FAROUDJA INC, 10-K, 1998-03-31

FAROUDJA INC
10-K, 1998-03-31
HOUSEHOLD AUDIO & VIDEO EQUIPMENT

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SECURITIES AND EXCHANGE COMMISSION
WASHINGTON, D.C. 20549

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FORM 10-K

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

FOR THE FISCAL YEAR ENDED DECEMBER 31, 1997

COMMISSION FILE NUMBER 0-23107

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FAROUDJA, INC.

(Exact name of registrant as specified in its charter)

<TABLE>
<S> <C>
DELAWARE 77-0444978
(State or other jurisdiction (I.R.S. Employer Identification
of No.)
incorporation and
organization)
</TABLE>

750 PALOMAR AVENUE, SUNNYVALE, CA 94086

(Address of principal executive offices, including zip code)

(408) 735-1492

(Registrant's telephone number)

Securities registered pursuant to Section 12(b) of the Act:

NONE

Securities registered pursuant to Section 12(g) of the Act:

COMMON STOCK, PAR VALUE $.001 PER SHARE

(Title of class)

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Indicate by check mark whether the Registrant: (1) has filed all reports
required to be filed by Section 13 or 15(d) of the Securities Exchange Act of
1934 during the preceding 12 months (or for such shorter period that the
Registrant was required to file such reports), and (2) has been subject to such
filing requirements for the past 90 days. Yes /X/ No / /

Indicate by check mark if disclosure of delinquent filers pursuant to Item
405 of Regulation S-K is not contained herein, and will not be contained, to the
best of Registrant's knowledge, in definitive proxy or information statements
incorporated by reference in Part III of this Form 10-K or any amendment to this
Form 10-K. /X/

The aggregate market value of the voting stock held by non-affiliates of the
Registrant, based on the closing price of the Common Stock on March 1, 1998, as
reported on the NASDAQ National Market, was approximately $35 million. Shares of
Common Stock held by each officer and director and by each person who owns 5% or
more of the outstanding Common Stock have been excluded from this computation in
that such persons may be deemed to be affiliates. This determination of
affiliate status is not necessarily a conclusive determination for other
purposes.

As of March 1, 1998 the Registrant had outstanding 12,058,913 shares of
Common Stock.

DOCUMENTS INCORPORATED BY REFERENCE

1. Portions of the Registrant's Annual Report to Stockholders for the fiscal
year ended December 31, 1997 are incorporated by reference into Part II of
this Form 10-K Report. With the exception of those portions which are
incorporated by reference, the Registrant's 1997 Annual Report is not deemed
filed as part of this Report.

2. Portions of the Registrant's Proxy Statement for the Annual Meeting of
Stockholders to be held on June 10, 1998 are incorporated by reference into
Part III of this Form 10-K Report.

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FAROUDJA, INC.

FORM 10-K

DECEMBER 31, 1997

INDEX

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PAGE
NO.
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PART I

Item 1. BUSINESS......................................................... 3

EXECUTIVE OFFICERS OF THE COMPANY................................ 23

Item 2. PROPERTIES....................................................... 23

Item 3. LEGAL PROCEEDINGS................................................ 24

Item 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS.............. 24

PART II

Item 5. MARKET FOR REGISTRANT'S COMMON EQUITY AND RELATED STOCKHOLDER
MATTERS........................................................ 25

Item 6. SELECTED FINANCIAL DATA.......................................... 25

Item 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND
RESULTS OF OPERATIONS.......................................... 25

Item 7A. QUANTITIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK......... 25

Item 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA...................... 25

Item 9. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND
FINANCIAL DISCLOSURE........................................... 25

PART III

Item 10. DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANT............... 25

Item 11. EXECUTIVE COMPENSATION........................................... 25

Item 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT... 25

Item 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS................... 26

PART IV

Item 14. EXHIBITS, FINANCIAL STATEMENT SCHEDULES, AND REPORTS ON FORM
8-K............................................................ 26

SIGNATURES ................................................................. 27
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THIS FORM 10-K CONTAINS FORWARD LOOKING STATEMENTS CONCERNING THE COMPANY'S
FUTURE PRODUCTS, EXPENSES, REVENUE, LIQUIDITY AND CASH NEEDS AS WELL AS THE
COMPANY'S PLANS AND STRATEGIES. THESE FORWARD-LOOKING STATEMENTS ARE BASED ON
CURRENT EXPECTATIONS AND THE COMPANY ASSUMES NO OBLIGATIONS TO UPDATE THIS
INFORMATION. NUMEROUS FACTORS COULD CAUSE ACTUAL RESULTS TO DIFFER SIGNIFICANTLY
FROM THE RESULTS DESCRIBED IN THESE FORWARD-LOOKING STATEMENTS. FOR A DISCUSSION
OF VARIOUS RISKS AND UNCERTAINTIES AFFECTING THE COMPANY'S FUTURE OPERATIONS SEE
"FACTORS AFFECTING FUTURE OPERATING RESULTS."

PART I

ITEM 1. BUSINESS

GENERAL

Faroudja Inc. (the "Company"), designs, develops and markets a range of
video image enhancement products for the high-end home theater, industrial and
broadcast markets through its wholly-owned subsidiary, Faroudja Laboratories,
Inc. The Company is currently seeking to apply its technologies and experience
to address opportunities in the emerging digital television ("DTV") and high
definition television ("HDTV") broadcast and display environments and to
facilitate the convergence of the personal computer ("PC") and the TV.

The Company began operations in 1971 through two related companies, Faroudja
Laboratories, Inc. ("FLI") and later Faroudja Research Enterprises, Inc.
("FRE"). The Company was incorporated in December 1996 under the laws of the
state of Delaware to succeed to the business of FLI and FRE. Thereafter, FRE was
merged into FLI with FLI surviving the merger and FLI was subsequently merged
into a newly-formed wholly-owned subsidiary of the Company.

BACKGROUND

Video images are pervasive in today's society as sources of entertainment
and information. Images are displayed on a variety of electronic media including
color TVs, projection systems and PCs. Historically, there has been a
substantial difference in the quality of these various media, ranging from low
quality TV pictures to very high quality cinema pictures. This difference
resulted from a host of technical issues related to the capture, transmission
and display of video images. Current technologies make it possible to replicate
cinema quality on TVs, projection systems and PCs.

With U.S. households owning approximately 250 million television sets, TV is
the dominant medium for viewing video images. While TV is an integral part of
modern life, it is optimized around image production, transmission and display
technology created more than 40 years ago. TV signals are produced in accordance
with the NTSC standard developed in the 1940s for black and white programs. This
standard was last modified in the 1950s to make possible the compatible
transmission of black and white and color programs. Technical compromises
required to achieve compatibility introduce image degrading imperfections, known
as artifacts. Additionally, analog transmission introduces noise in the TV
image. While always present, these imperfections are less evident on TV screens
smaller than 25 inches in size than on larger screens. Over the last decade,
consumer interest in larger screen TVs has increased dramatically, fueled by
decreasing equipment prices and an expanding universe of movies, sporting events
and other programming available via cable TV, video cassette, direct broadcast
satellite, laser disc and, most recently, digital video disc ("DVD"). As TV
screen sizes have increased, impairments in the image, such as low resolution,
artifacts and noise, have become more readily apparent. The better quality
images produced by DVDs, digital satellite transmission and high resolution
computer monitors have made viewers more discriminating and have elevated their
image quality expectations.

The Company believes that this trend will accelerate with the announced
introduction of HDTV by some broadcasters in late 1998. HDTV images are expected
to incorporate cinema-like image quality in a wider screen format. The Federal
Communications Commission ("FCC") recently established standards

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for DTV broadcasting in the United States and adopted rules mandating the
gradual introduction of DTV broadcasting. The FCC has targeted the eventual
phase-out of analog (NTSC) broadcasting by the year 2006. Current analog
broadcasting equipment is not compatible with the new DTV standards. In order to
transmit digital signals in accordance with the new DTV standards, broadcasters
will need to acquire new equipment, including digital transmission equipment, at
costs estimated to be as high as $10 million per station. Broadcasters are
seeking to reduce the costs of transitioning from analog to digital broadcasting
through strategies which will allow them to continue to use much of their
existing equipment.

Advances in microprocessors, the availability of low cost memory and
storage, high quality displays, sophisticated software and the emergence of the
World Wide Web have fueled the growth in multimedia applications on the PC. The
PC is increasingly being used to view video stored on hard disk, CD-ROM, DVD and
laser disc, and video over the Internet. The Company believes that the use of
the PC as an entertainment device in the future will depend in large part on the
PC's ability to display TV images. Since TV signals use an interlaced format
while PCs use a progressive scanning display format, a TV signal must be
converted before being displayed on a PC. Until now, the interlace/progressive
conversion, along with other steps in the conversion of the TV signal, has
caused color distortion, motion artifacts, noise and other imperfections, which
have resulted in poor video quality on the PC. Image problems become even more
apparent when TV signals are viewed on a PC, as PC users sit relatively close to
their screens and PC monitors have higher resolution than most TVs.

FAROUDJA SOLUTIONS

Faroudja designs, develops and markets video image enhancement products that
significantly improve images to achieve a cinema-like quality.

The Company's products for the TV market substantially reduce the
imperfections inherent in analog NTSC signals, which become increasingly
apparent on large screen TV displays. The Company's technology improves picture
quality by removing artifacts and noise, detecting and compensating for motion,
enhancing resolution, and multiplying the number of lines displayed. Faroudja's
product sales for the TV market include sales of stand alone products to home
and industrial customers and board level products to original equipment
manufacturer ("OEM") customers.

Faroudja is developing products which support the transition from analog to
DTV/HDTV broadcasting. As broadcasters make significant investments to satisfy
regulatory requirements, the Company believes that product solutions which
interface with additional necessary digital transmission equipment and current
studio equipment will help broadcasters minimize transition costs and maintain
flexibility in responding to evolving regulatory and market requirements. The
Company is developing standards conversion and upscaling products which it
believes will enable broadcasters to use much of the equipment present in their
existing studios to produce programming in various DTV/HDTV video formats. The
Company is currently testing prototypes of its first product in this field, the
Digital Format Translator-TM-.

The Company is also developing products and technology that are intended to
solve the interlacing problem by significantly reducing the noise and artifacts
inherent in the display of high quality TV pictures on PC screens.

STRATEGY

The Company's objective is to maintain and expand its position as the
industry standard of excellence for video image quality. Key elements of the
Company's strategy to achieve this objective include:

MAINTAIN AND EXTEND TECHNOLOGY LEADERSHIP. The Company intends to build
upon its technology leadership in video image processing by increasing its
investment in research and development. These efforts will focus on developing
patentable technology and innovative products for the TV and broadcast

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markets. The Company also intends to leverage its image enhancement expertise in
TV into broadcast, DTV display and PC products and applications.

PENETRATE BROADER MARKET SEGMENTS. The Company has historically sold
products that addressed the needs of the industrial and high-end home theater
markets. The Company recently introduced a decoder and signal enhancer with
prices and capabilities targeting the consumer markets. The Company intends to
continue to seek opportunities in new and broader market segments, such as the
converging PC and TV markets and the emerging DTV/HDTV broadcast and display
markets.

INCREASE BRAND NAME AWARENESS. The Company has established a reputation for
excellence in video processing and video image enhancement in the commercial
broadcast, industrial and high-end home theater markets. The Company intends to
increase brand name awareness through increased advertising, the marketing of
stand alone image enhancement products and video source players carrying the
Company's trademarks, and co-branding agreements with OEM customers. The
distribution of Company-branded and co-branded products (particularly PC/TV
products) in new and broader market segments is also intended to increase
Faroudja brand awareness.

BUILD AND LEVERAGE STRATEGIC RELATIONSHIPS. The Company intends to
establish and maintain strategic relationships with companies whose technology,
products and product strategies complement those of the Company. Through
selective licensing of its patented technologies, the Company intends to
increase penetration and recognition of its capabilities in markets currently
served and to facilitate migration into new markets.

EXPAND INTERNATIONAL PRESENCE. The Company intends to expand its
international presence in order to increase its export sales. These efforts will
include establishing a sales force and marketing activities for the European and
Asian markets, expanding the Company's international network of distributors and
dealers, continuing the development of OEM relationships with customers serving
international markets, such as Hughes/JVC Technology Corporation ("Hughes/JVC"),
Vidikron of America, Inc. ("Vidikron"), Cinema Pro Corporation dba Runco
International ("Runco") and NEC Technologies, Inc. USA ("NEC"), and product
development that incorporates various international specifications.

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PRODUCTS

Faroudja designs, develops and markets a range of video image enhancement
products for the TV and broadcast markets. The following table sets forth
certain information regarding the Company's current stand alone industrial and
home products:

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MARKET PRODUCT DESCRIPTION
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TV-Image VP401 Line quadrupler and video processor for large screen high resolution video
Enhancement/ Line VP401U projection system
Multiplying

VP201 Line doubler and video processor for large screen high resolution video
VP201U projection system
VP251
VP281FD

VP301 Line tripler and video processor for large screen high resolution video
projection system

VP100 Video decoder with detail and color enhancement
VP100P

Rear Screen System RP4800 Rear screen projection system with line doubler

TV-Source DV1000 DVD/CD player with detail and color enhancement
Players LD1000 Laser disc player with audio enhancement

Broadcast DFD-U Low noise video decoder/frame synchronizer with video adjustments. Analog and
digital red, green and blue (RGB) outputs.

CFD-SN Very low noise video decoder with video adjustments and analog red, green and
blue (RGB) outputs.
</TABLE>

TV PRODUCTS

LINE QUADRUPLERS (VP401 AND VP401U). Faroudja line quadrupler video
processors produce cinema-like images. The processors accept input from sources
formatted for conventional 525-line or 625-line TV standards, and convert them
into line-quadrupled, noticeably artifact-free, high resolution signals for
direct-view or projection TV systems. The processors are precision instruments
employing three complex digital signal processes utilizing patented technology
in the fields of decoding, scan conversion and detail enhancement. These
products substantially reduce color blurring, rainbow patterns, dot crawl and
visible scan lines, and deliver sharp image details.

LINE TRIPLING VIDEO PROCESSORS (VP301). The Company's line tripling video
processors utilize certain of the same technologies as the Company's line
quadruplers, and deliver similar results for smaller direct-view or projection
TV systems.

LINE DOUBLING VIDEO PROCESSORS (VP201, VP201U, VP251, VP281FD). The
Company's line doubling video processors utilize certain of the same
technologies as the Company's line quadruplers, and deliver similar results for
smaller direct-view or projection TV systems.

VP100 TV ENHANCER AND VP100P. The VP100 and VP100P set top components apply
patented adaptive decoding, detail processing and color alignment correction for
use in standard and large screen S-video compatible TVs. These products
substantially reduce color decoding artifacts and greatly increase

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image detail and depth. These products offer consumers a moderately priced video
enhancement technology that plugs directly into the TV unit.

REAR PROJECTION SYSTEM (RP4800). The Company's 48 inch wide rear screen
projection system incorporates a VP250 line doubling video processor. This
display system is designed for customers with space, remodeling or lighting
constraints and provides HDTV quality images.

DV1000 HIGH DEFINITION DIGITAL VIDEO DISC AND CD PLAYER. The DV1000 applies
custom circuitry to both video and audio processing to provide significantly
enhanced image detail and depth exceeding what is expected to be available from
standard DVD players.

LD1000 HIGH DEFINITION LASER DISC AND CD PLAYER. The LD1000 applies custom
circuitry for audio enhancement to provide an experience exceeding what is
available from standard laser disc players.

TV product sales as a percentage of total revenues for fiscal 1995, 1996 and
1997 were 80%, 80% and 88%, respectively.

BROADCAST PRODUCTS

DFD-U DIGITAL DECODER. The DFD-U uses 10-bit processing with patented
decoding and bandwidth expansion circuitry to convert PAL or NTSC analog signals
into the digital component data required for video compression. Additional
circuits include time base correction and full frame synchronization. The
combination results in a significantly artifact-free digital signal that enables
additional channel capacity with reduced noise levels and higher quality video
signals from MPEG video compression engines.

CFD-SN. The CFD decodes NTSC signals into high quality, artifact-free
components prior to the time the signal is transmitted. The output signal is
used in applications such as studio manipulation, display and digital video
compression.

Broadcast product sales as a percentage of total revenues for fiscal 1995 ,
1996 and 1997 were 20%, 16% and 2%, respectively.

OEM PRODUCTS

The Company has designed and developed board level products incorporating
the Company's technologies for the OEM market. To date, sales from board level
products have not been material.

RESEARCH AND DEVELOPMENT; NEW PRODUCTS

The Company has devoted, and expects to continue to devote, significant
resources to its research and development efforts. In 1996, the Company
established a VLSI design group to develop high performance video ASICs. In June
1997, the Company expanded its VLSI department by establishing a facility in
Phoenix, Arizona with five engineers. As of December 31, 1997, the Company had a
staff of 29 full-time research and development personnel. During 1995, 1996 and
1997, the Company's research and development expenses were approximately $1.5
million, $2.5 million and $4.2 million, respectively. The Company anticipates
that its research and development expenses will increase in absolute dollars for
the foreseeable future.

The Company has a number of products in development with introduction
planned during the next several years. For the TV market, the Company is
developing an advanced line multiplier and scaling video processor for very
large screen high resolution systems, a video processor for liquid crystal
display ("LCD") and Digital Light Processing based projector systems ("DLP")
products and a video processor for less sophisticated industrial applications.
The Company is also developing a 58 inch wide rear screen projection TV system
incorporating the Company's line multiplication and enhancement technology. For

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the OEM TV projection market, the Company is developing a board level decoder
with video enhancement features.

For the broadcast market, the Company is developing an upconverter that
utilizes Faroudja technology to deliver HDTV quality video images in a variety
of DTV and HDTV video formats from NTSC sources. The Company is currently
testing prototypes of this product which it calls the Digital Format
Translator-TM-. If such testing is successful, the Company expects to begin
shipment of this product in the second quarter of 1998. The Digital Format
Translator-TM- is intended to provide broadcasters with the ability to leverage
their existing analog equipment and systems to produce programming in various
DTV/ HDTV video formats. The Company is also developing studio quality NTSC/PAL
decoders for broadcast and postproduction applications.

For the PC/TV market, the Company is in the final stages of developing a
video decoder integrated circuit, which includes synchronization, time base
correction and detail enhancement. The Company is also developing "Presentation
Plus-TM-," a line multiplier and scaling product for high resolution video
computer monitors that incorporates time base correction, image enhancement and
video synchronization.

The Company's other planned research products include expanded development
of line multipliers and compression pre-processors which include noise reduction
to increase compressor efficiency, and the extension of the Company's technology
to low bandwidth use for such applications as teleconferencing and video
telephones.

The markets for the Company's products are characterized by evolving
industry standards, rapid technological change, frequent new product
introductions and short product life cycles. The Company's future success will
depend, in large part, on its ability to continue to enhance its existing
products, to develop new products and features to meet changing customer
requirements and evolving industry standards and to identify prospective
licensees and enter into royalty-generating license agreements. The Company
anticipates that sales from its line multiplier product lines will experience
limited growth, or may decline, in future periods. In the fourth quarter of
1997, the home theater market exhibited weakness which the Company attributes to
consumer confusion over HDTV. The Company believes that such confusion and
related market weakness could continue until HDTV broadcast begins as currently
anticipated at the end of the third quarter of 1998. The Company expects that
more than one-half of its total revenues in 1998 will be derived from licensing
revenue and sales of recently introduced products, as well as products which the
Company is developing. The success of new products depends on a number of
factors, including proper selection and timely introduction of planned new
products, successful and timely completion of product development, accurate
estimation of demand for new products, market acceptance of new products of the
Company and its OEM customers, the Company's ability to offer new products at
competitive prices, the availability of adequate staffing to produce and sell
such new products, and competition from products introduced by competitors.
Certain of these factors are outside the control of the Company. Sales of the
Company's board level products, and future license and royalty revenues, depend
in part upon the ability of the Company's OEM customers and licensees to
successfully develop and market products incorporating the Company's products or
technology. The Company's products intended for the digital broadcast market are
not expected to be available for sale until the second quarter of 1998. There
can be no assurance that the Company's broadcast products, assuming timely
development and satisfactory completion of field tests, will be accepted by the
broadcast market. There can be no assurance as to the amount of royalties, if
any, that the Company will receive in the future as S3 has advised the Company
that it will not make any payments necessary to maintain its exclusive license
rights with respect to any periods after March 31, 1998 and the Company does not
currently have any other license agreements in effect pursuant to which it
expects to receive substantial royalties.

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Company to manage the transition from older products in order to minimize
disruption in customer ordering patterns, to avoid excessive levels of older
product inventories and to ensure that adequate supplies of new products can be
delivered to meet customer demand.

There can be no assurance that the Company will identify new product
opportunities, will successfully develop and bring to market new products, will
achieve design wins or will respond effectively to technological changes or
product announcements by others, or that the Company's new products will achieve
market acceptance. A failure in any of these areas would have a material adverse
effect on the Company's business, financial condition and operating results.

TECHNOLOGY

The Company has significant expertise in a number of technologies relating
to video image enhancement.

ENCODING TECHNOLOGY. A NTSC or PAL signal consists of a luminance signal
and two color-difference signals. In a conventional NTSC or PAL encoder, the
color-difference signals are modulated on a subcarrier and added to the
luminance signal. In this case, the spectrum of both the luminance signal and
the modulated chrominance signal are mixed together, which generates "rainbow
patterns," "dot crawl" and other artifacts in TV receivers. Faroudja's patented
pre-filtering technology is applied to luminance and chrominance signals
separately so that they will not interfere with each other. The two signals are
added together without an overlaid spectrum, which significantly reduces rainbow
patterns and other artifacts.

DECODING TECHNOLOGY. The color section of the NTSC standard was originally
designed with severe bandwidth restrictions. This causes colors in various video
images to "blur" and "smear." These effects are aggravated by storage media,
such as VHS tapes, that further degrade the chroma or color signal. The Faroudja
decoder technology utilizes proprietary circuitry to recreate and correct color
details. This is accomplished by making use of the sharper black and white
transitions to develop a correction signal that is then used to sharpen the
color transitions. As a result, colors are restored with sharp details and video
images retain their original crisp image. Digital adaptive comb filter circuitry
eliminates decoding errors from imperfect separation of the luminance and
chrominance signals and enables the reproduction of sharper, cleaner color
images. The Company's decoder technology has two separate correction circuits
that create color transitions that are clear, sharp and natural by eliminating
dot crawl, a rapid upward movement of colored dots on sharp vertical
transitions, and hanging dots which lie underneath all the colored horizontal
transitions. Dot crawl and hanging dots are easily apparent with large, highly
saturated, stationary graphics such as titles and credits.

LINE MULTIPLIER TECHNOLOGY. The line multiplier technology reduces scan
line visibility resulting from utilizing a 525 line broadcast standard on
today's large screen TVs by changing the interlaced video signal to a
progressively scanned signal. The Company's line multiplier technology detects
motion and interpolates correctly to "fill in the blanks." This technology can
detect the difference between a film image that has been transferred to video or
a video image that emanates from a video camera. After detecting the image type,
the line multiplier technology selects its algorithm to compensate accordingly.
This is critical because today's home theaters are primarily used to show films
that were transferred to video, whether on tape, laser disc or off the air.

DETAIL ENHANCEMENT TECHNOLOGY. The best video sources such as DVD (if
properly recorded) provide good resolution while others such as digital
satellite reception and laser discs often provide acceptable resolution.
However, common sources such as broadcast or VHS tapes are noticeably deficient.
The problem is compounded when scan lines are doubled or quadrupled and when
other signal processing is applied. The resulting picture is free of artifacts
(including visible scan lines) but dull, with loss of definition and a general
blurriness. The Company's proprietary technology increases the visibility of
small

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image details, whether horizontal or vertical, without introducing ringing or
noise artifacts and without modifying large edge response. The Company's
technology also uses a form of non-linear processing similar to controlled
distortion. This technique expands the bandwidth of large edge signals without
introducing artifacts, such as ringing, in both the horizontal and vertical
domains. The combination of these two techniques results in a line doubled or
quadrupled image that gives a greater feeling of depth.

MOTION COMPENSATION TECHNOLOGY. The inherent scan and frame rate changes
that are required to display the enhanced video image make motion compensation
necessary in the reconstruction of the enhanced picture. TV images are
transmitted in an interlaced fashion in which the picture is transmitted in two
parts, the first being the odd lines of the picture, the second the even lines.
This creates a time delay of 16 milliseconds between the odd and even lines of
the image. If motion is present, artifacts can be generated in the conversion to
a line doubled or quadrupled image. Also, while TV images are displayed at
approximately 60 frames per second, cinema film sources are displayed at 24
frames per second. To ensure an image noticeably free from artifacts, the motion
of the video has to be taken into account and identification of the source
material as video or film is necessary. The Company's motion and film detection
technology is used in most of its video enhancement products.

NOISE REDUCTION. All analog video sources contain some degree of picture
noise. This is manifested as low level moving or shimmering artifacts, or an
excessive graininess in the picture. High quality digital sources such as DVDs
have much reduced noise content. Noise reduction processing is required to bring
analog sources, either existing archive material or new material from
traditional cameras, up to digital standards. Small static details in the
picture have to be distinguished from the moving noise artifacts so that correct
discrimination can be accomplished. The Company makes use of its motion
detection and adaptive video filtering technologies to optimize noise reduction
in the video images.

TIME BASE CORRECTION. Video sources which are being transmitted from a
broadcast studio or by a satellite or cable TV head end derive line and frame
scan rates from stable crystal controlled sources which are timing accurate.
Video produced by consumer video cassette recorders, camcorders and, to a lesser
extent, video discs are subject to timing errors, because the playback relies on
the mechanical rotation of the storage medium for timing accuracy. In the case
of VCRs, line lengths may vary causing color decoding and video picture
alignment problems. If a VCR source is to be transmitted in the industry
standard digital D1 format, this line timing variability is not permissible. The
Company's time base correction technology permits its decoders not only to
separate the luminance and chrominance components of the video source but to
re-lock the video to a crystal reference. This stabilizes the picture,
particularly when video is overlaid on other video sources, and makes it
compliant with digital studio transmission standards.

SCALING. As new video standards become available, the need to reformat the
video picture by scaling in both the horizontal and vertical domains becomes
more important. The Company currently produces line doublers and quadruplers
which scale the picture by a factor of two. The Company has under development
products which scale the picture by non-integer ratios. This will be required
for the Company's PC interface products, which will permit the adjustment of the
size of a video image in a window on the PC monitor. This is a completely
variable scaling application. LCD panels or TI's DLP mirror products have finite
numbers of pixels in the display format. At present, 800 horizontal pixels by
600 vertical pixels is a common size and was developed to match computer SVGA
display sizes. In the case of video being interfaced to pixel based displays to
ensure that video artifacts are not developed at the display device, the video
source is scaled to convert the original number of lines to the number of lines
in the display device. Non-integer scaling is employed in this transfer. Scaling
will also be used in the conversion of video between traditional sources and the
new DTV and HDTV formats.

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SALES AND MARKETING

Faroudja markets its products for the TV market through a network of home
theater, industrial and commercial dealers as well as OEM customers. As of
December 31, 1997, the Company maintained a sales force of eight persons at its
headquarters in Sunnyvale, California, and five employees in regional offices.
The Company's marketing programs include trade shows, training seminars, public
relations and advertising. Revenues from Hughes/JVC accounted for 12.1% of total
revenues in 1995. Revenues from Vidikron accounted for 10.5% of total revenues
in 1996. Revenues from S3 and Vidikron accounted for 10.6% and 11.1%
respectively, of total revenues in 1997.

The Company currently distributes its home theater products through
approximately 330 home theater dealers throughout the United States. This
distribution channel is managed by a Company national sales manager, three
regional managers, one field training manager, independent sales representatives
and a customer service department.

The Company services industrial applications, such as corporate boardrooms,
executive conference centers and auditoriums, through a network of more than 70
industrial dealers. These dealers typically provide installation, product
integration, on site training and customer support. This network is managed
directly by a national sales manager and three regional managers.

For the broadcast market, the Company has relied, and expects to continue to
rely in the future, on direct sales and marketing. The Company has two employees
who sell directly to the broadcast markets.

The Company has OEM relationships with Runco, Vidikron and Ampro Corporation
("Ampro"). Vidikron is also integrating the VP100 decoder into certain of its
projection systems, including the new Helios I projector based on Texas
Instrument Incorporated's ("TI") DLP. There can be no assurance that the Company
will continue to receive any revenues from any of these relationships.

The Company has entered into co-branding arrangements with NEC and Runco
pursuant to which NEC and Runco have non-exclusive distribution rights to the
Company's line multiplier products. NEC and Runco are required to purchase a
certain minimum number of units per year to maintain their rights to co-brand
Company products. Under the NEC agreement, the Company has afforded NEC certain
price protections with respect to products listed therein. Specifically, in the
event of a price decrease for any such product, the Company will provide a
credit equal to the decrease for all such products remaining in inventory at
NEC. The Company has also entered into a co-branding arrangement with Ampro for
the development and sale of decoder boards for incorporation into the Ampro
three chip DLP product. There can be no assurance that the Company will continue
to receive any revenues from any of these arrangements.

In 1995, 1996 and 1997, the Company generated approximately 13.1%, 15.3%,
and 13.2%, respectively, of its total revenues from export sales. The decrease
in the percentage of total revenues generated from export sales in 1997 from the
prior year was primarily due to (i) increased sales to certain U.S. customers
which, the Company believes, in turn exported the Company's products and (ii) a
reduction in international sales personnel. The Company intends to expand its
international presence in order to increase its export sales and intends to hire
a sales manager in 1998 to handle export sales. Consequently, the Company
believes that export sales will increase as a percentage of total revenues in
future periods. The Company has a non-exclusive worldwide distribution
arrangement with Vidikron pursuant to which Vidikron distributes the Company's
line doublers and line quadruplers. Further, Faroudja has a non-exclusive
worldwide distribution arrangement with Hughes/JVC for the industrial and
consumer market. Hughes/JVC distributes Faroudja's line doublers, quadruplers
and broadcast products. In addition, Faroudja has distributors or dealers in
over 35 countries worldwide. Export sales to international customers entail a
number of risks, including unexpected changes in, or impositions of, legislative
or regulatory requirements, delays resulting from difficulty in obtaining export
licenses for certain technology, tariffs, quotas and other trade barriers and
restrictions, longer payment cycles, greater difficulty in

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accounts receivable collection, potential adverse taxes, currency exchange
fluctuations, the burdens of complying with a variety of foreign laws and other
factors beyond the Company's control.

The Company's future success will depend, in large part, on the continued
efforts of its network of direct and indirect distributors and dealers. The loss
of, or reduction in sales to any of the Company's key customers could have a
material adverse effect on the Company's operating results.

The Company's business is characterized by short lead times and quick
delivery schedules. As a result, the Company does not believe that backlog at
any given time is a meaningful indication of future sales.

MANUFACTURING

TV AND BROADCAST PRODUCTS. The Company's manufacturing operations are
located in Sunnyvale, California and consist mainly of materials procurement,
final assembly, testing, quality assurance and shipping of products. The only
product assembly performed by the Company is final assembly, which consists of
building chassis and installing circuit boards and wires and cables. The Company
performs testing and quality assurance of all products, except for rear
projection systems, at its Sunnyvale facilities and plans to expand its in-house
automated testing efforts as its product volume increases.

The Company subcontracts other manufacturing functions, including the
production of its printed circuit boards. Bestronics, Inc. ("Bestronics")
assembles more than 80% of the Company's circuit boards. The Company's reliance
on independent printed circuit board assemblers limits its control over delivery
schedules, quality assurance and product cost. The Company also relies on
suppliers for components, such as DC Electronics, Inc. ("DC Electronics") which
builds all of the Company's wire and cable harnesses.

The Company's RP4800 Rear Projection System utilizes a projector chassis
provided by Audio Video Source, Inc. ("AVS") and modified to the Company's
specifications. AVS also manufactures the RP4800 for the Company on a contract
basis including integrating, assembling and testing the various components of
the system.

Disruption in service by any of the Company's subcontractors or the
Company's suppliers could lead to supply constraints or delays in the delivery
of the Company's products. Such supply constraints or delays could have a
material adverse effect on the Company's business, operating results and
financial condition.

WAFER FABRICATION. The Company contracts all of its wafer fabrication,
assembly and testing to independent foundries and contractors, which enables the
Company to focus on its design strengths, minimize fixed costs and capital
expenditures and gain access to advanced manufacturing facilities. As the
Company continues to develop ASIC products, it will continue to contract out its
wafer production. The Company's engineers work closely with the Company's
foundries and subcontractors to increase yields, lower manufacturing costs and
assure quality. The Company's primary foundry is SGS-Thomson Microelectronics,
Inc. ("SGS-Thomson"). In addition, Micro Devices Technology, Inc. ("MDT") and
TEMIC North America, Inc. ("TEMIC") have manufactured the Company's integrated
circuits since 1993 and 1996, respectively. Most of the Company's devices are
currently fabricated using complementary metal oxide semiconductor ("CMOS")
process technology with 0.8 micron feature sizes. New devices that are being
designed are in 0.5 micron and 0.35 micron sizes. The Company currently
purchases products from all of its foundries under individually negotiated
purchase orders. The Company does not currently have a long-term supply contract
with any of its wafer fabrication foundries and, therefore, none are obligated
to supply products to the Company for any specific period, in any specific
quantity or at any specified price, except as may be provided in a particular
purchase order. The Company's reliance on independent foundries and assembly and
testing houses involves a number of risks.

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COMPETITION

The markets in which the Company competes are intensely competitive and are
characterized by rapid technological change, rapid product obsolescence and
price competition. The Company expects competition to increase in the future
from existing competitors and from other companies that may enter the Company's
existing or future markets with products or technologies which may be less
costly or provide higher performance or more desirable features than the
Company's products. The Company's existing and potential competitors include
several large domestic and international companies that have substantially
greater financial, manufacturing, technical, marketing, distribution and other
resources than the Company. In the market for TV video processors, the Company's
principal competitors are DWIN Electronics, Inc. ("DWIN"), Extron Electronics
("Extron"), NEC, Snell & Wilcox, Inc. ("Snell & Wilcox"), Sony Corporation
("Sony") and Yamashita Engineering Manufacturing, Inc. ("YEM"). In the market
for broadcast products, the Company's principal competitors are Extron, Leitch
Incorporated ("Leitch"), Matsushita Consumer Electronics Co. ("Matsushita"),
Snell & Wilcox, Sony Broadcast Products, Incorporated ("Sony Broadcast") and
Vistek Electronics, Ltd. ("Vistek"). As the Company's products penetrate broader
markets and as these markets become commercial markets, the Company expects to
face competition from diversified electronic and semiconductor companies.

Yves Faroudja, the Company and General Instrument Corporation ("GI") are
parties to a royalty free, world-wide license agreement dated May 1, 1996
pursuant to which GI licensed certain patents to the Company and the Company
licensed certain patents to GI relating to video compression and decompression.
As a result of that agreement, GI could produce products in the field of scan
conversion of source material presented to a compression system competitive with
the Company's upconverter.

The Company's licensees and OEM customers may be larger and have greater
market recognition and financial, technological engineering, manufacturing and
distribution capabilities than the Company. In addition, such licensees and OEM
customers may use such technologies and subsystems either alone or in
combination with other technologies to develop products which could compete with
the Company's technologies and products. At the present, the Company believes
that S3 and GI are licensees which could compete with certain of the Company's
technologies and products.

Certain of the Company's principal competitors maintain their own
manufacturing facilities, including semiconductor foundries, and may therefore
benefit from certain capacity, cost and technical advantages. Since the Company
does not operate its own semiconductor manufacturing, assembly or testing
facilities, it may not be able to reduce its costs as rapidly as companies that
operate their own facilities. The failure of the Company to introduce lower cost
versions of its products in a timely manner or to successfully manage its
manufacturing, assembly and testing relationships would have a material adverse
effect on its business, operating results and financial condition.

The Company believes that its ability to compete successfully in the rapidly
evolving markets for high performance video image enhancement technology depends
on a number of factors, including protection of its proprietary technology and
information, the price, quality and performance of the Company's and its
competitors' products, the timing and success of new product introductions by
the Company, its customers and its competitors, the emergence of new industry
standards, the Company's ability to obtain adequate foundry capacity, the number
and nature of the Company's competitors in a given market and general market and
economic conditions. There can be no assurance that the Company will compete
successfully in the future with respect to these or any other competitive
factors.

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customers may use such technologies and subsystems either alone or in
combination with other technologies to develop products which could compete with
the Company's technologies and products. While the Company may sell board level
or chip level products and receive royalties from such licensees, there can be
no assurance that the technologies and products offered by such licensees and
OEM customers will not compete directly with those of the Company, have
performance, cost or other advantages over those of the Company or have an
adverse impact on the sales or other licensing activities of the Company.

PROPRIETARY RIGHTS AND LICENSES

The Company's future success depends in part upon its ability to protect its
proprietary technology and information. Although the Company relies on a
combination of licensed patents, copyrights, trademarks, trade secrets and
licensing arrangements with third parties to protect certain of its intellectual
property, the Company believes that factors such as the technological and
creative skills of its personnel and the success of its ongoing product
development efforts are more important in maintaining its competitive position.
The Company generally enters into confidentiality or license agreements with its
employees, distributors, customers and potential customers and limits access to
its proprietary information. Yves Faroudja, the Company's founder and Chief
Technical Officer, personally holds or was assigned 35 U.S. and 8 foreign
patents, and 7 U.S. and 22 foreign patent applications, which have been licensed
to the Company, and on which the Company depends for the enhancement of its
current products and the development of future products. Mr. Faroudja has
granted the Company a perpetual, royalty-free, license to use patented and
unpatented technologies developed by him prior to January 20, 1997. As the
Company is a licensee of such patents and applications, it is subject to risks
not generally faced by other companies which own the intellectual property upon
which their businesses rely. There can be no assurance that patents will issue
from any pending applications or that any claims allowed from pending
applications will be of sufficient scope or strength, or be issued in all
countries where the Company's products can be sold, to provide meaningful
protection or any commercial advantage to the Company. Also, competitors of the
Company may be able to design around the licensed patents. The laws of certain
foreign countries in which the Company's products are or may be developed,
manufactured or sold, including various countries in Asia, may not protect the
Company's products or intellectual property rights to the same extent as the
laws of the United States, and thus, may increase the likelihood of piracy of
the Company's technology and products. There can be no assurance that the steps
taken by the Company to protect its intellectual property rights will be
adequate to prevent misappropriation of its technology or that the Company's
competitors will not independently develop technologies that are substantially
equivalent or superior to the Company's technology.

The video image enhancement and related industries are characterized by
vigorous protection and pursuit of intellectual property rights or positions,
which have resulted in significant and often protracted and expensive
litigation. The Company may from time to time be subject to proceedings alleging
infringement by the Company of intellectual property rights owned by third
parties. If necessary or desirable, the Company may seek licenses under such
intellectual property rights. However, there can be no assurance that such
licenses will be offered or that the terms of any offered license will be
acceptable to the Company. The failure to obtain such a license from a third
party for technology used by the Company could cause the Company to incur
substantial liabilities and to suspend or cease the manufacture of products
requiring such technology.

The Company may initiate claims or litigation against third parties for
infringement of the Company's proprietary rights or to establish the validity of
the Company's proprietary rights. For example, in January 1997 and May 1997, the
Company filed actions against DWIN and Snell & Wilcox, respectively, seeking
relief and damages for the infringement of US Patent Number 4,876,596 owned by
Yves Faroudja and licensed to the Company. DWIN and Snell & Wilcox have raised
defenses and counterclaims that the patent is invalid and not infringed.

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EMPLOYEES

As of December 31, 1997, the Company had 71 full-time and nine part-time and
contract employees, including 29 full-time employees primarily involved in
research and development activities, 13 in marketing and sales, 11 in finance
and administration and 18 in manufacturing and quality assurance. Most employees
are based at the Company's headquarters in Sunnyvale, California. The Company's
employees are not represented by any collective bargaining unit with respect to
their employment with the Company, and the Company has never experienced a work
stoppage. The Company believes that its employee relations are good. The Company
intends to expand its employee base in 1998, primarily in research and
development and sales and marketing, and believes that its future success will
depend largely on its ability to attract and retain highly-skilled managerial,
sales and marketing personnel. Competition for such personnel is intense. The
Company's future success will depend to a significant extent upon the continued
services of members of senior management and other key employees of the Company.
The loss of the service of any of these individuals could have a material
adverse effect on the Company.

FACTORS AFFECTING FUTURE OPERATING RESULTS

POTENTIAL FLUCTUATIONS IN FUTURE OPERATING RESULTS; SEASONALITY. The
Company's operating results have varied in the past and are likely to vary
significantly in the future from period to period as a result of a number of
factors, including the volume and timing of orders received during the period,
fluctuations in the amount and timing of license and royalty revenues, the
timing of new product introductions by the Company and its competitors, demand
for and market acceptance of the Company's products, product line maturation,
the impact of price competition on the Company's average selling prices, delays
encountered by the Company's strategic partners, the availability and pricing of
components for the Company's products, changes in product or distribution
channel mix, product returns or price protection charges from customers and the
unexpected loss of key customers. Many of these factors are beyond the Company's
control. In addition, due to the short product life cycles that characterize the
markets for the Company's products, the Company's failure to introduce new,
competitive products consistently and in a timely manner could materially
adversely affect operating results for one or more product cycles. The Company
had a license agreement with S3 pursuant to which the Company received quarterly
prepaid license fees to maintain exclusivity. S3 has advised the Company that it
will not make any payments necessary to maintain its exclusive license rights
with respect to any periods after March 31, 1998.

Gross margins may vary from period to period as a result of a number of
factors, including the mix of products sold, new product introductions,
fluctuations in the receipt of license and royalty revenues and the mix of
distribution channels. The Company's gross margins may also be adversely
affected by shortages in the availability of key components for the Company's
products. To maintain favorable margin levels on product sales, the Company must
introduce new products, must introduce enhanced versions of its products, and
must continue its cost reduction efforts. The Company anticipates that it will
incur lower overall gross margins in future periods as it introduces lower
margin products for consumer markets.

Customers generally order on an as-needed basis and, accordingly, the
Company has historically operated with a relatively small backlog.
Notwithstanding the difficulty in forecasting future sales and the relatively
small level of backlog at any given time, the Company generally must plan
production, order components and undertake its development, sales and marketing
activities and other commitments months in advance of orders for its products.
Accordingly, any shortfall in revenues in a given quarter may adversely impact
the Company's operating results due to an inability to adjust expenses during
the quarter to offset any reduced level of revenues for the quarter.

The Company currently derives a substantial portion of its total revenues
from the sale of a relatively small number of high priced products. The
Company's backlog at the beginning of a quarter typically does not include all
sales required to achieve the Company's sales objectives for that quarter.
Consequently, the Company's total revenues and operating results for a quarter
depend upon the Company obtaining orders

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or products to be shipped in the same quarter. In addition, from time to time, a
significant portion of the Company's sales have been derived from sales of
multiple products to a limited number of customers. The volume and timing of
orders received during a quarter are difficult to forecast. As a result of the
Company's typical sales cycle, a disproportionate percentage of the Company's
total revenues in any quarter may be generated in the last month of a quarter.
As a result, a shortfall in sales in any quarter as compared to expectations may
not be identifiable until the end of the quarter. A delay in shipment near the
end of a particular quarter, due, for example, to an unanticipated shipment
rescheduling, to cancellations by customers or to unexpected manufacturing
difficulties experienced by the Company or its suppliers may cause total
revenues in a particular quarter to fall significantly below the Company's
expectations and may thus materially adversely affect the Company's operating
results for such quarter. The Company's industry is subject to a high degree of
seasonality, and demand for the Company's products has historically been highest
in the third and fourth quarters of each calendar year. As a result, sales are
typically highest in these quarters and may be lower in following quarters.

RISKS ASSOCIATED WITH NEW MARKETS AND APPLICATIONS; MARKET ACCEPTANCE. A
substantial portion of the Company's revenues in 1997 were derived from sales of
products that address the high-end home theater and industrial TV markets.
Certain of the Company's current products and certain of its planned future
products generally address markets that are not now and may never become
substantial commercial markets. The Company's future growth will depend, in
large part, on the Company's ability to identify new markets for its products
and to apply its video enhancement technology to evolving markets and
applications that require superior visual images. There can be no assurance that
these markets will become substantial commercial markets or that they will
evolve in such a manner that the Company's products achieve market acceptance.
The Company also intends to exploit what it believes will be the convergence of
the TV and PC markets. There can be no assurance that the TV and PC markets will
converge, that this new market will present substantial commercial
opportunities, or that the Company's products will adequately address this
market in a timely manner. The Company has experienced, and expects to continue
to experience, technological and pricing constraints that may preclude the
development of products that address emerging markets. There can be no assurance
that the Company or its OEM customers will continue their existing product
development efforts, or, if continued, that such efforts will be successful,
that markets will develop in a timely manner, or at all, for any of the
Company's or such customers' products, or that the Company's and its customers'
products will not be superseded by other technology or products.

RISKS ASSOCIATED WITH CHANGING TV STANDARDS. The Company is developing
products that are designed to conform with certain current industry broadcast
standards. However, there can be no assurance that manufacturers will continue
to follow these standards or that competing standards will not emerge which will
be preferred by manufacturers or consumers. The acceptance of the Company's
products also depends in part upon third-party content providers developing and
marketing content for end user systems, such as video and audio playback
systems, in a format compatible with the Company's products. There can be no
assurance that these or other factors beyond the Company's control will not
adversely affect the development of markets for the Company's products.

The FCC has required broadcasters to begin broadcasting digital signals in
May 1999, targeting the phase out of the current analog signals by the year
2006. There is considerable uncertainty among broadcasters and providers of
broadcast, reception and display equipment as to how DTV will be implemented, as
to how broadly and rapidly DTV will be deployed, and as to when, if ever, analog
TV will be discontinued. There can be no assurance that the market for the
Company's products will continue following the introduction of DTV or if
competing standards or technologies emerge that are preferred by manufacturers
and consumers. In addition, there can be no assurance that DTV and related
products will gain market acceptance or that third-party content providers will
develop and market content for end user systems using a digital format or a
format compatible with the Company's products. There can be no

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assurance that such factors beyond the Company's control will not adversely
affect the development of markets for the Company's products.

DEPENDENCE ON NEW PRODUCT DEVELOPMENT AND RISK OF TECHNOLOGICAL CHANGE. The
markets for the Company's products are characterized by evolving industry
standards, rapid technological change, frequent new product introductions and
short product life cycles. The Company's future success will depend, in large
part, on its ability to continue to enhance its existing products, to develop
new products and features to meet changing customer requirements and evolving
industry standards and to identify and enter into royalty-generating license
agreements with prospective licensees. The Company anticipates that sales from
its line multiplier product lines will experience limited growth, or may
decline, in future periods. In the fourth quarter of 1997, the home theater
market exhibited weakness which the Company believes is attributable to consumer
confusion over HDTV. The Company believes that such confusion and related market
weakness could continue until HDTV broadcast begins as currently anticipated at
the end of the third quarter of 1998. The Company expects that more than
one-half of its total revenues in 1998 will be derived from licensing revenue
and sales of recently introduced products, as well as products which the Company
is developing. The success of new products depends on a number of factors,
including proper selection and timely introduction of planned new products,
successful and timely completion of product development, accurate estimation of
demand for new products, market acceptance of new products of the Company and
its OEM customers, the Company's ability to offer new products at competitive
prices, the availability of adequate staffing to produce and sell such new
products, and competition from products introduced by competitors. Certain of
these factors are outside the control of the Company. Sales of the Company's
board level products, and future license and royalty revenues, depend in part
upon the ability of the Company's OEM customers and licensees to successfully
develop and market products incorporating the Company's products or technology.
The Company's products intended for the digital broadcast market are not
expected to be available for sale until the second quarter of 1998. There can be
no assurance that the Company's broadcast products, assuming timely development
and satisfactory completion of field tests, will be accepted by the broadcast
market. There can be no assurance as to the amount of royalties, if any, that
the Company will receive going forward as S3 has advised the Company that it
will not make any payments necessary to maintain its exclusive license rights
with respect to any periods after March 31, 1998 and the Company does not
currently have any other license agreements in effect pursuant to which it
expects to receive substantial future royalties.

The incorporation of the Company's products into its OEM customers' product
designs often requires significant expenditures by the Company, which
expenditures may precede volume sales of the Company's products, if any, by one
year or more. The introduction of new or enhanced products also requires the
Company to manage the transition from older products in order to minimize
disruption in customer ordering patterns, to avoid excessive levels of older
product inventories and to ensure that adequate supplies of new products can be
delivered to meet customer demand.

COMPETITION. The markets in which the Company competes are intensely
competitive and are characterized by rapid technological change, rapid product
obsolescence and price competition. The Company expects competition to increase
in the future from existing competitors and from other companies that may enter
the Company's existing or future markets with products or technologies which may
be less costly or provide higher performance or more desirable features than the
Company's products. The Company's existing and potential competitors include
several large domestic and international companies that have substantially
greater financial, manufacturing, technical, marketing, distribution and other
resources than the Company. In the market for TV video processors, the Company's
principal

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competitors are DWIN, Extron, NEC, Snell & Wilcox, Sony and YEM. In the market
for broadcast products, the Company's principal competitors are Extron, Leitch,
Matsushita, Snell & Wilcox, Sony Broadcast and Vistek. As the Company's products
penetrate broader markets and as these markets become commercial markets, the
Company expects to face competition from diversified electronic and
semiconductor companies.

Yves Faroudja, the Company and GI are parties to a royalty free, world-wide
license agreement dated May 1, 1996 pursuant to which GI licensed certain
patents to the Company and the Company licensed certain patents to GI relating
to video compression and decompression. As a result of that agreement, GI could
produce products in the field of scan conversion of source material presented to
a compression system competitive with the Company's proposed upconverter.

The Company believes that its ability to compete successfully in the rapidly
evolving markets for high performance video technology depends on a number of
factors, including protection of its proprietary technology and information, the
price, quality and performance of the Company's and its competitors products,
the timing and success of new product introductions by the Company, its
customers and its competitors, the emergence of new industry standards, the
Company's ability to obtain and locate adequate foundry capacity, the number and
nature of the Company's competitors in a given market and general market and
economic conditions. There can be no assurance that the Company will compete
successfully in the future with respect to these or any other competitive
factors.

DEPENDENCE ON STRATEGIC RELATIONSHIPS. The Company expects that a
significant portion of its annual revenues and profits in the future will depend
on strategic relationships. The Company depends on Runco and Vidikron to sell
products which incorporate the Company's technology and a failure by these
companies to make such sales will adversely affect the Company's total revenues
in the future. There can be no assurance that the Company will identify new
strategic partners or enter into additional strategic relationships or that any
of the Company's strategic relationships will result in the introduction of new
products incorporating the Company's technology or will result in substantial
revenues for the Company. In the event that the Company's strategic
relationships fail to result in substantial revenues to the

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Company, the Company's business, financial condition and operating results will
be materially adversely affected.

The Company has licensed and intends to continue to license its technologies
and intellectual property. The Company also offers for sale board level or chip
level products, developed by or for the Company, which implement certain of the
Company's technologies. The Company's licensees and OEM customers may be larger
and have greater market recognition and financial, technological, engineering,
manufacturing and distribution capabilities than the Company. In addition, such
licensees and OEM customers may use such technologies and subsystems either
alone or in combination with other technologies to develop products which could
compete with the Company's technologies and products. While the Company may sell
board level or chip level products and receive royalties from such licensees,
there can be no assurance that the technologies and products offered by such
licensees and OEM customers will not compete directly with those of the Company,
have performance, cost or other advantages over those of the Company or have an
adverse impact on the sales or other licensing activities of the Company.

RISKS ASSOCIATED WITH EXPORT SALES AND OPERATIONS. The Company intends to
expand its international presence in order to increase its export sales and
believes that export sales will increase as a percentage of total revenues in
future periods. Export sales to international customers entail a number of
risks, including unexpected changes in, or impositions of, legislative or
regulatory requirements, delays resulting from difficulty in obtaining export
licenses for certain technology, tariffs, quotas and other trade barriers and
restrictions, longer payment cycles, greater difficulty in accounts receivable
collection, potentially adverse taxes, currency exchange fluctuations, the
burdens of complying with a variety of foreign laws and other factors beyond the
Company's control. The Company would also be subject to general geopolitical
risks in connection with international operations, such as political, social and
economic instability, potential hostilities and changes in diplomatic and trade
relationships. Although the Company has not to date experienced any material
adverse effect on its operations as a result of such regulatory, geopolitical
and other factors, there can be no assurance that such factors will not
adversely affect the Company's operations in the future or require the Company
to modify its current business practices. There can be no assurance that one or
more of the foregoing factors will not have a material adverse effect on the
Company's business, financial condition and operating results or require the
Company to modify its current business practices.

DISTRIBUTION RISKS; DIVERSIFICATION OF SALES CHANNELS. The Company sells
its products domestically and internationally through distributors and dealers,
as well as to OEM customers, and the Company's success depends on the continued
efforts of its network of direct and indirect distributors and dealers. The loss
of, or reduction in sales to, any of the Company's key customers could have a
material adverse affect on the Company's operating results. The short life
cycles of the Company's products and the difficulty in predicting future sales
increase the risk that new product introductions, price reductions by the
Company or its competitors or other factors affecting the video imaging industry
could result in significant product returns. In addition, there can be no
assurance that new product introductions by competitors or other market factors
will not require the Company to reduce prices in a manner or at a time which has
a material adverse impact upon the Company's business, financial condition and
operating results.

An integral element of the Company's strategy is to enhance and diversify
its international and domestic distribution channels. The Company's ability to
achieve revenue growth in the future will depend in large part on its success in
recruiting and training sufficient sales personnel, distributors and resellers.
Certain of the Company's existing distributors currently distribute, or may in
the future distribute, the product lines of the Company's competitors. There can
be no assurance that the Company will be able to attract, train and retain a
sufficient number of its existing or future third-party distributors or direct
sales personnel or that such third-party distributors will recommend, or
continue to recommend, the Company's products or devote sufficient resources to
market and provide the necessary customer support for such products. All of
these factors could have a material adverse effect on the Company's business,
financial condition and operating results.

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RELIANCE ON INDEPENDENT FOUNDRIES AND MANUFACTURING. The Company currently
relies on independent foundries to manufacture, assemble and test all of its
semiconductor components and products. These independent foundries fabricate
products for other companies and may also manufacture products of their own
design. The Company currently purchases products from all of its foundries
pursuant to individually negotiated purchase orders. The Company does not have a
long-term supply contract with any of these foundries, and, therefore, none of
them is obligated to supply products to the Company for any specific period, in
any specific quantity or at any specified price, except as may be provided in a
particular purchase order.

The Company's reliance on independent foundries involves a number of risks,
including the inability to obtain adequate capacity, unavailability of or
interruption of access to certain process technologies, reduced control over
delivery schedules, quality assurance, manufacturing yields and cost, and
potential misappropriation of the Company's intellectual property. From time to
time, the semiconductor industry has experienced severe capacity constraints,
and this pattern is expected to continue. The Company obtains foundry capacity
through forecasts that are generated in advance of expected delivery dates, and
the Company places purchase orders up to six months prior to scheduled delivery.
The Company's ability to obtain the foundry capacity necessary to meet the
demand for its products is based in part on its ability to accurately forecast
demand. If the Company fails to accurately forecast its future demand, the
Company may be unable to obtain adequate supplies of integrated circuits on a
timely basis. There can be no assurance that the Company will be able to
accurately forecast the demand for its products or obtain sufficient foundry
capacity in the future. In addition, the Company's obligation to place purchase
orders in advance of delivery subjects the Company to inventory risks, including
the risk of obsolescence.

While the Company has not experienced any material disruptions in supply to
date, there can be no assurance that manufacturing problems will not occur in
the future. In the event that any of the Company's foundries are unable or
unwilling to produce sufficient supplies of the Company's products in required
volumes at acceptable costs, the Company will be required to reallocate
production among its other existing foundries or to identify and qualify
acceptable alternative foundries. This qualification process could take six
months or longer, and no assurance can be given that any additional source would
become available to the Company or would be in a position to satisfy the
Company's production requirements on a timely basis. The loss of any of the
Company's foundries as a supplier, the inability of the Company in a period of
increased demand for its products to expand supply or the Company's inability to
obtain timely and adequate deliveries from its current or future suppliers could
reduce or delay shipments of the Company's products. Any of these developments
could damage relationships with the Company's current and prospective customers
and could have a material adverse effect on the Company's business, financial
condition and operating results.

The Company subcontracts the manufacturing of its broadcast and TV products
pursuant to individually negotiated purchase orders. The Company does not have
any long term agreements with its subcontractors and contract manufacturers. The
Company's reliance on third-party manufacturers limits its control over delivery
schedules, quality assurance and product cost. Disruptions in the provision of
services by the Company's assemblers or other circumstances that would require
the Company to seek alternative sources of assembly could lead to supply
constraints or delays in the delivery of the Company's products. In addition,
the need for high quality assurance by the Company may increase costs paid by
the Company to third parties for manufacturing and assembly of the Company's
products. These constraints or delays could damage relationships with current
and prospective customers and could have a material adverse effect on the
Company's business, financial condition and operating results.

LIMITED PROTECTION OF PROPERTY RIGHTS: RISK OF THIRD PARTY
INFRINGEMENT. The Company's future success depends in part upon its ability to
protect its technology and information. The Company seeks to protect its
intellectual property rights and to limit access to its proprietary information
through a combination of patents, trademarks, copyrights, trade secrets, and
nondisclosure and licensing arrangements, all of which afford only limited
protection. There can be no assurance that patents will issue from any pending

20
<PAGE>
applications or that any claims allowed from pending applications will be of
sufficient scope or strength, or be issued in all countries where the Company's
products can be sold, to provide meaningful protection or any commercial
advantage to the Company. Also, competitors of the Company may be able to design
around the licensed patents. The laws of certain foreign countries in which the
Company's products are or may be developed, manufactured or sold, including
various countries in Asia, may not protect the Company's products or
intellectual property rights to the same extent as the laws of the United
States, and thus, may increase the likelihood of piracy of the Company's
technology and products. There can be no assurance that the steps taken by the
Company to protect its intellectual property rights will be adequate to prevent
misappropriation of its technology or that the Company's competitors will not
independently develop technologies that are substantially equivalent or superior
to the Company's technology.

There can be no assurance that the Company's intellectual property rights,
if challenged, will be upheld as valid, will be adequate to prevent
misappropriation of its technology or will prevent the development of
competitive products. Additionally, there can be no assurance that the Company
will be able to license or obtain patents or other intellectual property
protection in the future.

Substantially all of the intellectual property used by the Company is
licensed to the Company by Yves Faroudja. The Company faces certain risks
because the Company is a licensee and not the owner of such intellectual
property rights. Under his agreement with the Company, Mr. Faroudja retains the
non-exclusive right to license his patents and technologies to third parties for
use outside the Company's field of use. Notwithstanding the particular terms of
the license agreement with Mr. Faroudja, the Company faces the risk that he may
attempt to terminate the granted licenses and that such an attempt may be
successful or that the response to such attempt may consume substantial
financial and personnel resources. In the event the Company's resources are so
consumed, such consumption may have a material adverse affect on the Company's
business, financial condition and operating results.

The video image enhancement and related industries are characterized by
vigorous protection and pursuit of intellectual property rights or positions,
which have resulted in significant and often protracted and expensive
litigations. The Company may from time to time be subject to proceedings
alleging infringement by the Company of intellectual property rights owned by
third parties. If necessary or desirable, the Company may seek licenses under
such intellectual property rights. However, there can be no assurance that such
licenses will be offered or that the terms of any offered license will be
acceptable to the Company. The failure to obtain such a license from a third
party for technology used by the Company could cause the Company to incur
substantial liabilities and to suspend or cease the manufacture of products
requiring such technology.

The Company may initiate claims or litigations against third parties for
infringement of the Company's proprietary rights or to establish the validity of
the Company's proprietary rights. Litigation by or against the Company could
result in significant expense to the Company and could divert the efforts of the
Company's technical and management personnel, whether or not such litigation
results in a favorable determination for the Company and such diversion may have
a material adverse effect on the Company's business, financial condition and
operating results. In addition, such litigation could result in the assertion of
counter claims against the Company. In the event of an adverse result in any
such litigation, the Company could be required to pay substantial damages,
attorney fees, costs and expenses, to cease infringing a third-party's
intellectual property rights (including, marketing, using, selling and importing
infringing products, and employing infringing methods or processes), to expend
significant resources to develop non-infringing technology, or to obtain
licenses to the technology allegedly infringed. There can be no assurance that
the Company would be successful in such development or that any such license
would be available on reasonable terms, or at all, and any such development or
license could require expenditures by the Company of substantial time and other
resources. In the event that any third party makes a successful intellectual
property claim against the Company or its customers, the Company's business,
financial condition and operating results could be materially adversely
affected.

21
<PAGE>
DEPENDENCE ON SENIOR MANAGEMENT AND OTHER KEY EMPLOYEES. The Company's
future success will depend to a significant extent upon the continued service of
members of senior management and other key employees of the Company,
particularly Yves Faroudja, the Company's founder and Chief Technical Officer
("CTO"), and Michael Moone, the Company's President and Chief Executive Officer.
The loss of the service of any of these individuals could have a material
adverse effect on the Company. Mr. Faroudja has entered into an agreement with
the Company pursuant to which he will serve as the Company's CTO until a new CTO
is identified and hired. Thereafter, Mr. Faroudja will serve as a Senior Fellow
to the Company, advising the Company in a variety of areas, with time to be
devoted at Mr. Faroudja's discretion. The Company does not maintain key man life
insurance on any of its employees. The Company believes that its future success
will depend to a significant extent upon its ability to attract, train and
retain highly skilled technical, management, sales, marketing and consulting
personnel. Competition for such personnel is intense, and the Company expects
that such competition will continue for the foreseeable future. The Company has
from time to time experienced difficulty in locating candidates with appropriate
qualifications. There can be no assurance that the Company will be successful in
attracting or retaining such personnel, and the failure to attract or retain
such personnel could have a material adverse effect on the Company's business,
financial condition and operating results.

SHARES ELIGIBLE FOR FUTURE SALES. Sales of substantial amounts of Common
Stock (including shares issued upon the exercise of outstanding options) in the
public market could materially adversely affect the market price of the
Company's Common Stock. Such sales might also make it more difficult for the
Company to sell equity securities or equity related securities in the future at
a time and price that the Company deems appropriate. As of December 31, 1997
there were 12,058,913 shares of Common Stock outstanding, 8,608,913 of which are
"restricted" shares under the Securities Act of 1993, as amended (the
"Securities Act"). In addition to the 3,450,000 shares currently available for
sale in the public market, approximately 8,608,913 shares will be available for
sale in the public market on April 28, 1998 upon expiration of certain lockup
agreements and pursuant to Rules 144, 144(k) or 701 promulgated under the
Securities Act, subject in some cases to certain volume and other resale
restrictions pursuant to Rule 144. In addition, the Company is required to
register for re-sale by April 28, 1998 an aggregate of 8,200,000 shares of
Common Stock. The Company intends to register on a registration statement on
Form S-8 a total of 2,442,620 shares of Common Stock for issuance pursuant to
the Company's 1995 Stock Option Plan (the "1995 Option Plan"), 1997 Performance
Stock Option Plan (the "1997 Option Plan"), 1997 Directors Stock Option Plan
(the "Directors Plan") and the 1997 Employee Stock Purchase Plan ("Purchase
Plan"). BancAmerica Robertson Stephens in its sole discretion and at any time
without notice can release all or any portion of the securities subject to
lock-up agreements.

POSSIBLE VOLATILITY OF STOCK PRICE

Factors such as announcements of developments related to the Company's
business, announcements of technological innovations or new products or
enhancements by the Company or its competitors, sales of the Company's Common
Stock into the public market, developments in the Company's relationships with
its customers, distributors and suppliers, shortfalls or changes in total
revenues, gross margin, earnings or other financial results from analysts'
expectations, regulatory developments, fluctuations in results of operations and
general conditions in the Company's market or the market served by the Company's
customers or the economy could cause the price of the Company's Common Stock to
fluctuate, perhaps substantially. In addition, in recent years the stock market
in general, and the market for shares of small capitalization and technology
stocks in particular, have experienced extreme price and volume fluctuations,
which have often been unrelated or disproportionate to the operating performance
of affected companies. There can be no assurance that the market price of the
Company's Common Stock will not decline substantially from the initial public
offering price, or otherwise experience significant fluctuations in the future,
including fluctuations that are unrelated to the Company's performance.

22
<PAGE>
EXECUTIVE OFFICERS OF THE COMPANY

Set forth below is the name, age and offices held with the Company of each
of the executive officers of the Company as of March 15, 1998 and such executive
officers' other business experience during the past five years. Except as
otherwise indicated, each such executive officer was elected at the meeting of
the Board of Directors held after the annual meeting of stockholders held on
August 12, 1997. The term of office for each executive officer extends until the
next meeting of the Board of Directors for the election of officers and until
their respective successors are duly elected.

MICHAEL J. MOONE (age 51) has served as President, Chief Executive Officer
and a director of the Company since joining the Company in July 1996. From
February 1995 to June 1996, Mr. Moone was President, Chief Executive Officer and
a director of Healthrider, Inc., a home fitness equipment supplier. In June
1993, he co-founded Kid One, Inc., a developer of electronic toys and games, and
served as its Chief Executive Officer and a director through February 1995. In
1985, Mr. Moone founded Merchantec International, a credit card processing
company, and served as its President, Chief Executive Officer and a director
through May 1993.

YVES C. FAROUDJA (age 64) is co-founder of the Company and has served as a
director of the Company since its inception in 1971. Mr. Faroudja served as the
Company's President from 1971 to July 1996, has been the Company's Chief
Technical Officer since July 1996 and is currently Chairman of its Executive
Committee of the Board of Directors.

MICHAEL C. HOBERG (age 46) joined the Company in December 1996 as Vice
President--Finance and Chief Financial Officer. From March 1995 to December
1996. Mr. Hoberg was Principal Accounting Officer of DSP Group, Inc. ("DSP"), a
semiconductor company, and from January 1994 to March 1995 he was DSP's
Corporate Controller. From March 1992 to January 1994, Mr. Hoberg served as Vice
President of Finance and Chief Financial Officer at Arix Corporation ("Arix"), a
UNIX superminicomputer manufacturer, and from 1989 to March 1992 was Arix's
Corporate Controller.

DONALD S. BUTLER (age 52) joined the Company in May 1996 as Vice President
and General Manager of the VLSI Division. In October 1996, as Vice
President--Engineering, he assumed responsibility for all engineering functions
other than research and development. Prior to joining the Company, Mr. Butler
was Vice President of Engineering at the Integrated Systems Center of GI, a
manufacturer of satellite and cable TV equipment, a position he held from 1989
to May 1996. From 1974 to 1989, he held several engineering and engineering
management positions within GI's Microelectronics Division.

THOMAS A. HARVEY (age 49) joined the Company in June 1997 as Vice
President--Sales and Marketing. From September 1990 to May 1997, Mr. Harvey was
Senior Vice President of the Western Zone Sales Consumer Products Group of Sony
Electronics, Inc. ("Sony Electronics"), a leading electronics supplier. From
June 1989 to August 1990, Mr. Harvey was the President of the Consumer Sales
Company division of Sony Electronics. From August 1987 to May 1989, he was the
President of the Consumer Audio Products group of Sony Electronics.

KENNETH S. BOSCHWITZ (age 44) joined the Company in June 1997 as Vice
President--Business Development and General Counsel. From May 1984 to September
1996, Mr. Boschwitz held various legal and management positions with GI,
including Vice President & General Counsel of GI's Communications Division.

ITEM 2. PROPERTIES

The Company's headquarters is located in approximately 20,000 square feet of
space in Sunnyvale, California pursuant to a lease which expires September 30,
2003. In 1997, the Company also entered into a lease for approximately 10,000
square feet to expand its headquarters in Sunnyvale, California which expires in
September 2003 and for approximately 2,000 square feet for a research and
development facility in Phoenix, Arizona which expires in June 1999. The
aggregate annual gross rent for the Company's

23
<PAGE>
facilities was approximately $186,000 in 1996 and $289,000 in 1997, and the
Company estimates that this amount will increase to approximately $431,000 in
1998.

ITEM 3. LEGAL PROCEEDINGS

In January 1997 and May 1997, the Company filed actions against DWIN and
Snell & Wilcox, respectively, seeking relief and damages for the infringement of
US Patent Number 4,876,596, which was issued on October 24, 1989, is owned by
Yves Faroudja and is licensed to the Company. DWIN and Snell & Wilcox have
raised defenses and counterclaims that the patent is invalid and not infringed.
The actions against DWIN and Snell & Wilcox were filed in the United States
District Court, Northern District of California, San Jose Division as Civil
Action No. C-97 20010 SW (PVT) and Civil Action No. C-97 20422 SW (PVT),
respectively. The Company is seeking an injunction and unspecified monetary
damages against both DWIN and Snell & Wilcox. DWIN and Snell & Wilcox have filed
counterclaims seeking declaratory judgements that all of the claims of the
patents are invalid and/or that US Patent Number 4,876,596 has not been
infringed. They are also seeking recovery of their respective attorneys' fees
and costs. Discovery has commenced in both matters. The Company's management
believes that a finding that all of the claims of the patent are invalid or that
the patent has not been infringed in one or both actions would not have a
material adverse effect on the Company because the Company's products and
business are protected by a variety of patents and the Company will remain
competitive even in the absence of the protection afforded by the patent which
is the subject of these litigation matters.

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

None.

24
<PAGE>
PART II

ITEM 5. MARKET FOR REGISTRANT'S COMMON EQUITY AND RELATED STOCKHOLDER MATTERS.

The section labeled "Price Range of Common Stock" appearing on page 14 of
the Registrant's Annual Report to Stockholders for the year ended December 31,
1997 (the "1997 Annual Report") is incorporated herein by reference.

ITEM 6. SELECTED FINANCIAL DATA.

The section labeled "Selected Consolidated Financial Data" appearing on page
14 of the Registrant's 1997 Annual Report is incorporated herein by reference.

ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS
OF OPERATION.

The section labeled "Management's Discussion and Analysis of Financial
Condition and Results of Operations" appearing on pages 15 through 19 of the
1997 Annual Report is incorporated herein by reference.

ITEM 7A. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISKS.

Not Applicable.

ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA.

The consolidated financial statements and related notes and independent
auditors report appearing on pages 20 through 32 of the 1997 Annual Report are
incorporated herein by reference.

The section labeled "Quarterly Data" appearing on page 14 of the 1997 Annual
Report is incorporated herein by reference.

ITEM 9. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND
FINANCIAL DISCLOSURE.

Not applicable.

PART III

ITEM 10. DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANT.

Information concerning directors of the Company is incorporated herein by
reference from the Registrant's definitive proxy statement to be filed for the
annual meeting of stockholders to be held on June 10, 1998 ("1998 Proxy
Statement"). Information concerning the executive officers of the Registrant is
included in Part I, page 23, of this annual report on Form 10-K.

ITEM 11. EXECUTIVE COMPENSATION.

The section labeled "Executive Compensation" of the 1998 Proxy Statement is
incorporated herein by reference.

ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT.

The section labeled "Security Ownership of Certain Beneficial Owners" of the
1998 Proxy Statement is incorporated herein by reference.

25
<PAGE>
ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS.

The section labeled "Certain Relationships and Related Transactions" of the
1998 Proxy Statement is incorporated herein by reference.

PART IV

ITEM 14. EXHIBITS, FINANCIAL STATEMENT SCHEDULES, AND REPORTS ON FORM 8-K.

(a) The following documents have been filed as a part of this Annual Report
on Form 10-K.

1. Index to Financial Statements.

The following financial statements and related notes and auditor's reports
are included in the 1997 Annual Report and are incorporated herein by reference
pursuant to Item 8.

<TABLE>
<CAPTION>
PAGE IN 1997
DESCRIPTION ANNUAL REPORT
- ------------------------------------------------------------------------------- -------------
<S> <C>
Consolidated Balance Sheets as of December 31, 1997 and 1996................... 20

Consolidated Statements of Income for the years ended December 31, 1997, 1996
and 1995..................................................................... 21

Consolidated Statements of Stockholders' Equity for the years ended December
31, 1997, 1996 and 1995...................................................... 22

Consolidated Statements of Cash Flows for the years ended
December 31, 1997, 1996 and 1995............................................. 23

Notes to Consolidated Financial Statements..................................... 24 to 31

Report of Ernst & Young LLP, Independent Auditors.............................. 32
</TABLE>

2. Index to Financial Statement Schedules.

The following financial statement schedules and related auditor's reports
are filed as part of this Annual Report on Form 10-K:

<TABLE>
<CAPTION>
PAGE IN THIS
ANNUAL REPORT
DESCRIPTION ON FORM 10-K
- ------------------------------------------------------------------------------- -----------------
<S> <C>
Schedule II: Valuation and Qualifying Accounts................................. S-1
</TABLE>

All other schedules are omitted because they are not applicable or not
required or because the required information is included in the Consolidated
Financial Statements or the Notes thereto.

3. Exhibits

The exhibits noted in the accompanying Index to Exhibits on pages 30 to 31
are filed as part of this Annual Report on Form 10-K.

(b) Reports on Form 8-K.

No reports on Form 8-K were filed during the last quarter of 1997.

26
<PAGE>
SIGNATURES

Pursuant to the requirements of Section 13 or 15(d) of the Securities
Exchange Act of 1934, the Registrant has duly caused this report to be signed on
its behalf by the undersigned, thereunto duly authorized.

<TABLE>
<S> <C> <C>
FAROUDJA, INC.

By: /s/ MICHAEL J. MOONE
---------------------------------------
Michael J. Moone
PRESIDENT AND CHIEF EXECUTIVE OFFICER

Date: March 27, 1998
</TABLE>

Pursuant to the requirements of the Securities Exchange Act of 1934, this
report has been signed below by the following persons on behalf of the
Registrant and in the capacities and on the dates indicated.

<TABLE>
<CAPTION>
SIGNATURE TITLE DATE
- ------------------------------ --------------------------- -------------------

<C> <S> <C>
Chief Executive Officer,
/s/ MICHAEL J. MOONE President and Director
- ------------------------------ (Principal Executive March 27, 1998
Michael J. Moone Officer)

Vice President--Finance and
/s/ MICHAEL C. HOBERG Chief Financial Officer
- ------------------------------ (Principal Financial and March 27, 1998
Michael C. Hoberg Accounting Officer)

Chief Technical Officer,
/s/ YVES C. FAROUDJA Director and Chairman of
- ------------------------------ the Executive Committee, March 27, 1998
Yves C. Faroudja Secretary

/s/ WILLIAM J. TURNER
- ------------------------------ Director March 27, 1998
William J. Turner

/s/ KEVIN B. KIMBERLIN
- ------------------------------ Director March 27, 1998
Kevin B. Kimberlin

/s/ MATTHEW D. MILLER
- ------------------------------ Director March 27, 1998
Matthew D. Miller
</TABLE>

27
<PAGE>
<TABLE>
<CAPTION>
SIGNATURE TITLE DATE
- ------------------------------ --------------------------- -------------------

<C> <S> <C>
/s/ WILLIAM N. SICK
- ------------------------------ Director March 27, 1998
William N. Sick

/s/ MERV L. ADELSON
- ------------------------------ Director March 27, 1998
Merv L. Adelson

/s/ STUART D. BUCHALTER
- ------------------------------ Director March 27, 1998
Stuart D. Buchalter
</TABLE>

28
<PAGE>
FAROUDJA, INC.

SCHEDULE II--VALUATION AND QUALIFYING ACCOUNTS

(IN THOUSANDS)

<TABLE>
<CAPTION>
BALANCE AT CHARGED TO CHARGED TO BALANCE
BEGINNING COSTS AND OTHER DEDUCTIONS END OF
OF PERIOD EXPENSES ACCOUNTS (1) PERIOD
------------- ------------- ------------- ------------- -----------
<S> <C> <C> <C> <C> <C>
Year ended December 31, 1997 deducted from asset
accounts:
Allowance for doubtful accounts..................... $ 110 $ 101 $ 44 $ 167
----- ----- ----- ----- -----
Year ended December 31, 1996 deducted from asset
accounts:
Allowance for doubtful accounts..................... $ 10 $ 143 $ -- $ 43 $ 110
----- ----- ----- ----- -----
Year ended December 31, 1995 deducted from asset
account:
Allowance for doubtful account...................... $ 10 $ -- $ -- $ -- $ 10
----- ----- ----- ----- -----
</TABLE>

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

(1) Uncollectible accounts written off, net of recoveries.

29
<PAGE>
FAROUDJA, INC.

INDEX TO EXHIBITS

(ITEM 14(C))

<TABLE>
<CAPTION>
EXHIBIT
NUMBER DESCRIPTION
- ----------- --------------------------------------------------------------------------------------------------------
<C> <S>
3.1 The Company's Restated Certificate of Incorporation, as amended on August 12, 1997. (1)
3.2 The Company's By-Laws. (1)
4.1 Warrant, dated January 20, 1997, for the purchase of Common Stock issued to Yves Faroudja. (1)
4.2 Warrant, dated December 17, 1997, for the purchase of Common Stock issued to Adelson Investors, LLC.
4.3 Specimen of Common Stock Certificate. (1)
10.1 Letter Agreement, dated December 31, 1996, between the Company and Merv L. Adelson for certain
consulting services. (1)
10.2 Amendment to Letter Agreement, dated December 17, 1997, between the Company and Merv L. Adelson.
10.3 Letter Agreement, dated November 13, 1995, by and among certain stockholders of the Company listed
therein and Spencer Trask Holdings, Inc. (1)
10.4 Amendment to Letter Agreement, dated February 9, 1996, among certain stockholders of the Company listed
therein and Spencer Trask Holdings, Inc. (1)
10.5 Lease Agreement, dated August 27, 1997, by and among the Company and the Landlords listed therein. (1)
10.6 The Company's 1995 Stock Option Plan, dated August 1, 1995 and amended on August 19, 1996, February 11,
1997, April 30, 1997 and June 13, 1997. (1)
10.7 The Company's 1997 Non-Employee Directors Stock Option Plan, dated January 2, 1997. (1)
10.8 The Company's 1997 Performance Stock Option Plan, dated January 2, 1997 and amended on June 13, 1997.
(1)
10.9 The Company's Amended 1997 Employee Stock Purchase Plan, dated January 2, 1997 and amended on August 12,
1997 and September 30, 1997. (1)
10.10 Employment Agreement, dated as of July 8, 1996, between the Company and Michael J. Moone. (1)
10.11 Employment Agreement, dated March 8, 1996, between the Company and Yves C. Faroudja. (1)
10.12 Registration and Shareholders' Rights Agreement, dated March 7, 1997, among the Company and Yves &
Isabell Faroudja and certain Stockholders of the Company. (1)
10.13 Three (3) Registration Rights Agreements, dated December 31, 1996 among the Company and each of Adelson
Investors, LLC, Images Partners, LP and Roger K. Baumberger as Liquidating Trustee for Faroudja
Images, Inc. (1)
10.14 Registration Rights Agreement, dated March 7, 1997 among the Company and Faroudja Images Investors, LLC.
(1)
10.15 Agreement, dated January 20, 1997 among Yves Faroudja and the Company for the transfer of intellectual
property to the Company. (1)
10.16 License Agreement, dated March 31, 1997, between the Company and S3 Incorporated. (1) (2)
10.17 Stock Purchase Agreement, dated June 30, 1997, between the Company and S3 Incorporated. (1)
10.18 Investor's Rights Agreement, dated June 30, 1997, between the Company and S3 Incorporated. (1)
</TABLE>

30
<PAGE>
FAROUDJA, INC.

INDEX TO EXHIBITS

(ITEM 14(C))

<TABLE>
<CAPTION>
EXHIBIT
NUMBER DESCRIPTION
- ----------- --------------------------------------------------------------------------------------------------------
<C> <S>
10.19 Business Loan Agreement, dated April 5, 1997, between the Company and Silicon Valley Bank. (1)
10.20 Commercial Guaranty, dated April 5, 1997, by the Company for the benefit of Silicon Valley Bank. (1)
10.21 Commercial Security Agreement, dated April 5, 1997, by the Company for the benefit of Silicon Valley
Bank. (1)
10.22 Promissory Note, dated April 5, 1997, by the Company for the benefit of Silicon Valley Bank. (1)
10.23 Promissory Note, dated June 6, 1997, by the Company for the benefit of Silicon Valley Bank. (1)
10.24 Loan Modification Agreement, dated June 6, 1997, by and between the Company and Silicon Valley Bank. (1)
10.25 Three (3) Amended and Restated Options to Purchase Shares of Common Stock of the Company, dated March 7,
1997 among the Company, Yves Faroudja and Isabell Faroudja, Faroudja Images, Inc. and each of Adelson
Investors, LLC, Faroudja Images Investors, LLC and Images Partners, LP. (1)
10.26 Amended and Restated Option to Purchase Shares of Common Stock of the Company, dated December 31, 1996
among the Company, Yves Faroudja and Isabell Faroudja, Faroudja Images, Inc. and Roger K. Baumberger
as Liquidating Trustee of Faroudja Images, Inc. (1)
10.27 Consulting Services Agreement, dated July 22, 1997, between the Company and Matthew D. Miller. (1)
10.28 License Agreement, dated May 1, 1996 between the Company, Yves Faroudja and General Instrument
Corporation of Delaware. (1) (2)
10.29 Purchase Agreement dated December 18, 1997, between the Company and Audio Video Source, Inc. (3)
10.30 Agreement, dated March 8, 1998, between the Company and Yves Faroudja for advisory services.
13.1 Annual Report to Stockholders for the year ended December 31, 1997.
21.1 List of the Subsidiaries of the Company. (1)
23.0 Consent of Ernst & Young LLP, Independent Auditors.
27 Financial Data Schedules.
</TABLE>

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

(1) Filed as an exhibit to the Registrant's Registration Statement on Form S-1,
File No. 333-32375, and incorporated herein by reference.

(2) Confidential treatment has been granted. Non-public information has been
omitted and filed separately with Commission.

(3) Confidential treatment has been requested. Non-public information has been
omitted and filed separately with the Commission.

<PAGE>
AMENDMENT
---------

Amendment dated as of the 17th day of December, 1997 by and among Merv
Adelson, c/o East-West Capital Associates, 10900 Wilshire Boulevard, Suite
750, Los Angeles, CA 90024 ("Adelson"), and Faroudja, Inc. ("FI"), a Delaware
corporation, and its wholly-owned subsidiary, Faroudja Laboratories, Inc.
("FLI"), a California corporation, with offices at 750 Palomar Avenue,
Sunnyvale, CA 94086 (FI and FLI referred to hereinafter collectively as the
"Company").

WITNESSETH:

WHEREAS, the parties have entered into an agreement dated as of December
31, 1996 pursuant to which Adelson serves as a consultant to the Company for
the analysis and implementation of potential strategic alliances (the
"Agreement");

WHEREAS, the parties wish to modify certain provisions of the
Agreement relating to the timing of Adelson's compensation;

NOW, THEREFORE, in consideration of the foregoing and the mutual
promises contained herein and in the Agreement, the parties hereto hereby
agree to amend the Agreement as follows:

Defined terms in this Amendment shall have the meanings ascribed to them
in the Agreement unless otherwise indicated.

The first paragraph of Section 2 of the Agreement shall be deleted and
replaced with the following:

"COMPENSATION. As compensation for the services to be rendered by
Mr. Adelson, FI shall immediately grant to Adelson Investors, LLC,
a warrant to purchase from FI, at a price of $.15 per share, up to
65,152 shares of Common Stock of FI. The warrant shall be in the
form of Exhibit A attached hereto. The actual number of shares
for which the warrant may be exercised shall be determined from
time to time by the Board of Directors of FI, based upon the
Consideration (as defined below) received by FLI as a result of
Mr. Adelson's services. If FLI receives Consideration of
$5,000,000 or more as a result of Mr. Adelson's services, the
Board of Directors of FI shall declare the warrant exercisable
with respect to all 65,152 shares. If FLI receives Consideration
of less than $5,000,000 for such services, the Board of Directors
may, from time to time, in its sole discretion, declare the
warrant exercisable with respect to a number of shares not greater
than the product of multiplying 65,152

<PAGE>

by the fraction created by dividing the Consideration received by
FLI, by $5,000,000."

3. The form of warrant attached to this Amendment as Exhibit A, shall
replace Exhibit A to the Agreement.

4. The Agreement shall in all other respects remain in full force and
effect.

IN WITNESS WHEREOF, the parties hereto have caused this Amendment to the
Agreement to be executed as of the date first set forth above.

MERV ADELSON FAROUDJA, INC.

/s/ Merv Adelson By: /s/ Michael Moone
- ------------------------------ ------------------------------

Name: MICHAEL MOONE
----------------------------

Title: PRESIDENT, CEO
---------------------------

FAROUDJA LABORATORIES, INC.

By: /s/ Michael Moone
------------------------------

Name: MICHAEL MOONE
----------------------------

Title: PRESIDENT, CEO
---------------------------

2
<PAGE>

EXHIBIT A

[FORM OF WARRANT]

THE SECURITIES REPRESENTED HEREBY HAVE NOT BEEN REGISTERED UNDER THE
SECURITIES ACT OF 1933 AND MAY NOT BE TRANSFERRED IN VIOLATION OF SUCH ACT OR
THE RULES AND REGULATIONS THEREUNDER.

WARRANT TO PURCHASE

SHARES OF

FAROUDJA, INC.

COMMON STOCK

Faroudja, Inc., a Delaware corporation (the "Company") hereby issues to
Adelson Investors, LLC (the "Holder") this warrant to purchase from the
Company, at any time or from time to time on or before the third anniversary
of the date of this warrant (or any earlier date specified by the Company in
a written notice given by the Company to the Holder), for a price per share
equal to $.15, up to 65,152 shares of common stock of the Company.

This warrant is subject to the following terms and conditions:

1. EXERCISE. The rights represented by this warrant may be exercised,
at any time or from time to time in whole or in part, by (a) the surrender of
this warrant, along with the purchase form attached as exhibit A-1 (the
"Purchase Form"), properly executed, at the address of the Company set forth
in section 8.2 (or such other address as the Company may designate by notice
in writing to the Holder at its address set forth in section 8.2) and (b) the
payment to the Company of the exercise price by check, payable to the order
of the Company, for the number of shares specified in the Purchase Form,
together with any applicable stock transfer taxes. A certificate
representing the shares so purchased and, in the event of an exercise of
fewer than all the rights represented by this warrant, a new warrant in the
form of this warrant issued in the name of the Holder or its designee(s) and
representing a new warrant to purchase a number of shares equal to the number
of shares as to which this warrant was theretofore exercisable less the
number of shares as to which this warrant shall theretofore have been
exercised, shall be delivered to the Holder or such designee(s) as promptly
as practicable, but in no event later than three business days, after this
warrant shall have been so exercised.

<PAGE>

2. ADJUSTMENT OF THE NUMBER OF SHARES. If the Company shall (a) pay a
dividend in common stock or make a distribution in common stock, (b)
subdivide its outstanding common stock, (c) combine its outstanding common
stock into a smaller number of shares of common stock or (d) issue by
reclassification of its common stock, spin-off, split-up, recapitalization,
merger, consolidation or any similar corporate event or arrangement other
securities of the Company, the kind and number of shares of common stock
purchasable upon exercise of this warrant shall be adjusted immediately prior
to the exercise of this warrant so that the Holder shall be entitled to
receive the kind and number of shares or other securities of the Company to
which the Holder would have been entitled to receive after the happening of
any of the events described above had this warrant been exercised immediately
prior to the happening of such event or the record date with respect to such
event.

3. RESERVATION OF SHARES. From and after the date of this warrant, the
Company shall at all times reserve and keep available for issuance upon the
exercise of this warrant a number of its authorized but unissued shares of
common stock sufficient to permit the exercise in full of this warrant.

4. TRANSFER. Subject to applicable law, this warrant may be
transferred at any time, in whole or in part, to any entity, entities, person
or persons. Any transfer shall be effected by the surrender of this warrant,
along with the form of assignment attached as exhibit A-2, properly executed,
at the address of the Company set forth in section 7.2 (or such other address
as the Company may designate by notice in writing to the Holder at its
address set forth in section 7.2). Thereupon, the Company shall issue in the
name or names specified by the Holder a new warrant or warrants of like tenor
and representing a warrant or warrants to purchase in the aggregate a number
of shares equal to the number of shares to which this warrant was theretofore
exercisable less the number of shares as to which this warrant shall
theretofore have been exercised.

5. PAYMENT OF TAXES. The Company shall cause all shares of common
stock issued upon the exercise of this warrant to be validly issued, fully
paid and nonassessable and not subject to preemptive rights. The Company
shall pay all expenses in connection with, and all taxes and other
governmental charges that may be imposed with respect to, the issuance or
delivery of the shares of common stock upon exercise of this warrant, unless
such tax or charge is imposed by law upon the Holder.

6. PIGGYBACK REGISTRATION.

6.1 INCLUSION IN REGISTRATION. If at any time after the date of
this warrant until the expiration of this warrant, the Company proposes to
register any of its shares of common stock under the Securities Act of 1933
(other than in connection with a merger or pursuant to Form S-8 or S-4 or a
comparable registration statement) it will promptly give notice to the Holder
of its intention to do so. If the Holder notifies the Company within twenty
(20) days after receipt of any such notice of its desire to include any
Warrant Shares (as defined in section 6.3) in such proposed registration, the
Company shall afford the

2
<PAGE>

Holder the opportunity to have such Warrant Shares registered under such
registration statement.

Notwithstanding anything in this section 6 to the contrary, the Company
shall have the right at any time after it shall have given any notice
pursuant to this section 6 (irrespective of whether a written request for
inclusion of any Warrant Shares shall have been made), to elect to postpone
or not to file such proposed registration statement or to withdraw the same
after filing but prior to the effective date thereof.

6.2 UNDERWRITING REQUIREMENTS. In connection with any offering
involving an underwriting of shares being sold by the Company, the Company
shall not be required under this section 6 to include any Warrant Shares in
such underwriting unless the Holder accepts the terms of the underwriting as
agreed upon between the Company and the underwriters selected by it, and then
only in such quantity as will not, in the opinion of the underwriters,
jeopardize the success of the offering by the Company. If the total number
of shares, including the Warrant Shares, requested by shareholders, including
the Holder, to be included in the offering exceeds the number of shares sold
other than by the Company that the underwriters reasonably believe compatible
with the success of the offering, then the number of selling shareholders'
shares that may be included in the offering shall be apportioned pro rata
among the selling shareholders according to the total number of shares
entitled to be included in the offering owned by each selling shareholder or
in such other proportions as shall mutually be agreed to by the selling
shareholders.

6.3 DEFINITION. As used in this section 6, the term "Warrant
Shares" means shares of common stock of Faroudja issued or issuable upon the
exercise of this warrant.

7. MISCELLANEOUS.

7.1 SECURITIES ACT RESTRICTIONS. The Holder acknowledges that this
warrant may not be sold, transferred or otherwise disposed of without
registration under the Securities Act of 1933 (the "Act") or an applicable
exemption from the registration requirements of the Act and, accordingly,
this warrant and all certificates representing the common stock and any other
securities issuable upon the exercise of this warrant shall bear a legend in
the form set forth on the top of page one of this warrant.

7.2 NOTICES. All notices and other communications under this
agreement shall be in writing and may be given by any of the following
methods: (a) personal delivery; (b) facsimile transmission; (c) registered or
certified mail, postage prepaid, return receipt requested; or (d) overnight
delivery service. Notices shall be sent to the appropriate party at its, his
or her address or facsimile number given below (or at such other address or
facsimile number for that party as shall be specified by notice given under
this section 7.2):

3
<PAGE>

if to the Holder, to it at:

Adelson Investors, LLC
10900 Wilshire Boulevard, Suite 750
Los Angeles, California 90024
Attention: Merv Adelson
Fax: (310) 209-6160

with a copy to:

East-West Capital Associates
10900 Wilshire Boulevard, Suite 750
Los Angeles, California 90024
Attention: Paul J. Nadel
Fax: (310) 209-6160

if to the Company, to it at:

Faroudja, Inc.
750 Palomar Avenue
Sunnyvale, California 94086
Attention: Michael Hoberg, CFO
Fax: (408) 735-8571

with a copy to:

Buchalter, Nemer, Fields & Younger
601 South Figueroa Street, Suite 2400
Los Angeles, California 90017
Attention: Stuart D. Buchalter, Esq.
Fax: (213) 896-0400

All such notices and communications shall be deemed received upon (a) actual
receipt by the addressee, (b) actual delivery to the appropriate address or
(c) in the case of a facsimile transmission, upon transmission by the sender
and issuance by the transmitting machine of a confirmation slip confirming
that the number of pages constituting the notice have been transmitted
without error. In the case of notices sent by facsimile transmission, the
sender shall contemporaneously mail a copy of the notice to the addressee at
the address provided for above. However, such mailing shall in no way alter
the time at which the facsimile notice is deemed received.

7.3 AMENDMENT. This warrant may be modified or amended or the
provisions of this warrant may be waived only with the written consent of the
Company and the Holder.

4
<PAGE>

7.4 GOVERNING LAW. This warrant shall be governed by the law of
the state of Delaware, without regard to the provisions thereof relating to
conflicts of laws.

8. VESTING. This warrant shall be currently exercisable with respect
to that number of shares of Common Stock of the Company as the Company shall
from time to time advise the Holder in writing. The warrant is currently
exercisable with respect to 21,178 shares of Common Stock of the Company.

December 17, 1997

FAROUDJA, INC.

By:____________________________________
Michael Moone,
President and CEO

5
<PAGE>

EXHIBIT A-1

PURCHASE FORM

[To be executed only upon exercise of warrant]

The undersigned registered owner of this warrant irrevocably exercises
this warrant for the purchase of _____________________ shares of common stock
of Faroudja, Inc. and herewith makes payment therefor, all at the price and
on the terms and conditions specified in this warrant and requests that
certificates for the shares of common stock hereby purchased be issued in the
name of and delivered to _________________________________ whose address is
_______________________________________________ and, if such shares of common
stock shall not include all of the shares of common stock issuable as
provided in this warrant, that a new warrant of like tenor and date for the
balance of the shares of common stock issuable hereunder be delivered to the
undersigned.

Dated:______________________

______________________________________
(Name of Registered Owner)

______________________________________
(Signature of Registered Owner)

______________________________________
(Street Address)

______________________________________
(City) (State) (Zip Code)

Exhibit A-1
-1-
<PAGE>

EXHIBIT A-2

ASSIGNMENT FORM

FOR VALUE RECEIVED, the undersigned registered owner of this warrant
hereby sells, assigns and transfers to the assignee named below all of the
rights of the undersigned under this warrant with respect to the number of
shares of common stock set forth below:

No. of shares
Name and Address of Assignee Common Stock
- ---------------------------- -------------

and does hereby irrevocably constitute and appoint ___________________________
attorney-in-fact to register such transfer on the books of Faroudja, Inc.
maintained for the purpose, with full power of substitution in the premises.

Dated:______________________ Print Name:______________________________

Signature: ______________________________

Witness:_________________________________

Exhibit A-2
-1-

<PAGE>

[ ] INDICATES TEXT FOR WHICH CONFIDENTIAL TREATMENT HAS BEEN REQUESTED, WHICH
NON-PUBLIC INFORMATION HAS BEEN FILED WITH THE SECURITIES AND EXCHANGE
COMMISSION.

PURCHASE AGREEMENT

This PURCHASE AGREEMENT is made as of the 18th day of December, 1997, by
and between FAROUDJA LABORATORIES, INC., a California corporation with a
place of business at 750 Palomar Avenue, Sunnyvale, CA 94086 ("Buyer"), and
AUDIO VIDEO SOURCE, INC., a California corporation with a place of business
at 21717 Plummer Street, Chatsworth, CA 91311 ("Seller").

WHEREAS, Buyer and Seller are parties to an agreement dated August 11,
1997 (the "Letter Agreement") pursuant to which Seller agreed to develop a
rear screen projection system exclusively for sale by Buyer; and

WHEREAS, the parties wish to enter into an agreement pursuant to which
Seller will supply to Buyer rear screen projection systems conforming to the
specifications set forth on APPENDIX A to this Agreement (the "Product") on
the terms and conditions set forth below.

NOW, THEREFORE, in consideration of the premises and mutual covenants
set forth herein, the parties hereby agree as follows:

1. During the term of this Agreement, Buyer shall have the right to
purchase Products from Seller and Seller agrees to sell the Products to
Buyer on the terms and subject to the conditions set forth herein.

2. Subject to Seller's performance of its obligations under this
Agreement, Buyer agrees to purchase a minimum of [ ] units of the
Product. It is Buyer's present intention to purchase approximately [ ]
units per month during the 24-month period commencing on the date of
the first shipment of the production version of the Product. The
parties understand and agree that Buyer's stated intention does not
constitute a binding commitment.

3. Concurrently with the execution of this Agreement, Buyer will issue a
purchase order for [ ] units to be delivered in December 1997, [ ]
units to be delivered in January, 1998 and [ ] units to be
delivered in February 1998. The December order shall be firm, the
January order may be modified by 50% and the February order may be
changed by 100%, in Buyer's discretion. Thereafter, purchase orders
will be issued monthly for Products to be produced during the month
starting sixty days after the order date and delivered not more than
ninety days after the order date. At the beginning of each month,
Buyer will also furnish Seller with non-binding forecasts for its
requirements during the months starting 90, 120 and 150 days after the
order date.

4. The unit price for the Product is $[ ], FOB Seller's
production/warehouse facility. The price will not exceed this amount
until the earlier of (a) delivery of the first 1,000

<PAGE>

units, or (b) twelve months from the first delivery of Products.
Within one month of the occurrence of the earlier of these events, and
annually thereafter, the parties agree to review pricing for the next
twelve months taking into consideration cost, volume and other relevant
factors.

5. Buyer will take steps that are reasonable, in Buyer's sole discretion,
to assist Seller in procuring high value items required for the
production of the Products. Such assistance may include the purchase
of high value components directly by Buyer or actions to support
Seller's credit. Seller agrees to advise Buyer of its need for
assistance at the earliest possible date and Buyer will consider and
act upon requests for assistance promptly, on a case by case basis.

6. To assist Seller in obtaining cabinets for the Products from Hitachi,
Buyer agrees to order such cabinets for units to be delivered by Seller
during 1997 directly from Hitachi. Seller agrees to purchase all
cabinets purchased by Buyer from Hitachi on a pass-through basis, i.e.
on the same terms as the Buyer purchases such units from Hitachi.

7. Buyer will supply Seller with Buyer's VP-250 chassis and remote
control, at Buyer's sole expense, for integration into the Product.

8. With each Product Seller will supply a remote control for the
projector, an operating manual for the projector and a shipping carton.

9. Seller warrants that all Products will be free from defects in design,
material and workmanship and conform to the Product specifications set
forth on Appendix A (the "Specifications"). Without limiting the
foregoing, the Products shall be tested and listed for compliance with
FCC (Type B) and DHHS. The warranty shall extend for 90 days from in
service date for Products used commercially and for the shorter of (a)
12 months from shipment to an end-user, or (b) 18 months from shipment
by Seller for all other Products. Seller will not be responsible for
defects due to improper use or modification. With respect to the
VP-250, Seller's warranty only relates to integration into the
Products. Claims from users including, but not limited to, fitness for
application, loss of use or other consequential damages are not covered
in any form by Seller.

10. Within 4 months from the date hereof the Products shall be tested and
listed for compliance with UL and CSA requirements. Seller will use
its best efforts to test and list the Products with CE and SEMKO
requirements within the same 4 month period. UL certification will be
obtained at no additional cost to Buyer. CSA, CE and SEMKO
certification will be obtained at the cost of the approval process plus
15%.

11. Seller's obligations with respect to supply of the Products shall
include the following:

a. Provide projection system conforming to the Specification.
b. Specify and oversee procurement, manufacture and delivery of
cabinets.

2
<PAGE>

c. Provide and install mirrors and screens.
d. Install the projection system.
e. Align projectors to cabinets.
f. Install VP250.
g. Test components and Products in accordance with good industry
practices.
h. Develop and follow mutually agreed quality control measures.

12. Seller shall provide warranty and repair support for the Products.
Such obligation shall include, without limitation, the maintenance of a
supply of spare and replacement parts necessary to comply with legal
and regulatory support requirements and good industry practices.
Service will be provided only for units returned to Seller's production
facility, freight prepaid. Seller will return units repaired under
warranty, freight prepaid, provided, that Seller's responsibility for
shipping costs shall be limited to the cost of shipping the projector
chassis. If the defect rate for all units exceeds 10% from all causes,
or 5% from any one cause, Seller will be responsible for (a) the cost
of return shipment, or (b) the cost of one service call with respect to
the affected units, at Buyer's option. Seller reserves the right to
make reasonable charges for the time involved in servicing units found
not to be defective.

13. Seller shall provide customer support for the product including
maintenance of a separate phone line for Buyer inquiries or inquiries
referred by Buyer. Service literature accompanying the Products will
not identify Seller and will instruct customers to contact Buyer
directly. Buyer will not refer customer calls to Seller until it has
made reasonable efforts to resolve the customer issue internally.
Customer support shall be available from the hours of 8am to 6pm
Pacific Time. Seller shall supply Buyer with a complete set of service
and repair manuals and documentation.

14. Completed products will be stored in a separate, secured area of the
production facility. Seller will ship the Products to customer
locations in accordance with Buyer's instructions. Seller's fee for
storage and drop shipping shall be $100, which approximates Seller's
cost of providing such services.

15. Seller will invoice Buyer semi-monthly for all Product completed in
accordance with delivery schedules set forth in Buyer's purchase orders
and moved to the designated storage area, and weekly when units of the
Product are shipped directly to customers. Payment will be made net 30
days from the date of invoice. Title and risk of loss for Products
completed and moved to the designated storage area shall shift to Buyer
upon receipt of Seller's invoice. Buyer may offset amounts due from
Seller to Buyer for high value items purchased by Buyer to support
Seller's production efforts against amounts due from Buyer to Seller.

16. The parties agree that information exchanged between the parties
relating to this Agreement is confidential information and will be held
in confidence in accordance with the non-disclosure agreement between
the parties dated August 11, 1997. The parties also agree that the
contents and terms of this Agreement shall be confidential

3
<PAGE>

16. and not disclosed to any third party unless disclosure is required by
law or government regulation.

17. Seller represents and warrants that it has all necessary rights,
approvals, authorizations and licenses for Seller to sell the Products
to Buyer and for Seller to use, lease, sell or otherwise transfer the
Products.

18. This Agreement shall have a term of 2 years from the date hereof and
shall be automatically extended in one year increments unless
terminated by Buyer with 30 days written notice to Seller.

19. A party may terminate this Agreement if the other party breaches any
provision of this Agreement and fails to cure such breach within 30
days written notice of such breach. Notwithstanding the foregoing,
repeated failure to deliver Products on schedule shall entitle Buyer to
terminate this Agreement even if delivery occurs within the 30 day cure
period.

20. A party shall not be liable to the other for any loss incurred due to
causes beyond the reasonable control of the party such as riots,
storms, fires, war, embargo, government boycott or other governmental
action, acts of God or unavailability of key components.

21. The failure to enforce any provision of this Agreement shall not be
construed as a waiver of such provision or of the right thereafter to
enforce the same, and no waiver of any breach shall be construed as an
agreement to waive any subsequent breach.

22. Seller may not assign (whether by operation of law or otherwise) any of
its rights or obligations under this Agreement without the prior
written consent of Buyer. Seller has advised Buyer of its intention to
form a separate manufacturing company to perform services of the type
undertaken in this Agreement. Seller may assign its rights under this
Agreement to such a company with the prior written consent of Buyer.
Buyer will not unreasonably withhold its consent to such an assignment
if Seller demonstrates to the satisfaction of Buyer that the assignment
will not result in a diminution of Buyer's rights under this Agreement.

23. Seller agrees that Seller is an independent contractor and not an agent
or employee of the Buyer and shall not hold itself out as a legal
representative, agent, joint venturer, partner or employee of the Buyer
for any purpose whatsoever. Seller has no right or authority to assume
or create any obligations of any kind on behalf of Buyer or to bind
Buyer in any respect.

4
<PAGE>

IN WITNESS WHEREOF, the parties hereto have executed this Agreement as
of the date first above written.

FAROUDJA LABORATORIES, INC. AUDIO VIDEO SOURCE, INC.

By: /s/ Kenneth S. Boschwitz By: /s/ Manh Nguyen
----------------------------- -----------------------------
Title: VP Business Development Title: President
& General Counsel

<PAGE>

AGREEMENT

between

YVES C. FAROUDJA

and

Faroudja Laboratories, Inc.

DATED MARCH 8, 1998

Faroudja Laboratories, Inc. (the "Company"), a California
corporation, and Yves C. Faroudja (the "Advisor") agree as follows:

1. FUNCTIONS AND DUTIES.

(a) The Company shall use the services of the Advisor, and
the Advisor shall provide services to the Company, as Founder, director,
Chairman of the Executive Committee and ex-officio member of the Compensation
Committee of Faroudja, Inc. ("FI"). In addition, the Advisor will serve as
Chief Technical Officer ("CTO") of the Company until such time as another CTO
is hired, at which time the Advisor will take the title of "Senior Fellow" of
the Company.

(b) The Advisor will assist the Company in the following
areas:

(i) Recruit a replacement CTO;

(ii) Present the Company's position at public forums,
including CES, NAB and IBC;

(iii)As director and as a member of the Executive
Committee, participate in the decision making process for major changes of
policy, definition of new products, acquisitions, licenses and other
significant business events;

(iv) Provide technical and development assistance;

(v) Provide assistance in the prosecution of patents
where the Advisor was or is an inventor or was or is one of the co-inventors;
and

(vi) Provide assistance for litigation relating to
the Company's intellectual property.

(c) The amount of time devoted by the Advisor as well as
the time periods, will be at the sole discretion of the Advisor. The Advisor
will participate in the CES, NAB and IBC shows.

1
<PAGE>

(d) The Advisor will provide his services as an
independent contractor to the Company and not as an employee.

2. TERM OF SERVICES. The term of the Advisor's services under
this Agreement shall commence on the date of this Agreement and shall continue
until the close of business on the third anniversary of this Agreement, except
that the Advisor's services shall be subject to earlier termination under
Section 9 and, with the mutual agreement of the parties, shall be subject to
extension after the third anniversary of this Agreement. This Agreement shall
supersede the Employment Agreement dated March 8, 1996 between the Company and
Advisor effective as of the date of this Agreement.

3. COMPENSATION.

(a) As compensation for all services the Advisor renders
during the term of this Agreement the Company shall pay the Advisor a fee at
the rate of $150,000 per year for the term of this Agreement. The Advisor's
fee shall be payable in equal installments at least monthly.

(b) Advisor shall also be granted a five (5) year option
under the 1997 Performance Stock Option Plan for an aggregate of 22,500 shares
which become exercisable as to 1/36 of such shares on a monthly basis.

4. EXPENSES. During the term of this Agreement, the Company
shall reimburse the Advisor for reasonable business expenses incurred by him
in the performance of his duties on behalf of the Company, FI or any of their
affiliates upon presentation of vouchers or other evidence of such expenses in
accordance with the policies of the Company.

5. MEDICAL INSURANCE. Medical insurance will be purchased by
the Company for the Advisor and his family, and the benefits provided by such
an insurance policy shall be comparable to those provided to the Company's
employees under the best medical plan presently offered by the Company,
provided, however, that the Company shall only be responsible for paying
premiums and reimbursing deductible amounts not to exceed $13,680 per year,
with the Advisor responsible for the balance, if any.

6. AUTOMOBILE. During the term of this Agreement, the Advisor
shall have use, at no charge, of the company car that he presently uses
(license number 3NDV219). Upon expiration or termination of this Agreement
for any reason, the Company shall transfer to the Advisor title to that car at
no charge.

7. KEY MAN LIFE INSURANCE. During the term of this Agreement,
the Company may at any time and from time to time obtain insurance on the
Advisor's life in such amounts and in such forms as the Company may in its
sole discretion determine (it being understood that the Advisor shall have no
interest in such insurance and, if the Company so requests, the Advisor shall
submit

2
<PAGE>

to such medical examinations, supply such information and execute such
documents as may reasonably be required to obtain such insurance).

8. LOCATION. Advisor intends to render his services from outside
the United States. Company will not make any withholding for U.S. or state
taxes. Advisor will travel to trade shows and to Company's headquarters in
the U.S. for liaison purposes when mutually agreed or FI Board of Directors
meetings.

9. TERMINATION

(a) The term of Advisor's services shall terminate upon
his death, and may be terminated at any earlier time at the option of the
Company as a result of Advisor's Disability or for Cause (as defined below).
On the termination of the Advisor's services as a result of his death or at
the Company's option as a result of the Advisor's Disability or for Cause, the
Company shall pay the Advisor (or his named beneficiary or estate) the amount
of his salary and other benefits accrued to the date of termination (with no
reduction for any period of Disability prior to termination), plus if such
termination is as a result of Advisor's Disability, salary for an additional
six (6) months. Except as specifically provided in this Agreement, the
Company shall have no other obligation to the Advisor (or his named
beneficiary or estate).

(b) As used in this Agreement,

(i) the term "Disability" means the failure of the
Advisor substantially to perform his duties and obligations under this
Agreement for 90 consecutive days because of any mental or physical
incapacity, as determined by a physician mutually agreed upon by the Company
and the Advisor, or if, after 30 days, they are unable to agree about the
identity of the physician, by a physician selected by the American Arbitration
Association, and

(ii) the term "Cause" means (A) any action by the
Advisor that constitutes dishonesty, a violation of law or a fraud against the
Company or any of its affiliates, (B) the conviction of the Advisor for a
felony, (C) willful misconduct, drunkenness or abuse of any controlled
substance by the Advisor (but only if such misconduct, drunkenness or abuse
adversely affects the Advisor's performance under this Agreement) or (D) any
material breach by the Advisor of this Agreement provided that Advisor is
provided with thirty (30) days prior notice and has not cured such event
during such notice period.

(c) Advisor shall have the right to terminate his services
and this Agreement prior to the end of the term by providing six (6) months
notice to Company.

3
<PAGE>

10. NON-SOLICITATION.

The Advisor shall not at any time during the term of this
Agreement or for a period of two years thereafter hire on his own behalf, or
on behalf of any other enterprise, any individual who was an employee of the
Company, FI or any of their affiliates at any time during the one-year period
immediately preceding the termination of the Advisor's services by the
Company.

11. CONFIDENTIALITY.

The Advisor shall at all times during the term of his
services and thereafter hold in confidence all Confidential Information (as
defined below) that may have come or may come into his possession or within
his knowledge concerning the products, services, processes, businesses,
suppliers, customers and clients of the Company, FI or any of their
affiliates. The Advisor agrees that neither he nor any person or enterprise
controlled by him will for any reason directly or indirectly, for himself or
any other person, use or disclose any trade secrets, proprietary or
confidential information, inventions, processes or procedures, patents,
trademarks, trade names, customer lists, service marks, service names,
copyrights, applications for any of the foregoing or licenses or other rights
in respect thereof (collectively, "Confidential Information"), owned or used
by, or licensed to, the Company, FI or any of their affiliates; provided, that
the Advisor may disclose Confidential Information that has become generally
available to the public other than as a result of a breach of this Agreement
by the Advisor or pursuant to an order of a court of competent jurisdiction or
of a governmental agency, department or commission or that arises after the
fifth anniversary of this Agreement. Upon termination of this Agreement, the
Advisor shall promptly surrender to the Company all documents that contain
Confidential Information and that are within his possession or control.

12. PERMITTED INVESTMENTS. Nothing contained in this Agreement
shall prohibit the Advisor from owning as a passive investment not more than
ten percent of the outstanding securities of any class of any publicly-held
company.

13. LICENSE AGREEMENT. Sections 2.2(c) and 14.1 of the
agreement dated as of January 20, 1997 between the Advisor and the Company
(the "License Agreement") shall each be amended by replacing the clause
"employee of Company," with "an advisor to the Company under the Agreement
between Faroudja and the Company dated as of March 8, 1998".

14. NOTICES. All notices and other communications under this
Agreement shall be in writing and may be given by any of the following
methods: (a) personal delivery, (b) facsimile transmission, (c) registered or
certified mail, postage prepaid, return receipt requested or (d) overnight
delivery service. Notices shall be sent to the appropriate party at his or
its address or facsimile number given below (or at such other address

4
<PAGE>

or facsimile number for that party as shall be specified by notice given
under this Section 12:

if to the Advisor, to him at:

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

if to-the Company, to it at:

Faroudja Laboratories, Inc.
750 Palomar Avenue
Sunnyvale, CA 94086
Fax: (408) 735-8571
Attn: President

All such notices and communications shall be deemed received upon (a) actual
receipt by the addressee, (b) actual delivery to the appropriate address or
(c) in the case of a facsimile transmission, upon transmission by the sender
and issuance by the transmitting machine of a confirmation slip confirming the
number of pages constituting the notice have been transmitted without error.
In the case of notices sent by facsimile transmission, the sender shall
contemporaneously mail a copy of the notice to the addressee at the address
provided for above. However, such mailing shall in no way alter the time at
which the facsimile notice is deemed received.

15. ASSIGNMENT. This Agreement shall be binding upon, and inure
to the benefit of, the parties' respective successors, assigns, heirs and
legal representatives. This Agreement shall be assigned to and shall inure to
the benefit of any successor to substantially all the assets and business of
the Company as a going concern, whether by merger, consolidation, liquidation
or sale of substantially all the assets of the Company or otherwise, and the
Company shall cause its successors to assume its obligations under this
Agreement (but no such assignment shall relieve it of its obligations under
this Agreement).

16. SEVERABILITY. If any provision of this Agreement, or the
application of any provision to any person or circumstance, shall for any
reason or to any extent be invalid or unenforceable,, the remainder of this
Agreement and the application of that provision to other persons or
circumstances shall not be affected, but shall be enforced to the full extent
permitted by law.

17. WAIVER. The failure of a party to insist upon strict
adherence to any term of this Agreement on any occasion shall not be
considered a waiver or deprive that party of the right thereafter to insist
upon strict adherence to that term or any other term of this Agreement. Any
waiver must be in writing.

5
<PAGE>

18. GOVERNING LAW. This Agreement shall be governed by and
construed in accordance with the law of the state of California (without
application of conflict of law provisions).

19. ARBITRATION. All claims, disputes and other matters as to
which the parties disagree arising out of this Agreement, or the
interpretation or breach or alleged breach of this Agreement, shall be decided
by final and binding arbitration in accordance with the Rules of Practice and
Procedure of the Judicial Arbitration and Mediation Services/Endispute
("JAMS") then in effect, unless the parties mutually agree otherwise. The
arbitration shall be conducted before a retired judge selected by Agreement of
the parties from the JAMS panel. If the parties cannot agree upon the
arbitrator, JAMS will provide a list of three available retired judges and
each party may strike one. The remaining judge will serve as arbitrator. The
arbitration shall be held in San Jose, California at a location selected by
the arbitrator. This Agreement to arbitrate shall be specifically enforceable
under applicable law in any court of competent jurisdiction. Notice of the
demand for arbitration shall be filed in writing with the other party to this
Agreement and with JAMS. The demand for arbitration shall be made within a
reasonable time after the claim, dispute or other matter in question has
arisen, and in no event shall it be made after the date when institution of
legal or equitable proceedings based on such claim, dispute or other matter in
question would be barred by the applicable contractual, or other, statute of
limitations. It is the parties' objective to expedite the arbitration
proceedings by placing the following limitations on discovery: (a) each party
may propound only one interrogatory requesting the name, business affiliation
and address of each witness to be called at the arbitration hearing; (b) on a
date to be determined at the prehearing conference, each party may serve one
request for the production of documents, the requests shall be limited to 30,
including subparts, and the documents are to be exchanged 30 days later; and
(c) each party may depose two witnesses. Each deposition must be concluded
within four hours-and all depositions must be completed within 30 days of the
prehearing conference. Any party deposing an opponent's expert must pay the
expert's fee for attending the deposition. The arbitration proceedings shall
remain confidential. Any monetary award of the arbitrators may include
interest at the prime rate as published from time to time by The Chase
Manhattan Bank, N.A., plus one percent, which interest shall accrue from the
date the claim, dispute or other matter in question was rightfully due and
payable under this Agreement until the date the award is paid to the
prevailing party. There shall be no restriction on the power of the
arbitrator to award punitive damages in the appropriate case. The award
rendered by the arbitrator shall be final and judgment may be entered in
accordance with applicable law and in any court having jurisdiction thereof.
Each party shall pay the fees of its own attorneys, expenses of witnesses and
all other expenses connected with.the presentation of such party's case. The
cost of the arbitration, including the cost of the record or transcripts of
the record, if any, administrative fees and all

6
<PAGE>

other fees involved, shall be shared equally, unless the arbitrator otherwise
directs.

Notwithstanding anything to the contrary in this Section 19, this
Section 19 shall not govern any claim, dispute or other matter as to which the
parties disagree arising out of the License Agreement.

20. COUNTERPARTS. This Agreement may be executed in
counterparts, each of which shall be considered an original, but both of which
together shall constitute the same instrument.

FAROUDJA LABORATORIES, INC.

By: /s/ Michael J. Moone
---------------------------
Name: Michael J. Moone
Title: President, CEO

/s/ Yves Faroudja
---------------------------
Yves Faroudja

<PAGE>
SELECTED CONSOLIDATED FINANCIAL DATA

<TABLE>
<CAPTION>
Year Ended December 31
(In thousands, except per share amounts) 1997 1996 1995 1994 1993
<S> <C> <C> <C> <C> <C>
CONSOLIDATED STATEMENT OF OPERATIONS DATA:
Total revenues $17,006 $13,126 $11,954 $8,065 $5,684
Net income 1,251 NA NA NA NA
Pro forma net income(1) NA 1,319(1) 3,070(1) 1,228(1) 1,251
Net income per share (diluted) $ 0.13 NA NA NA NA
Pro forma net income per share (diluted)(1) NA $ 0.16(1) $ 0.43(1) $ 0.15(1) NA
Shares used in diluted per share computation 9,925 8,191 7,176 7,979 NA

CONSOLIDATED BALANCE SHEET DATA:
Cash, cash equivalents and short-term
investments $23,549 $ 3,083 $ 2,759 $1,064 $1,455
Working capital 26,987 5,861 4,744 2,223 2,599
Total assets 33,489 9,604 6,734 3,434 3,652
Total long-term debt -- -- -- -- 996
Total stockholders' equity 29,348 7,245 5,515 2,826 2,166
</TABLE>

QUARTERLY DATA:
(Unaudited, in thousands, except per share amounts)

<TABLE>
<CAPTION>
1997 1996
4th 3rd 2nd 1st 4th 3rd 2nd 1st
<S> <C> <C> <C> <C> <C> <C> <C> <C>
Total revenues $4,130 $5,012 $4,279 $3,585 $3,874 $3,663 $2,753 $2,837
Gross profit 2,820 3,346 2,992 2,586 2,416 2,390 1,757 1,766
Net income 326 391 285 249 318 385 188 NA
Pro forma net income NA NA NA NA NA NA NA 428(1)
Net income per share
(diluted) $ 0.03 $ 0.04 $ 0.03 $ 0.03 $ 0.04 $ 0.04 $ 0.02 NA
Pro forma net income
per share (diluted) NA NA NA NA NA NA NA $ 0.06(1)
</TABLE>

(1) Reflects the pro forma effect of the Company being treated as a C
Corporation rather than an S Corporation for federal and state income tax
purposes from January 1, 1994.

(2) See Note 1 of Notes to Consolidated Financial Statements for an
explanation of the basis used to calculate net income per share.

PRICE RANGE OF COMMON STOCK

The Company's Common Stock (Nasdaq symbol "FDJA") began trading publicly on
the Nasdaq Stock Market on October 30, 1997. Prior to that date, there was
no public market for the Company's Common Stock. The following table
presents for the periods indicated the intraday high and low sale prices for
the Common Stock as reported by the Nasdaq Stock Market.

<TABLE>
<CAPTION>
High Low
<S> <C> <C>
Fourth Quarter (from October 30, 1997) $10.50 $ 5.50
</TABLE>

As of March 27, 1998, there were approximately 145 holders of record of the
Company's Common Stock which the Company believes represents more than 1,600
beneficial holders. The Company has not paid cash dividends on its Common
Stock and presently intends to retain any earnings for investment in its
business.

<PAGE>

MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF
OPERATIONS

THE FOLLOWING MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND
RESULTS OF OPERATIONS CONTAINS FORWARD-LOOKING STATEMENTS BASED UPON CURRENT
EXPECTATIONS THAT INVOLVE RISKS AND UNCERTAINTIES. THE COMPANY'S ACTUAL
RESULTS AND TIMING OF CERTAIN EVENTS COULD DIFFER MATERIALLY FROM THOSE
ANTICIPATED IN THESE FORWARD-LOOKING STATEMENTS AS A RESULT OF CERTAIN
FACTORS, INCLUDING THOSE SET FORTH UNDER "FACTORS AFFECTING FUTURE OPERATING
RESULTS" AS DESCRIBED IN THE COMPANY'S ANNUAL REPORT ON FORM 10-K.

OVERVIEW

Faroudja, Inc. (the "Company") began operations in 1971 through two related
companies, Faroudja Laboratories, Inc. ("FLI") and later Faroudja Research
Enterprises, Inc. ("FRE"). The Company was incorporated in December 1996
under the laws of the state of Delaware to succeed to the business of FLI and
FRE. From inception to 1988 the Company specialized in the development,
manufacturing and sale of products to the broadcast industry. In 1988 the
Company introduced its initial product for the high-end home theater market,
a line multiplier. In 1997 and 1996, sales of products for the home theater
and industrial markets comprised approximately 88% and 80%, respectively, of
the Company's total revenues. As the Company emphasized product development
for the home theater and industrial markets, sales of existing broadcast
products have declined.

The Company's total revenues increased sequentially on an annual basis
from 1995 through 1997, primarily as a result of the introduction of a number
of new products for the home theater and industrial markets. In 1996, the
Company established an in-house very large scale integration ("VLSI") design
department to develop high performance application specific integrated
circuits ("ASIC") to enhance video image quality in the Company's traditional
home theater market as well as for use in the TV and PC industries. Net
income declined in 1997 from 1996 and 1996 from 1995 primarily as a result of
increased research and development expenses, as well as expenses relating to
the expansion of the sales and marketing staff, and, in 1996, a provision for
income taxes resulting from the termination of the Company's status as an S
Corporation in March 1996.

To maintain favorable margin levels on product sales, the Company must
introduce new products, introduce enhanced versions of its products, and
continue its cost reduction efforts. The Company anticipates that it will
incur lower overall gross margins in future periods as it introduces lower
margin products for consumer markets until such time as royalties, if
received, become a significantly larger percentage of revenues. The Company
intends to increase both engineering and sales and marketing efforts in the
design, development and sale of board and chip level products while
continuing the sale of stand-alone products for the high-end home theater,
industrial and broadcast markets. On an absolute dollar basis, sales and
marketing expenses, general and administrative expenses and research and
development expenses are expected to increase in 1998 over 1997.
Consequently, without a corresponding increase in revenues, net income will
be adversely impacted.

The Company's operating results have varied in the past and are likely to
vary significantly in the future from period to period as a result of a
number of factors, including the volume and timing of orders received during
the period, fluctuations in the amount, and timing of, license and royalty
revenues, the timing of new product introductions by the Company and its
competitors, demand for, and market acceptance of, the Company's products,
product line maturation, the impact of price competition on the Company's
average selling prices, delays encountered by the Company's strategic
partners, the availability and pricing of components for the Company's
products, changes in product or distribution channel mix and product returns
or price protection charges from customers. Many of these factors are beyond
the Company's control. In addition, due to the short product life cycles that
characterize the markets for the Company's products, the Company's failure to
introduce new, competitive products consistently and in a timely manner could
materially adversely affect operating results for one or more product cycles.

The Company has received quarterly prepaid license fees from S3
Incorporated ("S3") to maintain exclusivity under its license agreement
with the Company. S3 has advised the Company that no prepayments will be made
with respect to any periods after March 31, 1998. There can be no assurance
as to the amount of royalties, if any, the Company will

15
<PAGE>

receive in the future as the Company does not have any other license
agreements in effect pursuant to which it expects to receive substantial
royalties.

RESULTS OF OPERATIONS

The following table sets forth certain items from the Company's
consolidated statements of income expressed as a percentage of total revenues
for the periods indicated.

<TABLE>
<CAPTION>
Year Ended December 31
1997 1996 1995
<S> <C> <C> <C>
Revenues:
Product sales 91.2% 96.2% 100.0%
License and royalty revenues 8.8 3.8 --
Total revenues 100.0 100.0 100.0
Cost of product sales 30.9 36.5 35.3
Gross margin 69.1 63.5 64.7
Operating expenses:
Research and development 24.8 18.8 12.3
Sales and marketing 20.4 16.2 9.0
General and administrative 12.8 12.4 9.9
Financing expense 1.8 -- --
Total operating expenses 59.8 47.4 31.2
Operating income 9.3 16.1 33.5
Other income:
Interest income 2.1 0.6 0.7
Other, net 0.5 -- --
Income before provision for income taxes 11.9 16.7 34.2
Provision for income taxes 4.5 5.2 0.7
Net income 7.4% 11.5% 33.5%
</TABLE>

Total Revenues.

Total revenues increased 29.5% and 9.8%, respectively, for 1997 and 1996 from
their respective prior years.

The increase in 1997 was due primarily to increased shipments of line
multiplier products for the home theater, shipments of new products including
the VP100 decoder, DV1000 Digital Video Disc player, VP300 line tripler, and
VP280 frame doubler, and $1.5 million of license and royalty revenues from
S3. These factors offset a reduction in sales to the broadcast market. The
increase in 1996 was primarily due to the introduction of the LD200 NTSC line
doubler for the home theater market, increased shipments of the DFD-U
PAL/NTSC digital decoder, which was first introduced in 1995 for the direct
broadcast satellite market, fees on the license of the Company's technology
for ASIC products for the personal computer ("PC") market and the expansion
of the home theater dealer network. These factors were partially offset by a
reduction in sales in 1996 of the CFD decoder for the broadcast market
resulting from a sharp decline in sales to this product's primary customer,
which began developing its own products internally. Revenues from S3
accounted for 10.6% of total revenues in 1997. Sales to Vidikron accounted
for 11.1% and 10.5% of total revenues in 1997 and 1996. Sales to Hughes/JVC
accounted for 12.1% of total revenues in 1995.

Export sales, consisting primarily of VP400 and LD200 products shipped to
dealers and distributors in Asia and Europe, represented 13.1%, 15.3% and
13.2% of total revenues in 1997, 1996 and 1995, respectively. All export
sales are denominated in U.S. dollars. The Company intends to pursue efforts
to increase its export sales in the future; however, there can be no
assurance that any growth in export sales will be achieved. The Company
believes that current economic conditions in Asia might adversely impact any
increase in sales to that region in 1998.

The Company's future success will depend, in large part, on its ability to
continue to enhance its existing

<PAGE>

products and to develop new products and features to meet changing customer
requirements and evolving industry standards. The Company anticipates that
sales from its line multiplier product line will experience limited growth,
or may decline, in future periods. In the fourth quarter of 1997, the home
theater market exhibited weakness which the Company attributes to consumer
confusion over high definition television ("HDTV"). The Company believes that
such confusion and related market weakness could continue until HDTV
broadcasting begins on a wide-scale basis, as currently anticipated at the
end of the third quarter of 1998. The Company expects that approximately
one-half of its total revenues in 1998 will be derived from license and
royalty revenues and from sales of products introduced in 1997 and scheduled
to be introduced in 1998.

Gross Profit.

Gross profit as a percentage of total revenues was 69.1% in 1997, 63.5% in
1996 and 64.7% in 1995. The increase in gross margin in 1997 compared to 1996
was primarily due to license and royalty revenues. Product gross margin as a
percentage of product sales increased to 66.1% in 1997 from 62.01% in 1996,
primarily due to product cost reduction efforts. Product gross margin
declined in 1996 to 62.0% from 64.7% in 1995 primarily due to an increased
proportion of sales to distributors and original equipment manufacturers
("OEM"), who typically receive higher discounts than dealers, increased
dealer discounts, the introduction of a new, lower margin product line and
increased manufacturing costs and expenses.

Research and Development Expenses.

Research and development expenses increased to $4.2 million in 1997 from $2.5
million in 1996 and $1.5 million in 1995. The increases were primarily due to
costs incurred by the Company for the development of ASIC components used in
the full range of the Company's products. Research and development expenses
as a percentage of total revenues increased to 24.8% in 1997 due to expansion
of the VLSI department. Research and development expenses increased as a
percentage of total revenues to 18.8% in 1996 due to the establishment in
1996 of the VLSI design department. The Company increased its engineering and
management personnel, and related equipment, to enable the ongoing
development of its high performance VLSI design capability. The Company
intends to increase its engineering efforts in the design and development of
board and chip level products, and therefore expects that research and
development expenses will continue to increase in absolute dollars.

Sales and Marketing Expenses.

Sales and marketing expenses increased to $3.5 million in 1997 from $2.1
million in 1996 and $1.1 million in 1995. Sales and marketing expenses
increased as a percentage of total revenues to 20.4% in 1997 from the prior
year primarily due to increases in the Company's sales and marketing staff,
including the addition of sales executives and the development of a network
of regional managers and sales representatives. The Company intends to
increase its sales and marketing efforts, and intends to increase its
international market presence. Accordingly, sales and marketing expenses are
expected to increase in absolute dollars in the future.

General and Administrative Expenses.

General and administrative expenses increased to $2.2 million in 1997 from
$1.6 million in 1996 and $1.2 million in 1995. General and administrative
expenses increased as a percentage of total revenues to 12.8% in 1997 and
12.4% in 1996, primarily due to additions to the Company's general and
administrative staff, including the hiring of a new chief executive officer,
chief financial officer and general counsel, and an increase in professional
fees. The Company anticipates that it will incur significant increases in
general and administrative expenses in future periods associated with the
Company's growth and with legal, accounting and other expenses of being a
public company.

<PAGE>

Financing Expense.

The Company incurred $312,000 of expenses related to financing activities in
the first quarter of 1997.

Other Income.

Interest and other income was $447,000 in 1997, $83,000 in 1996 and $87,000
in 1995. The increase in 1997 from 1996 was due to the investment in November
1997 of the $15.6 million net proceeds of the Company's initial public
offering, and a $5 million investment by S3 in June 1997. Accordingly, the
Company anticipates that interest income will increase significantly in 1998.

Provision for Income Taxes.

The Company's FLI subsidiary was an S Corporation from inception until March
1996. As an S Corporation, FLI earnings were taxed directly to its
stockholders, and FLI's tax provision through March 1995 consisted solely of
a California franchise fee. FRE was a C Corporation since its inception. The
Company has incurred minimal foreign taxes. The pro forma provision for
income taxes, calculated assuming FLI's S Corporation status terminated
January 1, 1994, reflects an effective tax rate for the years ended December
31, 1996 and 1995 of 40% and 25%, respectively. The Company's effective tax
rate for 1997 was 38%. The Company anticipates implementing certain tax
planning strategies to reduce the effective tax rate in future periods.

LIQUIDITY AND CAPITAL RESOURCES

The Company has historically funded its capital requirements from its cash
flow from operations. Funding requirements in the past have been primarily
related to the growth in accounts receivable, inventories and capital
equipment.

Operating Activities.

In 1997, net cash provided by operating activities was $1,106,000, primarily
composed of (i) $1.3 million of net income, (ii) $561,000 of depreciation and
amortization, (iii) a $716,000 increase in accounts payable, (iv) a $545,000
increase in accrued compensation, (v) a $756,000 increase in income taxes
payable and (vi) a $265,000 increase in other accrued liabilities. These were
primarily offset by (i) a $330,000 increase in accounts receivable, (ii) a
$1.3 million increase in inventory, (iii) a $481,000 increase in deferred tax
assets, (iv) a $372,000 increase in other current assets and (v) a $500,000
decrease in deferred revenues.

In 1996, net cash provided by operating activities was $1.3 million,
primarily composed of (i) $1.5 million of net income, (ii) $422,000 of
depreciation and amortization, (iii) a $128,000 increase in accounts payable,
(iv) a $186,000 increase in accrued compensation and benefits, (v) a $258,000
increase in other liabilities and (vi) $500,000 of deferred revenues. These
were partially offset by (i) a $1.2 million increase in accounts receivable
primarily attributable to $1.0 million due from a licensing customer from an
agreement completed in December, 1996, (ii) a $96,000 increase in inventory
and (iii) an increase in deferred tax assets of $462,000.

In 1995, net cash provided by operating activities was $3.4 million,
primarily composed of (i) $4.0 million of net income, (ii) $224,000 of
depreciation and amortization, (iii) a $417,000 increase in accounts payable
and (iv) a $118,000 increase in accrued compensation and benefits. These were
partially offset by (i) a $642,000 increase in accounts receivable and (ii) a
$793,000 increase in inventory.

Investing Activities.

Capital equipment purchases in 1997, 1996 and 1995 were $1.2 million,
$967,000 and $392,000, respectively, primarily for computer hardware and
software used in research and development, engineering test equipment and
furniture and fixtures.

<PAGE>

Financing Activities.

The Company effected its initial public offering in October 1997. Net
proceeds, after underwriting discounts and commissions and expenses
associated with the offering, were $15.6 million. The Company invested the
net proceeds of the offering in short-term, interest bearing investment grade
securities. In June 1997, the Company also received $5.0 million from a
private placement with S3. In 1996, the Company raised $4.0 million through
the issuance of its Common Stock. In connection with its status as a
Subchapter S Corporation, the Company distributed $4.0 million, and $1.5
million in 1996 and 1995 respectively.

Liquidity.

At December 31, 1997, the Company's principal sources of liquidity consisted
of cash, cash equivalents and short-term investments totaling $23.5 million,
and a bank credit facility for $2.0 million. The Company's working capital at
December 31, 1997 was $27.0 million. In April 1997, the Company established a
bank revolving line of credit which expires in May 1998. The line of credit
is secured by substantially all of the Company's tangible assets. Borrowings
are limited to defined percentages of eligible accounts receivable. In
addition, the Company must satisfy certain financial covenants. In June 1997,
the line of credit was increased to $2.0 million.

The Company's future capital requirements are expected to include (i)
supporting the expansion of the research and development and sales and
marketing departments, (ii) funding the acquisition of capital equipment,
primarily for research and development and consisting of such items as
engineering equipment, computers and furniture, and (iii) funding the growth
of working capital items such as receivables and inventory.

The Company may investigate means to acquire greater control over
semiconductor production, whether by joint venture, prepayments, equity
investments in or loans to wafer suppliers. In addition, as part of its
business strategy, the Company occasionally evaluates potential acquisitions
of businesses, products and technologies. Accordingly, a portion of its
available cash may be used for the acquisition of complementary products,
technologies or businesses or to assure foundry capacity. Such potential
transactions may require substantial capital resources, which may require the
Company to seek additional debt or equity financing. There can be no
assurance that the Company will consummate any such transactions.

The Company believes that its current cash, cash equivalents and
short-term investments will be sufficient to support the Company's planned
activities through at least the next twelve months.

Year 2000.

The Company has determined that its present internal management information
systems are not compliant with Year 2000 requirements and has implemented
plans to upgrade both its software and hardware in the normal course of
business during 1998. It will also be initiating discussions with its
significant suppliers, customers and financial institutions to ensure that
their systems are Year 2000 compliant. The Company expects the total costs of
these upgrades to be less than $500,000 and is scheduled to complete its
upgrades by the end of 1998. It does not anticipate the cost of such upgrade
to have a significant impact on its operations or financial position.

<PAGE>

CONSOLIDATED BALANCE SHEETS

<TABLE>
<CAPTION>
December 31
1997 1996
<S> <C> <C>
ASSETS
Current assets:
Cash and cash equivalents $ 23,272,300 $ 1,215,591
Short-term investments 276,605 1,867,896
Trade accounts receivable, less allowance for doubtful
accounts of $166,681 in 1997 and $110,000 in 1996 3,097,709 2,767,331
Inventories 2,943,471 1,683,550
Deferred tax assets 942,255 461,519
Prepaid expenses and other current assets 596,060 224,426

Total current assets 31,128,400 8,220,313

Property and equipment, net 2,025,910 1,383,807
Other assets 334,722 --
$ 33,489,032 $ 9,604,120

LIABILITIES AND STOCKHOLDERS' EQUITY
Current liabilities:
Accounts payable $ 1,445,361 $ 729,320
Accrued compensation and benefits 1,216,433 671,863
Income taxes payable 872,393 116,602
Other accrued liabilities 606,818 341,444
Deferred revenue -- 500,000

Total current liabilities 4,141,005 2,359,229

Commitments

Stockholders' equity:
Preferred Stock $0.001 par value; 5,000,000 shares
authorized (2,000,000 in 1996), none issued and
outstanding -- --
Common Stock $0.001 par value; 50,000,000 shares
authorized (18,000,000 in 1996); 12,058,913, and
8,200,000 shares issued and outstanding in 1997
and 1996, respectively 12,059 8,200
Additional paid-in capital 28,977,725 7,824,823
Unrealized gains on available-for-sale securities,
net of tax effect -- 66,737
Deferred compensation (237,564) --
Retained earnings (deficit) 595,807 (654,869)

Total stockholders' equity 29,348,027 7,244,891
$ 33,489,032 $ 9,604,120
</TABLE>

See accompanying notes.

<PAGE>

CONSOLIDATED STATEMENTS OF INCOME

<TABLE>
<CAPTION>
Year Ended December 31
1997 1996 1995
<S> <C> <C> <C>
Revenues:
Product sales $15,506,498 $12,626,183 $11,953,658
License and royalty revenues 1,500,000 500,000 --

Total revenues 17,006,498 13,126,183 11,953,658
Cost of product sales 5,261,664 4,797,516 4,214,753

Gross profit 11,744,834 8,328,667 7,738,905
Operating expenses:
Research and development 4,215,346 2,463,838 1,483,388
Sales and marketing 3,465,025 2,126,686 1,070,045
General and administrative 2,182,641 1,623,453 1,178,990
Financing expenses 311,572 -- --

Total operating expenses 10,174,584 6,213,977 3,732,423

Operating income 1,570,250 2,114,690 4,006,482
Other income:
Interest income 363,490 83,179 81,746
Other, net 83,456 -- 4,986

Income before provision for income taxes 2,017,196 2,197,869 4,093,214
Provision for income taxes 766,520 687,054 83,981

Net income $ 1,250,676 $ 1,510,815 $ 4,009,233

Pro forma data (unaudited):
Historical income before provision for income taxes $ 2,197,869 $ 4,093,214
Pro forma provision for income taxes 879,148 1,023,188

Pro forma net income $ 1,318,721 $ 3,070,026

Per share data:
Net income per share Basic $ 0.14
Diluted $ 0.13
Pro forma net income
per share (unaudited) Basic $ 0.17 $ 0.43
Diluted $ 0.16 $ 0.43
Shares used in per share
computations Basic 9,040,616 7,976,892 7,156,895
Diluted 9,924,558 8,191,303 7,176,115
</TABLE>

See accompanying notes.

<PAGE>

CONSOLIDATED STATEMENT OF STOCKHOLDERS' EQUITY

<TABLE>
<CAPTION>
Unrealized
Gains on
Additional Available Retained Total
Common Stock Paid-In for-Sale Deferred Earnings Stockholders'
Shares Amounts Capital Securities Compensation (Deficit) Equity
<S> <C> <C> <C> <C> <C> <C> <C>
Balance at
December 31, 1994 7,156,895 $ 3,611,023 $ -- $ -- $ -- $ (784,988) $ 2,826,035

Net income -- -- -- -- -- 4,009,233 4,009,233

Unrealized gain on
available-for-sale
securities -- -- -- 34,885 -- -- 34,885

Distribution to
stockholders -- -- -- -- -- (1,355,000) (1,355,000)

Balance at
December 31, 1995 7,156,895 3,611,023 -- 34,885 -- 1,869,245 5,515,153

Sale of Common Stock 1,043,105 4,000,000 -- -- -- -- 4,000,000
Issuance of warrants to
purchase Common
Stock for future
services -- -- 222,000 -- -- -- 222,000

Reincorporation in
Delaware -- (7,602,823) 7,602,823 -- -- -- --

Net income -- -- -- -- -- 1,510,815 1,510,815

Change in unrealized gain
on available-for-sale
securities, net of tax -- -- -- 31,852 -- -- 31,852

Distributions to
stockholders -- -- -- -- -- (4,034,929) (4,034,929)

Balance at
December 31, 1996 8,200,000 8,200 7,824,823 66,737 -- (654,869) 7,244,891

Sale of Common Stock,
net of issue costs 3,833,334 3,833 20,532,373 -- -- -- 20,536,206

Issuance of Common
Stock for services and
upon exercise of
options and warrants 25,579 26 99,029 -- -- -- 99,055

Issuance of warrants to
purchase Common
Stock for technology
acquired -- -- 250,000 -- -- -- 250,000

Deferred compensation
on employee stock
option grants -- -- 271,500 -- (271,500) -- --

Amortization of deferred
compensation -- -- -- -- 33,936 -- 33,936

Net income -- -- -- -- -- 1,250,676 1,250,676

Change in unrealized gain
on available-for-sale
securities, net of tax -- -- -- (66,737) -- -- (66,737)

Balance at
December 31, 1997 12,058,913 $ 12,059 $28,977,725 $ -- $(237,564) $ 595,807 $29,348,027
</TABLE>

See accompanying notes.

<PAGE>

CONSOLIDATED STATEMENTS OF CASH FLOWS

<TABLE>
<CAPTION>
Year Ended December 31

1997 1996 1995
<S> <C> <C> <C>
Operating Activities
Net income $ 1,250,676 $ 1,510,815 $ 4,009,233
Adjustments to reconcile net income to net cash
provided by (used in) operating activities:
Depreciation and amortization 560,974 422,376 223,988
Amortization of deferred compensation 33,936 -- --
Loss on disposal of equipment 5,178 -- --
Gain on sales of short-term investments (83,456) -- --
Changes in operating assets and liabilities:
Trade accounts receivable (330,378) (1,193,465) (642,490)
Inventories (1,259,921) (96,480) (793,149)
Deferred tax assets (480,736) (461,519) --
Other current assets (371,634) (27,174) (1,513)
Accounts payable 716,041 128,114 417,306
Accrued compensation and benefits 544,570 185,927 118,135
Income taxes payable 755,791 68,009 46,574
Other accrued liabilities 265,374 258,375 29,058
Deferred revenue (500,000) 500,000 --

Net cash provided by operating activities 1,106,415 1,294,978 3,407,142

INVESTING ACTIVITIES
Purchases of equipment (1,200,219) (967,130) (391,907)
Proceeds from sale of equipment 12,864 -- --
Other assets (110,000) -- --
Purchases of short-term investments -- (1,061,000) (1,751,075)
Sales of short-term investments 1,612,388 -- --
Maturities of short-term investments -- 460,916 750,000

Net cash provided by (used in) investing activities 315,033 (1,567,214) (1,392,982)

FINANCING ACTIVITIES
Issuance of Common Stock 20,635,261 4,000,000 --
Repayment of loan payable -- -- --
Distribution to stockholders -- (4,034,929) (1,355,000)
Net cash provided by (used in) financing activities 20,635,261 (34,929) (1,355,000)

Increase (decrease) in cash and cash equivalents 22,056,709 (307,165) 659,160
Cash and cash equivalents at beginning of year 1,215,591 1,522,756 863,596
Cash and cash equivalents at end of year $23,272,300 $ 1,215,591 $ 1,522,756

SUPPLEMENTAL DISCLOSURE OF CASH FLOW INFORMATION
Cash paid during the period for income taxes $ 465,119 $ 1,116,656 $ 32,157

SUPPLEMENTAL DISCLOSURES OF NONCASH FINANCING ACTIVITIES
Issuance of warrants to acquire Common Stock
for future services $ -- $ 222,000 $ --
Issuance of warrants to acquire Common Stock
for technology acquired $ 250,000 $ -- $ --
</TABLE>

See accompanying notes.

<PAGE>

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

1. BUSINESS AND SIGNIFICANT ACCOUNTING POLICIES

Business and Basis of Presentation

Faroudja, Inc. (the "Company") designs, develops and sells a range of video
image enhancement products and technology for the home television,
professional broadcast and personal computer markets. Although traditional
business has been directed to sales of complete subsystem units, the Company
has recently expanded its activities to include the design and development of
board and chip level products for applications in the television as well as
the personal computer markets.

The accompanying financial statements reflect the operations of Faroudja
Laboratories, Inc. ("FLI") and Faroudja Research Enterprises, Inc. ("FRE"),
both of which were California corporations. FLI and FRE, which were owned by
common stockholders, were merged in December 1996, with FLI surviving the
merger. Subsequently, in order to effect a reverse stock split and a
reincorporation in Delaware, FLI merged with a wholly owned subsidiary of a
newly formed Delaware corporation, Faroudja, Inc. In this transaction, the
FLI stockholders received 0.69185 shares of the Company's Common Stock for
each share of FLI Common Stock held by them.

All outstanding stock options and warrants to purchase FLI Common Stock
were assumed by the Company at the same exchange ratio. The effect of this
exchange on Common Stock, stock options and warrants has been reflected in
the accompanying financial statements on a retroactive basis. All
intercompany balances and transactions between the Company and FLI have been
eliminated.

On December 30, 1996, FLI and FRE were merged through the exchange of
0.21258 shares of FLI Common Stock for each outstanding share of FRE Common
Stock. As the outstanding shares of both entities were held in the same
percentage by identical stockholders prior to the merger, this transaction
was accounted for as if it were a pooling-of-interests.

Prior to March 1996, FRE and FLI were each owned 100% by two individuals
(the "Founders"). In March 1996, new investors acquired a 56.25% ownership
interest in both entities through the purchase of shares held by the Founders
($14,000,000) and newly issued FLI shares ($4,000,000). Simultaneous with
this transaction, the Founders received a distribution from FLI in the amount
of $4,000,000. The new investors also acquired an option from the Founders to
acquire an additional 1,537,500 shares held by the Founders for a total of
$6,000,000. Such option was exercised on September 5, 1997. Prior to the
March 1996 transaction, FLI had elected to be treated as an S Corporation for
income tax purposes. FRE was a C Corporation for income tax purposes.

Use of Estimates

The preparation of financial statements in conformity with generally accepted
accounting principles requires management to make estimates and assumptions
that affect the amounts reported in the financial statements and accompanying
notes. Actual results could differ from these estimates.

Sources of Supply

The Company currently relies on a limited number of independent foundries to
manufacture, assemble and test all of its semiconductor components and
products. In addition, the Company subcontracts the manufacturing of its
broadcast and television products with three principal suppliers. While
alternate sources of supply exist, in the event of the discontinuance of any
of the above supplier relationships, the Company would be required to locate
and qualify new suppliers, which could take several months.

Cash Equivalents

The Company considers all highly liquid investments with a maturity of three
months or less when purchased, to be cash equivalents. Cash equivalents
consist primarily of deposits in banks, money market accounts, commercial
paper and government agency discount notes.

Short-Term Investments

The Company accounts for its short-term investments in accordance with
Statement of Financial Accounting Standards No. 115, "Accounting for Certain
Investments in Debt and Equity Securities" ("SFAS 115").

Under SFAS 115, all affected debt and equity securities must be stated at
fair value and classified as held-to-maturity, trading or available-for-sale.
Management determines the appropriate classification of securities at the
time of purchase and reevaluates such designation as of each balance sheet
date.

At December 31, 1997 and 1996, all debt and equity securities were
designated as available-for-sale. Available-for-sale securities are carried
at fair value, with unrealized gains and losses reported net of tax as a
separate component of stockholders' equity. Realized gains and losses and
declines in value judged to be

<PAGE>

other-than-temporary, if any, on available-for-sale securities are included
in other income. The cost of securities sold is based on the specific
identification method. Interest on securities classified as
available-for-sale is included in interest income.

Concentration of Credit Risk

The Company sells its products primarily through a network of distributors,
dealers and through original equipment manufacturing ("OEM") arrangements. The
Company performs ongoing credit evaluations of its customers and generally does
not require collateral. Uncollectible accounts receivable have not been
significant in any period presented.

At December 31, 1997, four customers accounted for 45% of the accounts
receivable balance. At December 31, 1996 two customers accounted for 48% of
the accounts receivable balance. No other single customer accounted for more
than 10% of the Company's ending accounts receivable balances.

Inventories

Raw materials, work-in-process and finished goods inventories are stated at
the lower of standard cost (which approximates actual cost on a first-in,
first-out cost method) or market value.

Property and Equipment

Property and equipment are recorded at cost. Depreciation and amortization
are provided using the straight-line method over the estimated useful lives
of the assets (ranging from three to seven years). Leasehold improvements are
amortized over the shorter of the lease term or the estimated useful life.
Depreciation expense was $540,074, $248,758 and $207,092 for 1997, 1996 and
1995, respectively.

Revenue Recognition

Sales revenue is recognized upon shipment of products to customers net of
discounts, rebates and allowances. The Company does not grant rights of
return and customarily does not provide price protection to distributors.
Non-refundable minimum royalties are recognized as revenue in the period to
which they relate.

Advertising Costs

The Company expenses advertising costs as incurred. Advertising expense
amounted to $429,817, $394,578 and $204,155 in the years ended 1997, 1996 and
1995, respectively.

Financing Expense

In 1997, the Company incurred and expensed approximately $312,000 of expenses
related to financing activities.

Stock-Based Compensation

As permitted by Statement of Financial Accounting Standards No. 123,
"Accounting for Stock-Based Compensation" ("SFAS 123"), the Company has
elected to follow Accounting Principles Board Opinion No. 25, "Accounting for
Stock Issued to Employees" ("APB 25") and related interpretations in
accounting for its employee and director stock option and purchase plans.
Under APB 25, if the exercise price of the Company's employee stock options
is not less than the market price of the underlying stock on the date of
grant, no compensation expense is recognized.

Net Income Per Share

In December 1997, the Company adopted the provisions of Statement of
Financial Accounting Standards No. 128, "Earnings per Share" ("SFAS 128") and
Staff Accounting Bulletin No. 98 ("SAB 98"), and restated all prior periods.
Under the provisions of SFAS 128, basic earnings per share is calculated
based on the weighted average number of common shares outstanding during the
period. Diluted earnings per share also gives effect to the dilutive effect
of stock options and warrants (calculated based on the treasury stock
method). SAB 98 eliminated certain dilutive issuances which were included in
the calculation for periods prior to the Company's initial public offering. A
reconciliation of shares used in the calculation follows:

1997 1996 1995
<S> <C> <C> <C>
Weighted average shares outstanding 9,040,616 7,976,892 7,156,895
Dilutive effect of stock options and warrants 883,942 214,411 19,220
Shares used in computation of diluted net
income per share 9,924,558 8,191,303 7,176,115
</TABLE>

<PAGE>

Options and warrants to purchase 445,200 shares of the Company's common
stock would have been anti-dilutive in 1997 and were, therefore, excluded
from the 1997 diluted calculation.

Recently Issued Accounting Pronouncements

In June 1997, the Financial Accounting Standards Board issued Statement of
Financial Accounting Standards ("SFAS") No. 130, "Reporting Comprehensive
Income" ("SFAS 130") and SFAS No. 131, "Disclosures about Segments of an
Enterprise and Related Information" ("SFAS 131"). SFAS 130 establishes
standards for reporting comprehensive income and is effective in 1998. SFAS
131 establishes standards for annual and interim disclosures of operating
segments, products and services, geographic areas and major customers, and is
also effective in 1998. The Company is in the process of evaluating the
disclosure requirements of the new standards, the adoption of which will have
no impact on Faroudja's results of operations or financial condition.

2. SHORT-TERM INVESTMENTS

The following is a summary of available-for-sale securities at December 31, 1997
and 1996:

Unrealized Fair
Gains Market
Cost (Losses) Value
<S> <C> <C> <C>
At December 31, 1997
Certificates of deposit $ 276,605 $ -- $ 276,605
Commercial paper 5,106,171 -- 5,106,171
Discount notes 11,779,873 -- 11,779,873
$17,162,649 -- $17,162,649
Reported as:
Cash equivalents $16,886,044 $ -- $16,886,044
Government agency short-term investments 276,605 -- 276,605
$17,162,649 $ -- $17,162,649

At December 31, 1996:
Mutual funds-principally emerging growth equities $ 900,000 $107,980 $ 1,007,980
Other mutual funds 400,000 (3,084) 396,916
Certificates of deposit 263,000 -- 263,000
U.S. Treasury Bill 193,973 6,027 200,000
$ 1,756,973 $110,923 $ 1,867,896
Reported as:
Short-term investments $ 1,756,973 $110,923 $ 1,867,896
</TABLE>

The estimated fair value amounts discussed above have been determined
by the Company using available market information and appropriate valuation
methodologies. There were no unrealized gains or losses in 1997. In 1996,
gross unrealized losses were not material and thus have not been presented
separately in the above table.

Realized gains and losses for the year ended December 31, 1997 were
$185,309 and $101,853, respectively. There were no realized gains or losses
for the year ended December 31, 1996. As of December 31, 1997, the average
portfolio duration is approximately three months and the contractual maturity
of the investments does not exceed one year.

3. INVENTORIES

Inventories consist of the following at December 31:

<TABLE>
<CAPTION>
1997 1996
<S> <C> <C>
Raw materials $ 769,749 $ 615,865
Work-in-process 1,508,461 630,630
Finished goods 665,261 437,055
$2,943,471 $1,683,550
</TABLE>

<PAGE>

4. PROPERTY AND EQUIPMENT

Property and equipment consist of the following at December 31:

<TABLE>
<CAPTION>
1997 1996
<S> <C> <C>
Machinery and equipment $ 2,372,918 $ 1,705,845
Purchased computer software 915,041 492,471
Furniture, fixtures and equipment 289,998 234,976
Vehicles 84,448 241,802
Leasehold improvements 199,812 143,508
3,862,217 2,818,602
Accumulated depreciation (1,836,307) (1,434,795)
$ 2,025,910 $ 1,383,807
</TABLE>

5. OPERATING LEASES

The Company leases its main facilities in Sunnyvale, California under two
lease agreements from the same landlord expiring September 30, 2003. The
lease agreement for the primary facility is cancelable at the Company's
option upon four months' notice. Payments are adjusted annually based on
changes in the Consumer Price Index. At December 31, 1997, future estimated
minimum payments under these and other leases are approximately as follows:

<TABLE>
<S> <C>
1998 $ 431,041
1999 421,591
2000 411,091
2001 417,091
2002 423,591
Thereafter 321,568
Total minimum lease payments $2,425,973
</TABLE>

Rent expense under operating leases amounted to $288,740, $185,709 and
$168,948 in 1997, 1996 and 1995, respectively.

Purchase Commitments

In 1997, the Company entered into an agreement for the development,
manufacture and sale of a rear screen projection system. Under the agreement,
the Company is committed to purchase a specified number of units over the
two-year period of the contract. As of December 31, 1997, the Company had an
outstanding purchase commitment of $998,600.

6. STOCKHOLDERS' EQUITY

Initial Public Offering

In October 1997 the Company sold a total of 3,000,000 shares of Common Stock
at $6.00 per share through its initial public offering. Net proceeds, after
underwriters' discounts, commissions and fees, and other costs associated
with the offering, totaled $15,588,006. In connection with the offering, S3
Incorporated ("S3") received an additional 307,018 shares of Common Stock
pursuant to certain anti-dilution provisions which the Company had granted
under a Stock Purchase Agreement (see Note 7).

Warrants

In April 1992, the Company issued three warrants to purchase a total of
14,449 shares of Common Stock at a price of $3.40 per share to a consultant.
The warrants were exercised in August 1997.

In 1996, the Company issued a warrant to purchase 65,152 shares of
Common Stock at an exercise price of $0.15 to a limited liability company in
which a member of the Company's Board of Directors has a substantial
interest. The warrant was issued in exchange for services to be performed by
the director. As of December 31, 1997, 21,718 shares under the warrant were
exercisable. The remaining 43,434 shares will become exercisable if certain
defined events occur prior to February 1999. The warrant expires on December
31, 1999. The Company is expensing $222,000, the value of the warrant, over
the related service period.

<PAGE>

In 1997, one of the Founders granted to the Company an exclusive
(excluding certain rights retained by the Founder), worldwide, perpetual,
irrevocable and royalty-free right and license to patents owned by him. The
Founder has a nonexclusive, nontransferable right to the patents for
applications and uses outside of the Company's business as defined in the
license agreement. In exchange for rights granted, the Founder received a
warrant to purchase 100,000 shares of Common Stock at $7.50 a share. The
warrant vests over a three-year period and expires in January 2002. The
Company is amortizing $250,000, the value of the warrant, over the estimated
useful economic life of the patents.

Stock Plans

In 1995, the Company adopted the 1995 Stock Option Plan (the "1995 Plan"). A
total of 1,700,000 shares of Common Stock were reserved for issuance under
the 1995 Plan. In January 1997, the Board of Directors adopted, and the
stockholders approved, the 1997 Performance Stock Option Plan (the "1997
Plan"). The 1997 Plan succeeds the 1995 Plan and has terms similar to that
Plan. No additional options will be granted under the 1995 Plan and shares
reserved for future option grants thereunder are available for grant under
the terms of the 1997 Plan. In June 1997, the Board of Directors adopted and
the stockholders' approved an amendment to the 1997 Plan increasing the
number of shares reserved for issuance by 250,000 shares. Under the terms of
the 1997 Plan, the Board of Directors may grant options to directors,
employees and consultants. Options may be either incentive stock options or
nonstatutory stock options, at the discretion of the Board of Directors.
Incentive stock options may be granted to employees with exercise prices of
no less than the fair value, and nonstatutory options may be granted to
employees, directors, and consultants with exercise prices of no less than
85% of the fair value, of the common stock on the date of grant, as
determined by the Board of Directors. If, at the time of grant, the optionee
owns stock possessing 10% or more of the voting power of all classes of
stock, the option price shall be at least 110% of the fair value, and the
option shall not be exercised more than five years after the date of grant.
Except as noted above, options expire ten years after the date of grant, or
earlier if employment or service is terminated. Options become exercisable as
determined by the Board of Directors. Options generally vest over three or
four years.

In December 1996, the Board of Directors adopted, and in 1997 the
stockholders approved, the 1997 Non-Employee Directors Stock Option Plan (the
"Directors Plan"). A total of 100,000 shares of Common Stock were reserved
for issuance pursuant to the terms of the Directors Plan, which provides for
the grant of nonqualified stock options to nonemployee directors of the
Company.

In January 1997, the Board of Directors adopted, and the stockholders
approved, the 1997 Employee Stock Purchase Plan (the "Purchase Plan"). A
total of 400,000 shares were reserved for future issuance under the Purchase
Plan. The Purchase Plan permits eligible employees to purchase common stock
through payroll deductions at a price equal to the lower of 85% of the fair
value of the Company's common stock at the beginning or end of the applicable
offering period. No shares have been issued under the Purchase Plan.

A summary of the Company's stock option activity, and related
information follows:

<TABLE>
<CAPTION>
Years Ended December 31

Weighted- Weighted- Weighted-
Average Average Average
1997 Exercise 1996 Exercise 1995 Exercise
Options Price Options Price Options Price
<S> <C> <C> <C> <C> <C>
Outstanding at January 1 1,441,988 $3.46 180,576 $1.16 -- $ --
Granted 432,570 7.55 1,261,412 3.79 180,576 1.16
Exercised (7,380) 1.68 -- -- -- --
Canceled (207,988) 3.90 -- -- -- --
Outstanding at end of period 1,659,190 $4.48 1,441,988 $3.46 180,576 $ 1.16
Weighted-average fair value of
options granted during the period $2.19 $1.23 $0.36
</TABLE>

<PAGE>

December 31, 1997

Options Outstanding Options Exercisable

Weighted-
Average Weighted- Weighted-
Remaining Average Average
Range of Number of Contractual Exercise Number of Exercise
Exercise Prices Options Life Price Options Price
<S> <C> <C> <C> <C> <C>
$1.16 170,198 7.72 1.16 170,198 1.16
$2.02 31,134 8.03 2.02 31,134 2.02
$3.83-$3.91 1,059,558 8.61 3.85 1,006,073 3.85
$7.00-$7.50 335,600 9.46 7.42 -- --
$9.50 62,700 3.97 9.50 10,416 9.50
1,659,190 8.50 4.48 1,217,821 3.47
</TABLE>

Pursuant to APB 25, for certain options granted in June 1997, the Company
recognized as deferred compensation expense the excess of the deemed value
for financial reporting purposes of the common stock issuable upon the
exercise of such options over the aggregate exercise price of such options.
The total deferred compensation expense of $271,500 is being amortized over
the vesting period of such options.

During 1996, the Company adopted SFAS 123. In accordance with the
Statement, the Company applies APB 25 in accounting for option grants to
employees under the Plan and, accordingly, does not recognize compensation
expense for options granted to employees with exercise prices of not less
than fair value on the date of grant.

Had the Company valued its stock options granted to employees according
to the provisions of SFAS 123, pro forma net income and basic net income per
share would have been as follows for the years ended December 31:

<TABLE>
<CAPTION>
1997 1996
<S> <C> <C>
Net income--as reported (includes impact of
pro forma tax adjustment in 1996) $1,250,676 $1,318,721

Net income--pro forma 867,735 1,168,364

Basic net income per share--as reported $0.14 $0.17
Basic net income per share--pro forma $0.10 $0.15
</TABLE>

The pro forma impact on reported results for the year ended December
31, 1995 was not significant and has not been presented herein. The value of
options granted prior to the Company's initial public offering were
determined using the minimum value method using the following weighted
average assumptions in 1997 and 1996, respectively: risk free interest rate
of 5.63% and 6.35%, an expected option life of 72 months and no dividends.
The value of options granted following the initial public offering were
determined using the Black-Scholes method and the weighted average
assumptions were as follows: an expected volatility factor of 0.7764, a risk
free interest rate of 5.63%, an expected option life of 72 months and no
dividends.

Reserved Shares

The Company has reserved shares of Common Stock for future issuance as
follows:

<TABLE>
<CAPTION>
December 31,
1997
<S> <C>
Warrants 165,152
Stock purchase plan 400,000
Stock option plans:
Outstanding options 1,659,190
Reserved for future grants 383,430
2,607,772
</TABLE>

<PAGE>

7. LICENSE AGREEMENT

In March 1997, the Company licensed certain of its technology to S3, a
leading supplier of advanced graphics accelerators for use in mainstream
multimedia personal computer ("PC") systems. In December 1996, S3 paid the
Company $1 million, $500,000 of which was refundable if a definitive license
agreement between the parties was not consummated. Accordingly, the Company
recognized $500,000 of license and royalty revenue in 1996 and the remaining
$500,000 in March 1997.

On June 30, 1997, the Company sold a total of 526,316 shares of its Common
Stock to S3 pursuant to a Stock Purchase Agreement for $4,948,200, net of
expenses associated with the transaction. S3 is entitled to certain
anti-dilution, registration and other rights as set forth in the Stock
Purchase Agreement. As a result of the anti-dilution rights, S3 received an
additional 307,018 shares of Common Stock upon completion of the Company's
initial public offering in October 1997.

8. INCOME TAXES

The provision for income taxes computed under Statement of Financial
Accounting Standards, No. 109, "Accounting for Income Taxes," consists of the
following for the years ended December 31:

<TABLE>
<CAPTION>
Pro Forma

1997 1996 1995 1996 1995
(Unaudited) (Unaudited)
<S> <C> <C> <C> <C> <C>
Federal:
Current $1,058,623 $ 991,744 $23,000 $1,157,285 $ 885,687
Deferred (368,801) (439,614) -- (455,627) 5,463
689,822 552,130 23,000 701,658 891,150
State:
Current 144,447 201,016 60,981 247,312 151,242
Deferred (67,749) (66,092) -- (69,822) (19,204)
76,698 134,924 60,981 177,490 132,038
$ 766,520 $ 687,054 $83,981 $ 879,148 $1,023,188
</TABLE>

The provision for income taxes differs from the amount computed by
applying the statutory federal income tax rate to income before taxes. The
sources and tax effects of the differences are as follows for the years ended
December 31:

<TABLE>
<CAPTION>
Pro Forma

1997 1996 1995 1996 1995
(Unaudited) (Unaudited)
<S> <C> <C> <C> <C> <C>
Tax at U.S. statutory rate $ 685,847 $ 747,275 $1,391,693 $747,275 $1,391,693
State income taxes, net of
federal benefit 31,239 78,615 60,981 106,709 132,088
S Corporation earnings prior to change
in tax status -- (251,758) (868,150) -- --
Deferred taxes recorded due to change
in tax status -- (148,993) -- -- --
Research and development tax credits (137,736) (8,725) -- -- --
Net operating losses utilized -- -- (500,543) -- (500,543)
Other 187,170 270,640 -- 25,164 --
$ 766,520 $ 687,054 $ 83,981 $879,148 $1,023,188
</TABLE>

The pro forma provision for income taxes in 1996 and 1995 reflects the
additional tax expense which would have been incurred had FLI's status as an
S Corporation terminated on January 1, 1995, exclusive of the effects of the
establishment of deferred tax assets and liabilities at that date.

<PAGE>

Deferred income taxes reflect the net effects of temporary differences
between the carrying amounts of assets and liabilities for financial
reporting purposes and the amounts used for income tax purposes. Significant
components of the Company's deferred tax liabilities and assets are as
follows at December 31:

<TABLE>
<CAPTION>
1997 1996
<S> <C> <C>
Deferred tax assets:
Accrued liabilities $686,370 $354,284
Other, net 323,840 208,954
Deferred tax liabilities:
Depreciation of property and equipment (67,955) (57,533)
Valuation of investment portfolio -- (44,186)
Total deferred taxes $942,255 $461,519
</TABLE>

Management has concluded that a valuation allowance for deferred tax
assets is not required based on its assessment that current levels of taxable
income and the reversal of taxable temporary differences will be sufficient
to realize the tax benefit.

9. EXPORT SALES AND SIGNIFICANT CUSTOMERS

The Company had export sales by region as follows for the years ended
December 31:

<TABLE>
<CAPTION>
1997 1996 1995
<S> <C> <C> <C>
Revenues to customers:
Asia $1,182,000 $1,115,000 $ 986,000
Europe 345,000 479,000 263,000
Canada 269,000 200,000 138,000
Latin America and other 425,000 220,000 190,000
$2,221,000 $2,014,000 $1,577,000
</TABLE>

In 1997, sales to two customers accounted for 11% of total revenues. In
1996, sales to one customer accounted for 11% of total revenues. In 1995,
sales to a different customer accounted for 12% of total revenues.

10. 401K PLAN

During 1994, the Company adopted a defined contribution retirement plan under
Internal Revenue Service Code Section 401(k). Employees are eligible,
following one month of employment, to contribute a specified percentage of
their salary, not to exceed the statutory limit, to the plan. The Company
matches a percentage of employee contributions. The Company's contributions
were $147,015 in 1997 and were insignificant during 1996 and 1995.

11. CREDIT FACILITIES

In March 1997, the Company established a revolving line of credit with a bank
for borrowings of up to $1,000,000. In May 1997, the line was increased to
$2,000,000, including secured letters of credit. The line of credit
agreement, which includes certain financial covenants, expires on April 4,
1998. Borrowings under the line of credit are collaterized by substantially
all of the Company's tangible assets and contract rights are limited to a
defined percentage of eligible accounts receivable. Borrowings against the
line of credit bear interest at prime plus 1.5% (8.5% at December 31, 1997).
At December 31, 1997, there were no borrowings against the line of credit,
and the aggregate amount available under the revolving line of credit was
$2,000,000.

<PAGE>

REPORT OF ERNST & YOUNG LLP, INDEPENDENT AUDITORS

The Board of Directors and Stockholders
Faroudja, Inc.

We have audited the accompanying consolidated balance sheets of Faroudja,
Inc. as of December 31, 1997 and 1996, and the related consolidated
statements of income, stockholders' equity and cash flows for each of the
three years in the period ended December 31, 1997. 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 audits.

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 provide a
reasonable basis for our opinion.

In our opinion, the financial statements referred to above present fairly,
in all material respects, the consolidated financial position of Faroudja,
Inc. at December 31, 1997 and 1996, and the consolidated results of its
operations and its cash flows for each of the three years in the period ended
December 31, 1997, in conformity with generally accepted accounting
principles.

ERNST & YOUNG LLP

Palo Alto, California
January 29, 1998

<PAGE>
EXHIBIT 23

FAROUDJA, INC.
CONSENT OF ERNST & YOUNG LLP, INDEPENDENT AUDITORS

We consent to the incorporation by reference in this Annual Report (Form 10-K)
of Faroudja, Inc. of our report dated January 29, 1998 included in the 1997
Annual Report to Stockholders of Faroudja, Inc.

Our audits also included the financial statement schedule of Faroudja, Inc.
listed in Item 14(a). This schedule is the responsibility of the Company's
management. Our responsibility is to express an opinion based on our audits. In
our opinion, the financial statement schedule referred to above, when considered
in relation to the basic financial statements taken as a whole, presents fairly
in all material respects the information set forth therein.

Ernst & Young LLP

March 27, 1998
Palo Alto, California

<PAGE>
<ARTICLE> 5

<S> <C>
<PERIOD-TYPE> YEAR
<FISCAL-YEAR-END> DEC-31-1997
<PERIOD-START> JAN-01-1997
<PERIOD-END> DEC-31-1997
<CASH> 23,272,300
<SECURITIES> 276,605
<RECEIVABLES> 3,097,709
<ALLOWANCES> 166,681
<INVENTORY> 2,943,471
<CURRENT-ASSETS> 31,128,400
<PP&E> 2,025,910
<DEPRECIATION> 1,836,307
<TOTAL-ASSETS> 33,489,032
<CURRENT-LIABILITIES> 4,141,005
<BONDS> 0
0
0
<COMMON> 12,059
<OTHER-SE> 29,335,968
<TOTAL-LIABILITY-AND-EQUITY> 33,489,032
<SALES> 15,506,498
<TOTAL-REVENUES> 17,006,498
<CGS> 5,261,664
<TOTAL-COSTS> 5,261,664
<OTHER-EXPENSES> 4,526,918
<LOSS-PROVISION> 0
<INTEREST-EXPENSE> 0
<INCOME-PRETAX> 2,017,196
<INCOME-TAX> 766,520
<INCOME-CONTINUING> 1,250,676
<DISCONTINUED> 0
<EXTRAORDINARY> 0
<CHANGES> 0
<NET-INCOME> 1,250,676
<EPS-PRIMARY> .14
<EPS-DILUTED> .13

</TABLE>

<PAGE>
<ARTICLE> 5
<LEGEND>
THIS SCHEDULE WHICH HAS BEEN RESTATED FOR SFAS 128 CONTAINS SUMMARY FINANCIAL
INFORMATION EXTRACTED FROM REGISTRATION STATEMENT ON FORM S1 AND IS QUALIFIED IN
ITS ENTIRETY BY REFERENCE TO SUCH FINANCIAL STATEMENTS.
</LEGEND>
<RESTATED>

<S> <C> <C> <C>
<PERIOD-TYPE> YEAR 9-MOS 6-MOS
<FISCAL-YEAR-END> DEC-31-1996 DEC-31-1997 DEC-31-1997
<PERIOD-START> JAN-01-1996 JAN-01-1997 JAN-01-1997
<PERIOD-END> DEC-31-1996 SEP-30-1997 JUN-30-1997
<CASH> 1,215,591 6,934,266 7,520,481
<SECURITIES> 1,867,896 272,227 272,227
<RECEIVABLES> 2,767,331 3,319,400 2,644,616
<ALLOWANCES> 110,000 199,000 181,000
<INVENTORY> 1,683,550 2,634,408 2,093,922
<CURRENT-ASSETS> 8,220,313 14,546,666 13,486,454
<PP&E> 1,383,807 1,911,230 1,503,404
<DEPRECIATION> 1,434,795 1,629,859 1,569,476
<TOTAL-ASSETS> 9,604,120 16,738,867 15,224,995
<CURRENT-LIABILITIES> 2,359,229 3,321,705 2,301,905
<BONDS> 0 0 0
0 0 0
0 0 0
<COMMON> 8,200 8,752 8,734
<OTHER-SE> 7,236,691 13,408,410 12,914,356
<TOTAL-LIABILITY-AND-EQUITY> 9,604,120 16,738,867 15,224,995
<SALES> 12,626,183 11,625,514 6,863,531
<TOTAL-REVENUES> 13,126,183 12,875,514 7,863,531
<CGS> 4,797,516 3,951,075 2,285,785
<TOTAL-COSTS> 4,797,516 3,951,075 2,285,785
<OTHER-EXPENSES> 2,463,838 3,288,242 2,151,450
<LOSS-PROVISION> 0 0 0
<INTEREST-EXPENSE> 0 0 0
<INCOME-PRETAX> 2,197,869 1,491,567 861,780
<INCOME-TAX> 687,054 566,782 327,472
<INCOME-CONTINUING> 1,510,815 924,785 534,308
<DISCONTINUED> 0 0 0
<EXTRAORDINARY> 0 0 0
<CHANGES> 0 0 0
<NET-INCOME> 1,510,815 924,785 534,308
<EPS-PRIMARY> .17 0.11 0.07
<EPS-DILUTED> .16 0.10 0.06

</TABLE>