now being implemented in 0.13-micron and in 0.09-micronmanufacturing process technologies.

*Importance of Integration*

For decades, thesemiconductor industry has continuously increased the value of integratedcircuits by improving their density, power consumption, speed and cost. Themain driver for these improvements has been the success of shrinking the sizeof the basic semiconductor building block, or transistor. Transistors havebecome small enough to make it economical to combine multiple functions, suchas microprocessors, graphics, memory, analog components and digital signalprocessors, on a single integrated circuit, or System-on-Chip (SoC). Highlyintegrated circuits such as SoCs often offer advantages in density, powerconsumption, speed and cost that cannot be matched using separate, discreteintegrated circuits. SoCs are essential for most electronic products, such ascellular phones, video game consoles, portable media players, communication andnetworking equipment and internet appliances, to achieve increasing performancerequirements at a reasonable cost.

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*Importance of Embedded Memory*

Historically,semiconductor companies implemented memory in separate integrated circuits.Rather than using separate memory chips, semiconductor companies today areembedding memory on highly integrated circuits in order to optimize performanceand size. At the same time, the increasing sophistication of electronicproducts is driving a rapid increase in the amount of memory required. Currentindustry estimates are that more than half of the chip area of a SoC iscomprised of embedded memory and this proportion is forecasted to increase inthe future with the growth of more memory-intensive applications.

The high cost ofincorporating the memory component represents a major challenge to achievinghigh levels of integration. As embedded memories account for an increasingpercentage of the size of a highly integrated circuit, they are often theslowest or limiting function in the circuit. Not only must integrated circuitscontain a larger amount of embedded memory, this memory must be dense enough tobe economically attractive and must offer sufficiently high speed and low powerconsumption. In many applications, embedded memory has become a crucial designconsideration for determining the overall cost and performance of highlyintegrated circuits and the growing number of electronic products in which theyare incorporated.

*Traditional SRAM*

Themost common form of embedded memory today utilizes traditional static randomaccess memory, or SRAM technology, that we refer to as traditional SRAM. Thistechnology is in the public domain and can be used by any semiconductorcompany. Traditional SRAM has the following characteristics—

·       itcan operate at the same high speeds as other functions of the integratedcircuit;

·       itprovides a simple and familiar interface that allows for quick design into anintegrated circuit with less risk that the design will not function accordingto specification; and

·       itutilizes the standard logic manufacturing process that is both economical andthe most widely available.

Asmemory requirements increase, however, traditional SRAM becomes relatively moreexpensive compared to the total cost of the integrated circuit. Specifically,traditional SRAM has the following drawbacks that can lead to higher cost—

·       itrequires a substantial amount of silicon area because of its low density; and

·       itconsumes a significant amount of power when operating at high speeds.

To overcome the densitylimitations of traditional SRAM, some manufacturers have utilized embeddeddynamic random access memory, or embedded DRAM. While embedded DRAM is denserthan traditional SRAM, it is typically ten times slower. Manufacturing embeddedDRAM also requires additional process steps and results in low yields, whichtranslate into increased manufacturing time and cost. Additionally, because ofits complex interface requirements, embedded DRAM is more difficult toincorporate on integrated circuits, leading to a higher risk of failure. Asintegrated circuit designers have experimented with embedded DRAM, they havediscovered that these limitations of embedded DRAM preclude its use in almostall applications. Therefore, traditional SRAM continues to be the most widelyused technology for embedded memory. One of the major challenges for thesemiconductor industry today is to find an embedded memory solution thatcombines high density, low power consumption, high speed and low cost.

**Our Solution**

Wehave developed a series of innovative memory technologies, 1T-SRAMtechnologies, which provide major advantages over traditional SRAM in density,power consumption and cost, thus making it 

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more economical for designers to incorporate largeamounts of embedded memory in their designs. In addition, our 1T-SRAMtechnologies offer all the benefits of traditional SRAM, such as high speed,simple interface and ease of manufacturability. Its core circuitry is alreadyproduction proven in millions of our memory chips and offers integrated circuitdesigners the following characteristics compared to traditional SRAM:
| **Parameters** | ** ** | **Typical Characteristics of 1T-SRAM  technologies vs. traditional SRAM**                                           |
|----------------|------------|---------------------------------------------------------------------------------------------------------------------|
| Density        |       | Uses  50% to 75% less silicon for the same amount of memory                                                         |
| Cost           |       | 50  to 70% less cost for the same amount of memory                                                                  |
| Power          |       | Can  save up to three-quarters the power when operating at the same speed                                           |
| Speed          |       | Can  provide speeds equal to or greater than those offered by traditional SRAM,  especially for larger memory sizes |

 

Our 1T-SRAM technologiescan achieve these advantages while utilizing standard logic manufacturingprocesses and providing the simple, standard SRAM interface that designers areaccustomed to today.

*High Density*

Embedded memory utilizingour 1T-SRAM technologies is typically two to three times denser thantraditional SRAM. Increased density enables manufacturers of electronicproducts, such as cellular phones, video game consoles and digital cameras andcamcorders, to incorporate additional functionality into a single integratedcircuit, resulting in overall cost savings. Semiconductor designers can takeadvantage of the high density of our 1T-SRAM technologies and embed large quantitiesof high-performance memory and other components that in the past might not havebeen feasible.

*Low Power Consumption*

Embedded memory utilizingour 1T-SRAM technologies can consume as little as one-quarter the power andgenerates less heat than traditional SRAM when operating at the same speed.This feature facilitates longer battery life, reduces system level coolingcosts and enables reliable operation using lower-cost packaging.

*High Speed*

Embedded memory utilizingour 1T-SRAM technologies typically provides speeds equal to or greater than thespeeds of traditional SRAM, especially for larger memory sizes. Our 1T-SRAMmemory designs can sustain random access cycle times of less than threenanoseconds. In today’s 0.13-micron manufacturing process technology, our1T-SRAM technologies can operate with a random access frequency in excess of400 megahertz for multi-megabit memory.

*Manufacturing Process Independence*

We have been able toimplement our technology without requiring the manufacturer to make any significantchanges to either standard logic or alternative manufacturing processes. 1T-SRAM’sportability, or the ease with which it can be implemented in differentsemiconductor manufacturing facilities, has been proven operational in thefabrication of chips at Taiwan Semiconductor Manufacturing Co., Ltd., or TSMC,United Microelectronics Corporation, or UMC, Chartered SemiconductorManufacturing Ltd., or Chartered and Semiconductor Manufacturing InternationalCorporation or SMIC, the world’s largest independent foundries. 1T-SRAM’sscalability, or the ease with which it can be implemented in different generationsof manufacturing processes, has already been demonstrated in the fabrication ofchips in 0.25-micron, 0.18-micron, 0.15-micron, 0.13-micron and 0.09-micronprocess generations, without extensive modifications. We expect our technologyto continue to scale readily to future process generations. This portabilityand scalability provides for wide availability, inexpensive implementation andquick product time to market for our licensees.

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*Simplicity of Interface*

Our 1T-SRAM technologies’internal circuitry connects to the simple, standard SRAM interface thatdesigners are accustomed to today. Our use of this standard high-performanceinterface minimizes design time, thus optimizing time to market for ourlicensees. This simple interface also helps minimize the risk that integratedcircuit designs will not operate according to specifications.

***Our Strategy***

Our goal is to establish our 1T-SRAM technologies asthe standard for all large embedded memories in SoC applications. We intend toachieve this goal by licensing our technology on a non-exclusive and worldwidebasis to foundries, integrated device manufacturers, fabless semiconductorcompanies and electronic product manufacturers.

We have extended the coverage of our technologies tosmaller memory blocks by offering our 6T-SRAM memory compilers. Utilizing thesame low-power benefits built into our 1T-SRAM technologies, our licensees canhave a complete range of low-powered embedded memory solutions to meet theirdemanding SoC requirements.

The following are integralaspects of our strategy.

*Target Large and Growing Markets*

We target the large andgrowing market for system-on-a-chip applications requiring large embeddedmemories, which are in excess of one megabyte. Our 1T-SRAM technologies thatoffer chip designers improved performance in embedded memories thus optimizingthe cost and performance of the SoC.

Although our 1T-SRAMtechnologies are applicable to many markets, we presently focus on the rapidlygrowing consumer electronics and communications sectors. These sectorsincreasingly require embedded memory solutions with higher density, lower powerconsumption, higher speeds and lower cost. We also will focus over the longerterm on other markets that are projected to achieve strong, long-term growth.

*Work Closely with Semiconductor Companies andFoundries to Deliver Optimal Technology Solutions*

We work closely withsemiconductor companies to gain broad and detailed insight into their own andtheir customers’ current and next-generation technology requirements. Thisinsight helps us identify trends and focus our development efforts onoptimizing our technology solution, resulting in shorter product time to marketand lower costs. We plan to continue to qualify and license our technology withthe leading foundries to help us understand changing market requirements and toobtain access to advance manufacturing processes.

*Extend our Technology Offerings*

Ourgoal is to continue to enhance our 1T-SRAM technologies and increase our shareof the embedded memory market. We will continue to develop our technology inorder to offer even higher-density, lower-power consumption, higher-speedand lower-cost designs for our licensees. As such, we continue to investheavily in research to develop more advanced memory technologies. Since theintroduction of 1T-SRAM in 1998, we have introduced and currently offer thefollowing improved versions of the technology:

·       1T-SRAM-R,a version that includes Transparent Error CorrectionTM (TEC), whichautomatically corrects memory errors during operation, including soft errorscaused by high-energy particles, and eliminates the need for laser repair inmanufacturing test. This is accomplished without adding silicon area or cost.Introduced in November 2001, our 1T-SRAM-R has now become the standardversion of 1T-SRAM in most of our licensing activities.

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·       1T-SRAM-M,a lower power version that is well-suited to particular applications requiringvery low operating and standby power, such as cell phone handsets, digitalcameras, personal digital assistants and other consumer wireless devices. Weintroduced 1T-SRAM-M in April 2001.

·       1T-SRAM-Q,an extended density memory that has twice the density of the original versionof our technology and up to four times the density of traditional SRAM. Weintroduced our 1T-SRAM-Q in December 2002.

·       6T-SRAM-R,a memory compiler built on the same technologies that deliver the quality andlow-power advantages offered by our 1T-SRAM technologies for large memories arenow incorporated into our 6T-SRAM-R compilers to extend these benefits to smallmemories, those less than one megabit in size, in customers’ chip designs. Thecompiler, along with our 1T-SRAM technologies, offers semiconductor designers acomplete range of embedded memories to meet their demanded SoC requirements.

In addition, we havedeveloped new generations of our 1T-SRAM technologies, most recently in the 0.09-micronmanufacturing process. We intend to continue to develop our technologies forfuture process generations.

**Licensingand Distribution Strategy**

We offer our technology ona non-exclusive and worldwide basis to semiconductor companies, electronicproduct manufacturers, foundries, intellectual property companies and designcompanies through product development, technology licensing and joint marketingrelationships.

*Licensing*

We license our technologyto semiconductor companies who incorporate our technology into integratedcircuits that they then sell to their customers. We also license our technologyto electronic product manufacturers, who then require their suppliers to adoptour technology. In addition, we engage in joint marketing activities withfoundries, intellectual property companies and design companies to promote ourtechnology to a wide base of customers. These distribution channels havebroadened the acceptance and availability of our technology in the industry. Asour technology becomes available through an increasing number of channels, webelieve it will be less likely that customers will have to alter theirprocurement practices in order to acquire our technology. We intend to continueto expand significantly this base of strategic relationships to furtherproliferate our technology.

We form product developmentand licensing relationships directly with semiconductor companies andelectronic product manufacturers. Generally, we require the prospectivelicensee to identify one or more specific projects for the use of ourtechnology. The prospective licensee’s implementation of our 1T-SRAMtechnologies typically includes customized development. Usually, theserelationships involve both engineering work to implement our technology in thespecified product and licensing the technology for manufacture and sale of theproduct. Although the precise terms contained in our 1T-SRAM macro developmentand license agreements vary, every agreement provides for the payment ofcontract fees to us at the beginning of the contract and the joint developmentof specifications and initial product design and engineering. The agreementsusually provide for payment of contract fees to us upon the achievement ofspecified development milestones. The vast majority of our contracts allowbilling between milestones based on work performed. Typically under ouragreements, the licensee is obligated to complete the project within a statedtimeframe, including assisting us in completing the final milestone, and if weperform the contracted services, is obligated to pay the license fees even if thelicensee fails to complete verification or cancels the project prior tocompletion. The agreements also often provide for the payment of additionalcontract fees if we provide engineering or manufacturing support servicesrelated to the manufacture of the product. Provisions in all of our licenseagreements require the payment of royalties to us based on the future sale ormanufacture of products utilizing our 1T-SRAM technologies. Generally, 

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ourlicenses grant rights on a nonexclusive, nontransferable basis, limited to theuse of our technology as modified for the project covered by the licenseagreement or amendment. Our license agreements generally have a fixed five-yearterm and are subject to renewal. Each new project requires a separate agreementor an addendum to modify an existing agreement.

In addition, we also offerour technology to semiconductor companies through 1T-SRAM technology licenseagreements, under which we grant the licensee the additional right to createand modify 1T-SRAM designs to offer to its own customers. The contract feesassociated with these arrangements require the licensee to pay us to port ourtechnology to its manufacturing process and develop a template design that thelicensee will be able to use to generate future designs. These agreements alsoobligate the licensee to pay contract fees to us upon the achievement ofspecified development milestones and may provide for the payment of additionalcontract fees if we provide engineering or manufacturing support services.Under these agreements we will be entitled to receive royalties based on thefuture sale or manufacture of products utilizing our 1T-SRAM technologies. Thelicenses are nonexclusive and nontransferable and authorize the licensee tomodify designs for its customers from the template design that we provide underthe agreement. Typically, the template design applies only to a specifiedmanufacturing process generation. The licensee may add future processgenerations to the license agreement for additional contract fees.

We have license agreementswith many companies, including Agere Systems, Inc., Agilent Technologies,Analog Devices, Inc., Applied Micro Circuits Corporation, BroadcomCorporation, eSilicon Corporation, Fujitsu Limited, Hitachi, Ltd., Hudson SoftCompany Limited, LG Electronics, Inc., LSI Logic Corporation, MarvellSemiconductor, Inc., Matsushita Communication Industrial Co., Ltd.,Motorola, Inc., National Semiconductor Corporation, NEC ElectronicsCorporation, Nintendo, Philips Semiconductors, Inc., Pixelworks, Inc.,Pixim, Inc., Sanyo Electric Co., Ltd., SONY Corporation, Stepmind SA,Switchcore AB, TSMC, UMC, Via Technologies, Inc., and Via NetworkingTechnologies, Inc.

*Joint Marketing Arrangement*

We have formed jointmarketing relationships with dedicated foundries such as TSMC, UMC Charteredand SMIC. These foundries have cooperated with us to prove themanufacturability of integrated circuits utilizing our 1T-SRAM technologies intheir particular manufacturing process. Once manufacturability has been proven,the foundries can then offer their manufacturing services to our licensees, andtheir integrated circuit device customers can fabricate integrated circuitsincorporating our 1T-SRAM technologies.

We also have formed analliance consisting of design service firms to enable our licensees to morerapidly incorporate 1T-SRAM technologies into their design. This DesignServices Alliance (DSA) program is intended to provide our licensees withspecialized support as the use of our technology in SoC designs increases. EachDSA member company has been trained to provide our licensees with designexpertise and product engineering resources in order to reduce the design cycletime as well as accelerate the ramp to volume production.

*Custom Memory Designs*

We offer directly to ourlicensees customized 1T-SRAM memory designs to meet their specific designparameters. We also offer a variety of options for optimizing the designspecification in order to improve performance and cost effectiveness.

*Standard Macro Designs*

In addition to licensingour customized 1T-SRAM designs, companies also can license standard 1T-SRAMoff-the-shelf memory designs from us. These readily available standard memorydesigns can assist the licensee in getting its SoC quickly to market.

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*Memory Compilers*

In 2004, we introduced our6T-SRAM-R memory compilers to offer our customers a low power alternative totraditional embedded six-transistor SRAM in applications requiring smallermemory sizes. We plan to offer future compiler products on advanced generationsof manufacturing processes.

Our compilers are offeredon a per use basis or under an unlimited use license for fees ranging from tenof thousands of dollars to several hundred thousands of dollars. As with all ofour technologies, the licensee is obligated to pay us royalties for productsmanufactured or sold utilizing our technologies.

*Technology Licenses*

We have licensed ourtechnologies to the two leading foundries; TSMC and UMC. Increasingly, thesefoundries are now providing design services and third-party intellectualproperty directly to their customers. Under our technology license agreementswith them, both TSMC and UMC have acquired a right to offer as part of theirdesign services, 1T-SRAM designs that they create for their customers. Theseagreements require them to pay us licensing and development fees, as well asroyalties on silicon wafers manufactured by them that incorporate our licensedtechnology and a percentage of the design fees that they charge their customersfor providing our technology.

We also offer ourtechnologies to leading integrated device manufacturers or, IDMs. Underour technology license agreement with Fujitsu Limited, which is our first IDMtechnology licensee, we have granted Fujitsu a worldwide non-exclusive,non-transferable right to offer its own implementation of our 1T-SRAMtechnologies directly to its customers along with its own design andmanufacturing services. Fujitsu has agreed to pay us a license fee for ourservices in porting our 1T-SRAM technologies to Fujitsu’s manufacturing process.Fujitsu also is obligated to pay us fees for technical support for the firstyear, and for each additional year thereafter if it requests such support.Further, we will be entitled to receive royalties on all integrated circuitsincorporating our licensed technologies that are sold by Fujitsu and itssubsidiaries.

**Technology**

Our innovative 1T-SRAMtechnologies include many new and proprietary features. Development of ourmemory chips during the early years of our existence was critical to validatingelements of the 1T-SRAM technologies we license today. These technologiescombine the high-density advantages of DRAM with the high performance andutility of SRAM. Underlying this technology are several distinct pieces of ourproprietary technology.

*Single-Transistor Memory Storage Cell*

The high density of our1T-SRAM technologies stems from the use of a single-transistor, or 1T,which is similar to DRAM, with a storage cell for each bit of information. Our1T storage cell using one transistor and one capacitor represents a verysignificant improvement in density over the six-transistor storage cells usedby traditional SRAM.

The following diagrams,drawn to scale, but not to actual size, are electrical schematics of thetraditional SRAM storage cell and our 1T-SRAM storage cell. The comparison ofthe two diagrams illustrates the small size and reduced complexity of the1T-SRAM storage cell. This results in significant cost savings because lesssilicon space is required by 1T-SRAM storage cells.

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*MultiBank Technology*

The high speed and lowpower consumption of 1T-SRAM are enabled by our MultiBank technology, asillustrated above. This technology efficiently partitions the memory into many,typically hundreds, of fast, small sub-blocks of memory, or banks, that canoperate independently over high-speed data buses. Only one small bankcontaining the required memory data must be active for each access to thememory. Therefore, the remaining banks can stay in a low-power, standby mode,reducing the overall power consumption of the memory.

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*Pipelined Self-timed Access*

The easy to use standardSRAM interface of 1T-SRAM technologies is enabled by our innovative andproprietary circuit designs, generating all the necessary dynamic memory arrayoperation timing signals transparently to user’s application.

*Refresh Management Circuitry*

Refresh operationsrequired to ensure data is maintained to a minimum level in dynamic cells maybe performed transparently to a user’s application, allowing designers to fullydisregard to any of the traditional requirements of dynamic cell arrays.

*Leakage Suppression Circuitry*

Our unique patentedarchitecture, circuits and proprietary design techniques that manage processleakage allow MoSys’ 1T-SRAM technologies to be manufactured on any CMOSprocess, including generic ASIC processes, thus removing the need forcomplicated embedded memory process development.

*Transparent Error Correction (TEC)*

We offer our 1T-SRAMtechnologies with TEC for higher reliability and quality. TEC automaticallycorrects memory errors during operation, including soft errors caused byhigh-energy particles, and eliminates the need for laser repair inmanufacturing test. This is accomplished without adding any additional siliconarea or cost. TEC is also incorporated into our 6T-SRAM-R memory compilersextending the same benefits provided in our 1T-SRAM technologies to the small memory block requirements incustomers’ chip designs.

*Folded Area Capacitor (FAC)*

Using an innovativecapacitor technology called Folded Area Capacitor (FAC), we can provide ourlicensees with a very high-density memory solution. Requiring only oneadditional non-critical mask during the manufacturing process, utilizing ourFolded Area Capacitor, our 1T-SRAM-Q can achieve densities up to four timesthat of traditional SRAM and twice the density of the original version of ourtechnology.

***AdvancedManufacturing Processes***

Wehave continued to implement our 1T-SRAM technologies on advanced generations ofmanufacturing processes. As a result, our licensees are able to implementintegrated circuits incorporating 1T-SRAM embedded memories on the highestperformance manufacturing processes available. The chart below illustrates asampling of test chips we have produced made in initially implementing andverifying 1T-SRAM technologies on the latest generations of manufacturingprocesses nodes. The processes with the smaller micron dimensions have higherrandom access speeds and typically enable larger capacity memories.
| **Process  Generation**      | ** ** | **0.18-micron**   | ** ** | **0.15-micron** | ** ** | **0.13-micron** | ** ** | **0.09-micron**   |
|------------------------------|------------|-------------------|------------|-----------------|------------|-----------------|------------|-------------------|
| Date of 1T-SRAM Verification |       | January 2000 |       | May 2000   |       | April 2001 |       | January 2003 |
| Typical Memory               |       | 1-32              |       | 1-48            |       | 1-64            |       | 1-64              |
| Capacity                     |       | megabits          |       | megabits        |       | megabits        |       | megabits          |
| Random Access Speed          |       | 100-250 MHz       |       | 100-250 MHz     |       | 100-400 MHz     |       | 100-450 MHz       |

 

**Research andDevelopment**

Our ability to compete inthe future will depend on improving our technology to meet the market’sincreasing demand for higher performance and lower cost requirements. We haveassembled a team of highly skilled engineers whose activities are focused ondeveloping even higher-density, lower-power consumption, higher-speedand lower-cost 1T-SRAM designs. We expect to continue to focus our research 

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anddevelopment efforts on extending our 1T-SRAM technologies and developing newmemory technologies. We also intend to continue our focus on porting ourtechnology to additional semiconductor manufacturing facilities and scaling ourtechnology to new generations of manufacturing process technologies.

As of December 31,2004, we employed 48 engineers, representing 70% of our employees, withspecific expertise in circuit design, layout and a variety of manufacturingprocesses. Effective November 10, 2004, we closed the ATMOS’ research anddevelopment facility and terminated the employment of approximately 20employees in ATMOS. We have a design center in Seoul, South Korea where nine ofour engineers reside. For the years ended December 31, 2004, 2003, and2002, research and development expenditures totaled approximately $8.1 million,$8.6 million, and $6.6 million, respectively.

**Sales and Marketing**

As of December 31,2004, we had a staff of 10 sales and marketing executives managing ourtechnology licensing activities. We have six sales and marketing personnel inU.S. who are responsible for licensing activities in North America and Asia.One is located in Sophia-Antipolis, France and is responsible for licensingactivities in Europe and the Middle East. Three sales and marketing personnelare located in Yokohama, Japan and are responsible for licensing activities inJapan. This group manages the negotiation of license agreements, provides technicalsupport during the sales cycle to licensees and administers the contracts. Aswe have multiple sales channels through our relationships with semiconductorcompanies, foundries, intellectual property companies and design companies, wedo not believe that we require a large internal sales force. Our marketing andpromotional activities include participation in industry trade shows,distribution of collateral marketing material, publication of articles in tradejournals and publicizing our licensing activities and technology achievements.We also provide presentations and working sessions with the senior technicaland business staff of prospective customers.

We are expanding ourworldwide sales and market presence through the addition of channel salesrepresentatives to augment our current direct sales personnel, increase salescoverage and provide better support for customers throughout the world.Qualified independent sales representatives can address regional customerrequirements and needs where direct sales activities are not practical, or aretoo costly. We have appointed independent sales representative in Israel,Taiwan and China. Independent sales representatives receive commissions basedon license fees generated from projects with their customers for ourtechnologies, thus limiting the upfront fixed cost and providing a costeffective solution to broaden our sales coverage.

**IntellectualProperty**

We regard our patents,copyrights, trademarks, trade secrets and similar intellectual property as criticalto our success, and rely on a combination of patent, trademark, copyright, andtrade secret laws to protect our proprietary rights. As of December 31,2004, we held 75 U.S. patents on various aspects of our technology, withexpiration dates ranging from 2011 to 2023. These 75 patents include claimsrelating to multibank partitioning, 1T-SRAM internal operation and circuittechniques, high-speed operation techniques, 1T-SRAM refresh managementtechniques and the interface of embedded 1T-SRAM storage cells in logicprocesses. We currently have eight pending U.S. patent applications, and havereceived notices of allowance with respect to two of these applications. Wealso hold 37 foreign patents with expiration dates ranging from 2012 to 2022,and we have 21 pending foreign patent applications. There can be no assurancethat others will not independently develop similar or competing technology ordesign around any patents that may be issued to us, or that we will be able toenforce our patents against infringement.

The semiconductor industryis characterized by frequent litigation regarding patent and other intellectualproperty rights. Our licensees or we might, from time to time, receive noticeof claims that we 

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haveinfringed patents or other intellectual property rights owned by others. Forexample, on March 31, 2004, we were sued by UniRAM Technology, Inc.in United States District Court for the Northern District of California basedon claims of patent infringement and misappropriation of trade secrets thatwere allegedly disclosed by UniRAM to TSMC, which allegedly improperly providedthem to us. In addition, litigation may be necessary in the future to enforceour patents and other intellectual property rights, to protect our tradesecrets, to determine the validity and scope of the proprietary rights ofothers, or to defend against claims of infringement or invalidity, and therecan be no assurance that we would prevail in any future litigation. Any suchlitigation, whether or not determined in our favor or settled by us, would becostly and would divert the efforts and attention of our management andtechnical personnel from normal business operations, which could have amaterial adverse effect on our business, financial condition and results of operations.Adverse determinations in litigation could result in the loss of ourproprietary rights, subject us to significant liabilities, require us to seeklicenses from third parties or prevent us from licensing our technology, any ofwhich could have a material adverse effect on our business, financial conditionand results of operations. Moreover, the laws of certain foreign countries inwhich our technology is or may in the future be licensed may not protect ourintellectual property rights to the same extent as the laws of the UnitedStates, thus increasing the possibility of infringement of our intellectualproperty.

**Competition**

Inorder to remain competitive, we believe we must continue to provide higher-density,lower-power-consumption, higher-speed and lower-costtechnology solutions to the semiconductor industry and electronic productmanufacturers. We believe that the principal competitive factors in ourindustry are—

·       densityand cost;

·       powerconsumption;

·       speed;

·       portabilityto different manufacturing processes;

·       scalabilityto different manufacturing process generations;

·       reliabilityand low manufacturing costs;

·       interfacerequirements; and

·       theease with which technology can be customized for and incorporated intocustomers’ products.

We believe that our1T-SRAM technologies offer a high degree of overall performance improvementover traditional SRAM. Semiconductorcompanies may satisfy their embedded memory needs through traditionalSRAM and embedded DRAM. Traditional SRAM relies on publicly available processtechnology and circuit designs, which semiconductor companies can buildinternally or acquire through a license from a third party provider, withoutpaying a royalty to us. This is currently the preferred choice for embeddedmemory solutions in SoCs. Companies providing traditional SRAM embeddedmemories include Artisan Components and Virage Logic. Embedded DRAM isprimarily offered by current or former DRAM suppliers, who utilize their ownmanufacturing process to compete in the semiconductor foundry business.Suppliers of embedded DRAM include substantial competitors such as Toshiba Ltd.and IBM, among others. Although each of these two embedded DRAM suppliers hasexperienced some success in obtaining new customers for its technology, webelieve that many semiconductor companies using embedded memory may prefer tolicense our technology instead of implementing either of these alternativesbecause of 1T-SRAM’s overall advantages.

Not all embedded memoryapplications benefit sufficiently from technological advantages offered by our1T-SRAM technologies to justify the increased cost to the licensee, however.Our licensees and prospective licensees can meet their current needs forembedded memory using other memory solutions 

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withdifferent cost and performance parameters. For example, our technologies arenot suitable for replacing lower-cost traditional DRAM memory chips if higheraccess speed is unnecessary. In addition, alternative solutions may be morecost-effective for memory block sizes of less than 1 megabit, or applicationsin which the embedded memory portion is less than 20% of the total chip area. Toprovide a technology offering for these uses, however, in January 2004 weintroduced our 6T-SRAM-R memory compilers which incorporate the same qualityand low-power advantagesavailable in our 1T-SRAM technologies and extend these benefits to the smallmemories in customers’ chip designs. Both Artisan Components and Virage Logiclicense their traditional SRAM embedded memories thorough the sale ofcompilers.

Moreover, some companiesassess greater uncertainty and risk in relying on our newly established 1T-SRAMtechnologies. As a result, our ability to compete effectively may be limitedbecause such companies may prefer to use more established traditional memorysolutions that are freely available without a license.

We have designed thecircuitry of our 1T-SRAM technologies so that our licensees can manufacture itin standard logic process, as well as other widely used embedded memoryprocesses.

**Employees**

As of December 31,2004, we had 69 full-time employees, consisting of 48 in research anddevelopment and engineering, 10 in sales and marketing and 11 in finance andadministration. We believe our future success will depend, in part, on ourability to continue to attract and retain qualified technical and managementpersonnel, particularly highly skilled design engineers involved in new productdevelopment, for whom competition is intense. Our employees are not representedby any collective bargaining unit, and we have not experienced any workstoppage. We believe that our employee relations are good.

**RISK FACTORS**

*If any of the following risks actually occur, ourbusiness, results of operations and financial condition could suffersignificantly.*

**Oursuccess depends upon the semiconductor market’s acceptance of our 1T-SRAMtechnologies.**

The future prospects ofour business depend on the acceptance by our target markets of our 1T-SRAMtechnologies for embedded memory applications and any future technology wemight develop. Our technology is intended to allow our licensees to developembedded memory integrated circuits to replace other embedded memory technologywith different cost and performance parameters. Our 1T-SRAM technologiesutilize fundamentally different internal circuitry that is not widely known inthe semiconductor industry. Therefore, one of our principal challenges, whichwe might fail to meet, is to convince a substantial percentage of SOC designersto adopt our technology instead of other memory solutions, which have proveneffective in their products.

An important part of ourstrategy to gain market acceptance is to penetrate new markets by targetingmarket leaders as licensees of our technology. This strategy is designed toencourage other participants in those markets to follow these leaders inadopting our technology. If a high-profile industry participant adopts ourtechnology for one or more of its products but fails to achieve success withthose products, or unable to successfully implement our technology, otherindustry participants’ perception of our technology could be harmed. Any suchevent could reduce the number of future licenses of our technology. Likewise,were a market leader to adopt and achieve success with a competing technology,our reputation and licensing program could be harmed.

Our embedded memorytechnology might not integrate as well as anticipated with other semiconductorfunctions in all intended applications, which would slow or prevent adoption ofour technology and reduce our revenue. Detailed aspects of our technology couldcause unforeseen problems in the efficient integration of our technology withother functions of particular integrated circuits. Any 

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significantcompatibility problems with our technology could reduce the attractiveness ofour solution, impede its acceptance in the industry and result in a decrease indemand for our technology.

We rely on third-partyfoundries to manufacture our silicon test chips, to provide references to theircustomers and to assist us in the focus of our research and developmentactivities. If we are unable to maintain our existing relationships with thesefoundries or enter into new relationships with other foundries, we will beunable to verify our technologies for their manufacturing processes and ourability to develop new technologies will be hampered. We would then be unableto license our IP to fabless semiconductor companies that use these foundriesto manufacture their silicon chips, which is a significant source of ourrevenues.

**Ourlengthy licensing cycle and our licensees’ lengthy product development cyclesmake the operating results of our licensing business difficult to predict.**

We anticipate difficultyin accurately predicting the timing and amounts of revenue generated fromlicensing our 1T-SRAM technologies. The establishment of a businessrelationship with a potential licensee is a lengthy process, generally takingfrom three to nine months, and sometimes longer during slower periods in ourindustry. Following the establishment of the relationship, the negotiation oflicensing terms can be time-consuming, and a potential licensee may require anextended evaluation and testing period.

Once a license agreementhas been executed, the timing and amount of licensing and royalty revenue fromour licensing business will remain difficult to predict. The completion of thelicensees’ development projects and the commencement of production will besubject to the licensees’ efforts, development risks and other factors outsideour control. Our royalty revenue will depend on such factors as success of thelicensees’ project, the licensees’ production and shipment volumes, the timingof product shipments and when the licensees report to us the manufacture orsale of products that include our 1T-SRAM technologies. All of these factorswill prevent us from making predictions of revenue with any certainty and couldcause us to experience substantial period-to-period fluctuations in operatingresults.

None of our licensees areunder any obligation to incorporate our technology in any present or futureproduct or to pursue the manufacture or sale of any product incorporating ourtechnology. A licensee’s decision to complete a project or manufacture a productis subject to changing economic, marketing or strategic factors. The longdevelopment cycle of our licensees’ products increases the risk that thesefactors will cause the licensee to change its plans. In the past, some of ourlicensees have discontinued development of products incorporating ourtechnology. These customers’ decisions were based on factors unrelated to ourtechnology, but, as a result, it is unlikely that we will receive royalties inconnection with those products. We expect that occasionally our licensees willdiscontinue a product line or cancel a product introduction, which couldadversely affect our future operating results and business.

**Ifthe market for system-on-a-chip integrated circuits does not expand, ourbusiness may suffer.**

Our ability to achievesustained revenue growth and profitability in the future will depend on thecontinued development of the market for SoC integrated circuits, particularlythose requiring embedded memory sizes of one megabit or more.  In addition, our ability to achieve designwins with customers is dependent upon the growth of embedded memories requiredin SoCs. SoCs are characterized by rapid technological change and competitionfrom an increasing number of alternate design strategies such as combining multipleintegrated circuits to create a system-on-a-package.

We cannot be certain thatthe market for SoCs will continue to develop or grow at a rate sufficient tosupport our business.   SoC providersdepend on the demand for products requiring SoCs such as cellular phones, gameconsoles, PDAs, digital cameras, DVD players and digital media players to namea few. The demand for such products is uncertain and difficult to predict anddepends on factors beyond our control. If the market fails to grow or developsmore slowly than expected, our business may suffer.

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**Thesemiconductor industry is cyclical in nature and subject to periodic downturns,which can negatively affect our revenue.**

The semiconductor industryis cyclical and experienced a pronounced downturn in recent years. To respondto any downturn, many semiconductor manufacturers and their customers will slowtheir research and development activities, cancel or delay new productdevelopments, reduce their workforces and inventories and take a cautiousapproach to acquiring new equipment and technologies. As a result, our businesshas been in the past and could be adversely affected in the future from adownturn that could negatively impact our future revenue and profitability. Thecyclical nature of the semiconductor industry may cause our operating resultsto fluctuate significantly from year-to-year, which also may tend to increasethe volatility of the price of our common stock.

**Wemight be unable to deliver our customized memory technology within an agreedtechnical specification in the time frame demanded by our licensees, whichcould damage our reputation, harm our ability to attract future licensees andimpact operating results.**

Our licenses require us todeliver a customized 1T-SRAM memory block or several blocks, within an agreedtechnical specification by a certain delivery timetable. This requires us tofurnish a specific design for each customer, which can make the developmentschedule difficult to predict and involves extensive interaction with ourcustomers’ engineers. From time to time we experience delays in delivering ourcustomized memory technology that meets the agreed technical specifications,which can result from slower engineering progress than we originallyanticipated or there might be factors outside of our control, such as thecustomer’s delay in completing verification of the its chip. Such delays mayaffect the timing of recognition of revenues from a particular project and canadversely affect our operating results.

In addition, any failureto meet the time requirements as well as the agreed upon technicalspecifications of our customized memory technology could lead to the failure tocollect or a delay in payment from our licensee, damage our reputation in theindustry, harm our ability to attract new licensees and negatively impact ouroperating results. In addition, a customer may assert that we are responsiblefor delays and cost overruns and demand reimbursement for some of its costs. In2004, we reduced revenue by $450,000 for a reimbursement given to a customerfor excess verification costs incurred by the customer.

**Ourbusiness model relies on royalties as a key component in the licensing of ourtechnologies, and if we fail to realize expected royalties our operatingresults will suffer.**

We believe that ourlong-term success is substantially dependent on the receipt of future royalties.Royalty payments owed to us are calculated based on factors such as ourlicensees’ selling prices, wafer production, and other variables as provided ineach license agreement. The amount of royalties we will receive depends on thelicensees’ business success, production volumes and other factors beyond ourcontrol. This exposes our business model to risks that we cannot minimizedirectly and may result in significant fluctuations in our royalty revenue andoperating results from quarter-to-quarter. We recognize royalty revenue in thequarter in which we receive a royalty report from our licensee. As a result,our recognition of royalty revenue typically lags behind the quarter in whichthe related integrated circuit is manufactured or sold by our licensee by atleast one quarter. We cannot be certain that our business strategy will besuccessful in expanding the number of licensees, nor can we be certain that wewill receive significant royalty revenue in the future.

**Weexpect our revenue to be highly concentrated among a small number of licenseesand customers, and our results of operations could be harmed if we lose andfail to replace this revenue.**

Our overall revenue hasbeen highly concentrated, with a few customers accounting for a significantpercentage of our total revenue. For the year ended December 31, 2004, ourthree largest customers, NEC, Fujitsu and Marvel represented 19%, 17% and 11%of total revenue, respectively. We expect that a 

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relativelysmall number of licensees will continue to account for a substantial portion ofour revenue for the foreseeable future.

Furthermore, our royaltyrevenue has been highly concentrated among a few licensees, and we expect thistrend to continue for the foreseeable future. In particular, a substantialportion of our licensing and royalty revenue in 2004, 2003 and 2002 has comefrom the licenses for integrated circuits used by Nintendo in its GAMECUBE®.Royalties earned from the production of Gamecube chips incorporating our1T-SRAM technology represented 15%, 11% and 41% of total revenue in the 2004,2003 and 2002, respectively. Nintendo faces intense competitive pressure in thevideo game market, which is characterized by extreme volatility, costly newproduct introductions and rapidly shifting consumer preferences, and we cannotassure you that Nintendo’s sales of product incorporating our technology willincrease beyond prior or current levels.

As a result of thisrevenue concentration, our results of operations could be impaired by thedecision of a single key licensee or customer to cease using our technology orproducts or by a decline in the number of products that incorporate ourtechnology that are sold by a single licensee or customer or by a small groupof licensees or customers.

**Ourrevenue concentration may also pose credit risks, which could negatively affectour cash flow and financial condition.**

We might also face creditrisks associated with the concentration of our revenue among a small number oflicensees and customers. As of December 31, 2004, three customersrepresented 74% of total trade receivables. Our failure to collect receivablesfrom any customer that represents a large percentage of receivables on a timelybasis, or at all, could adversely affect our cash flow or results of operationsand might cause our stock price to fall.

**Anythingthat negatively affects the businesses of our licensees could negatively impactour revenue.**

The timing and level ofour licensing and royalty revenues are dependent on our licensees and thebusiness environment in which they operate. Licensing and royalty revenue arethe largest source of our revenues; anything that negatively affects asignificant licensee or group of licensees could negatively affect our resultsof operations and financial condition. Many issues beyond our control influencethe success of our licensees, including, for example, the highly competitiveenvironment in which they operate, the strength of the markets for theirproducts, their engineering capabilities and their financial and otherresources

Likewise, we have nocontrol over the product development, pricing and marketing strategies of ourlicensees, which directly affect the licensing of our technology andcorresponding future royalties payable to us from our licensees. Our royaltyrevenues are subject to our licensees’ ability to market, produce and shipproducts incorporating our technology. A decline in sales of our licensees’royalty-generating products for any reason would reduce our royalty revenue. Inaddition, seasonal and other fluctuations in demand for our licensees’ productscould cause our operating results to fluctuate, which could cause our stockprice to fall.

**Werely on semiconductor foundries to assist us in attracting potential licensees,and a loss or failure of these relationships could inhibit our growth andreduce our revenue.**

Part of our marketingstrategy relies upon our relationships and agreements with semiconductorfoundries, such as TSMC, UMC, Chartered, and SMIC among others. These foundrieshave existing relationships, and continually seek new relationships, withcompanies in the markets we target, and have agreed to utilize theserelationships to introduce our technology to potential licensees. If we fail tomaintain and expand our current relationships with these foundries, we mightfail to achieve anticipated growth. Our relationship with these foundries isnot exclusive, and they are free to promote or develop 

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otherembedded memory technologies, including their own. The foundries’ promotions ofalternative technologies reduce the size of our potential market and mayadversely affect our revenues and operating results.

Additionally, we rely onthird-party foundries to manufacture our silicon test chips, to providereferences to their customers and to assist us in the focus of our research anddevelopment activities. If we are unable to maintain our existing relationshipswith these foundries or enter into new relationships with other foundries, wewill be unable to verify our technologies for their manufacturing processes andour ability to develop new technologies will be hampered. We would then beunable to license our IP to fabless semiconductor companies that use thesefoundries to manufacture their silicon chips, which is a significant source ofour revenues.

**Ourembedded memory technology is unique and the occurrence of manufacturingdifficulties or low production yields could hinder market acceptance of ourtechnology and reduce future revenue.**

Complex technologies likeours could be adversely affected by difficulties in adapting our 1T-SRAMtechnologies to our licensees’ product design or to the manufacturing processtechnology of a particular foundry or semiconductor manufacturer. Any decreasein manufacturing yields of integrated circuits utilizing our technology couldimpede the acceptance of our technology in the industry. The discovery ofdefects or problems regarding the reliability, quality or compatibility of ourtechnology could require significant expenditures and resources to fix,significantly delay or hinder market acceptance of our technology, reduceanticipated revenues and damage our reputation.

**Ourfailure to compete effectively in the market for embedded memory technologycould reduce our revenue.**

There exists significantcompetition in the market for embedded memory technologies. Our licensees andprospective licensees can meet their need for embedded memory by usingtraditional memory solutions with different cost and performance parameters, whichthey may internally develop or acquire from third party vendors. In the pasttwo years, the demand for applications for which our 1T-SRAM technologiesprovide distinct advantages has not experienced significant growth. Ifalternative technologies are developed that provide comparable systemperformance at lower cost than our 1T-SRAM technologies for certainapplications and/or do not require the payment of comparable royalties, or ifthe industry generally demonstrates a preference for applications for which our1T-SRAM technologies do not offer significant advantages, our ability torealize revenue from our 1T-SRAM technologies could be impaired.

We might be challenged bycompetitive developers of alternative technologies who are more established,benefit from greater market recognition and have substantially greaterfinancial, development, manufacturing and marketing resources than we have.These advantages might permit these developers to respond more quickly to newor emerging technologies and changes in licensee requirements. We cannot assureyou that future competition will not have a material adverse effect on theadoption of our technology and our market penetration.

**Ourfailure to continue to enhance our technology or develop new technology on a timelybasis could diminish our ability to attract and retain licensees and productcustomers.**

The existing and potentialmarkets for memory products and technology are characterized by ever increasingperformance requirements, evolving industry standards, rapid technologicalchange and product obsolescence. These characteristics lead to frequent newproduct and technology introductions and enhancements, shorter product lifecycles and changes in consumer demands. In order to attain and maintain asignificant position in the market, we will need to continue to enhance ourtechnology in anticipation of these market trends.

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In addition, the semiconductor industry might adopt ordevelop a completely different approach to utilizing memory for manyapplications, which could render our existing technology unmarketable orobsolete. We might not be able to successfully develop new technology, or adaptour existing technology, to comply with these innovative standards.

Our future performance depends on a number of factors,including our ability to—

·       identifytarget markets and relevant emerging technological trends, including new standardsand protocols;

·       developand maintain competitive technology by improving performance and addinginnovative features that differentiate our technology from alternativetechnologies;

·       enablethe incorporation of enhanced technology in our licensees’ and customers’products on a timely basis and at competitive prices;

·       implementour technology at future manufacturing process generation; and

·       respondeffectively to new technological developments or new product introductions byothers.

Since its introduction in1998, we have introduced enhancements to our 1T-SRAM technology designed tomeet market requirements. However, we cannot assure you that the design andintroduction schedules of any additions and enhancements to our existing andfuture technology will be met, that this technology will achieve marketacceptance or that we will be able to license this technology on terms that arefavorable to us. Our failure to develop future technology that achieves marketacceptance could harm our competitive position and impede our future growth.

**Wemay incur substantial litigation expense, which would adversely affect ourprofitability.**

On March 31, 2004, UniRAM Technology, Inc.filed a complaint against us in the United States District Court for theNorthern District of California, alleging trade secret misappropriation andpatent infringement. UniRAM’s complaint asserts that it provided trade secretinformation to Taiwan Semiconductor Manufacturing Corporation (TSMC) in 1996-97and speculated that we improperly obtained unspecified trade secrets of UniRAMfrom TSMC in an unknown manner. Subsequent to March 31, 2004, UniRAM hasamended its complaint twice to add TSMC as a defendant and additionalallegations to the suit, and to drop all infringement claims for one of the twopatents identified in the initial complaint. We believe that UniRAM’s complaintlacks merit and intend to vigorously defend against it.

We expect to incursubstantial expenses litigating the matter during 2005, at least, andpotentially thereafter but much lower than our 2004 legal fees, which pertainedprimarily to our litigation with Synopsys. In addition, although we expect toprevail in the lawsuit, if we do not, we may be required to pay substantialdamages and/or the attorneys’ fees and expenses of the other party, as well asour own. Any such damages and/or expenses could adversely affect our results ofoperation and cause net losses for the periods in which we record them.

**Ourquarterly revenues may fluctuate significantly and as a result we cannotprovide assurance of our future profitability.**

Our quarterlyrevenues have fluctuated in the past, and may in the future as a result of manyfactors, some of which are beyond our control. These factors would include thefollowing:

·       thelength of our sales cycle;

·       deferredspending decisions by customers;

·       thecyclical nature of the semiconductor industry and the general economicenvironment;

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·       thetiming and completion of milestones under license agreements; and

·       changesin the demand for integrated circuits that incorporate our technology.

We believe thatperiod-to-period comparisons of our revenues and operating results are notnecessarily meaningful and these comparisons are not indicators of futureperformance. We intend to continue our investment in research and developmentas well as in the marketing and licensing of our technology in an effort tomaximize future results. If revenue falls below our expectations in any quarterand we are not able to adjust spending in a timely manner, we may incur anoperating loss. As a result, we cannot assure you that we will be profitable ona quarterly or annual basis in the future.

**Royaltyamounts owed to us might be difficult to verify, and we might find itdifficult, expensive and time-consuming to enforce our license agreements.**

The standard terms of ourlicense agreements require our licensees to document the manufacture and saleof products that incorporate our technology and report this data to us afterthe end of each quarter. Though our standard license terms give us the right toaudit the books and records of any licensee to attempt to verify theinformation provided to us in these reports, an audit of a licensee’s recordscan be expensive and time consuming, and potentially detrimental to thebusiness relationship. A failure to fully enforce the royalty provisions of ourlicense agreements could cause our revenue to decrease and impede our abilityto maintain profitability.

**Wemight not be able to protect and enforce our intellectual property rights,which could impair our ability to compete and reduce the value of ourtechnology.**

Our technology is complexand is intended for use in complicated integrated circuits. A very large numberof new and existing products utilize embedded memory, and a large number ofcompanies manufacture and market these products. Because of these factors,policing the unauthorized use of our intellectual property is difficult andexpensive. We cannot be certain that we will be able to detect unauthorized useof our technology or prevent other parties from designing and marketingunauthorized products based on our technology. Although we are not aware of anypast or present infringement of our patents, copyrights or trademarks, or anyviolation of our trade secrets, confidentiality procedures or licensingagreements, we cannot assure you that the steps taken by us to protect ourproprietary information will be adequate to prevent misappropriation of ourtechnology. Our inability to protect adequately our intellectual property wouldreduce significantly the barriers of entry for directly competing technologiesand could reduce the value of our technology. Furthermore, we might initiateclaims or litigation against third parties for infringement of our proprietaryrights or to establish the validity of our proprietary rights. Litigation by uscould result in significant expense and divert the efforts of our technical andmanagement personnel, whether or not such litigation results in a determinationfavorable to us.

**Ourexisting patents might not provide us with sufficient protection of ourintellectual property, and our patent applications might not result in theissuance of patents, either of which could reduce the value of our coretechnology and harm our business.**

We rely on a combinationof patents, trademarks, copyrights, trade secret laws and confidentialityprocedures to protect our intellectual property rights. As of December 31,2004, we held 75 patents in the United States, which expire at various timesfrom 2011 to 2023, and 37 corresponding foreign patents. In addition, as of December 31,2004, we had eight patent applications pending in the United States and 21pending foreign applications, and had received notice of allowance of twopatent applications pending in the United States. We cannot be sure that anypatents will issue from any of our pending applications or that any claimsallowed from pending applications will be of sufficient scope or strength, orissued in all countries where our products can be sold, to provide meaningfulprotection or any commercial advantage 

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to us.Also, competitors might be able to design around our patents. Failure of ourpatents or patent applications to provide meaningful protection might allowothers to utilize our technology without any compensation to us and impair ourability to increase our licensing revenue.

**Anyclaim that our products or technology infringe third-party intellectualproperty rights could increase our costs of operation and distract managementand could result in expensive settlement costs or the discontinuance of ourtechnology licensing or product offerings.**

The semiconductor industryis characterized by vigorous protection and pursuit of intellectual propertyrights or positions, which has resulted in often protracted and expensivelitigation. For example, on March 31, 2004, we were sued by UniRAMTechnology, Inc. in United States District Court for the Northern Districtof California based on claims of patent infringement and misappropriation oftrade secrets that were allegedly disclosed by UniRAM to TSMC, which allegedlyimproperly provided them to us. Additionally, our licensees or we might, fromtime to time, receive notice of claims that we have infringed patents or otherintellectual property rights owned by others. Litigation against us, includingthe UniRAM suit, could result in significant expense and divert the efforts ofour technical and management personnel, whether or not the litigation resultsin a determination adverse to us. Although we believe that UniRAM’s claims lackmerit and we intend to rigorously defend against them, in the event of anadverse result in any such litigation, we could be required to pay damages inan amount we cannot presently predict, cease the licensing of certain technologyand expend resources to develop non-infringing technology or obtain licensesfor the infringing technology. We cannot assure you that we would be successfulin such development or that such licenses would be available on reasonableterms, or at all.

**Thediscovery of defects in our technology could expose us to liability fordamages.**

The discovery of a defectin our 1T-SRAM technology could lead our licensees to seek damages from us. Ourstandard license terms include provisions waiving implied warranties regardingour technology and limiting our liability to our licensees. We also maintaininsurance coverage that is intended to protect us against potential liabilityfor defects in our technology. We cannot be certain, however, that the waiversor limitations of liability contained in our license contracts will beenforceable, that insurance coverage will continue to be available onreasonable terms or in amounts sufficient to cover one or more large claims orthat our insurer will not disclaim coverage as to any future claim. Thesuccessful assertion of one or more large claims that exceed availableinsurance coverage or changes in our insurance policies, including premiumincreases or the imposition of large deductible or co-insurance requirements, couldcause our expenses to rise significantly and consequently harm ourprofitability.

**Ourfailure to manage the growth of our business could reduce our potential revenueand threaten our future profitability.**

The size of ourcompany has increased substantially as we grew from 43 employees in January 2001to 69 employees in December 2004. We expect to increase the size of ourengineering and sales staffs substantially in 2005. The efficient management ofour planned expansion of the development, licensing and marketing of ourtechnology, including through the acquisition of other companies will requireus to continue to—

·       implementand manage new marketing channels to penetrate different and broader marketsfor our 1T-SRAM technologies;

·       managean increasing number of complex relationships with licensees and co-marketersand their customers and other third parties;

·       expandour capabilities to deliver our technologies to our customers;

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·       improveour operating systems, procedures and financial controls on a timely basis;

·       hireadditional key management and technical personnel; and

·       expand,train and manage our workforce and, in particular, our development, sales,marketing and support organizations.

We cannot assure you thatwe will adequately manage our growth or meet the foregoing objectives. A failureto do so could jeopardize our future revenues and cause our stock price tofall.

**If wefail to retain key personnel, our business and growth could be negativelyaffected.**

Our business has beendependent to a significant degree upon the services of a small number ofexecutive officers and technical employees, including Dr. Wingyu Leung,our Executive Vice President and Chief Technical Officer. The loss of hisservices could negatively impact our technology development efforts and ourability to perform our existing agreements and obtain new customers. Wegenerally have not entered into employment or non-competition agreements withany of our employees and do not maintain key-man life insurance on the lives ofany of our key personnel.

**Ourfailure to successfully address the potential difficulties associated with ourinternational operations could increase our costs of operation and negativelyimpact our revenue.**

We are subject to many difficulties posed by doing businessinternationally, including—

·       foreigncurrency exchange fluctuations;

·       unanticipatedchanges in local regulation;

·       potentiallyadverse tax consequences, such as withholding taxes;

·       difficultiesregarding timing and availability of export and import licenses;

·       politicaland economic instability; and

·       reducedor limited protection of our intellectual property.

Because we anticipate thatlicenses to companies that operate primarily outside the United States willaccount for a substantial portion of our licensing revenue in future periods,the occurrence of any of these circumstances could significantly increase ourcosts of operation, delay the timing of our revenue and harm our profitability.

**Provisionsof our certificate of incorporation and bylaws or Delaware law might delay orprevent a change of control transaction and depress the market price of ourstock.**

Various provisions of our certificate of incorporationand bylaws might have the effect of making it more difficult for a third partyto acquire, or discouraging a third party from attempting to acquire, controlof our company. These provisions could limit the price that certain investorsmight be willing to pay in the future for shares of our common stock. Certainof these provisions eliminate cumulative voting in the election of directors,limit the right of stockholders to call special meetings and establish specificprocedures for director nominations by stockholders and the submission of otherproposals for consideration at stockholder meetings.

We are also subject to provisions of Delaware lawwhich could delay or make more difficult a merger, tender offer or proxycontest involving our company. In particular, Section 203 of the DelawareGeneral Corporation Law prohibits a Delaware corporation from engaging in anybusiness combination with any interested stockholder for a period of threeyears unless specific conditions are met. Any of these provisions could havethe effect of delaying, deferring or preventing a change in control, includingwithout 

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limitation, discouraging aproxy contest or making more difficult the acquisition of a substantial blockof our common stock.

Our board of directors mayissue up to 20,000,000 shares of preferred stock without stockholder approvalon such terms as the board might determine. The rights of the holders of commonstock will be subject to, and might be adversely affected by, the rights of theholders of any preferred stock that might be issued in the future.

**Ourstockholder rights plan could prevent stockholders from receiving a premiumover the market price for their shares from a potential acquiror.**

We have adopted astockholder rights plan, which entitles our stockholders to rights to acquireadditional shares of our common stock generally when a third party acquires 15%of our common stock or commences or announces its intent to commence a tenderoffer for at least 15% of our common stock. In 2004, we amended our stockholderrights plan twice; once, in connection with the proposed acquisition of corporationby Synopsys, Inc, and a second time to permit the acquisition of sharesrepresenting more than 15% of our common stock by a brokerage firm that managesindependent customer accounts and generally does not have any discretionaryvoting power with respect to such shares. Notwithstanding amendments of thisnature, our intention is to maintain and enforce the terms of this plan, whichcould delay, deter or prevent an investor from acquiring us in a transactionthat could otherwise result in stockholders receiving a premium over the marketprice for their shares of common stock.

**Alimited number of stockholders have the ability to influence the outcome ofdirector elections and other matters requiring stockholder approval.**

Our executive officers,directors and their affiliates or non-affiliate related entities, in theaggregate, beneficially own approximately 16% of our common stock. Thesestockholders acting together have the ability to exert substantial influenceover all matters requiring the approval of our stockholders, including theelection and removal of directors and any proposed acquisition, consolidationor sale of all or substantially all of our assets. In addition, they coulddictate the management of our business and affairs. This concentration ofownership could have the effect of delaying, deferring or preventing a changein control, or impeding an acquisition, consolidation, takeover or otherbusiness combination, which might otherwise involve the payment of a premiumfor your shares of our common stock.

**Potentialvolatility of the price of our common stock could negatively affect yourinvestment.**

We cannot assure you that there will continue to be anactive trading market for our common stock. Recently, the stock market, as wellas our common stock, has experienced significant price and volume fluctuations.Market prices of securities of technology companies have been highly volatileand frequently reach levels that bear no relationship to the operatingperformance of such companies. These market prices generally are notsustainable and are subject to wide variations. If our common stock trades tounsustainably high levels, it is likely that the market price of our commonstock will thereafter experience a material decline. In April 2004, we announcedthat our board of directors had authorized the repurchase of up to $25 millionof our common stock from time to time over the succeeding 12 months. To date werepurchased approximately $4.7 million or 1.2 million of our common stock. Anysuch repurchases could impact the price of our common stock and increasevolatility.

In the past, securitiesclass action litigation has often been brought against a company followingperiods of volatility in the market price of its securities. We could be thetarget of similar litigation in the future. Securities litigation could causeus to incur substantial costs, divert management’s attention and resources,harm our reputation in the industry and the securities markets and reduce ourprofitability.

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**The price of ourstock could decrease as a result of shares being sold in the market bydirectors, officers and other significant stockholders.**

Sales of a substantialnumber of shares of common stock in the public market could adversely affectthe market price of the common stock prevailing from time to time. The numberof shares of our common stock available for sale in the public market islimited by restrictions under the Securities Act of 1933, as amended, or theSecurities Act, but taking into account sales of stock made in accordance withthe provisions of Rules 144(k), 144 and 701, substantially all the sharesof common stock currently outstanding are eligible for sale in the publicmarket.

**Failure to achieveand maintain effective internal controls in compliance with Section 404 ofthe Sarbanes-Oxley Act could have an adverse effect on our business and stockprice.**

In connection with our2004 year-end financial statement audit, we tested and evaluated our internalcontrol over financial reporting to assess their effectiveness as requiredunder Section 404 of the Sarbanes-Oxley Act of 2002. Based on our assessment, weidentified two material weaknesses for ineffective controls over thepreparation and review of account reconciliations and application of ourrevenue recognition policy. As a result of these ineffective controls,adjustments were recorded in the fourth quarter of 2004 to correct theidentified errors.  Because of material weaknesses identified, we have concluded that our internal controls overfinancial reporting are ineffectiveas of December 31, 2004.

Despite the significantexpense, time, and effort being expended on our efforts to remediate ourinternal controls, there is no assurance that we will be able to preventadditional errors, or that we will be able to successfully remediate thesignificant deficiencies or material weaknesses in our internal controls. Potentialconsequences of a failure to remediate such significant deficiencies andmaterial weaknesses could include, among other things: enforcement actionagainst us by the SEC or other federal or state regulatory agency, lawsuits byprivate plaintiffs, adverse reaction by investors and potential investors, andharm to our reputation in the business and financial community. If any of ourinternal control significant deficiencies or material weaknesses are notadequately addressed, we could continue to experience accounting errors thatcould result in misstatements of our results of operations, restatements of ourfinancial statements, loss of confidence in us as a company, a decline in ourstock price, or otherwise adversely affect our business, reputation and resultsof operations.

**Executive Officers**

Thenames of the Company’s executive officers as of December 31, 2004 andcertain information about them are set forth below:
| **Name**     | ** ** | ** ** | ** ** | **Age**                                                                                   | ** ** | **Position(s) with the Company** |
|--------------|------------|------------|------------|-------------------------------------------------------------------------------------------|------------|---------------------------------------|
| Wingyu Leung |       | 50         |       | Executive Vice  President, Chief Technical Officer and Director                           |
| Mark Voll    |       | 50         |       | Vice President,  Finance & Administration, Chief Financial Officer and Secretary |
|         |       |       |       | Interim Chief Executive  Officer                                                          |
| Karen Lamar  |       | 43         |       | Vice President Sales and  Marketing                                                       |

 

*Wingyu Leung.  *Dr. Leunghas served as our Executive Vice President, Engineering, and Chief TechnicalOfficer and as a member of our board of directors since April 1992. Dr. Leungalso served as our Secretary from April 1992 until May 1996 and againfrom May 1997 until August 2000. Prior to joining us, Dr. Leungserved as a technology consultant to several high technology companies,including Rambus, Inc., a developer of a high-speed chip-to-chip interfacetechnology. Prior to that time, Dr. Leung served as a member of thetechnical staff of Rambus, and as a senior engineering manager at Integrated 

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Device Technology, Inc.,where he managed and participated in circuit design activities. Dr. Leungholds a B.S. in electrical engineering from the University of Maryland, a M.S.in electrical engineering from the University of Illinois, and a Ph.D. inelectrical engineering and computer science from the University of Californiaat Berkeley.

*Mark Voll.  *Effectiveon December 30, 2004, our board of directors authorized Mr. Voll to serveas interim Chief Executive Officer and report directly to the board. Mr. Voll has served as our Vice President ofFinance and Administration and Chief Financial Officer since June 2002. Mr. Vollpreviously held the same position with us from March 1998 to June 2000.From June 2000 to May 2002, Mr. Voll served as the ChiefFinancial Officer for Axis Systems, Inc., a developer of semiconductorverification tools. Mr. Voll holds a B.S. in business administration fromProvidence College.

*KarenLamar.  *Ms. Lamar became our Vice President ofSales and Marketing on September 8, 2004. Ms. Lamar held the positionof Vice President of Sales at SuperH, a semiconductor intellectual propertylicensing company that is a joint venture between Renesas Technology and STMicroelectronics from June 2003 to August 2004. From September 2000to June 2003, Ms. Lamar held the position of Vice President ofWorldwide Strategic Account Sales at Arc International. Ms. Lamar held theposition of Senior Partner Manager at Advanced RISC Machines (ARM) and wasresponsible for negotiating licensing transaction with strategic customers fromMay 1999 to September 2000. Ms. Lamar holds a B.S. in Biologyand a M.S. in Electrical Engineering from Boston University.

***Item 2***. Properties

Our principaladministrative, sales, marketing, support and research and developmentfunctions are located in a leased facility in Sunnyvale, California. Wecurrently occupy approximately 19,500 square feet of space in the Sunnyvalefacility, the lease for which extends through June 2005. We hold an optionto extend our lease for three additional years. We have leased approximately19,000 square feet of space in Ontario, Canada for our research and developmentfacility. The lease expires at the end of April 2008. In connection withthe closure of ATMOS’ operation, we are attempting to sublease this facility. Wehave leased approximately 1,400 square feet of space in Seoul, South Korea forour engineering design center. The lease expires at the end of April 2005.Additionally, we have leased approximately 1,340 square feet of space inYokohama, Japan and 140 square feet of space in Sophia-Antipolis, France forour sales and marketing offices. These leases expire at the end of November 2006and March 2005, respectively. We believe that our existing facilities areadequate to meet our current needs.

***Item 3***. Legal Proceedings

On March 31, 2004, UniRAM Technology, Inc.filed a complaint against us in the United States District Court for theNorthern District of California, alleging trade secret misappropriation andpatent infringement. UniRAM’s complaint asserts that it provided trade secretinformation to Taiwan Semiconductor Manufacturing Corporation (TSMC) in 1996-97and speculated that we improperly obtained unspecified trade secrets of UniRAMfrom TSMC in an unknown manner. Subsequent to March 31, 2004, UniRAMamended its complaint twice to add TSMC as a defendant and additionalallegations to the suit, and to drop all infringement claims for one of the twopatents identified in the initial complaint. We believe that UniRAM’s complaintlacks merit and intend to vigorously defend against it.

From time to time we maybe subject to legal proceedings and claims in the ordinary course of business. Theseclaims, even if not meritorious, could result in the expenditure of significantfinancial resources.

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***Item 4***. Submission ofMatters to a Vote of Security Holders

(a)          The Annual Meeting ofStockholders of Monolithic System Technology, Inc. was held at 9:30 a.m.Pacific Daylight Time, on November 11, 2004 at our corporate headquarterslocated at 1020 Stewart Drive, Sunnyvale, California 94085.

The three proposalspresented at the meeting were:

1.                 To elect sixmembers of the Board of Directors to hold office until the next Annual Meetingof Stockholders.

2.                 To approval ofthe Amended and Restated 2000 Stock Option Plan and Equity Incentive Plan,including approval of its material terms of such Plan and the performance goalsthereunder for purposes of Internal Revenue Code Section 162(m).

3.                 To ratify theappointment of Ernst & Young LLP as the Company’s independentregistered public accounting firm for the year ended December 31, 2004.

(b)         Eachof the six individuals nominated to serve as a member of the Board of Directorswas elected to hold office until the next Annual Meeting of Stockholders andreceived the number of votes set forth below:
| ** **     | ** ** | **For**    | ** ** | **Withhold** | ** ** |
|----------------|------------|------------|------------|--------------|------------|
| Fu-Chieh Hsu   |       | 26,644,524 |       | 1,380,918    |       |
| Wingyu Leung   |       | 26,647,609 |       | 1,377,833    |       |
| Carl E. Berg   |       | 26,345,774 |       | 1,679,668    |       |
| Tommy Eng      |       | 26,677,074 |       | 1,348,368    |       |
| James D. Kupec |       | 26,351,560 |       | 1,673,882    |       |
| Chi-Ping Hsu   |       | 26,351,560 |       | 1,673,882    |       |

 

There were no abstentions or broker non-votes.

(c)          TheCompany’s Amended and Restated 2000 Stock Option Plan and Equity Incentive Planwere approved by the votes set forth below:
| **For**    | ** ** | **Against** | ** ** | **Abstain** | ** ** | **Broker Non Vote** |
|------------|------------|-------------|------------|-------------|------------|---------------------|
| 13,837,325 |       | 1,568,600   |       | 10,225      |       | 12,609,292          |

 

(d)         Theratification of the appointment of the accounting firm of Ernst &Young LLP as the Company’s independent registered accounting firm for the yearended December 31, 2004 was approved by the votes set forth below:
| **For**    | ** ** | **Against** | ** ** | **Abstain** |
|------------|------------|-------------|------------|-------------|
| 27,891,625 |       | 105,376     |       | 28,441      |

 

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**Part II**

***Item 5***. Market forRegistrant’s Common Equity and Related Stockholder Matters

Our common stock is quotedon the NASDAQ National Market under the symbol MOSY. The following table setsforth the range of high and low sales prices of our common stock for eachperiod indicated.
| **Quarter ended**  | ** ** | ** ** | ** ** | **High** | ** ** | **Low** | ** ** |
|-------------------------|------------|------------|------------|----------|------------|---------|------------|
| December 31, 2004  |       | $          | 6.66       |     | $          | 4.07    |       |
| September 30, 2004 |       | $          | 8.30       |     | $          | 3.67    |       |
| June 30, 2004      |       | $          | 13.45      |     | $          | 6.45    |       |
| March 31, 2004     |       | $          | 13.40      |     | $          | 6.90    |       |
| December 31, 2003  |       | $          | 9.05       |     | $          | 6.64    |       |
| September 30, 2003 |       | $          | 13.12      |     | $          | 8.10    |       |
| June 30, 2003      |       | $          | 9.40       |     | $          | 5.70    |       |
| March 31, 2003     |       | $          | 12.64      |     | $          | 5.35    |       |

 

We had 44 shareholders ofrecord as of February 23, 2005. We have not declared orpaid any cash dividends on its common stock and presently intends to retain itsfuture earnings, if any, to fund the development and growth of its businessand, therefore, do not anticipate paying any cash dividends in the foreseeablefuture.

*Stock RepurchasePlan.*

On April 19, 2004, we announced that our board ofdirectors authorized us to purchase up to $25 million of our common stockover the next 12 months. The share repurchases may be made, from time to timein the open market subject to market conditions and other factors, such as ourbelief that the repurchase will be beneficial to stockholders. Theserepurchases may be commenced or suspended at any time or from time to timewithout prior notice. To date, we have repurchased 1,182,000 shares of ourcommon stock at a cost of approximately $4.7 million, all in the third quarterof 2004.

Ourstock repurchases under the above plan are summarized below (in thousandsexcept for share values):
| **Period**                                             | ** ** | ** ** | ** ** | **Total Number  of Shares  Purchased** | ** ** | **Average Price  Paid per Share** | ** ** | **Total Dollar Value  Purchased as  Part of Publicly  Announced Plan** | ** ** | **Maximum  Dollar Value that  May Yet Be  Purchased  Under Plan** | ** ** |
|--------------------------------------------------------|------------|------------|------------|--------------------------------------------------|------------|--------------------------------------------------|------------|------------------------------------------------------------------------------------------------------|------------|--------------------------------------------------------------------------------------------|------------|
| April 19,  2004 – July 31, 2004         |       |       | —     |                                             |       |                                             | $          | —                                                                                               |       |                                                                                       |       | $ | — |   |   |   | $ | 25,000 |   |   |
| August 1,  2004 – August 31, 2004       |       |       | 1,117      |                                             |       |                                             | 3.93       |                                                                                                 |       |                                                                                       | 4,386      |   |   |   | 20,614 |   |   |
| September 1,  2004 – September 30, 2004 |       |       | 65         |                                             |       |                                             | 4.11       |                                                                                                 |       |                                                                                       | 267        |   |   |   | 20,347 |   |   |
| October 1,  2004 – December 31, 2004    |       |       | —     |                                             |       |                                             | —     |                                                                                                 |       |                                                                                       | —     |   |   |   | 20,347 |   |   |
| Total                                                  |       |       | 1,182      |                                             |       |                                             | $          | 3.94                                                                                                 |       |                                                                                       |       | $ | 4,653 |   |   |   |   |   |   |

 

*Other Information*

The Securities and Exchange Commission declared theCompany’s first registration statement, filed on Form S-1 under theSecurities Act of 1933 (File No. 333-43122) relating to the Company’sinitial public offering (IPO) of its common stock, effective on June 27,2001. The Company realized approximately $51.6 million after offering expenses.To date, the Company has not used any of the net proceeds of the IPO except toacquire short-term and long-term investments and cash equivalents.

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***Item 6***. Selected FinancialData

Thefollowing selected financial data presented below are derived from ourconsolidated financial statements. The selected financial data should be readin conjunction with our financial statements and notes related to thosestatements, and with “Management’s Discussion and Analysis of FinancialCondition and Results of Operations” included herein.
| ** **                                                     | ** ** | **Year Ended December 31,**                         | ** ** |
|----------------------------------------------------------------|------------|--------------------------------------------------------------------|------------|
| ** **                                                     | ** ** | **2004**                                                           | ** ** | **2003** | ** ** | **2002** | ** ** | **2001** | ** ** | **2000** | ** ** |
| ** **                                                     | ** ** | **(in thousands, except per share data)** | ** ** |
| Net revenue:                                                   |       |                                                               |       |   |   |   |   |   |   |   |   |
| Product                                                        |       | $                                                                  | 952        |   | $ | 1,904 |   | $ | 2,924 |   | $ | 12,991 |   | $ | 12,893 |   |
| Licensing                                                      |       | 4,544                                                              |       | 10,418 |   | 10,523 |   | 6,053 |   | 1,440 |   |
| Royalty                                                        |       | 5,325                                                              |       | 6,911 |   | 14,344 |   | 3,446 |   | 10 |   |
|                                                           |       | 10,821                                                             |       | 19,233 |   | 27,791 |   | 22,490 |   | 14,343 |   |
| Cost of net  revenue:                                          |       |                                                               |       |   |   |   |   |   |   |   |   |
| Product                                                        |       | 655                                                                |       | 1,217 |   | 1,668 |   | 5,776 |   | 5,388 |   |
| Licensing                                                      |       | 1,613                                                              |       | 1,970 |   | 1,730 |   | 633 |   | 517 |   |
|                                                           |       | 2,268                                                              |       | 3,187 |   | 3,398 |   | 6,409 |   | 5,905 |   |
| Gross profit                                                   |       | 8,553                                                              |       | 16,046 |   | 24,393 |   | 16,081 |   | 8,438 |   |
| Operating  expenses:                                           |       |                                                               |       |   |   |   |   |   |   |   |   |
| Research and development                                       |       | 8,096                                                              |       | 8,741 |   | 6,926 |   | 5,201 |   | 3,915 |   |
| Selling, general and administrative                            |       | 13,331                                                             |       | 6,432 |   | 5,266 |   | 5,340 |   | 4,034 |   |
| Restructuring expense                                          |       | 585                                                                |       | — |   | — |   | — |   | — |   |
| Total operating expenses                                       |       | 22,012                                                             |       | 15,173 |   | 12,192 |   | 10,541 |   | 7,949 |   |
| Income (loss)  from operations                                 |       | (13,459                                                            | )          | 873 |   | 12,201 |   | 5,540 |   | 489 |   |
| Interest and other  income                                     |       | 11,578                                                             |       | 1,914 |   | 1,539 |   | 1,818 |   | 1,149 |   |
| Income (loss)  before provision for income taxes               |       | (1,881                                                             | )          | 2,787 |   | 13,740 |   | 7,358 |   | 1,638 |   |
| Provision for income taxes                                     |       | (26                                                                | )          | (279 | ) | (1,373 | ) | (367 | ) | (308 | ) |
| Net income (loss)                                              |       | $                                                                  | (1,907     | ) | $ | 2,508 |   | $ | 12,367 |   | $ | 6,991 |   | $ | 1,330 |   |
| Net income (loss) per  share:                                  |       |                                                               |       |   |   |   |   |   |   |   |   |
| Basic                                                          |       | $                                                                  | (0.06      | ) | $ | 0.08 |   | $ | 0.41 |   | $ | 0.35 |   | $ | 0.13 |   |
| Diluted                                                        |       | $                                                                  | (0.06      | ) | $ | 0.08 |   | $ | 0.40 |   | $ | 0.25 |   | $ | 0.05 |   |
| Shares used in computing  net income (loss) per share:         |       |                                                               |       |   |   |   |   |   |   |   |   |
| Basic                                                          |       | 30,750                                                             |       | 30,504 |   | 29,902 |   | 19,709 |   | 10,013 |   |
| Diluted                                                        |       | 30,750                                                             |       | 30,998 |   | 31,275 |   | 28,390 |   | 25,624 |   |
| Allocation of  stock-based compensation to operating expenses: |       |                                                               |       |   |   |   |   |   |   |   |   |
| Research and development                                       |       | $                                                                  | 44         |   | $ | 148 |   | $ | 340 |   | $ | 781 |   | $ | 574 |   |
| Selling, general and administrative                            |       | 24                                                                 |       | 311 |   | 316 |   | 654 |   | 511 |   |
|                                                           |       | $                                                                  | 68         |   | $ | 459 |   | $ | 656 |   | $ | 1,435 |   | $ | 1,085 |   |

 

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| ** **                                              | ** ** | **December 31,** | ** ** |
|---------------------------------------------------------|------------|-----------------------|------------|
| ** **                                              | ** ** | **2004**              | ** ** | **2003** | ** ** | **2002** | ** ** | **2001** | ** ** | **2000** | ** ** |
| **Balance Sheet Data:**                                 |       |                  |       |   |   |   |   |   |   |   |   |   |   |
| Cash, cash equivalents and short-term investments  |       |                  | $          | 62,349 |   |   | $ | 41,365 |   | $ | 68,433 |   | $ | 84,293 |   | $ | 23,397 |   |
| Working capital                                         |       |                  | 62,535     |   |   | 44,426 |   | 71,213 |   | 82,343 |   | 20,733 |   |
| Total assets                                            |       |                  | 104,582    |   |   | 106,892 |   | 103,090 |   | 89,596 |   | 29,798 |   |
| Deferred revenue                                        |       |                  | 501        |   |   | 506 |   | 1,779 |   | 3,418 |   | 5,973 |   |
| Mandatorily  redeemable convertible preferred stock     |       |                  | —     |   |   | — |   | — |   | — |   | 35,591 |   |
| Stockholders’ equity  (deficit)                    |       |                  | 100,408    |   |   | 103,511 |   | 98,697 |   | 84,104 |   | (13,852 | ) |
|                                                         |            |                       |            |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |

 

***Item 7***. Management’sDiscussion and Analysis of Financial Condition and Results of Operations

*This Management’s Discussion and Analysis of FinancialCondition and Results of Operations should be read in conjunction with theaccompanying consolidated financial statements and notes included in thisreport.*

***Overview***

We design, develop, license and market memorytechnologies used by the semiconductor industry and electronic productmanufacturers. We have developed a patented semiconductor memory technology,called 1T-SRAM, that offers a combination of high density, low powerconsumption and high speed at performance and cost levels that other availablememory technologies do not match. We license this technology to companies thatincorporate, or embed, memory on complex integrated circuits, such as SoCs. Wehave also sold memory chips based on our 1T-SRAM technologies. In the secondquarter of 2004, we notified customers of our decision to discontinue the saleof our memory chip products.

Using elements of our existing memory technology as afoundation, we completed development of our first memory chips incorporatingour 1T-SRAM technologies in the fourth quarter of 1998. We signed our firstlicense agreement related to our 1T-SRAM technologies at the end of the fourthquarter of 1998 and recognized licensing revenue from our 1T-SRAM technologiesfor the first time in the first quarter of 2000. We have introduced improvedand enhanced versions of our technology, 1T-SRAM-R, 1T-STRAM-M, and1T-SRAM-Q.

We generate revenue from the licensing of ourintellectual property, which consists of both licensing revenues and royalties.Our licensing revenue consists of fees paid for engineering development and engineeringsupport services. Royalty revenues are earned under each of our licensingagreements when our licensees manufacture or sell products that incorporate anyof our 1T-SRAM technologies and report the results to us.

As of December 31, 2004,we had signed license agreements related to our 1T-SRAM technologies with 48companies, 13 of which have paid us royalties to date. Generally, we expect ourtotal sales cycle, or the period from our initial discussion with a prospectivelicensee to our receipt of royalties from the licensee’s use of our 1T-SRAMtechnologies, to run from 18 to 24 months after the commencement of theproject.

During 2002, we purchasedATMOS Corporation, a semiconductor memory company focused on creatinghigh-density, compiler-generated embedded memory solutions for SoCapplications. Effective November 10, 2004, we closed the ATMOS researchand development facility in Canada and terminated the employment ofapproximately 20 employees working there. Restructuring charges related to theclosure of approximately $585,000 were included in the 2004 results.

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***Sources of Revenue***

We generate three types of revenue: licensing,royalties and product sales. Prior to 2001, we derived almost all our revenuefrom the sale of memory chips. Since the beginning of 2001, product revenue asa percentage of our total revenue has declined significantly, while licensingand royalty revenues have grown substantially as a percentage of total revenue.In the third quarter of 2001, for the first time, combined license and royaltyrevenue exceeded product revenue. By the end of third quarter of 2004, we hadexited the product business except for minor ongoing sales of products requiredfrom time to time by customers.

*Licensing.*   Our license agreements involve long sales cycles,which makes it difficult to predict when the agreements will be signed andwhen, if ever, we will recognize revenues under the agreements. In addition,our licensing revenues fluctuate from period to period, and, it is difficultfor us to predict the timing and magnitude of such revenue fromquarter-to-quarter. Moreover, we believe that the amount of licensing revenuesfor any period is not necessarily indicative of results in any future period. Ourfuture revenue results are subject to a number of factors, particularly thosedescribed in Part I, “Business—Risk Factors”.

Our licensing revenue consists of fees for providingcircuit design, layout and design verification and granting a license to acustomer that is embedding our memory technology into its product. For somecustomers, we also provide engineering support services to assist in thecommencement of production of products utilizing the licensed 1T-SRAMtechnologies. License fees generally range from one hundred thousand dollars toseveral million dollars per contract, depending on the scope and complexity ofthe development project, the licensee’s rights and licensee generally pays thelicense fees in installments at the beginning of the license term and upon theattainment of specified milestones. The vast majority of our contracts allowbilling between milestones based on work performed. All license agreementsentered into to date require us to meet performance specifications. For agreementsinvolving performance specifications that we have not met and for which we lackthe historical experience to reasonably estimate the costs, we deferrecognition of revenue until the licensee manufactures products that meet thecontract performance specifications and recognize revenue under the completedcontract accounting method. Fees collected prior to revenue recognition arerecorded as deferred contract revenue. However, if the agreement involvesperformance specifications that we have significant experience in meeting andthe cost of contract completion can be reasonably estimated, we recognizerevenue over the period in which the contract services are performed under thepercentage of completion accounting method. Revenue is recognized when collectibilityis probable. We use actual direct labor hours incurred to measure progresstowards completion. If the amount of revenue recognized under the percentage ofcompletion method exceeds the amount of billings to a customer, then under thepercentage of completion accounting method, we account for the excess amount asan unbilled contract receivable. Our total unbilled contract receivable was$57,000, $1,106,000 and $693,000 as of December 31, 2004, 2003, and 2002,respectively.

From time to time, a licensee may cancel a projectduring the development phase. Such a cancellation is not within our control andis often caused by changes in market conditions or the licensee’s business.Cancellations of this nature are an aspect of our licensing business, and mostof our newer contracts allow us to retain all payments that we have received orare entitled to collect for items and services provided before the cancellationoccurs. We will consider a project to have been canceled even in the absence ofspecific notice from our licensee, if there has been no activity under thecontract for a significant period, and we believe that completion of thecontract is unlikely. In this event, we recognize revenue in the amount of cashreceived, if we have performed a sufficient portion of the development. If acancelled contract had been entered into before the establishment oftechnological feasibility, the costs associated with the contract would havebeen expensed prior to the recognition of revenue. In that case, there would beno costs associated with that revenue recognition, and gross margin wouldincrease for the corresponding period. In 2004, we recognized no licensingrevenue from cancelled contracts compared to $759,000 in 2003 and $804,000 in2002.

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*Royalties*.   Each license agreementprovides for royalty payments at a stated rate. We negotiate royalty rates bytaking into account such factors as the anticipated volume of the licensee’ssales of products utilizing our technologies and the cost savings to beachieved by the licensee through the use of our technology. Our licenseagreements require the licensee to report the manufacture or sale of productsthat include our technology after the end of the quarter in which the sale ormanufacture occurs. We recognize royalties from reports provided by thelicensee that are received in the quarter immediately following the quarterduring which the licensee has sold or manufactured products containing ourtechnology.

As with our licensing revenues, the timing and levelof royalties are difficult to predict. They depend on the licensee’s ability tomarket, produce and sell products incorporating our technology. Many of theproducts of our licensees that are currently subject to licenses from us areconsumer products, such as electronic game consoles, for which demand can beseasonal and generally highest in the fourth quarter. We would report royaltiesfrom products sold in the fourth quarter in the first quarter of the followingyear. If a licensee holds excess inventory of products using our licensedtechnology, we are unlikely to report additional royalty revenue attributableto that product until the quarter after the licensee restarts production. For adiscussion of factors that could contribute to the fluctuation of our revenues,see Part I “Business—Risk Factors—Our lengthy licensing cycle and ourlicensees’ lengthy development cycles will make the operating results of ourlicensing business difficult to predict,” and “Anything that negatively affectsthe business of our licensees could negatively impact our revenue.”

*Product sales.*   Product sales are typically ona purchase-order basis, with shipment of product occurring from one to sixmonths later. Allowances for sales returns or warranty liabilities are recordedbased upon historical experiences and any specific known pending customerreturns. Our products are manufactured, assembled and tested prior to shipmentby independent, third-party contractors. We contract for manufacturing serviceson a purchase-order basis and have no long-term commitments for the supply ofany of our memory chip products.

In the second quarter of2004, we have notified customers of our decision to discontinue sale of ourmemory chip products. As of the end of the third quarter of 2004, we had noremaining product inventory. Accordingly, we will have only minor ongoing salesof products required from time to time by customers.

***Critical Accounting Policies***

*Use of estimates.*   Our discussion and analysis ofour financial condition and results of operation are based upon ourconsolidated financial statements, which have been prepared in accordance withaccounting principles generally accepted in the United States. The preparationof these financial statements requires us to make certain estimates andjudgments that affect the reported amounts of assets, liabilities, revenues andexpenses. On an ongoing basis we make these estimates based on our historicalexperience and on assumptions that we consider reasonable under thecircumstances. Actual results may differ from these estimates, and reportedresults could differ under different assumptions or conditions.

We believe that thefollowing accounting policies are affected by estimates and judgments in thefollowing manner:

*Revenue.*

*License.*   In accordance with SOP 81-1“Accounting for performance of construction-type and certain production typecontracts”, when license agreements include deliverables that require “significantproduction, modification or customization”, contract accounting is applied. Ifa licensing contract involves performance specifications that we havesignificant experience in meeting and the direct labor hours to be incurred tocomplete the contract can be reasonably estimated, we recognize the revenueover the period in which the contract services are performed using thepercentage of completion method. The percentage 

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of completion methodincludes judgmental elements, such as determining that we have the experienceto meet the design specifications and estimation of the total direct laborhours. We follow this method because we can obtain reasonably dependableestimates of the direct labor hours to perform the contracted services. Thedirect labor hours for the development of the licensee’s design are estimatedat the beginning of the contract. As these direct labor hours are incurred,they are used as a measure of progress towards completion. We have the abilityto reasonably estimate direct labor hours on a contract to contract basis fromour experience in developing prior licensee’s designs. During the contractperformance period we review estimates of direct labor hours to complete thecontracts as the contract progresses to completion and will revise ourestimates of revenue and gross profit under the contract if we revise theestimations of the direct labor hours to complete. Our policy is to reflect anyrevision in the contract gross profit estimate in reported income in the periodin which the facts giving rise to the revision become known. Under thepercentage of completion method, provisions for estimated losses on uncompletedcontracts are recognized in the period in which the likelihood of such lossesis determined.

For contracts involving design specifications that wehave not met previously, we defer the recognition of revenue until the designmeets the contractual design specifications and expenses the cost of servicesas incurred. When we have experience in meeting design specifications but donot have significant experience to reasonably estimate the direct labor hoursrelated to services to meet a design specification, we defer both therecognition of revenue and the cost. For these arrangements, we recognizerevenue using the completed contract method. Under the completed contractmethod, we recognize revenue when we have knowledge that the customer hassuccessfully verified our design.

Under our support and maintenance arrangements, weprovide unspecified upgrades, design rule changes and technical support. Noother upgrades, products or other post-contract support are provided. Thesearrangements are renewable annually by the customer. Support and maintenancerevenue is recognized at its fair value ratably over the period during whichthe obligation exists, typically 12 months. The fair value of any support andmaintenance obligation is established based on the specified renewal rate forsuch support and maintenance. When we provide a combination of products andservices to customers, in addition to the considerations noted above, weevaluate the arrangements under EITF 00-21, *Revenue Arrangements with Multiple Deliverables*.

*Product.*   Revenue fromproduct sales is recognized upon shipment provided that persuasive evidence ofa sales arrangement exists, the price is fixed or determinable, title hastransferred, collection of resulting receivables is reasonably assured, thereare no customer acceptance requirements and there are no remaining significantobligations. For each of the periods presented, there were no formal acceptanceprovisions with our end customers.

*Royalty*.   Licensing contracts provide also forroyalty payments at a stated rate and require licensees to report themanufacture or sale of products that include our 1T-SRAM technologies after theend of the quarter in which the sale or manufacture occurs. We recognizeroyalties in the quarter in which we receive the licensee’s report.

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*Goodwill.  *Wereview goodwill, recorded from the acquisition of ATMOS Corp. on August 2002,for impairment annually and whenever events or changes in circumstancesindicate the carrying value of an asset may not be recoverable in accordancewith the Statement of Financial Accounting Standards (“SFAS”) No. 142, “Goodwilland Other Intangible Assets.”  Theprovisions of SFAS No. 142 require that a two-step impairment test beperformed on goodwill. In the first step, we compare the fair value of eachreporting unit to its carrying value. Using the guidance in SFAS No. 142,we consider there to be only one reporting unit at the entity level. For stepone, we determine the fair value of our reporting unit using the marketapproach. Under the market approach, we estimate the fair value based on themarket value of the reporting unit at the entity level. If the fair value ofthe reporting unit exceeds the carrying value of net assets assigned to thereporting unit, goodwill is not impaired and we are not required to performfurther testing. If the carrying value of the net assets assigned to thereporting unit exceeds the fair value of the reporting unit, we must performthe second step in order to determine the implied fair value of the reportingunit’s goodwill and compare it to the carrying value of the reporting unit’sgoodwill. If the carrying value of a reporting unit’s goodwill exceeds itsimplied fair value, then we must record an impairment loss equal to thedifference. We performed the annual impairment test during the third quarter of2004 and the test did not indicate impairment of goodwill as of September 30,2004. As of December 31, 2004, we found no indicators of potentialimpairment.

*Restructuring Charges.  *Inthe fourth quarter of 2004, we recorded significant restructuring chargesrelated to the closure of our ATMOS research and development facility inCanada. Those charges represented expenses incurred due to severance and fringebenefits and lease abandonment in connection with the closure of the facility.

Restructuring charges for exit costs require the useof estimates, primarily related to the cost of exiting facilities, includingestimates and assumptions related to future maintenance costs, our ability tosecure a sub-tenant, if applicable, and any sublease income to be received inthe future.

We accounted for the restructuring charges under SFAS No. 146*Accounting for Costs Associated with Exit orDisposal Activities*. SFAS No. 146 requires that a liability fora cost associated with an exit or disposal activity be recognized when theliability is incurred rather than at the date of an entity’s commitment to anexit plan. If we fail to make accurate estimates regarding these costs or toaccurately estimate the timing of the completion of planned activities, we maybe required to record additional expenses or expense reductions in the future.

*Taxvaluation allowance.  *When we prepare our consolidatedfinancial statements, we estimate our income tax liability for each of thevarious jurisdictions where we conduct business. This requires us to estimateour actual current tax exposure and to assess temporary differences that resultfrom differing treatment of certain items for tax and accounting purposes.These differences result in deferred tax assets and liabilities, which we showon our consolidated balance sheet under the category of other current assets.The net deferred tax assets are reduced by a valuation allowance if, based uponweighted available evidence, it is more likely than not that some or all of thedeferred tax assets will not be realized. When we establish a valuationallowance or increase this allowance in an accounting period, we must record atax expense in our consolidated statement of operations unless the increase isattributable to stock based compensation deductions, which has been recordeddirectly to equity. We must make significant judgments to determine ourprovision for income taxes, our deferred tax assets and liabilities and anyvaluation allowance to be recorded against our net deferred tax asset. As of December 31,2004, we had a valuation allowance of approximately $10.8 million, of which approximately$6.2 million was attributable to Canadian net operating losses and $4.1millionwas attributable to U.S. and state net operating loss and tax creditcarryforwards.

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**Results of Operations**

Thefollowing discussion compares the historical results of operations based onU.S. generally accepted accounting principles for the years ended December 31,2004, 2003 and 2002. Results of operations as a percentage of net revenue wereas follows:
| ** **                          | ** ** | **Year ended December 31,** | ** ** |
|-------------------------------------|------------|--------------------------------------------|------------|
| ** **                          | ** ** | **2004**                                   | ** ** | **2003** | ** ** | **2002** | ** ** |
| Net revenue:                        |       |                                       |       |   |   |   |   |
| Product                             |       | 9                                          | %          | 10 | % | 10 | % |
| Licensing.                          |       | 42                                         |       | 54 |   | 38 |   |
| Royalty                             |       | 49                                         |       | 36 |   | 52 |   |
|                                |       | 100                                        |       | 100 |   | 100 |   |
| Cost of net revenue:                |       |                                       |       |   |   |   |   |
| Product                             |       | 6                                          |       | 6 |   | 6 |   |
| Licensing                           |       | 15                                         |       | 11 |   | 6 |   |
|                                |       | 21                                         |       | 17 |   | 12 |   |
| Gross profit                        |       | 79                                         |       | 83 |   | 88 |   |
| Operating expenses:                 |       |                                       |       |   |   |   |   |
| Research and development            |       | 75                                         |       | 46 |   | 25 |   |
| Selling, general and administrative |       | 123                                        |       | 33 |   | 19 |   |
| Restructuring expense               |       | 5                                          |       | — |   | — |   |
| Total operating expenses            |       | 203                                        |       | 79 |   | 44 |   |
| Income (loss) from operations       |       | (124                                       | )          | 4 |   | 44 |   |
| Interest and  other income          |       | 106                                        |       | 10 |   | 6 |   |
| Provision for  income taxes         |       | —                                     |       | (1 | ) | (5 | ) |
| Net income (loss)                   |       | (18                                        | )%         | 13 | % | 45 | % |

 

*Years Ended December 31,2004, 2003 and 2002*

*Revenue.  *In2004, total revenue decreased to $10.8 million representing a 44% decline fromtotal revenue in 2003. The decline was mainly attributable to a significantdecrease in licensing revenue, which declined to $4.5 million in 2004 from$10.4 million in 2003. Licensing revenue decreased in 2004 because we did notadd new licensing projects to offset the decrease in licensing revenue earnedfrom older projects that we completed in 2004. In 2004, we reduced revenue by$450,000 for a reimbursement given to a customer for excess verification costsincurred by the customer. Royalty revenue decreased to $5.3 million in 2004from $6.9 million in 2003, which included a one-time past due royalty paymentof approximately $713,000 from Conexant in 2003. Excluding that one-timepayment, total royalties in 2004 declined by approximately $900,000 from 2003,as customer sales of chips incorporating our technology declined. For example,royalties related to the production of Nintendo Gamecube chips represented $1.7million in 2004 compared to $2.1 million in 2003.

In 2003, total revenue decreased to $19.2 million from$27.8 million representing a 31% decline from 2002. The decline was mainlyattributable to a significant decrease in royalty revenue, which declined to$6.9 million in 2003 from $14.3 million in 2002.  Gamecube-related revenue represented 11%of our total revenue in 2003, a decrease from 41% of our total revenue in 2002as Nintendo reduced its purchases of chips incorporating our licensedtechnology for its Gamecube consoles. Royalty revenues from other licenseesincreased in 2003 compared to 2002, however, mainly due to increased sales ofroyalty-bearing products first shipped in 2002. Licensing revenue alsodecreased slightly to $10.4 million in 2003 from $10.5 million in 2002 as weearned licensing revenue from our new projects started in 2003 largely offsetthe 

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decrease in licensingrevenue earned from the older projects completed in 2003. During the secondquarter of 2003, we collected $1.0 million in cash from Conexant for thetermination of its October 2000 license agreement with us. That paymentconsisted of current and past due royalty payments totaling $713,000, and acontract termination fee of $287,000, which we included in other income.

In 2002, total revenue was $27.8 million primarilyfrom licensing and royalty activities. Royalties earned from the sale ofGamecube chips incorporating our 1T-SRAM technology represented a significantportion of our total revenue in 2002. Royalty revenues from other licenseesalso increased in 2002 as we simultaneously increased and diversified ourlicensees and development projects during that year. Majority of licensingrevenue earned in 2002 was derived from development projects other thanGamecube related projects.

During the years ended December 31, 2004, 2003,and 2002, our product sales totaled $952,000, $1.9 million and $2.9 million, respectively. Sales of ourmemory chips have declined steadily as we shifted our primary focus fromproduct sales to the licensing of our 1T-SRAM technologies after 1999. In thesecond quarter of 2004, we notified customers of our decision to discontinuesale of our memory chip products. As of the end of the third quarter of 2004,we had no remaining product inventory of value. Accordingly, we will only haveminor ongoing sales of products required from time to time by customers. Wehave approximately $74,000 of product revenue from the products shipped fromthe inventory previously written off in 2004.

*Gross Profit.  *Grossprofit decreased to $8.6  millionin 2004 from $16.0 million in 2003 primarily due to the significantdecline in our licensing revenue. Our gross profit as a percentage of totalrevenue decreased to 79% in 2004 from 83% in 2003 primarily due to the declinein licensing gross profit which fell to 65% in 2004 from 81% in 2003. Thisdecline occurred because we incurred higher cost in fulfilling our obligationsunder new license agreements than we had originally estimated or hadhistorically experienced. In addition, we recognized revenue under some lowermargin license projects including a few contracts in which our estimated costexceeded the amount of revenue to be recognized.

Gross profit decreased to $16.0 million in 2003from $24.4 million in 2002 primarily due to the significant decline in ourroyalty revenue, which has no associated costs. Primarily for this reason, ourgross profit as a percentage of total revenue decreased to 83% in 2003 from 88%in 2002. Licensing gross profit declined to 81% in 2003 from 84% in 2002primarily because we recognized revenue under some lower margin licenseprojects in 2003.

In 2004, product gross margin as a percentage ofproduct revenue decreased to 31% compared to 36% in 2003 mainly due to an inventory write-off ofapproximately $ 230,000 in 2004, which was not previouslyreserved for. In 2003,product gross margin as a percentage of product revenue decreased to 36%compared to 43% in 2002. The decline resulted primarily from lower averageselling prices for our memory chips in 2003. In addition, in 2003 our fixedmanufacturing overhead costs were spread over a reduced number of our memorychips shipped in 2003 compared to 2002.

*Research and Development.  *Ourresearch and development expenses include development and design of variationsof the 1T-SRAM technologies for use in different manufacturing processes usedby licensees and the development and testing of prototypes to prove thetechnological feasibility of embedding our memory designs in the licensees’products. Research and development expenses decreased to $8.1 million in 2004from $8.7 million in 2003 mainly becausemore engineering time was spent on licensing development projects, therefore,more engineering expenses were allocated to cost of licensing revenue in 2004compared to 2003. Effective November 10, 2004, we closed the ATMOSresearch and development facility in Ottawa, Canada and terminated theemployment of approximately 20 employees working there. ATMOS research anddevelopment expenses represented approximately $2.2 million in 2004.

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Research and development expenses increased to $8.7million in 2003 from $6.9 million in 2002 because we hadincreased engineering staff from our acquisition of ATMOS and to support ourmemory compiler development. ATMOS’ research and development expensesrepresented approximately $2.6 million in 2003. In 2002, research anddevelopment expense increased to $6.9 million due to additionsto the engineering staff from additional hiring and our acquisition of ATMOS atthe end of August 2002. The ATMOS’ research and development expensesrepresented approximately $867,000 in 2002.

*Selling, General and Administrative.  *Selling,general and administrative expenses increased to $13.3 million in 2004 from $6.4 millionin 2003 due primarily to $6.3 million of expenses related to the abortedacquisition by Synopsys, Inc., litigation expenses related to litigationwith Synopsys over its abandonment of the acquisition and litigation expenseswith respect to the patent infringement and trade secret misappropriation suitbrought against us by UniRAM Technology, Inc. In 2004, expenses related totesting and assessment ofeffectiveness of our internalcontrol over financial reporting requiredby Section 404 of Sarbanes-Oxley Act were approximately $690,000. Selling,general and administrative expenses increased to $6.4 millionin 2003 from $5.3 million in 2002 dueprimarily to increased sales and marketing activities, including theestablishment of a sales office in Japan in January 2003 and higherprofessional fees. We do not expect to incur legal expenses at the level we didin 2004 in future periods.

*Restructuring Charges.  *On November 10,2004, we announced our plan to close the ATMOS research and developmentfacility in Canada in order to reduce operating expenses and to further alignour business with market conditions, future revenue expectations and plannedfuture product direction. As a part of the plan, we implemented a reduction inworkforce of approximately 20 employees, which represented 20% of ourworkforce. In addition, we are attempting to sublease the ATMOS research anddevelopment facility, which we occupy under long-term operating leases through2008.

We recorded restructuring costs of $585,000 in thefourth quarter of 2004, consisting of $179,000 of severance and fringe benefitsand lease abandonment charges of $406,000.

At December 31, 2004 we have a total restructuringaccrual of $429,000, comprised of unpaid employee severance costs of $19,000and estimated lease abandonment costs of $410,000. All employees to be affectedby our reduction in workforce were notified of the termination of theiremployment on November 10, 2004. Estimates related to sublease costs andincome were based on assumptions regarding sublease rates and the time requiredto locate sub-lessees, which were derived from market trend informationprovided by a commercial real estate broker. We review these estimatesperiodically if these assumptions materially change due to rental marketfactors, the ultimate restructuring expense for the abandoned facilities wouldbe adjusted.

Thefollowing table summarizes the activities under the 2004 Restructuring Plan:
| ** **                                         | ** ** | **Abandoned  Space**    | ** ** | **Severance  Related** | ** ** | **Total** | ** ** |
|----------------------------------------------------|------------|-------------------------|------------|------------------------|------------|-----------|------------|
| ** **                                         | ** ** | **(in thousands)** | ** ** |
| 2004 provision                                     |       |                    | $          | 406                    |       |      |       | $ | 179 |   |   | $ | 585 |   |
| Cash payments                                      |       |                    | —     |                   |       |      | (160       | ) |   | (160 | ) |
| Foreign exchange  fluctuations                     |       |                    | 4          |                   |       |      | —     |   |   | 4 |   |
| Restructuring  liability at December 31, 2004 |       |                    | $          | 410                    |       |      |       | $ | 19 |   |   | $ | 429 |   |
| Less current  portion                              |       |                    | 171        |                   |       |      | 19         |   |   | 190 |   |
| Long-term portion of  restructuring liability      |       |                    | $          | 239                    |       |      |       | $ | — |   |   | $ | 239 |   |

 

*Interest and Other Income.  *Interestand other income increased to $11.6 million in 2004 from $1.9million in 2003primarily because of a $10 million termination fee paid by Synopsys, Inc. related to the aborted acquisition. Inaddition, interest income increased slightly to $1.5 million in 2004 from $1.4million in 2003 as income attributable to higher interest rates in 2004 wasimpacted adversely by the requirement 

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that we liquidated theshort-term and long-term investments in the second quarter of 2004 prior to theabandonment of its acquisition of our company by Synopsys, Inc. In 2003,interest and other income increased to $1.9 million from $1.5 million in 2002primarily due to the $287,000 contract termination fee from Conexant and$241,000 of Canadian research and development incentive tax credits. Interestincome was $1.4 million and $1.5 million in 2003 and 2002, respectively. Thisfluctuation in interest income levels corresponded to differences in averagecash and investment balances for the periods and the applicable correspondinginterest rates, which declined each year in 2003 and 2002. There was no otherincome recorded in 2002. We incurred no interest expense in 2004, 2003, and2002.

*Deferred stock-basedcompensation cost to employees.  *During the years ended December 31,2004, 2003 and 2002, we recorded deferred compensation cost of approximately$74,000, $0, and $314,000 respectively, which cost would be amortized in futureperiods. The 2004 deferred compensation cost represents the intrinsic value ofoptions granted to purchase shares of our stock to newly appointed members ofour board of directors that had an exercise price less than the fair marketvalue of our common stock on the date of the option grant. This deferredcompensation cost will be amortized over the vesting period of 36 months usingthe graded vesting method. The 2002 deferred compensation cost represented theshares of common stock issued to certain employees of ATMOS as part of theacquisition that were subject to vesting requirements, which cost is beingamortized over the vesting period of 36 months using the graded vesting method.

During the years ended December 31, 2004, 2003and 2002, we recorded stock compensation expenses of $68,000, $459,000, and$656,000, respectively, of which $50,000, $211,000, and $582,000, respectively,was attributable to the excess of the fair market value of our common stockover the price at which we granted stock options to employees. Stockcompensation expenses in 2004, 2003 and 2002 also included $13,000, $227,000and $74,000, respectively, for amortization of deferred compensation costattributable to the fair market value of shares of our common stock issued tocertain employees of ATMOS. In addition, we incurred $5,000 of stockcompensation expense in 2004 related to the issuance of options to purchase ourstock to newly appointed members of our board of directors that had an exerciseprice less than the fair market value of our stock on the date of the optiongrant. We also incurred $21,000 of stock compensation expense in 2003 due tomodification of our 2000 employee stock option held by a former member of ourboard of directors.

Deferred compensation expense is being amortized usingthe graded vesting method over the vesting period of each respective option,generally four years. The accelerated amortization results in expensingapproximately 52% of the total award in the first year, 27% in the second year,15% in the third year and 6% in the fourth year.

In December 2004, the Financial AccountingStandards Board (FASB) issued Statement of Financial Accounting Standards No. 123,*Share-Based Payment*(SFAS 123R)which will become effective beginning in the third quarter of 2005. SFAS 123Rwill result in the recognition of substantial compensation expense relating toour employee stock options and employee stock purchase plans. Under the newrules, we are required to adopt a fair-value-based method for measuring thecompensation expense related to employee stock awards and therefore this willlead to substantial additional compensation expense that will be included inour results of operations.

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*Provisionfor Income Taxes.  *Provisions for income taxes ofapproximately $26,000, $279,000, and $1.4 million, were recorded in 2004, 2003,and 2002, respectively. The effective income tax rate was negative 1.4% for2004 and 10% for each of 2003 and 2002. As of December 31, 2004, we hadnet operating loss carryforwards of approximately $4.5 million for federal taxpurposes, approximately $1.3 million for state tax purposes and approximately$13.6 million for Canadian tax purposes that we expect to be available toreduce future income tax liabilities to the extent permitted under federal,Canadian and applicable state income tax laws. The net operating losscarryforwards expire from 2005 to 2024. In 2005, we anticipate that oureffective income tax rate will be less than the federal statutory tax rate buthigher than the 2004 effective income tax rate.

**Liquidity andCapital Resources**

As of December 31, 2004, we had cash and cashequivalents of $31.7 million, short-term investments of $30.6 millionand long-term investments of $24.6 million resulting in a total balance ofcash, cash equivalents, and investments of $86.9 million. As of the same date,the Company had total working capital of $62.5 million. In July 2001,the Company completed the sale of a total of 5,750,000 shares of common stockin its initial public offering. The Company realized total net proceeds ofapproximately $51.6 million upon the close of the IPO, which proceeds havenot been used to fund our operations to date. Our primary capital requirementsare to fund working capital needs. We believe that our current focus onlicensing and royalty revenues with reduced levels of memory chip sales hasgenerally enabled us to steadily improve our cash position.

Net cash provided by operating activities was $2.7million, $4.7 million, and $7.9 million for the years ended 2004,2003, and 2002, respectively. In 2004, net cash provided by operatingactivities consisted primarily of net loss of $1.9 million offset by anon-cash charge of $1.5 million for depreciation and amortization, reducedunbilled contract receivables of $1.0 million, and prepaid expenses and otherassets of $858,000, which included a reduction in deferred tax assets in 2004. Inaddition, net cash provided by operating activities in 2004 includedrestructuring related liabilities of $429,000.

In 2003, net cash provided by operating activities wasprincipally represented by our net profit of $2.5 million plus a non-cashcharge of $2.0 million for depreciation and amortization, although deferredrevenue associated with cash receipts in excess of recognized revenue declinedby $1.3 million. In 2002, net cash provided by operating activities resultedprimarily from net income of $12.4 million plus a non-cash charge ofdepreciation and amortization of $1.3 million. Prepaid expenses and otherassets increased by $2.9 million as we recorded deferred tax assets of$2.4 million from the realization of tax benefits through the utilizationof net operating loss carryforwards. In addition, deferred revenue declined by$1.6 million and accounts payable declined by $1.3 million.

Net cash provided by investing activities wasapproximately $7.9 million in 2004. Net cash used in investing activities wasapproximately $10.8 million and $29.9 million for the years ended 2003 and2002. Aside from investing in marketable securities, we purchased $349,000 and$493,000 of property and equipment in 2004 and 2003, respectively, consistingprincipally of engineering design software. In 2002, we purchased $1.4 millionof property and equipment mainly consisting of engineering design software andused $12.0 million for the acquisition of ATMOS.

Net cash used in financing activities wasapproximately $1.0 million in 2004 and net cash provided by financingactivities was $1.8 million and $1.0 million for the years ended 2003 and2002. In 2004, the major financing use of cash was $ 4.7 million for therepurchase of 1.2 million shares of common stock. We received proceeds in theamount of $3.7 million from the exercise of employee options to purchase commonstock during 2004. As of December 31, 2004, approximately $20.0 millionremained available for repurchase of common stock under the existing repurchaseauthorization. Cash received upon the issuance 

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of common stock in connectionwith the exercise of options totaled $1.9 million in 2003 and $909,000 in 2002.

Our futureliquidity and capital requirements are expected to vary from quarter toquarter, depending on numerous factors, including—

·       leveland timing of licensing and royalty revenues;

·       cost,timing and success of technology development efforts;

·       marketacceptance of our existing and future technologies and products;

·       competingtechnological and market developments;

·       costof maintaining and enforcing patent claims and intellectual property rights;

·       variationsin manufacturing yields, materials costs and other manufacturing risks;

·       costsof acquiring other businesses and integrating the acquired operations;

·       profitabilityof our business; and

·       litigationexpenses.

We expect that existing cash, and equivalents,short-term and long-term investments along with our existing capital and cashgenerated from operations, if any, will be sufficient to meet our capitalrequirements for the foreseeable future. We expect that a licensing businesssuch as ours generally will require less cash to support operations aftermultiple licensees begin to ship products and pay royalties.

However, we cannot becertain that we will not require additional financing at some point in time.Should our cash resources prove inadequate, we may need to raise additionalfunding through public or private financing. There can be no assurance thatsuch additional funding will be available to us on favorable terms, if at all.The failure to raise capital when needed could have a material, adverse effecton our business and financial condition.

**Lease Commitmentsand Off Balance Sheet Financing**

Theimpact that our contractual obligations as of December 31, 2004 areexpected to have on our liquidity and cash flow in future periods is asfollows:
| ** **                   | ** ** | **Payment Due by Period** | ** ** |
|------------------------------|------------|------------------------------------------|------------|
| ** **                   | ** ** | **Total**                                | ** ** | **Less than 1 year** | ** ** | **1-3 years** | ** ** | **4-5 years** | ** ** | **Over 5 years** | ** ** |
| Operating Lease  Obligations |       | $                                        | 1,764      |   |   | $ | 908 |   |   |   | $ | 739 |   |   |   | $ | 117 |   |   |   | $ | — |   |   |
|                              |            |                                          |            |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |

 

The Company did not haveany unconditional purchase obligations as of December 31, 2004.

**Recent AccountingPronouncements**

See Note 1 of theConsolidated Financial Statements for a full description of recent accountingpronouncements including the respective expected dates of adoption and effectson results of operations and financial condition.

***Item7A***. Quantitative and Qualitative Discussion of MarketInterest Rate Risk

Our investment portfolioconsists of money market funds, corporate-backed debt obligations andmortgage-backed government obligations generally due within one year. Ourprimary objective with investment portfolio is to invest available cash whilepreserving principal and meeting liquidity needs. In accordance with ourinvestment policy, we place investments with high credit quality issuers andlimit the 

40

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amountof credit exposure to any one issuer. These securities, which approximate $79.4million as of December 31, 2004, and have an average interest rate ofapproximately 1.79%, which are subject to interest rate risks. However, basedon the investment portfolio contents and our ability to hold these investmentsuntil maturity, we believe that if a significant change in interest rates wereto occur, it would not have a material effect on our financial condition.

***Item8***. Financial Statements and Supplementary Data

Reference is made to thefinancial statements listed under the heading (a) (1) FinancialStatements and Report of Ernst & Young LLP of Item 15, whichfinancial statements are incorporated by reference in response to thisItem 8.

**Quarterly Resultsof Operations**

Thefollowing tables set forth unaudited results of operations data for the eightquarters ended December 31, 2004. This unaudited information has beenprepared on a basis consistent with our audited financial statements appearingelsewhere in this report and, in the opinion of our management, includes alladjustments, consisting only of normal recurring adjustments, necessary for afair presentation of the information for the periods presented. The unauditedquarterly information should be read in conjunction with the financialstatements and notes included elsewhere in this report. For a discussion ofcharges and other income pertaining to the aborted acquisition of our companyby Synopsys, Inc. and restructuring charges associated with the closing ofour ATMOS research and development operation, which significantly affected thelast three quarters of 2004, refer to Item 7. Management’s Discussion andAnalysis of Financial Condition and Results of Operations—“Results of Operations.”
| ** **                                            | ** ** | **Dec. 31,** | ** ** | **Sep. 30,** | ** ** | **Jun. 30,** | ** ** | **Mar. 31,** | ** ** | **Dec. 31,** | ** ** | **Sep. 30,** | ** ** | **Jun. 30,** | ** ** | **Mar. 31,** | ** ** |
|-------------------------------------------------------|------------|-------------------|------------|-------------------|------------|-------------------|------------|-------------------|------------|-------------------|------------|-------------------|------------|-------------------|------------|-------------------|------------|
| ** **                                            | ** ** | **2004**          | ** ** | **2004**          | ** ** | **2004**          | ** ** | **2004**          | ** ** | **2003**          | ** ** | **2003**          | ** ** | **2003**          | ** ** | **2003**          | ** ** |
| Net revenue:                                          |       |              |       |              |       |              |       |              |       |              |       |              |       |              |       |              |       |
| Product                                               |       | $                 | 33         |              | $          | 76                |       | $                 | 681        |              | $          | 162               |       | $                 | 334        |              | $          | 511 |   | $ | 515 |   | $ | 544 |   |
| Licensing                                             |       | 118               |       | 128               |       | 1,310             |       | 2,988             |       | 1,929             |       | 1,780             |       | 2,196             |       | 4,513             |       |
| Royalty                                               |       | 1,069             |       | 1,488             |       | 1,415             |       | 1,353             |       | 1,088             |       | 1,208             |       | 1,759             |       | 2,856             |       |
|                                                  |       | 1,220             |       | 1,692             |       | 3,406             |       | 4,503             |       | 3,351             |       | 3,499             |       | 4,470             |       | 7,913             |       |
| Cost of net revenue:                                  |       |              |       |              |       |              |       |              |       |              |       |              |       |              |       |              |       |
| Product                                               |       | 25                |       | 86                |       | 394               |       | 150               |       | 259               |       | 260               |       | 291               |       | 407               |       |
| Licensing                                             |       | 519               |       | 236               |       | 483               |       | 375               |       | 426               |       | 588               |       | 341               |       | 615               |       |
|                                                  |       | 544               |       | 322               |       | 877               |       | 525               |       | 685               |       | 848               |       | 632               |       | 1,022             |       |
| Total gross profit                                    |       | 676               |       | 1,370             |       | 2,529             |       | 3,978             |       | 2,666             |       | 2,651             |       | 3,838             |       | 6,891             |       |
| Operating  expenses:                                  |       |              |       |              |       |              |       |              |       |              |       |              |       |              |       |              |       |
| Research and development                              |       | 1,728             |       | 2,174             |       | 1,968             |       | 2,226             |       | 2,112             |       | 2,126             |       | 2,206             |       | 2,297             |       |
| Selling, general and administrative                   |       | 1,355             |       | 3,949             |       | 5,263             |       | 2,764             |       | 1,476             |       | 1,553             |       | 1,659             |       | 1,744             |       |
| Restructuring expenses                                |       | 585               |       | —            |       | —            |       | —            |       | —            |       | —            |       | —            |       | —            |       |
| Total operating expenses                              |       | 3,668             |       | 6,123             |       | 7,231             |       | 4,990             |       | 3,588             |       | 3,679             |       | 3,865             |       | 4,041             |       |
| Income (loss) from operations                         |       | (2,992            | )          | (4,753            | )          | (4,702            | )          | (1,012            | )          | (922              | )          | (1,028            | )          | (27               | )          | 2,850             |       |
| Interest and other income                             |       | 550               |       | 10,398            |       | 269               |       | 361               |       | 461               |       | 311               |       | 652               |       | 490               |       |
| Income (loss) before income taxes                     |       | (2,442            | )          | 5,645             |       | (4,433            | )          | (651              | )          | (461              | )          | (717              | )          | 625               |       | 3,340             |       |
| Benfefit (provision) for income taxes                 |       | 31                |       | (565              | )          | 378               |       | 130               |       | 46                |       | 468               |       | (125              | )          | (668              | )          |
| Net income (loss)                                     |       | $                 | (2,411     | )                 | $          | 5,080             |       | $                 | (4,055     | )                 | $          | (521              | )          | $                 | (415       | )                 | $          | (249 | ) | $ | 500 |   | $ | 2,672 |   |
| Net income (loss) per share:                          |       |              |       |              |       |              |       |              |       |              |       |              |       |              |       |              |       |
| Basic                                                 |       | $                 | (0.08      | )                 | $          | 0.16              |       | $                 | (0.13      | )                 | $          | (0.02             | )          | $                 | (0.01      | )                 | $          | (0.01 | ) | $ | 0.02 |   | $ | 0.09 |   |
| Diluted                                               |       | $                 | (0.08      | )                 | $          | 0.15              |       | $                 | (0.13      | )                 | $          | (0.02             | )          | $                 | (0.01      | )                 | $          | (0.01 | ) | $ | 0.02 |   | $ | 0.09 |   |
| Shares used in computing net income (loss) per share: |       |              |       |              |       |              |       |              |       |              |       |              |       |              |       |              |       |
| Basic                                                 |       | 30,296            |       | 31,074            |       | 30,786            |       | 30,845            |       | 30,704            |       | 30,614            |       | 30,395            |       | 30,302            |       |
| Diluted                                               |       | 30,296            |       | 33,350            |       | 30,786            |       | 30,845            |       | 30,704            |       | 30,614            |       | 30,848            |       | 30,539            |       |

 

41

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In the third quarter of2004, interest and other income included a $10 million termination fee paid by Synopsys,Inc. related to the aborted acquisition.

***Item 9***.Changes in and Disagreements with Accountants on Accounting and FinancialDisclosure

Not applicable.

***Item 9A***. Controls andProcedures

(a) Management’s annual report on internalcontrol over financial reporting

Monolithic System Technology, Inc.’s managementis responsible for establishing and maintaining adequate internal control overthe Company’s financial reporting. Because of inherent limitations, internalcontrol over financial reporting may not prevent or detect misstatements. Also,projections of any evaluation of effectiveness to future periods are subject tothe risk that controls may become inadequate because of changes in conditions,or that the degree of compliance with the policies or procedures maydeteriorate.

We assessed the effectiveness of the Company’sinternal control over financial reporting as of December 31, 2004. Inmaking this assessment, we used the criteria set forth by the Committee ofSponsoring Organizations of the Treadway Commission (COSO) on Internal Control—IntegratedFramework.

An internal control significant deficiency is acontrol deficiency, or combination of control deficiencies, that adverselyaffects the company’s ability to initiate, authorize, record, process, orreport external financial data reliably in accordance with generally acceptedaccounting principles such that there is more than a remote likelihood that amisstatement of the company’s annual or interim financial statements that ismore than inconsequential will not be prevented or detected. An internalcontrol material weakness is a significant deficiency, or combination ofsignificant deficiencies, that results in more than a remote likelihood that amaterial misstatement of the annual or interim financial statements will not beprevented or detected. Our assessment of internal control over financialreporting as of December 31, 2004 identified two material weaknesses whichare described below.

We identified a material weakness for ineffectivecontrols over the preparation and review of account reconciliations. As aresult of these ineffective controls, several errors have been identifiedrelating to fixed assets, prepaid expenses, deferred costs, other receivablesand accrued liabilities. Adjustments were recorded in the consolidatedfinancial statements for year ended December 31, 2004 to correct theidentified errors.

We also identified a material weakness for ineffectivecontrols over the application of the company’s revenue recognition policy forrecording  revenue under long termlicense development contracts using the percentage-of-completion method ofaccounting. As a result of these ineffective controls, an adjustment wasrecorded in the fourth quarter of 2004 to revenue and cost of goods sold tocorrect errors identified.

Because of the material weaknesses described above,management concluded that the Company’s internal control over financialreporting was not effective based on the criteria set forth by COSO, as of December 31,2004.

Management’s assessment of our internal control overfinancial reporting as of December 31, 2004 has been audited by ourindependent registered public accounting firm, as stated in their report whichis included elsewhere herein.

42

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(b) Evaluation of disclosure controls andprocedures

Under the supervision and with the participation ofour management, including our principal executive officer and principal financialofficer, and principal accounting officer, we conducted an evaluation of theeffectiveness of the design and operation of our disclosure controls andprocedures, as defined in Rules 13a-15(e) and 15d-15(e) underthe Securities Exchange Act of 1934, as amended, as of the end of the yearcovered by this report. Based on this evaluation, our principal executiveofficer, principal financial officer and principal accounting officer, concludedthat as of December 31, 2004 our disclosure controls and procedures were ineffectivesuch that the information relating to us, including our consolidatedsubsidiaries, required to be disclosed in our reports filed with the Securitiesand Exchange Commission is recorded, processed, summarized and reported withinthe time periods specified in SEC rules and forms, and is accumulated andcommunicated to our management, including our principal executive officer, principalfinancial officer, and principal accounting officer, as appropriate to allowtimely decisions regarding required disclosure.

(c) Changes in internal control

An evaluation by our Audit Committee carried out by athird-party independent contractor identified deficiencies in our financialcontrol over financial reporting which led to post-closing adjustments in theaudit of our 2004 financial statements. Under COSO, an internal controlmaterial weakness is a significant deficiency, or combination of significantdeficiencies that results in more than a remote likelihood that a materialmisstatement of the annual or interim financial statements will not beprevented or detected. We have conducted a review of the errors requiring thesepost-closing adjustments, including a separate review by our audit committee todetermine what remedial measures were necessary. We believe our management hastaken or is in the process of taking the steps necessary to correct the errorsand avoid similar errors in the future. The net effect of such adjustments onreported net income or loss during 2004 was not material.

Our aborted acquisition by Synopsys delayed ourimplementation of Section 404 and thus reduced the amount of timenecessary to identify and remediate any ineffective controls based on enhancedtesting and scrutiny by our outside contractors. Nevertheless, we haveidentified two important measures that we believe will increase theeffectiveness of our controls. First, we have allocated addition resources tosecure personnel in order to effectively manage the control process. Second, wehave increased the amount of time necessary to allow for a thorough review ofall journal entries and a full reconciliation of all keys accounts prior to therelease of the financial statements for audit or review by our independentregistered public accounting firm.

Other than the foregoinginitiatives, there were no significant changes in our internal control overfinancial reporting or to our knowledge, in other factors that couldsignificantly affect such internal controls subsequent to the date of theirevaluation.

***Item9B***. Other Information

None.

43

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**Part III**

***Item 10***. Directors andExecutive Officers of the Registrant

Information regarding ourdirectors is incorporated by reference from the sections titled “Management”and “Section 16(A) Beneficial Ownership Reporting Compliance” in theRegistrant’s Proxy Statement for its 2005 Annual Meeting of Stockholders.Information regarding current executive officers found under the heading “ExecutiveOfficers” in Item 1 of Part I hereof is also incorporated by referenceinto this Item 10.

***Item 11***. Executive Compensation

The response to this itemis incorporated by reference from the section titled “Executive Compensation”,but not from the Sections titled “Executive Compensation—Performance Graph” and“Executive Compensation—Report on Executive Compensation by the Compensationand Management Development Committee of the Board of Directors”, in theRegistrant’s Proxy Statement for its 2005 Annual Meeting of Stockholders.

***Item 12***. Security Ownershipof Certain Beneficial Owners and Management

The response to this itemis incorporated by reference from the sections titled “Share Ownership ofCertain Beneficial Owners and Management and “Securities Authorized forIssuance Under Equity Compensation Plans” in the Registrant’s Proxy Statementfor its 2005 Annual Meeting of Stockholders.

***Item 13***. CertainRelationships and Related Transactions

The response to this itemis incorporated by reference from the section titled “Certain Relationships andRelated Transactions” in the Registrant’s Proxy Statement for its 2005 AnnualMeeting of Stockholders.

***Item 14***. Accountant Fees andServices

The response to this itemis incorporated by reference from the section titled “Ratification ofIndependent Registered Public Accounting Firm for 2005” in the Registrant’sProxy Statement for its 2005 Annual Meeting of Stockholders.

44

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**Part IV**

***Item 15***. Exhibits, FinancialStatement Schedules and Reports on the Form 8-K

(a)           The following documentsare filed as part of this report:

(1)         Financial Statements andReports of Independent Registered Public Accounting Firm, which are set forthin the index to Consolidated Financial Statements on pages 44 through 68of this report.
| Reports of Independent  Registered Public Accounting Firm | 49 |
|-----------------------------------------------------------|----|
| Consolidated Balance Sheets                               | 52 |
| Consolidated Statements of  Operations                    | 53 |
| Consolidated Statements of  Stockholders’ Equity     | 54 |
| Consolidated Statements of Cash  Flows                    | 56 |
| Notes to Consolidated Financial  Statements               | 57 |

 

(2)         Financial StatementSchedule—Schedule II—Valuation and Qualifying Accounts

(3)         Exhibits
| 2.1(1)         |   | Merger Agreement  regarding the Registrant’s reincorporation in Delaware                                                                                                                                                                                                    |
|----------------|--------|----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
| 2.2(4)         |   | Share Purchase Agreement for the shares for ATMOS  Corporation                                                                                                                                                                                                                   |
| 2.3(5)         |   | Agreement and Plan of Reorganization, dated  February 23, 2004, among Synopsys, Inc., Mountain Acquisition  Sub, Inc., a wholly owned subsidiary of Synopsys, Inc., and  Monolithic System Technology, Inc.—Terminated agreement.                  |
| 2.4(6)         |   | Form of Stockholder Agreement, dated  February 23, 2004, among Synopsys, Inc., Mountain Acquisition  Sub, Inc., a wholly owned subsidiary of Synopsys, Inc., and the  stockholder of Monolithic System Technology, Inc.—Terminated agreement. |
| 3.1            |   | Not currently in use                                                                                                                                                                                                                                                             |
| 3.2            |   | Not currently in use                                                                                                                                                                                                                                                             |
| 3.3(1)         |   | Restated Certificate of Incorporation of the  Registrant                                                                                                                                                                                                                         |
| 3.4(1)         |   | Bylaws of the Registrant                                                                                                                                                                                                                                                         |
| 4.1(1)         |   | Specimen common stock certificate                                                                                                                                                                                                                                                |
| 4.2(1)         |   | Third Amended and Restated Investor Rights Agreement  dated September 27, 1997                                                                                                                                                                                              |
| 4.3(1)         |   | Rights Agreement                                                                                                                                                                                                                                                                 |
| 4.3.1(7)       |   | First Amendment to Rights Agreement, dated as of  February 23, 2004.                                                                                                                                                                                                        |
| 4.3.2(8)       |   | Second Amendment to Rights Agreement, dated as of  December 14, 2004.                                                                                                                                                                                                       |
| 10.1(1)        |   | Form of Indemnity Agreement between the  Registrant and each of its directors and executive officers                                                                                                                                                                        |
| 10.2(1)        |   | 1992 Stock Option Plan and form of Option Agreement  thereunder                                                                                                                                                                                                                  |
| 10.3(1)        |   | 1996 Stock Plan and form of Option Agreement  thereunder                                                                                                                                                                                                                         |
| 10.4(1)        |   | Form of Restricted Stock Purchase Agreement                                                                                                                                                                                                                                 |
| 10.5(1)        |   | 2000 Employee Stock Option Plan and form of Option  Agreement thereunder                                                                                                                                                                                                         |
| 10.5.1(9)      |   | Amended and Restated 2000 Equity Incentive and Stock  Option Plan                                                                                                                                                                                                                |
| 10.6(1)        |   | 2000 Employee Stock Purchase Plan and form of  Subscription Agreement thereunder                                                                                                                                                                                                 |
| 10.7(1)        |   | Standard Industrial Lease, dated September 24,  1996, between the Registrant and McCandless Properties                                                                                                                                                                      |
| 10.8(1)        |   | First Amendment to Lease, dated June 30, 2000,  between the Registrant and McCandless Properties                                                                                                                                                                            |
| 10.9(1)        |   | Agreement between Nintendo Co., Ltd. and the  Registrant dated August 31, 1999                                                                                                                                                                                              |
| 10.10†(1) |   | License Agreement between NEC Corporation and the  Registrant dated January 31, 1999                                                                                                                                                                                        |
| 10.11(1)(2)    |   | License Agreement between NEC Corporation and the  Registrant dated December 17, 1999                                                                                                                                                                                       |

45

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| 10.12(1) |   | Employment Agreement between Registrant and F.  Judson Mitchell dated July 17, 2000 |
|----------|--------|------------------------------------------------------------------------------------------|
| 21.1     |   | List of subsidiaries                                                                     |
| 23.1     |   | Consent of Independent Registered Public Accounting  Firm                                |
| 24.1(3)  |   | Power of Attorney                                                                        |
| 31.1     |   | Rule 13a-14 certification                                                           |
| 31.2     |   | Rule 13a-14 certification                                                           |
| 32       |   | Section 1350 certification                                                          |

----

(1)          Incorporated byreference to the same-numbered exhibit to the Company’s Registration Statementon Form S-1, as amended, originally filed August 4, 2000, declaredeffective June 27, 2001 (Commission file No. 333-43122).

(2)          Portions of this exhibithave been omitted pursuant to Order Granting Confidential Treatment Under theSecurities Act of 1933 dated June 27, 2001 (Commission File No. 333-43122—CF#10183).

(3)          Set forth on page 47of this report.

(4)          Incorporated byreference to the same-numbered exhibit to the Company’s report on Form 8-K/Afiled on November 13, 2002.

(5)          Incorporated byreference to Exhibit 2.1 of the Current Report on Form 8-K filed bySynopsys, Inc. on February 26, 2004, (Commission File No. 000-19807).

(6)          Incorporated byreference to Exhibit 2.2 of the Current Report on Form 8-K filed bySynopsys, Inc. on February 26, 2004. (Commission File No. 000-19807).

(7)          Incorporated byreference to Exhibit 1 to Form 8-A/A filed by the Company on December 22,2004 (Commission File No. 000-32929).

(8)          Incorporated byreference to Exhibit 4.01 to Form 8-K filed by the Company on December 20,2004 (Commission File No. 000-32929).

(9)          Incorporated byreference to the Company’s proxy statement on Schedule 14A filed on October 7,2004 (Commission File No. 000-32929).

(b)          Reports on Form 8-K

On October 28, 2004, we filed a report on Form 8-Kregarding our results of operations and financial condition for the thirdquarter of 2004.

On November 16, 2004, we filed a report on Form 8-Kregarding our plan to close the research and development facility in Kanata,Ontario, which we acquired when we completed an acquisition of ATMOSCorporation in August 2002.

On December 20, 2004, we filed a report on Form 8-Kregarding our Board of Directors’ authorization of a Second Amendment to RightsAgreement.

46

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**SIGNATURES**

Pursuantto the requirements of the Section 13 or 15(d) of the SecuritiesExchange Act of 1934, the Registrant has duly caused this report to be signedon its behalf by the undersigned, thereunto duly authorized, on the 16th day ofMarch 2005.
|        | MONOLITHIC SYSTEM TECHNOLOGY, INC. |
|--------|------------------------------------|
|   | By:                                | /s/ MARK VOLL |
|   |                               | Mark Voll |
|   |                               | Principal Executive Officer,Vice President of  Finance and Administration, Secretary and  Chief Financial Officer |

 

**POWEROF ATTORNEY**

KNOW ALL MEN BY THESEPRESENTS, that each person whose signature appears below constitutes andappoints Mark Voll as his true and lawful attorney-in-fact and agent, with fullpower of substitution and resubstitution, for him and in his name, place andstead, in any and all capacities, to sign any and all amendments to his Reporton Form 10-K, and to file the same, with all exhibits thereto, andother documents in connection therewith, with the Securities and ExchangeCommission, granting unto said attorney-in-fact and agent full power andauthority to do and perform each and every act and thing requisite andnecessary to be done in connection therewith, as fully to all intents andpurposes as he might or could do in person, hereby ratifying and confirming allthat said attorney-in-fact and agent, or his substitute or substitutes, maylawfully do or cause to be done by virtue hereof.

Pursuantto the requirements of the Securities Exchange Act of 1934, this report hasbeen signed below by the following persons on behalf of the registrant and inthe capacities and on the dates indicated.
| Signature         | ** ** | **Title**                                                          | ** ** | **Date**             | ** ** |
|-------------------|------------|--------------------------------------------------------------------|------------|----------------------|------------|
| /s/ MARK VOLL     |       | Principal Executive  Officer,Vice President of                     |       | March 16,  2005 |       |
| Mark Voll         |       | Finance and Administration, Secretary and  Chief Financial Officer |       |                 |       |
| /s/ WINGYU LEUNG  |       | Director                                                           |       | March 16,  2005 |       |
| Wingyu Leung      |       |                                                               |       |                 |       |
| /s/ CARL E. BERG  |       | Director                                                           |       | March 16,  2005 |       |
| Carl E. Berg      |       |                                                               |       |                 |       |
| /s/ TOMMY ENG     |       | Director                                                           |       | March 16,  2005 |       |
| Tommy Eng         |       |                                                               |       |                 |       |
| /s/ JAMES D KUPEC |       | Director                                                           |       | March 16,  2005 |       |
| James D Kupec     |       |                                                               |       |                 |       |
| /s/ CHI-PING HSU  |       | Director                                                           |       | March 16,  2005 |       |
| Chi-Ping Hsu      |       |                                                               |       |                 |       |
| /s/  CHENMING HU  |       | Director                                                           |       | March 16,  2005 |       |
| Chenming Hu       |       |                                                               |       |                 |       |

 

47

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**MONOLITHIC SYSTEMTECHNOLOGY, INC.INDEX TO CONSOLIDATED FINANCIAL STATEMENTS**
| Reports of Independent  Registered Public Accounting Firm |   | 49 |
|-----------------------------------------------------------|--------|----|
| Consolidated Balance Sheets                               |   | 52 |
| Consolidated  Statements of Operations                    |   | 53 |
| Consolidated  Statements of Stockholders’ Equity     |   | 54 |
| Consolidated  Statements of Cash Flows                    |   | 56 |
| Notes  to Consolidated Financial Statements               |   | 57 |
| Schedule II Valuation and  Qualifying Accounts            |   | 76 |

 

48

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**REPORT OF INDEPENDENT REGISERED PUBLIC ACCOUNTING FIRM**

The Board of Directors andStockholders ofMonolithic System Technology, Inc.

We have audited the accompanying consolidated balancesheets of Monolithic System Technology, Inc. as of December 31, 2004and 2003, and the related consolidated statements of operations, stockholders’equity, and cash flows for each of the three years in the period ended December 31,2004. Our audits also included the financial statement schedule listed in theIndex at Item 15(a). These financial statements and schedule are theresponsibility of the Company’s management. Our responsibility is to express anopinion on these financial statements and schedule based on our audits.

We conducted our audits in accordance with standardsof Public Company Accounting Oversight Board (United States). Those standardsrequire that we plan and perform the audits to obtain reasonable assuranceabout whether the financial statements are free of material misstatement. Anaudit includes examining, on a test basis, evidence supporting the amounts anddisclosures in the financial statements. An audit also includes assessing theaccounting principles used and significant estimates made by management, aswell as evaluating the overall financial statement presentation. We believethat our audits provide a reasonable basis for our opinion.

In our opinion, the financial statements referred toabove present fairly, in all material respects, the consolidated financialposition of Monolithic System Technology, Inc. at December 31, 2004and 2003, and the consolidated results of their operations and their cash flowsfor each of the three years in the period ended December 31, 2004, inconformity with U.S. generally accepted accounting principles. Also, in ouropinion, the related financial statement schedule, when considered in relationto the basic financial statements taken as a whole, presents fairly in allmaterial respects the information set forth therein.

Wealso have audited in accordance with the standards of Public Company AccountingOversight Board (United States), the effectiveness of Monolithic SystemTechnology, Inc.’s internal control over financial reporting as of December 31,2004, based on criteria established in Internal Control—Integrated Frameworkissued by the Committee of Sponsoring Organizations of the Treadway Commissionand our reported dated March 15, 2005 expressed an unqualified opinion onmanagement’s assessment of internal control over financial reporting and anadverse opinion on the effectiveness of internal control over financialreporting.
|                      | */s/   Ernst & Young Llp* |
|----------------------|----------------------------------------------|
| San Jose, California | * *                                     |
| March 15, 2005  | * *                                     |

 

49

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**REPORT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTINGFIRM**

**The Board ofDirectors and Shareholders ofMonolithic System Technology, Inc.**

We have audited management’s assessment, included inthe accompanying Management’s Annual Report on Internal Control Over FinancialReporting, that Monolithic System Technology, Inc. did not maintaineffective internal control over financial reporting as of December 31,2004, because of the effect of the materialweaknesses identified in management’s assessment and described below, basedon criteria established in InternalControl—Integrated Framework issued by the Committee of SponsoringOrganizations of the Treadway Commission (the COSO criteria).****Monolithic System Technology, Inc.’s management isresponsible for maintaining effective internal control over financial reportingand for its assessment of the effectiveness of internal control over financialreporting. Our responsibility is to express an opinion on management’sassessment and an opinion on the effectiveness of the company’s internalcontrol over financial reporting based on our audit.

We conducted our audit in accordance with thestandards of the Public Company Accounting Oversight Board (United States).Those standards require that we plan and perform the audit to obtain reasonableassurance about whether effective internal control over financial reporting wasmaintained in all material respects. Our audit included obtaining anunderstanding of internal control over financial reporting, evaluatingmanagement’s assessment, testing and evaluating the design and operatingeffectiveness of internal control, and performing such other procedures as weconsidered necessary in the circumstances. We believe that our audit provides areasonable basis for our opinion.

A company’s internal control over financial reportingis a process designed to provide reasonable assurance regarding the reliabilityof financial reporting and the preparation of financial statements for externalpurposes in accordance with generally accepted accounting principles. A company’sinternal control over financial reporting includes those policies andprocedures that (1) pertain to the maintenance of records that, inreasonable detail, accurately and fairly reflect the transactions anddispositions of the assets of the company; (2) provide reasonableassurance that transactions are recorded as necessary to permit preparation offinancial statements in accordance with generally accepted accountingprinciples, and that receipts and expenditures of the company are being madeonly in accordance with authorizations of management and directors of thecompany; and (3) provide reasonable assurance regarding prevention ortimely detection of unauthorized acquisition, use, or disposition of thecompany’s assets that could have a material effect on the financial statements.

Because of its inherent limitations, internal controlover financial reporting may not prevent or detect misstatements. Also,projections of any evaluation of effectiveness to future periods are subject tothe risk that controls may become inadequate because of changes in conditions,or that the degree of compliance with the policies or procedures maydeteriorate.

A material weakness is a control deficiency, orcombination of control deficiencies, that results in more than a remotelikelihood that a material misstatement of the annual or interim financialstatements will not be prevented or detected. The following material weaknesseshave been identified and included in management’s assessment:

We identified a material weakness for ineffectivecontrols over the preparation and review of account reconciliations. As aresult of these ineffective controls, several errors have been identifiedrelating to fixed assets, prepaid expenses, deferred costs, other receivablesand accrued liabilities. Adjustments were recorded in the consolidatedfinancial statements for year ended December 31, 2004 to correct theidentified errors.

We also identified a material weakness for ineffectivecontrols over the application of the company’s revenue recognition policy forrecording revenue under long term license development 

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contracts using thepercentage-of-completion method of accounting. As a result of these ineffectivecontrols, adjustments were recorded in the fourth quarter of 2004 to revenueand cost of goods sold to correct errors identified.

These material weaknesses were considered indetermining the nature, timing, and extent of audit tests applied in our auditof the 2004 financial statements, and this report does not affect our reportdated March 15, 2005 on those financial statements.

In ouropinion, management’s assessment that Monolithic System Technology, Inc.did not maintain effective internal control over financial reporting as of December 31,2004, is fairly stated, in all material respects, based on the COSO controlcriteria. Also, in our opinion, because of the effect of the materialweaknesses described above on the achievement of the objectives of the controlcriteria, Monolithic System Technology, Inc. has not maintained effectiveinternal control over financial reporting as of December 31, 2004, basedon the COSO control criteria.
|                      | */s/   Ernst & Young LLP* |
|----------------------|----------------------------------------------|
| San Jose, California |                                         |
| March 15, 2005  |                                         |

 

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**MONOLITHIC SYSTEMTECHNOLOGY, INC.CONSOLIDATED BALANCE SHEETS(In thousands, except per share data)**
| ** **                                                                                                                                                              | ** ** | **December 31,** | ** **                               |
|-------------------------------------------------------------------------------------------------------------------------------------------------------------------------|------------|-----------------------|------------------------------------------|
| ** **                                                                                                                                                              | ** ** | **2004**              | ** **                               | **2003** | ** ** |
| **ASSETS**                                                                                                                                                              |       |                  |                                     |   |   |   |   |
| Current assets:                                                                                                                                                         |       |                  |                                     |   |   |   |   |
| Cash and cash equivalents                                                                                                                                               |       |                  | $ 31,714                            |   |   | $ 22,033 |   |
| Short-term investments                                                                                                                                                  |       |                  | 30,635                                   |   |   | 19,332 |   |
| Accounts receivable                                                                                                                                                     |       |                  | 1,125                                    |   |   | 1,027 |   |
| Unbilled contract receivable                                                                                                                                            |       |                  | 57                                       |   |   | 1,106 |   |
| Inventories                                                                                                                                                             |       |                  | —                                   |   |   | 474 |   |
| Prepaid expenses and other current assets                                                                                                                               |       |                  | 2,939                                    |   |   | 3,822 |   |
| Total current assets                                                                                                                                                    |       |                  | 66,470                                   |   |   | 47,794 |   |
| Long-term  investments                                                                                                                                                  |       |                  | 24,562                                   |   |   | 44,462 |   |
| Property and  equipment, net                                                                                                                                            |       |                  | 685                                      |   |   | 1,796 |   |
| Goodwill                                                                                                                                                                |       |                  | 12,326                                   |   |   | 12,326 |   |
| Other assets                                                                                                                                                            |       |                  | 539                                      |   |   | 514 |   |
| Total assets                                                                                                                                                            |       |                  | $ 104,582                           |   |   | $ 106,892 |   |
| **LIABILITIES  AND STOCKHOLDERS’ EQUITY**                                                                                                                          |       |                  |                                     |   |   |   |   |
| Current liabilities:                                                                                                                                                    |       |                  |                                     |   |   |   |   |
| Accounts payable                                                                                                                                                        |       |                  | $      120 |   |   | $      116 |   |
| Accrued expenses and other liabilities                                                                                                                                  |       |                  | 3,314                                    |   |   | 2,733 |   |
| Deferred revenue                                                                                                                                                        |       |                  | 501                                      |   |   | 506 |   |
| Current portion of capital lease obligations                                                                                                                            |       |                  | —                                   |   |   | 13 |   |
| Total current liabilities                                                                                                                                               |       |                  | 3,935                                    |   |   | 3,368 |   |
| Long-term portion  of capital lease obligations                                                                                                                         |       |                  | —                                   |   |   | 13 |   |
| Long-term portion  of restructuring liability                                                                                                                           |       |                  | 239                                      |   |   | — |   |
| Total liabilities                                                                                                                                                       |       |                  | 4,174                                    |   |   | 3,381 |   |
| Commitment and  contingencies                                                                                                                                           |       |                  |                                     |   |   |   |   |
| Stockholders’  equity:                                                                                                                                             |       |                  |                                     |   |   |   |   |
| Preferred stock, $0.01 par value; 20,000 shares  authorized; none issued and outstanding at December 31, 2004 and  December 31, 2003                          |       |                  | —                                   |   |   | — |   |
| Common stock, $0.01 par value; 120,000 shares  authorized; 30,296 shares and 30,724 shares issued and outstanding at  December 31, 2004 and December 31, 2003 |       |                  | 303                                      |   |   | 307 |   |
| Additional paid-in capital                                                                                                                                              |       |                  | 98,278                                   |   |   | 99,719 |   |
| Deferred stock-based compensation                                                                                                                                       |       |                  | (69                                      | ) |   | (626 | ) |
| Accumulated other comprehensive income (loss)                                                                                                                           |       |                  | (252                                     | ) |   | 56 |   |
| Retained earnings                                                                                                                                                       |       |                  | 2,148                                    |   |   | 4,055 |   |
| Total stockholders’ equity                                                                                                                                         |       |                  | 100,408                                  |   |   | 103,511 |   |
| Total liabilities  and stockholders’ equity                                                                                                                        |       |                  | $ 104,582                           |   |   | $ 106,892 |   |

 

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

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**MONOLITHIC SYSTEMTECHNOLOGY, INC.CONSOLIDATED STATEMENTS OF OPERATIONS(In thousands, except per share data)**
| ** **                                                     | ** ** | **Year Ended December 31,** | ** ** |
|----------------------------------------------------------------|------------|--------------------------------------------|------------|
| ** **                                                     | ** ** | **2004**                                   | ** ** | **2003** | ** ** | **2002** | ** ** |
| Net revenue:                                                   |       |                                       |       |   |   |   |   |
| Product                                                        |       | $                                          | 952        |   | $ | 1,904 |   | $ | 2,924 |   |
| Licensing                                                      |       | 4,544                                      |       | 10,418 |   | 10,523 |   |
| Royalty                                                        |       | 5,325                                      |       | 6,911 |   | 14,344 |   |
|                                                           |       | 10,821                                     |       | 19,233 |   | 27,791 |   |
| Cost of net revenue:                                           |       |                                       |       |   |   |   |   |
| Product                                                        |       | 655                                        |       | 1,217 |   | 1,668 |   |
| Licensing                                                      |       | 1,613                                      |       | 1,970 |   | 1,730 |   |
|                                                           |       | 2,268                                      |       | 3,187 |   | 3,398 |   |
| Gross profit                                                   |       | 8,553                                      |       | 16,046 |   | 24,393 |   |
| Operating expenses:                                            |       |                                       |       |   |   |   |   |
| Research and development                                       |       | 8,096                                      |       | 8,741 |   | 6,926 |   |
| Selling, general and administrative                            |       | 13,331                                     |       | 6,432 |   | 5,266  |   |
| Restructuring expense                                          |       | 585                                        |       | — |   | — |   |
| Total operating expenses                                       |       | 22,012                                     |       | 15,173 |   | 12,192 |   |
| Income (loss)  from operations                                 |       | (13,459                                    | )          | 873 |   | 12,201 |   |
| Interest and other  income                                     |       | 11,578                                     |       | 1,914 |   | 1,539 |   |
| Income (loss)  before provision for income taxes               |       | (1,881                                     | )          | 2,787 |   | 13,740 |   |
| Provision for  income taxes                                    |       | (26                                        | )          | (279 | ) | (1,373 | ) |
| Net income (loss)                                              |       | $                                          | (1,907     | ) | $ | 2,508 |   | $ | 12,367 |   |
| Net income (loss)  per share:                                  |       |                                       |       |   |   |   |   |
| Basic                                                          |       | $                                          | (0.06      | ) | $ | 0.08 |   | $ | 0.41 |   |
| Diluted                                                        |       | $                                          | (0.06      | ) | $ | 0.08 |   | $ | 0.40 |   |
| Shares used in computing  net income (loss) per share:         |       |                                       |       |   |   |   |   |
| Basic                                                          |       | 30,750                                     |       | 30,504 |   | 29,902 |   |
| Diluted                                                        |       | 30,750                                     |       | 30,998 |   | 31,275 |   |
| Allocation of  stock-based compensation to operating expenses: |       |                                       |       |   |   |   |   |
| Research and development                                       |       | $                                          | 44         |   | $ | 148 |   | $ | 340 |   |
| Selling, general and administrative                            |       | 24                                         |       | 311 |   | 316 |   |
|                                                           |       | $                                          | 68         |   | $ | 459 |   | $ | 656 |   |

 

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

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**MONOLITHIC SYSTEMTECHNOLOGY, INC.CONSOLIDATED STATEMENTS OF STOCKHOLDERS’ EQUITY(In thousands)**
| ** **                                                                             | ** ** | **Common Stock** | ** ** | **Additional  Paid-In** | ** ** | **Notes  Receivable  from** | ** ** | **Deferred  Stock-Based** | ** ** | **Accumulated  Other  Comprehensive** | ** ** | **Retained  Earnings  (Accumulated** | ** ** | ** **   | ** ** |
|----------------------------------------------------------------------------------------|------------|-----------------------|------------|-------------------------|------------|-----------------------------|------------|---------------------------|------------|---------------------------------------|------------|--------------------------------------|------------|--------------|------------|
| ** **                                                                             | ** ** | **Shares**            | ** ** | **Amount**              | ** ** | **Capital**                 | ** ** | **Stockholders**          | ** ** | **Compensation**                      | ** ** | **Income**                           | ** ** | **Deficit)** | ** ** | **Total** | ** ** |
| Balance at  December 31, 2001                                                     |       | 29,492                |       |                    | 295        |                        |       |                      | 96,272     |                                  |       |                                 | (253       | )            |       |   | (1,406 | ) |   |   | 16 |   |   |   | (10,820 | ) |   | 84,104 |   |
| Issuance of Common  Stock upon exercise of options                                     |       | 159                   |       |                    | 2          |                        |       |                      | 498        |                                  |       |                                 | —     |         |       |   | — |   |   |   | — |   |   |   | — |   |   | 500 |   |
| Issuance of Common  Stock for Employee Stock Purchase Plan                             |       | 47                    |       |                    | —     |                        |       |                      | 409        |                                  |       |                                 | —     |         |       |   | — |   |   |   | — |   |   |   | — |   |   | 409 |   |
| Issuance of Common  Stock for acquisition of  ATMOS                                    |       | 62                    |       |                    | —     |                        |       |                      | 622        |                                  |       |                                 | —     |         |       |   | (314 | ) |   |   | — |   |   |   | — |   |   | 308 |   |
| Issuance of Common  Stock upon exercise of cashless warrants                           |       | 470                   |       |                    | 5          |                        |       |                      | (5         | )                                     |       |                                 | —     |         |       |   | — |   |   |   | — |   |   |   | — |   |   | — |   |
| Repayment of note  issued to stockholder                                               |       | —                |       |                    | —     |                        |       |                      | —     |                                  |       |                                 | 253        |         |       |   | — |   |   |   | — |   |   |   | — |   |   | 253 |   |
| Amortization of  deferred stock-based compensation and other change in employee status |       | —                |       |                    | —     |                        |       |                      | —     |                                  |       |                                 | —     |         |       |   | 656 |   |   |   | — |   |   |   | — |   |   | 656 |   |
| Other  comprehensive income—unrealized gain on available-for-sale investments     |       | —                |       |                    | —     |                        |       |                      | —     |                                  |       |                                 | —     |         |       |   | — |   |   |   | 100 |   |   |   | — |   |   | 100 |   |
| Net income                                                                             |       | —                |       |                    | —     |                        |       |                      | —     |                                  |       |                                 | —     |         |       |   | — |   |   |   | — |   |   |   | 12,367 |   |   | 12,367 |   |
| Comprehensive  income                                                                  |       |                  |       |                    |       |                        |       |                      |       |                                  |       |                                 |       |         |       |   |   |   |   |   |   |   |   |   |   |   |   | 12,467 |   |
| Balance at  December 31, 2002                                                     |       | 30,230                |       |                    | 302        |                        |       |                      | 97,796     |                                  |       |                                 | —     |         |       |   | (1,064 | ) |   |   | 116 |   |   |   | 1,547 |   |   | 98,697 |   |
| Issuance of Common  Stock upon exercise of options                                     |       | 439                   |       |                    | 5          |                        |       |                      | 1,460      |                                  |       |                                 | —     |         |       |   | — |   |   |   | — |   |   |   | — |   |   | 1,465 |   |
| Issuance of Common  Stock for Employee Stock Purchase Plan                             |       | 55                    |       |                    | —     |                        |       |                      | 442        |                                  |       |                                 | —     |         |       |   | — |   |   |   | — |   |   |   | — |   |   | 442 |   |
| Amortization of  deferred stock-based compensation and other change in employee status |       | —                |       |                    | —     |                        |       |                      | 21         |                                  |       |                                 | —     |         |       |   | 438 |   |   |   | — |   |   |   | — |   |   | 459 |   |
| Other  comprehensive income—unrealized loss on available-for-sale investments     |       | —                |       |                    | —     |                        |       |                      | —     |                                  |       |                                 | —     |         |       |   | — |   |   |   | (60 | ) |   |   | — |   |   | (60 | ) |
| Net income                                                                             |       | —                |       |                    | —     |                        |       |                      | —     |                                  |       |                                 | —     |         |       |   | — |   |   |   | — |   |   |   | 2,508 |   |   | 2,508 |   |
| Comprehensive  income                                                                  |       |                  |       |                    |       |                        |       |                      |       |                                  |       |                                 |       |         |       |   |   |   |   |   |   |   |   |   |   |   |   | 2,448 |   |

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| Balance at December 31, 2003                                                      |   | 30,724 |   |   | 307    |   |   |   | 99,719 |   |   |   | — |   |   |   | (626   | )      |   |   | 56     |   |   |   | 4,055  |   |   | 103,511 |   |
|----------------------------------------------------------------------------------------|--------|--------|--------|--------|--------|--------|--------|--------|--------|--------|--------|--------|--------|--------|--------|--------|--------|--------|--------|--------|--------|--------|--------|--------|--------|--------|--------|---------|--------|
| Issuance of Common  Stock upon exercise of options                                     |   | 688    |   |   | 7      |   |   |   | 3,226  |   |   |   | — |   |   |   | — |   |   |   | — |   |   |   | — |   |   | 3,233   |   |
| Issuance of Common  Stock for Employee Stock Purchase Plan                             |   | 66     |   |   | 1      |   |   |   | 463    |   |   |   | — |   |   |   | — |   |   |   | — |   |   |   | — |   |   | 464     |   |
| Repurchase and  Retirement of Common Stock                                             |   | (1,182 | )      |   | (12    | )      |   |   | (4,641 | )      |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   | (4,653  | )      |
| Amortization of  deferred stock-based compensation and other change in employee status |   | — |   |   | — |   |   |   | (489   | )      |   |   | — |   |   |   | 557    |   |   |   | — |   |   |   |   |   |   | 68      |   |
| Other  comprehensive income—unrealized loss on available-for-sale investments     |   | — |   |   | — |   |   |   | — |   |   |   | — |   |   |   | — |   |   |   | (308   | )      |   |   | — |   |   | (308    | )      |
| Net income (loss)                                                                      |   | — |   |   | — |   |   |   | — |   |   |   | — |   |   |   | — |   |   |   | — |   |   |   | (1,907 | )      |   | (1,907  | )      |
| Comprehensive  income                                                                  |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   | (2,215  | )      |
| Balance at  December 31, 2004                                                     |   | 30,296 |   |   | $      | 303    |   |   |   | $      | 98,278 |   |   |   | $      | — |   |   |   | $      | (69    | )      |   |   | $      | (252   | )      |    |   | $ | 2,148 |   |   | $ | 100,408 |   |
|                                                                                        |        |        |        |        |        |        |        |        |        |        |        |        |        |        |        |        |        |        |        |        |        |        |        |        |        |        |        |         |        |  |  |  |  |  |  |  |

 

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

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**MONOLITHIC SYSTEMTECHNOLOGY, INC.CONSOLIDATED STATEMENTS OF CASH FLOWS(In thousands)**
| ** **                                                                                             | ** ** | **Year Ended December 31,** | ** ** |
|--------------------------------------------------------------------------------------------------------|------------|--------------------------------------------|------------|
| ** **                                                                                             | ** ** | **2004**                                   | ** ** | **2003** | ** ** | **2002** | ** ** |
| **Cash flows from operating  activities:**                                                             |       |                                       |       |   |   |   |   |
| Net income (loss)                                                                                      |       | $                                          | (1,907     | ) | $ | 2,508 |   | $ | 12,367 |   |
| Adjustments to  reconcile net income (loss) to net cash provided by operating activities:              |       |                                       |       |   |   |   |   |
| Depreciation and amortization                                                                          |       | 1,460                                      |       | 2,049 |   | 1,315 |   |
| Amortization of deferred stock-based compensation                                                      |       | 68                                         |       | 459 |   | 656 |   |
| Interest income on notes receivable from stockholder                                                   |       | —                                     |       | — |   | (8 | ) |
| Changes in  current assets and liabilities:                                                            |       |                                       |       |   |   |   |   |
| Accounts receivable                                                                                    |       | (98                                        | )          | (84 | ) | (600 | ) |
| Unbilled contract receivable                                                                           |       | 1,049                                      |       | (413 | ) | (693 | ) |
| Inventories                                                                                            |       | 474                                        |       | 563 |   | 656 |   |
| Prepaid expenses and other assets                                                                      |       | 858                                        |       | 570 |   | (2,917 | ) |
| Deferred revenue                                                                                       |       | (5                                         | )          | (1,273 | ) | (1,639 | ) |
| Accounts payable                                                                                       |       | 4                                          |       | (16 | ) | (1,292 | ) |
| Accrued expenses and other liabilities                                                                 |       | 391                                        |       | 365 |   | 40 |   |
| Restructuring liability                                                                                |       | 429                                        |       | — |   | — |   |
| Net cash provided by operating activities                                                              |       | 2,723                                      |       | 4,728 |   | 7,885 |   |
| **Cash flows from investing  activities:**                                                             |       |                                       |       |   |   |   |   |
| Purchase of property and equipment                                                                     |       | (349                                       | )          | (493 | ) | (1,356 | ) |
| Purchase of marketable securities                                                                      |       | (461,047                                   | )          | (269,094 | ) | (219,204 | ) |
| Proceeds from sales and maturity of marketable  securities                                             |       | 469,336                                    |       | 258,752 |   | 202,722 |   |
| Acquisition of business and related expenses, net of  cash acquired                                    |       | —                                     |       | — |   | (12,049 | ) |
| Net cash provided by (used in) investing activities                                                    |       | 7,940                                      |       | (10,835 | ) | (29,887 | ) |
| **Cash flows from financing  activities:**                                                             |       |                                       |       |   |   |   |   |
| Payment of capital lease obligations                                                                   |       | (26                                        | )          | (88 | ) | (210 | ) |
| Repayment of notes receivable from stockholder                                                         |       | —                                     |       | — |   | 261 |   |
| Repurchase and retirement of common stock                                                              |       | (4,653                                     | )          | — |   | — |   |
| Proceeds from issuance of common stock                                                                 |       | 3,697                                      |       | 1,907 |   | 909 |   |
| Net cash provided by (used in) financing activities                                                    |       | (982                                       | )          | 1,819 |   | 960 |   |
| Net increase  (decrease) in cash and cash equivalents                                                  |       | 9,681                                      |       | (4,288 | ) | (21,042 | ) |
| Cash and cash  equivalents at beginning of period                                                      |       | 22,033                                     |       | 26,321 |   | 47,363 |   |
| Cash and cash  equivalents at end of period                                                            |       | $                                          | 31,714     |   | $ | 22,033 |   | $ | 26,321 |   |
| **Supplemental disclosure:**                                                                           |       |                                       |       |   |   |   |   |
| Cash paid for income taxes                                                                             |       | $                                          | 24         |   | $ | 394 |   | $ | 3,255 |   |
|                                                                                                   |       | $                                          |       |   | $ |   |   | $ |   |   |
| Deferred compensation from common shares related to  ATMOS acquisition subject to vesting requirements |       | $                                          | —     |   | $ | — |   | $ | 314 |   |
| Cashless warrant  exercises                                                                            |       | $                                          | —     |   | $ | — |   | $ | 5 |   |

 

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

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**MONOLITHIC SYSTEMTECHNOLOGY, INC.**

**NOTES TO CONSOLIDATED FINANCIAL STATEMENTS**

**Note 1—TheCompany and Summary of Significant Accounting Policies:**

***The Company***

Monolithic System Technology, Inc. (the “Company”)was incorporated in California on September 16, 1991 to design, developand market high performance semiconductor memory products and technologies usedby the semiconductor industry and electronic product manufacturers. On September 12,2000, the stockholders approved the Company’s reincorporation in Delaware.

The Company has developedan innovative embedded-memory technology, called 1T-SRAM, which theCompany licenses on a non-exclusive and worldwide basis to semiconductorcompanies and electronic product manufacturers. From its inception in 1991through 1998, the Company focused primarily on the sale of stand-alonememory products. In the fourth quarter of 1998, the Company changed theemphasis of its business model to focus primarily on the licensing of its1T-SRAM technologies and completed this transition in 2002 when a majority ofthe Company’s revenues were derived from licensing and royalty of its 1T-SRAMtechnologies. In the second quarter of 2004, the Company notified its customersof its decision to discontinue sales of its memory chip products and onlylicense its technology.

***Basis of Presentation***

The consolidated financialstatements include the accounts of the Company and its wholly-ownedsubsidiaries. All significant intercompany transactions and balances have beeneliminated in consolidation. The Company reports financial results on acalendar year. Certain amounts reported in previous years have beenreclassified to confirm the 2004 presentation.

***Use of estimates***

The preparation offinancial statements in accordance with accounting principles generallyaccepted in the United States of America requires management to make estimatesand assumptions that affect the reported amounts of assets and liabilities, thedisclosure of contingent assets and liabilities at the date of the financialstatements and the reported amounts of revenues and expenses during thereported period. Actual results could differ from those estimates.

***Revenue Recognition***

*Licensing*

Licensing revenue consists of fees paid forengineering development and engineering support services. All contracts theCompany has entered into to date require the Company to develop a design thatmeets a licensee’s specifications. In accordance with SOP 81-1 “Accounting forperformance of construction-type and certain production type contracts”, whenlicense agreements include deliverables that require “significant production,modification or customization”, contract accounting is applied. For contractsinvolving design specifications that the Company has not previously met, theCompany defers the recognition of revenue until the design meets thecontractual design specifications and expenses the cost of revenue as incurred.When the Company has experience in meeting design specifications but does nothave significant experience to reasonably estimate the cost of services to meeta design specification, the Company defers both the recognition of revenue andthe cost. For these arrangements, the Company recognizes revenue using thecompleted contract method. However, if the Company has significant experiencein meeting the design specification involved in the contract and the directlabor hours related to services under the contract can be reasonably estimated,the Company recognizes revenue over the period 

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in which the contractservices are performed. For these arrangements, the Company recognizes revenueusing the percentage of completion method. Revenues are only recognized when collectionis probable. The direct labor hours for the development of the licensee’sdesign are estimated at the beginning of the contract. As these direct laborhours are incurred, they are used as a measure of progress towards completion.The Company has the ability to reasonably estimate the direct labor hours on acontract-by-contract basis based on its experience in developing priorlicensees’ designs. Under the percentage to completion method, provisions forestimated losses on uncompleted contracts are recognized in the period in whichthe likelihood of such losses is determined. If inherent risks make estimatesdoubtful, the contract is accounted for under the completed contract method.Completion of the contract is based on silicon validated by the customer.

Under the Company’s support and maintenancearrangements, it provides unspecified upgrades, design rule changes andtechnical support. No other upgrades, products or other post-contract supportare provided. These arrangements are renewable annually by the customer.Support and maintenance revenue is recognized at its fair value ratably overthe period during which the obligation exists, typically 12 months. The fairvalue of any support and maintenance obligation is established based on thespecified renewal rate for such support and maintenance. When the Companyprovides a combination of products and services to customers, in addition tothe considerations noted above, it evaluates the arrangements under EITF 00-21,*Revenue Arrangements with MultipleDeliverables*, which is effective for transactions entered into afterJune 30, 2003. EITF 00-21 addresses certain aspects of accounting forarrangements under which the Company will perform multiple revenue generatingactivities. Application of EITF 00-21 did not have a material effect on theCompany’s consolidated financial position or results of operations.

From time to time, alicensee may cancel a project during the development phase. Such a cancellationis not within the Company’s control and is often caused by changes in marketconditions or the licensee’s business. Cancellations of this nature are an aspectof the Company’s licensing business, and most of its newer contracts allow theCompany to retain all payments that the Company has received or are entitled tocollect for items and services provided before the cancellation occurs.Typically under our agreements, the licensee is obligated to complete theproject within a stated timeframe, including assisting us in completing thefinal milestone, and if the Company performs the contracted services, isobligated to pay the license fees even if the licensee fails to completeverification or cancels the project prior to completion. The Company willconsider a project to have been canceled even in the absence of specific noticefrom its licensee, if there has been no activity under the contract for asignificant period, and the Company believes that completion of the contract isunlikely. In this event, the Company recognizes revenue in the amount of cashreceived, if the Company has performed a sufficient portion of the developmentservices. If a cancelled contract had been entered into before theestablishment of technological feasibility, the costs associated with thecontract would have been expensed prior to the recognition of revenue. In thatcase, there would be no costs associated with that revenue recognition, andgross margin would increase for the corresponding period. In 2004 there was nolicense revenue from cancelled projects. In 2003, and 2002 the Companyrecognized $759,000, and $804,000 of licensing revenue from cancelled projects,respectively.

*Product*

Revenue from product salesis recognized upon shipment provided that persuasive evidence of a salesarrangement exists, the price is fixed or determinable, title has transferred,collection of resulting receivables is reasonably assured, there are nocustomer acceptance requirements and there are no remaining significantobligations. For each of the periods presented, there were no formal acceptanceprovisions with the Company’s end customers.

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*Royalty*

Licensing contractsprovide also for royalty payments at a stated rate and require licensees toreport the manufacture or sale of products that include the Company’stechnology after the end of the quarter in which the sale or manufactureoccurs. The Company recognizes royalties in the quarter in which the Companyreceives the licensee’s report. During 2003, the Company entered a terminationagreement with one of its licensees and recognized $713,000 of royalty revenuefrom the terminated contract in 2003. There was no royalty revenue fromterminated contracts in 2004 or 2002.

***Inventory***

TheCompany states inventories at the lower of cost or market, determined using thefirst-in, first-out method. Its policy is to write down its inventory forestimated obsolescence or unmarketable inventory to the extent the cost exceedsthe estimated market value. The Company bases its estimate on its assumptionsabout historical and forecasted sales and market conditions. If actual marketconditions are less favorable than those assumed in its estimates, additionalinventory write-downs might be required. The Company’s policy is toreflect any revaluation of inventory in reported income for the period in whichthe facts giving rise to the inventory revaluation become known. In the secondquarter of 2004, the Company notified customers of its decision to discontinuesale of its memory chip products. The Company has written off approximately$404,000 of inventory in 2004. As of the end of the third quarter of 2004, theCompany had no remaining product inventory. The Company had approximately $74,000of product revenue from the products shipped from the inventory previouslywritten off in 2004.
| ** **       | ** ** | **December 31,**   | ** ** |
|------------------|------------|-------------------------|------------|
| ** **       | ** ** | **2004**                | ** ** | **2003** | ** ** |
| ** **       | ** ** | **(in thousands)** | ** ** |
| **Inventories:** |       |                    |       |   |   |
| Work-in-progress |       | $                       | —     |   | $ | 195 |   |
| Finished goods   |       | —                  |       | 279 |   |
|             |       | $                       | —     |   | $ | 474 |   |

 

***Goodwill***

The Company reviewsgoodwill, recorded from the acquisition of ATMOS Corp. on August 2002, forimpairment annually and whenever events or changes in circumstances indicatethe carrying value of an asset may not be recoverable in accordance with theStatement of Financial Accounting Standards (“SFAS”) No. 142, “Goodwilland Other Intangible Assets.”  Theprovisions of SFAS No. 142 require that a two-step impairment test beperformed on goodwill. In the first step, the Company compares the fair valueof each reporting unit to its carrying value. Using the guidance in SFAS No. 142,the Company determines that it has only one reporting unit at the entity level.For step one, the Company determines the fair value of its reporting unit usingthe market approach. Under the market approach, the Company estimates the fairvalue based on the market value of the reporting unit at the entity level. Ifthe fair value of the reporting unit exceeds the carrying value of net assetsto the reporting unit, goodwill is not impaired and the Company is not requiredto perform further testing. If the carrying value of the net assets to thereporting unit exceeds the fair value of the reporting unit, then the Companymust perform the second step in order to determine the implied fair value ofthe reporting unit’s goodwill and compare it to the carrying value of thereporting unit’s goodwill. If the carrying value of a reporting unit’s goodwillexceeds its implied fair value, then the Company must record an impairment lossequal to the difference. The Company performed the annual impairment testduring the third quarter of 2004, and the test did not indicate impairment ofgoodwill as of September 30, 2004. In addition, every quarter the Companyassesses whether there are indicators of potential impairment. As of December 31,2004, it found no indicators of potential impairment.

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***Foreign Currency Translation***

The Company has foreignoffices located in Canada, Korea, Japan and France, which are operated bysubsidiaries of the Company. The functional currency of the Company’s foreignentities is the U.S. dollar. Accordingly, the financial statements of theseentities, which are maintained in the local currency, are remeasured into U.S. dollarsin accordance with Statement of Financial Accounting Standards No. 52, “ForeignCurrency Translation.” Exchange gains or losses from remeasurement of monetaryassets and liabilities that are not denominated in U.S. dollar were notmaterial for any period presented and are included in the consolidatedstatements of operations.

***Cash Equivalents, Short-term and Long-term Investments***

The Company accounts for investments in accordancewith Statement of Financial Accounting Standards No. 115 “Accounting forCertain Investments in Debt and Equity Securities”. Management determines theappropriate classification of debt securities at the time of purchase. TheCompany’s short-term and long-term investments are carried at fair value, basedon quoted market prices, with the unrealized holding gains and losses reportedin stockholders’ equity. Realized gains and losses and declines in the valuejudged to be other-than-temporary are included in interest income. The cost ofsecurities sold is based on the specific identification method.

The Company invests itsexcess cash in money market accounts and debt instruments and considers allhighly liquid debt instruments purchased with an original maturity of threemonths or less to be cash equivalents. Investments with original maturitiesgreater than three months and remaining maturities less than one year areclassified as short-term investments. Investments with remaining maturitiesgreater than one year are classified as long-term investments.

***Property and equipment***

Propertyand equipment are stated at cost. Depreciation is generally computed using thestraight-line method over the estimated useful lives of the assets, generallythree years. Depreciation and amortization expense for the years ended December 31,2004, 2003 and 2002 was $1.5 million, $2.0 million, and $1.3 million,respectively.
| ** **                        | ** ** | **December 31,**   | ** ** |
|-----------------------------------|------------|-------------------------|------------|
| ** **                        | ** ** | **2004**                | ** ** | **2003** | ** ** |
| ** **                        | ** ** | **(in thousands)** | ** ** |
| **Property  and equipment:**      |       |                    |       |   |   |
| Equipment, furniture and fixtures |       | $                       | 5,638      |   | $ | 6,219 |   |
| Acquired software                 |       | 4,888                   |       | 4,501 |   |
|                              |       | 10,526                  |       | 10,720 |   |
| Less: Accumulated depreciation    |       | (9,841                  | )          | (8,924 | ) |
|                              |       | $                       | 685        |   | $ | 1,796 |   |

 

***Valuation of long-lived assets***

Long-lived assets, such asproperty, plant and equipment, are evaluated for impairment whenever events orchanges in circumstances indicate the carrying value of an asset may not berecoverable. An impairment loss is recognized when estimated undiscountedfuture cash flows expected to result from the use of the asset plus netproceeds expected from disposition of the asset (if any) are less than thecarrying value of the asset. When impairment is identified, the carrying amountof the asset is reduced to its estimated fair value.

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***Cost of revenue***

*Product*

Cost of product revenueconsists primarily of costs associated with the manufacture, assembly andtesting of the Company’s memory chip products by independent, third-partycontractors.

*Licensing*

Cost of licensingrevenue consists primarily of engineering costs directly related to engineeringdevelopment projects specified in agreements we have with licensees of our1T-SRAM technologies. These projects typically include customization of 1T-SRAMcircuitry to enable embedding our memory on a licensee’s integrated circuit andmay include engineering support to assist in the commencement of production ofa licensee’s products. We recognize costs of licensing revenue in the followingmanner:

·       Iflicensing revenue is recognized using the percentage of completion method, theassociated cost of licensing revenue is recognized in the period in which weincur the engineering costs.

·       Iflicensing revenue is recognized using the completed contract method, and to theextent that the amount of engineering cost does not exceed the amount of therelated licensing revenue, this cost is deferred on a contract-by-contractbasis from the time we have established technological feasibility of theproduct to be developed under the license. Technological feasibility isestablished when we have completed all activities necessary to demonstrate thatthe licensee’s product can be produced to meet the performance specificationswhen incorporating our technology. Deferred costs are charged to cost oflicensing revenue when the related revenue is recognized.

·       For contracts entered intoprior to establishing technological feasibility, we do not defer relateddevelopment costs, but rather expense them in the period in which they areincurred. Consequently, upon completion of these contracts, we recognize therelated revenues without any corresponding costs.

*Royalty*

There are no reportedcosts associated with royalty revenue.

***Advertising***

Advertising costs areexpensed as incurred and are not material.

***Unbilled contract receivable***

Under the percentage of completion method, if theamount of revenue recognized exceeds the amount of billings to a customer; theexcess amount is carried as an unbilled contract receivable. The Companyrecorded $57,000 and $1.1 million of unbilled contract receivable as of December 31,2004 and December 31, 2003, respectively.

***Research and development***

Engineering cost isgenerally recorded as research and development expense in the period incurred.

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***Stock-based compensation***

The Company accounts for stock-basedcompensation arrangements in accordance with the provisions of APB No. 25(“APB No. 25”), “Accounting for Stock Issued to Employees” and complieswith the disclosure provisions of Statement of Financial Accounting Standard No. 123(“SFAS No. 123”), “Accounting for Stock-Based Compensation.” UnderAPB No. 25, compensation cost is, in general, recognized based on theexcess, if any, of the fair market value of the Company’s stock on the date ofgrant over the amount an employee must pay to acquire the stock. Equityinstruments issued to non-employees are accounted for in accordance with theprovisions of SFAS No. 123 and Emerging Issues Task Force 96-18.Deferred stock-based compensation is being amortized using straight-linevesting over the vesting period of each respective option, which is generallyfour years.

Hadcompensation cost for the Company’s option plans been determined based on thefair value at the grant dates, as prescribed in SFAS 123, the Company’snet income (loss) would have been as follows (in thousands, except per shareamounts):
| ** **                                                                                                                  | ** ** | **Years Ended December 31,** | ** ** |
|-----------------------------------------------------------------------------------------------------------------------------|------------|---------------------------------------------|------------|
| ** **                                                                                                                  | ** ** | **2004**                                    | ** ** | **2003** | ** ** | **2002** | ** ** |
| Net income (loss):                                                                                                          |       |                                        |       |   |   |   |   |
| As reported                                                                                                                 |       | $                                           | (1,907     | ) | $ | 2,508 |   | $ | 12,367 |   |
| Stock-based compensation expense reported in  consolidated statements of operations                                         |       | 68                                          |       | 459 |   | 656 |   |
| Less: stock compensation related to stock awards  assumed during the ATMOS acquisition                                      |       | —                                      |       | (248 | ) | (74 | ) |
| Total stock-based compensation expense determined  under fair value based method for all awards, net of related tax effects |       | (4,434                                      | )          | (4,537 | ) | (3,229 | ) |
| Pro forma                                                                                                                   |       | $                                           | (6,273     | ) | $ | (1,818 | ) | $ | 9,720 |   |
| Earnings (losses) per  share:                                                                                               |       |                                        |       |   |   |   |   |
| Basic—as reported                                                                                                      |       | $                                           | (0.06      | ) | $ | 0.08 |   | $ | 0.41 |   |
| Basic—pro forma                                                                                                        |       | $                                           | (0.20      | ) | $ | (0.06 | ) | $ | 0.33 |   |
| Diluted—as reported                                                                                                    |       | $                                           | (0.06      | ) | $ | 0.08 |   | $ | 0.40 |   |
| Diluted—pro forma                                                                                                      |       | $                                           | (0.20      | ) | $ | (0.06 | ) | $ | 0.31 |   |

 

Thefair value of each grant is estimated on the date of grant using the Black-Scholesmethod with the following assumptions used for grants during the applicableperiods:
| ** **                           | ** ** | **Years ended December 31,** | ** ** |
|--------------------------------------|------------|---------------------------------------------|------------|
| **Employee stock options** | ** ** | ** **                                  | ** ** | **2004** | ** ** | **2003** | ** ** | **2002** | ** ** |
| Expected life (in  years)            |       | 5.0                                         |       | 5.0 |   | 5.0 |   |
| Risk-free  interest rate             |       | 3.2%-3.7                                    | %          | 2.1%-3.6 | % | 2.7%-4.7 | % |
| Volatility                           |       | 0.8                                         |       | 0.8 |   | 0.7 |   |
| Dividend yield                       |       | 0                                           | %          | 0 | % | 0 | % |
|                                      |            |                                             |            |  |  |  |  |  |  |

 
| **Employee stock purchase plan shares** | ** ** | ** ** | ** ** | **2004** | ** ** | **2003** | ** ** | **2002** | ** ** |
|-------------------------------------------------------------|------------|------------|------------|----------|------------|----------|------------|----------|------------|
| Expected life (in  years)                                   |       | 1.0        |       | 1.0      |       | 1.0      |       |
| Risk-free  interest rate                                    |       | 1.2%-2.2   | %          | 1.1%-1.4 | %          | 1.8%-2.3 | %          |
| Volatility                                                  |       | 0.8        |       | 0.7      |       | 0.8      |       |
| Dividend yield                                              |       | 0          | %          | 0        | %          | 0        | %          |

 

The Company selected theBlack-Scholes option valuation model, which is one of the permittedmethods to estimate the fair market value of options under SFAS No. 123.The weighted average fair value 

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ofoptions granted during 2004, 2003 and 2002 was $4.08, $4.97, and $4.30,respectively. The weighted average estimated fair value of shares granted underthe employee stock purchase plan during 2004, 2003 and 2002 was $2.95, $4.21and $4.26, respectively.

***Per share amounts***

Basic net income (loss) per share is computed bydividing net income (loss) for the period by the weighted-average numberof shares of common stock outstanding during the period. Diluted net income pershare for the years ended December 31, 2003 and 2002 were computed bydividing the net income for the period by the weighted average number of commonand potential common equivalent shares outstanding during the period. Potentialcommon shares are composed of incremental shares of common stock issuable uponthe exercise of stock options or warrants. Diluted net loss per share for theyear ended December 31, 2004 is the same as basic net loss per share forthe same period because the impact of including potential common shares is anti-dilutive.For year ended December 31, 2004, stock options to purchase 1.3 millionshares with exercise prices greater than the average market prices of commonstock were excluded from computation of diluted net loss per share as theirinclusion would be antidilutive.

Thefollowing table sets forth the computation of basic and diluted net income pershare for the periods indicated (in thousands, except per share amounts):
| ** **                                                    | ** ** | **Year Ended December 31,** | ** ** |
|---------------------------------------------------------------|------------|--------------------------------------------|------------|
| ** **                                                    | ** ** | **2004**                                   | ** ** | **2003** | ** ** | **2002** | ** ** |
| Numerator:                                                    |       |                                       |       |   |   |   |   |
| Net income (loss)                                             |       | $                                          | (1,907     | ) | $ | 2,508 |   | $ | 12,367 |   |
| Denominator:                                                  |       |                                       |       |   |   |   |   |
| Shares used in computing net income (loss) per  share:        |       |                                       |       |   |   |   |   |
| Basic                                                         |       | 30,750                                     |       | 30,504 |   | 29,902 |   |
| Employee stock options and unvested common stock  outstanding |       | —                                     |       | 494 |   | 1,083 |   |
| Warrants                                                      |       | —                                     |       | — |   | 290 |   |
| Diluted                                                       |       | 30,750                                     |       | 30,998 |   | 31,275 |   |
| Net income (loss)  per share:                                 |       |                                       |       |   |   |   |   |
| Basic                                                         |       | $                                          | (0.06      | ) | $ | 0.08 |   | $ | 0.41 |   |
| Diluted                                                       |       | $                                          | (0.06      | ) | $ | 0.08 |   | $ | 0.40 |   |

 

***Income taxes***

The Company accounts fordeferred income taxes under the liability approach whereby the expected futuretax consequences of temporary differences between the book and tax basis ofassets and liabilities are recognized as deferred tax assets and liabilities. Avaluation allowance is established for any deferred tax assets for whichrealization is more likely than not.

***Comprehensive income (loss)***

Statement of Financial Accounting Standards No. 130“Reporting Comprehensive Income” (“SFAS No. 130”) requires the Company todisplay comprehensive income and its components as part of the financialstatements. The Company’s only component of comprehensive income (loss) isunrealized gains and losses on available for sale securities. Accumulated othercomprehensive income (loss) as of December 31, 2004, 2003 and 2002 was($252,000), $56,000 and $116,000, respectively.

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Thechanges in other comprehensive income (loss) were as follows, for the yearsended December 31, 2004, 2003, and 2002:
| ** **                                                    | ** ** | **2004**                | ** ** | **2003** | ** ** | **2002** | ** ** |
|---------------------------------------------------------------|------------|-------------------------|------------|----------|------------|----------|------------|
| ** **                                                    | ** ** | **(in thousands)** | ** ** |
| Net income (loss)                                             |       | $                       | (1,907     | )        | $          | 2,508    |       | $ | 12,367 |   |
| Net unrealized gain  (loss) on available-for-sale securities: |       |                    |       |     |       |     |       |
| Change in net  unrealized gains (losses)                      |       | (308                    | )          | (60      | )          | 100      |       |
| Comprehensive income  (loss)                                  |       | $                       | (2,215     | )        | $          | 2,448    |       | $ | 12,467 |   |

 

***Segment reporting***

Financial AccountingStandards Board Statement No. 131, “Disclosure about Segments of anEnterprise and Related Information” (“SFAS No. 131”) requires thatcompanies report separately in the financial statements certain financial anddescriptive information about operating segments profit or loss, certainspecific revenue and expense items and segment assets. The Company operates inone segment, using one measurement of profitability for its business. TheCompany has sales outside the United States that are described in Note 9.The vast majority of long-lived assets are maintained in the United States.

***Recent accounting pronouncements***

In March 2004, the FASB issued EITF Issue No. 03-1,“The Meaning of Other-Than-Temporary Impairment and Its Application to CertainInvestments” which provides new guidance for assessing impairment losses ondebt and equity investments. Additionally, EITF Issue No. 03-1 includesnew disclosure requirements for investments that are deemed to be temporarilyimpaired. The adoption of EITF No. 03-1 did not have a material effect onthe Company’s financial position, results of operations, or cash flows for theyear ended December 31, 2004. See Note 4, “Fair Value of FinancialInstruments”.

In December 2004, theFinancial Accounting Standards Board (FASB) issued Statement of FinancialAccounting Standards No. 123, *Share-BasedPayment*(SFAS 123R) which will become effective beginning inthe third quarter of 2005. SFAS 123R will result in the recognition ofsubstantial compensation expense relating to our employee stock options andemployee stock purchase plans. The Company currently uses the intrinsic valuemethod to measure compensation expense for stock-based awards to its employees.Under this standard, the Company generally does not recognize any compensationrelated to stock option grants the Company issues under its stock option plansor related to the discounts the Company provides under its employee stockpurchase plans. Under the new rules however, the Company is required toadopt a fair-value-based method for measuring the compensation expense relatedto employee stock awards and therefore this will lead to substantial additionalcompensation expense that will be included in the Company’s reported results ofoperations. The footnote section above entitled *Stock Based Compensation*provides the pro forma net income(loss) and earnings (losses) per share as if the Company had used a fair-value-basedmethod similar to the methods required under SFAS 123R to measure thecompensation expense for employee stock awards during 2004, 2003 and 2002.

**Note 2—Restructuring**

On November 10, 2004, the Company announced itsplan to close the ATMOS research and development facility in Canada to reduceoperating expenses and to further align the Company’s business with marketconditions, future revenue expectations and planned future product direction.As part of this plan, the Company implemented a reduction in workforce ofapproximately 20 employees, which represented 20% of its workforce. Inaddition, the Company is attempting to sublease the ATMOS research anddevelopment facility, which the Company occupies under long-term operatingleases through 2008.

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The Company recorded restructuring costs of $585,000in the fourth quarter of 2004, consisting of $179,000 of severance and fringebenefits and lease abandonment charges of $406,000. 

At December 31, 2004 the Company has a totalrestructuring accrual of $429,000, comprised of unpaid employee severance costsof $19,000 and estimated lease abandonment costs of $410,000. All employeesaffected by the Company’s reduction in workforce were notified of thetermination of their employment on November 10, 2004. Estimates related tosublease costs and income were based on assumptions regarding sublease ratesand the time required to locate sub-lessees, which were derived from markettrend information provided by a commercial real estate broker. The Companyreviews these estimates periodically, if these assumptions materially changedue to rental market factors, the ultimate restructuring expense for theabandoned facilities would be adjusted.

Thefollowing table summarizes the activities under the 2004 Restructuring Plan:
| ** **                                         | ** ** | **Abandoned  Space**    | ** ** | **Severance  Related** | ** ** | **Total** | ** **                |
|----------------------------------------------------|------------|-------------------------|------------|------------------------|------------|-----------|---------------------------|
| ** **                                         | ** ** | **(in thousands)** | ** ** |
| 2004 provision                                     |       |                    | $ 406 |                   |       |      | $ 179                |   |   | $ 585 |   |
| Cash payments                                      |       |                    | —     |                   |       |      | (160                      | ) |   | (160 | ) |
| Foreign exchange  fluctuations                     |       |                    | 4          |                   |       |      | —                    |   |   | 4 |   |
| Restructuring  liability at December 31, 2004 |       |                    | $ 410 |                   |       |      | $   19     |   |   | $ 429 |   |
| Less current  portion                              |       |                    | 171        |                   |       |      | 19                        |   |   | 190 |   |
| Long-term portion of  restructuring liability      |       |                    | $ 239 |                   |       |      | $   — |   |   | $ 239 |   |

 

**Note 3—Detailsof Balance Sheet Components and Consolidated Statements of Operations:**
| ** **                                     | ** ** | **December 31,**   | ** ** |
|------------------------------------------------|------------|-------------------------|------------|
| ** **                                     | ** ** | **2004**                | ** ** | **2003** | ** ** |
| ** **                                     | ** ** | **(in thousands)** | ** ** |
| **Prepaid expenses and other  current costs:** |       |                    |       |   |   |
| Deferred costs of revenue                      |       | $  338        |       | $       3 |   |
| Deferred tax assets                            |       | 831                     |       | 1,654 |   |
| Prepaid expenses and other assets              |       | 1,770                   |       | 2,165 |   |
|                                           |       | $2,939                  |       | $ 3,822 |   |
| **Accrued  expenses and other liabilities:**   | ** ** | ** **              | ** ** | ** ** | ** ** |
| Accrued wages and employee benefits            |       | $  621        |       | $  831 |   |
| Professional fees                              |       | 711                     |       | 326 |   |
| Deferred rent                                  |       | 65                      |       | 175 |   |
| Accrued restructuring liability                |       | 190                     |       | — |   |
| Income taxes payable                           |       | 19                      |       | 188 |   |
| Withholding tax payable                        |       | 1,052                   |       | 1,052 |   |
| License fees payable                           |       | 453                     |       | — |   |
| Other                                          |       | 203                     |       | 161 |   |
|                                           |       | $3,314                  |       | $ 2,733 |   |

 

**Interest and otherincome**
| ** **      | ** ** | **2004**                | ** **    | **2003** | ** ** | **2002**     | ** ** |
|-----------------|------------|-------------------------|---------------|----------|------------|--------------|------------|
| ** **      | ** ** | **(in thousands)** | ** **    |
| Interest Income |       |                    | $ 1,527  |     |       | $ 1,350 |       | $ 1,539 |   |
| Other Income    |       |                    | 10,051        |     |       | 564          |       | — |   |
| Total           |       |                    | $ 11,578 |     |       | $ 1,914 |       | $ 1,539 |   |

 

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In July, 2004, the Companyand Synopsys entered into a settlement agreement (“the settlement”) regarding alawsuit arising from the termination by Synopsys of an agreement and plan ofmerger and reorganization dated February 23, 2004, between the twoparties. Under the terms of the settlement, the Company and Synopsys agreed toresolve the merger termination lawsuit without further liability or paymentprovided Synopsys pay the Company liquidating damages in the amount of $10million. In July 2004, the Company received the $10 million terminationfee. In 2003, other income included the $287,000 contract termination fee fromConexant.

**Note4:   Fair Value of Financial Instruments**

Theestimated fair values of financial instruments outstanding at fiscal year-endswere as follows:
| ** **                                  | ** ** | **2004**                | ** **    |
|---------------------------------------------|------------|-------------------------|---------------|
| ** **                                  | ** ** | **Adjusted Cost**  | ** **    | **Gross  Unrealized  Gain** | ** ** | **Gross  Unrealized  Loss** | ** ** | **Estimated Fair  Value** | ** ** |
| ** **                                  | ** ** | **(in thousands)** | ** **    |
| Cash                                        |       |                    | $ 7,564  |   |   |   | $ — |   |   |   | $   — |   |   |   | $ 7,564 |   |   |
| Cash Equivalents:                           |       |                    |          |   |   |   |   |   |   |   |   |   |   |   |   |   |   |
| Commercial and US government agencies paper |       |                    | 24,150        |   |   |   | — |   |   |   | — |   |   |   | 24,150 |   |   |
| Total cash and cash equivalents             |       |                    | $ 31,714 |   |   |   | $ — |   |   |   | $   — |   |   |   | $ 31,714 |   |   |
| Short-term investments:                     |       |                    |          |   |   |   |   |   |   |   |   |   |   |   |   |   |   |
| US government debt securities               |       |                    | $ 11,800 |   |   |   | $ — |   |   |   | $ (39 | ) |   |   | $ 11,761 |   |   |
| Corporate notes                             |       |                    | 17,949        |   |   |   | — |   |   |   | (75 | ) |   |   | 17,874 |   |   |
| Market auction preferred securities         |       |                    | 1,000         |   |   |   | — |   |   |   | — |   |   |   | 1,000 |   |   |
| Total short-term investments                |       |                    | $ 30,749 |   |   |   | $ — |   |   |   | $ (114 | ) |   |   | $ 30,635 |   |   |
| Long-term investments:                      |       |                    |          |   |   |   |   |   |   |   |   |   |   |   |   |   |   |
| US government debt securities               |       |                    | $ 17,500 |   |   |   | $ — |   |   |   | $ (80 | ) |   |   | $ 17,420 |   |   |
| Corporate notes                             |       |                    | 7,200         |   |   |   | — |   |   |   | (58 | ) |   |   | 7,142 |   |   |
| Total long-term  investments                |       |                    | $ 24,700 |   |   |   | $ — |   |   |   | $ (138 | ) |   |   | $ 24,562 |   |   |

 
| ** **                                  | ** ** | **2003**                | ** **    |
|---------------------------------------------|------------|-------------------------|---------------|
| ** **                                  | ** ** | **Adjusted Cost**  | ** **    | **Gross  Unrealized  Gain** | ** ** | **Gross  Unrealized  Loss** | ** ** | **Estimated Fair  Value** | ** ** |
| ** **                                  | ** ** | **(in thousands)** | ** **    |
| Cash                                        |       |                    | $ 4,883  |   |   |   | $ — |   |   |   | $ — |   |   |   | $ 4,883 |   |   |
| Cash Equivalents:                           |       |                    |          |   |   |   |   |   |   |   |   |   |   |   |   |   |   |
| Commercial and US government agencies paper |       |                    | 17,150        |   |   |   | — |   |   |   | — |   |   |   | 17,150 |   |   |
| Total cash and cash equivalents             |       |                    | $ 22,033 |   |   |   | $ — |   |   |   | $ — |   |   |   | $ 22,033 |   |   |
| Short-term  investments:                    |       |                    |          |   |   |   |   |   |   |   |   |   |   |   |   |   |   |
| US government debt securities               |       |                    | $ 3,700  |   |   |   | $ — |   |   |   | $ — |   |   |   | $ 3,700 |   |   |
| Corporate notes                             |       |                    | 6,760         |   |   |   | 22 |   |   |   | — |   |   |   | 6,782 |   |   |
| Market auction preferred securities         |       |                    | 8,850         |   |   |   | — |   |   |   | — |   |   |   | 8,850 |   |   |
| Total short-term investments                |       |                    | $ 19,310 |   |   |   | $ 22 |   |   |   | $ — |   |   |   | $ 19,332 |   |   |
| Long-term  investments:                     |       |                    |          |   |   |   |   |   |   |   |   |   |   |   |   |   |   |
| US government debt securities               |       |                    | $ 39,707 |   |   |   | $ 27 |   |   |   | $ — |   |   |   | $ 39,734 |   |   |
| Corporate notes                             |       |                    | 4,721         |   |   |   | 7 |   |   |   | — |   |   |   | 4,728 |   |   |
| Total long-term  investments                |       |                    | $ 44,428 |   |   |   | $ 34 |   |   |   | $ — |   |   |   | $ 44,462 |   |   |

 

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Thefollowing table shows the fair value and net carrying amount of cashequivalents and short-term and long-term investments based on the following twomaturity groups as of December 31, 2004:
| ** **        | ** ** | **Adjusted Cost** | ** ** | **Gross Unrealized  Loss** | ** ** | **Estimated Fair Value** | ** ** |
|-------------------|------------|------------------------|------------|---------------------------------|------------|--------------------------|------------|
| Due within 1 year |       |                   | $          | 54,899                          |       |                     |       | $ | (114 | ) |   |   | $ | 54,785 |   |   |
| Due 1-2  years    |       |                   | 24,700     |                            |       |                     | (138       | ) |   |   | 24,562 |   |   |
| Total             |       |                   | $          | 79,599                          |       |                     |       | $ | (252 | ) |   |   | $ | 79,347 |   |   |

 

There were no realized gains or losses for 2004, 2003and 2002.

Thefollowing table shows the gross unrealized losses and fair value of Company’sinvestments with unrealized losses that are not deemed to beother-than-temporarily impaired, aggregated by investment category and lengthof time that individual securities have been in a continuous unrealized loss position,at December 31, 2004 (amounts in thousands):
| ** **                     | ** ** | **Less than 12  months**          | ** ** | **12 months or  greater** | ** ** | **Total**       | ** ** |
|--------------------------------|------------|---------------------------------------------|------------|-------------------------------------|------------|-----------------|------------|
| ** **                     | ** ** | **  Fair Value  ** | ** ** | **Unrealized  Losses**              | ** ** | **Fair  Value** | ** ** | **Unrealized  Losses** | ** ** | **  Fair Value  ** | ** ** | **Unrealized  Losses** | ** ** |
| **Description  of securities** |       |                                        |       |                                |       |            |       |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |
| US Government  Debt Securities |       |                                        | $          | 11,761                              |       |            |       | $ | (39 | ) |   | $ | 17,420 |   |   | $ | (80 | ) |   |   | $ | 29,181 |   |   |   | $ | (119 | ) |   |
| Corporate Notes                |       |                                        | 17,874     |                                |       |            | (75        | ) |   | 7,142 |   |   | (58 | ) |   |   | 25,016 |   |   |   | (133 | ) |   |
| Total                          |       |                                        | $          | 29,635                              |       |            |       | $ | (114 | ) |   | $ | 24,562 |   |   | $ | (138 | ) |   |   | $ | 54,197 |   |   |   | $ | (252 | ) |   |

 

**U.S. Government Debt Securities.  **TheCompany’s investment in U.S. Government Debt Securities consists of low riskgovernment agency bonds typically with a rating of AAA. The unrealized losseson the Company’s investments in U.S. Government Debt Securities were caused byinterest rate increases occurred during 2004. Because the Company has theability and intent to hold these investments until a recovery of fair value,which may be maturity, the Company does not consider these investments to beother-than-temporarily impaired at December 31, 2004.

**CorporateNotes.**   The Company’s investment in corporate notesconsists primarily of investment grade corporate bonds and notes. Theunrealized losses on the Company’s investment grade corporate bonds and noteswere caused by interest rate increases occurred during 2004. Due to the factthat the decline in market value is attributable to changes in interest ratesand not credit quality, and because the severity and duration of the unrealizedlosses were not significant, the Company considered these unrealized losses tobe temporary at December 31, 2004.

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**Note 5—IncomeTaxes:**

Theprovision for income taxes consists of the following (in thousands):
| ** **       | ** ** | **Year Ended December 31,** | ** ** |
|------------------|------------|--------------------------------------------|------------|
| ** **       | ** ** | **2004**                                   | ** ** | **2003** | ** ** | **2002** | ** ** |
| Current portion: |       |                                       |       |   |   |   |   |
| U.S. federal     |       | $                                          | (904       | ) | $ | (634 | ) | $ | 3,567 |   |
| State            |       | 3                                          |       | 2 |   | 121 |   |
| Foreign          |       | 104                                        |       | 150 |   | 100 |   |
|             |       | (797                                       | )          | (482 | ) | 3,788 |   |
| Deferred:        |       |                                       |       |   |   |   |   |
| U.S. federal     |       | 823                                        |       | 761 |   | (2,415 | ) |
| State            |       | —                                     |       | — |   | — |   |
| Foreign          |       | —                                     |       | — |   | — |   |
|             |       | 823                                        |       | 761 |   | (2,415 | ) |
| Total            |       | $                                          | 26         |   | $ | 279 |   | $ | 1,373 |   |

 

Deferredtax assets consist of the following (in thousands):
| ** **                                    | ** ** | **December 31,** | ** ** |
|-----------------------------------------------|------------|-----------------------|------------|
| ** **                                    | ** ** | **2004**              | ** ** | **2003** | ** ** |
| **Deferred  tax assets:**                     |       |                  |       |   |   |   |   |
| Federal and state loss carryforwards          |       |                  | $          | 1,614 |   |   | $ | 1,357 |   |
| Inventory                                     |       |                  | —     |   |   | 460 |   |
| Reserves, accruals and other                  |       |                  | 271        |   |   | 279 |   |
| Deferred revenue                              |       |                  | 799        |   |   | 311 |   |
| Depreciation and amortization                 |       |                  | (212       | ) |   | (499 | ) |
| Deferred compensation                         |       |                  | 455        |   |   | 257 |   |
| Research and development credit carryforwards |       |                  | 2,013      |   |   | 1,164 |   |
| Foreign tax credits                           |       |                  | 435        |   |   | 387 |   |
| Canadian net operating loss                   |       |                  | 6,238      |   |   | 6,173 |   |
|                                          |       |                  | 11,613     |   |   | 9,889 |   |
| Less: Valuation  allowance                    |       |                  | (10,782    | ) |   | (8,235 | ) |
| Net deferred tax assets                       |       |                  | $          | 831 |   |   | $ | 1,654 |   |

 

The valuation allowance increased by $2.5 million andincreased by $7.5 million, during the years ended December 31, 2004 and2003, respectively. The valuation allowance at December 31, 2004 includes$3.1 million related to stock option deductions, the benefit of which will becredited to additional paid in capital when realized.

As of December 31, 2004, the Company had netoperating loss carryforwards of approximately $4.5 million for federal incometax purposes and approximately $1.3 million for state income tax purposes. Theselosses are available to reduce taxable income and expire beginning 2005 through2024. The Company also had federal research and development tax creditcarryforwards of approximately $1.6 million, which will expire beginning in2012, and California research and development credits of approximately $848,000which do not have an expiration date. The Company had foreign tax creditsavailable for federal income tax purposes of approximately $435,000, which willbegin to expire in 2008. The Company had Canadian net operating losscarryforwards of $13.6 million, which will begin to expire in 2005. Utilizationof the Company’s net operating loss and tax credit carryforwards may be subjectto a substantial annual limitation due to the ownership change limitationsprovided by the Internal Revenue 

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Code and similar stateprovisions. Such an annual limitation could result in the expiration orelimination of the net operating loss and tax credit carryforwards beforeutilization. Management does not believe it is likely that utilization will infact be significantly limited due to these provisions.

The Company’s U.S. income tax return for 2001 and 2002are under examination. Management believes that adequate amounts have beenprovided for any adjustments that may ultimately result from this examination.

Areconciliation of income taxes provided at the federal statutory rate (35% in2004, 2003 and 2002) to actual income tax expense follows:
| ** **                                                   | ** ** | **Year Ended December 31,** | ** ** |
|--------------------------------------------------------------|------------|--------------------------------------------|------------|
| ** **                                                   | ** ** | **2004**                                   | ** ** | **2003** | ** ** | **2002** | ** ** |
| ** **                                                   | ** ** | **(in thousands)**                    | ** ** |
| Income tax  provision computed at federal statutory rate     |       |                                       | $          | (659 | ) |   | $ | 976 |   | $ | 4,809 |   |
| State income tax  (net of federal benefit)                   |       |                                       | 3          |   |   | 2 |   | 608 |   |
| Foreign income  tax at rate different from US statutory rate |       |                                       | 28         |   |   | (15 | ) | 100 |   |
| Utilization of  previously reserved NOL’s               |       |                                       | —     |   |   | (834 | ) | (932 | ) |
| Utilization of  tax credits                                  |       |                                       | —     |   |   | — |   | (200 | ) |
| Change in  valuation allowance                               |       |                                       | 641        |   |   | 73 |   | (3,197 | ) |
| Tax benefit from  extraterritorial income exclusion          |       |                                       | —     |   |   | (206 | ) | — |   |
| Other                                                        |       |                                       | 13         |   |   | 283 |   | 185 |   |
|                                                         |       |                                       | $          | 26 |   |   | $ | 279 |   | $ | 1,373 |   |

 

Thedomestic and foreign components of earnings before taxes were as follows forthe years ended December 31, 2004, 2003 and 2002:
| ** ** | ** ** | **2004**                | ** ** | **2003** | ** ** | **2002** | ** ** |
|------------|------------|-------------------------|------------|----------|------------|----------|------------|
| ** ** | ** ** | **(in thousands)** |
| U.S.       |       |                    | $          | (1,685   | )          |     | $          | 2,316 |   | $ | 13,549 |   |
| Non-U.S.   |       |                    | (196       | )        |       | 471      |       | 191 |   |
|       |       |                    | $          | (1,881   | )          |     | $          | 2,787 |   | $ | 13,740 |   |

 

**Note 6—Guarantees:**

***Indemnifications***

In the ordinary course ofbusiness, the Company enters into contractual arrangements under which theCompany may agree to indemnify the third party to such arrangement from anylosses incurred relating to the services they perform on behalf of the Companyor for losses arising from certain events as defined within the particularcontract, which may include, for example, litigation or claims relating topatent infringement. Such indemnification obligations may not be subject tomaximum loss clauses. To date, the Company has not made any payments related tothese indemnifications.

**Note 7—Stockholders’ Equity:**

***Common Stock Option Plans***

The 1992 Stock Option Plan (the “1992 Plan”)authorizes the board of directors to grant incentive stock options andnonqualified stock options for up to 3,300,000 shares of common stock toemployees, directors and consultants. Under the 1992 Plan, incentive stock optionsare to be granted at a price not less than 100% of the fair value of the stockat the date of grant, as determined by the board of directors. Nonqualifiedstock options are to be granted at a price not less than 85% of the fair valueof the stock at the date of grant, as determined by the board of directors.Options generally vest over a four-year period 

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and are exercisable for amaximum period of ten years after the date of grant. The 1992 Plan wasterminated in 1996, and no further options were granted under the plan.

In 1996, the Company adopted the 1996 Stock Plan (the “1996Plan”), which authorizes the board of directors to grant incentive stockoptions and nonqualified stock options for up to 2,500,000 shares of commonstock to employees, directors and consultants. The option terms under the 1996Plan are substantially the same as the 1992 Plan except that options grantedunder the 1996 Plan may be exercised immediately. Common stock purchasedpursuant to the exercise of an unvested option is subject to repurchase by theCompany, at the exercise price, under certain conditions. Options generallyvest over a four-year period and are exercisable for a maximum period of tenyears after the date of grant.

The Company’s 2000 employee stock option plan (the “2000plan”) was adopted in October 2000 in connection with the Company’sreincorporation in the state of Delaware. In 2004, the Company obtainedshareholders’ approval to its Amended andRestated 2000 Stock Option and Equity Incentive Plan (the “Amended 2000 Plan”) toprovide additional incentive to ouremployees and directors. The Amended 2000 plan authorizes the board orCommittee to grant a broad range of awards in addition to stock options,including stock grants, restricted stock, performance-based awards,restricted stock units representing a right to acquire shares in the future andstock appreciation rights and to determine the applicable terms, includingprice, of such awards. Under the Amended 2000 plan, the maximum number of shares, which are reserved for issuance is6,707,000, plus an annual increase of 500,000 on January 1 of each year,or a lesser amount determined by our board of directors. The term ofoptions granted under the Amended 2000 plan may not exceed ten years. The termof all incentive stock options granted to an optionee who, at the time ofgrant, owns stock representing more than 10% of the voting power of all classesof the Company’s stock may not exceed five years. Generally, 25% of the optionsgranted under the Amended 2000 Plan will vest and become exercisable on thefirst anniversary of the date of grant, and 1/48th of the options will vest andbecome exercisable each month thereafter.

The exercise price of incentive stock options grantedunder the Amended 2000 Plan must be at least equal to the fair market value ofthe shares on the date of grant. The exercise price of nonstatutory stockoptions granted under the amended 2000 plan will be determined by the board ofdirectors and the exercise price of a nonqualified stock option will not besubject to any price restriction under the Amended 2000 Plan. No incentivestock option may be granted to any employee who on the date of grant owns morethan ten percent of our common stock, unless the exercise price of the optionis equal to at least 110% of the fair market value of such shares on the dateof grant. In addition, the Amended 2000 Plan provides for automaticacceleration of vesting for options granted to non-employee directors in theevent of an acquisition of the Company.

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Asummary of the status of all the Company’s stock option plans as of December 31,2002, 2003 and 2004 and changes during the years ended on these dates arepresented below (in thousands, except per share amounts):
| ** **                                 | ** ** | **Options Outstanding**  | ** ** |
|--------------------------------------------|------------|-------------------------------|------------|
| ** **                                 | ** ** | **Available  for Grant** | ** ** | **Number of  Shares** | ** ** | **Weighted  Average  Exercise  Prices** | ** ** |
| Balance at  December 31, 2001         |       |                          | 4,637      |   |   |   | 3,044 |   |   |   | $ | 6.05 |   |   |
| Additional  authorized under the 2000 Plan |       |                          | 500        |   |   |   |   |   |   |   |   |   |   |
| Granted                                    |       |                          | (1,534     | ) |   |   | 1,534 |   |   |   | $ | 10.02 |   |   |
| Cancelled                                  |       |                          | 314        |   |   |   | (314 | ) |   |   | $ | 8.43 |   |   |
| Exercised                                  |       |                          | —     |   |   |   | (159 | ) |   |   | $ | 2.93 |   |   |
| Balance at  December 31, 2002         |       |                          | 3,917      |   |   |   | 4,105 |   |   |   | $ | 7.47 |   |   |
| Additional  authorized under the 2000 Plan |       |                          | 500        |   |   |   |   |   |   |   |   |   |   |
| Granted                                    |       |                          | (1,066     | ) |   |   | 1,066 |   |   |   | $ | 7.99 |   |   |
| Cancelled                                  |       |                          | 360        |   |   |   | (360 | ) |   |   | $ | 8.60 |   |   |
| Exercised                                  |       |                          | —     |   |   |   | (439 | ) |   |   | $ | 3.30 |   |   |
| Balance at  December 31, 2003         |       |                          | 3,711      |   |   |   | 4,372 |   |   |   | $ | 7.92 |   |   |
| Additional  authorized under the 2000 Plan |       |                          | 500        |   |   |   |   |   |   |   |   |   |   |
| Granted                                    |       |                          | (3,324     | ) |   |   | 3,324 |   |   |   | $ | 4.00 |   |   |
| Cancelled                                  |       |                          | 1,251      |   |   |   | (1,251 | ) |   |   | $ | 7.62 |   |   |
| Exercised                                  |       |                          | —     |   |   |   | (688 | ) |   |   | $ | 4.70 |   |   |
| Balance at  December 31, 2004         |       |                          | 2,138      |   |   |   | 5,757 |   |   |   | $ | 6.11 |   |   |

 

Informationrelating to stock options outstanding at December 31, 2004 is as follows(in thousands, except per share amounts):
| ** **                                 | ** ** | **Options Outstanding at December 31, 2004** | ** ** | **Options Exercisable at** | ** ** |
|--------------------------------------------|------------|-----------------------------------------------------------------------|------------|--------------------------------------|------------|
| **Range of Exercise Price** | ** ** | ** **                                                            | ** ** | **Number  Outstanding**              | ** ** | **Weighted Average  Remaining  Contractual Life  (in Years)** | ** ** | **Weighted Average  Exercise Price** | ** ** | **December 31, 2004** | ** ** |
| ** **                                 | ** ** | **Average**                                                           |
| **Number**                                 | ** ** | **Weighted**                                                          |
| **Outstanding**                            | ** ** | **Exercise Price**                                               |
| $1.00-$4.05                                |       |                                                                  | 2,395      |                                 |       |   | 8.89 |   |   |   | $ | 3.53 |   |   |   | 298 |   |   |   | $ | 1.26 |   |   |
| $4.06-$8.00                                |       |                                                                  | 1,873      |                                 |       |   | 8.39 |   |   |   | $ | 5.99 |   |   |   | 720 |   |   |   | $ | 7.36 |   |   |
| $8.01-$10.00                               |       |                                                                  | 578        |                                 |       |   | 7.24 |   |   |   | $ | 9.45 |   |   |   | 433 |   |   |   | $ | 9.56 |   |   |
| $10.01-$16.00                              |       |                                                                  | 911        |                                 |       |   | 7.23 |   |   |   | $ | 11.02 |   |   |   | 648 |   |   |   | $ | 11.05 |   |   |
|                                       |       |                                                                  | 5,757      |                                 |       |   |   |   |   |   |   |   |   |   | 2,099 |   |   |   |   |   |   |

 

The Company’s board ofdirectors may issue up to 20,000,000 shares of preferred stock withoutstockholder approval on such terms as the board might determine. The rights ofthe holders of common stock will be subject to, and might be adversely affectedby, the rights of the holders of any preferred stock that might be issued inthe future.

***Employee stock purchase plan***

The Company’s 2000 employee stock purchase plan wasadopted in October 2000 in connection with the Company’s Delawarere-incorporation, to become effective upon the pricing date of the Company’sinitial public offering. A total of 500,000 shares of common stock have beenreserved for issuance under the purchase plan. In addition, the purchase planprovides for an automatic annual increase in the number of shares reservedunder the plan on January 1 of each year, equal to the lesser of 100,000shares, one percent of the Company’s outstanding shares of common stock on suchdate or a lesser amount 

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determined by the board ofdirectors. The purchase plan, which is intended to qualify under Section 423of the Internal Revenue Code, is administered by the board of directors or acommittee appointed by the board of directors.

Employees, including officers and employee directorsbut excluding 5% stockholders, are eligible to participate if they arecustomarily employed for at least 20 hours per week and for more than fivemonths in any calendar year. The purchase plan permits eligible employees topurchase common stock through payroll deductions, which may not exceed 10% ofan employee’s compensation. Employees will be permitted to invest a maximum of$25,000 in any offering period.

The purchase plan has been implemented in a series ofoverlapping offering periods, each to be approximately 12 months induration. Offering periods begin on the first trading day on or after January 1and July 1 of each year and end on the last trading day in the periodending twelve months later. Each participant is granted an option on the firstday of the offering period, and such option will be automatically exercised atthe end of month six of the offering period and on the last day of the offeringperiod. The purchase price of the common stock under the purchase plan is equalto 85% of the lesser of the fair market value per share of common stock on thestart date of the offering period or on the date on which the option isexercised. Employees may end their participation in an offering period at anytime during that period, and participation ends automatically on termination ofemployment with the Company. The purchase plan will terminate in June 2010,unless sooner terminated by the board of directors.

Of the 500,000 sharesauthorized to be issued under the purchase plan, 332,000 shares remainedavailable for issuance at December 31, 2004. Employees purchased 66,000,55,000 and 47,000 shares in 2004, 2003 and 2002, respectively.

***Deferred stock-based compensation cost toemployees***

During the years ended December 31, 2004, 2003and 2002, the Company recorded deferred compensation cost of approximately$74,000, $0, and $314,000 respectively, which cost will be amortized in futureperiods. The 2004 deferred compensation cost represents the intrinsic value ofoptions granted to purchase shares of the Company’s stock to newly appointedmembers of the Company’s board of directors that had an exercise price lessthan the fair market value of the Company’s common stock on the date of theoption grant. This deferred compensation cost will be amortized over the optionvesting period of 36 months using the graded vesting method. The 2002 deferredcompensation cost represented the shares of common stock issued to certainemployees of ATMOS part of the acquisition that were subject to vestingrequirements, which cost is being amortized over the vesting period of 36months using the graded vesting method.

During the years ended December 31, 2004, 2003and 2002, the Company recorded stock compensation expenses of $68,000,$459,000, and $656,000, respectively, of which $50,000, $211,000, and $582,000,respectively, was attributable to the excess of the fair market value of theCompany’s common stock over the price at which the Company granted stockoptions to employees. Stock compensation expenses in 2004, 2003 and 2002 alsoincluded $13,000, $227,000 and $74,000, respectively, for amortization ofdeferred compensation cost attributable to the fair market value of shares ofthe Company’s common stock issued to certain employees of ATMOS. In addition,the Company incurred $5,000 of stock compensation expense in 2004 related tothe issuance of options to purchase the Company’s stock to newly appointedmembers of the Company’s board of directors that had an exercise price lessthan the fair market value of the Company’s stock on the date of the optiongrant. The Company also incurred $21,000 of stock compensation expense in 2003due to modification of the Company’s 2000 employee stock option held a formermember of the Company’s board of directors.

Deferred compensationexpense is being amortized using the graded vesting method over the vestingperiod of each respective option, generally four years. The acceleratedamortization results in expensing 

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approximately52% of the total award in the first year, 27% in the second year, 15% in the thirdyear and 6% in the fourth year.

***Stockholder Rights Plan***

The Company’s Stockholder Rights Plan, which wasadopted in October 2000 and became effective June 27, 2001, isintended to protect stockholders from unfair or unfriendly takeover practices.In accordance with this plan, the board of directors declared a dividenddistribution of one Series AA preferred stock purchase right on eachoutstanding share of its common stock held as of June 27, 2001, and oneach share of common stock issued by the Company thereafter. Each rightentitles the registered holder to purchase from the Company one one-thousandthshare of Series AA preferred stock at a price of $110. The rights becomeexercisable in certain circumstances, including the acquisition by any person orgroup, or the commencement or announcement of a tender or exchange offer forthe acquisition, of beneficial ownership of 15 % or more of the Company’scommon stock without the approval of the board of directors (except for certainaffiliates prior to the effective date of the Plan as to whom this ownershiplimit is 25%). The rights do not confer any rights as a stockholder until theyare exercised. In the event the rights become exercisable, each right willentitle the holder to acquire shares of common stock of the Company or theacquiring corporation (in the event of merger or similar business combination)having a value equal to twice the purchase price of the right. The rights areredeemable by the Company prior to exercise at $0.01 per right and expire on October 11,2010.

In 2004, the Companyamended its Stockholder Rights Plan twice; once, in connection with theproposed acquisition of corporation by Synopsys, Inc, and a second time topermit the acquisition of shares representing more than 15% of its common stockby a brokerage firm that manages independent customer accounts and generallydoes not have any discretionary voting power with respect to such shares.Notwithstanding amendments of this nature, the Company’s intention is tomaintain and enforce the terms of this plan, which could delay, deter orprevent an investor from acquiring the Company in a transaction that couldotherwise result in stockholders receiving a premium over the market price fortheir shares of common stock.

***Stock Repurchase Plan***

On April 19, 2004, the Company announced that itsboard of directors authorized it to purchase up to $25 million of itscommon stock over the next 12 months. The share repurchases may be made, fromtime to time in the open market subject to market conditions and other factors,such as the Company’s belief that the repurchase will be beneficial tostockholders. These repurchases may be commenced or suspended at any time orfrom time to time without prior notice. To date the Company has repurchasedapproximately $4.7 million or 1.2 million shares of its common stock. Allshares repurchased to date were retired in the third quarter of 2004.

TheCompany’s stock repurchases under the above plan are summarized below (inthousands except for share values):
| **Period**                                             | ** ** | ** ** | ** ** | **Total Number  of Shares  Purchased** | ** ** | **Average Price  Paid per Share** | ** ** | **Total Dollar Value  Purchased as  Part of Publicly  Announced Plan** | ** ** | **Maximum  Dollar Value that  May Yet Be  Purchased  Under Plan** | ** ** |
|--------------------------------------------------------|------------|------------|------------|--------------------------------------------------|------------|--------------------------------------------------|------------|------------------------------------------------------------------------------------------------------|------------|--------------------------------------------------------------------------------------------|------------|
| April 19,  2004 – July 31, 2004         |       |       | —     |                                             |       |                                             | $          | —                                                                                               |       |                                                                                       |       | $ | — |   |   |   | $ | 25,000 |   |   |
| August 1,  2004 – August 31, 2004       |       |       | 1,117      |                                             |       |                                             | 3.93       |                                                                                                 |       |                                                                                       | 4,386      |   |   |   | 20,614 |   |   |
| September 1,  2004 – September 30, 2004 |       |       | 65         |                                             |       |                                             | 4.11       |                                                                                                 |       |                                                                                       | 267        |   |   |   | 20,347 |   |   |
| October 1,  2004 – December 31, 2004    |       |       | —     |                                             |       |                                             | —     |                                                                                                 |       |                                                                                       | —     |   |   |   | 20,347 |   |   |
| Total                                                  |       |       | 1,182      |                                             |       |                                             | $          | 3.94                                                                                                 |       |                                                                                       |       | $ | 4,653 |   |   |   |   |   |   |

 

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**Note 8—Retirement Savings Plan:**

Effective January 1997,the Company adopted the MoSys 401(k) Plan (the “Savings Plan”) whichqualifies as a thrift plan under Section 401(k) of the InternalRevenue Code. All full-time employees who are at least 21 years old areeligible to participate in the Savings Plan at the time of hire. Participantsmay contribute up to 15% of their earnings to the Savings Plan. The Companymakes a Matching Contribution on behalf of each Participant in an amount equalto 25% of a Participant’s Deferral Contributions during the Plan Year. TheCompany made matching contributions of $110,000, $107,000, and $98,000 in 2004,2003 and 2002, respectively.

**Note 9—BusinessSegments, Concentration of Credit Risk and Significant Customers:**

The Company has adopted SFAS No. 131, “Disclosureabout Segments of an Enterprise and Related Information.” Although the Companyoffers various intellectual property components and services to its customers,the Company does not manage its operations by these intellectual propertycomponents and services, but instead views the Company as one operating segmentwhen making business decisions. The Company does not manage its operations on ageographical basis. Revenue attributed to the United States and to all foreigncountries is based on the geographical location of the customer. The Companyuses one measurement of profitability for its business.

The Company supplies semiconductor memories to theelectronics industry. This industry segment is characterized by rapidtechnological change and significant competition.

Financial instruments that potentially subject theCompany to significant concentrations of credit risk consist principally ofcash, cash equivalents short-term and long-term investments and accounts receivable.Cash, cash equivalents short-term and long term investments are deposited withhigh credit quality institutions.

TheCompany sells its products and licenses its 1T-SRAM technologies to customersin the Far East, North America and Europe as follows (in thousands):
| ** **    | ** ** | **Years Ended December 31,** | ** ** |
|---------------|------------|---------------------------------------------|------------|
| ** **    | ** ** | **2004**                                    | ** ** | **2003** | ** ** | **2002** | ** ** |
| North America |       | $                                           | 4,602      |   | $ | 7,767 |   | $ | 8,007 |   |
| Japan         |       | 4,609                                       |       | 7,146 |   | 13,365 |   |
| Asia          |       | 1,191                                       |       | 3,969 |   | 5,646 |   |
| Europe        |       | 419                                         |       | 351 |   | 773 |   |
| Total         |       | $                                           | 10,821     |   | $ | 19,233 |   | $ | 27,791 |   |

 

Customerswho accounted for at least 10% of total revenues were as follows:
| ** ** | ** ** | **Year Ended December 31,** | ** ** |
|------------|------------|--------------------------------------------|------------|
| ** ** | ** ** | **2004**                                   | ** ** | **2003** | ** ** | **2002** | ** ** |
| NEC        |       |                                       | 19         | % |   |   | 14 | % |   |   | 38 | % |   |
| Fujitsu    |       |                                       | 17         | % |   |   | — | % |   |   | — | % |   |
| Marvel     |       |                                       | 11         | % |   |   | — | % |   |   | — | % |   |
| Sony       |       |                                       | —     | % |   |   | 17 | % |   |   | — | % |   |
| UMC        |       |                                       | —     | % |   |   | 11 | % |   |   | 12 | % |   |

 

Three customers accounted for 46%, 17% and 11% ofgross accounts receivable, respectively, at December 31, 2004. Fivecustomers accounted for 21%, 18%, 12%, 11% and 10% of gross accountsreceivable, respectively, at December 31, 2003. The Company has notexperienced any significant credit losses from its accounts receivable and noneare currently expected. The Company performs ongoing

 

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credit evaluations of its customers’ financialcondition and maintains an allowance for uncollectible accounts receivablebased upon the expected collectibility of all accounts receivable. No amountswere written off in 2004, 2003 and 2002.

Netproperty, plant and equipment, classified by major geographic areas were asfollows at December 31, 2004 and 2003.
| ** ** | ** ** | **December 31,**   | ** ** |
|------------|------------|-------------------------|------------|
| ** ** | ** ** | **2004**                | ** ** | **2003** | ** ** |
| ** ** | ** ** | **(in thousands)** | ** ** |
| U.S.       |       | $                       | 621        |   | $ | 1,110 |   |
| Non-U.S.   |       | 64                      |       | 686 |   |
| Total      |       | $                       | 685        |   | $ | 1,796 |   |

 

**Note 10—Commitmentsand Contingencies:**

TheCompany leases its facilities under non-cancelable operating leases that expirein 2005 through 2008. Rent expense was approximately $1,157,000, $1,143,000,and $925,000 for the years ended December 31, 2004, 2003 and 2002,respectively. The leases provide for monthly payments and are being charged tooperations ratably over the lease terms. In addition to the minimum leasepayments, the Company is responsible for property taxes, insurance and certainother operating costs. Future minimum lease payments under the non-cancelableoperating leases as of December 31, 2004 are as follows (in thousands):
| **Year Ended December 31,** | ** ** | ** ** | ** ** | **Operating Leases** | ** ** |
|--------------------------------------------|------------|------------|------------|---------------------------|------------|
| 2005                                       |       |       | $          | 908                       |       |   |
| 2006                                       |       |       | 393        |                      |       |
| 2007                                       |       |       | 346        |                      |       |
| 2008                                       |       |       | 117        |                      |       |
| Total minimum payments                     |       |       | $          | 1,764                     |       |   |

 

The Company leases certainequipment under non-cancelable lease agreements that are accounted for ascapital leases. During Q4 2004 the Company paid in full all capital leaseobligations. Equipment under these capital lease arrangements included inproperty and equipment aggregated approximately $176,000 at December 31,2004 and has been fully depreciated. The Company has no non-cancelable purchaseorders outstanding as of December 31, 2004.

***Legal Matters***

On March 31, 2004,UniRAM Technology, Inc. filed a complaint against the Company in theUnited States District Court for the Northern District of California, allegingtrade secret misappropriation and patent infringement. UniRAM’s complaintasserts that it provided trade secret information to Taiwan SemiconductorManufacturing Corporation (TSMC) in 1996-97 and speculated that weimproperly obtained unspecified trade secrets of UniRAM from TSMC in an unknownmanner. Subsequent to March 31, 2004, UniRAM amended its complaint twiceto add TSMC as a defendant and additional allegations to the suit, and to dropall infringement claims for one of the two patents identified in the initialcomplaint. The Company believes that UniRAM’s complaint lacks merit and intendsto vigorously defend against it.

From time to time theCompany may be subject to legal proceedings and claims in the ordinary courseof business. These claims, even if not meritorious, could result in theexpenditure of significant financial resources.

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**Schedule II**—Valuation andQualifying Accounts(In thousands)
| **Description**                              | ** ** | ** ** | ** ** | **Balance at  beginning of  period** | ** ** | **Charged to  expenses** | ** ** | **Credited to  expenses** | ** ** | **Balance at  end of  period** | ** ** |
|----------------------------------------------|------------|------------|------------|------------------------------------------------|------------|-------------------------------|------------|--------------------------------|------------|------------------------------------------|------------|
| Allowance for doubtful  accounts receivable: |       |       |       |                                           |       |                          |       |                           |       |                                     |       |   |   |   |   |   |   |
| Fiscal year ended December 31, 2004     |       |       | $          | —                                         |       |                          |       | $                              | —     |                                     |       |   | $ | — |   |   |   | $ | — |   |   |
| Fiscal year ended December 31, 2003     |       |       | $          | —                                         |       |                          |       | $                              | —     |                                     |       |   | $ | — |   |   |   | $ | — |   |   |
| Fiscal year ended  December 31, 2002    |       |       | $          | 200                                            |       |                          |       | $                              | 75         |                                     |       |   | $ | 275 |   |   |   | $ | — |   |   |

 

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