10-Q 1 b40500nte10-q.txt NETSILICON, INC. 1 SECURITIES AND EXCHANGE COMMISSION WASHINGTON, D.C. 20549 FORM 10-Q (Mark One) [X] QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES Exchange Act of 1934 for the quarterly period ended July 28, 2001. [ ] TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES Exchange Act of 1934 for the transition period from ____ to ____. Commission file number 0-26761 NETSILICON, INC. (Exact name of registrant as specified in its charter) MASSACHUSETTS 04-2826579 (State of incorporation) (I.R.S. Employer Identification No.) 411 WAVERLEY OAKS RD., BLDG. 227, WALTHAM, MASSACHUSETTS 02452 (Address of principal executive office) (781) 647-1234 (Telephone number) Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days. Yes [X] No [ ] Indicate the number of shares outstanding of each of the issuer's classes of Common Stock, as of the latest practicable date. 7,093,700 shares of Voting Common Stock, $0.01 par value, as of September 6, 2001; 6,972,700 shares of Non-Voting Common Stock, $0.01 par value, as of September 6, 2001. 2 NETSILICON, INC. TABLE OF CONTENTS Page ---- PART I. FINANCIAL INFORMATION ITEM 1. Financial Statements Condensed Consolidated Balance Sheets July 28, 2001 and January 31, 2001 ............................... 1 Condensed Consolidated Statements of Operations Three Months and Six Months Ended July 28, 2001 and July 29, 2000 .................................................... 2 Condensed Consolidated Statements of Cash Flows Six Months Ended July 28, 2001 and July 29, 2000 ................. 3 Notes to Condensed Consolidated Financial Statements ............. 4 ITEM 2. Management's Discussion and Analysis of Financial Condition and Results of Operations .............................. 7 ITEM 3. Quantitative and Qualitative Disclosure About Market Risk ........ 23 PART II. OTHER INFORMATION ITEM 1. Legal Proceedings ................................................ 23 ITEM 2. Changes in Securities and Use of Proceeds ........................ 24 ITEM 3. Defaults Upon Senior Securities .................................. 24 ITEM 4. Submission of Matters to a Vote of Security Holders .............. 24 ITEM 5. Other Information ................................................ 24 ITEM 6. Exhibits and Reports on Form 8-K ................................. 24 Signatures ................................................................. 25 3 PART I. FINANCIAL INFORMATION ITEM 1. Financial Statements NETSILICON, INC. CONDENSED CONSOLIDATED BALANCE SHEETS

See accompanying notes to condensed consolidated financial statements. 1 4 NETSILICON, INC. CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS (Unaudited)

See accompanying notes to condensed consolidated financial statements. 2 5 NETSILICON, INC. CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS (Unaudited)

See accompanying notes to condensed consolidated financial statements. 3 6 NETSILICON, INC. NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (Unaudited) 1. Basis of presentation: In the opinion of management, the accompanying condensed consolidated financial statements include all adjustments necessary for a fair presentation of NetSilicon, Inc.'s (the "Company") financial position, results of operations and cash flows for this interim period. This quarterly information should be read in conjunction with the audited financial statements and accompanying notes included in the Company's 2001 Form 10-K as filed with the Securities and Exchange Commission ("SEC") on May 1, 2001. The financial statements are prepared in conformity with generally accepted accounting principles which require management to make estimates that affect the reported amounts of assets, liabilities, revenues and expenses, and the disclosure of contingent assets and liabilities. Actual results could differ from these estimates. Certain prior period amounts have been reclassified to conform to the current period presentation. These reclassifications had no effect on net income (loss) or stockholders' equity. Operating results for the interim period are not necessarily indicative of results that may be expected for the entire fiscal year. 2. Inventories: Inventories are stated at the lower of cost (first-in, first-out) or market. Cost is computed using standard costs, which approximate actual cost on a first-in, first-out basis. Inventories consist of: July 28, January 31, 2001 2001 ---------- ---------- Raw material $4,711,300 $6,543,000 Work in process 68,000 118,100 Finished Goods 305,200 45,900 ---------- ---------- Total Inventory $5,084,500 $6,707,000 ========== ========== 3. Earnings per share calculation: Basic earnings per share is computed based on the weighted average number of shares outstanding during the period. Diluted earnings per share is computed based on the weighted average number of shares outstanding during the period increased by the effect of dilutive potential common shares which consist of shares issuable under stock benefit plans and warrants. 4 7 The following is a reconciliation of the numerator and denominators of the basic and diluted per share computations:

The shares issuable upon exercise of options and warrants represent the shares issuable at exercise net of the shares assumed to have been purchased, at the average market price for the period, with the assumed exercise proceeds. Accordingly, options and warrants with exercise prices in excess of the average market price for the period are excluded because their effect would be anti-dilutive. The Company had a net loss for the three and six months ended July 28, 2001. The effect of dilutive securities including stock options and warrants to acquire common stock are not included in the calculation of earnings (loss) per share for the periods ended July 28, 2001 because their effect would be anti-dilutive. 4. Acquisition: On February 16, 2001, the Company purchased all of the equity securities of Dimatech Corporation ("Dimatech") pursuant to a Stock Purchase Agreement, dated as of February 16, 2001, by and among Dimatech, Hiroyuki Kataoka and the Company. Prior to the acquisition, Dimatech was a major distributor of the Company's product in Japan and Asia and Hiroyuki Kataoka was the President and owner of Dimatech. Dimatech, under a new name, continues to operate in Japan and Asia as a distributor of the Company's products and provides technical support and other services to customers in the region. Hiroyuki Kataoka has joined NetSilicon as Vice President of Intelligent Device Markets for Japan. The purchase price was allocated to the tangible and intangible assets acquired and liabilities assumed on the basis of their respective estimated fair values on the acquisition date. The following represents a preliminary allocation of the purchase price: Cash ............................................... $ 761,400 Accounts receivable ................................ 1,017,900 Other tangible assets .............................. 161,900 Customer list ...................................... 351,400 Workforce .......................................... 148,000 Goodwill ........................................... 134,400 ---------- Total purchase price ............................... $2,575,000 ========== The purchase price consisted of 241,667 shares of the common stock of the Company, valued at $1,239,100, assumed liabilities of $969,400, $250,000 in cash and $116,500 of acquisition related costs, including legal and accounting fees. 5 8 5. Comprehensive Income (Loss): Comprehensive income (loss) is defined as a change in equity of a company during a period from transactions and other events and circumstances excluding transactions resulting from investments by owners and distributions to owners. The difference between net income (loss) and comprehensive income (loss) for NetSilicon results from foreign currency translation adjustments and unrealized gains and losses on available-for-sale securities, net of taxes. Comprehensive income (loss) consisted of the following:

6. Contingencies: On August 31, 2000, Websprocket, LLC filed a suit against the Company in the United States District Court for the Northern District of California (Websprocket, LLC v. NetSilicon, Inc., Civil Action No. C-00-20915), claiming breach of contract. The complaint alleges that the Company breached a technology development contract that was executed between the Company and Websprocket, LLC in December 1999. Websprocket, LLC seeks relief including alleged damages of $2,000,000 plus attorney's fees, a declaration of its rights under the technology development contract and an injunction requiring the Company to cease using and return all property of Websprocket, LLC. The Company believes that it has meritorious defenses to the claims and intends to contest the lawsuit vigorously. On or about October 31, 2000, the Company filed an Answer and Counterclaim denying the allegations in Websprocket, LLC's complaint and asserting counterclaims against Websprocket, LLC that included breach of contract, fraud, and negligent misrepresentation. Websprocket, LLC filed a reply to the Company's counterclaims on November 25, 2000, denying the allegations. An unfavorable resolution of the action could have a material adverse effect on the business, results of operations or financial condition of the Company. On or about August 9, 2001, a purported securities class action lawsuit captioned "Ellis Investments, Ltd. v. NetSilicon, Inc., et al." (01-CV-7281) was filed in the United States District Court for the Southern District of New York. A second, nearly identical complaint was filed in the same Court on or about August 15, 2001 in a lawsuit captioned "Michael Rasner v. NetSilicon, Inc., et al." (01-CV-7651). The suits name as defendants the Company, certain of its officers and directors, and certain underwriters involved in the Company's initial public offering ("IPO"). The Ellis Investments suit also names Osicom Technologies, Inc. as a defendant. The complaints in these actions are allegedly brought on behalf of purchasers of the Company's common stock during the period from September 15, 1999 to December 6, 2000, and assert, among other things, that the Company's IPO prospectus and registration statement violated federal securities laws because they contained material misrepresentations and/or omissions regarding the conduct of the Company's IPO underwriters in allocating shares in the Company's IPO to the underwriters' customers. The actions seek recission or recissory and other damages, fees and costs associated with the litigation, and interest. The Company understands that various plaintiffs have filed substantially similar lawsuits against over a hundred other publicly traded companies in connection with the underwriting of their initial public offerings. The Company and its officers and directors believe that the allegations in the complaint are without merit and intend to contest them vigorously. An unfavorable resolution of the action could have a material adverse effect on the business, results of operations or financial condition of the Company. 7. Recent Accounting Pronouncements: In June 2001, the Financial Accounting Standards Board finalized FASB Statement No. 141, "Business Combinations ("SFAS 141"), and No. 142, Goodwill and Other Intangible Assets ("SFAS 142"). SFAS 141 requires the use of the purchase method of accounting and prohibits the use of the pooling-of-interests method of accounting for business combinations initiated after June 30, 2001. SFAS 141 also requires that the Company recognize acquired intangible assets apart from goodwill if the acquired intangible assets meet certain criteria. SFAS 141 applies to all business combinations initiated after June 30, 2001 and for purchase business combinations completed on or after July 1, 2001. Upon adoption of SFAS 142, it requires that the Company reclassify the carrying amounts of intangible assets and goodwill based on the criteria in SFAS 141. SFAS 142 requires, among other things, that companies no longer amortize goodwill, but instead test goodwill for impairment at least annually. In addition, SFAS 142 requires that the Company identify reporting units for the purposes of assessing potential future impairments of goodwill, reassess the useful lives of other existing recognized intangible assets, and cease amortization of intangible assets with an indefinite useful life. An intangible asset with an indefinite useful life should be tested for impairment in accordance with the guidance in SFAS 142. SFAS 142 is required to be applied in fiscal years beginning after December 15, 2001 to all goodwill and other intangible assets recognized at that date, regardless of when those assets were initially recognized. SFAS 142 requires the Company to complete a transitional goodwill impairment test six months from the date of adoption. The Company is also required to reassess the useful lives of other intangible assets within the first interim quarter after adoption of SFAS 142. The Company's previous business combinations were accounted for using the purchase method. As of July 28, 2001, the net carrying amount of intangible assets is $1,680,800. Amortization expense during the six-month period ended July 28, 2001 was $304,800. Currently, the Company is assessing but has not yet determined how the adoption of SFAS 141 and SFAS 142 will impact its financial position and results of operations. 6 9 ITEM 2. Management's Discussion and Analysis of Financial Condition and Results of Operations Some of the information in this discussion and analysis contains forward-looking statements within the meaning of the federal securities laws. These statements include, among others, statements regarding our financial performance, expected future revenue, product development plans, projected capital expenditures, liquidity and business strategy. Forward-looking statements typically are identified by use of terms such as may, will, expect, anticipate, estimate and similar words, although some forward-looking statements are expressed differently. You should be aware that our actual results could differ materially from those contained in the forward-looking statements due to a number of factors, including delays in product introductions, interruptions in supply and competitive product introductions. You should also consider carefully the "Business" and "Risk Factors" sections contained in the Company's 2001 Form 10-K as filed with the SEC and the "Risk Factors" section contained herein, which address additional factors that could cause our actual results to differ from those set forth in the forward-looking statements. You should read this discussion together with the unaudited financial statements and other information included in this document. OVERVIEW We develop and market embedded Ethernet networking solutions, which combine advanced microprocessors and software, to manufacturers building intelligent, network-enabled devices. We commenced our operations in 1984 as Digital Products, Inc. From our inception, we have developed and marketed networking products for embedded systems that enable the connection of electronic devices to networks. In September 1996, Sorrento Networks Corporation, formerly Osicom Technologies, Inc. ("Sorrento"), acquired all of our outstanding capital stock from our stockholders. We were a wholly-owned subsidiary of Sorrento from the date of the acquisition through our initial public offering in September of 1999. RESULTS OF OPERATIONS The following table sets forth information derived from our Statements of Operations expressed as a percentage of net sales for the three and six month periods ended July 28, 2001 and July 29, 2000.

7 10 Three and Six Months Ended July 28, 2001 compared to Three and Six Months Ended July 29, 2000: Net sales. Net sales were $7.1 million for the three months ended July 28, 2001 compared to $9.9 million for the three months ended July 29, 2000, representing a decrease of 28.5%. Net sales decreased to $14.0 million for the six months ended July 28, 2001 from $18.9 million for the six months ended July 29, 2000, a decrease of 25.6%. The decrease in net sales in the three and six month periods was due primarily to an economic slowdown that has affected our imaging customers. Revenue from our imaging customers was $5.6 and $11.2 for the three and six month periods, respectively, ended July 28, 2001 compared to $8.0 and $15.6 for the three and six month periods, respectively, ended July 29, 2000. Backlog for our products and service was approximately $4.5 and $8.1 million at July 28, 2001 and July 29, 2000, respectively, all of which was scheduled to be shipped within 12 months. Our embedded networking semiconductor and controller products accounted for 90.0% and 88.7% of total net sales for the six months ended July 28, 2001 and July 29, 2000, respectively. Software development tools and development boards accounted for 5.7% of total net sales for the six months ended July 28, 2001 and 5.3% of total net sales for the prior year six month period. Royalty, maintenance and service revenue was 4.3% and 6.0% of total net sales for the six months ended July 28, 2001 and July 29, 2000, respectively. During the six months ended July 28, 2001, international sales accounted for 51.8% of net sales compared to 52.9% of net sales for the six month period ended July 29, 2000. Cost of sales; gross margin. Costs of goods sold consists principally of the cost of raw material components and subcontractor labor assembly from outside manufacturers and suppliers. Cost of sales also includes amortization of software development costs. Gross margin decreased to $3.6 million, or 51.6% of net sales, for the three months ended July 28, 2001 from $5.7 million, or 58.1% of net sales, for the three months ended July 29, 2000, representing a decrease of 36.4%. Gross margin decreased 31.9% to $7.6 million, or 54.5% of net sales, for the six months ended July 28, 2001 from $11.2 million, or 59.5% of net sales, for the six months ended July 29, 2000. The decrease in gross margin percent for the three and six months periods ended July 28, 2001 from the prior year periods was due primarily to (i) a decrease in high-margin sales of software products and development kits; (ii) a decrease in royalty revenue; and (iii) the overall decrease in sales. Selling and marketing expenses. Selling and marketing expenses consist mainly of employee-related expenses, commissions to sales representatives, trade shows, publicity and travel expenses. Selling and marketing expenses decreased from $2.8 million, or 28.0% of net sales, for the three months ended July 29, 2000 to $2.5 million, or 35.2% of net sales, for the three months ended July 28, 2001, representing a decrease of 10.3%. Selling and marketing expenses were $5.4 million, or 38.3% of net sales, for the six 8 11 month period ended July 28, 2001 compared to $5.3 million, or 28.3% of net sales, for the six month period ended July 29, 2000. The decrease in selling and marketing expenses for the three months ended July 28, 2001 compared to the three months ended July 29, 2000 was the result of (i) a decrease in commission to sales representatives due to the decrease in revenue; (ii) the absence of commission payable to Dimatech Corporation, our former distributor in Japan that we acquired in February 2001; and (iii) decreases in several discretionary costs due to our cost reduction initiatives. Selling and marketing expenses for the six month period ended July 28, 2001 were consistent with selling and marketing expenses for the six month period ended July 29, 2000 due to the fact that the cost savings realized in the three month period ended July 28, 2001 were offset by increased costs in the three month period ended April 28, 2001 compared to the prior year period ended April 29, 2000. These increased costs included (i) additional payroll costs related to the expansion of our direct sales and marketing teams, including those costs related to our acquisition of Dimatech Corporation and certain assets of Pacific Softworks, Inc.; (ii) payroll recruiting and other costs associated with investments made to expand our customer support department; and (iii) an increase in marketing costs associated with the introduction of new products, expanded advertising and publicity programs, and greater participation in trade shows. Engineering, research and development. Engineering, research and development expenses consist primarily of salaries and the related costs of employees engaged in research, design and development activities. Engineering, research and development expenses increased to $2.0 million, or 27.8% of net sales, for the three months ended July 28, 2001 from $1.4 million, or 14.2% of net sales, for the three months ended July 29, 2000, representing an increase of 40.3%. Engineering, research and development expenses increased 37.2% to $3.8 million, or 27.3% of net sales, for the six months ended July 28, 2001 from $2.8 million, or 14.8% of net sales, for the six months ended July 29, 2000. This increase is due primarily to increased payroll costs associated with an increase in headcount from 43 employees engaged in research and development activities at July 29, 2000 to 52 employees at July 28, 2001. The increase in headcount includes the addition of 10 engineers acquired in connection with our purchase of certain assets of Pacific Softworks in August 2000. In addition, the increase in engineering, research and development expenses is attributable to increases in recruiting costs, depreciation and amortization of purchased software tools, and amortization of purchased intangible assets related to our purchase of certain Pacific Softworks assets in August 2000. These increases were offset in part by decreases in several discretionary costs due to our cost reduction initiatives. General and administrative expenses. General and administrative expenses consist mainly of salaries, employee-related expenses, legal expenses, audit fees and reserves for accounts receivable allowances. General and administrative expenses increased to $1.4 million, or 20.3% of net sales, for the three months ended July 28, 2001 from $1.1 million, or 10.7% of net sales, for the three months ended July 29, 2000, an increase of 34.9%. General and administrative expenses increased 32.6% to $2.7 million, or 19.3% of net sales, for the six months ended July 28, 2001 from $2.0 million, or 10.8% of net sales, for the six months ended July 29, 2000. The increase in general and administrative expenses is attributable to an increase in legal, accounting and insurance costs, increases in rent expense related to our lease of additional space at our headquarters in Massachusetts and our new facilities in California and Japan. The increase is also due to higher employee-related expenses including payroll costs and 9 12 severance costs for terminated employees. These increases were offset in part by decreases in several discretionary costs due to our cost reduction initiatives. Amortization of intangibles. Amortization of intangible assets consists of the amortization of intangible assets acquired in connection with the purchase of certain assets of Pacific Softworks, Inc. in August 2000 and our acquisition of Dimatech Corporation in February 2001. Amortization of intangibles increased to $154,200, or 2.2% of net sales, and $304,800, or 2.2% of net sales, for the three and six months ended July 28, 2001, respectively, from $0 for the three and six months ended July 29, 2000. Interest income, net. Interest income includes interest earned on cash and short-term investment balances. Net interest income was $112,100, or 1.6% of net sales, and $240,700, or 2.4% of net sales, for the three months ended July 28, 2001 and July 29, 2000, respectively. Net interest income was $271,900, or 1.9% of net sales, and $464,900, or 2.5% of net sales, for the six months ended July 28, 2001 and July 29, 2000, respectively. The decrease in interest income is due to a decrease in cash and short-term investments. Provision for income taxes. The provision for income taxes for the three and six months ended July 28, 2001 totaled $22,100, or 0.3% of net sales, and $65,200, or 0.5% of net sales, respectively, and related to foreign taxes for our Japanese subsidiary. There was no net provision for U.S. income taxes for the three and six months ended July 28, 2001 and July 29, 2000 due to the net losses in the periods ended July 28, 2001 and the utilization of available net operating loss carryforwards in the periods ended July 29, 2000. Liquidity and Capital Resources Prior to our public offering in September 1999, we financed our operations through advances from Sorrento and borrowings under our short-term bank line of credit. The Company received proceeds, net of offering costs, of approximately $22.2 million as a result of the initial public offering and sale of our stock. At July 28, 2001, we had working capital of $15.0 million, cash and cash equivalents of $8.2 million and short-term investments of $3.1 million. Our operating activities used cash of $1.2 million and $492,500 for the six months ended July 28, 2001 and July 29, 2000, respectively. Cash used by operating activities in the six month period ended July 28, 2001 was attributable to the net loss and a decrease in accounts payable, offset in part by decreases in accounts receivable and inventory and the non-cash impact of depreciation and amortization. The decrease in accounts receivable is due to the decrease in sales and strong collection efforts and the decrease in inventory is attributable to a decrease in purchasing activity and the consumption of electronic components that were previously purchased in large volumes to decrease the risk to our operations of the sharp fluctuations in market supply of the components. Cash used during the six months ended July 29, 2000 was attributable to an increase in accounts receivable and inventory, offset in part by net income, an increase in accounts payable and the non-cash impact of depreciation and amortization. Our sales and marketing expenses, engineering, research and development expenses and general and administrative expenses each may increase in the fiscal year ending January 31, 2002 and thereafter compared to the amounts of such expenses in the fiscal year ending January 31, 2001. Due in part to an economic slowdown affecting our imaging customers, we anticipate a decline in imaging revenue growth in fiscal year 2002, from fiscal year 2001, which will adversely effect our results of operations and financial condition and may result in operating losses for all or part of fiscal year 2002. There can be no assurance that our available cash and cash flow from operations will be sufficient to fund such additional expenses. 10 13 Our standard payment terms are net 30 days. While we actively pursue collection within that time, receivables have frequently taken longer to collect in part because we sell products to large companies in Asia. Our investing activities provided cash of $3.3 million and used cash of $4.0 million during the six months ended July 28, 2001 and July 29, 2000, respectively. Cash provided by investing activities during the six months ended July 28, 2001 related primarily to proceeds of $3.6 million from short-term investments and net cash acquired in the acquisition of Dimatech Corporation of $413,600, offset in part by purchases of property and equipment of $495,200. Cash used in investing activities during the six months ended July 29, 2000 related primarily to the purchase of $2.0 million of short-term investments and purchases of $1.4 million of property and equipment. On August 31, 2000, we issued 90,000 shares of common stock, valued at $2.3 million and incurred $570,000 of acquisition-related costs in connection with the acquisition of the strategic network technology assets of Pacific Softworks, Inc. The total purchase price was $2.8 million and was allocated to the tangible and intangible assets acquired. On February 16, 2001, we issued 241,667 shares of common stock valued at $1.2 million, paid cash of $250,000, incurred $116,500 of acquisition-related costs and assumed $969,400 of liabilities in connection with the acquisition of Dimatech Corporation. The total purchase price was $2.6 million and was allocated to the tangible and intangible assets acquired. Cash provided by financing activities was $45,700 and cash used by financing activities was $905,900 during the six months ended July 28, 2001 and July 29, 2000, respectively. Cash provided by financing during the period ended July 28, 2001 related to proceeds from the issuance of stock. Cash used in financing activities in the period ended July 29, 2000 was attributable to repayments of short term debt of $779,700 and a loan to an officer of the Company in the amount of $621,200, offset in part by proceeds from the exercise of stock options of $734,900. We anticipate that our available cash resources will be sufficient to meet our presently anticipated capital requirements through the next 12 months. Nonetheless, we may elect to sell additional equity securities or obtain additional credit. Our future capital requirements may vary materially from those now planned and will depend on many factors, including, but not limited to, the levels at which we maintain inventory and accounts receivable; the market acceptance of our products; the levels of promotion and advertising required to launch products or enter markets and attain a competitive position in the marketplace; volume pricing concessions; our business, product, capital expenditure and research and development plans and technology roadmap; capital improvements to new and existing facilities; technological advances; the response of competitors to our products; and our relationships with suppliers and customers. In addition, we may require an increase in the level of working capital to accommodate planned growth, hiring and infrastructure needs. Additional capital may be required for consummation of any acquisitions of businesses, products or technologies. We may need to raise additional funds through public or private financings or borrowings if existing resources and cash generated from operations are insufficient to fund our future activities. No assurance can be given that additional financing will be available or that, if available, such financing can be obtained on terms favorable to our shareholders and us. If additional funds are raised through the issuance of equity securities, the percentage ownership of then current stockholders of us will be reduced and such equity securities may have rights, preferences or privileges senior to those of holders of our common stock. If adequate funds are not available to satisfy short- or long-term capital requirements, we may be required to limit our operations significantly. Impact of Recent Accounting Pronouncements: In June 2001, the Financial Accounting Standards Board finalized FASB Statement No. 141, "Business Combinations ("SFAS 141"), and No. 142, Goodwill and Other Intangible Assets ("SFAS 142"). SFAS 141 requires the use of the purchased method of accounting and prohibits the use of the pooling-of-interests method of accounting for business combinations initiated after June 30, 2001. SFAS 141 also requires that the Company recognize acquired intangible assets apart from goodwill if the acquired intangible assets meet certain criteria. SFAS 141 applies to all business combinations initiated after June 30, 2001 and for purchase business combinations completed on or after July 1, 2001. Upon adoption of SFAS 142, it requires that the Company reclassify the carrying amounts of intangible assets and goodwill based on the criteria in SFAS 141. SFAS 142 requires, among other things, that companies no longer amortize goodwill, but instead test goodwill for impairment at least annually. In addition, SFAS 142 requires that the Company identify reporting units for the purposes of assessing potential future impairments of goodwill, reassess the useful lives of other existing recognized intangible assets, and cease amortization of intangible assets with an indefinite useful life. An intangible asset with an indefinite useful life should be tested for impairment in accordance with the guidance in SFAS 142. SFAS 142 is required to be applied in fiscal years beginning after December 15, 2001 to all goodwill and other intangible assets recognized at that date, regardless of when those assets were initially recognized. SFAS 142 requires the Company to complete a transitional goodwill impairment test six months from the date of adoption. The Company is also required to reassess the useful lives of other intangible assets within the first interim quarter after adoption of SFAS 142. The Company's previous business combinations were accounted for using the purchase method. As of July 28, 2001, the net carrying amount of intangible assets is $1,680,800. Amortization expense during the six-month period ended July 28, 2001 was $304,800. Currently, the Company is assessing but has not yet determined how the adoption of SFAS 141 and SFAS 142 will impact its financial position and results of operations. 11 14 RISK FACTORS You should carefully consider the following risks before investing in our common stock. These are not the only risks facing our company. Additional risks may also impair our business operations. If any of the following risks come to fruition, our business, results of operations or financial condition could be materially adversely affected. In that case, the trading price of our common stock could decline, and you may lose all or part of your investment. You should also refer to the other information set forth in this document, including our financial statements and the accompanying notes. WE HAVE A HISTORY OF LOSSES AND AN ACCUMULATED DEFICIT THAT MAKE FUTURE OPERATING RESULTS AND PROFITABILITY DIFFICULT TO PREDICT. We incurred net losses from continuing operations for the fiscal years ended January 31, 1997, 1998, 1999 and 2001. At January 31, 2001, we had an accumulated deficit of $3.6 million. There can be no assurance that we will be able to achieve profitability on a quarterly or annual basis in the future. In addition, revenue growth is not necessarily indicative of future operating results and there can be no assurance that we will be able to sustain revenue growth. We continue to invest significant financial resources in product development, marketing and sales, and a failure of such expenditures to result in significant increases in revenue could have a material adverse effect on us. Due to the limited history and undetermined market acceptance of our new products, the rapidly evolving nature of our business and markets, potential changes in product standards that significantly influence many of the markets for our products, the high level of competition in the industries in which we operate and the other factors described elsewhere in these Risk Factors, there can be no assurance that our investment in these areas will result in increases in revenue or that any revenue growth that is achieved can be sustained. Our history of losses, coupled with the factors described below, make future operating results difficult to predict. We and our future prospects must be considered in light of the risks, costs and difficulties frequently encountered by emerging companies. As a result, there can be no assurance that we will be profitable in any future period. THE UNPREDICTABILITY OF OUR QUARTERLY RESULTS MAY ADVERSELY AFFECT THE TRADING PRICE OF OUR COMMON STOCK. Our net sales and operating results have in the past and may in the future fluctuate substantially from quarter to quarter and from year to year. These results have varied significantly due to a number of factors, including: - market acceptance of and demand for our products and those of our customers; - unanticipated delays or problems in the introduction of our products; - the timing of large customer orders; - the timing and success of our customers' development cycles; - our ability to introduce new products in accordance with customer design requirements and design cycles; - new product announcements or product introductions by us and our competitors; - availability and cost of manufacturing sources for our products; 12 15 - the volume of orders that are received and can be filled in a quarter; - the rescheduling or cancellation of orders by customers; - changes in product mix; - timing of "design wins" with our customers and related revenue; and - changes in currency exchange rates. Our operating results could also be harmed by: - the growth rate of markets into which we sell our products; - changes in the mix of sales to customers and sales representatives; - costs associated with protecting our intellectual property; and - changes in product costs and pricing by us and our competitors. We budget expenses based in part on future revenue projections. We may be unable to adjust spending in a timely manner in response to any unanticipated declines in revenues. As a result of these and other factors, investors should not rely solely upon period-to-period comparisons of our operating results as an indication of future performance. It is likely that in some future period our operating results or business outlook will be below the expectations of securities analysts or investors, which would likely result in a significant reduction in the market price of the shares of our common stock. OUR FAILURE TO INCREASE SALES TO MANUFACTURERS OF INTELLIGENT, NETWORK-ENABLED DEVICES AND OTHER EMBEDDED SYSTEMS WILL ADVERSELY AFFECT OUR FINANCIAL RESULTS. Our financial performance and future growth is dependent upon our ability to sell our products to manufacturers of intelligent, network-enabled devices and other embedded systems in various markets, including markets in which networking solutions for embedded systems have not historically been sold, such as the industrial automation equipment, data acquisition and test equipment, Internet devices and security equipment markets. A substantial portion of our recent development efforts have been directed toward the development of new products for markets that are new and rapidly evolving. There can be no assurance that: - the additional intelligent device markets targeted by us for our products and services will develop; - developers within each market targeted by us will choose our products and services to meet their needs; - we will successfully develop products to meet the industry-specific requirements of developers in our targeted markets or that design wins will result in significant sales; or - developers in our targeted markets will gain market acceptance for their devices which incorporate our products. 13 16 We have limited experience in designing our products to meet the requirements of developers in these industries. Moreover, our products and services have, to date, achieved limited acceptance in these industries. WE ARE DEPENDENT ON THE IMAGING MARKET FOR A LARGE PORTION OF OUR REVENUES. The imaging market has historically accounted for substantially all of our revenues. In the fiscal years ended January 31, 2001, 2000 and 1999, 79%, 95% and 95%, respectively, of our revenues were generated from customers in the imaging market. Our success has been and continues to be dependent on the continued success of the imaging market. Many of our customers face competition from larger, more established companies which may exert competitive or other pressures on them. Any decline in sales to the imaging market would have a material adverse effect on our business, results of operations and financial condition. Due in part to an economic slowdown affecting our imaging customers, we anticipate a decline in imaging revenue growth in fiscal year 2002, from fiscal year 2001, which will adversely affect our results of operations and financial condition. The imaging market is characterized by declining prices of existing products and a transition from higher priced network interface cards to semiconductor devices. Therefore, continual improvements in manufacturing efficiencies and the introduction of new products and enhancements to existing products are required for us to maintain our gross margins. In response to customer demands or competitive pressures, or to pursue new product or market opportunities, we may take certain pricing or marketing actions, such as price reductions or volume discounts. These actions could have a material adverse effect on us. A significant amount of our customers in the imaging market are headquartered in Japan. Our customers are subject to declines in their local economies, which have affected them from time to time in the past and may affect them in the future. The success of our customers affects their purchases from us. OUR HIGHLY CONCENTRATED CUSTOMER BASE INCREASES THE POTENTIAL ADVERSE EFFECT ON US FROM THE LOSS OF ONE OR MORE CUSTOMERS. Our products have historically been sold into the imaging markets for use in products such as printers, scanners, fax machines, copiers and multi-function peripherals. This market is highly concentrated. Accordingly, our sales are derived from a limited number of customers, with our top five OEM customers accounting for 55%, 72% and 52% of total revenues for the fiscal years ended 2001, 2000 and 1999, respectively. In particular, sales to Dimatech and Ricoh accounted for 23% and 20% of total revenues, respectively, for the fiscal year ended January 31, 2001. We expect that a small number of customers will continue to account for a substantial portion of our total revenues for the foreseeable future. All of our sales are made on the basis of purchase orders rather than under long-term agreements, and therefore, any customer could cease purchasing our products at any time without penalty. The decision of any key customer to cease using our products or a material decline in the number of units purchased by a significant customer would have a material adverse effect on us. 14 17 THE LONG AND VARIABLE SALES CYCLE FOR OUR PRODUCTS MAKES IT MORE DIFFICULT FOR US TO PREDICT OUR OPERATING RESULTS AND MANAGE OUR BUSINESS. The sale of our products typically involves a significant technical evaluation and commitment of capital and other resources by potential customers, as well as delays frequently associated with customers' internal procedures to deploy new technologies within their products and to test and accept new technologies. For these and other reasons, the sales cycle associated with our products is typically lengthy, lasting nine months or longer, and is subject to a number of significant risks, including customers' internal acceptance reviews, that are beyond our control. Because of the lengthy sales cycle and the large size of customer orders, if orders forecasted for a specific customer for a particular quarter are not realized in that quarter, our operating results for that quarter could be materially adversely affected. OUR RELATIVELY LOW LEVEL OF BACKLOG INCREASES THE POTENTIAL VARIABILITY OF OUR QUARTERLY OPERATING RESULTS. Our backlog at the beginning of each quarter typically is not sufficient to achieve expected sales for the quarter. To achieve our sales objectives, we are dependent upon obtaining orders during each quarter for shipment during that quarter. Furthermore, our agreements with our customers typically permit them to change delivery schedules. Non-imaging customers may cancel orders within specified time frames (typically 30 days or more prior to the scheduled shipment date under our policies) without significant penalty. Our customers have in the past built, and may in the future build, significant inventory in order to facilitate more rapid deployment of anticipated major products or for other reasons. Decisions by such customers to reduce their inventory levels have led and could lead to reductions in their purchases from us. These reductions, in turn, have caused and could cause adverse fluctuations in our operating results. OUR DEPENDENCE ON NEW PRODUCT DEVELOPMENT AND THE RAPID TECHNOLOGICAL CHANGE THAT CHARACTERIZES OUR INDUSTRY MAKE US SUSCEPTIBLE TO LOSS OF MARKET SHARE RESULTING FROM COMPETITORS' PRODUCT INTRODUCTIONS AND SIMILAR RISKS. The semiconductor and networking industries are characterized by rapidly changing technologies, evolving industry standards, frequent new product introductions, short product life cycles and rapidly changing customer requirements. The introduction of products embodying new technologies and the emergence of new industry standards can render existing products obsolete and unmarketable. Our future success will depend on our ability to enhance our existing products, to introduce new products to meet changing customer requirements and emerging technologies, and to demonstrate the performance advantages and cost-effectiveness of our products over competing products. Any failure by us to modify our products to support new local-area network, or LAN, wide-area network, or WAN, and Internet technologies, or alternative technologies, or any failure to achieve widespread customer acceptance of such modified products could have a material adverse effect on us. In particular, we have dedicated significant resources to developing products based on the Linux operating system and on the Java programming language, and the failure of these products to achieve widespread acceptance could have a material adverse effect on us. We have in the past and may in the future experience delays in developing and marketing product enhancements or new products that respond to technological change, evolving industry standards and changing customer requirements. There can be no assurance that we will not experience difficulties that could delay or prevent the successful development, introduction and marketing of these products or product enhancements, or that our new products and product enhancements will adequately meet the requirements of the marketplace and achieve any significant or sustainable degree of market 15 18 acceptance in existing or additional markets. Failure by us, for technological or other reasons, to develop and introduce new products and product enhancements in a timely and cost-effective manner would have a material adverse effect on us. In addition, the future introductions or announcements of products by us or one of our competitors embodying new technologies or changes in industry standards or customer requirements could render our then-existing products obsolete or unmarketable. There can be no assurance that the introduction or announcement of new product offerings by us or one or more of our competitors will not cause customers to defer the purchase of our existing products. Such deferment of purchases could have a material adverse effect on us. OUR FAILURE TO EFFECTIVELY MANAGE PRODUCT TRANSITIONS COULD HAVE A MATERIAL ADVERSE EFFECT ON US. From time to time, we or our competitors may announce new products, capabilities or technologies that may replace or shorten the life cycles of our existing products. Announcements of currently planned or other new products may cause customers to defer or stop purchasing our products until new products become available. Furthermore, the introduction of new or enhanced products requires us to manage the transition from older product inventories and ensure that adequate supplies of new products can be delivered to meet customer demand. Our failure to effectively manage transitions from older products could have a material adverse effect on our business, results of operations and financial condition. OUR FAILURE TO COMPETE SUCCESSFULLY IN OUR HIGHLY COMPETITIVE MARKET COULD RESULT IN REDUCED PRICES AND LOSS OF MARKET SHARE. The markets in which we operate are intensely competitive and characterized by rapidly changing technology, evolving industry standards, declining average selling prices and frequent new product introductions. A number of companies offer products that compete with one or more elements of our products. We believe that the competitive factors affecting the market for our products include product performance, price and quality, product functionality and features, the availability of products for existing and future platforms, the ease of integration with other hardware and software components of the customer's products, and the quality of support services, product documentation and training. The relative importance of each of these factors depends upon the specific customer involved. There can be no assurance that we will be able to compete successfully against current and future competitors, or that competitive factors faced by us will not have a material adverse effect on us. We primarily compete with the internal development departments of large manufacturing companies that have developed their own networking solutions, as well as established developers of embedded systems software and chips such as Axis Communications, Echelon, Emulex, Hitachi, Intel, Milan Technology, a division of Digi International, Motorola, Peerless Systems, Samsung and Wind River. In addition, we are aware of certain companies which have recently introduced products that address the markets targeted by us. We have experienced and expect to continue to experience increased competition from current and potential competitors, many of which have substantially greater financial, technical, sales, marketing and other resources, as well as greater name recognition and larger customer bases than ours. In particular, established companies in the networking or semiconductor industries may seek to expand their product offerings by designing and selling products using competitive technology that could render our products obsolete or have a material adverse effect on our sales. Increased competition may result in further price reductions, reduced gross margins and loss of market share. 16 19 WE DEPEND ON THIRD-PARTY SOFTWARE THAT WE USE UNDER LICENSES THAT MAY EXPIRE. We rely on certain software that we license from third parties, including software that is integrated with internally developed software and used in our products to perform key functions. These software license agreements are with Express Logic, Inc., Allegro Software Development Corporation and Wind River, each of which terminates only if we default under the respective agreement; with Novell, Inc., which is renewable annually at the option of both parties; with InterNiche Technologies, Inc., which renews until terminated by either party; and with Peerless Systems Corporation, which expires in 2004 and is subject to year-to-year renewals thereafter at the option of both parties. These third-party software licenses may not continue to be available to us on commercially reasonable terms, and the related software may not continue to be appropriately supported, maintained or enhanced by the licensors. The loss of licenses to use, or the inability of licensors to support, maintain, and enhance any of such software, could result in increased costs, delays or reductions in product shipments until equivalent software is developed or licensed, if at all, and integrated. WE DEPEND ON MANUFACTURING, ASSEMBLING AND PRODUCT TESTING RELATIONSHIPS AND ON LIMITED SOURCE SUPPLIERS, AND ANY DISRUPTIONS IN THESE RELATIONSHIPS MAY CAUSE DAMAGE TO OUR CUSTOMER RELATIONSHIPS. We do not have our own semiconductor fabrication assembly or testing operations or contract manufacturing capabilities. Instead, we rely upon independent contractors to manufacture our components, subassemblies, systems and products. Currently, all of our semiconductor devices are being manufactured, assembled and tested by Atmel Corporation in the United States and Europe, and we expect that we will continue to rely upon Atmel to manufacture, assemble and test a significant portion of our semiconductor devices in the future. In the past, we experienced a delay in the introduction of one of our products due to a problem with Atmel's design tools. While we are in the process of qualifying other suppliers, any qualification and pre-production periods could be lengthy and may cause delays in providing products to customers in the event that the sole source supplier of the semiconductor devices fails to meet our requirements. For example, Atmel uses its manufacturing facilities for its own products as well as those it manufactures on a contract basis. There is no assurance that Atmel will have adequate capacity to meet the needs of its contract manufacturing customers. In addition, semiconductor manufacturers generally experience periodic constraints on their manufacturing capacity. We also rely upon limited-source suppliers for a number of other components used in our products. There can be no assurance that these independent contractors and suppliers will be able to meet our future requirements for manufactured products, components and subassemblies in a timely fashion. We generally purchase limited-source components under purchase orders and have no guaranteed supply arrangements with these suppliers. In addition, the availability of many of these components to us is dependent in part on our ability to provide our suppliers with accurate forecasts of our future requirements. Any extended interruption in the supply of any of the key components currently obtained from limited sources would disrupt our operations and have a material adverse effect on our business, results of operations and financial condition. Delays or lost sales have been and could be caused by other factors beyond our control, including late deliveries by vendors of components, changes in implementation priorities or slower than anticipated growth in the market for networking solutions for embedded systems. Operating results in the past have also been adversely affected by delays in receipt of significant purchase orders from customers. In addition, we have experienced delays as a result of the need to modify our products to comply with unique customer 17 20 specifications. In general, the timing and magnitude of our revenues are highly dependent upon our achievement of design wins, the timing and success of our customers' development cycles, and our customers' product sales. Any of these factors could have a material adverse effect on our business, results of operations and financial condition. THE CYCLICALITY OF THE SEMICONDUCTOR INDUSTRY MAY RESULT IN SUBSTANTIAL PERIOD-TO-PERIOD FLUCTUATIONS. Our semiconductor products provide networking capabilities for intelligent, network-enabled devices and other embedded systems. The semiconductor industry is highly cyclical and subject to rapid technological change and has been subject to significant economic downturns at various times, characterized by diminished product demand, accelerated erosion of average selling prices and production overcapacity. The semiconductor industry also periodically experiences increased demand and production capacity constraints. As a result, we may experience substantial period-to-period fluctuations in future operating results due to general semiconductor industry conditions, overall economic conditions or other factors. OUR ABILITY TO COMPETE COULD BE JEOPARDIZED IF WE ARE UNABLE TO PROTECT OUR INTELLECTUAL PROPERTY RIGHTS. Our ability to compete depends in part on our proprietary rights and technology. We have no patents and rely primarily on a combination of copyright and trademark laws, trade secrets, confidentiality procedures and contract provisions to protect our proprietary rights. We generally enter into confidentiality agreements with our employees, and sometimes with our customers and potential customers and limit access to the distribution of our software, hardware designs, documentation and other proprietary information. There can be no assurance that the steps taken by us in this regard will be adequate to prevent the misappropriation of our technology. While we have filed two patent applications and plan to file various additional applications, such applications may be denied. Any patents, once issued, may be circumvented by our competitors. Furthermore, there can be no assurance that others will not develop technologies that are superior to ours. Despite our efforts to protect our proprietary rights, unauthorized parties may attempt to copy aspects of our products or to obtain and use information that we regard as proprietary. In addition, the laws of some foreign countries do not protect our proprietary rights as fully as do the laws of the United States. There can be no assurance that our means of protecting our proprietary rights in the United States or abroad will be adequate or that competing companies will not independently develop similar technology. Our failure to adequately protect our proprietary rights could have a material adverse effect on our business, results of operations and financial condition. We exclusively license the right to use the NET+ARM trademark from ARM Limited according to a royalty-free agreement expiring in 2008. We depend on ARM to enforce its rights to the trademark against third-party infringement. There can be no assurance that ARM will promptly and adequately enforce these rights which could have a material adverse effect on our business, results of operations and financial condition. WE COULD BECOME SUBJECT TO CLAIMS AND LITIGATION REGARDING INTELLECTUAL PROPERTY RIGHTS, WHICH COULD SERIOUSLY HARM US AND REQUIRE US TO INCUR SIGNIFICANT COSTS. The semiconductor and networking industries are characterized by frequent litigation regarding patent and other intellectual property rights. Although we have not been notified that our products infringe any third-party intellectual property rights, there can be 18 21 no assurance that we will not receive such notification in the future. Any litigation to determine the validity of third-party infringement claims, whether or not determined in our favor or settled by us, would at a minimum be costly and divert the efforts and attention of our management and technical personnel from productive tasks, which could have a material adverse effect on our business, results of operations and financial condition. There can be no assurance that any infringement claims by third parties or any claims for indemnification by customers or end users of our products resulting from infringement claims will not be asserted in the future or that such assertions, if proven to have merit, will not materially adversely affect our business, results of operations or financial condition. In the event of an adverse ruling in any such matter, we would be required to pay substantial damages, cease the manufacture, use and sale of infringing products, discontinue the use of certain processes or be required to obtain a license under the intellectual property rights of the third party claiming infringement. There can be no assurance that a license would be available on reasonable terms or at all. Any limitations on our ability to market our products, or delays and costs associated with redesigning our products or payments of license fees to third parties, or any failure by us to develop or license a substitute technology on commercially reasonable terms could have a material adverse effect on our business, results of operations and financial condition. WE FACE RISKS ASSOCIATED WITH OUR INTERNATIONAL OPERATIONS AND EXPANSION THAT COULD IMPAIR OUR ABILITY TO GROW OUR REVENUES ABROAD. In the fiscal years ended January 31, 2001, 2000 and 1999, international sales constituted approximately 55%, 50% and 51% of our net sales and approximately 68%, 77% and 46% of our domestic sales were to customers headquartered in Asia, respectively. We believe that our future growth is dependent in part upon our ability to increase sales in international markets, and particularly to manufacturers located in Japan, which sell their products worldwide. These sales are subject to a variety of risks, including fluctuations in currency exchange rates, tariffs, import restrictions and other trade barriers, unexpected changes in regulatory requirements, longer accounts receivable payment cycles and potentially adverse tax consequences and export license requirements. In addition, we are subject to the risks inherent in conducting business internationally, including political and economic instability and unexpected changes in diplomatic and trade relationships. In particular, the economies of certain countries in the Asia-Pacific region are experiencing considerable economic instability and downturns. Because our sales to date have been denominated in United States dollars, increases in the value of the United States dollar could increase the price in local currencies of our products in non-US markets and make our products more expensive than competitors' products denominated in local currencies. In addition, an integral part of our business strategy is to form strategic alliances for the manufacture and distribution of our products with third parties, including foreign corporations. There can be no assurance that one or more of the factors described above will not have a material adverse effect on our business, results of operations and financial condition. We intend to expand our presence in Europe to address new markets. One change resulting from the formation of a European Economic and Monetary Union ("EMU") required EMU member states to irrevocably fix their respective currencies to a new currency, the euro, as of January 1, 1999. Business in the EMU member states will be conducted in both the existing national currency such as the French franc or the Deutsche mark, and the euro through 2002. As a result, companies operating or conducting business in EMU member states will need to ensure that their financial and other software systems are capable of processing transactions and properly handling these currencies, including the euro. There can be no assurance that the conversion to the euro will not 19 22 have a material adverse effect on our business, results of operations and financial condition. IF WE LOSE KEY PERSONNEL IT COULD PREVENT US FROM EXECUTING OUR BUSINESS STRATEGY. Our business and prospects depend to a significant degree upon the continuing contributions of our executive officers and our key technical personnel. Competition for such personnel is intense, and there can be no assurance that we will be successful in attracting and retaining qualified personnel. Our stock price and the number of options outstanding with exercise prices in excess of their market price could make it more difficult to attract and retain key personnel. Failure to attract and retain key personnel could result in our failure to execute our business strategy and have a material adverse effect on us. We have employment contracts with our Vice President, Intelligent Device Markets Europe; Executive Vice President, Finance and Operations and the Chairman and Chief Executive Officer. We do not maintain any key-man life insurance policies. ANY FAILURE TO COMPLY WITH SIGNIFICANT REGULATIONS AND EVOLVING INDUSTRY STANDARDS COULD DELAY INTRODUCTION OF OUR PRODUCTS. The market for our products is subject to a significant number of communications regulations and industry standards, some of which are evolving as new technologies are deployed. In the United States, our products must comply with various regulations defined by the Federal Communications Commission and standards established by Underwriters' Laboratories. Some of our products may not comply with current industry standards, and this noncompliance must be addressed in the design of those products. Standards for networking are still evolving. As the standards evolve, we may be required to modify our products or develop and support new versions of our products. The failure of our products to comply or delays in compliance, with the various existing and evolving industry standards could delay introduction of our products, which could have a material adverse effect on our business, results of operations and financial condition. ANY MATERIAL PRODUCT DEFECTS COULD RESULT IN LOSS OF MARKET SHARE, DELAY OF MARKET ACCEPTANCE OR PRODUCT LIABILITY CLAIMS OR LOSSES. Complex products such as those offered by us may contain undetected or unresolved defects when first introduced or as new versions are released. The occurrence of material errors in the future could, and the failure or inability to correct such errors would, result in the loss of market share, the delay or loss of market acceptance of our products, material warranty expense, diversion of engineering and other resources from our product development efforts, the loss of credibility with our customers or product recall. The use of our products for applications in devices that interact directly with the general public, where the failure of the embedded system could cause property damage or personal injury, could expose us to significant product liability claims. Although we have not experienced any product liability or economic loss claims to date, the sale and support of our products may entail the risk of such claims. Any of such occurrences could have a material adverse effect upon our business, results of operations and financial condition. IF WE DO NOT SUCCESSFULLY MANAGE OUR GROWTH, IT COULD HAVE A MATERIAL ADVERSE EFFECT ON US. We have limited internal infrastructure and any significant growth would place a substantial strain on our financial and management personnel and information systems 20 23 and controls. Such growth would require us to implement new and enhance existing financial and management information systems and controls and add and train personnel to operate such systems effectively. Our intention to continue to pursue our growth strategy through efforts to increase sales of existing products and new products can be expected to place even greater pressure on our existing personnel and compound the need for increased personnel, expanded information systems, and additional financial and administrative control procedures. There can be no assurance that we will be able to successfully manage expanding operations. Our inability to manage our expanded operations effectively could have a material adverse effect on our business, results of operations and financial condition. A SUBSTANTIAL NUMBER OF SHARES OF OUR COMMON STOCK COULD BE SOLD INTO THE PUBLIC MARKET, WHICH COULD DEPRESS OUR STOCK PRICE. Sales of a substantial number of shares of common stock in the public market could adversely affect the market price for our common stock and could make it more difficult for us to raise funds through equity offerings in the future. Subject to applicable federal and securities laws and the restrictions set forth below, Sorrento Networks Corporation, formerly Osicom Technologies, Inc. ("Sorrento"), a holder of 6,972,700 shares of our non-voting common stock, may sell any and all of the shares of common stock beneficially owned by it or distribute any or all such shares of common stock to its stockholders. Sales or distributions by Sorrento of substantial amounts of common stock in the public market or to its stockholders, or the perception that such sales or distribution could occur, could adversely affect the prevailing market prices for the common stock. Sorrento is not subject to any obligation to retain its shares in NetSilicon. As a result, there can be no assurance concerning the period of time during which Sorrento will maintain its beneficial ownership of our common stock. Moreover, there can be no assurance that, in any transfer by Sorrento of a controlling interest in us, any holders of common stock will be able to participate in such transaction or will realize any premium with respect to their shares of common stock. At January 31, 2001, options to purchase an aggregate of 5,051,149 shares of our common stock were outstanding. Of these options, 852,394 were exercisable as of January 31, 2001, with additional vesting to occur from time to time. ANY ACQUISITIONS WE HAVE MADE OR WILL MAKE COULD DISRUPT OUR BUSINESS AND SERIOUSLY HARM OUR FINANCIAL CONDITION. We continue to consider investments in complementary companies, products or technologies. We may buy businesses, products or technologies in the future. In the event of any future purchases, we could: - issue stock that would dilute our current stockholders' percentage ownership; - incur debt; - assume liabilities; - incur amortization expenses related to goodwill and other intangible assets; or - incur large and immediate write-offs. 21 24 OUR OPERATION OF ANY ACQUIRED BUSINESS WILL ALSO INVOLVE NUMEROUS RISKS, INCLUDING: - problems combining the purchased operations, technologies or products; - unanticipated costs; - diversion of management's attention from our core business; - difficulties integrating businesses in different countries and cultures; - adverse effects on existing business relationships with suppliers and customers; - risks associated with entering markets in which we have no or limited prior experience; and - potential loss of key employees, particularly those of the purchased organizations. We cannot assure you that we will be able to successfully integrate any businesses, products, technologies or personnel that we have acquired or that we might acquire in the future and any failure to do so could disrupt our business and seriously harm our financial condition. BECAUSE THE NASDAQ NATIONAL MARKET IS LIKELY TO EXPERIENCE EXTREME PRICE AND VOLUME FLUCTUATIONS, THE PRICE OF OUR COMMON STOCK MAY DECLINE. The market price of our shares is likely to be highly volatile and could be subject to wide fluctuations in response to numerous factors, including the following: - actual or anticipated variations in our quarterly operating results or those of our competitors; - announcements by us or our competitors of new products or technological innovations; - introduction and adoption of new industry standards; - changes in financial estimates or recommendations by securities analysts; - changes in the market valuations of our competitors; - announcements by us or our competitors of significant acquisitions or partnerships; and - sales of our common stock. Many of these factors are beyond our control and may negatively impact the market price of our common stock, regardless of our performance. In addition, the stock market in general, and the market for technology companies in particular, has been highly volatile. Our common stock may not trade at the same levels of shares as that of other technology companies and shares of technology companies, in general, may not sustain their current market prices. In the past, securities class action litigation has often been brought against 22 25 a company following periods of volatility in the market price of its securities. We may be the target of similar litigation in the future. Securities litigation could result in substantial costs and divert management's attention and resources, which could seriously harm our business and operating results. PROVISIONS OF OUR CHARTER DOCUMENTS, OUR SHAREHOLDER RIGHTS PLAN AND LAW MAY HAVE ANTI-TAKEOVER EFFECTS THAT COULD PREVENT A CHANGE OF CONTROL. Provisions of our amended and restated articles of organization, bylaws, our shareholder rights plan, and of Massachusetts law could make it more difficult for a third party to acquire us, even if doing so would be beneficial to our stockholders. Operating alone or together, the above provisions or statutes may render more difficult or discourage a merger, consolidation or tender offer, the assumption of control by a holder of a large block of our shares, and the removal of incumbent management. ITEM 3. Quantitative and Qualitative Disclosure About Market Risk We own financial instruments that are sensitive to market risks as part of our investment portfolio. The investment portfolio is used to preserve our capital until it is required to fund operations, including our research and development activities. None of these market-risk sensitive instruments are held for trading purposes. We do not own derivative financial instruments in our investment portfolio. The investment portfolio contains instruments that are subject to the risk of a decline in interest rates. Investment Rate Risk. Our investment portfolio includes debt instruments that primarily have durations of less than one year. These bonds are subject to interest rate risk, and could decline in value if interest rates fluctuate. Our investment portfolio also at times includes certain commercial paper which is also subject to interest rate risk. Due to the short duration and conservative nature of these instruments, we do not believe that we have a material exposure to interest rate fluctuations. We have foreign operations in Europe and Japan. As a result, we are exposed to fluctuations in foreign exchange rates. However, we do not expect that changes in foreign exchange rates will have a significant impact on our results of operations, financial position or cash flows. We plan to continue to expand our operations globally which may increase our exposure to foreign exchange fluctuations. PART II. OTHER INFORMATION ITEM 1. Legal Proceedings On August 31, 2000, Websprocket, LLC filed a suit against the Company in the United States District Court for the Northern District of California (Websprocket, LLC v. NetSilicon, Inc., Civil Action No. C-00-20915), claiming breach of contract. The complaint alleges that the Company breached a technology development contract that was executed between the Company and Websprocket, LLC in December 1999. Websprocket, LLC seeks relief including alleged damages of $2,000,000 plus attorney's fees, a declaration of its rights under the technology development contract and an injunction requiring the Company to cease using and return all property of Websprocket, LLC. The Company believes that it has meritorious defenses to the claims and intends to contest the lawsuit vigorously. On or about October 31, 2000, the Company filed an Answer and Counterclaim denying the 23 26 allegations in Websprocket, LLC's complaint and asserting counterclaims against Websprocket, LLC that included breach of contract, fraud, and negligent misrepresentation. Websprocket, LLC filed a reply to the Company's counterclaims on November 25, 2000, denying the allegations. An unfavorable resolution of the action could have a material adverse effect on the business, results of operations or financial condition of the Company. On or about August 9, 2001, a purported securities class action lawsuit captioned "Ellis Investments, Ltd. v. NetSilicon, Inc., et al." (01-CV-7281) was filed in the United States District Court for the Southern District of New York. A second, nearly identical complaint was filed in the same Court on or about August 15, 2001 in a lawsuit captioned "Michael Rasner v. NetSilicon, Inc., et al." (01-CV-7651). The suits name as defendants the Company, certain of its officers and directors, and certain underwriters involved in the Company's initial public offering ("IPO"). The Ellis Investments suit also names Osicom Technologies, Inc. as a defendant. The complaints in these actions are allegedly brought on behalf of purchasers of the Company's common stock during the period from September 15, 1999 to December 6, 2000, and assert, among other things, that the Company's IPO prospectus and registration statement violated federal securities laws because they contained material misrepresentations and/or omissions regarding the conduct of the Company's IPO underwriters in allocating shares in the Company's IPO to the underwriters' customers. The actions seek recission or recissory and other damages, fees and costs associated with the litigation, and interest. The Company understands that various plaintiffs have filed substantially similar lawsuits against over a hundred other publicly traded companies in connection with the underwriting of their initial public offerings. The Company and its officers and directors believe that the allegations in the complaint are without merit and intend to contest them vigorously. An unfavorable resolution of the action could have a material adverse effect on the business, results of operations or financial condition of the Company. ITEM 2. Changes in Securities and Use of Proceeds None ITEM 3. Defaults Upon Senior Securities None ITEM 4. Submission of Matters to a Vote of Security Holders The following proposals were voted upon by the Company's stockholders at the Annual Stockholders' Meeting held on June 13, 2001. The following nominees were elected as Class II Directors of the Company to serve for a three year term or until their successors are elected and qualified. Total Votes Total Votes Withheld Nominee for Nominee for Nominee ----------------- ----------- -------------------- Francis E. Girard 6,347,874 44,293 F. Grant Saviers 6,347,874 44,293 The term of office for the following directors continued after the meeting: Michael K. Ballard (Class I), William Johnson (Class I), Edward B. Roberts (Class III) and Cornelius Peterson, VIII (Class III). A proposal to approve the Company's 2001 Stock Option and Incentive Plan was adopted and approved with 2,868,685 shares voting in favor; 338,738 shares voting against; 7,756 shares abstaining; and 3,176,988 shares not voting. The election of BDO Siedman, LLP as independent auditors for the fiscal year ending January 31, 2002 was ratified, with 6,371,839 shares voting in favor, 11,720 voting against, and 8,608 abstaining. ITEM 5. Other Information None ITEM 6. Exhibits and Reports on Form 8-K a) Exhibits Exhibit Number Description -------- ----------- 10.1 Employment Agreement Between NetSilicon, Inc. and Cornelius Peterson, VIII 10.2 Employment Agreement Between NetSilicon, Inc. and Daniel J. Sullivan b) Reports on 8-K None 24 27 SIGNATURES Pursuant to the requirements of the Securities and Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned thereunto duly authorized. NetSilicon, Inc. ------------------------------------- (Registrant) September 11, 2001 By /s/ Cornelius Peterson ------------------ -------------------------------------- (Cornelius Peterson, VIII, Chairman and Chief Executive Officer) September 11, 2001 By /s/ Daniel J. Sullivan ------------------ ------------------------------------- (Daniel J. Sullivan, Executive Vice President, Finance and Operations) 25

NETSILICON INC 10-Q