**UNITED STATESSECURITIES AND EXCHANGE COMMISSION**

**Washington,D.C. 20549**

**FORM 10-K**

x                              ANNUALREPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACTOF 1934

**Forthe Fiscal Year December 31, 2005, or**

**o**                                 TRANSITIONREPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACTOF 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 |   | (IRS Employer           |
| incorporation or  organization)  |   | Identification  Number) |

 

**755 N. Mathilda Avenue, Suite 100Sunnyvale, California 94085**

(Address of principalexecutive offices)

**(408) 731-1800**

(Registrant’s telephone number, 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 $0.01per shareSeries AA Preferred Stock, par value $0.01 per share**

(Title of Class)

Indicate by check mark ifthe registrant is a well-known seasoned issuer, as defined in Rule 405 ofthe Securities Act.   Yes o   No x

Indicate by check mark ifthe registrant is not required to file reports pursuant to Section 13 or Section 15(d) ofthe Act.   Yes o   No x

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 preceding 12months (or for such shorter period that the registrant was required to filesuch reports), and (2) has been subject to such filing requirements forthe past 90 days.   Yes x   No o

Indicate by check mark ifdisclosure of delinquent filers pursuant to Item 405 of Regulation S-K (§229.405 of this chapter) is not contained herein, and will not be contained, tothe best of registrant’s knowledge, in definitive proxy or informationstatements incorporated by reference in Part III of this Form 10-Kor any amendment to this Form 10-K.   o

Indicateby check mark whether the registrant is a large accelerated filer, anaccelerated filer, or a non-accelerated filer. See definition of “acceleratedfiler and large accelerated filer” in Rule 12b-2 of the ExchangeAct. (Check one):

| Large accelerated filer o |   | Accelerated  filer x |   | Non-accelerated  filer o |
|--------------------------------|--------|---------------------------|--------|-------------------------------|

 

Indicate by check markwhether the registrant is a shell company (as defined in Rule 12b-2of the Act).   Yes o   No x

The aggregate market valueof the common stock held by non-affiliates of the Registrant, as of June 30,2005 was approximately $141,050,000 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 ofMarch 1, 2006, 31,102,247 shares of the registrant’s common stock, $0.01per value, were outstanding.

 

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**DOCUMENTS INCORPORATED BY REFERENCE**

Portions of the registrant’s proxy statement to bedelivered to stockholders in connection with the registrant’s 2006 AnnualMeeting of Stockholders to be held on or about May 25, 2006 areincorporated by reference into Part III of this Form 10-K. Theregistrant intends to file its proxy statement within 120 days after its fiscalyear end.

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**TABLE OF CONTENTS**
| **Part I**   |
|-------------------|
| Item 1.           |   | Business |   | 4 |
| Item 1A.          |   | Risk Factors |   | 16 |
| Item 1B.          |   | Unresolved Staff Comments |   | 26 |
| 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 and Issuer Purchases of Equity Securities |   | 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  |   | 41 |
| Item 9A.          |   | Controls and Procedures |   | 42 |
| Item  9B.         |   | Other  Information |   | 42 |
| **Part III** |
| Item 10.          |   | Directors and Executive Officers of the Registrant |   | 43 |
| Item 11.          |   | Executive Compensation |   | 43 |
| Item 12.          |   | Security Ownership of Certain Beneficial Owners and  Management and Related Stockholder Matters    |   | 43 |
| Item 13.          |   | Certain Relationships and Related Transactions |   | 43 |
| Item 14.          |   | Principal Accountant Fees and Services |   | 43 |
| **Part IV**  |
| Item 15.          |   | Exhibits and Financial Statement Schedules |   | 44 |
|              |   | Signatures |   | 46 |

 

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**Part I**

*This Annual Reporton Form 10-K and the documents incorporated herein by referencecontain forward-looking statements within the meaning of Section 27Aof the Securities Act of 1933 and Section 21E of the Securities ExchangeAct of 1934, which include, without limitation, statements about the market forour technology, our strategy, competition, expected financial performance andother aspects of our business identified in this Annual Report, as well asother reports that we file from time to time with the Securities and ExchangeCommission. Any statements about our business, financial results, financialcondition and operations contained in this Annual Report that are notstatements 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., Item 1A, “Risk Factors,” and elsewhere in this report. Weundertake 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.**                        Business

**Company Overview**

We design, develop, market and license 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 asSystem-on-Chip or SoC. We have also sold memory chips based on our 1T-SRAMtechnologies, but in 2004, we ceased shipments of 1T-SRAM memory chips. We donot expect to make and sell memory chips in the future.

We signed our first license agreement related to our1T-SRAM technologies at the end of the fourth quarter of 1998 and recognizedlicensing revenue from our 1T-SRAM technologies for the first time in the firstquarter of 2000. Since then, we have introduced improved and enhanced versionsof our technology.

We generate revenue from the licensing of our memorytechnologies, which consists of licensing revenues, customization services,maintenance and support fees and royalties. Royalty revenues are earned undereach of our license agreements when our licensees manufacture or sell productsthat incorporate any of our 1T-SRAM technologies and report the results to us.Generally, we expect our total sales cycle, or the period from our initialdiscussion with a prospective licensee to our receipt of royalties from thelicensee’s use of our 1T-SRAM technologies, to run from 18 to 24 monthsafter the commencement of the project.

In 2005, we begandelivering our new family of 1T-SRAM CLASSIC Memory Macro products to licensees.These macros are silicon-proven, high-density solutions offering customersrapid memory block integration into their SoC designs. They are pre-configuredand require minimal additional customization. They are targeted for high volumeconsumer products that require larger embedded memory to support deviceenhancements, such as higher resolution cameras and high quality audio andvideo capabilities.

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**Industry Background**

*Trends in theSemiconductor Industry*

Electronic products play an increasingly important rolein our lives, as evidenced by the growth of the personal computer, wirelesscommunications, networking equipment and consumer electronics markets. Thesemarkets are characterized by intensifying competition, rapid innovation,increasing performance requirements and continuing cost pressures. Tomanufacture electronic products that achieve optimal performance and costlevels, semiconductor companies must produce integrated circuits that offerhigher performance, greater functionality and lower cost.

Two important measures of performance are speed andpower consumption. Higher-speed integrated circuits allow electronicproducts to operate faster, enabling the performance of more functions.Reducing the power consumption of integrated circuits contributes to increasedbattery life and reduced heat generation in electronic products. Reduced powerconsumption also enables integrated circuit designers to overcome costly designhurdles, such as meeting the thermal limitations of low-cost packagingmaterials.

In addition to offering high-performance products,semiconductor companies must produce integrated circuits that are costeffective. High-density integrated circuits require less silicon, thus reducingtheir size and cost. Cost reductions also can be achieved by simplifying theintegrated circuit’s manufacturing process and improving the manufacturingyield.

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. Today, the industry is predominantly using 0.25-micron,0.18-micron and 0.15-micron manufacturing process technology.However, current designs are now being implemented in 0.13-micron and in90 nanometers (nm) manufacturing process technologies, with 65nm technologiesanticipated in the near future.

*Importance ofIntegration*

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 SoC. Highly integrated circuits such as SoCs often offeradvantages in density, power consumption, speed and cost that cannot be matchedusing separate, discrete integrated circuits. SoCs are essential for mostelectronic products, such as cellular phones, video game consoles, portablemedia players, communication and networking equipment and internet appliances,to achieve increasing performance requirements at a reasonable cost.

*Importance ofEmbedded Memory*

Historically, semiconductor companies implementedmemory in separate integrated circuits. Rather than using separate memorychips, many semiconductor companies today are embedding memory on highlyintegrated circuits in order to optimize performance and power consumption. Atthe same time, the increasing sophistication of electronic products is drivinga rapid increase in the amount of memory required. Current industry estimatesare that more than half of the chip area of a SoC is comprised of embeddedmemory and this proportion is forecasted to increase in the future with the growthof more memory-intensive applications.

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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 SRAMand Embedded DRAM*

The most commonform of embedded memory today utilizes traditional static random access memory,or SRAM. This technology is in the public domain and can be designed by anysemiconductor company. 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.

As memory requirements increase, however, traditionalSRAM becomes relatively more expensive compared to the total cost of theintegrated circuit. Specifically, traditional SRAM has the following drawbacksthat 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 lower 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 mostapplications. Therefore, traditional SRAM continues to be the most widely usedtechnology 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**

We have developed a seriesof innovative memory technologies, 1T-SRAM technologies, which provide majoradvantages over traditional SRAM in density, power consumption and cost, thusmaking it more economical for designers to incorporate large amounts ofembedded memory in their designs. In 

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addition, our1T-SRAM technologies offer all the benefits of traditional SRAM, such as highspeed, simple interface and ease of manufacturability. Its core circuitry isalready production proven in millions of memory chips and offers integratedcircuit designers 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 75% of  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 and camcorders,to incorporate additional functionality into a single integrated circuit,resulting in overall cost savings. Semiconductor designers can take advantageof the high density of our 1T-SRAM technologies and embed large quantities ofhigh-performance memory and other components that in the past might not havebeen feasible.

*Low PowerConsumption*

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.

*ManufacturingProcess Independence*

We have been able toimplement our technology without requiring the manufacturer to make anysignificant changes to either standard logic or alternative manufacturingprocesses. 1T-SRAM’s portability, or the ease with which it can be implementedin different semiconductor manufacturing facilities, has been provenoperational in the fabrication of chips at the world’s largest independentfoundries, including Taiwan Semiconductor Manufacturing Co., Ltd., or TSMC,United Microelectronics Corporation, or UMC, Chartered SemiconductorManufacturing Ltd., or Chartered, and Semiconductor Manufacturing InternationalCorporation, or SMIC. It has also been proven in the manufacturing processes ofintegrated device manufacturers, or IDM’s, such as Fujitsu and NEC Electronics.1T-SRAM’s scalability, or the ease with which it can be implemented indifferent generations of manufacturing processes, has already been demonstratedin the fabrication of chips in 0.25-micron, 0.18-micron, 0.15-micron,0.13-micron and 90nm process generations, without extensivemodifications. We expect our technology to continue to scale 

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readilyto future process generations. This portability and scalability provides forwide availability, inexpensive implementation and quick product time to marketfor our licensees.

*Simplicity ofInterface*

Our 1T-SRAM technologiesinternal 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 integrated circuitdesigns 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.

The following are integralaspects of our strategy.

*Target Large andGrowing Markets*

We target the large and growing market for SoCapplications requiring large embedded memories, which are in excess of onemegabyte, with our 1T-SRAM technologies that offer chip designers improvedperformance in embedded memories thus optimizing the cost and performance of theSoC.

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 withSemiconductor Companies and Foundries to Deliver Optimal Technology Solutions*

We work closely withsemiconductor companies to gain broad and detailed insight into their and theircustomers’ current and next-generation technology requirements. This insighthelps us identify trends and focus our development efforts on optimizing ourtechnology solution, resulting in shorter product time to market and lowercosts. We plan to continue to qualify and license our technology with theleading IDM’s and foundries in order to provide a wide range of manufacturingchoices for our customers.

*Extend ourTechnology Offerings*

Our goal is tocontinue to enhance our 1T-SRAM technologies and increase our share of theembedded memory market. We will continue to develop our technology in order tooffer 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 improvements to the 1T-SRAM technology:

·       TEC® Error Correction Circuitry, 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 TEC® Error CorrectionCircuitry has now become the standard within 1T-SRAM in most of ourlicensing activities.

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·       Lowerpower version of 1T-SRAM memory macros, well-suited to particular applicationsrequiring very low operating and standby power, such as cell phone handsets,digital cameras, personal digital assistants and other consumer, wirelessdevices. We introduced the 1T-SRAM Low-Power family of products in April 2001.

·       1T-SRAMwith extended density memory (twice the density of the original version of ourtechnology) and up to four times the density of traditional SRAM. Theseproducts embed our advanced, folded capacitor 1T-Q bit cell. We introduced our1T-Q-based products in December 2002.

In addition, we havedeveloped new generations of our 1T-SRAM technologies, most recently in the90nm manufacturing process. We intend to continue to develop our technologiesfor future process generations such as 65nm and 45nm.

**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 technology to semiconductor companieswho incorporate our technology into integrated circuits that they sell to theircustomers. In addition, we engage in joint marketing activities with foundries,intellectual property companies and design companies to promote our technologyto a wide base of customers. These distribution channels have broadened theacceptance and availability of our technology in the industry. As ourtechnology 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 development and licensingrelationships directly with semiconductor companies and original equipmentmanufacturers or OEM. 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. Contract feesinclude licensing fees, development fees for customizations based on theachievement of specified development milestones and royalties. The vastmajority of our contracts allow billing between milestones based on workperformed. Typically under our agreements, the licensee is obligated tocomplete the project within a stated timeframe and to assist us in completingthe final milestone. If we perform the contracted services, usually thelicensee is obligated to pay the license fees even if the licensee fails tocomplete verification or cancels the project prior to completion. Theagreements often also provide for the payment of additional contract fees if weprovide engineering or manufacturing support services related to themanufacture of the product. Provisions in all of our license agreements requirethe payment of royalties to us based on the future sale or manufacture ofproducts utilizing our 1T-SRAM technologies. Generally, our licenses grantrights on a non-exclusive, non-transferable basis, limited to the use of ourtechnology as modified for the project covered by the license agreement. Ourlicense agreements generally have a fixed five-year term and are subject torenewal. Each new project requires a separate agreement or an addendum to modifyan existing agreement.

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We have license agreementswith many companies, including Agere Systems, Inc., Agilent Technologies,Analog Devices, Inc., Broadcom Corporation, eSilicon Corporation, FujitsuLimited, Hitachi, Ltd., Kawasaki Micoroelectronics, Inc., LG Electronics, Inc.,LSI Logic Corporation, Marvell Semiconductor, Inc., MatsushitaCommunication Industrial Co., Ltd., National Semiconductor Corporation, NECElectronics Corporation,  Open-Silicon, Inc.,Philips Semiconductors, Inc., Pixelworks, Inc., Pixim, Inc.,SMIC, Sanyo Electric Co., Ltd., Sony Corporation, TSMC, UMC, and ViaTechnologies, Inc.

*JointMarketing 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.

*CustomMemory 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.

*StandardMacro Designs*

In addition to licensingour customized 1T-SRAM designs, companies also can license standard 1T-SRAMoff-the-shelf memory designs from us, known as CLASSIC Macros. These readilyavailable standard memory designs can assist the licensee in getting its SoCquickly to market.

*TechnologyLicenses*

We also offer our technology to semiconductor companiesthrough 1T-SRAM technology license agreements, under which we grant thelicensee the additional right to create and modify 1T-SRAM designs to offer toits own customers. The contract fees associated with these arrangements requirethe licensee to pay us to port our technology to its manufacturing process anddevelop a template design that the licensee will be able to use to generatefuture designs. These agreements also obligate the licensee to pay contractfees to us upon the achievement of specified development milestones and mayprovide for the payment of additional contract fees if we provide engineeringor manufacturing support services. Under these agreements we will be entitledto receive royalties based on the future sale or manufacture of productsutilizing our 1T-SRAM technologies. The licenses are non-exclusive andnon-transferable and authorize the licensee to modify designs for its customersfrom the template design that we provide under the agreement. Typically, thetemplate design applies only to a specified manufacturing process generation.The licensee may add future process generations to the license agreement foradditional contract fees.

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**Technology**

Our innovative 1T-SRAMtechnologies include many new and proprietary features. 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-TransistorMemory Storage Cell*

The high density of our 1T-SRAM technologies stemsfrom the use of a single-transistor, or 1T, which is similar to DRAM,with a storage cell for each bit of information. Our 1T storage cell using onetransistor and one capacitor represents a very significant improvement indensity over the six-transistor storage cells used by traditional SRAM.

The following diagrams, drawn to scale, but not toactual size, are electrical schematics of the traditional SRAM storage cell andour 1T-SRAM storage cell. The comparison of the two diagrams illustrates thesmall size and reduced complexity of the 1T-SRAM storage cell. This results insignificant cost savings because less silicon space is required by 1T-SRAMstorage cells.

*MultiBankTechnology*

The high speed and low power consumption of 1T-SRAMare enabled by our MultiBank technology, as illustrated above. This technologyefficiently partitions the memory into many, typically hundreds, of fast, smallsub-blocks of memory, or banks, that can operate independently over high-speeddata buses. Only one small bank containing the required memory data must beactive for each access to the memory. Therefore, the remaining banks can stayin a low-power, standby mode, reducing the overall power consumption of thememory.

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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 ManagementCircuitry*

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 any of the traditional requirements of dynamic cell arrays.

*Leakage SuppressionCircuitry*

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.

*TEC*® Error Correction Circuitry

We offer our 1T-SRAMtechnologies with embedded error correction circuitry for higher reliabilityand quality. This circuitry automatically corrects memory errors duringoperation, including soft errors caused by high-energy particles, andeliminates the need for laser repair in manufacturing test. This isaccomplished without adding any additional silicon area or cost. The TEC® ErrorCorrection Circuitry is currently incorporated into all of our designsdeveloped targeting 0.13-micron and more recent technologies.

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*1T-Q*® Folded AreaCapacitor (FAC)

Using an innovativecapacitor technology called Folded Area Capacitor (FAC), we can provide ourlicensees with a very high-density memory solution. Requiring only twoadditional non-critical masks during the manufacturing process, utilizing our1T-Q® Folded Area Capacitor, our 1T-SRAM productscan achieve densities up to four times that of traditional SRAM and twice thedensity of the original version of our technology.

***Advanced Manufacturing 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 made for initially implementing and verifying1T-SRAM technologies on the latest generations of manufacturing processesnodes. The processes with the smaller micron dimensions have higher randomaccess speeds and typically enable larger capacity memories.

| **Processes Generation**      | ** ** | ** **        | ** ** | **0.18-micron** | ** ** | **0.15-micron** | ** ** | **0.13-micron**    | ** ** | **90nm** | ** ** |
|-------------------------------|------------|-------------------|------------|-----------------|------------|-----------------|------------|--------------------|------------|----------|------------|
| Date of 1T-SRAM  Verification |       | January 2000 |       | May 2000   |       | April 2001 |       | December 2005 |       |
| Typical Memory                |       | 1-32              |       | 1-48            |       | 1-64            |       | 1-128              |       |
| Capacity                      |       | megabits          |       | megabits        |       | megabits        |       | megabits           |       |

 

**Research and Development**

Our ability to compete in the future will depend onimproving our technology to meet the market’s increasing demand for higherperformance and lower cost requirements. We have assembled a team of highlyskilled engineers whose activities are focused on developing even higher-density,lower-power consumption, higher-speed and lower-cost 1T-SRAMdesigns. We expect to continue to focus our research and development efforts onextending our 1T-SRAM technologies and developing new memory technologies. Wealso intend to continue our focus on porting our technology to additionalsemiconductor manufacturing facilities and scaling our technology to newgenerations of manufacturing process technologies.

As of December 31,2005, we employed 51 engineers, representing 67% 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 of ATMOS. We have a design center in Seoul, South Korea where 10 ofour engineers reside. For the years ended December 31, 2005, 2004, and2003, research and development expenditures totaled approximately $5.8 million,$8.1 million, and $8.7 million, respectively.

**Sales and Marketing**

As of December 31,2005, we had a staff of 14 sales and marketing executives managing ourtechnology licensing activities. We have 11 sales and marketing personnel inthe United States who are responsible for licensing activities in North Americaand Asia. Two are located in Sophia-Antipolis, France and are responsible forlicensing activities in Europe and the Middle East. One sales and marketingmanager is located in Yokohama, Japan and is responsible for licensingactivities in Japan. This group manages the negotiation of license agreements,provides technical support during the sales cycle to licensees and administersthe contracts. As we have multiple sales channels through our relationshipswith semiconductor companies, foundries, intellectual property companies anddesign companies, we do not believe that we require a large internal salesforce. Our marketing and promotional activities include participation inindustry trade shows, distribution of collateral marketing material,publication of articles in 

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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.

**Intellectual Property**

We regard our patents, copyrights, trademarks, tradesecrets and similar intellectual property as critical to our success, and relyon a combination of patent, trademark, copyright, and trade secret laws toprotect our proprietary rights. As of December 31, 2005, we held 80 U.S.patents on various aspects of our technology, with expiration dates rangingfrom 2011 to 2023. These 80 patents include claims relating to multibankpartitioning, 1T-SRAM internal operation and circuit techniques, high-speedoperation techniques, 1T-SRAM refresh management techniques and the interfaceof embedded 1T-SRAM storage cells in logic processes. We currently have ninepending U.S. patent applications, and have received notices of allowance withrespect to one of these applications. We also hold 40 foreign patents withexpiration dates ranging from 2012 to 2022, and we have 19 pending foreignpatent applications. There can be no assurance that others will notindependently develop similar or competing technology or design around anypatents that may be issued to us, or that we will be able to enforce ourpatents 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 have infringed patents or other intellectual property rightsowned by others. Our successful protection of our patents and otherintellectual property rights are subject to a number of factors, particularlythose described in Part I, Item 1A. “Risk Factors.”

**Competition**

In order to remaincompetitive, we believe we must continue to provide higher-density, lower-power-consumption,higher-speed and lower-cost technology solutions to the semiconductorindustry and electronic product manufacturers. We believe that the principalcompetitive factors in our industry 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 our 1T-SRAM technologies offer a highdegree of overall performance improvement over traditional SRAM. Semiconductor companies may satisfytheir embedded memory needs through traditional SRAM and embedded DRAM.Traditional SRAM relies on publicly available process technology and circuitdesigns, which semiconductor companies can build internally or acquire througha license from a third party provider, without paying a royalty to us. This iscurrently the preferred choice for embedded memory solutions in SoCs. Companiesproviding traditional SRAM embedded memories include Artisan Components andVirage Logic. Embedded DRAM is primarily offered by current or former DRAMsuppliers, who utilize their own manufacturing process to compete in thesemiconductor foundry business. Suppliers of embedded DRAM include substantialcompetitors such as Toshiba Ltd. and IBM, among others. Although each of thesetwo embedded DRAM suppliers has experienced some 

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success in obtaining newcustomers for its technology, we believe that many semiconductor companiesusing embedded memory may prefer to license our technology instead ofimplementing either of these alternatives because of 1T-SRAM’s overalladvantages.

Not all embedded memory applications benefitsufficiently from technological advantages offered by our 1T-SRAM technologiesto justify the increased cost to the licensee, however. Our licensees andprospective licensees can meet their current needs for embedded memory usingother memory solutions with different cost and performance parameters. Forexample, our technologies are not suitable for replacing lower-cost traditionalDRAM memory chips if higher access speed is unnecessary. In addition,alternative solutions may be more cost-effective for memory block sizes of lessthan 1 megabit, or applications in which the embedded memory portion is lessthan 20% of the total chip area.

Moreover, some companies assess greater uncertaintyand risk in relying on our newly established 1T-SRAM technologies. As aresult, our ability to compete effectively may be limited because suchcompanies may prefer to use more established traditional memory solutions thatare 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 31,2005, we had 76 full-time employees, consisting of 51 in research anddevelopment and engineering, 14 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.

**Available Information**

Our Web site address iswww.mosys.com. The information in our Web site is not incorporated by referenceinto this report. Through a link on the Investor section of our Web site, wemake available our annual report on Form 10-K, quarterly reports on Form 10-Q,current reports on Form 8-K, and any amendments to those reportsfiled or furnished pursuant to Section 13(a) or 15(d) of theSecurities Exchange Act of 1934 as soon as reasonably practicable after theyare filed with, or furnished to, the Securities and Exchange Commission.

**Executive Officers**

Thenames of the Company’s executive officers as of December 31, 2005 andcertain information about them are set forth below:

| **Name**             | ** ** | ** ** | ** ** | **Age**                                                         | ** ** | **Position(s) with the Company** |
|----------------------|------------|------------|------------|-----------------------------------------------------------------|------------|---------------------------------------|
| Chester J. Silvestri |       | 57         |       | Chief Executive Officer  and Director                           |
| Wingyu Leung         |       | 51         |       | Executive Vice  President, Chief Technical Officer and Director |
| Dhaval Ajmera        |       | 48         |       | Vice President of  Worldwide Sales and Business Development     |

 

*ChesterJ. Silvestri,*   Mr. Silvestri was appointedour Chief Executive Officer and a member of our board of directors on July 26,2005. Mr. Silvestri held the positionof Chief Executive Officer, President and a member of Board of Directorsat Ceva, Inc., a leading provider of licensable digital signal processor 

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(DSP) cores andplatform-level IP, from June 2003 to May 2005 and also served asChairman of Ceva’s Board of Directors from February 2004 to May 2005.From January to May 2003, Mr. Silvestri was a private investorand previously, from 1999 to 2002, Mr. Silvestri held the position ofChief Executive Officer of Arcot Systems, a developer of credit cardauthentication software. Mr. Silvestri also has served as Chief OperatingOfficer of Tripath Technology, Inc., President of the MicroelectronicDivision of SUN Microsystems, Inc., and Vice President and General Managerof the Technology Licensing division of MIPS Computer Systems, Inc. Since June 2003,Mr. Silvestri has served as a member of the board of directors of MagmaDesign Automation, Inc. Mr. Silvestri earned his bachelor of scienceand master of science degrees in electrical engineering from Michigan StateUniversity and his MBA from the Harvard Graduate School of Business.

*WingyuLeung,**  *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 IntegratedDevice Technology, Inc., where he managed and participated in circuitdesign activities. Dr. Leung holds a B.S. in electrical engineering fromthe University of Maryland, a M.S. in electrical engineering from theUniversity of Illinois, and a Ph.D. in electrical engineering and computerscience from the University of California at Berkeley.

*Dhaval Ajmera,*   Mr. Ajmerabecame our Vice President of Worldwide Sales and Business Development on October 3,2005. Prior to joining the MoSys, Mr. Ajmera held a position of the VicePresident of North American Sales at Ceva, Inc., a leading provider oflicensable digital signal processor (DSP) cores and platform-level IP, from March 2004to July 2005.  Prior to that, he wasVice President of World Wide Marketing and Sales for Emuzed, Inc., aleader in multimedia solutions from June 2002 through November 2003,and was instrumental in launching the World’s first Media Center PC along withMicrosoft and very large PC OEMS Worldwide including HP, Dell, Samsung andothers. Mr. Ajmera has a MSEE from University of Florida and BSEE fromUniversity of Bombay.

***Item 1A.****                  RiskFactors*

*If any ofthe following risks actually occur, our business, results of operations andfinancial condition could suffer significantly.*

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

The future prospects of our business depend on theacceptance by our target markets of our 1T-SRAM technologies for embeddedmemory applications and any future technology we might develop. Our technologyis intended to allow our licensees to develop embedded memory integratedcircuits to replace other embedded memory technology with different cost andperformance parameters. Our 1T-SRAM technologies utilize fundamentallydifferent internal circuitry that is not widely known in the semiconductorindustry. Therefore, one of our principal challenges, which we might fail tomeet, is to convince a substantial percentage of SoC designers to adopt ourtechnology instead of other memory solutions, which may have proven effectivein their products.

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·       Animportant part of our strategy to gain market acceptance is to penetrate newmarkets by targeting market leaders as licensees of our technology. Thisstrategy is designed to encourage other participants in those markets to followthese leaders in adopting our technology. If a high-profile industryparticipant adopts our technology for one or more of its products but fails toachieve success with those products, or is unable to successfully implement ourtechnology, other industry participants’ perception of our technology could beharmed. Any such event could reduce the number of future licenses of ourtechnology. Likewise, if a market leader were to adopt and achieve success witha competing technology, our reputation and licensing program could be harmed.

Our embedded memory technology might not integrate aswell as anticipated with other semiconductor functions in all intendedapplications, which would slow or prevent adoption of our technology and reduceour revenue. Detailed aspects of our technology could cause unforeseen problemsin the efficient integration of our technology with other functions ofparticular integrated circuits. Any significant compatibility problems with ourtechnology could reduce the attractiveness of our solution, impede its acceptancein the industry and result in a decrease in demand for our technology.

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

We anticipate difficulty in accurately predicting thetiming and amounts of revenue generated from licensing our 1T-SRAMtechnologies. The establishment of a business relationship with a potentiallicensee is a lengthy process, generally taking from three to nine months, andsometimes longer during slower periods in our industry. Following theestablishment of the relationship, the negotiation of licensing terms can betime-consuming, and a potential licensee may require an extended evaluation andtesting period.

Once a license agreement has been executed, the timingand amount of licensing and royalty revenue from our licensing business remaindifficult to predict. The completion of the licensee’s development projects andthe commencement of production are subject to the licensee’s efforts,development risks and other factors outside our control. Our royalty revenuewill depend on such factors as success of the licensee’s project, thelicensee’s production and shipment volumes, the timing of product shipments andwhen the licensee reports to us the manufacture or sale of products thatinclude our 1T-SRAM technologies. All of these factors will prevent us frommaking predictions of revenue with any certainty and could cause us toexperience substantial period-to-period fluctuations in operating results.

None of our licensees are under any obligation toincorporate our technology in any present or future product or to pursue themanufacture or sale of any product incorporating our technology. A licensee’sdecision to complete a project or manufacture a product is subject to changingeconomic, marketing or strategic factors. The long development cycle of alicensee’s products increases the risk that these factors will cause thelicensee to change its plans. In the past, some of our licensees havediscontinued development of products incorporating our technology. Although inmost cases their decisions were based on factors unrelated to our technology,it is unlikely that we will receive royalties in connection with thoseproducts. We expect that occasionally our licensees will discontinue a productline or cancel a product introduction, which could adversely affect our futureoperating results and business.

**Ifthe market for SoC integrated circuits does not expand, our business will suffer.**

Our ability to achieve sustained revenue growth andprofitability in the future will depend on the continued development of themarket for SoC integrated circuits, particularly those requiring embeddedmemory 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 combiningmultiple integrated circuits to create a System-on-a-Package.

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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 will suffer.

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

The semiconductor industryis cyclical and has experienced pronounced downturns for sustained periods ofup to several years. To respond to any downturn, many semiconductormanufacturers and their customers will slow their research and developmentactivities, cancel or delay new product developments, reduce their workforcesand inventories and take a cautious approach to acquiring new equipment andtechnologies. As a result, our business has been in the past and could beadversely affected in the future by an industry downturn, which couldnegatively impact our future revenue and profitability. Also, the cyclicalnature of the semiconductor industry may cause our operating results tofluctuate significantly from year-to-year, which may tend to increase thevolatility 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 andadversely impact operating results.**

Many of our licenses require us to deliver acustomized 1T-SRAM memory block or several blocks, within an agreed technicalspecification by a certain delivery timetable. This requires us to furnish aunique 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 customer’s chip. Such delaysmay affect the timing of recognition of revenues from a particular project andcan adversely affect our operating results.

In addition, any failureto meet our customers’ timetables, as well as the agreed upon technicalspecifications of our customized memory technology could lead to the failure tocollect, or a delay in collecting royalties and licensing fee payments from ourlicensees, damage our reputation in the industry, harm our ability to attractnew licensees and negatively impact our operating results. Furthermore, acustomer may assert that we are responsible for delays and cost overruns anddemand reimbursement for some of its costs, which we may elect to reimburse inwhole or in part in order to address the customer’s concerns. For example, in2004, we reduced revenue by $450,000 for a reimbursement given to a customerfor excess verification costs incurred by the customer. In 2005, we alsosettled with one of our licensees for the amount of $375,000 related to a claimmade for excess verification costs incurred by the licensee.

**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 

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manufacturedor sold by our licensee by at least one quarter. We cannot be certain that ourbusiness strategy will be successful in expanding the number of licensees, norcan we be certain that we will receive significant royalty revenue in thefuture.

**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 has been highly concentrated, witha few customers accounting for a significant percentage of our total revenue.For the year ended December 31, 2005, our two largest customers, NEC andFujitsu represented 35% and 17% of total revenue, respectively. For the yearended December 31, 2004, our three largest customers NEC, Fujitsu andMarvell represented 19%, 17% and 11% of total revenue, respectively. For theyear ended December 31, 2003, our three largest customers, Sony, NEC andUMC represented 17%, 14% and 11% of total revenue, respectively. We expect thata relatively small number of licensees will continue to account for asubstantial portion of our revenue for the foreseeable future.

Furthermore, our royalty revenue has been highlyconcentrated among a few licensees, and we expect this trend to continue forthe foreseeable future. In particular, a substantial portion of our licensingand royalty revenue in 2005 and 2004 has come from the licenses for integratedcircuits used by Nintendo in its GAMECUBE®. Royalties earned from theproduction of Gamecube chips incorporating our 1T-SRAM technology represented14%, 15%, and 11% of total revenue in the 2005, 2004 and 2003, respectively.Nintendo faces intense competitive pressure in the video game market, which ischaracterized by extreme volatility, costly new product introductions andrapidly shifting consumer preferences, and we cannot assure you that Nintendo’ssales of products incorporating our technology will increase beyond prior orcurrent levels.

As a result of thisrevenue concentration, our results of operations could be impaired by the decisionof a single key licensee or customer to cease using our technology or productsor by a decline in the number of products that incorporate our technology thatare sold by a single licensee or customer or by a small group of licensees orcustomers.

**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, 2005, three customersrepresented 82% 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 of our licensing and royaltyrevenues are dependent on our licensees and the business environment in whichthey operate. Licensing and royalty revenue are the largest source of ourrevenues; anything that negatively affects a significant licensee or group oflicensees could negatively affect our results of operations and financialcondition. Many issues beyond our control influence the success of ourlicensees, including, for example, the highly competitive environment in whichthey operate, the strength of the markets for their products, their engineeringcapabilities and their financial and other resources.

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 

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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 marketing strategy relies upon ourrelationships and agreements with semiconductor foundries, such as TSMC, UMC,Chartered, and SMIC among others. These foundries have existing relationships,and continually seek new relationships, with companies in the markets wetarget, and have agreed to utilize these relationships to introduce ourtechnology to potential licensees. If we fail to maintain and expand our currentrelationships with these foundries, we might fail to achieve anticipated growth.Our relationship with these foundries is not exclusive, and they are free topromote or develop other embedded memory technologies, including their own. Thefoundries’ promotions of alternative technologies reduce the size of ourpotential market and may adversely 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 intellectual property to fabless semiconductor companiesthat use these foundries to manufacture their silicon chips, which is asignificant source of our revenues.

**Ourembedded memory technology is unique and the occurrence of manufacturingdifficulties or low production yields, if not corrected, could hinder marketacceptance of our technology and reduce future revenue.**

Complex technologies like ours could be adverselyaffected by difficulties in adapting our 1T-SRAM technologies to our licensees’product designs or to the manufacturing process technology of a particularfoundry or semiconductor manufacturer. Some of our customers have experiencedlower than expected yields when initially integrating our design into their SoC.We work closely with our customers to resolve any design or process issues inorder to achieve the optimum production yield.

Any decrease in manufacturingyields of integrated circuits utilizing our technology could impede theacceptance of our technology in the industry. The discovery of defects orproblems regarding the reliability, quality or compatibility of our technologycould require significant expenditures and resources to fix, significantlydelay or hinder market acceptance of our technology, reduce anticipatedrevenues and damage our reputation.

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

There exists significant competition in the market forembedded memory technologies. Our licensees and prospective licensees can meettheir need for embedded memory by using traditional memory solutions withdifferent cost and performance parameters, which they may internally develop oracquire from third-party vendors. In the past two years, the demand forapplications for which our 1T-SRAM technologies provide distinct advantages hasnot experienced significant growth. If alternative technologies are developedthat provide comparable system performance at lower cost than our 1T-SRAMtechnologies for certain applications and/or do not require the payment ofcomparable royalties, or if the industry 

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generally demonstrates apreference for applications for which our 1T-SRAM technologies do not offersignificant advantages, our ability to realize revenue from our 1T-SRAMtechnologies 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 atimely basis could diminish our ability to attract and retain licensees andproduct customers.**

The existing and potential markets for memory productsand technology are characterized by ever increasing performance requirements,evolving industry standards, rapid technological change and productobsolescence. These characteristics lead to frequent new product and technologyintroductions and enhancements, shorter product life cycles and changes inconsumer demands. In order to attain and maintain a significant position in themarket, we will need to continue to enhance our technology in anticipation ofthese market trends.

In addition, the semiconductor industry might adopt ordevelop a completely different approach to utilizing memory for many applications,which could render our existing technology unmarketable or obsolete. We mightnot be able to successfully develop new technology, or adapt our existingtechnology, to comply with these innovative standards.

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

·       identify target markets andrelevant emerging technological trends, including new standards and protocols;

·       develop and maintaincompetitive technology by improving performance and adding innovative featuresthat differentiate our technology from alternative technologies;

·       enable the incorporation ofenhanced technology in our licensees’ and customers’ products on a timely basisand 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 additional 

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allegations to the suit,and to drop all infringement claims of patent infringement with respect to oneof the two patents originally identified in the initial complaint. UniRAMcontinues to assert its claims of patent infringement with respect to the otherpatent. We believe that UniRAM’s complaint lacks merit and intend to vigorouslydefend against it.

We expect to incursubstantial expenses litigating the matter in 2006, at least, and potentially thereafter.In addition, although we expect to prevail in the lawsuit, if we do not, we maybe required to pay substantial damages and/or the attorneys’ fees and expensesof the other party, as well as our own and perhaps the court would enter aninjunction. The payment of such damages and expenses could adversely affect ourresults of operations and cause net losses for the periods in which we recordthem.

**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. In the event we identify 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 31,2005, we held 80 patents in the United States, which expire at various timesfrom 2011 to 2023, and 40 corresponding foreign patents. In addition, as of December 31,2005, we had nine patent applications pending in the United States and 19pending foreign applications, and had received notice of allowance of onepatent application 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 certaintechnology and expend resources to develop non-infringing technology or obtainlicenses for the infringing technology. We cannot assure you that we would besuccessful in such development or that such licenses would be available onreasonable terms, 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,could cause 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 76 employees in December 2005. The efficient management of our plannedexpansion of the development, licensing and marketing of our technology,including through the acquisition of other companies will require us tocontinue to—

·       implement and manage newmarketing channels to penetrate different and broader markets for our 1T-SRAMtechnologies;

·       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;

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

 

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·       hire additional keymanagement 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. Afailure to do so could jeopardize our future revenues and cause our stock priceto fall.

**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 tomany difficulties posed by doing business internationally, including—

·       foreign currency exchangefluctuations;

·       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 that licenses to companies thatoperate primarily outside the United States will account for a substantialportion of our licensing revenue in future periods, the occurrence of any ofthese circumstances could significantly increase our costs of operation, delaythe timing of our revenue and harm our profitability.

**Provisions of our certificate of incorporation andbylaws or Delaware law might delay or prevent a change of control transactionand depress the market price of our stock.**

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 limitation, discouraging a proxy contest or making more difficult theacquisition of a substantial block of our common stock.

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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 acquirer.**

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 ofcorporation by Synopsys, Inc, and a second time to permit the acquisition ofshares representing more than 15% of our common stock by a brokerage firm thatmanages independent customer accounts and generally does not have anydiscretionary voting power with respect to such shares. Notwithstandingamendments of this nature, our intention is to maintain and enforce the termsof this plan, which could delay, deter or prevent an investor from acquiring usin a transaction that could otherwise result in stockholders receiving apremium over the market price 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 11% 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 of ownershipcould have the effect of delaying, deferring or preventing a change in control,or impeding an acquisition, consolidation, takeover or other businesscombination, which might otherwise result in stockholders receiving a premiumover the market price for their shares of 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, weannounced that our board of directors had authorized the repurchase of up to$25 million of our common stock from time to time over the succeeding 12months, and as result, we repurchased approximately $4.7 million or 1.2 millionshares of our common stock. On April 29, 2005, we announced a repurchaseprogram for up to $20 million of outstanding common stock over the next 12months. Any such repurchases could impact the price of our common stock andincrease volatility.

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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**Theprice of our stock could decrease as a result of shares being sold in themarket by directors, officers and other significant stockholders.**

Sales of a substantial number of shares of commonstock in the public market could adversely affect the market price of thecommon stock prevailing from time to time. The number of shares of our commonstock available for sale in the public market is limited by restrictions underthe Securities Act of 1933, as amended, or the Securities Act, but taking intoaccount sales of stock made in accordance with the provisions of Rules 144(k),144 and 701, substantially all the shares of common stock currently outstandingare eligible for sale in the public market.

Our Executive Vice President, ChiefTechnical Officer, and Director, Wingyu Leung has entered into a new plan underRule 10b5-1 of the Securities Exchange Act of 1934. It provides foraggregate sales of 500,000 shares in blocks of 25,000 shares each on the 3rd day and the 18th day of eachmonth. Sales are executed using a market not held order entered prior to marketopen on the 3rd day and the 18th day of each month. Trading shall commence on March 3,2006. The duration of this plan is from February 20, 2006 to December 29,2006. Sales of the shares are further subject to the volume restrictions setforth in SEC Rule 144(e). The plan provides for termination upon thecompletion of the specified trading program, the instruction of thestockholder, or the occurrence of other specified events, whichever isearliest. All of the shares are sold through broker-dealers in ordinary markettransactions. Pre-designated trading under this plan may cause unexpecteddeclines in the market price of our common stock. In addition, subject tocompliance with applicable securities laws and our insider trading policies,each of our directors and executive officers may sell shares of common stockfrom time to time.

***Item 1B.****                  UnresolvedStaff Comments*

None.

***Item 2.****                          Properties*

On May 6, 2005, wesigned a new lease agreement for our facility to accommodate our principaladministrative, sales, marketing, support and research and developmentfunctions. Under the new lease agreement, we occupy approximately 26,000 squarefeet of space in Sunnyvale, California. This lease expires at the end of June 2010.The lease for our previous facility expired at the end of June 2005. Wehave leased approximately 19,000 square feet of space in Ontario, Canada forour research and development facility. The lease expires at the end of April 2008.In connection with the closure of ATMOS’ operation, in July 2005, wesigned an agreement to sublease the ATMOS facility, which we occupy underlong-term leases in Canada. The sublease expires at the end of April 2008.We have leased approximately 3,700 square feet of space in Seoul, South Koreafor our engineering design center. This lease expires at the end of April 2008.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 2006, respectively. We believe that our existing facilities areadequate to meet our current needs.

***Item 3.****                          LegalProceedings*

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 

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complaint. UniRAMcontinues to maintain its claims of patent infringement with respect to theother patent being asserted against us. In October 2005, the court held a “Markmanhearing” to construe and interpret the claims of the patent that UniRAMcontinues to assert against us and TSMC. As yet, the court has not issued itsclaim construction ruling. We believe that UniRAM’s complaint lacks merit andintend to vigorously defend against it.

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

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

No matter wassubmitted to a vote of stockholders during the fourth quarter of the fiscalyear covered by this report. The 2006 Annual Meeting of Stockholders will beheld at 9:30 a.m., local time, on or about May 25, 2006, at ourprincipal executive office located at 755 North Mathilda Avenue, Sunnyvale,California 94085.

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**Part II**

***Item 5.****                          Marketfor Registrant’s Common Equity and Related Stockholder Matters and IssuerPurchases of Equity Securities*

Ourcommon stock is quoted on the NASDAQ National Market under the symbol MOSY. Thefollowing table sets forth the range of high and low sales prices of our commonstock for each period indicated.

| **Quarter ended**        | ** ** | ** ** | ** ** | **High** | ** ** | **Low** | ** ** |
|--------------------------|------------|------------|------------|----------|------------|---------|------------|
| December 31,  2005  |       | $          | 6.22       |     | $          | 4.99    |       |
| September 30,  2005 |       | $          | 5.66       |     | $          | 4.60    |       |
| June 30,  2005      |       | $          | 6.18       |     | $          | 4.83    |       |
| March 31,  2005     |       | $          | 6.42       |     | $          | 5.44    |       |
| 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    |       |

 

*Dividend Policy*

We have not declared orpaid any cash dividends on our common stock and presently intend to retainfuture earnings, if any, to fund the development and growth of our businessand, therefore, do not anticipate paying any cash dividends in the foreseeablefuture.

*Purchases of EquitySecurities by the Issuer and Affiliated Purchasers*

On April 29, 2005, weannounced a repurchase program for up to $20 million of outstanding commonstock over the next 12 months. No repurchases were made pursuant to thisprogram in 2005.

*Use of Proceedsfrom Registered Securities*

The Securities and ExchangeCommission declared the Company’s first registration statement, filed on Form S-1under the Securities Act of 1933 (File No. 333-43122) relating tothe Company’s initial 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.

*Securities Authorized for Issuanceunder Equity Compensation Plan*

See Item 12.—SecurityOwnership of Certain Beneficial Owners and Management and Related StockholderMatters.

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***Item 6.****                          SelectedFinancial Data*

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,**                         | ** ** |
|---------------------------------------------------------------|------------|--------------------------------------------------------------------|------------|
| ** **                                                    | ** ** | **2005 ***                                                    | ** ** | **2004 *** | ** ** | **2003 *** | ** ** | **2002** | ** ** | **2001** | ** ** |
| ** **                                                    | ** ** | **(In thousands, except per share data)** | ** ** |
| Net revenue:                                                  |       |                                                               |       |   |   |   |   |   |   |   |   |
| Product                                                       |       | $                                                                  | 10         |   | $ | 952 |   | $ | 1,904 |   | $ | 2,924 |   | $ | 12,991 |   |
| Licensing                                                     |       | 7,725                                                              |       | 4,544 |   | 10,418 |   | 10,523 |   | 6,053 |   |
| Royalty                                                       |       | 4,547                                                              |       | 5,325 |   | 6,911 |   | 14,344 |   | 3,446 |   |
| Total net revenue                                             |       | 12,282                                                             |       | 10,821 |   | 19,233 |   | 27,791 |   | 22,490 |   |
| Cost of net  revenue                                          |       |                                                               |       |   |   |   |   |   |   |   |   |
| Product                                                       |       | —                                                             |       | 655 |   | 1,217 |   | 1,668 |   | 5,776 |   |
| Licensing                                                     |       | 1,986                                                              |       | 1,613 |   | 1,970 |   | 1,730 |   | 633 |   |
| Total cost of net  revenue                                    |       | 1,986                                                              |       | 2,268 |   | 3,187 |   | 3,398 |   | 6,409 |   |
| Gross profit                                                  |       | 10,296                                                             |       | 8,553 |   | 16,046 |   | 24,393 |   | 16,081 |   |
| Operating expenses:                                           |       |                                                               |       |   |   |   |   |   |   |   |   |
| Research and development                                      |       | 5,839                                                              |       | 8,096 |   | 8,741 |   | 6,926 |   | 5,201 |   |
| Selling, general and administrative                           |       | 9,922                                                              |       | 13,331 |   | 6,432 |   | 5,266 |   | 5,340 |   |
| Restructuring expenses                                        |       | 119                                                                |       | 585 |   | — |   | — |   | — |   |
| Total operating  expenses                                     |       | 15,880                                                             |       | 22,012 |   | 15,173 |   | 12,192 |   | 10,541 |   |
| Operating income  (loss)                                      |       | (5,584                                                             | )          | (13,459 | ) | 873 |   | 12,201 |   | 5,540 |   |
| Interest and other  income                                    |       | 2,591                                                              |       | 11,578 |   | 1,914 |   | 1,539 |   | 1,818 |   |
| Income (loss)  before income taxes                            |       | (2,993                                                             | )          | (1,881 | ) | 2,787 |   | 13,740 |   | 7,358 |   |
| Income tax benefit  (provision)                               |       | 11                                                                 |       | (26 | ) | (279 | ) | (1,373 | ) | (367 | ) |
| Net income (loss)                                             |       | $                                                                  | (2,982     | ) | $ | (1,907 | ) | $ | 2,508 |   | $ | 12,367 |   | $ | 6,991 |   |
| Net income (loss) per share:                                  |       |                                                               |       |   |   |   |   |   |   |   |   |
| Basic                                                         |       | $                                                                  | (0.10      | ) | $ | (0.06 | ) | $ | 0.08 |   | $ | 0.41 |   | $ | 0.35 |   |
| Diluted                                                       |       | $                                                                  | (0.10      | ) | $ | (0.06 | ) | $ | 0.08 |   | $ | 0.40 |   | $ | 0.25 |   |
| Shares used in  computing net income (loss) per share:        |       |                                                               |       |   |   |   |   |   |   |   |   |
| Basic                                                         |       | 30,534                                                             |       | 30,750 |   | 30,504 |   | 29,902 |   | 19,709 |   |
| Diluted                                                       |       | 30,534                                                             |       | 30,750 |   | 30,998 |   | 31,275 |   | 28,390 |   |
| Allocation of  stock-based compensation to operating expenses |       |                                                               |       |   |   |   |   |   |   |   |   |
| Research and development                                      |       | $                                                                  | —     |   | $ | 44 |   | $ | 148 |   | $ | 340 |   | $ | 781 |   |
| Selling, general and administrative                           |       | 36                                                                 |       | 24 |   | 311 |   | 316 |   | 654 |   |
|                                                          |       | $                                                                  | 36         |   | $ | 68 |   | $ | 459 |   | $ | 656 |   | $ | 1,435 |   |

 

| ** **                                                                     | ** ** | **Year Ended December 31,** | ** ** |
|--------------------------------------------------------------------------------|------------|--------------------------------------------|------------|
| ** **                                                                     | ** ** | **2005 ***                            | ** ** | **2004 *** | ** ** | **2003** | ** ** | **2002** | ** ** | **2001** | ** ** |
| ** **                                                                     | ** ** | **(In thousands)**                    | ** ** |
| **Balance  Sheet Data:**                                                       |       |                                       |       |   |   |   |   |   |   |   |   |
| Cash, cash  equivalents and short-term investments and auction rate securities |       | $                                          | 68,650     |   | $ | 62,349 |   | $ | 41,365 |   | $ | 68,433 |   | $ | 84,293 |   |
| Working capital                                                                |       | 68,179                                     |       | 62,535 |   | 44,426 |   | 71,213 |   | 82,343 |   |
| Total assets                                                                   |       | 103,637                                    |       | 104,582 |   | 106,892 |   | 103,090 |   | 89,596 |   |
| Deferred revenue                                                               |       | 1,309                                      |       | 501 |   | 506 |   | 1,779 |   | 3,418 |   |
| Long-term  obligations                                                         |       | 196                                        |       | 239 |   | 13 |   | 25 |   | — |   |
| Stockholders’ equity                                                      |       | 99,332                                     |       | 100,408 |   | 103,511 |   | 98,697 |   | 84,104 |   |
|                                                                                |            |                                            |            |  |  |  |  |  |  |  |  |  |  |  |  |  |

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*                    Derivedfrom the financial statements that are included in Item 8.

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***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, market and license 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, but in 2004, weceased actively selling them. We do not expect to make and sell memory chips inthe future.

Using elements of our existing memory technology as afoundation, however, we completed development of our first memory chipsincorporating our 1T-SRAM technologies in the fourth quarter of 1998. We signedour first license agreement related to our 1T-SRAM technologies at the end ofthe fourth quarter of 1998 and recognized licensing revenue from our 1T-SRAMtechnologies for the first time in the first quarter of 2000. Since then, wehave introduced improved and enhanced versions of our technology, such as1T-SRAM-R, 1T-SRAM-M, and 1T-SRAM-Q.

We generate revenue from the licensing of our memorytechnologies, which consists of licensing revenues, customization services,maintenance and support fees and royalties. Royalty revenues are earned undereach of our license agreements when our licensees manufacture or sell productsthat incorporate any of our 1T-SRAM technologies and report the results to us. Generally,we expect our total sales cycle, or the period from our initial discussion witha prospective licensee to our receipt of royalties from the licensee’s use ofour 1T-SRAM technologies, to run from 18 to 24 months after thecommencement of the project.

During 2002, we purchased ATMOS Corporation, asemiconductor memory company focused on creating high-density,compiler-generated embedded memory solutions for SoC applications. Effective November 10,2004, we closed the ATMOS research and development facility in Canada andterminated the employment of approximately 20 employees working there. Werecorded restructuring charges related to the closure of approximately $119,000in 2005 and $585,000 in the fourth quarter of 2004. The charges incurred in2005 were related to our revised estimate due to the new sublease agreementsigned in the second quarter of 2005.

In 2005, we began delivering our new family of 1T-SRAMCLASSIC Memory Macro products to licensees. These macros are silicon-proven,high-density solutions offering customers rapid memory block integration intotheir SoC designs. They are pre-configured and require minimal additionalcustomization and we believe they will enable us to increase our penetration ofthe market for very dense, low power, high speed embedded memory applications.

 

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***Sources of Revenue***

We generate two types of revenue: licensing androyalties. In the past, we also sold our proprietary memory chips, and prior to2001, we derived almost all our revenue from them. From 2001 through 2004,product revenue as a percentage of our total revenue declined significantly,while licensing and royalty revenues grew substantially as a percentage oftotal revenue. In the third quarter of 2001, for the first time, combinedlicense and royalty revenue exceeded product revenue. By the end of thirdquarter of 2004, we had exited the product business except for minor sales ofproducts required by our historical customers from time-to-time.

*Licensing.*   Our license agreements involve long sales cycles,which makes it difficult to predict when the agreements will be signed. Inaddition, our licensing revenues fluctuate from period-to-period, and it isdifficult for 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.Our future revenue results are subject to a number of factors, particularlythose described in Part I, Item 1A. “Risk Factors.”

Our licensing revenue consists of fees for providingcircuit design, layout and design verification and granting a license to acustomer for embedding our memory technology into its product. For somecustomers, we also provide engineering support services to assist in theinitial production of products utilizing the licensed 1T-SRAM technologies.License fees generally range from $80,000 to several million dollars percontract, depending on the scope and complexity of the development project, andthe licensee’s rights. The licensee generally pays the license fees ininstallments at the beginning of the license term and upon the attainment ofspecified milestones. The vast majority of our contracts allow billing betweenmilestones based on work performed. All license agreements entered into to daterequire us to meet performance specifications. Fees collected prior to revenuerecognition are recorded as deferred contract revenue. However, if theagreement involves performance specifications that we have significantexperience in meeting and the cost of contract completion can be reasonablyestimated, we recognize revenue over the period in which the contract servicesare performed under the percentage of completion accounting method. Revenue isrecognized when collectibility is probable. We use actual direct labor hoursincurred to measure progress towards completion. We periodically evaluate theactual status of each project to determine whether the estimates to completeeach contract remain accurate and update our estimated costs to complete as necessary.Revenue recognized in any period is dependent on our progress toward completionof projects in progress. Significant management judgment and discretion areused to estimate total direct labor hours. Changes in or deviations from theseestimates could have a material effect on the amount of revenue we recognize inany period. 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$368,000, $57,000 and $1.1 million as of December 31, 2005, 2004, and2003, respectively. For agreements involving performance specifications that wehave not met and for which we lack the historical experience to reasonablyestimate the costs, we defer recognition of all revenue until the licenseemanufactures products that meet the contract performance specifications andrecognize revenue under the completed contract accounting method.

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. Cancellationsof this nature are an aspect of our licensing business, and most of our newercontracts allow us to retain all payments that we have received or are entitledto collect for items and services provided before the cancellation occurs. Wewill consider a project to have been canceled even in the absence of specificnotice from our licensee, if there has been no activity under the contract fora significant period, and we believe that completion of the contract isunlikely. In this event, we recognize revenue in the amount of cash received,if we have performed a sufficient portion of the development services. If a 

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cancelled contract hadbeen entered into before the establishment of technological feasibility, thecosts associated with the contract would have been expensed prior to therecognition of revenue. In that case, there would be no costs associated withthat revenue recognition, and gross margin would increase for the correspondingperiod. In 2005, we recognized $240,000 of licensing revenue from cancelledcontracts, compared to none in 2004 and $759,000 in 2003.

*Royalty.*   Eachlicense agreement provides for royalty payments at a stated rate. We negotiateroyalty rates by taking into account such factors as the anticipated volume ofthe licensee’s sales of products utilizing our technologies and the costsavings to be achieved by the licensee through the use of our technology. Ourlicense agreements require the licensee to report the manufacture or sale ofproducts that include our technology after the end of the quarter in which thesale or manufacture 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 level ofroyalties 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 do not reportroyalties from products sold in the fourth quarter until the first quarter ofthe following year. Also, if a licensee holds excess inventory of productsusing our licensed technology, we are unlikely to report additional royaltyrevenue attributable to that product until the quarter after the licenseerestarts production. For a discussion of factors that could contribute to thefluctuation of our revenues, see Part I, Item 1A. “Risk Factors—Ourlengthy licensing cycle and our licensees’ lengthy development cycles will makethe operating results of our licensing business difficult to predict,” and “—Anythingthat negatively affects the business of our licensees could negatively impactour revenue.”

*Product sales.**  *In the second quarter of 2004, wenotified customers of our decision to discontinue sales of our memory chipproducts. As of the end of the third quarter of 2004, we had no remainingproduct inventory. We do not expect to develop, market and sell memory chips inthe future.

***Critical Accounting Policies***

*Useof estimates.*   Ourdiscussion and analysis of our financial condition and results of operation arebased upon our consolidated financial statements, which have been prepared inaccordance with accounting principles generally accepted in the United States.The preparation of these financial statements requires us to make certainestimates and judgments that affect the reported amounts of assets,liabilities, revenues and expenses. On an ongoing basis we make these estimatesbased on our historical experience and on assumptions that we considerreasonable under the circumstances. Actual results may differ from theseestimates, and reported results could differ under different assumptions orconditions.

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

*Revenue.*

*Licensing.**  *In accordance with SOP 81-1 “Accountingfor performance of construction-type and certain production type contracts”,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 of completion method includesjudgmental elements, such as determining that we have the experience to meetthe design specifications and estimation of the total direct labor hours. Wefollow this method 

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because we can obtainreasonably dependable estimates of the direct labor hours to perform thecontracted services. 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.We have the ability to reasonably estimate direct labor hours on a contract tocontract basis from our experience in developing prior licensee’s designs.During the contract performance period, we review estimates of direct laborhours to complete the contracts as the contract progresses to completion andwill revise our estimates of revenue and gross profit under the contract if werevise the estimations of the direct labor hours to complete. Our policy is toreflect any revision in the contract gross profit estimate in reported incomein the period in which the facts giving rise to the revision become known.Under the percentage of completion method, provisions for estimated losses onuncompleted contracts are recognized in the period in which the likelihood ofsuch losses is determined.

Prior to 2005, we recorded deferred revenue when cashwas received. However, the terms of our license contracts allow us to billcustomers upon achieving the milestones stated in the contracts. We believethat now we have adequate history and experience in fulfilling licensingcontract obligations to our customers and collecting payments from them.Therefore, starting in 2005, we began recording accounts receivable anddeferred revenue at the time of billing. This change had no impact on thestatement of operations, or net cash provided by (used in) operations,investing, or financing activities in the statement of cash flows. The December 31,2004 accounts receivable and deferred revenue amounts are presented by reducingboth accounts receivable and deferred revenue by $871,000, consistent with thepresentation used in 2004.

For contracts involving design specifications that wehave not met previously, we defer the recognition of revenue until the designmeets the contractual design specifications and expense the cost of services asincurred. When we have experience in meeting design specifications but do nothave 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. In 2005 and 2004, none of our license revenuewas recognized under the completed contract method.

We also provide support and maintenance. Under thesearrangements, we provide unspecified upgrades, design rule changes andtechnical support. No other upgrades, products or other post-contract supportare provided. When we provide a combination of services related to licensingand support and maintenance to customers, in addition to the considerationsnoted above, we evaluate the arrangements under EITF 00-21, “RevenueArrangements with Multiple Deliverables”. Specifically, we analyze the separateelements to determine if vendor specific objective evidence, or VSOE, existsfor the undelivered elements. We believe we have established VSOE for oursupport and maintenance arrangements. These arrangements are renewable annuallyby the customer. Support and maintenance revenue is recognized at its fairvalue ratably over the period during which the obligation exists, typically 12months. The fair value of any support and maintenance obligation is establishedbased on the specified renewal rate for such support and maintenance. Revenuefrom support and maintenance service represented $512,000 and $60,000 in 2005and 2004, respectively, and was included in licensing revenue in the statementof operations.

*Royalty.*   Licensingcontracts provide also for royalty payments at a stated rate and requirelicensees to report the manufacture or sale of products that include our1T-SRAM technologies after the end of the quarter in which the sale ormanufacture occurs. We recognize royalties in the quarter in which we receivethe licensee’s report. Generally, royalty payments are made by the licenseesaround the time we receive their reports.

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*Goodwill.**  *We review goodwill, recorded fromthe acquisition of ATMOS Corp. in August 2002, for impairment annually andwhenever events or changes in circumstances indicate the carrying value of anasset may not be recoverable in accordance with the Statement of FinancialAccounting Standards (“SFAS”) No. 142, “Goodwill and Other IntangibleAssets.”  The provisions of SFAS No. 142require that a two-step impairment test be performed on goodwill. In the firststep, we compare the fair value of each reporting unit to its carrying value. Subsequentto the acquisition of ATMOS, its business became an integrated part of ouroperations. In 2004, we closed the operation of ATMOS as our Canadian researchand development facility. Using the guidance in SFAS No. 142, we considerthere to be only one reporting unit at the entity level. For step one, wedetermine the fair value of our reporting unit using the market approach. Underthe market approach, we estimate the fair value based on the market value ofthe reporting unit at the entity level. If the fair value of the reporting unitexceeds the carrying value of net assets assigned to the reporting unit,goodwill is not impaired, and we are not required to perform further testing. Ifthe carrying value of the net assets assigned to the reporting unit exceeds thefair value of the reporting unit, we must perform the second step in order todetermine the implied fair value of the reporting unit’s goodwill and compareit to the carrying value of the reporting unit’s goodwill. If the carryingvalue of a reporting unit’s goodwill exceeds its implied fair value, then wemust record an impairment loss equal to the difference. We performed the annualimpairment test during the third quarter of 2005 and the test did not indicateimpairment of goodwill as of September 30, 2005. As of December 31,2005, we found no indicators of potential impairment.

*RestructuringCharges.*   Restructuring charges related to theclosure of our ATMOS research and development facility in Canada in 2004require the use of estimates, primarily related to the cost of exitingfacilities, including estimates and assumptions related to future maintenancecosts, our ability to secure a sub-tenant, and any sublease income to bereceived in the 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.

*Tax valuation 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 are 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 31,2005, we had a valuation allowance of approximately $10.9 million, of whichapproximately $6.1 million was attributable to Canadian loss and research anddevelopment pool carryforwards, and $4.1million was attributable to U.S. andstate net operating loss and tax credit carryforwards.

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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 31,2005, 2004 and 2003. For these three years, results of operations as apercentage of net revenue were as follows:

| ** **                          | ** ** | **Year Ended December 31,** | ** ** |
|-------------------------------------|------------|--------------------------------------------|------------|
| ** **                          | ** ** | **2005**                                   | ** ** | **2004** | ** ** | **2003** | ** ** |
| Net revenue:                        |       |                                       |       |   |   |   |   |   |   |   |   |
| Product                             |       |                                       | —     | % |   | 9 | % |   | 10 | % |   |
| Licensing                           |       |                                       | 63         |   |   | 42 |   |   | 54 |   |   |
| Royalty                             |       |                                       | 37         |   |   | 49 |   |   | 36 |   |   |
| Total net revenue                   |       |                                       | 100        |   |   | 100 |   |   | 100 |   |   |
| Cost of net  revenue                |       |                                       |       |   |   |   |   |   |   |   |   |
| Product                             |       |                                       | —     |   |   | 6 |   |   | 6 |   |   |
| Licensing                           |       |                                       | 16         |   |   | 15 |   |   | 11 |   |   |
| Total cost of net revenue           |       |                                       | 16         |   |   | 21 |   |   | 17 |   |   |
| Gross profit                        |       |                                       | 84         |   |   | 79 |   |   | 83 |   |   |
| Operating  expenses:                |       |                                       |       |   |   |   |   |   |   |   |   |
| Research and development            |       |                                       | 48         |   |   | 75 |   |   | 46 |   |   |
| Selling, general and administrative |       |                                       | 81         |   |   | 123 |   |   | 33 |   |   |
| Restructuring expenses              |       |                                       | —     |   |   | 5 |   |   | — |   |   |
| Total operating expenses            |       |                                       | 129        |   |   | 203 |   |   | 79 |   |   |
| Operating income (loss)             |       |                                       | (45        | ) |   | (124 | ) |   | 4 |   |   |
| Interest and  other income          |       |                                       | 21         |   |   | 106 |   |   | 10 |   |   |
| Income tax  benefit (provision)     |       |                                       | —     |   |   | — |   |   | (1 | ) |   |
| Net income (loss)                   |       |                                       | (24        | )% |   | (18 | )% |   | 13 | % |   |

 

*Years Ended December 31, 2005, 2004 and 2003*

*Revenue.**  *In 2005, total revenue increased to$12.3 million representing a 14% increase from total revenue in 2004. Licensingrevenue increased to $7.7 million in 2005 from $4.5 million in 2004 mainly dueto increased numbers of projects commenced under new contracts signed in 2005and revenue generated under a large contract signed in 2003 and completed in2005. Royalty revenue decreased to $4.5 million in 2005 from $5.3 million in2004 as customer sales of chips incorporating our technology declined.Royalties related to the production of Nintendo Gamecube chips in 2005 was $1.7million, which was consistent with royalties in 2004.

In 2004, total revenuedecreased to $10.8 million representing a 44% decline from total revenue in2003. Licensing revenue declined to $4.5 million in 2004 from $10.4 million in2003 because we did not add new licensing projects to offset the decrease inlicensing revenue earned from older projects that we completed in 2004. In2004, we reduced revenue by $450,000 for a reimbursement given to a customerfor excess verification costs incurred by the customer. Royalty revenuedecreased to $5.3 million in 2004 from $6.9 million in 2003, which included aone-time past due royalty payment of approximately $713,000 from Conexant.Excluding that one-time payment, total royalties in 2004 declined byapproximately $900,000 from 2003, as customer sales of chips incorporating ourtechnology declined. For example, royalties related to the production ofNintendo Gamecube chips represented $1.7 million in 2004 compared to $2.1million in 2003.

In 2003, total revenue was$19.2 million primarily from licensing and royalty activities. Themajority of licensing revenue earned in 2003 was derived from developmentprojects other than Gamecube-related 

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projects.Royalties earned from the sale of Gamecube chips incorporating our 1T-SRAMtechnology represented 11% of our total revenue in 2003. A significant portionof royalty revenues from other licensees in 2003 represented sales ofroyalty-bearing products first shipped in 2002. During the second quarter of2003, we collected $1.0 million in cash from Conexant for the termination ofits October 2000 license agreement with us. That payment consisted ofcurrent and past due royalty payments totaling $713,000, and a contracttermination fee of $287,000, which we included in other income.

During the years ended December 31,2005, 2004, and 2003, our product sales totaled $10,000, $952,000 and  $1.9 million, respectively. Sales of ourmemory chips have declined sharply as we shifted our primary focus from productsales to the licensing of our 1T-SRAM technologies after 1999. In the secondquarter of 2004, we notified customers of our decision to discontinue sale ofour memory chip products. As of the end of the third quarter of 2004, we had noremaining product inventory of value. Accordingly, we will only have minorongoing sales of products required from time to time by customers. In thefuture, we do not expect to develop, market and sell memory chips.

*Gross Profit.*   Grossprofit increased to $10.3 million in 2005 from $8.6 million in 2004primarily due to an increase in our licensing revenue. Our gross profit as apercentage of total revenue increased to 84% in 2005 from 79% in 2004 primarilydue to a higher licensing gross profit, which increased to 74% of total revenuein 2005 from 65% of total revenue in 2004. This increase occurred because lowercost for fulfilling our obligations under new license agreements that requiredless customization.

Gross profit decreased to$8.6 million in 2004 from $16.0 million in 2003 primarily due to thesignificant decline in our licensing revenue. Our gross profit as a percentageof total revenue decreased to 79% in 2004 from 83% in 2003 primarily due to thedecline in licensing gross profit which fell to 65% of total revenue in 2004from 81% of total revenue in 2003. This decline occurred because we incurredhigher cost under new license agreements than we had originally estimated orhad historically experienced. In addition, we recognized revenue under somelower margin license projects including a few contracts in which our estimatedcost exceeded the amount of revenue to be recognized.

In 2004, product grossmargin as a percentage of product revenue decreased to 31% compared to 36% in2003 mainly due to an inventory write-off of approximately $230,000 in 2004,which was not previously reserved for. In 2003, product gross margin as apercentage of product revenue decreased to 36% compared to 43% in 2002. Thedecline resulted primarily from lower average selling prices for our memorychips in 2003.

*Research and Development.**  *Our research and developmentexpenses include development and design of variations of the 1T-SRAMtechnologies for use in different manufacturing processes used by licensees andthe development and testing of prototypes to prove the technologicalfeasibility of embedding our memory designs in the licensees’ products.Research and development expenses decreased to $5.8 million in 2005 from $8.1million in 2004 mainly due to the closure of our ATMOS research and developmentfacility in Ottawa, Canada in November of 2004. There were no research anddevelopment expenses incurred at the ATMOS facility in 2005 as compared to $2.2million incurred in 2004.

Research and developmentexpenses decreased to $8.1 million in 2004 from $8.7 million in 2003 mainlybecause more engineering time was spent on licensing development projects,therefore, more engineering expenses were allocated to cost of licensingrevenue in 2004 compared to 2003. Effective November 10, 2004, we closedthe ATMOS research and development facility in Ottawa, Canada and terminatedthe employment of approximately 20 employees working there.

Research and developmentexpenses increased to $8.7 million in 2003 because we had increased engineeringstaff from our acquisition of ATMOS and to support our memory compilerdevelopment. ATMOS’ research and development expenses represented approximately$2.6 million in 2003.

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*Selling, General andAdministrative.**  *Selling,general and administrative expenses decreased to $9.9 million in 2005 from$13.3 million in 2004 primarily due to $5.5 million of expenses incurredin 2004 related to the aborted acquisition by Synopsys, Inc. and legalexpenses related to litigation with Synopsys over its abandonment of theacquisition and $800,000 of litigation expenses with respect to the patentinfringement and trade secret misappropriation suit brought against us byUniRAM Technology, Inc. incurred in 2004. We did not incurSynopsys-related costs in 2005, but incurred approximately $1.6 million oflegal expenses related to the clams brought by UniRAM. Expenses related totesting and assessment of effectiveness of our internal control over financialreporting required by Section 404 of Sarbanes-Oxley Act were approximately$466,000 in 2005. We expect the expenses related to UniRAM litigation andtesting and assessment required by Section 404 of Sarbanes-Oxley Act tocontinue in 2006.

Selling, general andadministrative expenses increased to $13.3 million in 2004 from$6.4 million in 2003 due primarily to expenses related to the abortedacquisition by Synopsys and litigation expenses related to litigation with Synopsysand UniRAM. In 2004, expenses related to testing and assessment ofeffectiveness of our internal control over financial reporting required by Section 404of Sarbanes-Oxley Act were approximately $690,000. Selling, general andadministrative expenses increased to $6.4 million in 2003 due primarily toincreased sales and marketing activities, including the establishment of asales office in Japan in January 2003 and higher professional fees.

*Restructuring Charges.**  *On November 10, 2004, we announced our plan toclose the ATMOS research and development facility in Canada in order to reduceoperating expenses and to further align our business with market conditions,future revenue expectations and planned future product direction. As a part ofthe plan, we implemented a reduction in workforce of approximately 20employees, which represented 20% of our workforce.

We recorded restructuringcosts of $585,000 in the fourth quarter of 2004, consisting of $179,000 ofseverance and fringe benefits and lease abandonment charges of $406,000. At December 31,2004, we have a total restructuring accrual of $429,000, comprised of unpaidemployee severance costs of $19,000 and estimated lease abandonment costs of$410,000. All employees to be affected by our reduction in workforce werenotified of the termination of their employment on November 10, 2004.

On July 15, 2005, wesigned an agreement to sublease the ATMOS facility, which we occupy under along-term operating lease through April 2008. The sublease expires at theend of April 2008.As a result of the sublease, we incurred $119,000 ofadditional restructuring expenses in 2005. As of December 31, 2005, we hada total restructuring estimated lease abandonment accrual of $293,000. Wereview these estimates periodically if these assumptions materially change dueto rental market factors, the ultimate restructuring expense for the abandonedfacilities would be adjusted.

*Interest and Other Income.**  *Interest and other income decreasedto $2.6 million in 2005 from $11.6 million in 2004, which included the $10million Synopsys termination fee related to the aborted acquisition. Interestincome increased to $2.6 million in 2005 from $1.5 million in 2004 due tohigher interest rates in 2005. Interest and other income increased to $11.6million in 2004 from $1.9 million in 2003 primarily due to a $10.0 milliontermination fee paid by Synopsys.In addition, interest income increased slightly to $1.5 million in 2004 from$1.4 million in 2003 as income attributable to higher interest rates in 2004was impacted adversely by the requirement that we liquidated the short-term andlong-term investments in the second quarter of 2004 prior to the abandonment ofits acquisition of our company by Synopsys. In 2003, interest and other incomeincreased to $1.9 million primarily due to the $287,000 contract terminationfee from Conexant and $241,000 of Canadian research and development incentivecredits. Interest income was $1.4 million in 2003. We incurred no interestexpense in 2005, 2004, and 2003.

*Deferred stock-basedcompensation cost to employees.**  *During the year ended December 31,2004, we recorded deferred compensation cost of $74,000, which would be amortized in future periods. No such costs wereincurred in 2005 or 2003. The 2004 deferred compensation costs represented theintrinsic value 

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of options grantedto purchase shares of our stock to newly appointed members of our board ofdirectors that had an exercise price less than the fair market value of ourcommon stock on the date of the option grant. This deferred compensation costwill be amortized over the vesting period of 36 months using the graded vestingmethod.

During the years ended December 31,2005, 2004, and 2003, we recorded stock compensation expenses of $36,000,$68,000, and $459,000, respectively, of which $0, $50,000 and $211,000,respectively, was attributable to the excess of the fair market value of ourcommon stock over the price at which we granted stock options to employees. In2005 and 2004, we incurred $36,000 and $5,000, respectively, of stockcompensation expenses related to the issuance of options to purchase our stockto newly appointed members of our board of directors that had an exercise priceless than the fair market value of our stock on the date of the option grant.Stock compensation expenses in 2004 and 2003 also included $13,000 and$227,000, respectively, for amortization of deferred compensation costattributable to the fair market value of shares of our common stock issued tocertain employees of ATMOS. We also incurred $21,000 of stock compensationexpense in 2003 due to modification of our 2000 employee stock option held by aformer member of our 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 approximately 52% of the total award in thefirst year, 27% in the second year, 15% in the third year and 6% in the fourthyear.

In December 2004, theFinancial Accounting Standards Board (FASB) issued Statement of FinancialAccounting Standards No. 123 (revised 2004), *Share-Based Payment*(SFAS 123R) which will becomeeffective beginning in the first quarter of 2006. SFAS 123R will result inthe recognition of substantial compensation expense relating to our employeestock options and employee stock purchase plans. We currently use the intrinsicvalue method to measure compensation expense for stock-based awards to itsemployees. Under this standard, we generally do not recognize any compensationrelated to stock option grants under our stock option plans or related to thediscounts provided under our employee stock purchase plans. Under the new rules however,we will be required to adopt a fair-value-based method for measuring thecompensation expense related to employee stock awards. We estimate the impactof adopting SFAS No. 123R will have an earnings impact of approximatelynine to ten cents per share in 2006, based on estimated compensation expensefrom unvested options outstanding as of the end of December 31, 2005. Compensationexpense calculated upon adoption of SFAS No. 123R for future grants maydiffer from pro-forma amounts currently disclosed in our footnotes based onchanges in the fair value of our common stock, the treatment of tax benefits,different assumptions and treatment of forfeitures under SFAS No. 123R,and changes in interest rates or other factors. We are currently consideringour method of adoption, modified prospective approach or modified retrospectiveapproach.

*Provision for IncomeTaxes.**  *Provisions(benefit) for income taxes of approximately ($11,000), $26,000, and $279,000,were recorded in 2005, 2004, and 2003, respectively. The effective income taxrate was (0.4%) for 2005, 1.4% for 2004, and 10% for 2003. As of December 31,2005, we had net operating loss carryforwards of approximately $9.4 million forfederal tax purposes, approximately $6.9 million for state tax purposes andCanadian loss and research and development pool carryforwards of approximately$12.1 million that we expect to be available to reduce future income taxliabilities to the extent permitted under federal, Canadian and applicablestate income tax laws. The net operating loss carryforwards expire from 2008 to2025. The decrease in our effective tax rate in 2005 was mainly due to a stateincome tax refund received in 2005 as a result of an amended 2001 Californiaincome tax return. In 2006, we anticipate that our effective income tax ratewill be less than the federal statutory tax rate but higher than the 2005effective income tax rate.

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**Liquidity and Capital Resources**

As of December 31, 2005, we had cash and cashequivalents of $9.2 million, short-term investments and auction ratesecurities of $59.5 million and long-term investments of$17.3 million resulting in a total balance of cash, cash equivalents, andinvestments of $86.0 million. As of the same date, we had total working capitalof $68.2 million. As of December 31, 2004, we had cash and cashequivalents of $31.7 million, short-term investments and auction ratesecurities of $30.6 million and long-term investments of$24.6 million resulting in a total balance of cash, cash equivalents, andinvestments of $86.9 million. In July 2001, we completed the sale ofa total of 5,750,000 shares of common stock in our initial public offering. Werealized total net proceeds of approximately $51.6 million upon the closeof the IPO, which proceeds have not been used to fund our operations to date.Our primary capital requirements are to fund working capital needs. We believethat our current focus on licensing and royalty revenues with reduced levels ofmemory chip sales has generally enabled us to steadily improve our liquidity.

Net cash provided by (used in) operating activitieswas ($1.3) million, $2.7 million, and $4.7 million for the years ended2005, 2004 and 2003, respectively. In 2005, net cash used in operatingactivities consisted primarily of net loss of $3.0 million offset by anon-cash charge of $614,000 for depreciation and amortization and higherdeferred revenue of $808,000 in 2005. In addition, net cash used in operatingactivities in 2005 included tax benefits associated with the exercise of stockoptions of $482,000, which was recorded under additional paid in capital.  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.In addition, net cash provided by operating activities in 2004 includedrestructuring related liabilities of $429,000. In 2003, net cash provided byoperating activities was principally represented by our net profit of$2.5 million plus a non-cash charge of $2.0 million for depreciationand amortization, although deferred revenue associated with cash receipts inexcess of recognized revenue declined by $1.3 million.

Net cash provided by (used in) investing activitieswas approximately ($22.8) million, $7.9 million, and ($10.8) million for theyears ended 2005, 2004 and 2003, respectively. Aside from investing inmarketable securities, we added $1.1 million of property and equipment in 2005primarily due to leasehold improvements related to our new office lease for ourU.S. corporate headquarters beginning in June 2005, new testing equipmentand engineering design software. We purchased $349,000 and $493,000 of propertyand equipment in 2004 and 2003, respectively, consisting principally ofengineering design software.

Net cash provided by (used in) financing activitieswas approximately $1.5 million, ($982,000), and $1.8 million for the yearsended 2005, 2004 and 2003, respectively. In 2005, we received proceeds in theamount of $1.5 million from the exercise of employee options to purchase commonstock. On April 29, 2005, we announced a repurchase program for up to $20million of outstanding common stock over the next 12 months. However, norepurchases were made in 2005. In 2004, the major financing use of cash was$4.7 million for the repurchase of 1.2 million shares of common stock. Wereceived proceeds in the amount of $3.7 million from the exercise of employeeoptions to purchase common stock during 2004. Cash received upon the issuanceof common stock in connection with the exercise of options totaled $1.9 millionin 2003.

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;

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·       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.

**LeaseCommitments and Off Balance Sheet Financing**

Theimpact that our contractual obligations as of December 31, 2005 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** | ** ** |
| Minimum Lease  Commitments |       | $                                        | 2,796      |   |   | $ | 870 |   |   |   | $ | 1,367 |   |   |   | $ | 559 |   |   |   | $ | — |   |   |
| Sublease Income            |       | 384                                      |       |   | 201 |   |   |   | 183 |   |   |   | — |   |   |   | — |   |   |
| Net Lease Commitments      |       | $                                        | 2,412      |   |   | $ | 669 |   |   |   | $ | 1,184 |   |   |   | $ | 559 |   |   |   | $ | — |   |   |

 

The Company did not haveany unconditional purchase obligations as of December 31, 2005.

**Recent Accounting Pronouncements**

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.

***Item 7A.****                  Quantitativeand Qualitative Discussion of Market Interest 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 amount of credit exposure to any one issuer. These securities, whichapproximate $76.8 million as of December 31, 2005, and have an averageinterest rate of approximately 3.00%, are subject to interest rate risks. As ofDecember 31, 2005, our portfolio had unrealized losses of approximately$389,000 as a result of rising interest rates. We believe these losses aretemporary and expect to hold these investments to maturity. However, based onthe investment portfolio contents and our ability to hold these investments 

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untilmaturity, we believe that if a significant change in interest rates were tooccur, it would not have a material effect on our financial condition.

***Item 8.****                          FinancialStatements and Supplementary Data*

Reference is made to thefinancial statements listed under the heading (a) (1) FinancialStatements and Reports of BDO Seidman LLP and Ernst & Young LLPof Item 15, which financial statements are incorporated by reference inresponse to this Item 8.

**Quarterly Results of Operations**

Thefollowing tables set forth unaudited results of operations data for the eightquarters ended December 31, 2005. 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 a fairpresentation 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 ofOperations.”

| ** **   | ** ** | **Dec. 31,**                                                  | ** ** | **Sep. 30,** | ** ** | **Jun. 30,** | ** ** | **Mar. 31,** | ** ** | **Dec. 31,** | ** ** | **Sep. 30,** | ** ** | **Jun. 30,** | ** ** | **Mar. 31,** | ** ** |
|--------------|------------|--------------------------------------------------------------------|------------|-------------------|------------|-------------------|------------|-------------------|------------|-------------------|------------|-------------------|------------|-------------------|------------|-------------------|------------|
| ** **   | ** ** | **2005**                                                           | ** ** | **2005**          | ** ** | **2005**          | ** ** | **2005**          | ** ** | **2004**          | ** ** | **2004**          | ** ** | **2004**          | ** ** | **2004**          | ** ** |
| ** **   | ** ** | **(In thousands, except per share data)** | ** ** |
| ** **   | ** ** | **(Unaudited—All periods)**                              | ** ** |
| Net revenue: |       |                                                               |       |              |       |              |       |              |       |              |       |              |       |              |       |              |       |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |
|              |            |                                                                    |            |                   |            |                   |            |                   |            |                   |            |                   |            |                   |            |                   |            |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |

| Product                                                |   |   | $      | — |   |   |   | $      | — |   |   |   | $      | 6      |   |   |   | $      | 4      |   |   |   | $      | 33     |   |   |   | $      | 76     |   |   |   | $      | 681    |   |   |   | $ | 162   |   |   |
|--------------------------------------------------------|--------|--------|--------|--------|--------|--------|--------|--------|--------|--------|--------|--------|--------|--------|--------|--------|--------|--------|--------|--------|--------|--------|--------|--------|--------|--------|--------|--------|--------|--------|--------|--------|--------|--------|--------|--------|--------|---|-------|--------|--------|
| Licensing                                              |   |   | 1,339  |   |   |   | 3,233  |   |   |   | 1,940  |   |   |   | 1,213  |   |   |   | 118    |   |   |   | 128    |   |   |   | 1,310  |   |   |   | 2,988  |   |   |
| Royalty                                                |   |   | 1,063  |   |   |   | 897    |   |   |   | 1,121  |   |   |   | 1,466  |   |   |   | 1,069  |   |   |   | 1,488  |   |   |   | 1,415  |   |   |   | 1,353  |   |   |
| Total net revenue                                      |   |   | 2,402  |   |   |   | 4,130  |   |   |   | 3,067  |   |   |   | 2,683  |   |   |   | 1,220  |   |   |   | 1,692  |   |   |   | 3,406  |   |   |   | 4,503  |   |   |
| Cost  of net revenue                                   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |
| Product                                                |   |   | — |   |   |   | — |   |   |   | — |   |   |   | — |   |   |   | 25     |   |   |   | 86     |   |   |   | 394    |   |   |   | 150    |   |   |
| Licensing                                              |   |   | 243    |   |   |   | 668    |   |   |   | 609    |   |   |   | 466    |   |   |   | 519    |   |   |   | 236    |   |   |   | 483    |   |   |   | 375    |   |   |
| Total cost of net  revenue                             |   |   | 243    |   |   |   | 668    |   |   |   | 609    |   |   |   | 466    |   |   |   | 544    |   |   |   | 322    |   |   |   | 877    |   |   |   | 525    |   |   |
| Gross profit                                           |   |   | 2,159  |   |   |   | 3,462  |   |   |   | 2,458  |   |   |   | 2,217  |   |   |   | 676    |   |   |   | 1,370  |   |   |   | 2,529  |   |   |   | 3,978  |   |   |
| Operating  expenses:                                   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |
| Research and  development                              |   |   | 1,557  |   |   |   | 1,359  |   |   |   | 1,320  |   |   |   | 1,603  |   |   |   | 1,728  |   |   |   | 2,174  |   |   |   | 1,968  |   |   |   | 2,226  |   |   |
| Selling, general  and administrative                   |   |   | 2,519  |   |   |   | 2,721  |   |   |   | 2,206  |   |   |   | 2,476  |   |   |   | 1,355  |   |   |   | 3,949  |   |   |   | 5,263  |   |   |   | 2,764  |   |   |
| Restructuring  expenses                                |   |   | 5      |   |   |   | — |   |   |   | 114    |   |   |   | — |   |   |   | 585    |   |   |   | — |   |   |   | — |   |   |   | — |   |   |
| Total operating expenses                               |   |   | 4,081  |   |   |   | 4,080  |   |   |   | 3,640  |   |   |   | 4,079  |   |   |   | 3,668  |   |   |   | 6,123  |   |   |   | 7,231  |   |   |   | 4,990  |   |   |
| Operating income  (loss)                               |   |   | (1,922 | )      |   |   | (618   | )      |   |   | (1,182 | )      |   |   | (1,862 | )      |   |   | (2,992 | )      |   |   | (4,753 | )      |   |   | (4,702 | )      |   |   | (1,012 | )      |   |
| Interest and other  income                             |   |   | 794    |   |   |   | 679    |   |   |   | 605    |   |   |   | 513    |   |   |   | 550    |   |   |   | 10,398 |   |   |   | 269    |   |   |   | 361    |   |   |
| Income (loss)  before income taxes                     |   |   | (1,128 | )      |   |   | 61     |   |   |   | (577   | )      |   |   | (1,349 | )      |   |   | (2,442 | )      |   |   | 5,645  |   |   |   | (4,433 | )      |   |   | (651   | )      |   |
| Income tax benefit  (provision)                        |   |   | 44     |   |   |   | (11    | )      |   |   | (2     | )      |   |   | (20    | )      |   |   | 31     |   |   |   | (565   | )      |   |   | 378    |   |   |   | 130    |   |   |
| Net income (loss)                                      |   |   | $      | (1,084 | )      |   |   | $      | 50     |   |   |   | $      | (579   | )      |   |   | $      | (1,369 | )      |   |   | $      | (2,411 | )      |   |   | $      | 5,080  |   |   |   | $      | (4,055 | )      |   |   | $ | (521  | )      |   |
| Net income (loss) per share:                           |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |
| Basic                                                  |   |   | $      | (0.04  | )      |   |   | $      | — |   |   |   | $      | (0.02  | )      |   |   | $      | (0.04  | )      |   |   | $      | (0.08  | )      |   |   | $      | 0.16   |   |   |   | $      | (0.13  | )      |   |   | $ | (0.02 | )      |   |
| Diluted                                                |   |   | $      | (0.04  | )      |   |   | $      | — |   |   |   | $      | (0.02  | )      |   |   | $      | (0.04  | )      |   |   | $      | (0.08  | )      |   |   | $      | 0.15   |   |   |   | $      | (0.13  | )      |   |   | $ | (0.02 | )      |   |
| Shares  used in computing net income (loss) per share: |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |
| Basic                                                  |   |   | 30,698 |   |   |   | 30,531 |   |   |   | 30,465 |   |   |   | 30,442 |   |   |   | 30,296 |   |   |   | 31,074 |   |   |   | 30,786 |   |   |   | 30,845 |   |   |
| Diluted                                                |   |   | 30,698 |   |   |   | 31,504 |   |   |   | 30,465 |   |   |   | 30,442 |   |   |   | 30,296 |   |   |   | 33,350 |   |   |   | 30,786 |   |   |   | 30,845 |   |   |

 

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

***Item 9.****                          Changesin and Disagreements with Accountants on Accounting and Financial Disclosure*

None.

41

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***Item 9A.****                  Controlsand Procedures*

(a)           Management’s annualreport on internal control over financial reporting

Monolithic System Technology, Inc.’s managementis responsible for establishing and maintaining adequate internal control overfinancial reporting, as such term is defined in Rule 13a-15(f) underthe Securities Exchange Act of 1934. Indesigning and evaluating the disclosure controls and procedures, managementrecognizes that any controls and procedures, no matter how well designed andoperated, can provide only reasonable assurance of achieving the desiredcontrol objectives and management necessarily is required to apply its judgmentin evaluating the cost-benefit relationship of possible controls. Internalcontrol over financial reporting cannot provide absolute assurance of achievingfinancial reporting objectives because of its inherent limitations. Internalcontrol over financial reporting is a process that involves human diligence andcompliance and is subject to lapses in judgment and breakdowns resulting fromhuman failures. Internal control over financial reporting also can becircumvented by collusion or improper management override. Because of suchlimitations, there is a risk that material misstatements may not be preventedor detected on a timely basis by internal control over financial reporting. However,these inherent limitations are known features of the financial reportingprocess. Therefore, it is possible to design into the process safeguards toreduce, though not eliminate, this risk. Under the supervision and withthe participation of our management, including our principal executive officerand principal financial officer, and principal accounting officer, we conductedan evaluation of the effectiveness of our internal control over financialreporting based on the framework in *InternalControl—Integrated Framework*issued by the Committee of SponsoringOrganizations of the Treadway Commission. Based on the evaluation, ourmanagement concluded that our internal control over financial reporting waseffective as of December 31, 2005.

BDO Seidman, LLP,the independent registered public accounting firm that audited the 2005 consolidatedfinancial statements included in this Annual Report on Form 10-K,has also audited management’s assessment of our internal control over financialreporting and the effectiveness of our internal control over financialreporting as of December 31, 2005, as stated in their report which isincluded elsewhere herein.

(b)          Evaluation of disclosurecontrols and procedures

Under thesupervision and with the participation of our management, including ourprincipal executive officer and principal financial officer, and principalaccounting officer, we conducted an evaluation of the effectiveness of thedesign and operation of our disclosure controls and procedures, as defined in Rules 13a-15(e) and15d-15(e) under the Securities Exchange Act of 1934. Based on thisevaluation, our management concluded that as of December 31, 2005, ourdisclosure controls and procedures were effective such that the informationrelating to us, including our consolidated subsidiaries, required to bedisclosed in our reports filed with the Securities and Exchange Commission isrecorded, processed, summarized and reported within the time periods specifiedin SEC rules and forms and is accumulated and communicated to ourmanagement including our Chief Executive Officer and our principal accountingofficer, as appropriate to allow timely decisions regarding requireddisclosure.

(c)           Changes in internalcontrol

There was no change in theinternal control over financial reporting during the fourth fiscal quarter of2005 that has materially affected, or is reasonably likely to materially affectour internal control over financial reporting.

***Item 9B.****                  OtherInformation*

None.

42

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**Part III**

***Item 10.****                   Directorsand Executive Officers of the Registrant*

Information regarding our directors is incorporated byreference from the sections titled “Management” and “Section 16(A) BeneficialOwnership Reporting Compliance” in the Registrant’s Proxy Statement for its2006 Annual Meeting of Stockholders. Information regarding current executiveofficers found under the heading “Executive Officers” in Item 1 of Part Ihereof is also incorporated by reference into this Item 10.

We have adopted a code of ethics that applies to allof our employees. The code of ethics is designed to deter wrongdoing and topromote, among other things, honest and ethical conduct, full, fair, accurate,timely, and understandable disclosures in reports and documents submitted tothe Securities and Exchange Commission and other public communications,compliance with applicable governmental laws, rules and regulations, theprompt internal reporting of violations of the code to an appropriate person orpersons identified in the code and accountability for adherence to such code.

The code of ethics isavailable on our website www.mosys.com. If we make any substantive amendmentsto the code of ethics or grant any waiver, including any implicit waiver, froma provision of the code to our Chief Executive Officer, Chief Financial Officeror Corporate Controller, or persons performing similar functions, where suchamendment or waiver is required to be disclosed under applicable SEC rules, weintend to disclose the nature of such amendment or waiver on our website.

***Item 11.****                   ExecutiveCompensation*

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 CompensationCommittee of the Board of Directors”, in the Registrant’s Proxy Statement forits 2006 Annual Meeting of Stockholders.

***Item 12.****                   SecurityOwnership of Certain Beneficial Owners and Management and Related StockholderMatters*

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 2006 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 2006 AnnualMeeting of Stockholders.

***Item 14.****                   PrincipalAccountant Fees and Services*

The response to this itemis incorporated by reference from the section titled “Ratification ofIndependent Registered Public Accounting Firm for 2006” in the Registrant’sProxy Statement for its 2006 Annual Meeting of Stockholders.

43

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**Part IV**

***Item 15.****                   Exhibitsand Financial Statement Schedules*

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

(1)         FinancialStatements and Reports of Independent Registered Public Accounting Firm, whichare set forth in the index to Consolidated Financial Statements on pages 48through 79 of this report.

| Reports of Independent Registered  Public Accounting Firm—BDO Seidman LLP    |   | 50 |   |
|-----------------------------------------------------------------------------------|--------|----|--------|
| Report of Independent Registered Public Accounting  Firm—Ernst and Young LLP |   | 52 |   |
| Consolidated Balance Sheets                                                       |   | 53 |   |
| Consolidated Statements of Operations                                             |   | 54 |   |
| Consolidated Statements of Stockholders’ Equity                              |   | 55 |   |
| 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)      |   | Not currently in use                                                                                                                                                                                                                                                             |
| 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)     |   | Not currently in use                                                                                                                                                                                                                                                             |
| 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)     |   | Not currently in use                                                                                                                                                                                                                                                             |
| 10.8(1)     |   | Not currently in use                                                                                                                                                                                                                                                             |
| 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                                                                                                                                                                                       |
| 10.12(1)    |   | Not currently in use                                                                                                                                                                                                                                                             |

44

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| 10.13(10) |   | Employment offer letter agreement and Mutual  Agreement to Arbitrate between the Registrant and Chester J. Silvestri dated  July 21, 2005 |
|-----------|--------|------------------------------------------------------------------------------------------------------------------------------------------------|
| 10.14(10) |   | Change-in-Control Agreement between the Registrant  and Chester J. Silvestri dated as of July 21, 2005                                    |
| 10.15(10) |   | Form of Stock Option Agreement pursuant to  Amended and Restated 2000 Stock Option and Equity Incentive Plan                              |
| 10.16     |   | Lease Agreement between Registrant and Sunnyvale  Mathilda Investors, LLC dated as of May 6, 2005                                         |
| 10.17     |   | Employment offer letter agreement between the  Registrant and Dhaval Ajmera dated October 3, 2005                                         |
| 21.1      |   | List of subsidiaries                                                                                                                           |
| 23.1      |   | Consent of Independent Registered Public Accounting  Firm—BDO Seidman LLP                                                                 |
| 23.2      |   | Consent of Independent Registered Public Accounting  Firm—Ernst and Young LLP                                                             |
| 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,declared effective 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 46of 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 by referenceto 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-Kfiled by Synopsys, 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).

(10)   Incorporated by reference tothe same-numbered exhibit to Form 10-Q filed by the Company on August 9,2005.

45

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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 dayof March 2006.

|        | MONOLITHIC SYSTEM TECHNOLOGY, INC. |
|--------|------------------------------------|
|   | By:                                |   | /s/ CHESTER J. SILVESTRI |
|   |                               |   | Chester J. Silvestri |
|   |                               |   | Chief Executive Officer and President |

 

**POWER OF ATTORNEY**

KNOW ALL MEN BY THESE PRESENTS, that each person whosesignature appears below constitutes and appoints Chester J. Silvestri as histrue and lawful attorney-in-fact and agent, with full power of substitution andresubstitution, for him and in his name, place and stead, in any and allcapacities, to sign any and all amendments to his Report on Form 10-K,and to file the same, with all exhibits thereto, and other documents inconnection therewith, with the Securities and Exchange Commission, grantingunto said attorney-in-fact and agent full power and authority to do and performeach and every act and thing requisite and necessary to be done in connectiontherewith, as fully to all intents and purposes as he might or could do inperson, hereby ratifying and confirming all that said attorney-in-fact andagent, or his substitute or substitutes, may lawfully do or cause to be done byvirtue 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/ CHESTER J. SILVESTRI |       | Chief Executive Officer  and President             |       | March 16, 2006 |
| Chester J. Silvestri     |       | (Principal Executive Officer and Principal         |       |                |
|                     |       | Financial Officer)                                 |       |                |
| /s/ YOSHIKO RIBAR        |       | Controller (Principal  Accounting Officer)         |       | March 16, 2006 |
| Yoshiko Ribar            |       |                                               |       |                |
| /s/WINGYU LEUNG          |       | Executive Vice  President, Chief Technical Officer |       | March 16, 2006 |
| Wingyu Leung             |       | and Director                                       |       |                |
| /s/ CARL E. BERG         |       | Director                                           |       | March 16, 2006 |
| Carl E. Berg             |       |                                               |       |                |
| /s/ TOMMY ENG            |       | Director                                           |       | March 16, 2006 |
| Tommy Eng                |       |                                               |       |                |
| /s/ CHI-PING HSU         |       | Director                                           |       | March 16, 2006 |
| Chi-Ping Hsu             |       |                                               |       |                |
| /s/ JAMES D. KUPEC       |       | Director                                           |       | March 16, 2006 |
| James D. Kupec           |       |                                               |       |                |
| /s/ CHENMING HU          |       | Director                                           |       | March 16, 2006 |
| Chenming  Hu             |       |                                               |       |                |

 

46

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**INDEX OF 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)      |   | Not currently in  use                                                                                                                                                                                                                                                             |
| 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)     |   | Not currently in  use                                                                                                                                                                                                                                                             |
| 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)     |   | Not currently in  use                                                                                                                                                                                                                                                             |
| 10.8(1)     |   | Not currently in  use                                                                                                                                                                                                                                                             |
| 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                                                                                                                                                                                        |
| 10.12(1)    |   | Not currently in  use                                                                                                                                                                                                                                                             |
| 10.13(10)   |   | Employment offer  letter agreement and Mutual Agreement to Arbitrate between the Registrant and  Chester J. Silvestri dated July 21, 2005                                                                                                                                    |
| 10.14(10)   |   | Change-in-Control  Agreement between the Registrant and Chester J. Silvestri dated as of  July 21, 2005                                                                                                                                                                      |
| 10.15(10)   |   | Form of  Stock Option Agreement pursuant to Amended and Restated 2000 Stock Option and  Equity Incentive Plan                                                                                                                                                                |
| 10.16       |   | Lease Agreement  between Registrant and Sunnyvale Mathilda Investors, LLC dated as of  May 6, 2005                                                                                                                                                                           |
| 10.17       |   | Employment offer  letter agreement between the Registrant and Dhaval Ajmera dated  October 3, 2005                                                                                                                                                                           |
| 21.1        |   | List of  subsidiaries                                                                                                                                                                                                                                                             |
| 23.1        |   | Consent of  Independent Registered Public Accounting Firm-BDO Seidman LLP                                                                                                                                                                                                         |
| 23.2        |   | Consent of  Independent Registered Public Accounting Firm-Ernst and Young LLP                                                                                                                                                                                                     |
| 24.1(3)     |   | Power of Attorney                                                                                                                                                                                                                                                                 |
| 31.1        |   | Rule 13a-14  certification                                                                                                                                                                                                                                                   |
| 31.2        |   | Rule 13a-14  certification                                                                                                                                                                                                                                                   |
| 32          |   | Section 1350  certification                                                                                                                                                                                                                                                  |

 

47

----

----

(1)          Incorporated byreference to the same-numbered exhibit to the Company’s Registration Statementon Form S-1, as amended, originally filed August 4, 2000,declared effective 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 46of 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-Kfiled by Synopsys, Inc. on February 26, 2004, (Commission File No. 000-19807).

(6)          Incorporated byreference to Exhibit 2.2 of the Current Report on Form 8-Kfiled by Synopsys, 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).

(10)   Incorporated by reference tothe same-numbered exhibit to Form 10-Q filed by the Company on August 9,2005.

48

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**MONOLITHIC SYSTEM TECHNOLOGY, INC.**

**INDEXTO CONSOLIDATED FINANCIAL STATEMENTS**

| Reports of Independent  Registered Public Accounting Firm—BDO Seidman LLP    |   | 50 |   |
|-----------------------------------------------------------------------------------|--------|----|--------|
| Report of Independent Registered Public Accounting  Firm—Ernst and Young LLP |   | 52 |   |
| Consolidated Balance Sheets                                                       |   | 53 |   |
| Consolidated Statements of Operations                                             |   | 54 |   |
| Consolidated Statements of Stockholders’ Equity                              |   | 55 |   |
| Consolidated Statements of Cash Flows                                             |   | 56 |   |
| Notes to Consolidated Financial Statements                                        |   | 57 |   |
| Schedule II: Valuation and Qualifying Accounts                                    |   | 77 |   |

 

49

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**Reportof Independent Registered Public Accounting Firm**

Board of Directors and StockholdersMonolithic Systems Technology, Inc.Sunnyvale, California

We have audited the accompanying consolidated balancesheet of Monolithic Systems Technology, Inc. (“MoSys”) as of December 31, 2005and the related consolidated statements of operations, stockholders’ equity,and cash flows for the year then ended. These financial statements are theresponsibility of MoSys’ management. We have also audited Schedule II—Valuationand Qualifying Accounts as of and for the year ended December 31, 2005. Ourresponsibility is to express an opinion on these financial statements andschedule 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 the financial statements and schedule are free ofmaterial misstatement. An audit includes examining, on a test basis, evidencesupporting the amounts and disclosures in the financial statements andschedule, assessing the accounting principles used and significant estimatesmade by management, as well as evaluating the overall presentation of thefinancial statements and schedule. We believe that our audit provides areasonable basis for our opinion.

In our opinion, the consolidated financial statementsreferred to above present fairly, in all material respects, the financialposition of MoSys at December 31, 2005, and the results of its operations andits cash flows for the year then ended, in conformity with accountingprinciples generally accepted in the United States of America. Also, in ouropinion, Schedule II—Valuation and Qualifying Accounts presents fairly, in allmaterial respects, the information set forth therein as of and for the yearended December 31, 2005.

We also have audited, inaccordance with the standards of the Public Company Accounting Oversight Board(United States), the effectiveness of MoSys’ internal control over financialreporting as of December 31, 2005, based on criteria established in *Internal Control—Integrated Framework*issuedby the Committee of Sponsoring Organizations of the Treadway Commission (COSO)and our report dated February 24, 2006 expressed an unqualified opinionthereon.

/s/ BDO Seidman, LLP

San Francisco, CaliforniaFebruary 24, 2006

50

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**REPORTOF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRMON INTERNAL CONTROL OVER FINANCIAL REPORTING**

Board of Directors and StockholdersMonolithic Systems Technology, Inc.Sunnyvale, California

We have audited management’s assessment, included inthe accompanying Management Report on InternalControl over Financial Reporting, that Monolithic Systems Technology Inc. (“MoSys”)maintained effective internal control over financial reporting as of December 31,2005, based on criteria established in Internal Control—Integrated Framework issuedby the Committee of Sponsoring Organizations of the Treadway Commission (theCOSO criteria). The Company’s management is responsible for maintaining effectiveinternal control over financial reporting and for its assessment of the effectivenessof internal control over financial reporting. Our responsibility is to expressan opinion on management’s assessment and an opinion on the effectiveness ofthe Company’s internal control 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 an understandingof internal control over financial reporting, evaluating management’sassessment, testing and evaluating the design and operating effectiveness ofinternal control, and performing such other procedures as we considered necessaryin the circumstances. We believe that our audit provides a reasonable basis forour opinion.

A company’s internal control overfinancial reporting is a process designed to provide reasonable assuranceregarding the reliability of financial reporting and the preparation offinancial statements for external purposes in accordance with generallyaccepted accounting principles. A company’s internal control over financial reportingincludes those policies and procedures that (1) pertain to the maintenanceof records that, in reasonable detail, accurately and fairly reflect the transactionsand dispositions of the assets of the company; (2) provide reasonable assurancethat transactions are recorded as necessary to permit preparation of financialstatements in accordance with generally accepted accounting principles, andthat receipts and expenditures of the company are being made only in accordancewith authorizations of management and directors of the company; and (3) providereasonable assurance regarding prevention or timely detection of unauthorized acquisition, use, or disposition of the company’sassets 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.

In our opinion, management’s assessment that MoSysmaintained effective internal control over financial reporting as of December 31,2005, is fairly stated, in all material respects, based on the COSO criteria.Also, in our opinion, MoSys maintained, in all material respects, effectiveinternal control over financial reporting as of December 31, 2005, basedon the COSO criteria.

We also have audited, inaccordance with the standards of the Public Company Accounting Oversight Board(United States), the consolidated balance sheet as of December 31, 2005and the related consolidated statements of operations, stockholders’ equity andcash flows for the year then ended, and the 2005 financial statement schedulelisted in the accompanying index, of MoSys and our report dated February 24,2006, expressed an unqualified opinion thereon.

\s\ BDO Seidman, LLP

San Francisco, CaliforniaFebruary 24, 2006

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**Reportof Independent Registered Public Accounting Firm**

The Board of Directors and Stockholders ofMonolithic System Technology, Inc.

We have audited the accompanying consolidated balancesheet of Monolithic System Technology, Inc. as of December 31, 2004,and the related consolidated statements of operations, stockholders’ equity,and cash flows for each of the two years in the period ended December 31,2004. Our audits also included the financial statement schedule for each of thetwo years in the period ended December 31, 2004 listed in the Index atItem 15(a)(2). These financial statements and schedule are the responsibilityof the Company’s management. Our responsibility is to express an opinion onthese financial statements and schedule based on our audits.

We conducted our audits in accordance with the standardsof the Public Company Accounting Oversight Board (United States). Thosestandards require that we plan and perform the audits to obtain reasonableassurance about whether the financial statements are free of materialmisstatement. An audit includes examining, on a test basis, evidence supportingthe amounts and disclosures in the financial statements. An audit also includesassessing the accounting principles used and significant estimates made bymanagement, as well as evaluating the overall financial statement presentation.We believe that our audits provide a reasonable basis for our opinion.

In ouropinion, the financial statements referred to above present fairly, in allmaterial respects, the consolidated financial position of Monolithic SystemTechnology, Inc. at December 31, 2004, and the consolidated resultsof their operations and their cash flows for each of the two years in the period ended December 31, 2004, inconformity with U.S. generally accepted accounting principles. Also, in ouropinion, the related financial statement schedule for each of the two years inthe period ended December 31, 2004, when considered in relation to thebasic financial statements taken as a whole, presents fairly in all materialrespects the information set forth therein.
|                       | */s/  Ernst & Young LLP* |
|-----------------------|---------------------------------------------|
| San Jose,  California | * *                                    |
| March 15,  2005  | * *                                    |

 

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**MONOLITHICSYSTEM TECHNOLOGY, INC.CONSOLIDATED BALANCE SHEETS(In thousands, except per share data)**

| ** **                                                                                                                                                              | ** ** | **December 31,** | ** ** |
|-------------------------------------------------------------------------------------------------------------------------------------------------------------------------|------------|-----------------------|------------|
| ** **                                                                                                                                                              | ** ** | **2005**              | ** ** | **2004** | ** ** |
| **ASSETS**                                                                                                                                                              | ** ** | ** **            | ** ** | ** ** | ** ** |
| Current assets:                                                                                                                                                         |       |                  |       |   |   |
| Cash and cash equivalents                                                                                                                                               |       | $                     | 9,171      |   | $ | 31,714 |   |
| Short-term investments and auction rate securities                                                                                                                      |       | 59,479                |       | 30,635 |   |
| Accounts receivable, net                                                                                                                                                |       | 638                   |       | 1,125 |   |
| Unbilled contract receivable                                                                                                                                            |       | 368                   |       | 57 |   |
| Prepaid expenses and other current assets                                                                                                                               |       | 2,632                 |       | 2,939 |   |
| Total current assets                                                                                                                                                    |       | 72,288                |       | 66,470 |   |
| Long-term  investments                                                                                                                                                  |       | 17,339                |       | 24,562 |   |
| Property and  equipment, net                                                                                                                                            |       | 1,121                 |       | 685 |   |
| Goodwill                                                                                                                                                                |       | 12,326                |       | 12,326 |   |
| Other assets                                                                                                                                                            |       | 563                   |       | 539 |   |
| Total assets                                                                                                                                                            |       | $                     | 103,637    |   | $ | 104,582 |   |
| **LIABILITIES  AND STOCKHOLDERS’ EQUITY**                                                                                                                          | ** ** | ** **            | ** ** | ** ** | ** ** |
| Current liabilities:                                                                                                                                                    |       |                  |       |   |   |
| Accounts payable                                                                                                                                                        |       | $                     | 236        |   | $ | 120 |   |
| Accrued expenses and other liabilities                                                                                                                                  |       | 2,564                 |       | 3,314 |   |
| Deferred revenue                                                                                                                                                        |       | 1,309                 |       | 501 |   |
| Total current liabilities                                                                                                                                               |       | 4,109                 |       | 3,935 |   |
| Long-term portion  of restructuring liability                                                                                                                           |       | 196                   |       | 239 |   |
| Total liabilities                                                                                                                                                       |       | 4,305                 |       | 4,174 |   |
| Commitment and  contingencies                                                                                                                                           |       |                  |       |   |   |
| Stockholders’  equity:                                                                                                                                             |       |                  |       |   |   |
| Preferred stock, $0.01 par value; 20,000 shares  authorized; none issued and outstanding at December 31, 2005 and  December 31, 2004                          |       | —                |       | — |   |
| Common stock, $0.01 par value; 120,000 shares  authorized; 30,768 shares and 30,296 shares issued and outstanding at  December 31, 2005 and December 31, 2004 |       | 308                   |       | 303 |   |
| Additional paid-in capital                                                                                                                                              |       | 100,280               |       | 98,278 |   |
| Deferred stock-based compensation                                                                                                                                       |       | (33                   | )          | (69 | ) |
| Accumulated other comprehensive loss                                                                                                                                    |       | (389                  | )          | (252 | ) |
| Retained earnings (deficit)                                                                                                                                             |       | (834                  | )          | 2,148 |   |
| Total stockholders’ equity                                                                                                                                         |       | 99,332                |       | 100,408 |   |
| Total liabilities  and stockholders’ equity                                                                                                                        |       | $                     | 103,637    |   | $ | 104,582 |   |

 

 

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

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**MONOLITHICSYSTEM TECHNOLOGY, INC.CONSOLIDATED STATEMENTS OF OPERATIONS(In thousands, except per share data)**

| ** **                                                    | ** ** | **Year Ended December 31,** | ** ** |
|---------------------------------------------------------------|------------|--------------------------------------------|------------|
| ** **                                                    | ** ** | **2005**                                   | ** ** | **2004** | ** ** | **2003** | ** ** |
| Net revenue:                                                  |       |                                       |       |   |   |   |   |
| Product                                                       |       | $                                          | 10         |   | $ | 952 |   | $ | 1,904 |   |
| Licensing                                                     |       | 7,725                                      |       | 4,544 |   | 10,418 |   |
| Royalty                                                       |       | 4,547                                      |       | 5,325 |   | 6,911 |   |
| Total net revenue                                             |       | 12,282                                     |       | 10,821 |   | 19,233 |   |
| Cost of net  revenue                                          |       |                                       |       |   |   |   |   |
| Product                                                       |       | —                                     |       | 655 |   | 1,217 |   |
| Licensing                                                     |       | 1,986                                      |       | 1,613 |   | 1,970 |   |
| Total cost of net revenue                                     |       | 1,986                                      |       | 2,268 |   | 3,187 |   |
| Gross profit                                                  |       | 10,296                                     |       | 8,553 |   | 16,046 |   |
| Operating  expenses:                                          |       |                                       |       |   |   |   |   |
| Research and development                                      |       | 5,839                                      |       | 8,096 |   | 8,741 |   |
| Selling, general and administrative                           |       | 9,922                                      |       | 13,331 |   | 6,432 |   |
| Restructuring expenses                                        |       | 119                                        |       | 585 |   | — |   |
| Total operating expenses                                      |       | 15,880                                     |       | 22,012 |   | 15,173 |   |
| Income (loss) from operations                                 |       | (5,584                                     | )          | (13,459 | ) | 873 |   |
| Interest and  other income                                    |       | 2,591                                      |       | 11,578 |   | 1,914 |   |
| Income (loss) before income taxes                             |       | (2,993                                     | )          | (1,881 | ) | 2,787 |   |
| Income tax  benefit (provision)                               |       | 11                                         |       | (26 | ) | (279 | ) |
| Net income (loss)                                             |       | $                                          | (2,982     | ) | $ | (1,907 | ) | $ | 2,508 |   |
| Net income (loss)  per share:                                 |       |                                       |       |   |   |   |   |
| Basic                                                         |       | $                                          | (0.10      | ) | $ | (0.06 | ) | $ | 0.08 |   |
| Diluted                                                       |       | $                                          | (0.10      | ) | $ | (0.06 | ) | $ | 0.08 |   |
| Shares used in computing  net income (loss) per share:        |       |                                       |       |   |   |   |   |
| Basic                                                         |       | 30,534                                     |       | 30,750 |   | 30,504 |   |
| Diluted                                                       |       | 30,534                                     |       | 30,750 |   | 30,998 |   |
| Allocation of  stock-based compensation to operating expenses |       |                                       |       |   |   |   |   |
| Research and development                                      |       | $                                          | —     |   | $ | 44 |   | $ | 148 |   |
| Selling, general and administrative                           |       | 36                                         |       | 24 |   | 311 |   |
|                                                          |       | $                                          | 36         |   | $ | 68 |   | $ | 459 |   |

 

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

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**MONOLITHICSYSTEM TECHNOLOGY, INC.CONSOLIDATED STATEMENTS OF STOCKHOLDERS’ EQUITY(In thousands)**

| ** **                                                                             | ** ** | ** **            | ** ** | ** **  | ** ** | ** **      | ** ** | ** **        | ** ** | **Accumulated**        | ** ** | **Retained** | ** ** | ** ** | ** ** |
|----------------------------------------------------------------------------------------|------------|-----------------------|------------|-------------|------------|-----------------|------------|-------------------|------------|------------------------|------------|--------------|------------|------------|------------|
| ** **                                                                             | ** ** | ** **            | ** ** | ** **  | ** ** | **Additional**  | ** ** | **Deferred**      | ** ** | **Other**              | ** ** | **Earnings** | ** ** | ** ** | ** ** |
| ** **                                                                             | ** ** | **Common Stock** | ** ** | **Paid-In** | ** ** | **Stock-Based** | ** ** | **Comprehensive** | ** ** | **(Accumulated**       | ** ** | ** **   | ** ** |
| ** **                                                                             | ** ** | **Shares**            | ** ** | **Amount**  | ** ** | **Capital**     | ** ** | **Compensation**  | ** ** | **Income (Loss)** | ** ** | **Deficit)** | ** ** | **Total**  | ** ** |
| 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 |   |
| 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 (loss)                                                       |       |                  |       |        |       |            |       |              |       |                   |       |         |       |       |       |   |   |   |   |   |   | (2,215 | ) |
| Balance at December 31,2004                                                  |       | 30,296                |       |        | 303        |            |       | 98,278            |       |                   | (69        | )            |       |       | (252       | ) |   |   | 2,148 |   |   | 100,408 |   |
| Issuance of Common Stock upon exercise of options                                      |       | 406                   |       |        | 4          |            |       | 1,205             |       |                   | —     |         |       |       | —     |   |   |   | — |   |   | 1,209 |   |
| Issuance of Common Stock for Employee Stock Purchase  Plan                             |       | 66                    |       |        | 1          |            |       | 315               |       |                   | —     |         |       |       | —     |   |   |   | — |   |   | 316 |   |
| Amortization of deferred stock-based compensation                                      |       | —                |       |        | —     |            |       | —            |       |                   | 36         |         |       |       | —     |   |   |   | — |   |   | 36 |   |
| Tax benefits associated with exercise of stock  options                                |       | —                |       |        | —     |            |       | 482               |       |                   | —     |         |       |       | —     |   |   |   | — |   |   | 482 |   |
| Other comprehensive income—unrealized loss on  available-for-sale investments     |       | —                |       |        | —     |            |       | —            |       |                   | —     |         |       |       | (137       | ) |   |   | — |   |   | (137 | ) |
| Net income (loss)                                                                      |       | —                |       |        | —     |            |       | —            |       |                   | —     |         |       |       | —     |   |   |   | (2,982 | ) |   | (2,982 | ) |
| Comprehensive income (loss)                                                       |       |                  |       |        |       |            |       |              |       |                   |       |         |       |       |       |   |   |   |   |   |   | (3,119 | ) |
| Balance at  December 31,2005                                                 |       | 30,768                |       |        | $          | 308             |       |              | $          | 100,280                |       |         | $          | (33        | )          |   |   | $ | (389 | ) |   |   | $ | (834 | ) |   | $ | 99,332 |   |

 

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

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**MONOLITHICSYSTEM TECHNOLOGY, INC.CONSOLIDATED STATEMENTS OF CASH FLOWS(In thousands)**

| ** **                                                                                | ** ** | **Year Ended December 31,** | ** ** |
|-------------------------------------------------------------------------------------------|------------|--------------------------------------------|------------|
| ** **                                                                                | ** ** | **2005**                                   | ** ** | **2004** | ** ** | **2003** | ** ** |
| **Cash flows from operating  activities:**                                                |       |                                       |       |   |   |   |   |
| Net income (loss)                                                                         |       | $                                          | (2,982     | ) | $ | (1,907 | ) | $ | 2,508 |   |
| Adjustments to  reconcile net income (loss) to net cash provided by operating activities: |       |                                       |       |   |   |   |   |
| Provision for doubtful accounts                                                           |       | 105                                        |       | — |   | — |   |
| Depreciation and amortization                                                             |       | 614                                        |       | 1,460 |   | 2,049 |   |
| Amortization of deferred stock-based compensation                                         |       | 36                                         |       | 68 |   | 459 |   |
| Changes in current  assets and liabilities:                                               |       |                                       |       |   |   |   |   |
| Accounts receivable                                                                       |       | 382                                        |       | (98 | ) | (84 | ) |
| Unbilled contract receivable                                                              |       | (311                                       | )          | 1,049 |   | (413 | ) |
| Inventories                                                                               |       | —                                     |       | 474 |   | 563 |   |
| Prepaid expenses and other assets                                                         |       | 765                                        |       | 858 |   | 570 |   |
| Deferred revenue                                                                          |       | 808                                        |       | (5 | ) | (1,273 | ) |
| Accounts payable                                                                          |       | 116                                        |       | 4 |   | (16 | ) |
| Accrued expenses and other liabilities                                                    |       | (657                                       | )          | 391 |   | 365 |   |
| Restructuring liability                                                                   |       | (136                                       | )          | 429 |   | — |   |
| Net cash provided by (used in) operating activities                                       |       | (1,260                                     | )          | 2,723 |   | 4,728 |   |
| **Cash flows from investing  activities:**                                                |       |                                       |       |   |   |   |   |
| Purchase of property and equipment                                                        |       | (1,051                                     | )          | (349 | ) | (493 | ) |
| Proceeds from sales and maturity of marketable  securities                                |       | 225,879                                    |       | 469,336 |   | 258,752 |   |
| Purchase of marketable securities                                                         |       | (247,636                                   | )          | (461,047 | ) | (269,094 | ) |
| Net cash provided by (used in) investing activities                                       |       | (22,808                                    | )          | 7,940 |   | (10,835 | ) |
| **Cash flows from financing  activities:**                                                |       |                                       |       |   |   |   |   |
| Payment of capital lease obligations                                                      |       | —                                     |       | (26 | ) | (88 | ) |
| Proceeds from issuance of common stock                                                    |       | 1,525                                      |       | 3,697 |   | 1,907 |   |
| Repurchase and retirement of common stock                                                 |       | —                                     |       | (4,653 | ) | — |   |
| Net cash provided by (used in) financing activities                                       |       | 1,525                                      |       | (982 | ) | 1,819 |   |
| Net increase  (decrease) in cash and cash equivalents                                     |       | (22,543                                    | )          | 9,681 |   | (4,288 | ) |
| Cash and cash equivalents  at beginning of year                                           |       | 31,714                                     |       | 22,033 |   | 26,321 |   |
| Cash and cash  equivalents at end of year                                                 |       | $                                          | 9,171      |   | $ | 31,714 |   | $ | 22,033 |   |
| **Supplemental disclosure:**                                                              |       |                                       |       |   |   |   |   |
| Cash paid for  income taxes                                                               |       | $                                          | 29         |   | $ | 24 |   | $ | 394 |   |

 

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:The Company 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 intercompany transactions and balances have been eliminatedin consolidation. The Company reports financial results on a calendar fiscalyear.

***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 under the percentage ofcompletion and expenses during the reported period. Actual results could differfrom those estimates.

***Foreign Currency Translation***

The Company has foreignoffices located in Korea, Japan and France, which are operated by subsidiariesof the Company. The functional currency of the Company’s foreign entities isthe U.S. dollar. Accordingly, the financial statements of these entities areremeasured into U.S. dollars in accordance with Statement of FinancialAccounting Standards No. 52, “Foreign Currency Translation.” Exchangegains or losses from remeasurement of monetary assets and liabilities that arenot denominated in U.S. dollar were not material for any period presented andare included in the consolidated statements 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. Allsecurities are classified as available-for-sale. The Company’s short-term andlong-term investments are carried at fair value, based on quoted market prices,with the unrealized holding gains and losses reported in stockholders’ equity.The Company evaluates declines in market value for potential impairment if the 

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decline results in a valuebelow cost and is determined to be other than temporary. Realized gains andlosses and declines in the value judged to be other-than-temporary are includedin interest income. The cost of securities sold is based on the specificidentification 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.

***Allowance for Doubtful Accounts.***

The Company determines itsallowance for doubtful accounts to ensure its trade receivables balances arenot overstated due to uncollectibility. The Company performs ongoing customercredit evaluation within the context of the industry in which it operates. Aspecific allowance of up to 100% of the invoice value will be provided for anyproblematic customer balances. Delinquent account balances are written offafter management has determined that the likelihood of collection is notpossible. As of December 31, 2005, the Company reported a balance of$105,000 in its allowance for doubtful accounts. There was no balance ofallowance for doubtful accounts in 2004.

***Unbilled Contract Receivable***

Under the percentage ofcompletion method, if the amount of revenue recognized exceeds the amount ofbillings to a customer; the excess amount is carried as an unbilled contractreceivable. The Company has recorded $368,000 and $57,000 of unbilled contractreceivable as of December 31, 2005 and 2004, respectively.

***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. During the year, the Company wrote off approximately $9.4 millionof fully depreciated assets. Depreciation and amortization expense for theyears ended December 31, 2005, 2004 and 2003 was $614,000, $1.5 million,and  $2.0 million, respectively.

| ** **                        | ** ** | **December 31,** | ** ** |
|-----------------------------------|------------|-----------------------|------------|
| ** **                        | ** ** | **2005**              | ** ** | **2004** | ** ** |
| **Property  and equipment:**      |       |                  |       |   |   |
| Equipment, furniture and fixtures |       | $                     | 1,364      |   | $ | 5,638 |   |
| Acquired software                 |       | 836                   |       | 4,888 |   |
|                              |       | 2,200                 |       | 10,526 |   |
| Less: Accumulated depreciation    |       | (1,079                | )          | (9,841 | ) |
|                              |       | $                     | 1,121      |   | $ | 685 |   |

 

***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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***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. Subsequent to the acquisition ofATMOS, its business became integrated part of the Company’s operations. In2004, the Company closed the operation of ATMOS as its Canadian research anddevelopment facility. Using the guidance in SFAS No. 142, the Companydetermined that it has only one reporting unit at the entity level. For stepone, the Company determines the fair value of its reporting unit using themarket 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 performs its annual impairment test duringthe third quarter of each year and at times impairment indicators are noted.The Company performed the annual impairment test during the third quarter of2005 and the test did not indicate impairment of goodwill as of September 30,2005. As of December 31, 2005, the Company found no indicators ofpotential impairment.

***Revenue Recognition***

*Licensing*

Licensing revenue consists of fees earned 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 “Accountingfor Performance of Construction-Type and Certain Production-Type Contracts”,when license agreements include deliverables that require “significantproduction, modification or customization”, contract accounting is applied.When the Company has significant experience in meeting the design specificationinvolved in the contract and the direct labor hours related to services underthe contract can be reasonably estimated, the Company recognizes revenue overthe period in which the contract services are performed. For these arrangements,the Company recognizes revenue using the percentage of completion method.Revenues are only recognized when collection is probable. The direct laborhours for the development of the licensee’s design are estimated at thebeginning of the contract. As these direct labor hours are incurred, they areused as a measure of progress towards completion. The Company has the abilityto reasonably estimate the direct labor hours on a contract-by-contract basisbased on its experience in developing prior licensees’ designs. The Companyperiodically evaluates the actual status of each project to ensure that theestimates to complete each contract remain accurate and updates its estimatedcosts to complete as necessary. Under the percentage of completion method, provisionsfor estimated losses on uncompleted contracts are recognized in the period inwhich the likelihood of such losses is determined. Revenue recognized in anyperiod is dependent on the Company’s progress toward completion of projects inprogress. Significant management judgment and discretion are used to estimatetotal direct labor hours. Any changes in or deviation from these estimatescould have a material effect on the amount of revenue the Company recognizes inany period. If inherent risks make estimates doubtful, the contract isaccounted for under the completed contract method. Completion of the contractis based on the production of integrated circuit devices that have beenvalidated by the customer.

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Prior to 2005, the Company recorded deferred revenuewhen cash was received. However, the terms of the license contracts allow theCompany to bill customers upon achieving the milestones stated in thecontracts. The Company believes that now it has adequate history and experiencein fulfilling licensing contract obligations to its customers and collectingpayments from them. Therefore, starting in 2005, the Company began recordingaccounts receivable and deferred revenue at the time of billing. This changehad no impact on the statement of operations, or net cash provided by (used in)operations, investing, or financing activities in the statement of cash flows.The December 31, 2004 accounts receivable and deferred revenue amounts arepresented by reducing both accounts receivable and deferred revenue by$871,000, consistent with the presentation used in 2004.

For contracts involving design specifications that theCompany has not previously met, the Company defers the recognition of allrevenue until the design meets the contractual design specifications andexpenses the cost of revenue as incurred. When the Company has experience inmeeting design specifications but does not have significant experience toreasonably estimate the cost of services to meet a design specification, theCompany defers both the recognition of revenue and the cost. For thesearrangements, the Company recognizes revenue using the completed contractmethod. In  2005 and 2004, none of theCompany’s license revenue was recognized under the completed contract method.

The Company also provides support and maintenance. Underthese arrangements, the Company provides unspecified upgrades, design rule changesand technical support. No other upgrades, products or other post-contractsupport are provided. When the Company provides a combination of servicesrelated to licensing and support and maintenance to customers, in addition tothe considerations noted above, the Company evaluates the arrangements underEITF 00-21, “Revenue Arrangements with Multiple Deliverables”. Specifically,the Company analyzes the separate elements to determine if vendor specificobjective evidence, or VSOE, exists for the undelivered elements. The Companybelieves it has established VSOE for its support and maintenance arrangements.These arrangements are renewable annually by the customer. Support andmaintenance revenue is recognized at its fair value ratably over the periodduring which the obligation exists, typically 12 months. The fair value of anysupport and maintenance obligation is established based on the specifiedrenewal rate for such support and maintenance. Revenue from support andmaintenance service represented $512,000 and $60,000 in 2005 and 2004,respectively, and was included in licensing revenue in the statement ofoperations.

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 anaspect of the Company’s licensing business, and, in general license contractssigned since the beginning of 2002 allow the Company to retain all paymentsthat the Company has received or is entitled to collect for items and servicesprovided before the cancellation occurs. Typically under our agreements, thelicensee is obligated to complete the project within a stated timeframe,including assisting us in completing the final milestone, and if the Companyperforms the contracted services, is obligated to pay the license fees even ifthe licensee fails to complete verification or cancels the project prior tocompletion. The Company will consider a project to have been canceled even inthe absence of specific notice from its licensee, if there has been no activityunder the contract for a significant period, and the Company believes thatcompletion of the contract is unlikely. In this event, the Company recognizesrevenue in the amount of cash received, if the Company has performed asufficient portion of the development services. If a cancelled contract hadbeen entered into before the establishment of technological feasibility, thecosts associated with the contract would have been expensed prior to therecognition of revenue. In that case, there would be no costs associated withthat revenue recognition, and gross margin would increase for the correspondingperiod. In 2005, the Company recognized $240,000 of licensing revenue fromcancelled contracts, compared to none in 2004 and $759,000 in 2003.

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*Royalty*

Licensing contracts providealso for royalty payments at a stated rate and require licensees to report themanufacture or sale of products that include the Company’s technology after theend of the quarter in which the sale or manufacture occurs. The Companyrecognizes royalties in the quarter in which the Company receives the licensee’sreport. Generally, royalty payments are made by the licensees at about the sametime as the Company receives their reports.**TheCompany recognized no royalty revenue from terminated contracts in 2005 and2004, compared to $713,000 in 2003.

*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. During 2004, we phased out salesof our proprietary 1T-SRAM memory chips. The Company does not expect to sellmemory chips in the future.

***Cost of Revenue***

*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.

·       Forcontracts entered into prior to establishing technological feasibility, we donot defer related development costs, but rather expense them in the period inwhich they are incurred. Consequently, upon completion of these contracts, werecognize the related revenues without any corresponding costs.

In addition, cost oflicensing revenue includes costs related to support and maintenance services.

*Royalty*

There are no reportedcosts associated with royalty 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. There were no 

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reportedcosts associated with product revenue in 2005 as the products were sold fromthe inventory previously written off.

***Research and Development***

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

***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 the gradedvesting method over the vesting period of each respective option, which isgenerally four 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):

| ** **                                                                                                                  | ** ** | **Year Ended December 31,** | ** ** |
|-----------------------------------------------------------------------------------------------------------------------------|------------|--------------------------------------------|------------|
| ** **                                                                                                                  | ** ** | **2005**                                   | ** ** | **2004** | ** ** | **2003** | ** ** |
| Net income (loss):                                                                                                          |       |                                       |       |   |   |   |   |
| As reported                                                                                                                 |       | $                                          | (2,982     | ) | $ | (1,907 | ) | $ | 2,508 |   |
| Add: stock-based compensation expense reported in  consolidated statements of operations, net of related tax effects        |       | 36                                         |       | 68 |   | 459 |   |
| Less: stock compensation related to stock awards  assumed during the ATMOS acquisition, net of related tax effects          |       |                                       |       |   |   | (248 | ) |
| Total stock-based compensation expense determined  under fair value based method for all awards, net of related tax effects |       | (6,046                                     | )          | (4,434 | ) | (4,537 | ) |
|                                                                                                                        |       | $                                          | (8,992     | ) | $ | (6,273 | ) | $ | (1,818 | ) |
| Earnings (losses) per  share:                                                                                               |       |                                       |       |   |   |   |   |
| Basic—as reported                                                                                                      |       | $                                          | (0.10      | ) | $ | (0.06 | ) | $ | 0.08 |   |
| Basic—pro forma                                                                                                        |       | $                                          | (0.29      | ) | $ | (0.20 | ) | $ | (0.06 | ) |

 

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:

| ** **                           | ** ** | **Year Ended December 31,** | ** ** |
|--------------------------------------|------------|--------------------------------------------|------------|
| **Employee stock options** | ** ** | ** **                                 | ** ** | **2005** | ** ** | **2004** | ** ** | **2003** | ** ** |
| Expected life (in  years)            |       | 4.0 - 5.0                             |       | 5.0 |   | 5.0 |   |
| Risk-free  interest rate             |       | 3.7% - 4.5                            | %          | 3.2% - 3.7 | % | 2.1% - 3.6 | % |
| Volatility                           |       | 56.7                                       | %          | 81.5 | % | 75.9 | % |
| Dividend yield                       |       | 0                                          | %          | 0 | % | 0 | % |
|                                      |            |                                            |            |  |  |  |  |  |  |

 

| **Employee stock purchase plan shares** | ** ** | ** **      | ** ** | **2005**        | ** ** | **2004**        | ** ** | **2003** | ** ** |
|-------------------------------------------------------------|------------|-----------------|------------|-----------------|------------|-----------------|------------|----------|------------|
| Expected life (in  years)                                   |       | 1.0             |       | 1.0             |       | 1.0             |       |
| Risk-free  interest rate                                    |       | 2.8% - 3.5 | %          | 1.2% - 2.2 | %          | 1.1% - 1.4 | %          |
| Volatility                                                  |       | 44.0            | %          | 80.3            | %          | 69.9            | %          |
| Dividend yield                                              |       | 0               | %          | 0               | %          | 0               | %          |

 

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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 of options granted during 2005, 2004 and 2003was $3.38, $4.08, and $4.97, respectively. The weighted average estimated fairvalue of shares granted under the employee stock purchase plan during 2005,2004 and 2003 was $2.22, $2.95 and $4.21, respectively. On December 14,2005, the Company fully accelerated the vesting of all outstanding stockoptions that have an exercise price greater than or equal to $7.42 and weregranted before April 19, 2004, pursuant to the authorization of theCompensation Committee of the board of directors. As a result of this optionvesting acceleration, approximately $1.1 million of additional stock-basedcompensation expense was included in the pro forma stock-based compensationexpense of $6.0 million in 2005 under SFAS No. 123.

*Per Share Amounts*

Basicnet income (loss) per share is computed by dividing net income (loss) for theperiod by the weighted-average number of shares of common stockoutstanding during the period. Diluted net income per share for the year ended December 31,2003 was computed by dividing the net income for the period by the weightedaverage number of common and potential common equivalent shares outstandingduring the period. Potential common shares are composed of incremental sharesof common stock issuable upon the exercise of stock options or warrants. Dilutednet loss per share for the years ended December 31, 2005 and 2004 are thesame as basic net loss per share for the same period because the impact ofincluding potential common shares is anti-dilutive. For the years ended December 31,2005 and 2004, stock options to purchase 1.4 and 1.3 million shares withexercise prices greater than the average market prices of common stock wereexcluded from computation of diluted net loss per share as their inclusionwould be anti-dilutive. The following table sets forth the computation of basicand diluted net income per share for the periods indicated (in thousands,except per share amounts):

| ** **                                                    | ** ** | **Year Ended December 31,** | ** ** |
|---------------------------------------------------------------|------------|--------------------------------------------|------------|
| ** **                                                    | ** ** | **2005**                                   | ** ** | **2004** | ** ** | **2003** | ** ** |
| Numerator:                                                    |       |                                       |       |   |   |   |   |
| Net income (loss)                                             |       | $                                          | (2,982     | ) | $ | (1,907 | ) | $ | 2,508 |   |
| Denominator:                                                  |       |                                       |       |   |   |   |   |
| Shares used in  computing net income (loss) per share:        |       |                                       |       |   |   |   |   |
| Basic                                                         |       | 30,534                                     |       | 30,750 |   | 30,504 |   |
| Employee stock options and unvested common stock  outstanding |       |                                       |       |   |   | 494 |   |
| Diluted                                                       |       | 30,534                                     |       | 30,750 |   | 30,998 |   |
| Net income (loss) per  share:                                 |       |                                       |       |   |   |   |   |
| Basic                                                         |       | $                                          | (0.10      | ) | $ | (0.06 | ) | $ | 0.08 |   |
| Diluted                                                       |       | $                                          | (0.10      | ) | $ | (0.06 | ) | $ | 0.08 |   |

 

***Income Taxes***

The Company accounts for income taxes using the assetand liability method as prescribed by Statement of Financial AccountingStandards No. 109, Accounting for Income Taxes (“SFAS 109”). Under theasset and liability method, the expected future tax consequences of temporarydifferences between the book and tax basis of assets and liabilities arerecognized as deferred tax assets and liabilities. A valuation allowance is establishedfor any deferred tax assets for which realization is more likely than not thatall or a portion of the deferred tax assets will not be realized.

***ComprehensiveIncome (Loss)***

Statement ofFinancial Accounting Standards No. 130 “Reporting Comprehensive Income” (“SFASNo. 130”) requires the Company to display comprehensive income and itscomponents as part of the 

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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, 2005, 2004 and 2003 was($389,000), ($252,000) and $56,000, respectively. The changes in othercomprehensive income (loss) were as follows, for the years ended December 31,2005, 2004, and 2003:

| ** **                                             | ** ** | **2005**           | ** ** | **2004** | ** ** | **2003** | ** ** |
|--------------------------------------------------------|------------|--------------------|------------|----------|------------|----------|------------|
| ** **                                             | ** ** | **(in thousands)** | ** ** |
| Net income (loss)                                      |       | $                  | (2,982     | )        | $          | (1,907   | )          | $ | 2,508 |   |
| Net unrealized loss on  available-for-sale securities: |       |               |       |     |       |     |       |
| Change in net unrealized loss                          |       | (137               | )          | (308     | )          | (60      | )          |
| Comprehensive income  (loss)                           |       | $                  | (3,119     | )        | $          | (2,215   | )          | $ | 2,448 |   |

 

***Segment Reporting***

Financial Accounting Standards Board Statement No. 131,“Disclosure about Segments of an Enterprise and Related Information” (“SFAS No. 131”)requires that companies report separately in the financial statements certainfinancial and descriptive information about operating segment profit or loss,certain specific revenue and expense items and segment assets. The Companyoperates in one segment, using one measurement of profitability for itsbusiness. The Company has sales outside the United States that are described inNote 9. The vast majority of long-lived assets are maintained in theUnited States.

***Recent AccountingPronouncements***

In December 2004, the Financial AccountingStandards Board (FASB) issued Statement of Financial Accounting Standards No. 123(revised 2004), “Share-Based Payment”**(SFAS 123R)which will become effective beginning in the first quarter of 2006.SFAS 123R will result in the recognition of substantial compensationexpense relating to our employee stock options and employee stock purchaseplans. The Company currently uses the intrinsic value method to measurecompensation expense for stock-based awards to its employees. Under thisstandard, the Company generally does not recognize any compensation related tostock option under its stock option plans or related to the discounts theCompany provided under its employee stock purchase plans. Under the new rules however,the Company will be required to adopt a fair-value-based method for measuring thecompensation expense related to employee stock awards. The Company estimatesthe impact of adopting SFAS No. 123R will have an earnings impact ofapproximately nine to ten cents per share in 2006, based on estimatedcompensation expense from unvested options outstanding as of the end of December 31,2005. Compensation expense calculated upon adoption of SFAS No. 123R forfuture grants may differ from pro-forma amounts currently disclosed in ourfootnotes based on changes in the fair value of our common stock, the treatmentof tax benefits, different assumptions and treatment of forfeitures under SFAS No. 123R,and changes in interest rates or other factors. The Company is currentlyconsidering its method of adoption, modified prospective approach or modifiedretrospective approach”

In May 2005, the FASB issued Statement ofFinancial Accounting Standards No. 154, “Accounting Changes and ErrorCorrections”, which is a replacement of APB Opinion No. 20, AccountingChanges, and FASB Statement No. 3, Reporting Accounting Changes in InterimFinancial Statements. This statement changes the requirements for theaccounting for and reporting of a change in accounting principle. It applies toall voluntary changes in accounting principle. It requires retrospectiveapplication to prior periods’ financial statements of changes in accountingprinciple unless it is impracticable. It is effective for accounting changesand corrections of errors made in fiscal years beginning after December 15,2005.

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**Note 2:Restructuring**

On November 10, 2004,the Company announced its plan to close the ATMOS research and developmentfacility in Canada to reduce operating expenses and to further align theCompany’s business with market conditions, future revenue expectations andplanned future product direction. As part of this plan, the Company implementeda reduction in workforce of approximately 20 employees, which represented 20%of its workforce. On July 15, 2005, the Company signed an agreement to subleasethe ATMOS facility, which the Company occupies under long-term operating leasesthrough 2008.

The Company had a total restructuring estimated leaseabandonment accrual of $293,000 and $429,000 for the years ended 2005 and 2004,respectively. The Company reviews these estimates periodically, and if thepertinent assumptions materially change, the ultimate restructuring expense forthe abandoned facilities will be adjusted in accordance with SFAS No. 146,“Accounting for Costs Associated with Exit or Disposal Activities”.

The following table summarizes 2005 activities under the RestructuringPlan (amounts in thousands):

| ** **                                         | ** ** | **Abandoned** | ** ** | **Severance** | ** ** | ** ** | ** ** |
|----------------------------------------------------|------------|---------------|------------|---------------|------------|------------|------------|
| ** **                                         | ** ** | **Space**     | ** ** | **Related**   | ** ** | **Total**  | ** ** |
| Restructuring  liability at December 31, 2004 |       |          | $          | 410           |       |       |       | $ | 19 |   |   | $ | 429 |   |
| Less current  portion                              |       |          | 171        |          |       |       | 19         |   |   | 190 |   |
| Long-term portion  of restructuring liability      |       |          | 239        |          |       |       | —     |   |   | 239 |   |
| 2005 adjustments                                   |       |          | 121        |          |       |       | —     |   |   | 121 |   |
| Cash payments                                      |       |          | (247       | )             |       |       | (18        | ) |   | (265 | ) |
| Foreign exchange  fluctuations                     |       |          | 9          |          |       |       | (1         | ) |   | 8 |   |
| Restructuring  liability at December 31, 2005 |       |          | 293        |          |       |       | —     |   |   | 293 |   |
| Less current  portion                              |       |          | 97         |          |       |       | —     |   |   | 97 |   |
| Long-term portion of  restructuring liability      |       |          | $          | 196           |       |       |       | $ | — |   |   | $ | 196 |   |

 

** Note 3: Details of Balance Sheet Components and Consolidated Statements ofOperations**

| ** **                                           | ** ** | **December 31,** | ** ** |
|------------------------------------------------------|------------|-----------------------|------------|
| ** **                                           | ** ** | **2005**              | ** ** | **2004** | ** ** |
| ** **                                           | ** ** | **(in  thousands)**   | ** ** |
| **Prepaid expenses and other  current assets:**      |       |                  |       |   |   |
| Deferred costs of revenue                            |       | $                     | 24         |   | $ | 338 |   |
| Deferred tax assets                                  |       | 1,316                 |       | 831 |   |
| Prepaid expenses and other assets                    |       | 1,292                 |       | 1,770 |   |
|                                                 |       | $                     | 2,632      |   | $ | 2,939 |   |
| **Accrued expenses and other liabilities:**          |       |                  |       |   |   |
| Accrued wages and employee benefits                  |       | $                     | 631        |   | $ | 621 |   |
| Professional fees                                    |       | 432                   |       | 711 |   |
| Deferred rent                                        |       | 51                    |       | 65 |   |
| Accrued restructuring liability—current portion |       | 97                    |       | 190 |   |
| Income taxes payable                                 |       | 22                    |       | 19 |   |
| Withholding tax payable                              |       | 1,052                 |       | 1,052 |   |
| License fees payable                                 |       | —                |       | 453 |   |
| Other                                                |       | 279                   |       | 203 |   |
|                                                 |       | $                     | 2,564      |   | $ | 3,314 |   |

 

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**Interestand other income:**

| ** **           | ** ** | **2005**            | ** ** | **2004** | ** ** | **2003** | ** ** |
|----------------------|------------|---------------------|------------|----------|------------|----------|------------|
| ** **           | ** ** | **(in  thousands)** | ** ** |
| Interest Income      |       | $                   | 2,608      |     | $          | 1,527    |       | $ | 1,350 |   |
| Other Income  (loss) |       | (17                 | )          | 10,051   |       | 564      |       |
|                 |       | $                   | 2,591      |     | $          | 11,578   |       | $ | 1,914 |   |

 

In  2004, the Company received the $10 milliontermination fee from Synopsys as a result of the settlement agreement regardingthe aborted merger. In 2003, other income included the $287,000 contracttermination fee from Conexant.

**Note4:  Fair Value of Financial Instruments**

The estimated fair valuesof financial instruments outstanding at fiscal year-ends were as follows:

| ** **                                                | ** ** | **2005**            | ** ** |
|-----------------------------------------------------------|------------|---------------------|------------|
| ** **                                                | ** ** | ** **          | ** ** | **Gross** | ** ** | ** ** | ** ** |
| ** **                                                | ** ** | ** **          | ** ** | **Unrealized** | ** ** | **Fair** | ** ** |
| ** **                                                | ** ** | **Cost**            | ** ** | **Loss** | ** ** | **Value** | ** ** |
| ** **                                                | ** ** | **(in  thousands)** | ** ** |
| Cash                                                      |       | $                   | 8,148      |   |   | $ | — |   |   | $ | 8,148 |   |
| Cash Equivalents:                                         |       |                |       |   |   |   |   |   |   |
| Commercial and US government agencies paper               |       | 1,027               |       |   | (4 | ) |   | 1,023 |   |
| Total cash and cash equivalents                           |       | $                   | 9,175      |   |   | $ | (4 | ) |   | $ | 9,171 |   |
| Short-term investments  and auction rate securities:      |       |                |       |   |   |   |   |   |   |
| Corporate notes                                           |       | $                   | 12,063     |   |   | $ | (83 | ) |   | $ | 11,980 |   |
| US government debt securities                             |       | 21,490              |       |   | (141 | ) |   | 21,349 |   |
| Market auction rate certificates                          |       | 26,150              |       |   | — |   |   | 26,150 |   |
| Total short-term investments and auction rate  securities |       | $                   | 59,703     |   |   | $ | (224 | ) |   | $ | 59,479 |   |
| Long-term investments:                                    |       |                |       |   |   |   |   |   |   |
| US government debt securities                             |       | $                   | 12,179     |   |   | $ | (107 | ) |   | $ | 12,072 |   |
| Corporate notes                                           |       | 5,321               |       |   | (54 | ) |   | 5,267 |   |
| Total long-term  investments                              |       | $                   | 17,500     |   |   | $ | (161 | ) |   | $ | 17,339 |   |

 

| ** **                                                | ** ** | **2004**            | ** ** |
|-----------------------------------------------------------|------------|---------------------|------------|
| ** **                                                | ** ** | ** **          | ** ** | **Gross** | ** ** | ** ** | ** ** |
| ** **                                                | ** ** | ** **          | ** ** | **Unrealized** | ** ** | **Fair** | ** ** |
| ** **                                                | ** ** | **Cost**            | ** ** | **Loss** | ** ** | **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  and auction rate securities:      |       |                |       |   |   |   |   |   |   |
| 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 and auction rate  securities |       | $                   | 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 |   |

 

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Thefollowing table shows the cost and fair value of cash equivalents, short-termand long-term investments based on two maturity groups as of December 31,2005 (amounts in thousands):

| ** **        | ** ** | **Cost** | ** ** | **Gross Unrealized  Loss** | ** ** | **Fair Value** | ** ** |
|-------------------|------------|----------|------------|---------------------------------|------------|---------------------|------------|
| Due within 1 year |       | $        | 60,730     |                            |       | $                   | (228       | ) |   |   | $ | 60,502 |   |   |
| Due 1-2  years    |       | 17,500   |       |                            | (161       | )                   |       |   | 17,339 |   |   |
| Total             |       | $        | 78,230     |                            |       | $                   | (389       | ) |   |   | $ | 77,841 |   |   |

 

There were no realized gains or losses for 2005, 2004and 2003.

Thefollowing table shows the fair value of the Company’s investments with unrealizedlosses that are not deemed to be other-than-temporarily impaired, aggregated byinvestment category and length of time that individual securities have been ina continuous unrealized loss position, at December 31, 2005 (amounts inthousands):

| ** **                           | ** ** | **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  |       |                                   | $          | 21,349                                  |       |                |       | $ | (141 | ) |   |   | $ | 12,072 |   |   |   | $ | (107 | ) |   |   | $ | 33,421 |   |   |   | $ | (248 | ) |   |
| Corporate Notes                      |       |                                   | 13,003     |                                    |       |                | (87        | ) |   |   | 5,267 |   |   |   | (54 | ) |   |   | 18,270 |   |   |   | (141 | ) |   |
| Total                                |       |                                   | $          | 34,352                                  |       |                |       | $ | (228 | ) |   |   | $ | 17,339 |   |   |   | $ | (161 | ) |   |   | $ | 51,691 |   |   |   | $ | (389 | ) |   |

 

**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 during 2005. Because the Company has the ability andintent to hold these investments until a recovery of fair value, which may bematurity, the Company does not consider these investments to beother-than-temporarily impaired at December 31, 2005.

**Corporate Notes.**   TheCompany’s investment in corporate notes consists primarily of investment gradecorporate bonds and notes. The unrealized losses on the Company’s investmentgrade corporate bonds and notes were caused by interest rate increases during2005. Due to the fact that the decline in market value is attributable tochanges in interest rates and not credit quality, and because the severity andduration of the unrealized losses were not significant, the Company consideredthese unrealized losses to be temporary at December 31, 2005. Because theCompany has the ability and intent to hold these investments until a recoveryof fair value, which may be maturity, the Company does not consider theseinvestments to be other-than-temporarily impaired at December 31, 2005.

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**Note 5: Income Taxes**

The(provision) benefit for income taxes consists of the following (in thousands):

| ** **       | ** ** | **Year Ended December 31,** | ** ** |
|------------------|------------|--------------------------------------------|------------|
| ** **       | ** ** | **2005**                                   | ** ** | **2004** | ** ** | **2003** | ** ** |
| Current portion: |       |                                       |       |   |   |   |   |
| U.S. federal     |       | $                                          | —     |   | $ | 904 |   | $ | 634 |   |
| State            |       | 31                                         |       | (3 | ) | (2 | ) |
| Foreign          |       | (23                                        | )          | (104 | ) | (150 | ) |
|             |       | 8                                          |       | 797 |   | 482 |   |
| Deferred:        |       |                                       |       |   |   |   |   |
| U.S. federal     |       | 3                                          |       | (823 | ) | (761 | ) |
| State            |       | —                                     |       | — |   | — |   |
| Foreign          |       | —                                     |       | — |   | — |   |
|             |       | 3                                          |       | (823 | ) | (761 | ) |
|             |       | $                                          | 11         |   | $ | (26 | ) | $ | (279 | ) |

 

Deferred income taxes reflect the net tax effects oftemporary differences between the carrying amount of assets and liabilities forfinancial reporting purposes and the amounts used for income tax purposes.

Significantcomponents of the Company’s deferred tax assets and liabilities were asfollows:

| ** **                                                     | ** ** | **December 31,** | ** ** |
|----------------------------------------------------------------|------------|-----------------------|------------|
| ** **                                                     | ** ** | **2005**              | ** ** | **2004** | ** ** |
| **Deferred tax assets (liabilities):**          |       |                  |       |   |   |
| Federal and state loss carryforwards                           |       | 3,586                 |       | 1,614 |   |
| Reserves, accruals and other                                   |       | 490                   |       | 271 |   |
| Deferred revenue                                               |       | —                |       | 799 |   |
| Depreciation and amortization                                  |       | (94                   | )          | (212 | ) |
| Deferred compensation                                          |       | 268                   |       | 455 |   |
| Research and development credit carryforwards                  |       | 1,301                 |       | 2,013 |   |
| Foreign tax credits                                            |       | 553                   |       | 435 |   |
| Canadian loss and research and development pool  carryforwards |       | 6,124                 |       | 6,238 |   |
|                                                           |       | 12,228                |       | 11,613 |   |
| Less: Valuation  allowance                                     |       | (10,912               | )          | (10,782 | ) |
| Net deferred tax assets                                        |       | $                     | 1,316      |   | $ | 831 |   |
|                                                                |            |                       |            |  |  |  |  |

 

The valuation allowance increased by $130,000 and $2.5million, during the years ended December 31, 2005 and 2004, respectively.The valuation allowance at December 31, 2005 includes $1.9 million relatedto stock option deductions, the benefit of which will be credited to additionalpaid in capital when realized.

As of December 31, 2005, the Company had netoperating loss carryforwards of approximately $9.4 million for federal incometax purposes and approximately $6.9 million for state income tax purposes.These losses are available to reduce taxable income and expire beginning 2013through 2025. The Company also had federal research and development tax creditcarryforwards of approximately $750,000, which will expire beginning in 2021,and California research and development credits of approximately $842,000,which do not have an expiration date. The Company had foreign tax creditsavailable for federal income tax purposes of approximately $553,000, which willbegin to expire in 2008. The Company had 

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Canadian operating lossand research and development pool carryforwards of $12.1 million, which willbegin to expire in 2008. Utilization of the Company’s net operating loss andtax credit carryforwards may be subject to a substantial annual limitation dueto the ownership change limitations provided by the Internal Revenue Code andsimilar state provisions. Such an annual limitation could result in theexpiration or elimination of the net operating loss and tax credit carryforwardsbefore utilization. Management does not believe it is likely that utilizationwill in fact be significantly limited due to ownership change limitationprovisions.

The Company’s U.S. income tax return for 2002 is underexamination. Management believes that adequate amounts have been provided forany adjustments that may ultimately result from this examination.

Areconciliation of income taxes provided at the federal statutory rate (35% in2005, 2004 and 2003) to actual income tax expense follows:

| ** **                                                         | ** ** | **Year Ended December 31,** | ** ** |
|--------------------------------------------------------------------|------------|--------------------------------------------|------------|
| ** **                                                         | ** ** | **2005**                                   | ** ** | **2004** | ** ** | **2003** | ** ** |
| ** **                                                         | ** ** | **(in thousands)**                    | ** ** |
| Income tax  (provision) benefit computed at federal statutory rate |       | $                                          | 1,048      |   | $ | 659 |   | $ | (976 | ) |
| State income tax  (net of federal benefit)                         |       | (4                                         | )          | (3 | ) | (2 | ) |
| Foreign income  tax at rate different from US statutory rate       |       | (47                                        | )          | (28 | ) | 15 |   |
| Utilization of  previously reserved NOL’s                     |       | —                                     |       | — |   | 834 |   |
| Research &  development credits                           |       | 96                                         |       | — |   | — |   |
| Valuation  allowance changes affecting tax provision               |       | (1,029                                     | )          | (641 | ) | (73 | ) |
| Tax benefit from  extraterritorial income exclusion                |       | —                                     |       | — |   | 206 |   |
| Other                                                              |       | (53                                        | )          | (13 | ) | (283 | ) |
|                                                               |       | $                                          | 11         |   | $ | (26 | ) | $ | (279 | ) |

 

Thedomestic and foreign components of earnings before taxes were as follows forthe years ended December 31, 2005, 2004 and 2003:

| ** ** | ** ** | **2005**                | ** ** | **2004** | ** ** | **2003** | ** ** |
|------------|------------|-------------------------|------------|----------|------------|----------|------------|
| ** ** | ** ** | **(in thousands)** | ** ** |
| U.S.       |       | $                       | (2,851     | )        | $          | (1,685   | )          | $ | 2,316 |   |
| Non-U.S.   |       | (142                    | )          | (196     | )          | 471      |       |
|       |       | $                       | (2,993     | )        | $          | (1,881   | )          | $ | 2,787 |   |

 

**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. The maximum amount of indemnification the Company could berequired to make under these agreements is generally limited to the feesreceived by the Company, although in some contracts the Company’s potential obligationcould be equal to the third parties’ actual damages and losses. The Company hasnot estimated the maximum potential amount of indemnification liability underthese agreements due to the limited history of prior claims and the uniquefacts and circumstances applicable to 

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eachparticular agreement. To date, the Company has not made any payments related tothese indemnifications.

**Note 7: Stockholders’ Equity**

***Common Stock Option Plans***

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 is7,207,000, 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 31,2003, 2004 and 2005 and changes during the years ended on these dates arepresented below (in thousands, except per share amounts):

| ** **                                 | ** ** | **Options Outstanding** | ** ** |
|--------------------------------------------|------------|------------------------------|------------|
| ** **                                 | ** ** | ** **                   | ** ** | ** ** | ** ** | **Weighted** | ** ** |
| ** **                                 | ** ** | ** **                   | ** ** | ** ** | ** ** | **Average** | ** ** |
| ** **                                 | ** ** | **Available**                | ** ** | **Number of** | ** ** | **Exercise** | ** ** |
| ** **                                 | ** ** | **for Grant**           | ** ** | **Options** | ** ** | **Prices** | ** ** |
| 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 |   |   |
| Additional  authorized under the 2000 Plan |       |                         | 500        |   |   |   |   |   |   |   |   |   |   |
| Granted                                    |       |                         | (2,648     | ) |   |   | 2,648 |   |   |   | $ | 5.41 |   |   |
| Cancelled                                  |       |                         | 1,522      |   |   |   | (1,522 | ) |   |   | $ | 5.80 |   |   |
| Exercised                                  |       |                         | —     |   |   |   | (406 | ) |   |   | $ | 2.98 |   |   |
| Balance at  December 31, 2005         |       |                         | 1,512      |   |   |   | 6,477 |   |   |   | $ | 6.09 |   |   |

 

Options exercisable under the Company’s options planswere 2.7 million, 2.1 million and 2.3 million in 2005, 2004 and 2003,respectively.

Informationrelating to stock options outstanding at December 31, 2005 is as follows(in thousands, except per share amounts):

| ** **                                 | ** ** | **Options Outstanding at December 31, 2005** | ** ** | **Options Exercisable  at December 31, 2005** | ** ** |
|--------------------------------------------|------------|-----------------------------------------------------------------------|------------|-------------------------------------------------------------------|------------|
| **Range of Exercise Price** | ** ** | ** **                                                            | ** ** | **Number  Outstanding**                                           | ** ** | **Weighted Average  Remaining  Contractual Life  (in Years)** | ** ** | **Weighted Average  Exercise Price** | ** ** | **Number  Outstanding** | ** ** | **Weighted Average  Exercise Price** | ** ** |
| $1.00-$4.09                                |       |                                                                  | 1,870      |                                                              |       |   | 8.15 |   |   |   | $ | 3.67 |   |   |   | 696 |   |   |   | $ | 3.35 |   |   |
| $4.10-$8.00                                |       |                                                                  | 3,350      |                                                              |       |   | 8.86 |   |   |   | $ | 5.82 |   |   |   | 794 |   |   |   | $ | 7.17 |   |   |
| $8.01-$10.00                               |       |                                                                  | 489        |                                                              |       |   | 6.14 |   |   |   | $ | 9.46 |   |   |   | 489 |   |   |   | $ | 9.46 |   |   |
| $10.01-$15.69                              |       |                                                                  | 768        |                                                              |       |   | 6.26 |   |   |   | $ | 11.06 |   |   |   | 768 |   |   |   | $ | 11.06 |   |   |
|                                       |       |                                                                  | 6,477      |                                                              |       |   |   |   |   |   |   |   |   |   | 2,747 |   |   |   |   |   |   |
|                                            |            |                                                                       |            |                                                                   |            |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |

 

The Company’s board of directors may issue up to20,000,000 shares of preferred stock without stockholder approval on such termsas the board might determine. The rights of the holders of common stock will besubject to, and might be adversely affected by, the rights of the holders ofany preferred stock that might be issued in the future.

On December 14, 2005, the Company fullyaccelerated the vesting of all outstanding stock options granted under theCompany’s Amended 2000 Plan that have an exercise price greater than or equalto $7.42 and were granted before April 19, 2004, pursuant to theauthorization of the Compensation Committee of the board of directors. As aresult of this action, options to purchase approximately 220,000 shares of theCompany’s common stock became immediately exercisable. This option vestingacceleration 

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eliminated approximately$1.1 million of stock-based compensation expense that would have been recordedover the remaining terms of the affected options under Statement of FinancialAccounting Standards No. 123 (revised 2004), Share-Based Payment (“SFAS123R”), which became effective for the Company on January 1, 2006.

On December 14, 2005,pursuant to authorization by the Compensation Committee of the board ofdirectors, the Company commenced an offer of restricted shares of its commonstock under the Amended 2000 Plan to the United States employees holdingoutstanding options to purchase common stock granted before April 19, 2004having an exercise price of $7.42 or more per share upon the surrender of 100%such options for cancellation. If all eligible options were tendered, theCompany would issue approximately 284,000 shares of restricted stock, whichwould vest in annual installments over three years and would cancel options topurchase approximately 1,276,000 shares of common stock. See Note 11, “SubsequentEvents”.

***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 determined by the board of directors. The purchaseplan, which is intended to qualify under Section 423 of the InternalRevenue Code, is administered by the board of directors or a committeeappointed 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.

On December 14, 2005, pursuant to authorizationby the Compensation Committee of the board of directors the Company announcedthat there would be no offering period from January 1, 2006 to June 30,2006 under the Company’s 2000 Employee Stock Purchase Plan (the “ESPP”). Thisaction avoids the recognition of stock-based compensation expense for sharespurchased under the ESPP under SFAS 123R, which took effect for the Company asof January 1, 2006.

Of the 600,000 sharesauthorized to be issued under the purchase plan, 365,000 shares remainedavailable for issuance at December 31, 2005. Employees purchased 66,000,66,000 and 55,000 shares in 2005, 2004 and 2003, respectively.

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***Deferred Stock-based Compensation Cost toEmployees***

During the year ended December 31, 2004, theCompany recorded deferred compensation cost of approximately $74,000, which isamortized to expense over 36 months. The 2004 deferred compensation costrepresents the intrinsic value of options granted to purchase shares of theCompany’s stock to newly appointed members of the Company’s board of directorsthat had an exercise price less than the fair market value of the Company’scommon stock on the date of the option grant. This deferred compensation costwill be amortized over the option vesting period of 36 months using the gradedvesting method. No deferred stock compensation cost was recorded in 2005 or2003.

During the years ended December 31, 2005, 2004and 2003, the Company recorded stock compensation expenses of $36,000, $68,000,and $459,000, respectively, of which $0, $50,000, and $211,000, respectively,was attributable to the excess of the fair market value of the Company’s commonstock over the price at which the Company granted stock options to employees.Stock compensation expenses in 2005, 2004 and 2003 also included $0, $13,000and $227,000, respectively, for amortization of deferred compensation costattributable to the fair market value of shares of the Company’s common stockissued to certain employees of ATMOS. In addition, the Company incurred $5,000of stock compensation expense in 2004 related to the issuance of options topurchase the Company’s stock to newly appointed members of the Company’s boardof directors that had an exercise price less than the fair market value of theCompany’s stock on the date of the option grant. The Company also incurred$21,000 of stock compensation expense in 2003 due to modification of theCompany’s 2000 employee stock option held by a former member of the Company’sboard 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 approximately 52% of the total award in thefirst year, 27% in the second year, 15% in the third year and 6% in the fourthyear.

***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 personor group, 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 the Company 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 

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thatcould otherwise result in stockholders receiving a premium over the market pricefor their shares of common stock.

***Stock Repurchase Plan***

On April 19, 2004,the Company announced that its board of directors authorized the repurchase ofup to $25 million of its common stock over the next 12 months. The Companyrepurchased approximately $4.7 million or 1.2 million shares of its commonstock in 2004 under that repurchase program. On April 29, 2005, theCompany’s board of directors authorized a new stock repurchase program for thepurchase of up to $20 million of the Company’s common stock over the next 12months.  No shares were repurchased underthe new stock repurchase program in 2005.

**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 $127,000, $110,000, and $107,000 in2005, 2004 and 2003, respectively.

**Note 9:Business Segments, 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 accountsreceivable. Cash, cash equivalents short-term and long term investments aredeposited with high 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,** | ** ** |
|---------------|------------|---------------------------------------------|------------|
| ** **    | ** ** | **2005**                                    | ** ** | **2004** | ** ** | **2003** | ** ** |
| North America |       | $                                           | 3,630      |   | $ | 4,602 |   | $ | 7,767 |   |
| Japan         |       | 7,636                                       |       | 4,609 |   | 7,146 |   |
| Asia          |       | 1,016                                       |       | 1,191 |   | 3,969 |   |
| Europe        |       | —                                      |       | 419 |   | 351 |   |
| Total         |       | $                                           | 12,282     |   | $ | 10,821 |   | $ | 19,233 |   |

 

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Customerswho accounted for at least 10% of total revenues were as follows:

| ** ** | ** ** | **Years Ended December 31,** | ** ** |
|------------|------------|---------------------------------------------|------------|
| ** ** | ** ** | **2005**                                    | ** ** | **2004** | ** ** | **2003** | ** ** |
| NEC        |       |                                        | 35         | % |   |   | 19 | % |   |   | 14 | % |   |
| Fujitsu    |       |                                        | 17         | % |   |   | 17 | % |   |   | — |   |   |
| Marvel     |       |                                        | —     |   |   |   | 11 | % |   |   | — |   |   |
| UMC        |       |                                        | —     |   |   |   | — |   |   |   | 11 | % |   |
| Sony       |       |                                        | —     |   |   |   | — |   |   |   | 17 | % |   |

 

Three customers accounted for 40%, 22% and 20% ofgross accounts receivable, respectively, at December 31, 2005. Threecustomers accounted for 46%, 17% and 11% of gross accounts receivable,respectively, at December 31, 2004. The Company performs ongoing creditevaluations of its customers’ financial condition and maintains an allowancefor uncollectible accounts receivable based upon the expected collectibility ofall accounts receivable. $105,000 was reserved in the allowance foruncollectible accounts receivable in 2005. No amounts were written off in 2004and 2003.

Netproperty, plant and equipment, classified by major geographic areas were asfollows at December 31, 2005 and 2004.

| ** ** | ** ** | **December 31,**   | ** ** |
|------------|------------|-------------------------|------------|
| ** ** | ** ** | **2005**                | ** ** | **2004** | ** ** |
| ** ** | ** ** | **(in thousands)** | ** ** |
| U.S.       |       | $                       | 1,075      |   | $ | 621 |   |
| Non-U.S.   |       | 46                      |       | 64 |   |
| Total      |       | $                       | 1,121      |   | $ | 685 |   |

 

**Note 10:Commitments and Contingencies**

TheCompany leases its facilities under non-cancelable operating leases that expirein 2006 through 2010. Rent expense was approximately $797,000, $1,157,000, and$1,143,000 for the years ended December 31, 2005, 2004 and 2003,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, 2005 are as follows (in thousands):

| **Year Ended December 31,** | ** ** | ** ** | ** ** | **Minimum Lease  Commitments** | ** ** | **Sublease Income** | ** ** | **Net Lease  Commitments** | ** ** |
|--------------------------------------------|------------|------------|------------|-------------------------------------|------------|--------------------------|------------|---------------------------------|------------|
| 2006                                       |       |       | $          | 870                                 |       |                     |       | $                               | 201        |   |   |   | $ | 669 |   |   |
| 2007                                       |       |       | 842        |                                |       |                     | 137        |                            |       |   | 705 |   |   |
| 2008                                       |       |       | 525        |                                |       |                     | 46         |                            |       |   | 479 |   |   |
| 2009                                       |       |       | 370        |                                |       |                     | —     |                            |       |   | 370 |   |   |
| 2010 and  thereafter                       |       |       | 189        |                                |       |                     | —     |                            |       |   | 189 |   |   |
| Total minimum payments                     |       |       | $          | 2,796                               |       |                     |       | $                               | 384        |   |   |   | $ | 2,412 |   |   |

 

In July 2005, one ofthe Company’s customers filed a claim concerning excess verification costsincurred by the customer in implementing a custom design for 1T-SRAM memorytechnology under a licensing contract. The claim was settled in December 2005with a net-down of $304,000 in accounts receivable and contingent liability.There was no contingent liability as of December 31, 2005, however, theCompany has given up the right to receive $71,000 in future royalties from thiscustomer, should they be earned.

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***Legal Matters***

On March 31, 2004, UniRAM Technology, Inc.filed a complaint against the Company in the United States District Court forthe Northern 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. The Company believes that UniRAM’scomplaint lacks merit and intends to vigorously defend against it. In October 2005,the court held a “Markman hearing” to construe and interpret the claims of thepatent which UniRAM continues to assert against the Company and TSMC. As yet,the court has not issued its claim construction order.

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.

**Note 11: Subsequent Events**

On December 14, 2005, pursuant to authorizationby the Compensation Committee of the board of directors, the Company commencedan offer of restricted shares of its common stock under the Amended 2000 Planto the United States employees holding outstanding options to purchase commonstock granted before April 19, 2004 having an exercise price of $7.42 ormore per share upon the surrender of such options for cancellation.

The offer expired at midnight, Pacific Time, onFriday, January 13, 2006. The eligible participants elected to surrenderfor cancellation an aggregate of approximately 318,054 shares of Company commonstock underlying eligible options and received an aggregate of approximately76,654 shares of restricted Company common stock. The value of the Company’scommon stock on the offer termination date was $5.91 per share. Upon the termsand subject to the conditions of the offer, the Company promptly issued to eligibleparticipants restricted shares of Company common stock. No executive officerselected to accept the offer.

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**Schedule II—Valuationand Qualifying Accounts(In thousands)**

| ** **                              | ** ** | ** ** | ** ** | **Additions**                                  | ** ** | **Deductions**                                | ** ** | ** **                           | ** ** |
|-----------------------------------------|------------|------------|------------|------------------------------------------------|------------|-----------------------------------------------|------------|--------------------------------------|------------|
| **Description**                         | ** ** | ** ** | ** ** | **Balance at  beginning of  period** | ** ** | **Charged to  costs and  expenses** | ** ** | **Charged to  other  accounts** | ** ** | **Amount  recovered  (written off)** | ** ** | **Balance at  end of  period** | ** ** |
| Year ended  December 31, 2005      |       |       |       |                                           |       |                                          |       |                                 |       |   |   |   |   |   |   |   |   |   |   |   |   |
| Allowance for  doubtful accounts        |       |       | $          | —                                         |       |                                          |       | $                                    | 105        |   |   |   | $ | — |   |   |   | $ | — |   |   |   | $ | 105 |   |   |
| Deferred tax  asset valuation allowance |       |       | $          | 10,782                                         |       |                                          |       | $                                    | —     |   |   |   | $ | 133 |   |   |   | $ | (3 | ) |   |   | $ | 10,912 |   |   |
| Year ended  December 31, 2004      |       |       |       |                                           |       |                                          |       |                                 |       |   |   |   |   |   |   |   |   |   |   |   |   |
| Allowance for  doubtful accounts        |       |       | $          | —                                         |       |                                          |       | $                                    | —     |   |   |   | $ | — |   |   |   | $ | — |   |   |   | $ | — |   |   |
| Year ended  December 31, 2003      |       |       |       |                                           |       |                                          |       |                                 |       |   |   |   |   |   |   |   |   |   |   |   |   |
| Allowance for  doubtful accounts        |       |       | $          | —                                         |       |                                          |       | $                                    | —     |   |   |   | $ | — |   |   |   | $ | — |   |   |   | $ | — |   |   |
|                                         |            |            |            |                                                |            |                                               |            |                                      |            |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |

 

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