<PAGE>

================================================================================

                                  UNITED STATES
                       SECURITIES AND EXCHANGE COMMISSION
                             Washington, D.C. 20549

                                    FORM 10-Q

             QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(D) OF THE
                         SECURITIES EXCHANGE ACT OF 1934

                       FOR THE QUARTER ENDED JUNE 30, 2005

                        COMMISSION FILE NUMBER 000-21129


                                   AWARE, INC.
                                   -----------
             (Exact Name of Registrant as Specified in Its Charter)


              MASSACHUSETTS                                 04-2911026
              -------------                                 ----------
     (State or Other Jurisdiction of                     (I.R.S. Employer
      Incorporation or Organization)                    Identification No.)


              40 MIDDLESEX TURNPIKE, BEDFORD, MASSACHUSETTS, 01730
              ----------------------------------------------------
                    (Address of Principal Executive Offices)
                                   (Zip Code)

                                 (781) 276-4000
                                 --------------
              (Registrant's Telephone Number, Including Area Code)


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

Indicate by check mark whether the registrant is an accelerated filer (as
defined in Rule 12b-2). YES _X_ NO ___


Indicate the number of shares outstanding of the issuer's common stock as of
July 22, 2005:

              CLASS                             NUMBER OF SHARES OUTSTANDING
              -----                             ----------------------------
Common Stock, par value $0.01 per share               23,077,087 shares

================================================================================

<PAGE>

                                   AWARE, INC.
                                    FORM 10-Q
                       FOR THE QUARTER ENDED JUNE 30, 2005

                                TABLE OF CONTENTS


                                                                           Page
                                                                           ----

PART I     FINANCIAL INFORMATION

Item 1.    Consolidated Financial Statements

           Consolidated Balance Sheets as of
           June 30, 2005 and December 31, 2004..........................     3

           Consolidated Statements of Operations for the
           Three and Six Months Ended June 30, 2005
           and June 30, 2004............................................     4

           Consolidated Statements of Cash Flows for the
           Six Months Ended June 30, 2005
           and June 30, 2004............................................     5

           Notes to Consolidated Financial Statements...................     6

Item 2.    Management's Discussion and Analysis of Financial
           Condition and Results of Operations..........................    10

Item 3.    Quantitative and Qualitative Disclosures about
           Market Risk..................................................    22

Item 4.    Controls and Procedures......................................    23

PART II    OTHER INFORMATION

Item 1.    Legal Proceedings............................................    24

Item 4.    Submission of Matters to a Vote of Security Holders..........    24

Item 6.    Exhibits ....................................................    25

           Signatures...................................................    25


                                       2
<PAGE>
<TABLE>
<CAPTION>

                                               PART I. FINANCIAL INFORMATION
                                         ITEM 1: CONSOLIDATED FINANCIAL STATEMENTS
                                                        AWARE, INC.
                                                CONSOLIDATED BALANCE SHEETS
                                      (IN THOUSANDS, EXCEPT SHARE AND PER SHARE DATA)
                                                        (UNAUDITED)


                                                                                         JUNE 30,           DECEMBER 31,
                                                                                           2005                2004
                                                                                     -----------------    ----------------
<S>                                                                                        <C>                   <C>
                                     ASSETS
Current assets:
     Cash and cash equivalents................................................             $13,088               $7,482
     Short-term investments...................................................              24,659               27,483
     Accounts receivable, net.................................................               1,926                3,070
     Inventories..............................................................                 122                  143
     Prepaid expenses and other current assets................................                 516                  417
                                                                                     -----------------    ----------------
           Total current assets...............................................              40,311               38,595
                                                                                     -----------------    ----------------

Property and equipment, net...................................................               8,133                8,287
Investments...................................................................               1,001                3,301
                                                                                     -----------------    ----------------

           Total assets.......................................................             $49,445              $50,183
                                                                                     =================    ================

                      LIABILITIES AND STOCKHOLDERS' EQUITY

Current liabilities:
     Accounts payable........................................................                 $489                 $361
     Accrued expenses ........................................................                 129                  157
     Accrued compensation ....................................................                 652                  625
     Accrued professional.....................................................                 144                  169
     Deferred revenue.........................................................                 562                  115
                                                                                     -----------------    ----------------
             Total current liabilities........................................               1,976                1,427
                                                                                     -----------------    ----------------

Stockholders' equity:
      Preferred stock, $1.00 par value; 1,000,000 shares authorized,
             none outstanding.................................................                   -                    -
      Common stock, $.01 par value; 70,000,000 shares authorized; issued
             and outstanding, 23,076,627 in 2005 and 22,908,918 in 2004......                  231                  229
      Additional paid-in capital..............................................              78,429               77,882
      Accumulated deficit....................................................              (31,191)             (29,355)
                                                                                     -----------------    ----------------
             Total stockholders' equity......................................               47,469               48,756
                                                                                     -----------------    ----------------

             Total liabilities and stockholders' equity.......................             $49,445              $50,183
                                                                                     =================    ================


                   The accompanying notes are an integral part of the consolidated financial statements.
</TABLE>

                                                             3
<PAGE>
<TABLE>
<CAPTION>

                                                        AWARE, INC.
                                           CONSOLIDATED STATEMENTS OF OPERATIONS
                                           (IN THOUSANDS, EXCEPT PER SHARE DATA)
                                                        (UNAUDITED)


                                                               THREE MONTHS ENDED                 SIX MONTHS ENDED
                                                                    JUNE 30,                          JUNE 30,
                                                         -------------------------------    ------------------------------
                                                              2005            2004               2005            2004
                                                         --------------- ---------------    --------------- --------------
<S>                                                                <C>           <C>                <C>            <C>
Revenue:
    Product sales.......................................           $785          $1,028             $1,746         $2,251
    Contract revenue....................................            978           1,791              3,141          3,069
    Royalties...........................................            920             906              2,020          2,007
                                                         --------------- ---------------    --------------- --------------
     Total revenue.....................................           2,683           3,725              6,907          7,327

Costs and expenses:
    Cost of product sales...............................             62             195                122            532
    Cost of contract revenue............................            718             653              1,558          1,320
    Research and development............................          2,360           2,503              4,913          5,174
    Selling and marketing...............................            710             667              1,343          1,271
    General and administrative..........................            627             630              1,296          1,223
                                                         --------------- ---------------    --------------- --------------
     Total costs and expenses...........................          4,477           4,648              9,232          9,520

Loss from operations....................................         (1,794)           (923)            (2,325)        (2,193)
Interest income.........................................            272             115                489            238
                                                         --------------- ---------------    --------------- --------------

Loss before provision for income taxes..................         (1,522)           (808)            (1,836)        (1,955)
Provision for income taxes..............................              -               -                                 -
                                                         --------------- ---------------    --------------- --------------

Net loss................................................        ($1,522)          ($808)           ($1,836)       ($1,955)
                                                         =============== ===============    =============== ==============


Net loss per share - basic and diluted................           ($0.07)         ($0.04)           ($0.08)        ($0.09)


Weighted average shares - basic and diluted.............         23,019          22,766             22,982         22,759


                   The accompanying notes are an integral part of the consolidated financial statements.
</TABLE>

                                                             4
<PAGE>
<TABLE>
<CAPTION>

                                                  AWARE, INC.
                                     CONSOLIDATED STATEMENTS OF CASH FLOWS
                                                (IN THOUSANDS)
                                                  (UNAUDITED)


                                                                                  SIX MONTHS ENDED
                                                                                      JUNE 30,
                                                                         ------------------------------------
                                                                              2005                2004
                                                                         ----------------    ----------------
<S>                                                                             <C>                 <C>
Cash flows from operating activities:
   Net loss........................................................             ($1,836)            ($1,955)

   Adjustments to reconcile net loss to net cash provided by
    (used in) operating activities:
    Depreciation and amortization..................................                 295                 563
      Increase (decrease) from changes in assets and liabilities:
         Accounts receivable.......................................               1,144                 632
         Inventories...............................................                  21                  (4)
         Prepaid expenses..........................................                 (99)                187
         Accounts payable..........................................                 128                 148
         Accrued expenses..........................................                 (26)                417
         Deferred revenue..........................................                 447                (347)
                                                                         ----------------    ----------------
            Net cash provided by (used in) operating activities....                  74                (359)
                                                                         ----------------    ----------------

Cash flows from investing activities:
    Purchases of property and equipment............................                (141)               (101)
    Sales of investments...........................................              16,374              24,547
    Purchases of investments.......................................             (11,250)            (13,240)
                                                                         ----------------    ----------------
            Net cash provided by investing activities..............               4,983              11,206
                                                                         ----------------    ----------------

Cash flows from financing activities:
     Proceeds from issuance of common stock........................                 549                  95
                                                                         ----------------    ----------------
            Net cash provided by financing activities..............                 549                  95
                                                                         ----------------    ----------------

Increase in cash and cash equivalents..............................               5,606              10,942
Cash and cash equivalents, beginning of period.....................               7,482               2,304
                                                                         ----------------    ----------------

Cash and cash equivalents, end of period...........................             $13,088             $13,246
                                                                         ================    ================


             The accompanying notes are an integral part of the consolidated financial statements.
</TABLE>

                                                      5
<PAGE>

                                   AWARE, INC.
                   NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
                                   (UNAUDITED)


A)      BASIS OF PRESENTATION

        The accompanying unaudited consolidated balance sheet, statements of
        operations, and statements of cash flows reflect all adjustments
        (consisting only of normal recurring items) which are, in the opinion of
        management, necessary for a fair presentation of financial position at
        June 30, 2005, and of operations and cash flows for the interim periods
        ended June 30, 2005 and 2004.

        The accompanying unaudited consolidated financial statements have been
        prepared in accordance with the instructions for Form 10-Q and therefore
        do not include all information and footnotes necessary for a complete
        presentation of our financial position, results of operations and cash
        flows, in conformity with generally accepted accounting principles. We
        filed audited financial statements which included all information and
        footnotes necessary for such presentation for the three years ended
        December 31, 2004 in conjunction with our 2004 Annual Report on Form
        10-K.

        Auction rate securities in the amount of $17.2 million at December 31,
        2003 and $11.6 million at June 30, 2004 have been reclassified from cash
        and cash equivalents to short-term investments in the statement of cash
        flows for the six months ended June 30, 2004 to conform to the 2005
        financial statement presentation. Accordingly, the statement of cash
        flows for the quarter ended June 30, 2004 reflects the gross purchases
        and sales of these securities as investing activities rather than as a
        component of cash and cash equivalents.

        The results of operations for the interim period ended June 30, 2005 are
        not necessarily indicative of the results to be expected for the year.

B)      INVENTORY

        Inventory consists primarily of the following (in thousands):

                                           JUNE 30,             DECEMBER 31,
                                             2005                   2004
                                      -------------------    -------------------
        Raw materials...............           $122                   $143
                                      ===================    ===================


                                       6
<PAGE>

C)      COMPUTATION OF EARNINGS PER SHARE

        Basic earnings per share is computed by dividing net income or loss by
        the weighted average number of common shares outstanding. Diluted
        earnings per share is computed by dividing net income or loss by the
        weighted average number of common shares outstanding plus additional
        common shares that would have been outstanding if dilutive potential
        common shares had been issued. For the purposes of this calculation,
        stock options are considered common stock equivalents in periods in
        which they have a dilutive effect. Stock options that are anti-dilutive
        are excluded from the calculation.

        Net income or loss per share is calculated as follows (in thousands,
        except per share data):

<TABLE>
<CAPTION>
                                                              THREE MONTHS ENDED             SIX MONTHS ENDED
                                                                   JUNE 30,                      JUNE 30,
                                                          ---------------------------   ---------------------------
                                                              2005          2004            2005          2004
                                                          ------------- -------------   ------------- -------------
<S>                                                           <C>             <C>           <C>           <C>
        Net loss..........................................    ($1,522)        ($808)        ($1,836)      ($1,955)

        Weighted average common shares outstanding........     23,019        22,766          22,982         22,759
        Additional dilutive common stock equivalents......          -             -               -              -
                                                          ------------- -------------   ------------- -------------
        Diluted shares outstanding .......................     23,019        22,766          22,982         22,759
                                                          ============= =============   ============= =============

        Net loss per share - basic........................     ($0.07)       ($0.04)         ($0.08)       ($0.09)
        Net loss per share - diluted......................     ($0.07)       ($0.04)         ($0.08)       ($0.09)
</TABLE>

        For the three month periods ended June 30, 2005 and 2004, potential
        common stock equivalents of 1,594,581 and 317,117, respectively, were
        not included in the per share calculation for diluted EPS, because we
        had net losses and the effect of their inclusion would be anti-dilutive.
        For the six month periods ended June 30, 2005 and 2004, potential common
        stock equivalents of 1,651,837 and 377,258, respectively, were not
        included in the per share calculation for diluted EPS, because we had
        net losses and the effect of their inclusion would be anti-dilutive. For
        the three month periods ended June 30, 2005 and 2004, options to
        purchase 1,877,917 and 316,916 shares of common stock, respectively,
        were outstanding, but were not included in the computation of diluted
        EPS because the options' exercise prices were greater than the average
        market price of the common stock and thus would be anti-dilutive. For
        the six month periods ended June 30, 2005 and 2004, options to purchase
        1,877,917 and 316,916 shares of common stock, respectively, were
        outstanding, but were not included in the computation of diluted EPS
        because the options' exercise prices were greater than the average
        market price of the common stock and thus would be anti-dilutive.


                                       7
<PAGE>

D)      STOCK-BASED COMPENSATION

        We grant stock options to our employees and directors. Such grants are
        for a fixed number of shares with an exercise price equal to the fair
        value of the shares at the date of grant. As permitted by SFAS No. 123,
        "Accounting for Stock-Based Compensation", we account for stock option
        grants in accordance with Accounting Principles Board ("APB") Opinion
        No. 25, "Accounting for Stock Issued to Employees" and FASB
        Interpretation No. 44 ("FIN 44"), "Accounting for Certain Transactions
        Involving Stock Compensation." Accordingly, we have adopted the
        provisions of SFAS No. 123 through disclosure only.

        No stock-based employee compensation cost is reflected in net loss, as
        all options granted under those plans had an exercise price equal to the
        fair market value of the underlying common stock on the date of grant.
        The following table illustrates the pro forma effect on net loss and
        earnings per share if we had applied the fair value recognition
        provisions of SFAS No. 123 and SFAS No. 148 to stock-based employee
        compensation (in thousands, except per share data):

<TABLE>
<CAPTION>
                                                              THREE MONTHS ENDED             SIX MONTHS ENDED
                                                                   JUNE 30,                      JUNE 30,
                                                          ---------------------------   ---------------------------
                                                              2005          2004            2005          2004
                                                          ------------- -------------   ------------- -------------
<S>                                                           <C>             <C>           <C>           <C>
        Net loss - as reported............................    ($1,522)        ($808)        ($1,836)      ($1,955)
        Deduct: Total stock-based employee compensation
          expense determined under fair value based
          method for all awards...........................        713         2,111           8,449         5,549
                                                          ------------- -------------   ------------- -------------
        Net loss - pro forma .............................    ($2,235)      ($2,919)       ($10,285)      ($7,504)
                                                          ============= =============   ============= =============

        Basic loss per share - as reported................     ($0.07)       ($0.04)         ($0.08)       ($0.09)
        Basic loss per share - pro forma..................     ($0.10)       ($0.13)         ($0.45)       ($0.33)

        Diluted loss per share - as reported..............     ($0.07)       ($0.04)         ($0.08)       ($0.09)
        Diluted loss per share - pro forma................     ($0.10)       ($0.13)         ($0.45)       ($0.33)
</TABLE>

        The fair value of options on their grant date was measured using the
        Black-Scholes option pricing model. Key assumptions used to apply this
        pricing model are as follows:

<TABLE>
<CAPTION>
                                                              THREE MONTHS ENDED             SIX MONTHS ENDED
                                                                   JUNE 30,                      JUNE 30,
                                                          ---------------------------   ---------------------------
                                                              2005          2004            2005          2004
                                                          ------------- -------------   ------------- -------------
<S>                                                              <C>           <C>             <C>           <C>
        Average risk-free interest rate...................       3.87%         3.72%           3.88%         3.36%
        Expected life of option grants....................     5 years       5 years         5 years       5 years
        Expected volatility of underlying stock...........         84%           95%             86%           95%
        Expected dividend yield...........................           -             -               -             -
</TABLE>


                                       8
<PAGE>

F)      BUSINESS SEGMENTS

        The Company organizes itself as one segment and conducts its operations
        in the United States.

        The Company sells its products and technology to domestic and
        international customers. Revenues were generated from the following
        geographic regions (in thousands):

<TABLE>
<CAPTION>
                                                             THREE MONTHS ENDED             SIX MONTHS ENDED
                                                                  JUNE 30,                      JUNE 30,
                                                         ----------------------------  ----------------------------
                                                             2005           2004           2005          2004
                                                         -------------  -------------  ------------- --------------
<S>                                                           <C>            <C>            <C>           <C>
        United States....................................     $1,651         $1,857         $3,676        $3,894
        Germany..........................................        735          1,113          1,915         2,353
        Rest of World....................................        297            755          1,316         1,080
                                                         -------------  -------------  ------------- --------------
                                                              $2,683         $3,725         $6,907        $7,327
                                                         =============  =============  ============= ==============
</TABLE>

G)      RECENT ACCOUNTING PRONOUNCEMENTS

        In December 2004, the Financial Accounting Standards Board ("FASB")
        issued Statement of Financial Accounting Standard No. 123 (revised
        2004), Share-Based Payment ("SFAS 123R"). This Statement is a revision
        to SFAS 123, ACCOUNTING FOR STOCK-BASED COMPENSATION, and supersedes APB
        Opinion No. 25, ACCOUNTING FOR STOCK ISSUED TO EMPLOYEES. SFAS 123R
        requires the measurement of the cost of employee services received in
        exchange for an award of equity instruments based on the grant-date fair
        value of the award. The cost will be recognized over the period during
        which an employee is required to provide service in exchange for the
        award. No compensation cost is recognized for equity instruments for
        which employees do not render service. The planned effective date of
        SFAS 123R was to be the first interim or annual reporting period that
        began after June 15, 2005. In April 2005, the effective date was
        extended for calendar year companies until January 1, 2006. We expect
        that the adoption of SFAS 123R will have a significant impact on our
        results of operations. We do not expect the adoption of SFAS 123R to
        impact our overall financial position.


                                       9
<PAGE>

                                     ITEM 2:
                     MANAGEMENT'S DISCUSSION AND ANALYSIS OF
                  FINANCIAL CONDITION AND RESULTS OF OPERATIONS


CAUTIONARY STATEMENT FOR PURPOSES OF THE "SAFE HARBOR" PROVISIONS OF THE PRIVATE
SECURITIES LITIGATION REFORM ACT OF 1995

SOME OF THE INFORMATION IN THIS FORM 10-Q CONTAINS FORWARD-LOOKING STATEMENTS
THAT INVOLVE SUBSTANTIAL RISKS AND UNCERTAINTIES. YOU CAN IDENTIFY THESE
STATEMENTS BY FORWARD-LOOKING WORDS SUCH AS "MAY," "WILL," "EXPECT,"
"ANTICIPATE," "BELIEVE," "ESTIMATE," "CONTINUE" AND SIMILAR WORDS. YOU SHOULD
READ STATEMENTS THAT CONTAIN THESE WORDS CAREFULLY BECAUSE THEY: (1) DISCUSS OUR
FUTURE EXPECTATIONS; (2) CONTAIN PROJECTIONS OF OUR FUTURE OPERATING RESULTS OR
FINANCIAL CONDITION; OR (3) STATE OTHER "FORWARD-LOOKING" INFORMATION. HOWEVER,
WE MAY NOT BE ABLE TO PREDICT FUTURE EVENTS ACCURATELY. THE RISK FACTORS LISTED
IN THIS SECTION, AS WELL AS ANY CAUTIONARY LANGUAGE IN THIS FORM 10-Q, PROVIDE
EXAMPLES OF RISKS, UNCERTAINTIES AND EVENTS THAT MAY CAUSE OUR ACTUAL RESULTS TO
DIFFER MATERIALLY FROM THE EXPECTATIONS WE DESCRIBE IN OUR FORWARD-LOOKING
STATEMENTS. YOU SHOULD BE AWARE THAT THE OCCURRENCE OF ANY OF THE EVENTS
DESCRIBED IN THESE RISK FACTORS AND ELSEWHERE IN THIS FORM 10-Q COULD MATERIALLY
AND ADVERSELY AFFECT OUR BUSINESS.


RESULTS OF OPERATIONS

        PRODUCT SALES. Product sales consist primarily of revenue from the sale
of hardware and software products. Hardware products include ADSL test and
development systems, modules, and modems. Software products consist of standard
off-the-shelf software products for biometric, medical imaging and digital
imaging applications, as well as DSL test and diagnostics software.

Product sales decreased 24% from $1.0 million in the second quarter of 2004 to
$0.8 million in the current year quarter. As a percentage of total revenue,
product sales increased from 28% in the second quarter of 2004 to 29% in the
current year quarter. For the six months ended June 30, product sales decreased
22% from $2.3 million in 2004 to $1.7 million in 2005. As a percentage of total
revenue, product sales decreased from 31% in the first six months of 2004 to 25%
in the corresponding period of 2005.

For the three month period, the dollar decrease was due to a $0.3 million
decrease in revenue from the sale of hardware products, partially offset by an
increase in revenue of $0.1 million from the sale of software products. For the
six month period, the dollar decrease was due to a $0.8 million decrease in
revenue from the sale of hardware products, partially offset by an increase in
revenue of $0.3 million from the sale of software products.

        CONTRACT REVENUE. Contract revenue consists primarily of license and
engineering service fees that we receive under agreements with our customers to
develop ADSL (including ADSL2, ADSL2plus or VDSL2) chipsets.

Contract revenue decreased 45% from $1.8 million in the second quarter of 2004
to $1.0 million in the current year quarter. As a percentage of total revenue,
contract revenue decreased from 48% in the second quarter of 2004 to 36% in the
current year quarter. The dollar decrease was due to lower license fee revenues
associated with the achievement of milestones.


                                       10
<PAGE>

For the six months ended June 30, contract revenue increased 2% and was
approximately $3.1 million in both 2004 and 2005. As a percentage of total
revenue, contract revenue increased from 42% in the first six months of 2004 to
45% in the corresponding period of 2005.

While we believe that the transition to ADSL2plus technology in the ADSL
industry and the establishment of a VDSL2 standard by the International
Telecommunications Union increase the value proposition of our technology, both
existing and prospective ADSL chipset licensees have continued to be reluctant
to begin new development projects given: (i) generally weak worldwide economic
conditions, (ii) a difficult and uncertain environment in the semiconductor and
telecommunications industries, and (iii) intense ADSL chipset competition and
falling chipset prices. During the last several years, customers and potential
customers cautiously evaluated new chipset projects or delayed or cancelled
projects in the face of such conditions.

        ROYALTIES. Royalties consist of royalty payments that we receive under
licensing agreements. We receive royalties from customers for the right to use
our technology in their chipsets or solutions.

Royalties increased 2% from the second quarter of 2004 and were approximately
$0.9 million in both the current and prior year's comparable quarter. As a
percentage of total revenue, royalties increased from 24% in the second quarter
of 2004 to 34% in the current year quarter. For the six months ended June 30,
royalties increased 1% from 2004 and were approximately $2.0 million in both
2004 and 2005. As a percentage of total revenue, royalties increased from 27% in
the first six months of 2004 to 29% in the corresponding period of 2005.

Our royalty revenue comes predominantly from ADSL chipset sales by Analog
Devices, Inc. ("ADI"), and Infineon Technologies AG ("Infineon"). Despite steady
growth of worldwide ADSL subscribers over the last several years, the
availability of ADSL chipsets from a number of suppliers and intense competition
among those suppliers has caused chipset prices to steadily decline. We are
uncertain how the transition to ADSL2plus and VDSL2 will impact our customers in
the near term, how quickly sales of our customers' chipsets will increase and
whether such increases will contribute meaningful royalties to us.

        COST OF PRODUCT SALES. Since the cost of software product sales is
minimal, cost of product sales consists primarily of the cost of hardware
product sales. Cost of product sales decreased 68% from $195,000 in the second
quarter of 2004 to $62,000 in the current year quarter. As a percentage of
product sales, cost of product sales decreased from 19% in the second quarter of
2004 to 8% in the current year quarter. This percentage decrease was primarily
due to lower hardware sales during the current quarter. In terms of dollars, the
decrease in cost of product sales and product margin was primarily due to lower
hardware product sales. The increase in product margin as a percent of product
sales was primarily due to a larger proportion of software sales in the product
sales revenue mix.

For the six months ended June 30, cost of product sales decreased 77% from
$532,000 in 2004 to $122,000 in 2005. As a percentage of product sales, cost of
product sales decreased from 24% in the first six months of 2004 to 7% in the
corresponding period of 2005. In terms of dollars, the decrease in cost of
product sales and product margin was primarily due to lower hardware product
sales. The increase in product margin as a percent of product sales was
primarily due to a larger proportion of software sales in the product sales
revenue mix.


                                       11
<PAGE>

        COST OF CONTRACT REVENUE. Cost of contract revenue consists primarily of
salaries for engineers and expenses for consultants, technology licensing fees,
recruiting, supplies, equipment, depreciation and facilities associated with
customer development projects. Our total engineering costs are allocated between
cost of contract revenue and research and development expense. In a given
period, the allocation of engineering costs between cost of contract revenue and
research and development is a function of the level of effort expended on each.

Cost of contract revenue increased 10% from the second quarter of 2004 to the
second quarter of 2005, and was approximately $0.7 million in both quarters. As
a percentage of contract revenue, cost of contract revenue increased from 36% in
the second quarter of 2004 to 73% in the current year quarter. For the six
months ended June 30, cost of contract revenue increased 18% from $1.3 million
in 2004 to $1.6 million in 2005. As a percentage of contract revenue, cost of
contract revenue increased from 43% in the first six months of 2004 to 50% in
the corresponding period of 2005.

For the three and six month periods, the dollar increase in cost of contract
revenue was primarily due to more customer projects in the first three and six
month periods of 2005 as compared with 2004. Since our cost of contract revenue
is based on the level of effort we expend on customer projects and the number of
customer projects increased, cost of contract revenue increased as well.

        RESEARCH AND DEVELOPMENT EXPENSE. Research and development expense
consists primarily of salaries for engineers and expenses for consultants,
recruiting, supplies, equipment, depreciation and facilities related to
engineering projects to improve our broadband intellectual property offerings,
as well as our software and hardware product technology. Research and
development expense decreased 6% from $2.5 million in the second quarter of 2004
to $2.4 million in 2005. As a percentage of total revenue, research and
development expense increased from 67% in the second quarter of 2004 to 88% in
the current year quarter. For the six months ended June 30, research and
development expense decreased 5% from $5.2 million in 2004 to $4.9 million in
2005. As a percentage of total revenue, research and development expense was
approximately 71% in the first six months of both 2004 and 2005.

For the three month period, the dollar decrease was primarily attributable to
lower depreciation expense. For the six month period the dollar decrease was
from $0.2 million decreased spending resulting from a shift of engineers to
customer projects, where spending is classified as cost of contract revenue.
This shift occurred because we had more customer projects in 2005 than in 2004.
The dollar decrease in spending was also attributable to $0.2 million lower
depreciation expense. The dollar decreases were partially offset by a $0.3
million increase for chip design and tape out costs associated with our
StratiPHY3 product.

Our research and development spending was principally focused on improving our
ADSL, ADSL2 and ADSL2plus StratiPHY2+(TM) technology and chips, developing our
VDSL2 StratiPHY3 technology and chips, developing test and diagnostics hardware
and software and developing imaging and biometrics software.

        SELLING AND MARKETING EXPENSE. Selling and marketing expense consists
primarily of salaries for sales and marketing personnel, travel, advertising and
promotion, recruiting, and facilities expense. Sales and marketing expense
increased 6% in the current quarter compared with the corresponding quarter of
2004, and was approximately $0.7 million in the second


                                       12
<PAGE>

quarter of both 2004 and 2005. As a percentage of total revenue, sales and
marketing expense increased from 18% in the second quarter of 2004 to 26% in the
current year quarter. For the current six months ended June 30, selling and
marketing expense increased 6% and was approximately $1.3 million in both 2004
and 2005. As a percentage of total revenue, selling and marketing expense
increased from 17% in the first six months of 2004 to 19% in the corresponding
period of 2005. For both the three and six month periods, the dollar increases
were mainly attributable to higher compensation costs.

        GENERAL AND ADMINISTRATIVE EXPENSE. General and administrative expense
consists primarily of salaries for administrative personnel, facility costs, bad
debt, audit, legal, stock exchange and insurance expenses. General and
administrative expenses were approximately $0.6 million in the second quarter of
both 2004 and 2005. As a percentage of total revenue, general and administrative
expense increased from 17% in the second quarter of 2004 to 23% in the
corresponding quarter of the current year. For the six months ended June 30,
general and administrative expense increased 6% from $1.2 million in 2004 to
$1.3 million in 2005. As a percentage of total revenue, general and
administrative expense increased from 17% in the first six months of 2004 to 19%
in the corresponding period of 2005.

For the six month period, the dollar increase in 2005 was primarily due to
higher spending on salary and fringe benefits.

        INTEREST INCOME. Interest income increased 137% from $115,000 in the
second quarter of 2004 to $272,000 in the current year quarter. For the six
months ended June 30, interest income increased 105% from $238,000 in 2004 to
$489,000 in 2005. For the three and six month periods, the dollar increase was
due to higher interest rates earned on our cash and investment balances.

        INCOME TAXES. We made no provision for income taxes in the first six
months of 2005 and 2004 due to net losses incurred. In 2002, we determined that
due to our continuing operating losses as well as the uncertainty of the timing
of profitability in future periods, we should fully reserve our deferred tax
assets. As of June 30, 2005, our deferred tax assets continue to be fully
reserved. We will continue to evaluate, on a quarterly basis, the positive and
negative evidence affecting the realizability of our deferred tax assets.


LIQUIDITY AND CAPITAL RESOURCES

At June 30, 2005, we had cash, cash equivalents, short-term investments and
investments of $38.7 million, which represents an increase of $0.5 million from
December 31, 2004. The increase was from $0.5 million of proceeds from the
exercise of employee stock options, $0.1 million of cash provided by operations
partially offset by capital expenditures of $0.1 million.

Cash provided by operations in the first six months of 2005 was primarily from
changes in working capital. Capital spending was primarily related to the
purchase of computer hardware and software, and laboratory equipment used
principally in engineering activities.

At June 30, 2004, we had cash, cash equivalents, short-term investments and
investments of $38.6 million, which represents a decrease of $0.4 million from
December 31, 2003. The decrease was primarily due to $0.4 million of cash used
in operations


                                       13
<PAGE>

Cash used in operations in the first six months of 2004 was primarily the result
of operating losses and working capital requirements. Capital spending was
primarily related to the purchase of computer hardware and software, and
laboratory equipment used principally in engineering activities.

While we can not assure you that we will not require additional financing, or
that such financing will be available to us, we believe that our cash, cash
equivalents and investments will be sufficient to fund our operations for at
least the next twelve months.


RECENT ACCOUNTING PRONOUNCEMENTS

In December 2004, the Financial Accounting Standards Board ("FASB") issued
Statement of Financial Accounting Standard No. 123 (revised 2004), Share-Based
Payment ("SFAS 123R"). This Statement is a revision to SFAS 123, ACCOUNTING FOR
STOCK-BASED COMPENSATION, and supersedes APB Opinion No. 25, ACCOUNTING FOR
STOCK ISSUED TO EMPLOYEES. SFAS 123R requires the measurement of the cost of
employee services received in exchange for an award of equity instruments based
on the grant-date fair value of the award. The cost will be recognized over the
period during which an employee is required to provide service in exchange for
the award. No compensation cost is recognized for equity instruments for which
employees do not render service. The planned effective date of SFAS 123R was to
be the first interim or annual reporting period that began after June 15, 2005.
In April 2005, the effective date was extended for calendar year companies until
January 1, 2006. We expect that the adoption of SFAS 123R will have a
significant impact on our results of operations. We do not expect the adoption
of SFAS 123R to impact our overall financial position.


RISK FACTORS

We believe that the occurrence of any one or some combination of the following
risk factors could seriously harm our business.

OUR QUARTERLY RESULTS ARE UNPREDICTABLE AND MAY FLUCTUATE SIGNIFICANTLY

Our quarterly revenue and operating results are difficult to predict and may
fluctuate significantly from quarter-to-quarter. Because our revenue components
fluctuate and are difficult to predict, and our expenses are largely independent
of revenues in any particular period, it is difficult for us to accurately
forecast revenues and profitability. When appropriate, we recognize contract
revenues ratably over the period during which we expect to deliver technology
and provide engineering services. While this means that contract revenues from
certain current agreements are generally predictable, changes can be introduced
by a reevaluation of the length of the development period, or by the termination
of a contract. The initial estimate of this period is subject to revision as the
product being developed under a contract nears completion, and a revision may
result in an increase or decrease to the quarterly revenue for that contract. In
addition, accurate prediction of revenues from new contracts or licensees is
difficult because contract negotiation is a lengthy process, frequently spanning
a year or more, and the fiscal period in which a new license agreement will be
entered into, if at all, and the financial terms of such an agreement are
difficult to predict. Contract revenues also include fees for engineering
services, which are dependent upon the varying level of assistance desired by
licensees and, therefore, the revenue from these services is also difficult to
predict.


                                       14
<PAGE>

It is also difficult for us to make accurate forecasts of royalty revenues.
Royalties are recognized in the quarter in which we receive a report from a
licensee regarding the shipment of licensed integrated circuits in the prior
quarter, and are dependent upon fluctuating sales volumes and/or prices of chips
containing our technology, all of which are beyond our ability to control or
assess in advance.

Our business is subject to a variety of additional risks, which could materially
adversely affect quarterly and annual operating results, including:

        |X|     market acceptance of broadband technologies we supply by
                semiconductor or equipment companies;
        |X|     the extent and timing of new license transactions with
                semiconductor companies;
        |X|     changes in our and our licensees' development schedules and
                levels of expenditure on research and development;
        |X|     the loss of a strategic relationship or termination of a project
                by a licensee;
        |X|     equipment companies' acceptance of integrated circuits produced
                by our licensees;
        |X|     the loss by a licensee of a strategic relationship with an
                equipment company customer;
        |X|     announcements or introductions of new technologies or products
                by us or our competitors;
        |X|     delays or problems in the introduction or performance of
                enhancements or of future generations of our technology;
        |X|     failures or problems in our hardware or software products;
        |X|     delays in the adoption of new industry standards or changes in
                market perception of the value of new or existing standards;
        |X|     competitive pressures resulting in lower contract revenues or
                royalty rates;
        |X|     competitive pressures resulting in lower software or hardware
                product revenues;
        |X|     personnel changes, particularly those involving engineering and
                technical personnel;
        |X|     costs associated with protecting our intellectual property;
        |X|     the potential that licensees could fail to make payments under
                their current contracts;
        |X|     ADSL market-related issues, including lower ADSL chipset unit
                demand brought on by excess channel inventory and lower average
                selling prices for ADSL chipsets as a result of market
                surpluses;
        |X|     regulatory developments; and
        |X|     general economic trends and other factors.

As a result of these factors, we believe that period-to-period comparisons of
our revenue levels and operating results are not necessarily meaningful. You
should not rely on our quarterly revenue and operating results to predict our
future performance.


WE EXPERIENCED NET LOSSES

We had a net loss during 2001, 2002, 2003, 2004 and the first six months of
2005. We may continue to experience losses in the future if:

        |X|     the semiconductor and telecommunications markets do not improve;
        |X|     our existing customers do not increase their revenues from sales
                of chipsets with our technology;


                                       15
<PAGE>

        |X|     new or existing customers do not choose to license our
                intellectual property for new chipset products; or
        |X|     new or existing customers do not choose to use our software or
                hardware products.


WE HAVE A UNIQUE BUSINESS MODEL

The success of our business model depends upon our ability to license our
technology to semiconductor and equipment companies, and our customers'
willingness and ability to sell products that incorporate our technology so that
we may receive significant royalties that are consistent with our plans and
expectations.

We face numerous risks in successfully obtaining suitable licensees on terms
consistent with our business model, including, among others:

        |X|     we must typically undergo a lengthy and expensive process of
                building a relationship with a potential licensee before there
                is any assurance of a license agreement with such party;
        |X|     we must persuade semiconductor and equipment manufacturers with
                significant resources to rely on us for critical technology on
                an ongoing basis rather than trying to develop similar
                technology internally;
        |X|     we must persuade potential licensees to bear development costs
                associated with our technology applications and to make the
                necessary investment to successfully manufacture chipsets and
                products using our technology; and
        |X|     we must successfully transfer technical know-how to licensees.

Moreover, the success of our business model also depends on the receipt of
royalties from licensees. Royalties from our licensees are often based on the
selling prices of our licensees' chipsets and products, over which we have
little or no control. We also have little or no control over our licensees'
promotional and marketing efforts. They are not prohibited from competing
against us.

Our business could be seriously harmed if:

        |X|     we cannot obtain suitable licensees;
        |X|     our licensees fail to achieve significant sales of chipsets or
                products incorporating our technology; or
        |X|     we otherwise fail to implement our business strategy
                successfully.


THERE HAS BEEN AND MAY CONTINUE TO BE AN OVERSUPPLY OF ADSL CHIPSETS, AND THERE
IS INTENSE COMPETITION FOR ADSL CHIPSETS, WHICH HAS CAUSED OUR ROYALTY REVENUE
TO DECLINE

The royalties we receive are influenced by many of the risks faced by the ADSL
market in general, including reduced average selling prices ("ASPs") for ADSL
chipsets during periods of surplus. In 2000, 2001, and 2002, the ADSL industry
had experienced an oversupply of ADSL chipsets and central office equipment.
Excessive inventory levels led to soft chipset demand, which in turn led to
declining ASPs. ASPs have also been under pressure because of intense
competition in the ADSL chipset marketplace. As a result of the soft demand and
declining ASPs for ADSL chipsets, our royalty revenue has decreased
substantially from the levels we achieved


                                       16
<PAGE>

in 2000. Price decreases for ADSL chipsets, and the corresponding decreases in
per unit royalties received by us, can be sudden and dramatic. Pricing pressures
may continue during the remainder of 2005 and beyond. Our royalty revenue may
decline over the long term.


WE DEPEND SUBSTANTIALLY UPON A LIMITED NUMBER OF LICENSEES

There are a relatively limited number of semiconductor and equipment companies
to which we can license our broadband technology in a manner consistent with our
business model. If we fail to maintain relationships with our current licensees
or fail to establish a sufficient number of new licensing relationships, our
business could be seriously harmed. In addition, our prospective customers may
use their superior size and bargaining power to demand license terms that are
unfavorable to us and prospective customers may not elect to license from us.


WE DERIVE A SIGNIFICANT AMOUNT OF REVENUE FROM A SMALL NUMBER OF CUSTOMERS

In 2002, 2003, 2004 and the first six months of 2005, we derived 32%, 27%, 28%
and 27%, respectively, of our total revenue from ADI and 15%, 17%, 28%, and 27%
respectively, of our total revenue from Infineon. ADI and Infineon have
developed many generations of ADSL chipsets based upon our technology. Our
royalty revenue in the near term is highly dependent upon ADI's and Infineon's
ADSL chipset market share and pricing. The ADSL market has experienced
significant price erosion, which has adversely affected ADSL chipset revenues,
which in turn has adversely affected our royalty revenue. To the extent that ADI
or Infineon loses market share, is unable to transition its product to support
new ADSL2 and ADSL2plus standards, or experiences further price erosion in its
ADSL chipsets, our royalty revenue could decline.


OUR SUCCESS REQUIRES ACCEPTANCE OF OUR TECHNOLOGY BY EQUIPMENT COMPANIES

Due to our business strategy, our success is dependent on our ability to
generate significant royalties from our licensing arrangements with
semiconductor manufacturers. Our ability to generate significant royalties is
materially affected by the willingness of equipment companies to purchase
integrated circuits that incorporate our technology from our licensees. There
are other competitive solutions available for equipment companies seeking to
offer broadband communications products. We face the risk that equipment
manufacturers will choose those alternative solutions. Generally, our ability to
influence equipment companies' decisions whether to purchase integrated circuits
that incorporates our technology is limited.

We also face the risk that equipment companies that elect to use integrated
circuits that incorporate our technology into their products will not compete
successfully against other equipment companies. Many factors beyond our control
could influence the success or failure of a particular equipment company that
uses integrated circuits based on our technology, including:

        |X|     competition from other businesses in the same industry;
        |X|     market acceptance of its products;
        |X|     its engineering, sales and marketing, and management
                capabilities;
        |X|     technical challenges of developing its products unrelated to our
                technology; and
        |X|     its financial and other resources.


                                       17
<PAGE>

Even if equipment companies incorporate chipsets based on our intellectual
property into their products, their products may not achieve commercial
acceptance or result in significant royalties to us.


OUR SUCCESS REQUIRES TELEPHONE COMPANIES TO INSTALL ADSL SERVICE IN VOLUME

The success of our ADSL licensing business depends upon telephone companies
installing ADSL service in significant volumes. Factors that affect the volume
deployment of ADSL service include:

        |X|     the desire of telephone companies to install ADSL service, which
                is dependent on the development of a viable business model for
                ADSL service, including the capability to market, sell, install
                and maintain the service;
        |X|     the pricing of ADSL services by telephone companies;
        |X|     the transition by telephone companies to new ADSL technologies,
                such as ADSL2, ADSL2plus and VDSL2;
        |X|     the quality of telephone companies' networks;
        |X|     deployment by phone companies of fiber-to-the home or broadband
                wireless services;
        |X|     government regulations; and
        |X|     the willingness of residential telephone customers to demand
                ADSL service in the face of competitive service offerings, such
                as cable modems, fiber-based service or broadband wireless
                access.

If telephone companies do not install ADSL service in significant volumes, or if
telephone companies install broadband service based on other technology, our
business will be seriously harmed.


OUR INTELLECTUAL PROPERTY IS SUBJECT TO LIMITED PROTECTION

Because we are a technology provider, our ability to protect our intellectual
property and to operate without infringing the intellectual property rights of
others is critical to our success. We regard our technology as proprietary, and
we have a number of patents and pending patent applications. We also rely on a
combination of trade secrets, copyright and trademark law and non-disclosure
agreements to protect our unpatented intellectual property. Despite these
precautions, it may be possible for a third party to copy or otherwise obtain
and use our technology without authorization.

As part of our licensing arrangements, we typically work closely with our
semiconductor and equipment manufacturer licensees, many of whom are also our
potential competitors, and provide them with proprietary know-how necessary for
their development of customized chipsets based on our ADSL technology. Although
our license agreements contain non-disclosure provisions and other terms
protecting our proprietary know-how and technology rights, it is possible that,
despite these precautions, some of our licensees might obtain from us
proprietary information that they could use to compete with us in the
marketplace. Although we intend to defend our intellectual property as
necessary, the steps we have taken may be inadequate to prevent
misappropriation.


                                       18
<PAGE>

In the future, we may choose to bring legal action to enforce our intellectual
property rights. Any such litigation could be costly and time-consuming for us,
even if we were to prevail. Moreover, even if we are successful in protecting
our proprietary information, our competitors may independently develop
technologies substantially equivalent or superior to our technology. The
misappropriation of our technology or the development of competitive technology
could seriously harm our business.

Our technology, software or products may infringe the intellectual property
rights of others. A large and increasing number of participants in the
telecommunications and compression industries have applied for or obtained
patents. Some of these patent holders have demonstrated a readiness to commence
litigation based on allegations of patent and other intellectual property
infringement. Third parties may assert patent, copyright and other intellectual
property rights to technologies that are important to our business. In the past,
we have received claims from other companies that our technology infringes their
patent rights. Intellectual property rights can be uncertain and can involve
complex legal and factual questions. We may infringe the proprietary rights of
others, which could result in significant liability for us. If we were found to
have infringed any third party's patents, we could be subject to substantial
damages and an injunction preventing us from conducting our business.


OUR BUSINESS IS SUBJECT TO RAPID TECHNOLOGICAL CHANGE

The semiconductor and telecommunications industries, as well as the market for
high-speed network access technologies, are characterized by rapid technological
change, with new generations of products being introduced regularly and with
ongoing evolutionary improvements. We expect to depend on our ADSL technology
for a substantial portion of our revenue for the foreseeable future. Therefore,
we face risks that others could introduce competing technology that renders our
ADSL technology less desirable or obsolete. Also, the announcement of new
technologies could cause our licensees or their customers to delay or defer
entering into arrangements for the use of our existing technology. Either of
these events could seriously harm our business.

We expect that our business will depend to a significant extent on our ability
to introduce enhancements and new generations of our ADSL technology as well as
new technologies that keep pace with changes in the telecommunications and
broadband industries and that achieve rapid market acceptance. We must
continually devote significant engineering resources to achieving technical
innovations. These innovations are complex and require long development cycles.
Moreover, we may have to make substantial investments in technological
innovations before we can determine their commercial viability. We may lack
sufficient financial resources to fund future development. Also, our licensees
may decide not to share certain research and development costs with us. Revenue
from technological innovations, even if successfully developed, may not be
sufficient to recoup the costs of development.

One element of our business strategy is to assume the risks of technology
development failure while reducing such risks for our licensees. In the past, we
have spent significant amounts on development projects that did not produce any
marketable technologies or products, and we cannot assure you that it will not
occur again.


                                       19
<PAGE>

WE FACE INTENSE COMPETITION FROM A WIDE RANGE OF COMPETITORS

Our success as an intellectual property supplier depends on the willingness and
ability of semiconductor manufacturers to design, build and sell integrated
circuits based on our intellectual property. The semiconductor industry is
intensely competitive and has been characterized by price erosion, rapid
technological change, short product life cycles, cyclical market patterns and
increasing foreign and domestic competition.

As an intellectual property supplier to the semiconductor industry, we face
intense competition from internal development teams within potential
semiconductor customers. We must convince potential licensees to license from us
rather than develop technology internally. Furthermore, semiconductor customers,
who have licensed our intellectual property, may choose to abandon joint
development projects with us and develop chipsets themselves without using our
technology. In addition to competition from internal development teams, we
compete against other independent suppliers of intellectual property. We
anticipate intense competition from suppliers of intellectual property for ADSL.

The market for ADSL chipsets is also intensely competitive. Our success within
the ADSL industry requires that ADSL equipment manufacturers buy chipsets from
our semiconductor licensees, and that telephone companies buy ADSL equipment
from those equipment manufacturers. Our customers' chipsets compete with
products from other vendors of standards-based and ADSL chipsets, including
Broadcom, Centillium, Conexant, ST Microelectronics and Texas Instruments.

ADSL services offered over copper telephone networks also compete with
alternative broadband transmission technologies that use the telephone network
as well as other network architectures. Alternative technologies for the
telephone network include symmetric high speed DSL (also known as HDSL, SDSL and
G.SHDSL), and very high speed DSL, also known as VDSL. These DSL technologies
may be based on techniques other than those used by ADSL to transport high-speed
data over telephone lines. While we are actively developing VDSL technology and
products that meet new VDSL2 standards, we are not certain that we will be able
to participate in future VDSL deployments. Alternative technologies that use
other network architectures to provide high-speed data service include cable
modems using cable networks, wireless solutions using wireless networks, and
optical solutions using fiber optics technology. These alternative broadband
technologies may be more successful than ADSL and we may not be able to
participate in the markets involving these alternative technologies.

Many of our current and prospective ADSL licensees, as well as chipset
competitors that compete with our semiconductor licensees, including Broadcom,
Conexant, ST Microelectronics and Texas Instruments have significantly greater
financial, technological, manufacturing, marketing and personnel resources than
we do. We may be unable to compete successfully, and competitive pressures could
seriously harm our business.


WE MUST MAKE JUDGMENTS IN THE PROCESS OF PREPARING OUR FINANCIAL STATEMENTS

We prepare our financial statements in accordance with generally accepted
accounting principles and certain critical accounting polices that are relevant
to our business. The application of these principles and policies requires us to
make significant judgments and estimates. In the event that


                                       20
<PAGE>

judgments and estimates we make are incorrect, we may have to change them, which
could materially affect our financial position and results of operations.

Moreover, accounting standards have been subject to rapid change and evolving
interpretations by accounting standards setting organizations over the past few
years. The implementation of new standards requires us to interpret and apply
them appropriately. If our current interpretations or applications are later
found to be incorrect, our financial position and results of operations could be
materially affected.


OUR STOCK PRICE MAY BE EXTREMELY VOLATILE

Volatility in our stock price may negatively affect the price you may receive
for your shares of common stock and increases the risk that we could be the
subject of costly securities litigation. The market price of our common stock
has fluctuated substantially and could continue to fluctuate based on a variety
of factors, including:

        |X|     quarterly fluctuations in our operating results;
        |X|     changes in future financial guidance that we may provide to
                investors and public market analysts;
        |X|     changes in our relationships with our licensees;
        |X|     announcements of technological innovations or new products by
                us, our licensees or our competitors;
        |X|     changes in ADSL market growth rates as well as investor
                perceptions regarding the investment opportunity that companies
                participating in the ADSL industry afford them;
        |X|     changes in earnings estimates by public market analysts;
        |X|     key personnel losses;
        |X|     sales of common stock; and
        |X|     developments or announcements with respect to industry
                standards, patents or proprietary rights.

In addition, the equity markets have experienced volatility that has
particularly affected the market prices of equity securities of many high
technology companies and that often has been unrelated or disproportionate to
the operating performance of such companies. These broad market fluctuations may
adversely affect the market price of our common stock.


OUR BUSINESS MAY BE AFFECTED BY GOVERNMENT REGULATIONS

The extensive regulation of the telecommunications industry by federal, state
and foreign regulatory agencies, including the Federal Communications
Commission, and various state public utility and service commissions, could
affect us through the effects of such regulation on our licensees and their
customers. In addition, our business may also be affected by the imposition of
certain tariffs, duties and other import restrictions on components that our
customers obtain from non-domestic suppliers or by the imposition of export
restrictions on products sold internationally and incorporating our technology.
Changes in current or future laws or regulations, in the United States or
elsewhere, could seriously harm our business.


                                       21
<PAGE>

                                     ITEM 3:
           QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK


Our exposure to market risk relates primarily to our investment portfolio, and
the effect that changes in interest rates would have on that portfolio. Our
investment portfolio has included:

        |X|     Cash and cash equivalents, which consist of financial
                instruments with original maturities of three months or less;
                and
        |X|     Investments, which consist of financial instruments that meet
                the high quality standards specified in our investment policy.
                This policy dictates that all instruments mature in three years
                or less, and limits the amount of credit exposure to any one
                issue, issuer, and type of instrument.

We do not use derivative financial instruments for speculative or trading
purposes. As of June 30, 2005, we had $37.7 million in cash, cash equivalents
and short-term investments that matured in twelve months or less. Due to the
short duration of these financial instruments, we do not expect that an increase
in interest rates would result in any material loss to our investment portfolio.

As of June 30, 2005, we had invested $1.0 million in long-term investments that
matured in one to three years. These long-term securities are invested in high
quality U.S. government securities. Despite the high quality of these
securities, they may be subject to interest rate risk. This means that if
interest rates increase, the principal amount of our investment would probably
decline. A large increase in interest rates may cause a material loss to our
long-term investments. The following table (dollars in thousands) presents
hypothetical changes in the fair value of our long-term investments at June 30,
2005. The modeling technique measures the change in fair value arising from
selected potential changes in interest rates. Movements in interest rates of
plus or minus 50 basis points (BP) and 100 BP reflect immediate hypothetical
shifts in the fair value of these investments.

<TABLE>
<CAPTION>
                                       Valuation of securities                        Valuation of securities
                                        given an interest rate                         given an interest rate
                                             decrease of              No change             increase of
                                       -------------------------     in interest      -------------------------
Type of security                         (100BP)      (50 BP)           rates           100 BP        50 BP
---------------------------------------------------------------------------------------------------------------
<S>                                          <C>         <C>               <C>               <C>          <C>
Long-term investments with
  maturities of one to three years           $1,015      $1,008            $1,001            $986         $993
</TABLE>


                                       22
<PAGE>

                                     ITEM 4:
                             CONTROLS AND PROCEDURES

Our management, including our chief executive officer and chief financial
officer, has evaluated our disclosure controls and procedures as of the end of
the quarterly period covered by this Form 10-Q and has concluded that our
disclosure controls and procedures are effective. They also concluded that there
were no changes in our internal control over financial reporting that occurred
during the quarterly period covered by this Form 10-Q that have materially
affected, or are reasonably likely to materially affect, our internal control
over financial reporting.


                                       23
<PAGE>

                           PART II. OTHER INFORMATION

                                     ITEM 1:
                                LEGAL PROCEEDINGS


From time to time we are involved in litigation incidental to the conduct of our
business. We are not party to any lawsuit or proceeding that, in our opinion, is
likely to seriously harm our business.


                                     ITEM 4:
               SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS

On May 25, 2005, we held our Annual Meeting of Stockholders (the "Annual
Meeting"). Matters voted on and the results of those votes are set forth below:

(1)     Each of Frederick D. D'Alessio, Adrian F. Kruse and Edmund C. Reiter was
        elected to serve as a Class III director of the Company for a term
        expiring at the annual meeting of stockholders of the Company in 2008 or
        a special meeting in lieu thereof. Each of John K. Kerr, David Ehreth,
        G. David Forney, and Michael A. Tzannes continued to serve as a director
        following the Annual Meeting.

        The votes cast to elect the Class III directors were:

        Name                                 For                 Abstain
        ----                                 ---                 -------

        Frederick D. D'Alessio               21,273,212          748,264
        Adrian F. Kruse                      21,576,498          444,978
        Edmund C. Reiter                     21,577,263          444,213



                                       24
<PAGE>

                                     ITEM 6:
                                    EXHIBITS


(A)     EXHIBITS


        Exhibit 31.1    Certification of Chief Executive Officer pursuant to
                        Section 302 of the Sarbanes-Oxley Act of 2002.

        Exhibit 31.2    Certification of Chief Financial Officer pursuant to
                        Section 302 of the Sarbanes-Oxley Act of 2002.

        Exhibit 32.1    Certification of Chief Executive Officer and Chief
                        Financial Officer pursuant to Section 906 of the
                        Sarbanes-Oxley Act of 2002.


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


                                   SIGNATURES


        Pursuant to the requirements of the Securities Exchange Act of 1934, the
Registrant has duly caused this report to be signed on its behalf by the
undersigned thereunto duly authorized.


                                        AWARE, INC.


        Date: August 9, 2005            By:  /s/ Michael A. Tzannes
                                             ----------------------
                                             Michael A. Tzannes, Chief Executive
                                             Officer


        Date: August 9, 2005            By:  /s/ Robert J. Weiskopf
                                             ----------------------
                                             Robert J. Weiskopf, Chief Financial
                                             Officer (Principal Financial and
                                             Accounting Officer)


                                       25