PART I—FINANCIAL INFORMATION

 

Item 1. Financial Statements

 

MONOLITHIC SYSTEM TECHNOLOGY, INC.
CONDENSED CONSOLIDATED BALANCE SHEETS
(In thousands)

 

		June 30,			December 31,
		2005			2004
		(unaudited)
ASSETS
Current assets:
Cash and cash equivalents		$	8,496		$	31,714
Short-term investments		52,057			30,635
Accounts receivable		1,224			1,996
Unbilled contract receivable		100			57
Prepaid expenses and other current assets		3,076			2,939
Total current assets		64,953			67,341
Long-term investments		25,740			24,562
Property and equipment, net		1,051			685
Goodwill		12,326			12,326
Other assets		593			539
Total assets		$	104,663		$	105,453
LIABILITIES AND STOCKHOLDERS’ EQUITY
Current liabilities:
Accounts payable		$	51		$	120
Accrued expenses and other liabilities		3,554			3,314
Deferred revenue		2,050			1,372
Total current liabilities		5,655			4,806
Long-term portion of restructuring liability		232			239
Total liabilities		5,887			5,045
Commitment and contingencies
Stockholders’ equity:
Preferred stock, $0.01 par value; 20,000 shares authorized; none issued and outstanding at June 30, 2005 and December 31, 2004
Common stock, $0.01 par value; 120,000 shares authorized; 30,477 shares and 30,296 shares issued and outstanding at June 30, 2005 and December 31, 2004		304			303
Additional paid-in capital		98,636			98,278
Deferred stock-based compensation		(50		)	(69		)
Accumulated other comprehensive loss		(314		)	(252		)
Retained earnings		200			2,148
Total stockholders’ equity		98,776			100,408
Total liabilities and stockholders’ equity		$	104,663		$	105,453

 

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

 

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MONOLITHIC SYSTEM TECHNOLOGY, INC.
CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS
(Unaudited)
(In thousands, except per share amounts)

 

		Three Months Ended						Six Months Ended
		June 30,						June 30,
		2005			2004			2005			2004
Net revenue:
Product		$	6		$	681		$	10		$	843
Licensing		1,940			1,310			3,153			4,298
Royalty		1,121			1,415			2,587			2,768
Total net revenue		3,067			3,406			5,750			7,909
Cost of net revenue
Product		—			394			—			544
Licensing		609			483			1,075			858
Total cost of net revenue		609			877			1,075			1,402
Gross profit		2,458			2,529			4,675			6,507
Operating expenses:
Research and development		1,320			1,968			2,923			4,194
Selling, general and administrative		2,206			5,263			4,682			8,027
Restructuring expenses		114			—			114			—
Total operating expenses		3,640			7,231			7,719			12,221
Operating loss		(1,182		)	(4,702		)	(3,044		)	(5,714		)
Interest and other income		605			269			1,118			630
Loss before provision for income taxes		(577		)	(4,433		)	(1,926		)	(5,084		)
Benefit (provision) for income taxes		(2		)	378			(22		)	508
Net loss		$	(579	)	$	(4,055	)	$	(1,948	)	$	(4,576	)
Net loss per share:
Basic		$	(0.02	)	$	(0.13	)	$	(0.06	)	$	(0.15	)
Diluted		$	(0.02	)	$	(0.13	)	$	(0.06	)	$	(0.15	)
Shares used in computing net loss per share:
Basic		30,465			30,786			30,453			30,816
Diluted		30,465			30,786			30,453			30,816
Allocation of stock-based compensation to operating expenses
Research and development		$	—		$	13		$	—		$	32
Selling, general and administrative		9			13			19			20
		$	9		$	26		$	19		$	52

 

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

 

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MONOLITHIC SYSTEM TECHNOLOGY, INC.

CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS

(Unaudited)

(In thousands)

 

		Six Months Ended
		June 30,
		2005			2004
Cash flows from operating activities:
Net loss		$	(1,948	)	$	(4,576	)
Adjustments to reconcile net loss to net cash provided by operating activities:
Depreciation and amortization		328			850
Amortization of deferred stock-based compensation		19			52
Changes in current assets and liabilities:
Accounts receivable		772			27
Unbilled contract receivable		(43		)	(157		)
Inventories		—			386
Prepaid expenses and other assets		(191		)	979
Deferred revenue		678			(486		)
Accounts payable		(69		)	1,294
Accrued expenses and other liabilites		280			1,090
Restructuring liability		(47		)	—
Net cash used in operating activities		(221		)	(541		)
Cash flows from investing activities:
Purchase of property and equipment		(696		)	(277		)
Proceeds from sales and maturity of marketable securities		86,934			245,264
Purchase of marketable investments		(109,594		)	(229,277		)
Net cash provided by (used in) investing activities		(23,356		)	15,710
Cash flows from financing activities:
Payment of capital lease obligations		—			(8		)
Proceeds from exercise of common stock upon exercise of options		359			3,010
Net cash provided by financing activities		359			3,002
Net increase (decrease) in cash and cash equivalents		(23,218		)	18,171
Cash and cash equivalents at beginning of period		31,714			22,033
Cash and cash equivalents at end of period		$	8,496		$	40,204

 

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

 

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MONOLITHIC SYSTEM TECHNOLOGY, INC.
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
(Unaudited)

 

Note 1. Background and Basis of Presentation

 

The Company

 

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

 

The Company has developed an innovative embedded-memory technology, called 1T-SRAM, which the Company licenses on a non-exclusive and worldwide basis to semiconductor companies and electronic product manufacturers. From its inception in 1991 through 1998, the Company focused primarily on the sale of stand-alone memory products. In the fourth quarter of 1998, the Company changed the emphasis of its business model to focus primarily on the licensing of its 1T-SRAM technologies and completed this transition in 2002 when a majority of the Company’s revenues were derived from licensing and royalty of its 1T-SRAM technologies. In the second quarter of 2004, the Company notified its customers of its decision to discontinue sales of its memory chip products and only license its technology.

 

The accompanying condensed consolidated financial statements of the Company have been prepared without audit in accordance with the rules and regulations of the Securities and Exchange Commission.   The Balance Sheet at December 31, 2004 has been derived from the audited financial statements at that date.  Certain information and disclosures normally included in financial statements prepared in accordance with accounting principles generally accepted in the United States have been condensed or omitted in accordance with these rules and regulations. The information in this report should be read in conjunction with the Company’s financial statements and notes thereto included in its most recent annual report on Form 10-K filed with the Securities and Exchange Commission.

 

In the opinion of management, the accompanying unaudited condensed financial statements reflect all adjustments (consisting only of normal recurring adjustments) necessary to summarize fairly the Company’s financial position, results of operations and cash flows for the interim periods presented. The operating results for the three-month and six-month periods ended June 30, 2005 are not necessarily indicative of the results that may be expected for the year ending December 31, 2005 or for any other future period.

 

Basis of Presentation

 

The consolidated financial statements include the accounts of the Company and its wholly-owned subsidiaries. All significant intercompany transactions and balances have been eliminated in consolidation. The Company reports financial results on a calendar fiscal year. Certain amounts reported in the previous periods have been reclassified to conform to the presentation in the second quarter of 2005.

 

Use of estimates

 

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

 

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Revenue Recognition

 

Licensing

 

Licensing revenue consists of fees earned for engineering development and engineering support services. All contracts the Company has entered into to date require the Company to develop a design that meets a licensee’s specifications. In accordance with SOP 81-1 “Accounting for Performance of Construction-Type and Certain Production -Type Contracts”, when license agreements include deliverables that require “significant production, modification or customization”, contract accounting is applied. When the Company has significant experience in meeting the design specification involved in the contract and the direct labor hours related to services under the contract can be reasonably estimated, the Company recognizes revenue over the period in which the contract services are performed. For these arrangements, the Company recognizes revenue using the percentage of completion method. Revenues are only recognized when collection is probable. The direct labor hours for the development of the licensee’s design are estimated at the beginning of the contract. As these direct labor hours are incurred, they are used as a measure of progress towards completion. The Company has the ability to reasonably estimate the direct labor hours on a contract-by-contract basis based on its experience in developing prior licensees’ designs. The Company periodically evaluates the actual status of each project to ensure that the estimates to complete each contract remain accurate. Under the percentage to completion method, provisions for estimated losses on uncompleted contracts are recognized in the period in which the likelihood of such losses is determined. Revenue recognized in any period is dependent on the Company’s progress toward completion of projects in progress. Significant management judgment and discretion are used to estimate total direct labor hours. Any changes in or deviation from these estimates could have a material effect on the amount of revenue the Company recognizes in any period. If inherent risks make estimates doubtful, the contract is accounted for under the completed contract method. Completion of the contract is based on the production of integrated circuit devices that have been validated by the customer.

 

For contracts involving design specifications that the Company has not previously met, the Company defers the recognition of revenue until the design meets the contractual design specifications and expenses the cost of revenue as incurred. When the Company has experience in meeting design specifications but does not have significant experience to reasonably estimate the cost of services to meet a design specification, the Company defers both the recognition of revenue and the cost. For these arrangements, the Company recognizes revenue using the completed contract method. In the first six months ending June 30 of 2005 and 2004, none of license revenue was recognized under the completed contract method.

 

When the Company provides a combination of products and services to customers, in addition to the considerations noted above, it evaluates the arrangements under EITF 00-21, “Revenue Arrangements with Multiple Deliverables”. EITF 00-21 addresses certain aspects of accounting for arrangements under which the Company will perform multiple revenue generating activities. Under the Company’s support and maintenance arrangements, it provides unspecified upgrades, design rule changes and technical support. No other upgrades, products or other post-contract support are provided. These arrangements are renewable annually by the customer. Support and maintenance revenue is recognized at its fair value ratably over the period during which the obligation exists, typically 12 months. The fair value of any support and maintenance obligation is established based on the specified renewal rate for such support and maintenance.

 

From time to time, a licensee may cancel a project during the development phase. Such a cancellation is not within the Company’s control and is often caused by changes in market conditions or the licensee’s business. Cancellations of this nature are an aspect of the Company’s licensing business, and most of its newer contracts allow the Company to retain all payments that the Company has received or is entitled to collect for items and services provided before the cancellation occurs. Typically under our agreements, the licensee is obligated to complete the project within a stated timeframe, including assisting us in completing the final milestone, and if the Company performs the contracted services, is obligated to pay the license fees even if the licensee fails to complete verification or cancels the project prior to completion. The Company will consider a project to have been canceled even in the absence of specific notice from its licensee, if there has been no activity under the contract for a significant period, and the Company believes that completion of the contract is unlikely. In this event, the Company recognizes revenue in the amount of cash received, if the Company has performed a sufficient portion of the development services. If a cancelled contract had been entered into before the establishment of technological feasibility, the costs associated with the contract would have been expensed prior to the recognition of revenue. In that case, there would be no costs associated with that revenue recognition, and gross margin would increase for the

 

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corresponding period. In the first six months of 2005 and 2004, there was no license revenue from cancelled projects.

 

Royalty

 

Licensing contracts also provide for royalty payments at a stated rate and require licensees to report the manufacture or sale of products that include the Company’s 1T-SRAM technologies after the end of the quarter in which the sale or manufacture occurs. The Company recognizes royalties in the quarter in which the Company receives the licensee’s report.

 

Product

 

Revenue from product sales is recognized upon shipment provided that persuasive evidence of a sales arrangement exists, the price is fixed or determinable, title has transferred, collection of resulting receivables is reasonably assured, there are no customer acceptance requirements and there are no remaining significant obligations.  For each of the periods presented, there were no formal acceptance provisions with the end customers of our products.  In 2004, we phased out of selling our proprietary 1T-SRAM memory chips.  Currently, our product sales consist of selling the inventory previously written off.

 

Cost of revenue

 

Licensing

 

Cost of licensing revenue consists primarily of engineering costs directly related to engineering development projects specified in agreements we have with licensees of our 1T-SRAM technologies. These projects typically include customization of 1T-SRAM circuitry to enable embedding our memory on a licensee’s integrated circuit and may include engineering support to assist in the commencement of production of a licensee’s products. We recognize costs of licensing revenue in the following manner:

 

•       If licensing revenue is recognized using the percentage of completion method, the associated cost of licensing revenue is recognized in the period in which we incur the engineering costs.

 

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

 

•       For contracts entered into prior to establishing technological feasibility, we do not defer related development costs, but rather expense them in the period in which they are incurred. Consequently, upon completion of these contracts, we recognize the related revenues without any corresponding costs.

 

Royalty

 

There are no reported costs associated with royalty revenue.

 

Product

 

Cost of product revenue consists primarily of costs associated with the manufacture, assembly and testing of the Company’s memory chip products by independent, third-party contractors. There are no reported costs associated with product revenue in the first two quarters of 2005 as the products were sold from the inventory

 

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previously written off.

 

Goodwill

 

The Company reviews goodwill recorded from the acquisition of ATMOS Corp. on August 2002 for impairment annually and whenever events or changes in circumstances indicate the carrying value of an asset may not be recoverable in accordance with the Statement of Financial Accounting Standards (“SFAS”) No. 142, “Goodwill and Other Intangible Assets.”  The provisions of SFAS No. 142 require that a two-step impairment test be performed on goodwill. In the first step, the Company compares the fair value of each reporting unit to its carrying value. Using the guidance in SFAS No. 142, the Company has determined that it has only one reporting unit at the entity level. For step one, the Company determines the fair value of its reporting unit using the market approach. Under the market approach, the Company estimates the fair value based on the market value of the reporting unit at the entity level. If the fair value of the reporting unit exceeds the carrying value of net assets to the reporting unit, goodwill is not impaired and the Company is not required to perform further testing. If the carrying value of the net assets of the reporting unit exceeds the fair value of the reporting unit, then the Company must perform the second step in order to determine the implied fair value of the reporting unit’s goodwill and compare it to the carrying value of the reporting unit’s goodwill. If the carrying value of a reporting unit’s goodwill exceeds its implied fair value, then the Company must record an impairment loss equal to the difference. The Company performed the annual impairment test during the third quarter of 2004, and the test did not indicate impairment of goodwill as of September 30, 2004. In addition, every quarter the Company assesses whether there are indicators of potential impairment. As of June 30, 2005, it found no indicators of potential impairment.

 

Foreign Currency Translation

 

The Company has foreign offices located in Korea, Japan and France.  The functional currency of the Company’s foreign entities is the U.S. dollar. Accordingly, the financial statements of these entities, which are maintained in the local currency, are remeasured into U.S. dollars in accordance with Statement of Financial Accounting Standards No. 52, “Foreign Currency Translation.” Exchange gains or losses from remeasurement of monetary assets and liabilities that are not denominated in U.S. dollar were not material for any period presented and are included in the consolidated statements of operations.

 

Cash Equivalents, Short-term and Long-term Investments

 

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

 

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

 

Unbilled contract receivable

 

Under the percentage of completion method, if the amount of revenue recognized exceeds the amount of billings to a customer; the excess amount is carried as an unbilled contract receivable. The Company recorded $100,000 and $57,000 of unbilled contract receivable as of June 30, 2005 and December 31, 2004, respectively.

 

Research and development

 

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

 

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Stock-based compensation

 

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

 

In December 2004, the Financial Accounting Standards Board (FASB) issued Statement of Financial Accounting Standards No. 123, “Share-Based Payment” (SFAS 123R) which will become effective beginning in the first quarter of 2006. SFAS 123R will result in the recognition of substantial compensation expense relating to our employee stock options and employee stock purchase plans. The Company currently uses the intrinsic value method to measure compensation expense for stock-based awards to its employees. Under this standard, the Company generally does not recognize any compensation related to stock option under its stock option plans or related to the discounts the Company provided under its employee stock purchase plans. Under the new rules however, the Company will be required to adopt a fair-value-based method for measuring the compensation expense related to employee stock awards.  The Company expects this to lead to substantial additional compensation expense that will be included in the Company’s reported results of operations beginning January 1, 2006.

 

SFAS No. 123 pro forma disclosures

 

Had compensation cost for the Company’s option plans been determined based on the fair value at the grant dates, as prescribed in SFAS 123, the Company’s net loss would have been as follows (in thousands, except per share amounts):

 

		Three Months Ended						Six Months Ended
		June 30,						June 30,
		2005			2004			2005			2004
Net loss:
As reported		$	(579	)	$	(4,055	)	$	(1,948	)	$	(4,576	)
Stock-based compensation expense reported in consolidated statements of operations		9			26			19			52
Total stock-based compensation expense determined under fair value based method for all awards, net of related tax effects		(1,117		)	(1,112		)	(2,267		)	(2,322		)
		$	(1,687	)	$	(5,141	)	$	(4,196	)	$	(6,846	)
Losses per share:
Basic - as reported		$	(0.02	)	$	(0.13	)	$	(0.06	)	$	(0.15	)
Basic - pro forma		$	(0.06	)	$	(0.17	)	$	(0.14	)	$	(0.22	)
Diluted - as reported		$	(0.02	)	$	(0.13	)	$	(0.06	)	$	(0.15	)
Diluted - pro forma		$	(0.06	)	$	(0.17	)	$	(0.14	)	$	(0.22	)

 

The fair value of each grant is estimated on the date of grant using the Black-Scholes method with the following assumptions used for grants during the applicable periods:

 

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		Three Months Ended				Six Months Ended
		June 30,				June 30,
Employee stock options		2005		2004		2005		2004
Expected life (in years)		5.0		5.0		5.0		5.0
Risk-free interest rate		3.7%-4.1	%	3.6	%	3.7%-4.1	%	3.2%-3.6	%
Volatility		77.5	%	100.0	%	78.5	%	85.9	%
Dividend yield		0	%	0	%	0	%	0	%
Employee stock purchase plan shares		2005		2004		2005		2004
Expected life (in years)		n/a		1.0		1.0		1.0
Risk-free interest rate		n/a		1.5	%	2.8	%	1.3%-1.5	%
Volatility		n/a		84.1	%	88.5	%	84.5	%
Dividend yield		n/a		0	%	0	%	0	%

 

The Company selected the Black-Scholes option valuation model, which is one of the permitted methods to estimate the fair market value of options under SFAS No. 123. The Black-Scholes option valuation model was developed for use in estimating the fair value of traded options that have no vesting restrictions and are fully transferable. In addition, option valuation models require the input of highly subjective assumptions, including the expected stock price volatility. Because the Company’s employee stock options have characteristics significantly different from those of traded options, and because changes in the subjective input assumptions can materially affect the fair value estimated, in the opinion of management, the existing models do not necessarily provide a reliable single measure of the fair value of employee stock options.  Under this valuation model, the weighted average fair value of options granted for the three months ended June 30, 2005 and 2004 was $3.83 and $5.16 respectively. The weighted average fair value of options granted for six months ended June 30, 2005 and 2004 was $3.85 and $5.15 respectively.  In the second quarter of 2005, there were no stock purchases under the employee stock purchase plan.  In the second quarter of 2004, the additional stock purchases under the employee stock purchase plan were made due to the planned acquisition by Synopsys.  For the three months ended June 30, 2004, the weighted average estimated fair value of shares granted under the additional stock purchases was $3.25.  The weighted average estimated fair value of shares granted under the employee stock purchase plan for the six months ended June 30, 2005 and 2004 was $2.66 and $3.22, respectively.

 

Net loss per share

 

Basic net loss per share is computed by dividing net loss for the period by the weighted-average number of shares of common stock outstanding during the period. Diluted net loss per share is computed by dividing the net loss for the period by the weighted average number of common and potential common equivalent shares outstanding during the period. Potential common shares are composed of incremental shares of common stock issuable upon the exercise of stock options.  For the three months ended June 30, 2005 and 2004, stock options to purchase 1.6 million and 764,000 shares, respectively, and for the six months ended June 30, 2005 and 2004 stock options to purchase 1.8 million and 785,000 shares, respectively, which options had exercise prices greater than the average market prices of common stock at the end of each period were excluded from the respective computations of diluted net loss per share as their inclusion would be antidilutive.

 

The following table presents the calculation of basic and diluted income per share (in thousands, except per share amounts):

 

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		Three Months Ended						Six Months Ended
		June 30,						June 30,
		2005			2004			2005			2004
Numerator:
Net loss		$	(579	)	$	(4,055	)	$	(1,948	)	$	(4,576	)
Denominator:
Shares used in computing net loss per share:
Basic		30,465			30,786			30,453			30,816
Diluted		30,465			30,786			30,453			30,816
Net loss per share:
Basic		$	(0.02	)	$	(0.13	)	$	(0.06	)	$	(0.15	)
Diluted		$	(0.02	)	$	(0.13	)	$	(0.06	)	$	(0.15	)

 

Income taxes

 

The Company accounts for deferred income taxes under the liability approach whereby the expected future tax consequences of temporary differences between the book and tax basis of assets and liabilities are recognized as deferred tax assets and liabilities. A valuation allowance is established for any deferred tax assets for which realization is more likely than not. As of December 31, 2004 and June 30, 2005, deferred tax assets of $831,000 were included in prepaid expenses and other current assets.

 

Comprehensive loss

 

Statement of Financial Accounting Standards No. 130 “Reporting Comprehensive Income” (“SFAS No. 130”) requires the Company to display comprehensive income and its components as part of the financial statements. The Company’s only component of comprehensive loss is unrealized gains and losses on available for sale securities. Accumulated other comprehensive loss as of June 30, 2005 and December 31, 2004 was $314,000 and $252,000, respectively.

 

The changes in other comprehensive loss were as follows, for the three months ended June 30, 2005 and 2004 (in thousands):

 

		June 30,						June 30,
		2005			2004			2005			2004
Net loss		$	(579	)	$	(4,055	)	$	(1,948	)	$	(4,576	)
Net unrealized gain/(loss) on available-for-sale securities:
Change in net unrealized gain/(loss)		142			(385		)	(62		)	(265		)
Comprehensive loss		$	(437	)	$	(4,440	)	$	(2,010	)	$	(4,841	)

 

Segment reporting

 

Financial Accounting Standards Board Statement No. 131, “Disclosure about Segments of an Enterprise and Related Information” (“SFAS No. 131”) requires that companies report separately in the financial statements certain financial and descriptive information about operating segments profit or loss, certain specific revenue and expense items and segment assets. The Company operates in one segment, using one measurement of profitability for its business. The Company has sales outside the United States that are described in Note 4. The majority of long-lived assets are maintained in the United States.

 

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Note 2. Restructuring

 

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

 

On June 30, 2005, the Company had a total restructuring estimated lease abandonment accrual of $381,000. This estimate was revised from previous quarters to take into account the new sublease agreement that the Company signed on July 15, 2005. The Company reviews these estimates periodically, and if the pertinent assumptions materially change, the ultimate restructuring expense for the abandoned facilities will be adjusted in accordance with SFAS No. 146, “Accounting for Costs Associated with Exit or Disposal Activities”. As a result of the new sublease, the Company incurred $114,000 of additional restructuring expenses in the second quarter of 2005.

 

The following table summarizes the activities under the 2004 Restructuring Plan from December 31, 2004 through June 30, 2005:

 

		Abandoned			Severance
		Space			Related			Total
2004 provision		$	406		$	179		$	585
Cash charges		—			(160		)	(160		)
Non-cash adjustment		4			—			4
Restructuring liability at December 31, 2004		410			19			429
Less current portion		171			19			190
Long-term portion of restructuring liability		$	239		$	—		$	239
First quarter 2005 Cash charges		(68		)	(12		)	(80		)
First quarter 2005 Non-cash adjustment		(6		)	—			(6		)
Restructuring liability at March 31, 2005		336			7			343
Less current portion		117			7			124
Long-term portion of restructuring liability		$	219		$	—		$	219
Second quarter 2005 Provision		114			—			114
Second quarter 2005 Cash charges		(67		)	(6		)	(73		)
Second quarter 2005 Non-cash adjustment		(2		)	(1		)	(3		)
Restructuring liability at June 30, 2005		381			—			381
Less current portion		149			—			149
Long-term portion of restructuring liability		$	232		$	—		$	232

 

Note 3. Guarantees

 

In the ordinary course of business, the Company enters into contractual arrangements under which the Company may agree to indemnify the other party to such arrangement from any losses incurred relating to losses arising from certain events as defined within the particular contract, which may include, for example, litigation or claims relating to patent infringement.  The maximum amount of indemnification the Company could be required to make under these agreements is generally limited to the fees received by the Company, although in some contracts

 

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the Company’s potential obligation may be greater. To date, the Company has not made any payments related to these indemnifications.

 

Note 4. Segment Information

 

The Company operates in a single industry segment, supplying semiconductor memories to the electronics industry. The Company sells its products and technology to customers in the Far East, North America and Europe. Net revenue by geographic area was (in thousands):

 

		Three Months Ended						Six Months Ended
		June 30,						June 30,
		2005			2004			2005			2004
United States		$	928		$	1,777		$	1,731		$	3,052
Japan		2,005			931			3,585			3,553
Taiwan		130			339			207			878
Other Asian Countries		4			7			227			16
Europe		—			352			—			410
Total		$	3,067		$	3,406		$	5,750		$	7,909

 

For three months ended June 30, 2005, NEC represented 56% of total revenue. For the quarter ended June 30, 2004, our two largest customers, NEC and Advanced Power Components represented 23% and 10% of total revenue, respectively. For the first half of 2005, NEC represented 50% of total revenue. For the six months ended June 30, 2004, Fujitsu and NEC represented 23% and 14% of total revenue, respectively. As of the end of June 30, 2005, the majority of long-lived assets are maintained in the United States.

 

Note 5. Contingencies

 

From time to time, the Company may be subject to legal proceedings and claims in the ordinary course of business.  These claims, even if not meritorious, could result in the expenditure of significant financial and other resources.  On March 31, 2004, UniRAM Technology, Inc. filed a complaint against the Company in the United States District Court for the Northern District of California, alleging trade secret misappropriation and patent infringement.  UniRAM’s complaint asserts that it provided trade secret information to Taiwan Semiconductor Manufacturing Corporation (TSMC) in 1996-97 and speculated that the Company improperly obtained unspecified trade secrets of UniRAM from TSMC in an unknown manner.  Subsequent to March 31, 2004, UniRAM amended its complaint twice, initially to add TSMC as a defendant and additional allegations to the suit, and the second time to drop all infringement claims for one of the two patents identified in the initial complaint.  The Company believes that UniRAM’s complaint lacks merit and intends to continue vigorously defending itself.

 

In the second quarter of 2005, the Company recorded a contingent liability of  $240,000 related to a claim made by one of the Company’s customers concerning excess verification costs incurred by the customer in implementing a custom design for 1T-SRAM memory technology under a licensing contract.  The total claim made by the customer was approximately $840,000, but the Company does not believe the claim is valid. The customer has successfully incorporated the Company’s technology to its products, and the Company believes that it performed its obligations as required under the contract. This customer owes additional licensing fees and accrued royalties to the Company, which has taken a reserve for a contingent liability equal to the amount of the current receivables, while seeking to negotiate a resolution of this claim with the customer. Due to the offsetting amounts, there was no increase in the net loss during the period. The Company reviews this estimate periodically and will adjust the amount of this contingent liability in accordance with SFAS No. 5, “Accounting for Contingencies” as required.

 

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Note 6. Provision for Income Taxes

 

The Company’s effective tax rate is based on the estimated annual effective tax rate in accordance with Statement of Financial Accounting Standards No. 109 “Accounting for Income Taxes”. A provision for income taxes of  $22,000 was recorded in the first six months of 2005 and a benefit for income taxes of  $508,000 was recorded in the same period of 2004.  The effective income tax rate was (1%) for the six months ended June 30, 2005 and 10% for the same period in 2004.  The effective tax rate changed in 2005 compared to 2004 primarily due to a forecasted U.S. tax loss and the valuation allowance on deferred tax assets.

 

Note 7. Stock Repurchase Program

 

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

 

Note 8. Subsequent Event

 

On July 15, 2005, the Company signed an agreement to sublease the ATMOS facility, which the Company occupies under long-term operating leases through the end of April 2008. Under the agreement, the Company subleases approximately 15,000 square feet of space in Ontario , Canada. The sublease expires at the end of April 2008.

 

ITEM 2. Management’s Discussion and Analysis of Financial Condition and Results of Operations

 

This Management’s Discussion and Analysis of Financial Condition and Results of Operations should be read in conjunction with the accompanying condensed consolidated financial statements and notes included in this report. This Form 10-Q contains forward-looking statements within the meaning of Section 27A of the Securities Act of 1933 and Section 21E of the Securities Exchange Act of 1934, which include, without limitation, statements about the market for our technology, our strategy, competition, expected financial performance, all information disclosed under Item 3 of this Part I, and other aspects of our business identified in the Company’s most recent annual report on Form 10-K filed with the Securities and Exchange Commission and in other reports that we file from time to time with the Securities and Exchange Commission. Any statements about our business, financial results, financial condition and operations contained in this Form 10-Q that are not statements of historical fact may be deemed to be forward-looking statements. Without limiting the foregoing, the words “believes,” “anticipates,” “expects,” “intends,” “plans,” “projects,” or similar expressions are intended to identify forward-looking statements. Our actual results could differ materially from those expressed or implied by these forward-looking statements as a result of various factors, including the risk factors described in Risk Factors and elsewhere in this report. We undertake no obligation to update publicly any forward-looking statements for any reason, except as required by law, even as new information becomes available or events occur in the future.

 

MoSys® and 1T-SRAM® are our trademarks. Product names, trade names and trademarks of other companies are also referred to in this report.

 

Overview

 

We design, develop, license and market memory technologies used by the semiconductor industry and electronic product manufacturers. We have developed a patented semiconductor memory technology, called 1T-SRAM that offers a combination of high density, low power consumption and high speed at performance and cost levels that other available memory technologies do not match. We license this technology to companies that incorporate, or embed, memory on complex integrated circuits, such as SoCs. We have also sold memory chips based on our 1T-SRAM technologies. In 2004, we ceased actively selling our proprietary 1T-SRAM memory chips.  Currently, our product sales consist of selling the inventory previously written off.  We do not expect to make and sell memory chips in the future.

 

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Using elements of our existing memory technology as a foundation, we completed development of our first memory chips incorporating our 1T-SRAM technologies in the fourth quarter of 1998. We signed our first license agreement related to our 1T-SRAM technologies at the end of the fourth quarter of 1998 and recognized licensing revenue from our 1T-SRAM technologies for the first time in the first quarter of 2000. We have introduced improved and enhanced versions of our technology, 1T-SRAM-R, 1T-STRAM-M, and 1T-SRAM-Q.

 

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

 

As of June 30, 2005, we had signed license agreements related to our 1T-SRAM technologies with 49 companies, 17 of which have paid us royalties to date. Generally, we expect our total sales cycle, or the period from our initial discussion with a prospective licensee to our receipt of royalties from the licensee’s use of our 1T-SRAM technologies, to run from 18 to 24 months after the commencement of the project.

 

During 2002, we purchased ATMOS Corporation, a semiconductor memory company focused on creating high-density, compiler-generated embedded memory solutions for SoC applications. Effective November 10, 2004, we closed the ATMOS research and development facility in Canada and terminated the employment of approximately 20 employees working there. We recorded restructuring charges related to the closure of approximately $585,000 in the fourth quarter of 2004 and $114,000 in the second quarter of 2005.

 

During the second quarter of 2005, we announced the availability of the first of what we anticipate will be a family of 1T-SRAM “CLASSIC Memory Macros”, which will be pre-configured, high-density, high-speed, low-power memory macros using silicon-proven 0.13-micron cores requiring far less custom design by us.  By adding this set of macros to our custom-designed embedded memory products, we hope to provide our customers with less expensive silicon-proven 1T-SRAM memories for rapid integration of high-density embedded memory into their SoC designs.

 

We also announced during the second quarter of 2005 the availability of our 1T-SRAM memory compiler for standard 0.13-micron CMOS logic processes. The compiler targets processes from all the leading foundries including Chartered Semiconductor Manufacturing Ltd., or Chartered, Semiconductor Manufacturing International Corporation or SMIC, Taiwan Semiconductor Manufacturing Co., Ltd., or TSMC and United Microelectronics Corporation, or UMC.  Our memory compiler is a web-accessible tool automatically generating a wide variety of design scenarios for our 1T-SRAM memories, enabling design engineers to evaluate different memory configurations for their designs more quickly and easily. 

 

Sources of Revenue

 

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

 

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

 

Our licensing revenue consists of fees for providing circuit design, layout and design verification and granting a license to a customer that is embedding our memory technology into its product. For some customers, we

 

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also provide engineering support services to assist in the commencement of production of products utilizing the licensed 1T-SRAM technologies. License fees generally range from eighty thousand dollars to several million dollars per contract, depending on the scope and complexity of the development project, and the licensee’s rights. The licensee generally pays the license fees in installments at the beginning of the license term and upon the attainment of specified milestones. The vast majority of our contracts allow billing between milestones based on work performed. All license agreements entered into to date require us to meet performance specifications. Fees collected prior to revenue recognition are recorded as deferred contract revenue. However, if the agreement involves performance specifications that we have significant experience in meeting and the cost of contract completion can be reasonably estimated, we recognize revenue over the period in which the contract services are performed under the percentage of completion accounting method. Revenue is recognized when collectibility is probable. We use actual direct labor hours incurred to measure progress towards completion. We periodically evaluate the actual status of each project to determine whether the estimates to complete each contract remain accurate. Revenue recognized in any period is dependent on our progress toward completion of projects in progress. Significant management judgment and discretion are used to estimate total direct labor hours. Changes in or deviations from these estimates could have a material effect on the amount of revenue we recognize in any period.  If the amount of revenue recognized under the percentage of completion method exceeds the amount of billings to a customer, then under the percentage of completion accounting method, we account for the excess amount as an unbilled contract receivable. Our total unbilled contract receivable was $100,000 and $1.3 million as of June 30, 2005 and 2004, respectively. For agreements involving performance specifications that we have not met and for which we lack the historical experience to reasonably estimate the costs, we defer recognition of revenue until the licensee manufactures products that meet the contract performance specifications and recognize revenue under the completed contract accounting method.

 

From time to time, a licensee may cancel a project during the development phase. Such a cancellation is not within our control and is often caused by changes in market conditions or the licensee’s business. Cancellations of this nature are an aspect of our licensing business, and most of our newer contracts allow us to retain all payments that we have received or are entitled to collect for items and services provided before the cancellation occurs. We will consider a project to have been canceled even in the absence of specific notice from our licensee, if there has been no activity under the contract for a significant period, and we believe that completion of the contract is unlikely. In this event, we recognize revenue in the amount of cash received, if we have performed a sufficient portion of the development services.  If a cancelled contract had been entered into before the establishment of technological feasibility, the costs associated with the contract would have been expensed prior to the recognition of revenue. In that case, there would be no costs associated with that revenue recognition, and gross margin would increase for the corresponding period. During each of the three- month and six-month periods ended June 30, 2005 and 2004, we recognized no licensing revenue from cancelled contracts.

 

Royalties.    Each license agreement provides for royalty payments at a stated rate. We negotiate royalty rates by taking into account such factors as the anticipated volume of the licensee’s sales of products utilizing our technologies and the cost savings to be achieved by the licensee through the use of our technology. Our license agreements require the licensee to report the manufacture or sale of products that include our technology after the end of the quarter in which the sale or manufacture occurs. We recognize royalties from reports provided by the licensee that are received in the quarter immediately following the quarter during which the licensee has sold or manufactured products containing our technology.

 

As with our licensing revenues, the timing and level of royalties are difficult to predict.  They depend on the licensee’s ability to market, produce and sell products incorporating our technology. Many of the products of our licensees that are currently subject to licenses from us are consumer products, such as electronic game consoles, for which demand can be seasonal and generally highest in the fourth quarter.  We would report royalties from products sold in the fourth quarter in the first quarter of the following year. If a licensee holds excess inventory of products using our licensed technology, we are unlikely to report additional royalty revenue attributable to that product until the quarter after the licensee restarts production. For a discussion of factors that could contribute to the fluctuation of our revenues, see “Risk Factors—Our lengthy licensing cycle and our licensees’ lengthy development cycles will make the operating results of our licensing business difficult to predict,” and “Anything that negatively affects the business of our licensees could negatively impact our revenue.”

 

Product sales.   In the second quarter of 2004, we have notified customers of our decision to discontinue

 

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sale of our memory chip products. As of the end of the third quarter of 2004, we had no remaining product inventory. In the future, we anticipate only minor ongoing sales of products that are required from time to time by their historical customers.

 

Critical Accounting Policies

 

Use of estimates.   The preparation of financial statements in accordance with accounting principles generally accepted in the United States of America requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities, the disclosure of contingent assets and liabilities at the date of the financial statements and the reported amounts of revenues and expenses during the reported period. Actual results could differ from those estimates.

 

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

 

Revenue .

 

Licensing.  In accordance with SOP 81-1 “Accounting for performance of construction-type and certain production type contracts”, when license agreements include deliverables that require “significant production, modification or customization”, contract accounting is applied. If a licensing contract involves performance specifications that we have significant experience in meeting and the direct labor hours to be incurred to complete the contract can be reasonably estimated, we recognize the revenue over the period in which the contract services are performed using the percentage of completion method. The percentage of completion method includes judgmental elements, such as determining that we have the experience to meet the design specifications and estimation of the total direct labor hours. We follow this method because we can obtain reasonably dependable estimates of the direct labor hours to perform the contracted services. The direct labor hours for the development of the licensee’s design are estimated at the beginning of the contract. As these direct labor hours are incurred, they are used as a measure of progress towards completion. We have the ability to reasonably estimate direct labor hours on a contract to contract basis from our experience in developing prior licensee’s designs. During the contract performance period, we review estimates of direct labor hours to complete the contracts as the contract progresses to completion and will revise our estimates of revenue and gross profit under the contract if we revise the estimations of the direct labor hours to complete. Our policy is to reflect any revision in the contract gross profit estimate in reported income in the period in which the facts giving rise to the revision become known. Under the percentage of completion method, provisions for estimated losses on uncompleted contracts are recognized in the period in which the likelihood of such losses is determined.

 

For contracts involving design specifications that we have not met previously, we defer the recognition of revenue until the design meets the contractual design specifications and expense the cost of services as incurred. When we have experience in meeting design specifications, but do not have significant experience to reasonably estimate the direct labor hours related to services to meet a design specification, we defer both the recognition of revenue and the cost. For these arrangements, we recognize revenue using the completed contract method. Under the completed contract method, we recognize revenue when we have knowledge that the customer has successfully verified our design. In the first six months of 2005 and 2004, none of our license revenue was recognized under the completed contract method.

 

Under our support and maintenance arrangements, we provide unspecified upgrades, design rule changes and technical support. No other upgrades, products or other post-contract support are provided. These arrangements are renewable annually by the customer. Support and maintenance revenue is recognized at its fair value ratably over the period during which the obligation exists, typically 12 months. The fair value of any support and maintenance obligation is established based on the specified renewal rate for such support and maintenance. When we provide a combination of products and services to customers, in addition to the considerations noted above, we evaluate the arrangements under EITF 00-21, “Revenue Arrangements with Multiple Deliverables”.

 

Product.   Revenue from product sales is recognized upon shipment provided that persuasive evidence of a sales arrangement exists, the price is fixed or determinable, title has transferred, collection of resulting receivables is reasonably assured, there are no customer acceptance requirements and there are no remaining significant

 

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obligations.  For each of the periods presented, there were no formal acceptance provisions with our end customers.

 

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

 

Goodwill. We review goodwill, recorded from the acquisition of ATMOS Corp. on August 2002, for impairment annually and whenever events or changes in circumstances indicate the carrying value of an asset may not be recoverable in accordance with the Statement of Financial Accounting Standards (“SFAS”) No. 142, “Goodwill and Other Intangible Assets.”  The provisions of SFAS No. 142 require that a two-step impairment test be performed on goodwill.  In the first step, we compare the fair value of each reporting unit to its carrying value.  Using the guidance in SFAS No. 142, we consider there to be only one reporting unit at the entity level.  For step one, we determine the fair value of our reporting unit using the market approach.  Under the market approach, we estimate the fair value based on the market value of the reporting unit at the entity level.  If the fair value of the reporting unit exceeds the carrying value of net assets assigned to the reporting unit, goodwill is not impaired and we are not required to perform further testing.  If the carrying value of the net assets assigned to the reporting unit exceeds the fair value of the reporting unit, we must perform the second step in order to determine the implied fair value of the reporting unit’s goodwill and compare it to the carrying value of the reporting unit’s goodwill.  If the carrying value of a reporting unit’s goodwill exceeds its implied fair value, then we must record an impairment loss equal to the difference. We performed the annual impairment test during the third quarter of 2004 and the test did not indicate impairment of goodwill as of September 30, 2004. As of June 30, 2005, we found no indicators of potential impairment.

 

Restructuring Charges. Restructuring charges related to the closure of our ATMOS research and development facility in Canada in 2004 require the use of estimates, primarily related to the cost of exiting facilities, including estimates and assumptions related to future maintenance costs, our ability to secure a sub-tenant, and any sublease income to be received in the future.

 

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

 

Tax valuation allowance. When we prepare our consolidated financial statements, we estimate our income tax liability for each of the various jurisdictions where we conduct business. This requires us to estimate our actual current tax exposure and to assess temporary differences that result from differing treatment of certain items for tax and accounting purposes. These differences result in deferred tax assets and liabilities, which we show on our consolidated balance sheet under the category of other current assets. The net deferred tax assets are reduced by a valuation allowance if, based upon weighted available evidence, it is more likely than not that some or all of the deferred tax assets will not be realized. When we establish a valuation allowance or increase this allowance in an accounting period, we must record a tax expense in our consolidated statement of operations unless the increase is attributable to stock based compensation deductions, which has been recorded directly to equity. We must make significant judgments to determine our provision for income taxes, our deferred tax assets and liabilities and any valuation allowance to be recorded against our net deferred tax asset. As of June 30, 2005, we had deferred tax assets of $11.6 million of which approximately $10.8 million was offset by a valuation allowance. This allowance consisted of approximately $6.2 million in Canadian net operating losses and $4.1 million in U.S. federal and state net operating loss and tax credit carryforwards.

 

Results of Operations

 

Three Months Ended June 30, 2005 and 2004

 

Revenue.   Total revenue decreased to $3.1 million for the three months ended June 30, 2005 from $3.4 million for the three months ended June 30, 2004. Licensing revenue increased to $1.9 million in the second quarter

 

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of 2005 from $1.3 million in the same period of 2004 as more revenue was recognized from new projects in the second quarter of 2005 than the same period in 2004. Licensing revenue represented 63% of total revenue in the second quarter of 2005, compared to 38% in the same period in 2004. Royalty revenue decreased to $1.1 million in the second quarter of 2005 from $1.4 million in the same period of 2004, and represented 37% of total revenue in the second quarter of 2005, compared to 42% for the same period in 2004. In the three months ended June 30, 2005, royalties earned from the production of Gamecube chips incorporating our 1T-SRAM technology represented 13% of total revenue, an increase from 11% of our total revenue from the same period in 2004.

 

A small number of customers continues to account for a significant percentage of our total revenue. For three months ended June 30, 2005, NEC represented 56% of total revenue. For the quarter ended June 30, 2004, our two largest customers, NEC and Advanced Power Components represented 23% and 10% of total revenue, respectively. For the first half of 2005, NEC represented 50% of total revenue. For the six months ended June 30, 2004, Fujitsu and NEC represented 23% and 14% of total revenue, respectively. For information regarding revenues recorded by us in three months and six months ended June 30, 2005 and 2004 from customers residing in the United States or residing in a foreign country, please refer to note 4, “Segment Information,” of Notes to Consolidated Financial Statements. All of our sales are denominated in U.S. dollars. For a discussion of certain risks related to our revenue concentration, please see “Risk Factors—We expect our revenue to be highly concentrated”.

 

Gross Profit.   Gross profit was $2.5 million in the three months ended June 30, 2005 and in the same period of 2004. Gross profit as a percentage of total revenue increased to 80% in the second quarter of 2005 from 74% in the corresponding period of 2004 due to the increased licensing gross profit mainly due to revenue recognized under higher margin projects we signed contracts for in the first quarter of 2005.  In addition, in the second quarter of 2005, we had higher proportion of licensing revenue compared to the same quarter in 2004, which increased the gross profit as a percentage of total revenue in the second quarter of 2005. 

 

Research and Development.   Our research and development expenses include development and design of variations of the 1T-SRAM technologies for use in different manufacturing processes used by licensees and the development and testing of prototypes to prove the technological feasibility of embedding our memory designs in the licensees’ products.  Research and development expenses decreased to $1.3 million in the second quarter of 2005 from $2.0 million in the same quarter of 2004 due to the closure of our ATMOS research and development facility in Ottawa, Canada in November of 2004. There were no research and development expenses incurred at the ATMOS facility in the second quarter of 2005 compared to $600,000 incurred in the same quarter of 2004.

 

Selling, General and Administrative.   Selling, general and administrative expenses decreased to $2.2 million in the second quarter of 2005 from $5.3 million in the same period of 2004. In the second quarter of 2004, legal and professional fees were higher compared to the same period in 2005 due to $3.7million of costs associated with the aborted acquisition by Synopsys and litigation expenses related to the Synopsys and UniRAM Technology matters. In the second quarter of 2005, selling, general and administrative expenses included legal expenses related to the UniRAM litigation of $440,000.

 

Restructuring Charges.  On November 10, 2004, we announced our plan to close the ATMOS research and development facility in Canada to reduce operating expenses and to further align our business with market conditions, future revenue expectations and planned future product direction. As part of this plan, we implemented a reduction in workforce of approximately 20 employees, which represented 20% of our workforce. On July 15, 2005, we signed an agreement to sublease the ATMOS facility, which we occupy under long-term operating leases through 2008. 

 

On June 30, 2005, we had a total restructuring accrual of $381,000 which represented an estimated lease abandonment costs. This estimate was revised from previous quarters to take into account the new sublease agreement that we signed on July 15, 2005. We review these estimates periodically, and if the pertinent assumptions materially change, the ultimate restructuring expense for the abandoned facilities will be adjusted in accordance with SFAS No. 146, “Accounting for Costs Associated with Exit or Disposal Activities”. As a result of the new sublease, we incurred $114,000 of additional restructuring expenses in the second quarter of 2005.

 

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The following table summarizes activities under the 2004 Restructuring Plan from December 31, 2004 through June 30, 2005:

 

		Abandoned			Severance
		Space			Related			Total
2004 provision		$	406		$	179		$	585
Cash charges		—			(160		)	(160		)
Non-cash adjustment		4			—			4
Restructuring liability at December 31, 2004		410			19			429
Less current portion		171			19			190
Long-term portion of restructuring liability		$	239		$	—		$	239
First quarter 2005 Cash charges		(68		)	(12		)	(80		)
First quarter 2005 Non-cash adjustment		(6		)	—			(6		)
Restructuring liability at March 31, 2005		336			7			343
Less current portion		117			7			124
Long-term portion of restructuring liability		$	219		$	—		$	219
Second quarter 2005 Provision		114			—			114
Second quarter 2005 Cash charges		(67		)	(6		)	(73		)
Second quarter 2005 Non-cash adjustment		(2		)	(1		)	(3		)
Restructuring liability at June 30, 2005		381			—			381
Less current portion		149			—			149
Long-term portion of restructuring liability		$	232		$	—		$	232

 

Interest and Other Income.   Interest and other income increased to $605,000 in the second quarter of 2005 from $269,000 in the same period of 2004 due primarily to higher interest rates paid on our cash equivalents and marketable securities.  In addition, interest income in the second quarter of 2004 was lower due to the liquidation of short-term and long-term investments required just prior to the termination of the acquisition by Synopsys.

 

Provision for Income Taxes.   Our effective tax rate is based on the estimated annual effective tax rate in accordance with Statement of Financial Accounting Standards No. 109 “Accounting for Income Taxes”.  A provision for income taxes of $2,000 was recorded in the second quarter of 2005 and a benefit for income taxes of $378,000 was recorded in the second quarter of 2004. Although we had a net loss for the second quarter of 2005, the tax provision for the second quarter was necessary for state minimum tax and foreign taxes.

 

Six Months Ended June 30, 2005 and 2004

 

Revenue.   Total revenue decreased to $5.8 million for the six months ended June 30, 2005 from $7.9 million in the same period of 2004.  Licensing revenue decreased to $3.2 million in the first six months of 2005 from $4.3 million in the same period of 2004 as revenue recognized from new projects did not offset a decline in revenue from existing projects. Licensing revenue was 55% of total revenue for the first six months of 2005 compared to 54% of total revenue in the first six months of 2004. In the six months ended June 30, 2005, royalty revenue decreased to $2.6 million from $2.8 million in the same period of 2004, and represented 45% of total revenue, compared to 35% in the same period in 2004.   In the six months ended June 30, 2005, royalties earned from the production of Gamecube chips incorporating our 1T-SRAM technology represented 20% of total revenue, an increase from 9% of our total revenue from the same period in 2004, as Nintendo had increased its purchases of

 

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chips incorporating our licensed technology for its Gamecube consoles in the fourth quarter of 2004 and the first quarter of 2005.

 

Gross Profit.   Gross profit decreased to $4.7 million in the first half of 2005 from $6.5 million in the corresponding period of 2004 primarily due to decreased product and licensing revenue. Gross profit as a percentage of total revenue decreased slightly to 81% in the six months of 2005 from 82% in the corresponding period of 2004 mainly due to lower licensing gross profit offset by royalties, which represented a higher percentage of total revenue. Licensing gross profit declined to 66% in the first six months of 2005 from 80% in the same period of 2004. This decline in licensing gross profit resulted from higher cost incurred in fulfilling our obligations under new license agreements than we had originally estimated or had historically experienced in the first quarter of 2005.

 

Research and Development.   Research and development expenses decreased to $2.9 million in the six months ended June 30, 2005 from $4.2 million in the same period of 2004 mainly due to the closure of our ATMOS research and development facility in Ottawa, Canada in November of 2004. There were no research and development expenses incurred at the ATMOS facility in the first six months of 2005 compared to $1.2 million incurred in the same period of 2004.

 

Selling, General and Administrative.   Selling, general and administrative expenses decreased to $4.7 million in the first half of 2005 from $8.0 million in same period of 2004, which included $ 4.6 million of expenses related to the planned acquisition by Synopsys and litigation expenses related to the termination of that acquisition by Synopsys and the UniRAM litigation.

 

Interest and Other Income.   Interest and other income increased to $1.1 million in the first six months of 2005 from $630,000 in the same period of 2004 due primarily to higher interest rates paid on our cash equivalents and marketable securities.  In addition, interest income in the first half of 2004 was lower due to the liquidation of short-term and long-term investments required just prior to the termination of the acquisition by Synopsys.

 

Provision for Income Taxes. A provision for income taxes of  $22,000 was recorded in the first six months of 2005 and a benefit for income taxes of  $508,000 was recorded in the same period of 2004.  The effective income tax rate was (1%) for the six months ended June 30, 2005 and 10% for the same period in 2004.  Our effective tax rate changed in 2005 compared to 2004 primarily due to a forecasted U.S. tax loss and the valuation allowance on deferred tax assets.

 

Liquidity and Capital Resources

 

Cash Flows

 

As of June 30, 2005, we had cash and cash equivalents and long and short-term investments of $86.3 million. As of the same date, we had total working capital of $59.3 million. Our primary capital requirements are to fund working capital needs.

 

Net cash used in operating activities was $221,000 in the first six months of 2005 primarily due to the net loss of $1.9 million offset by non cash impact depreciation and amortization expense of  $328,000, lower accounts receivable of $772,000 and higher deferred revenue of $678,000, which resulted mainly from billings related to new licensing agreements entered in the first quarter of 2005. Net cash used in operating activities for the first six months of 2004 was $541,000 primarily due to the net loss offset by higher accounts payable and accrued liabilities due to increased litigation related expenses. 

 

Net cash used in investing activities was approximately $23.4 million in the first six months of 2005 compared to net cash provided by investing activities of approximately $15.7 million in the first half of 2004. Net cash used in investing activities for the first six months of 2005 resulted primarily from purchases of short-term and long-term marketable securities of $22.7 million, net of proceeds from the disposition of investment securities.  Net cash provided by investing activities for the first six months of 2004 consisted primarily of investment transactions of short-term and long-term marketable securities of $16.0 million, net of proceeds from the disposition and purchases of investment securities. 

 

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Net cash provided by financing activities was $359,000 and $3.0 million in the first six months of 2005 and 2004, respectively. Net cash provided by financing activities for the first six months of 2005 and 2004 primarily consisted of proceeds received from the exercise of employee options to purchase common stock.  In the first half of 2004, there were more option exercises by employees acquiring shares to tender in the planned acquisition by Synopsys or sell in the market

 

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

 

•                                           level and timing of licensing and royalty revenues;

•                                           cost, timing and success of technology development efforts;

•                                           market acceptance of our existing and future technologies and products;

•                                           competing technological and market developments;

•                                           cost of maintaining and enforcing patent claims and intellectual property rights;

•                                           variations in manufacturing yields, materials costs and other manufacturing risks;

•                                           costs of acquiring other businesses and integrating the acquired operations;

•                                           profitability of our business; and

•                                           litigation expenses.

 

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

 

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

 

Lease Commitments and Off Balance Sheet Financing

 

As of June 30, 2005, we had $2.6 million of total future net lease commitments compared to $2.3 million in the same period in 2004. The following table identifies our contractual obligations as of June 30, 2005 that will impact our liquidity and cash flow in future periods:

 

		Paymemt Due by Period
		Total			Less than 1 year			1-3 years			4-5 years
Minimum Lease Commitments		$	3,056		$	806		$	1,510		$	740
Sublease Income		455			177			278			—
Net Lease Commitments		$	2,601		$	629		$	1,232		$	740

 

On May 6, 2005, we signed a new lease agreement for our facility to accommodate our principal administrative, sales, marketing, support and research and development functions. Under the new lease agreement, we occupy approximately 26,000 square feet of space in Sunnyvale, California. The lease expires at the end of June 2010. The lease for our old facility expired at the end of June 2005. On July 15, 2005, we signed an agreement to sublease the ATMOS facility, which we occupy under long-term operating leases in Canada.  The sublease expires at the end of April 2008.  We did not have any unconditional purchase obligations as of June 30, 2005. 

 

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Recent Accounting Pronouncements

 

In December 2004, the Financial Accounting Standards Board (FASB) issued Statement of Financial Accounting Standards No. 123, Share-Based Payment (SFAS 123R) which will become effective beginning in the first quarter of 2006. SFAS 123R will result in the recognition of substantial compensation expense relating to our employee stock options and employee stock purchase plans. We currently use the intrinsic value method to measure compensation expense for stock-based awards to its employees. Under this standard, we generally do not recognize any compensation related to stock option grants under our stock option plans or related to the discounts provided under our employee stock purchase plans. Under the new rules however, we will be required to adopt a fair-value-based method for measuring the compensation expense related to employee stock awards. We expect this to lead to substantial additional compensation expense that will be included in our reported results of operations beginning January 1, 2006.

 

RISK FACTORS

 

If any of the following risks actually occur, our business, results of operations and financial condition could suffer significantly.

 

Our success depends upon the semiconductor market’s acceptance of our 1T-SRAM technologies.

 

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

 

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

 

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

 

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

 

Our lengthy licensing cycle and our licensees’ lengthy product development cycles make the operating results of our licensing business difficult to predict.

 

We anticipate difficulty in accurately predicting the timing and amounts of revenue generated from licensing our 1T-SRAM technologies. The establishment of a business relationship with a potential licensee is a lengthy process, generally taking from three to nine months, and sometimes longer during slower periods in our industry. Following the establishment of the relationship, the negotiation of licensing terms can be time-consuming,

 

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and a potential licensee may require an extended evaluation and testing period.

 

Once a license agreement has been executed, the timing and amount of licensing and royalty revenue from our licensing business will remain difficult to predict. The completion of the licensees’ development projects and the commencement of production will be subject to the licensees’ efforts, development risks and other factors outside our control. Our royalty revenue will depend on such factors as success of the licensees’ project, the licensees’ production and shipment volumes, the timing of product shipments and when the licensees report to us the manufacture or sale of products that include our 1T-SRAM technologies. All of these factors will prevent us from making predictions of revenue with any certainty and could cause us to experience substantial period-to-period fluctuations in operating results.

 

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

 

If the market for system-on-a-chip integrated circuits does not expand, our business may suffer.

 

Our ability to achieve sustained revenue growth and profitability in the future will depend on the continued development of the market for SoC integrated circuits, particularly those requiring embedded memory sizes of one megabit or more.  In addition, our ability to achieve design wins with customers is dependent upon the growth of embedded memories required in SoCs. SoCs are characterized by rapid technological change and competition from an increasing number of alternate design strategies such as combining multiple integrated circuits to create a system-on-a-package.

 

We cannot be certain that the market for SoCs will continue to develop or grow at a rate sufficient to support our business.   SoC providers depend on the demand for products requiring SoCs such as cellular phones, game consoles, PDAs, digital cameras, DVD players and digital media players to name a few. The demand for such products is uncertain and difficult to predict and depends on factors beyond our control. If the market fails to grow or develops more slowly than expected, our business may suffer.

 

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

 

The semiconductor industry is cyclical and has experienced a pronounced downturn in recent years.  To respond to any downturn, many semiconductor manufacturers and their customers will slow their research and development activities, cancel or delay new product developments, reduce their workforces and inventories and take a cautious approach to acquiring new equipment and technologies.  As a result, our business has been in the past and could be adversely affected in the future from a downturn that could negatively impact our future revenue and profitability.  The cyclical nature of the semiconductor industry may cause our operating results to fluctuate significantly from year-to-year, which also may tend to increase the volatility of the price of our common stock.

 

We might be unable to deliver our customized memory technology within an agreed technical specification in the time frame demanded by our licensees, which could damage our reputation, harm our ability to attract future licensees and impact operating results.

 

Our licenses require us to deliver a customized 1T-SRAM memory block or several blocks, within an agreed technical specification by a certain delivery timetable. This requires us to furnish a unique design for each customer, which can make the development schedule difficult to predict and involves extensive interaction with our customers’ engineers.  From time to time, we experience delays in delivering our customized memory technology that meets the agreed technical specifications, which can result from slower engineering progress than we originally

 

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anticipated or there might be factors outside of our control, such as the customer’s delay in completing verification of the customer’s chip.  Such delays may affect the timing of recognition of revenues from a particular project and can adversely affect our operating results.

 

In addition, any failure to meet the time requirements as well as the agreed upon technical specifications of our customized memory technology could lead to the failure to collect or a delay in royalties and licensing fee payments from our licensee, damage our reputation in the industry, harm our ability to attract new licensees and negatively impact our operating results. Furthermore, a customer may assert that we are responsible for delays and cost overruns and demand reimbursement for some of its costs, which we may elect to reimburse in whole or in part in order to address the customer’s concerns.  For example, in 2004, we reduced revenue by $450,000 for a reimbursement given to a customer for excess verification costs incurred by the customer. In the second quarter of 2005, we recorded a contingent liability of $240,000 related to a claim made by one of our customers concerning excess verification costs incurred by the customer in implementing a custom design for 1T-SRAM memory technology under a licensing contract, although to date we have not reimbursed any amount to this customer. 

 

Our business model relies on royalties as a key component in the licensing of our technologies, and if we fail to realize expected royalties our operating results will suffer.

 

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

 

We expect our revenue to be highly concentrated among a small number of licensees and customers, and our results of operations could be harmed if we lose and fail to replace this revenue.

 

Our overall revenue has been highly concentrated, with a few customers accounting for a significant percentage of our total revenue. For the three months ended June 30, 2005, NEC represented 56% of total revenue. For the quarter ended June 30, 2004, our two largest customers, NEC and Advanced Power Components represented 23% and 10% of total revenue, respectively. For the first half of 2005, NEC represented 50% of total revenue. For the six months ended June 30, 2004, Fujitsu and NEC represented 23% and 14% of total revenue, respectively. We expect that a relatively small number of licensees will continue to account for a substantial portion of our revenue for the foreseeable future.

 

Furthermore, our royalty revenue has been highly concentrated among a few licensees, and we expect this trend to continue for the foreseeable future. In particular, a substantial portion of our licensing and royalty revenue in 2005 and 2004 has come from the licenses for integrated circuits used by Nintendo in its GAMECUBE®. Royalties earned from the production of Gamecube chips incorporating our 1T-SRAM technology represented 13% and 11% of total revenue in the second quarter of 2005 and 2004, respectively. Royalties earned from the production of Gamecube chips incorporating our 1T-SRAM technology represented 20% and 9% of total revenue in the first six months of 2005 and 2004, respectively.  Nintendo faces intense competitive pressure in the video game market, which is characterized by extreme volatility, costly new product introductions and rapidly shifting consumer preferences, and we cannot assure you that Nintendo’s sales of product incorporating our technology will increase beyond prior or current levels.

 

As a result of this revenue concentration, our results of operations could be impaired by the decision of a single key licensee or customer to cease using our technology or products or by a decline in the number of products that incorporate our technology that are sold by a single licensee or customer or by a small group of licensees or customers.

 

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Our revenue concentration may also pose credit risks, which could negatively affect our cash flow and financial condition.

 

We might also face credit risks associated with the concentration of our revenue among a small number of licensees and customers. As of June 30, 2005, three customers represented 71% of total trade receivables. Our failure to collect receivables from any customer that represents a large percentage of receivables on a timely basis, or at all, could adversely affect our cash flow or results of operations and might cause our stock price to fall.

 

Anything that negatively affects the businesses of our licensees could negatively impact our revenue.

 

The timing and level of our licensing and royalty revenues are dependent on our licensees and the business environment in which they operate.  Licensing and royalty revenue are the largest source of our revenues; anything that negatively affects a significant licensee or group of licensees could negatively affect our results of operations and financial condition.  Many issues beyond our control influence the success of our licensees, including, for example, the highly competitive environment in which they operate, the strength of the markets for their products, their engineering capabilities and their financial and other resources.

 

Likewise, we have no control over the product development, pricing and marketing strategies of our licensees, which directly affect the licensing of our technology and corresponding future royalties payable to us from our licensees.  Our royalty revenues are subject to our licensees’ ability to market, produce and ship products incorporating our technology.  A decline in sales of our licensees’ royalty-generating products for any reason would reduce our royalty revenue. In addition, seasonal and other fluctuations in demand for our licensees’ products could cause our operating results to fluctuate, which could cause our stock price to fall.

 

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

 

Part of our marketing strategy relies upon our relationships and agreements with semiconductor foundries, such as TSMC, UMC, Chartered, and SMIC among others. These foundries have existing relationships, and continually seek new relationships, with companies in the markets we target, and have agreed to utilize these relationships to introduce our technology to potential licensees. If we fail to maintain and expand our current relationships with these foundries, we might fail to achieve anticipated growth.  Our relationship with these foundries is not exclusive, and they are free to promote or develop other embedded memory technologies, including their own. The foundries’ promotions of alternative technologies reduce the size of our potential market and may adversely affect our revenues and operating results.

 

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

 

Our embedded memory technology is unique and the occurrence of manufacturing difficulties or low production yields, that if not corrected, could hinder market acceptance of our technology and reduce future revenue.

 

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

 

Any decrease in manufacturing yields of integrated circuits utilizing our technology could impede the

 

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acceptance of our technology in the industry. The discovery of defects or problems regarding the reliability, quality or compatibility of our technology could require significant expenditures and resources to fix, significantly delay or hinder market acceptance of our technology, reduce anticipated revenues and damage our reputation.

 

Our failure to compete effectively in the market for embedded memory technology could reduce our revenue.

 

There exists significant competition in the market for embedded memory technologies. Our licensees and prospective licensees can meet their need for embedded memory by using traditional memory solutions with different cost and performance parameters, which they may internally develop or acquire from third party vendors. In the past two years, the demand for applications for which our 1T-SRAM technologies provide distinct advantages has not experienced significant growth.  If alternative technologies are developed that provide comparable system performance at lower cost than our 1T-SRAM technologies for certain applications and/or do not require the payment of comparable royalties, or if the industry generally demonstrates a preference for applications for which our 1T-SRAM technologies do not offer significant advantages, our ability to realize revenue from our 1T-SRAM technologies could be impaired.

 

We might be challenged by competitive developers of alternative technologies who are more established, benefit from greater market recognition and have substantially greater financial, development, manufacturing and marketing resources than we have. These advantages might permit these developers to respond more quickly to new or emerging technologies and changes in licensee requirements. We cannot assure you that future competition will not have a material adverse effect on the adoption of our technology and our market penetration.

 

Our failure to continue to enhance our technology or develop new technology on a timely basis could diminish our ability to attract and retain licensees and product customers.

 

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

 

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

 

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

 

•                                           identify target markets and relevant emerging technological trends, including new standards and protocols;

 

•                                           develop and maintain competitive technology by improving performance and adding innovative features that differentiate our technology from alternative technologies;

 

•                                           enable the incorporation of enhanced technology in our licensees’ and customers’ products on a timely basis and at competitive prices;

 

•                                           implement our technology at future manufacturing process generation; and

 

•                                           respond effectively to new technological developments or new product introductions by others.

 

Since its introduction in 1998, we have introduced enhancements to our 1T-SRAM technology designed to meet market requirements. However, we cannot assure you that the design and introduction schedules of any additions and enhancements to our existing and future technology will be met, that this technology will achieve market acceptance or that we will be able to license this technology on terms that are favorable to us. Our failure to

 

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develop future technology that achieves market acceptance could harm our competitive position and impede our future growth.

 

We may incur substantial litigation expense, which would adversely affect our profitability.

 

On March 31, 2004, UniRAM Technology, Inc. filed a complaint against us in the United States District Court for the Northern District of California, alleging trade secret misappropriation and patent infringement.  UniRAM’s complaint asserts that it provided trade secret information to Taiwan Semiconductor Manufacturing Corporation (TSMC) in 1996-97 and speculated that we improperly obtained unspecified trade secrets of UniRAM from TSMC in an unknown manner.  Subsequent to March 31, 2004, UniRAM has amended its complaint twice to add TSMC as a defendant and additional allegations to the suit, and to drop all infringement claims for one of the two patents identified in the initial complaint.  We believe that UniRAM’s complaint lacks merit and intend to vigorously defend against it.

 

We expect to incur substantial expenses litigating the matter during 2005, at least, and potentially thereafter.  In addition, although we expect to prevail in the lawsuit, if we do not, we may be required to pay substantial damages and/or the attorneys’ fees and expenses of the other party, as well as our own.  Any such damages and/or expenses could adversely affect our results of operation and cause net losses for the periods in which we record them.

 

Royalty amounts owed to us might be difficult to verify, and we might find it difficult, expensive and time-consuming to enforce our license agreements.

 

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

 

We might not be able to protect and enforce our intellectual property rights, which could impair our ability to compete and reduce the value of our technology.

 

Our technology is complex and is intended for use in complicated integrated circuits. A very large number of new and existing products utilize embedded memory, and a large number of companies manufacture and market these products. Because of these factors, policing the unauthorized use of our intellectual property is difficult and expensive. We cannot be certain that we will be able to detect unauthorized use of our technology or prevent other parties from designing and marketing unauthorized products based on our technology. Although we are not aware of any past or present infringement of our patents, copyrights or trademarks, or any violation of our trade secrets, confidentiality procedures or licensing agreements, we cannot assure you that the steps taken by us to protect our proprietary information will be adequate to prevent misappropriation of our technology. Our inability to protect adequately our intellectual property would reduce significantly the barriers of entry for directly competing technologies and could reduce the value of our technology. Furthermore, we might initiate claims or litigation against third parties for infringement of our proprietary rights or to establish the validity of our proprietary rights. Litigation by us could result in significant expense and divert the efforts of our technical and management personnel, whether or not such litigation results in a determination favorable to us.

 

Our existing patents might not provide us with sufficient protection of our intellectual property, and our patent applications might not result in the issuance of patents, either of which could reduce the value of our core technology and harm our business.

 

We rely on a combination of patents, trademarks, copyrights, trade secret laws and confidentiality procedures to protect our intellectual property rights. As of June 30, 2005, we held 78 patents in the United States, which expire at various times from 2011 to 2023, and 39 corresponding foreign patents. In addition, as of June 30, 2005, we had nine patent applications pending in the United States and 21 pending foreign applications, and had received notice of allowance of one patent application pending in the United States. We cannot be sure that any

 

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patents will issue from any of our pending applications or that any claims allowed from pending applications will be of sufficient scope or strength, or issued in all countries where our products can be sold, to provide meaningful protection or any commercial advantage to us. Also, competitors might be able to design around our patents. Failure of our patents or patent applications to provide meaningful protection might allow others to utilize our technology without any compensation to us and impair our ability to increase our licensing revenue.

 

Any claim that our products or technology infringe third-party intellectual property rights could increase our costs of operation and distract management and could result in expensive settlement costs or the discontinuance of our technology licensing or product offerings.

 

The semiconductor industry is characterized by vigorous protection and pursuit of intellectual property rights or positions, which has resulted in often protracted and expensive litigation. For example, on March 31, 2004, we were sued by UniRAM Technology, Inc. in United States District Court for the Northern District of California based on claims of patent infringement and misappropriation of trade secrets that were allegedly disclosed by UniRAM to TSMC, which allegedly improperly provided them to us.  Additionally, our licensees or we might, from time to time, receive notice of claims that we have infringed patents or other intellectual property rights owned by others. Litigation against us, including the UniRAM suit, could result in significant expense and divert the efforts of our technical and management personnel, whether or not the litigation results in a determination adverse to us. Although we believe that UniRAM’s claims lack merit and we intend to rigorously defend against them, in the event of an adverse result in any such litigation, we could be required to pay damages in an amount we cannot presently predict, cease the licensing of certain technology and expend resources to develop non-infringing technology or obtain licenses for the infringing technology. We cannot assure you that we would be successful in such development or that such licenses would be available on reasonable terms, or at all.

 

The discovery of defects in our technology could expose us to liability for damages.

 

The discovery of a defect in our 1T-SRAM technology could lead our licensees to seek damages from us. Our standard license terms include provisions waiving implied warranties regarding our technology and limiting our liability to our licensees. We also maintain insurance coverage that is intended to protect us against potential liability for defects in our technology. We cannot be certain, however, that the waivers or limitations of liability contained in our license contracts will be enforceable, that insurance coverage will continue to be available on reasonable terms or in amounts sufficient to cover one or more large claims or that our insurer will not disclaim coverage as to any future claim. The successful assertion of one or more large claims that exceed available insurance coverage or changes in our insurance policies, including premium increases or the imposition of large deductible or co-insurance requirements, could cause our expenses to rise significantly and consequently harm our profitability.

 

Our failure to manage the growth of our business could reduce our potential revenue and threaten our future profitability.

 

The size of our company has increased substantially as we grew from 43 employees in January 2001 to 73 employees in June 2005. The efficient management of our planned expansion of the development, licensing and marketing of our technology, including through the acquisition of other companies will require us to continue to—

 

•                                           implement and manage new marketing channels to penetrate different and broader markets for our 1T-SRAM technologies;

 

•                                           manage an increasing number of complex relationships with licensees and co-marketers and their customers and other third parties;

 

•                                           expand our capabilities to deliver our technologies to our customers;

 

•                                           improve our operating systems, procedures and financial controls on a timely basis;

 

•                                           hire additional key management and technical personnel; and

 

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

 

We cannot assure you that we will adequately manage our growth or meet the foregoing objectives. A failure to do so could jeopardize our future revenues and cause our stock price to fall.

 

If we fail to retain key personnel, our business and growth could be negatively affected.

 

Our business has been dependent to a significant degree upon the services of a small number of executive officers and technical employees, including Dr. Wingyu Leung, our Executive Vice President and Chief Technical Officer. The loss of his services could negatively impact our technology development efforts and our ability to perform our existing agreements and obtain new customers. We generally have not entered into employment or non-competition agreements with any of our employees and do not maintain key-man life insurance on the lives of any of our key personnel.

 

Our failure to successfully address the potential difficulties associated with our international operations could increase our costs of operation and negatively impact our revenue.

 

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

 

•                                           foreign currency exchange fluctuations;

 

•                                           unanticipated changes in local regulation;

 

•                                           potentially adverse tax consequences, such as withholding taxes;

 

•                                           difficulties regarding timing and availability of export and import licenses;

 

•                                           political and economic instability; and

 

•                                           reduced or limited protection of our intellectual property.

 

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

 

Provisions of our certificate of incorporation and bylaws or Delaware law might delay or prevent a change of control transaction and depress the market price of our stock.

 

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

 

We are also subject to provisions of Delaware law which could delay or make more difficult a merger, tender offer or proxy contest involving our company. In particular, Section 203 of the Delaware General Corporation Law prohibits a Delaware corporation from engaging in any business combination with any interested stockholder for a period of three years unless specific conditions are met. Any of these provisions could have the effect of delaying, deferring or preventing a change in control, including without limitation, discouraging a proxy contest or making more difficult the acquisition of a substantial block of our common stock.

 

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