**U.S. SECURITIES AND EXCHANGE COMMISSION**Washington,D.C. 20549

**FORM 10-KSB**

**(Mark One)**
| x      | **ANNUAL REPORT UNDER SECTION 13 OR 15(d) OF THE SECURITIES  EXCHANGE ACT OF 1934**     |
|--------|---------------------------------------------------------------------------------------------------|
|   | **For  the fiscal year ended October 2, 2004**                                               |
| o      | **TRANSITION REPORT UNDER SECTION 13 OR 15(d) OF THE  SECURITIES EXCHANGE ACT OF 1934** |

 

**Forthe transition period from             to             **

**CommissionFile No. 1-6635**

**InnovativeMicro Technology, Inc****.******(Name of smallbusiness issuer in its charter)
| **Delaware**  (State or other jurisdiction of incorporation or organization) |   | **95-1950506**(I.R.S. Employer Identification No.) |
|------------------------------------------------------------------------------|--------|----------------------------------------------------|

 

**75Robin Hill Road, Goleta, California 93117**(Address of principalexecutive offices) (Zip Code)

Issuer’s telephone number:**(805) 681-2800**

Securities registeredunder Section 12(b) of the Exchange Act: **None**

Securities registeredunder Section 12(g) of the Exchange Act:

**Common Stock, $.0001 par value**(Title of Class)

Check whether the issuer (1) filedall reports required to be filed by Section 13 or 15(d) of theExchange Act during the past 12 months (or for such shorter period thatthe registrant was required to file such reports), and (2) has beensubject to such filing requirements for the past 90 days. Yes o    No x

Check if there is no disclosure of delinquent filerspursuant to Item 405 of Regulation S-B contained in this form, and nodisclosure will be contained, to the best of the registrant’s knowledge, indefinitive proxy or information statements incorporated by reference in Part IIIof this Form 10-KSB or in any amendment to this Form 10-KSB. o

The issuer’s revenues forits most recently completed fiscal year were $10,114,000

There is no public marketfor the registrant’s Common Stock. As of November 27, 2004, the aggregatebook value of the registrant’s Common Stock held by non-affiliates was$5,183,000.

(ISSUERS INVOLVED INBANKRUPTCY PROCEEDINGS DURING THE PAST FIVE YEARS)

Check whether the issuerhas filed all documents and reports required to be filed by Sections 12, 13 or15(d) of the Exchange Act after the distribution of securities under aplan confirmed by a court. Yes x    No o

Asof December 27, 2004, there were 6,937,443 shares of the Company’s commonstock outstanding.

 

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**DOCUMENTS INCORPORATED BY REFERENCE**

Portions of the registrant’s definitive proxystatement relating to its 2004 annual meeting of stockholders, which will befiled with the Securities and Exchange Commission pursuant to Regulation 14Awithin 120 days of the close of the registrant’s last fiscal year, areincorporated by reference into Part III of this report.

*In this AnnualReport on Form 10-KSB, the words “believe,” “estimate,” “anticipate,” “expect,”“intend,” “plan” and similar expressions identify forward-looking statementswithin the meaning of Section 27A of the Securities Act of 1933, asamended, and Section 21E of the Securities Exchange Act of 1934, asamended. These forward-looking statements speak only as of the date hereof. Allof the forward-looking statements are based on estimates and assumptions madeby management of the Company, which, although believed to be reasonable, areinherently uncertain and difficult to predict. Therefore, undue reliance shouldnot be placed upon such estimates. Such statements are subject to certain risksand uncertainties inherent in the Company’s business that could cause actualresults to differ materially from those projected. These risks anduncertainties include, but are not limited to, those discussed under thecaption “Risk Factors Affecting the Company’s Business” and elsewhere in thisreport and our other documents filed with the SEC, and, the following: theCompany’s ability to make the transition to volume production of MEMS products;the Company’s history of losses and bankruptcy; changing technology;competition; the company’s ability to protect intellectual property;fluctuations in the Company’s quarterly and annual operating results; lack ofan active trading market; risks related to international transactions;environmental laws and regulations; supplies of raw materials; anti-takeoverprovisions of the Company’s charter and Delaware law; and general economic andpolitical uncertainty. The Company does not assume any obligation to update orcorrect forward-looking statements to reflect subsequent events or actualresults.*

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**PART I**

**ITEM 1. DESCRIPTION OF BUSINESS**

Innovative MicroTechnology, Inc (“the Company”) designs and manufactures MEMS devices. MEMS isan acronym for micro-electro-mechanical system. The Company’s headquarters islocated in Goleta, California.

**History**

The Company wasincorporated in California in 1957 and was reincorporated in Delaware in 1987under the name “Applied Magnetics Corporation.” The Company was an independentmanufacturer of head gimbal assemblies (“HGAs”) and head stack assemblies(which consist of multiple HGAs assembled together with other components) tothe disk drive industry. The Company filed for protection under Chapter 11 ofthe U.S. Bankruptcy code on January 7, 2000. The Company exited Chapter 11on November 16, 2001 under a court approved plan of reorganization (the “ReorganizationPlan”) and changed its name to Innovative Micro Technology, Inc.

**The Company’s MEMS Business**

The Company used the Chapter 11 reorganization processto reposition its operations in the MEMS business. MEMS devices were firstdeveloped in the late 1970s and early 1980s. MEMS devices are made using modernwafer-processing technology, similar to that used in making silicon electronicdevices or thin-film recording heads for magnetic storage devices. However,what distinguishes MEMS devices is that they include moving components, hencethe “mechanical” part of the name. By using wafer techniques, the performanceof mechanical systems can be enhanced due to their smaller size and/orcomplexity. MEMS devices can be manufactured at a lower cost due to the largenumber of devices that can be made on a single wafer.

Common uses for MEMSdevices are automotive air-bag sensors (accelerometers), pressure and airflowsensors, and ink­jet printer heads. Future uses for MEMS devices are expectedto be numerous, in that many small-scale mechanical systems such aselectromagnetic relays, which today are built using assembly techniques, couldbe made using MEMS. In addition, many electrical systems may be replaced byMEMS. An example of this is optical fiber switching, used in telecommunications.MEMS versions of these switches are now beginning to find their way into themarketplace. Another example is components for wireless communicationtechnology. High performance inductors, variable capacitors andtransmit/receive switches could be replaced by MEMS devices at lower cost,using less space and providing higher performance. The Company’s businessactivity is currently at the product development and low-volume prototype phaseof production. The Company fabricates MEMS products on a six-inch silicon waferwhich, depending upon the size of the individual part, is cut into multiplefinished parts referred to as dies.

**Other Lines of Business**

The Company’s three additional lines of businessare:  “Santa Barbara Tool & Die,”“IMT Analytical” and leasing of excess space in its owned facility underlong-term lease contracts.

Santa Barbara Tool & Die is a precisionmachining and tooling service that provides customers with prototyping, developmentand production tool and die manufacturing. Santa Barbara Tool & Die’stechnology permits high precision manufacturing of tooling, and theorganization features electron-discharge machining (EDM), which includes metalsand ceramics capabilities.

IMT Analytical is a precision semiconductor and MEMSanalysis service provider. IMT Analytical’s laboratory technology includeselectron microscopy in a variety of forms and a focused ion beam tool 

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which can precisely makethree-dimensional cuts in samples to reveal detailed information as todimension, material makeup, and material crystal properties.

Santa Barbara Tool &Die and IMT Analytical are both strategic parts of the core company in thattheir services are used to make the core business more competitive, and bothalso provide service to outside customers using the portion of their capacitythat is excess to that required by the Company. In addition, the Company hasapproximately 51,000 square feet of building space available to lease. As of October 2,2004, approximately 34,000 square feet were under long term lease arrangementswith annual rental income of approximately $0.5 million.

**Employees**

Highly trainedengineers and technicians maintain and operate the sophisticated equipment usedin the fabrication of MEMS devices. Most of these individuals play a dual rolein operations as well as in process development. The employees cover thefollowing technical areas:

·       photolithography,including resist application, resist development, and patterned exposure;

·       deposition,including sputtering, ion beam deposition, plating;

·       etching,including wet-etching and dry (vacuum) processing;

·       planarization,including chemical-mechanical polishing;

·       waferslicing;

·       assembly,including die bonding, electrical bonding, precision alignment; and

·       testing,including mechanical and electrical testing.

The Santa Barbara Tool & Die employees haveextensive tool and die experience and the IMT Analytical employees are trainedto operate sophisticated analytical tools.

As of October 2,2004, the Company had 72 employees at its headquarters in Goleta, California.

**Technology**

The Company has three main forms of technology:manufacturing, design, and service.

The manufacturing technology encompassesphotolithography, material deposition, and material removal, which are theessential methods of producing integrated wafers. Additional manufacturingtechnology includes wafer bonding, assembly and testing procedures, includingprecision alignment and assembly, ceramic bonding, wire attachment, and testingalgorithms. The Company’s techniques in this area have been developed overseveral years of manufacturing.

Design technology the Company possesses comes fromyears of recording head manufacturing experience, which afforded the Company specialskills in the art of making magnetic materials and finding uses for them. Tothat end, some of the Company’s intended products surround magnetic MEMSdevices. Specifically, the Company has skill and experience with generatinghigh magnetic fields efficiently using thin-film coils coupled with highsaturation magnetization materials capable of carrying magnetic flux. Coupledwith MEMS concepts, this allows the Company to design and manufacture magneticactuators of various types.

The Company’s servicetechnology comes in the form of the specialized tool fabrication businessoffered by Santa Barbara Tool & Die and the specialized test servicesoffered by IMT Analytical (See—OtherLines of Business).

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**Intellectual Property**

The Company regards elements of its manufacturingprocesses, product designs and equipment as proprietary and seeks to protectits proprietary rights through a combination of employee and third partynondisclosure agreements, internal procedures and patent protection. TheCompany has filed ten patent applications with the United States Patent Officesince January 2000, and more are in preparation for the MEMS business. Seven of these patents have beenissued by the U.S. Patent Office to the Company.

The Company believes that its success depends on theinnovative skills and technological competence of its employees and upon properprotection of its intellectual properties. The Company has, from time to time,been notified of claims that it may be infringing patents owned by others. Ifit appears necessary or desirable, the Company may seek licenses under patentsthat it is allegedly infringing. Although patent holders commonly offer suchlicenses, no assurance can be given that licenses will be offered or that theterms of any offered licenses will be acceptable to the Company. The failure toobtain a key patent license from a third party could cause the Company to incursubstantial liabilities or to suspend the manufacture of the products using thepatented invention.

The Company may face costly damages or litigationcosts if a third party claims that the Company infringed on its intellectualproperty. Advanced technology products such as the Company’s are increasingly subject tothird-party infringement claims. In addition, former employers of the Company’scurrent and future employees may assert that its employees have disclosedconfidential or proprietary information to the Company. Any of these claimseven if they are without merit, could be expensive and time consuming todefend.

Inaddition, intellectual property claims against the Company, with or withoutmerit, could require it to enter into royalty or licensing agreements. Theseroyalty or licensing agreements, if required, may not be available on termsacceptable to the Company or atall, which could seriously harm its business. A successful claim ofinfringement against the Company or its failure or inability to license theinfringed or similar technology could adversely affect its business because theCompany would not be ableto sell the affected product without redeveloping the product or itsmanufacturing process, incurring significant additional expenses.

**Vendors**

The Company purchasesmaterials from a variety of vendors, including providers of manufacturingsupplies, office supplies, and raw materials. The Company is not solelydependent on any of its vendors, and in the majority of the cases there is ageneral market for the required products.

**Industry Segments**

The Company analyzes its businessresults based on its four lines of business: MEMS, Santa Barbara Tool & Die, IMT Analytical and RentalIncome. The following table shows the percentages of revenue from each segmentduring both fiscal 2004 and fiscal 2003. 

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**Revenue by Segment**
| ** **                         | ** ** | **For the Periods:**                       | ** ** |
|------------------------------------|------------|------------------------------------------------------|------------|
| ** **                         | ** ** | **Year Ended  October 2,  2004**           | ** ** | **Year Ended  September 27,  2003** | ** ** |
| ** **                         | ** ** | **(As a percentage of revenue)** | ** ** |
| MEMS                               |       |                                                 | 82         | % |   |   | 74 | % |   |
| Santa Barbara  Tool & Die |       |                                                 | 12         | % |   |   | 14 | % |   |
| IMT Analytical                     |       |                                                 | 1          | % |   |   | 3 | % |   |
| Rental Income                      |       |                                                 | 5          | % |   |   | 9 | % |   |
| Total                              |       |                                                 | 100        | % |   |   | 100 | % |   |

 

**Customers**

The Company’s customers are in four categoriesrepresenting its four business segments: MEMS and wafer customers, machine shoptool and die customers, tenants of excess building space and analytical labservice customers.

The MEMS business customers are in the inertialnavigation, telecommunication, RF wireless, and the biomedical industries.Inertial navigation MEMS refers to MEMS gyroscopes and accelerometers. TheCompany is a subcontractor to L-3 Communications Corporation (“L-3”)for a long-term government contract to produce gyroscopes and accelerometersfor use in inertial navigation. The Company completed an equity financingtransaction with L-3 on September 3, 2003 for $2.5 million in cash(see Note 8 to the financial statements—FinancingTransaction). In addition, L-3 exercised warrants to purchase 167,000shares of the common stock of the Company at a price of $5.35 per share for atotal value of $0.9 million on October 31, 2003 (see Note 8 to the accompanyingfinancial statements—FinancingTransaction). Biomedical MEMS includes the Company’s assistance agreement fromthe U.S. Defense Advanced Research Project Agency (“DARPA”) for prototypedevelopment for rapid and efficient isolation of human hematopoietic stem cellsfor medical and defense applications. The Company leases approximately 34,000square feet of excess space within its owned facility to tenants underlong-term contracts, of which OCCAM Networks, Inc., an unrelated party,leases approximately 31,000 square feet. The Company’s revenue with Marubeniwas for the development of a telecommunications optical switch, which wascompleted in the second quarter of fiscal 2004. The Company’s revenue withGalaxy Scientific Corp. was funded by a contract from the U.S. Army to supportthe development of the inertial navigation device that the Company isdeveloping for L-3. The Galaxy contract was completed in the firstquarter of fiscal 2004. The Company’s business with Turnstone Systems, Inc.(“Turnstone”) was for the development of an electrostatic relay array used inthe telephone industry. This business ceased when Turnstone filed fordissolution on December 4, 2003. The Company currently has contracts withcustomers in the RF wireless industry, which includes RF switching andphase-shifting electronics. The Company’s revenue by significant customer forboth fiscal 2004 and fiscal 2003 are displayed on the following chart.

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**Revenue by Customer**
| ** **                  | ** ** | **For the Periods:**                       | ** ** |
|-----------------------------|------------|------------------------------------------------------|------------|
| ** **                  | ** ** | **Year Ended  October 2,  2004**           | ** ** | **Year Ended  September 27,  2003** | ** ** |
| ** **                  | ** ** | **(As a percentage of revenue)** | ** ** |
| L-3                         |       |                                                 | 40         | % |   |   | 0 | % |   |
| DARPA assistance  agreement |       |                                                 | 11         | % |   |   | 11 | % |   |
| OCCAM  Networks, Inc.  |       |                                                 | 5          | % |   |   | 9 | % |   |
| Marubeni  Solutions         |       |                                                 | 4          | % |   |   | 13 | % |   |
| Galaxy Scientific           |       |                                                 | 1          | % |   |   | 14 | % |   |
| Spectra                     |       |                                                 | 1          | % |   |   | 9 | % |   |
| Turnstone Systems           |       |                                                 | 0          | % |   |   | 12 | % |   |
| All Others                  |       |                                                 | 38         | % |   |   | 32 | % |   |
| Total                       |       |                                                 | 100        | % |   |   | 100 | % |   |

 

The Company’s products and services are sold in theUnited States, Canada and Japan by its direct sales personnel.

**Government Approval**

The Company is asubcontractor to DARPA and L-3 in certain long-term contracts of L-3 with theU.S. Army to produce gyroscopes and accelerometers for use in inertialnavigation. The Company’s status as a subcontractor, and the products itproduces in that capacity, are subject to substantial government regulation andcontinuing agency approval.

**Competition**

The Company competes with other independent MEMSmanufacturers. They are generally private entities, and information about theirfinancial status is unavailable to the Company. The names of some of thesefirms are Micralyne, Colibrys, Applied MEMS, Tronics, XFab and Issys. Some ofthese companies operate wafer fabrication (“wafer fab”) facilities using afour-inch diameter wafer compared to the six-inch format used by the Company.The larger wafer used by the Company has approximately twice the physicaluseable area, which provides approximately twice as many die per wafer comparedto the smaller four-inch wafer. This feature provides the Company with certaincost advantages.

The Company also competes with large integratedcircuit manufacturers with six-inch wafer fab facilities. These firms includeHoneywell, Dalsa, Analog Devices, Texas Instruments and Motorola. Thesecompetitors are all significantly larger than the Company with greaterfinancial, technical and marketing resources than the Company. In some cases,these firms operate wafer fabs based on Complimentary Metal Oxide Semiconductor(“CMOS”) technology which limits their use compared to the Company’s equipmentcapabilities.

The Company also competes with captive wafer fabsowned by vertically integrated MEMS users. These include: Intellisense, ownedby Corning, Inc., which recently closed its fab; and Cronos, owned byMemscap S. A. These firms are primarily focused on producing products for theirrespective parents, but they also service external customers.

The principal competitivefactors in the Company’s markets are price, product performance, quality,product availability and responsiveness to customers and technologicalsophistication. See “Customers.”

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**Environmental Compliance**

The Company uses hazardous chemicals in itsmanufacturing and is subject to a variety of environmental and land useregulations related to their use, storage and disposal. If the Company fails tocomply with present or future regulations, liability for the cost ofremediation, damages or penalties, and production suspension or delay couldresult. In addition, environmental or land use regulations could restrict theCompany’s ability to expand its current production facilities or establishadditional facilities in other locations, or could require the Company toacquire costly equipment, or to incur other significant expenses for compliancewith environmental regulations or to clean up prior discharges.

The Company has been subject to regulatory and legalproceedings related to past environmental contamination, and other similarproceedings could arise in the future. In fiscal 2002, the Company was advisedby the U.S. Environmental Protection Agency that it may be required to pay forpart of the remediation of a solvent and refrigerant recycling and treatmentfacility formerly operated by the Omega Chemical Company in Whittier,California. The EPA alleges that the Company provided solvent and refrigerantwaste to this facility for recycling and disposal. The Company is stillexploring legal defenses, including defenses arising out of the bankruptcyproceedings. At this time, the Company intends to defend this matter vigorously.If these legal defenses are unsuccessful, the Company could be required to payan amount of less than $0.1 million. The Company is also remediating andmonitoring ground water contaminated with volatile organic compounds (“VOCs”)at a former site leased by the Company in Goleta, California under an order ofthe California Regional Water Quality Control Board (“CRWQCB”). VOCcontamination at the site has been reduced and the Company does not expectfuture expenditures related to the site to be material.

In fiscal 2003, the Company sold its Hollisterfacility. The environmental testing performed by the Company in support of thissale determined that the soil showed no metal or VOC contamination. However,ground water samples showed low levels of VOC contamination. The CRWQCBrequired the Company to install one monitoring well, and test results confirmedthe low level VOC concentration. The Company has been asked by the CRWQCB tosubmit semi-annual sample results from its well. One property adjacent to theCompany is conducting a remediation project on its site for this same VOC andthe CRWQCB required this property to place monitoring wells between the twoproperties. Their testing detected the presence of breakdown products of thesame VOC. The owners of the adjacent property have been asked to conductsemi-annual sampling of the wells. A second property adjacent to the Company isconducting site characterization under the guidance of the CRWQCB related tothe same VOC found on the Company’s site. In the fourth fiscal quarter of 2004,the CRWQCB issued a letter to the Company indicating that their investigationof the adjacent properties led them to the conclusion that the VOC present onthe Company’s site was the Company’s responsibility. The CRWQCB has requestedthat the Company continue to submit results from the semi-annual monitoring ofits well. The Company is unable to make a determination of potential futurecosts for this situation. The Company has a $5.0 million environmentalinsurance policy covering potential liability relating to this property. TheCompany’s accumulated cost to date for these matters related to the Hollisterfacility has been less than $0.1 million.

The Company believes itconducts its business in a manner that complies with environmental laws andregulations. While the Company’s known environmental liabilities have largelybeen resolved and are not, either individually or taken together, material toits business and financial condition, there can be no assurance that materialenvironmental claims will not arise in the future. If such claims arise, theycould be extremely expensive to contest or to resolve if the Company is foundresponsible and does not have applicable insurance coverage, which would resultin material harm to its business.

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**ExecutiveOfficers of the Registrant**

Thefollowing table sets forth information as to the name, age, and office(s) heldby each executive officer of the Company as of December 15, 2004:
| **Name**                 | ** ** | ** ** | ** ** | **Age**                                                      | ** ** | **Position or Office** | ** ** |
|--------------------------|------------|------------|------------|--------------------------------------------------------------|------------|------------------------|------------|
| Dr. John S.  Foster |       | 46         |       | Chief  Executive Officer and Chairman of the Board           |       |
| Peter T. Altavilla       |       | 51         |       | Chief Financial Officer,  Corporate Controller and Secretary |       |

 

Dr. John S. Foster hasover 17 years of experience in technology and operations management. He joinedthe Company in 1993. He has held a variety of senior management positionsincluding two years as the Company’s Managing Director of its former operationin Penang, Malaysia and as the Vice President of Worldwide Operations.Dr. Foster holds a doctorate in Applied Physics from Stanford University. Hewas elected to the position of Chief Executive Officer of the Company on November 16,2001 and to the position of Chairman of the Board on November 19, 2001.

Peter T. Altavilla hasbeen employed by the Company since 1987. He served as Assistant Controlleruntil August 1, 1994, when he was elected to the position of CorporateController. Mr. Altavilla was elected Secretary on February 9, 1996. Hewas elected to the position of Chief Financial Officer of the Company on November 16,2001.

**ITEM 2. DESCRIPTION OF PROPERTY.**

The Company owns its headquarters, office, plant andwarehouse in Goleta, California. The facility, used for marketing,manufacturing and engineering, is 130,000 square feet, and includes a 30,000square foot wafer fabrication plant.

The Company believes itsexisting manufacturing facilities are adequate to support customer requirementsduring fiscal 2005.

**ITEM 3. LEGAL PROCEEDINGS**

The Company is involved in ongoing complianceactivities with local environmental agencies. See “Item 1—Descriptionof Business—EnvironmentalCompliance.”

A neighbor of the Company’sformer 6300 Hollister facility filed an environmental related complaint againstthe Company and several other neighboring properties in August 2004. Theclaim stems from environmental monitoring activity that the claimant was causedto perform by the California Regional Water Quality Control Board (RWQCB). Thecomplaint is in defense of claims against it in order to avoid or minimize itsalleged liability associated with responding to soil and groundwatercontamination orders from the California Regional Water Quality Control Board.The Company has a $5.0 million environmental insurance policy coveringpotential liability relating to this property, including legal defense.

**ITEM4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS**

**None**

**PART II**

**ITEM 5. MARKET FOR COMMON EQUITY, RELATED STOCKHOLDERMATTERS AND SMALL BUSINESS ISSUER PURCHASES OF EQUITY SECURITIES.**

The Company’s Common Stock is not traded on anyexchange or quoted on NASDAQ.

As of December 13, 2004, there were approximately983 holders of record of the Company’s Common Stock.

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The Company has not paiddividends in the last two fiscal years. Because the Company is not yetprofitable and because it intends to reinvest any earnings in the expansion ofits business, the Company does not expect to pay dividends on its Common Stockfor the foreseeable future.

**RecentSales of Unregistered Securities**

On September 30, 2003, the Company reached asettlement with the holders of its Professional Notes, who had providedprofessional services to the Company during its Chapter 11 reorganizationand received convertible promissory notes (“Professional Notes”) evidencing theCompany’s indebtedness for those services. As partial consideration for thecancellation of the Professional Notes, the Company issued 368,113 shares ofCommon Stock, 18-month warrants for the purchase of a total of 16,437 shares ofCommon Stock at a price of $5.35 per share, which will expire on March 30,2005, and three-year warrants for the purchase of a total of 68,777 shares ofCommon Stock at a purchase price of $7.29 per share, which will expire on September 30,2006. Of these securities, 276,287 shares of Common Stock were issued pursuantto the exemption from registration under the Securities Act under Section 1145(a) ofthe Bankruptcy Code for the sale of securities by a debtor under a plan ofreorganization in exchange for a claim against or interest in the debtor,including a claim for administrative expense in the bankruptcy case. Of theCommon Stock and the warrants described in this paragraph, 91,826 shares weresold pursuant to the exemption from registration available under Section 4(2) ofthe Securities Act for transactions by an issuer not involving any publicoffering.

On October 31, 2003, the Company sold 167,000shares of Common Stock to L-3 at a price of $5.35 per share, upon L-3’sexercise of an 18-month warrant that it had purchased on August 1, 2003. Theshares were sold pursuant to the exemption from registration available under Section 4(2) ofthe Securities Act for transactions by an issuer not involving any publicoffering.

No underwriter or agent was involved in any of theabove transactions.

On January 25,2005, subsequent to the end of the fiscal year, the Company privately soldequity securities sold to an investor group made up of Investor Growth CapitalLimited, BA Venture Partners and Miramar Venture Partners (“Investor Group”)The Investor Group invested a total of $17.0 million in the Company in exchangefor 1,000,000 shares of redeemable preferred stock, 1,000,000 shares ofconvertible preferred stock and a warrant for the purchase of up to 500,000shares of common stock. The net proceeds to the Company were approximately$16.0 million. The Company plans to use approximately $1.6 million of the netproceeds to pay off the Note due to L-3. The remainder of the net proceeds willbe used for general working capital needs and other corporate purposes.

W.R. Hambrecht & Co. advised the Company inarranging the above transaction.

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**ITEM6. MANAGEMENT’S DISCUSSION AND ANALYSIS OR PLAN OF OPERATION**

**Selected Financial Data**

Thefollowing selected financial data should be read in conjunction with theFinancial Statements provided in this report and with Management’s Discussionand Analysis of Financial Condition and Results of Operations.
| ** **                                                                   | ** ** | **Year Ended  October 2,  2004**                                                 | ** ** | **Year Ended  September 27,  2003** | ** ** |
|------------------------------------------------------------------------------|------------|--------------------------------------------------------------------------------------------|------------|-----------------------------------------------|------------|
| ** **                                                                   | ** ** | **(In thousands, except per  share and employment amounts)** | ** ** |
| **OPERATIONS**                                                               |       |                                                                                       |       |                                          |       |   |   |   |   |
| Net revenue                                                                  |       |                                                                                       | $          | 10,114                                        |       |   |   | $ | 5,531 |   |   |
| Net loss                                                                     |       |                                                                                       | $          | (4,264                                        | )          |   |   | $ | (5,524 | ) |   |
| Loss per common share—basic and diluted                                 |       |                                                                                       | $          | (.62                                          | )          |   |   | $ | (.97 | ) |   |
| Weighted average number of common shares outstanding—basic  and diluted |       |                                                                                       | 6,888      |                                          |       |   | 5,684 |   |   |
| **BALANCE  SHEET**                                                           |       |                                                                                       |       |                                          |       |   |   |   |   |
| Working capital  deficit                                                     |       |                                                                                       | $          | (2,746                                        | )          |   |   | $ | (802 | ) |   |
| Total assets                                                                 |       |                                                                                       | 19,499     |                                          |       |   | 22,573 |   |   |
| Long term debt                                                               |       |                                                                                       | 9,112      |                                          |       |   | 12,057 |   |   |
| Shareholders’  equity                                                   |       |                                                                                       | 5,524      |                                          |       |   | 5,777 |   |   |
| **OTHER  DATA**                                                              |       |                                                                                       |       |                                          |       |   |   |   |   |
| Period-end employment                                                        |       |                                                                                       | 72         |                                          |       |   | 65 |   |   |

 

The following discussionshould be read together with the financial statements and related notesincluded elsewhere in this Annual Report on Form 10-KSB. This discussioncontains forward-looking statements that involve risks and uncertainties.Actual results could differ materially from those anticipated in theseforward-looking statements as a result of various factors, including thosedescribed under “Risk Factors Affecting Our Business” and elsewhere in thisreport.

**Overview**

The Company has incurred net losses and losses fromoperations for each quarter since 1999. The Company filed for protection underChapter 11 of the U.S. Bankruptcy Code in January 2000 and, on emergencefrom bankruptcy, all of the previously issued and outstanding common stock wascanceled without consideration to the holders. The Company has incurred substantialcumulative losses since its emergence from bankruptcy including a net loss of $4.3 million for thefiscal year ended October 2, 2004. The Company expects toincur increasing sales and marketing, research and development and general andadministrative expenses. As a result, it will need to significantly increaseits revenues to achieve and sustain profitability. In order to fund that growth, on January 25,2005, subsequent to the end of the fiscal year, the Investor Group invested atotal of $17.0 million in the Company in a private placement of equitysecurities. The net proceeds to the Company were approximately $16.0 million.In exchange for the investment, the Investor Group received 1,000,000 shares ofredeemable preferred stock, 1,000,000 shares of convertible preferred stock anda warrant for the purchase of up to 500,000 shares of common stock. The Companyplans to use approximately $1.6 million of the net proceeds to pay off the Notedue to L-3. The remainder of the net proceeds will be used for general workingcapital needs.

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The Company has reorganized itself from a manufacturerof magnetic recording heads for the disk drive industry to a manufacturer ofmicro-electro-mechanical systems (“MEMS”) operating in a number of industrysegments. MEMS deviceswere first developed in the late 1970s and early 1980s. Generally speaking,MEMS devices are made using modern wafer-processing technology, similar to thatused in making silicon electronic devices or thin-film recording heads formagnetic storage devices. However, what distinguishes MEMS devices is that theyare designed to include moving parts, hence the “mechanical” part of the name.By using modern wafer techniques, device complexity and performance isenhanced, and cost is lowered owing to the large number of devices that can bemade on a single wafer.

Common uses for MEMS devices are automotive air-bagsensors (accelerometers), pressure and airflow sensors, and ink­jet printerheads. Future uses for MEMS devices are expected to be numerous, in that manymechanical systems currently built using conventional techniques could bereplaced and improved with MEMS. Examples of this include electromagneticrelays. In addition, many electrical systems may be replaced by MEMS. Anexample of this is optical fiber switching, used in telecommunications. In thefuture, it is possible that it can be done mechanically using MEMS. Anotherexample is components for wireless communication technology. High-Q inductors,variable capacitors and transmit/receive switches could be replaced by MEMSdevices at lower cost, using less space and providing higher performance. TheCompany fabricates MEMS products on a six-inch silicon wafer, which, dependingupon the size of the individual part, is cut into multiple finished parts referredto as dies.

The Company’s threeadditional lines of business are:  “SantaBarbara Tool & Die,” “IMT Analytical” and leasing of excess space inits owned facility under long-term lease contracts (see Item 1—Descriptionof Business—OtherLines of Business).

**Annual Results of Operations**

Thefollowing table sets forth certain financial data for the Company for the lasttwo fiscal years and provides a presentation of this information as apercentage of net revenue.
| ** **                                | ** ** | **Year Ended:  October 2, 2004**            | ** ** | **Year Ended:  September 27, 2003** | ** ** |
|-------------------------------------------|------------|------------------------------------------------------------|------------|----------------------------------------------------|------------|
| ** **                                | ** ** | **% of Revenue**                                 | ** ** | **% of Revenue**                         | ** ** |
| ** **                                | ** ** | **(in thousands except % of revenue)** | ** ** |                                               |
| Net revenue                               |       |                                                       |       |                                               |       |   |   |   |   |   |   |   |   |   |   |   |
| MEMS and other                            |       |                                                       | $          | 9,579                                              |       |   |   | 94.7 | % |   |   | $ | 5,013 |   |   | 90.6 | % |   |
| Rental income                             |       |                                                       | 535        |                                               |       |   | 5.3 | % |   |   | 518 |   |   | 9.4 | % |   |
| Total                                     |       |                                                       | 10,114     |                                               |       |   | 100.0 | % |   |   | 5,531 |   |   | 100.0 | % |   |
| Cost of revenue                           |       |                                                       |       |                                               |       |   |   |   |   |   |   |   |   |   |   |   |
| MEMS and other                            |       |                                                       | 10,858     |                                               |       |   | 107.4 | % |   |   | 6,140 |   |   | 111.0 | % |   |
| Rental income                             |       |                                                       | 135        |                                               |       |   | 1.3 | % |   |   | 152 |   |   | 2.8 | % |   |
| Total                                     |       |                                                       | 10,993     |                                               |       |   | 108.7 | % |   |   | 6,292 |   |   | 113.8 | % |   |
| Gross loss                                |       |                                                       | (879       | )                                                  |       |   | (8.7 | )% |   |   | (761 | ) |   | (13.8 | )% |   |
| Research and development                  |       |                                                       | 530        |                                               |       |   | 5.2 | % |   |   | 939 |   |   | 17.0 | % |   |
| Selling, general and administrative       |       |                                                       | 1,790      |                                               |       |   | 17.7 | % |   |   | 2,447 |   |   | 44.2 | % |   |
| Gain on building sale                     |       |                                                       | —     |                                               |       |   | 0.0 | % |   |   | (623 | ) |   | (11.3 | )% |   |
| Loss from operations                      |       |                                                       | (3,199     | )                                                  |       |   | (31.6 | )% |   |   | (3,524 | ) |   | (63.7 | )% |   |
| Interest income                           |       |                                                       | 4          |                                               |       |   | 0.0 | % |   |   | 15 |   |   | 0.3 | % |   |
| Interest expense                          |       |                                                       | (1,159     | )                                                  |       |   | (11.5 | )% |   |   | (2,021 | ) |   | (36.6 | )% |   |
| Other income, net                         |       |                                                       | 103        |                                               |       |   | 1.0 | % |   |   | 42 |   |   | 0.8 | % |   |
| Other expense                             |       |                                                       | (1,052     | )                                                  |       |   | (10.5 | )% |   |   | (1,964 | ) |   | (35.5 | )% |   |
| Loss from operations  before income taxes |       |                                                       | (4,251     | )                                                  |       |   | (42.1 | )% |   |   | (5,488 | ) |   | (99.2 | )% |   |
| Provision for income  taxes               |       |                                                       | 13         |                                               |       |   | 0.1 | % |   |   | 36 |   |   | 0.7 | % |   |
| Net loss                                  |       |                                                       | $          | (4,264                                             | )          |   |   | (42.2 | )% |   |   | $ | (5,524 | ) |   | (99.9 | )% |   |
|                                           |            |                                                            |            |                                                    |            |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |

 

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**NetRevenue:****  **Netrevenue increased to $10.1 million in fiscal 2004 compared to net revenue of$5.5 million in fiscal 2003. The revenue increase was due to growth in revenuefor the MEMS portion of the business and an increase in revenue for SantaBarbara Tool & Die. The MEMS portion of the business had revenue of$8.3 million and $4.1 million for fiscal 2004 and 2003, respectively. TheCompany has added new customers through its marketing efforts and is beginningto see a resulting growth in revenue. Santa Barbara Tool & Die revenueincreased to $1.2 million in fiscal 2004, compared to $0.7 million in fiscal2003. IMT Analytical had revenue of $0.1 million and $0.2 million in fiscal2004 and fiscal 2003, respectively. The leasing of excess space generated $0.5million in revenue in fiscal 2004 and $0.5 million for fiscal 2003. The Companyexpects its revenue to continue to grow, but it is uncertain whether thecurrent rate of growth is indicative of the future growth rate.

**GrossLoss:****  **Grossloss, which is the amount by which costs of revenue exceeded revenue, was $0.9million or 8.7% of revenue for fiscal 2004 compared to $0.8 million or 13.8% ofrevenue for fiscal 2003. As the Company migrates toward highvolume production it expects to be able to increase the absorption of its fixed costs  (eg, depreciation, utilities). TheMEMS portion of the business had a gross loss of $1.6 million or a negative18.8% in fiscal 2004 and a $1.3 million gross loss or a negative 31.0% infiscal 2003. The MEMS gross loss in fiscal 2003 included $0.4 million inamortization of employee stock incentives. Santa Barbara Tool & Diehad a $0.2 million gross profit in fiscal 2004 compared to $0.1 million infiscal 2003. IMT Analytical generated a $0.1million gross profit infiscal 2004 and a minimal gross profit infiscal 2003. The leasing of space to third party tenants provided a grossprofit of $0.4 million in both fiscal 2004 and fiscal 2003. The Company hadsixty-one production employees at the end of fiscal 2004, compared tofifty-four at the end of fiscal 2003.

**Researchand Development:****  **Researchand development expenses (“R&D”) were $0.5 million in fiscal 2004 comparedto $0.9 million in fiscal 2003. The fiscal 2003 amount includes $0.3 million inamortization of employee stock incentives. The R&D expenses represented5.2% and 17.0% of net revenue in fiscal 2004 and 2003, respectively.

R&D expenditures for the Company focus ondevelopment of new MEMS devices and the associated production processes for thetelecommunication, inertial navigation, wireless communication, and thebiomedical product areas. R&D expenditures are expected to grow as theCompany continues to diversify into new product areas. The Company had fouremployees focused on the development of new products and manufacturingprocesses at the end of fiscal 2004, which is the same headcount as in fiscal2003.

**Selling,General and Administrative Expenses:****  **Selling, general and administrative (“SG&A”)expenses were $1.8 million and $2.4 million in fiscal 2004 and 2003,respectively. The fiscal 2003 amount included $0.1 million of property tax,insurance and utility expense related to the Hollister property which theCompany sold in the second fiscal quarter of 2003. SG&A expenses included$0.1 million and $0.6 million in amortization of employee stock incentives infiscal 2004 and 2003, respectively.

The decrease in SG&A expenses from fiscal 2003 tofiscal 2004 was due to the $0.5 million decrease in the amount of theamortization of the employee stock incentives between the two periods. Thetotal S,G&A expenses decreased as a percentage of revenue from 44.2% to17.7% respectively, for such periods. The Company currently has seven employeesproviding the services reported as SG&A which is the same as reported forfiscal 2003.

**InterestExpense:****  **Interestexpense was $1.2 million and $2.0 million in fiscal 2004 and 2003, respectively.The Company sold its Hollister facility in the second fiscal quarter of 2003and paid off its mortgage. The reduction in interest expense due to themortgage payoff is approximately $0.4 million. In the first fiscal quarter of2004, the Company completed the negotiations for the payoff of its ProfessionalNotes, which cancelled notes with an annual interest expense of approximately$0.4 million.

**Other income.****  **The Company****recognized$0.1 million in other income in fiscal 2004 from the final payment associatedwith the sale of a minority ownership position in Magnetic Data Technologies,LLC, a 

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former subsidiaryof the Company compared to $0.7 million associated with the sale of itsHollister property and other miscellaneous income for fiscal 2003.

**Provision for IncomeTaxes:****  **The****fiscal 2004 and 2003 provision for income taxes includedminimum state income taxes.

Due to the change incontrol as a result of the bankruptcy, the Company may not be able to receivethe full benefit from net operating loss carryforwards accumulated prior to thebankruptcy. Portions of the Company’s pre-bankruptcy tax losses, however, maybe eligible for use in future periods. The Company is currently evaluatingthese amounts. From the commencement of the Chapter 11 Reorganization through October 2,2004, the Company has accumulated net operating loss carryforwards ofapproximately $32.2 million for federal tax purposes and $16.1 million forstate tax purposes. Once the Company has utilized these remaining net operatingloss carry forwards, future U.S. earnings will be taxed at the U.S. statutoryrates less available tax credits, if any. To the extent not used, the netoperating loss carryforwards expire in varying amounts beginningin 2021 for federal purposes and2011 for state purposes. At October 2,2004, all identified deferred tax assets are offset by a valuation allowancedue to the uncertainty of future realization of those additional operating losscarryforwards; therefore, recognizing any additional operating losscarryforwards would not result in a benefit in the provision for income taxes.

If future taxable incomeenables the Company to realize its deferred tax assets, the valuation allowancewill be reversed in whole or in part, and the Company will recognize an incometax benefit.

**Backlog andBillings**

As of October 2,2004, the Company had $2.9 million in sales order backlog and $4.1 million inbillings on uncompleted contracts. These amounts are substantially related tocontracts the Company has with L-3 and DARPA. The Company’s development projectwith DARPA had $0.9 million in billings and $0.8 million in capitalized costsresulting in $0.1 million in billings in excess of costs. The Company’sdevelopment project with L-3 had $1.6 million in billings and $0.9 million incapitalized costs resulting in $0.7 million in billings in excess of costs. TheCompany expects to complete the L-3 contract for a value of $1.6 million in itsfirst fiscal quarter of 2005. The Company presents the billings in excess ofcosts on uncompleted contracts as a net figure in accordance with ARB45.

**Liquidity andCapital Resources**

The Company’s principal funding need is for workingcapital to fund continuing operations, research and development and expansionof the business. The Company expects to meet the needs for liquidity duringfiscal 2005 with funds from operations and the proceeds of the sale of equitysecurities completed on January 25, 2005. The Company’s ability togenerate revenue from operations in the future will depend heavily on itsability to achieve volume production of its MEMS products on a timely basis.Although the Company is devoting substantial engineering and manufacturingresources to its production goals, there can be no assurances that the Companywill achieve planned production levels. Accordingly, in the future  the Company may need to obtain additionalfunds for operations by the sale of equity securities or borrowing, but it cangive no assurance that debt or equity financing will be available on terms thatare acceptable to the Company, or at all.

The Company’s cash balancewas $0.4 million at October 2, 2004 compared to $2.5 million at September 27,2003. The decrease in cash was primarily due to the net use of cash byoperations of $1.8 million and the use of $0.2 million to pay  downits property tax debt. OnSeptember 30, 2003, the Company used $2.4 million in cash as part of theagreement to cancel its Professional Notes. The Company also issued 368,113shares of Common Stock, 16,437 warrants for the purchase of Common Stock at aprice of $5.35 and 68,777 warrants for the purchase of Common Stock at a price of$7.29 to these note holders. This transaction cancelled $5.1 million in notesand accrued interest. The Company received an additional equity investment of$0.9 million from L-3 on October 31, 2003, when L-3 exercised warrants topurchase 

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167,000 shares of Common Stock that it had receivedas part of its August 2003 investment in the Company. On March 15,2004, the Company entered into an agreement for a Secured Promissory Note “(Note”)for $1.5 million with L-3. The Note is due upon demand from L-3 and L-3 has theoption to convert the Note plus its accrued interest to common stock of theCompany at the price of $5.35 per share. The accrued and unpaid interest on theNote will be compounded quarterly at a rate equal to the prime rate publishedin the Wall Street Journal at the end of each quarter plus 2%. The Company is asubcontractor to L-3 for a long-term government contract to produce gyroscopesand accelerometers for use in inertial navigation.

The MEMS industry iscapital intensive and requires expenditures for manufacturing equipment andresearch and development in order to develop and take advantage oftechnological improvements and new technologies. In fiscal 2005, the Companyplans approximately $1.1 million in capital expenditures primarily to continuedevelopment and production of new MEMS technologies and products and toincrease overall production capacity. Capital equipment purchase commitmentswere minimal at October 2, 2004.

On January 25,2005, the Investor Group invested a total of $17.0 million in the Company in aprivate placement of equity securities. The net proceeds to the Company wereapproximately $16.0 million. In exchange for the investment, the Investor Groupreceived 1,000,000 shares of redeemable preferred stock, 1,000,000 shares ofconvertible preferred stock and a warrant for the purchase of up to 500,000shares of common stock. The Company plans to use approximately $1.6 million ofthe net proceeds to pay off the Note due to L-3. The remainder of the netproceeds will be used for general working capital needs andother corporate purposes.

The Company is stillattempting to refinance its existing 12% interest mortgage with current lowerrates. The Company cannot give assurance that refinancing of this mortgage willbe available or, if available, that its terms will be favorable to the Company.If the Company is unable to achieve its production goals or obtain additionalfinancing on acceptable terms, on a timely basis, there will be a materialadverse effect on the Company’s financial condition and competitive position.

The Company has incurrednet losses and losses from operations for each quarter since 1999. The Companyfiled for reorganization under Chapter 11 of the U.S. Bankruptcy Code in January 2000and, on emergence from bankruptcy, all of the previously issued and outstandingcommon stock was canceled without consideration to the holders. The Companyincurred a net loss of $4.3 million for the fiscal year ended October 2,2004 and has incurred substantial cumulative losses since its emergence frombankruptcy. The Company expects to incur increasing sales and marketing,research and development and general and administrative expenses. As a result,it will need to significantly increase its revenues to achieve profitability. Althoughthe Company’s revenues have increased, the growth may not continue at thecurrent rate or at all. On January 25, 2005, subsequent to the end ofthe fiscal year, the Investor Group invested a total of $17.0 million in theCompany in a private placement of equity securities. The net proceeds to theCompany were approximately $16.0 million. In exchange for the investment, theInvestor Group received 1,000,000 shares of redeemable preferred stock,1,000,000 shares of convertible preferred stock and a warrant for the purchaseof up to 500,000 shares of common stock. The Company plans to use approximately$1.6 million of the net proceeds to pay off the Note due to L-3. The remainderof the net proceeds will be used for general working capital needs andother corporate purposes.

The Company’s principalremaining indebtedness is the mortgage on its headquarters and operatingfacility. The Company has not been in default under this indebtedness.

**Commitments andContingencies**

The Company’s use ofhazardous chemicals in its manufacturing subjects it to a variety ofenvironmental and land use regulations related to their use, storage anddisposal. The Company is currently engaged in efforts to remedy soil and watercontamination under the supervision of government 

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agencies.If the Company fails to comply with present or future regulations, liabilityfor the cost of remediation, damages and penalties, and production suspensionor delay could result.

The Company believes itconducts its business in a manner that complies with environmental laws andregulations. While the Company’s known environmental liabilities have largelybeen resolved and are not, either individually or taken together, material toits business and financial condition, there can be no assurance that materialenvironmental claims will not arise in the future. If such claims arise, theycould be extremely expensive to contest or to resolve if the Company is foundresponsible and does not have applicable insurance coverage, which would resultin material harm to its business. See “Item 1. Business—EnvironmentalCompliance.”

Purchase commitmentsassociated with capital expenditures were minimal at October 2, 2004

The Company has no leases under which it is thelessee.

The company is required to comply with therequirements of Sarbanes Oxley Section 404 during its fiscal year ending October 1,2005. This process will involve the design, documentation and testing of thecompany’s internal financial reporting controls. The ultimate cost of thisprocess cannot be determined at this time.

The following summarizesthe Company’s significant contractual obligations at October 2, 2004 andthe effects such obligations are expected to have on liquidity and cash flow infuture periods.

**PaymentsDue by Period**(in thousands)
| **Significant Contractual Obligations** | ** ** | ** ** | ** ** | **Total** | ** ** | **Less than  1 Year** | ** ** | **1-3 Years** | ** ** | **4-5 Years** | ** ** | **After  5 Years** | ** ** |
|---------------------------------------------------|------------|------------|------------|-----------|------------|---------------------------------|------------|--------------------|------------|--------------------|------------|-------------------------|------------|
| Property Mortgage                                 |       | $          | 8,830      |      |       | $                               | —     |               |       |               | $          | 8,830                   |       |   |   | $ | — |   |   |   | $ | — |   |   |
| Secured  Promissory Note                          |       | 1,500      |       |      | 1,500      |                            |       |               | —     |               |       |                    | —     |   |   |   | — |   |   |
| Property Taxes                                    |       | 470        |       |      | 188        |                            |       |               | 282        |               |       |                    | —     |   |   |   | — |   |   |
| Long-Term Debt                                    |       | $          | 10,800     |      |       | $                               | 1,688      |               |       |               | $          | 9,112                   |       |   |   | $ | — |   |   |   | $ | — |   |   |

 

**Critical Accounting Policies**

Application of the Company’s accounting policiesrequires management to make judgments and estimates about the amounts reflectedin the financial statements. Management uses historical experience and allavailable information to make these estimates and judgments, although differingamounts would be reported if the assumptions and estimates changed. Estimatesare used for, but not limited to, the accounting for the allowance for doubtfulaccounts, inventory allowances, impairment costs and other special charges,depreciation and amortization, warranty costs and contingencies. Management hasidentified the following accounting policies as critical to an understanding ofits financial statements and as areas most dependent on management’s judgmentand estimates.

**RevenueRecognition and Warranty Policies:****  **TheCompany uses the completed contract method of accounting for its productdevelopment projects due to the inability to accurately estimate percentage ofcompletion during performance of the contract. Costs are capitalized during theproject and recorded as cost of revenue at its completion along with therecognition of revenue. Losses on projects are recognized as they aredetermined. The Company’s MEMS development contracts include milestones thatrequire delivery of engineering reports, wafers and/or dies. The Company’s MEMSdevelopment contracts are determined to be complete after all contractmilestones have been completed, reviewed and accepted by the customer. SantaBarbara Tool & Die delivers a finished product to the customer andrevenue is recognized after both the product is shipped and title passes. IMTAnalytical has service related revenue and this revenue is recognized uponcompletion of the service for the customer. The Company’s MEMS 

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development contracts donot have any rights of return. Santa Barbara Tool & Die and IMTAnalytical did not have any sales returns in fiscal 2004 or 2003. The Company’swarranty policy provides for the replacement of defective parts when thecustomer’s return request is approved within thirty days of the originalshipment date. To date, warranty costs have not been significant.

**Long-lived Assets:****  **The Company reviews long-lived assets for impairmentwhenever events or changes in circumstances indicate that an asset’s carryingvalue may exceed the undiscounted expected future cash flows to be derived fromthat asset. Whenever undiscounted expected future cash flows are less than thecarrying value, the asset will be reduced to an amount equal to the net presentvalue of the expected future cash flows and an impairment loss will berecognized.

**Recent Accounting Pronouncements**

In December 2003, the SEC issued SAB 104, whichsupercedes SAB 101. While the wording of SAB 104 has changed to reflectthe issuance of Emerging Issues Task Force Issue No. 00-21 “Accountingfor Revenue Arrangements with Multiple Deliverables” (EITF 00-21), therevenue recognition principles of SAB 101 remain largely unchanged by theissuance of SAB 104. The adoption of SAB 104 did not have a material effect onthe Company’s financial condition or results of operations.

In December 2003, the FASB issued Interpretation46R (FIN 46R), a revision to Interpretation 46 (FIN 46), Consolidation ofVariable Interest Entities. FIN 46R clarifies some of the provisions of FIN 46and exempts certain entities from its requirements. FIN 46R is effective at theend of the first interim period ending after March 15, 2004. Entities thathave adopted FIN 46 prior to this effective date can continue to apply theprovisions of FIN 46 until the effective date of FIN 46R or elect earlyadoption of FIN 46R. The adoption of FIN 46R did not have a material impact onthe Company’s financial statements.

In December 2004, the FASB issued SFAS 123R “Share-BasedPayment,” a revision to FASB No. 123. SFAS 123R replaces existing requirementsunder SFAS No. 123 and APB Opinion No. 25, and requires publiccompanies to recognize the cost of employee services received in exchange forequity instruments, based on the grant-date fair value of those instruments,with limited exceptions. SFAS 123R also affects the pattern in whichcompensation cost is recognized, the accounting for employee share purchaseplans, and the accounting for income tax effects of share-based paymenttransactions. For small-business filers, SFAS 123R will be effective forinterim periods beginning after December 15, 2005. The Company iscurrently determining what impact the proposed statement would have on itsresults of operations and financial position.

The FASB has proposed FASBStaff Position No. FAS 109-a, “Application of FASB Statement No. 109,Accounting for Income Taxes, for the Tax Deduction Provided to U.S. BasedManufacturers by the American Jobs Creation Act of 2004.”  On October 22, 2004, the American JobsCreation Act of 2004 (the “ACT”) was signed into law by the President. This Actincludes tax relief for domestic manufacturers by providing a tax deduction upto 9 percent (when fully phased-in) of the lesser of (a) “qualifiedproduction activities income,” as defined in the Act, or (b) taxableincome (after the deduction for the utilization of any net operating loss carryforwards). As a result of this Act, an issue has arisen as to whether thisdeduction should be accounted for as a special deduction or a tax ratereduction under Statement 109. The FASB staff believes that the domesticmanufacturing deduction’s characteristics are similar to special deductionsbecause the domestic manufacturing deduction is based on the future performanceof specific activities, including the level of wages. Accordingly, the FASBstaff believes that the deduction provided for under the Act should beaccounted for as a special deduction in accordance with Statement 109 and notas a tax rate reduction. This provision of the Act is not expected to have amaterial impact on the Company’s financial statements.

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**RiskFactors Affecting the Company’s Business**

*In addition to the factors discussed elsewhere inthis report, the following are important factors that could cause a materialadverse effect on the Company’s financial condition and competitive positionand cause actual results or events to differ materially from those contained inany forward- looking statements made by or on behalf of the Company.*

*The Company has incurred losses since 1999; itrecently emerged from bankruptcy and expects to incur losses in futurequarters.*

The Company has incurrednet losses and losses from operations for each quarter since 1999. The Companyfiled for reorganization under Chapter 11 of the U.S. Bankruptcy Code in January 2000and, on emergence from bankruptcy, all of the previously issued and outstandingcommon stock was canceled without consideration to the holders. The Companyincurred a net loss of $4.3 million for the fiscal year ended October 2,2004 and has incurred substantial cumulative losses since its emergence frombankruptcy. The Company expects to incur increasing sales and marketing,research and development and general and administrative expenses. As a result,it will need to significantly increase its revenues to achieve and sustainprofitability. Although the Company’s revenues have increased, the growth maynot continue at the current rate or at all.

*The Company cannotsatisfy its liquidity requirements without the infusion of capital.*

Since emerging from bankruptcy, the Company’sprincipal sources of liquidity have been sales of equity securities andborrowing. On January 25, 2005, subsequent to the end ofthe fiscal year, the Investor Group invested a total of $17.0 million in theCompany in a private placement of equity securities. The net proceeds to theCompany were approximately $16.0 million. In exchange for the investment, theInvestor Group received 1,000,000 shares of redeemable preferred stock,1,000,000 shares of convertible preferred stock and a warrant for the purchaseof up to 500,000 shares of common stock. The Company plans to use approximately$1.6 million of the net proceeds to pay off the Note due to L-3. Theremainder of the net proceeds will be used for general working capital needs  and other corporate purposes.While the proceeds of the private placement along with funds from operationswill satisfy the Company’s need for liquidity in the near future, unless theCompany can achieve increased sales, it may need to seek additional equity ordebt financing. These sources of financing may not be available on acceptableterms or at all.

The Company is stillattempting to refinance its existing 12% interest mortgage with current lowerrates. The Company cannot give assurance that re-financing of this mortgagewill be available or, if available, that its terms will be favorable to theCompany.

*The Companyoperates in the MEMS industry, which is capital intensive.*

The MEMS industry is capital intensive and requiresexpenditures for facilities, equipment and research and development to developand keep pace with technological improvements. The Company believes that toachieve its objectives, it will need additional resources over the next severalyears for capital expenditures, working capital and research and development. TheCompany purchased minimal property, plant and equipment in fiscal 2004. Duringfiscal 2005, the Company plans to purchase or enter into lease financing forapproximately $1.1 million of property, plant and equipment. The Companybelieves that it will be able to fund future expenditures from a combination ofnew capital infusion, existing cash balances and cash flow from operations. TheCompany may need additional sources ofcapital to meet requirements in future years. There is no assurance thatadditional funds will be available to the Company or, if available, that theterms and conditions will be acceptable to the Company. If the Company cannotobtain sufficient capital, it would need to curtail its operating and capitalexpenditures, which would adversely affect the Company’s future operatingresults and could prevent the Company from competing successfully in the MEMSindustry.

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*The Company hashigh fixed costs and excess capacity due to its current low production volumes.*

The fixed costs ofoperating and maintaining the Company’s 30,000 square foot wafer fabricationfacility and other elements of its production capacity are high. Most of itscurrent production consists of prototypes and new product development. Theseare low-volume projects, which leave the Company’s facilities underutilized andunable to absorb the fixed costs. As a result the Company experiences operatinglosses. The Company plans to shift from low-volume prototype and developmentorders to high-volume production for its customers as their developmentprograms mature into production contracts, which will make fuller use of theCompany’s excess capacity. However, making this shift depends on the success ofthe Company’s engineers in developing efficient high-volume productiontechnology, the success of its customers in developing marketable uses for MEMStechnology, and the general growth and acceptance of MEMS technology. If theCompany cannot successfully make the transition to high-volume production, itwill continue to experience losses and suffer material harm to its operatingresults and liquidity.

*TechnologicalChanges.*

The MEMS business has beencharacterized by rapidly changing technology. The demand for greater capabilitywill cause competitors to continue to build greater performance into theirrespective products. There can be no assurance that the Company’s products willachieve such performance. There can be no assurance that the Company will notexperience manufacturing and product quality problems in the future. Newtechnologies may require manufacturing equipment and techniques that it does not yet possess. TheCompany’s future success depends in large part on its ability to develop andqualify new products on a timely basis and to manufacture them in sufficientquantities to compete effectively on the basis of price and performance.

*Competition.*

The Company competes withother independent MEMS manufacturers, with large integrated circuitmanufacturers, and with captive wafer fabs owned by vertically integrated MEMSusers. Many of these competitors are larger than the Company and have greaterfinancial resources. If the Company is unable to equal or surpass itscompetitors in the area of price, performance, quality or customerresponsiveness, then the business will be unsuccessful.

*The Company’ssuccess depends in part upon the ability to protect its intellectual property.*

The Company’s success depends in large part upon itsproprietary technology. The Company relies on a combination of patents, tradesecret protection, confidentiality and nondisclosure agreements and licensingarrangements to establish and protect its intellectual property rights. TheCompany’s patents may be successfully challenged or may not provide it with theintended competitive advantages. Important technology developed by the Companymay not be patentable. Despite the Company’s efforts to protect its proprietaryrights, unauthorized parties may attempt to copy aspects of its products or toobtain and use information that is regarded as proprietary. Policingunauthorized use of the Company’s proprietary technology is difficult. Inaddition, the laws of some foreign countries do not protect these proprietaryrights to as great an extent as do the laws of the United States. The Company’smeans of protecting its proprietary rights may not be adequate and itscompetitors may independently develop similar technology, duplicate its products,or design around its proprietary intellectual property.

The Company may face costly damages or litigationcosts if a third party claims that the Company infringed on its intellectualproperty. Advanced technology products such as the Company’s are increasinglysubject to third-party infringement claims. In addition, former employers ofthe Company’s current and future employees may assert that its employees havedisclosed confidential or proprietary 

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information to theCompany. Any of these claims even if they are without merit, could be expensiveand time consuming to defend.

In addition, intellectualproperty claims against the Company, with or without merit, could require it toenter into royalty or licensing agreements. These royalty or licensing agreements,if required, may not be available on terms acceptable to the Company or at all,which could seriously harm its business. A successful claim of infringementagainst the Company or its failure or inability to license the infringed orsimilar technology could adversely affect its business because the Companywould not be able to sell the affected product without redeveloping the productor its manufacturing process, incurring significant additional expenses.

*Fluctuations inquarterly and annual operating results may adversely affect the Company’sbusiness.*

The Company’s operatingresults have fluctuated and may continue to fluctuate from quarter to quarterand year to year. The Company’s sales are generally made pursuant to individualpurchase orders and production is scheduled on the basis of such purchaseorders. Because the market for  MEMSproducts is new, and the Company is constantly introducing new designs orderedby customers, the sales cycles are long and unpredictable. The sales cycle forthe Company’s products typically ranges from three to six months. Moreover, ascustomer programs mature, the Company may have to write-down inventory andequipment. In addition, the Company must qualify on future programs to sell itsproducts. Cancellation, rescheduling and reductions of orders in the futurecould result in inventory losses, under-utilization of production capacity andwrite-downs of tooling and equipment which would have a material adverse effecton the Company’s future operating results. In particular, in the past theCompany’s operating results have been adversely affected when productioncapacity is underutilized, and will likely be so affected in the future.

*The Company’s common stock may be illiquid and sufferfrom price volatility because it has not been publicly traded.*

There has not been apublic market for the Common Stock since January, 2000. The Company’soutstanding Common Stock, which was issued after the emergence of the Companyfrom bankruptcy, is not listed for trading on any stock market. The companyintends to apply for listing of its common stock, but there can be no assuranceit will be successful. Even if listed, it is likely that the stock willinitially be thinly traded and the Company cannot predict when or if investor interestin the Company will lead to the development of an active, liquid trading market.Active trading markets generally result in lower price volatility and moreefficient execution of buy and sell orders for investors. A thin trading marketin the Company’s stock will likely depress the trading price, make it moredifficult for investors to buy or sell its common stock, and result in pricevolatility.

*Internationalrevenue could expose the Company to risk.*

The Company sellsits products to foreign customers and expects this to be an important part ofits future business. Accordingly, the Company will face risks inherent inconducting business internationally, such as:

·       difficultiesin collecting accounts receivable and longer collection periods;

·       seasonalbusiness activity in certain parts of the world;

·       potentiallyadverse tax consequences;

·       fluctuationsin currency exchange rates;

·       politicaland economic instability; and

20

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·       tradebarriers.

Any of these factors couldseriously harm the Company’s international operations and, consequently,business.

*Environmental lawsand regulations.*

The Company’smanufacturing processes employ hazardous substances and are subject toregulation pursuant to various federal and state laws governing the environment.In the past, the Company has been subject to claims by government agencies andindividuals related to disposal of hazardous materials. See “Item 1. Business—EnvironmentalCompliance” and “Item 3.—Legal Procedings.” The Company believes it conductsits business in a manner that complies with environmental laws and regulations.Nevertheless, other material environmental claims could arise in the future,which could have a material adverse effect on the Company.

*Interruptions inthe Company’s supply of raw materials could adversely affect its business.*

The Company’s operationsrequire raw materials that meet exacting standards. The Company generally hasmultiple sources of supply for its raw materials; however, only a limitednumber of suppliers are capable of delivering certain raw materials that meetits standards. Various factors could reduce the availability of raw materialssuch as silicon wafers, photomasks, chemicals, and gases. In addition, anytransportation problems could delay the Company’s receipt of raw materials.Although raw materials shortages or transportation problems have notinterrupted its operations in the past, shortages may occur from time to timein the future. Also, lead times for the supply of raw materials have beenextended in the past. If the Company’s supply of raw materials is interruptedor its lead times extended, then its cash flow would be reduced, orders may becancelled or diverted to competitors, and its business would suffer significantharm.

*The Company’s certificate of incorporation and bylawscould delay or prevent an acquisition or sale of the Company.*

The Company’s Certificate of Incorporation empowersthe Board of Directors to establish and issue a class of preferred stock, andto determine the rights, preferences and privileges of the preferred stock. Thisgives the Board of Directors the ability to deter, discourage or make moredifficult a change in control of the Company, even if such a change in controlwould be in the interest of a significant number of our stockholders or if sucha change in control would provide its stockholders with a substantial premiumfor their shares over the then-prevailing market price for the common stock.

The Company’sAmended and Restated Bylaws contain other provisions that could have an anti-takeovereffect, including the following:

·       onlyone of the three classes of directors is elected each year;

·       stockholdershave limited ability to remove directors;

·       stockholderscannot call a special meeting of stockholders; and

·       stockholdersmust give advance notice to nominate directors or submit proposals forconsideration at stockholder meetings.

*Anti-takeoverprovisions of Delaware law could delay or prevent an acquisition of theCompany.*

The Company is subject tothe anti-takeover provisions of Section 203 of the Delaware GeneralCorporation Law, which regulates corporate acquisitions. These provisions coulddiscourage potential acquisition proposals and could delay or prevent a changein control transaction. They could also have the 

21

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effectof discouraging others from making tender offers for the Company’s common stockor preventing changes in its management.

*Current economicand political uncertainties may harm the Company’s business.*

Deteriorating globaleconomic conditions and the effects of ongoing military actions againstterrorists may cause significant disruptions to commerce throughout the world. Tothe extent that such disruptions result in delays or cancellations of customerorders, a general decrease in corporate spending on advanced technology, or theCompany’s inability to effectively market, manufacture or ship its products,its business, results of operations and financial conditions could suffer harm.In addition, the Company’s ability to raise capital for purposes of researchand development, capital expenditures and ongoing operations depends on accessto financing. During times of adverse global economic and political conditions,general investor confidence could decrease and make it more difficult for theCompany to find potential investors. If the Company does not have access tofinancing, it could be unable to fund operations, invest in capitalexpenditures and fully carry out its research and development efforts, whichcould adversely affect the business, results of operations and financialconditions.

**ITEM 7.  FINANCIALSTATEMENTS. (See Pages F-1 through F-21)**

**ITEM8.  CHANGES IN AND DISAGREEMENTS WITHACCOUNTANTS ON ACCOUNTING AND FINANCIAL DISCLOSURE.**

None.

**ITEM 8A.  CONTROLSAND PROCEDURES.**

The Company’s Chief Executive Officer, John S. Foster,and Chief Financial Officer, Peter T. Altavilla, with the participation ofthe Company’s management, carried out an evaluation of the effectiveness of theCompany’s disclosure controls and procedures pursuant to Exchange Act Rule 13a-15(e).Based upon that evaluation, the Chief Executive Officer and the Chief FinancialOfficer believe that, as of the end of the period covered by this report, theCompany’s disclosure controls and procedures are effective in making known tothem material information relating to the Company (including its consolidatedsubsidiaries) required to be included in this report.

Disclosure controls and procedures, no matter how welldesigned and implemented, can provide only reasonable assurance of achieving anentity’s disclosure objectives. The likelihood of achieving such objectives isaffected by limitations inherent in disclosure controls and procedures. Theseinclude the fact that human judgment in decision-making can be faulty and thatbreakdowns in internal control can occur because of human failures such assimple errors, mistakes or intentional circumvention of the establishedprocesses.

There was no change in theCompany’s internal control over financial reporting, known to the ChiefExecutive Officer or the Chief Financial Officer, that occurred during theperiod covered by this report that has materially affected, or is reasonablylikely to materially affect, the Company’s internal control over financialreporting.

**ITEM 8B.  OTHERINFORMATION.**

None.

22

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**PART III**

**ITEMS 9, 10, 11, 12 AND 14.**

The information requiredin these items is incorporated herein by reference to portions of the ProxyStatement for Annual Meeting of Shareholders to be filed with the Securitiesand Exchange Commission within 120 days of the close of the fiscal year ended October 2,2004.

**ITEM13. EXHIBITS AND REPORTS ON FORM 8-K**
| Exhibit  Number | ** ** | **Description**                                                                                                                                                                                                                                                                            |
|-----------------|------------|--------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
| 2.1             |       | Debtor’s Third Amended  Plan of Reorganization Under Chapter 11 of the Bankruptcy Code Dated as of  September 24, 2001 (incorporated by reference to Exhibit 2.1 to the  Company’s Current Report on Form 8-K filed November 20, 2001).                      |
| 3.1             |       | Amended and Restated  Certificate of Incorporation, as amended to date (incorporated by reference  to Exhibit 3.1 to the Company’s Annual Report on Form 10-KSB for  the fiscal year ended September 29, 2001).                                                        |
| 3.2             |       | Amended and Restated  Bylaws of Innovative Micro Technology, Inc. (incorporated by reference  to Exhibit 3.2 to the Company’s Annual Report on Form 10-KSB for  the fiscal year ended September 29, 2001).                                                        |
| 4.1             |       | Form of Warrant  Agreement between the Company and Certain Claimants Under the Plan of  Reorganization (incorporated by reference to Exhibit 4.1 to the  Company’s Annual Report on Form 10-KSB for the fiscal year ended September 29,  2001).                   |
| 4.2             |       | Warrant Agreement  between the Company and L-3 Communications Corporation, dated August 1,  2003 (incorporated by reference to Exhibit 4.2 to the Company’s Current  Report on Form 8-K filed August 13, 2003).                                                   |
| 4.3             |       | Warrant Agreement between  the Company and L-3 Communications Corporation, dated September 3, 2003  (incorporated by reference to Exhibit 4.3 to the Company’s Quarterly  Report on Form 10-Q for the period ended June 26, 2004).                                |
| 4.4             |       | Warrant Agreement  between the Company and Stutman Treister & Glatt, Professional  Corporation, dated September 30, 2003 (incorporated by reference to  Exhibit 4.4 to the Company’s Quarterly Report on Form 10-Q for the  period ended June 26, 2004). |
| 10.1            |       | Change in Control  Agreement between the Company and John Foster, dated April 15, 2003  (incorporated by reference to Exhibit 10.1 to the Company’s Annual  Report on Form 10-KSB for the fiscal year ended September 29,  2001).                                 |
| 10.2            |       | Change in Control  Agreement between the Company and Peter T. Altavilla, dated April 15,  2003 (incorporated by reference to Exhibit 10.2 to the Company’s Annual  Report on Form 10-KSB for the fiscal year ended September 29,  2001).                          |
| 10.3            |       | Form of  Indemnification Agreement for directors and officers (incorporated by  reference to Exhibit 10.3 to the Company’s Annual Report on  Form 10-KSB for the fiscal year ended September 29, 2001).                                                           |
| 10.4            |       | Stock Purchase Agreement  between the Company and L-3 Communications Corporation, dated August 1,  2003 (incorporated by reference to Exhibit 10.4 to the Company’s Current  Report on Form 8-K filed August 13, 2003).                                           |
| 10.5            |       | 2001 Stock Incentive  Plan, as amended (incorporated by reference to Appendix B to the                                                                                                                                                                                                     |

 

23

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|       |   | Company’s Proxy  Statement on Schedule 14A filed on January 28, 2004).                                                                                                                                                                                                                                                                                                                                                                  |
|-------|--------|---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
| 10.6  |   | Form of Stock  Option Agreement under 2001 Stock Incentive Plan (incorporated by reference  to Exhibit 10.6 to the Company’s Annual Report on Form 10-KSB for  the fiscal year ended September 29, 2001).                                                                                                                                                                                                                |
| 10.7  |   | Form of Restricted  Stock Agreement under 2001 Stock Incentive Plan (incorporated by reference to  Exhibit 10.7 to the Company’s Annual Report on Form 10-KSB for the  fiscal year ended September 29, 2001).                                                                                                                                                                                                            |
| 10.8  |   | Fixed Rate Note of the  Company, payable to Owens Financial Group, Inc., dated December 20,  2001 (incorporated by reference to Exhibit 10.8 to the Company’s Annual  Report on Form 10-KSB for the fiscal year ended September 29,  2001).                                                                                                                                                                         |
| 10.9  |   | Deed of Trust, Security  Agreement and Assignment of Leases and Rents, between the Company, Owens  Financial Group, Inc. and Investors Yield, Inc., dated  December 20, 2001 (incorporated by reference to Exhibit 10.9 to the  Company’s Annual Report on Form 10-KSB for the fiscal year ended  September 29, 2001).                                                                                         |
| 10.10 |   | Worldwide Cash Profit  Sharing Plan (incorporated by reference to Exhibit 10 to Amendment  No. 1 to the Company’s Report on Form 10-Q filed March 4,  1996).                                                                                                                                                                                                                                                             |
| 10.11 |   | Recapitalization  Agreement, dated as of March 20, 1999 and as amended by Amendment  No. 1 dated as of April 9, 1999, among MDT Holdings, LLC, Applied  Magnetics Corporation, DDCI, LLC, Vestro Investments Group Limited, Milestone  Acquisitions II, LLC and Magnetic Data Technologies, LLC (incorporated by  reference to Exhibit 2.1 to the Company’s Current Report on  Form 8-K filed April 26, 1999). |
| 10.12 |   | Stock Purchase Agreement  between the Company and L-3 Communications Corporation, dated  September 3, 2003.                                                                                                                                                                                                                                                                                                                                  |
| 10.13 |   | Letter Agreement between  Stutman Treister & Glatt, Professional Corporation, Houlihan Lokey  Howard & Zukin, O’Melveny & Myers LLP, Sheppard Mullin  Richter & Hampton LLP and the Company for the settlement of the  Professional Persons Notes, dated as of September 22, 2003.                                                                                                                  |
| 10.14 |   | Promissory Note dated  March 15, 2004 by Innovative Micro Technology in favor of L-3  Communications Corporation (incorporated by reference to Exhibit 10.14  to the Company’s Current Report on Form 8-K filed on March 30,  2004).                                                                                                                                                                                     |
| 10.15 |   | Security Agreement dated  March 15, 2004 by and between the Company and L-3 Communications  Corporation (incorporated by reference to Exhibit 10.15 to the Company’s  Current Report on Form 8-K filed on March 30, 2004).                                                                                                                                                                                               |
| 10.16 |   | Supplemental Agreement  dated March 15, 2004 by and between the Company and L-3 Communications  Corporation (incorporated by reference to Exhibit 10.16 to the Company’s  Current Report on Form 8-K filed on March 30, 2004).                                                                                                                                                                                           |
| 31.1  |   | Certification Pursuant  to Rule 13a-14(a) of the Securities Exchange Act of 1934, Adopted  Pursuant to Section 302 of the Sarbanes-Oxley Act of 2003.                                                                                                                                                                                                                                                                              |
| 31.2  |   | Certification Pursuant  to Rule 13a-14(a) of the Securities Exchange Act of 1934, Adopted  Pursuant to Section 302 of the Sarbanes-Oxley Act of 2003.                                                                                                                                                                                                                                                                              |
| 32    |   | Certification Pursuant  to 18 U.S.C. Section 1350, Adopted Pursuant to Section 906 of the  Sarbanes-Oxley Act of 2003.                                                                                                                                                                                                                                                                                                                  |

 

24

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**SIGNATURES**

Inaccordance with Section 13 or 15(d) of the Exchange Act, theregistrant caused this report to be signed on its behalf by the undersigned,thereunto duly authorized.
|        | **INNOVATIVE MICRO TECHNOLOGY, INC.** |
|--------|---------------------------------------|
|   | By:                                   | /s/ JOHN S. FOSTER |
|   |                                  | Dr. John S. Foster |
|   |                                  | *Chairman and Chief Executive Officer* |
|   | Date:                                 | January 27, 2005 |

 

In accordance with theExchange Act, this report has been signed below by the following persons onbehalf of the registrant and in the capacities and on the dates indicated.
| By: /s/ JOHN  S. FOSTER                                                                            |   | By: /s/ PETER  T. ALTAVILLA                                                                                           |
|----------------------------------------------------------------------------------------------------|--------|-----------------------------------------------------------------------------------------------------------------------|
| Dr. John S. Foster   Chairman and Chief Executive Officer  Date:  January 27 , 2005 |   | Peter T. Altavilla

Chief Financial  Officer, Corporate Controller and Secretary

Date:   January 27 , 2005 |
| By: /s/ MALCOLM CURRIE                                                                        |   | By: /s/ CALVIN QUATE                                                                                             |
| Dr. Malcolm Currie  Director  Date:  January 27 , 2005                              |   | Dr. Calvin Quate  Director  Date:  January 27 , 2005                                                   |
| By: /s/ SCOTT AVILA                                                                                |   | By: /s/ DANIEL E. ARMEL                                                                                               |
| Scott Avila  Director  Date:  January 27 , 2005                                          |   | Daniel E. Armel  Director  Date:  January 27 , 2005                                                         |
| By: /s/ WILLIAM HOWARD                                                                             |   | By: /s/ JILL WITTELS                                                                                                  |
| Dr. William Howard  Director  Date:  January 27 , 2005                              |   | Dr. Jill Wittels  Director  Date:  January 27 , 2005                                                   |
| By: /s/ A. MICHAEL ANDREWS II                                                                      |   |                                                                                                                  |
| Dr. Michael Andrews  Director  Date:  January 27 , 2005                             |   |                                                                                                                  |

 

25

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**Innovative MicroTechnology, Inc.**

**ITEM 7. FINANCIAL STATEMENTS**

**Index to Financial Statements and Related Information**
| **Financial Statements:**                                                                                      |   |   |   |
|----------------------------------------------------------------------------------------------------------------|--------|--------|--------|
| Report  of Independent Registered Public Accounting Firm                                                       |   | F-2    |   |
| Balance  Sheet as of October 2, 2004                                                                      |   | F-3    |   |
| Statements of Operations for  the years ended October 2, 2004 and September 27, 2003                 |   | F-4    |   |
| Statements  of Shareholders’ Equity for the years ended October 2, 2004 and  September 27, 2003 |   | F-5    |   |
| Statements of Cash Flows for  the years ended October 2, 2004 and September 27, 2003                 |   | F-6    |   |
| Notes to  Financial Statements                                                                                 |   | F-7    |   |

 

F-1

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**REPORT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTINGFIRM**

To the Board of Directors and Stockholders ofInnovative Micro Technology, Inc.

We have audited the balance sheet of Innovative MicroTechnology, Inc. as of October 2, 2004, and the related statements ofoperations, shareholders’ equity, and cash flows for the years ended October 2,2004 and September 27, 2003. These financial statements are theresponsibility of the Company’s management. Our responsibility is to express anopinion on these financial statements based on our audits.

We conducted our audits in accordance with auditingstandards of the Public Company Accounting Oversight Board (United States).Those standards require that we plan and perform the audits to obtainreasonable assurance about whether the financial statements are free ofmaterial misstatement. An audit includes examining, on a test basis, evidencesupporting the amounts and disclosures in the financial statements. An auditalso includes assessing the accounting principles used and significantestimates made by management, as well as evaluating the overall financialstatement presentation. We believe that our audits provide a reasonable basisfor our opinion.

In our opinion, thefinancial statements referred to above present fairly, in all materialrespects, the financial position of Innovative Micro Technology, Inc. asof October 2, 2004, and the results of its operations and its cash flowsfor the years ended October 2, 2004 and September 27, 2003 inconformity with accounting principles generally accepted in the United Statesof America.

**/s/ BDOSeidman, LLPLos Angeles, CaliforniaNovember 19, 2004, except for footnotes 1 and 11,     which are as of January 25,2005**

F-2

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**Innovative Micro Technology, IncBALANCE SHEET(In thousands, except share and par value data)**
| ** **                                                                                                                     | ** ** | **As of  October 2,  2004** | ** ** |
|--------------------------------------------------------------------------------------------------------------------------------|------------|---------------------------------------|------------|
| **ASSETS**                                                                                                                     |       |                                  |       |
| Current assets:                                                                                                                |       |                                  |       |
| Cash                                                                                                                           |       | $                                     | 429        |   |
| Accounts receivable, net of allowance for doubtful  accounts of $0                                                             |       | 1,159                                 |       |
| Accounts receivable—related  party                                                                                        |       | 128                                   |       |
| Costs in excess of billings on development projects                                                                            |       | 33                                    |       |
| Prepaid expenses and other                                                                                                     |       | 278                                   |       |
| Total current  assets                                                                                                          |       | 2,027                                 |       |
| Property, plant and  equipment, at cost:                                                                                       |       |                                  |       |
| Land                                                                                                                           |       | 8,750                                 |       |
| Buildings                                                                                                                      |       | 9,408                                 |       |
| Manufacturing equipment                                                                                                        |       | 2,184                                 |       |
| Total property,  plant and equipment, at cost                                                                                  |       | 20,342                                |       |
| Less—accumulated  depreciation and amortization                                                                           |       | (3,163                                | )          |
| Total property,  plant and equipment                                                                                           |       | 17,179                                |       |
| Other assets                                                                                                                   |       | 293                                   |       |
| Total assets                                                                                                                   |       | $                                     | 19,499     |   |
| **LIABILITIES  AND SHAREHOLDERS’ EQUITY**                                                                                 |       |                                  |       |
| Current liabilities:                                                                                                           |       |                                  |       |
| Current portion of long-term debt                                                                                              |       | $                                     | 1,688      |   |
| Accounts payable                                                                                                               |       | 783                                   |       |
| Accrued payroll and benefits                                                                                                   |       | 576                                   |       |
| Accrued audit and legal                                                                                                        |       | 133                                   |       |
| Accrued property taxes                                                                                                         |       | 34                                    |       |
| Billings in excess of costs for development projects                                                                           |       | 595                                   |       |
| Billings in excess of costs for development projects—related  party                                                       |       | 693                                   |       |
| Other current liabilities                                                                                                      |       | 271                                   |       |
| Total current  liabilities                                                                                                     |       | 4,773                                 |       |
| Long-term debt                                                                                                                 |       | 9,112                                 |       |
| Other long-term  liabilities                                                                                                   |       | 90                                    |       |
| Shareholders’  equity:                                                                                                    |       |                                  |       |
| Preferred stock, $.0001 par  value, authorized 2,500,000 shares, none issued and outstanding                                   |       | —                                |       |
| Common stock, $.0001 par value, 25,000,000 shares  authorized, 6,937,443 shares issued and outstanding at October 2, 2004 |       | 1                                     |       |
| Paid-in capital                                                                                                                |       | 23,056                                |       |
| Accumulated deficit                                                                                                            |       | (17,533                               | )          |
| Total  shareholders’ equity                                                                                               |       | 5,524                                 |       |
| Total liabilities and  shareholders’ equity                                                                               |       | $                                     | 19,499     |   |

 

The accompanying Notes to Financial Statements are an integral part of these statements.

F-3

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**Innovative Micro Technology, Inc.STATEMENTS OF OPERATIONS(In thousands, except per share data)**

 
| ** **                                                                                                                                                               | ** ** | **Year Ended  October 2,  2004** | ** ** | **Year Ended  September 27,  2003** | ** ** |
|--------------------------------------------------------------------------------------------------------------------------------------------------------------------------|------------|--------------------------------------------|------------|-----------------------------------------------|------------|
| Net revenue                                                                                                                                                              |       |                                       |       |                                          |       |   |   |   |   |
| MEMS and Other                                                                                                                                                           |       |                                       | $          | 9,579                                         |       |   |   | $ | 5,013 |   |   |
| Rental income                                                                                                                                                            |       |                                       | 535        |                                          |       |   | 518 |   |   |
| Total                                                                                                                                                                    |       |                                       | 10,114     |                                          |       |   | 5,531 |   |   |
| Cost of revenues                                                                                                                                                         |       |                                       |       |                                          |       |   |   |   |   |
| Cost of MEMS and Other revenue  (including stock-based compensation of $47 and $378 for the years ended  October 2, 2004 and September 27, 2003)               |       |                                       | 10,858     |                                          |       |   | 6,140 |   |   |
| Expenses applicable to rental income                                                                                                                                     |       |                                       | 135        |                                          |       |   | 152 |   |   |
| Total                                                                                                                                                                    |       |                                       | 10,993     |                                          |       |   | 6,292 |   |   |
| Gross loss                                                                                                                                                               |       |                                       | (879       | )                                             |       |   | (761 | ) |   |
| Research and  development expenses (including stock-based compensation of $40 and $316 for  the years ended October 2, 2004 and September 27, 2003)            |       |                                       | 530        |                                          |       |   | 939 |   |   |
| Selling, general  and administrative expenses (including stock-based compensation of $70 and $556  for the years ended October 2, 2004 and September 27, 2003) |       |                                       | 1,790      |                                          |       |   | 2,447 |   |   |
| Gain on sale of  building                                                                                                                                                |       |                                       | —     |                                          |       |   | (623 | ) |   |
| Loss from Operations                                                                                                                                                     |       |                                       | (3,199     | )                                             |       |   | (3,524 | ) |   |
| Interest income                                                                                                                                                          |       |                                       | 4          |                                          |       |   | 15 |   |   |
| Interest expense                                                                                                                                                         |       |                                       | (1,159     | )                                             |       |   | (2,021 | ) |   |
| Other income                                                                                                                                                             |       |                                       | 103        |                                          |       |   | 42 |   |   |
| Other expense                                                                                                                                                            |       |                                       | (1,052     | )                                             |       |   | (1,964 | ) |   |
| Loss from operations before provision for income  taxes                                                                                                                  |       |                                       | (4,251     | )                                             |       |   | (5,488 | ) |   |
| Provision for  income taxes                                                                                                                                              |       |                                       | 13         |                                          |       |   | 36 |   |   |
| Net loss                                                                                                                                                                 |       |                                       | $          | (4,264                                        | )          |   |   | $ | (5,524 | ) |   |
| Net loss per  share:                                                                                                                                                     |       |                                       |       |                                          |       |   |   |   |   |
| Loss per common share—basic and diluted                                                                                                                             |       |                                       | $          | (0.62                                         | )          |   |   | $ | (0.97 | ) |   |
| Weighted average  number of common shares outstanding:                                                                                                                   |       |                                       |       |                                          |       |   |   |   |   |
| Common shares—basic and  diluted                                                                                                                                    |       |                                       | 6,888      |                                          |       |   | 5,684 |   |   |

 

The accompanying Notes to Financial Statements are an integral part of these statements.

F-4

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**Innovative Micro Technology, Inc.STATEMENTS OF SHAREHOLDERS’EQUITY (DEFICIENCY)(In thousands, except share amounts)**

 
| ** **                                                | ** ** | **Successor  Common Stock** | ** ** | ** ** | ** ** | ** **           | ** ** | ** **               | ** ** | ** **            | ** ** |                           |
|-----------------------------------------------------------|------------|----------------------------------|------------|------------|------------|----------------------|------------|--------------------------|------------|-----------------------|------------|--------------------------------|
| ** **                                                | ** ** | **Number  of Shares**       | ** ** | **Amount** | ** ** | **Paid-in  Capital** | ** ** | **Accumulated  Deficit** | ** ** | **Restricted  Stock** | ** ** | **Shareholders’  Equity** | ** ** |
| Balance,  September 28, 2002                         |       | 5,434,998                        |       |       | $          | 1                    |       |                     | $          | 16,714                |       |                           | $ | (7,745 | ) |   |   | $ | (1,406 | ) |   |   | $ | 7,564 |   |   |
| Private equity  sale                                      |       | 467,500                          |       |       |       |                 |       | 2,488                    |       |                  |       |                           |   |   |   |   |   |   | 2,488 |   |   |
| Amortization and  deemed issuance of restricted stock     |       | 250,000                          |       |       |       |                 |       |                     |       |                  |       |                           |   |   | 1,249 |   |   |   | 1,249 |   |   |
| Net loss                                                  |       |                             |       |       |       |                 |       |                     |       |                  | (5,524     | )                              |   |   |   |   |   |   | (5,524 | ) |   |
| Balance,  September 27, 2003                         |       | 6,152,498                        |       |       | 1          |                 |       | 19,202                   |       |                  | (13,269    | )                              |   |   | (157 | ) |   |   | 5,777 |   |   |
| Private equity  sale                                      |       | 167,000                          |       |       |       |                 |       | 894                      |       |                  |       |                           |   |   |   |   |   |   | 894 |   |   |
| Cancellation of  shares                                   |       | (167                             | )          |       |       |                 |       |                     |       |                  |       |                           |   |   |   |   |   |   | — |   |   |
| Conversion of professional  notes payable to common stock |       | 368,113                          |       |       |       |                 |       | 2,960                    |       |                  |       |                           |   |   |   |   |   |   | 2,960 |   |   |
| Amortization and  deemed issuance of restricted stock     |       | 250,000                          |       |       |       |                 |       |                     |       |                  |       |                           |   |   | 157 |   |   |   | 157 |   |   |
| Net loss                                                  |       |                             |       |       |       |                 |       |                     |       |                  | (4,264     | )                              |   |   |   |   |   |   | (4,264 | ) |   |
| Balance,  October 2, 2004                            |       | 6,937,444                        |       |       | $          | 1                    |       |                     | $          | 23,056                |       |                           | $ | (17,533 | ) |   |   | $ | — |   |   |   | $ | 5,524 |   |   |

 

The accompanying Notes to Financial Statements are an integral part of these statements.

F-5

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**Innovative Micro Technology, IncSTATEMENTS OF CASH FLOWS(In thousands)**
| ** **                                                                       | ** ** | **Twelve Months  Ended  October 2, 2004** | ** ** | **Twelve Months  Ended  September 27, 2003** | ** ** |
|----------------------------------------------------------------------------------|------------|----------------------------------------------------------|------------|-------------------------------------------------------------|------------|
| Cash Flows from Operating Activities:                                            |       |                                                     |       |                                                        |       |   |   |   |   |
| Net loss                                                                         |       |                                                     | $          | (4,264                                                      | )          |   |   | $ | (5,524 | ) |   |
| Adjustments to reconcile net loss to net cash  provided by operating activities: |       |                                                     |       |                                                        |       |   |   |   |   |
| Depreciation and  amortization                                                   |       |                                                     | 1,155      |                                                        |       |   | 1,165 |   |   |
| Employee  restricted stock amortization                                          |       |                                                     | 157        |                                                        |       |   | 1,249 |   |   |
| Amortization of  loan costs                                                      |       |                                                     | —     |                                                        |       |   | 46 |   |   |
| Induced conversion  of professional notes                                        |       |                                                     | 203        |                                                        |       |   | — |   |   |
| Gain on sale of  assets                                                          |       |                                                     | —     |                                                        |       |   | (623 | ) |   |
| Non-cash interest                                                                |       |                                                     | 574        |                                                        |       |   | 574 |   |   |
| Changes in assets and  liabilities:                                              |       |                                                     |       |                                                        |       |   |   |   |   |
| Accounts  receivable                                                             |       |                                                     | (525       | )                                                           |       |   | 21 |   |   |
| Accounts  receivable—related party                                          |       |                                                     | 308        |                                                        |       |   | (280 | ) |   |
| Costs in excess of  billings on development projects                             |       |                                                     | (33        | )                                                           |       |   | 48 |   |   |
| Costs in excess of  billings on development projects—related party          |       |                                                     | —     |                                                        |       |   | 25 |   |   |
| Prepaid expenses  and other                                                      |       |                                                     | (6         | )                                                           |       |   | (37 | ) |   |
| Other assets                                                                     |       |                                                     | 155        |                                                        |       |   | 70 |   |   |
| Accounts payable                                                                 |       |                                                     | 156        |                                                        |       |   | (41 | ) |   |
| Accrued payroll  and benefits                                                    |       |                                                     | 190        |                                                        |       |   | 100 |   |   |
| Accrued property  taxes                                                          |       |                                                     | 1          |                                                        |       |   | (30 | ) |   |
| Accrued audit and  legal                                                         |       |                                                     | 79         |                                                        |       |   | (35 | ) |   |
| Billings in excess  of costs for development projects                            |       |                                                     | 289        |                                                        |       |   | 204 |   |   |
| Billings in excess  of costs for development projects—related party         |       |                                                     | 157        |                                                        |       |   | 536 |   |   |
| Other current  liabilities                                                       |       |                                                     | (392       | )                                                           |       |   | (135 | ) |   |
| Other long-term  liabilities                                                     |       |                                                     | (42        | )                                                           |       |   | (42 | ) |   |
| Net cash used in  operating activities                                           |       |                                                     | (1,838     | )                                                           |       |   | (2,709 | ) |   |
| Cash Flows from Investing Activities:                                            |       |                                                     |       |                                                        |       |   |   |   |   |
| Purchases of property,  plant and equipment                                      |       |                                                     | (14        | )                                                           |       |   | (64 | ) |   |
| Proceeds from sale of  building                                                  |       |                                                     | —     |                                                        |       |   | 6,198 |   |   |
| Proceeds from sale of  equipment                                                 |       |                                                     | —     |                                                        |       |   | 5 |   |   |
| Net cash provided by  (used in) investing activities                             |       |                                                     | (14        | )                                                           |       |   | 6,139 |   |   |
| Cash Flows from Financing Activities:                                            |       |                                                     |       |                                                        |       |   |   |   |   |
| Proceeds from sale of  common stock                                              |       |                                                     | 894        |                                                        |       |   | 2,500 |   |   |
| Equity issuance costs                                                            |       |                                                     | —     |                                                        |       |   | (12 | ) |   |
| Proceeds from issuance of  debt                                                  |       |                                                     | 1,500      |                                                        |       |   | — |   |   |
| Repayment of debt                                                                |       |                                                     | (2,576     | )                                                           |       |   | (6,345 | ) |   |
| Net cash used in  financing activities                                           |       |                                                     | (182       | )                                                           |       |   | (3,857 | ) |   |
| Net decrease in  cash                                                            |       |                                                     | (2,034     | )                                                           |       |   | (427 | ) |   |
| Cash at beginning of year                                                        |       |                                                     | 2,463      |                                                        |       |   | 2,890 |   |   |
| Cash at end of year                                                              |       |                                                     | $          | 429                                                         |       |   |   | $ | 2,463 |   |   |
| Supplemental Cash Flow Data:                                                     |       |                                                     |       |                                                        |       |   |   |   |   |
| Interest paid                                                                    |       |                                                     | $          | 1,113                                                       |       |   |   | $ | 1,406 |   |   |
| Income taxes paid                                                                |       |                                                     | $          | 25                                                          |       |   |   | $ | 22 |   |   |
| Supplemental disclosure on non-cash financing activity:                          |       |                                                     |       |                                                        |       |   |   |   |   |
| Conversion of professional notes payable to common  stock                        |       |                                                     | $          | 2,757                                                       |       |   |   | $ | — |   |   |

 

The accompanying Notes to Financial Statements are an integral part of these statements.

F-6

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**Innovative Micro Technology, IncNOTES TO FINANCIAL STATEMENTS**

**1.   Reorganization, Basis of Presentation**

Innovative Micro Technology, Inc. (the “Company”)was incorporated in California in 1957 and was reincorporated in Delaware in1987. The Company is engaged in the business of the design and manufacture ofMEMS devices. MEMS is anacronym for micro-electro-mechanical system. To date these operations haveconsisted of product development contracts. The Company’s business plan is totransition itself to a high volume manufacturer. MEMS devices were firstdeveloped in the late 1970s and early 1980s. Generally, MEMS devices are madeusing modern wafer-processing technology, similar to that used in makingsilicon electronic devices or thin-film recording heads for magnetic storagedevices. MEMS devices, however, are distinguished in that they are designed toinclude moving parts, hence the “mechanical” part of the name. By using modernwafer techniques, device complexity and performance is enhanced, and cost islowered due to the large number of devices that can be made on a single wafer.Common uses for MEMS devices are automotive air-bag sensors (accelerometers),pressure and airflow sensors, and ink­jet printer heads.

The Company used the Chapter 11 reorganizationdiscussed below to reposition itself in the MEMS business. The core competencyof the Company is wafer manufacturing and assembly. To that end, the Companyhas determined that the MEMS business allows use of the manufacturing facility,many of the manufacturing techniques, and the skills of its employees obtainedwhile manufacturing magnetic recording heads in the past.

The Company’s three additional lines of businessare:  “Santa Barbara Tool & Die,”“IMT Analytical” and leasing of excess space in its owned facility underlong-term lease contracts. Santa Barbara Tool & Die’s technologypermits high precision manufacturing of tooling, and the business featureselectron-discharge machining (EDM) which includes metals and ceramicscapabilities. IMT Analytical’s laboratory technology includes electronmicroscopy in a variety of forms and features operation of a focused ion beamtool which can precisely make three-dimensional cuts in samples and revealdetailed information as to dimension, material makeup, and material crystalproperties. Santa Barbara Tool & Die and IMT Analytical are strategicparts of the core company in that their services are used to make the corebusiness more competitive; and both use the capacity that exceeds internalCompany needs to provide services to outside customers. In addition, the Company has approximately51,000 square feet of building space available to lease. As of October 2,2004, approximately 34,000 square feet were under long term lease arrangementswith annual rental income of approximately $0.5 million.

The Company has incurred net losses and losses fromoperations for each quarter since 1999. The Company filed for reorganizationunder Chapter 11 of the U.S. Bankruptcy Code in January 2000 and, onemergence from bankruptcy, all of the previously issued and outstanding commonstock was canceled without consideration to the holders. The Company incurred anet loss of $4.3 million for the year ended October 2, 2004 and has aworking capital deficit of $2.7 million as of October 2, 2004. The Companyexpects to have increasing sales and marketing, research and development andgeneral and administrative expenses. As a result, it will need to significantlyincrease its revenues to achieve profitability. Although the Company’s revenueshave increased, the growth may not continue at the current rate or at all.

On September 30, 2003, the Company used $2.4million in cash as part of the agreement to cancel its Professional Notes (SeeNote 5). The Company also issued 368,113 shares of Common Stock, 16,437warrants for the purchase of Common Stock at a price of $5.35 and 68,777warrants for the purchase of Common Stock at a price of $7.29 to cancel theseProfessional Notes. This transaction cancelled $4.1 million in notes and $1.0 millionin accrued interest.

F-7

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On October 31, 2003, L-3 CommunicationsCorporation (“L-3”) exercised 167,000 warrants for the purchase of Common Stockat a price of $5.35 per share for a total of $0.9 million. L-3 received thesewarrants, as well as a thirty-six month warrant for the purchase of 700,000shares of Common Stock at $7.29 per share, as part of its $5.0 million August 2002investment in the Company. The Company used the funds for working capitalrequirements.

On March 15, 2004, the Company entered into anagreement for a Secured Promissory Note (“Note”) for $1.5 million with L-3. TheNote is due upon demand from L-3, and L-3 has the option to convert the Noteplus its accrued interest to common stock of the Company at the price of $5.35per share. The accrued and unpaid interest on the Note will be compoundedquarterly at a rate equal to the prime rate published in the Wall StreetJournal at the end of each quarter plus 2%. The Company used the funds forworking capital requirements.

On January 25, 2005, subsequent to the end ofthe fiscal year, the Company privately sold equity securities to an investorgroup made up of Investor Growth Capital Limited, BA Venture Partners andMiramar Venture Partners (“Investor Group”). The Investor Group invested a totalof $17.0 million in the Company in exchange for 1,000,000 shares of redeemablepreferred stock, 1,000,000 shares of convertible preferred stock and a warrantfor the purchase of up to 500,000 shares of common stock. The net proceeds tothe Company were approximately $16.0 million. The Company plans to useapproximately $1.6 million of the net proceeds to pay off the Note due to L-3. Theremainder of the net proceeds will be used for general working capital needs and other corporate purposes.  (SeeNote 11).

The Company is still attempting to refinance itsexisting 12% interest mortgage with current lower rates. The Company cannotgive assurance that refinancing of this mortgage will be available or, ifavailable, that its terms will be favorable to the Company. If the Company isunable to achieve its production goals or obtain additional financing onacceptable terms on a timely basis, there will be a material adverse effect onthe Company’s financial condition and competitive position.

The Company exited Chapter 11 on November 16,2001 (“Effective Date”). The Company adopted the fresh start reportingrequirements of Statement of Position 90-7, “Financial Reporting by Entities inReorganization under the Bankruptcy Code” during the first quarter of fiscal2002. In accordance with the fresh start reporting requirements, thereorganization value of the Company was allocated to the Company’s assets inconformity with the procedures specified by Statement of Financial AccountingStandards (“SFAS”) No. 142, “Goodwill and Other Intangible Assets.” Asprovided for under the Company’s reorganization plan (the “Reorganization Plan”),the Company converted approximately $12 million of its secured liabilities todebt and $304 million of unsecured liabilities to equity in the reorganizedentity.

A provision of theReorganization Plan related to the treatment of subordinated Note claims. TheCompany’s former Malaysian subsidiary had credit facilities with five MalaysianBanks (“Malaysian Banks”) that were guaranteed by the Company, and thatprovided them with a credit position that was senior to the Company’s noteholders. The Company’s 14% Note, 2% Notes and 7% Notes each containedsubordination provisions. Pursuant to these provisions the Malaysian Banks, theholder of the 14% Note, the holders of the 2% Notes, and the holders of the 7%Notes have certain subordinated rights and claims. A Warrant Agreement wasincluded in the Reorganization Plan to provide a method for the subordinatedclaimants to participate in the anticipated future growth in value of theCompany’s Common Stock that was issued pursuant to the Reorganization Plan (“NewCommon Stock”). The Company has no remaining guaranties. The Warrant Agreementterminated on November 16, 2004, subsequent to fiscal 2004 year end, andall warrants were cancelled.

F-8

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**2.   Summary of Significant Accounting Policies**

**Useof Estimates:****  **Thepreparation of financial statements in conformity with  accounting principles generally accepted inthe United States of America requires management to make estimates andassumptions that affect the reported amounts of assets and liabilities anddisclosure of contingent assets and liabilities at the date of the financialstatements and the reported amounts of revenues and expenses during the reportingperiod. Actual results could differ from these estimates.

Management believes that these estimates andassumptions provide a reasonable basis for the fair presentation of theconsolidated financial statements.

**Depreciationand Amortization Policies:****  **Inaccordance with the fresh start reporting requirements, property, plant, andequipment are stated at fair value at the Effective Date and are depreciated oramortized over their estimated useful lives using the straight-line method,except for leasehold improvements which are amortized over the shorter of theestimated useful life or the life of the lease.

Estimated useful lives areas follows:
| ** **               | ** ** | **Average Useful Life** | ** **  |
|--------------------------|------------|-----------------------------------|-------------|
| Buildings                |       |                              | 25 Years    | ** ** |   |
| Manufacturing  equipment |       |                              | 3 - 5 Years | ** ** |   |
| Other equipment          |       |                              | 1 - 5 Years | ** ** |   |
| Building improvements    |       |                              | 10 Years    | ** ** |   |

 

Depreciation and amortization expense amounted to $1.2million for fiscal 2004 and fiscal 2003.

**Long-livedAssets:****  **TheCompany reviews long-lived assets for impairment whenever events or changes incircumstances indicate that an asset’s carrying value may exceed theundiscounted expected future cash flows to be derived from that asset. Wheneverundiscounted expected future cash flows are less than the carrying value, theasset will be reduced to an amount equal to the net present value of theexpected future cash flows and an impairment loss will be recognized.

**Billingsin excess of costs on development projects:****  **These amounts reflect the excess of billings over theaccumulated costs as defined in the completed contract method of accounting forlong-term contracts. Billings in excess of costs at October 2, 2004 were$1.3 million related to capitalized costs under the completed contract methodof accounting, as described below. Contracts with L-3 (a related party) accountfor $0.7 million of this billings in excess of costs on development projectsbalance.

**RevenueRecognition and Warranty Policies:****  **TheCompany uses the completed contract method of accounting for its productdevelopment projects due to the inability to accurately estimate percentage ofcompletion during performance of the contract. Costs are capitalized during theproject and recorded as cost of revenue at its completion along with therecognition of revenue. Losses on projects are recognized as they aredetermined. The Company’s MEMS development contracts include milestones thatrequire delivery of engineering reports, wafers and/or dies. The Company’s MEMSdevelopment contracts are determined to be complete after all contractmilestones have been completed, reviewed and accepted by the customer. SantaBarbara Tool & Die delivers a finished product to the customer andrevenue is recognized after both the product is shipped and title passes. IMTAnalytical has service related revenue and this revenue is recognized uponcompletion of the service for the customer. The Company’s MEMS developmentcontracts do not have any rights of return. Santa Barbara Tool & Dieand IMT Analytical did not have any sales returns in fiscal 2004 or 2003. TheCompany’s warranty policy provides for the replacement of defective parts whenthe customers return request is approved within thirty days of the originalshipment date. To date, warranty costs have not been significant.

F-9

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Aportion of the Company’s facilities are leased to tenants under long-termcontracts. The terms of the leases expire within the next two years withrenewal at the option of the tenants. Future minimum lease income for theseagreements, as of October 2, 2004 are as follows (in thousands):
| **Fiscal Year** | ** ** | ** ** | ** ** | **Rental  Income** | ** ** |
|----------------------|------------|------------|------------|--------------------|------------|
| 2005                 |       |       | $          | 493                |       |   |
| 2006                 |       |       | 462        |               |       |
| Total minimum income |       |       | $          | 955                |       |   |

 

**FairValue of Financial Instruments:****  **Thecarrying amounts of cash, customer receivables, trade accounts payable andother accrued liabilities approximate their fair value because of the shortmaturity of these financial instruments. The carrying amount of approximately$8.8 million of the Company’s mortgage indebtedness at October 2, 2004 hasan interest rate of 12% and is carried at its full value. The 8% interest rateon $0.5 million of debt due on delinquent property taxes is at rates belowmarket. The fair value of the debt would be $0.3 million based on the Company’scost of capital of 12%. The 6% interest rate on $1.5 million of debt due on theNote with L-3 is at rates below market. The fair value of the debt would be$0.8 million based on the Company’s cost of capital of 12%.

**NetLoss per Common Share.****  **Basicloss per share is computed by dividing net loss by the weighted average numberof common shares outstanding. Diluted loss per share is computed by dividingnet loss by the sum of the weighted average number of common shares outstandingfor the period plus the assumed exercise of all dilutive securities. However,in the case of a loss per share, dilutive securities outstanding would beantidilutive and would, therefore, be excluded from the computation of dilutedloss per share.

The following dilutive securities were outstanding at September 27,2003: 250,000 shares of restricted Common Stock issuable in accordance with theReorganization Plan, options to purchase 1,664,897 common shares at pricesranging from $5.00 to $5.35, warrants to purchase 167,000 common shares at aprice of $5.35 per share with a term of eighteen months ending February 1,2004, warrants to purchase 700,000 common shares at a price of $7.29 per sharewith a term of thirty-six months ending August 1, 2005, warrants topurchase 83,500 common shares at a price of $5.35 per share with a term ofeighteen months ending March 3, 2005, warrants to purchase 350,000 commonshares at a price of $7.29 per share with a term of thirty- six months ending September 3,2006, and approximately 504,500 common shares from the potential conversion ofthe Professional Persons convertible debt which is due November 16, 2003(See Note 11). The warrants issuable to the subordinated note claimantspursuant to the Reorganization Plan, which were exercisable for 1,880,564common shares as of September 27, 2003, were not considered dilutive asthe Company had an offsetting right to repurchase an equal number of shares atthe same prices.

The following dilutive securities were outstanding at October 2,2004: 500,000 shares of restricted Common Stock issuable in accordance with theReorganization Plan, options to purchase 1,723,652 common shares at pricesranging from $5.00 to $5.35, warrants to purchase 700,000 common shares at aprice of $7.29 per share with a term of thirty-six months ending August 1,2005, warrants to purchase 83,500 common shares at a price of $5.35 per sharewith a term of eighteen months ending March 3, 2005, warrants to purchase350,000 common shares at a price of $7.29 per share with a term of thirty-sixmonths ending September 3, 2006, warrants to purchase 16,437 common sharesat a price of $5.35 with a term of eighteen months ending March 30, 2005and warrants to purchase 68,777 common shares at a price of $7.29 per sharewith a term of thirty-six months ending September 30, 2006. The Warrantsissuable to the subordinated note claimants pursuant to the ReorganizationPlan, which were exercisable for 1,880,564 common shares as of October 2,2004, are not considered dilutive as the Company had an offsetting right torepurchase an equal number of shares at the same prices. The warrants issued tothe subordinated note 

F-10

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claimants terminated on November 16,2004, subsequent to fiscal 2004 year end, along with all related repurchaserights of the Company.

**Stock Based Compensation:****  **The Company accounts for its equity compensation  plans in accordance with AccountingPrinciples Board Opinion No. 25. As stock options granted in the currentperiod were granted at or above fair market value, no compensation expense hasbeen recorded. Had the Company instead determined compensation cost on thebasis of fair value pursuant to SFAS No. 123, “Accounting for Stock-BasedCompensation,” net loss and basic and diluted EPS would have been as follows(in thousands, except per share amounts):
| ** **                                                         | ** ** | **Year Ended  October 2, 2004** | ** ** | **Year Ended  September 27, 2003** | ** ** |
|--------------------------------------------------------------------|------------|------------------------------------------------|------------|---------------------------------------------------|------------|
| Net loss—as  reported                                         |       |                                           | $          | (4,264                                            | )          |   |   | $ | (5,524 | ) |   |
| Less—fair value  of stock-based employee compensation expense |       |                                           | (1,135     | )                                                 |       |   | (1,099 | ) |   |
| Net loss—pro  forma                                           |       |                                           | $          | (5,399                                            | )          |   |   | $ | (6,623 | ) |   |
| Net loss per share  (basic and diluted)—as reported           |       |                                           | $          | (.62                                              | )          |   |   | $ | (.97 | ) |   |
| Net loss per share  (basic and diluted)—pro forma             |       |                                           | $          | (.78                                              | )          |   |   | $ | (1.17 | ) |   |

 

In assessing the effect had the fair value method beenused, the fair value of each option is estimated on the date of grant using theBlack-Scholes option pricing model with the following assumptions for the yearended October 2, 2004: weighted average risk-free interest rate of 3.71%,expected volatility of 66%, an expected option life of 4 years, and no expecteddividends. The assumptions for the fiscal 2003 period are as follows: weightedaverage risk-free interest rate of 3.80%, expected volatility of 72%, anexpected option life of 4 years, and no expected dividends. The fair value ofthe option grants was $4.7 million for the year ended October 2, 2004 and$4.8 million for the year ended September 27, 2003.

**Researchand Development Expenses:****  **TheCompany is actively engaged in basic technology and applied research anddevelopment programs, which are designed to develop new products and productapplications and related manufacturing processes. The costs of these programsare classified as research and development expenses and are charged tooperations as incurred.

**Income Taxes:****  **Income taxes are computed using the liability method.The provision for income taxes includes income taxes payable for the currentperiod and the deferred income tax consequences of transactions that have beenrecognized in the Company’s financial statements or income tax returns. Thecarrying value of deferred income tax assets is determined based on anevaluation of whether the Company is more likely than not to realize theassets. Temporary differences result primarily from basis differences inproperty, plant and equipment and net operating loss carryforwards. Thevaluation allowance is reviewed periodically to determine the amount ofdeferred tax asset considered realizable.

**Recent Accounting Pronouncements:**

In December 2003, the SEC issued SAB 104, whichsupercedes SAB 101. While the wording of SAB 104 has changed to reflectthe issuance of Emerging Issues Task Force Issue No. 00-21 “Accounting forRevenue Arrangements with Multiple Deliverables” (EITF 00-21), the revenuerecognition principles of SAB 101 remain largely unchanged by the issuance ofSAB 104. The adoption of SAB 104 did not have a material effect on the Company’sfinancial condition or results of operations.

In December 2003, the FASB issued Interpretation46R (FIN 46R), a revision to Interpretation 46 (FIN 46), Consolidation ofVariable Interest Entities. FIN 46R clarifies some of the provisions of FIN 46and exempts certain entities from its requirements. FIN 46R is effective at theend of the first interim period ending after March 15, 2004. Entities thathave adopted FIN 46 prior to this effective date can 

F-11

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continue to apply theprovisions of FIN 46 until the effective date of FIN 46R or elect early adoptionof FIN 46R. The adoption of FIN 46R did not have a material impact on theCompany’s financial statements.

In December 2004, the FASB issued SFAS 123R “Share-BasedPayment,” a revision to FASB No. 123. SFAS 123R replaces existingrequirements under SFAS No. 123 and APB Opinion No. 25, and requirespublic companies to recognize the cost of employee services received inexchange for equity instruments, based on the grant-date fair value of thoseinstruments, with limited exceptions. SFAS 123R also affects the pattern inwhich compensation cost is recognized, the accounting for employee sharepurchase plans, and the accounting for income tax effects of share-basedpayment transactions. For small-business filers, SFAS 123R will be effectivefor interim periods beginning after December 15, 2005. The Company iscurrently determining what impact the proposed statement would have on itsresults of operations and financial position.

The FASB has proposed FASB Staff Position No. FAS109-a, “Application of FASB Statement No. 109, Accounting for IncomeTaxes, for the Tax Deduction Provided to U.S. Based Manufacturers by theAmerican Jobs Creation Act of 2004.”  On October 22,2004, the American Jobs Creation Act of 2004 (the “ACT”) was signed into law bythe President. This Act includes tax relief for domestic manufacturers byproviding a tax deduction up to 9 percent (when fully phased-in) of the lesserof (a) “qualified production activities income,” as defined in the Act, or(b) taxable income (after the deduction for the utilization of any netoperating loss carry forwards). As a result of this Act, an issue has arisen asto whether this deduction should be accounted for as a special deduction or atax rate reduction under Statement 109. The FASB staff believes that thedomestic manufacturing deduction’s characteristics are similar to specialdeductions because the domestic manufacturing deduction is based on the futureperformance of specific activities, including the level of wages. Accordingly,the FASB staff believes that the deduction provided for under the Act should beaccounted for as a special deduction in accordance with Statement 109 and notas a tax rate reduction. This provision of the Act is not expected to have amaterial impact on the Company’s financial statements.

**RiskConcentrations:****  **Financialinstruments that potentially subject the Company to concentrations of creditrisk consist primarily of accounts receivable. The Company performs ongoingcredit evaluations of its customers and maintains an allowance for potentialcredit losses.

The table below shows the revenue by customer andindicates that L-3 represented 40% of the Company’s revenue for the year ended October 2,2004. The Company had $0.1 million of accounts receivable from this customer,representing 10% of the Company’s accounts receivable balance at October 2,2004. An assistance agreement from the U.S. Defense Advanced Research ProjectsAgency (“DARPA”) represented 11% of the Company’s revenue for the year ended October 2,2004. The Company had $0.2 million of outstanding accounts receivable from thiscustomer, representing 17% of the Company’s accounts receivable balance at October 2,2004.

GalaxyScientific Corp. represented 14% of the Company’s revenue for the year ended September 27,2003. Marubeni Solutions represented 13% of the Company’s revenue for the yearended September 27, 2003. Turnstone Systems Inc. represented 12% of theCompany’s revenue for the year ended September 27, 2003. An assistanceagreement from the U.S. Defense Advanced Research Projects Agency (“DARPA”)represented 11% of the Company’s revenue for the year ended September 27,2003.

F-12

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**Revenue by Customer**
| ** **                  | ** ** | **Year Ended  October 2, 2004**       | ** ** | **Year Ended  September 27, 2003** | ** ** |
|-----------------------------|------------|------------------------------------------------------|------------|---------------------------------------------------|------------|
| ** **                  | ** ** | **(As a percentage of revenue)** | ** ** |
| L-3                         |       |                                                 | 40         | %                                                 |       |   | 0 | % |   |
| DARPA assistance  agreement |       |                                                 | 11         | %                                                 |       |   | 11 | % |   |
| OCCAM  Networks, Inc.  |       |                                                 | 5          | %                                                 |       |   | 9 | % |   |
| Marubeni  Solutions         |       |                                                 | 4          | %                                                 |       |   | 13 | % |   |
| Galaxy Scientific           |       |                                                 | 1          | %                                                 |       |   | 14 | % |   |
| Spectra                     |       |                                                 | 1          | %                                                 |       |   | 9 | % |   |
| Turnstone Systems           |       |                                                 | 0          | %                                                 |       |   | 12 | % |   |
| All Others                  |       |                                                 | 38         | %                                                 |       |   | 32 | % |   |
| Total                       |       |                                                 | 100        | %                                                 |       |   | 100 | % |   |

 

**CashConcentration:****  **TheCompany places its cash with major financial institutions. At times, cash andcash equivalents balances may be in excess of amounts insured by Federalagencies. At October 2, 2004, uninsured cash balances approximated $0.3million.

**Advertising:****  **The Company expenses advertising costs when incurred.Advertising expense was immaterial for both fiscal 2004 and 2003.

**Fiscal Year:****  **The Company’s fiscal year ends on the Saturdayclosest to September 30. Fiscal years 2004 and 2003 ended on October 2,2004 and September 27, 2003, respectively. Fiscal 2004 included 53 weeksand fiscal 2002 included 52 weeks. References to years in these financialstatements relate to fiscal years rather than calendar years.

**3.   Segments ofBusiness**

Indicated below is the information required to complywith SFAS No. 131, “Disclosuresabout Segments of an Enterprise and Related Information.” Under SFAS No. 131,“operating segments” are components of an enterprise about which separatefinancial information is available that is evaluated regularly by the chiefoperating decision maker in deciding how to allocate resources and in assessingperformance. Generally, financial information is required to be reported on thebasis that it is used internally for evaluating segment performance anddeciding how to allocate resources to segments.

The Company operates in four business segments. Itmanufactures MEMS devices for several industries. It also operates a machine,model and die shop, a materials science analytical lab and leases excess spacein its owned facility to tenants under long-term lease contracts. The Company’sassets are all located in the United States.

The Company’s management evaluates performance of eachsegment primarily on net revenue and gross profit (loss), as well as long-livedassets. The information in the following table is derived directly from thesegments’ internal financial reporting used for corporate management purposes.Research and development and general and administrative expenses are notallocated to or among the segments.

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Thefollowing table represents net revenue, gross profit (loss), depreciationexpense and long-lived assets by segment (in thousands):
| ** **                                                     | ** ** | **MEMS**          | ** ** | **Santa Barbara  Tool & Die** | ** ** | **IMT  Analytical** | ** ** | **Rental  Income** | ** ** | **United States  Total** | ** ** |
|----------------------------------------------------------------|------------|-------------------|------------|--------------------------------------------------|------------|---------------------|------------|--------------------|------------|-------------------------------|------------|
| ** **                                                     | ** ** | **($000’s)** | ** ** |
| **Year Ended: October 2,  2004**                          | ** ** | ** **        | ** ** |                                             | ** ** | ** **          |       |               | ** ** | ** **                    |       | ** ** | ** ** |   | ** ** | ** ** |   |
| Net revenue                                                    |       | $                 | 8,310      |                                             |       | $                   | 1,200      | ** **         |       |                          | $          | 69 | ** ** |   | $ | 535 |   |   | $ | 10,114 | ** ** |   |
| Intercompany  Revenue                                          |       | $                 | 12         |                                             |       | $                   | 68         | ** **         |       |                          | $          | 361 | ** ** |   | $ | — |   |   | $ | — | ** ** |   |
| Gross profit  (loss)                                           |       | $                 | (1,560     | )                                                |       | $                   | 166        | ** **         |       |                          | $          | 115 | ** ** |   | $ | 400 |   |   | $ | (879 | **)** |   |
| Depreciation  Expense                                          |       | $                 | 956        |                                             |       | $                   | 55         | ** **         |       |                          | $          | 23 | ** ** |   | $ | 121 |   |   | $ | 1,155 | ** ** |   |
| Cost of Revenues portion  of Non-Cash Stock Based Compensation |       | $                 | 47         |                                             |       | $                   | —     | ** **         |       |                          | $          | — | ** ** |   | $ | — |   |   | $ | 47 | ** ** |   |
| Long-Lived Assets                                              |       | $                 | 14,661     |                                             |       | $                   | 83         | ** **         |       |                          | $          | 23 | ** ** |   | $ | 2,412 |   |   | $ | 17,179 | ** ** |   |
| **Year  Ended: September 27, 2003**                       | ** ** | ** **        | ** ** |                                             | ** ** | ** **          |       |               | ** ** | ** **                    |       | ** ** | ** ** |   | ** ** | ** ** |   |
| Net revenue                                                    |       | $                 | 4,076      |                                             |       | $                   | 766        | ** **         |       |                          | $          | 171 | ** ** |   | $ | 518 |   |   | $ | 5,531 | ** ** |   |
| Intercompany  Revenue                                          |       | $                 | 7          |                                             |       | $                   | 90         | ** **         |       |                          | $          | 291 | ** ** |   | $ | — |   |   | $ | — | ** ** |   |
| Gross profit  (loss)                                           |       | $                 | (1,264     | )                                                |       | $                   | 89         | ** **         |       |                          | $          | 48 | ** ** |   | $ | 366 |   |   | $ | (761 | **)** |   |
| Depreciation  Expense                                          |       | $                 | 972        |                                             |       | $                   | 51         | ** **         |       |                          | $          | 23 | ** ** |   | $ | 119 |   |   | $ | 1,165 | ** ** |   |
| Cost of Revenues  portion of Non-Cash Stock Based Compensation |       | $                 | 378        |                                             |       | $                   | —     | ** **         |       |                          | $          | — | ** ** |   | $ | — |   |   | $ | 378 | ** ** |   |
| Long-Lived Assets                                              |       | $                 | 15,617     |                                             |       | $                   | 125        | ** **         |       |                          | $          | 46 | ** ** |   | $ | 2,532 |   |   | $ | 18,320 | ** ** |   |

 

The MEMS intercompany revenue results from managementservices provided to IMT Analytical and is charged at the cost of suchservices. The Santa Barbara Tool & Die and IMT Analytical intercompanyrevenue provided to the MEMS segment, for the services received, is recorded atmarket prices for their services.

Capital additions for fiscal 2004 were minimal.Capital additions for fiscal 2003 were $0.1 million. The fiscal 2003 additionswere predominantly related to the MEMS portion of the business.

Thefollowing table represents the Company’s net revenue for domestic and foreigncustomers (in thousands):
| ** **   | ** ** | **Year Ended  October 2, 2004** | ** ** | **Year Ended  September 27, 2003** | ** ** |
|--------------|------------|------------------------------------------------|------------|---------------------------------------------------|------------|
| Net revenue: |       |                                           |       |                                              |       |   |   |   |   |
| Domestic     |       |                                           | $          | 9,413                                             |       |   |   | $ | 4,830 |   |   |
| Foreign      |       |                                           | 701        |                                              |       |   | 701 |   |   |
| Total        |       |                                           | $          | 10,114                                            |       |   |   | $ | 5,531 |   |   |

 

The Company’s products aresold in the United States, Canada and Japan by its direct sales personnel.

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**4.   IncomeTaxes**

Theprovision for income taxes for the following fiscal years consists of (inthousands):
| ** **            | ** ** | **Year Ended  October 2, 2004** | ** ** | **Year Ended  September 27, 2003** | ** ** |
|-----------------------|------------|------------------------------------------------|------------|---------------------------------------------------|------------|
| Federal Income  Taxes |       |                                           |       |                                              |       |   |   |   |   |
| Current               |       |                                           | $          | —                                            |       |   |   | $ | — |   |   |
| Deferred              |       |                                           | —     |                                              |       |   | — |   |   |
| State Income  Taxes   |       |                                           |       |                                              |       |   |   |   |   |
| Current               |       |                                           | 13         |                                              |       |   | 36 |   |   |
| Deferred              |       |                                           | —     |                                              |       |   | — |   |   |
| Total                 |       |                                           | $          | 13                                                |       |   |   | $ | 36 |   |   |

 

Reconciliationof the actual provisions for income taxes to the income tax calculated at theUnited States Federal rates for operations were as follows (in thousands):
| ** **                                                                | ** ** | **Year Ended  October 2, 2004** | ** ** | **Year Ended  September 27, 2003** | ** ** |
|---------------------------------------------------------------------------|------------|------------------------------------------------|------------|---------------------------------------------------|------------|
| Expected income  tax benefit at the United States federal income tax rate |       |                                           | $          | (1,446                                            | )          |   |   | $ | (1,878 | ) |   |
| State income  taxes, net of federal income tax benefit                    |       |                                           | (246       | )                                                 |       |   | (295 | ) |   |
| Change in  valuation allowance                                            |       |                                           | 1,705      |                                              |       |   | 2,209 |   |   |
|                                                                      |       |                                           | $          | 13                                                |       |   |   | $ | 36 |   |   |

 

Thecomponents of deferred income taxes at October 2, 2004 are as follows (inthousands):
| Net operating  loss carryforwards                  |   | $       | 12,896 |   |
|----------------------------------------------------|--------|---------|--------|--------|
| Basis difference  in property, plant and equipment |   | 986     |   |
| Other                                              |   | 1,632   |   |
| Total deferred  tax asset                          |   | 15,514  |   |
| Valuation  allowance                               |   | (15,514 | )      |
| Total net deferred tax  asset                      |   | $       | — |   |

 

SFAS 109 requires that all deferred tax balances bedetermined using the tax rates and limitations expected to be in effect whenthe taxes will actually be paid or recovered. Consequently, the income taxprovision will increase or decrease in the period in which a change in tax rateor limitation is enacted. As of October 2, 2004, the Company had totaldeferred tax assets of $15.5 million. The Company recorded a valuationallowance in the full amount of $15.5 million at October 2, 2004, againstthe amount by which deferred tax assets exceed deferred tax liabilities. Thisrepresents an increase in the valuation allowance of $1.7 million at year-end2004 over year-end 2003. The valuation reserve at October 2, 2004 has beenprovided due to the uncertainty of the amount of future taxable income. TheCompany provides a valuation allowance in the full amount of its deferred taxassets because under the criteria of SFAS No. 109, the Company does nothave a basis to conclude that it is more likely than not that it will realizethe deferred tax assets.

Due to the change incontrol that resulted from the bankruptcy, the Company may not be able toreceive the full benefit of net operating loss carryforwards accumulated priorto the bankruptcy. Portions of the Company’s pre-bankruptcy tax losses,however, may be eligible for use in future periods. The Company iscurrently evaluating these amounts. From the commencement of the Chapter 11 

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reorganizationthrough October 2, 2004, the Company has accumulated net operating losscarryforwards of approximately $32.2 million for federal tax purposes and $16.1million for state tax purposes. Once the Company has utilized these remainingnet operating loss carry forwards, future U.S. earnings will be taxed at theU.S. statutory rates less available tax credits, if any. To the extent notused, the net operating loss carryforwards for federal and state purposesexpire in varying amounts beginning in 2021 and 2011, respectively**.** At October 2, 2004, all identified deferred taxassets are reduced by a valuation allowance therefore, any additional operatingloss carryforwards not recognized would not result in a benefit in theprovision for income taxes due to the uncertainty of future realization ofthose additional operating loss carryforwards.

**5.   Debt**

The Reorganization Plan provided for the treatment ofthe unpaid professional persons involved in the reorganization process. Thetotal amount owed to these professional persons as of the Effective Date was$4.1 million. The Bankruptcy Code provides that each Professional Person,defined as the law firms and investment bankers employed by the Company duringthe Chapter 11 reorganization, is entitled to be paid cash, in full, at theEffective Date in an amount equal to their Professional Person’s AllowedAdministrative Claim. In consideration for each Professional Person waivingthis right and agreeing to accept a convertible promissory note, theReorganization Plan provided for each Professional Person to have an AllowedAdministrative Claim as of the Effective Date. The convertible notes were dueon November 15, 2003. The notes required interest-only payments at 12%annual interest rate. The notes were convertible to common stock of the Companyat a conversion price of $8.20 per share. The Company had not made any of themonthly interest payments to the Professional Persons and, in accordance with theSecured Promissory Note, the Company had accrued an additional 3% of annualinterest due to default. Consequently, the notes were considered to be currentdebt. As of September 27, 2003, the amount of accrued interest associatedwith these notes was $1.0 million and was recorded as part of other currentliabilities. The notes were secured by substantially all of the assets of theCompany.

On September 30, 2003, the Company paid $2.4million in cash and issued 368,113 shares of Common Stock, warrants for thepurchase 16,437 common shares at a price of $5.35 and warrants for the purchaseof 68,777 common shares at a price of $7.29 to cancel its Professional Notes.This transaction cancelled $4.1 million in notes and $1.0 million in accruedinterest. The Company issued 91,826 common shares at $5.35 per share, which wasbelow the original conversion price of the Notes of $8.20. This reduced priceplus warrants to purchase additional common stock were offered to induce theholders to take a reduced amount of cash for their final agreement with theCompany. The Company recognized approximately $0.2 million in expense in thefirst fiscal quarter of 2004 related to this transaction.

The Company settled two claims during the Chapter 11reorganization that were secured by its owned properties. One of these claimsis a property mortgage of $9.6 million due on November 24, 2005. Upon thesale of the Company’s Hollister facility, in the second quarter of fiscal 2003,a portion of the proceeds were used to reduce this debt to $8.8 million. Thebalance of the proceeds were used to pay, in full, a separate loan with abalance of $5.4 million. The remaining mortgage requires interest-only paymentsat a 12% annual interest rate. The other claim was for delinquent property taxesof $0.9 million, of which $0.5 million remains outstanding at October 2,2004. The settlement requires semi-annual principal and interest payments on November 1stand May 1st of each year with an 8% annual interest rate. Thefinal payment is due on November 1, 2006.

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TheCompany’s long-term debt is summarized below (in thousands):
| ** **                 | ** ** | **October 2,  2004** | ** ** |
|----------------------------|------------|---------------------------|------------|
| Secured  Promissory Note   |       | $                         | 1,500      |   |
| Property Mortgage          |       | 8,830                     |       |
| Property Taxes             |       | 470                       |       |
|                       |       | 10,800                    |       |
| Less—Current  portion |       | (1,688                    | )          |
| Total                      |       | $                         | 9,112      |   |

 

Theaggregate maturities of long-term debt are as follows (in thousands):
| **Fiscal Year** | ** ** | ** ** | ** ** | ** ** | ** ** |
|----------------------|------------|------------|------------|------------|------------|
| 2005                 |       | $          | 1,688      |       |
| 2006                 |       | 9,018      |       |
| 2007                 |       | 94         |       |
| Total                |       | $          | 10,800     |       |

 

**6.  Commitmentsand Contingencies**

The Company uses hazardous chemicals in itsmanufacturing and is subject to a variety of environmental and land useregulations related to their use, storage and disposal. If the Company fails tocomply with present or future regulations, liability, production suspension ordelay could result. In addition, environmental or land use regulations couldrestrict the Company’s ability to expand its current production facilities orestablish additional facilities in other locations, or could require theCompany to acquire costly equipment, or to incur other significant expenses forcompliance with environmental regulations or to clean up prior discharges. TheCompany currently maintains a restricted cash account of $0.1 million in otherassets as required by the Department of Toxic Substance Control.

The Company has been subject to regulatory and legalproceedings related to past environmental contamination, and other similarproceedings could arise in the future. The Company has recently been advised bythe U.S. Environmental Protection Agency that it may be required to pay forpart of the remediation of a solvent and refrigerant recycling and treatmentfacility formerly operated by the Omega Chemical Company in Whittier,California. The EPA alleges that the Company provided solvent and refrigerantwaste to this facility for recycling and disposal. The Company is stillexploring legal defenses, including defenses arising out of the bankruptcyproceedings. At this time, the Company intends to defend this matter vigorously.If these legal defenses are unsuccessful, the Company could be required to payan amount of less than $0.1 million. The Company is also remediating andmonitoring ground water contaminated with volatile organic compounds (“VOCs”)at a former site leased by the Company in Goleta, California, under an order ofthe California Regional Water Quality Control Board (“CRWQCB”). VOCcontamination at the site has been reduced and the Company does not expectfuture expenditures related to the site to be material.

In fiscal 2003, the Company sold its Hollisterfacility. The environmental testing performed by the Company in support of thissale determined that the soil showed no metal or VOC contamination. However,ground water samples showed low levels of VOC contamination. The CRWQCBrequired the Company to install one monitoring well, and test results confirmedthe low level VOC concentration. The Company has been asked by the CRWQCB tosubmit semi-annual sample results from its well. One property adjacent to theCompany is conducting a remediation project on its site for this same VOC andthe CRWQCB required this property to place monitoring wells between the twoproperties. Their testing detected the presence of breakdown products of thesame VOC. The owners of the adjacent property have 

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been asked to conductsemi-annual sampling of the wells. A second property adjacent to the Company isconducting site characterization under the guidance of the CRWQCB related tothe same VOC found on the Company’s site. In the fourth fiscal quarter of 2004,the CRWQCB issued a letter to the Company indicating that their investigationof the adjacent properties led them to the conclusion that the VOC present onthe Company’s site was the Company’s responsibility. The CRWQCB has requestedthat the Company continue to submit results from the semi-annual monitoring ofits well. The Company is unable to make a determination of potential futurecosts for this situation. The Company has a $5.0 million environmentalinsurance policy covering potential liability relating to this property. TheCompany’s accumulated cost to date for these matters related to the Hollisterfacility has been less than $0.1 million.

Purchase commitments associated with capitalexpenditures were minimal at October 2, 2004.

The Company has no leases under which it is thelessee.

The company is required to comply with therequirements of Sarbanes Oxley Section 404 during its fiscal year ending October 1,2005. This process will involve the design, documentation and testing of thecompany’s internal financial reporting controls. The ultimate cost of thisprocess cannot be determined at this time.

Under its bylaws andindemnification agreements, the Company has agreed, subject to certainexceptions, to indemnify its officers and directors for certain events oroccurrences arising as a result of the officer and director’s serving in suchcapacity, to the fullest extent authorized or permitted by the Delaware GeneralCorporation Law. The maximum potential amount of future payments the Companycould be required to make under these indemnification agreements is unlimited.However, the Company has a directors and officers liability insurance policythat limits its exposure and enables it to recover a portion of any futureamounts paid. As a result of its insurance policy coverage, the Companybelieves the estimated fair value of these indemnification agreements isminimal and has no liabilities recorded for these agreements as of October 2,2004.

**7.  EmployeeBenefit Plans**

The Company has aqualified retirement plan (the “401(k) Plan”) under the provisions of section401(k) of the Internal Revenue Code, in which eligible employees mayparticipate. Substantially all participants in this plan are able to defercompensation up to the annual maximum amount allowable under Internal RevenueService regulations. The Company has a 401(k) cash match program which providesa match of one half of the first five percent of an employee’s contributions.This matching contribution was less than $0.1 million in both fiscal 2004 and2003. The Company’s 401(k) Plan has a provision that provides management withan option to make a discretionary contribution to the plan. Additionally, theCompany has a profit sharing plan, in which all eligible employees participate.There was less than $0.1 million in compensation expense recorded under thecash profit sharing plan in both fiscal 2004 and fiscal 2003. The Company madeno discretionary 401(k) contributions during either fiscal 2004 or fiscal 2003under this plan.

**8.  FinancingTransactions**

On September 30, 2003, the Company reached asettlement with the holders of its Professional Notes, who had providedprofessional services to the Company during its Chapter 11 reorganizationand received convertible promissory notes evidencing the Company’s indebtednessfor those services. As partial consideration for the cancellation of theProfessional Notes, the Company issued 368,113 shares of Common Stock, eighteenmonth warrants for the purchase of a total of 16,437 common shares at a priceof $5.35 per share, which will expire on March 30, 2005, and thirty-sixmonth warrants for the purchase of a total of 68,777 common shares at apurchase price of $7.29 per share, which will expire on September 30,2006.

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The Company completed a sale of Common Stock andwarrants to L-3 on September 3, 2003 for $2.5 million in cash. TheCompany is a subcontractor to L-3 for a long-term government contract toproduce gyroscopes and accelerometers for use in inertial navigation. TheCompany issued 467,500 shares of Common Stock to L-3 along with twowarrants. The first warrant has a term of eighteen months to purchase 83,500shares of Common Stock at a price of $5.35 per share. The second warrant has aterm of thirty-six months to purchase 350,000 shares of Common Stock at a priceof $7.29 per share.The value of the warrants is not reflected separately inthe accompanying financial statements as it was recorded within Common Stock.

L-3 made a previousinvestment in the Company on August 2, 2002 for $5 million in cash. TheCompany issued 935,000 shares of Common Stock to L-3 along with two warrants.The first warrant had a term of eighteen months to purchase 167,000 shares ofCommon Stock at a price of $5.35 per share. This warrant was exercised by L-3on October 31, 2003 for an aggregate amount of $0.9 million. The secondwarrant has a term of thirty-six months to purchase 700,000 shares of CommonStock at a price of $7.29 per share.The value of the warrants is notreflected separately in the accompanying financial statements as it wasrecorded within Common Stock. 

**9.  Restricted Stock and Stock Option Program**

The Company’s stock option and long-term incentiveplans were cancelled as part of the Reorganization Plan. The Company hadapproximately 3.8 million options outstanding as of the date of its petitionfor protection under Chapter 11 of the Bankruptcy code. The Reorganization Planprovided for future stock incentives for the employees and directors of theCompany. Pursuant to the Reorganization Plan the Company, as of the effectivedate of the Reorganization Plan on November 16, 2001 (“Effective Date”),adopted the 2001 Stock Incentive Plan, authorizing the grant of restrictedshares of Common Stock and options to purchase shares of Common Stock toemployees. Pursuant to the Reorganization Plan, the Company issued, as of theEffective Date, restricted shares of Common Stock and options allocated andvested as provided for in the 2001 Stock Incentive Plan.

Pursuantto the Reorganization Plan, 2,250,000 shares of New Common Stock were reservedfor the grants of restricted shares of Common Stock and options, as follows:
| **Class**                           | ** ** | ** ** | ** ** | **Number Of Shares  Of New Common Stock** | ** ** |
|-------------------------------------|------------|------------|------------|--------------------------------------------------------------------|------------|
| New Employee  Options               |       |       | 1,000,000  |                                                               |       |
| Employee/Director  Reserved Options |       |       | 750,000    |                                                               |       |
| Restricted stock                    |       |       | 500,000    |                                                               |       |
| Total                               |       |       | 2,250,000  |                                                               |       |

 

Each new employee option provided for an exerciseprice of $5.00 per share. Each employee/director reserved option provides for apurchase price for each share of Common Stock to be determined by the Board ofDirectors as the then fair market value of the new Common Stock . Fifty percentof each grant of employee restricted stock vested one year after the EffectiveDate and the remaining 50% vested two years after the Effective Date. Therestricted stock agreement contains additional vesting provisions, which theCompany does not intend to enforce. Accordingly, the Company measured thecompensation expense associated with the Plan on November 16, 2001 and isrecognizing the expense over two years. The new employee options vest ratablyover three years. Upon vesting, the new employee options can be exercised ifand only if all of the following conditions have been satisfied: (i) notmore than ten (10) years after the issuance of the option has lapsed; and (ii) therecipient of the New Option is employed by the Company at the time therecipient seeks to exercise the option (or not more than ninety (90) days havepassed since such employee’s employment has been terminated); provided, however,if the recipient is not employed by the Company at the time of exercise byreason of the recipient’s death, the recipient’s heir (or estate) can 

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exercise the option for aperiod of eighteen months after the death of a recipient who was employed atthe time of his death. The New Employee Restricted Stock and Option Agreementrelated to each grant provides for accelerated vesting upon certain specifiedconditions related to a transfer of ownership or sale of the business. 

The 500,000 shares of Common Stock issued under the2001 Incentive Plan, was determined to have a market value of $2.5 million,based on a $5.00 per share price determined by the Board of Directors.****The employees received the common stock at a purchase priceof $0.0001, subject to a two-year vesting period. The Company recorded $0.2million and $1.2 million in amortization expense for the years ended October 2,2004 and September 27, 2003, respectively. The combination of Cost ofrevenue and Research and Development were charged with approximately $0.1million and Selling, General and Administrative incurred $0.1 million of theamortization expense in fiscal 2004. Cost of revenue was charged with $0.4million, Research and Development was charged with $0.3 million and Selling,General and Administrative incurred $0.6 million of the amortization expense infiscal 2003. 

The Shareholders approved an amendment to the Company’s2001 Stock Incentive Plan at its February 27, 2004 Annual ShareholdersMeeting, increasing the number of shares of common stock reserved for issuancethereunder from 2,250,000 to 3,000,000.

Stockoption activity of the Company is as follows:
| ** **                       | ** ** | **Options Outstanding** | ** ** |
|----------------------------------|------------|------------------------------|------------|
| ** **                       | ** ** | **Number  of Shares**   | ** ** | **Exercise Price  Per Option** | ** ** | **Weighted Average  Exercise Price** | ** ** |
| Balance  September 28, 2002 |       | 1,265,110                    |       | $5.00 - $5.35 |   |   | $ | 5.01 |   |   |
| Granted                          |       | 411,855                      |       | $5.35 |   |   | $ | 5.35 |   |   |
| Exercised                        |       | —                       |       |   |   |   |   |   |   |
| Cancelled                        |       | (12,068                      | )          | $5.00 - $5.35 |   |   | $ | 5.10 |   |   |
| Balance  September 27, 2003 |       | 1,664,897                    |       | $5.00 - $5.35 |   |   | $ | 5.09 |   |   |
| Granted                          |       | 88,100                       |       | $5.35 |   |   | $ | 5.35 |   |   |
| Exercised                        |       | —                       |       |   |   |   |   |   |   |
| Cancelled                        |       | (29,345                      | )          | $5.00 - $5.35 |   |   | $ | 5.17 |   |   |
| Balance October 2,  2004    |       | 1,723,652                    |       | $5.00 - $5.35 |   |   | $ | 5.10 |   |   |

 

Warrantactivity of the Company is as follows:
| ** **                       | ** ** | **Warrants Outstanding** | ** ** |
|----------------------------------|------------|-------------------------------|------------|
| ** **                       | ** ** | **Number  of Shares**    | ** ** | **Exercise Price  Per warrant** | ** ** | **Weighted Average  Exercise Price** | ** ** |
| Balance  September 28, 2002 |       | 867,000                       |       | $5.35 - $7.29 |   |   | $ | 6.92 |   |   |
| Granted                          |       | 433,500                       |       | $5.35 - $7.29 |   |   | $ | 6.92 |   |   |
| Exercised                        |       | —                        |       |   |   |   |   |   |   |
| Cancelled                        |       | —                        |       |   |   |   |   |   |   |
| Balance  September 27, 2003 |       | 1,300,500                     |       | $5.35 - $7.29 |   |   | $ | 6.92 |   |   |
| Granted                          |       | 85,214                        |       | $5.35 - $7.29 |   |   | $ | 6.92 |   |   |
| Exercised                        |       | (167,000                      | )          | $5.35 |   |   | $ | 5.35 |   |   |
| Cancelled                        |       | —                        |       |   |   |   |   |   |   |
| Balance October 2,  2004    |       | 1,218,714                     |       | $5.35 - $7.29 |   |   | $ | 7.13 |   |   |

 

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Thefollowing table summarizes information regarding options outstanding at October 2,2004:
| **Options Outstanding**            | ** ** | **Options Exercisable**  | ** ** |
|-----------------------------------------|------------|-------------------------------|------------|
| **Range of  Exercise Prices** | ** ** | **Number   Outstanding** | ** ** | **Weighted  Average  Remaining  Contractual Life** | ** ** | **Weighted  Average  Exercise Price** | ** ** | **Number  Exercisable** | ** ** | **Weighted  Average  Exercise Price** | ** ** |
| $5.00                                   |       | 1,222,710                     |       |   | 7.14 |   |   |   | $ | 5.00 |   |   | 847,332 |   |   | $ | 5.00 |   |   |
| $5.35                                   |       | 500,942                       |       |   | 8.48 |   |   |   | $ | 5.35 |   |   | 155,435 |   |   | $ | 5.35 |   |   |
|                                    |       | 1,723,652                     |       |   |   |   |   |   |   |   |   | 1,002,767 |   |   |   |   |   |

 

Theweighted average fair value of options granted during the years ended October 2,2004 and September 27, 2003 totaled $2.83 and $2.95, respectively.

**10. Related Party Transactions.**

TheCompany had revenue of $4.0 million, billings in excess of costs on developmentprojects of $0.7 million, which includes capitalized costs of $0.9 million, andaccounts receivable of $0.1 million from L-3, a stockholder and customer, as ofand for the year ended October 2, 2004. The Company had revenue of $0.5million from L-3, a stockholder and customer, for the year ended September 27,2003.

**11. Subsequent Events.**

On January 25, 2005, the Investor Groupinvested a total of $17.0 million in a private sale of equity securities of theCompany. The net proceeds to the Company were approximately $16.0 million. Inexchange for the investment, the Investor Group received 1,000,000 shares ofredeemable preferred stock, 1,000,000 shares of convertible preferred stock anda warrant for the purchase of up to 500,000 shares of common stock. The Companyplans to use approximately $1.6 million of the net proceeds to pay off the Notedue to L-3. The remainder of the net proceeds will be used for general workingcapital needs and other corporate purposes.

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