PHOTON DYNAMICS INC, S-3/A, 2000-01-28

PHOTON DYNAMICS INC
S-3/A, 2000-01-28
SPECIAL INDUSTRY MACHINERY, NEC

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<PAGE>
AS FILED WITH THE SECURITIES AND EXCHANGE COMMISSION ON JANUARY 28, 2000
REGISTRATION NO. 333-92937
- --------------------------------------------------------------------------------
- --------------------------------------------------------------------------------

SECURITIES AND EXCHANGE COMMISSION

WASHINGTON, D.C. 20549
--------------------------

AMENDMENT NO. 1
TO
FORM S-3

REGISTRATION STATEMENT

UNDER

THE SECURITIES ACT OF 1933
--------------------------

PHOTON DYNAMICS, INC.

(Exact name of registrant as specified in its charter)

<TABLE>
<S> <C> <C>
CALIFORNIA 3559 94-3007502
(State or other jurisdiction (Primary Standard Industrial (I.R.S. Employer
of Classification Code Number) Identification No.)
incorporation or organization)
</TABLE>

6325 SAN IGNACIO AVENUE
SAN JOSE, CALIFORNIA 95119-1202
(408) 226-9900
(Address and telephone number of principal executive offices)

VINCENT F. SOLLITTO
PRESIDENT AND CHIEF EXECUTIVE OFFICER
PHOTON DYNAMICS, INC.
6325 SAN IGNACIO AVENUE
SAN JOSE, CALIFORNIA 95119-1202
(408) 226-9900
(Name, address, and telephone number of agent for service)
--------------------------

COPIES TO:

<TABLE>
<S> <C>
ALAN C. MENDELSON, ESQ. VICTOR A. HEBERT, ESQ.
MATTHEW W. SONSINI, ESQ. RANDALL B. SCHAI, ESQ.
Cooley Godward LLP Heller Ehrman White & McAuliffe
Five Palo Alto Square 333 Bush Street
3000 El Camino Real San Francisco, California 94104
Palo Alto, California 94036 (415) 772-6000
(650) 843-5000
</TABLE>

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

APPROXIMATE DATE OF COMMENCEMENT OF PROPOSED SALE TO THE PUBLIC:

AS SOON AS PRACTICABLE AFTER THE EFFECTIVE DATE OF THIS REGISTRATION STATEMENT.
--------------------------

If the only securities being registered on this form are being offered
pursuant to dividend or interest reinvestment plans, please check the following
box. / /

If any of the securities being registered on this Form are to be offered on
a delayed or continuous basis pursuant to Rule 415 under the Securities Act of
1933, other than securities offered only in connection with dividend or interest
reinvestment plans, check the following box. / /

If this form is filed to register additional securities for an offering
pursuant to Rule 462(b) under the Securities Act, please check the following box
and list the Securities Act registration statement number of the earlier
effective registration statement for the same offering. / /

If this form is a post-effective amendment filed pursuant to
Rule 462(c) under the Securities Act, check the following box and list the
Securities Act registration statement number of the earlier effective
registration statement for the same offering. / /

If delivery of the prospectus is expected to be made pursuant to Rule 434,
please check the following box. / /

THE REGISTRANT HEREBY AMENDS THIS REGISTRATION STATEMENT ON SUCH DATE OR
DATES AS MAY BE NECESSARY TO DELAY ITS EFFECTIVE DATE UNTIL THE REGISTRANT SHALL
FILE A FURTHER AMENDMENT WHICH SPECIFICALLY STATES THAT THIS REGISTRATION
STATEMENT SHALL THEREAFTER BECOME EFFECTIVE IN ACCORDANCE WITH SECTION 8(a) OF
THE SECURITIES ACT OF 1933 OR UNTIL THE REGISTRATION STATEMENT SHALL BECOME
EFFECTIVE ON SUCH DATE AS THE COMMISSION, ACTING PURSUANT TO SAID SECTION 8(a),
MAY DETERMINE.

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<PAGE>
The information in this prospectus is not complete and may be changed. We may
not sell these securities until the registration statement filed with the
Securities and Exchange Commission is effective. This prospectus is not an offer
to sell these securities and we are not soliciting offers to buy these
securities in any state where the offer or sale is not permitted.
<PAGE>
Prospectus (not complete)
Issued January 28, 2000

2,000,000 SHARES

[PHOTON DYNAMICS LOGO]

COMMON STOCK
----------------

Photon Dynamics, Inc. is offering 1,320,687 shares of our common stock, and
the selling shareholder is offering 679,313 shares of our common stock in a
firmly underwritten offering. We will not receive any of the proceeds from the
sale of shares by the selling shareholder.

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

Our common stock is traded on the Nasdaq National Market under the symbol
"PHTN." The last reported sale price of our common stock on the Nasdaq National
Market on January 25, 2000 was $61.00 per share.
---------------------

INVESTING IN OUR COMMON STOCK INVOLVES A HIGH DEGREE OF RISK. SEE "RISK
FACTORS" BEGINNING ON PAGE 5.

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

<TABLE>
<CAPTION>
Per Share Total
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<S> <C> <C>
Offering Price $ $
Discounts and Commissions to Underwriters $ $
Offering Proceeds to Photon Dynamics, Inc. $ $
Offering Proceeds to the Selling Shareholder $ $
</TABLE>

Neither the Securities and Exchange Commission nor any state securities
commission has approved or disapproved of these securities or determined if this
prospectus is truthful or complete. Any representation to the contrary is a
criminal offense.

We have granted the underwriters the right to purchase up to an additional
300,000 shares from Photon Dynamics, Inc. to cover over-allotments. The
underwriters can exercise this right at any time within thirty days after the
offering. The underwriters expect to deliver the shares of common stock to
investors on , 2000.

JOINT LEAD AND BOOK-RUNNING MANAGERS

BANC OF AMERICA SECURITIES LLC NEEDHAM & COMPANY, INC.
----------------

SOUNDVIEW TECHNOLOGY GROUP
----------------

, 2000
<PAGE>
[Inside Front Cover Graphic:

Located in the center of the page is the Photon Dynamics logo and name and a
caption which reads "Photon Dynamics, Inc. provides yield management solutions
to the flat panel display, printed circuit board assembly and advanced
semiconductor packaging industries."

Surrounding caption on the top half of the page, photographs of the following
consumer products incorporating active matrix flat panel displays from left to
right: DVD player, flat panel display monitor and computer keyboard, flat panel
television and laptop computer.

Surrounding caption on the bottom half of the page are photographs of the
following mobile consumer products which incorporate small, dense printed
circuit boards and advanced semiconductor packages from left to right: global
positioning system, personal digital assistant, cellular phone and handheld
video game.

In the background of the bottom half of the page is a photograph of a ball grid
array and a printed circuit board.]
<PAGE>
[Gatefold Graphic:

Left center of page is the following caption: "Photon Dynamics--Our test, repair
and inspection systems provide integrated yield management solutions for
ActiveMatrix Liquid Crystal Display (AMLCD) manufacturing. AMLCDs are currently
the predominant source of revenue in the flat panel display industry."

To the right of the above-described caption and along the top of the page are
photographs of the following products of Photon Dynamics:

- ArrayChecker FPD test system, with two close-up photographs coming out
of the machine. One photograph is a voltage-image map, which displays a
detected defect in a flat panel display, coming from the test system
monitor with the caption "Voltage Imaging Map". The second photograph
depicts a voltage sensor coming out from the test equipment with the
caption "Voltage Sensor";

- ArraySaver FPD repair system, with a photograph of the graphical user
interface coming out of the monitor with the caption "Intuitive Graphical
User Interface"; and

- PanelMaster 300 FPD inspection system, with photograph of Mura defect
coming from the test system monitor with the caption of "Enhanced Mura
Image".

Below the respective product photos are the following bulleted points:

- ArrayChecker Test System

- Proprietary non-contact Voltage Imaging technology

- Creates high-resolution voltage image map of the entire display

- Provides complete pixel defect data

- ArraySaver Repair System

- Proprietary PixeLaser and BeamBlender technology

- Automated high-speed, precision stage

- Semi-automatic repair

- Panel Master 300 Inspection System

- Proprietary MuraLook and N-Aliasing technology

- Advanced image analysis algorithms

- Enables quantitative quality standards

Underneath the above product pictures is a two-way horizontal arrow running the
length of the product photos with the following caption immediately underneath
the line: "Pixel defect data files pass information between test, repair and
inspection equipment to provide for an integrated yield management solution."

Underneath the product photos and related descriptions and arrow is a graphic
depicting the AMLCD manufacturing process with the caption "AMLCD manufacturing
process". The graphics depicts a series of boxes connected by arrows
representing the following key steps of the AMLCD manufacturing process: array
fabrication; array pattern inspection; array repair; array test; array repair;
cell assembly; cell inspection; cell repair; module assembly; module inspection;
and module repair. The array fabrication, array pattern inspection, array
repair, and array test boxes are grouped by a dotted line with the caption
"Array Fabrication Phase". The cell assembly, cell inspection and cell repair
boxes are grouped by a dotted line with the caption "Cell Assembly Phase". The
module assembly, module inspection, and module repair boxes are grouped by a
dotted line with the caption "Module Assembly Phase".

The steps in the manufacturing process in which FPD manufacturers use PDI's
systems are indicated in bold. Text beneath the diagram is a box followed by the
text: "Indicates steps that use our systems."]
<PAGE>
[Inside Back Cover Graphic:

Right center of page--caption: "We provide inspection systems to the printed
circuit board assembly and advanced semiconductor packaging industries. Our
systems use proprietary image processing technology and intuitive graphical user
interfaces for flexibility in manufacturing requirements."

Left side of page from top to bottom--Three photographs of the following X-ray
and optical inspection products of Photon Dynamics:

- X-ray Inspection Equipment, with one close-up photograph coming from the
monitor of an X-ray image with the caption "X-ray Image".

- Optical Inspection Equipment; and

- Combined X-ray and Automated Optical Inspection Equipment.

To the right of the respective product photos is the description of the
equipment and the following bulleted points:

- X-ray Inspection Equipment

- Inspects hidden solder connections under ball grid array devices

- Inspects features inside semiconductor packaging

- Allows non-destructive defect detection

- Optical Inspection Equipment

- Inspects for component presence, correct component, orientation,
polarity, skew, solder integrity and other defects on printed circuit
board assemblies

- Offers various automation options

- Accommodates a wide range of printed circuit board sizes

- Combined X-ray and Automated Optical Inspection Equipment

- Inspects visible and hidden feature simultaneously on a printed
circuit board

- Reduces handling

- Increases throughput

- Saves floor space]
<PAGE>
TABLE OF CONTENTS

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PAGE
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<S> <C>
Prospectus Summary.......................................... 1
Risk Factors................................................ 5
Forward-Looking Statements.................................. 14
Use of Proceeds............................................. 15
Price Range of Our Common Stock............................. 16
Dividend Policy............................................. 16
Capitalization.............................................. 17
Selected Supplemental Consolidated Financial Data........... 18
Management's Discussion and Analysis of Financial Condition
and Results of Operations................................. 19
Business.................................................... 25
Management.................................................. 40
Principal and Selling Shareholders.......................... 42
Underwriting................................................ 44
Legal Matters............................................... 46
Experts..................................................... 46
Where You Can Find More Information......................... 46
Incorporation of Certain Documents by Reference............. 47
Index to Supplemental Consolidated Financial Statements..... F-1
</TABLE>

You should rely only on the information contained in this prospectus. We
have not authorized any other person to provide you with information that is
different. We are offering to sell, and seeking offers to buy, shares of common
stock only in jurisdictions where offers and sales are permitted. This
prospectus may only be used where it is legal to sell these securities. The
information in this document may only be accurate on the date of this
prospectus, regardless of the time of delivery of this prospectus or of any sale
of our equity shares.

Information contained in our web site does not constitute part of this
document.

Flying P Design-Registered Trademark-, MuraLook-Registered Trademark-,
Photon Dynamics-Registered Trademark-, Voltage Imaging-Registered Trademark- and
the PDI logo are our registered trademarks in the U.S. and other jurisdictions.
BeamBlender-TM-, N-Aliasing-TM- and PixeLaser-TM- are also our trademarks. This
prospectus also contains registered trademarks or servicemarks of other
entities.
<PAGE>
PROSPECTUS SUMMARY

THIS SUMMARY HIGHLIGHTS SELECTED INFORMATION CONTAINED ELSEWHERE IN THIS
PROSPECTUS. THIS SUMMARY DOES NOT CONTAIN ALL OF THE INFORMATION THAT YOU SHOULD
CONSIDER BEFORE MAKING AN INVESTMENT DECISION. THIS PROSPECTUS CONTAINS
FORWARD-LOOKING STATEMENTS WHICH INVOLVE RISKS AND UNCERTAINTIES. OUR RESULTS
COULD DIFFER MATERIALLY FROM THOSE ANTICIPATED IN THESE FORWARD-LOOKING
STATEMENTS AS A RESULT OF VARIOUS FACTORS, INCLUDING THOSE SET FORTH IN "RISK
FACTORS" AND ELSEWHERE IN THIS PROSPECTUS. EXCEPT AS OTHERWISE INDICATED, ALL
INFORMATION IN THIS PROSPECTUS ASSUMES NO EXERCISE OF THE UNDERWRITERS'
OVER-ALLOTMENT OPTION. REFERENCES TO "WE," "US," "OUR" AND "PDI" MEAN PHOTON
DYNAMICS, INC. AND ALL ENTITIES OWNED OR CONTROLLED BY PHOTON DYNAMICS, INC.

PHOTON DYNAMICS, INC.

We believe we are the leading provider of yield management solutions to the
flat panel display, or FPD, industry. We also offer yield management solutions
to the printed circuit board, or PCB, assembly and advanced semiconductor
packaging industries. Our test, repair and inspection systems are used by
manufacturers to collect data, analyze product quality and identify and repair
product defects at critical steps in the manufacturing process.

The end markets served by our customers include a number of large markets
that have experienced rapid growth. These markets include mobile devices such as
notebook computers and cellular phones, and stationary devices such as flat
panel desktop monitors and digital televisions. Manufacturers of mobile
electronic devices are continually seeking ways to increase the performance and
quality, as well as reduce the size, weight and power requirements of the
components incorporated into these devices, such as displays, electronic
assemblies and semiconductors. The market for mobile computers, including
notebook computers and handheld devices, is expected to grow at a rate of 25%
from 18.8 million units in 1998 to 45.2 million units in 2002, according to
Dataquest. Similarly, the cellular phone market is expected to grow at a rate of
27% from 175.4 million units in 1998 to 461.1 million units in 2002, according
to Dataquest. In addition, for stationary applications such as desktop computer
monitors and televisions, consumers have increasingly demanded FPDs due to their
higher resolution and performance and their smaller footprint, lower power
consumption and reduced heat emission. The market for liquid crystal displays,
the principal type of FPD, is expected to grow at a rate of 86% from
approximately 1.3 million units, or 1.5% of the desktop monitor market in 1998,
to 15.5 million units, or 11% of the desktop market by 2002, according to
International Data Corporation.

FPD manufacturers use our test, repair and inspection equipment to increase
yields and quality and to reduce costs. By identifying defects and gathering
data during the manufacturing process, our equipment assists manufacturers in
controlling and refining their manufacturing processes to achieve the production
of zero defect displays at high yields. Our proprietary technologies include:

- Voltage Imaging technology to detect, locate, quantify and characterize
electrical, contamination and other defects in FPDs after array
fabrication;

- PixeLaser and BeamBlender laser technologies for the repair of FPD panels;
and

- N-Aliasing and MuraLook technologies to inspect FPD panels for pixel, line
and blemish defects after cell and module assembly.

We also offer a broad line of X-ray and optical systems for non-destructive
inspection of PCB assemblies and advanced semiconductor packaging. Our X-ray
systems inspect for hidden features inside semiconductor packaging and on PCB
assemblies that have ball grid array, or BGA, solder connections. Our optical
inspection systems inspect PCB assemblies for component presence, correct
component, orientation, polarity, skew, solder integrity and other defects. Our
combined X-ray and optical in-line inspection products enable simultaneous
inspection of both visible and hidden features on PCB assemblies.

1
<PAGE>
Our objective is to enhance our position as a leading supplier of yield
management solutions to the FPD industry and to become a leading supplier of
yield management solutions to advanced segments of the electronics assembly and
semiconductor packaging industries. We plan to achieve these goals by:

- further penetrating existing markets;

- expanding our yield management product offerings;

- extending our technology leadership;

- maintaining and enhancing existing customer relationships; and

- fostering industry standards for yield management and quality.

We maintain our principal offices at 6325 San Ignacio Avenue, San Jose,
California 95119-1202, and our telephone number is (408) 226-9900. Our web site
is located at www.photondynamics.com. Information contained on our web site does
not constitute part of this prospectus.

RECENT DEVELOPMENTS

In November 1999, we acquired all of the outstanding capital stock of CR
Technology, Inc. in exchange for 1,834,251 shares of our common stock. This
transaction was accounted for as a pooling of interests. This strategic
acquisition complements our core capabilities of data acquisition, image
analysis and systems engineering and broadens our product lines to include yield
management solutions to the PCB assembly and advanced semiconductor packaging
markets.

For the quarter ended December 31, 1999, our net revenue was $16.9 million,
compared to net revenue of $6.5 million for the quarter ended December 31, 1998.
Our gross profit for the quarter ended December 31, 1999 was $7.6 million, or
45.0% of net sales, compared to gross profit of $2.3 million, or 34.7% of net
sales, for the quarter ended December 31, 1998. Our net income for the quarter
ended December 31, 1999 was $1.5 million, or $0.14 per diluted share, compared
to a net loss of $1.5 million, or ($0.16) per diluted share, for the quarter
ended December 31, 1998. For the period ended December 31, 1999, shares used in
the computation of income per diluted share were 10.7 million. For the period
ended December 31, 1998, shares used in the computation of loss per diluted
share were 9.1 million.

Operating expenses for the quarter ended December 31, 1999 were
$5.8 million, comprised as follows: $2.2 million of research and development
expenses, $2.7 million of selling, general and administrative expenses and
$0.9 million of non-recurring acquisition expenses. The net income from
operations was $1.8 million for this quarter, with interest income (expense),
net of $76,000, resulting in income before income taxes of $1.9 million. As of
December 31, 1999, we had cash and cash equivalents and short-term investments
of $11.0 million, total assets of $34.4 million and total stockholders' equity
of $24.7 million.

Our bookings for the quarter ended December 31, 1999 were $24.7 million. Our
backlog was $30.0 million as at December 31, 1999. Although our gross margin
fluctuates on a quarterly basis due to production volume and product mix, we
achieved a gross margin of 45% for the quarter ended December 31, 1999, compared
with 35% for the quarter ended December 31, 1998.

2
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THE OFFERING

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<S> <C>
Common stock offered by PDI........................ 1,320,687 shares

Common stock offered by the selling shareholder.... 679,313 shares

Common stock to be outstanding after this
offering......................................... 10,978,168 shares

Use of proceeds.................................... For working capital, capital expenditures,
general corporate purposes and potential
acquisitions. See "Use of Proceeds." We will not
receive any proceeds from the sale of common
stock by the selling shareholder.

Nasdaq National Market symbol...................... PHTN
</TABLE>

The number of shares of our common stock to be outstanding after this
offering is based on the number of shares outstanding as of November 30, 1999
and does not include the following:

- 1,294,587 shares of common stock issuable upon exercise of outstanding
stock options with a weighted average exercise price of approximately
$6.38 per share;

- 636,720 shares of common stock reserved for future issuance under our
stock option plans;

- 312,172 shares of common stock reserved for sale under our employee stock
purchase plan; and

- warrants to purchase 12,067 shares of common stock, exercisable at $5.40
per share.

3
<PAGE>
SUMMARY SUPPLEMENTAL CONSOLIDATED FINANCIAL DATA

The following tables present our summary supplemental consolidated statement
of operations data for fiscal 1995 through 1999 and our summary supplemental
consolidated balance sheet data as of September 30, 1999. Supplemental
consolidated balance sheet data is presented on an actual basis and as adjusted
to reflect the sale of 1,320,687 shares of common stock offered by us in this
offering at an assumed public offering price of $61.00 per share and after
deducting the estimated underwriting discounts and offering expenses and giving
effect to the application of the net proceeds.

Prior to the acquisition, CR Technology prepared its financial statements
based on a fiscal year ended December 31. For fiscal 1999, the selected
supplemental consolidated statements of operations data combine the PDI and CR
Technology results for the twelve months ended September 30, 1999. However, for
fiscal 1995 through 1998, the summary supplemental consolidated statements of
operations data combine the PDI fiscal year ended September 30 with the CR
Technology fiscal year ended December 31. Therefore, the supplemental
consolidated statement of operations data for the fiscal years ended
September 30, 1998 and 1999 both include the CR Technology results of operations
for the three months ended December 31, 1998. The summary supplemental
consolidated balance sheet data as of September 30, 1999 combines the PDI and CR
Technology consolidated balance sheet data as of that date.

Basic net income (loss) per share.............. $ 0.12 $ 0.15 $ (0.22) $ (0.14) $ 0.24
Diluted net income (loss) per share............ $ 0.10 $ 0.14 $ (0.22) $ (0.14) $ 0.23

Shares used in computing:
Basic net income (loss) per share.............. 5,335 8,095 8,702 8,930 9,282
Diluted net income (loss) per share............ 6,160 9,099 8,702 8,930 9,935
</TABLE>

<TABLE>
<CAPTION>
AS OF SEPTEMBER 30, 1999
---------------------------
ACTUAL AS ADJUSTED
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(IN THOUSANDS)
<S> <C> <C>
SUPPLEMENTAL BALANCE SHEET DATA:
Cash, cash equivalents and short-term investments........... $ 8,026 $ 83,526
Working capital............................................. 20,461 95,961
Total assets................................................ 32,067 107,567
Total shareholders' equity.................................. 23,046 98,546
</TABLE>

4
<PAGE>
RISK FACTORS

YOU SHOULD CAREFULLY CONSIDER THE RISKS DESCRIBED BELOW BEFORE INVESTING IN
OUR COMMON STOCK. IF ANY OF THE FOLLOWING RISKS ACTUALLY OCCUR, OUR BUSINESS
COULD BE HARMED. THIS COULD CAUSE THE PRICE OF OUR STOCK TO DECLINE, AND YOU MAY
LOSE PART OR ALL OF YOUR INVESTMENT. THIS PROSPECTUS CONTAINS FORWARD-LOOKING
STATEMENTS THAT INVOLVE RISKS AND UNCERTAINTIES, INCLUDING STATEMENTS ABOUT OUR
FUTURE PLANS, OBJECTIVES, INTENTIONS AND EXPECTATIONS. MANY FACTORS, INCLUDING
THOSE DESCRIBED BELOW, COULD CAUSE ACTUAL RESULTS TO DIFFER MATERIALLY FROM
THOSE DISCUSSED IN ANY FORWARD-LOOKING STATEMENTS.

OUR OPERATING RESULTS ARE DIFFICULT TO PREDICT.

Our quarterly results of operations fluctuate significantly. Many factors
influence our results of operations in a particular quarter. These include:

- volume, mix and timing of orders from our customers;

- scheduling, rescheduling or cancellation of shipments;

- pricing pressures;

- our ability to design, manufacture and commercialize new products on a
cost-effective and timely basis;

- the delay between the time we incur expenses in developing our marketing
and service capabilities and the time we receive benefits from our
improved capabilities;

- costs of components and subsystems incorporated into our products;

- the announcement and introduction of new products by our competitors; and

- changing conditions in the FPD industry.

We currently derive a majority of our revenues from the sale of a small number
of FPD yield management systems ranging in price from $400,000 to $1.5 million.
As a result, the timing of the sale of a single system could have a significant
impact on our quarterly results of operations.

WE DEPEND ON SALES TO A FEW LARGE CUSTOMERS.

The FPD industry is extremely concentrated, with a small number of
manufacturers producing the majority of the world's FPDs. Direct sales to our
top four customers, each of which is a FPD manufacturer, accounted for 55% of
our total revenue in fiscal 1999 and 67% in fiscal 1998. In fiscal 1999, sales
to Ishikawajima-Harima Heavy Industries Co., Ltd., or IHI, Samsung, LG
Electronics and Unipac accounted for 18%, 16%, 11% and 10% of our revenues,
respectively. We currently have no long-term purchase commitments from our
customers, and our sales are generally made through purchase orders. Orders for
our products may be delayed or cancelled with limited or no penalty to our
customers. If one or more of our customers cancel or delay their orders, or if
we lose one or more of our customers, our business could be harmed.

CAPITAL INVESTMENT BY THE FPD INDUSTRY CAN BE HIGHLY CYCLICAL AND MAY DECLINE IN
THE FUTURE.

Our business depends in large part upon the amount of money spent by FPD
manufacturers on capital equipment. This, in turn, depends on the current and
anticipated market demand for FPDs and products incorporating FPDs. Capital
investment by the FPD industry has been highly cyclical as the industry has
reacted to capacity shortages and surpluses. Future industry overcapacity would
likely reduce capital equipment expenditures by FPD manufacturers and reduce the
demand for our products. In addition, we must continually invest in engineering,
research and development and marketing to penetrate our target markets and to
maintain extensive worldwide customer service and support

5
<PAGE>
capabilities. Our ability to quickly reduce these expenses is limited, and,
therefore, any downturns or slowdowns in capital investment by the FPD industry
would harm our business.

WE FACE RISKS ASSOCIATED WITH SELLING SUBSTANTIALLY ALL OF OUR FPD YIELD
MANAGEMENT PRODUCTS TO COMPANIES LOCATED OUTSIDE THE U.S.

Sales to customers outside the U.S. are subject to a number of specialized
risks. Over three-quarters of our total revenue for fiscal 1999 came from
international sales, particularly sales in Japan, Korea and Taiwan. We expect
that most of our sales will continue to come from these countries, where most of
the world's FPD manufacturing occurs. Risks related to international sales
include:

- foreign countries may experience political and economic instability;

- we may have more difficulty in servicing our international customers and
otherwise administering our business internationally;

- we have limited protection for our intellectual property;

- we may have difficulty in accessing local legal protections if we have a
dispute with a local business;

- there may be changes in tariffs and taxes in foreign countries;

- trade restrictions exist between the U.S. and other countries, and
additional restrictions may be adopted;

- we must comply with a wide variety of foreign and U.S. export laws and
restrictions; and

- we must comply with technical standards established by foreign regulatory
bodies.

Our sales to Japan, Taiwan and Korea have been hurt by downturns in these
economies, most recently in 1998. A future downturn in economic conditions in
these countries could result in our customers failing to place new orders for
our products. Also, if the Japanese, Taiwanese and Korean FPD markets do not
grow as we have anticipated, our business would be harmed.

Because our sales and sales through our value-added reseller, IHI, are
denominated in U.S. dollars, fluctuations in currency exchange rates may impact
the price of our products in foreign countries. As a result, both direct sales
by us and sales through IHI may be affected by changes in demand resulting from
fluctuations in interest and currency exchange rates. In addition, to the extent
our sales and costs are denominated in foreign currency, our revenue and results
of operations may be directly affected by fluctuations in foreign currency
exchange rates.

WE MAY HAVE DIFFICULTY IN INTEGRATING THE BUSINESSES OF PDI AND CR TECHNOLOGY.

Integrating PDI and CR Technology may be a complex, time-consuming and
expensive process. Before the merger, PDI and CR Technology operated
independently. Each company had its own business culture, customers, employees
and systems. Following the merger, PDI and CR Technology have commenced
operations as a combined organization, using common information and
communications systems, operating procedures, financial controls and human
resource practices. We may experience difficulties in integrating PDI and CR
Technology. These difficulties may include:

- diversion of management resources from the business of the combined
company;

- incompatibility of business cultures;

- perceived adverse changes in customer service standards, business focus,
billing practices or service offerings available to customers;

6
<PAGE>
- perceived uncertainty in career opportunities, benefits and the long-term
value of stock options available to employees;

- costs and delays in implementing common systems and procedures; and

- potential inefficiencies in delivering services to the customers of the
combined company.

Any of these difficulties could increase our operating costs, harm our
financial performance or cause the loss of customers or employees. Many of these
factors are outside of our control.

WE MAY NOT BE ABLE TO OBTAIN CRITICAL COMPONENTS FROM OUR SINGLE OR LIMITED
SOURCE SUPPLIERS.

We obtain some of the components included in our FPD, PCB assembly and
advanced semiconductor packaging yield management products from a single or a
limited group of suppliers. For example, we currently obtain materials handling
platforms, ultra high-resolution cameras and high-speed image processing systems
for our FPD products from single source suppliers. We also currently obtain
X-ray sources for our PCB assembly and advanced semiconductor packaging products
from limited source suppliers. We have not entered into formal agreements with
any of these suppliers, other than long-term purchase orders and, in some cases,
volume pricing agreements. In addition, alternative sources of supply for these
components may not be available or may be available on unfavorable terms.
Disruptions in supply, price increases for these components, or other changes in
material terms could:

- increase our manufacturing costs or delay product shipments while we
qualify a new supplier;

- require redesigning our products; and

- harm our customer relationships.

WE DEPEND ON OUR RELATIONSHIP WITH IHI TO MARKET OUR FPD PRODUCTS IN JAPAN.

Since June 1997, we have depended on IHI as our exclusive value-added
reseller to sell our array test, repair and inspection systems in Japan, and we
anticipate that this relationship will continue in the future. In fiscal 1999
and fiscal 1998, 18% and 33% of our revenues came from sales to IHI.
Historically, foreign companies have experienced difficulty penetrating the
Japanese market and often depend upon local sales channels to sell their
products in Japan. If IHI reduced the resources allocated to the development,
systems construction, customization, sale and support of our array test, repair
and inspection systems in Japan, our business would be harmed.

In addition, IHI's rights to continue as our exclusive value-added reseller
in Japan are currently unresolved. IHI may have the right to market some or all
of our products in Japan on an exclusive basis, even as to us. If so, we may not
be able to compete effectively in Japan. Although IHI must purchase certain
critical components from us, IHI may manufacture competing array test systems
based on our technology. If this occurs, our business could be harmed.

We have granted IHI the non-exclusive right to manufacture and sell array
test systems based on our technology (excluding technology incorporated into
some critical components) in Korea, Taiwan and several other countries. Although
IHI has never manufactured these products, nor sold these products in countries
other than Japan, our business could be harmed if IHI manufactures and sells
array test systems in competition with our own in these countries.

7
<PAGE>
OUR BACKLOG MAY NOT RESULT IN FUTURE SALES.

We schedule the production of our systems based in part upon order backlog.
Due to possible customer changes in delivery schedules and cancellations of
orders, our backlog at any particular date is not necessarily indicative of
actual sales for any succeeding period. A reduction of backlog during any
particular period, or the failure of our backlog to result in future revenue,
could harm our business.

WE MUST COMPETE EFFECTIVELY IN OUR TARGET MARKETS OR WE WILL LOSE MARKET SHARE.

The FPD, PCB assembly and advanced semiconductor packaging industries are
highly competitive. We face competition from established companies, some of
which are larger, have greater financial, engineering and manufacturing
resources and have larger service organizations. Some of these companies also
have long-standing customer relationships with major manufacturers. In the FPD
industry, our competitors include Micronics Japan Corporation in array test,
NTN Corporation and Hoya Corporation in array repair for the Japanese market,
and several competitors in the cell and module inspection market. In the X-ray
inspection market, our competitors include Nicolet Imaging, Agilent Technologies
and FeinFocus. In the optical inspection market, our competitors include GSI
Lumonics, Hewlett-Packard Company and Omron.

In particular, our success will depend upon our ability to compete
successfully in Japan, Taiwan and Korea. Most of the world's FPD manufacturing
occurs in these countries. Our ability to compete in these countries depends on
the following factors:

- our ability to maintain and establish satisfactory relationships with
leading companies in Japan, Taiwan and Korea;

- our ability to maintain our relationship in Japan with IHI;

- our ability to develop products that meet the technical requirements of
our customers; and

- continued free trade among Japan, Korea and Taiwan and the U.S.

We believe that our Japanese competitors have an advantage in that country
because of the preference of some customers for local equipment suppliers. Also,
local FPD equipment suppliers may have longer standing or closer business
relationships with their customers.

We expect that we will face competition from new entrants in the FPD, PCB
assembly and advanced semiconductor packaging industries and from competitors
using new technologies. We expect that our competitors will continue to improve
the design and performance of their products and will introduce new products
with competitive price/performance characteristics. Our customers may also
develop technology and equipment which may reduce or eliminate their need to
purchase our products.

WE RELY UPON SALES OF A LIMITED RANGE OF PRODUCTS.

A substantial percentage of our revenues have come from a limited range of
products for the FPD, PCB assembly and advanced semiconductor packaging
industries. We expect that these products will continue to account for a
substantial percentage of our revenues. We currently market two primary products
for the FPD industry, our array test and array repair equipment. For the PCB
assembly and advanced semiconductor packaging industries, our primary products
include our X-ray and optical inspection systems. Revenues from these four
products represented 89% of our total revenues in fiscal 1999. The remaining 11%
is based on sales of spare and replacement parts and services. Continued market
acceptance of these primary products is critical to our success. Any decline in
demand for, or failure to achieve continued market acceptance of, our primary
products or any new version of these products, could harm our business.

8
<PAGE>
WE MAY NOT BE ABLE TO DEVELOP AND INTRODUCE NEW PRODUCTS THAT RESPOND TO
EVOLVING INDUSTRY REQUIREMENTS IN A TIMELY MANNER.

The markets for our products are characterized by rapidly changing
technologies and frequent new product introductions. For example, the size of
FPD substrates and resolution of FPDs have changed frequently and may continue
to change, requiring us to redesign or reconfigure our FPD products. Similarly,
as semiconductors, PCBs and semiconductor packaging technologies have become
more complex, CR Technology has been forced to continually redefine its product
offerings. Our success will depend in part upon our ability to continue to
enhance our existing products and to develop or acquire new products in response
to evolving industry requirements. If we are not able to do this, our business
may be harmed. We have experienced delays in the development of new products and
product enhancements in the past and could experience delays in the future.

WE MUST ATTRACT AND RETAIN KEY EMPLOYEES TO MAINTAIN AND GROW OUR BUSINESS.

Our success will depend, in part, on our ability to retain certain key
employees, particularly our senior members of management and engineers. In order
to grow, we must also attract skilled employees in all areas of our business. We
may not be able to retain our existing employees or attract additional skilled
employees in the future. Our failure to do so could harm our business. We have
not entered into employment contracts with any of our employees, other than
Richard Amtower, Vice President of PDI and President of CR Technology, and do
not maintain key employee life insurance for our key employees other than
Richard Amtower.

WE RELY ON OUR SALES REPRESENTATIVES.

We sell our FPD products in Taiwan through a sales representative. We also
market and sell our PCB assembly and advanced semiconductor packaging inspection
products domestically and internationally primarily through sales
representatives. These sales representatives could reduce or discontinue sales
of our products. They may not devote the resources necessary to provide
effective sales and marketing support to us. In addition, we depend upon the
continued viability and financial resources of these representatives, many of
which are small organizations with limited working capital. These
representatives, in turn, depend substantially on general economic conditions
and other factors affecting the markets for the products they sell. We believe
that our success will continue to depend upon these sales representatives. If
some or all of our sales representatives experience financial difficulties, or
otherwise become unable or unwilling to promote and sell our products, our
business could be harmed.

PERFORMANCE, RELIABILITY OR QUALITY PROBLEMS WITH OUR PRODUCTS MAY CAUSE OUR
CUSTOMERS TO REDUCE THEIR ORDERS.

We believe that future orders of our products will depend in part on our
ability to maintain the performance, reliability and quality standards required
by our customers. If our products have performance, reliability or quality
problems, then we may experience:

- delays in collecting accounts receivable;

- reduced orders;

- additional warranty and service expenses; and

- higher manufacturing costs.

9
<PAGE>
WE DEPEND ON THE STRENGTH OF THE AMLCD FPD INDUSTRY.

While our technology is applicable to other FPD technologies, our experience
has been limited to active matrix liquid crystal display, or AMLCD,
applications. Currently, we derived our revenue primarily from sales of products
based upon AMLCD technology. An industry shift away from AMLCD technology to
existing or new competing technologies could reduce the demand for our products
and harm our business.

WE MAY NOT EFFECTIVELY MANAGE POSSIBLE FUTURE GROWTH OR SUCCESSFULLY INTEGRATE
ACQUIRED BUSINESSES.

To manage possible future growth, our management must improve financial and
management controls, management processes, business and management information
systems and expand, train and manage our work force. We may not be successful in
performing these actions. In addition, we may acquire complementary companies,
products or technologies in the future. Managing an acquired business, product
or technology may entail numerous operational and financial risks, including
difficulties in assimilating acquired operations, diversion of management's
attention to other business concerns, amortization of acquired intangible assets
and potential losses of key employees or customers of acquired operations. To be
successful, our management must respond to these challenges effectively. At
present, we do not know if we will be able to effectively achieve and manage
growth, or that our management, personnel or systems will be adequate to support
our operations.

OUR BUSINESS COULD BE HARMED IF WE FAIL TO PROPERLY PROTECT OUR INTELLECTUAL
PROPERTY.

Our success depends in part on our ability to protect our intellectual
property. We rely on patent, trademark and copyright laws and trade secrets to
protect our intellectual property. Any patent owned or licensed by us could be
invalidated, circumvented, or challenged by others. Also, our pending or future
patent applications may not be issued as broadly as we wish, or at all. Even if
issued, rights granted under these patents may not provide significant
competitive advantages to us. Our competitors may develop technologies that are
similar or superior to our technology, duplicate our technology or design around
the patents owned by us. The steps we have taken to protect our intellectual
property may not prevent misappropriation of our technology. Litigation may be
necessary in the future to enforce our patents and other intellectual property
rights, to protect our trade secrets or to determine the validity and scope of
the proprietary rights of others. Even if successful, litigation could be
expensive and divert important management resources. If our intellectual
property is not properly protected, our business would be harmed.

LITIGATION MAY BE NECESSARY TO DEFEND US AGAINST CLAIMS OF INTELLECTUAL PROPERTY
INFRINGEMENT.

Our domestic and international competitors, many of which have substantially
greater resources and have made substantial investments in competing
technologies, may have patents that will prevent, limit or interfere with our
ability to manufacture and sell our products. We have not conducted an
independent review of patents issued to third parties. Third parties may assert
infringement claims, successful or otherwise, against us, and litigation may be
necessary to defend against claims of infringement or invalidity. An adverse
outcome in the defense of a patent suit could subject us to significant
liabilities to third parties, require disputed rights to be licensed from third
parties or require us to cease selling our products. Even successful defenses of
patent suits can be costly and time-consuming.

OUR BUSINESS MAY BE HARMED IF WE FAIL TO COMPLY WITH GOVERNMENTAL REGULATIONS.

Some of our PCB assembly and advanced semiconductor packaging products are
subject to regulation by the U.S. Food and Drug Administration, the California
Department of Public Health and other agencies in each jurisdiction where these
products are sold or used. Compliance with these

10
<PAGE>
regulations is time-consuming and expensive and may delay or even prevent sales
in the U.S. or other jurisdictions. If we fail to comply with these regulations,
we could face fines or penalties, and sales of our products could be prohibited.
These fines, penalties, and prohibitions could harm our business.

Our business is also subject to a variety of governmental regulations
related to the discharge or disposal of toxic, volatile, or otherwise hazardous
chemicals used in our manufacturing process. If we fail to comply with these
regulations, fines could be imposed on us, or we could be ordered to suspend our
production or cease our operations altogether. New environmental regulations
could also require us to purchase expensive equipment or incur other significant
expenses to ensure compliance. Unanticipated environmental compliance costs
could harm our business.

WE MAY EXPERIENCE UNANTICIPATED WARRANTY CLAIMS.

We typically provide a limited warranty on our products for a period of one
year from final acceptance by customers. In addition, for some custom-designed
systems, we may need to comply with certain performance specifications for a
specific application. We may incur substantial warranty claim expenses on our
products or with respect to our obligations to meet custom performance
specifications. Actual warranty claims may exceed recorded allowances, resulting
in harm to our business.

YEAR 2000 ISSUES MAY DISRUPT OUR BUSINESS.

The Year 2000 issue is the result of computer programs being written using
two digits rather than four to define the applicable year. Any of our computer
programs that have date-sensitive software may recognize a date using "00" as
the year 1900 rather than the year 2000. This could result in a system failure
or miscalculations causing the disruption of operations. Specific problems could
include our temporary inability to process transactions, send invoices or engage
in normal business activities. We may not have foreseen and corrected all Year
2000 problems which may result in harm to our business. We do not have a
contingency plan for addressing Year 2000 issues and do not intend to establish
one.

WE FACE RISKS DUE TO OUR RELIANCE ON THE YEAR 2000 COMPLIANCE OF THIRD PARTIES.

We use software developed by third parties in our products and to operate
our business. Our third party software may be affected by Year 2000 issues. We
also rely on third parties to supply some components incorporated into our
products. Our third party suppliers may also be affected by Year 2000 issues.
The failure of third party software or components used by us or by our third
party suppliers to properly process dates for the year 2000 and thereafter could
require us to incur unanticipated expenses to remedy any problems. It could also
disrupt the supply of components necessary for our products.

EARTHQUAKES MAY DAMAGE OUR FACILITIES.

Our corporate and manufacturing facilities in California are located near
major earthquake faults which have experienced earthquakes in the past. In
addition, some of our Asian customers are located near fault lines. In the event
of a major earthquake or other disaster in or near the San Francisco Bay Area or
Southern California, our facilities may sustain significant damage and our
operations could be harmed. Similarly, a major earthquake in Asia, like the one
that occurred in Taiwan in September 1999, could disrupt our operations or the
operations of our Asian customers, which could reduce demand for our products.

11
<PAGE>
OUR STOCK PRICE MAY FLUCTUATE SIGNIFICANTLY.

Our stock price will fluctuate in the future. Price fluctuations may occur
in response to a variety of factors, including the following:

- our quarterly results of operations;

- announcements of new products by us or our competitors;

- changes in either our earnings estimates or investment recommendations by
stock market analysts;

- announcements of technological innovations;

- conditions or trends in the FPD, PCB assembly and advanced semiconductor
packaging industries;

- announcements by us or our competitors of acquisitions, strategic
partnerships or joint ventures; and

- additions or departures of our senior management and other events or
factors many of which are beyond our control.

In addition, in recent years, the stock market in general, and shares of
technology companies in particular, have experienced extreme price fluctuations.
These extreme price fluctuations may continue. These broad market and industry
fluctuations may harm the market price of our common stock.

YOU WILL BE RELYING ON THE JUDGMENT OF OUR MANAGEMENT REGARDING OUR USE OF
PROCEEDS.

We have not designated any specific use for the net proceeds from our sale
of common stock described in this prospectus. Rather, we expect to use the net
proceeds for working capital, capital expenditures, general corporate purposes
and potential acquisitions. Consequently, our management will have significant
flexibility in applying the net proceeds of this offering. You will be relying
on the judgment of our management regarding the application of the proceeds. Our
management will have the ability to change the application of the proceeds of
this offering without shareholder approval.

SOME ANTI-TAKEOVER PROVISIONS MAY AFFECT THE PRICE OF OUR COMMON STOCK.

Our Articles of Incorporation authorize the board of directors to issue up
to 5,000,000 shares of preferred stock. The board also has the authority to
determine the price, rights, preferences and privileges, including voting
rights, of those shares without any further vote or action by the shareholders.
The rights of our shareholders will be subject to, and may be impaired by, the
rights of the holders of any preferred stock that may be issued in the future.
The Articles of Incorporation require advance notice of shareholder proposals
and director nominations. These and other provisions contained in our charter
documents and applicable provisions of California law could serve to depress our
stock price or discourage a hostile bid in which shareholders could receive a
premium for their shares. In addition, these provisions could make it more
difficult for a third party to acquire a majority of our outstanding voting
stock or otherwise effect a change of control of the Company.

FUTURE SALES OF OUR COMMON STOCK MAY CAUSE OUR STOCK PRICE TO DECLINE.

All of our outstanding shares are freely tradeable without restriction or
further registration. Affiliates must sell all shares they own in compliance
with the volume and other requirements of Rule 144, except for the holding
period requirements. Our directors and executive officers and the selling
shareholder have agreed that for a period of 90 days after the date of this
prospectus, they will not directly or indirectly sell any shares of common stock
without the consent of Banc of America Securities LLC and Needham & Company,
Inc. Sales of substantial amounts of common stock by our

12
<PAGE>
shareholders, or even the potential for such sales, may have a depressive effect
on the market price of our common stock and could impair our ability to raise
capital through the sale of our equity securities.

INVESTORS WILL SUFFER IMMEDIATE AND SUBSTANTIAL DILUTION FROM THIS OFFERING.

The public offering price per share in this offering will significantly
exceed our net tangible book value per share. Accordingly, investors purchasing
shares in this offering at an assumed public offering price of $61.00 per share
will suffer immediate and substantial dilution to their investment of $58.61 per
share.

WE DO NOT PAY CASH DIVIDENDS.

We have never paid any cash dividends on our common stock and do not
anticipate that we will pay cash dividends in the future. Instead, we intend to
apply any earnings to the expansion and development of our business.

13
<PAGE>
FORWARD-LOOKING STATEMENTS

This prospectus includes 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. We intend such forward-looking statements to be covered by
the safe harbor provisions for forward-looking statements contained in the
Private Securities Litigation Reform Act of 1995, and we are including this
statement for purposes of complying with these safe harbor provisions. We have
based these forward-looking statements on our current expectations and
projections about future events. These forward-looking statements are not
guarantees of future performance and are subject to risks, uncertainties and
assumptions, including those set forth under "Risk Factors."

Words such as "expect," "anticipate," "intend," "plan," "believe,"
"estimate" and variations of such words and similar expressions are intended to
identify such forward-looking statements. We undertake no obligations to
publicly update or revise any forward-looking statements, whether as a result of
new information, future events or otherwise. In light of these risks,
uncertainties and assumptions, the forward-looking events discussed in this
prospectus might not occur.

14
<PAGE>
USE OF PROCEEDS

We estimate that the net proceeds from the sale of the 1,320,687 shares of
common stock that we are offering at an assumed public offering price of $61.00
per share will be approximately $75.5 million after deducting the underwriting
discounts and commissions and estimated offering expenses payable by us. If the
underwriters exercise their over-allotment option in full, we estimate the net
proceeds from this offering will be approximately $92.7 million.

We expect to use the net proceeds from this offering for working capital,
capital expenditures and general corporate purposes. We may also use a portion
of the net proceeds to acquire other complementary products, technologies or
businesses when the opportunity arises; however, we currently have no
commitments or agreements and are not involved in any other negotiations with
respect to any such transactions. As of the date of this prospectus, we cannot
specify with certainty the particular uses for the net proceeds we will receive
in this offering. Accordingly, our management will have broad discretion in
applying our net proceeds of this offering. Pending such uses, the net proceeds
of this offering will be invested in investment grade, interest-bearing
instruments.

15
<PAGE>
PRICE RANGE OF OUR COMMON STOCK

Our common stock has been traded on the Nasdaq National Market under the
symbol "PHTN" since November 15, 1995. The following table sets forth for the
period indicated the high and low sale prices for our common stock, as reported
by the Nasdaq National Market.

<TABLE>
<CAPTION>
HIGH LOW
-------- --------
<S> <C> <C>
Fiscal year ended September 30, 1998
First Quarter............................................ $ 7.38 $ 2.50
Second Quarter........................................... 3.75 2.38
Third Quarter............................................ 5.56 3.19
Fourth Quarter........................................... 3.63 2.00

Fiscal year ended September 30, 1999
First Quarter............................................ $ 5.63 $ 2.25
Second Quarter........................................... 8.25 3.94
Third Quarter............................................ 12.38 7.00
Fourth Quarter........................................... 25.75 10.63

Fiscal year ended September 30, 2000
First Quarter............................................ $43.25 $20.125
Second Quarter (through January 25, 2000)................ 69.00 32.375
</TABLE>

On January 25, 2000 the last reported sale price of our common stock on the
Nasdaq National Market was $61.00. As of November 30, 1999 there were 9,657,481
shares of our common stock outstanding held by approximately 120 holders of
record.

DIVIDEND POLICY

We have never declared or paid any cash dividends on our capital stock. We
currently intend to retain earnings, if any, to support the development of our
business and do not anticipate paying cash dividends for the foreseeable future.
Payment of future dividends, if any, will be at the discretion of our board of
directors after taking into account various factors, including our financial
condition, operating results and current and anticipated cash needs.

16
<PAGE>
CAPITALIZATION

The following table sets forth on an unaudited basis our capitalization as
of September 30, 1999 and as adjusted to reflect the sale of the 1,320,687
shares of common stock we are offering at an assumed public offering price of
$61.00 per share and the receipt of the estimated net proceeds, after deducting
the underwriting discounts and our estimated offering expenses.

<TABLE>
<CAPTION>
AS OF SEPTEMBER 30, 1999
-------------------------
ACTUAL AS ADJUSTED
----------- -----------
(IN THOUSANDS,
EXCEPT SHARE DATA)
<S> <C> <C>
Cash, cash equivalents and short-term investments........... $ 8,026 $ 83,526
======== ========

Shareholders' equity:
Preferred stock; no par value; 5,000,000 shares
authorized; none issued and outstanding, actual and as
adjusted................................................ -- --
Common stock; no par value; 20,000,000 shares authorized;
9,648,571 shares issued and outstanding, actual and as
adjusted................................................ 45,972 121,472
Accumulated deficit......................................... (22,929) (22,929)
Accumulated other comprehensive income...................... 3 3
-------- --------
Total shareholders' equity.............................. 23,046 98,546
-------- --------
Total capitalization.................................... $ 23,046 $ 98,546
======== ========
</TABLE>

The number of outstanding shares as of September 30, 1999 excludes:

- 1,197,752 shares of common stock issuable upon exercise of outstanding
stock options with a weighted average exercise price of approximately
$4.62 per share;

- 392,664 shares of common stock reserved for future issuance under our
stock option plans;

- 62,172 shares of common stock reserved for sale under our employee stock
purchase plan; and

- warrants to purchase 12,067 shares of common stock, exercisable at $5.40
per share.

17
<PAGE>
SELECTED SUPPLEMENTAL CONSOLIDATED FINANCIAL DATA

The following selected supplemental consolidated financial information of
PDI as of September 30, 1998 and 1999 and for the fiscal years ended
September 30, 1998 and 1999, has been derived from and should be read in
conjunction with the audited supplemental consolidated financial statements of
PDI included elsewhere in this prospectus. The selected historical consolidated
financial information of PDI as of September 30, 1995, 1996 and 1997 and for the
fiscal years ended September 30, 1995, 1996 and 1997 has been combined from the
separate audited consolidated financial statements of PDI and CR Technology
which are not included in this prospectus.

Prior to the acquisition, CR Technology prepared its financial statements
based on a fiscal year ended December 31. For fiscal 1999, the selected
supplemental consolidated statements of operations data combine the PDI and CR
Technology results for the twelve months ended September 30, 1999. However, for
fiscal 1995 through 1998, the selected supplemental consolidated statements of
operations data combine the PDI fiscal year ended September 30 with the CR
Technology fiscal year ended December 31. Therefore, the consolidated
supplemental statement of operations data for the fiscal years ended
September 30, 1998 and 1999 both include the CR Technology results of operations
for the three months ended December 31, 1998.

The selected supplemental consolidated balance sheet data as of
September 30, 1999 combines the PDI and CR Technology consolidated balance sheet
data as of that date. However, for fiscal 1995 through 1998, the September 30
selected supplemental consolidated balance sheet data combines the PDI balance
sheet data as of September 30 with the CR Technology balance sheet data as of
December 31.

<TABLE>
<CAPTION>
FISCAL YEAR ENDED SEPTEMBER 30,
----------------------------------------------------
1995 1996 1997 1998 1999
-------- -------- -------- -------- --------
(IN THOUSANDS, EXCEPT PER SHARE DATA)
<S> <C> <C> <C> <C> <C>
STATEMENT OF OPERATIONS DATA:
Revenue..................................................... $21,617 $28,388 $30,215 $30,970 $45,431
Cost of revenue............................................. 13,297 15,033 16,967 17,879 25,573
------- ------- ------- ------- -------
Gross margin................................................ 8,320 13,355 13,248 13,091 19,858
Operating expenses:
Research and development.................................. 1,881 4,303 8,067 6,523 5,943
Selling, general and administrative....................... 5,266 7,304 7,445 8,321 11,140
Asset write-off (recovery) related to product line
disposal................................................ -- 844 -- (350) --
------- ------- ------- ------- -------
Total operating expenses.................................... 7,147 12,451 15,512 14,494 17,083
------- ------- ------- ------- -------
Operating income (loss)..................................... 1,173 904 (2,264) (1,403) 2,775
Interest income (expense) and other......................... (515) 393 268 269 171
------- ------- ------- ------- -------
Income (loss) before income taxes........................... 658 1,297 (1,996) (1,134) 2,946

Provision (benefit) for income taxes........................ 14 52 (114) 73 673
------- ------- ------- ------- -------
Net income (loss)........................................... $ 644 $ 1,245 $(1,882) $(1,207) $ 2,273
======= ======= ======= ======= =======
Basic net income (loss) per share........................... $ 0.12 $ 0.15 $ (0.22) $ (0.14) $ 0.24
======= ======= ======= ======= =======
Diluted net income (loss) per share......................... $ 0.10 $ 0.14 $ (0.22) $ (0.14) $ 0.23
======= ======= ======= ======= =======
Shares used in computing:
Basic net income (loss) per share......................... 5,335 8,095 8,702 8,930 9,282
Diluted net income (loss) per share....................... 6,160 9,099 8,702 8,930 9,935
</TABLE>

<TABLE>
<CAPTION>
AS OF SEPTEMBER 30,
----------------------------------------------------
1995 1996 1997 1998 1999
-------- -------- -------- -------- --------
(IN THOUSANDS)
<S> <C> <C> <C> <C> <C>
BALANCE SHEET DATA:
Cash, cash equivalents and short-term investments........... $ 596 $10,118 $ 5,401 $ 6,295 $ 8,026
Working capital............................................. 1,461 19,219 17,243 16,993 20,461
Total assets................................................ 12,311 27,730 27,325 25,191 32,067
Total shareholders' equity.................................. 2,375 21,982 20,568 19,568 23,046
</TABLE>

18
<PAGE>
MANAGEMENT'S DISCUSSION AND ANALYSIS OF
FINANCIAL CONDITION AND RESULTS OF OPERATIONS

THE FOLLOWING DISCUSSION OF OUR FINANCIAL CONDITION AND RESULTS OF
OPERATIONS SHOULD BE READ IN CONJUNCTION WITH OUR SUPPLEMENTAL CONSOLIDATED
FINANCIAL STATEMENTS INCLUDED ELSEWHERE IN THIS PROSPECTUS. THIS DISCUSSION
CONTAINS FORWARD-LOOKING STATEMENTS WHICH INVOLVE RISKS AND UNCERTAINTIES. OUR
ACTUAL RESULTS COULD DIFFER MATERIALLY FROM THOSE ANTICIPATED IN THE
FORWARD-LOOKING STATEMENTS AS A RESULT OF CERTAIN FACTORS, INCLUDING BUT NOT
LIMITED TO THOSE DISCUSSED IN "RISK FACTORS" AND ELSEWHERE IN THIS PROSPECTUS.

OVERVIEW

We believe we are the leading provider of yield management solutions to the
FPD industry. We also offer yield management solutions for the PCB assembly and
advanced semiconductor packaging industries. Our test, repair and inspection
systems are used by manufacturers to collect data, analyze product quality and
identify and repair product defects at critical steps in the manufacturing
process.

We derive our revenue primarily from sales in Japan, Korea and Taiwan, where
FPD production is concentrated. However, with our recent acquisition of CR
Technology, which derives the majority of its revenues in North America, we have
diversified our geographic revenue mix. We derived approximately 76% of our
revenue in fiscal 1999 and 72% in fiscal 1998 from customers outside North
America. Substantially all of our sales are made in U.S. dollars.

Sales outside North America accounted for $34.3 million of our revenue in
fiscal 1999 and $22.1 million in fiscal 1998. Sales in Japan decreased to
$8.3 million, or 18% of revenue, in fiscal 1999 from $10.2 million, or 33% of
revenue, in fiscal 1998. Sales in Taiwan increased to $11.3 million, or 25% of
revenue, in fiscal 1999 from $927,000, or 3% of revenue, in fiscal 1998. Sales
in Korea increased to $12.2 million, or 27% of revenue, in fiscal 1999 from
$10.4 million, or 34% of revenue, in fiscal 1998.

In 1998, financial difficulties in Japan and Korea, combined with a decline
in FPD prices, caused our FPD customers to reduce their capital equipment
purchases. We incurred losses in 1998, not only because of this downturn, but
also because we continued to invest in research and development and in building
our infrastructure. In 1999, our revenues increased and we returned to
profitability in large part because the financial environment improved in Japan
and Korea, FPD industry conditions recovered and we captured a larger share of
the FPD market.

We derive most of our revenues from a small number of customers, and we
expect this to continue. Our top four customers, each of which is an FPD
manufacturer, contributed 55% of revenue in fiscal 1999, compared to 67% in
fiscal 1998. Our products for the FPD industry accounted for 69% of revenue in
fiscal 1999, compared to 72% in fiscal 1998.

We generally recognize revenues from product sales upon shipment, which
usually precedes final acceptance, and record a provision for estimated warranty
costs at that time. We typically provide a limited warranty on our products for
a period of one year from final acceptance by customers. We recognize revenues
from service contracts ratably over the contract period. We sell our products on
net-30 day terms with a small portion held back until final acceptance; however,
a substantial portion of our customers, primarily foreign, remit payments on
significantly longer terms.

We obtain revenues from the FPD industry through direct sales in Korea, our
sales representative in Taiwan and our value-added reseller, IHI, in Japan.
Sales to IHI were $8.3 million in fiscal 1999 as compared to $10.2 million in
fiscal 1998. IHI purchases our equipment for resale in Japan and we recognize
revenues from IHI upon shipment. IHI provides installation, certain custom
modifications and field service support to their customers. Our personnel at our
wholly-owned Japanese subsidiary engage in joint sales and service activities in
conjunction with IHI. In fiscal 1999 and fiscal 1998, 18% and 33%, of our
revenues came from sales to IHI.

19
<PAGE>
In November 1999, we acquired all of the outstanding capital stock of CR
Technology, Inc. in exchange for 1,834,251 shares of our common stock. This
strategic acquisition complements our core capabilities of data acquisition,
image analysis and systems engineering and enables us to broaden our product
lines to offer yield management solutions to the PCB assembly and advanced
semiconductor packaging markets.

COMPARISON OF THE FISCAL YEARS ENDED SEPTEMBER 30, 1998 AND 1999

In connection with the acquisition of CR Technology in November 1999,
accounted for as a pooling of interests, all financial data for the prior
periods have been restated to include CR Technology.

CONSOLIDATED RESULTS OF OPERATIONS

The following table sets forth operating data as a percentage of revenue.

<TABLE>
<CAPTION>
FISCAL YEAR ENDED
SEPTEMBER 30,
---------------------
1998 1999
-------- --------
<S> <C> <C>
Revenue..................................................... 100.0% 100.0%
Cost of revenue............................................. 57.7 56.3
----- -----
Gross margin................................................ 42.3 43.7
----- -----
Operating expenses:
Research and development.................................. 21.1 13.1
Selling, general and administrative....................... 26.8 24.5
Asset recovery related to product line disposal........... (1.1) 0.0
----- -----
Total operating expenses................................ 46.8 37.6
----- -----
Operating income (loss)..................................... (4.5) 6.1
Interest income (expense) and other......................... 0.8 0.4
----- -----
Income (loss) before income taxes........................... (3.7) 6.5
Provision for income taxes.................................. 0.2 1.5
----- -----
Net income (loss)........................................... (3.9)% 5.0%
===== =====
</TABLE>

REVENUE. Revenue increased 46% to $45.4 million in fiscal 1999 from
$31.0 million in fiscal 1998. The increase in revenue for fiscal 1999 was due to
increased shipments of FPD yield management equipment, particularly in Taiwan,
and increased sales of our X-ray and optical inspection system products. Our
backlog was approximately $21.4 million at September 30, 1999 as compared to
approximately $10.4 million as of September 30, 1998. Our backlog may not result
in future revenues.

GROSS MARGIN. Our gross margin increased to 44% in fiscal 1999 from 42% in
fiscal 1998 largely due to manufacturing efficiencies resulting from higher
production volumes. These margin improvements were partially offset by lower
than typical gross margins from shipments to Taiwan. Overall gross margins will
fluctuate on a quarterly basis due to our production volume and product mix,
among other factors.

20
<PAGE>
RESEARCH AND DEVELOPMENT. We reduced our research and development expenses
to $5.9 million, or 13% of revenue, in fiscal 1999 from $6.5 million, or 21% of
revenue, in fiscal 1998, primarily due to reduced spending for consultants and
materials for development activities. In fiscal 1998, we were developing major
enhancements to our ArrayChecker test system which were largely complete by
fiscal 1999. We expect that our investment in research and development will
increase in fiscal 2000 as we begin new development projects.

SELLING, GENERAL AND ADMINISTRATIVE. Selling, general and administrative
expenses increased to $11.1 million, or 25% of revenue, in fiscal 1999 from
$8.3 million, or 27% of revenue, in fiscal 1998, largely due to higher
commissions and other selling expenses related to increases in orders and
revenue. Business development expenses also increased in fiscal 1999. Selling
expenses fluctuate based on our product and geographic sales mix, which have
different sales channels and associated cost structures. We expect selling,
general and administrative expenses to increase in fiscal 2000 and in future
periods.

ASSET RECOVERY RELATED TO PRODUCT LINE DISPOSAL. During the quarter ended
December 31, 1997, we received $350,000 related to discontinuing our defect
monitoring tool product in September 1996. We expensed the inventory and assets
associated with this product in fiscal 1996.

INTEREST INCOME (EXPENSE) AND OTHER. Interest income (expense) and other
decreased to $171,000 in fiscal 1999 from $269,000 in fiscal 1998. Interest
income (expense) and other consists of interest income, interest expense,
foreign exchange gains and losses, and other miscellaneous income and expenses.

PROVISION FOR INCOME TAXES. The fiscal 1999 tax provision of $673,000 is
lower than the expected tax at statutory rates due to the utilization of net
operating losses. As of September 30, 1999, we had federal and state net
operating loss carryforwards of approximately $12.1 million and $320,000,
respectively. We also had federal and state research and development tax credit
carryforwards of approximately $1.3 million and $750,000, respectively. The net
operating loss and credit carryforwards will expire at various times beginning
in 2000 through 2018, if not utilized. As of September 30, 1999, we had deferred
tax assets of approximately $9.7 million, which has been fully reserved by
valuation allowance and which consist primarily of net operating loss, research
and development tax credit carryforwards, and reserves and other accrued
expenses not yet deductible for income tax purposes. These deferred tax assets
will be recognized in future periods as taxable income is realized and
consistent profits are reported.

21
<PAGE>
QUARTERLY RESULTS OF OPERATIONS

The following table presents unaudited consolidated statement of operations
data for each of the eight quarters ended September 30, 1999, as well as such
data expressed as a percentage of net sales. The consolidated quarterly
statement of operations below combines the PDI and CR Technology results of
operations in the same manner as the annual statements such that the operating
results of CR Technology for the three months ended December 31, 1998 are
included in the results for both the quarters ended September 30, 1998 and
December 31, 1998. We believe that all necessary adjustments have been included
to fairly present the quarterly information when read in conjunction with the
consolidated financial statements. The operating results for any quarter are not
necessarily indicative of the results for any subsequent quarter.

<TABLE>
<CAPTION>
QUARTER ENDED
-------------------------------------------------------------------------------------
DEC. 31, MAR. 31, JUN. 30, SEP. 30, DEC. 31, MAR. 31, JUN. 30, SEP. 30,
1997 1998 1998 1998 1998 1999 1999 1999
-------- -------- -------- -------- -------- -------- -------- --------
(IN THOUSANDS)
<S> <C> <C> <C> <C> <C> <C> <C> <C>
Revenue................................... $7,379 $9,472 $7,637 $ 6,482 $ 6,504 $10,326 $13,700 $14,901
Cost of revenue........................... 3,804 5,435 4,255 4,385 4,249 5,857 7,499 7,968
------ ------ ------ ------- ------- ------- ------- -------
Gross margin.............................. 3,575 4,037 3,382 2,097 2,255 4,469 6,201 6,933
Operating expenses:
Research and development................ 1,989 1,599 1,578 1,357 1,309 1,353 1,641 1,640
Selling, general and administrative..... 1,903 2,065 1,891 2,462 2,471 2,780 2,823 3,066
Asset recovery related to product line
disposal.............................. (350) -- -- -- -- -- -- --
------ ------ ------ ------- ------- ------- ------- -------
Total operating expenses.................. 3,542 3,664 3,469 3,819 3,780 4,133 4,464 4,706
------ ------ ------ ------- ------- ------- ------- -------
Operating income (loss)................... 33 373 (87) (1,722) (1,525) 336 1,737 2,227
Interest income (expense) and other....... 56 50 116 47 (9) 53 60 67
------ ------ ------ ------- ------- ------- ------- -------
Income (loss) before income taxes......... 89 423 29 (1,675) (1,534) 389 1,797 2,294
Provision (benefit) for income taxes...... -- 64 (30) 39 (46) 110 319 290
------ ------ ------ ------- ------- ------- ------- -------
Net income (loss)......................... $ 89 $ 359 $ 59 $(1,714) $(1,488) $ 279 $ 1,478 $ 2,004
====== ====== ====== ======= ======= ======= ======= =======
</TABLE>

<TABLE>
<CAPTION>
QUARTER ENDED
-------------------------------------------------------------------------------------
DEC. 31, MAR. 31, JUN. 30, SEP. 30, DEC. 31, MAR. 31, JUN. 30, SEP. 30,
1997 1998 1998 1998 1998 1999 1999 1999
-------- -------- -------- -------- -------- -------- -------- --------
(PERCENTAGE OF REVENUE)
<S> <C> <C> <C> <C> <C> <C> <C> <C>
Revenue................................... 100.0% 100.0% 100.0% 100.0% 100.0% 100.0% 100.0% 100.0%
Cost of revenue........................... 51.6 57.4 55.7 67.6 65.3 56.7 54.7 53.5
----- ----- ----- ----- ----- ----- ----- -----
Gross margin.............................. 48.4 42.6 44.3 32.4 34.7 43.3 45.3 46.5
Operating expenses:
Research and development................ 26.9 16.9 20.6 20.9 20.1 13.1 12.0 11.0
Selling, general and administrative..... 25.8 21.8 24.8 38.0 38.0 26.9 20.6 20.6
Asset recovery related to product line
disposal.............................. (4.7) -- -- -- -- -- -- --
----- ----- ----- ----- ----- ----- ----- -----
Total operating expenses.................. 48.0 38.7 45.4 58.9 58.1 40.0 32.6 31.6
----- ----- ----- ----- ----- ----- ----- -----
Operating income (loss)................... 0.4 3.9 (1.1) (26.5) (23.4) 3.3 12.7 14.9
Interest income (expense) and other....... 0.8 0.6 1.5 0.7 (0.2) 0.5 0.4 0.4
----- ----- ----- ----- ----- ----- ----- -----
Income (loss) before income taxes......... 1.2 4.5 0.4 (25.8) (23.6) 3.8 13.1 15.3
Provision (benefit) for income taxes...... 0.0 0.7 (0.4) 0.6 (0.7) 1.1 2.3 1.9
----- ----- ----- ----- ----- ----- ----- -----
Net income (loss)......................... 1.2% 3.8% 0.8% (26.4)% (22.9)% 2.7% 10.8% 13.4%
===== ===== ===== ===== ===== ===== ===== =====
</TABLE>

In 1998, financial difficulties in Japan and Korea combined with a decline
in FPD prices caused our FPD customers to reduce their capital equipment
purchases. Despite incurring net losses in the third and fourth calendar
quarters of 1998, we continued to invest in research and development and build
our infrastructure. Beginning in the first calendar quarter of 1999, our
revenues increased and we returned to profitability in large part because the
financial environment improved in Japan and Korea, FPD industry conditions
recovered and we captured a larger share of the FPD market.

22
<PAGE>
Research and development expenses decreased in the third calendar quarter of
1998, primarily due to reduced spending for consultants and materials for
development activities. We were developing major enhancements to our
ArrayChecker test system which were largely complete by the second calendar
quarter of 1998. Our investment in research and development increased in the
first calendar quarter of 1999 as we began new development projects.

LIQUIDITY AND CAPITAL RESOURCES

We have financed our growth primarily by a combination of equity financing,
loans, lines of credit, and cash flows from operations. As of September 30,
1999, we had working capital of $20.5 million of which $8.0 million was cash,
cash equivalents and short-term investments.

Cash provided by operating activities was $1.4 million for fiscal 1999.
Working capital items that significantly impacted cash balances were accounts
receivable, inventories, accounts payable, and accrued expenses and other
liabilities. Our accounts receivable balance increased $6.2 million to
$13.6 million in fiscal 1999 from $7.4 million in fiscal 1998 due to higher
shipments. We reduced inventories $1.1 million to $7.1 million in fiscal 1999
from $8.2 million in fiscal 1998. Accounts payable increased $973,000 to
$2.8 million in fiscal 1999 from $1.9 million in fiscal 1998 due to the purchase
of additional materials required to meet increased production requirements. The
increase of $1.9 million in accrued expenses and other liabilities to
$5.5 million in fiscal 1999 from $3.6 million in fiscal 1998 is attributable to
the higher number of systems under warranty in addition to higher commission and
incentive expenses associated with increases in orders and revenue.

Capital expenditures were $908,000 in fiscal 1999 and were $790,000 in
fiscal 1998.

We have entered into a $3.5 million bank line of credit which expires in
March 2000. This line of credit is secured by substantially all of the Company's
assets and contains certain financial and other covenants. We are eligible to
borrow against accounts receivable and a portion of inventories. Borrowings
under this line of credit bear interest at prime rate plus 1.00% to 1.25% (9.25%
to 9.50% as of September 30, 1999). As of September 30, 1999, no amounts were
outstanding under this bank line of credit, and we were in compliance with all
bank covenants.

We also have a $1.5 million revolving bank line of credit which we acquired
as part of the CR Technology acquisition. This line of credit expires in
February 2001 and is secured by substantially all of CR Technology's assets and
contains certain financial and other covenants. We are eligible to borrow on an
unsecured basis. Borrowings under this line of credit bear interest at prime
rate (8.25% as of September 30, 1999). As of September 30, 1999, no amounts were
outstanding under this revolving line of credit, and we were in compliance with
all bank covenants.

We believe that cash, cash equivalents, short-term investments, borrowings
from the line of credit and cash flows from operations will be sufficient to
satisfy working capital requirements and capital equipment needs for at least
the next twelve months. As of September 30, 1999, we had no material outstanding
commitments to purchase or lease capital equipment.

We believe that success in our industry requires substantial capital in
order to maintain flexibility to take advantage of opportunities as they may
arise. We may, from time to time, invest in or acquire complementary businesses,
products or technologies and may seek additional equity or debt financing to
fund such activities. There can be no assurance that such funding will be
available to us on commercially reasonable terms. The sale of additional equity
or convertible debt could result in dilution to our shareholders.

23
<PAGE>
YEAR 2000 COMPUTER SYSTEM COMPLIANCE

The Year 2000 issue is the result of computer programs being written using
two digits rather than four to define the applicable year. Any of our computer
programs that have date-sensitive software may recognize a date using "00" as
the year 1900 rather than the year 2000. This could result in a system failure
or miscalculations causing disruptions of operations, including, among other
things, a temporary inability to process transactions, send invoices or engage
in similar normal business activities. In addition to our own systems, we rely,
directly and indirectly, on external systems of our customers, creditors,
financial organizations, utility providers, and government entities, both
domestic and international. Consequently, we could be affected by disruptions in
the operations of these third parties with which we interact.

We have established a task force to address internal and external Year 2000
issues. To date, we have made several modifications to our product software,
enterprise software and network software to help ensure Year 2000 compliance.
Although we believe that our products and internal systems are currently Year
2000 compliant, third parties with which we interact may not be Year 2000
compliant. Failure of third party enterprises to achieve Year 2000 compliance
could harm our business.

We continue to evaluate the estimated costs associated with the efforts to
prepare for Year 2000 based on actual experience. While the efforts will involve
additional costs, we believe that we will be able to manage our total Year 2000
transition without harm to our business. As of September 30, 1999, we had
incurred approximately $36,000 in costs to achieve Year 2000 compliance. The
actual outcomes and results could be affected by many factors. These factors
include:

- continued availability of skilled personnel;

- cost control;

- ability to locate and correct software code problems;

- critical suppliers and subcontractors meeting their commitments to be Year
2000 compliant; and

- timely actions by customers.

We anticipate that we will remediate all Year 2000 risks and be able to
conduct normal operations without having to establish a Year 2000 contingency
plan. Accordingly, we do not have a contingency plan and do not intend to
establish one. Furthermore, we may not have foreseen and corrected all Year 2000
problems which may disrupt our business.

24
<PAGE>
BUSINESS

INTRODUCTION

We believe we are the leading provider of yield management solutions to the
flat panel display, or FPD, industry. We also offer yield management solutions
for the printed circuit board, or PCB, assembly and advanced semiconductor
packaging industries. Our test, repair and inspection systems are used by
manufacturers to collect data, analyze product quality and identify and repair
product defects at critical steps in the manufacturing process.

INDUSTRY BACKGROUND

Advancing technology and increasing demand for connectivity among electronic
devices have promoted the development and growing use of increasingly
sophisticated mobile electronic devices, such as notebook computers, cellular
phones, personal digital assistants and portable video games. Consequently,
manufacturers of mobile electronic devices are continually seeking ways to
increase the performance and quality, as well as reduce the size, weight and
power requirements of the components incorporated into these devices, such as
displays, electronic assemblies and semiconductors. The market for mobile
computers, including notebook computers and handheld devices, is expected to
grow at a rate of 25% from 18.8 million units in 1998 to 45.2 million units in
2002, according to Dataquest. Similarly, the cellular phone market is expected
to grow at a rate of 27% from 175.4 million units in 1998 to 461.1 million units
in 2002, according to Dataquest.

For stationary devices, including desktop computer monitors and televisions,
consumers have increasingly demanded higher resolution and performance, as well
as reduced footprint, power consumption and heat emission. In response to these
market demands, the desktop monitor and television industries have increasingly
adopted FPDs, as an alternative to traditional cathode ray tube, or CRT,
technology. The market for liquid crystal displays, or LCDs, the principal type
of FPD, is expected to grow at a rate of 86% from approximately 1.3 million
units, or 1.5% of the desktop monitor market in 1998, to 15.5 million units, or
11% of the desktop market by 2002, according to International Data Corporation.

As advanced electronics manufacturers ramp up production to meet increased
market demands, they are also seeking to improve the quality and reduce the cost
of their products by improving manufacturing yields and throughput. To do so,
they are increasing the use of more advanced test, repair and inspection
equipment and other yield management technologies.

THE FLAT PANEL DISPLAY INDUSTRY

Growth in the mobile electronic devices market has driven the demand for
FPDs, which offer many advantages over CRTs for mobile applications. FPDs offer
reduced size, weight, power consumption and heat emission and better picture
quality. As a result, FPDs have emerged as the dominant display technology for
mobile electronic devices and have also made inroads into stationary display
markets, such as the desktop monitor and television markets.

In recent years, the FPD manufacturing industry has matured significantly.
Korea and Taiwan have emerged as major centers of FPD manufacturing, whereas
previously the industry had been concentrated in Japan. The emergence of new
competition in the FPD industry has accelerated advances in the FPD
manufacturing process, including a move towards adoption of a standard, larger
plate size. By moving to a standard plate size, FPD manufacturers may prolong
the useful life of their equipment, thereby reducing costs. This larger plate
size also increases flexibility to manufacture different and larger display
sizes. In addition, the competition has resulted in a move to a zero defect
quality standard. Furthermore, as the supply of displays and their importance to
computer systems have become more critical, computer OEMs, such as Dell Computer
Corporation and Apple Computer, Inc.,

25
<PAGE>
have invested in or entered into long-term supply agreements with FPD
manufacturers. As the industry has matured, better manufacturing processes have
been developed, leading to lower cost, higher quality and higher resolution
displays.

In addition to their dominance of high performance portable display
applications, FPDs offer key advantages for stationary display applications,
even though they are currently more expensive than CRTs with comparable viewing
areas. Key advantages of FPDs over CRTs include:

- reduced size;

- less weight;

- less power consumption;

- reduced heat emission; and

- sharper, higher resolution images.

Improvements in FPD technology together with the following market trends
have contributed to the growth in demand for FPDs in stationary display markets,
such as desktop monitors and televisions.

- The growth of the world wide web has resulted in a dramatic increase in
the use of mobile and stationary devices for entertainment and information
gathering purposes. As a result, consumers spend more time viewing their
monitors, which has spurred the demand for both mobile and stationary
display technologies with sharper, higher resolution images.

- Emerging technologies, such as high-definition television and very
high-resolution desktop applications, are better viewed on FPDs that
provide for higher resolution pictures than CRTs.

- Consumers today have more disposable income, which may be allocated to
purchases of more sophisticated electronic products.

- Computers and other electronic devices are becoming less expensive,
allowing consumers to allocate a greater portion of the overall system
cost to the display.

- OEMs are promoting sales of FPDs by bundling computers with FPDs.

The highest performance FPD available today is the active matrix liquid
crystal display, or AMLCD, which produces full color images and operates at much
faster refresh rates than earlier passive monochrome LCDs. The color capability,
resolution, speed and picture quality of AMLCDs currently make these displays a
preferred choice for high performance portable computer, multimedia and other
applications requiring the display of video and graphics. DisplaySearch
estimates that AMLCDs will represent approximately 78% of the overall dollar
volume of the FPD market in 1999.

THE AMLCD MANUFACTURING PROCESS

The manufacture of AMLCDs is an extremely complex process, which is
developed and refined for different panel sizes and resolutions through research
and development, pre-production prototyping and commercial production.
Manufacturing an AMLCD involves a series of three principal phases. The first
phase is to fabricate an array of thin-film transistors on a glass substrate
through a process which is essentially the same as that used to create
electronic circuitry on a semiconductor device. In a high-quality color AMLCD,
each pixel, the smallest addressable dot on the display, is represented by three
transistors, one for each of the display's primary colors, red, green and blue.
The second phase, cell assembly, involves attaching a color filter to the
transistor-embedded substrate and injecting liquid crystal material between the
color filter and the transistor array. The color filter enables the display to
attain color capability by selectively filtering out the light emissions from
each multi-color pixel array to produce the desired color mix in the displayed
image. At the cell assembly phase, each individual pixel is created through the
combination of transistors and the color filter. The third phase in the process,

26
<PAGE>
module assembly, involves packaging the display and attaching the electronics
that will allow the device to display the text, graphics and video images
directed by the computer or other electronic systems to the AMLCD. This step
also involves sealing the FPD and installing the electronics that connect the
FPD to other electronic devices like a computer. The following diagram
illustrates these three principal phases in the manufacture of an AMLCD:

[Graphic depicting the AMLCD manufacturing process with the caption "AMLCD
manufacturing process". The graphics depicts a series of boxes connected by
arrows representing the following key steps of the AMLCD manufacturing process:
array fabrication; array pattern inspection; array repair; array test; array
repair; cell assembly; cell inspection; cell repair; module assembly; module
inspection; and module repair. The array fabrication, array pattern inspection,
array repair, and array test boxes are grouped by a dotted line with the caption
"Array Fabrication Phase". The cell assembly, cell inspection and cell repair
boxes are grouped by a dotted line with the caption "Cell Assembly Phase". The
module assembly, module inspection, and module repair boxes are grouped by a
dotted line with the caption "Module Assembly Phases". The steps in the
manufacturing process in which FPD manufacturers use PDI's systems are indicated
in bold. Text beneath the diagram is a box followed by the text: "Indicates
steps that use our systems."]

The ability of FPD manufacturers to improve yields of AMLCDs and other FPDs
depends in large part on their ability to test and inspect displays both during
and upon completion of the manufacturing process and to use test and inspection
data to refine the manufacturing process. Through test and inspection, the FPD
manufacturer seeks to identify defects at an early stage in the process to
permit repair or to avoid wasting costly materials on continued manufacturing of
a defective product. We estimate that approximately two-thirds of the overall
cost of manufacturing a typical full color AMLCD is incurred in later stage
manufacturing steps after the array fabrication phase. Many of these material
costs can be avoided through in-process testing for defects at earlier stages in
the manufacturing process. In addition, systematized test and inspection
provides qualitative feedback to the FPD manufacturer and enables it to address
yield problems and to optimize the manufacturing process. At present, FPD
manufacturers are utilizing a number of different approaches to test, repair and
inspect at the array and cell phases of the FPD manufacturing process.

ARRAY TEST. After the array fabrication and prior to attaching the color
filter plate and injecting the liquid crystal material, functional electrical
tests are performed. Comprehensive testing at the array fabrication phase is
critical to yield management and cost reduction.

Traditional methods for testing array fabrications have increasing
limitations as resolutions and quality standards increase and as manufacturing
flexibility becomes more important. Traditional array testing methods
sequentially exercise each individual pixel from the edge of the display panel
through each row and column, while simultaneously measuring the electrical
characteristics of the pixel. The sequential measurement of the very large
number of pixels on each panel imposes throughput limitations. In order to
contact each row and column, traditional methods require the use of probe cards
to make thousands of physical contacts around the edge of the display panel.
These high precision probe cards are expensive and can only be used for one
display resolution and size. The sheer number of lines to be probed generally
results in several missed contacts during each test. As resolutions increase,
more probes are necessary, with tighter spacing between each probe making it
prohibitively difficult to use probe cards for array testing. Furthermore, by
measuring each pixel indirectly from the end of its respective row and column,
traditional array testing methods have certain other inaccuracies and
measurement limitations.

27
<PAGE>
REPAIR. Laser-based repair systems enable FPD manufacturers to improve
yields by repairing panels at several steps in the manufacturing process. Repair
systems can download defect data from test and inspection systems to aid
operators in locating defects. Repairs can be made during the array fabrication
process, after functional electrical test of the completed array plate and after
cell inspection. The probability of successful defect repair is highest during
the early phases of the manufacturing process. Once a defect is located,
operators repair the defect using a laser to either remove or weld material.

In order to repair defects with high throughput, the large plate substrate
must be moved rapidly with micron-level accuracy to successive repair sites.
There are many different types of defects that FPD manufacturers seek to repair
and each type of defect requires different repair processing. Traditional repair
equipment requires significant and repeated operator intervention not only to
position the repair site accurately, but also to select the required repair
process parameters such as the type of cut, cut points, the power and wavelength
of the laser, and the number of repetitions. Traditional repair systems have
used equipment stages with limited speed, accuracy and repeatability. These
systems have also been characterized by labor intensive user interfaces and
limited position automation. These factors have constrained throughput and
limited the success rate of repairs. Thus, there is a need for automated
equipment that more precisely and rapidly positions large FPD plates and
determines and executes the correct repair with minimal human intervention.

CELL AND MODULE INSPECTION. Human visual inspection has traditionally been
the main method of inspection after cell assembly and at various stages of
module assembly. To facilitate human inspection at the cell assembly phase, a
probing system is used to electronically exercise each pixel. The probing system
employs a probe card that contains thousands of probe pins to physically contact
every gate and data line. At the module phase, after attachment of the driver
electronics, humans inspect the display as the driver electronics exercise each
pixel. Inspections at both the cell assembly phase and the module phase include
pixel, line and blemish (also known as Mura) defects. Additional inspections at
the module stage include: polarizer defects, such as bubbles, particles and
scratches; driver integrated circuit defects, such as poor bond joints and
circuit defects; and backlighting defects, such as non-uniform brightness and
particles. For each of these inspections, the operator manually logs the results
for use in repair and statistical process control.

Human visual inspection suffers from high labor costs, high labor turnover,
inconsistency and inefficiency. Human inspection is generally subjective, lacks
quantitative standards and does not facilitate the analysis of test and
inspection data to isolate and eliminate yield reduction factors. Moreover, as
the resolution of displays increases, it becomes more difficult for operators to
find single pixel defects and more costly to manufacture and maintain the probe
cards. Additionally, OEMs desire specific panel and lot quality control data for
FPDs purchased from manufacturers. Providing this information to OEMs is
difficult or impossible without automated inspection, data acquisition and
quality grading systems. Some of these requirements may be beyond the
capabilities of human inspectors. Consequently, as the industry seeks to adopt
tighter quality standards, there is a need for automated, high throughput,
standard inspection procedures.

Historically, automated inspections systems have employed a variety of image
acquisition and processing techniques, including a variety of CCD sensor
configurations. These techniques provide high-resolution images that allow
excellent pixel and line defect detection. However, these techniques generally
are complex and expensive, have difficulty identifying low contrast Mura defects
and have slow image acquisition times. Thus, neither human inspection nor
current automated equipment meets the complete inspection needs of FPD
manufacturers as the industry moves towards larger, higher resolution panels
with zero defects.

28
<PAGE>
NEED FOR ADVANCED TEST, REPAIR AND INSPECTION EQUIPMENT AND OTHER YIELD
MANAGEMENT TECHNOLOGIES IN THE FPD MANUFACTURING PROCESS

A number of trends in the FPD industry are driving the need for more
sophisticated yield management solutions and highlighting the deficiencies of
existing test, repair and inspection systems.

DEMAND FOR HIGHER QUALITY. Increased competition among FPD manufacturers,
improvements in the manufacturing process and higher consumer expectations are
moving the FPD industry towards a zero defect standard. The manufacturing
challenges presented by the requirement for zero defect products have been
compounded by the increasing demand for higher resolution and larger displays,
which are more difficult to manufacture.

INCREASING DISPLAY RESOLUTIONS. Resolutions of advanced FPDs now involve
more than a million pixels, presenting a challenge when test and inspection
equipment must exercise each pixel. Traditional methods of physically contacting
each row and column of pixels with probe cards have difficulty handling current
advanced displays. New techniques, such as non-contact pixel-addressing
mechanisms, are required to more effectively handle these displays.

HIGH COST OF MATERIALS. Materials costs comprise approximately 57% of FPDs
in contrast to only approximately 11% for semiconductors. High materials costs
expose the FPD manufacturer to high costs from yield loss throughout the
manufacturing process. Therefore, it is important to test and repair early in
the manufacturing process before expensive materials are added to the display in
the assembly phases.

NEED FOR INCREASED YIELD AND GREATER THROUGHPUT. Optimizing yield and
throughput is critical to cost reduction because of the high cost of
constructing, operating and maintaining an FPD manufacturing facility. Test,
inspection and repair tools are essential to increase manufacturing yields.
These tools must function rapidly and accurately in production to provide for
greater throughput.

NEED FOR FLEXIBILITY. The FPD industry is producing a larger number of
different panel sizes as the variety of applications incorporating FPDs has
increased. Therefore, manufacturers are seeking test, repair and inspection
equipment that can be reconfigured quickly and accurately for different panel
sizes with minimal production downtime.

The FPD manufacturer's need for a yield management solution that reduces
costs, increases throughput and improves product quality has driven the demand
for new FPD test, repair and inspection technologies while underscoring the
shortcomings of traditional technologies. Because of the critical role of yield
to FPD manufacturers in reducing their costs, the FPD industry is now generally
recognizing the need for automated FPD test, repair and inspection equipment and
is looking for yield enhancing solutions at all stages of the FPD manufacturing
process. This need has become more acute as FPDs have become increasingly
complex and the market has moved to higher resolution displays.

PCB ASSEMBLY AND ADVANCED SEMICONDUCTOR PACKAGING MARKETS

Just as the growing demand for increasingly sophisticated mobile and
interconnected electronic devices is driving the market for new display
technologies, this demand has caused electronics manufacturers to seek to reduce
the size, power consumption and cost of the other components contained in these
devices. Additionally, as the functionality and sophistication of mobile
electronic devices have increased, so has the complexity of their electronic
components. These factors are driving the development of smaller, denser and
more complex PCBs, the backplanes upon which semiconductors and other electronic
components are attached and interconnected. These factors are also contributing
to the development of advanced semiconductor packaging technologies.

As semiconductors continue to shrink and become more complex, an increasing
number of wire connectors, or leads, must be attached to the semiconductor
package. Ball grid array, or BGA,

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semiconductor packaging technology was developed to address the problems
associated with greater lead counts required for advanced semiconductors. A BGA
package has leads on the bottom of the package in the form of small bumps or
balls. These balls can be distributed over the entire bottom surface of the
semiconductor package, rather than just its perimeter, allowing greater distance
between the individual leads. A number of other high-lead count interconnect
solutions with hidden solder joints have been developed, including flip chip and
chip scale packaging. The BGA market is estimated to grow at a rate of 46% from
1.8 billion units in 1998 to 12.3 billion units in 2003, according to Electronic
Trend Publications.

Because the leads in BGA semiconductor packages are located under the
package and, therefore, are not visible after the package has been affixed to a
PCB, the inspection of these solder joints requires the use of alternatives to
visual inspection technologies, such as X-ray inspection or ultrasound
technologies. Furthermore, as the number of leads on semiconductor packages
continues to increase, inspection technology must become more sophisticated and
precise.

At the same time, electronic device OEMs are increasingly focusing on their
core competencies and outsourcing the manufacture of many components
incorporated into their products. This trend has resulted in the rapid expansion
of the contract manufacturing industry. The contract manufacturing industry
represented 16% of the $554 billion electronics manufacturing market in 1998 and
is projected to increase to 26% of the $682 billion market in 2001, according to
Technology Forecasters. The contract manufacturing industry has consolidated in
recent years and is currently dominated by a few large companies, including SCI
Systems Inc., Solectron Corporation, Celestica Inc. and Jabil Circuit Inc.

Increased competition is causing contract manufacturers to focus on reducing
costs while differentiating themselves through improved quality. One way in
which contract manufacturers may reduce manufacturing costs is through yield
improvements and increased throughput, which may be achieved through increased
and more sophisticated inspection. Contract manufacturers are moving towards
100% inspection standards and adopting new inspection technologies as they seek
to provide high quality products while reducing costs. Also, the contract
manufacturing industry is characterized by shorter product life cycles, a
greater variety of products manufactured in smaller lot sizes and a high
employee turnover rate. These factors require contract manufacturers to adopt a
flexible approach to manufacturing with inspection equipment that is intuitive,
easy to use and easily configured.

THE PHOTON DYNAMICS SOLUTION

We believe we are the leading provider of yield management solutions for the
FPD industry. We also offer yield management solutions to the PCB assembly and
advanced semiconductor packaging industries. Our extensive test, repair and
inspection systems are used to collect data, analyze product quality and repair
product defects at critical steps in the manufacturing process.

Through our years of experience, we have developed extensive application
knowledge and skills in data acquisition, image analysis, high precision
electromechanical and electro-optical engineering and systems engineering. In
the U.S., we have 35 patents issued and active and 7 additional patents pending.

FPD SOLUTION

Our FPD yield management products include test, repair and inspection
equipment. Our test and inspection equipment identifies and characterizes
defects at early stages of the manufacturing process so that the panels may be
repaired before the next stage, or, if necessary, discarded, minimizing the loss
of time and materials. Our products gather comprehensive data which enable FPD
manufacturers to control and tune their processes to produce zero defect
displays at high yields.

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<PAGE>
FPD ARRAY TEST EQUIPMENT. Our test tools utilize our proprietary Voltage
Imaging technology, which provides a high-resolution voltage map of the entire
display without contacting the panel. Our proprietary software algorithms
convert this voltage map into comprehensive defect and performance data for each
pixel. Our technology can pinpoint subtle differences in signal strength such as
interlayer shorts, line opens, deposition faults and leaky transistors. PDI's
Voltage Imaging technology more completely and accurately identifies and
characterizes defective pixels than traditional probe technology, which measures
pixel performance indirectly from the edge of the display. Our test tools also
record information regarding defective pixels to a data file for use by the FPD
repair or inspection systems or by manufacturing engineers for process design
and yield improvement analysis.

FPD REPAIR EQUIPMENT. Our repair equipment analyzes data files from array
test and inspection systems to locate defects and automatically position the
panel for repair. Our repair equipment generates laser energy in multiple
wavelengths to repair most types of defects. The automation and versatility of
our repair equipment allows manufacturers to produce zero defect plates
efficiently with high yields. Also, the ability to repair FPDs lowers material
costs as the number of discarded panels is reduced.

FPD INSPECTION EQUIPMENT. Our MuraLook technology uses our proprietary
software algorithms to identify and characterize blemishes and other defects on
panels. Our MuraLook technology automates the inspection process thereby
eliminating human errors and implementing consistent objective measurement
standards. Our team of leading experts on image analysis has re-engineered our
MuraLook software based on a rigorous image analysis theory to provide a
comprehensive, automated solution. We believe our next-generation MuraLook
technology will reinforce our position as the leader in providing yield
management solutions for the FPD industry.

PCB ASSEMBLY AND ADVANCED SEMICONDUCTOR PACKAGING SOLUTIONS

Our recent acquisition of CR Technology complements our core capabilities of
data acquisition, image analysis and systems engineering, and provides yield
management solutions to the PCB assembly and advanced semiconductor packaging
industries.

Our X-ray and optical inspection systems enable PCB assembly and advanced
semiconductor packaging manufacturers to meet the challenges of shorter product
life cycles, higher standards for quality and increased need for manufacturing
flexibility. PDI's intuitive graphical user interface and configuration software
speeds operator training and the setup of inspection for new circuit boards
which are important in this fast-turnaround manufacturing environment that
suffers from high employee turnover.

X-RAY INSPECTION EQUIPMENT. Our X-ray inspection systems provide an
effective, non-destructive means of verifying hidden solder connections such as
under BGA packages. These systems also verify connections such as die
attachments and wire bonds inside semiconductor packaging.

OPTICAL INSPECTION EQUIPMENT. Our optical inspection systems inspect PCB
assemblies for component presence, correct component, orientation, polarity,
skew, solder integrity and other defects.

COMBINED X-RAY AND AUTOMATED OPTICAL INSPECTION EQUIPMENT. Our combination
X-ray and automated optical inspection equipment reduces handling, speeds
throughput and saves floor space by simultaneously inspecting both visible and
hidden features of PCB assemblies.

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PDI'S STRATEGY

Our objective is to enhance our position as a leading supplier of yield
management solutions to the FPD industry and to become a leading supplier of
yield management solutions to advanced segments of the electronics assembly and
semiconductor packaging industries. Essential elements of our strategy are as
follows:

FURTHER PENETRATE EXISTING MARKETS

We plan to leverage our global presence, technology leadership and extensive
customer relationships to further penetrate the market for yield management
solutions. For example, in Japan, although we have a strong customer base and
major market share for FPD test and inspection equipment, we are just beginning
to penetrate the market for repair equipment. We also intend to leverage our
position as a technology leader in the FPD industry to offer our next-generation
products and further penetrate our existing customer base.

In addition, through the acquisition of CR Technology, we have gained access
to the PCB assembly and advanced semiconductor packaging markets. CR Technology
has been focused on sales to U.S. entities in part due to its limited
international infrastructure. As a result, approximately 14% of CR Technology's
current revenues come from Asia, a region that represents approximately 40% of
the PCB assembly and advanced semiconductor packaging markets. We plan to
leverage our global infrastructure in Asia to grow our position in these
markets.

EXPAND YIELD MANAGEMENT PRODUCT OFFERINGS

Through internal development and acquisitions, we intend to broaden our
product offerings for the FPD industry and to expand into new markets within the
electronics industry where we can leverage our core competencies. For example,
in November 1999 we completed the acquisition of CR Technology, a supplier of
advanced X-ray and optical inspection systems to the PCB assembly and advanced
semiconductor packaging markets. We will continue to seek new acquisitions or
develop strategic partnerships to enhance our technological expertise and yield
management product line.

EXTEND TECHNOLOGY LEADERSHIP

We believe that our proprietary technology provides us with competitive
advantages. We intend to continue to invest in research and development to
extend our technology leadership position. We recently formed a technical
advisory panel of academic and industry experts to assist us in assessing future
developments in our core competencies and in our served markets. In addition, we
will continue to build our patent portfolio to bolster our technological
competitive advantage.

MAINTAIN AND ENHANCE EXISTING CUSTOMER RELATIONSHIPS

We have established close working relationships with the leaders in the FPD
industry, which is concentrated among a small number of major manufacturers. We
will continue to work with our key customers to develop next generation products
to solve their yield management problems. As we extend our product line, we will
provide more comprehensive yield management solutions to our customers. We also
intend to add focus on certain strategic customers within the PCB assembly and
advanced semiconductor packaging industries. Furthermore, we plan to expand and
strengthen our service offerings to our customers as well as grow the number of
our sales and field applications personnel.

FOSTER INDUSTRY STANDARDS FOR YIELD MANAGEMENT AND QUALITY

Our yield management solutions have been instrumental in the development of
more rigorous quality standards for the FPD industry. Our recently introduced
second generation of test and repair

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equipment has allowed the industry to cost-effectively produce panels with no
defects. As a result, a new zero defect quality standard is emerging in the FPD
industry. In addition, we are working to establish quality standards for
blemishes and other defects. We have been asked by the Video Electronics
Standards Association to assist in the establishment of standards for blemish
characterization. We plan to continue to drive quality standards in the FPD
industry as well as the PCB assembly and the advanced semiconductor packaging
industries.

PRODUCTS AND TECHNOLOGIES

FPD PRODUCTS

We offer products that test, repair and inspect AMLCDs, which are estimated
to represent 78% of the FPD market in 1999, according to DisplaySearch. Our
test, repair and inspection systems use similar software-based controls,
processing and graphical user interfaces. Products can be networked together so
that defect data can be stored, analyzed and used throughout the manufacturing
process. Our highly reliable systems are also compatible with a variety of
material handling automation systems.

The following tables summarizes our products for the FPD manufacturing
industry.

<TABLE>
TYPE OF
PRODUCT PRODUCT STAGE OF PROCESS FUNCTION TECHNOLOGY
<S> <C> <C> <C> <C>
ArrayChecker Test After array Analysis of the Voltage Imaging
fabrication and performance of each
before color filter pixel
is attached
ArrayChecker 2000 Test After array Analysis of the Voltage Imaging;
(Introduction planned fabrication and performance of each higher resolution
for mid-2000) before color filter pixel and throughput;
is attached larger plate size
ArraySaver Repair During and after Repairs line and PixeLaser;
array fabrication pixel defects BeamBlender
multiple wavelength
laser; fast high-
precision stage
PanelMaster Inspection After cell assembly Locates and Optical N-Aliasing
and module assembly characterizes line, imaging; MuraLook
cluster, pixel and image analysis
blemish (Mura) algorithms
defects
</TABLE>

ARRAYCHECKER TEST SYSTEMS. Our ArrayChecker test system detects, locates,
quantifies and characterizes electrical, contamination and other defects in
AMLCDs after array fabrication. The system uses our proprietary non-contact
Voltage Imaging technology to provide a high-resolution voltage map of the
entire display and our proprietary image analysis software converts this voltage
map into complete pixel defect data. The ArrayChecker determines whether
individual pixels or lines of pixels are functional, and also finds more subtle
defects such as variations in individual pixel voltage. These defect data files
are then used for repair and statistical process control. Our software driven
ArrayChecker test system can be configured rapidly for testing different panel
sizes relative to traditional systems that require a different probe card for
each panel size.

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<PAGE>
Our Voltage Imaging technology does not require each pixel to be
individually driven. Thus, the probe frames necessary to drive the pixels have
significantly reduced complexity through the use of shorting bars which are
already incorporated on the array plate for electrostatic discharge protection.
These much lower cost, less complex probe frames facilitate easy changeover in
panel designs and sizes and increase the reliability of the testing process. We
have patented the method of testing and inspecting FPDs through shorting bars
rather than through individual contact points.

Our current ArrayChecker system is an enhanced version of our earlier array
test products with improved Voltage Imaging sensors, image processing software,
graphical user interface and materials transport features. These enhancements
substantially increased the throughput and reliability of our array test systems
to provide throughput rates that are similar to or higher than traditional probe
card based systems. At the same time, our current ArrayChecker system provides
substantially improved defect detection, while continuing to provide the
superior functionality, flexibility and cost-efficient features of our earlier
array test systems.

We are now developing our next-generation ArrayChecker 2000 which we believe
will deliver further significant improvements in throughput and reliability
while accommodating the largest glass plate sizes currently anticipated in the
industry. This generation of ArrayChecker is intended to incorporate features
which provide for longer life Voltage Imaging sensors, thereby further reducing
overall cost of ownership.

ARRAYSAVER REPAIR SYSTEMS. Our array repair system utilizes our proprietary
PixeLaser technology and BeamBlender multiple wavelength laser technology to
repair defects in FPDs during and after array fabrication. Our system can use
defect data files downloaded from our array test systems, or other test and
inspection systems, to automatically position the panel for repair, thereby
eliminating the time spent by operators locating defects.

The ArraySaver system includes a high-precision stage and a user-friendly
graphical user interface allowing for high throughput and the capability to
repair all current panel sizes. Our fast high-precision stage fully automates
the precise positioning of the plate for each successive repair, thereby
substantially increasing throughput. Our graphical user interface and software
supports semi-automated setup of repair programs for common types of defects so
that repairs can be executed rapidly and accurately. These programs provide a
series of actions that the system automatically executes to repair the
particular defect type.

PANELMASTER INSPECTION SYSTEMS. Our PanelMaster inspection systems use our
proprietary MuraLook image analysis algorithms and N-Aliasing technology to
inspect FPD panels for visual defects after cell assembly, and also during and
after module assembly. The systems use a high-resolution camera and a computer
workstation to quantitatively measure visual characteristics such as contrast,
luminance and color balance, and to precisely locate and characterize line,
cluster, pixel and blemish defects. Inspection data generated by the systems is
displayed on a video monitor for immediate interpretation and can be stored or
sent to a repair system to effect repairs. Our inspection systems offer
different levels of resolution, functionality and flexibility to suit customers'
needs. The systems are available either as stand-alone units or as modular units
that can be integrated with manufacturers' material handling equipment.

We believe our next-generation PanelMaster inspection systems will enable
new objective quality standards to be adopted by the FPD industry. We expect our
systems to provide quantitative data providing end users with individual display
and lot quality data. The need for quality standards in FPDs will require
significantly increased statistical process control and lot quality data similar
to those that exist in most other segments of the electronics industry.
Providing this information to OEMs is not feasible without automated inspection,
data acquisition and quality grading systems. These requirements are beyond the
capabilities of human inspectors.

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<PAGE>
PCB ASSEMBLY AND ADVANCED SEMICONDUCTOR PACKAGING PRODUCTS

We also offer a broad line of X-ray and optical systems for non-destructive
inspection of PCB assemblies and advanced semiconductor packaging. Customers use
these systems to detect and identify defects on PCB assemblies and within
advanced semiconductor packaging. Both our X-ray and optical inspection product
lines are based on our proprietary image processing technology and are
integrated with a graphical user interface designed for ease of use on the
production line. Our user-friendly, flexible configuration interface is a
critical feature for many of our customers whose manufacturing operations must
cope with fast turnaround, short production runs and workforces with limited
skills and high turnover rates. These products use a common Windows-based
computing platform and can be networked together to provide factory and
enterprise wide access to product defect data. We offer fully automated systems
for use in high volume production lines and also offer lower cost systems for
use off the production line.

The following table summarizes our products for the PCB assembly and
advanced semiconductor packaging industries.

<TABLE>
HANDLER SIZE
PRODUCT FUNCTION (INCHES) SPECIAL FEATURES
<S> <C> <C> <C>
X-RAY INSPECTION
CRX-80 Die attach, wire bond, BGA, chip scale 18 X 24 Up to 80 kev; up to 50x
package, flip chip and QFP solder magnification
integrity
CRX-1000 Die attach, wire bond, BGA, chip scale 12 X 12 Rotation and tilt
package, flip chip and QFP solder capabilities; up to 160
integrity kev; up to 1000x
magnification
CRX-2000 Die attach, wire bond, BGA, chip scale 18 X 24 Rotation and tilt
package, flip chip and QFP solder capabilities; up to 160
integrity kev; up to 1000x
magnification
OPTICAL INSPECTION
RTI-6500 Component presence, correct component, 24 X 24 Illumination options
orientation, polarity, skew, solder for full inspection
integrity and other defects capability; for large
complex PCB assemblies
RTI-6520 Component presence, correct component, 18 X 20 Illumination options
orientation, polarity, skew, solder for full inspection
integrity and other defects capability; production
line automation
AOI-2020 Component presence, correct component, 9 X 12 Compact table-top
orientation, polarity, skew, and other system; advanced
defects scanner technology
COMBINATION X-RAY AND AUTOMATED OPTICAL INSPECTION
XRV-Combination BGA, chip scale package and flip chip 18 X 20 Production line
solder verification; component presence, automation; optimized
correct component, orientation, polarity, for PCB assemblies
skew, solder integrity and other defects using advanced
semiconductor packaging
</TABLE>

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<PAGE>
CRX X-RAY INSPECTION SYSTEMS. Our CRX systems utilize X-ray images to
inspect for hidden features in both PCB assemblies and advanced semiconductor
packaging. Customers use the sharp, high magnification images provided by these
CRX systems to analyze failures which cannot be detected by optical means. PCB
assembly manufacturers use our systems to inspect the hidden solder connections
between PCBs and BGA devices. Semiconductor manufacturers use our systems to
inspect for features within advanced semiconductor packaging including die
attach, wire bond and flip chip solder bump connections.

We offer a variety of CRX systems to meet customer requirements for handler
size, resolution, magnification, power, pricing and other factors. Magnification
ranges from 50 times to 1000 times, power from 80 kev to 160 kev and handler
size from 12 inches to 24 inches on a side.

OPTICAL INSPECTION SYSTEMS. Our optical inspection systems inspect PCB
assemblies for defects either before or after the soldering step in the
manufacturing process. Many of the defects detected by our systems cannot be
detected electrically. Our systems inspect for component presence, correct
component, orientation, polarity, skew, solder integrity and other defects. We
offer a variety of optical inspection products from a low-cost table-top PCB
inspection system targeted to small, cost-sensitive contract manufacturers, to
an integrated multi-camera system focused on high-volume production of large
complex PCB assemblies.

Our RTI-6500 and RTI-6520 products feature integrated cameras and lighting
heads which pass over the surface of the PCB, selecting different magnifications
depending on the size of the components. The RTI-6500 is an off-line system
which inspects PCB sizes up to 24 by 24 inches. The RTI-6520 is an in-line
system with a built-in conveyor to inspect PCB sizes up to 18 by 20 inches on
the production conveyor line.

Our AOI-2020 system is a low-cost, table-top PCB inspection system for
customers who regard price as the most important criteria influencing their
purchasing decision. With a maximum PCB size of 9 by 12 inches, the AOI-2020
system is well suited for inspection of notebook computer motherboards and
similar compact, complex assemblies.

COMBINED X-RAY AND AUTOMATED OPTICAL INSPECTION SYSTEMS. Our XRV combined
X-ray and automated optical inspection systems enable the simultaneous
inspection of both visible and hidden features on a PCB. This reduces handling,
increases throughput and saves floor space.

CUSTOMERS

We sell our products to FPD manufacturers, semiconductor manufacturers, PCB
manufacturers and assemblers, and other electronic product manufacturers. Most
of our FPD customers are located in Japan, Taiwan and Korea, where FPD
production is concentrated. Our installed customer base for our FPD products
includes eight out of the ten leading FPD manufacturers. The majority of our PCB
assembly and advanced semiconductor packaging customers are located in the U.S.

We derive most of our revenues from a small number of customers, and we
expect this to continue. Our top four customers, each of which is a FPD
manufacturer, contributed 55% of revenue in fiscal 1999, compared to 67% in
fiscal 1998. Our products for the FPD industry accounted for 69% of revenue in
fiscal 1999, compared to 72% in fiscal 1998. Sales to IHI, our value-added
reseller in Japan, represented approximately 18% of revenue in fiscal 1999 and
approximately 33% of revenue in fiscal 1998.

SALES AND SERVICE

We sell our products for the FPD industry directly to our customers in
Korea, through a sales representative in Taiwan, and through our value-added
reseller, IHI, in Japan. We sell our products for the PCB assembly and advanced
semiconductor packaging markets primarily through sales

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<PAGE>
representatives. We service our products worldwide directly, except in Japan,
where IHI services our products.

We generally sell our products on net-30 day terms, with a small portion
held back until final acceptance. However, a substantial portion of our
customers, primarily foreign, remit payments on significantly longer terms. We
typically provide a limited warranty on our products for a period of one year
from final acceptance by customers. Our field service providers provide
customers with repair and maintenance services and customers may enter into
repair and maintenance service contracts covering our products.

As of November 30, 1999, we had approximately 30 sales and service
personnel, 16 of which are located in the U.S. and 14 of which are located in
Asia. We have increased the number of our sales and service personnel
approximately 30% over the last twelve months and we anticipate further
increases in the future.

In the FPD market, our sales and marketing strategy is to provide our
customers with increased manufacturing yields and throughput, improved quality
and greater overall efficiency in their manufacturing process. In the PCB
assembly and advanced semiconductor packaging industries, we focus on high-end
applications where our high-resolution, advanced image processing and optical
inspection technologies and products provide our customers with product quality
assurance capabilities. Our sales and marketing strategy is also to focus on the
rapidly expanding contract manufacturing industry. Operating on narrow margins,
contract manufacturers compete by reducing costs and improving quality, as well
as promoting their advanced capabilities. These customers require flexible
systems that are easy to set up and cost-efficient.

RESEARCH AND DEVELOPMENT

The FPD, PCB assembly and advanced semiconductor packaging industries are
characterized by rapid and continuous technological development and product
innovation. We believe that it is necessary to maintain our competitive position
through continued and timely development of new products and enhancements to
existing products. Accordingly, we devote a significant portion of our personnel
and financial resources to research and development. Our research and
development expenses, consisting primarily of salaries and project materials,
were $5.9 million in fiscal 1999, or 13% of revenue. We also maintain close
relationships with our customers which helps us remain responsive to their
product needs.

We are directing our current research and development for the FPD market to
increase the performance of our array test, repair and inspection systems and to
expand the application of our inspection systems for use in related markets.
Almost one-half of our research and development personnel are software
developers. Our current research and development for the PCB assembly and
advanced semiconductor packaging markets is focused on increasing the
performance, reliability and functionality of our inspection systems, expanding
the application of our inspection systems for use in related markets and
developing new X-ray and optical inspection products.

MANUFACTURING AND SUPPLIERS

We manufacture our products for the FPD industry in San Jose, California and
for the PCB assembly and advanced semiconductor packaging industries in Aliso
Viejo, California. Our manufacturing activities consist primarily of final
assembly and test of components and subassemblies which are purchased from third
party vendors.

We schedule production based upon customer purchase orders and anticipated
orders during the planning cycle. We generally expect to be able to accept a
customer order, build the required machinery and ship to the customer within
16 weeks for our FPD products and within 8 weeks for our

37
<PAGE>
the PCB assembly and advanced semiconductor packaging products. Quality control
is maintained through incoming inspection of components, in-process inspection
during equipment assembly and final inspection and operation of all manufactured
equipment prior to shipment. We work in close collaboration with our customers
and suppliers and train all of our employees in quality assurance. Although we
conduct assembly of some components and final testing of our systems under
limited clean room conditions, most of our manufacturing occurs in standard
manufacturing space.

Under the terms of our relationship with IHI, we retain the exclusive right
to manufacture some critical components based on technology not shared with IHI
and to sell these components to IHI at prices that are mutually established from
time to time. IHI has the right to manufacture, assemble and sell array test
systems incorporating these components. To date, we have manufactured all array
test systems sold by IHI. Furthermore, IHI has sold products only in its
capacity as our value-added reseller in Japan.

Some of the parts included in our systems are obtained from a single source
or a limited group of suppliers. The partial or complete loss of such suppliers
could increase our costs, delay shipments and/or require redesigns of our
products.

INTELLECTUAL PROPERTY

We have 35 patents issued and active and 7 patents pending in the U.S., some
of which are also issued or pending in Korea or Japan. None of these patents are
scheduled to expire before 2008, subject to payment of applicable maintenance
fees. In addition, PDI and IHI have jointly filed patent applications in Japan
relating to some aspects of the array test systems.

We frequently review our inventions and attempt to determine which
inventions will provide substantial differentiation between our products and
those of our competitors. In certain cases, we may also choose to keep an
invention or a process as a trade secret. Trade secrets are routinely employed
in our manufacturing processes. We have entered into non-disclosure agreements
to protect our proprietary technology with our employees and consultants and in
some instances with our suppliers, our customers and IHI.

The patent position of any manufacturer, including us, is subject to
uncertainties and may involve complex legal and factual issues. Claims allowed
by any existing or future patents issued to PDI may be challenged, invalidated
or circumvented, and any rights granted by those patents may not provide us with
adequate protection. Litigation may be necessary in the future to enforce our
patents and other intellectual property rights or to defend against claims of
infringement or invalidity.

BACKLOG

Our backlog was $21.4 million as of September 30, 1999, as compared to
$10.4 million as of September 30, 1998. Our backlog consists of orders for which
we have accepted purchase orders and assigned shipment dates within the next
eight to twelve months.

All orders are subject to delay or cancellation with limited or no penalty
to the customer. Because of possible changes in product delivery schedules and
cancellation of product orders, among other factors, our backlog may vary
significantly and at any particular date is not necessarily indicative of actual
sales for any succeeding period.

COMPETITION

The FPD equipment and the component inspection systems industries are highly
competitive. We face substantial competition from many established companies,
many of which have greater financial, engineering and manufacturing resources
than us and have larger service organizations and long-standing customer
relationships with key existing and potential customers. In addition, our

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<PAGE>
competitors can be expected to continue to improve the design and performance of
their products and to introduce new products with competitive price and
performance characteristics. PDI's customers may choose to develop proprietary
technology which may obviate or lessen their need to purchase PDI's products.
Moreover, competitive pressures may necessitate price reductions, which could
harm our results of operations.

In the FPD industry, our competitors include Micronics Japan Corporation in
array testing, NTN Corporation and Hoya Corporation in array repair, and several
competitors in the cell and module inspection market. In the X-ray inspection
market, our competitors include Nicolet Imaging, Agilent Technologies and
Feinfocus. In the optical inspection market, our competitors include GSI
Lumonics, Hewlett-Packard Company and Omron. In addition, some of our current
and potential competitors have also been acquired by larger companies who seek
to enter our markets. We may also face additional competition from new entrants
into the FPD, PCB assembly and advanced semiconductor packaging industries. In
addition, PDI may face increased competition if IHI elects to begin competing
with us.

We believe that we can compete effectively with our competitors by building
on our substantial installed customer base, providing technologically superior,
competitively priced products and continuing to emphasize our easy-to-use user
interfaces and customer support. However, realizing and maintaining such
advantages will require a continued high level of investment by PDI in
engineering, research and development, marketing and customer service and
support. We may not have sufficient resources to continue to make such
investments. Even if sufficient funds are available, we may not be able to make
the technological advances necessary to maintain such competitive advantages.

EMPLOYEES

As of November 30, 1999, we employed a total of 159 persons, including 46 in
engineering, 54 in manufacturing, 20 in service, 15 in sales and marketing, and
24 in administration. Of these employees, 143 are located in the U.S., 3 are
located in Taiwan, 9 are located in Korea and 4 are located in Japan. No
employees are represented by a labor union or covered by a collective bargaining
agreement. We consider our relationships with our employees to be good.

FACILITIES

Our corporate headquarters is located in San Jose, California and consists
of a 50,000 square foot facility. We also lease approximately 19,700 square feet
in Aliso Viejo, California. In addition, we lease office space for our sales and
service operations in Seoul, Korea and Tokyo, Japan.

39
<PAGE>
MANAGEMENT

Our executive officers and directors, and their ages as of November 30,
1999, are as follows:

<TABLE>
<CAPTION>
NAME AGE POSITION
- ---- -------- --------
<S> <C> <C>
Vincent F. Sollitto, Jr................... 51 President, Chief Executive Officer and
Director
Richard L. Dissly......................... 55 Chief Financial Officer, Vice President of
Operations and Secretary
William K. Pratt.......................... 62 Chief Technical Officer
Jeffrey A. Hawthorne...................... 41 Vice President of Development
Richard E. Amtower........................ 56 Vice President of PDI and President of CR
Technology, Inc.
Bruce P. Delmore.......................... 38 Vice President of Marketing, Strategy and
Business Development
Steve Song................................ 44 Vice President of Sales
E. Floyd Kvamme........................... 61 Chairman of the Board
Barry L. Cox.............................. 57 Director
Francois J. Henley........................ 40 Director
Michael J. Kim............................ 54 Director
Malcolm J. Thompson....................... 54 Director
</TABLE>

Set forth below is certain information relating to our executive officers
and directors.

VINCENT F. SOLLITTO became Chief Executive Officer in June 1996 and became a
member of our board of directors in July 1996. From August 1993 to 1996, he was
the General Manager of Business Unit Operations for Fujitsu
Microelectronics, Inc. From April 1991 to August 1993, he was the Executive Vice
President of Technical Operations at Supercomputer Systems, Incorporated. Prior
to joining Supercomputer Systems, Incorporated, Mr. Sollitto spent twenty-one
years in various management positions at IBM, including Director of Technology
and Process. Mr. Sollitto serves as a director of Irvine Sensors Corp. and
Applied Films Corporation. Mr. Sollitto holds a B.S. degree in Electrical
Engineering from Tufts College.

RICHARD L. DISSLY became Chief Financial Officer and Vice President of
Operations in November 1998 and became Secretary in October 1999. Prior to
joining PDI, he was the Chief Financial Officer at a number of companies,
including Semaphore Communications from January 1997 to October 1998, CrossCheck
Technology from July 1992 to December 1996, Award Software from 1989 to 1991,
and Megatest Corporation from 1980 to 1988. Mr. Dissly holds an M.B.A. from
Santa Clara University and is a licensed certified public accountant.

WILLIAM K. PRATT became the Chief Technical Officer in October 1996. In
1993, Dr. Pratt founded Pixelsoft, Inc., an image processing software
development company, and served in various management and technical positions
until 1996. From 1988 to 1994, he was Director of Multimedia and Imaging
Technology at Sun Microsystems, Inc. Prior to 1988, he was Senior Vice President
at Compression Labs, Incorporated. Dr. Pratt received a B.S. degree in
Electrical Engineering from Bradley University and an M.S. and Ph.D. in
Electrical Engineering from University of Southern California. He holds five
patents and is the author of several books on image processing.

JEFFREY A. HAWTHORNE joined PDI in November 1991 and became Vice President
of Development in September 1994. From June 1990 to November 1991, he was a
consultant with Display Tech, Inc., which provided consulting services in the
area of LCDs. He received a B.S. in Engineering Physics from the University of
Colorado in 1987 and a M.S. in Optical Engineering from the University of
Rochester in 1990.

RICHARD E. AMTOWER joined PDI as Vice President in November 1999. Since
1984, he was the President and Chief Executive Officer of CR Technology and
served as a member of its board of directors. Prior to 1984, Mr. Amtower was
Vice President and General Manager of EOCOM Electronic

40
<PAGE>
Systems, a leading developer and manufacturer of laser imaging systems for the
newspaper and printed circuit board industries. Mr. Amtower is a graduate of the
University of California at Riverside, where he received a B.A. degree in
Physics in 1965.

BRUCE P. DELMORE became Vice President of Marketing, Strategy and Business
Development in August 1999. From 1997 to 1999, he was President of Strategos, a
marketing consulting firm. From 1994 to 1997, he was Director of EDA and
Strategic ASIC Development at Fujitsu Microelectronics, Inc. and from 1987 to
1994, he was Product Manager at Supercomputer Systems, Inc. Mr. Delmore holds a
B.S. degree in Mechanical Engineering from the University of Wisconsin-Madison.

STEVE SONG joined PDI in April 1994 and became Vice President of Sales in
August 1998. Prior to joining PDI, Mr. Song was the General Manager of Universal
Technology International, a manufacturer of helicopter and fixed-wing aircraft.
Mr. Song holds a B.S. degree in Electrical Engineering from Korea University in
Seoul Korea.

E. FLOYD KVAMME became a member of our board of directors in 1986. Since
1984, he has been a general partner of Kleiner Perkins Caufield & Byers.
Mr. Kvamme also serves on the boards of directors of Harmonic, Inc., Brio
Technology, National Semiconductor, Power Integrations, Inc. and several
privately held companies. Mr. Kvamme received a B.S. degree in Electrical
Engineering. from the University of California, Berkeley and an M.S. degree in
Engineering from Syracuse University.

BARRY L. COX became a member of our board of directors in 1990. Mr. Cox
joined Quantum Effect Devices in July 1998 and has served as its Chairman of the
Board since September 1999. From January 1996 to July 1998, he was a consultant
for various companies. From 1992 to 1993, he was the President, Chief Operating
Officer and a director of Weitek Corporation, and from 1993 to 1995, served as
its President and Chief Executive Officer. From 1987 to 1992 Mr. Cox served as
President and Chief Executive Officer of ATEQ Corporation, a semiconductor
capital equipment manufacturer. In addition to Quantum Effective Devices,
Mr. Cox serves on the boards of several privately held technology companies.
Mr. Cox received a B.S. degree in Engineering from the U.S. Air Force Academy
and an M.B.A. from Boston University.

FRANCOIS J. HENLEY founded PDI in 1986 and has been a member of our board of
directors since that time. From 1986 to July 1997, he also held various
management and technical positions at PDI, including President and Chief
Technical Officer. Since June 1997, he has served as Chief Executive Officer of
Silicon Genesis Corporation. Prior to 1986, he held various engineering
positions at Hewlett-Packard Company, Intel Corporation and Spectrum
Sciences, Inc. Mr. Henley received a B.S. degree in Electrical Engineering from
Rensselaer Polytechnic Institute in 1980 and an M.S. degree in Electrical
Engineering from the University of California, Berkeley in 1982.

MICHAEL J. KIM has been a member of our board of directors since 1991. Since
September 1999, he has been the Vice President of Business Development at FDS,
Philips Components. From 1993 to February 1999, he was Senior Vice President of
LG Electronics, Inc., a manufacturer of FPDs, and served as the head of the San
Jose Technology Center of LG Electronics. From 1988 to 1992, Mr. Kim was Vice
President at Goldstar Technology, Inc., formerly a subsidiary of LG Electronics.
Mr. Kim received a B.S. degree in Electrical Engineering from the University of
Illinois, Chicago and an M.S. degree in Electrical Engineering from the
University of Santa Clara.

MALCOLM J. THOMPSON has been a member of our board of directors since 1992.
Since 1998, he has been President and Chief Executive Officer of Novalux, Inc.
From 1996 to 1998, he was President and Chief Executive Officer of dpiX Inc. and
from 1981 to 1996, he was the Chief Technologist for Xerox PARC. He also has
served as Chairman of the Board of the Unites States Display Consortium (USDC),
an industry-government consortium of over 135 member companies. Dr. Thompson
received a B.S. and a Ph.D. in Applied Physics from the University of Brighton,
Sussex in the United Kingdom.

41
<PAGE>
PRINCIPAL AND SELLING SHAREHOLDERS

The following table sets forth certain information regarding the ownership
of our common stock as of November 30, 1999 by: (i) each director; (ii) each of
our executive officers; (iii) all executive officers and directors of the
Company as a group; (iv) all those known by us to be beneficial owners of more
than five percent (5%) of our common stock; and (v) each of our current
shareholders who is expected to sell in the offering.

<TABLE>
<CAPTION>
SHARES BENEFICIALLY
OWNED SHARES BENEFICIALLY
PRIOR TO THE OWNED AFTER THE
OFFERING NUMBER OF OFFERING
------------------- SHARES BEING -------------------
BENEFICIAL OWNER(1) NUMBER PERCENT OFFERED NUMBER PERCENT
- ------------------- -------- ------- ------------ -------- -------
<S> <C> <C> <C> <C> <C>
WFC Holdings Corporation(2).................... 760,971 7.9% 679,313 81,658 *
555 Montgomery Street
17th Floor
San Francisco, CA 94111

Kern Capital Management LLC(3)................. 689,600 7.1% -- 689,600 6.3 %
114 West 47th Street
Suite 1926
New York, NY 10036

Fidelity Management(4)......................... 520,600 5.4% -- 520,600 4.7 %
One Federal Street
Boston, MA 02109

Vincent F. Sollitto, Jr.(5).................... 171,586 1.8% -- 171,586 1.5 %
Richard L. Dissly(6)........................... 24,493 * -- 24,493 *
William K. Pratt(7)............................ 44,616 * -- 44,616 *
Jeffrey A. Hawthorne(8)........................ 82,811 * -- 82,811 *
Richard E. Amtower(9).......................... 203,169 2.1% -- 203,169 1.8 %
E. Floyd Kvamme(10)............................ 28,470 * -- 28,470 *
Barry L. Cox(11)............................... 26,667 * -- 26,667 *
Francois J. Henley(12)......................... 147,778 1.5% -- 147,778 1.3 %
Malcolm J. Thompson(13)........................ 26,667 * -- 26,667 *
Michael J. Kim(14)............................. 7,500 * -- 7,500 *
All executive officers and directors as a group
(12 persons)(15)............................. 800,040 7.9% -- 800,040 7.0 %
</TABLE>

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

* Represents less than 1%.

(1) This table is based upon information supplied by officers, directors and
principal shareholders and Schedules 13D and 13G filed with the Securities
and Exchange Commission (the "SEC"). Unless otherwise indicated in the
footnotes to this table and subject to community property laws where
applicable, the Company believes that each of the shareholders named in
this table has sole voting and investment power with respect to the shares
indicated as beneficially owned. Applicable percentages are based on
9,657,481 shares outstanding on November 30, 1999, adjusted as required by
rules promulgated by the SEC.

(2) Hall, Morris & Drufva II, L.P, or HMD, is currently the record owner of the
shares listed next to WFC Holdings Corporation's name. WFC Holdings is the
holder of a 99% limited partnership interest in HMD. Pursuant to the HMD
partnership agreement, HMD plans to distribute approximately 680,000 shares
of the common stock it holds to WFC Holdings. The number of shares which
WFC Holdings will receive will be determined based on the average of the
closing

42
<PAGE>
price of our common stock on the 20 days prior to the distribution of the
shares to WFC Holdings. WFC Holdings expects this distribution to take
place in January, 2000.

(3) Robert Kern and David Kern are controlling members of Kern Capital and may
be deemed the beneficial owner of the securities in that they might be
deemed to share the power to direct the voting or disposition of the
securities. This filing does not constitute an admission that either Robert
Kern or David Kern is, for any purpose, the beneficial owner of these
securities, and such beneficial ownership is expressly denied.

(4) As of November 30, 1999, Fidelity Management & Research Company indirectly
held 520,600 shares of the issued and outstanding shares of Photon
Dynamics. Fidelity had sole dispositive power with respect to the 520,600
shares of Photon Dynamics and sole voting power with respect to zero
shares. Fidelity carries out the voting of shares under written guidelines
by the funds' Board of Trustees.

(5) Includes 146,573 shares subject to stock options held by Mr. Sollitto
exercisable within 60 days of November 30, 1999.

(6) Includes 23,599 shares subject to stock options held by Mr. Dissly
exercisable within 60 days of November 30, 1999.

(7) Includes 44,018 shares subject to stock options held by Dr. Pratt
exercisable within 60 days of November 30, 1999.

(8) Includes 74,578 shares subject to stock options held by Mr. Hawthorne
exercisable within 60 days of November 30, 1999.

(9) Includes 10,288 shares subject to stock options held by Mr. Amtower
exercisable within 60 days of November 30, 1999.

(10) Includes 5,000 shares subject to stock options held by Mr. Kvamme
exercisable within 60 days of November 30, 1999.

(11) Includes 10,800 shares subject to stock options held by Mr. Cox
exercisable within 60 days of November 30, 1999.

(12) Includes 36,912 shares subject to stock options held by Mr. Henley
exercisable within 60 days of November 30, 1999.

(13) Includes 26,667 shares subject to stock options held by Dr. Thompson
exercisable within 60 days of November 30, 1999.

(14) Includes 7,500 shares subject to stock options held by Mr. Kim exercisable
within 60 days of November 30, 1999.

(15) Includes 408,584 shares which certain executive officers, directors and
principal shareholders of the Company have the right to acquire within
60 days of November 30, 1999 pursuant to outstanding options.

43
<PAGE>
UNDERWRITING

PDI and the selling shareholder are offering the shares of common stock
described in this prospectus through a number of underwriters. Banc of America
Securities LLC and Needham & Company, Inc. are the representatives of the
underwriters. PDI and the selling shareholder have entered into a firm
commitment underwriting agreement with the representatives. Subject to the terms
and conditions of the underwriting agreement, PDI and the selling shareholder
have agreed to sell to the underwriters, and each underwriter has agreed to
purchase, the number of shares of common stock listed next to its name below at
the public offering price less the underwriting discount and commissions on the
cover page of the prospectus:

<TABLE>
<CAPTION>
UNDERWRITERS NUMBER OF SHARES
- ------------ ----------------
<S> <C>
Banc of America Securities LLC..............................
Needham & Company, Inc......................................
SoundView Technology Group, Inc.............................
-----------
Total..................................................... 2,000,000
===========
</TABLE>

The underwriting agreement is subject to a number of terms and conditions
and provides that the underwriters must buy all of the shares if they buy any of
them. The underwriters will sell the shares to the public when and if the
underwriters buy the shares from us and the selling shareholder.

The underwriters initially will offer shares to the public at thc price
specified on the cover page of this prospectus. The underwriter may allow to
some dealers a concession of not more than $ per share. The underwriters
may also allow, and any other dealers may reallow, a concession of not more than
$ per share to some other dealers. If all the shares are not sold at the
public offering price, the underwriters may change the public offering price and
the other selling terms. No change in the selling terms will vary the proceeds
to be received by us as specified on the cover page to the prospectus. The
common stock is offered subject to a number of conditions, including:

- receipt and acceptance of the common stock by the underwriters; and

- the right on the part of the underwriters to reject orders in whole or in
part.

We have granted the underwriters an option to buy up to 300,000 additional
shares of common stock. These additional shares would cover sales of shares by
the underwriters that exceed the number of shares specified in the table above.
The underwriters may exercise this option at any time within 30 days after the
date of this prospectus. If the underwriters exercise this option, they will
each purchase, subject to a number of terms and conditions, additional shares
approximately in proportion to the amounts specified in the table above.

The following table shows the per share and total underwriting discounts and
commissions to be paid to the underwriters. These amounts are shown assuming no
exercise and full exercise of thc underwriters' option to purchase additional
shares.

<TABLE>
<CAPTION>
FULL
NO EXERCISE EXERCISE
----------- --------
<S> <C> <C>
Per share underwriting discounts and commissions............ $ $
Total underwriting discounts and commissions to be paid
by us..................................................... $ $
Total underwriting discounts and commissions to be paid by
the selling shareholder................................... $ $
</TABLE>

The expenses of the offering, not including underwriting discounts and
commissions, are estimated to be approximately $650,000 and will be paid by us
and the selling shareholder. Expenses of the

44
<PAGE>
offering, exclusive of underwriting discounts and commissions, include the SEC
filing fee, printing expenses, transfer agent and registration and other
miscellaneous fees.

We, our executive officers and directors, certain of our shareholders and
the selling shareholder have entered into lock-up agreements with the
underwriters. Under these agreements, subject to exceptions, we may not issue
any new shares of common stock, and our executive officers and directors,
certain of our shareholders and the selling shareholder may not offer, sell,
contact to sell, or otherwise dispose of or hedge any common stock or securities
convertible into or exchangeable for shares of common stock. These restrictions
will be in effect for a period of 90 days after the date of this prospectus, At
any time and without notice, Banc of America Securities LLC and Needham &
Company, Inc. jointly may, in their sole discretion, release all or some of the
securities from these lock-up agreements.

PDI and the selling shareholder will indemnify the underwriters against some
liabilities, including some liabilities under the Securities Act. If we or the
selling shareholder are unable to provide this indemnification, PDI and the
selling shareholder will contribute to payments the underwriters may be required
to make in respect of those liabilities.

In connection with this offering, the underwriters may engage in activities
that stabilize, maintain or otherwise affect the price of the common stock.
These transactions may include:

- short sales;

- over-allotment;

- purchases to cover positions created by short sales; and

- stabilizing transactions.

Short sales involve the sale by the underwriters of a greater number of
shares than they are required to purchase in this offering. In order to cover a
short position, the underwriters may bid for and purchase shares of common stock
in the open market or may exercise their over-allotment option. Stabilizing
transactions consist of bids or purchases made for the purpose of preventing or
retarding a decline in the market price of the common stock while this offering
is in progress.

The underwriters may also impose a penalty bid. This means that if the
representatives purchase shares in the open market in stabilizing transactions
or to cover short sales, the representatives can require the underwriters that
sold those shares as part of this offering to repay the underwriting discount
received by them.

As a result of these activities, the price of the common stock may be higher
than the price that otherwise might exist in the open market. If the
underwriters commence these activities, they may discontinue them at any time.
The underwriters may carry out these transactions on the Nasdaq National Market,
in the over-the-counter market or otherwise.

In connection with this offering, some underwriters and any selling group
members who are qualified market makers on the Nasdaq National Market may engage
in passive market making transactions in the common stock on thc Nasdaq National
Market in accordance with Rule 103 of Regulation M. Rule 103 permits passive
market making during thc period when Regulation M would otherwise prohibit
market making activity by the participants in this offering. Passive market
making may occur during the business day before the pricing of the offering,
before the commencement of offers or sales of the common stock. Passive market
makers must comply with applicable volume and price limitations and must be
identified as a passive market maker. In general, a passive market maker must
display its bid at a price not in excess of the highest independent bid for the
security. If all independent bids are lowered below the passive market maker's
bid, however, the bid must then be lowered when purchase limits are exceeded.
Net purchases by a passive market maker on each day are

45
<PAGE>
limited to a specified percentage of the passive market maker's average daily
trading volume in the common stock during a specified period and must be
discontinued when such limit is reached. Underwriters and dealers are not
required to engage in passive market making and may end passive market making
activities at any time.

LEGAL MATTERS

The validity of the issuance of the common stock offered hereby will be
passed upon for us by Cooley Godward LLP, Palo Alto, California. Certain legal
matters in connection with this offering will be passed upon for the
underwriters by Heller Ehrman White & McAuliffe, San Francisco, California.

EXPERTS

The consolidated financial statements of Photon Dynamics, Inc. appearing in
Photon Dynamics, Inc.'s Annual Report on Form 10-KSB for the year ended
September 30, 1999, have been audited by Ernst & Young LLP, independent
auditors, as set forth in their report thereon included therein and incorporated
herein by reference. Such financial statements are incorporated by reference in
reliance upon such report given upon the authority of such firm as experts in
accounting and auditing.

The supplemental consolidated financial statements of Photon Dynamics, Inc.
at September 30, 1998 and 1999 and for the years then ended, appearing in this
Prospectus and Registration Statement have been audited by Ernst & Young LLP,
independent auditors, as set forth in their report thereon appearing elsewhere
herein which, as to the year ended 1998 are based in part on the report of the
Cacciamatta Accountancy Corporation, independent auditors. The financial
statements referred to above are included in reliance upon such reports given on
the authority of such firms as experts in accounting and auditing.

The consolidated financial statements of CR Technology, Inc. appearing in
Photon Dynamics, Inc.'s Current Report on Form 8-K dated December 15, 1999, have
been audited by the Cacciamatta Accountancy Corporation, independent auditors,
as set forth in their report thereon included therein and incorporated herein by
reference. Such financial statements are incorporated herein by reference in
reliance upon such report given on the authority of such firm as experts in
accounting and auditing.

WHERE YOU CAN FIND MORE INFORMATION

We are a reporting company and file annual, quarterly and special reports,
proxy statements and other information with the Securities and Exchange
Commission, or the SEC. You may read and copy such materials at the public
reference facilities maintained by the SEC at 450 Fifth Street, N.W.,
Washington, D.C. 20549. You may also obtain copies of such material from the SEC
at prescribed rates for the cost of copying by writing to the Public Reference
Section of the SEC at the same address. You may call the SEC at 1-800-SEC-0330
for more information on the public reference rooms. You can also find our SEC
filings at the SEC's web site at www.sec.gov.

46
<PAGE>
INCORPORATION OF CERTAIN DOCUMENTS BY REFERENCE

The SEC allows us to "incorporate by reference" information that we file
with them, which means that we can disclose important information to you by
referring you to those documents. The information incorporated by reference is
an important part of this prospectus, and information that we file later with
the SEC will automatically update and supersede this information. We incorporate
by reference the documents listed below and any future filings we will make with
the SEC under Section 13(a), 13(c), 14 or 15(d) of the Securities Exchange Act
of 1934:

- Annual Report on Form 10-KSB filed October 27, 1999.

- Current Report on Form 8-K filed December 15, 1999.

- The description of the common stock contained in PDI's Registration
Statement on Form 8-A filed on November 14, 1995.

You may request a copy of these filings at no cost, by writing or
telephoning us at the following address:

Photon Dynamics, Inc.
6325 San Ignacio Avenue
San Jose, California 95119-1202
(408) 226-9900

47
<PAGE>
PHOTON DYNAMICS, INC.

INDEX TO SUPPLEMENTAL CONSOLIDATED FINANCIAL STATEMENTS

<S> <C>
Report of Ernst & Young LLP, Independent Auditors........... F-2
Report of Cacciamatta Accountancy Corporation, Independent
Auditors.................................................. F-3
Supplemental Consolidated Balance Sheets as of
September 30, 1998 and September 30, 1999................. F-4
Supplemental Consolidated Statements of Operations for the
Fiscal Years Ended September 30, 1998 and 1999............ F-5
Supplemental Consolidated Statements of Cash Flows for the
Fiscal Years Ended September 30, 1998 and 1999............ F-6
Supplemental Consolidated Statements of Shareholders' Equity
for the Fiscal Years Ended September 30, 1998 and 1999.... F-7
Notes to Supplemental Consolidated Financial Statements..... F-8
</TABLE>

F-1
<PAGE>
REPORT OF ERNST & YOUNG LLP, INDEPENDENT AUDITORS

The Board of Directors and Shareholders
Photon Dynamics, Inc.

We have audited the supplemental consolidated balance sheets of Photon
Dynamics, Inc. (formed as a result of the consolidation of Photon
Dynamics, Inc. and CR Technology, Inc.) as of September 30, 1998 and 1999, and
the related supplemental consolidated statements of operations, shareholders'
equity, and cash flows for the years then ended. The supplemental consolidated
financial statements give retroactive effect to the merger of Photon
Dynamics, Inc. and CR Technology, Inc. on November 30, 1999, which has been
accounted for using the pooling of interests method as described in the notes to
the supplemental consolidated financial statements. These supplemental financial
statements are the responsibility of the management of Photon Dynamics, Inc. Our
responsibility is to express an opinion on these financial statements based on
our audits. We did not audit the financial statements of CR Technology, Inc. for
the year ended December 31, 1998, which statements reflect total assets of
$4.2 million included in the related supplemental consolidated financial
statement totals as of September 30, 1998, and which reflect net income of
$258,000 included in the related 1998 supplemental consolidated financial
statement totals for the year ended September 30, 1998. Those statements were
audited by other auditors whose report has been furnished to us, and our
opinion, insofar as it relates to data included for CR Technology, Inc., is
based solely on the report of the other auditors.

We conducted our audits in accordance with generally accepted auditing
standards. Those standards require that we plan and perform the audit to obtain
reasonable assurance about whether the financial statements are free of material
misstatement. An audit includes examining, on a test basis, evidence supporting
the amounts and disclosures in the financial statements. An audit also includes
assessing the accounting principles used and significant estimates made by
management, as well as evaluating the overall financial statement presentation.
We believe that our audits and the report of other auditors provide a reasonable
basis for our opinion.

In our opinion, based on our audits and the report of other auditors, the
supplemental financial statements referred to above present fairly, in all
material respects, the supplemental consolidated financial position of Photon
Dynamics, Inc. as of September 30, 1998 and 1999, and the supplemental
consolidated results of its operations and its cash flows for the years then
ended, after giving retroactive effect to the merger of CR Technology, Inc., as
described in the notes to the supplemental consolidated financial statements, in
conformity with generally accepted accounting principles.

/s/ ERNST & YOUNG LLP

San Jose, California
October 18, 1999 (except for the
second paragraph
under "Principles of Consolidation and
Basis of
Presentation" in Note 1 and except for
Note 2
as to which the date is November 30,
1999)

F-2
<PAGE>
REPORT OF CACCIAMATTA ACCOUNTANCY CORPORATION, INDEPENDENT AUDITORS

The Board of Directors and Shareholders
CR Technology, Inc.

We have audited the accompanying consolidated balance sheet of CR
Technology, Inc. and Subsidiary as of December 31, 1998, and the related
consolidated statements of income, stockholders' equity and cash flows for the
year then ended (not presented separately herein). These financial statements
are the responsibility of the Company's management. Our responsibility is to
express an opinion on these financial statements based on our audit.

We conducted our audit in accordance with generally accepted auditing
standards. Those standards require that we plan and perform the audit to obtain
reasonable assurance about whether the financial statements are free of material
misstatement. An audit includes examining, on a test basis, evidence supporting
the amounts and disclosures in the financial statements. An audit also includes
assessing the accounting principles used and significant estimates made by
management, as well as evaluating the overall financial statement presentation.
We believe that our audit provides a reasonable basis for our opinion.

In our opinion, the consolidated financial statements referred to above
present fairly, in all material respects, the financial position of CR
Technology, Inc. and Subsidiary as of December 31, 1998, and the results of
their consolidated operations and cash flows for the year then ended in
conformity with generally accepted accounting principles.

/s/ CACCIAMATTA ACCOUNTANCY
CORPORATION

Irvine, California
May 7, 1999
(except for Note 11, as to which the
date is August 25, 1999)

F-3
<PAGE>
PHOTON DYNAMICS, INC.

SUPPLEMENTAL CONSOLIDATED BALANCE SHEETS

<TABLE>
<CAPTION>
AS OF SEPTEMBER 30,
---------------------
1998 1999
--------- ---------
(IN THOUSANDS, EXCEPT
SHARE DATA)
<S> <C> <C>
ASSETS

Current assets:
Cash and cash equivalents................................. $ 6,117 $ 6,421
Short-term investments.................................... 178 1,605
Accounts receivable, net of allowance of $1,010 and $1,301
as of September 30, 1998 and 1999, respectively......... 7,449 13,630
Inventories............................................... 8,234 7,112
Prepaid expenses and other current assets................. 638 714
-------- --------
Total current assets........................................ 22,616 29,482

Property, equipment and leasehold improvements, net......... 1,949 1,817

Other assets................................................ 626 768
-------- --------
Total assets................................................ $ 25,191 $ 32,067
======== ========

LIABILITIES AND SHAREHOLDERS' EQUITY

Current liabilities:
Accounts payable.......................................... $ 1,858 $ 2,831
Accrued expenses and other liabilities.................... 3,647 5,535
Deferred revenue and customer deposits.................... 118 655
-------- --------
Total current liabilities................................... 5,623 9,021
-------- --------
Commitments and contingencies

Shareholders' equity:
Preferred stock, no par value, 5,000,000 shares
authorized, none issued and outstanding................. -- --
Common stock, no par value, 20,000,000 shares authorized,
9,030,108 and 9,648,571 shares issued and outstanding as
of September 30, 1998 and 1999, respectively............ 44,985 45,972
Accumulated deficit....................................... (25,135) (22,929)
Accumulated other comprehensive income (loss)............. (197) 3
Notes receivable from shareholders........................ (85) --
-------- --------
Total shareholders' equity.................................. 19,568 23,046
-------- --------
Total liabilities and shareholders' equity.................. $ 25,191 $ 32,067
======== ========
</TABLE>

See accompanying notes to supplemental consolidated financial statements.

F-4
<PAGE>
PHOTON DYNAMICS, INC.

SUPPLEMENTAL CONSOLIDATED STATEMENTS OF OPERATIONS

<TABLE>
<CAPTION>
FISCAL YEAR ENDED
SEPTEMBER 30,
---------------------
1998 1999
--------- ---------
(IN THOUSANDS, EXCEPT
PER SHARE DATA)
<S> <C> <C>
Revenue..................................................... $30,970 $45,431
Cost of revenue............................................. 17,879 25,573
------- -------
Gross margin................................................ 13,091 19,858
------- -------
Operating expenses:
Research and development.................................. 6,523 5,943
Selling, general and administrative....................... 8,321 11,140
Asset recovery related to product line disposal........... (350) --
------- -------
Total operating expenses.................................... 14,494 17,083
------- -------
Operating income (loss)..................................... (1,403) 2,775

Interest income............................................. 282 305
Interest expense and other.................................. (13) (134)
------- -------
Income (loss) before provision for income taxes............. (1,134) 2,946
Provision for income taxes.................................. 73 673
------- -------
Net income (loss)........................................... $(1,207) $ 2,273
======= =======

Basic net income (loss) per share........................... $ (0.14) $ 0.24
======= =======
Diluted net income (loss) per share......................... $ (0.14) $ 0.23
======= =======
Shares used in computing basic net income (loss) per
share..................................................... 8,930 9,282
Shares used in computing diluted net income (loss) per
share..................................................... 8,930 9,935
</TABLE>

See accompanying notes to supplemental consolidated financial statements.

F-5
<PAGE>
PHOTON DYNAMICS, INC.
SUPPLEMENTAL CONSOLIDATED STATEMENTS OF CASH FLOWS

<TABLE>
<CAPTION>
FISCAL YEAR ENDED
SEPTEMBER 30,
-------------------
1998 1999
-------- --------
(IN THOUSANDS)
<S> <C> <C>
Operating activities:
Net income (loss)......................................... $(1,207) $ 2,273
Adjustments to reconcile net income (loss) to net cash
provided by operating activities:
Depreciation and amortization........................... 1,378 1,093
Unrealized loss on investments.......................... -- (2)
Changes in operating assets and liabilities:
Accounts receivable................................... 3,910 (6,074)
Inventories........................................... (1,727) 1,399
Prepaid expenses and other current assets............. 243 (422)
Other assets.......................................... 14 69
Accounts payable...................................... (1,573) 555
Accrued expenses and other liabilities................ 794 2,061
Deferred revenue and customer deposits................ (305) 423
------- -------
Net cash provided by operating activities........... 1,527 1,375

Investing activities:
Purchases of property and equipment, net.................. (790) (908)
Purchases of short-term investments....................... (25) (1,500)
Proceeds from sale of short-term investments.............. 140 177
------- -------
Net cash used in investing activities............... (675) (2,231)

Financing activities:
Payments on line of credit................................ (50) --
Repurchase of common stock................................ (45) --
Proceeds from issuance of common stock.................... 405 989
Proceeds from notes receivable to shareholders............ 30 85
------- -------
Net cash provided by financing activities........... 340 1,074
------- -------
Adjustment to conform fiscal year of CR Technology, Inc..... -- (116)
Effect of exchange rate changes on cash..................... (183) 202
------- -------
Net increase in cash and cash equivalents................... 1,009 304
Cash and cash equivalents at beginning of year.............. 5,108 6,117
------- -------
Cash and cash equivalents at end of year.................... $ 6,117 $ 6,421
======= =======
Supplemental disclosure of cash flow information:
Interest paid............................................. $ 10 $ 20
======= =======
Income taxes paid......................................... $ 84 $ 201
======= =======
</TABLE>

See accompanying notes to supplemental consolidated financial statements.

F-6
<PAGE>
PHOTON DYNAMICS, INC.
SUPPLEMENTAL CONSOLIDATED STATEMENTS OF SHAREHOLDERS' EQUITY

<TABLE>
<CAPTION>
ACCUMULATED NOTES
COMMON STOCK OTHER RECEIVABLE TOTAL
-------------------- ACCUMULATED COMPREHENSIVE FROM SHAREHOLDERS'
SHARES AMOUNT DEFICIT INCOME (LOSS) SHAREHOLDERS EQUITY
--------- -------- ----------- ------------- ------------ -------------
(IN THOUSANDS, EXCEPT SHARE DATA)
<S> <C> <C> <C> <C> <C> <C>
Balance at September 30, 1997... 8,841,391 $44,625 $(23,928) $ (14) $(115) $20,568
Net loss........................ -- -- (1,207) -- -- (1,207)
Net translation adjustments..... -- -- -- (183) -- (183)
-------
Total comprehensive loss........ (1,390)
-------
Issuance of common stock........ 234,486 405 -- -- -- 405
Repurchase of common stock...... (45,769) (45) -- -- -- (45)
Repayment of notes receivable... -- -- -- -- 30 30
--------- ------- -------- ----- ----- -------
Balance at September 30, 1998... 9,030,108 44,985 (25,135) (197) (85) 19,568
Net income...................... -- -- 2,273 -- -- 2,273
Net translation adjustment...... -- -- -- 202 -- 202
Net unrealized loss on
investments................... -- -- -- (2) -- (2)
-------
Total comprehensive income...... 2,473
-------
Pooling adjustment with CR
Technology, Inc............... -- -- (67) -- -- (67)
Issuance of common stock........ 618,463 987 -- -- -- 987
Repayment of notes receivable... -- -- -- -- 85 85
--------- ------- -------- ----- ----- -------
Balance at September 30, 1999... 9,648,571 $45,972 $(22,929) $ 3 $ -- $23,046
========= ======= ======== ===== ===== =======
</TABLE>

See accompanying notes to supplemental consolidated financial statements.

F-7
<PAGE>
PHOTON DYNAMICS, INC.

NOTES TO SUPPLEMENTAL CONSOLIDATED FINANCIAL STATEMENTS

NOTE 1--SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES

ORGANIZATION. Photon Dynamics, Inc. ("PDI" or the "Company") is a leading
provider of yield management solutions to the flat panel display ("FPD")
industry. The Company also offers yield management solutions to the printed
circuit board ("PCB") assembly and advanced semiconductor packaging industries.
The Company's test, repair and inspection systems are used by manufacturers to
collect data, analyze product quality, and identify and repair product defects
at critical steps in the manufacturing process.

The Company sells its products for the FPD industry directly to customers in
Korea, through a sales representative in Taiwan, and through a value-added
reseller, IHI, in Japan. The Company sells products for the PCB assembly and
advanced semiconductor packaging markets primarily through sales
representatives. A significant portion of the Company's revenue is derived from
a small number of customers in the FPD industry. Most of the Company's FPD
customers are located in Japan, Taiwan and Korea, where FPD production is
concentrated. The majority of the Company's PCB assembly and advanced
semiconductor packaging customers are located in the U.S.

REVENUE RECOGNITION. The Company generally recognizes revenues from product
sales upon shipment, which usually precedes final acceptance. The Company
generally recognizes revenues from service contracts ratably over the contract
period.

PRINCIPLES OF CONSOLIDATION AND BASIS OF PRESENTATION. The consolidated
financial statements include the accounts of the Company and its subsidiaries,
all of which are wholly-owned. Significant intercompany accounts and
transactions have been eliminated in consolidation.

On November 30, 1999, the Company acquired CR Technology, Inc. ("CR
Technology"), a California corporation. This transaction was accounted for as a
pooling of interests. The consolidated financial statements for the years ended
September 30, 1998 and 1999 have been restated to include the financial
position, results of operations and cash flows of CR Technology. Financial
information for PDI's fiscal years ended September 30, 1998 and 1999 have been
combined with CR Technology for the fiscal year ended December 31, 1998 and the
twelve months ended September 30, 1999, respectively. Therefore, the results of
operations for the three months ended December 31, 1998 for CR Technology has
been included in both years. CR Technology's net income for the three months
ended December 31, 1998 has been reflected as an adjustment to shareholders'
equity in the accompanying financial statements during the year ended
September 30, 1999. The unaudited results of operations of CR Technology are
summarized as follows:

<TABLE>
<CAPTION>
THREE MONTHS ENDED
DECEMBER 31, 1998
------------------
(IN THOUSANDS)
<S> <C>
Revenue................................................... $2,423
Operating income.......................................... $ 9
Net income................................................ $ 67
</TABLE>

These supplemental consolidated financial statements will become the
historical financial statements upon the issuance of the financial statements
for the quarter ended December 31, 1999. See Note 2.

USE OF ESTIMATES. The preparation of the financial statements in conformity
with generally accepted accounting principles requires management to make
estimates and assumptions that affect the

F-8
<PAGE>
PHOTON DYNAMICS, INC.

NOTES TO SUPPLEMENTAL CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)

NOTE 1--SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES (CONTINUED)

amounts in the financial statements and accompanying notes. Actual results could
differ from those estimates.

CASH AND CASH EQUIVALENTS. The Company considers all highly liquid
investments with a maturity of three months or less when purchased to be cash
equivalents.

SHORT-TERM INVESTMENTS. Short-term investments consist of marketable
securities with a maturity of less than one year but not less than three months.
Short-term investments are available for sale and are recorded at fair value.

INVENTORIES. Inventories are priced at the lower of cost or market using
the first-in, first-out ("FIFO") method for all inventories. Inventories
consisted of the following:

<TABLE>
<CAPTION>
AS OF SEPTEMBER 30,
-------------------
1998 1999
-------- --------
(IN THOUSANDS)
<S> <C> <C>
Raw materials............................................ $2,475 $3,769
Work-in-progress......................................... 3,024 2,686
Finished goods........................................... 2,735 657
------ ------
$8,234 $7,112
====== ======
</TABLE>

PROPERTY, EQUIPMENT AND LEASEHOLD IMPROVEMENTS. Property, equipment and
leasehold improvements are stated on the basis of cost. Depreciation is computed
principally by the straight-line method for financial reporting purposes.
Estimated useful lives for financial reporting purposes range from three to five
years.

Property, equipment and leasehold improvements consisted of the following:

<TABLE>
<CAPTION>
AS OF SEPTEMBER 30,
-------------------
1998 1999
-------- --------
(IN THOUSANDS)
<S> <C> <C>
Equipment................................................ $ 4,979 $ 5,853
Office furniture and fixtures............................ 407 417
Leasehold improvements................................... 521 545
------- -------
5,907 6,815
Less accumulated depreciation and amortization........... (3,958) (4,998)
------- -------
$ 1,949 $ 1,817
======= =======
</TABLE>

WARRANTY. The Company typically provides a limited warranty on its products
for a period of one year from final acceptance by customers. A provision for
estimated warranty costs is recorded upon shipment.

FOREIGN CURRENCY TRANSLATION. The financial statements of foreign
subsidiaries have been translated into U.S. dollars in accordance with FASB
Statement No. 52, FOREIGN CURRENCY TRANSLATION. All balance sheet accounts have
been translated using the exchange rates in effect at the balance sheet date.
Income statement amounts have been translated using the average exchange rate
for the year.

F-9
<PAGE>
PHOTON DYNAMICS, INC.

NOTES TO SUPPLEMENTAL CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)

NOTE 1--SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES (CONTINUED)

Translation adjustments are included as a separate component of shareholders'
equity. Foreign currency transaction gains and losses are included in results of
operations and have been immaterial for all periods presented.

STOCK BASED COMPENSATION. The Company accounts for its stock option and
employee stock purchase plans in accordance with the provisions of APB Opinion
No. 25, ACCOUNTING FOR STOCK ISSUED TO EMPLOYEES ("APB 25") and related
Interpretations. Pro forma information regarding earnings per share is disclosed
as required by FASB Statement No. 123, ACCOUNTING FOR STOCK-BASED COMPENSATION
("FAS 123"). See Note 12.

ADVERTISING EXPENSES

Advertising expenditures are charged to operations as incurred. Advertising
expense for the fiscal years ended September 30, 1998 and 1999 amounted to
$81,000 and $122,000, respectively.

EARNINGS PER SHARE. Basic and diluted earnings per share are calculated in
accordance with FASB Statement No. 128, EARNINGS PER SHARE ("FAS 128"). See
Note 14.

COMPREHENSIVE INCOME. As of October 1998, the Company adopted FASB
Statement No. 130, REPORTING COMPREHENSIVE INCOME ("FAS 130") which establishes
new rules for the reporting and display of comprehensive income and its
components. FAS 130 requires unrealized gains or losses on the Company's
available-for-sale investments and foreign currency translation adjustments,
which prior to adoption were reported separately in shareholders' equity, to be
included in accumulated other comprehensive income. Prior year financial
statements have been reclassified to conform to the requirements of FAS 130. The
adoption of FAS 130 had no impact on the Company's net income (loss) or
shareholder's equity.

SEGMENT INFORMATION. As of October 1998, the Company adopted FASB Statement
No. 131, DISCLOSURES ABOUT SEGMENTS OF AN ENTERPRISE AND RELATED INFORMATION
("FAS 131"). FAS 131 superseded FASB Statement No. 14, FINANCIAL REPORTING FOR
SEGMENTS OF A BUSINESS ENTERPRISE. FAS 131 establishes standards for the way
that public business enterprises report information about operating segments in
annual financial statements and requires that those enterprises report selected
information about operating segments in interim financial reports. FAS 131 also
establishes standards for related disclosures about products and services,
geographic areas, and major customers. The adoption of FAS 131 did not affect
consolidated results of operations or financial position. See Note 11.

IMPACT OF RECENTLY ISSUED ACCOUNTING STANDARDS. In June 1998, the FASB
issued Statement No. 133, ACCOUNTING FOR DERIVATIVE INSTRUMENTS AND HEDGING
ACTIVITIES ("FAS 133"). FAS 133 will require the Company to recognize all
derivatives on the balance sheet at fair value. The Company does not anticipate
that the adoption of FAS 133 will have a significant effect on its results of
operations or financial condition.

In July 1999, the FASB issued Statement No. 137, ACCOUNTING FOR DERIVATIVE
INSTRUMENTS AND HEDGING ACTIVITIES--DEFERRAL OF THE EFFECTIVE DATE OF FAS 133
("FAS 137"). FAS 137 defers the effective date of FAS 133 to fiscal quarters
ended and years beginning after June 15, 2000. Accordingly, the Company is
required to adopt FAS 133 for the fiscal year ending September 30, 2001.

F-10
<PAGE>
PHOTON DYNAMICS, INC.

NOTES TO SUPPLEMENTAL CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)

NOTE 2--BUSINESS COMBINATION

On November 30, 1999, the Company acquired CR Technology, a supplier of
advanced X-ray and optical inspection systems to the PCB assembly and advanced
semiconductor packaging industries. In exchange for 1,834,251 shares of the
Company's common stock, the Company acquired all of the outstanding capital
stock of CR Technology, using an exchange ratio of 1.203343 shares of the
Company's common stock for each share of CR Technology. In addition, all
outstanding CR Technology stock options were converted, at the common stock
exchange ratio, into options to purchase the Company's common stock. This
transaction was approved by a vote of the Company's and CR Technology's
shareholders.

As of September 30, 1999, direct acquisition costs of $404,000 in connection
with the acquisition, primarily relating to legal, investment banking and
accounting fees, have been capitalized as prepaid expenses and will be expensed
during the three months ended December 31, 1999, the period in which the
transaction was consummated.

The following presents certain statement of operations data of the Company
and CR Technology for the periods prior to the acquisition:

<TABLE>
<CAPTION>
FISCAL YEAR ENDED
SEPTEMBER 30,
-------------------
1998 1999
-------- --------
(IN THOUSANDS)
<S> <C> <C>
Net revenue:
PDI..................................................... $22,420 $31,562
CR Technology........................................... 8,550 13,869
------- -------
Consolidated net revenue................................ $30,970 $45,431
======= =======

Net income (loss):
PDI..................................................... $(1,465) $ 1,170
CR Technology........................................... 258 1,103
------- -------
Consolidated net income (loss).......................... $(1,207) $ 2,273
======= =======
</TABLE>

NOTE 3--ACCRUED EXPENSES AND OTHER LIABILITIES

Accrued expenses and other liabilities consisted of the following:

<TABLE>
<CAPTION>
AS OF SEPTEMBER 30,
-------------------
1998 1999
-------- --------
(IN THOUSANDS)
<S> <C> <C>
Warranty................................................. $1,199 $1,640
Compensation............................................. 1,159 1,518
Commissions.............................................. 371 968
Other accrued expenses................................... 918 1,409
------ ------
$3,647 $5,535
====== ======
</TABLE>

F-11
<PAGE>
PHOTON DYNAMICS, INC.

NOTES TO SUPPLEMENTAL CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)

NOTE 4--NOTES RECEIVABLE FROM SHAREHOLDERS

Notes receivable from shareholders arose from certain employees exercising
their stock options and advances to purchase stock on the open market. The notes
bear interest at 6.83% per annum and are secured by the shares purchased. As of
September 30, 1999, all notes receivable from shareholders had been collected.

NOTE 5--ASSET RECOVERY RELATED TO PRODUCT LINE DISPOSAL

During the quarter ended December 31, 1997, the Company received $350,000
related to discontinuing its defect monitoring tool product in September 1996.
The Company had expensed the inventory and assets associated with this product
in the previous year.

NOTE 6--CREDIT ARRANGEMENTS

The Company has entered into a $3.5 million bank line of credit which
expires in March 2000. This line of credit is secured by substantially all of
the Company's assets and contains certain financial and other covenants. The
Company is eligible to borrow against accounts receivable and a portion of
inventories. Borrowings under this line of credit bear interest at prime rate
plus 1.00% to 1.25% (9.25% to 9.50% as of September 30, 1999). As of
September 30, 1999, no amounts were outstanding under this bank line of credit,
and the Company was in compliance with all bank covenants.

The Company has assumed a $1.5 million revolving bank line of credit which
was acquired as part of the CR Technology acquisition. This bank line of credit
expires in February 2001. This line of credit is secured by substantially all of
CR Technology's assets and contains certain financial and other covenants. CR
Technology is eligible to borrow on an unsecured basis. Borrowings under this
line of credit bear interest at prime rate (8.25% as of September 30, 1999). As
of September 30, 1999, no amounts were outstanding under this revolving line of
credit, and CR Technology was in compliance with all bank covenants.

NOTE 7--SHAREHOLDERS' EQUITY

STOCK RESERVED FOR FUTURE ISSUANCE. As of September 30, 1999, the Company
has reserved 1,664,655 shares of common stock for future issuance.

WARRANTS. There are warrants outstanding to purchase from the Company
12,067 shares of common stock. The purchase price for the shares is $5.40 per
share. These warrants will expire in June 2000.

F-12
<PAGE>
PHOTON DYNAMICS, INC.

NOTES TO SUPPLEMENTAL CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)

NOTE 8--INCOME TAXES

The provision for income taxes consists of the following:

<TABLE>
<CAPTION>
FISCAL YEAR ENDED
SEPTEMBER 30,
-------------------
1998 1999
-------- --------
(IN THOUSANDS)
<S> <C> <C>
Current:
Federal................................................. $ 7 $111
State................................................... 118 151
Foreign................................................. 108 71

Deferred:
Federal................................................. (160) 340
----- ----
Total............................................... $ 73 $673
===== ====
</TABLE>

The provisions for taxes on income differed from the provisions calculated
by applying the federal statutory rate to income before taxes are as follows:

<TABLE>
<CAPTION>
FISCAL YEAR ENDED
SEPTEMBER 30,
-------------------
1998 1999
-------- --------
(IN THOUSANDS)
<S> <C> <C>
Expected provision (benefit) at statutory rate............ $(385) $1,002
Alternative minimum taxes................................. 28 66
State taxes............................................... 117 151
Losses (benefited)/not benefited.......................... 313 (546)
----- ------
$ 73 $ 673
===== ======
</TABLE>

As of September 30, 1999, the Company has federal and state net operating
loss carryforwards of approximately $12.1 million and $320,000, respectively.
The Company also has federal and state research and development tax credit
carryforwards of $1.3 million and $750,000, respectively. The net operating loss
and credit carryforwards will expire at various times beginning in 2000 through
2018, if not utilized.

Under certain provisions of the Internal Revenue Code of 1986, as amended,
the availability of the Company's net operating loss and tax credit
carryforwards may be subject to limitation if it should be determined that there
has been a change in ownership of more that 50% of the value of the Company's
stock. Such determination could limit the utilization of net operating loss and
tax credit carryforwards.

Deferred tax assets reflect the net tax effects of temporary differences
between the carrying amounts of assets and liabilities for financial reporting
purposes, the amounts used for income tax purposes and net operating loss and
credit carryforwards.

F-13
<PAGE>
PHOTON DYNAMICS, INC.

NOTES TO SUPPLEMENTAL CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)

NOTE 8--INCOME TAXES (CONTINUED)

Significant components of the Company's deferred tax assets are as follows:

<TABLE>
<CAPTION>
FISCAL YEAR ENDED
SEPTEMBER 30,
-------------------
1998 1999
-------- --------
(IN THOUSANDS)
<S> <C> <C>
Deferred tax assets:
Net operating loss carryforwards....................... $ 5,410 $ 4,150
Research credit carryforwards.......................... 1,698 1,800
Capitalized research costs............................. 538 419
Inventory writedowns................................... 754 980
Depreciation........................................... 613 462
Other individually immaterial items.................... 1,539 1,859
-------- -------
Total deferred tax assets................................ 10,552 9,670
Valuation allowance...................................... (10,212) (9,670)
-------- -------
Net deferred tax assets.................................. $ 340 $ --
======== =======
</TABLE>

NOTE 9--COMMITMENTS

The Company leases two facilities under non-cancelable operating lease
agreements. The lease for the building in San Jose, California may be renewed
for one five-year period during fiscal 2002. The lease for the building in Aliso
Viejo, California may be renewed for one five-year period during fiscal 2005.
Total future minimum payments under non-cancelable operating leases with initial
terms of one year or more consisted of the following as of September 30, 1999:

<TABLE>
<CAPTION>
OPERATING
LEASES
--------------
(IN THOUSANDS)
<S> <C>
2000........................................................ $ 925
2001........................................................ 1,013
2002........................................................ 358
2003........................................................ 309
2004........................................................ 321
------
Total minimum lease payments................................ $2,926
======
</TABLE>

Rental expense for the years ended September 30, 1998 and 1999 was $895,000
and $910,000, respectively.

F-14
<PAGE>
PHOTON DYNAMICS, INC.

NOTES TO SUPPLEMENTAL CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)

NOTE 10--FINANCIAL INSTRUMENTS

CONCENTRATIONS OF CREDIT RISK. Financial instruments that potentially
subject the Company to significant concentrations of credit risk consist
principally of trade accounts receivable. Most of the Company's principle
customers are located in Asia, primarily Japan, Taiwan and Korea. Therefore, the
Company's sales to these countries may be adversely affected by the overall
health of these economies, including the effects of currency exchange rate
fluctuations. The Company generally sells its products on net-30 day terms to
its customers with a small portion held back until final acceptance. Although a
substantial portion of its customers, primarily foreign, remit payments on
significantly longer terms, the Company generally does not require collateral
for its trade accounts receivable. The Company believes its credit evaluation
and monitoring mitigates this credit risk.

FAIR VALUE OF FINANCIAL INSTRUMENTS. The Company has evaluated its fair
value disclosures for financial instruments. The carrying amount reported in the
balance sheet for cash and cash equivalents, short-term investments, accounts
receivable, accounts payable and accrued expenses approximates its fair value.

NOTE 11--OPERATIONS BY INDUSTRY SEGMENT AND GEOGRAPHIC AREA

The Company conducts business in two operating segments: FPD products and
PCB assembly and advanced semiconductor packaging inspection products
(collectively, "semiconductor inspection products"). The Company's FPD yield
management products include test, repair and inspection equipment. The Company's
FPD test and inspection equipment identifies and characterizes defects at early
stages of the manufacturing process so that the panels may be repaired before
the next stage, or, if necessary, discarded, minimizing the loss of time and
materials. The Company's FPD products gather comprehensive data that enable FPD
manufacturers to control and tune their processes to produce zero defect
displays at high yields. The Company's X-ray and optical inspection systems
enable PCB assembly and advanced semiconductor packaging manufacturers to detect
and identify defects, thereby increasing yields and quality and reducing costs.

Prior to the acquisition of CR Technology on November 30, 1999, the Company
only operated in the FPD products segment. The Company's management has
determined the operating segments based upon how the business is managed and
operated. There are no significant intersegment sales or transfers and
substantially all of the Company's long-lived assets are located in the U.S. The
Company's principal markets are Asian-based FPD manufacturers and North
American-based PCB assembly and advanced semiconductor packaging manufacturers.

F-15
<PAGE>
PHOTON DYNAMICS, INC.

NOTES TO SUPPLEMENTAL CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)

NOTE 11--OPERATIONS BY INDUSTRY SEGMENT AND GEOGRAPHIC AREA (CONTINUED)

The Company's operating segments consisted of the following:

<TABLE>
<CAPTION>
FISCAL YEAR ENDED
SEPTEMBER 30,
-------------------
1998 1999
-------- --------
(IN THOUSANDS)
<S> <C> <C>
Net sales to external customers:
FPD products............................................ $22,420 $31,562
Semiconductor inspection products....................... 8,550 13,869
------- -------
Consolidated net sales to external customers............ $30,970 $45,431
======= =======
Operating income (loss):
FPD products............................................ $(1,589) $ 1,180
Semiconductor inspection products....................... 186 1,595
------- -------
Consolidated operating income (loss).................... $(1,403) $ 2,775
======= =======
Identifiable assets:
FPD products............................................ $21,033 $25,288
Semiconductor inspection products....................... 4,158 6,779
------- -------
Consolidated identifiable assets........................ $25,191 $32,067
======= =======
</TABLE>

The Company's geographic operations consisted of the following:

<TABLE>
<CAPTION>
FISCAL YEAR ENDED
SEPTEMBER 30,
-------------------
1998 1999
-------- --------
(IN THOUSANDS)
<S> <C> <C>
Net sales to external customers:
Asia.................................................... $21,710 $33,313
North America........................................... 8,825 11,116
Other................................................... 435 1,002
------- -------
Consolidated net sales to external customers............ $30,970 $45,431
======= =======
</TABLE>

Sales outside North America accounted for 72% and 76% of revenue in fiscal
1998 and fiscal 1999, respectively.

Direct sales to the Company's top four customers, each of which is a FPD
manufacturer, in fiscal 1998 and fiscal 1999 accounted for 67% and 55% of total
revenue, respectively. In fiscal 1998, sales to two unaffiliated and one
affiliated customer in the FPD products segment accounted for 33%, 12% and 20%,
respectively. In fiscal 1999, sales to three unaffiliated and one affiliated
customer in the FPD products segment represented 18%, 16%, 10% and 11% of total
revenue, respectively.

F-16
<PAGE>
PHOTON DYNAMICS, INC.

NOTES TO SUPPLEMENTAL CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)

NOTE 12--EMPLOYEE STOCK PURCHASE AND STOCK OPTION PLANS

EMPLOYEE PURCHASE PLAN. In January 1999, the board of directors amended the
1995 Employee Stock Purchase Plan ("Purchase Plan") to increase the number of
shares authorized for issuance to an aggregate of 350,000 shares. The Purchase
Plan permits eligible employees to purchase common stock, through payroll
deductions, at 85% of the lower of the fair market value of the common stock at
market close on the date at the beginning of the two-year offering period or the
last day of the purchase period. Substantially all employees are eligible to
participate in the Purchase Plan. Employees purchased 120,445 shares in fiscal
1999 for $293,000 as compared to 102,343 shares for $239,000 in fiscal 1998. As
of September 30, 1999, 62,172 shares were available for issuance under the plan.
Employees of CR Technology did not participate in the Purchase Plan prior to the
acquisition.

STOCK OPTION PLANS. Under the 1987 and 1995 Stock Option Plans ("Option
Plans"), the board of directors may, at its discretion, grant incentive or
nonqualified stock options to employees and directors. Options granted under the
Option Plans have exercise prices at least equal to the market price at the date
of grant and, subject to termination of employment, expire 10 years from the
date of grant, are not transferable other than on death, and are generally
exercisable in 50 equal installments commencing 6 months from the date of grant.

In November 1998, the board of directors authorized the repricing of options
granted to employees effective as of the close of business on November 27, 1998
to the then fair market value of $4.50 per share. Under the terms of the
repricing, employees surrendered 431,833 of existing options in exchange for
353,464 replacement options, which contained a provision that the replacement
options could not be exercised for a six month period and that extended the
original option vesting schedule by six months. The number of replacement
options issued was determined based on a conversion formula. No members of the
Company's board of directors participated in the repricing.

On November 30, 1999, 104,500 outstanding CR Technology stock options were
converted, at the common stock exchange ratio in accordance with the business
acquisition agreement, into 125,742 options to purchase the Company's common
stock at an average converted exercise price of $0.26. The options are
exercisable in four equal annual installments commencing one year from the
original date of grant and expire ten years from the original date of grant.

The following table summarizes the stock option activity and related
information:

<TABLE>
<CAPTION>
WEIGHTED
SHARES UNDER AVERAGE
OPTION EXERCISE PRICE
------------ --------------
<S> <C> <C>
Outstanding as of September 30, 1997............... 1,252,174 $4.28

Granted............................................ 429,513 $3.76
Exercised.......................................... (131,639) $1.05
Canceled........................................... (276,200) $5.43
--------- -----
Outstanding as of September 30, 1998............... 1,273,848 $4.19

Granted............................................ 772,680 $5.75
Exercised.......................................... (299,825) $2.13
Canceled........................................... (548,951) $6.59
--------- -----
Outstanding as of September 30, 1999............... 1,197,752 $4.62
========= =====
</TABLE>

F-17
<PAGE>
PHOTON DYNAMICS, INC.

NOTES TO SUPPLEMENTAL CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)

NOTE 12--EMPLOYEE STOCK PURCHASE AND STOCK OPTION PLANS (CONTINUED)

404,345 and 392,664 stock option shares are available for grant as of
September 30, 1998 and 1999, respectively. 625,551 and 530,883 stock option
shares are exercisable as of September 30, 1998 and 1999, respectively.

The following table summarizes information about stock options outstanding
as of September 30, 1999:

<TABLE>
<CAPTION>
OPTIONS OUTSTANDING OPTIONS EXERCISABLE
-------------------------------------------------- -----------------------------
NUMBER WEIGHTED AVERAGE WEIGHTED NUMBER WEIGHTED
RANGE OF OUTSTANDING REMAINING AVERAGE OUTSTANDING AVERAGE
EXERCISE AS OF CONTRACTUAL LIFE EXERCISE AS OF EXERCISE
PRICES SEPTEMBER 30, 1999 (YEARS) PRICE SEPTEMBER 30, 1999 PRICE
- ----------------- ------------------- ----------------- -------- ------------------ --------
<S> <C> <C> <C> <C> <C>
0.$08-$0.90..... 186,716 5.32 $ 0.41 119,939 $ 0.43
2.$40-$3.60..... 212,454 8.09 $ 3.20 89,642 $ 3.09
4.$13-$4.13..... 165,000 9.14 $ 4.13 33,500 $ 4.13
4.$50-$4.50..... 291,651 9.16 $ 4.50 186,906 $ 4.50
4.$63-$7.50..... 205,631 8.52 $ 5.67 75,756 $ 5.91
8.$44-$10.63.... 60,500 9.13 $10.22 19,900 $ 9.39
11$.00-$14.38... 75,800 9.62 $13.10 5,240 $11.00
--------- ---- ------ ------- ------
0.$08-$14.38.... 1,197,752 8.29 $ 4.62 530,883 $ 3.77
</TABLE>

The weighted average fair value of stock options granted in fiscal 1998 and
fiscal 1999 was $1.99 and $2.66, respectively. The weighted average fair value
of stock purchases under the Purchase Plan in fiscal 1998 and fiscal 1999 was
$1.59 and $1.86, respectively.

ACCOUNTING FOR STOCK BASED COMPENSATION PLANS. In accordance with the
provisions of FAS 123, the Company applies APB 25 and related Interpretations in
accounting for its stock option and employee stock purchase plans and,
accordingly, does not recognize compensation expense in the statement of
operations because the exercise price of the employees' stock options equals the
market price of the underlying stock at market close on the date of grant. If
the Company had elected to recognize compensation expense based on the fair
value of the options granted at the grant date as prescribed by FAS 123,
earnings and earnings per share would have been adjusted to the pro forma
amounts as follows:

<TABLE>
<CAPTION>
FISCAL YEAR ENDED
SEPTEMBER 30,
-------------------
1998 1999
-------- --------
(IN THOUSANDS,
EXCEPT PER SHARE
DATA)
<S> <C> <C>
Net income (loss) as reported.............................. $(1,207) $2,273
Net income (loss) pro forma................................ $(1,833) $1,228
Basic net income (loss) per share--as reported............. $ (0.14) $ 0.24
Diluted net income (loss) per share--as reported........... $ (0.14) $ 0.23
Basic net income (loss) per share--pro forma............... $ (0.21) $ 0.13
Diluted net income (loss) per share--pro forma............. $ (0.21) $ 0.12
</TABLE>

F-18
<PAGE>
PHOTON DYNAMICS, INC.

NOTES TO SUPPLEMENTAL CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)

NOTE 12--EMPLOYEE STOCK PURCHASE AND STOCK OPTION PLANS (CONTINUED)

The effects on pro forma disclosures of applying FAS 123 are not likely to
be representative of the effects on pro forma disclosures of future years
because FAS 123 is applicable only to options granted subsequent to October 1,
1995. Compensation expense for the fair value of each stock option grant is
estimated on the date of grant using the Black-Scholes option pricing model for
the multiple option approach with the following weighted average assumptions:

<TABLE>
<CAPTION>
OPTIONS ESPP
------------------- --------------------
1998 1999 1998 1999
-------- -------- --------- --------
<S> <C> <C> <C> <C>
Expected dividend yield................. -- -- -- --
Expected stock price volatility......... 0.80 0.80 0.79 0.80
Risk free interest rate................. 5.54% 4.73% 5.30% 5.31%
Expected life of options from date of
grant................................. 3 years 2 years 1.5 years 2 years
</TABLE>

NOTE 13--RETIREMENT SAVINGS PLAN

Under the Company's retirement savings plan (the "401(k) Plan"), a U.S.
employee may defer and invest up to 20% of his or her annual compensation,
subject to an annual dollar limitation. All U.S. full-time employees, twenty-one
years or older, are eligible to participate in the 401(k) Plan. The Company has
not elected to make matching contributions. Employees of CR Technology became
eligible under the 401(k) Plan after the acquisition.

NOTE 14--EARNINGS PER SHARE

For the years ended September 30, 1998 and 1999, basic and diluted earnings
per share is computed using the weighted average number of shares of common
stock outstanding. As the Company incurred a loss for the year ended
September 30, 1998, the effect of dilutive securities totaling approximately
468,000 from stock options and warrants has been excluded from the computation
of diluted earnings per share as their effect is antidilutive. The following
table sets forth the computation of basic and diluted earnings per share:

<TABLE>
<CAPTION>
FISCAL YEAR ENDED
SEPTEMBER 30,
-------------------
1998 1999
-------- --------
(IN THOUSANDS,
EXCEPT PER SHARE
DATA)
<S> <C> <C>
Numerator for basic and diluted earnings per share--net
income (loss)............................................. $(1,207) $2,273
======= ======
Denominator for basic earnings per share--weighted average
shares.................................................... 8,930 9,282
Effect of dilutive securities:
Employee stock options.................................... -- 592
Warrants.................................................. -- 61
------- ------
Denominator for diluted earnings per share--adjusted for
weighted average shares from options and warrants......... 8,930 9,935
======= ======

Basic net income (loss) per share........................... $ (0.14) $ 0.24
Diluted net income (loss) per share......................... $ (0.14) $ 0.23
</TABLE>

F-19
<PAGE>
PHOTON DYNAMICS, INC.

NOTES TO SUPPLEMENTAL CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)

NOTE 15--RELATED PARTIES

During fiscal 1998, the Company sold $6.2 million of its systems to LG
Electronics, Inc. ("LG"), and accounts receivable as of September 30, 1998
included $1.1 million of receivable from LG. During fiscal 1999, the Company
sold $4.9 million of its systems to LG, and accounts receivable as of
September 30, 1999 included $298,000 of receivable from LG. At September 30,
1998, LG owned approximately 8% of the Company's common stock and warrants to
purchase 28,333 shares of the Company's common stock at an exercise price of
$0.60 per share and also held a seat on the Company's board of directors. At
September 30, 1999, LG owned less than 1% of the Company's common stock and is
no longer on the Company's board of directors.

F-20
<PAGE>
PART II
INFORMATION NOT REQUIRED IN PROSPECTUS

ITEM 14. OTHER EXPENSES OF ISSUANCE AND DISTRIBUTION.

The following table sets forth all expenses, other than the underwriting
discounts and commissions, payable by us in connection with the sale of the
common stock being registered. All the amounts shown are estimates except for
the registration fee.

<TABLE>
<S> <C>
SEC registration fee........................................ $ 20,967
NASD filing fee............................................. 8,442
Nasdaq additional listing fee............................... 17,500
Printing and engraving expenses............................. 125,000
Legal fees and expenses..................................... 300,000
Accounting fees and expenses................................ 150,000
Transfer agent and registrar fees and expenses.............. 10,000
Blue sky fees and expenses.................................. 0
Miscellaneous............................................... 18,091

Total....................................................... $650,000
========
</TABLE>

ITEM 15. INDEMNIFICATION OF OFFICERS AND DIRECTORS.

Our Bylaws provide that we will indemnify our directors and officers to the
fullest extent not prohibited by California law. We are also empowered under our
Articles of Incorporation and Bylaws to enter into indemnification contracts
with our directors, officers, employees and agents and to purchase insurance on
behalf of any person whom we are required or permitted to indemnify. Pursuant to
this provision, we have entered into indemnity agreements with each of our
directors and officers.

In addition, our Articles of Incorporation provide that, to the fullest
extent permitted by California law, our directors will not be liable for
monetary damages for breach of the directors' fiduciary duty of care to us and
our shareholders. This provision in the Articles of Incorporation does not
eliminate the duty of care, and in appropriate circumstances, equitable remedies
such as an injunction or other forms of non-monetary relief would remain
available under California law. Each director will continue to be subject to
liability for breach of the director's duty of loyalty to us, for acts or
omissions not in good faith or involving intentional misconduct or knowing and
culpable violations of law, that the director believes to be contrary to the
best interests of PDI or our shareholders, involving a reckless disregard for
the director's duty to PDI or our shareholders when the director was aware or
should have been aware of a risk of serious injury to PDI or our shareholders,
or an unexcused pattern of inattention that amounts to an abdication of the
director's duty to PDI or our shareholders, for improper transactions between
the director and PDI and for improper distributions to shareholders and loans to
directors and officers or for acts or omissions by the director as an officer.
This provision also does not affect a director's responsibilities under any
other laws, such as the federal securities laws or state or federal
environmental laws.

There is no pending litigation or proceeding involving a director, officer,
employee or other agent of PDI as to which indemnification is being sought, nor
is PDI aware of any pending or threatened litigation that may result in claims
for indemnification by any director, officer, employee or other agent.

II-1
<PAGE>
ITEM 16. EXHIBITS

INDEX TO EXHIBITS

<TABLE>
<CAPTION>
EXHIBIT
NUMBER DESCRIPTION OF DOCUMENT
- --------------------- -----------------------
<C> <S>
1.1 Underwriting Agreement.
4.1(1) First Amended and Restated Investor Rights Agreement between
Registrant and the shareholders set forth therein dated
May 11, 1994.
5.1 Legal Opinion of Cooley Godward LLP.
10.1(2) Sales Agreement between the Registrant & Zeus Technology
Corporation dated December 24, 1998.
10.2(2) Employment Agreement between Registrant & Richard Amtower
dated November 30, 1999.
10.3 Loan and Security Agreement between Pacific Century Bank and
CR Technology, Inc. dated as of July 20, 1998 as amended on
November 15, 1999.
10.4 Loan and Security Agreement between Silicon Valley Bank and
Registrant dated as of March 25, 1999.
23.1 Consent of Ernst & Young LLP, independent auditors.
23.2 Consent of Cacciamatta Accountancy Corporation, independent
auditors.
23.3 Consent of Cooley Godward LLP. (See Exhibit 5.1.)
24.1(2) Power of Attorney. (See page II-3.)
27.1 Financial Data Schedule.
</TABLE>

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

(1) Incorporated by reference to Registrant's Form 10-KSB filed with the SEC on
December 18, 1998.

(2) Previously filed.

ITEM 17. UNDERTAKINGS.

The undersigned registrant hereby undertakes to deliver or cause to be
delivered with the prospectus, to each person to whom the prospectus is sent or
given, the latest annual report to security holders that is incorporated by
reference in the prospectus and furnished pursuant to and meeting the
requirements of Rule 14-3 or Rule 14c-3 under the Securities Exchange Act of
1934; and, where interim financial information required to be presented by
Article 3 of Regulation S-X are not set forth in the prospectus, to deliver, or
cause to be delivered to each person to whom the prospectus is sent or given,
the latest quarterly report that is specifically incorporated by reference in
the prospectus to provide such interim financial information.

Insofar as indemnification for liabilities arising under the Securities Act
may be permitted to directors, officers and controlling persons of the
registrant pursuant to provisions described in Item 15, or otherwise, the
registrant has been advised that in the opinion of the Securities and Exchange
Commission such indemnification is against public policy as expressed in the
Securities Act and is, therefore, unenforceable. In the event that a claim for
indemnification against such liabilities (other than the payment by the
registrant of expenses incurred or paid by a director, officer or controlling
person of the registrant in the successful defense of any action, suit or
proceeding) is asserted by such director, officer or controlling person in
connection with the securities being registered, the registrant will, unless in
the opinion of its counsel the matter has been settled by controlling precedent,
submit to a court of appropriate jurisdiction the question whether such
indemnification by it is against public policy as expressed in the Securities
Act and will be governed by the final adjudication of such issue.

The undersigned registrant hereby undertakes that:

(1) For purposes of determining any liability under the Securities Act of
1933, the information omitted from the form of prospectus filed as part
of this registration statement in reliance upon Rule 430A and contained
in a form of prospectus filed by the registrant pursuant to
Rule 424(b)(1) or (4) or 497(h) under the Securities Act shall be deemed
to be part of this registration statement as of the time it was declared
effective.

(2) For the purpose of determining any liability under the Securities Act of
1933, each post-effective amendment that contains a form of prospectus
shall be deemed to be a new registration statement relating to the
securities offered therein, and the offering of such securities at that
time shall be deemed to be the initial bona fide offering thereof.

II-2
<PAGE>
SIGNATURES

Pursuant to the requirements of the Securities Act of 1933, PDI has duly
caused this Amendment to the Registration Statement to be signed on its behalf
by the undersigned, thereunto duly authorized, in the City of San Jose, County
of Santa Clara, State of California, on , 2000.

<TABLE>
<S> <C> <C>
PHOTON DYNAMICS, INC.

By: *
-----------------------------------------
Vincent F. Sollitto
PRESIDENT AND CHIEF EXECUTIVE OFFICER
</TABLE>

In accordance with the requirements of the Securities Act of 1933, as
amended, this Amendment to the Registration Statement has been signed below by
the following persons in the capacities and on the dates stated.

<TABLE>
<CAPTION>
SIGNATURE TITLE DATE
--------- ----- ----
<C> <S> <C>
*
------------------------------------------- Chairman of the Board , 2000
E. Floyd Kvamme

President, Chief Executive
* Officer and Director
------------------------------------------- (Principal Executive , 2000
Vincent F. Sollitto Officer)

Vice President of Finance
and Administration, Chief
/s/ RICHARD L. DISSLY Financial Officer and
------------------------------------------- Secretary (Principal , 2000
Richard L. Dissly Financial and Accounting
Officer)

*
------------------------------------------- Director , 2000
Barry L. Cox

*
------------------------------------------- Director , 2000
Francois J. Henley

*
------------------------------------------- Director , 2000
Michael J. Kim

*
------------------------------------------- Director , 2000
Malcolm J. Thompson
</TABLE>

<TABLE>
<S> <C> <C> <C>
*By: /s/ RICHARD L. DISSLY
--------------------------------------
Richard L. Dissly
ATTORNEY-IN-FACT
</TABLE>

II-3
<PAGE>
EXHIBIT INDEX

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

(1) Incorporated by reference to Registrant's Form 10-KSB filed with the SEC on
December 18, 1998.

(2) Previously filed.

<PAGE>

BANC OF AMERICA SECURITIES LLC
NEEDHAM & COMPANY, INC.
UNDERWRITING AGREEMENT
[Draft of January 26, 2000]

2,000,000 SHARES

PHOTON DYNAMICS, INC.

COMMON STOCK

UNDERWRITING AGREEMENT

DATED JANUARY 31, 2000

<PAGE>

UNDERWRITING AGREEMENT

January 31, 2000

BANC OF AMERICA SECURITIES LLC
NEEDHAM & COMPANY, INC.
As Representatives of the several Underwriters
c/o Banc of America Securities LLC
600 Montgomery Street
San Francisco, California 94111

Ladies and Gentlemen:

Photon Dynamics, Inc., a California corporation (the
"Company"), proposes to issue and sell to the several underwriters named in
SCHEDULE A (the "Underwriters") an aggregate of 1,320,687 shares of its Common
Stock, no par value per share (the "Common Stock"); and the shareholder of the
Company named in SCHEDULE B (the "Selling Shareholder") proposes to sell to the
Underwriters 679,313 shares of Common Stock. The 1,320,687 shares of Common
Stock to be sold by the Company and the 679,313 shares of Common Stock to be
sold by the Selling Shareholder are collectively called the "Firm Common
Shares". In addition, the Company has granted to the Underwriters an option to
purchase up to an additional 300,000 shares (the "Optional Common Shares") of
Common Stock, as provided in Section 2. The Firm Common Shares and, if and to
the extent such option is exercised, the Optional Common Shares are collectively
called the "Common Shares". Banc of America Securities LLC ("NMS") and Needham &
Company, Inc. ("Needham") have agreed to act as joint representatives of the
several Underwriters (in such capacity, the "Representatives") in connection
with the offering and sale of the Common Shares.

The Company has prepared and filed with the Securities and
Exchange Commission (the "Commission") a registration statement on Form S-3
(File No. 333-92937), which contains a form of prospectus to be used in
connection with the public offering and sale of the Common Shares. Such
registration statement, as amended, including the financial statements, exhibits
and schedules thereto, in the form in which it was declared effective by the
Commission under the Securities Act of 1933, as amended, and the rules and
regulations promulgated thereunder (collectively, the "Securities Act"), and all
information incorporated or deemed to be incorporated by reference therein
including any information deemed to be a part thereof at the time of
effectiveness pursuant to Rule 430A or Rule 434 under the Securities Act or the
Securities Exchange Act of 1934, as amended, and the rules and regulations
promulgated thereunder (collectively, the "Exchange Act"), is called the
"Registration Statement". Any registration statement filed by the Company
pursuant to Rule 462(b) under the Securities Act is called the "Rule 462(b)
Registration Statement", and from and after the date and time of filing of the
Rule 462(b) Registration Statement the term "Registration Statement" shall
include the Rule 462(b) Registration Statement. Such prospectus, in the form
first used by the Underwriters

-1-

<PAGE>

to confirm sales of the Common Shares, is called the "Prospectus". All
references in this Agreement to (i) the Registration Statement, the Rule
462(b) Registration Statement, a preliminary prospectus, the Prospectus, or
any amendments or supplements to any of the foregoing, shall include any copy
thereof filed with the Commission pursuant to its Electronic Data Gathering,
Analysis and Retrieval System ("EDGAR"). All references in this Agreement to
financial statements and schedules and other information which is
"contained," "included" or "stated" in the Registration Statement or the
Prospectus (and all other references of like import) shall be deemed to mean
and include all such financial statements and schedules and other information
which is or is deemed to be incorporated by reference in the Registration
Statement or the Prospectus, as the case may be; and all references in this
Agreement to amendments or supplements to the Registration Statement or the
Prospectus shall be deemed to mean and include the filing of any document
under the Exchange Act which is or is deemed to be incorporated by reference
in the Registration Statement or the Prospectus, as the case may be.

The Company and the Selling Shareholder hereby confirm their
respective agreements with the Underwriters as follows:

SECTION 1. REPRESENTATIONS AND WARRANTIES.

A. REPRESENTATIONS AND WARRANTIES OF THE COMPANY. The Company hereby
represents, warrants and covenants to each Underwriter as follows:

(a) COMPLIANCE WITH REGISTRATION REQUIREMENTS. The Registration
Statement and any Rule 462(b) Registration Statement have been declared
effective by the Commission under the Securities Act. The Company has
complied to the Commission's satisfaction with all requests of the Commission
for additional or supplemental information. No stop order suspending the
effectiveness of the Registration Statement or any Rule 462(b) Registration
Statement is in effect and no proceedings for such purpose have been
instituted or are pending or, to the best knowledge of the Company, are
contemplated or threatened by the Commission.

Each preliminary prospectus and the Prospectus when filed
complied in all material respects with the Securities Act and, if filed by
electronic transmission pursuant to EDGAR (except as may be permitted by
Regulation S-T under the Securities Act), was substantially identical to the
copy thereof delivered to the Underwriters for use in connection with the
offer and sale of the Common Shares. Each of the Registration Statement, any
Rule 462(b) Registration Statement and any post-effective amendment thereto,
at the time it became effective and at all subsequent times through the
Prospectus Delivery Period, complied and will comply in all material respects
with the Securities Act and did not and will not contain any untrue statement
of a material fact or omit to state a material fact required to be stated
therein or necessary to make the statements therein not misleading. The
Prospectus, as amended or supplemented, as of its date and at all subsequent
times through the Prospectus Delivery Period, did not and will not contain
any untrue statement of a material fact or omit to state a material fact
necessary in order to make the statements therein, in the light of the
circumstances under which they were made, not misleading. The representations
and warranties set forth in the two immediately preceding sentences do not
apply to statements in or omissions from the Registration Statement, any Rule
462(b) Registration Statement, or any post-effective amendment thereto, or
the Prospectus, or any amendments or supplements thereto, made in reliance
upon and in conformity with information relating to any Underwriter furnished
to the Company in writing by the Representatives expressly for use therein.
There are no contracts or other documents required to

-2-

<PAGE>

be described in the Prospectus or to be filed as exhibits to the Registration
Statement which have not been described or filed as required.

(b) OFFERING MATERIALS FURNISHED TO UNDERWRITERS. The Company has
delivered to the Representatives eight complete manually signed copies of the
Registration Statement and of each consent and certificate of experts filed as a
part thereof, and conformed copies of the Registration Statement (without
exhibits) and preliminary prospectuses and the Prospectus, as amended or
supplemented, in such quantities and at such places as the Representatives have
reasonably requested for each of the Underwriters.

(c) DISTRIBUTION OF OFFERING MATERIAL BY THE COMPANY. The Company has
not distributed and will not distribute, prior to the later of the Second
Closing Date (as defined below) and the completion of the Underwriters'
distribution of the Common Shares, any offering material in connection with the
offering and sale of the Common Shares other than a preliminary prospectus, the
Prospectus or the Registration Statement.

(d) THE UNDERWRITING AGREEMENT. This Agreement has been duly
authorized, executed and delivered by, and is a valid and binding agreement of,
the Company, enforceable in accordance with its terms, except as rights to
indemnification hereunder may be limited by applicable law and except as the
enforcement hereof may be limited by bankruptcy, insolvency, reorganization,
moratorium or other similar laws relating to or affecting the rights and
remedies of creditors or by general equitable principles.

(e) AUTHORIZATION OF THE COMMON SHARES. The Common Shares to be
purchased by the Underwriters from the Company have been duly authorized for
issuance and sale pursuant to this Agreement and, when issued and delivered by
the Company pursuant to this Agreement, will be validly issued, fully paid and
nonassessable.

(f) NO APPLICABLE REGISTRATION OR OTHER SIMILAR RIGHTS. There are no
persons with registration or other similar rights to have any equity or debt
securities registered for sale under the Registration Statement or included in
the offering contemplated by this Agreement with respect to the Common Shares
included in the Registration Statement, except for such rights as have been duly
waived.

(g) NO MATERIAL ADVERSE CHANGE. Except as otherwise disclosed in the
Prospectus, subsequent to the respective dates as of which information is given
in the Prospectus: (i) there has been no material adverse change, or any
development that could reasonably be expected to result in a material adverse
change, in the condition, financial or otherwise, or in the earnings, business,
operations or prospects, whether or not arising from transactions in the
ordinary course of business, of the Company and its subsidiaries, considered as
one entity (any such change is called a "Material Adverse Change"); (ii) the
Company and its subsidiaries, considered as one entity, have not incurred any
material liability or obligation, indirect, direct or contingent, not in the
ordinary course of business nor entered into any material transaction or
agreement not in the ordinary course of business; and (iii) there has been no
dividend or distribution of any kind declared, paid or made by the Company or,
except for dividends paid to the Company or other subsidiaries, any of its
subsidiaries on any class of capital stock or repurchase or redemption by the
Company or any of its subsidiaries of any class of capital stock.

-3-

<PAGE>

(h) INDEPENDENT ACCOUNTANTS. Ernst & Young LLP, who have expressed
their opinion with respect to the financial statements (which term as used in
this Agreement includes the related notes thereto) filed with the Commission as
a part of the Registration Statement and included in the Prospectus, are
independent public or certified public accountants as required by the Securities
Act and Exchange Act.

(i) PREPARATION OF THE FINANCIAL STATEMENTS. The financial statements
filed with the Commission as a part of the Registration Statement and included
in the Prospectus present fairly the consolidated financial position of the
Company and its subsidiaries as of and at the dates indicated and the results of
their operations and cash flows for the periods specified. Such financial
statements have been prepared in conformity with generally accepted accounting
principles applied on a consistent basis throughout the periods involved, except
as may be expressly stated in the related notes thereto. No other financial
statements or supporting schedules are required to be included in the
Registration Statement. The financial data set forth in the Prospectus under the
captions "Prospectus Summary-Summary Supplemental Consolidated Financial Data",
"Selected Supplemental Consolidated Financial Data" and "Capitalization" fairly
present the information set forth therein on a basis consistent with that of the
audited financial statements contained in the Registration Statement.

(j) INCORPORATION AND GOOD STANDING OF THE COMPANY AND ITS
SUBSIDIARIES. Each of the Company and its subsidiaries has been duly
incorporated or organized, as the case may be, and is validly existing as a
corporation in good standing (in jurisdictions in which, under the laws thereof,
the concept of good standing exists) under the laws of the jurisdiction of its
incorporation and has corporate power and authority to own, lease and operate
its properties and to conduct its business as described in the Prospectus and,
in the case of the Company, to enter into and perform its obligations under this
Agreement. Each of the Company and each subsidiary is duly qualified as a
foreign corporation to transact business and is in good standing in each
jurisdiction in which such qualification is required, whether by reason of the
ownership or leasing of property or the conduct of business, except for such
jurisdictions where the failure to so qualify or to be in good standing would
not, individually or in the aggregate, result in a Material Adverse Change. All
of the issued and outstanding capital stock of each subsidiary has been duly
authorized and validly issued, is fully paid and nonassessable and is owned by
the Company, directly or through subsidiaries, free and clear of any security
interest, mortgage, pledge, lien, encumbrance or claim. The Company does not own
or control, directly or indirectly, any corporation, association or other entity
other than CR Technology, Inc., a California corporation, K.K. Photon Dynamics,
a business entity organized pursuant to the laws of Japan, and Photon Dynamics,
Korea, a business entity organized pursuant to the laws of Korea.

(k) CAPITALIZATION AND OTHER CAPITAL STOCK MATTERS. The authorized,
issued and outstanding capital stock of the Company is as set forth in the
Prospectus under the caption "Capitalization" (other than for subsequent
issuances, if any, pursuant to employee benefit plans described in the
Prospectus or upon exercise of outstanding options described in the Prospectus).
The Common Stock (including the Common Shares) conforms in all material respects
to the description thereof contained in the Prospectus. All of the issued and
outstanding shares of Common Stock (including the shares of Common Stock owned
by the Selling Shareholder) have been duly authorized and validly issued, are
fully paid and nonassessable and have been issued in compliance with federal and
state securities laws. None of the outstanding shares of Common Stock were
issued in violation of any preemptive rights, rights of first refusal or other
similar

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rights to subscribe for or purchase securities of the Company. There are
no authorized or outstanding options, warrants, preemptive rights, rights of
first refusal or other rights to purchase, or equity or debt securities
convertible into or exchangeable or exercisable for, any capital stock of the
Company or any of its subsidiaries other than those accurately described in the
Prospectus. The description of the Company's stock option, stock bonus and other
stock plans or arrangements, and the options or other rights granted thereunder,
set forth in the Prospectus accurately and fairly presents the information
required to be shown with respect to such plans, arrangements, options and
rights.

(l) STOCK EXCHANGE LISTING. The Common Stock (including the Common
Shares) is registered pursuant to Section 12(g) of the Securities Exchange Act
of 1934 (the "Exchange Act") and is listed on the Nasdaq National Market, and
the Company has taken no action designed to, or reasonably likely to have the
effect of, terminating the registration of the Common Stock under the Exchange
Act or delisting the Common Stock from the Nasdaq National Market, nor has the
Company received any notification that the Commission or the National
Association of Securities Dealers, Inc. (the "NASD") is contemplating
terminating such registration or listing.

(m) NON-CONTRAVENTION OF EXISTING INSTRUMENTS; NO FURTHER
AUTHORIZATIONS OR APPROVALS REQUIRED. Neither the Company nor any of its
subsidiaries is in violation of its charter or by-laws or is in default (or,
with the giving of notice or lapse of time, would be in default) ("Default")
under any indenture, mortgage, loan or credit agreement, note, contract,
franchise, lease or other instrument to which the Company or any of its
subsidiaries is a party or by which it or any of them may be bound or to
which any of the property or assets of the Company or any of its subsidiaries
is subject (each, an "Existing Instrument"), except for such Defaults as
would not, individually or in the aggregate, result in a Material Adverse
Change. The Company's execution, delivery and performance of this Agreement
and consummation of the transactions contemplated hereby and by the
Prospectus (i) have been duly authorized by all necessary corporate action
and will not result in any violation of the provisions of the charter or
by-laws of the Company or any subsidiary, (ii) will not conflict with or
constitute a breach of, or Default under, or result in the creation or
imposition of any lien, charge or encumbrance upon any property or assets of
the Company or any of its subsidiaries pursuant to, or require the consent of
any other party to, any Existing Instrument, except for such conflicts,
breaches, Defaults, liens, charges or encumbrances as would not, individually
or in the aggregate, result in a Material Adverse Change, and (iii) will not
result in any violation of any law, administrative regulation or
administrative or court decree applicable to the Company or any subsidiary.
No consent, approval, authorization or other order of, or registration or
filing with, any court or other governmental or regulatory authority or
agency, is required for the Company's execution, delivery and performance of
this Agreement and consummation of the transactions contemplated hereby and
by the Prospectus, except such as have been obtained or made by the Company
and are in full force and effect under the Securities Act, applicable state
securities or blue sky laws and from the NASD.

(n) NO MATERIAL ACTIONS OR PROCEEDINGS. Except as otherwise disclosed
in the Prospectus, there are no legal or governmental actions, suits or
proceedings pending or, to the best of the Company's knowledge, threatened (i)
against or relating to the Company or any of its subsidiaries, (ii) which has as
the subject thereof, to the knowledge of the Company after reasonable inquiry,
any officer or director of, or property owned or leased by, the Company or any
of its subsidiaries, or (iii) relating to environmental or employment
discrimination matters,

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where in any such case (A) there is a reasonable possibility that such
action, suit or proceeding might be determined adversely to the Company or
such subsidiary, and (B) any such action, suit or proceeding, if so
determined adversely, would reasonably be expected to result in a Material
Adverse Change or adversely affect the consummation of the transactions
contemplated by this Agreement. No material labor dispute with the employees
of the Company or any of its subsidiaries, or with the employees of any
principal supplier of the Company which dispute is known to the Company,
exists or, to the best of the Company's knowledge, is threatened or imminent
and which would reasonably be expected to result in a Material Adverse Change.

(o) INTELLECTUAL PROPERTY RIGHTS. The Company and its subsidiaries
own or possess sufficient trademarks, trade names, patent rights, copyrights,
licenses, approvals, trade secrets and other similar rights (collectively,
"Intellectual Property Rights") reasonably necessary to conduct their
businesses as now conducted; and the expected expiration of any of such
Intellectual Property Rights would not result in a Material Adverse Change.
Neither the Company nor any of its subsidiaries has received any notice of
infringement or conflict with asserted Intellectual Property Rights of
others, which infringement or conflict, if the subject of an unfavorable
decision, would result in a Material Adverse Change.

(p) ALL NECESSARY PERMITS, ETC. The Company and each subsidiary
possess such valid and current certificates, authorizations or permits issued
by the appropriate state, federal or foreign regulatory agencies or bodies
necessary to conduct their respective businesses, except those the absence of
which could not reasonably be expected to result in a Material Adverse
Change, and neither the Company nor any subsidiary has received any notice of
proceedings relating to the revocation or modification of, or non-compliance
with, any such certificate, authorization or permit which, singly or in the
aggregate, if the subject of an unfavorable decision, ruling or finding,
could reasonably be expected to result in a Material Adverse Change.

(q) TITLE TO PROPERTIES. The Company and each of its subsidiaries
have good and marketable title to all the properties and assets reflected as
owned in the financial statements referred to in Section 1(A)(i) above as of
the dates of such financial statements (and all material property and assets
reflected as owned elsewhere in the Prospectus), in each case free and clear
of any security finterests, mortgages, liens, encumbrances, equities, claims
and other defects, except such as are disclosed in the Prospectus or did not
materially and adversely affect the value of such property and did not
materially interfere with the use made or proposed to be made of such
property by the Company or such subsidiary. The real property, improvements,
equipment and personal property held under lease by the Company or any
subsidiary are held under valid and enforceable leases, with such exceptions
as do not materially interfere with the use made or proposed to be made of
such real property, improvements, equipment or personal property by the
Company or such subsidiary.

(r) TAX LAW COMPLIANCE. The Company and its consolidated subsidiaries
have filed all necessary federal, state and foreign income and franchise tax
returns and have paid all taxes required to be paid by any of them and, if due
and payable, any related or similar assessment, fine or penalty levied against
any of them except as may be being contested in good faith and by appropriate
proceedings. The Company has made adequate charges, accruals and reserves in the
applicable financial statements referred to in Section 1(A)(i) above in respect
of all federal, state and foreign income and franchise taxes for all periods as
to which the tax liability of the Company or any of its consolidated
subsidiaries has not been finally determined.

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<PAGE>

(s) COMPANY NOT AN "INVESTMENT COMPANY". The Company has been
advised of the rules and requirements under the Investment Company Act of
1940, as amended (the "Investment Company Act"). The Company is not, and
after receipt of payment for the Common Shares will not be, an "investment
company" within the meaning of the Investment Company Act and will conduct
its business in a manner so that it will not become subject to the Investment
Company Act.

(t) EXCHANGE ACT COMPLIANCE. The documents incorporated by
reference in the Prospectus, at the time they were or hereafter are filed
with the Commission, complied and will comply in all material respects with
the requirements of the Exchange Act, and, when read together with the other
information in the Prospectus, at the time the Registration Statement and any
amendments thereto become effective and at the First Closing Date and the
Second Closing Date, as the case may be, will not contain an untrue statement
of a material fact or omit to state a material fact required to be stated
therein or necessary to make the statements therein, in the light of the
circumstances under which they were made, not misleading.

(u) INSURANCE. Each of the Company and its subsidiaries are insured
by recognized, financially sound and reputable institutions with policies in
such amounts and with such deductibles and covering such risks as are
generally deemed adequate and customary for their businesses including, but
not limited to, policies covering real and personal property owned or leased
by the Company and its subsidiaries against theft, damage, destruction, acts
of vandalism and earthquakes. The Company does not believe that it or any
subsidiary will not be able (i) to renew its existing insurance coverage as
and when such policies expire or (ii) to obtain comparable coverage from
similar institutions as may be necessary or appropriate to conduct its
business as now conducted and at a cost that would not result in a Material
Adverse Change.

(v) NO PRICE STABILIZATION OR MANIPULATION. The Company has not taken
and will not take, directly or indirectly, any action designed to or that might
be reasonably expected to cause or result in stabilization or manipulation of
the price of the Common Stock to facilitate the sale or resale of the Common
Shares.

(w) RELATED PARTY TRANSACTIONS. There are no business relationships or
related-party transactions involving the Company or any subsidiary or any other
person required to be described in the Prospectus which have not been described
as required.

(x) NO UNLAWFUL CONTRIBUTIONS OR OTHER PAYMENTS. Neither the Company
nor any of its subsidiaries nor, to the best of the Company's knowledge, any
employee or agent of the Company or any subsidiary, has made any contribution or
other payment to any official of, or candidate for, any federal, state or
foreign office in violation of any law or of the character required to be
disclosed in the Prospectus.

(y) COMPANY'S ACCOUNTING SYSTEM. The Company maintains a system of
accounting controls sufficient to provide reasonable assurances that (i)
transactions are executed in accordance with management's general or specific
authorization; (ii) transactions are recorded as necessary to permit
preparation of financial statements in conformity with generally accepted
accounting principles and to maintain accountability for assets; (iii) access
to assets is permitted only in accordance with management's general or
specific authorization; and (iv) the recorded accountability for assets is
compared with existing assets at reasonable intervals and appropriate action
is taken with respect to any differences.

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<PAGE>

(z) COMPLIANCE WITH ENVIRONMENTAL LAWS. Except as otherwise
disclosed in the Prospectus or as would not, individually or in the
aggregate, result in a Material Adverse Change (i) neither the Company nor
any of its subsidiaries is in violation of any federal, state, local or
foreign law or regulation relating to pollution or protection of human health
or the environment (including, without limitation, ambient air, surface
water, groundwater, land surface or subsurface strata) or wildlife, including
without limitation, laws and regulations relating to emissions, discharges,
releases or threatened releases of chemicals, pollutants, contaminants,
wastes, toxic substances, hazardous substances, petroleum and petroleum
products (collectively, "Materials of Environmental Concern"), or otherwise
relating to the manufacture, processing, distribution, use, treatment,
storage, disposal, transport or handling of Materials of Environmental
Concern (collectively, "Environmental Laws"), which violation includes, but
is not limited to, noncompliance with any permits or other governmental
authorizations required for the operation of the business of the Company or
its subsidiaries under applicable Environmental Laws, or noncompliance with
the terms and conditions thereof, nor has the Company or any of its
subsidiaries received any written communication, whether from a governmental
authority, citizens group, employee or otherwise, that alleges that the
Company or any of its subsidiaries is in violation of any Environmental Law;
(ii) there is no claim, action or cause of action filed with a court or
governmental authority, no investigation with respect to which the Company
has received written notice, and no written notice by any person or entity
alleging potential liability for investigatory costs, cleanup costs,
governmental responses costs, natural resources damages, property damages,
personal injuries, attorneys' fees or penalties arising out of, based on or
resulting from the presence, or release into the environment, of any Material
of Environmental Concern at any location owned, leased or operated by the
Company or any of its subsidiaries, now or in the past (collectively,
"Environmental Claims"), pending or, to the best of the Company's knowledge,
threatened against the Company or any of its subsidiaries or any person or
entity whose liability for any Environmental Claim the Company or any of its
subsidiaries has retained or assumed either contractually or by operation of
law; and (iii) to the best of the Company's knowledge, there are no past or
present actions, activities, circumstances, conditions, events or incidents,
including, without limitation, the release, emission, discharge, presence or
disposal of any Material of Environmental Concern, that reasonably could
result in a violation of any Environmental Law or form the basis of a
potential Environmental Claim against the Company or any of its subsidiaries
or against any person or entity whose liability for any Environmental Claim
the Company or any of its subsidiaries has retained or assumed either
contractually or by operation of law.

(aa) ERISA COMPLIANCE. The Company and its subsidiaries and any
"employee benefit plan" (as defined under the Employee Retirement Income
Security Act of 1974, as amended, and the regulations and published
interpretations thereunder (collectively, "ERISA")) established or maintained
by the Company, its subsidiaries or their "ERISA Affiliates" (as defined
below) are in compliance in all material respects with ERISA. "ERISA
Affiliate" means, with respect to the Company or a subsidiary, any member of
any group of organizations described in Sections 414(b),(c),(m) or (o) of the
Internal Revenue Code of 1986, as amended, and the regulations and published
interpretations thereunder (the "Code") of which the Company or such
subsidiary is a member. No "reportable event" (as defined under ERISA) has
occurred or is reasonably expected to occur with respect to any "employee
benefit plan" established or maintained by the Company, its subsidiaries or
any of their ERISA Affiliates which could reasonably be expected to result in
a Material Adverse Change. No "employee benefit plan" established or
maintained by the Company, its subsidiaries or any of their ERISA Affiliates,
if

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<PAGE>

such "employee benefit plan" were terminated, would have any "amount of
unfunded benefit liabilities" (as defined under ERISA) which could reasonably
be expected to result in a Material Adverse Change. Neither the Company, its
subsidiaries nor any of their ERISA Affiliates has incurred or reasonably
expects to incur any liability under (i) Title IV of ERISA with respect to
termination of, or withdrawal from, any "employee benefit plan" or (ii)
Sections 412, 4971, 4975 or 4980B of the Code. Each "employee benefit plan"
established or maintained by the Company, its subsidiaries or any of their
ERISA Affiliates that is intended to be qualified under Section 401(a) of the
Code is so qualified and to the Company's knowledge nothing has occurred,
whether by action or failure to act, which would cause the loss of such
qualification.

(bb) YEAR 2000. All disclosure regarding year 2000 compliance that
is required to be described under the Securities Act (including disclosures
required by Staff Legal Bulletin No. 5) has been included in the Prospectus.
The Company has not incurred and does not expect to incur any significant
operating expenses or costs to ensure that its information systems will be
year 2000 complaint, other than as disclosed in the Prospectus or which could
not reasonably be expected to result in a Material Adverse Change.

Any certificate signed by an officer of the Company and delivered to
the Representatives or to counsel for the Underwriters in connection with the
consummation of the transactions contemplated hereby shall be deemed to be a
representation and warranty by the Company to each Underwriter as to the
matters set forth therein.

B. REPRESENTATIONS AND WARRANTIES OF THE SELLING SHAREHOLDER. The
Selling Shareholder represents, warrants and covenants to each Underwriter as
follows:

(a) THE UNDERWRITING AGREEMENT. This Agreement has been duly
authorized, executed and delivered by or on behalf of the Selling Shareholder
and is a valid and binding agreement of the Selling Shareholder, enforceable
in accordance with its terms, except as rights to indemnification hereunder
may be limited by applicable law and except as the enforcement hereof may be
limited by bankruptcy, insolvency, reorganization, moratorium or other
similar laws relating to or affecting the rights and remedies of creditors or
by general equitable principles.

(b) THE CUSTODY AGREEMENT AND POWER OF ATTORNEY. Each of the (i)
Custody Agreement signed by the Selling Shareholder and Vincent F. Sollitto,
Jr. and Richard L. Dissley, as custodian (the "Custodian"), relating to the
deposit of the Common Shares to be sold by the Selling Shareholder (the
"Custody Agreement") and (ii) Power of Attorney appointing certain
individuals named therein as the Selling Shareholder's attorneys-in-fact
(each, an "Attorney-in-Fact") to the extent set forth therein relating to the
transactions contemplated hereby and by the Prospectus (the "Power of
Attorney"), of the Selling Shareholder has been duly authorized, executed and
delivered by the Selling Shareholder and is a valid and binding agreement of
the Selling Shareholder, enforceable in accordance with its terms, except as
rights to indemnification thereunder may be limited by applicable law and
except as the enforcement thereof may be limited by bankruptcy, insolvency,
reorganization, moratorium or other similar laws relating to or affecting the
rights and remedies of creditors or by general equitable principles.

(c) TITLE TO COMMON SHARES TO BE SOLD; ALL AUTHORIZATIONS OBTAINED.
The Selling Shareholder has, and on the First Closing Date (as defined below)
will have, good and valid title to all of the Common Shares which may be sold by
the Selling Shareholder pursuant to this

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<PAGE>

Agreement on such date and the legal right and power, and all authorizations
and approvals required by law and under its charter or by-laws, or other
organizational documents to enter into this Agreement and its Custody
Agreement and Power of Attorney, to sell, transfer and deliver all of the
Common Shares which may be sold by the Selling Shareholder pursuant to this
Agreement and to comply with its other obligations hereunder and thereunder.

(d) DELIVERY OF THE COMMON SHARES TO BE SOLD. Delivery of the
Common Shares which are sold by the Selling Shareholder pursuant to this
Agreement will pass good and valid title to such Common Shares, free and
clear of any security interest, mortgage, pledge, lien, encumbrance or other
claim.

(e) NON-CONTRAVENTION; NO FURTHER AUTHORIZATIONS OR APPROVALS
REQUIRED. The execution and delivery by the Selling Shareholder of, and the
performance by the Selling Shareholder of its obligations under, this
Agreement, the Custody Agreement and the Power of Attorney will not
contravene or conflict with, result in a breach of, or constitute a Default
under, or require the consent of any other party to, the charter or by-laws,
or other organizational documents of the Selling Shareholder or any other
agreement or instrument to which the Selling Shareholder is a party or by
which it is bound or under which it is entitled to any right or benefit, any
provision of applicable law or any judgment, order, decree or regulation
applicable to the Selling Shareholder of any court, regulatory body,
administrative agency, governmental body or arbitrator having jurisdiction
over the Selling Shareholder. No consent, approval, authorization or other
order of, or registration or filing with, any court or other governmental
authority or agency, is required for the consummation by the Selling
Shareholder of the transactions contemplated by this Agreement, except such
as have been obtained or made and are in full force and effect under the
Securities Act, applicable state securities or blue sky laws and from the
NASD.

(f) NO REGISTRATION OR OTHER SIMILAR RIGHTS. The Selling
Shareholder does not have any registration or other similar rights to have
any equity or debt securities registered for sale by the Company under the
Registration Statement or included in the offering contemplated by this
Agreement, except for such rights as are described in the Prospectus under
"Shares Eligible for Future Sale".

(g) NO FURTHER CONSENTS, ETC. Except for the consent of the Selling
Shareholder to the number of Common Shares to be sold by the Selling
Shareholder pursuant to this Agreement, no consent, approval or waiver is
required under any instrument or agreement to which the Selling Shareholder
is a party or by which it is bound or under which it is entitled to any right
or benefit, in connection with the offering, sale or purchase by the
Underwriters of any of the Common Shares which may be sold by the Selling
Shareholder under this Agreement or the consummation by the Selling
Shareholder of any of the other transactions contemplated hereby.

(h) DISCLOSURE MADE BY THE SELLING SHAREHOLDER IN THE PROSPECTUS.
All information furnished by or on behalf of the Selling Shareholder in
writing expressly for use in the Registration Statement and Prospectus is,
and on the First Closing Date will be, true, correct, and complete in all
material respects, and does not, and on the First Closing Date will not,
contain any untrue statement of a material fact or omit to state any material
fact necessary to make such information not misleading. The Selling
Shareholder confirms as accurate the number of shares of Common Stock set
forth opposite the Selling Shareholder's name in the Prospectus under the

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<PAGE>

caption "Principal and Selling Shareholder" (both prior to and after giving
effect to the sale of the Common Shares).

(i) NO PRICE STABILIZATION OR MANIPULATION. The Selling Shareholder
has not taken and will not take, directly or indirectly, any action designed
to or that might be reasonably expected to cause or result in stabilization
or manipulation of the price of the Common Stock to facilitate the sale or
resale of the Common Shares.

(j) NO MATERIAL INFORMATION. The Selling Shareholder is not
prompted to sell any shares of Common Stock by any material information
concerning the Company which is not set forth in the Registration Statement
and the Prospectus.

Any certificate signed by or on behalf of the Selling Shareholder
and delivered to the Representatives or to counsel for the Underwriters shall
be deemed to be a representation and warranty by the Selling Shareholder to
each Underwriter as to the matters covered thereby.

SECTION 2. PURCHASE, SALE AND DELIVERY OF THE COMMON SHARES.

THE FIRM COMMON SHARES. Upon the terms herein set forth,
(i) the Company agrees to issue and sell to the several Underwriters an
aggregate of 1,320,687 Firm Common Shares and (ii) the Selling Shareholder
agrees to sell to the several Underwriters an aggregate of 679,313 Firm
Common Shares. On the basis of the representations, warranties and agreements
herein contained, and upon the terms but subject to the conditions herein set
forth, the Underwriters agree, severally and not jointly, to purchase from
the Company and the Selling Shareholder the respective number of Firm Common
Shares set forth opposite their names on SCHEDULE A. The purchase price per
Firm Common Share to be paid by the several Underwriters to the Company and
the Selling Shareholder shall be $_____ per share.

THE FIRST CLOSING DATE. Notwithstanding the joint
representation provided by the Representatives, delivery of certificates for
the Firm Common Shares to be purchased by the Underwriters and payment
therefor shall be made at the offices of NMS (as to the Representatives
jointly) at 600 Montgomery Street, San Francisco, California 94111 (or such
other place as may be agreed to by the Company and the Representatives) at
6:00 a.m. San Francisco time, on February 4, 2000, or such other time and
date not later than 10:30 a.m. San Francisco time, on February 4, 2000 as the
Representatives shall designate by notice to the Company (the time and date
of such closing are called the "First Closing Date"). The Company and the
Selling Shareholder hereby acknowledge that the circumstances under which the
Representatives may provide notice to postpone the First Closing Date as
originally scheduled include, but are in no way limited to, any determination
by the Company, the Selling Shareholder or the Representatives to recirculate
to the public copies of an amended or supplemented Prospectus or a delay as
contemplated by the provisions of Section 10.

THE OPTIONAL COMMON SHARES; THE SECOND CLOSING DATE. In
addition, on the basis of the representations, warranties and agreements herein
contained, and upon the terms but subject to the conditions herein set forth,
the Company hereby grants an option to the several Underwriters to purchase,
severally and not jointly, up to an aggregate of 300,000 Optional Common Shares
from the Company at the purchase price per share to be paid by the Underwriters
for the Firm Common Shares. The option granted hereunder is for use by the
Underwriters solely in covering any over-allotments in connection with the sale
and distribution

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of the Firm Common Shares. The option granted hereunder may be exercised at
any time (but not more than once) upon notice by the Representatives to the
Company, which notice may be given at any time within 30 days from the date
of this Agreement. Such notice shall set forth (i) the aggregate number of
Optional Common Shares as to which the Underwriters are exercising the
option, (ii) the names and denominations in which the certificates for the
Optional Common Shares are to be registered, and (iii) the time, date and
place at which such certificates will be delivered (which time and date may
be simultaneous with, but not earlier than, the First Closing Date; and in
such case the term "First Closing Date" shall refer to the time and date of
delivery of certificates for the Firm Common Shares and the Optional Common
Shares). Such time and date of delivery, if subsequent to the First Closing
Date, is called the "Second Closing Date" and shall be determined by the
Representatives and shall not be earlier than three nor later than five full
business days after delivery of such notice of exercise. If any Optional
Common Shares are to be purchased, each Underwriter agrees, severally and not
jointly, to purchase the number of Optional Common Shares (subject to such
adjustments to eliminate fractional shares as the Representatives may
determine) that bears the same proportion to the total number of Optional
Common Shares to be purchased as the number of Firm Common Shares set forth
on SCHEDULE A opposite the name of such Underwriter bears to the total number
of Firm Common Shares. The Representatives may cancel the option at any time
prior to its expiration by giving written notice of such cancellation to the
Company.

PUBLIC OFFERING OF THE COMMON SHARES. The Representatives
hereby advise the Company and the Selling Shareholder that the Underwriters
intend to offer for sale to the public, as described in the Prospectus, their
respective portions of the Common Shares as soon after this Agreement has
been executed and the Registration Statement has been declared effective as
the Representatives, in their sole judgment, have determined is advisable and
practicable.

PAYMENT FOR THE COMMON SHARES. Payment for the Common
Shares to be sold by the Company shall be made at the First Closing Date
(and, if applicable, at the Second Closing Date) by wire transfer of
immediately available funds to the order of the Company. Payment for the
Common Shares to be sold by the Selling Shareholder shall be made at the
First Closing Date by wire transfer of immediately available funds to the
order of the Custodian.

It is understood that the Representatives have been
authorized, for their own account and the accounts of the several
Underwriters, to accept delivery of and receipt for, and make payment of the
purchase price for, the Firm Common Shares and any Optional Common Shares the
Underwriters have agreed to purchase. Either or both of NMS and Needham,
individually and not as the Representatives of the Underwriters, may (but
shall not be obligated to) make payment for any Common Shares to be purchased
by any Underwriter whose funds shall not have been received by the
Representatives by the First Closing Date or the Second Closing Date, as the
case may be, for the account of such Underwriter, but any such payment shall
not relieve such Underwriter from any of its obligations under this Agreement.

The Selling Shareholder hereby agrees that (i) it will pay
all stock transfer taxes, stamp duties and other similar taxes, if any,
payable upon the sale or delivery of the Common Shares to be sold by the
Selling Shareholder to the several Underwriters, or otherwise in connection
with the performance of the Selling Shareholder's obligations hereunder and
(ii) the Custodian is authorized to deduct from such payment any such amounts
from the proceeds to the Selling Shareholder hereunder and to hold such
amounts for the account of the Selling Shareholder with the Custodian under
the Custody Agreement.

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DELIVERY OF THE COMMON SHARES. The Company and the Selling
Shareholder shall deliver, or cause to be delivered, to the Representatives
for the accounts of the several Underwriters certificates for the Firm Common
Shares to be sold by them at the First Closing Date, against the irrevocable
release of a wire transfer of immediately available funds for the amount of
the purchase price therefor. The Company shall also deliver, or cause to be
delivered, to the Representatives for the accounts of the several
Underwriters, certificates for the Optional Common Shares the Underwriters
have agreed to purchase at the First Closing Date or the Second Closing Date,
as the case may be, against the irrevocable release of a wire transfer of
immediately available funds for the amount of the purchase price therefor.
The certificates for the Common Shares shall be in definitive form and
registered in such names and denominations as the Representatives shall have
requested at least two full business days prior to the First Closing Date (or
the Second Closing Date, as the case may be) and shall be made available for
inspection on the business day preceding the First Closing Date (or the
Second Closing Date, as the case may be) at a location in New York City as
the Representatives may designate. Time shall be of the essence, and delivery
at the time and place specified in this Agreement is a further condition to
the obligations of the Underwriters.

DELIVERY OF PROSPECTUS TO THE UNDERWRITERS. Not later than
12:00 p.m. on the second business day following the date the Common Shares
are first released by the Underwriters for sale to the public, the Company
shall deliver or cause to be delivered, copies of the Prospectus in such
quantities and at such places as the Representatives shall request.

SECTION 3. ADDITIONAL COVENANTS.

A. COVENANTS OF THE COMPANY. The Company further covenants and
agrees with each Underwriter as follows:

(a) REPRESENTATIVES' REVIEW OF PROPOSED AMENDMENTS AND SUPPLEMENTS.
During such period beginning on the date hereof and ending on the later of
the First Closing Date or such date, as in the opinion of counsel for the
Underwriters, the Prospectus is no longer required by law to be delivered in
connection with sales by an Underwriter or dealer (the "Prospectus Delivery
Period"), prior to amending or supplementing the Registration Statement
(including any registration statement filed under Rule 462(b) under the
Securities Act) or the Prospectus (including any amendment or supplement
through incorporation by reference of any report filed under the Exchange
Act), the Company shall furnish to the Representatives for review a copy of
each such proposed amendment or supplement, and the Company shall not file
any such proposed amendment or supplement to which the Representatives
reasonably object.

(b) SECURITIES ACT COMPLIANCE . After the date of this Agreement, the
Company shall promptly advise the Representatives in writing (i) of the receipt
of any comments of, or requests for additional or supplemental information from,
the Commission, (ii) of the time and date of any filing of any post-effective
amendment to the Registration Statement or any amendment or supplement to any
preliminary prospectus or the Prospectus, (iii) of the time and date that any
post-effective amendment to the Registration Statement becomes effective, and
(iv) of the issuance by the Commission of any stop order suspending the
effectiveness of the Registration Statement or any post-effective amendment
thereto or of any order preventing or suspending the use of any preliminary
prospectus or the Prospectus, or of any proceedings to remove, suspend or
terminate from listing or quotation the Common Stock from any securities
exchange upon which

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it is listed for trading or included or designated for quotation, or of the
threatening or initiation of any proceedings for any of such purposes. If the
Commission shall enter any such stop order at any time, the Company will use
its best efforts to obtain the lifting of such order at the earliest possible
moment. Additionally, the Company agrees that it shall comply with the
provisions of Rules 424(b), 430A and 434, as applicable, under the Securities
Act and will use its reasonable efforts to confirm that any filings made by
the Company under Rule 424(b) were received in a timely manner by the
Commission.

(c) AMENDMENTS AND SUPPLEMENTS TO THE PROSPECTUS AND OTHER
SECURITIES ACT MATTERS. If, during the Prospectus Delivery Period, any event
shall occur or condition exist as a result of which it is necessary to amend
or supplement the Prospectus in order to make the statements therein, in the
light of the circumstances when the Prospectus is delivered to a purchaser,
not misleading, or if in the opinion of the Representatives or counsel for
the Underwriters it is otherwise necessary to amend or supplement the
Prospectus to comply with law, the Company agrees to promptly prepare
(subject to Section 3(A)(a) hereof), file with the Commission and furnish at
its own expense to the Underwriters and to dealers, amendments or supplements
to the Prospectus so that the statements in the Prospectus as so amended or
supplemented will not, in the light of the circumstances when the Prospectus
is delivered to a purchaser, be misleading or so that the Prospectus, as
amended or supplemented, will comply with law. The Underwriters shall cease
to use the Prospectus upon reasonable notice that an amendment or supplement
to the Prospectus is required.

(d) COPIES OF ANY AMENDMENTS AND SUPPLEMENTS TO THE PROSPECTUS. The
Company agrees to furnish the Representatives, without charge, during the
Prospectus Delivery Period, as many copies of the Prospectus and any
amendments and supplements thereto (including any documents incorporated or
deemed incorporated by reference therein) as the Representatives may
reasonably request.

(e) BLUE SKY COMPLIANCE. The Company shall cooperate with the
Representatives and counsel for the Underwriters to qualify or register the
Common Shares for sale under (or obtain exemptions from the application of)
the state securities or blue sky laws or Canadian provincial securities laws
of those jurisdictions designated by the Representatives, shall comply with
such laws and shall continue such qualifications, registrations and
exemptions in effect so long as required for the distribution of the Common
Shares. The Company shall not be required to qualify as a foreign corporation
or to take any action that would subject it to general service of process in
any such jurisdiction where it is not presently qualified or where it would
be subject to taxation as a foreign corporation. The Company will advise the
Representatives promptly of the suspension of the qualification or
registration of (or any such exemption relating to) the Common Shares for
offering, sale or trading in any jurisdiction or any initiation or threat of
any proceeding for any such purpose, and in the event of the issuance of any
order suspending such qualification, registration or exemption, the Company
shall use its best efforts to obtain the withdrawal thereof at the earliest
possible moment.

(f) USE OF PROCEEDS. The Company shall apply the net proceeds from
the sale of the Common Shares sold by it in the manner described under the
caption "Use of Proceeds" in the Prospectus.

(g) TRANSFER AGENT. The Company shall engage and maintain, at its
expense, a registrar and transfer agent for the Common Stock.

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(h) EARNINGS STATEMENT. As soon as practicable, the Company will make
generally available to its security holders and to the Representatives an
earnings statement (which need not be audited) covering the twelve-month
period ending March 31, 2001 that satisfies the provisions of Section 11(a)
of the Securities Act.

(i) PERIODIC REPORTING OBLIGATIONS. During the Prospectus Delivery
Period the Company shall file, on a timely basis, with the Commission and the
Nasdaq National Market all reports and documents required to be filed under
the Exchange Act. Additionally, the Company shall report the use of proceeds
from the issuance of the Common Shares as may be required under Rule 463
under the Securities Act.

(j) AGREEMENT NOT TO OFFER OR SELL ADDITIONAL SECURITIES During the
period of 90 days following the date of the Prospectus, the Company will not,
without the prior written consent of the Representatives (which consent may
be withheld at the reasonable discretion of the Representatives), directly or
indirectly, sell, offer, contract or grant any option to sell, pledge,
transfer or establish an open "put equivalent position" within the meaning of
Rule 16a-1(h) under the Exchange Act, or otherwise dispose of or transfer, or
announce the offering of, or file any registration statement under the
Securities Act in respect of, any shares of Common Stock, options or warrants
to acquire shares of the Common Stock or securities exchangeable or
exercisable for or convertible into shares of Common Stock (other than as
contemplated by this Agreement with respect to the Common Shares); PROVIDED,
HOWEVER, that the Company may issue shares of its Common Stock or options to
purchase its Common Stock, or Common Stock upon exercise of options, pursuant
to any stock option, stock bonus or other stock plan or arrangement described
in the Prospectus, but only if the holders of such shares, options, or shares
issued upon exercise of such options, agree in writing not to sell, offer,
dispose of or otherwise transfer any such shares or options during such 90
day period without the prior written consent of the Representatives (which
consent may be withheld at the sole discretion of the Representatives).

(k) FUTURE REPORTS TO THE REPRESENTATIVES. During the period of
three years hereafter the Company will furnish to NMS at 600 Montgomery
Street, San Francisco, CA 94111 Attention: Jeffrey R. Lapic, Esq. and to
Needham at 445 Park Avenue, New York, NY 10022 Attention: Roger C. Cotta: (i)
as soon as practicable after the end of each fiscal year, copies of the
Annual Report of the Company containing the balance sheet of the Company as
of the close of such fiscal year and statements of income, shareholders'
equity and cash flows for the year then ended and the opinion thereon of the
Company's independent public or certified public accountants; (ii) as soon as
practicable after the filing thereof, copies of each proxy statement, Annual
Report on Form 10-K, Quarterly Report on Form 10-Q, Current Report on Form
8-K or other report filed by the Company with the Commission, the NASD or any
securities exchange; and (iii) as soon as available, copies of any report or
communication of the Company mailed generally to holders of its capital stock.

(l) EXCHANGE ACT COMPLIANCE. During the Prospectus Delivery Period,
the Company will file all documents required to be filed with the Commission
pursuant to Section 13, 14 or 15 of the Exchange Act in the manner and within
the time periods required by the Exchange Act.

B. COVENANTS OF THE SELLING SHAREHOLDER. The Selling Shareholder
further covenants and agrees with each Underwriter:

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<PAGE>

(a) AGREEMENT NOT TO OFFER OR SELL ADDITIONAL SECURITIES. The
Selling Shareholder will not, without the prior written consent of the
Representatives (which consent may be withheld in the sole discretion of the
Representatives), directly or indirectly, sell, offer, contract or grant any
option to sell (including without limitation any short sale), pledge,
transfer, establish an open "put equivalent position" within the meaning of
Rule 16a-1(h) under the Exchange Act, or otherwise dispose of any shares of
Common Stock, options or warrants to acquire shares of Common Stock, or
securities exchangeable or exercisable for or convertible into shares of
Common Stock currently or hereafter owned either of record or beneficially
(as defined in Rule 13d-3 under Securities Exchange Act of 1934, as amended)
by the undersigned, or publicly announce the undersigned's intention to do
any of the foregoing, for a period commencing on the date hereof and
continuing through the close of trading on the date 90 days after the date of
the Prospectus.

(b) DELIVERY OF FORMS W-8 AND W-9 . To deliver to the
Representatives prior to the First Closing Date a properly completed and
executed United States Treasury Department Form W-8 (if the Selling
Shareholder is a non-United States person) or Form W-9 (if the Selling
Shareholder is a United States Person).

The Representatives, on behalf of the several Underwriters,
may, in their sole discretion, waive in writing the performance by the
Company or any Selling Shareholder of any one or more of the foregoing
covenants or extend the time for their performance.

SECTION 4. PAYMENT OF EXPENSES. The Company agrees to pay all costs,
fees and expenses incurred in connection with the performance of its
obligations hereunder and in connection with the transactions contemplated
hereby, including without limitation (i) all expenses incident to the
issuance and delivery of the Common Shares (including all printing and
engraving costs), (ii) all fees and expenses of the registrar and transfer
agent of the Common Stock, (iii) all necessary issue, transfer and other
stamp taxes in connection with the issuance and sale of the Common Shares to
the Underwriters, (iv) all fees and expenses of the Company's counsel,
independent public or certified public accountants and other advisors, (v)
all costs and expenses incurred in connection with the preparation, printing,
filing, shipping and distribution of the Registration Statement (including
financial statements, exhibits, schedules, consents and certificates of
experts), each preliminary prospectus and the Prospectus, and all amendments
and supplements thereto, and this Agreement, (vi) all filing fees, reasonable
attorneys' fees and reasonable expenses incurred by the Company or the
Underwriters in connection with qualifying or registering (or obtaining
exemptions from the qualification or registration of) all or any part of the
Common Shares for offer and sale under the state securities or blue sky laws
or the provincial securities laws of Canada, and, if requested by the
Representatives, preparing and printing a "Blue Sky Survey" or memorandum,
and any supplements thereto, advising the Underwriters of such
qualifications, registrations and exemptions, (vii) the filing fees incident
to, and the reasonable fees and expenses of counsel for the Underwriters in
connection with, the NASD's review and approval of the Underwriters'
participation in the offering and distribution of the Common Shares, (viii)
the fees and expenses associated with including the Common Shares on the
Nasdaq National Market and (ix) all other fees, costs and expenses referred
to in Item 14 of Part II of the Registration Statement. Except as provided in
this Section 4, Section 6, Section 8 and Section 9 hereof, the Underwriters
shall pay their own expenses, including the fees and disbursements of their
counsel.

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<PAGE>

The Selling Shareholder further agrees with each
Underwriter to pay (directly or by reimbursement) all fees and expenses
incident to the performance of its obligations under this Agreement which are
not otherwise specifically provided for herein, including but not limited to
(i) fees and expenses of counsel and other advisors for the Selling
Shareholder, (ii) fees and expenses of the Custodian and (iii) expenses and
taxes incident to the sale and delivery of the Common Shares to be sold by
the Selling Shareholder to the Underwriters hereunder (which taxes, if any,
may be deducted by the Custodian under the provisions of Section 2 of this
Agreement).

This Section 4 shall not affect or modify any separate,
valid agreement relating to the allocation of payment of expenses between the
Company, on the one hand, and the Selling Shareholder, on the other hand.

SECTION 5. CONDITIONS OF THE OBLIGATIONS OF THE
UNDERWRITERS. The obligations of the several Underwriters to purchase and pay
for the Common Shares as provided herein on the First Closing Date and, with
respect to the Optional Common Shares, the Second Closing Date, shall be
subject to the accuracy of the representations and warranties on the part of
the Company and the Selling Shareholder set forth in Sections 1(A) and 1(B)
hereof as of the date hereof and as of the First Closing Date as though then
made and, with respect to the Optional Common Shares, as of the Second
Closing Date as though then made, to the timely performance by the Company
and the Selling Shareholder of their respective covenants and other
obligations hereunder, and to each of the following additional conditions:

(a) ACCOUNTANTS' COMFORT LETTER. On the date hereof, the
Representatives shall have received from Ernst & Young, LLP, independent
public or certified public accountants for the Company, a letter dated the
date hereof addressed to the Underwriters, in form and substance satisfactory
to the Representatives, containing statements and information of the type
ordinarily included in accountant's "comfort letters" to underwriters,
delivered according to Statement of Auditing Standards No. 72 (or any
successor bulletin), with respect to the audited and unaudited financial
statements and certain financial information contained in the Registration
Statement and the Prospectus (and the Representatives shall have received an
additional eight conformed copies of such accountants' letter for each of the
several Underwriters).

(b) COMPLIANCE WITH REGISTRATION REQUIREMENTS; NO STOP ORDER; NO
OBJECTION FROM NASD. For the period from and after effectiveness of this
Agreement and prior to the First Closing Date and, with respect to the
Optional Common Shares, the Second Closing Date:

(i) the Company shall have filed the Prospectus with the
Commission (including the information required by Rule 430A under the
Securities Act) in the manner and within the time period required by Rule
424(b) under the Securities Act; or the Company shall have filed a
post-effective amendment to the Registration Statement containing the
information required by such Rule 430A, and such post-effective amendment
shall have become effective; or, if the Company elected to rely upon Rule 434
under the Securities Act and obtained the Representatives' consent thereto,
the Company shall have filed a Term Sheet with the Commission in the manner
and within the time period required by such Rule 424(b);

(ii) no stop order suspending the effectiveness of the
Registration Statement, any Rule 462(b) Registration Statement, or any
post-effective amendment to the Registration

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<PAGE>

Statement, shall be in effect and no proceedings for such purpose shall have
been instituted or threatened by the Commission; and

(iii) the NASD shall have raised no objection to the
fairness and reasonableness of the underwriting terms and arrangements.

(c) NO MATERIAL ADVERSE CHANGE. For the period from and after the
date of this Agreement and prior to the First Closing Date and, with respect
to the Optional Common Shares, the Second Closing Date, in the reasonable
judgment of the Representatives there shall not have occurred any Material
Adverse Change.

(d) OPINION OF COUNSEL FOR THE COMPANY. On each of the First
Closing Date and the Second Closing Date, the Representatives shall have
received the favorable opinion of Cooley Godward, LLP, counsel for the
Company, dated as of such Closing Date, the form of which is attached as
EXHIBIT A-1 (and the Representatives shall have received an additional eight
conformed copies of such counsel's legal opinion for each of the several
Underwriters).

(e) OPINION OF COUNSEL FOR THE UNDERWRITERS. On each of the First
Closing Date and the Second Closing Date, the Representatives shall have
received the favorable opinion of Heller Ehrman White & McAuliffe, counsel
for the Underwriters, dated as of such Closing Date, with respect to the
matters set forth in paragraphs (i), (vii), (viii), (ix), (x), (xi), (xii)
and (xiii) (as to the caption "Underwriting" only) of EXHIBIT A-1 (and the
Representatives shall have received an additional eight conformed copies of
such counsel's legal opinion for each of the several Underwriters).

(f) OPINION OF COUNSEL FOR THE SELLING SHAREHOLDER. On the First
Closing Date, the Representatives shall have received the favorable opinion
of Gibson, Dunn & Crutcher LLP, counsel for the Selling Shareholder, dated as
of the First Closing Date, the form of which is attached as EXHIBIT A-2 (and
the Representatives shall have received an additional eight conformed copies
of such counsel's legal opinion for each of the several Underwriters).

(g) OFFICERS' CERTIFICATE. On each of the First Closing Date and the
Second Closing Date the Representatives shall have received a written
certificate executed by the Chief Executive Officer of the Company and the
Chief Financial Officer of the Company, dated as of such Closing Date, to the
effect set forth in subsection (b)(ii) of this Section 5, and further to the
effect that:

(i) for the period from and after the date of this
Agreement and prior to such Closing Date, there has not occurred any Material
Adverse Change;

(ii) the representations, warranties and covenants of the
Company set forth in Section 1(A) of this Agreement are true and correct in
all material respects (except for any representation, warranty and covenant
which is already limited as to consequence to "Material Adverse Change,"
which representation, warranty or covenant shall be true and correct in all
respects) with the same force and effect as though expressly made on and as
of such Closing Date; and

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<PAGE>

(iii) the Company has complied in all material respects
with all the agreements hereunder and satisfied all the conditions on its
part to be performed or satisfied hereunder at or prior to such Closing Date.

(h) BRING-DOWN COMFORT LETTER. On each of the First Closing Date,
and the Second Closing Date the Representatives shall have received from
Ernst & Young, LLP, independent public or certified public accountants for
the Company, a letter dated such date, in form and substance satisfactory to
the Representatives, to the effect that they reaffirm the statements made in
the letter furnished by them pursuant to subsection (a) of this Section 5,
except that the specified date referred to therein for the carrying out of
procedures shall be no more than three business days prior to the First
Closing Date or Second Closing Date, as the case may be (and the
Representatives shall have received an additional eight conformed copies of
such accountants' letter for each of the several Underwriters).

(i) SELLING SHAREHOLDER'S CERTIFICATE. On the First Closing Date the
Representatives shall receive a written certificate executed by the
Attorney-in-Fact of the Selling Shareholder, dated as of such Closing Date,
to the effect that:

(i) the representations, warranties and covenants of the
Selling Shareholder set forth in Section 1(B) of this Agreement are true and
correct with the same force and effect as though expressly made by the
Selling Shareholder on and as of such Closing Date; and

(ii) the Selling Shareholder has complied with all the
agreements and satisfied all the conditions on its part to be performed or
satisfied at or prior to such Closing Date.

(j) SELLING SHAREHOLDER'S DOCUMENTS. On the date hereof, the Company
and the Selling Shareholder shall have furnished for review by the
Representatives copies of the Powers of Attorney and Custody Agreements
executed by the Selling Shareholder and such further information,
certificates and documents as the Representatives may reasonably request.

(k) LOCK-UP AGREEMENT FROM CERTAIN SECURITYHOLDERS OF THE COMPANY
OTHER THAN THE SELLING SHAREHOLDER. On the date hereof, the Company shall
have furnished to the Representatives an agreement in the form of EXHIBIT C
hereto from each director and officer of the Company and certain designated
shareholders of the Company, and such agreement shall be in full force and
effect on each of the First Closing Date and the Second Closing Date.

(l) ADDITIONAL DOCUMENTS. On or before each of the First Closing
Date and the Second Closing Date, the Representatives and counsel for the
Underwriters shall have received such information, documents and opinions as
they may reasonably require for the purposes of enabling them to pass upon
the issuance and sale of the Common Shares as contemplated herein, or in
order to evidence the accuracy of any of the representations and warranties,
or the satisfaction of any of the conditions or agreements, herein contained.

If any condition specified in this Section 5 is not
satisfied when and as required to be satisfied, this Agreement may be
terminated by the Representatives by notice to the Company and the Selling
Shareholder at any time on or prior to the First Closing Date and, with
respect to the Optional Common Shares, by notice to the Company at any time
prior to the Second Closing Date, which termination shall be without
liability on the part of any party to any

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<PAGE>

other party, except that Section 4, Section 6, Section 8 and Section 9 shall at
all times be effective and shall survive such termination.

SECTION 6. REIMBURSEMENT OF UNDERWRITERS' EXPENSES. If this Agreement
is terminated by the Representatives pursuant to Section 5, Section 7, Section
10, Section 11 or Section 17, or if the sale to the Underwriters of the Common
Shares on the First Closing Date is not consummated because of any refusal,
inability or failure on the part of the Company or the Selling Shareholder to
perform any agreement herein or to comply with any provision hereof, the
Company agrees to reimburse the Representatives and the other Underwriters (or
such Underwriters as have terminated this Agreement with respect to
themselves), severally, upon demand for all out-of-pocket expenses that shall
have been reasonably incurred by the Representatives and the Underwriters in
connection with the proposed purchase and the offering and sale of the Common
Shares, including but not limited to fees and disbursements of counsel,
printing expenses, travel expenses, postage, facsimile and telephone charges.

SECTION 7. EFFECTIVENESS OF THIS AGREEMENT.

This Agreement shall not become effective until the later of
(i) the execution of this Agreement by the parties hereto and (ii) notification
by the Commission to the Company and the Representatives of the effectiveness
of the Registration Statement under the Securities Act.

Prior to such effectiveness, this Agreement may be terminated
by any party by notice to each of the other parties hereto, and any such
termination shall be without liability on the part of (a) the Company or the
Selling Shareholder to any Underwriter, except that the Company and the Selling
Shareholder shall be obligated to reimburse the expenses of the Representatives
and the Underwriters pursuant to Sections 4 and 6 hereof, (b) of any
Underwriter to the Company or the Selling Shareholder, or (c) of any party
hereto to any other party except that the provisions of Section 8 and Section 9
shall at all times be effective and shall survive such termination.

SECTION 8. INDEMNIFICATION.

(a) INDEMNIFICATION OF THE UNDERWRITERS. The Company and the Selling
Shareholder, jointly and severally, agree to indemnify and hold harmless each
Underwriter, its officers and employees, and each person, if any, who controls
any Underwriter within the meaning of the Securities Act and the Exchange Act,
and each Underwriter's counsel, against any loss, claim, damage, liability or
expense, as incurred, to which such Underwriter or such controlling person or
such counsel may become subject, under the Securities Act, the Exchange Act or
other federal or state statutory law or regulation, or at common law or
otherwise (including in settlement of any litigation, if such settlement is
effected with the written consent of the Company), insofar as such loss, claim,
damage, liability or expense (or actions in respect thereof as contemplated
below) arises out of or is based (i) upon any untrue statement or alleged
untrue statement of a material fact contained in the Registration Statement, or
any amendment thereto, including any information deemed to be a part thereof
pursuant to Rule 430A or Rule 434 under the Securities Act, or the omission or
alleged omission therefrom of a material fact required to be stated therein or
necessary to make the statements therein not misleading; or (ii) upon any
untrue statement or alleged untrue statement of a material fact contained in
any preliminary prospectus or the Prospectus (or any amendment or supplement
thereto), or the omission or alleged omission

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therefrom of a material fact necessary in order to make the statements therein,
in the light of the circumstances under which they were made, not misleading;
or (iii) in whole or in part upon any inaccuracy in the representations and
warranties of the Company or the Selling Shareholder contained herein; or (iv)
in whole or in part upon any failure of the Company or the Selling Shareholder
to perform their respective obligations hereunder or under law; or (v) any act
or failure to act or any alleged act or failure to act by any Underwriter in
connection with, or relating in any manner to, the Common Stock or the offering
contemplated hereby, and which is included as part of or referred to in any
loss, claim, damage, liability or action arising out of or based upon any
matter covered by clause (i) or (ii) above.

The Company and the Selling Shareholder shall not be liable
under clause (v) above to the extent that a court of competent jurisdiction
shall have determined by a final judgment that such loss, claim, damage,
liability or action resulted directly from any such acts or failures to act
undertaken or omitted to be taken by such Underwriter through its bad faith or
willful misconduct.

Each of the Company and the Selling Shareholder also agree to
reimburse each Underwriter and each such controlling person and each such
counsel for any and all expenses (including the fees and disbursements of
counsel chosen by the Representatives) as such expenses are reasonably incurred
by such Underwriter or such controlling person or such counsel in connection
with investigating, defending, settling, compromising or paying any such loss,
claim, damage, liability, expense or action; PROVIDED, HOWEVER, that the
indemnity agreement set forth in this Section 8(a) shall not apply to any loss,
claim, damage, liability or expense to the extent, but only to the extent,
arising out of or based upon any untrue statement or alleged untrue statement
or omission or alleged omission made in reliance upon and in conformity with
written information furnished to the Company and the Selling Shareholder by the
Representatives expressly for use in the Registration Statement, any
preliminary prospectus or the Prospectus (or any amendment or supplement
thereto); AND PROVIDED, FURTHER, that with respect to any preliminary
prospectus, the indemnity agreement set forth in this Section 8(a) shall not
inure to the benefit of any Underwriter from whom the person asserting any
loss, claim, damage, liability or expense purchased Common Shares, or any
person controlling such Underwriter, if copies of the Prospectus were timely
delivered to the Underwriter pursuant to Section 2 and a copy of the Prospectus
(as then amended or supplemented if the Company shall have furnished any
amendments or supplements thereto) was not sent or given by or on behalf of
such Underwriter to such person, if required by law so to have been delivered,
at or prior to the written confirmation of the sale of the Common Shares to
such person, and if the Prospectus (as so amended or supplemented) would have
cured the defect giving rise to such loss, claim, damage, liability or expense.

The indemnity agreement set forth in this Section 8(a) shall
be in addition to any liabilities that the Company and the Selling Shareholder
may otherwise have. The Company and the Selling Shareholder may agree, as among
themselves and without limiting the rights of the Underwriters under this
Agreement, as to the respective amounts of such liability for which they each
shall be responsible.

(b) INDEMNIFICATION OF THE COMPANY, ITS DIRECTORS AND OFFICERS.
Each Underwriter agrees, severally and not jointly, to indemnify and hold
harmless the Company, each of its directors, each of its officers who signed
the Registration Statement, each Company counsel, the Selling Shareholder and
each person, if any, who controls the Company or the Selling

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<PAGE>

Shareholder within the meaning of the Securities Act or the Exchange Act,
against any loss, claim, damage, liability or expense, as incurred, to which
the Company, or any such director, officer, counsel, Selling Shareholder or
controlling person may become subject, under the Securities Act, the Exchange
Act, or other federal or state statutory law or regulation, or at common law or
otherwise (including in settlement of any litigation, if such settlement is
effected with the written consent of such Underwriter), insofar as such loss,
claim, damage, liability or expense (or actions in respect thereof as
contemplated below) arises out of or is based upon any untrue or alleged untrue
statement of a material fact contained in the Registration Statement, any
preliminary prospectus or the Prospectus (or any amendment or supplement
thereto), or arises out of or is based upon the omission or alleged omission to
state therein a material fact required to be stated therein or necessary to
make the statements therein not misleading, in each case to the extent, but
only to the extent, that such untrue statement or alleged untrue statement or
omission or alleged omission was made in the Registration Statement, any
preliminary prospectus, the Prospectus (or any amendment or supplement
thereto), in reliance upon and in conformity with written information furnished
to the Company and the Selling Shareholder by or on behalf of the
Representatives expressly for use therein; and to reimburse the Company, or any
such director, officer, counsel, Selling Shareholder or controlling person for
any legal and other expense reasonably incurred by the Company, or any such
director, officer, Selling Shareholder or controlling person in connection with
investigating, defending, settling, compromising or paying any such loss,
claim, damage, liability, expense or action.

The Company and the Selling Shareholder, hereby acknowledges
that the only information that the Underwriters have furnished to the Company
and the Selling Shareholder expressly for use in the Registration Statement,
any preliminary prospectus or the Prospectus (or any amendment or supplement
thereto) are the statements set forth in the table in the first paragraph and
the third, ninth, tenth and eleventh paragraphs under the caption
"Underwriting" in the Prospectus; and the Underwriters confirm that such
statements are correct. The indemnity agreement set forth in this Section 8(b)
shall be in addition to any liabilities that each Underwriter may otherwise
have.

(c) NOTIFICATIONS AND OTHER INDEMNIFICATION PROCEDURES. Promptly
after receipt by an indemnified party under this Section 8 of notice of the
commencement of any action, such indemnified party will, if a claim in respect
thereof is to be made against an indemnifying party under this Section 8,
notify the indemnifying party (and if any indemnifying party is either the
Company or the Selling Shareholder, notice shall be provided to each of them)
in writing of the commencement thereof, but the omission so to notify each
potential indemnifying party will not relieve it from any liability which it
may have to any indemnified party for contribution or otherwise than under the
indemnity agreement contained in this Section 8 or to the extent it is not
prejudiced as a proximate result of such failure.

In case any such action is brought against any indemnified
party and such indemnified party seeks or intends to seek indemnity from an
indemnifying party, the indemnifying party will be entitled to participate in,
and, to the extent that it shall elect, jointly with all other indemnifying
parties similarly notified, by written notice delivered to the indemnified
party promptly after receiving the aforesaid notice from such indemnified
party, to assume the defense thereof with counsel reasonably satisfactory to
such indemnified party; PROVIDED, HOWEVER, if the defendants in any such action
include both the indemnified party and the indemnifying party and the
indemnified party shall have reasonably concluded that a conflict may arise
between the positions of the indemnifying party and any indemnified party so
electing

- 22 -

<PAGE>

in conducting the defense of any such action or that there may be legal
defenses available to it and/or other indemnified parties which are different
from or additional to those available to the indemnifying party, the
indemnified party or parties shall have the right to select separate counsel to
assume such legal defenses and to otherwise participate in the defense of such
action on behalf of such indemnified party or parties.

Upon receipt of notice from any indemnifying party to such
indemnified party of such indemnifying party's election so to assume the
defense of such action and approval by the indemnified party of counsel, the
indemnifying party will not be liable to such indemnified party under this
Section 8 for any legal or other expenses subsequently incurred by such
indemnified party in connection with the defense thereof unless (i) the
indemnified party shall have employed separate counsel in accordance with the
proviso set forth above (it being understood, however, that the indemnifying
party shall not be liable for the expenses of more than one separate counsel
(together with local counsel), approved by the indemnifying party (the
Representatives in the case of Section 8(b) and Section 9), representing the
indemnified parties who are parties to such action) or (ii) the indemnifying
party shall not have employed counsel satisfactory to the indemnified party to
represent the indemnified party within a reasonable time after notice of
commencement of the action, in each of which cases the fees and expenses of
counsel shall be at the expense of the indemnifying party.

(d) SETTLEMENTS. The indemnifying party under this Section 8
shall not be liable for any settlement of any proceeding effected without its
written consent, but if settled with such consent or if there be a final
judgment for the plaintiff, the indemnifying party agrees to indemnify the
indemnified party against any loss, claim, damage, liability or expense by
reason of such settlement or judgment. Notwithstanding the foregoing sentence,
if at any time an indemnified party shall have requested an indemnifying party
to reimburse the indemnified party for fees and expenses of counsel as
contemplated by Section 8(c) hereof, the indemnifying party agrees that it
shall be liable for any settlement of any proceeding effected without its
written consent if (i) such settlement is entered into more than 30 days after
receipt by such indemnifying party of the aforesaid request and (ii) such
indemnifying party shall not have reimbursed the indemnified party in
accordance with such request prior to the date of such settlement.

No indemnifying party shall, without the prior written
consent of the indemnified party, effect any settlement, compromise or consent
to the entry of judgment in any pending or threatened action, suit or
proceeding in respect of which any indemnified party is or could have been a
party and indemnity was or could have been sought hereunder by such indemnified
party, unless such settlement, compromise or consent includes an unconditional
release of such indemnified party from all liability on claims that are the
subject matter of such action, suit or proceeding.

(e) LIMITATION OF LIABILITY. The liability of the Selling
Shareholder under the indemnity and contribution agreements contained in this
Section 8 and Section 9 hereof shall be limited to an amount equal to its pro
rata share (based on the proportion that the Common Shares sold by the Selling
Shareholder bears to the total number of Common Shares sold by each of the
Selling Shareholder and the Company) of any loss, claim, damage, liability,
expense, or action covered by Sections 8(a) or 9, not to exceed an amount equal
to the net proceeds received by the Selling Shareholder from the Common Shares
sold by the Selling Shareholder. Notwithstanding the foregoing, if a loss
claim, damage, liability, expense, or action covered by Sections 8(a) or 9
arises out of or is based upon (i) any untrue or alleged untrue statement of a
material fact

- 23 -

<PAGE>

contained in any preliminary prospectus, the Registration Statement or the
Prospectus (or any amendment or supplement thereto), or arises out of or is
based upon the omission or alleged omission to state therein a material fact
required to be stated therein or necessary to make the statements therein not
misleading, in each case to the extent, but only to the extent, that such
untrue statement or alleged untrue statement or omission or alleged omission
was made in any preliminary prospectus, the Registration Statement or the
Prospectus (or any amendment or supplement thereto), in reliance upon and in
conformity with written information furnished to the Company and the
Underwriters by or on behalf of the Selling Shareholder expressly for use
therein; or (ii) any inaccuracy in the representations and warranties of the
Selling Shareholder contained herein; or (iii) any failure of the Selling
Shareholder to perform its obligations hereunder or under law, then the
liability of the Selling Shareholder under the indemnity and contribution
agreements contained in the provisions of this Section 8 and Section 9 hereof
shall be limited to an amount equal to the net proceeds received by the Selling
Shareholder from the Common Shares sold by the Selling Shareholder. Nothing in
this Section 8(e) shall in any way be interpreted to limit or absolve the
Company from any of its indemnification or contribution obligations for any
loss, claim, damage, liability, expense or action as set forth in Section 8(a)
of this Agreement or as otherwise provided by law.

SECTION 9. CONTRIBUTION.

If the indemnification provided for in Section 8 is for any
reason held to be unavailable to or otherwise insufficient to hold harmless an
indemnified party in respect of any losses, claims, damages, liabilities or
expenses referred to therein, then each indemnifying party shall contribute to
the aggregate amount paid or payable by such indemnified party, as incurred, as
a result of any losses, claims, damages, liabilities or expenses referred to
therein (i) in such proportion as is appropriate to reflect the relative
benefits received by the Company and the Selling Shareholder, on the one hand,
and the Underwriters, on the other hand, from the offering of the Common Shares
pursuant to this Agreement or (ii) if the allocation provided by clause (i)
above is not permitted by applicable law, in such proportion as is appropriate
to reflect not only the relative benefits referred to in clause (i) above but
also the relative fault of the Company and the Selling Shareholder, on the one
hand, and the Underwriters, on the other hand, in connection with the
statements or omissions or inaccuracies in the representations and warranties
herein which resulted in such losses, claims, damages, liabilities or expenses,
as well as any other relevant equitable considerations.

The relative benefits received by the Company and the Selling
Shareholder, on the one hand, and the Underwriters, on the other hand, in
connection with the offering of the Common Shares pursuant to this Agreement
shall be deemed to be in the same respective proportions as the total net
proceeds from the offering of the Common Shares pursuant to this Agreement
(before deducting expenses) received by the Company and the Selling
Shareholder, and the total underwriting discount received by the Underwriters,
in each case as set forth on the front cover page of the Prospectus (or, if
Rule 434 under the Securities Act is used, the corresponding location on the
Term Sheet) bear to the aggregate public offering price of the Common Shares as
set forth on such cover.

The relative fault of the Company and the Selling
Shareholder, on the one hand, and the Underwriters, on the other hand, shall be
determined by reference to, among other things, whether any such untrue or
alleged untrue statement of a material fact or omission or alleged omission to
state a material fact or any such inaccurate or alleged inaccurate
representation or

- 24 -

<PAGE>

warranty relates to information supplied by the Company or the Selling
Shareholder, on the one hand, or the Underwriters, on the other hand, and the
parties' relative intent, knowledge, access to information and opportunity to
correct or prevent such statement or omission.

The amount paid or payable by a party as a result of the
losses, claims, damages, liabilities and expenses referred to above shall be
deemed to include, subject to the limitations set forth in Section 8(c), any
legal or other fees or expenses reasonably incurred by such party in connection
with investigating or defending any action or claim. The provisions set forth
in Section 8(c) with respect to notice of commencement of any action shall
apply if a claim for contribution is to be made under this Section 9; PROVIDED,
HOWEVER, that no additional notice shall be required with respect to any action
for which notice has been given under Section 8(c) for purposes of
indemnification.

The Company, the Selling Shareholder and the Underwriters
agree that it would not be just and equitable if contribution pursuant to this
Section 9 were determined by pro rata allocation (even if the Underwriters were
treated as one entity for such purpose) or by any other method of allocation
which does not take account of the equitable considerations referred to in this
Section 9.

Notwithstanding the provisions of this Section 9, no
Underwriter shall be required to contribute any amount in excess of the
underwriting commissions received by such Underwriter in connection with the
Common Shares underwritten by it and distributed to the public. No person
guilty of fraudulent misrepresentation (within the meaning of Section 11(f) of
the Securities Act) shall be entitled to contribution from any person who was
not guilty of such fraudulent misrepresentation. The Underwriters' obligations
to contribute pursuant to this Section 9 are several, and not joint, in
proportion to their respective underwriting commitments as set forth opposite
their names in SCHEDULE A.

For purposes of this Section 9, each officer and employee of
an Underwriter and each person, if any, who controls an Underwriter within the
meaning of the Securities Act and the Exchange Act shall have the same rights
to contribution as such Underwriter, and each director of the Company, each
officer of the Company who signed the Registration Statement, and each person,
if any, who controls the Company with the meaning of the Securities Act and the
Exchange Act shall have the same rights to contribution as the Company.

SECTION 10. DEFAULT OF ONE OR MORE OF THE SEVERAL UNDERWRITERS. If, on
the First Closing Date or the Second Closing Date, as the case may be, any one
or more of the several Underwriters shall fail or refuse to purchase Common
Shares that it or they have agreed to purchase hereunder on such date, and the
aggregate number of Common Shares which such defaulting Underwriter or
Underwriters agreed but failed or refused to purchase does not exceed 10% of
the aggregate number of the Common Shares to be purchased on such date, the
other Underwriters shall be obligated, severally, in the proportions that the
number of Firm Common Shares set forth opposite their respective names on
SCHEDULE A bears to the aggregate number of Firm Common Shares set forth
opposite the names of all such non-defaulting Underwriters, or in such other
proportions as may be specified by the Representatives with the consent of the
non-defaulting Underwriters, to purchase the Common Shares which such
defaulting Underwriter or Underwriters agreed but failed or refused to purchase
on such date. If, on the First Closing Date or the Second Closing Date, as the
case may be, any one or more of the Underwriters shall fail or refuse to
purchase Common Shares and the aggregate number of Common Shares with respect to

- 25 -

<PAGE>

which such default occurs exceeds 10% of the aggregate number of Common Shares
to be purchased on such date, and arrangements satisfactory to the
Representatives and the Company for the purchase of such Common Shares are not
made within 48 hours after such default, this Agreement shall terminate without
liability of any party to any other party except that the provisions of Section
4, Section 6, Section 8 and Section 9 shall at all times be effective and shall
survive such termination. In any such case either the Representatives or the
Company shall have the right to postpone the First Closing Date or the Second
Closing Date, as the case may be, but in no event for longer than seven days in
order that the required changes, if any, to the Registration Statement and the
Prospectus or any other documents or arrangements may be effected.

As used in this Agreement, the term "Underwriter" shall be
deemed to include any person substituted for a defaulting Underwriter under
this Section 10. Any action taken under this Section 10 shall not relieve any
defaulting Underwriter from liability in respect of any default of such
Underwriter under this Agreement.

SECTION 11. TERMINATION OF THIS AGREEMENT. Prior to the First Closing
Date this Agreement may be terminated by the Representatives by notice given to
the Company and the Selling Shareholder if at any time (i) trading or quotation
in any of the Company's securities shall have been suspended or limited by the
Commission or by the Nasdaq National Market, or trading in securities generally
on the Nasdaq Stock Market shall have been suspended or limited, or minimum or
maximum prices shall have been generally established on any of such stock
exchanges by the Commission or the NASD; (ii) a general banking moratorium
shall have been declared by any of federal, New York or California authorities;
(iii) there shall have occurred any outbreak or escalation of national or
international hostilities or any crisis or calamity, or any change in the
United States or international financial markets, or any substantial change or
development involving a prospective substantial change in United States' or
international political, financial or economic conditions, as in the reasonable
judgment of the Representatives is material and adverse and makes it
impracticable to market the Common Shares in the manner and on the terms
described in the Prospectus or to enforce contracts for the sale of securities;
or (iv) in the reasonable judgment of the Representatives there shall have
occurred any Material Adverse Change. Any termination pursuant to this Section
11 shall be without liability on the part of (a) the Company or the Selling
Shareholder to any Underwriter, except that the Company and the Selling
Shareholder shall be obligated to reimburse the expenses of the Representatives
and the Underwriters pursuant to Sections 4 and 6 hereof, (b) any Underwriter
to the Company or the Selling Shareholder, or (c) of any party hereto to any
other party except that the provisions of Section 8 and Section 9 shall at all
times be effective and shall survive such termination.

SECTION 12. REPRESENTATIONS AND INDEMNITIES TO SURVIVE DELIVERY. The
respective indemnities, agreements, representations, warranties and other
statements of the Company, of its officers, of the Selling Shareholder and of
the several Underwriters set forth in or made pursuant to this Agreement will
remain in full force and effect, regardless of any investigation made by or on
behalf of any Underwriter or the Company or any of its or their partners,
officers or directors or any controlling person, or the Selling Shareholder, as
the case may be, and will survive delivery of and payment for the Common Shares
sold hereunder and any termination of this Agreement.

- 26 -

<PAGE>

SECTION 13 NOTICES. All communications hereunder shall be in writing
and shall be mailed, hand delivered or telecopied and confirmed to the parties
hereto as follows:

If to the Representatives:

Banc of America Securities LLC
600 Montgomery Street
San Francisco, CA 94111
Facsimile: (415) 913-5558
Attention: Richard A. Smith

with a copy to:

Banc of America Securities LLC
600 Montgomery Street
San Francisco, CA 94111
Facsimile: (415) 913-5553
Attention: Jeffrey R. Lapic, Esq.

and to:

Needham & Company, Inc.
445 Park Avenue
New York, NY 10022
Facsimile: (212) 751-1450
Attention: Roger C. Cotta

with a copy to:

Heller Ehrman White & McAuliffe
333 Bush Street
San Francisco, CA 94104
Facsimile: (415) 772-6268
Attention: Victor A. Hebert, Esq.

If to the Company:

Photon Dynamics, Inc.
6325 San Ignacio Avenue
San Jose, CA 95119
Facsimile: (408) 226-9910
Attention: Chief Executive Officer

with a copy to:

Cooley Godward LLC
5 Palo Alto Square
Palo Alto, CA 94306
Facsimile: (650) 857-0663

- 27 -

<PAGE>

Attention: Matthew Sonsini, Esq.

If to the Selling Shareholder:

WFC Holdings Corporation
555 Montgomery Street, 17th Floor
San Francisco, CA 94111
Facsimile: (415)
Attention: [___]

with a copy to:

Gibson, Dunn & Crutcher LLP
One Montgomery Street
Telesis Tower
San Francisco, CA 94104
Facsimile: (415) 986-5309
Attention: Stewart L. McDowell, Esq.

Any party hereto may change the address for receipt of communications by giving
written notice to the others.

SECTION 14. SUCCESSORS. This Agreement will inure to the benefit of
and be binding upon the parties hereto, including any substitute Underwriters
pursuant to Section 10 hereof, and to the benefit of the employees, officers
and directors and controlling persons referred to in Section 8 and Section 9,
and in each case their respective successors, and no other person will have any
right or obligation hereunder. The term "successors" shall not include any
purchaser of the Common Shares as such from any of the Underwriters merely by
reason of such purchase.

SECTION 15. PARTIAL UNENFORCEABILITY. The invalidity or
unenforceability of any Section, paragraph or provision of this Agreement shall
not affect the validity or enforceability of any other Section, paragraph or
provision hereof. If any Section, paragraph or provision of this Agreement is
for any reason determined to be invalid or unenforceable, there shall be deemed
to be made such minor changes (and only such minor changes) as are necessary to
make it valid and enforceable.

SECTION 16.

(a) GOVERNING LAW PROVISIONS. THIS AGREEMENT SHALL BE GOVERNED BY
AND CONSTRUED IN ACCORDANCE WITH THE INTERNAL LAWS OF THE STATE OF CALIFORNIA
APPLICABLE TO AGREEMENTS MADE AND TO BE PERFORMED IN SUCH STATE.

(b) CONSENT TO JURISDICTION. Any legal suit, action or proceeding
arising out of or based upon this Agreement or the transactions contemplated
hereby ("Related Proceedings") may be instituted in the federal courts of the
United States of America located in the City and

- 28 -

<PAGE>

County of San Francisco or the courts of the State of California in each case
located in the City and County of San Francisco (collectively, the "Specified
Courts"), and each party irrevocably submits to the exclusive jurisdiction
(except for proceedings instituted in regard to the enforcement of a judgment
of any such court (a "Related Judgment"), as to which such jurisdiction is
non-exclusive) of such courts in any such suit, action or proceeding. Service
of any process, summons, notice or document by mail to such party's address set
forth above shall be effective service of process for any suit, action or other
proceeding brought in any such court. The parties irrevocably and
unconditionally waive any objection to the laying of venue of any suit, action
or other proceeding in the Specified Courts and irrevocably and unconditionally
waive and agree not to plead or claim in any such court that any such suit,
action or other proceeding brought in any such court has been brought in an
inconvenient forum.

SECTION 17. FAILURE OF THE SELLING SHAREHOLDER TO SELL AND DELIVER
COMMON SHARES. If the Selling Shareholder shall fail to sell and deliver to the
Underwriters the Common Shares to be sold and delivered by the Selling
Shareholder at the First Closing Date pursuant to this Agreement, then the
Underwriters may at their option, by written notice from the Representatives to
the Company and the Selling Shareholder, either (i) terminate this Agreement
without any liability on the part of any Underwriter or, except as provided in
Sections 4, 6, 8 and 9 hereof, the Company or the Selling Shareholder, or (ii)
purchase the shares which the Company has agreed to sell and deliver in
accordance with the terms hereof. If Selling Shareholder shall fail to sell and
deliver to the Underwriters the Common Shares to be sold and delivered by the
Selling Shareholder pursuant to this Agreement at the First Closing Date, then
the Underwriters shall have the right, by written notice from the
Representatives to the Company and the Selling Shareholder, to postpone the
First Closing Date, but in no event for longer than seven days in order that
the required changes, if any, to the Registration Statement and the Prospectus
or any other documents or arrangements may be effected.

SECTION 18. GENERAL PROVISIONS. This Agreement constitutes the entire
agreement of the parties to this Agreement and supersedes all prior written or
oral and all contemporaneous oral agreements, understandings and negotiations
with respect to the subject matter hereof. This Agreement may be executed in
two or more counterparts, each one of which shall be an original, with the same
effect as if the signatures thereto and hereto were upon the same instrument.
This Agreement may not be amended or modified unless in writing by all of the
parties hereto, and no condition herein (express or implied) may be waived
unless waived in writing by each party whom the condition is meant to benefit.
The table of contents and the Section headings herein are for the convenience
of the parties only and shall not affect the construction or interpretation of
this Agreement.

Each of the parties hereto acknowledges that it is a
sophisticated business person who was adequately represented by counsel during
negotiations regarding the provisions hereof, including, without limitation,
the indemnification provisions of Section 8 and the contribution provisions of
Section 9, and is fully informed regarding said provisions. Each of the parties
hereto further acknowledges that the provisions of Sections 8 and 9 hereto
fairly allocate the risks in light of the ability of the parties to investigate
the Company, its affairs and its business in order to assure that adequate
disclosure has been made in the Registration Statement, any preliminary
prospectus and the Prospectus (and any amendments and supplements thereto), as
required by the Securities Act and the Exchange Act.

- 29 -

<PAGE>

If the foregoing is in accordance with your understanding of
our agreement, kindly sign and return to the Company and the Custodian the
enclosed copies hereof, whereupon this instrument, along with all counterparts
hereof, shall become a binding agreement in accordance with its terms.

Very truly yours,

PHOTON DYNAMICS, INC.

By:__________________________
Name: Vincent F. Sollitto, Jr.
Title: Chief Executive Officer

WFC HOLDINGS CORPORATION

By:__________________________
(Attorney-in-fact)

-30-
<PAGE>

The foregoing Underwriting Agreement is hereby confirmed and accepted
by the Representatives in San Francisco, California as of the date first above
written.

BANC OF AMERICA SECURITIES LLC
NEEDHAM & COMPANY, INC.

Acting as Representatives of the
several Underwriters named in
the attached Schedule A.

By: Banc of America Securities LLC

By:

- -------------------------------- ---------------------------------
[Name] [Name]
Managing Director Managing Director

By: Needham & Company, Inc.

By:

- --------------------------------
David K. Townes
Managing Director

-31-
<PAGE>

SCHEDULE A

<TABLE>
<CAPTION>
NUMBER OF
FIRM COMMON
UNDERWRITERS SHARES
TO BE PURCHASED
<S> <C>
Banc of America Securities LLC ........................... [___]
Needham & Company, Inc. [___]
SoundView Technology Group, Inc........................... [___]
[___] .................................................... [___]
[___] .................................................... [___]

Total............................................ 2,000,000
</TABLE>
<PAGE>

SCHEDULE B

WFC Holdings Corporation
<PAGE>

EXHIBIT A-1

Opinion of counsel for the Company to be delivered pursuant
to Section 5(d) of the Underwriting Agreement.

References to the Prospectus in this EXHIBIT A-1 include
any supplements thereto at the Closing Date. Capitalized terms shall have the
meaning as defined in the Underwriting Agreement.

(i) The Company has been duly incorporated and is validly
existing as a corporation in good standing under the laws of the State of
California.

(ii) The Company has corporate power and authority to own, lease
and operate its properties and to conduct its business as described in the
Prospectus and to enter into and perform its obligations under the
Underwriting Agreement.

(iii) The Company is duly qualified as a foreign corporation to
transact business and, to our knowledge, is in good standing in each other
jurisdiction in which such qualification is required, whether by reason of
the ownership or leasing of property or the conduct of business, except for
such jurisdictions where the failure to so qualify or to be in good standing
would not, individually or in the aggregate, result in a Material Adverse
Change.

(iv) CR Technology, Inc. has been duly incorporated and is
validly existing as a corporation in good standing under the laws of the
jurisdiction of its incorporation, has corporate power and authority to own,
lease and operate its properties and to conduct its business as described in
the Prospectus and, to the knowledge of such counsel, is duly qualified as a
foreign corporation to transact business and is in good standing in each
jurisdiction in which such qualification is required, whether by reason of
the ownership or leasing of property or the conduct of business, except for
such jurisdictions where the failure to so qualify or to be in good standing
would not, individually or in the aggregate, result in a Material Adverse
Change.

(v) All of the issued and outstanding capital stock of CR
Technology, Inc. has been duly authorized and validly issued, is fully paid
and non-assessable and is owned by the Company, directly or through
subsidiaries, free and clear of any security interest, mortgage, pledge,
lien, encumbrance or, to the knowledge of such counsel, any pending or
threatened claim.

(vi) The authorized, issued and outstanding capital stock of the
Company (including the Common Stock) conform to the descriptions thereof set
forth or incorporated by reference in the Prospectus. All of the outstanding
shares of Common Stock (including the shares of Common Stock owned by Selling
Shareholder) have been duly authorized and validly issued, are fully paid and
nonassessable and, to the best of such counsel's knowledge without
investigation, have been issued in compliance with the registration and
qualification requirements of federal and state securities laws. The form of
certificate used to evidence the Common Stock is in due and proper form and
complies with all applicable requirements of the charter and by-laws of the
Company and the General Corporation Law of the State of California. The
description of the

A-1
<PAGE>

Company's stock option, stock bonus and other stock plans or arrangements,
and the options or other rights granted and exercised thereunder, set forth
in the Prospectus accurately and fairly presents the information required to
be shown with respect to such plans, arrangements, options and rights.

(vii) No shareholder of the Company or any other person has any
preemptive right, right of first refusal or other similar right to subscribe
for or purchase securities of the Company arising by operation of the charter
or by-laws of the Company or the General Corporation Law of the State of
California.

(viii) The Underwriting Agreement has been duly authorized,
executed and delivered by, and is a valid and binding agreement of, the
Company, enforceable in accordance with its terms, except as rights to
indemnification thereunder may be limited by applicable law and except as the
enforcement thereof may be limited by bankruptcy, insolvency, reorganization,
moratorium or other similar laws relating to or affecting creditors' rights
generally or by general equitable principles.

(ix) The Common Shares to be purchased by the Underwriters from
the Company have been duly authorized for issuance and sale pursuant to the
Underwriting Agreement and, when issued and delivered by the Company pursuant
to the Underwriting Agreement against payment of the consideration set forth
therein, will be validly issued, fully paid and nonassessable.

(x) Each of the Registration Statement and the Rule 462(b)
Registration Statement, if any, has been declared effective by the Commission
under the Securities Act. To the best knowledge of such counsel, no stop
order suspending the effectiveness of either of the Registration Statement or
the Rule 462(b) Registration Statement, if any, has been issued under the
Securities Act and no proceedings for such purpose have been instituted or
are pending or are contemplated or threatened by the Commission. Any required
filing of the Prospectus and any supplement thereto pursuant to Rule 424(b)
under the Securities Act has been made in the manner and within the time
period required by such Rule 424(b).

(xi) The Registration Statement, including any Rule 462(b)
Registration Statement, the Prospectus including any document incorporated by
reference therein, and each amendment or supplement to the Registration
Statement and the Prospectus including any document incorporated by reference
therein, as of their respective effective or issue dates (other than the
financial statements and supporting schedules included or incorporated by
reference therein or in exhibits to or excluded from the Registration
Statement, as to which no opinion need be rendered) comply as to form in all
material respects with the applicable requirements of the Securities Act and
the Exchange Act.

(xii) The Common Shares have been approved for listing on the
Nasdaq National Market.

(xiii) The statements (i) in the Prospectus under the captions
"Risk Factors--We depend on sales to a few large customers", "Risk
Factors--We may not be able to obtain critical

A-2
<PAGE>

components from our single or limited source suppliers", Risk Factors--We
depend on our relationship with IHI to market our FPD products in Japan",
"Risk Factors--We must attract and retain key employees to maintain and grow
our business", "Risk Factors--Our business could be harmed if we fail to
properly protect our intellectual property", "Risk Factors--Litigation may be
necessary to defend us against claims of intellectual property infringement",
"Risk Factors--Our business may be harmed if we fail to comply with
governmental regulations", "Risk Factors--We may experience unanticipated
warranty claims", "Risk Factors--Some anti-takeover provisions may affect the
price of our common stock", "Management's Discussion and Analysis of
Financial Condition and Results of Operations--Liquidity and Capital
Resources", "Business--Intellectual Property", and "Underwriting" and (ii) in
Item 14 and Item 15 of the Registration Statement, insofar as such statements
constitute matters of law, summaries of legal matters, the Company's charter
or by-law provisions or legal proceedings, or legal conclusions, has been
reviewed by such counsel and fairly present and summarize, in all material
respects, the matters referred to therein.

(xiv) To the knowledge of such counsel, there are no legal or
governmental actions, suits or proceedings pending or threatened which are
required to be disclosed in the Registration Statement, other than those
disclosed therein.

(xv) To the knowledge of such counsel, there are no Existing
Instruments required to be described or referred to in the Registration
Statement or to be filed as exhibits thereto other than those described or
referred to therein or filed or incorporated by reference as exhibits
thereto; and the descriptions thereof and references thereto are correct in
all material respects.

(xvi) No consent, approval, authorization or other order of, or
registration or filing with, any court or other governmental authority or
agency, is required for the Company's execution, delivery and performance of
the Underwriting Agreement and consummation of the transactions contemplated
thereby and by the Prospectus, except as required under the Securities Act,
applicable state securities or blue sky laws and from the NASD.

(xvii) The execution and delivery of the Underwriting Agreement by
the Company and the performance by the Company of its obligations thereunder
(other than performance by the Company of its obligations under the
indemnification section of the Underwriting Agreement, as to which no opinion
need be rendered) (i) will not result in any violation of the provisions of
the charter or by-laws of the Company or any subsidiary; (ii) will not
constitute a breach of, or Default under, or result in the creation or
imposition of any lien, charge or encumbrance upon any property or assets of
the Company or any of its subsidiaries pursuant to the best knowledge of such
counsel, any other material Existing Instrument; or (iii) to the best
knowledge of such counsel, will not result in any violation of any law,
administrative regulation or administrative or court decree applicable to the
Company or any subsidiary.

(xviii) The Company is not, and after receipt of payment for the
Common Shares will not be, an "investment company" within the meaning of
Investment Company Act.

A-3
<PAGE>

(xix) To the knowledge of such counsel, there are no persons with
registration or other similar rights to have any equity or debt securities
registered for sale under the Registration Statement or included in the
offering contemplated by the Underwriting Agreement.

In addition, such counsel shall state that they have
participated in conferences with officers and other representatives of the
Company, representatives of the independent public or certified public
accountants for the Company and with representatives of the Underwriters at
which the contents of the Registration Statement and the Prospectus, and any
supplements or amendments thereto, and related matters were discussed and,
although such counsel is not passing upon and does not assume any
responsibility for the accuracy, completeness or fairness of the statements
contained in the Registration Statement or the Prospectus (other than as
specified above), and any supplements or amendments thereto, on the basis of
the foregoing, nothing has come to their attention which would lead them to
believe that either the Registration Statement or any amendments thereto, at
the time the Registration Statement or such amendments became effective,
contained an untrue statement of a material fact or omitted to state a
material fact required to be stated therein or necessary to make the
statements therein not misleading or that the Prospectus, as of its date or
at the First Closing Date or the Second Closing Date, as the case may be,
contained an untrue statement of a material fact or omitted to state a
material fact necessary in order to make the statements therein, in the light
of the circumstances under which they were made, not misleading (it being
understood that such counsel need express no belief as to the financial
statements or schedules or other financial or statistical data derived
therefrom, included or incorporated by reference in the Registration
Statement or the Prospectus or any amendments or supplements thereto).

In rendering such opinion, such counsel may rely (A) as to
matters involving the application of laws of any jurisdiction other than the
General Corporation Law of the State of California or the federal law of the
United States, to the extent they deem proper and specified in such opinion,
upon the opinion (which shall be dated the First Closing Date or the Second
Closing Date, as the case may be, shall be satisfactory in form and substance
to the Underwriters, shall expressly state that the Underwriters may rely on
such opinion as if it were addressed to them and shall be furnished to the
Representatives) of other counsel of good standing whom they believe to be
reliable and who are satisfactory to counsel for the Underwriters; PROVIDED,
HOWEVER, that such counsel shall further state that they believe that they
and the Underwriters are justified in relying upon such opinion of other
counsel, and (B) as to matters of fact, to the extent they deem proper, on
certificates of responsible officers of the Company and public officials.

A-4
<PAGE>

EXHIBIT A-2

Opinion of counsel for the Selling Shareholder to be delivered
pursuant to Section 5(f) of the Underwriting Agreement.

Capitalized terms shall have the meaning as defined in the
Underwriting Agreement.

(i) The Selling Shareholder has been duly incorporated and is
validly existing as a corporation in good standing under the laws of
__________.

(ii) The Selling Shareholder has the corporate power and
authority to enter into each of the Underwriting Agreement, the Custody
Agreement and the Power of Attorney, to sell, transfer and deliver all of the
Common Shares to be sold by the Selling Shareholder pursuant to the
Underwriting Agreement, and to comply with all of its other obligations under
each of the Underwriting Agreement, the Custody Agreement, and the Power of
Attorney.

(iii) Each of the Underwriting Agreement, the Custody Agreement
and the Power of Attorney (i) has been duly authorized, executed and
delivered by, and is a valid and binding agreement of, the Selling
Shareholder, enforceable in accordance with its terms, except as rights to
indemnification thereunder may be limited by applicable law and except as the
enforcement thereof may be limited by bankruptcy, insolvency, reorganization,
moratorium or other similar laws relating to or affecting creditors' rights
generally or by general equitable principles; (ii) will not result in any
violation of the provisions of the charter or by-laws of the Selling
Shareholder; and (iii) to the best knowledge of such counsel, will not result
in any violation of any law, administrative regulation or administrative or
court order or decree applicable to or binding on the Selling Shareholder and
the Common Shares being sold by the Selling Shareholder.

(iv) Immediately prior to the First Closing Date, the Selling
Shareholder had good and valid title to all of the Common Shares to be sold by
the Selling Shareholder pursuant to the Underwriting Agreement on such date.

(v) The statements in the Prospectus under the caption
"Principal and Selling Shareholder" insofar as they relate to the Selling
Shareholder, have been reviewed by such counsel and fairly present and
summarize, in all material respects, the matters referred to therein.

In rendering such opinion, such counsel may rely (A) as to
matters involving the application of laws of any jurisdiction other than the
General Corporation Law of the State of Delaware, the General Corporation Law
of the State of California or the federal law of the United States, to the
extent they deem proper and specified in such opinion, upon the opinion
(which shall be dated the First Closing Date, shall be satisfactory in form
and substance to the Underwriters, shall expressly state that the
Underwriters may rely on such opinion as if it were addressed to them and
shall be furnished to the Representatives) of other counsel of good

A-5
<PAGE>

standing whom they believe to be reliable and who are satisfactory to counsel
for the Underwriters; PROVIDED, HOWEVER, that such counsel shall further
state that they believe that they and the Underwriters are justified in
relying upon such opinion of other counsel, and (B) as to matters of fact, to
the extent they deem proper, on certificates of responsible officers of the
Selling Shareholder and public officials.

A-6
<PAGE>

EXHIBIT B

[Date]

Banc of America Securities LLC
Needham & Company, Inc.
As Representatives of the Several Underwriters
c/o Banc of America Securities LLC
600 Montgomery Street
San Francisco, California 94111

RE: Photon Dynamics, Inc. (the "Company")

Ladies & Gentlemen:

The undersigned is an owner of record or beneficially of certain shares of
Common Stock of the Company ("Common Stock") or securities convertible into or
exchangeable or exercisable for Common Stock. The Company proposes to carry out
a public offering of Common Stock (the "Offering") for which you will act as the
representatives of the underwriters. The undersigned recognizes that the
Offering will be of benefit to the undersigned and will benefit the Company by,
among other things, raising additional capital for its operations. The
undersigned acknowledges that you and the other underwriters are relying on the
representations and agreements of the undersigned contained in this letter in
carrying out the Offering and in entering into an Underwriting Agreement with
the Company with respect to the Offering (the "Underwriting Agreement").

In consideration of the foregoing, the undersigned hereby agrees that the
undersigned will not, without the prior written consent of the Representatives
(which consent may be withheld in their sole discretion), directly or
indirectly, sell, offer, contract or grant any option to sell (including without
limitation any short sale), pledge, transfer, establish an open "put equivalent
position" within the meaning of Rule 16a-1(h) under the Securities Exchange Act
of 1934, or otherwise dispose of any shares of Common Stock, options or warrants
to acquire shares of Common Stock, or securities exchangeable or exercisable for
or convertible into shares of Common Stock currently or hereafter owned either
of record or beneficially (as defined in Rule 13d-3 under the Securities
Exchange Act of 1934, as amended) by the undersigned, or publicly announce the
undersigned's intention to do any of the foregoing, for a period commencing on
the date hereof and continuing through the close of trading on the date 90 days
after the date of the Prospectus. The foregoing sentence shall not apply to
transactions relating to Common Stock or other securities convertible or
exchangeable for Common Stock (a) to be sold by the undersigned in the Offering,
(b) acquired in open-market transactions after the completion of the Offering,
or (c) disposed of (i) as a bona fide gift or gifts, (ii) by will or intestacy
to the undersigned's immediate family or to a trust the beneficiaries of which
are exclusively the undersigned and/or a member or members of the undersigned's
immediate family and/or a charity, or (iii) as a distribution to limited
partners, members of limited liability companies or shareholders of the
undersigned, in each case provided that any gift, transfer or distribution
pursuant to clauses (i), (ii) or (iii) above

B-1
<PAGE>

shall be conditioned upon the donee, transferee or distributee executing and
delivering a copy of this Lock-Up Letter Agreement to the Representatives.
The undersigned also agrees and consents to the entry of stop transfer
instructions with the Company's transfer agent and registrar against the
transfer of shares of Common Stock or securities convertible into or
exchangeable or exercisable for Common Stock held by the undersigned except
in compliance with the foregoing restrictions.

With respect to the Offering only, the undersigned waives any registration
rights relating to registration under the Securities Act of any Common Stock
owned either of record or beneficially by the undersigned, including any
rights to receive notice of the Offering.

It is understood that, if the Company notifies you that it does not intend to
proceed with the Offering, if the Underwriting Agreement does not become
effective or if the Underwriting Agreement (other than the provisions thereof
which survive termination) shall terminate or be terminated prior to the
payment for and delivery of the shares to be sold in the Offering, we will be
released from our obligations under this Lock-Up Letter Agreement. This
Lock-Up Letter Agreement will terminate if the closing date of the Offering
has not occurred prior to June 30, 2000.

This agreement is irrevocable and will be binding on the undersigned and the
respective successors, heirs, personal representatives, and assigns of the
undersigned.

- ---------------------------------------
Printed Name of Holder

By:
------------------------------------
Signature

- ---------------------------------------
Printed Name of Person Signing
(AND INDICATE CAPACITY OF PERSON SIGNING IF
SIGNING AS CUSTODIAN, TRUSTEE, OR ON BEHALF
OF AN ENTITY)

<PAGE>
EXHIBIT 5.1

January __, 2000

Photon Dynamics, Inc.
6325 San Ignacio Avenue
San Jose, California 95119-1202

Dear Ladies & Gentleman:

You have requested our opinion with respect to certain matters in connection
with the filing by Photon Dynamics, Inc. (the "Company") of a Registration
Statement on Form S-3 (the "Registration Statement") with the Securities and
Exchange Commission, covering an underwritten public offering of up to 2,000,000
shares of common stock, including 1,320,687 shares to be sold by the Company,
plus any shares to be sold by the Company in the over-allotment (the "Company
Shares") and 679,313 shares to be sold by the selling stockholder (the "Selling
Stockholder Shares"). The Company Shares and the Selling Stockholder Shares are
collectively referred to herein as "Common Stock."

In connection with this opinion, we have (i) examined and relied upon the
Registration Statement and related prospectus, the Company's Articles of
Incorporation and Bylaws, as amended, and the originals or copies certified to
our satisfaction of such records, documents, certificates, memoranda and other
instruments as in our judgment are necessary or appropriate to enable us to
render the opinion expressed below and (ii) assumed that the shares of Common
Stock will be sold by the Underwriters at a price established by the Board of
Directors of the Company.

On the basis of the foregoing, and in reliance thereon, we are of the
opinion that the Company Shares, when sold and issued in accordance with the
Registration Statement and related prospectus, will be validly issued, fully
paid and nonassessable.

We consent to the reference to our firm under the caption "Legal Matters" in
the prospectus included on the Registration Statement and to the filing of this
opinion as an exhibit to the Registration Statement.

Very truly yours,

COOLEY GODWARD LLP

By:
--------------------------

Matthew W. Sonsini

<PAGE>

[PACIFIC CENTURY BANK N.A. LOGO]

CHANGE IN TERMS AGREEMENT
- -------------------------------------------------------------------------------
- -------------------------------------------------------------------------------

Borrower: CR Technology, Inc. Lender: Pacific Century Bank, N.A.
125-B Columbia Orange County Loan Center (905)
Aliso Viejo, CA 92858 16030 Ventura Boulevard
Encino, CA 91436
- -------------------------------------------------------------------------------
- -------------------------------------------------------------------------------
Principal Amount: $1,500,000.00 Date of Agreement: November 15, 1999

DESCRIPTION OF EXISTING INDEBTEDNESS. Borrower is indebted to Lender in the
original principal amount of One Million Five Hundred Thousand & 00/100
Dollars ($1,500,000.00), as evidenced by a Promissory Note, dated as of July
20, 1998, as amended by the Change in Terms Agreement, dated as of August 13,
1999, executed by Borrower in favor of Lender.

DESCRIPTION OF COLLATERAL. The Note is secured by the Collateral as described
in the Commercial Security Agreement, dated as of July 20, 1998, as it may be
amended, modified, supplemented, restated, or replaced, from time to time,
executed by Grantor in favor of Lender.

DESCRIPTION OF CHANGE IN TERMS. Repayment schedule is amended as follows:
Borrower will pay this loan in one payment of all outstanding principal plus
all accrued unpaid interest on February 1, 2001. In addition, Borrower will
pay regular monthly payments of accrued unpaid interest beginning December 1,
1999, and all subsequent interest payments are due on the same day of each
month after that.

ARBITRATION. Lender and Borrower agree that all disputes, claims and
controversies between them, whether individual, joint, or class in nature,
arising from this Agreement or otherwise, including without limitation
contract and tort disputes, shall be arbitrated pursuant to the Rules of the
American Arbitration Association, upon request of either party. No act to
take or dispose of any collateral securing this Agreement shall constitute a
waiver of this arbitration agreement or be prohibited by this arbitration
agreement. This includes, without limitation, obtaining injunctive relief or a
temporary restraining order, invoking a power of sale under any deed of trust
or mortgage; obtaining a writ of attachment or imposition of a receiver, or
exercising any rights relating to personal property, including taking or
disposing of such property with or without judicial process pursuant to
Article 9 of the Uniform Commercial Code. Any disputes, claims, or
controversies concerning the lawfulness or reasonableness of any act, or
exercise of any right, concerning any collateral securing this Agreement,
including any claim to rescind, reform, or otherwise modify any agreement
relating to the collateral securing this Agreement, shall also be
arbitrated, provided however that no arbitrator shall have the right or the
power to enjoin or restrain any act of any party. Lender and Borrower agree
that in the event of an action for judicial foreclosure pursuant to
California Code of Civil Procedure Section 726, or any similar provision in
any other state, the commencement of such an action will not constitute a
waiver of the right to arbitrate and the court shall refer to arbitration as
much of such action, including counterclaims, as lawfully may be referred to
arbitration. Judgement upon any award rendered by any arbitrator may be
entered in any court having jurisdiction. Nothing in this Agreement shall
preclude any party from seeking equitable relief from a court of competent
jurisdiction. The statute of limitations, estoppel, waiver, laches, and
similar doctrines which would otherwise be applicable in an action brought by
a party shall be applicable in any arbitration proceeding, and the
commencement of an arbitration proceeding shall be deemed the commencement of
an action for these purposes. The Federal Arbitration Act shall apply to the
construction, interpretation, and enforcement of this arbitration provision.

CONTINUING VALIDITY. Except as expressly changed by this Agreement, the
terms of the original obligation or obligations, including all agreements
evidenced or securing the obligation(s), remain unchanged and in full force
and effect. Consent by Lender to this Agreement does not waive Lender's right
to strict performance of the obligation(s) as changed, nor obligate Lender to
make any future change in terms. Nothing in this Agreement will constitute a
satisfaction of the obligation(s). It is the intention of Lender to retain as
liable parties all makers and endorsers of the original obligation(s).
including accommodation parties, unless a party is expressly released by
Lender in writing. Any maker or endorser, including accommodation makers,
will not be released by virtue of this Agreement. If any person who signed
the original obligation does not sign this Agreement below, then all persons
signing below acknowledge that this Agreement is given conditionally, based
on the representation to Lender that the non-signing party consents to the
changes and provisions of this Agreement or otherwise will not be released by
it. This waiver applies not only to any initial extension, modification or
release, but also to all such subsequent actions.

PRIOR TO SIGNING THIS AGREEMENT, BORROWER READ AND UNDERSTOOD ALL THE
PROVISIONS OF THIS AGREEMENT. BORROWER AGREES TO THE TERMS OF THE AGREEMENT
AND ACKNOWLEDGES RECEIPT OF A COMPLETED COPY OF THE AGREEMENT.

BORROWER:

CR Technology, Inc.

By: /s/ Richard E. Amtower
-------------------------------
Richard E. Amtower, President
and Assistant Secretary

LENDER:

Pacific Century Bank, N.A.

By: /s/ Ben A. [ILLEGIBLE]
-------------------------------
Authorized Officer
- -------------------------------------------------------------------------------
- -------------------------------------------------------------------------------

<PAGE>

[CALIFORNIA UNITED BANK LOGO]

BUSINESS LOAN AGREEMENT
- -------------------------------------------------------------------------------
- -------------------------------------------------------------------------------

Borrower: CR Technology, Inc. Lender: California United Bank
27752 El Lazo Road Orange County Commercial
Laguna Nigel, CA 92677-3914 Loan Center
16030 Ventura Boulevard
Encino, CA 91436
- -------------------------------------------------------------------------------
- -------------------------------------------------------------------------------

THIS BUSINESS LOAN AGREEMENT BETWEEN CR TECHNOLOGY, INC. ("BORROWER") AND
CALIFORNIA UNITED BANK ("LENDER") IS MADE AND EXECUTED ON THE FOLLOWING TERMS
AND CONDITIONS. BORROWER HAS RECEIVED PRIOR COMMERCIAL LOANS FROM LENDER OR
HAS APPLIED TO LENDER FOR A COMMERCIAL LOAN OR LOANS AND OTHER FINANCIAL
ACCOMMODATIONS, INCLUDING THOSE WHICH MAY BE DESCRIBED ON ANY EXHIBIT OR
SCHEDULE ATTACHED TO THIS AGREEMENT. ALL SUCH LOANS AND FINANCIAL
ACCOMMODATIONS, TOGETHER WITH ALL FUTURE LOANS AND FINANCIAL ACCOMMODATIONS
FROM LENDER TO BORROWER, ARE REFERRED TO IN THIS AGREEMENT INDIVIDUALLY AS THE
"LOAN" AND COLLECTIVELY AS THE "LOANS." BORROWER UNDERSTANDS AND AGREES
THAT: (a) IN GRANTING, RENEWING, OR EXTENDING ANY LOAN, LENDER IS RELYING
UPON BORROWER'S REPRESENTATIONS, WARRANTIES, AND AGREEMENTS, AS SET FORTH IN
THIS AGREEMENT; (b) THE GRANTING, RENEWING, OR EXTENDING OF ANY LOAN BY
LENDER AT ALL TIMES SHALL BE SUBJECT TO LENDER'S SOLE JUDGEMENT AND
DISCRETION; AND (c) ALL SUCH LOANS SHALL BE AND SHALL REMAIN SUBJECT TO THE
FOLLOWING TERMS AND CONDITIONS OF THIS AGREEMENT.

TERM. This Agreement shall be effective as of July 20, 1998, and shall
continue thereafter until all Indebtedness of Borrower to Lender has been
performed in full and the parties terminate this Agreement in writing.

DEFINITIONS. The following words shall have the following meanings when used
in this Agreement. Terms not otherwise defined in this Agreement shall have
the meanings attributed to such terms in the Uniform Commercial Code. All
references to dollar amounts shall mean amounts in lawful money of the United
States of America.

AGREEMENT. The word "Agreement" means this Business Loan Agreement, as
this Business Loan Agreement may be amended or modified from time to
time, together with all exhibits and schedules attached to this Business
Loan Agreement from time to time.

BORROWER. The word "Borrower" means CR Technology, Inc. The word
"Borrower" also includes, as applicable, all subsidiaries and
affiliates of Borrower as provided below in the paragraph titled
"Subsidiaries and Affiliates."

CERCLA. The word "CERCLA" means the Comprehensive Environmental
Response, Compensation, and Liability Act of 1980, as amended.

COLLATERAL. The word "Collateral" means and includes without limitation
all property and assets granted as collateral security for a Loan,
whether real or personal property, whether granted directly or
indirectly, whether granted now or in the future, and whether granted
in the form of a security interest, mortgage, deed of trust,
assignment, pledge, chattel mortgage, chattel trust, factor's lien,
equipment trust, conditional sale, trust receipt, lien, charge, lien or
title retention contract, lease or consignment intended as a security
device, or any other security or lien interest whatsoever, whether
created by law, contract, or otherwise.

ERISA. The word "ERISA" means the Employee Retirement Income Security
Act of 1974, as amended.

EVENT OF DEFAULT. The words "Event of Default" mean and include without
limitation any of the Events of Default set forth below in the section
titled "EVENTS OF DEFAULT."

GRANTOR. The word "Grantor" means and includes without limitation each
and all of the persons or entities granting a Security Interest in any
Collateral for the Indebtedness, including without limitation all
Borrowers granting such a Security Interest.

GUARANTOR. The word "Guarantor" means and includes without limitation
each and all of the guarantors, sureties, and accommodation parties in
connection with any indebtedness.

INDEBTEDNESS. The word "Indebtedness" means and includes without
limitation all Loans, together with all other obligations, debts and
liabilities of Borrower to Lender, or any one or more of them, as well
as all claims by Lender against Borrower, or any one or more of them;
whether now or hereafter existing, voluntary or involuntary, due or not
due, absolute or contingent, liquidated or unliquidated; whether
Borrower may be liable individually or jointly with others; whether
Borrower may be obligated as a guarantor, surety, or otherwise; whether
recovery upon such Indebtedness may be or hereafter may become barred
by any statute of limitations; and whether such Indebtedness may be or
hereafter may become otherwise unenforceable.

LENDER. The word "Lender" means California United Bank, its successors
and assigns.

LOAN. The word "Loan" or "Loans" means and includes without limitation
any and all commercial loans and financial accommodations from Lender to
Borrower, whether now or hereafter existing, and however evidenced,
including without limitation those loans and financial accommodations
described herein or described on any exhibit or schedule attached to this
Agreement from time to time.

NOTE. The word "Note" means and includes without limitation Borrower's
promissory note or notes, if any, evidencing Borrower's Loan obligations
in favor of Lender, as well as any substitute, replacement or
refinancing note or notes therefor.

PERMITTED LIENS. The words "Permitted Liens" mean: (a) liens and
security interests securing indebtedness owed by Borrower to Lender; (b)
liens for taxes, assessments, or similar charges either not yet due or
being contested in good faith; (c) liens of materialmen, mechanics,
warehousemen, or carriers, or other like liens arising in the ordinary
course of business and securing obligations which are not yet delinquent;
(d) purchase money liens or purchase money security interests upon or in
any property acquired or held by Borrower in the ordinary course of
business to secure indebtedness outstanding on the date of this
Agreement or permitted to be incurred under the paragraph of this
Agreement titled "Indebtedness and Liens"; (e) liens and security
interests which, as of the date of this Agreement, have been disclosed to
and approved by the Lender in writing; and (f) those liens and security
interests which in the aggregate constitute an immaterial and
insignificant monetary amount with respect to the net value of
Borrower's assets.

RELATED DOCUMENTS. The words "Related Documents" mean and include
without limitation all promissory notes, credit agreements, loan
agreements, environmental agreements, guaranties, security agreements,
mortgages, deeds of trust, and all other instruments, agreements and
documents, whether now or hereafter existing, executed in connection with
the Indebtedness.

SECURITY AGREEMENT. The words "Security Agreement" mean and include
without limitation any agreements, promises, covenants, arrangements,
understandings or other agreements, whether created by law, contract,
or otherwise, evidencing, governing, representing, or creating a
Security Interest.

<PAGE>

BUSINESS LOAN AGREEMENT PAGE 2
LOAN NO. 6889 (Continued)

SECURITY INTEREST. The words "Security Interest" mean and include
without limitation any type of collateral security, whether in the form
of a lien, charge, mortgage, deed of trust, assignment, pledge, chattel
mortgage, chattel trust, factor's lien, equipment trust, conditional
sale, trust receipt, lien or title retention contract, lease or
consignment intended as a security device, or any other security or lien
interest whatsoever, whether created by law, contract, or otherwise.

SARA. The word "SARA" means the Superfund Amendments and
Reauthorization Act of 1986 as now or hereafter amended.

CONDITIONS PRECEDENT TO EACH ADVANCE. Lender's obligation to make the
initial Loan Advance and each subsequent Loan Advance under this Agreement
shall be subject to the fulfillment to Lender's satisfaction of all of the
conditions set forth in this Agreement and in the Related Documents.

LOAN DOCUMENTS. Borrower shall provide to Lender in form satisfactory
to Lender the following documents for the Loan: (a) the Note, (b)
Security Agreements granting to Lender security interests in the
Collateral, (c) Financing Statements perfecting Lender's Security
interests; (d) evidence of insurance as required below; and (e) any
other documents required under this Agreement or by Lender or its
counsel.

BORROWER'S AUTHORIZATION. Borrower shall have provided in form and
substance satisfactory to Lender properly certified resolutions, duly
authorizing the execution and delivery of this Agreement, the Note and
the Related Documents, and such other authorizations and other documents
and instruments as Lender or its counsel, in their sole discretion, may
require.

PAYMENT OF FEES AND EXPENSES. Borrower shall have paid to Lender all
fees, charges, and other expenses which are then due and payable as
specified in this Agreement or any Related Document.

REPRESENTATIONS AND WARRANTIES. The representations and warranties set
forth in this Agreement, in the Related Documents, and in any document
or certificate delivered to Lender under this Agreement are true and
correct.

NO EVENT OF DEFAULT. There shall not exist at the time of any advance a
condition which would constitute an Event of Default under this
Agreement.

REPRESENTATIONS AND WARRANTIES. Borrower represents and warrants to Lender,
as of the date of this Agreement, as of the date of each disbursement of Loan
proceeds, as of the date of any renewal, extension or modification of any
Loan, and at all times any Indebtedness exists:

ORGANIZATION. Borrower is a corporation which is duly organized,
validly existing, and in good standing under the laws of the State of
California and is validly existing and in good standing in all states in
which Borrower is doing business. Borrower has the full power and
authority to own its properties and to transact the businesses in which
it is presently engaged or presently proposes to engage. Borrower also
is duly qualified as a foreign corporation and is in good standing in
all states in which the failure to so qualify would have a material
adverse effect on its businesses or financial condition.

AUTHORIZATION. The execution, delivery, and performance of this
Agreement and all Related Documents by Borrower, to the extent to be
executed, delivered or performed by Borrower, have been duly authorized
by all necessary action by Borrower; do not require the consent or
approval of any other person, regulatory authority or governmental body;
and do not conflict with, result in a violation of, or constitute a
default under (a) any provision of its articles of incorporation or
organization, or bylaws, or any agreement or other instrument binding
upon Borrower or (b) any law, governmental regulation, court decree, or
order applicable to Borrower.

FINANCIAL INFORMATION. Each financial statement, and tax returns of
Borrower supplied to Lender truly and completely disclosed Borrower's
financial condition as of the date of the statement, and there has been
no material adverse change in Borrower's financial condition subsequent
to the date of the most recent financial statement supplied to Lender.
Borrower has no material contingent obligations except as disclosed in
such financial statements. Said financial statements shall (including
the disclosure of all liabilities as hereinabove mentioned) have been
prepared in accordance with generally accepted accounting principles
("GAAP"), consistently applied (provided, however, that tax returns may
be prepared using a basis of accounting other than GAAP).

LEGAL EFFECT. This Agreement constitutes, and any instrument or
agreement required hereunder to be given by Borrower when delivered will
constitute, legal, valid and binding obligations of Borrower enforceable
against Borrower in accordance with their respective terms.

PROPERTIES. Except as contemplated by this Agreement or as previously
disclosed in Borrower's financial statements or in writing to Lender and
as accepted by Lender, and except for property tax liens for taxes not
presently due and payable, Borrower owns and has good title to all of
Borrower's properties free and clear of all Security Interests, and has
not executed any security documents or financing statements relating to
such properties. All of Borrower's properties are titled in Borrower's
legal name, and Borrower has not used, or filed a financing statement
under, any other name for at least the last five (5) years.

HAZARDOUS SUBSTANCES. The terms "hazardous waste," "hazardous
substance," "disposal," "release," and "threatened release," as used in
this Agreement, shall have the same meanings as set forth in the
"CERCLA," "SARA," the Hazardous Materials Transportation Act, 49 U.S.C.
Section 1801, et seq., the Resource Conservation and Recovery Act, 42
U.S.C. Section 6901, et seq., Chapters 6.5 through 7.7 of Division 20 of
the California Health and Safety Code, Section 25100, et seq., or other
applicable state or Federal laws, rules, or regulations adopted pursuant
to any of the foregoing. Except as disclosed to and acknowledged by
Lender in writing, Borrower represents and warrants that: (a) During the
period of Borrower's ownership of the properties, there has been no
use, generation, manufacture, storage, treatment, disposal, release or
threatened release of any hazardous waste or substance by any person on,
under, about or from any of the properties. (b) Borrower has no
knowledge of, or reason to believe that there has been (i) any use,
generation, manufacture, storage, treatment, disposal, release, or
threatened release of any hazardous waste or substance on, under, about
or from the properties by any prior owners or occupants of any of the
properties, or (ii) any actual or threatened litigation or claims of
any kind by any person relating to such matters. (c) Neither Borrower
nor any tenant, contractor, agent or other authorized user of any of the
properties shall use, generate, manufacture, store, treat, dispose of,
or release any hazardous waste or substance on, under, about or from any
of the properties; and any such activity shall be conducted in
compliance with all applicable federal, state, and local laws,
regulations, and ordinances, including without limitation those laws,
regulations and ordinances described above. Borrower authorizes Lender
and its agents to enter upon the properties to make such inspections and
tests as Lender may deem appropriate to determine compliance of the
properties with this section of the Agreement. Any inspections or tests
made by Lender shall be at Borrower's expense and for Lender's purposes
only and shall not be construed to create any responsibility or liability
on the part of Lender to Borrower or to any other person. The
representations and warranties contained herein are based on Borrower's
due diligence in investigating the properties for hazardous waste and
hazardous substances. Borrower hereby (a) releases and waives any
future claims against Lender for indemnity or contribution in the event
Borrower becomes liable for cleanup or other costs under any such laws,
and (b) agrees to indemnify and hold harmless Lender against any and all
claims, losses, liabilities, damages, penalties, and expenses which
Lender may directly or indirectly sustain or suffer resulting from a
breach of a hazardous waste or substance on the properties. The
provisions of this section of the Agreement, including the obligation to
indemnify, shall survive the payment of the Indebtness and the
termination or expiration of this Agreement and shall not be affected by
Lender's acquisition of any interest in any of the properties, whether by
foreclosure or otherwise.

LITIGATION AND CLAIMS. No litigation, claim, investigation,
administrative proceeding or similar action (including those for unpaid
taxes) against Borrower is pending or threatened, and no other event has
occurred which may materially adversely affect Borrower's financial
condition or

<PAGE>

PAGE 3

properties, other than litigation, claims, or other events, if any, that
have been disclosed to and acknowledged by Lender in writing.

TAXES. To the best of Borrower's knowledge, all tax returns and reports
of Borrower that are or were required to be filed, have been filed, and
all taxes, assessments and other governmental charges have been paid in
full, except those presently being or to be contested by Borrower in
good faith in the ordinary course of business and for which adequate
reserves have been provided.

LIEN PRIORITY. Unless otherwise previously disclosed to Lender in
writing, Borrower has not entered into or granted any Security
Agreements, or permitted the filing or attachment of any Security
Interests on or affecting any of the Collateral directly or indirectly
securing repayment of Borrower's Loan and Note, that would be prior or
that may in any way be superior to Lender's Security Interests and
rights in and to such Collateral.

BINDING EFFECT. This Agreement, the Note, all Security Agreements
directly or indirectly securing repayment of Borrower's Loan and Note
and all of the Related Documents are binding upon Borrower as well as
upon Borrower's successors, representatives and assigns, and are legally
enforceable in accordance with their respective terms.

COMMERCIAL PURPOSES. Borrower intends to use the Loan proceeds solely
for business or commercial related purposes.

EMPLOYEE BENEFIT PLANS. Each employee benefit plan as to which Borrower
may have any liability complies in all material respects with all
applicable requirements of law and regulations, and (i) no Reportable
Event nor Prohibited Transaction (as defined in ERISA) has occurred with
respect to any such plan, (ii) Borrower has not withdrawn from any such
plan or initiated steps to do so, (iii) no steps have been taken to
terminate any such plan, and (iv) there are no unfunded liabilities
other than those previously disclosed to Lender in writing.

LOCATION OF BORROWER'S OFFICES AND RECORDS. Borrower's place of
business, or Borrower's Chief executive office, if Borrower has more
than one place of business, is located at 27752 El Lazo Road, Laguna
Nigel, CA 92677-3914. Unless Borrower has designated otherwise in
writing this location is also the office or offices where Borrower keeps
its records concerning the Collateral.

YEAR 2000. Borrower warrants and represents that all software utilized
in the conduct of Borrower's business will have appropriate capabilities
and compatibility for operation to handle calendar dates falling on or
after January 1, 2000, and all information pertaining to such calendar
dates, in the same manner and with the same functionality as the
software does respecting calendar dates falling on or before December
31, 1999. Further, Borrower warrants and represents that the
data-related user interface functions, data-fields, and data-related
program instructions and functions of the software include the
indication of the century.

INFORMATION. All information heretofore or contemporaneously herewith
furnished by Borrower to Lender for the purposes of or in connection
with this Agreement or any transaction contemplated hereby is, and all
information hereafter furnished by or on behalf of Borrower to Lender
will be, true and accurate in every material respect on the date as of
which such information is dated or certified; and none of such
information is or will be incomplete by omitting to state any material
fact necessary to make such information not misleading.

SURVIVAL OF REPRESENTATIONS AND WARRANTIES. Borrower understands and
agrees that Lender, without independent investigation, is relying upon
the above representations and warranties in extending Loan Advances to
Borrower. Borrower further agrees that the foregoing representations
and warranties shall be continuing in nature and shall remain in full
force and effect until such time as Borrower's Indebtedness shall be
paid in full, or until this Agreement shall be terminated in the manner
provide above, whichever is the last to occur.

AFFIRMATIVE COVENANTS. Borrower covenants and agrees with Lender that, while
this Agreement is in effect, Borrower will:

LITIGATION. Promptly inform Lender in writing of (a) all material
adverse changes in Borrower's financial condition, and (b) all existing
and all threatened litigation, claims, investigations, administrative
proceedings or similar actions affecting Borrower or any Guarantor which
could materially affect the financial condition of Borrower or the
financial condition of any Guarantor.

FINANCIAL RECORDS. Maintain its books and records in accordance with
generally accepted accounting principles, applied on a consistent basis,
and permit Lender to examine and audit Borrower's books and records at
all reasonable times.

ADDITIONAL INFORMATION. Furnish such additional information and
statements, lists of assets and liabilities, aging of receivables and
payables, inventory schedules, budgets, forecasts, tax returns, and
other reports with respect to Borrower's financial condition and
business operations as Lender may request from time to time.

INSURANCE. Maintain fire and other risk insurance, public liability
insurance, and such other insurance as Lender may require with respect
to Borrower's properties and operations, in form, amounts, coverages and
with insurance companies reasonably acceptable to Lender. Borrower,
upon request of Lender, will deliver to Lender from time to time the
policies or certificates of insurance in form satisfactory to Lender,
including stipulations that coverages will not be cancelled or
diminished without at least ten (10) days' prior written notice to
Lender. Each insurance policy also shall include an endorsement
providing that coverage in favor of Lender will not be impaired in any
way by any act, omission or default of Borrower or any other person. In
connection with all policies covering assets in which Lender holds or is
offered a security interest for the Loans, Borrower will provide Lender
with such loss payable or other endorsements as Lender may require.

INSURANCE REPORTS. Furnish to Lender, upon request of Lender, reports
on each existing insurance policy showing such information as Lender may
reasonably request, including without limitation the following: (a) the
name of the insurer; (b) the risks insured; (c) the amount of the
policy; (d) the properties insured; (e) the then current property values
on the basis of which insurance has been obtained, and the manner of
determining those values; and (f) the expiration date of the policy. In
addition, upon request of Lender (however not more often than annually),
Borrower will have an independent appraiser satisfactory to Lender
determine, as applicable, the actual cash value or replacement cost of
any Collateral. The cost of such appraisal shall be paid by Borrower.

OTHER AGREEMENTS. Comply with all terms and conditions of all other
agreements, whether now or hereafter existing, between Borrower and any
other party and notify Lender immediately in writing of any default in
connection with any other such agreements.

LOAN PROCEEDS. Use all Loan proceeds solely for Borrower's business
operations, unless specifically consented to the contrary by Lender in
writing.

TAXES, CHARGES AND LIENS. Pay and discharge when due all of its
indebtedness and obligations, including without limitation all
assessments, taxes, governmental charges, levies and liens, of every
kind and nature, imposed upon Borrower or its properties, income, or
profits, prior to the date on which penalties would attach, and all
lawful claims that, if unpaid, might become a lien or charge upon any of
Borrower's properties, income, or profits. Provided however, Borrower
will not be required to pay any discharge any such assessment, tax,
charge, levy, lien or claim so long as (a) the legality of the same
shall be contested in good faith by appropriate proceedings, and (b)
Borrower shall have established on its books adequate reserves with
respect to such contested assessment, tax, charge, levy, lien, or claim
in accordance with generally accepted accounting practices. Borrower,
upon demand of Lender, will furnish to Lender evidence of payment of the
assessments, taxes, charges, levies, liens and claims and will authorize
the appropriate governmental official to deliver to Lender at any time a
written statement of any assessments, taxes, charges, levies, liens and
claims against Borrower's properties, income, or profits.

PERFORMANCE. Perform and comply with all terms, conditions, and
provisions set forth in this Agreement and in the Related Documents in a
timely manner, and promptly notify Lender if Borrower learns of the
occurrence of any event which constitutes an Event of Default under this
Agreement

<PAGE>

PAGE 4

or under any of the Related Documents.

OPERATIONS. Maintain executive and management personnel with
substantially the same qualifications and experience as the present
executive and management personnel; provide written notice to Lender of
any change in executive and management personnel; conduct its business
affairs in a reasonable and prudent manner and in compliance with all
applicable federal, state and municipal laws, ordinances, rules and
regulations respecting its properties, charters, businesses and
operations, including without limitation, compliance with the Americans
With Disabilities Act and with all minimum funding standards and other
requirements of ERISA and other laws applicable to Borrower's employee
benefit plans.

INSPECTION. Permit employees or agents of Lender at any reasonable time
to inspect any and all Collateral for the Loan or Loans and Borrower's
other properties and to examine or audit Borrower's books, accounts, and
records and to make copies and memoranda of Borrower's books, accounts,
and records. If Borrower now or at any time hereafter maintains any
records (including without limitation computer generated records and
computer software programs for the generation of such records) in the
possession of a third party, Borrower, upon request of Lender, shall
notify such party to permit Lender free access to such records at all
reasonable times and to provide Lender with copies of any records it may
request, all at Borrower's expense.

ENVIRONMENTAL COMPLIANCE AND REPORTS. Borrower shall comply in all
respects with all environmental protection federal, state and local
laws, statutes, regulations and ordinances; not cause or permit to
exist, as a result of an intentional or unintentional action or omission
on its part or on the part of any third party, on property owned and/or
occupied by Borrower, any environmental activity where damage may result
to the environment, unless such environmental activity is pursuant to
and in compliance with the conditions of a permit issued by the
appropriate federal, state or local governmental authorities; shall
furnish to Lender promptly and in any event within thirty (30) days
after receipt thereof a copy of any notice, summons, lien, citation,
directive, letter or other communication from any governmental agency or
instrumentality concerning any intentional or unintentional action or
omission on Borrower's part in connection with any environmental
activity whether or not there is damage to the environment and/or other
natural resources.

ADDITIONAL ASSURANCES. Make, execute and deliver to Lender such
promissory notes, mortgages, deeds of trust, security agreements,
financing statements, instruments, documents and other agreements as
Lender or its attorneys may reasonably request to evidence and secure
the Loans and to perfect all Security Interests.

RECOVERY OF ADDITIONAL COSTS. If the imposition of or any change in any law,
rule, regulation or guideline, or the interpretation or application of any
thereof by any court or administrative or governmental authority (including
any request or policy not having the force of law) shall impose, modify or
make applicable any taxes (except U.S. federal, state or local income or
franchise taxes imposed on Lender), reserve requirements, capital adequacy
requirements or other obligations which would (a) increase the cost to Lender
for extending or maintaining the credit facilities to which this Agreement
relates, (b) reduce the amounts payable to Lender under this Agreement or the
Related Documents, or (c) reduce the rate of return on Lender's capital as a
consequence of Lender's obligations with respect to the credit facilities to
which this Agreement relates, then Borrower agrees to pay Lender such
additional amounts as will compensate Lender therefor, within five (5) days
after Lender's written demand for such payment, which demand shall be
accompanied by an explanation of such imposition or charge and a calculation
in reasonable detail of the additional amounts payable by Borrower, which
explanation and calculations shall be conclusive in the absence of manifest
error.

NEGATIVE COVENANTS. Borrower covenants and agrees with Lender that while
this Agreement is in effect, Borrower shall not, without the prior written
consent of Lender:

INDEBTEDNESS AND LIENS. (a) Except for trade debt incurred in the
normal course of business and indebtedness to Lender contemplated by
this Agreement, create, incur or assume indebtedness for borrowed money,
including capital leases, (b) except as allowed as a Permitted Lien,
sell, transfer, mortgage, assign, pledge, lease, grant a security
interest in, or encumber any of Borrower's assets, or (c) sell with
recourse any of Borrower's accounts, except to Lender.

CONTINUITY OF OPERATIONS. (a) Engage in any business activities
substantially different than those in which Borrower is presently engaged,
(b) cease operations, liquidate, merge, transfer, acquire or consolidate
with any other entity, change ownership, change its name, dissolve or
transfer or sell Collateral out of the ordinary course of business, (c)
pay any dividends on Borrower's stock (other than dividends payable in its
stock), provided, however that notwithstanding the foregoing, but only so
long as no Event of Default has occurred and is continuing or would result
from the payment of dividends, if Borrower is a "Subchapter S Corporation"
(as defined in the Internal Revenue Code of 1986, as amended), Borrower may
pay cash dividends on its stock to its shareholders from time to time in
amounts necessary to enable the shareholders to pay income taxes and make
estimated income tax payments to satisfy their liabilities under federal
and state law which arise solely from their status as Shareholders of a
Subchapter S Corporation because of their ownership of shares of stock of
Borrower, or (d) purchase or retire any of Borrower's outstanding shares
or alter or amend Borrower's capital structure.

LOANS, ACQUISITIONS AND GUARANTIES. (a) Loan, invest in or advance money
or assets, (b) purchase, create or acquire any interest in any other
enterprise or entity, or (c) incur any obligation as surety or guarantor
other than in the ordinary course of business.

CESSATION OF ADVANCES. If Lender has made any commitment to make any Loan to
Borrower, whether under this Agreement or under any other agreement, Lender
shall have no obligation to make Loan Advances or to disburse Loan proceeds
if: (a) Borrower or any Guarantor is in default under the terms of this
Agreement or any of the Related Documents or any other agreement that
Borrower or any Guarantor has with Lender; (b) Borrower or any Guarantor
becomes insolvent, files a petition in bankruptcy or similar proceedings, or
is adjudged a bankrupt; (c) there occurs a material adverse change in
Borrower's financial condition, in the financial condition of any Guarantor,
or in the value of any Collateral securing any Loan; (d) any Guarantor seeks,
claims or otherwise attempts to limit, modify or revoke such Guarantor's
guaranty of the Loan or any other loan with Lender; or (e) Lender in good
faith deems itself insecure, even though no Event of Default shall have
occurred.

FINANCIAL COVENANTS AND RATIOS. Borrower covenants and agrees with Lender that
while this Agreement is in effect, Borrower shall comply at all times with the
following financial covenants and ratios:

(a) EFFECTIVE TANGIBLE NET WORTH. Borrower shall maintain an Effective
Tangible Net Worth (defined as the aggregate net worth plus subordinated debt,
less any intangible assets, and less any amount due from shareholders, officers
and affiliates of Borrower) of not less than $2,800,000.00, with a step-up to
$3,000,000.00 at December 31, 1999.

(b) RATIO OF TOTAL DEBT TO EFFECTIVE TANGIBLE NET WORTH. Borrower shall
maintain a Ratio of Total Debt to Effective Tangible Net Worth (defined as
current liabilities and non-current liabilities less subordinated debt divided
by Effective Tangible Net Worth) of not more than 1.00 to 1.00.

(c) QUICK RATIO. Borrower shall maintain a Quick Ratio (defined as cash and
accounts receivable divided by total current liabilities) of not less than 1.25
to 1.00.

(d) PROFITABILITY. Borrower shall generate a net profit from operations at
the end of each fiscal year.

Compliance with the foregoing financial covenants and ratios shall be
determined as of the end of each fiscal year, except as otherwise specifically
provided above. All calculations made to determine compliance with the
requirements as set forth above shall be made in accordance with generally

<PAGE>

PAGE 5

accepted accounting principles consistently applied and used consistently with
prior practices.

BORROWER'S FINANCIAL REPORTS. Borrower shall maintain a system of accounting
established and administered in accordance with sound business practices to
permit preparation of the following financial reports in conformity with
generally accepted accounting principles. Borrower covenants and agrees with
Lender that while this Agreement is in effect, unless Lender shall otherwise
give its prior written consent, Borrower shall provide to Lender the following
financial reports; certified by Borrower as being true and correct:

(a) ANNUAL FINANCIAL STATEMENTS. As soon as available and in any event
within one hundred twenty (120) days after the end of each fiscal year,
Borrower shall deliver to Lender the financial statements of Borrower,
audited by certified public accountants acceptable to Lender, including, but
not limited to, a balance sheet, an income statement, a statement of cash
flows, and appropriate footnotes and schedules. Such financial statements
shall present fairly the financial condition of Borrower as at the dates
indicated as well as the results of its operations and cash flows for the
periods indicated in conformity with generally accepted accounting principles
applied on a basis consistent with prior years.

(b) QUARTERLY FINANCIAL STATEMENTS. As soon as available and in any event
within forty-five (45) days after the end of each fiscal quarter, Borrower
shall deliver to Lender the financial statements of Borrower, prepared by
Borrower, including, but not limited to, a balance sheet, an income statement,
and appropriate schedules.

OTHER REPORTS. Borrower covenants and agrees with Lender that while this
Agreement is in effect, unless Lender shall otherwise give its prior written
consent, Borrower shall provide to Lender with the following reports:

(a) ACCOUNTS RECEIVABLE AND ACCOUNTS PAYABLE AGINGS. As soon as available and
in any event within forty-five (45) days after the end of each fiscal quarter,
Borrower shall deliver to Lender (i) a detailed aging, by total and by
customer, of Borrower's accounts receivable, and (ii) a detailed aging, by
total and by vendor, of Borrower's accounts payable, both of which shall be set
forth in a form and shall contain such information as is acceptable to Lender.

(b) INVENTORY REPORT. As soon as available and in any event within forty-five
(45) days after the end of each fiscal quarter, Borrower shall deliver to
Lender an inventory report of Borrower, to be reconciled to the general ledger,
in such form and detail as Lender may require.

OUT OF DEBT PROVISION. Borrower shall maintain a zero balance on the revolving
line of credit for a period of at least thirty (30) consecutive days during the
term of this loan.

DEPOSIT ACCOUNTS. Borrower covenants and agrees with Lender that while this
Agreement is in effect, Borrower shall maintain its deposit accounts with
Lender.

RIGHT OF SETOFF. Borrower grants to Lender a contractual security interest
in, and hereby assigns, conveys, delivers, pledges, and transfers to Lender
all Borrower's right, title and interest in and to, Borrower's accounts with
Lender (whether checking, savings, or some other account), including without
limitation all accounts held jointly with someone else and all accounts
Borrower may open in the future, excluding however all IRA and Keogh
accounts, and all trust accounts for which the grant of a security interest
would be prohibited by law. Borrower authorizes Lender, to the extent
permitted by applicable law, to charge or setoff all sums owing on the
Indebtedness against any and all such accounts.

EVENTS OF DEFAULT. Each of the following shall constitute an Event of Default
under this Agreement:

DEFAULT ON INDEBTEDNESS. Failure of Borrower to make any payment when due
on the Loans.

OTHER DEFAULTS. Failure of Borrower or any Grantor to comply with or to
perform when due any other term, obligation, covenant or condition
contained in this Agreement or in any of the Related Documents, or failure
of Borrower to comply with or to perform any other term, obligation,
covenant or condition contained in any other agreement between Lender and
Borrower.

DEFAULT IN FAVOR OF THIRD PARTIES. Should Borrower or any Grantor default
under any loan, extension of credit, security agreement, purchase or sales
agreement, or any other agreement, in favor of any other creditor or
person that may materially affect any of Borrower's property or Borrower's
or any Grantor's ability to repay the Loans or perform their respective
obligations under this Agreement or any of the Related Documents.

FALSE STATEMENTS. Any warranty, representation or statement made, or
furnished to Lender by or on behalf of Borrower or any Grantor under this
Agreement or the Related Documents is false or misleading in any material
respect at the time made or furnished, or becomes false or misleading at
any time thereafter.

DEFECTIVE COLLATERALIZATION. This Agreement or any of the Related
Documents ceases to be in full force and effect (including failure of any
Security Agreement to create a valid and perfected Security Interest) at
any time and for any reason.

INSOLVENCY. The dissolution or termination of Borrower's existence as a
going business, the insolvency of the Borrower, the appointment of a
receiver for any part of Borrower's property, any assignment for the
benefit of creditors, any type of creditor workout, or the commencement of
any proceeding under any bankruptcy or insolvency laws by or against
Borrower.

CREDITOR OR FORFEITURE PROCEEDINGS. Commencement of foreclosure or
forfeiture proceedings, whether by judicial proceeding, self-help,
repossession or any other method, by any creditor of Borrower, any
creditor of any Grantor against any collateral securing the Indebtedness,
or by any governmental agency. This includes a garnishment, attachment,
or levy on or of any of Borrower's deposit accounts with Lender.

EVENTS AFFECTING GUARANTOR. Any of the preceding events occurs with
respect to any Guarantor of any of the Indebtedness or any Guarantor dies
or becomes incompetent, or revokes or disputes the validity of, or
liability under, any Guaranty of the Indebtedness.

CHANGE IN OWNERSHIP. Any change in ownership of twenty-five percent (25%)
or more of the common stock of Borrower.

ADVERSE CHANGE. A material adverse change occurs in Borrower's financial
condition, or Lender believes the prospect of payment or performance of
the Indebtedness is impaired.

INSECURITY. Lender, in good faith, deems itself insecure.

EFFECT OF AN EVENT OF DEFAULT. If any Event of Default shall occur, except
where otherwise provided in this Agreement or the Related Documents, all
commitments and obligations of Lender under this Agreement or the Related
Documents or any other agreement immediately will terminate (including any
obligation to make Loan Advances or disbursements), and, at Lender's option,
all Indebtedness immediately will become due and payable, all without notice of
any kind to Borrower, except that in the case of an Event of Default of the
type described in the "Insolvency" subsection above, such acceleration shall be
automatic and not optional. In addition, Lender shall have all the rights and
remedies provided in the Related Documents or available at law, in equity, or
otherwise. Except as may be prohibited by applicable law, all of Lender's
rights and remedies shall be cumulative and may be exercised singularly or
concurrently. Election by Lender to pursue any remedy shall not exclude
pursuit of any other remedy, and an election to make expenditures or to take
action to perform an obligation of Borrower or of any Grantor shall not affect
Lender's right to declare a default and to exercise its rights and remedies.

<PAGE>

BUSINESS LOAN AGREEMENT
LOAN NO 6889 (CONTINUED) PAGE 6
- ------------------------------------------------------------------------------
MISCELLANEOUS PROVISIONS. The following miscellaneous provisions are a part
of this Agreement:

AMENDMENTS. This Agreement, together with any Related Documents,
constitutes the entire understanding and agreement of the parties as to
the matters set forth in this Agreement. No alteration of or amendment to
this Agreement shall be effective unless given in writing and signed by
the party or parties sought to be charged or bound by the alteration or
amendment.

APPLICABLE LAW. THIS AGREEMENT HAS BEEN DELIVERED TO LENDER AND ACCEPTED
BY LENDER IN THE STATE OF CALIFORNIA. IF THERE IS A LAWSUIT, BORROWER
AGREES UPON LENDER'S REQUEST TO SUBMIT TO THE JURISDICTION OF THE COURTS
OF LOS ANGELES COUNTY, THE STATE OF CALIFORNIA. SUBJECT TO THE
PROVISIONS ON ARBITRATION, THIS AGREEMENT SHALL BE GOVERNED BY AND
CONSTRUED IN ACCORDANCE WITH THE LAWS OF THE STATE OF CALIFORNIA.

ARBITRATION. LENDER AND BORROWER AGREE THAT ALL DISPUTES, CLAIMS AND
CONTROVERSIES BETWEEN THEM, WHETHER INDIVIDUAL, JOINT, OR CLASS IN
NATURE, ARISING FROM THIS AGREEMENT OR OTHERWISE, INCLUDING WITHOUT
LIMITATION CONTRACT AND TORT DISPUTES, SHALL BE ARBITRATED PURSUANT TO
THE RULES OF THE AMERICAN ARBITRATION ASSOCIATION, UPON REQUEST OF
EITHER PARTY. No act to take or dispose of any Collateral shall
constitute a waiver of this arbitration agreement or be prohibited by
this arbitration agreement. This includes, without limitation, obtaining
injunctive relief or a temporary restraining order; invoking a power of
sale under any deed of trust or mortgage; obtaining a writ of attachment
or imposition of a receiver; or exercising any rights relating to
personal property, including taking or disposing of such property with
or without judicial process pursuant to Article 9 of the Uniform
Commercial Code. Any disputes, claims, or controversies concerning the
lawfulness or reasonableness of any act, or exercise of any right,
concerning any Collateral, including any claim to rescind, reform, or
otherwise modify any agreement relating to the Collateral, shall also be
arbitrated, provided however that no arbitrator shall have the right or
the power to enjoin or restrain any act of any party. Lender and Borrower
agree that in the event of an action for judicial foreclosure pursuant
to California Code of Civil Procedure Section 726, or any similar
provision in any other state, the commencement of such an action will not
constitute a waiver of the right to arbitrate and the court shall refer
to arbitration as much of such action, including counterclaims, as
lawfully may be referred to arbitration. Judgment upon any award
rendered by any arbitrator may be entered in any court having
jurisdiction. Nothing in this Agreement shall preclude any party from
seeking equitable relief from a court of competent jurisdiction. The
statute of limitations, estoppel, waiver, laches, and similar doctrines
which would otherwise be applicable in an action brought by a party
shall be applicable in any arbitration proceeding, and the commencement
of an arbitration proceeding shall be deemed the commencement of an
action for these purposes. The Federal Arbitration Act shall apply to
the construction, interpretation, and enforcement of this arbitration
provision.

CAPTION HEADINGS. Caption headings in this Agreement are for
convenience purposes only and are not to be used to interpret or define
the provisions of this Agreement.

CONSENT TO LOAN PARTICIPATION. Borrower agrees and consents to Lender's
sale or transfer, whether now or later, of one or more participation
interests in the Loans to one or more purchasers, whether related or
unrelated to Lender. Lender may provide, without any limitation
whatsoever, to any one or more purchasers, or potential purchasers, any
information or knowledge Lender may have about Borrower or about any
other matter relating to the Loan, and Borrower hereby waives any rights
to privacy it may have with respect to such matters. Borrower
additionally waives any and all notices of sale of participation
interests, as well as all notices of any repurchase of such
participation interests. Borrower also agrees that the purchasers of any
such participation interests will be considered as the absolute owners
of such interests in the Loans and will have all the rights granted
under the participation agreement or agreements governing the sale of
such participation interests. Borrower further waives all rights of
offset or counterclaim that it may have now or later against Lender or
against any purchaser of such a participation interest and
unconditionally agrees that either Lender or such purchaser may enforce
Borrower's obligation under the Loans irrespective of the failure or
insolvency of any holder of any interest in the Loans. Borrower further
agrees that the purchaser of any such participation interests may
enforce its interests irrespective of any personal claims or defenses
that Borrower may have against Lender.

COSTS AND EXPENSES. Borrower agrees to pay upon demand all of Lender's
expenses, including without limitation attorneys' fees, incurred in
connection with the preparation, execution, enforcement, modification
and collection of this Agreement or in connection with the Loans made
pursuant to this Agreement. Lender may pay someone else to help collect
the Loans and to enforce this Agreement, and Borrower will pay that
amount. This includes, subject to any limits under applicable law,
Lender's attorneys' fees and Lender's legal expenses, whether or not
there is a lawsuit, including attorneys' fees for bankruptcy proceedings
(including efforts to modify or vacate any automatic stay or injunction),
appeals, and any anticipated post-judgment collection services. Borrower
also will pay any court costs, in addition to all other sums provided by
law.

NOTICES. All notices required to be given under this Agreement shall be
given in writing, may be sent by telefacsimile (unless otherwise required
by law), and shall be effective when actually delivered or when
deposited with a nationally recognized overnight courier or deposited in
the United States mail, first class, postage prepaid, addressed to the
party to whom the notice is to be given at the address shown above. Any
party may change its address for notices under this Agreement by giving
formal written notice to other parties, specifying that the purpose of
the notice is to change the party's address. To the extent permitted by
applicable law, if there is more than one Borrower, notice to any
Borrower will constitute notice to all Borrowers. For notice purposes,
Borrower will keep Lender informed at all times of Borrower's current
address(es).

SEVERABILITY. If a court of competent jurisdiction finds any provision
of this Agreement to be invalid or unenforceable as to any person or
circumstance, such finding shall not render that provision invalid or
unenforceable as to any other persons or circumstances. If feasible, any
such offending provision shall be deemed to be modified to be within the
limits of enforceability or validity; however, if the offending provision
cannot be so modified, it shall be stricken and all other provisions of
this Agreement in all other respects shall remain valid and enforceable.

SUBSIDIARIES AND AFFILIATES OF BORROWER. To the extent the context of
any provisions of this Agreement makes it appropriate, including without
limitation any representation, warranty or covenant, the word "Borrower"
as used herein shall include all subsidiaries and affiliates of
Borrower. Notwithstanding the foregoing however, under no circumstances
shall this Agreement be construed to require Lender to make any Loan or
other financial accommodation to any subsidiary or affiliate of Borrower.

SUCCESSORS AND ASSIGNS. All covenants and agreements contained by or on
behalf of Borrower shall bind its successors and assigns and shall inure
to the benefit of Lender, its successors and assigns. Borrower shall
not, however, have the right to assign its rights under this Agreement
or any interest therein, without the prior written consent of Lender.

SURVIVAL. All warranties, representations, and covenants made by
Borrower in this Agreement or in any certificate or other instrument
delivered by Borrower to Lender under this Agreement shall be considered
to have been relied upon by Lender and will survive the making of the
Loan and delivery to Lender of the Related Documents, regardless of any
investigation made by Lender or on Lender's behalf.

TIME IS OF THE ESSENCE. Time is of the essence in the performance of
this Agreement.

WAIVER. Lender shall not be deemed to have waived any rights under this
Agreement unless such waiver is given in writing and signed by Lender.
No delay or omission on the part of Lender in exercising any right
shall operate as a waiver of such right or any other right. A waiver by
lender of a provision of this Agreement shall not prejudice or
constitute a waiver of Lender's right otherwise to demand strict
compliance with that provision or any other provision of this Agreement.
No prior waiver by Lender, nor any course of dealing between Lender and
Borrower, or between Lender and any Grantor, shall constitute a waiver
of any of Lender's rights or of any obligations of Borrower or of any
Grantor as to any future transactions. Whenever the consent of Lender is
required under this Agreement, the granting of such consent by Lender in
any instance shall not constitute continuing consent in subsequent
instances where such consent is required, and in all cases such consent
may be granted or

<PAGE>

PAGE 7

withheld in the sole discretion of Lender.

BORROWER ACKNOWLEDGES HAVING READ ALL THE PROVISIONS OF THIS BUSINESS LOAN
AGREEMENT, AND BORROWER AGREES TO ITS TERMS. THIS AGREEMENT IS DATED AS OF
JULY 20, 1998.

BORROWER:

CR Technology, Inc.

By: /s/ R. E. Amtower
----------------------------------------------------
Richard E. Amtower, President & Assistant Secretary

LENDER:
California United Bank

By:
----------------------------------------------------
Authorized Officer

<PAGE>

CALIFORNIA UNITED BANK

PROMISSORY NOTE
================================================================================

Borrower: CR Technology, Inc. Lender: California United Bank
27752 El Lazo Road Orange County Commercial Loan
Laguna Nigel, CA 92677-3914 Center
16030 Ventura Boulevard
Encino, CA 91436

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

Principal Amount: $1,500,000.00 Initial Rate: 8.500% Date of Note: July 20, 1998

PROMISE TO PAY. CR Technology, Inc. ("Borrower") promises to pay to California
United Bank ("Lender"), or order, in lawful money of the United States of
America, the principal amount of One Million Five Hundred Thousand & 00/100
Dollars ($1,500,000.00) or so much as may be outstanding, together with interest
on the unpaid outstanding principal balance of each advance. Interest shall be
calculated from the date of each advance until repayment of each advance.

PAYMENT. Borrower will pay this loan on demand, or if no demand is made, in one
payment of all outstanding principal plus all accrued unpaid interest on August
2, 1999. In addition, Borrower will pay regular monthly payments of accrued
unpaid interest beginning September 2, 1998, and all subsequent interest
payments are due on the same day of each month after that. The annual interest
rate for this Note is computed on a 365/360 basis; that is, by applying the
ratio of the annual interest rate over a year of 360 days, multiplied by the
outstanding principal balance, multiplied by the actual number of days the
principal balance is outstanding. Borrower will pay Lender at Lender's address
shown above or at such other place as Lender may designate in writing. Unless
otherwise agreed or required by applicable law, payments will be applied first
to any unpaid collection costs and any late charges, then to any unpaid
interest, and any remaining amount to principal. The receipt of any wire
transfer of funds, check or other item of payment by the bank shall be
immediately applied to conditionally reduce Borrower's obligations, but shall
not be considered a payment on account unless such wire transfer is of
immediately available federal funds and is made to the appropriate deposit
account of Bank or unless and until such check or other item of payment is
honored when presented for payment.

VARIABLE INTEREST RATE. The interest rate on this Note is subject to change
from time to time based on changes in an independent index which is the prime
rate published on a daily basis in the "Money Rates" section of the Western
Edition of The Wall Street Journal (the "Index"). The Index is not
necessarily the lowest rate charged by Lender on its loans. If the index
becomes unavailable during the term of this loan, Lender may designate a
substitute index after notice to Borrower. Lender will tell Borrower the
current Index rate upon Borrower's request. Borrower understands that Lender
may make loans based on other rates as well. The interest rate change will
not occur more often than each day. THE INDEX CURRENTLY IS 8.500%. THE
INTEREST RATE TO BE APPLIED TO THE UNPAID PRINCIPAL BALANCE OF THIS NOTE WILL
BE AT A RATE EQUAL TO THE INDEX, RESULTING IN AN INITIAL RATE OF 8.500%.
NOTICE: Under no circumstances will the interest rate on this Note be more
than the maximum rate allowed by applicable law.

PREPAYMENT; MINIMUM INTEREST CHARGE. In any event, even upon full prepayment
of this Note, Borrower understands that Lender is entitled to a minimum
interest charge of $250.00. Other than Borrower's obligation to pay any
minimum interest charge, Borrower may pay without penalty all or a portion of
the amount owed earlier than it is due. Early payments will not, unless
agreed to by Lender in writing, relieve Borrower of Borrower's obligation to
continue to make payments of accrued unpaid interest. Rather, they will
reduce the principal balance due.

LATE CHARGE. If a payment is 10 DAYS OR MORE LATE, Borrower will be charged
5.000% OF THE UNPAID PORTION OF THE REGULARLY SCHEDULED PAYMENT.

DEFAULT. Borrower will be in default if any of the following happens: (a)
Borrower fails to make any payment when due, (b) Borrower breaks any promise
Borrower has made to Lender, or Borrower fails to comply with or to perform when
due any other term, obligation, covenant, or condition contained in this Note or
any agreement related to this Note, or in any other agreement or loan Borrower
has with Lender, (c) Borrower defaults under any loan, extension of credit,
security agreement, purchase or sales agreement, or any other agreement, in
favor of any other creditor or person that may materially affect any of
Borrower's property or Borrower's ability to repay this Note or perform
Borrower's obligations under this Note or any of the Related Documents, (d) Any
representation or statement made or furnished to Lender by Borrower or on
Borrower's behalf is false or misleading in any material respect either now or
at the time made or furnished, (e) Borrower becomes insolvent, a receiver is
appointed for any part of Borrower's property, Borrower makes an assignment for
the benefit of creditors, or any proceeding is commenced either by Borrower or
against Borrower under any bankruptcy or insolvency laws, (f) Any creditor
tries to take any of Borrower's property on or in which Lender has a lien or
security interest. This includes a garnishment of any of Borrower's accounts
with Lender, (g) Any guarantor dies or any of the other events described in
this default section occurs with respect to any guarantor of this Note, (h) A
material adverse change occurs in Borrower's financial condition, or Lender
believes the prospect of payment or performance of the Indebtedness is impaired,
(i) Lender in good faith deems itself insecure.

LENDER'S RIGHTS. Upon default, Lender may declare the entire unpaid principal
balance on this Note and all accrued unpaid interest immediately due, without
notice, and then Borrower will pay that amount. Upon Borrower's failure to pay
all amounts declared due pursuant to this section, including failure to pay upon
final maturity, Lender, at its option, may also, if permitted under applicable
law, do one or both of the following: (a) increase the variable interest rate
on this Note to 5.000 percentage points over the Index, and (b) add any unpaid
accrued interest to principal and such sum will bear interest therefrom until
paid at the rate provided in this Note (including any increased rate). Lender
may hire or pay someone else to help collect this Note if Borrower does not pay.
Borrower also will pay Lender that amount. This includes, subject to any limits
under applicable law, Lender's attorneys' fees and Lender's legal expenses
whether or not there is a lawsuit, including attorneys' fees and legal expenses
for bankruptcy proceedings (including efforts to modify or vacate any automatic
stay or injunction), appeals, and any anticipated post-judgment collection
services. Borrower also will pay any court costs, in addition to all other sums
provided by law. THIS NOTE HAS BEEN DELIVERED TO LENDER AND ACCEPTED BY LENDER
IN THE STATE OF CALIFORNIA. IF THERE IS A LAWSUIT, BORROWER AGREES UPON
LENDER'S REQUEST TO SUBMIT TO THE JURISDICTION OF THE COURTS OF LOS ANGELES
COUNTY, THE STATE OF CALIFORNIA. SUBJECT TO THE PROVISIONS ON ARBITRATION, THIS
NOTE SHALL BE GOVERNED BY AND CONSTRUED IN ACCORDANCE WITH THE LAWS OF THE STATE
OF CALIFORNIA.

RIGHT OF SETOFF. Borrower grants to Lender a contractual security interest in,
and hereby assigns, conveys, delivers, pledges, and transfers to Lender all
Borrower's right, title and interest in and to, Borrower's accounts with Lender
(whether checking, savings, or some other account), including without limitation
all accounts held jointly with someone else and all accounts Borrower may open
in the future, excluding however all IRA and Keogh accounts, and all trust
accounts for which the grant of a security interest would be prohibited by law.
Borrower authorizes Lender, to the extent permitted by applicable law, to
charge or setoff all sums owing on this Note against any and all such accounts.

LINE OF CREDIT. This Note evidences a revolving line of credit. Advances under
this Note may be requested orally by Borrower or by an authorized person.
Lender may, but need not, require that all oral requests be confirmed in
writing. All communications, instructions, or directions by telephone or
otherwise to Lender are to be directed to Lender's officer shown above. The
following party or parties are authorized to request advances under the line
<PAGE>

PAGE 2
================================================================================
of credit until Lender receives from Borrower at Lender's address shown above
written notice of revocation of their authority: Richard E. Amtower, President
& Secretary; and Maria Molak, Controller. Borrower agrees to be liable for all
sums either: (a) advanced in accordance with the instructions of an authorized
person or (b) credited to any of Borrower's accounts with Lender. The unpaid
principal balance owing on this Note at any time may be evidenced by
endorsements on this Note or by Lender's internal records, including daily
computer print-outs. Lender will have no obligation to advance funds under this
Note if: (a) Borrower or any guarantor is in default under the terms of this
Note or any agreement that Borrower or any guarantor has with Lender, including
any agreement made in connection with the signing of this Note; (b) Borrower or
any guarantor ceases doing business or is insolvent; (c) any guarantor seeks,
claims or otherwise attempts to limit, modify or revoke such guarantor's
guarantee of this Note or any other loan with Lender; (d) Borrower has applied
funds provided pursuant to this Note for purposes other than those authorized by
Lender; or (e) Lender in good faith deems itself insecure under this Note or any
other agreement between Lender and Borrower.

ARBITRATION. LENDER AND BORROWER AGREE THAT ALL DISPUTES, CLAIMS AND
CONTROVERSIES BETWEEN THEM, WHETHER INDIVIDUAL, JOINT, OR CLASS IN NATURE,
ARISING FROM THIS NOTE OR OTHERWISE, INCLUDING WITHOUT LIMITATION CONTRACT
AND TORT DISPUTES, SHALL BE ARBITRATED PURSUANT TO THE RULES OF THE AMERICAN
ARBITRATION ASSOCIATION, UPON REQUEST OF EITHER PARTY. No act to take or
dispose of any collateral securing this Note shall constitute a waiver of
this arbitration agreement or be prohibited by this arbitration agreement.
This includes, without limitation, obtaining injunctive relief or a temporary
restraining order; invoking a power of sale under any deed of trust or
mortgage; obtaining a writ of attachment or imposition of a receiver; or
exercising any rights relating to personal property, including taking or
disposing of such property with or without judicial process pursuant to
Article 9 of the Uniform Commercial Code. Any disputes, claims, or
controversies concerning the lawfulness or reasonableness of any act, or
exercise of any right, concerning any collateral securing this Note,
including any claim to rescind, reform, or otherwise modify any agreement
relating to the collateral securing this Note, shall also be arbitrated,
provided however that no arbitrator shall have the right or the power to
enjoin or restrain any act of any party. Lender and Borrower agree that in
the event of an action for judicial foreclosure pursuant to California Code
of Civil Procedure Section 726, or any similar provision in any other state,
the commencement of such an action will not constitute a waiver of the right
to arbitrate and the court shall refer to arbitration as much of such action,
including counterclaims, as lawfully may be referred to arbitration.
Judgment upon any award rendered by any arbitrator may be entered in any
court having jurisdiction. Nothing in this Note shall preclude any party
from seeking equitable relief from a court of competent jurisdiction. The
statute of limitations, estoppel, waiver, laches, and similar doctrines which
would otherwise be applicable in an action brought by a party shall be
applicable in any arbitration proceeding, and the commencement of an
arbitration proceeding shall be deemed the commencement of an action for
these purposes. The Federal Arbitration Act shall apply to the construction,
interpretation, and enforcement of this arbitration provision.

BUSINESS LOAN AGREEMENT. Reference is made to that certain Business Loan
Agreement, dated as of July 20, 1998, as it may be amended, modified,
supplemented, replaced, or restated, from time to time, ("Business Loan
Agreement") for additional terms and conditions. Capitalized terms used but
not defined herein shall have the meanings given to them in the Business Loan
Agreement.

COLLATERAL. This Note is secured by the Collateral as described in that certain
Commercial Security Agreement, dated as of July 20, 1998, as it may be amended,
modified, supplemented, replaced, or restated, from time to time, executed by
Grantor in favor of Lender.

OUT OF DEBT PROVISION. Borrower shall maintain a zero balance on the revolving
line of credit for a period of at least thirty (30) consecutive days during the
term of this loan.

ADDITIONAL MATTERS. Lender reserves the right to sell, assign, transfer,
negotiate or grant participations in all or any part of, or any interest in
Lender's rights and benefits hereunder. In connection therewith, Lender may
disclose all documents and information which Lender now or hereafter may have
relating to Borrower.

GENERAL PROVISIONS. This Note is payable on demand. The inclusion of specific
default provisions or rights of Lender shall not preclude Lender's right to
declare payment of this Note on its demand. Lender may delay or forgo enforcing
any of its rights or remedies under this Note without losing them. Borrower
and any other person who signs, guarantees or endorses this Note, to the extent
allowed by law, waive any applicable statute of limitations, presentment, demand
for payment, protest and notice of dishonor. Upon any change in the terms of
this Note, and unless otherwise expressly stated in writing, no party who signs
this Note, whether as maker, guarantor, accommodation maker or endorser, shall
be released from liability. All such parties agree that Lender may renew or
extend (repeatedly and for any length of time) this loan, or release any party
or guarantor or collateral; or impair, fail to realize upon or perfect Lender's
security interest in the collateral; and take any other action deemed necessary
by Lender without the consent of or notice to anyone. All such parties also
agree that Lender may modify this loan without the consent of or notice to
anyone other than the party with whom the modification is made.

INTEGRATION; AMENDMENT. This Note and the other written documents and
instruments between Borrower and Lender set forth in full the terms of
agreement between the parties and are intended as the full, complete and
exclusive agreement governing the relationship between the parties. This
Note supersedes all prior discussions, promises, representations, warranties,
agreements and understandings between the parties. This Note may not be
modified or amended, nor may any rights hereunder be waived, except in a
writing signed by the party against whom enforcement of the modification,
amendment or waiver is sought. No course of dealing between the parties, no
usage of trade, and no parol or extrinsic evidence of any nature shall be
used or be relevant to supplement, explain or modify any term or provision of
this Note or any supplement or amendment hereto. There are no oral
agreements or understandings between Borrower and Lender regarding any
extension of the maturity of this Note or making any modifications to this
Note, or regarding any other matter.

MUTUAL WAIVER OF RIGHT TO JURY TRIAL. Lender and Borrower each hereby waive
the right to trial by jury in any action or proceeding based upon, arising out
of, or in any way relating to: (i) this Note; or (ii) any other present or
future instrument or agreement between Lender and Borrower; or (iii) any
conduct, acts or omissions of Lender or Borrower or any of their directors,
officers, employees, agents, attorneys or any other persons affiliated with
Lender or Borrower; in each of the foregoing cases, whether sounding in
contract or tort or otherwise.

<PAGE>

Page 3

PRIOR TO SIGNING THIS NOTE, BORROWER READ AND UNDERSTOOD ALL THE PROVISIONS
OF THIS NOTE, INCLUDING THE VARIABLE INTEREST RATE PROVISIONS. BORROWER
AGREES TO THE TERMS OF THE NOTE AND ACKNOWLEDGES RECEIPT OF A COMPLETED COPY
OF THE NOTE.

BORROWER:
CR Technology, Inc.

By: /s/ R.E. Amtower
-------------------------------------
Richard E. Amtower, President & Assistant Secretary

LENDER:
California United Bank

By: /s/ [ILLEGIBLE]
-------------------------------------
Authorized Officer

<PAGE>

[LETTERHEAD]

COMMERCIAL SECURITY AGREEMENT
===============================================================================

Borrower: CR Technology, Inc. Lender: California United Bank
27752 El Lazo Road Orange County Commercial Loan Center
Laguna Nigel, CA 92677-3914 16030 Ventura Boulevard
Encino, CA 91436
===============================================================================

THIS COMMERCIAL SECURITY AGREEMENT is entered into between CR Technology,
Inc. (referred to below as "Grantor"); and California United Bank (referred
to below as "Lender"). For valuable consideration, Grantor grants to Lender a
security interest in the Collateral to secure the indebtedness and agrees
that Lender shall have the rights stated in this Agreement with respect to
the Collateral, in addition to all other rights which Lender may have by law.

AGREEMENT. The word "Agreement" means this Commercial Security
Agreement, as this Commercial Security Agreement may be amended or
modified from time to time, together with all exhibits and schedules
attached to this Commercial Security Agreement from time to time.

COLLATERAL. The word "Collateral" means the following described property
of Grantor, whether now owned or hereafter acquired, whether now
existing or hereafter arising, and wherever located:

All Debtor's present and future accounts, contract rights,
instruments, documents, chattel paper, general intangibles
(including, but not limited to, trademarks, tradenames, patents,
copyrights and all other forms of intellectual property, and tax
refunds), returned and repossessed goods and all Debtor's rights as a
seller of goods; all collateral securing any of the foregoing; all
deposit accounts, special and general, whether on deposit with
Secured Party or others; all present and future letters of credit;

All Debtor's now owned or hereafter acquired inventory, including raw
materials, work in progress and finished goods, wherever located all
shipping and packing supplies used or usable in connection with the
sale of inventory; all Debtor's present and future claims against any
supplier of any of the foregoing, including claims arising out of
purchases by Debtor of defective goods or overpayments to or
undershipments by suppliers; all proceeds arising from the lease or
rental of any of the foregoing;

All Debtor's now owned and hereafter acquired equipment, including
furniture, fixtures, and motor vehicles, NONE OF WHICH THE DEBTOR IS
AUTHORIZED TO SELL, LEASE OR DISPOSE OF WITHOUT THE WRITTEN CONSENT
OF SECURED PARTY. All present and future warranty and other claims
which Debtor may have against any vendor or lessor of any of the
foregoing;
All cash and non-cash proceeds of any of the foregoing, in whatever
form (including proceeds in the form of inventory, equipment or any
other form of personal property, and insurance proceeds), including
proceeds of proceeds;

All books and records of any kind relating to any of the foregoing
collateral, and all computers and other equipment (and computer
software used in connection therewith) used in connection with
recordkeeping for the collateral.

In addition, the word "Collateral" includes all the following, whether now
owned or hereafter acquired, whether now existing or hereafter arising, and
wherever located:

(a) All attachments, accessions, accessories, tools, parts, supplies,
increases, and additions to and all replacements of and substitutions
for any property described above.

(b) All products and produce of any of the property described in this
Collateral section.

(c) All accounts, general intangibles, instruments, rents, monies,
payments, and all other rights, arising out of a sale, lease, or
other disposition of any of the property described in this Collateral
section.

(d) All proceeds (including insurance proceeds) from the sale,
destruction, loss, or other disposition of any of the property
described in this Collateral section.

(e) All records and data relating to any of the property described in
this Collateral section, whether in the form of a writing,
photograph, microfilm, microfiche, or electronic media, together with
all of Grantor's right, title, and interest in and to all computer
software required to utilize, create, maintain, and process any such
records or data on electronic media.

EVENT OF DEFAULT. The words "Event of Default" mean and include without
limitation any of the Events of Default set forth below in the section titled
"Events of Default."

GRANTOR. The word "Grantor" means CR Technology, Inc., its successors and
assigns

GUARANTOR. The word "Guarantor" means and includes without limitation each
and all of the guarantors, sureties, and accommodation parties in connection
with the indebtedness.

INDEBTEDNESS. The word "Indebtedness" means the indebtedness evidenced by the
Note, including all principal and interest, together with all other
indebtedness and costs and expenses for which Grantor is responsible under
this Agreement or under any of the Related Documents. In addition, the word
"Indebtedness" includes all other obligations, debts and liabilities, plus
interest thereon, of Grantor, or any one or more of them, to Lender, as well
as all claims by Lender against Grantor, or any one or more of them, whether
existing now or later; whether they are voluntary or involuntary, due or not
due, direct or indirect, absolute or contingent, liquidated or unliquidated;
whether Grantor may be liable individually or jointly with others; whether
Grantor may be obligated as guarantor, surety, accommodation party or
otherwise; whether recovery upon such indebtedness may be or hereafter may
become barred by any statute of limitations; and whether such indebtedness may
be or hereafter may become otherwise unenforceable.

LENDER. The word "Lender" means California United Bank, its successors and
assigns.

NOTE. The word "Note" means the Borrower's promissory notes or credit
agreements, if any, evidencing Borrower's loan obligations, together with all
renewals of, extensions of, modifications of, refinancings of, consolidations
of and substitutions for the notes or credit agreements.

<PAGE>

COMMERCIAL SECURITY AGREEMENT PAGE 2
(CONTINUED)

LOAN NO. 6889
- ------------------------------------------------------------------------------
RELATED DOCUMENTS. The words "Related Documents" mean and include
without limitation all promissory notes, credit agreements, loan
agreements, environmental agreements, guaranties, security agreements,
mortgages, deeds of trust, and all other instruments, agreements and
documents, whether now or hereafter existing, executed in connection
with the indebtedness.

RIGHT OF SETOFF. Grantor hereby grants Lender a contractual security interest
in and hereby assigns, conveys, delivers, pledges, and transfers all of
Grantor's right, title and interest in and to Grantor's accounts with Lender
(whether checking, savings, or some other account), including all accounts
held jointly with someone else and all accounts Grantor may open in the
future, excluding, however, all IRA and Keogh accounts, and all trust
accounts for which the grant of a security interest would be prohibited by
law. Grantor authorizes Lender, to the extent permitted by applicable law, to
charge or setoff all indebtedness against any and all such accounts.

OBLIGATIONS OF GRANTOR. Grantor warrants and covenants to Lender as follows:

PERFECTION OF SECURITY INTEREST. Grantor agrees to execute such financing
statements and to take whatever other actions are requested by Lender to
perfect and continue Lender's security interest in the Collateral. Upon
request of Lender, Grantor will deliver to Lender any and all of the
documents evidencing or constituting the Collateral, and Grantor will
note Lender's interest upon any and all chattel paper if not delivered to
Lender for possession by Lender. Grantor hereby appoints Lender as its
irrevocable attorney-in-fact for the purpose of executing any documents
necessary to perfect or to continue the security interest granted in this
Agreement. Lender may at any time, and without further authorization from
Grantor, file a carbon, photographic or other reproduction of any
financing statement or of this Agreement for use as a financing statement.
Grantor will reimburse Lender for all expenses for the perfection and the
continuation of the perfection of Lender's security interest in the
Collateral. Grantor promptly will notify Lender before any change in
Grantor's name including any change to the assumed business names of
Grantor. THIS IS A CONTINUING SECURITY AGREEMENT AND WILL CONTINUE IN
EFFECT EVEN THOUGH ALL OR ANY PART OF THE INDEBTEDNESS IS PAID IN FULL AND
EVEN THOUGH FOR A PERIOD OF TIME GRANTOR MAY NOT BE INDEBTED TO LENDER.

NO VIOLATION. The execution and delivery of this Agreement will not
violate any law or agreement governing Grantor or to which Grantor is a
party, and its certificate or articles of incorporation and bylaws do not
prohibit any term or condition of this Agreement.

ENFORCEABILITY OF COLLATERAL. To the extent the Collateral consists of
accounts, chattel paper, or general intangibles, the Collateral is
enforceable in accordance with its terms, is genuine, and complies with
applicable laws concerning form, content and manner of preparation and
execution, and all persons appearing to be obligated on the Collateral
have authority and capacity to contract and are in fact obligated as they
appear to be on the Collateral.

LOCATION OF THE COLLATERAL. Grantor, upon request of Lender, will deliver
to Lender in form satisfactory to Lender a schedule of real properties
and Collateral locations relating to Grantor's operations, including
without limitation the following: (a) all real property owned or being
purchased by Grantor; (b) all real property being rented or leased by
Grantor; (c) all storage facilities owned, rented, leased, or being used
by Grantor; and (d) all other properties where Collateral is or may be
located. Except in the ordinary course of its business, Grantor shall not
remove the Collateral from its existing locations without the prior
written consent of Lender.

REMOVAL OF COLLATERAL. Grantor shall keep the Collateral (or to the extent
the Collateral consists of intangible property such as accounts, the
records concerning the Collateral) at Grantor's address shown above, or
at such other locations as are acceptable to Lender. Except in the
ordinary course of its business, including the sales of inventory,
Grantor shall not remove the Collateral from its existing locations
without the prior written consent of Lender. To the extent that the
Collateral consists of vehicles, or other titled property, Grantor shall
not take or permit any action which would require application for
certificates of title for the vehicles outside the State of California,
without the prior written consent of Lender.

TRANSACTIONS INVOLVING COLLATERAL. Except for inventory sold or accounts
collected in the ordinary course of Grantor's business, Grantor shall
not sell, offer to sell, or otherwise transfer or dispose of the
Collateral. While Grantor is not in default under this Agreement, Grantor
may sell inventory, but only in the ordinary course of its business and
only to buyers who qualify as a buyer in the ordinary course of business.
A sale in the ordinary course of Grantor's business does not include a
transfer in partial or total satisfaction of a debt or any bulk sale.
Grantor shall not pledge, mortgage, encumber or otherwise permit the
Collateral to be subject to any lien, security interest, encumbrance, or
charge, other than the security interest provided for in this Agreement,
without the prior written consent of Lender. This includes security
interests even if junior in right to the security interests granted under
this Agreement. Unless waived by Lender, all proceeds from any disposition
of the Collateral (for whatever reason) shall be held in trust for Lender
and shall not be commingled with any other funds; provided, however, this
requirement shall not constitute consent by Lender to any sale or other
disposition. Upon receipt, Grantor shall immediately deliver any such
proceeds to Lender.

TITLE. Grantor represents and warrants to Lender that it holds good and
marketable title to the Collateral, free and clear of all liens and
encumbrances except for the lien of this Agreement. No financing statement
covering any of the Collateral is on file in any public office other than
those which reflect the security interest created by this Agreement or
to which Lender has specifically consented. Grantor shall defend Lender's
rights in the Collateral against the claims and demands of all other
persons.

COLLATERAL SCHEDULES AND LOCATIONS. Insofar as the Collateral consists of
inventory, Grantor shall deliver to Lender, as often as Lender shall
require, such lists, descriptions, and designations of such Collateral as
Lender may require to identify the nature, extent, and location of such
Collateral. Such information shall be submitted for Grantor and each of
its subsidiaries or related companies.

MAINTENANCE AND INSPECTION OF COLLATERAL. Grantor shall maintain all
tangible Collateral in good condition and repair. Grantor will not commit
or permit damage to or destruction of the Collateral or any part of the
Collateral. Lender and its designated representatives and agents shall
have the right at all reasonable times to examine, inspect, and audit the
Collateral wherever located. Grantor shall immediately notify Lender of
all cases involving the return, rejection, repossession, loss or damage
of or to any Collateral; of any request for credit or adjustment or of any
other dispute arising with respect to the Collateral; and generally of
all happenings and events affecting the Collateral or the value or the
amount of the Collateral.

TAXES, ASSESSMENTS AND LIENS. Grantor will pay when due all taxes,
assessments and liens upon the Collateral, its use or operation, upon this
Agreement, upon any promissory note or notes evidencing the indebtedness,
or upon any of the other Related Documents. Grantor may withhold any such
payment or may elect to contest any lien if Grantor is in good faith
conducting an appropriate proceeding to contest the obligation to pay and
so long as Lender's interest in the Collateral is not jeopardized in
Lender's sole opinion. If the Collateral is subjected to a lien which is
not discharged within fifteen (15) days, Grantor shall deposit with Lender
cash, a sufficient corporate surety bond or other security satisfactory to
Lender in an amount adequate to provide for the discharge of the lien
plus any interest, costs, attorneys' fees or other charges that could
accrue as a result of foreclosure or sale of the Collateral. In any
contest Grantor shall defend itself and Lender and shall satisfy any final
final adverse judgment before enforcement against the Collateral. Grantor
shall name Lender as an additional obligee under any surety bond furnished
in the contest proceedings.

COMPLIANCE WITH GOVERNMENTAL REQUIREMENTS. Grantor shall comply promptly
with all laws, ordinances, rules and regulations of all governmental
authorities, now or hereafter in effect, applicable to the ownership,
production, or use of the Collateral. Grantor may contest in good faith
any such law, ordinance or regulation and withhold compliance during any
proceeding, including appropriate appeals, so long as Lender's interest in
the Collateral, in Lender's opinion, is not jeopardized.

HAZARDOUS SUBSTANCES. Grantor represents and warrants that the Collateral
never has been, and never will be so long as this Agreement

<PAGE>

COMMERCIAL SECURITY AGREEMENT PAGE 3
(CONTINUED)

LOAN NO. 6889
- ------------------------------------------------------------------------------
for any part of Grantor's property, any assignment for the benefit of
creditors, any type of creditor workout, or the commencement of any
proceeding under any bankruptcy or insolvency laws by or against Grantor.

CREDITOR OR FORFEITURE PROCEEDINGS. Commencement of foreclosure or
forfeiture proceedings, whether by judicial proceeding, self-help,
repossession or any other method, by any creditor of Grantor or by any
governmental agency against the Collateral or any other collateral
securing the indebtedness. This includes a garnishment of any of Grantor's
deposit accounts with Lender.

EVENTS AFFECTING GUARANTOR. Any of the preceding events occurs with
respect to any Guarantor of any of the indebtedness or such Guarantor
dies or becomes incompetent.

ADVERSE CHANGE. A material adverse change occurs in Grantor's financial
condition, or Lender believes the prospect of payment or performance of
the indebtedness is impaired.

INSECURITY. Lender, in good faith, deems itself insecure.

RIGHTS AND REMEDIES ON DEFAULT. If an Event of Default occurs under this
Agreement, at any time thereafter, Lender shall have all the rights of a
secured party under the California Uniform Commercial Code. In addition and
without limitation, Lender may exercise any one or more of the following
rights and remedies:

ACCELERATE INDEBTEDNESS. Lender may declare the entire indebtedness,
including any prepayment penalty which Grantor would be required to
pay, immediately due and payable, without notice.

ASSEMBLE COLLATERAL. Lender may require Grantor to deliver to Lender all
or any portion of the Collateral and any and all certificates of title and
other documents relating to the Collateral. Lender may require Grantor to
assemble the Collateral and make it available to Lender at a place to be
designated by Lender. Lender also shall have full power to enter upon the
property of Grantor to take possession of and remove the Collateral. If
the Collateral contains other goods not covered by this Agreement at the
time of repossession, Grantor agrees Lender may take such other goods,
provided that Lender makes reasonable efforts to return them to Grantor
after repossession.

SELL THE COLLATERAL. Lender shall have full power to sell, lease,
transfer, or otherwise deal with the Collateral or proceeds thereof in its
own name or that of Grantor. Lender may sell the Collateral at public
auction or private sale. Unless the Collateral threatens to decline
speedily in value or is of a type customarily sold on a recognized
market, Lender will give Grantor reasonable notice of the time after
which any private sale or any other intended disposition of the
Collateral is to be made. The requirements of reasonable notice shall be
met if such notice is given at least ten (10) days, or such lesser time
as required by state law, before the time of the sale or disposition. All
expenses relating to the disposition of the Collateral, including without
limitation the expenses of retaking, holding, insuring, preparing for
sale and selling the Collateral, shall become a part of the indebtedness
secured by this Agreement and shall be payable on demand, with interest
at the Note rate from date of expenditure until repaid.

APPOINT RECEIVER. To the extent permitted by applicable law, Lender shall
have the following rights and remedies regarding the appointment of a
receiver: (a) Lender may have a receiver appointed as a matter of right,
(b) the receiver may be an employee of Lender and may serve without bond,
and (c) all fees of the receiver and his or her attorney shall become
part of the indebtedness secured by this Agreement and shall be payable on
demand, with interest at the Note rate from date of expenditure until
repaid.

COLLECT REVENUES, APPLY ACCOUNTS. Lender, either itself or through a
receiver, may collect the payments, rents, income, and revenues from the
Collateral. Lender may at any time in its discretion transfer any
Collateral into its own name or that of its nominee and receive the
payments, rents, income, and revenues therefrom and hold the same
as security for the indebtedness or apply it to payment of the
indebtedness in such order of preference as Lender may determine. Insofar
as the Collateral consists of accounts, general intangibles, insurance
policies, instruments, chattel paper, choses in action, or similar
property, Lender may demand, collect, receipt for, settle, compromise,
adjust, sue for, foreclose, or realize on the Collateral as Lender may
determine, whether or not indebtedness or Collateral is then due. For
these purposes, Lender may, on behalf of and in the name of Grantor,
receive, open and dispose of mail addressed to Grantor; change any address
to which mail and payments are to be sent; and endorse notes, checks,
drafts, money orders, documents of title, instruments and items
pertaining to payment, shipment, or storage of any Collateral. To
facilitate collection, Lender may notify account debtors and obligors on
any Collateral to make payments directly to Lender.

OBTAIN DEFICIENCY. If Lender chooses to sell any or all of the Collateral,
Lender may obtain a judgment against Grantor for any deficiency remaining
on the indebtedness due to Lender after application of all amounts
received from the exercise of the rights provided in this Agreement.
Grantor shall be liable for a deficiency even if the transaction
described in this subsection is a sale of accounts or chattel paper.

OTHER RIGHTS AND REMEDIES. Lender shall have all the rights and remedies
of a secured creditor under the provisions of the Uniform Commercial
Code, as may be amended from time to time. In addition, Lender shall have
and may exercise any or all other rights and remedies it may have
available at law, in equity, or otherwise.

CUMULATIVE REMEDIES. All of Lender's rights and remedies, whether
evidenced by this Agreement or the Related Documents or by any other
writing, shall be cumulative and may be exercised singularly or
concurrently. Election by Lender to pursue any remedy shall not
exclude pursuit of any other remedy, and an election to make expenditures
or to take action to perform an obligation of Grantor under this
Agreement, after Grantor's failure to perform, shall not affect Lender's
right to declare a default and to exercise its remedies.

MISCELLANEOUS PROVISIONS. The following miscellaneous provisions are a part
of this Agreement:

APPLICABLE LAW. This Agreement has been delivered to Lender and accepted
by Lender in the State of California. If there is a lawsuit, Grantor
agrees upon Lender's request to submit to the jurisdiction of the courts
of Los Angeles County, the State of California. Subject to the provisions
on arbitration, this Agreement shall be governed by and construed
in accordance with the laws of the State of California.

ARBITRATION. LENDER AND GRANTOR AGREE THAT ALL DISPUTES, CLAIMS AND
CONTROVERSIES BETWEEN THEM, WHETHER INDIVIDUAL, JOINT, OR CLASS IN
NATURE, ARISING FROM THIS AGREEMENT OR OTHERWISE, INCLUDING WITHOUT
LIMITATION CONTRACT AND TORT DISPUTES, SHALL BE ARBITRATED PURSUANT TO
THE RULES OF THE AMERICAN ARBITRATION ASSOCIATION, UPON REQUEST OF EITHER
PARTY. No act to take or dispose of any Collateral shall
constitute a waiver of this arbitration agreement or be prohibited by
this arbitration agreement. This includes, without limitation, obtaining
injunctive relief or a temporary restraining order; invoking a power of
sale under any deed of trust or mortgage; obtaining a writ of attachment
or imposition of a receiver; or exercising any rights relating to
personal property, including taking or disposing of such property with or
without judicial process pursuant to Article 9 of the Uniform Commercial
Code. Any disputes, claims, or controversies concerning the lawfulness or
reasonableness of any act, or exercise of any right, concerning any
Collateral, including any claim to rescind, reform, or otherwise modify
any agreement relating to the Collateral, shall also be arbitrated,
provided however that no arbitrator shall have the right or the power to
enjoin or restrain any act of any party. Lender and Grantor agree that in
the event of an action for judicial foreclosure pursuant to California
Code of Civil Procedure Section 726, or any similar provision in any
other state, the commencement of such an action will not constitute a
waiver of the right to arbitrate and the court

<PAGE>

COMMERCIAL SECURITY AGREEMENT PAGE 5
(CONTINUED)

LOAN NO. 6889
- ------------------------------------------------------------------------------
shall refer to arbitration as much of such action, including counterclaims,
as lawfully may be referred to arbitration. Judgment upon any award
rendered by any arbitrator may be entered in any court having
jurisdiction. Nothing in this Agreement shall preclude any party from
seeking equitable relief from a court of competent jurisdiction. The
statute of limitations, estoppel, waiver, laches, and similar doctrines
which would otherwise be applicable in an action brought by a party shall
be applicable in any arbitration proceeding, and the commencement of an
arbitration proceeding shall be deemed the commencement of an action for
these purposes. The Federal Arbitration Act shall apply to the
construction, interpretation, and endorsement of this arbitration
provision.

ATTORNEYS' FEES; EXPENSES. Grantor agrees to pay upon demand all of
Lender's costs and expenses, including attorneys' fees and Lender's legal
expenses, incurred in connection with the enforcement of this Agreement.
Lender may pay someone else to help enforce this Agreement, and Grantor
shall pay the costs and expenses of such enforcement. Costs and expenses
include Lender's attorneys' fees and legal expenses whether or not there
is a lawsuit, including attorneys' fees and legal expenses for bankruptcy
proceedings (and including efforts to modify or vacate any automatic stay
or injunction), appeals, and any anticipated post-judgment collection
services. Grantor also shall pay all court costs and such additional fees
as may be directed by the court.

CAPTION HEADINGS. Caption headings in this Agreement are for convenience
purposes only and are not to be used to interpret or define the
provisions of this Agreement.

NOTICES. All notices required to be given under this Agreement shall be
given in writing, may be sent by telefacsimile (unless otherwise required
by law), and shall be effective when actually delivered or when deposited
with a nationally recognized overnight courier or deposited in the United
States mail, first class, postage prepaid, addressed to the party to whom
the notice to be given at the address shown above. Any party may change
its address for notices under this Agreement by giving formal written
notice to the other parties, specifying that the purpose of the notice is
to change the party's address. To the extent permitted by applicable law,
if there is more than one Grantor, notice to any Grantor will constitute
notice to all Grantors. For notice purposes, Grantor will keep Lender
informed at all times of Grantor's current address(es).

POWER OF ATTORNEY. Grantor hereby appoints Lender as its true and lawful
attorney-in-fact, irrevocably, with full power of substitution to do the
following: (a) to demand, collect, receive, receipt for, sue and recover
all sums of money or other property which may now or hereafter become
due, owing or payable from the Collateral; (b) to execute, sign and
endorse any and all claims, instruments, receipts, checks, drafts or
warrants issued in payment for the Collateral; (c) to settle or compromise
any and all claims arising under the Collateral, and, in the place and
stead of Grantor, to execute and deliver its release and settlement for
the claim; and (d) to file any claim or claims or to take any action or
institute or take part in any proceedings, either in its own name or in
the name of Grantor, or otherwise, which in the discretion of Lender may
seem to be necessary or advisable. This power is given as security for
the indebtedness, and the authority hereby conferred is and shall be
irrevocable and shall remain in full force and effect until renounced by
Lender.

PREFERENCE PAYMENTS. Any monies Lender pays because of an asserted
preference claim in Borrower's bankruptcy will become a part of the
indebtedness and, at Lender's option, shall be payable by Borrower as
provided above in the "EXPENDITURES BY LENDER" paragraph.

SEVERABILITY. If a court of competent jurisdiction finds any provision of
this Agreement to be invalid or unenforceable as to any person or
circumstance, such finding shall not render that provision invalid or
unenforceable as to any other persons or circumstances. If feasible, any
such offending provision shall be deemed to be modified to be within the
limits of enforceability or validity; however, if the offending provision
cannot be so modified, it shall be stricken and all other provisions of this
Agreement in all other respects shall remain valid and enforceable.

SUCCESSOR INTERESTS. Subject to the limitations set forth above on
transfer of the Collateral, this Agreement shall be binding upon and
inure to the benefit of the parties, their successors and assigns.

WAIVER. Lender shall not be deemed to have waived any rights under this
Agreement unless such waiver is given in writing and signed by Lender. No
delay or omission on the part of Lender in exercising any right shall
operate as a waiver of such right or any other right. A waiver by Lender
of a provision of this Agreement shall not prejudice or constitute a
waiver of Lender's right otherwise to demand strict compliance with that
provision or any other provision of this Agreement. No prior waiver by
Lender, nor any course of dealing between Lender and Grantor, shall
constitute a waiver of any of Lender's rights or of any of Grantor's
obligations as to any future transactions. Whenever the consent of Lender
is required under this Agreement, the granting of such consent by Lender
in any instance shall not constitute continuing consent to subsequent
instances where such consent is required and in all cases such consent
may be granted or withheld in the sole discretion of Lender.

WAIVER OF CO-OBLIGOR'S RIGHTS. If more than one person is obligated for
the indebtedness, Borrower irrevocably waives, disclaims and relinquishes
all claims against such other person which Borrower has or would otherwise
have by virtue of payment of the indebtedness or any part thereof,
specifically including but not limited to all rights of indemnity,
contribution or exoneration.

GRANTOR ACKNOWLEDGES HAVING READ ALL THE PROVISIONS OF THIS COMMERCIAL
SECURITY AGREEMENT, AND GRANTOR AGREES TO ITS TERMS. THIS AGREEMENT IS DATED
JULY 20, 1998.

GRANTOR:

CR TECHNOLOGY, INC.

BY: /s/ Richard E. Amtower
---------------------------------------------------
Richard E. Amtower, President & Assistant Secretary

LENDER:

CALIFORNIA UNITED BANK

BY: -----------------------------------------------------
Authorized Officer

<PAGE>

PHOTON DYNAMICS, INC.

LOAN AND SECURITY AGREEMENT

<PAGE>

TABLE OF CONTENTS
<TABLE>
<CAPTION>
PAGE
----
<S> <C> <C>
1. DEFINITIONS AND CONSTRUCTION.....................................................................1
1.1 Definitions. .....................................................................1
1.2 Accounting Terms. ................................................................7

2. LOAN AND TERMS OF PAYMENT........................................................................7
2.1 Advances...........................................................................7
2.2 Overadvances. ....................................................................7
2.2 Intentionally Omitted..............................................................7
2.3 Interest Rates, Payments, and Calculations.........................................7
2.4 Crediting Payments. ..............................................................8
2.5 Fees...............................................................................8
2.6 Additional Costs. ................................................................8

3. CONDITIONS OF LOANS..............................................................................9
3.1 Conditions Precedent to Initial Advance. .........................................9
3.2 Conditions Precedent to Additional Advances........................................9

4. CREATION OF SECURITY INTEREST...................................................................10
4.1 Grant of Security Interest. .....................................................10
4.2 Delivery of Additional Documentation Required.....................................10
4.3 Right to Inspect..................................................................10

5. REPRESENTATIONS AND WARRANTIES..................................................................10
5.1 Due Organization and Qualification. .............................................10
5.2 Due Authorization; No Conflict. .................................................10
5.3 No Prior Encumbrances.............................................................10
5.4 Bona Fide Accounts................................................................10
5.5 Merchantable Inventory............................................................10
5.6 Intellectual Property. ..........................................................11
5.7 Name; Location of Chief Executive Office..........................................11
5.8 Litigation........................................................................11
5.9 No Material Adverse Change in Financial Statements................................11
5.10 Solvency.........................................................................11
5.11 Regulatory Compliance............................................................11
5.12 Environmental Condition..........................................................11
5.13 Taxes............................................................................12
5.14 Subsidiaries.....................................................................12
5.15 Government Consents..............................................................12
5.16 Full Disclosure..................................................................12

-i-

<PAGE>

6. AFFIRMATIVE COVENANTS...........................................................................12
6.1 Good Standing.....................................................................12
6.2 Government Compliance.............................................................12
6.3 Financial Statements, Reports, Certificates. .....................................12
6.4 Inventory; Returns................................................................13
6.5 Taxes.............................................................................13
6.6 Insurance.........................................................................13
6.7 Principal Depository..............................................................13
6.8 Quick Ratio. ....................................................................13
6.9 Debt-Net Worth Ratio. ...........................................................13
6.10 Profitability. ..................................................................14
6.11 Tangible Net Worth. .............................................................14
6.12 Registration of Intellectual Property Rights......................................14
6.13 Further Assurances................................................................14

7. NEGATIVE COVENANTS..............................................................................14
7.1 Dispositions......................................................................15
7.2 Change in Business................................................................15
7.3 Mergers or Acquisitions...........................................................15
7.4 Indebtedness......................................................................15
7.5 Encumbrances......................................................................15
7.6 Distributions.....................................................................15
7.7 Investments.......................................................................15
7.8 Transactions with Affiliates......................................................15
7.9 Intellectual Property Agreements..................................................15
7.10 Subordinated Debt................................................................15
7.11 Inventory........................................................................15
7.12 Compliance.......................................................................15

8. EVENTS OF DEFAULT...............................................................................16
8.1 Payment Default...................................................................16
8.2 Covenant Default. ...............................................................16
8.3 Material Adverse Change...........................................................16
8.4 Attachment........................................................................16
8.5 Insolvency........................................................................16
8.6 Other Agreements..................................................................16
8.7 Subordinated Debt.................................................................17
8.8 Judgments.........................................................................17
8.9 Misrepresentations................................................................17
8.10 Default Under Exim Loan Documents ...............................................17

<PAGE>

9. BANK'S RIGHTS AND REMEDIES......................................................................17
9.1 Rights and Remedies...............................................................17
9.2 Power of Attorney.................................................................18
9.3 Accounts Collection...............................................................18
9.4 Bank Expenses.....................................................................18
9.5 Bank's Liability for Collateral...................................................19
9.6 Remedies Cumulative...............................................................19
9.7 Demand; Protest...................................................................19

10. NOTICES.........................................................................................19

11. CHOICE OF LAW AND VENUE; JURY TRIAL WAIVER......................................................19

12. GENERAL PROVISIONS..............................................................................20
12.1 Successors and Assigns...........................................................20
12.2 Indemnification..................................................................20
12.3 Time of Essence..................................................................20
12.4 Severability of Provisions.......................................................20
12.5 Amendments in Writing, Integration...............................................20
12.6 Counterparts.....................................................................20
12.7 Survival.........................................................................20
</TABLE>

<PAGE>

This LOAN AND SECURITY AGREEMENT is entered into as of March 25, 1999,
by and between SILICON VALLEY BANK ("Bank") and PHOTON DYNAMICS, INC.
("Borrower").

RECITALS

Borrower wishes to obtain credit from time to time from Bank, and Bank
desires to extend credit to Borrower. This Agreement sets forth the terms on
which Bank will advance credit to Borrower, and Borrower will repay the amounts
owing to Bank.

AGREEMENT

The parties agree as follows:

1. DEFINITIONS AND CONSTRUCTION

1.1 DEFINITIONS. As used in this Agreement, the
following terms shall have the following definitions:

"Accounts" means all presently existing and
hereafter arising accounts, contract rights, and all other forms of obligations
owing to Borrower arising out of the sale or lease of goods (including, without
limitation, the licensing of software and other technology) or the rendering of
services by Borrower, whether or not earned by performance, and any and all
credit insurance, guaranties, and other security therefor, as well as all
merchandise returned to or reclaimed by Borrower and Borrower's Books relating
to any of the foregoing.

"Advance" or "Advances" means a cash advance under
the Revolving Facility.

"Affiliate" means, with respect to any Person, any
Person that owns or controls directly or indirectly such Person, any Person
that controls or is controlled by or is under common control with such Person,
and each of such Person's senior executive officers, directors and partners.

"Bank Expenses" means all: reasonable costs or
expenses (including reasonable attorneys' fees and expenses) incurred in
connection with the preparation, negotiation, administration, and enforcement
of the Loan Documents; and Bank's reasonable attorneys' fees and expenses
incurred in amending, enforcing or defending the Loan Documents, whether or not
suit is brought.

"Borrower's Books" means all of Borrower's books and
records including: ledgers; records concerning Borrower's assets or
liabilities, the Collateral, business operations or financial condition; and
all computer programs, or tape files, and the equipment, containing such
information.

"Borrowing Base" means an amount equal to
seventy-five percent (75%) of Eligible Accounts.

"Business Day" means any day that is not a Saturday,
Sunday, or other day on which banks in the State of California are authorized
or required to close.

"Closing Date" means the date of this Agreement.

"Code" means the California Uniform Commercial Code.

"Collateral" means the property described on EXHIBIT
A attached hereto.

<PAGE>

"Contingent Obligation" means, as applied to any
Person, any direct or indirect liability, contingent or otherwise, of that
Person with respect to (i) any indebtedness, lease, dividend, letter of credit
or other obligation of another, including, without limitation, any such
obligation directly or indirectly guaranteed, endorsed, co-made or discounted
or sold with recourse by that Person, or in respect of which that Person is
otherwise directly or indirectly liable; (ii) any obligations with respect to
undrawn letters of credit issued for the account of that Person; and (iii) all
obligations arising under any interest rate, currency or commodity swap
agreement, interest rate cap agreement, interest rate collar agreement, or
other agreement or arrangement designated to protect a Person against
fluctuation in interest rates, currency exchange rates or commodity prices;
provided, however, that the term "Contingent Obligation" shall not include
endorsements for collection or deposit in the ordinary course of business. The
amount of any Contingent Obligation shall be deemed to be an amount equal to
the stated or determined amount of the primary obligation in respect of which
such Contingent Obligation is made or, if not stated or determinable, the
maximum reasonably anticipated liability in respect thereof as determined by
such Person in good faith; provided, however, that such amount shall not in any
event exceed the maximum amount of the obligations under the guarantee or other
support arrangement.

"Copyrights" means any and all copyright rights,
copyright applications, copyright registrations and like protections in each
work or authorship and derivative work thereof, whether published or
unpublished and whether or not the same also constitutes a trade secret, now or
hereafter existing, created, acquired or held.

"Current Liabilities" means, as of any applicable
date, all amounts that should, in accordance with GAAP, be included as current
liabilities on the consolidated balance sheet of Borrower and its Subsidiaries,
as at such date, plus, to the extent not already included therein, all
outstanding Advances made under this Agreement, including all Indebtedness that
is payable upon demand or within one year from the date of determination
thereof unless such Indebtedness is renewable or extendible at the option of
Borrower or any Subsidiary to a date more than one year from the date of
determination.

"Daily Balance" means the amount of the Obligations
owed at the end of a given day.

"Eligible Accounts" means those Accounts that arise
in the ordinary course of Borrower's business that comply with all of
Borrower's representations and warranties to Bank set forth in Section 5.4;
PROVIDED, that standards of eligibility may be fixed and revised from time to
time by Bank in Bank's reasonable judgment and upon notification thereof to
Borrower in accordance with the provisions hereof. Unless otherwise agreed to
by Bank, Eligible Accounts shall not include the following:

(i) Accounts that the account debtor has
failed to pay within ninety (90) days of invoice date;

(ii) Accounts with respect to an account
debtor, fifty percent (50%) of whose Accounts the account debtor has failed to
pay within ninety (90) days of invoice date;

(iii) Accounts with respect to which the
account debtor is an officer, employee, or agent of Borrower;

(iv) Accounts with respect to which goods
are placed on consignment, guaranteed sale, sale or return, sale on approval,
bill and hold, or other terms by reason of which the payment by the account
debtor may be conditional;

(v) Accounts with respect to which the
account debtor is an Affiliate of Borrower;

(vi) Accounts with respect to which the
account debtor does not have its principal place of business in the United
States, except for Eligible Foreign Accounts;

<PAGE>

(vii) Accounts with respect to which the
account debtor is the United States or any department, agency, or
instrumentality of the United States, unless properly documented under the
Assignment of Claims Act;

(viii) Accounts with respect to which
Borrower is liable to the account debtor for goods sold or services rendered by
the account debtor to Borrower, but only to the extent of any amounts owing to
the account debtor against amounts owed to Borrower;

(ix) Accounts with respect to an account
debtor, including Subsidiaries and Affiliates, whose total obligations to
Borrower exceed twenty-five percent (25%) of all Accounts, except if the
account debtor is LG Electronics, Samsung America, Dpix or National
Semiconductor, the maximum percentage for such Accounts shall be fifty percent
(50%), or such other account debtors that Bank may approve in writing increased
concentration allowances on a case by case basis;

(x) Accounts with respect to which the
account debtor disputes liability or makes any claim with respect thereto as to
which Bank believes, in its sole discretion, that there may be a basis for
dispute (but only to the extent of the amount subject to such dispute or
claim), or is subject to any Insolvency Proceeding, or becomes insolvent, or
goes out of business; and

(xi) Accounts the collection of which
Bank reasonably determines to be doubtful.

"Eligible Foreign Accounts" means Accounts with
respect to which the account debtor does not have its principal place of
business in the United States and that are: (1) covered by credit insurance in
form and amount, and by an insurer satisfactory to Bank less the amount of any
deductible(s) which may be or become owing thereon; or (2) supported by one or
more letters of credit in favor of Bank as beneficiary, in an amount and of a
tenor, and issued by a financial institution, acceptable to Bank; or (3) that
Bank approves on a case-by-case basis.

"ERISA" means the Employee Retirement Income
Security Act of 1974, as amended, and the regulations thereunder.

"Exim Loan Documents" means that certain Loan and
Security Agreement by and between Borrower and Bank of even date herewith
guaranteed by the Export Import Bank and any other agreement entered into by
Borrower and Bank in connection therewith.

"GAAP" means generally accepted accounting
principles as in effect from time to time.

"Indebtedness" means (a) all indebtedness for
borrowed money or the deferred purchase price of property or services,
including without limitation reimbursement and other obligations with respect
to surety bonds and letters of credit, (b) all obligations evidenced by notes,
bonds, debentures or similar instruments, (c) all capital lease obligations and
(d) all Contingent Obligations.

"Insolvency Proceeding" means any proceeding
commenced by or against any person or entity under any provision of the United
States Bankruptcy Code, as amended, or under any other bankruptcy or insolvency
law, including assignments for the benefit of creditors, formal or informal
moratoria, compositions, extension generally with its creditors, or proceedings
seeking reorganization, arrangement, or other relief.

"Intellectual Property Collateral" means any and all
right, title and interest of Borrower in the following:

(a) Copyrights, Trademarks and Patents;

<PAGE>

(b) Any and all trade secrets, and any and all
intellectual property rights in computer software and computer software
products now or hereafter existing, created, acquired or held;

(d) Any and all claims for damages by way of
past, present and future infringement of any of the rights included above, with
the right, but not the obligation, to sue for and collect such damages for said
use or infringement of the intellectual property rights identified above;

(e) All licenses or other rights to use any of
the Copyrights, Patents or Trademarks, and all license fees and royalties
arising from such use to the extent permitted by such license or rights;

(f) All amendments, renewals and extensions of
any of the Copyrights, Trademarks or Patents; and

(g) All proceeds and products of the foregoing,
including without limitation all payments under insurance or any indemnity or
warranty payable in respect of any of the foregoing.

"Inventory" means all present and future inventory
in which Borrower has any interest, including merchandise, raw materials,
parts, supplies, packing and shipping materials, work in process and finished
products intended for sale or lease or to be furnished under a contract of
service, of every kind and description now or at any time hereafter owned by or
in the custody or possession, actual or constructive, of Borrower, including
such inventory as is temporarily out of its custody or possession or in transit
and including any returns upon any accounts or other proceeds, including
insurance proceeds, resulting from the sale or disposition of any of the
foregoing and any documents of title representing any of the above, and
Borrower's Books relating to any of the foregoing.

"Investment" means any beneficial ownership of
(including stock, partnership interest or other securities) any Person, or any
loan, advance or capital contribution to any Person.

"IRC" means the Internal Revenue Code of 1986, as
amended, and the regulations thereunder.

"Lien" means any mortgage, lien, deed of trust,
charge, pledge, security interest or other encumbrance.

"Loan Documents" means, collectively, this
Agreement, any note or notes executed by Borrower, and any other agreement
entered into between Borrower and Bank in connection with this Agreement, all
as amended or extended from time to time.

"Material Adverse Effect" means a material adverse
effect on (i) the business operations or condition (financial or otherwise) of
Borrower and its Subsidiaries taken as a whole or (ii) the ability of Borrower
to repay the Obligations or otherwise perform its obligations under the Loan
Documents.

"Maturity Date" means the date immediately preceding
the first (1st) anniversary of the Closing Date.

"Negotiable Collateral" means all of Borrower's
present and future letters of credit of which it is a beneficiary, notes,
drafts, instruments, securities, documents of title, and chattel paper, and
Borrower's Books relating to any of the foregoing.

<PAGE>

"New Equity" means the receipt of equity by Borrower
subsequent to the Closing Date in the form of cash proceeds from the sale of
its capital stock or Subordinated Debt, other than in a nonfinancing
transaction to employees, officers, directors and consultants of Borrower.

"Obligations" means all debt, principal, interest,
Bank Expenses and other amounts owed to Bank by Borrower pursuant to this
Agreement or any other agreement, whether absolute or contingent, due or to
become due, now existing or hereafter arising, including any interest that
accrues after the commencement of an Insolvency Proceeding and including any
debt, liability, or obligation owing from Borrower to others that Bank may have
obtained by assignment or otherwise.

"Patents" means all patents, patent applications and
like protections including without limitation improvements, divisions,
continuations, renewals, reissues, extensions and continuations-in-part of the
same.

"Payment Date" means the tenth (10th) calendar day
of the month.

"Periodic Payments" means all installments or
similar recurring payments that Borrower may now or hereafter become obligated
to pay to Bank pursuant to the terms and provisions of any instrument, or
agreement now or hereafter in existence between Borrower and Bank.

"Permitted Indebtedness" means:

(a) Indebtedness of Borrower in favor of Bank
arising under this Agreement or any other Loan Document;

(b) Indebtedness existing on the date of this
Agreement and disclosed in the Schedule;

(d) Subordinated Debt.

"Permitted Investment" means:

(a) Investments existing on the Date of this
Agreement disclosed in the Schedule; and

(b) (i) marketable direct obligations issued or
unconditionally guaranteed by the United States of America or any agency or any
State thereof maturing within one (1) year from the date of acquisition
thereof, (ii) commercial paper maturing no more than one (1) year from the date
of creation thereof and currently having the highest rating obtainable from
either Standard & Poor's Corporation or Moody's Investors Service, Inc., and
(iii) certificates of deposit maturing no more than one (1) year from the date
of investment therein issued by Bank.

"Permitted Liens" means the following:

(a) Any Liens existing on the date of this
Agreement and disclosed in the Schedule or arising under this Agreement or the
other Loan Documents;

(b) Liens for taxes, fees, assessments or other
governmental charges or levies, either not delinquent or being contested in
good faith by appropriate proceedings, PROVIDED the same have no priority over
any of Bank's security interests;

<PAGE>

(c) Liens (i) upon or in any equipment acquired
or held by Borrower or any of its Subsidiaries to secure the purchase price of
such equipment or indebtedness incurred solely for the purpose of financing the
acquisition of such equipment, or (ii) existing on such equipment at the time
of its acquisition, PROVIDED that the Lien is confined solely to the property
so acquired and improvements thereon, and the proceeds of such equipment; and

(d) Liens incurred in connection with the
extension, renewal or refinancing of the indebtedness secured by Liens of the
type described in clauses (a) and (c) above, PROVIDED that any extension,
renewal or replacement Lien shall be limited to the property encumbered by the
existing Lien and the principal amount of the indebtedness being extended,
renewed or refinanced does not increase.

"Person" means any individual, sole proprietorship,
partnership, limited liability company, joint venture, trust, unincorporated
organization, association, corporation, institution, public benefit
corporation, firm, joint stock company, estate, entity or governmental agency.

"Prime Rate" means the variable rate of interest,
per annum, most recently announced by Bank, as its "prime rate," whether or not
such announced rate is the lowest rate available from Bank.

"Quick Assets" means, at any date as of which the
amount thereof shall be determined, the unrestricted cash and cash-equivalents;
net, billed accounts receivable; and investments with maturities not to exceed
one year, of Borrower determined in accordance with GAAP.

"Responsible Officer" means each of the Chief
Executive Officer and the Chief Financial Officer of Borrower.

"Revolving Advance" means a cash advance or cash
advances under the Revolving Facility.

"Revolving Committed Line" means One Million Dollars
($1,000,000).

"Revolving Facility" means the facility under which
Borrower may request Bank to issue cash advances, as specified in Section 2.1
hereof.

"Schedule" means the schedule of exceptions attached
hereto, if any.

"Subordinated Debt" means any debt incurred by
Borrower that is subordinated to the debt owing by Borrower to Bank on terms
acceptable to Bank (and identified as being such by Borrower and Bank).

"Subsidiary" means any corporation or partnership in
which (i) any general partnership interest or (ii) more than 50% of the stock
of which by the terms thereof ordinary voting power to elect the Board of
Directors, managers or trustees of the entity shall, at the time as of which
any determination is being made, be owned by Borrower, either directly or
through an Affiliate.

"Tangible Net Worth" means at any date as of which
the amount thereof shall be determined, the consolidated total assets of
Borrower and its Subsidiaries MINUS, without duplication, (i) the sum of any
amounts attributable to (a) goodwill, (b) intangible items such as unamortized
debt discount and expense, patents, trade and service marks and names,
copyrights and research and development expenses except prepaid expenses, and
(c) all reserves not already deducted from assets, AND (ii) Total Liabilities.

"Total Liabilities" means at any date as of which
the amount thereof shall be determined, all obligations that should, in
accordance with GAAP be classified as liabilities on the consolidated balance
sheet of Borrower, including in any event all Indebtedness.

<PAGE>

"Trademarks" means any trademark and servicemark
rights, whether registered or not, applications to register and registrations
of the same and like protections, and the entire goodwill of the business of
Borrower connected with and symbolized by such trademarks.

1.2 ACCOUNTING TERMS. All accounting terms not
specifically defined herein shall be construed in accordance with GAAP and all
calculations made hereunder shall be made in accordance with GAAP. When used
herein, the terms "financial statements" shall include the notes and schedules
thereto.

2. LOAN AND TERMS OF PAYMENT

2.1 ADVANCES.

(a) REVOLVING LOAN. Subject to and upon the
terms and conditions of this Agreement, Bank agrees to make Advances to
Borrower under the Revolving Facility in an aggregate amount not to exceed the
lesser of the Revolving Committed Line or the Borrowing Base. Subject to the
terms and conditions of this Agreement, amounts borrowed pursuant to this
Section 2.1 may be repaid and reborrowed at any time prior to the Maturity
Date. The Revolving Facility shall terminate on the Maturity Date, at which
time all Revolving Advances under this Section 2.1 shall be immediately due and
payable.

(b) Interest shall accrue on the outstanding
Advances from the date of each Advance, at the rate specified in Section
2.3(a), and shall be payable monthly on the Payment Date of each month through
the Maturity Date, on which date the Advances and any accrued and unpaid
interest and other unpaid charges shall be payable.

(c) When Borrower desires an Advance, Borrower
will notify Bank by facsimile transmission or telephone no later than 2:00 p.m.
California time, on the Business Day that such Advance is to be made. Such
notification shall be promptly confirmed by a Payment/Advance Form in
substantially the form of EXHIBIT B hereto. Bank shall be entitled to rely on
any telephonic notice given by a person who Bank reasonably believes to be a
Responsible Officer, and Borrower shall indemnify and hold Bank harmless for
any damages or loss suffered by Bank as a result of such reliance. Bank will
credit the amount of the Advance to Borrower's deposit account.

2.2 OVERADVANCES. If, at any time, or for any reason,
the amount of Obligations owed by Borrower to Bank pursuant to Section 2.1 of
this Agreement is greater than the lesser of (i) the Committed Line or (ii) the
Borrowing Base, Borrower shall immediately pay to Bank, in cash, the amount of
such excess.

2.3 INTEREST RATES, PAYMENTS, AND CALCULATIONS.

(a) INTEREST RATE. Except as set forth in
Section 2.3(b), Advances shall bear interest, on the average Daily Balance
thereof, at a rate equal to one and one-quarter (1.25) percentage points above
the Prime Rate. Notwithstanding the foregoing, at such time as Borrower
achieves two (2) consecutive quarters of profitability as set forth in Section
6.10 herein, any Advances under this Agreement shall bear interest, on the
average Daily Balance thereof, at a rate equal to seventy five hundredths of
one (0.75) percentage point above the Prime Rate.

(b) DEFAULT RATE. All Obligations shall bear
interest, from and after the occurrence of an Event of Default, at a rate equal
to five (5) percentage points above the interest rate applicable immediately
prior to the occurrence of the Event of Default.

(c) PAYMENTS. Interest hereunder shall be due
and payable on the Payment Date of each month during the term hereof. Bank
shall, at its option, charge such interest, all Bank Expenses, and all Periodic
Payments against any of Borrower's deposit accounts or against the Revolving
Committed Line, in which case those amounts shall thereafter accrue interest at
the rate then applicable hereunder. Any interest not paid when

<PAGE>

due shall be compounded by becoming a part of the Obligations, and such
interest shall thereafter accrue interest at the rate then applicable hereunder.

(d) COMPUTATION. In the event the Prime Rate is
changed from time to time hereafter, the applicable rate of interest hereunder
shall be increased or decreased effective as of 12:01 a.m. on the day the Prime
Rate is changed, by an amount equal to such change in the Prime Rate. All
interest chargeable under the Loan Documents shall be computed on the basis of
a three hundred sixty (360) day year for the actual number of days elapsed.

2.4 CREDITING PAYMENTS. Prior to the occurrence of an
Event of Default, Bank shall credit a wire transfer of funds, check or other
item of payment to such deposit account or Obligation as Borrower specifies.
After the occurrence of an Event of Default, the receipt by Bank of any wire
transfer of funds, check, or other item of payment shall be immediately applied
to conditionally reduce Obligations, but shall not be considered a payment on
account unless such payment is of immediately available federal funds or unless
and until such check or other item of payment is honored when presented for
payment. Notwithstanding anything to the contrary contained herein, any wire
transfer or payment received by Bank after 12:00 noon California time shall be
deemed to have been received by Bank as of the opening of business on the
immediately following Business Day. Whenever any payment to Bank under the Loan
Documents would otherwise be due (except by reason of acceleration) on a date
that is not a Business Day, such payment shall instead be due on the next
Business Day, and additional fees or interest, as the case may be, shall accrue
and be payable for the period of such extension.

2.5 FEES. Borrower shall pay to Bank the following:

(a) FACILITY FEE. A facility fee equal to Five
Thousand Dollars ($5,000) which fee shall be due on the Closing Date and shall
be fully earned and nonrefundable;

(b) FINANCIAL EXAMINATION AND APPRAISAL FEES.
Bank's customary fees and out-of-pocket expenses for Bank's audits of
Borrower's Accounts, and for each financial analysis and examination of
Borrower performed from time to time by Bank or its agents provided that
Borrower's responsibility for Bank's audits shall be limited to Five Hundred
Dollars ($500) per occurrence; and

(c) BANK EXPENSES. Upon the date hereof, all
Bank Expenses incurred through the Closing Date, including reasonable
attorneys' fees and expenses, which in any event shall not exceed Five Thousand
Dollars ($5,000) in the aggregate for Bank Expenses and Exim Bank Expenses (as
defined in the Exim Loan Documents) incurred prior to the Closing Date, and,
after the date hereof, all Bank Expenses, including reasonable attorneys' fees
and expenses, as and when they become due.

2.6 ADDITIONAL COSTS. In case any change in any law,
regulation, treaty or official directive or the interpretation or application
thereof by any court or any governmental authority charged with the
administration thereof or the compliance with any guideline or request of any
central bank or other governmental authority (whether or not having the force
of law), in each case after the date of this Agreement:

(a) subjects Bank to any tax with respect to
payments of principal or interest or any other amounts payable hereunder by
Borrower or otherwise with respect to the transactions contemplated hereby
(except for taxes on the overall net income of Bank imposed by the United
States of America or any political subdivision thereof);

(b) imposes, modifies or deems applicable any
deposit insurance, reserve, special deposit or similar requirement against
assets held by, or deposits in or for the account of, or loans by, Bank; or

<PAGE>

and the result of any of the foregoing is to
increase the cost to Bank, reduce the income receivable by Bank or impose any
expense upon Bank with respect to any loans, Bank shall notify Borrower
thereof. Borrower agrees to pay to Bank the amount of such increase in cost,
reduction in income or additional expense as and when such cost, reduction or
expense is incurred or determined, upon presentation by Bank of a statement of
the amount and setting forth Bank's calculation thereof, all in reasonable
detail which statement shall be deemed true and correct absent manifest error.

(d) TERM. This Agreement shall become effective
on the Closing Date and, subject to Section 12.7, shall continue in full force
and effect for a term ending on the Maturity Date. Notwithstanding the
foregoing, Bank shall have the right to terminate its obligation to make any
Advances under this Agreement immediately and without notice upon the
occurrence and during the continuance of an Event of Default. Notwithstanding
termination, Bank's Lien on the Collateral shall remain in effect for so long
as any Obligations are outstanding.

3. CONDITIONS OF LOANS

3.1 CONDITIONS PRECEDENT TO INITIAL ADVANCE. The
obligation of Bank to make the initial Advance is subject to the condition
precedent that Bank shall have received, in form and substance satisfactory to
Bank, the following:

(a) this Agreement;

(b) a certificate of the Secretary of Borrower
with respect to incumbency and resolutions authorizing the execution and
delivery of this Agreement;

(d) accounts receivable audit with results
satisfactory to Bank;

(e) financing statement (Forms UCC-1);

(f) insurance certificate;

(g) payment of the fees and Bank Expenses then
due specified in Section 2.5 hereof;

(h) timely receipt of the Payment/Advance Form
as provided in Section 2.1; and

(i) such other documents, and completion of
such other matters, as Bank may reasonably deem necessary or appropriate.

3.2 CONDITIONS PRECEDENT TO ADDITIONAL ADVANCES.
CONDITIONS PRECEDENT TO ALL ADVANCES. The obligation of Bank to make each
Advance, including the initial Advance, is further subject to the following
conditions:

(a) timely receipt by Bank of the
Payment/Advance Form as provided in Section 2.1; and

(b) the representations and warranties
contained in Section 5 shall be true and correct in all material respects on
and as of the date of such Payment/Advance Form and on the effective date of
each Advance as though made at and as of each such date, and no Event of
Default shall have occurred and be continuing, or would result from such
Advance. Except as otherwise disclosed to Bank in writing, and approved by
Bank, the making of each Advance shall be deemed to be a representation and
warranty by Borrower on the date of such Advance as to the accuracy of the
facts referred to in this Section 3.2(b).

<PAGE>

4. CREATION OF SECURITY INTEREST

4.1 GRANT OF SECURITY INTEREST. Borrower grants and
pledges to Bank a continuing security interest in all presently existing and
hereafter acquired or arising Collateral in order to secure prompt repayment of
any and all Obligations and in order to secure prompt performance by Borrower
of each of its covenants and duties under the Loan Documents. Except as set
forth in the Schedule, such security interest constitutes a valid, first
priority security interest in the presently existing Collateral, and will
constitute a valid, first priority security interest in Collateral acquired
after the date hereof.

4.2 DELIVERY OF ADDITIONAL DOCUMENTATION REQUIRED.
Borrower shall from time to time execute and deliver to Bank, at the request of
Bank, all Negotiable Collateral, all financing statements and other documents
that Bank may reasonably request, in form satisfactory to Bank, to perfect and
continue perfected Bank's security interests in the Collateral and in order to
fully consummate all of the transactions contemplated under the Loan Documents.

4.3 RIGHT TO INSPECT. Bank (through any of its officers,
employees, or agents) shall have the right, upon reasonable prior notice, from
time to time during Borrower's usual business hours, to inspect Borrower's
Books and to make copies thereof and to check, test, and appraise the
Collateral in order to verify Borrower's financial condition or the amount,
condition of, or any other matter relating to, the Collateral.

5. REPRESENTATIONS AND WARRANTIES

Borrower represents and warrants as follows:

5.1 DUE ORGANIZATION AND QUALIFICATION. Borrower and
each Subsidiary is a corporation duly existing and in good standing under the
laws of its state of incorporation and qualified and licensed to do business
in, and is in good standing in, any state in which the conduct of its business
or its ownership of property requires that it be so qualified.

5.2 DUE AUTHORIZATION; NO CONFLICT. The execution,
delivery, and performance of the Loan Documents are within Borrower's powers,
have been duly authorized, and are not in conflict with nor constitute a breach
of any provision contained in Borrower's Articles of Incorporation or Bylaws,
nor will they constitute an event of default under any material agreement to
which Borrower is a party or by which Borrower is bound except to the extent
that certain intellectual property agreements prohibit the assignment of the
rights thereunder to a third party without the Borrower's or other party's
consent and the Loan Documents constitute an assignment. Borrower is not in
default under any agreement to which it is a party or by which it is bound,
which default could have a Material Adverse Effect.

5.3 NO PRIOR ENCUMBRANCES. Borrower has good and
indefeasible title to the Collateral, free and clear of Liens, except for
Permitted Liens.

5.4 BONA FIDE ELIGIBLE ACCOUNTS. The Eligible Accounts
are bona fide existing obligations. The property giving rise to such Eligible
Accounts has been delivered to the account debtor or to the account debtor's
agent for immediate shipment to and unconditional acceptance by the account
debtor. Borrower has not received notice of actual or imminent Insolvency
Proceeding of any account debtor.

5.5 MERCHANTABLE INVENTORY. All Inventory is in all
material respects of good and marketable quality, free from all material
defects.

5.6 INTELLECTUAL PROPERTY. Borrower is the sole owner of
the Intellectual Property Collateral, except for non-exclusive licenses granted
by Borrower to its customers in the ordinary course of business. To the best of
Borrower's knowledge, each of the Patents is valid and enforceable, and no part
of the Intellectual Property Collateral has been judged invalid or
unenforceable, in whole or in part, and no claim has been made that any part of
the Intellectual Property Collateral violates the rights of any third party.
Except for and upon the filing with the

<PAGE>

United States Patent and Trademark Office with respect to the Patents and
Trademarks and the Register of Copyrights with respect to the Copyrights
necessary to perfect the security interests created hereunder, and except as
has been already made or obtained, no authorization, approval or other action
by, and no notice to or filing with, any United States governmental authority
or United States regulatory body is required either (i) for the grant by
Borrower of the security interest granted hereby or for the execution, delivery
or performance of Loan Documents by Borrower in the United States or (ii) for
the perfection in the United States or the exercise by Bank of its rights and
remedies hereunder.

5.7 NAME; LOCATION OF CHIEF EXECUTIVE OFFICE. Except as
disclosed in the Schedule, Borrower has not done business under any name other
than that specified on the signature page hereof. The chief executive office of
Borrower is located at the address indicated in Section 10 hereof.

5.8 LITIGATION. Except as set forth in the Schedule,
there are no actions or proceedings pending by or against Borrower or any
Subsidiary before any court or administrative agency in which an adverse
decision could have a Material Adverse Effect or a material adverse effect on
Borrower's interest or Bank's security interest in the Collateral. Borrower
does not have knowledge of any such pending or threatened actions or
proceedings.

5.9 NO MATERIAL ADVERSE CHANGE IN FINANCIAL STATEMENTS.
All consolidated financial statements related to Borrower and any Subsidiary
that have been delivered by Borrower to Bank fairly present in all material
respects Borrower's consolidated financial condition as of the date thereof and
Borrower's consolidated results of operations for the period then ended. There
has not been a material adverse change in the consolidated financial condition
of Borrower since the date of the most recent of such financial statements
submitted to Bank.

5.10 SOLVENCY. The fair saleable value of Borrower's
assets (including goodwill minus disposition costs) exceeds the fair value of
its liabilities; Borrower is not left with unreasonably small capital after the
transactions contemplated by this Agreement; and Borrower is able to pay its
debts (including trade debts) as they mature.

5.11 REGULATORY COMPLIANCE. Borrower and each Subsidiary
has met the minimum funding requirements of ERISA with respect to any employee
benefit plans subject to ERISA. No event has occurred resulting from Borrower's
failure to comply with ERISA that is reasonably likely to result in Borrower's
incurring any liability that could have a Material Adverse Effect. Borrower is
not an "investment company" or a company "controlled" by an "investment
company" within the meaning of the Investment Company Act of 1940. Borrower is
not engaged principally, or as one of the important activities, in the business
of extending credit for the purpose of purchasing or carrying margin stock
(within the meaning of Regulations T and U of the Board of Governors of the
Federal Reserve System). Borrower has complied with all the provisions of the
Federal Fair Labor Standards Act. Borrower has not violated any statutes, laws,
ordinances or rules applicable to it, violation of which could have a Material
Adverse Effect.

5.12 ENVIRONMENTAL CONDITION. None of Borrower's or any
Subsidiary's properties or assets has ever been used by Borrower or any
Subsidiary or, to the best of Borrower's knowledge, by previous owners or
operators, in the disposal of, or to produce, store, handle, treat, release, or
transport, any hazardous waste or hazardous substance other than in accordance
with applicable law; to the best of Borrower's knowledge, none of Borrower's
properties or assets has ever been designated or identified in any manner
pursuant to any environmental protection statute as a hazardous waste or
hazardous substance disposal site, or a candidate for closure pursuant to any
environmental protection statute; no lien arising under any environmental
protection statute has attached to any revenues or to any real or personal
property owned by Borrower or any Subsidiary; and neither Borrower nor any
Subsidiary has received a summons, citation, notice, or directive from the
Environmental Protection Agency or any other federal, state or other
governmental agency concerning any action or omission by Borrower or any
Subsidiary resulting in the releasing, or otherwise disposing of hazardous
waste or hazardous substances into the environment.

5.13 TAXES. Borrower and each Subsidiary has filed or
caused to be filed all tax returns required to be filed, and has paid, or has
made adequate provision for the payment of, all taxes reflected therein.

<PAGE>

5.14 SUBSIDIARIES. Borrower does not own any stock,
partnership interest or other equity securities of any Person, except for
Permitted Investments.

5.15 GOVERNMENT CONSENTS. Borrower and each Subsidiary
has obtained all consents, approvals and authorizations of, made all
declarations or filings with, and given all notices to, all governmental
authorities that are necessary for the continued operation of Borrower's
business as currently conducted.

5.16 FULL DISCLOSURE. No representation, warranty or
other statement made by Borrower in any certificate or written statement
furnished to Bank contains any untrue statement of a material fact or omits to
state a material fact necessary in order to make the statements contained in
such certificates or statements not misleading.

6. AFFIRMATIVE COVENANTS

Borrower covenants and agrees that, until payment in full of
all outstanding Obligations, and for so long as Bank may have any commitment to
make an Advance hereunder, Borrower shall do all of the following:

6.1 GOOD STANDING. Borrower shall maintain its and each
of its Subsidiaries' corporate existence and good standing in its jurisdiction
of incorporation and maintain qualification in each jurisdiction in which the
failure to so qualify could have a Material Adverse Effect. Borrower shall
maintain, and shall cause each of its Subsidiaries to maintain, to the extent
consistent with prudent management of Borrower's business, in force all
licenses, approvals and agreements, the loss of which could have a Material
Adverse Effect.

6.2 GOVERNMENT COMPLIANCE. Borrower shall meet, and
shall cause each Subsidiary to meet, the minimum funding requirements of ERISA
with respect to any employee benefit plans subject to ERISA. Borrower shall
comply, and shall cause each Subsidiary to comply, with all statutes, laws,
ordinances and government rules and regulations to which it is subject,
noncompliance with which could have a Material Adverse Effect or a material
adverse effect on the Collateral or the priority of Bank's Lien on the
Collateral.

6.3 FINANCIAL STATEMENTS, REPORTS, CERTIFICATES.
Borrower shall deliver to Bank: (a) as soon as available, but in any event
within twenty (20) days after the end of each fiscal quarter, a company
prepared consolidating balance sheet and income statement covering Borrower's
operations during such period, certified by a Responsible Officer; (b) as
soon as available, but in any event within one hundred twenty (120) days
after the end of Borrower's fiscal year, audited consolidated financial
statements of Borrower prepared in accordance with GAAP, consistently
applied, together with an unqualified opinion on such financial statements of
an independent certified public accounting firm reasonably acceptable to Bank
and any accompanying management reports; (c) within five (5) days upon
becoming available, copies of all statements, reports and notices sent or
made available generally by Borrower to its security holders or to any
holders of Subordinated Debt and all reports on Form 10-K and 10-Q filed with
the Securities and Exchange Commission; (d) promptly upon receipt of notice
thereof, a report of any legal actions pending or threatened against Borrower
or any Subsidiary that could result in damages or costs to Borrower or any
Subsidiary of Two Hundred Fifty Thousand Dollars ($250,000) or more; and (e)
such budgets, sales projections, operating plans or other financial
information as Bank may reasonably request from time to time.

Within twenty (20) days after the last day of each
month, Borrower shall deliver to Bank a Borrowing Base Certificate signed by a
Responsible Officer in substantially the form of EXHIBIT D hereto, together
with aged listings of accounts receivable and accounts payable.

Borrower shall deliver to Bank with the quarterly
financial statements a Compliance Certificate signed by a Responsible Officer
in substantially the form of EXHIBIT E hereto, together with a backlog report.

Bank shall have a right from time to time hereafter
to audit Borrower's Accounts at Borrower's expense, which in no event shall
exceed Five Hundred Dollars ($500.00) per occurrence.

<PAGE>

6.4 INVENTORY; RETURNS. Borrower shall keep all
Inventory in good and marketable condition, free from all material defects.
Returns and allowances, if any, as between Borrower and its account debtors
shall be on the same basis and in accordance with the usual customary practices
of Borrower, as they exist at the time of the execution and delivery of this
Agreement. Borrower shall promptly notify Bank of all returns and recoveries
and of all disputes and claims, where the return, recovery, dispute or claim
involves more than Two Hundred Fifty Thousand Dollars ($250,000).

6.5 TAXES. Borrower shall make, and shall cause each
Subsidiary to make, due and timely payment or deposit of all material federal,
state, and local taxes, assessments, or contributions required of it by law,
and will execute and deliver to Bank, on demand, appropriate certificates
attesting to the payment or deposit thereof; and Borrower will make, and will
cause each Subsidiary to make, timely payment or deposit of all material tax
payments and withholding taxes required of it by applicable laws, including,
but not limited to, those laws concerning F.I.C.A., F.U.T.A., state disability,
and local, state, and federal income taxes, and will, upon request, furnish
Bank with proof satisfactory to Bank indicating that Borrower or a Subsidiary
has made such payments or deposits; provided that Borrower or a Subsidiary need
not make any payment if the amount or validity of such payment is contested in
good faith by appropriate proceedings and is reserved against (to the extent
required by GAAP) by Borrower.

6.6 INSURANCE.

(a) Borrower, at its expense, shall keep the
Collateral insured against loss or damage by fire, theft, explosion,
sprinklers, and all other hazards and risks, and in such amounts, as ordinarily
insured against by other owners in similar businesses conducted in the
locations where Borrower's business is conducted on the date hereof. Borrower
shall also maintain insurance relating to Borrower's ownership and use of the
Collateral in amounts and of a type that are customary to businesses similar to
Borrower's.

(b) All such policies of insurance shall be in
such form, with such companies and in such amounts as reasonably satisfactory
to Bank. All such policies of property insurance shall contain a lender's loss
payable endorsement, in a form satisfactory to Bank, showing Bank as an
additional loss payee thereof and all liability insurance policies shall show
the Bank as an additional insured, and shall specify that the insurer must give
at least twenty (20) days notice to Bank before canceling its policy for any
reason. Upon Bank's request, Borrower shall deliver to Bank certified copies of
such policies of insurance and evidence of the payments of all premiums
therefor. All proceeds payable under any such policy shall, at the option of
Bank, be payable to Bank for application to the Obligations.

6.7 PRINCIPAL DEPOSITORY. Borrower shall maintain its
principal depository and operating accounts with Bank on or before June 30,
1999.

6.8 QUICK RATIO. Borrower shall maintain, as of the last
day of each fiscal quarter, a ratio of Quick Assets to Current Liabilities of
at least 1.75 to 1.0.

6.9 DEBT-NET WORTH RATIO. Borrower shall maintain, as of
the last day of each fiscal quarter, a ratio of Total Liabilities less
Subordinated Debt to Tangible Net Worth plus Subordinated Debt of not more than
0.5 to 1.0.

6.10 PROFITABILITY. Borrower shall have a net profit as
of the last day of each fiscal quarter, and as of the last day of each fiscal
year; provided, however, that Borrower may incur a loss of up to Seven Hundred
Fifty Thousand Dollars ($750,000) for the fiscal quarter ending March 31, 1999.

6.11 TANGIBLE NET WORTH. Borrower shall maintain, as of
the last day of each fiscal quarter, a Tangible Net Worth of at least
$14,250,000, PLUS seventy-five percent (75%) of quarterly net profits, New
Equity and Subordinated Debt.

6.12 REGISTRATION OF INTELLECTUAL PROPERTY RIGHTS.

<PAGE>

(a) Borrower shall register or cause to be
registered (to the extent not already registered) with the United States Patent
and Trademark Office or the United States Copyright Office, as applicable,
those intellectual property rights listed on Exhibits A, B and C to the
Intellectual Property Security Agreement delivered to Bank by Borrower in
connection with this Agreement within thirty (30) days of the date of this
Agreement. Borrower shall register or cause to be registered with the United
States Patent and Trademark Office or the United States Copyright Office, as
applicable, those additional intellectual property rights developed or acquired
by Borrower from time to time in connection with any product prior to the sale
or licensing of such product to any third party, including without limitation
revisions or additions to the intellectual property rights listed on such
Exhibits A, B and C.

(b) Borrower shall execute and deliver such
additional instruments and documents from time to time as Bank shall reasonably
request to perfect Bank's security interest in the Intellectual Property
Collateral.

(c) Borrower shall (i) protect, defend and
maintain the validity and enforceability of the Trademarks, Patents and
Copyrights listed on Exhibits A, B and C of the Intellectual Property Security
Agreement, (ii) detect infringements of the Trademarks, Patents and Copyrights
listed on such Exhibits A, B and C and promptly advise Bank in writing of
material infringements detected and (iii) not allow any Trademarks, Patents or
Copyrights listed on such Exhibits A, B and C to be abandoned, forfeited or
dedicated to the public without the written consent of Bank, which shall not be
unreasonably withheld, unless Bank determines that reasonable business
practices suggest that abandonment is appropriate.

(d) Bank shall have the right, but not the
obligation, to take, at Borrower's sole expense, any actions that Borrower is
required under this Section 6.12 to take but which Borrower fails to take,
after fifteen (15) days' notice to Borrower. Borrower shall reimburse and
indemnify Bank for all reasonable costs and reasonable expenses incurred in the
reasonable exercise of its rights under this Section 6.12.

6.13 FURTHER ASSURANCES. At any time and from time to
time Borrower shall execute and deliver such further instruments and take such
further action as may reasonably be requested by Bank to effect the purposes of
this Agreement.

7. NEGATIVE COVENANTS

Borrower covenants and agrees that, so long as any credit
hereunder shall be available and until payment in full of the outstanding
Obligations or for so long as Bank may have any commitment to make the Advance,
Borrower will not do any of the following:

7.1 DISPOSITIONS. Convey, sell, lease, transfer or
otherwise dispose of (collectively, a "Transfer"), or permit any of its
Subsidiaries to Transfer, all or any part of its business or property, other
than: (i) Transfers of Inventory in the ordinary course of business; (ii)
Transfers of exclusive licenses and similar arrangements for the use of the
property of Borrower or its Subsidiaries; (iii) Transfers of worn-out or
obsolete Equipment or new Equipment financed by other vendors; or (iv)
Transfers of Equipment not in excess of Five Hundred Thousand Dollars
($500,000) provided that such Transfers do not cause an Event of Default.

7.2 CHANGE IN BUSINESS. Engage in any business, or
permit any of its Subsidiaries to engage in any business, other than the
businesses currently engaged in by Borrower and any business substantially
similar or related thereto (or incidental thereto) or suffer a material change
in Borrower's ownership. Borrower will not, without thirty (30) days prior
written notification to Bank, relocate its chief executive office.

7.3 MERGERS OR ACQUISITIONS. Merge or consolidate, or
permit any of its Subsidiaries to merge or consolidate, with or into any other
business organization, or acquire, or permit any of its Subsidiaries to
acquire, all or substantially all of the capital stock or property of another
Person.

<PAGE>

7.4 INDEBTEDNESS. Create, incur, assume or be or remain
liable with respect to any Indebtedness, or permit any Subsidiary so to do,
other than Permitted Indebtedness.

7.5 ENCUMBRANCES. Create, incur, assume or suffer to
exist any Lien in excess of One Hundred Thousand Dollars ($100,000) with
respect to any of its property, or assign or otherwise convey any right to
receive income, including the sale of any Accounts, or permit any of its
Subsidiaries so to do, except for Permitted Liens.

7.6 DISTRIBUTIONS. Pay any dividends or make any other
distribution or payment on account of or in redemption, retirement or purchase
of any capital stock.

7.7 INVESTMENTS. Directly or indirectly acquire or own,
or make any Investment in or to any Person, or permit any of its Subsidiaries
so to do, other than Permitted Investments.

7.8 TRANSACTIONS WITH AFFILIATES. Directly or indirectly
enter into or permit to exist any material transaction with any Affiliate of
Borrower except for transactions that are in the ordinary course of Borrower's
business, upon fair and reasonable terms that are no less favorable to Borrower
than would be obtained in an arm's length transaction with a nonaffiliated
Person.

7.9 INTELLECTUAL PROPERTY AGREEMENTS. Borrower shall not
permit the inclusion in any material contract to which it becomes a party of
any provisions that could or might in any way prevent the creation of a
security interest in Borrower's rights and interests in any property included
within the definition of the Intellectual Property Collateral acquired under
such contracts.

7.10 SUBORDINATED DEBT. Make any payment in respect of
any Subordinated Debt, or permit any of its Subsidiaries to make any such
payment, except if such payment (a) is in compliance with the terms of such
Subordinated Debt, (b) not in excess of Two Hundred Fifty Thousand Dollars
($250,000), and (c) does not cause an Event of Default under this Agreement, or
amend any provision contained in any documentation relating to the Subordinated
Debt without Bank's prior written consent.

7.11 INVENTORY. Store the Inventory with a bailee,
warehouseman, or similar party unless Bank has received a pledge of the
warehouse receipt covering such Inventory. Except for Inventory sold or shipped
in the ordinary course of business and except for such other locations as Bank
may approve in writing, Borrower shall keep the Inventory only at the location
set forth in Section 10 hereof and such other locations of which Borrower gives
Bank prior written notice and as to which Borrower signs and files a financing
statement where needed to perfect Bank's security interest.

7.12 COMPLIANCE. Become an "investment company"
controlled by an "investment company," within the meaning of the Investment
Company Act of 1940, or become principally engaged in, or undertake as one of
its important activities, the business of extending credit for the purpose of
purchasing or carrying margin stock, or use the proceeds of any Advance for
such purpose. Fail to meet the minimum funding requirements of ERISA, permit a
Reportable Event or Prohibited Transaction, as defined in ERISA, to occur, fail
to comply with the Federal Fair Labor Standards Act or violate any law or
regulation, which violation could have a Material Adverse Effect or a material
adverse effect on the Collateral or the priority of Bank's Lien on the
Collateral, or permit any of its Subsidiaries to do any of the foregoing.

8. EVENTS OF DEFAULT

Any one or more of the following events shall constitute an
Event of Default by Borrower under this Agreement:

8.1 PAYMENT DEFAULT. If Borrower fails to pay the
principal of, or any interest on, the Advance when due and payable; or fails to
pay any portion of any other Obligations not constituting such principal

<PAGE>

or interest, including without limitation Bank Expenses, within thirty (30)
days of receipt by Borrower of an invoice for such other Obligations;

8.2 COVENANT DEFAULT. If Borrower fails to perform any
obligation under Section 6.7, 6.8, 6.9, 6.10 or 6.11 or violates any of the
covenants contained in Article 7 of this Agreement, or fails or neglects to
perform, keep, or observe any other material term, provision, condition,
covenant, or agreement contained in this Agreement, in any of the Loan
Documents, or in any other present or future agreement between Borrower and
Bank and as to any default under such other term, provision, condition,
covenant or agreement that can be cured, has failed to cure such default within
ten (10) days after Borrower receives notice thereof or any officer of Borrower
becomes aware thereof; provided, however, that if the default cannot by its
nature be cured within the ten (10) day period or cannot after diligent
attempts by Borrower be cured within such ten (10) day period, and such default
is likely to be cured within a reasonable time, then Borrower shall have an
additional reasonable period (which shall not in any case exceed thirty (30)
days) to attempt to cure such default, and within such reasonable time period
the failure to have cured such default shall not be deemed an Event of Default
(provided that no Advance will be required to be made during such cure period);

8.3 MATERIAL ADVERSE CHANGE. If there occurs a material
adverse change in Borrower's business or financial condition, or if there is a
material impairment of the prospect of repayment of any portion of the
Obligations or a material impairment of the value or priority of Bank's
security interests in the Collateral;

8.4 ATTACHMENT. If any material portion of Borrower's
assets is attached, seized, subjected to a writ or distress warrant, or is
levied upon, or comes into the possession of any trustee, receiver or person
acting in a similar capacity and such attachment, seizure, writ or distress
warrant or levy has not been removed, discharged or rescinded within ten (10)
days, or if Borrower is enjoined, restrained, or in any way prevented by court
order from continuing to conduct all or any material part of its business
affairs, or if a judgment or other claim becomes a lien or encumbrance upon any
material portion of Borrower's assets, or if a notice of lien, levy, or
assessment is filed of record with respect to any of Borrower's assets by the
United States Government, or any department, agency, or instrumentality
thereof, or by any state, county, municipal, or governmental agency, and the
same is not paid within ten (10) days after Borrower receives notice thereof,
provided that none of the foregoing shall constitute an Event of Default where
such action or event is stayed or an adequate bond has been posted pending a
good faith contest by Borrower (provided that no Advance will be required to be
made during such cure period);

8.5 INSOLVENCY. If Borrower becomes insolvent, or if an
Insolvency Proceeding is commenced by Borrower, or if an Insolvency Proceeding
is commenced against Borrower and is not dismissed or stayed within ten (10)
days (provided that no Advance will be made prior to the dismissal of such
Insolvency Proceeding);

8.6 OTHER AGREEMENTS. If there is a default (i) in any
agreement to which Borrower is a party with a third party or parties resulting
in a right by such third party or parties, whether or not exercised, to
accelerate the maturity of any Indebtedness in an amount in excess of Two
Hundred Fifty Thousand Dollars ($250,000) or (ii) that could have a Material
Adverse Effect;

8.7 SUBORDINATED DEBT. If Borrower makes any payment on
account of Subordinated Debt, except to the extent such payment is allowed
under any subordination agreement entered into with Bank or in accordance with
Section 7.10 of this Agreement;

8.8 JUDGMENTS. If a judgment or judgments for the
payment of money in an amount, individually or in the aggregate, of at least
One Hundred Thousand Dollars ($100,000) shall be rendered against Borrower and
shall remain unsatisfied and unstayed for a period of ten (10) days (provided
that no Advance will be made prior to the satisfaction or stay of such
judgment);

8.9 MISREPRESENTATIONS. If any material
misrepresentation or material misstatement exists now or hereafter in any
warranty or representation set forth herein or in any certificate delivered to
Bank by any

<PAGE>

Responsible Officer pursuant to this Agreement or to induce Bank to enter
into this Agreement or any other Loan Document; or

8.10 DEFAULT UNDER EXIM LOAN DOCUMENTS. If there is a default
by Borrower under the Exim Loan Documents.

9. BANK'S RIGHTS AND REMEDIES

9.1 RIGHTS AND REMEDIES. Upon the occurrence and during the
continuance of an Event of Default, Bank may, at its election, without notice
of its election and without demand, do any one or more of the following, all
of which are authorized by Borrower:

(a) Declare all Obligations, whether evidenced by
this Agreement, by any of the other Loan Documents, or otherwise, immediately
due and payable (provided that upon the occurrence of an Event of Default
described in Section 8.5 all Obligations shall become immediately due and
payable without any action by Bank);

(b) Cease advancing money or extending credit to
or for the benefit of Borrower under this Agreement or under any other
agreement between Borrower and Bank;

(c) Settle or adjust disputes and claims directly
with account debtors for amounts, upon terms and in whatever order that Bank
reasonably considers advisable;

(d) Without notice to or demand upon Borrower,
make such payments and do such acts as Bank considers necessary or reasonable
to protect its security interest in the Collateral. Borrower agrees to
assemble the Collateral if Bank so requires, and to make the Collateral
available to Bank as Bank may designate. Borrower authorizes Bank to enter
the premises where the Collateral is located, to take and maintain possession
of the Collateral, or any part of it, and to pay, purchase, contest, or
compromise any encumbrance, charge, or lien which in Bank's determination
appears to be prior or superior to its security interest and to pay all
expenses incurred in connection therewith. With respect to any of Borrower's
owned premises, Borrower hereby grants Bank a license to enter into
possession of such premises and to occupy the same, without charge in order
to exercise any of Bank's rights or remedies provided herein, at law, in
equity, or otherwise;

(e) Without notice to Borrower set off and apply
to the Obligations any and all (i) balances and deposits of Borrower held by
Bank, or (ii) indebtedness at any time owing to or for the credit or the
account of Borrower held by Bank;

(f) Ship, reclaim, recover, store, finish,
maintain, repair, prepare for sale, advertise for sale, and sell (in the
manner provided for herein) the Collateral. Bank is hereby granted a license
or other right, solely pursuant to the provisions of this Section 9.1, to
use, without charge, Borrower's labels, patents, copyrights, rights of use of
any name, trade secrets, trade names, trademarks, service marks, and
advertising matter, or any property of a similar nature, as it pertains to
the Collateral, in completing production of, advertising for sale, and
selling any Collateral and, in connection with Bank's exercise of its rights
under this Section 9.1, Borrower's rights under all licenses and all
franchise agreements shall inure to Bank's benefit;

(g) Sell the Collateral at either a public or
private sale, or both, by way of one or more contracts or transactions, for
cash or on terms, in such manner and at such places (including Borrower's
premises) as Bank determines is commercially reasonable, and apply any
proceeds to the Obligations in whatever manner or order Bank deems
appropriate;

(h) Bank may credit bid and purchase at any public
sale; and

(i) Any deficiency that exists after disposition
of the Collateral as provided above will be paid immediately by Borrower.

<PAGE>

9.2 POWER OF ATTORNEY. Effective only upon the occurrence
and during the continuance of an Event of Default, Borrower hereby
irrevocably appoints Bank (and any of Bank's designated officers, or
employees) as Borrower's true and lawful attorney to: (a) send requests for
verification of Accounts or notify account debtors of Bank's security
interest in the Accounts; (b) endorse Borrower's name on any checks or other
forms of payment or security that may come into Bank's possession; (c) sign
Borrower's name on any invoice or bill of lading relating to any Account,
drafts against account debtors, schedules and assignments of Accounts,
verifications of Accounts, and notices to account debtors; (d) make, settle,
and adjust all claims under and decisions with respect to Borrower's policies
of insurance; (e) to modify, in its sole discretion, any intellectual
property security agreement entered into between Borrower and Bank without
first obtaining Borrower's approval of or signature to such modification by
amending Exhibit A, Exhibit B and Exhibit C, thereof, as appropriate, to
include reference to any right, title or interest in any Copyrights, Patents
or Trademarks and acquired by Borrower after the execution hereof or to
delete any reference to any right, title or interest in any Copyrights,
Patents or Trademarks in which Borrower no longer has or claims any right,
title or interest; (f) to file, in its sole discretion, one or more financing
or continuation statements and amendments thereto, relative to any of the
Collateral without the signature of Borrower where permitted by law; and (h)
to transfer the Intellectual Property Collateral into the name of Bank or a
third party to the extent permitted under the California Uniform Commercial
Code provided Bank may exercise such power of attorney to sign the name of
Borrower on any of the documents described in Section 4.2 regardless of
whether an Event of Default has occurred; and (g) settle and adjust disputes
and claims respecting the accounts directly with account debtors, for amounts
and upon terms which Bank determines to be reasonable; provided Bank may
exercise such power of attorney to sign the name of Borrower on any of the
documents described in Section 4.2 regardless of whether an Event of Default
has occurred. The appointment of Bank as Borrower's attorney in fact, and
each and every one of Bank's rights and powers, being coupled with an
interest, is irrevocable until all of the Obligations have been fully repaid
and performed and Bank's obligation to provide advances hereunder is
terminated.

9.3 ACCOUNTS COLLECTION. At any time from the date of this
Agreement, Bank may notify any Person owing funds to Borrower of Bank's
security interest in such funds and verify the amount of such Account.
Borrower shall collect all amounts owing to Borrower for Bank, receive in
trust all payments as Bank's trustee, and immediately deliver such payments
to Bank in their original form as received from the account debtor, with
proper endorsements for deposit.

9.4 BANK EXPENSES. If Borrower fails to pay any amounts or
furnish any required proof of payment due to third persons or entities, as
required under the terms of this Agreement, then Bank may do any or all of
the following: (a) make payment of the same or any part thereof; (b) set up
such reserves under the Revolving Facility as Bank deems necessary to protect
Bank from the exposure created by such failure; or (c) obtain and maintain
insurance policies of the type discussed in Section 6.6 of this Agreement,
and take any action with respect to such policies as Bank deems prudent. Any
amounts so paid or deposited by Bank shall constitute Bank Expenses, shall be
immediately due and payable, and shall bear interest at the then applicable
rate hereinabove provided, and shall be secured by the Collateral. Any
payments made by Bank shall not constitute an agreement by Bank to make
similar payments in the future or a waiver by Bank of any Event of Default
under this Agreement. Bank shall have a non-exclusive, royalty-free license
to use the Intellectual Property Collateral to the extent reasonably
necessary to permit Bank to exercise its rights and remedies upon the
occurrence of an Event of Default.

9.5 BANK'S LIABILITY FOR COLLATERAL. So long as Bank
complies with Section 9207 of the Code, Bank shall not in any way or manner
be liable or responsible for: (a) the safekeeping of the Collateral; (b) any
loss or damage thereto occurring or arising in any manner or fashion from any
cause; (c) any diminution in the value thereof; or (d) any act or default of
any carrier, warehouseman, bailee, forwarding agency, or other person
whomsoever. All risk of loss, damage or destruction of the Collateral shall
be borne by Borrower.

9.6 REMEDIES CUMULATIVE. Bank's rights and remedies under
this Agreement, the Loan Documents, and all other agreements shall be
cumulative. Bank shall have all other rights and remedies not inconsistent
herewith as provided under the Code, by law, or in equity. No exercise by
Bank of one right or remedy shall be deemed an election, and no waiver by
Bank of any Event of Default on Borrower's part shall be deemed a continuing
waiver. No delay by Bank shall constitute a waiver, election, or acquiescence
by it. No waiver by Bank

18
<PAGE>

shall be effective unless made in a written document signed on behalf of Bank
and then shall be effective only in the specific instance and for the
specific purpose for which it was given.

9.7 DEMAND; PROTEST. Borrower waives demand, protest,
notice of protest, notice of default or dishonor, notice of payment and
nonpayment, notice of any default, nonpayment at maturity, release,
compromise, settlement, extension, or renewal of accounts, documents,
instruments, chattel paper, and guarantees at any time held by Bank on which
Borrower may in any way be liable.

10. NOTICES

Unless otherwise provided in this Agreement, all notices or
demands by any party relating to this Agreement or any other agreement
entered into in connection herewith shall be in writing and (except for
financial statements and other informational documents which may be sent by
first-class mail, postage prepaid) shall be personally delivered or sent by a
recognized overnight delivery service, certified mail, postage prepaid,
return receipt requested, or by telefacsimile to Borrower or to Bank, as the
case may be, at its addresses set forth below:

If to Borrower: Photon Dynamics, Inc.
6325 San Ignacio Avenue
San Jose, CA 95119
Attn: Rick Dissly
FAX: (408) 360-3175

If to Bank: Silicon Valley Bank
3003 Tasman Drive
Santa Clara, CA 95054
Attn: Mr. Frederick Kreppel
FAX: (408) 496-2463

The parties hereto may change the address at which they are to
receive notices hereunder, by notice in writing in the foregoing manner given
to the other.

11. CHOICE OF LAW AND VENUE; JURY TRIAL WAIVER

This Agreement shall be governed by, and construed in
accordance with, the internal laws of the State of California, without regard
to principles of conflicts of law. Each of Borrower and Bank hereby submits
to the exclusive jurisdiction of the state and Federal courts located in the
County of Santa Clara, State of California. BORROWER AND BANK EACH HEREBY
WAIVE THEIR RESPECTIVE RIGHTS TO A JURY TRIAL OF ANY CLAIM OR CAUSE OF ACTION
BASED UPON OR ARISING OUT OF ANY OF THE LOAN DOCUMENTS OR ANY OF THE
TRANSACTIONS CONTEMPLATED THEREIN, INCLUDING CONTRACT CLAIMS, TORT CLAIMS,
BREACH OF DUTY CLAIMS, AND ALL OTHER COMMON LAW OR STATUTORY CLAIMS. EACH
PARTY RECOGNIZES AND AGREES THAT THE FOREGOING WAIVER CONSTITUTES A MATERIAL
INDUCEMENT FOR IT TO ENTER INTO THIS AGREEMENT. EACH PARTY REPRESENTS AND
WARRANTS THAT IT HAS REVIEWED THIS WAIVER WITH ITS LEGAL COUNSEL AND THAT IT
KNOWINGLY AND VOLUNTARILY WAIVES ITS JURY TRIAL RIGHTS FOLLOWING CONSULTATION
WITH LEGAL COUNSEL.

12. GENERAL PROVISIONS

12.1 SUCCESSORS AND ASSIGNS. This Agreement shall bind and
inure to the benefit of the respective successors and permitted assigns of
each of the parties; PROVIDED, HOWEVER, that neither this Agreement nor any
rights hereunder may be assigned by Borrower without Bank's prior written
consent, which consent may be granted or withheld in Bank's sole discretion.
Bank shall have the right without the consent of or notice to Borrower to
sell, transfer, negotiate, or grant participation in all or any part of, or
any interest in, Bank's obligations, rights and benefits hereunder.

<PAGE>

12.2 INDEMNIFICATION. Borrower shall defend, indemnify and
hold harmless Bank and its officers, employees, and agents against: (a) all
obligations, demands, claims, and liabilities claimed or asserted by any
other party in connection with the transactions contemplated by this
Agreement; and (b) all losses or Bank Expenses in any way suffered, incurred,
or paid by Bank as a result of or in any way arising out of, following, or
consequential to transactions between Bank and Borrower whether under this
Agreement, or otherwise (including without limitation reasonable attorneys
fees and expenses), except for losses caused by Bank's gross negligence or
willful misconduct.

12.3 TIME OF ESSENCE. Time is of the essence for the
performance of all obligations set forth in this Agreement.

12.4 SEVERABILITY OF PROVISIONS. Each provision of this
Agreement shall be severable from every other provision of this Agreement for
the purpose of determining the legal enforceability of any specific provision.

12.5 AMENDMENTS IN WRITING, INTEGRATION. This Agreement
cannot be amended or terminated orally. All prior agreements, understandings,
representations, warranties, and negotiations between the parties hereto with
respect to the subject matter of this Agreement, if any, are merged into this
Agreement and the Loan Documents.

12.6 COUNTERPARTS. This Agreement may be executed in any
number of counterparts and by different parties on separate counterparts,
each of which, when executed and delivered, shall be deemed to be an
original, and all of which, when taken together, shall constitute but one and
the same Agreement.

12.7 SURVIVAL. All covenants, representations and
warranties made in this Agreement shall continue in full force and effect so
long as any Obligations remain outstanding. The obligations of Borrower to
indemnify Bank with respect to the expenses, damages, losses, costs and
liabilities described in Section 12.2 shall survive until all applicable
statute of limitations periods with respect to actions that may be brought
against Bank have run.

<PAGE>

IN WITNESS WHEREOF, the parties hereto have caused this Agreement to
be executed as of the date first above written.

PHOTON DYNAMICS, INC.

By:
---------------------------------
Title:
------------------------------

SILICON VALLEY BANK

By:
---------------------------------
Title:
------------------------------

<PAGE>

EXHIBIT A

The Collateral shall consist of all right, title and interest of
Borrower in and to the following:

1. All goods and equipment now owned or hereafter acquired,
including, without limitation, all machinery, fixtures, vehicles (including
motor vehicles and trailers), and any interest in any of the foregoing, and
all attachments, accessories, accessions, replacements, substitutions,
additions, and improvements to any of the foregoing, wherever located;

2. All inventory, now owned or hereafter acquired, including,
without limitation, all merchandise, raw materials, parts, supplies, packing
and shipping materials, work in process and finished products including such
inventory as is temporarily out of Borrower's custody or possession or in
transit and including any returns upon any accounts or other proceeds,
including insurance proceeds, resulting from the sale or disposition of any
of the foregoing and any documents of title representing any of the above,
and Borrower's Books relating to any of the foregoing;

3. All contract rights and general intangibles now owned or
hereafter acquired, including, without limitation, goodwill, trademarks,
servicemarks, trade styles, trade names, patents, patent applications,
leases, license agreements, franchise agreements, blueprints, drawings,
purchase orders, customer lists, route lists, infringements, claims, computer
programs, computer discs, computer tapes, literature, reports, catalogs,
design rights, income tax refunds, payments of insurance and rights to
payment of any kind;

4. All now existing and hereafter arising accounts, contract rights,
royalties, license rights and all other forms of obligations owing to
Borrower arising out of the sale or lease of goods, the licensing of
technology or the rendering of services by Borrower, whether or not earned by
performance, and any and all credit insurance, guaranties, and other security
therefor, as well as all merchandise returned to or reclaimed by Borrower and
Borrower's Books relating to any of the foregoing;

5. All documents, cash, deposit accounts, securities, financial
assets, investment properties, securities accounts, securities entitlements,
letters of credit, certificates of deposit, instruments and chattel paper now
owned or hereafter acquired and Borrower's Books relating to the foregoing;

6. All copyright rights, copyright applications, copyright
registrations and like protections in each work of authorship and derivative
work thereof, whether published or unpublished, now owned or hereafter
acquired; all trade secret rights, including all rights to unpatented
inventions, know-how, operating manuals, license rights and agreements and
confidential information, now owned or hereafter acquired; all mask work or
similar rights available for the protection of semiconductor chips, now owned
or hereafter acquired; all claims for damages by way of any past, present and
future infringement of any of the foregoing; and

7. Any and all claims, rights and interests in any of the above and
all substitutions for, additions and accessions to and proceeds thereof.

<PAGE>
EXHIBIT 23.1

CONSENT OF ERNST & YOUNG LLP, INDEPENDENT AUDITORS

We consent to the reference to our firm under the captions "Experts" in the
Amendment No. 1 to Registration Statement (Form S-3 No. 333-92937) and related
Prospectus of Photon Dynamics, Inc. for the registration of 2,300,000 shares of
its common stock and to the use of our report dated October 18, 1999 (except for
the second paragraph under "Principles of Consolidation and Basis of
Presentation" in Note 1 and except for Note 2, as to which the date is
November 30, 1999) with respect to the supplemental consolidated financial
statements of Photon Dynamics, Inc. included therein and to the incorporation by
reference therein of our report dated October 18, 1999, with respect to the
consolidated financial statements of Photon Dynamics, Inc. included in its
Annual Report on Form 10-KSB for the year ended September 30, 1999, filed with
the Securities and Exchange Commission.

/s/ Ernst & Young LLP

San Jose, California
January 27, 2000

<PAGE>
EXHIBIT 23.2

CONSENT OF INDEPENDENT CERTIFIED PUBLIC ACCOUNTANT

We hereby consent to the reference to our firm under the caption "Experts"
and to the use of our report dated May 7, 1999, relating to the financial
statements of CR Technology, Inc. and Subsidiary, incorporated by reference in
the Amendment No. 1 to the Registration Statement (Form S-3) and Prospectus of
Photon Dynamics, Inc. for the registration of 2,300,000 shares of its common
stock.

/s/ Cacciamatta Accountancy Corporation

Irvine, CA
January 27, 2000

<PAGE>
<ARTICLE> 5
<MULTIPLIER> 1,000

<S> <C> <C>
<PERIOD-TYPE> YEAR YEAR
<FISCAL-YEAR-END> SEP-30-1998 SEP-30-1999
<PERIOD-START> OCT-01-1997 OCT-01-1998
<PERIOD-END> SEP-30-1998 SEP-30-1999
<CASH> 6,117 6,421
<SECURITIES> 178 1,605
<RECEIVABLES> 8,459 14,931
<ALLOWANCES> 1,010 1,301
<INVENTORY> 8,234 7,112
<CURRENT-ASSETS> 22,616 29,482
<PP&E> 5,907 6,815
<DEPRECIATION> 3,958 4,998
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0 0
0 0
<COMMON> 44,985 45,972
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<INCOME-TAX> 73 673
<INCOME-CONTINUING> (1,207) 2,273
<DISCONTINUED> 0 0
<EXTRAORDINARY> 0 0
<CHANGES> 0 0
<NET-INCOME> (1,207) 2,273
<EPS-BASIC> (0.14) 0.24
<EPS-DILUTED> (0.14) 0.23

</TABLE>