FAROUDJA INC, 10-K405, 1999-03-31

FAROUDJA INC
10-K405, 1999-03-31
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, 1998

COMMISSION FILE NUMBER 0-23107

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FAROUDJA, INC.
(Exact name of registrant as specified in its charter)

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

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,
1999, as reported on the NASDAQ National Market, was approximately $14.8
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, 1999 the Registrant had outstanding 12,242,597 shares of
Common Stock.

DOCUMENTS INCORPORATED BY REFERENCE

Portions of the Registrant's Proxy Statement for the Annual Meeting of
Stockholders to be held on June 10, 1999 are incorporated by reference into
Part III of this Form 10-K Report.

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FAROUDJA, INC.

FORM 10-K

DECEMBER 31, 1998

INDEX

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PAGE
NO.
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PART I

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

EXECUTIVE OFFICERS OF THE COMPANY. . . . . . . . . . . . . . . . 18

Item 2. PROPERTIES . . . . . . . . . . . . . . . . . . . . . . . . . . . 19

Item 3. LEGAL PROCEEDINGS. . . . . . . . . . . . . . . . . . . . . . . . 19

Item 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS. . . . . . . 19

PART II

Item 5. MARKET FOR REGISTRANT'S COMMON EQUITY AND RELATED STOCKHOLDER
MATTERS. . . . . . . . . . . . . . . . . . . . . . . . . . . . . 20

Item 6. SELECTED FINANCIAL DATA. . . . . . . . . . . . . . . . . . . . . 20

Item 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION
AND RESULTS OF OPERATIONS. . . . . . . . . . . . . . . . . . . . 21

Item 7A. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK . . . 26

Item 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA. . . . . . . . . . . 27

Item 9. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING
AND FINANCIAL DISCLOSURE . . . . . . . . . . . . . . . . . . . . 42

PART III

Item 10. DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANT . . . . . . . 42

Item 11. EXECUTIVE COMPENSATION . . . . . . . . . . . . . . . . . . . . . 42

Item 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT . 42

Item 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS . . . . . . . . . 42

PART IV

Item 14. EXHIBITS, FINANCIAL STATEMENT SCHEDULES, AND REPORTS ON
FORM 8-K . . . . . . . . . . . . . . . . . . . . . . . . . . . . 42

SIGNATURES . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 43
</TABLE>

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THIS FORM 10-K CONTAINS FORWARD LOOKING STATEMENTS WITHIN THE MEANING OF
THE PRIVATE SECURITIES LITIGATION REFORM ACT OF 1995 CONCERNING THE COMPANY'S
FUTURE PRODUCTS, EXPENSES, REVENUE, LIQUIDITY AND CASH NEEDS AS WELL AS THE
COMPANY'S PLANS AND STRATEGIES. SUCH FORWARD-LOOKING STATEMENTS INVOLVE
KNOWN AND UNKNOWN RISKS AND UNCERTAINTIES. THESE FORWARD-LOOKING STATEMENTS
ARE BASED ON CURRENT EXPECTATIONS. THE COMPANY'S ACTUAL RESULTS AND TIMING
OF CERTAIN EVENTS COULD DIFFER MATERIALLY FROM THE DESCRIPTIONS 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." THE COMPANY UNDERTAKES NO OBLIGATION TO
PUBLICLY UPDATE OR REVISE ANY FORWARD-LOOKING STATEMENTS, WHETHER AS A RESULT
OF NEW INFORMATION, FUTURE EVENTS, OR OTHERWISE.

PART I

ITEM 1. BUSINESS

GENERAL

Faroudja Inc. (the "Company") designs, develops and markets a range of
video image enhancement products for the home theater and industrial markets
and the broadcast market. 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 market,
to markets for new video display devices, and to markets resulting from new
applications such as 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. 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. These video images are displayed on a variety
of electronic media including color TVs, projection TV 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 smaller TV screens than on screens 25
inches in size and larger. 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
increase, impairments in the image, such as low resolution, artifacts and
noise, have become more 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 recent
introduction of HDTV. HDTV images are expected to incorporate cinema-like
image quality in a wider screen format. The Federal Communications Commission
("FCC") has established standards 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 range from $2
million per station to 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, as well as 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 high quality TV images. Since TV

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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. The
interlace/progressive conversion, along with other steps in the conversion of
the TV signal, have caused color distortion, motion artifacts, noise and
other imperfections, resulting 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

The Company designs, develops and markets video image enhancement
products, that dramatically improve image quality, producing cinema quality
images on a wide variety of displays.

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 sales of both board
level and application specific integrated circuit ("ASIC") products to
original equipment manufacturer ("OEM") customers.

The Company has also developed products that 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 current studio equipment will help
broadcasters minimize transition costs and maintain flexibility in responding
to evolving regulatory and market requirements. The Company believes that its
Digital Format Translator-TM- ("DFT") upconversion products will enable
broadcasters to use much of the equipment present in their existing studios
to produce programming in various DTV/HDTV video formats.

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 technologies and innovative products for the video
display and broadcast markets. The Company intends to leverage its image
enhancement expertise in TV into broadcast, DTV and other new displays, and
PC products and applications.

PENETRATE BROADER MARKET SEGMENTS. The Company has historically sold
products that address the needs of the industrial and home theater markets.
The Company is seeking product opportunities in new and broader market
segments, such as the converging PC and TV markets and the emerging DTV/HDTV
broadcast and new digital display markets.

BUILD AND LEVERAGE STRATEGIC RELATIONSHIPS. The Company intends to establish
and maintain strategic relationships with companies whose technology,
products and distribution 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.

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 home theater markets. The Company intends to
increase brand name awareness through advertising, the marketing of stand
alone image enhancement and display products carrying the Company's
trademarks, co-branding agreements with OEM customers and greater emphasis on
Internet marketing through its web site. The distribution of Company-branded
and co-branded products in new and broader market segments is also intended
to increase Faroudja-Registered Trademark- brand awareness.

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
home theater and industrial products and products for the broadcast market:

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<TABLE>
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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 projection system
Enhancement/
Line Multiplying VP301 Line tripler and video processor for large screen high resolution video projection system

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

VS50 NTSC/PAL low noise video decoder, frame synchronizer and image processor for large screen
standard resolution displays and video production

Large Screen RP5800 HDTV rear screen multimedia projection system with line doubler and video processor
Multimedia Display
Systems LS700 LCD-based front projection system with line doubler and video processor

Broadcast DFD U NTSC/PAL video decoder/frame synchronizer with 10-bit processing, time base correction,
patented 2D adaptive comb filter produces artifact-free digital D1 parallel and serial
outputs

A2D1F Low noise video decoder/frame synchronizer with video adjustments and D1 output

DFT-3 Base format translator for upconverting NTSC serial digital input to ATSC 720p or 1080i HDTV
video formats, includes multiple preset aspect ratios, standard and high definition frame
synchronization, digital color correction and HD-SDI outputs

DFT-3S DFT-3 format translator for upconverting NTSC serial digital input to ATSC 720p or 1080i HDTV
video formats, includes multiple preset aspect ratios, standard and high definition frame
synchronization, digital color correction, advanced video enhancement, HD-SDI outputs and
System Control Software

DFT-3A Fully featured format translator for upconverting a full range of NTSC signals through
patented 2D decoding, analog component and serial digital inputs to ATSC 480p, 720p and 1080i
DTV/HDTV video formats, includes full aspect ratio control, standard and high definition
frame synchronization, digital color correction, digital noise reduction, advanced video
enhancement, HD-SDI and analog outputs, and System Control Software
</TABLE>

TV PRODUCTS

LINE QUADRUPLERS (VP401). The Company's 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 projection TV systems and electronic cinema. 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 projection TV systems.

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

VS50 CHROMA DECODER. The VS50 decodes NTSC and PAL signals into high
quality, artifact-free components to greatly improve image quality for high
quality standard scan rate displays and video production.

REAR PROJECTION MULTIMEDIA DISPLAY SYSTEM (RP5800). The Company's 58 inch
wide, HDTV rear screen multimedia 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.
During 1998 the Company offered the RP4800, a 48 inch wide, rear screen
projection system. The RP4800, which is based on a different projector
chassis than the RP5800, was discontinued in December 1998 with the
introduction of the RP5800.

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LS-TM-700 LCD PROJECTOR. The LS700 is an LCD-based front projection system
produced by In Focus Systems, Inc. ("In Focus-Registered Trademark-"),
incorporating line doubling and video processing ASICs of the Company. This
product combines the image quality for which the Company is recognized with
the compact form factor, ease-of-use, reliability and low cost of ownership
of an LCD projector.

Home theater and industrial product sales as a percentage of total
revenues for fiscal 1998, 1997 and 1996 were 84%, 88% and 80%, 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.

A2D1F. The A2D1F 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 and digital video
compression.

The Company's Digital Format Translator-TM- ("DFT") products, used in
conjunction with existing NTSC production equipment at post-production,
network or network affiliate studios, provide broadcasters with the ability
to produce programming in various DTV and HDTV video formats. In addition to
translating standard resolution video into higher resolution formats, certain
of the DFT products enable broadcasters to transform standard source material
(4:3 aspect ratio) into a wide screen (16:9 aspect ratio) format. The
products provide user-friendly means for studio engineers to control a broad
range of factors that ultimately contribute to superior image quality. The
translators have a modular design and can be configured to suit particular
customer's needs. Examples of configurations are the DFT3, DFT3S and DFT3A
described below.

DFT3 - DIGITAL FORMAT TRANSLATOR. The DFT3 base model translator uses
patented Faroudja technologies to translate 525 line interlace serial digital
component video into the customers choice of either the ATSC 720 line
progressive or 1080 line interlace HDTV video formats. The product includes
the ability to choose from among multiple preset aspect ratios, standard and
high definition frame synchronization, digital color correction and HD-SDI
outputs.

DFT3S - DIGITAL FORMAT TRANSLATOR. The DFT3S contains all the features of
the DFT3, plus advanced video enhancement and Window's NT-based system
control software that allows the highest level of user control over system
features.

DFT3A - DIGITAL FORMAT TRANSLATOR. The DFT3A is a fully featured DFT3. It
contains all features of the DFT3S and Faroudja patented adaptive comb filter
decoding for upconverting the full range of NTSC signals (analog, composite
and digital) into the full range of ATSC DTV and HDTV video formats: 480
line progressive, 720 line progressive and 1080 line interlace. Digital
noise reduction and a variety of analog monitoring options are also added to
round out the DFT3A and make it the most advanced and feature rich product in
its class.

Broadcast product sales as a percentage of total revenues for fiscal
1998, 1997 and 1996 were 10%, 2% and 16 %, respectively.

OEM PRODUCTS

The Company co-brands certain of its stand alone video processing
products with Vidikron of America, Inc. ("Vidikron"). In 1998, sales to
Vidikron accounted for 10% of total Company revenues.

The Company has also designed and developed board level and ASIC products
incorporating the Company's technologies for the OEM market. ASIC product
offerings include the FLI2000 broadcast quality NTSC/PAL decoder integrated
circuit, with time base correction and detail enhancement, and the FLI9000
set of eight proprietary ASICs. The FLI9000 chip set includes the FLI2000
and additional deinterlacing and enhancement chips. In Focus incorporates
the FLI9000 chip set into the LS700 projector. To date, sales from board and
ASIC 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 application
specific integrated circuits ("ASICs"). As of December 31, 1998, the Company
had a staff of 20 full-time research and development personnel. During 1998,
1997 and 1996 the Company's research and development expenses were
approximately $4.8 million, $4.2 million and $2.5 million, respectively. The
Company anticipates that its research and development expenses will increase
in absolute dollars for the foreseeable future.

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The Company has a number of products in development with introduction
planned during the next several years. For the home theater and industrial
markets, the Company is developing new line multipliers with video scaling
capabilities for very large screen high resolution systems, liquid crystal
display ("LCD") and Digital Light Processing-Registered Trademark- based
projector systems ("DLP"), and a video processor for less sophisticated
industrial applications. For the broadcast market the Company is continuing
to develop and cost-reduce its DFT products to respond to the needs of the
emerging DTV/HDTV market.

The Company's other planned research products include expanded
development of line multipliers, compression pre-processors for broadcast
products which include noise reduction to increase compressor efficiency and
next-generation ASICs that include enhanced capabilities, greater integration
and denser chip geometries.

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, develop new products and features to meet changing
customer requirements and evolving industry standards, and enter into
royalty-bearing licenses. Sales from Company's line multiplier product lines
decreased in 1998 and the Company anticipates that sales of such products
will experience limited growth, or decline, in future periods. Home theater
and industrial market sales decreased in 1998, which the Company attributes
to increased competition, pricing pressure and consumer confusion over HDTV.
The Company believes that the confusion resulting from HDTV and related
market weakness could continue until HDTV broadcast begins on a wide-scale
basis. The Company expects that approximately one-half of its total revenues
in 1999 will be derived from sales of recently introduced products and
products which the Company is developing for introduction in 1999. The
success of new products depends on a number of factors, including proper
selection and timely introduction, successful and timely completion of
product development, accurate estimation of demand, 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 and ASIC 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. There can be no
assurance that the Company's broadcast products will be widely 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. The Company
does not currently have any license agreements in effect pursuant to which it
expects to receive substantial royalties.

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.

There can be no assurance that the Company will identify new product
opportunities, will successfully develop and bring to market new products,
will be chosen to supply board level or ASIC products for incorporation into
OEMs' products 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. See "Factors Affecting Future Operating Results -
DEPENDENCE ON NEW PRODUCT DEVELOPMENT AND RISK OF TECHNOLOGICAL CHANGE."

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

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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 the artifact known as "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 readily apparent with large,
highly saturated, stationary graphics such as titles and credits.

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.

LINE MULTIPLIER TECHNOLOGY. The line multiplier technology reduces scan line
visibility resulting from utilizing a 525 line interlaced 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, DVD 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 image details, whether horizontal or
vertical, without introducing ringing or noise artifacts and without
modifying large edge response through the use of non-linear processing. This
technique expands the apparent 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 an image that
gives a greater feeling of depth.

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 and display technologies emerge, 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 factors of two. DFT products
scale the picture by non-integer ratios to convert traditional video sources
to the new DTV and HDTV formats and the Company has under development line
multiplication products that scale by non-integer ratios. This capability is
required for PC interface products, and LCD and DLP-TM- based products, all
of which have finite numbers of pixels in their display format. When pixel
based displays are used to display video, the video source should be scaled
to convert the original number of lines to the number of lines in the display
device to avoid the creation of video artifacts.

STRATEGIC RELATIONSHIPS AND LICENSING

The Company believes that strategic relationships with other
manufacturers will provide opportunities to facilitate the entry of video
image enhancement products into new markets.

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In March 1997, the Company entered into a license agreement with S3
Incorporated ("S3"), which allows S3 to incorporate certain of the Company's
technologies, including line doubling, detail enhancement, cross-color
suppression, motion tracking and compensation and digital compression
filtering, in S3's advanced graphics accelerator products for mainstream
multimedia PC systems. To the extent that S3 incorporates the Company's
technologies in S3 products the Company will receive royalties. The license
agreement was exclusive for certain markets provided that certain conditions,
including the payment of minimum quarterly license fees, were satisfied. S3
has advised the Company that it will not make payments necessary to maintain
its exclusive rights with respect to any periods after March 31, 1998. S3
has not shipped any products that incorporate the Company's technology and
there can be no assurance that S3 will develop products or pay any future
royalties under the license agreement.

Yves Faroudja, the Company and General Instrument Corporation ("GI") are
parties to a 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. The licenses
are royalty-free so neither party is obligated to pay, nor entitled to
receive, license fees from the other party. The agreement grants exclusive
rights to each company in defined fields of use, includes the right to grant
sublicenses and extends until the last to expire of the licensed patents. 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 products.

In December 1998, the Company entered into a manufacturing, sales and
distribution agreement with In Focus, pursuant to which In Focus agreed to
incorporate the Company's line doubling and video processing circuitry into
an In Focus LCD projector to be known as the "LS-TM-700." The agreement
granted to the Company the exclusive right to sell the LS700 in the home
theater market. The Company also agreed that until May 30, 1999 it would not
allow any company other than In Focus to offer or sell any front-screen
LCD-based home theater projection devices incorporating the Company's
proprietary ASICs. Shipments of LS700s to the Company's home theater
customers began in January 1999.

The patented technologies which the Company uses to produce standalone
products for home theater, industrial and broadcast applications may also be
used in other applications, such as digital television sets and digital
set-top boxes, for improving the image quality displayed from standard
definition video sources. The Company may offer to license these
technologies, such as decoding, line multiplication, detail enhancement,
motion tracking, motion compensation, time base correction and scaling, to
strategic partners such as semiconductor chip manufacturers, for wide scale
deployment. The Company is not currently a party to any such license
agreements. There can be no assurance that the Company will identify
additional strategic partners or enter into additional license agreements for
the uses described or any other uses, or that any such relationships or
agreements will result in substantial revenues to the Company. See "Factors
Affecting Future Operating Results - DEPENDENCE ON STRATEGIC RELATIONSHIPS."

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, 1998, the Company maintained a sales force of eight persons
at its headquarters in Sunnyvale, California, and three employees in regional
offices. The Company's marketing programs include trade shows, training
seminars, public relations and advertising. The Company also uses its web
site (www.faroudja.com) for marketing, and intends to place greater emphasis
on Internet marketing in the future. Revenues from S3 and Vidikron accounted
for 10.6% and 11.1%, respectively, of total revenues in 1997. Revenues from
Vidikron accounted for 10% of total revenues in 1998.

The Company currently distributes its home theater products through
approximately 300 home theater dealers throughout the United States. This
distribution channel is managed by a Company national sales manager, two
regional managers, one field training manager, independent sales
representatives and a customer service department.

The Company also sells its products to the industrial market for uses
such as corporate boardrooms, executive conference centers and auditoriums,
through a network of more than 100 industrial dealers. These dealers
typically provide installation, product integration, on site training and
customer support. This network is managed directly by the national sales
manager and two regional managers that manage home theater distribution and
by independent industrial sales representatives.

For the broadcast market, the Company has relied, and expects to
continue to rely on, direct sales and marketing. The Company has two
employees who sell directly to the broadcast market. The Company may also
enter into reseller arrangements with companies, such as systems integrators,
that sell to the broadcast market.

The Company has OEM and/or co-branding relationships with Vidikron and
In Focus. OEM and/or co-branding relationships with Ampro Corporation
("Ampro"), CinemaPro Corporation dba Runco International ("Runco") and NEC
Technologies, Inc. USA ("NEC") ended in 1998. There can be no assurance that
the Company will continue to receive any revenues from continuing
relationships or that it be successful in developing additional OEM
relationships.

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<PAGE>

Export sales represented approximately 18.6%, 13.1% and 15.3% of the
Company's total revenues in 1998, 1997 and 1996, respectively. While export
sales remained flat in 1998, they increased as a percentage of total revenues
from the prior year because of the decrease in the Company's total revenues.
The Company has a non-exclusive worldwide distribution arrangement with
Vidikron pursuant to which Vidikron distributes the Company's line doublers
and line quadruplers. In addition, the Company 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
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. See "Factors Affecting Future
Operating Results - RISKS ASSOCIATED WITH EXPORT SALES AND OPERATIONS."

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. See "Factors Affecting Future Operating Results - DISTRIBUTION
RISKS; DIVERSIFICATION OF SALES CHANNELS."

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
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 RP4800 Rear Projection System, a 48 inch wide rear screen projection
system that was sold by the Company until December 1998, utilized a projector
chassis provided by Audio Video Source, Inc. ("AVS") and modified to the
Company's specifications. AVS also manufactured the RP4800 for the Company
on a contract basis including integrating, assembling and testing the various
components of the system.

The Company's RP5800 Rear Projection System utilizes a projector chassis
purchased from Barco, Inc. The RP5800 is manufactured for the Company on a
contract basis by Visual Structures, Inc. Visual Structures integrates,
assembles and tests the various components of the system, including the
Company's line doubler.

The LS700 projector is manufactured by In Focus incorporating ASICs
provided by the Company. The projector is co-branded with the names of both
In Focus and the Company.

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 outsource
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 ST Microelectronics,
Inc. ("ST"). In addition, Micro Devices Technology, Inc. ("MDT") and TEMIC
Semiconductors ("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 0.5 and 0.8 micron feature sizes. New devices that
are being designed are in 0.25 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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<PAGE>

See "Factors Affecting Future Operating Results - RELIANCE ON INDEPENDENT
FOUNDRIES AND MANUFACTURING."

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. For example, during the year ended December 31, 1998,
the low end of the Company's line multiplier family, line doublers, faced
heavy competition from other line processor manufacturers and from certain
projector manufacturers that included built-in line doublers in their
projectors. These trends are expected to continue. 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"), Miranda
Techologies Inc. ("Miranda"), NEC, Runco, Snell & Wilcox, Inc. ("Snell &
Wilcox"), Sony Corporation ("Sony") and Yamashita Engineering Manufacturing,
Inc. ("YEM"). DVDO, Inc. ("DVDO") and Genesis Microchip Inc. ("Genesis"),
have recently emerged as competitors with chip solutions. In the market for
broadcast products, the Company's principal competitors are Extron, Leitch
Incorporated ("Leitch"), Miranda, Panasonic Broadcast & Television Systems
Company ("Panasonic"), Snell & Wilcox, 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 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 has licensed and intends to continue to license its
technologies and intellectual property. The Company also offers for sale
board level or ASIC 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. At present, the Company believes that S3 and GI
are licensees which could compete with certain of the Company's technologies
and products. While the Company may sell board level or ASIC 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.

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, form factor 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. See "Factors
Affecting Future Operation Results - COMPETITION."

PROPRIETARY RIGHTS AND LICENSES

The Company's future success depends, in part, on its ability to protect
its proprietary technology and information. Although the Company relies on a
combination of 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. The Company
holds or is the exclusive licensee of 54 U.S. and 11 foreign patents, and 11
U.S. and 25 foreign

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<PAGE>

patent applications. The Company depends on these patents for the enhancement
of its current products and the development of future products. Most of
these patents and patent applications are owned by Yves Faroudja, the
Company's founder and Chief Technical Officer. Mr. Faroudja has granted the
Company an exclusive 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 that 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 necessary 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 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. See "Factors Affecting Future Operation
Results -LIMITED PROTECTION OF INTELLECTUAL PROPERTY RIGHTS; RISK OF THIRD
PARTY INFRINGEMENT."

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 certain
patents.

EMPLOYEES

As of December 31, 1998, the Company had 60 full-time employees,
including 20 full-time employees primarily involved in research and
development activities, 12 in marketing and sales, 12 in finance and
administration and 16 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 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 1999, primarily in research and development, and believes that its
future success will depend largely on its ability to attract and retain
highly-skilled engineering 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 period to period operating results have varied in the past and are
likely to vary significantly in the future as a result of a number of
factors, including the volume and timing of orders received during the
period, the amount and timing of 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 and other manufacturing problems,
changes in product or distribution channel mix, product returns, 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 life cycles of the Company's products, the Company's failure to
consistently introduce new, competitive products in a timely manner could
have a material adverse affect on operating results for one or more product
cycles.

Gross margins may vary from period to period as a result of various
factors, including the volume of sales, the mix of products sold, new product
introductions, fluctuations in the receipt of royalty revenues, the mix of
distribution channels and adjusting prices to meet competition. 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, introduce
enhanced versions of existing products and continuously reduce the cost of
its products. The Company anticipates that it will incur lower overall gross
margins in future periods as it introduces lower margin products for consumer
markets and as price competition increases for all products.

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<PAGE>

Customers generally do not order the Company's products in advance of
their needs. As a result, the Company's backlog is relatively small. Even
though backlogs are small and future sales are difficult to forecast, the
Company must undertake development projects, initiate sales and marketing
activities, stock inventory, plan production, order components and make other
commitments months in advance of receiving orders for its products. A
shortfall in revenues in a given quarter may adversely impact the Company's
operating results due to its inability to make a corresponding adjustment to
expenses during that quarter.

The Company currently derives a substantial portion of its total
revenues from the sale of a relatively low unit volume 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 new orders for
products to be shipped in the same quarter. On occasion, a significant
amount of the Company's quarterly sales are attributable to a limited number
of customers. These factors combine to make the volume and timing of orders
received by the Company during a quarter difficult to forecast.

A disproportionate percentage of the Company's total revenues result
from sales made 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. This sales cycle may also increase the impact
of a delay in shipment near the end of a particular quarter, due for example,
to shipment rescheduling or cancellation, or manufacturing difficulties
experienced by the Company or its suppliers. Either an unexpected shortfall
in sales late in a quarter or a delay in shipment 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
that quarter.

The Company's industry is subject to a high degree of seasonality.
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 1998 were derived from sales
of products that address the home theater and industrial TV markets. Certain
of the Company's current products and future product plans 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. There can be no assurance
that these markets will become substantial commercial markets or that the
Company's products will achieve market acceptance in those markets. The
Company also intends to exploit new display technologies and what it believes
will be the convergence of the TV and PC markets. There can be no assurance
that these new display technologies will be successful or that the TV and PC
markets will converge, that these new market will present substantial
commercial opportunities, or that the Company's products will adequately
address these markets in a timely manner. The Company has experienced, and
expects to continue to experience, technological and pricing constraints that
may interfere with its development of products that address emerging markets.
For example, price has been an issue for certain OEMs that considered
incorporating the Company's current ASICs into their products. In addition,
certain prospective development partners have deferred or abandoned joint
development plans for reasons including market uncertainties regarding which
technologies should be bundled on highly integrated chips. 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, if 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 technologies 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 more desirable standards will not
emerge. The acceptance of the Company's products also depends in part upon
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 DTV signals in
May 1999, targeting the eventual 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 home theater and industrial or broadcast
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 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 assurance that such
factors, all of which are 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

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<PAGE>

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 on its ability 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. The Company's home theater and industrial
sales decreased in 1998, which the Company attributes to increased
competition, pricing pressure and consumer confusion over HDTV. The Company
believes that the introduction of new products throughout 1999 and increased
emphasis on board and ASIC products will improve its competitive position.
The Company believes that the confusion associated with HDTV broadcast will
continue until HDTV broadcast begins on a wide-scale basis. The Company
expects that approximately one-half of its total revenues in 1999 will be
derived from sales of recently introduced products and products which the
Company is developing for introduction in 1999. The success of new products
depends on a number of factors, including proper selection and timely
introduction, successful and timely completion of product development,
accurate estimation of demand, 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 and ASIC 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. There can be no assurance that the
Company's broadcast products will be widely 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. The Company does not currently have any
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. During 1998 competition in
the home theater and industrial markets increased at the low end from
manufacturers of less expensive line multipliers, from projector
manufacturers building line multipliers into their projectors and from
companies offering relatively inexpensive chips performing functions
analogous to functions performed by 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, Extron, Miranda, NEC, Snell & Wilcox, Sony and YEM.
DVDO and Genesis have recently emerged as competitors with chip solutions.
In the market for broadcast products, the Company's principal competitors are
Extron, Leitch, Miranda, Panasonic, Snell & Wilcox, 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.

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 present, the Company
believes that S3 and GI are licensees which could compete with certain of the
Company's technologies and products.

-14-

<PAGE>

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 Company's failure 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 technology depends on a
number of factors, including protection of its intellectual property and, 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 companies like
Vidikron to sell, and In Focus to manufacture, products which incorporate the
Company's technology and a failure by these companies to do so 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 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 ASIC products, developed by 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 that compete with the Company's technologies
and products. While the Company may sell board level or ASIC 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.
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 this network of direct and indirect distributors and
dealers. In 1998, sales to Vidikron, an OEM customer accounted for 10% of
total Company revenues. 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 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 customer support for such

-15-

<PAGE>

products. All of these factors could have a material adverse effect on the
Company's business, financial condition and operating results.

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 INTELLECTUAL 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 applications, or that any claims allowed from pending
applications will be of sufficient scope or strength, or be issued in all
countries necessary to provide meaningful protection or 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. 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

-16-

<PAGE>

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 could have a material adverse affect on the
Company's business, financial condition and operating results.

The Company may initiate claims or litigation against third parties for
infringement of the Company's proprietary rights, like the suits it filed
against DWIN and Snell & Wilcox, 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 determination favorable to the Company. Such
diversion could have a material adverse effect on the Company's business,
financial condition and operating results. In addition, litigation initiated
by the Company 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. The Company could also be ordered to cease infringing a third
party's intellectual property rights (including, marketing, using, selling
and importing infringing products, and employing infringing methods or
processes). An adverse determination could also result in the Company
expending 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, if at all. 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.

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, Chief Technical Officer
("CTO") and Co-Chairman. The loss of the service of any of these individuals
could have a material adverse effect on the Company.

Mr. Faroudja entered into an agreement with the Company pursuant to
which he serves as an advisor, and continues to serve as the Company's CTO
until a new CTO is identified and appointed. The agreement further provides
that when a new CTO is appointed, Mr. Faroudja will become a Senior Fellow of
the Company. Mr. Faroudja has elected to terminate the agreement on June 30,
1999. The Company does not know how much time Mr. Faroudja will devote to
the Company's affairs in the future.

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.
During 1998, a number of VLSI engineers left the Company. While the Company
has not yet replaced the VLSI engineers, it has retained certain of the
engineers as consultants on an interim basis to complete projects in
progress. The Company has initiated recruiting efforts, but there can be no
assurance that the Company will be successful in attracting or retaining
qualified replacements for these VLSI engineers. The failure to attract or
retain such replacements could have a material adverse effect on the
Company's business, financial condition and operating results.

Competition for skilled executive, technical, management, sales,
marketing, consulting and other 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.

DEPENDENCE ON ROYALTY REVENUES. There can be no assurance as to the amount
of royalties, if any, that the Company will receive in the future under its
license agreement with S3. S3 has not made 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. Revenues from S3 accounted for 10.6% of the Company's
total revenues for the year ended December 31, 1997 and 6.1% of total
revenues for the year ended December 31, 1998.

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

-17-

<PAGE>

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, the market served by the
Company's customers or the economy as a whole, 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, or otherwise experience significant fluctuations
in the future, including fluctuations that are unrelated to the Company's
performance.

YEAR 2000 PROBLEM. Certain computers, software and equipment with embedded
computing capability recognize only the last two, rather than all four digits
of the year in any date. As a result they may fail to recognize and properly
process date information or otherwise malfunction unless they are
reprogrammed or replaced at the turn of the century (the "Year 2000
Problem"). While the Company does not believe the Year 2000 Problem will
impact the performance and functionality of its products and is actively
working to identify and address internal and external issues associated with
the Year 2000 Problem, there can be no assurance that the Company will
identify all of its Year 2000 Problems, resolve internal and external Year
2000 Problems on a timely or cost-effective basis, or be successful in
avoiding the impact of business disruptions which may be experienced by the
Company's suppliers, service providers and other third parties as a result of
Year 2000 Problems. Failure by the Company or third parties doing business
with the Company to identify and resolve Year 2000 problems on a timely basis
could have a material adverse effect on the Company's financial position,
liquidity or results of operations.

EXECUTIVE OFFICERS OF THE COMPANY

Set forth below is the name, age and office held with the Company of
each of the executive officers of the Company as of March 30, 1999 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 June 10, 1998. 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.

GLENN W. MARSCHEL, JR. (age 52) has served as President, Chief Executive
Officer and Co-Chairman of the Board of Directors since joining the Company
in October 1998. He has served as Executive Chairman of the Board of
Directors of Additech, Inc., a petrochemicals company, since October 1997.
From December 1995 to August 1997 Mr. Marschel was President and Chief
Executive Officer of Paging Network, Inc., a telecommunications company, and
from April 1995 to November 1995 he served as Vice Chairman of First
Financial Management Company, a company in the credit report and collections
business. Prior thereto, from January 1972 to January 1995, Mr. Marschel
held positions of increasing responsibility at Automatic Data Processing,
Inc., an information systems company, last serving as President of ADP's
Employer Services Group. Mr. Marschel is also a director of Sabre Group
Holdings, Inc.

YVES C. FAROUDJA (age 65) 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. Mr. Faroudja has served as Co-Chairman of
the Board of Directors since October 1998 and is Chairman of the Board's
Executive Committee.

ROBERT A. SHEFFIELD (age 50) joined the Company in July 1998 as Vice
President - Finance and Chief Financial Officer. From 1996 to June 1998, Mr.
Sheffield was the Vice President - Finance and Chief Financial Officer of
Asante Technologies, a designer, manufacturer and supplier of local area
networking products. From 1994 to 1995, Mr. Sheffield was the Vice President
of New Business Development for Time Warner/Atari Games ("Time Warner
Interactive"), a video arcade and consumer video entertainment software
company, and from 1988 to 1994, Mr. Sheffield was Time Warner Interactive's
Vice President - Finance and Chief Financial Officer. From 1985 to 1988 Mr.
Sheffield served as the Vice President - Finance and Chief Financial Officer
of Televideo Systems, Inc., a manufacturer of video display terminals,
personal computers and networks and, from 1984 to 1985 was Vice President -
Finance and Chief Financial Officer of Gill Management Services, Inc., a
computer services and software development firm.

DONALD S. BUTLER (age 53) 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, and in July 1998 he was promoted to the position of Senior Vice
President-Engineering. Prior to joining the Company, from 1989 to May 1996,
Mr. Butler was Vice President of Engineering at the Integrated Systems Center
of General Instrument Corporation, a manufacturer of cable and satellite TV
equipment. From 1974 to 1989, he held several engineering and engineering
management positions within GI's Microelectronics Division.

NIKHIL BALRAM, PH.D. (age 36 ) joined the Company in January 1999 as
Vice President-Advanced Technology. From July 1997 to January 1999, Dr.
Balram was Director of Systems Architecture and Manager of the Video Group at
S3 Incorporated, a manufacturer of multimedia integrated circuits. From
January 1995 to July 1997, Dr. Balram held various research and development
positions at Kaiser

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<PAGE>

Electronics, a manufacturer of military avionics display systems, last
serving as Staff Scientist. From June 1994 to January 1995, Dr. Balram did
marketing and engineering at the multimedia business unit of Rexon/Tecmar,
Inc., a data storage company. From March 1992 to June 1994, Dr. Balram was a
staff engineer with the Video/Graphics VLSI Development group of IBM
Corporation, a computer company.

THOMAS A. HARVEY (age 50) 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 45) joined the Company in June 1997 as Vice
President-Business Development and General Counsel. In June 1998, he became
Secretary of the Company. From May 1984 to September 1996, Mr. Boschwitz
held various legal and management positions with General Instrument
Corporation, a manufacturer of cable and satellite TV equipment, including
Vice President and General Counsel of GI's Communications Division.

ITEM 2. PROPERTIES

The Company occupies approximately 20,000 square feet of space in
Sunnyvale, California pursuant to a lease that extends until September 30,
2003. In 1997, the Company leased an additional 10,000 square feet of space
in Sunnyvale, California for a term which extends until September 2003 and
leased 2,000 square feet in Phoenix, Arizona for a research and development
facility. The Company determined that leased space exceeded its needs and
terminated the Phoenix lease on October 31, 1998 and is actively seeking to
sublease the additional 10,000 square feet in Sunnyvale. There can be no
assurance that the Company will be able to sublease the additional Sunnyvale
space or that the rent obtained from a sublease will be equal to the rent
payable on the Company's lease. The aggregate annual gross rent for the
Company's facilities was approximately $289,000 in 1997, approximately
$465,000 in 1998 and will be approximately $424,000 in 1999.

ITEM 3. LEGAL PROCEEDINGS

In January 1997 the Company filed an action against DWIN and in May 1997
filed an action against Snell & Wilcox, seeking injunctive relief and
unspecified monetary damages for the infringement of US Patent Number
4,876,596 (the "596 Patent"). Both actions were filed in the United States
District Court, Northern District of California, San Jose Division. The case
against DWIN is Civil Action No. C-97 20010 SW (PVT) and the case against
Snell & Wilcox is Civil Action No. C-97 20422 SW (PVT). The 596 Patent was
issued on October 24, 1989, is owned by Yves Faroudja and is licensed to the
Company. DWIN and Snell & Wilcox raised defenses and counterclaims that the
596 Patent is invalid and not infringed. They also sought to recover
attorneys' fees and costs.

On February 18, 1998, the court in the Snell & Wilcox action granted the
Company's motion for leave to amend its complaint to add claims of
infringement of U.S. Patent Number 4,998,287 (the "287 Patent") and U.S.
Patent Number 4,881,125 (the "125 Patent"), and to name additional Snell &
Wilcox products as being within the category of infringing products. The 287
patent was issued on March 5, 1991 and the 125 Patent was issued on November
14, 1989. The 287 and 125 patents are owned by General Instrument and
licensed to the Company. By order dated May 1, 1998, the court granted Snell
& Wilcox's motion for summary judgment as to the 596 Patent on the basis of
non-infringement. The Company, Snell & Wilcox and General Instrument settled
the case effective as of December 8, 1998. The settlement provides that
Snell & Wilcox home theater products are subject to a royalty-bearing license
from the Company. On January 21, 1999, the court's summary judgment ruling
as to the 596 Patent was vacated and had no further force or effect. The
case was dismissed on January 21, 1999, with prejudice as to licensed home
theater products and without prejudice as to other products.

In the DWIN action the Company amended its complaint to add claims of
infringement of the 287 Patent on August 17, 1998. On February 24, 1999, the
court in the DWIN action granted DWIN's motion for summary judgment as to the
596 Patent on the basis of non-infringement. The case continues with
respect to the 287 Patent and is in the early stages of discovery.

The Company's management believes that a finding that all of the claims
of the patents are invalid or that the patents have not been infringed in the
DWIN action will 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 patents which are involved in that litigation.

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

None.

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<PAGE>

PART II

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

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 follow 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>
Fiscal 1997 High Low
- ----------- -------- --------
<S> <C> <C>
Fourth Quarter (from October 30, 1997) $10.50 $5.50

Fiscal 1998 High Low
- ----------- -------- --------
<S> <C> <C>
First Quarter $11.13 $6.44
Second Quarter $12.38 $8.50
Third Quarter $8.63 $3.69
Fourth Quarter $4.31 $2.31
</TABLE>

As of March 1, 1999, there were approximately 350 holders of record of the
Company's Common Stock which the Company believes represents more than 3,000
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.

ITEM 6. SELECTED FINANCIAL DATA.

SELECTED CONSOLIDATED FINANCIAL DATA

<TABLE>
<CAPTION>
Year Ended December 31
- -----------------------------------------------------------------------------------------------------------------------
(IN THOUSANDS, EXCEPT PER SHARE AMOUNTS) 1998 1997 1996 1995 1994
----------------------------------------------------------
<S> <C> <C> <C> <C> <C>
CONSOLIDATED STATEMENT OF OPERATIONS DATA:
Total revenues $12,270 $17,006 $13,126 $11,954 $8,065
Net (loss) income (3,469) 1,251 N/A N/A N/A
Pro forma net (loss) income (1) N/A N/A 1,319 (1) 3,070 (1) 1,228 (1)
Net (loss) income per share (diluted) ($0.29) $0.13 N/A N/A N/A
Pro forma net (loss) income per share (diluted) (1) N/A N/A $0.16 (1) $0.43 (1) $0.15 (1)
Shares used in diluted per share
computation 12,146 9,925 8,191 7,176 7,979
- -----------------------------------------------------------------------------------------------------------------------
CONSOLIDATED BALANCE SHEET DATA:
Cash, cash equivalents and short-term
investments $20,419 $23,549 $3,083 $2,759 $1,064
Working capital 24,487 26,987 5,861 4,744 2,223
Total assets 28,721 33,489 9,604 6,734 3,434
Total long-term debt - - - - -
Total stockholders' equity 26,498 29,348 7,245 5,515 2,826

- -----------------------------------------------------------------------------------------------------------------------
</TABLE>

<TABLE>
<CAPTION>
QUARTERLY DATA:
1998 1997
--------------------------------------------- ----------------------------------------------
4th 3rd 2nd 1st 4th 3rd 2nd 1st
--------------------------------------------- ----------------------------------------------
<S> <C> <C> <C> <C> <C> <C> <C> <C>
Total revenues $2,554 $3,005 $3,353 $3,358 $4,130 $5,012 $4,279 $3,585
Gross profit 1,215 1,362 1,940 2,254 2,820 3,346 2,992 2,586
Net (loss) income (903) (1,821) (754) 8 326 391 285 249
Net (loss) income per share
(diluted) $(0.08) $(0.15) $(0.06) $ 0.00 $ 0.03 $ 0.04 $ 0.03 $ 0.03
</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 (loss) income per share.

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<PAGE>

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

THIS DISCUSSION CONTAINS FORWARD-LOOKING STATEMENTS WITHIN THE MEANING OF THE
PRIVATE SECURITIES LITIGATION REFORM ACT OF 1995 CONCERNING THE COMPANY'S
FUTURE PRODUCTS, EXPENSES, REVENUE, LIQUIDITY AND CASH NEEDS AS WELL AS THE
COMPANY'S PLANS AND STRATEGIES. SUCH FORWARD-LOOKING STATEMENTS INVOLVE
KNOWN AND UNKNOWN RISKS AND UNCERTAINTIES. THESE FORWARD-LOOKING STATEMENTS
ARE BASED UPON CURRENT EXPECTATIONS. THE COMPANY'S ACTUAL RESULTS AND TIMING
OF CERTAIN EVENTS COULD DIFFER MATERIALLY FROM THE DESCRIPTIONS IN THESE
FORWARD-LOOKING STATEMENTS AS A RESULT OF VARIOUS FACTORS, INCLUDING THOSE
SET FORTH BELOW. THE COMPANY UNDERTAKES NO OBLIGATION TO PUBLICLY UPDATE OR
REVISE ANY FORWARD-LOOKING STATEMENTS, WHETHER AS A RESULT OF NEW
INFORMATION, FUTURE EVENTS, OR OTHERWISE.

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 home theater and
industrial markets - a video processor referred to as a line multiplier. In
1998, 1997, and 1996, sales of products for the home theater and industrial
markets comprised approximately 84%, 88% and 80%, respectively, of the
Company's total revenues. In 1998 the Company focused significant attention
on re-entering the Broadcast market by introducing an upconverter to support
television broadcasters' transition from analog to digital television - the
Digital Format Translator-TM- ("DFT"). Due in part to this shift in focus,
sales of broadcast products increased as a percentage of total Company sales
in 1998 from 1997.

The Company's revenues declined in 1998 for the first time in more than
five years. Sales of home theater and industrial line multipliers
experienced the most significant year to year decline. From 1995 through
1997, the Company's total revenues increased sequentially on an annual basis,
primarily as a result of the introduction of a number of new products for the
home theater and industrial markets.

In 1998 the Company reported a significant net loss due to the
substantial drop in line multiplier sales in the home theater and industrial
markets. Net income declined in 1997 from 1996 primarily as a result of
increased research and development expenses, as well as expenses relating to
the expansion of the sales and marketing staff. 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 and industrial markets as well as for use in the TV and PC
industries.

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. In 1998 the Company increased research
and development efforts relating to the design and development of DFTs and
development of ASIC products. Sales and marketing expenses increased
slightly due to the Company's efforts to reenter the broadcast market.
General and administrative expenses rose significantly due to costs of being
a public company. In 1999, on an absolute dollar basis, research and
development expenses are expected to increase, marketing and sales expenses
are expected to remain level, and general and administrative expenses are
expected to decline from 1998. Consequently, to be profitable in 1999,
revenues will have to significantly increase.

The Company's quarterly 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.

In March 1997, the Company entered into a license agreement with S3,
Incorporated ("S3") pursuant to which significant royalty payments were
received for use of certain Company technology. No royalty payments have
been made by S3 with respect to any periods after March 31, 1998.

Results of Operations

-21-

<PAGE>

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,
-------------------------------------------
1998 1997 1996
-------------------------------------------
<S> <C> <C> <C>
Revenues:
Product sales 93.9% 91.2% 96.2%
License and royalty revenues 6.1 8.8 3.8
-------------------------------------------
Total revenues 100.0 100.0 100.0
Cost of sales 44.8 30.9 36.5
-------------------------------------------
Gross margin 55.2 69.1 63.5
Operating expenses:
Research and development 39.3 24.8 18.8
Sales and marketing 28.9 20.4 16.2
General and administrative 28.2 12.8 12.4
Financing expense - 1.8 -
-------------------------------------------
Total operating expenses 96.4 59.8 47.4
-------------------------------------------
Operating (loss) income (41.2) 9.3 16.1
Other income:
Interest income 9.2 2.1 0.6
Other, net 0.0 0.5 0.0
-------------------------------------------
(Loss) income before provision for income taxes (32.0) 11.9 16.7
Benefit (provision) for income taxes 3.7 (4.5) (5.2)
-------------------------------------------
Net (loss) income (28.3)% 7.4% 11.5%
-------------------------------------------
-------------------------------------------
</TABLE>

Total Revenues.

Total revenues in 1998 decreased by $4.7 million or 27.8% from revenues
recorded in 1997. Revenues increased $3.9 million or 29.5% for 1997 from
1996.

The decrease in revenues in 1998 was due in significant part to the
reduction in sales of line multiplier products for the home theater and
industrial markets. Sales of line multipliers decreased by $4.0 million in
1998 from 1997. The shortfall was largely attributable to a significant
reduction in sales of line multipliers to OEM customers. OEMs either sell
the Company's video processors with their projection systems or integrate the
Company's video processing components into their projection systems, with the
resulting combination representing the most significant part of a home
theater installation. Sales of line multipliers were also negatively
impacted by the increased market acceptance of video processors produced by
other manufacturers, pricing pressure from those competing products and
consumer confusion over high definition television ("HDTV"). Licensing
revenue decreased by $.8 million in 1998 from 1997, primarily as a result of
the discontinuance of royalty payments from S3 after March 31, 1998. It is
likely that license revenues will continue to decline in 1999, unless the
Company is successful in entering into royalty bearing license agreements
with third parties. In 1998, the Company re-entered the Broadcast market
with the introduction of the DFT. This resulted in a $.9 million increase in
sales of Broadcast products in 1998 from 1997. In 1998, sales to Vidikron
accounted for 10% of total Company revenues.

The increase in sales in 1997 was due primarily to increased shipments
of line multiplier products for the home theater and industrial markets,
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. Revenues from S3 accounted for 10.6% of total
revenues in 1997. Sales to Vidikron accounted for 11.1% of total revenues in
1997. By the end of 1998, sales of VP100s and DV1000s were negligible and
those products will be completely phased out in the first half of 1999.

Export sales, consisting primarily of line multiplier products shipped
to dealers and distributors in Asia, Europe and Canada, represented 18.6%,
13.1%, and 15.3% of total revenues in 1998, 1997, and 1996, respectively. In
absolute dollars, total export sales for 1998 were only slightly higher than
in 1997. All export sales are denominated in U.S. dollars. The Company has
not experienced nor does it anticipate any foreign currency exchange
exposures. 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 1999.

-22-

<PAGE>

The Company's future success will depend, in large part, on its ability
to continue to enhance its existing products and to develop new products and
features to meet changing customer requirements and evolving industry
standards. Sales from the Company's line multiplier product lines decreased
in 1998 and the Company anticipates that sales of such products will
experience limited growth, or decline, in future periods. Home theater and
industrial market sales decreased in 1998, which the Company attributes to
increased competition, pricing pressure, and consumer confusion over HDTV.
The Company believes that the confusion resulting from HDTV and related
market weakness could continue until HDTV broadcasting begins on a wide-scale
basis. With the continuing rollout of HDTV in 1999, the Company anticipates
that sales of its Broadcast products, and specifically the DFT will increase
in 1999 and over the next several years.

Gross Profit.

Gross profit as a percentage of total revenues was 55.2% in 1998, 69.1%
in 1997, and 63.5% in 1996. The 14% absolute percentage decrease in gross
margin in 1998 from 1997 was due to several factors. First, gross margins of
line multipliers decreased as prices of certain major product families were
significantly reduced in August 1998. Second, high gross margin licensing
revenues were reduced in 1998 with the end of payments from S3. Third, in
the third quarter of 1998 certain excess and obsolete inventory items were
written down to their net realizable value. Fourth, the new Broadcast market
product, the DFT, produced only $1.0 million revenue in its first year of
sales.

The increase in gross margin in 1997 compared to 1996 was primarily due
to increased license and royalty revenues. Product gross margin as a
percentage of product sales increased to 66.1% in 1997 from 62.01% in 1996,
due primarily to product cost reduction efforts.

Research and Development Expenses.

Research and development expenses increased to $4.8 million in 1998 from
$4.2 million in 1997 and from $2.5 million in 1996. The increase in 1998 was
primarily due to the development of the DFT and for the costs associated with
development of ASICs. Research and development expenses as a percentage of
total revenues rose in 1998 to 39.3% due to the increased spending of $.6
million in 1998 from 1997 coupled with the significant decline in total
revenues in 1998 from 1997.

In 1997 the increases were primarily due to costs incurred by the
Company for the development of ASICs 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 from 1996 due to expansion of the Company's VLSI
department which was established in 1996. The Company intends to increase
its research and development efforts in 1999, primarily in the design and
development of board and ASIC 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 $3.6 million in 1998 from $3.5
million in 1997 and from $2.1 million in 1996. In 1998, due to the decline
in revenues from 1997, sales and marketing expenses were higher as a
percentage of total revenue at 28.9%. Categories of expenses that rose in
1998 were expenses for trade shows such as the Consumer Electronics Show and
the National Association of Broadcasters Show, and for advertising and
brochures. Categories of expenses that declined in 1998 were commissions to
outside sales representatives as the Company shifted sales responsibilities
more to direct employee sales staff.

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 expects its sales and marketing expenses in 1999
to remain similar to 1998 spending levels.

General and Administrative Expenses.

General and administrative expenses increased to $3.5 million in 1998
from $2.2 million in 1997 and from $1.6 million in 1996. Due to the
significant increase in general and administrative expenses coupled with the
year over year decline in total revenues, the percentage of expenses to
revenue increased to 28.2% in 1998. The increases in absolute expenses were
due primarily to expenses of being a public company such as outside
professional legal and accounting fees associated with annual reports,
registration statements and other SEC filings, for legal expenses involving
patent litigation, and for one time charges for management changes.

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,

-23-

<PAGE>

chief financial officer and general counsel, and an increase in professional
fees.

The Company expects that general and administrative expenses both in
absolute dollars and as a percentage of total revenues will decrease in 1999.

Financing Expense.

In 1997 the Company spent $.3 million in the first quarter related to
financing activity. There were no such expenses in 1998.

Other Income.

Interest and other income increased to $1.1 million in 1998 from
$447,000 in 1997, and from $83,000 in 1996. The increase in interest income
in 1998 over 1997 is derived from investments in short-term, interest bearing
investment grade securities as a result of two investments made in the
Company in 1997. They include the investment of the $15.6 million net
proceeds from the Company's initial public offering completed in October
1997, and the $5 million investment by S3 in the Company in June 1997. The
Company anticipates that interest income will decrease slightly in 1999.

Provision for Income Taxes.

The Company's benefit for income taxes was 11.6% for 1998 compared to
provisions for income taxes of 38% and 40% for 1997 and 1996, respectively.
The 1998 tax rate reflects the benefit of refundable taxes offset by state
taxes and the valuation allowance for certain deferred tax assets. The 1997
tax rate is lower than the pro forma 1996 tax rate primarily due to tax
credits.

Under the Statement of Financial Accounting Standards No. 109 ("SFAS
109"), deferred tax assets and liabilities are determined based on differences
between financial reporting and tax bases of assets and liabilities and are
measured using the enacted tax rates and laws that will be in effect when the
differences are expected to reverse. SFAS 109 provides for the recognition
of deferred tax assets if realization of such assets is more likely than not.
Based on the weight of available evidence, the Company has provided a
valuation allowance against deferred tax assets for 1998. The Company will
continue to evaluate the realization of the deferred tax assets on a
quarterly basis.

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. FRE was a C Corporation since its inception. 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 year ended
December 31, 1996 of 40%.

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 1998, net cash used by operating activities was $3.2 million,
primarily composed of (i) $3.5 million of net loss, (ii) a $.9 million
decrease in accrued income taxes payable, (iii) a $.7 million increase in
income taxes receivable; (iv) a $.6 million decrease in accrued compensation
and benefits, (v) a $.4 million increase in inventories, (vi) and a $.3
million decrease in accounts payable. These were primarily offset by (i) a
$1.3 million decrease in accounts receivable, (ii) a $.9 million decrease in
deferred tax assets and (iii) $.9 million of depreciation and amortization.

In 1997, net cash provided by operating activities was $1.1 million,
primarily composed of (i) $1.3 million of net income, (ii) $.6 million of
depreciation and amortization, (iii) a $.7 million increase in accounts
payable, (iv) a $.5 million increase in accrued compensation, (v) a $.8
million increase in income taxes payable and (vi) a $.3 million increase in
other accrued liabilities. These were primarily offset by (i) a $.3 million
increase in accounts receivable, (ii) a $1.3 million increase in inventory,
(iii) a $.5 million increase in deferred tax assets, (iv) a $.4 million
increase in other current assets and (v) a $.5 million 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) $.4 million of
depreciation and amortization, (iii) a $.2 million increase in accrued
compensation and benefits, (v) a $.3 million increase in other liabilities
and (vi) $.5 million of deferred revenues. These were partially offset by a
(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, and (ii) an increase in deferred tax assets of $.5 million.

-24-

<PAGE>

Investing Activities.

Capital equipment purchases in 1998, 1997 and 1996 were $.5 million,
$1.2 million, and $1.0 million, respectively, primarily for computer hardware
and software used in research and development, research and development test
equipment and furniture and fixtures.

Financing Activities.

In October 1997, the Company effected its initial public offering. Net
proceeds, after underwriting discounts and commissions and expenses
associated with the offering, were $15.6 million. In June 1997, the Company
also received $5.0 million from a private placement of Common Stock with S3.
In 1996, the Company raised $4.0 million through a private placement of its
Common Stock to a group of investors. In connection with its status as a
Subchapter S Corporation, the Company distributed $4.0 million in 1996 to the
Company's stockholders.

Liquidity.

At December 31, 1998, the Company had approximately $20.4 million of
cash and cash equivalents, a bank credit facility for $2.0 million, and
working capital of approximately $24.5 million.

The cash and cash equivalents are predominantly held in three types of
cash investments. These investments are obligations issued by U.S. federal
agencies, money market funds that subject the Company to limited interest
rate or credit risk, and commercial paper of U.S. corporations with A1/P1
credit ratings.

Cash, cash equivalents and short-term investments at December 31, 1998
declined by $3.1 million or 13.3% from the balances at December 31, 1997.
The most significant reason for the cash decrease was that total gross
profits from total revenues were significantly less than operating expenses.
Cash was also used to purchase both engineering test equipment and product
inventory, and to reduce the accounts payable balances. The decline in cash,
cash equivalents and short-term investments was partially offset by strong
customer collections that reduced accounts receivable balances.

In April 1998, the Company renewed its bank revolving line of credit
that expires in April, 1999. 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. No borrowings were made under the
line of credit agreement in either 1998 or 1997.

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

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.

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.

Year 2000.

Certain computers, software and equipment with embedded computing
capability recognize only the last two, rather than all four digits of the
year in any date. As a result they may fail to recognize and properly
process date information or otherwise malfunction unless they are
reprogrammed or replaced at the turn of the century (the "Year 2000
Problem"). The Company is dependent upon computers, software and equipment
with embedded computing capability for all phases of its operations including
production, distribution and accounting. The Company has developed a plan to
determine the impact of the Year 2000 Problem on its operations. This plan
covers an assessment of internal and external Year 2000 Problems, formal
contacts with the Company's significant suppliers, customers, financial
organizations, service providers and others to determine their Year 2000
readiness,

-25-

<PAGE>

remediation of problems where found, and a contingency plan for problems
which cannot be solved on a timely or cost-effective basis.

The Company has completed an assessment of the products it designs,
manufactures and distributes and believes that the performance and
functionality of such products will not be affected by Year 2000 Problems.

With regard to internal risks associated with Year 2000 Problems, the
Company recently completed a major upgrade of its main business computer
systems, which replaced a majority of its existing systems, and plans to
complete this system upgrade during the first half of 1999. The system
selected is Year 2000 compliant and is expected to eliminate most of the
Company's internal Year 2000 Problems. The Company will test its main
operations computer systems and continue testing other internal systems,
including engineering workstations and desktop computers, for Year 2000
compliance. The Company intends to address any problems identified
immediately and to replace any deficient element of its systems that cannot
be made Year 2000 compliant by other means. The Company believes that any
significant Year 2000 Problems will be solved by the fourth quarter of 1999.
The Company has developed a contingency plan for its operations activities
that involves a full detail paper backup for its production, purchase order
and inventory requirements for the first six months of the year 2000. While
it is not presently possible to precisely quantify the overall cost of this
work, the Company does not believe that the cost of addressing the Year 2000
Problem, as it relates to the Company's internal systems, will have a
material adverse effect on the Company's financial position, liquidity or
results of operations. The Company has incurred total costs to date of
approximately $65,000 to address Year 2000 Problems and expects that such
costs will not exceed an additional $35,000 for the remainder of 1999.

In addition to the Company's own systems and equipment, the Company
relies, directly and indirectly, on the systems and equipment of its
suppliers, distributors, customers, creditors, financial organizations,
utility companies, telecommunication service companies and other service
providers. Some of these third parties may have Year 2000 Problems outside
of the Company's control that could adversely affect the Company.

There can be no assurance that the Company will identify all of its Year
2000 Problems, resolve its internal Year 2000 Problems on a timely or
cost-effective basis, or be successful in avoiding the impact of business
disruptions which may be experienced by the Company's suppliers, service
providers and other third parties as a result of Year 2000 Problems. Failure
by the Company or third parties doing business with the Company to identify
and resolve Year 2000 problems on a timely basis could have a material
adverse effect on the Company's financial position, liquidity or results of
operations.

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

INTEREST RATE RISK. The Company's exposure to interest rate risk relates
primarily to its investment portfolio. Fixed rate securities may have their
fair market value adversely impacted by a rise in interest rates, while
floating rate securities may produce less income than expected if interest
rates fall. Due in part to these factors, the Company's future investment
income may fall short of expectations due to changes in interest rates or the
Company may suffer losses in principal if forced to sell securities which
have declined in market value due to changes in interest rates.

The Company invests its excess cash in debt instruments of the U.S.
Government and its agencies, and in high-quality corporate issuers. Due to
the short-term nature of all of the Company's investments in 1998 (average
portfolio duration and contractual maturity of investments were approximately
three months) the Company has assessed that there is no material exposure
risk arising from its investments.

-26-

<PAGE>

ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA.

<TABLE>
<CAPTION>
INDEX TO FINANCIAL STATEMENTS AND FINANCIAL STATEMENT SCHEDULE
--------------------------------------------------------------
Financial Statements: Page
<S> <C>
Consolidated Balance Sheets as of December 31, 1998 and 1997........................... 28

Consolidated Statements of Income for the years ended December 31, 1998, 1997 and 1996. 29

Consolidated Statements of Stockholders' Equity for the years ended December 31, 1998,
1997 and 1996 ...................................................................... 30

Consolidated Statements of Cash Flows for the years ended
December 31, 1998, 1997 and 1996.................................................. 31

Notes to Consolidated Financial Statements............................................. 32

Report of Ernst & Young LLP, Independent Auditors...................................... 41

Financial Statement Schedule:

Schedule II: Valuation and Qualifying Accounts......................................... 44
</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.

-27-

<PAGE>

CONSOLIDATED BALANCE SHEETS
(In thousands, except share data)

<TABLE>
<CAPTION>
December 31,
1998 1997
---------------------------
<S> <C> <C>
ASSETS
Current assets:
Cash and cash equivalents $ 20,419 $ 23,272
Short-term investments - 277
Trade accounts receivable, less allowance for doubtful
Accounts of $136 in 1998 and $167 in 1997 1,764 3,098
Inventories 3,348 2,943
Deferred tax assets - 942
Income taxes receivable 738 -
Prepaid expenses and other current assets 441 596
---------------------------
Total current assets 26,710 31,128

Property and equipment, net 1,778 2,026
Other assets 233 335
---------------------------
TOTAL ASSETS $ 28,721 $ 33,489
---------------------------
---------------------------

LIABILITIES AND STOCKHOLDERS' EQUITY
Current liabilities:
Accounts payable $ 1,125 $ 1,445
Accrued compensation and benefits 587 1,217
Income taxes payable - 872
Other accrued liabilities 511 607
---------------------------
Total current liabilities 2,223 4,141

Commitments

Stockholders' equity:
Preferred Stock $0.001 par value; 5,000,000 shares
authorized, none issued and outstanding - -
Common Stock $0.001 par value; 50,000,000 shares
authorized; 12,205,147, and 12,058,913 shares
issued and outstanding in 1998 and 1997,
respectively 12 12
Additional paid-in capital 30,027 28,978
Deferred compensation (173) (238)
Retained earnings (accumulated deficit) (3,368) 596
---------------------------
Total stockholders' equity 26,498 29,348
---------------------------
TOTAL LIABILITIES AND STOCKHOLDERS' EQUITY $ 28,721 $ 33,489
---------------------------
---------------------------
</TABLE>

See accompanying notes.

-28-

<PAGE>

CONSOLIDATED STATEMENTS OF INCOME
(In thousands, except share and per share data)

<TABLE>
<CAPTION>
YEAR ENDED DECEMBER 31,
1998 1997 1996
----------------------------------------------------------
<S> <C> <C> <C>
Revenues:
Product sales $ 11,520 $ 15,506 $ 12,626
License and royalty revenues 750 1,500 500
----------------------------------------------------------
Total revenues 12,270 17,006 13,126

Cost of product sales 5,499 5,262 4,797
----------------------------------------------------------
Gross profit 6,771 11,744 8,329

Operating expenses:
Research and development 4,822 4,215 2,464
Sales and marketing 3,551 3,465 2,127
General and administrative 3,458 2,182 1,623
Financing expenses - 312 -
----------------------------------------------------------
Total operating expenses 11,831 10,174 6,214
----------------------------------------------------------

Operating (loss) income (5,060) 1,570 2,115
Other income:
Interest income 1,134 364 83
Other, net - 83 -
----------------------------------------------------------
(Loss) income before income taxes (3,926) 2,017 2,198

Benefit (provision) for income taxes 457 (766) (687)
----------------------------------------------------------
Net (loss) income $ (3,469) $ 1,251 $ 1,511
----------------------------------------------------------
----------------------------------------------------------
Pro forma data (unaudited):
Historical income before provision for income taxes $ 2,198
Pro forma provision for income taxes (879)
------------
Pro forma net income $ 1,319
------------
------------

Per share data:
Net (loss) income per share Basic ($0.29) $ 0.14
Diluted ($0.29) $ 0.13
------------------------------------
------------------------------------
Pro forma net income
per share (unaudited) Basic $ 0.17
Diluted $ 0.16
------------
------------
Shares used in per share
computations Basic 12,145,781 9,040,616 7,976,892
Diluted 12,145,781 9,924,558 8,191,303
----------------------------------------------------------
----------------------------------------------------------
</TABLE>
See accompanying notes.

-29-

<PAGE>

CONSOLIDATED STATEMENT OF STOCKHOLDERS' EQUITY
(In thousands, except share data)

Retained Accumulated
Additional Earnings Other
Common Stock Paid-In Deferred Accumulated Comprehensive
Shares Amount Capital Compensation (Deficit) Income Total
--------------------------------------------------------------------------------------------
<S> <C> <C> <C> <C> <C> <C> <C>
Balance at December 31, 1995 7,156,895 $ 3,611 $ - $ - $ 1,869 $ 35 $ 5,515
Net Income - - - - 1,511 - 1,511
Unrealized gain on
available-for-sale
securities of $32 - - - - - 32 32
-------
Comprehensive income 1,543

-------
Sale of Common Stock 1,043,105 4,000 - - - - 4,000
Issuance of warrants to
purchase Common Stock
for future services - - 222 - - - 222
Reincorporating in
Delaware - (7,603) 7,603 - - - -
Distribution to
stockholders - - - - (4,035) - (4,035)
--------------------------------------------------------------------------------------------
Balance at
December 31, 1996 8,200,000 8 7,825 - (655) 67 7,245
Net Income - - - - 1,251 - 1,251
Reclassification adjustment for
gains included in net income
of $67 - - - - - (67) (67)
-------
Comprehensive income 1,184
-------
Sale of Common Stock
net of issue costs 3,833,334 4 20,532 - - - 20,536
Issuance of Common
Stock for services and
upon exercise of
option and warrants 25,579 - 99 - - - 99
Issuance of warrants to
purchase Common Stock
for technology acquired - - 250 - - - 250
Deferred compensation
on employee stock
option grants - - 272 (272) - - -
Amortization of deferred
compensation - - - 34 - - 34
--------------------------------------------------------------------------------------------
Balance at
December 31, 1997 12,058,913 12 28,978 (238) 596 - 29,348
Net loss - - - - (3,469) - (3,469)
-------
Comprehensive loss (3,469)
-------
Issuance of Common Stock
for cash upon exercise
of options and employee
stock purchase plan 146,234 - 554 - - - 554
Reclassification of undistributed
retained earnings - - 495 - (495) - -
Amortization of
deferred compensation - - - 65 - - 65
--------------------------------------------------------------------------------------------
Balance at December 31, 1998 12,205,147 $ 12 $30,027 $(173) $(3,368) $ - $26,498
--------------------------------------------------------------------------------------------
--------------------------------------------------------------------------------------------
</TABLE>
See accompanying notes.

-30-

<PAGE>

CONSOLIDATED STATEMENTS OF CASH FLOWS

(In thousands)
<TABLE>
<CAPTION>

YEAR ENDED DECEMBER 31,
1998 1997 1996
------------------------------------
<S> <C> <C> <C>
OPERATING ACTIVITIES
Net (loss) income $ (3,469) $ 1,251 $ 1,511
Adjustments to reconcile net (loss) income to net cash
provided by (used in) operating activities:
Depreciation and amortization 921 561 422
Amortization of deferred compensation 65 34 -
Loss on disposal of equipment - 5 -
Gain on sales of short-term investments - (83) -
Changes in operating assets and liabilities:
Trade accounts receivable 1,334 (330) (1,193)
Inventories (405) (1,260) (96)
Deferred tax assets 942 (482) (462)
Income taxes receivable (738) - -
Prepaid expenses and other current assets 81 (372) (27)
Accounts payable (320) 716 128
Accrued compensation and benefits (630) 545 186
Income taxes payable (872) 756 68
Other accrued liabilities (96) 265 258
Deferred revenue - (500) 500
------------------------------------
Net cash provided by (used in) operating activities (3,187) 1,106 1,295
------------------------------------
INVESTING ACTIVITIES
Purchases of equipment (497) (1,200) (967)
Proceeds from sale of equipment - 13 -
Other assets - (110) -
Purchases of short-term investments - - (1,061)
Sales of short-term investments - 1,612 -
Maturities of short-term investments 277 - 461
------------------------------------
Net cash provided by (used in) investing activities (220) 315 (1,567)
------------------------------------
FINANCING ACTIVITIES
Issuance of Common Stock 554 20,635 4,000
Distribution to stockholders - - (4,035)
------------------------------------
Net cash provided by (used in) financing activities 554 20,635 (35)
------------------------------------
(Decrease) increase in cash and cash equivalents (2,853) 22,056 (307)
Cash and cash equivalents at beginning of year 23,272 1,216 1,523
------------------------------------
Cash and cash equivalents at end of year $ 20,419 $ 23,272 $ 1,216
------------------------------------
------------------------------------
SUPPLEMENTAL DISCLOSURE OF CASH FLOW INFORMATION
Cash paid during the period for income taxes $ 225 $ 465 $ 1,117
------------------------------------
------------------------------------
SUPPLEMENTAL DISCLOSURES OF NONCASH FINANCING ACTIVITIES
Issuance of warrants to acquire Common Stock
for future services $ - $ - $ 222
------------------------------------
------------------------------------
Issuance of warrants to acquire Common Stock
for technology acquired $ - $ 250 $ -
------------------------------------
------------------------------------
</TABLE>
See accompanying notes.

-31-

<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
for ($14,000,000) and newly issued FLI shares for ($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 two 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 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, 1998 and 1997, 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 part of
accumulated other comprehensive income in stockholders' equity. Realized
gains and losses and declines in value judged to be other-than-temporary, if
any, on available-for-sale securities are

-32-

<PAGE>

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, 1998, seven customers accounted for 45% of the accounts
receivable balance, including one customer that accounted for 22% of the
accounts receivable balance.

At December 31, 1997 four customers accounted for 45% of the accounts
receivable balance and no other single customer accounted for more than 10%
of the Company's ending accounts receivable balance.

Inventories

Raw materials, work-in-process and finished goods inventories are stated at
the lower of standard cost (which approximates actual cost) 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 $745,000, $540,000 and $249,000 for 1998, 1997 and
1996, 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. 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 $374,000, $430,000 and $395,000 in 1998, 1997 and 1996,
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 (Loss) Per Share

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). A reconciliation of shares
used in the calculation follows:

<PAGE>

<TABLE>
<CAPTION>
1998 1997 1996
--------------------------------------------
<S> <C> <C> <C>
Weighted average shares outstanding 12,145,781 9,040,616 7,976,892
Dilutive effect of stock options and warrants - 833,942 214,411
--------------------------------------------
Shares used in computation of diluted net (loss) income per
share 12,145,781 9,874,558 8,191,303
--------------------------------------------
--------------------------------------------
</TABLE>

Options and warrants to purchase 1,991,905 and 445,200 shares of the
Company's common stock would have been anti-dilutive in 1998 and 1997,
respectively and were, therefore, excluded from the respective diluted
calculation.

-33-

<PAGE>

Comprehensive Income (Loss)

As of January 1, 1998, the Company adopted Statement of Financial Accounting
Standard No. 130, Reporting Comprehensive Income ("SFAS 130"). SFAS 130
establishes new rules for the reporting and display of comprehensive income
and its components; however, the adoption of this Statement had no impact on
the Company's net income or stockholders' equity. SFAS 130 requires
unrealized gains or losses on the Company's available-for-sale securities,
which prior to adoption, were reported separately in stockholders' equity, to
be included in comprehensive income. Prior year financial statements have
been reclassified to conform to the requirement of SFAS 130.

Recent Accounting Pronouncements

Effective January 1998, the Company adopted Statement of Financial Accounting
Standards No. 131, "Disclosures about Segments of an Enterprise and Related
Information" ("SFAS 131"), which established revised standards for the
reporting of financial and descriptive information about operating segments
in financial statements. The Company has determined that it operates in only
one segment, which is the development, manufacture and supply of video image
enhancement technology.

In June 1998, the Financial Accounting Standards Board issued Statement of
Financial Accounting Standards No. 133, "Accounting for Derivative Financial
Instruments and for Hedging Activities" ("SFAS 133") which provides a
comprehensive and consistent standard for the recognition and measurement of
derivatives and hedging activities. SFAS 133 is effective for years beginning
after June 15, 1999 and is not anticipated to have an impact on the Company's
results of operations or financial condition when adopted.

2. SHORT-TERM INVESTMENTS

The following is a summary of available-for-sale securities at December 31,
1998 and 1997 (in thousands):

<TABLE>
<CAPTION>
Cost and
Fair Market
Value
-----------
<S> <C>
At December 31, 1998:
Commercial paper $ 6,977
Government agency discount notes 10,844
-----------
$17,821
-----------
-----------

Reported as:
Cash equivalents $17,821
-----------
$17,821
-----------
-----------

At December 31, 1997:
Certificates of deposit $ 277
Commercial paper 5,106
Government agency discount notes 11,780
-----------
$17,163
-----------
-----------

Reported as:
Cash equivalents $16,886
Short-term investments 277
-----------
$17,163
-----------
-----------
</TABLE>

The estimated fair value amounts discussed above have been determined by the
Company using available market information. The investments are held in
commercial paper of U.S. corporations with A1/P1 credit ratings and U.S.
federal agency discount obligations.

As of December 31, 1998, the average portfolio duration and contractual
maturity of the investments were approximately three months.

There were no realized gains or losses for the year ended December 31, 1998.
Realized gains and losses for the year ended December 31, 1997 were $185,000
and $102,000, respectively.

-34-

<PAGE>

3. INVENTORIES

Inventories consist of the following (in thousands):

<TABLE>
<CAPTION>
December 31,
1998 1997
--------- ---------
<S> <C> <C>
Raw materials $1,072 $ 770
Work-in-process 1,048 1,508
Finished goods 1,228 665
--------- ---------
$3,348 $2,943
--------- ---------
--------- ---------
</TABLE>

4. PROPERTY AND EQUIPMENT

Property and equipment consist of the following (in thousands):

<TABLE>
<CAPTION>
December 31,
1998 1997
-------- ---------
<S> <C> <C>
Machinery and equipment $ 2,782 $ 2,373
Purchased computer software 952 915
Furniture, fixtures and equipment 314 290
Vehicles 84 84
Leasehold improvements 227 200
-------- ---------
4,359 3,862
Accumulated depreciation (2,581) (1,836)
-------- ---------
$ 1,778 $ 2,026
-------- ---------
-------- ---------
</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 on one lease and increase $.60 per square
foot per year under the other lease. At December 31, 1998, future estimated
minimum payments under these leases are approximately as follows (in
thousands):

<TABLE>
<S> <C>
1999 $ 424
2000 439
2001 456
2002 472
2003 364
--------
Total minimum lease payments $2,155
--------
--------
</TABLE>

Rent expense under operating leases amounted to $465,000, $289,000 and
$186,000 in 1998, 1997 and 1996, respectively.

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 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, 1998, 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.

-35-

<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 per 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. Payroll deductions are at the election of the employee
subject to a maximum of 10% of the employee's salary. In 1998, 41,223 shares
were issued under the Purchase Plan. There were no shares issued in 1997.

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.

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
1998 Exercise 1997 Exercise 1996 Exercise
Options Price Options Price Options Price
----------------------------------------------------------------------------------
<S> <C> <C> <C> <C> <C>
Outstanding at January 1 1,659,190 $4.48 1,441,988 $3.46 180,576 $1.16
Granted 670,950 4.72 432,570 7.55 1,261,412 3.79
Exercised (105,013) 3.27 (7,380) 1.68 - -
Canceled (398,374) 5.33 (207,988) 3.90 - -
----------- ---------- ----------
Outstanding at end of period (1,826,753) $4.49 1,659,190 $4.48 1,441,988 $3.46
----------- ---------- ----------
----------- ---------- ----------
Weighted-average fair value of
options granted during the period $2.50 $2.19 $1.23
</TABLE>

-36-

<PAGE>

<TABLE>
<CAPTION>
DECEMBER 31, 1998
-----------------
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-$2.63 204,030 7.24 $1.51 164,948 $1.28
$3.69-$3.75 481,850 9.76 $3.74 116,666 $3.75
$3.83-$3.91 718,404 7.62 $3.85 512,632 $3.85
$7.00-$8.12 279,446 8.11 $7.49 101,980 $7.47
$8.50-$10.38 143,023 8.89 $8.63 14,393 $9.50
----------- ----------
1,826,753 8.32 $4.49 910,619 $3.86
----------- ----------
----------- ----------
</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 $272,000 is being amortized over
the vesting period of such options.

Reserved Shares

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

<TABLE>
<CAPTION>
December 31,
1998
------------
<S> <C>
Warrants 165,152
Stock purchase plan 358,777
Stock option plans:
Outstanding options 1,826,753
Reserved for future grants 629,604
-----------
2,980,286
-----------
-----------
</TABLE>

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 (in thousands except per share data):

<TABLE>
<CAPTION>
December 31,
1998 1997
------------------------------
<S> <C> <C>
Net income (loss)--as reported ($3,469) $1,251

Net income (loss)--pro forma (4,210) 868

Basic net income per share--as reported ($0.29) $0.14
Basic net income per share--pro forma ($0.35) $0.10
</TABLE>

The pro forma net loss is not necessarily indicative of potential pro forma
effects on results for future years.

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: a risk free interest rate of 5.63%, an expected
option life of 72 months and no dividends. The value of options granted
following the initial public offering in 1997 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.

-37-

<PAGE>

The value of options granted in 1998 were determined using the Black-Scholes
method and the weighted average assumptions were as follows: an expected
volatility factor of 0.66, a risk free interest rate of 5.46%, an expected
option life of 48 months and no dividends.

Reclassification

In accordance with Securities and Exchange Commission Staff Accounting
Bulletin Topic 4.B., the Company reclassified $495,000 from retained earnings
to paid-in capital to reflect the undistributed accumulated earnings of
Faroudja Laboratories, Inc. There was no impact on total stockholders' equity
as a result of this reclassification.

7. LICENSE AGREEMENT

In March 1997, the Company entered into a license agreement with S3
Incorporated covering the incorporation of the Company's video processing
technologies into integrated circuits for use in PCs. Portions of the license
were exclusive for certain markets for a period of five years provided that
performance criteria, including minimum license fees, were satisfied. S3 made
no minimum license payments necessary to maintain its exclusive rights 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 receive in the future as
the Company does not currently have any license agreements in effect pursuant
to which it expects to receive substantial royalties.

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 was 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 (benefit) for income taxes computed under Statement of
Financial Accounting Standards, No. 109, "Accounting for Income Taxes,"
consists of the following (in thousands):

<TABLE>
<CAPTION>
Pro Forma
December 31, December 31, December 31, December 31,
1998 1997 1996 1996
---- ---- ---- ----
(Unaudited)
<S> <C> <C> <C> <C>
Federal:
Current $(1,386) $ 1,059 $ 992 $ 1,157
Deferred 808 (369) (440) (455)
------- ------- ------- -------
(578) 690 552 702

State:
Current (13) 143 201 247
Deferred 134 (67) (66) (70)
------- ------- ------- -------
121 76 135 177
------- ------- ------- -------
Provision (benefit) for income taxes $ (457) $ 766 $ 687 $ 879
------- ------- ------- -------
------- ------- ------- -------
</TABLE>

-38-

<PAGE>

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 (in thousands):

<TABLE>
<CAPTION>
Pro Forma
December 31, December 31, December 31, December 31,
1998 1997 1996 1996
---- ---- ---- ----
(Unaudited)
<S> <C> <C> <C> <C>
Tax at U.S. Statutory
Rate $(1,335) $ 686 $ 747 $ 747
State income taxes,
net of federal benefit 120 30 79 107
S Corporation
earnings prior to change
in tax status -- -- (252) --
Deferred taxes
recorded due to change
in tax status -- -- (149) --
Research and development
tax credits -- (137) (9) --
Valuation allowance 632 -- -- --
Other 126 187 271 25
------- ------- ------- -------
$ (457) $ 766 $ 687 $ 879
------- ------- ------- -------
------- ------- ------- -------
</TABLE>

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

Deferred income taxes reflect the net tax 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 (in thousands):

<TABLE>
<CAPTION>
December 31,
1998 1997
---- ----
<S> <C> <C>
Reserves and accruals not currently deductible $ 591 $ 686
Tax credit 151 -
State net operating losses 107 -
Other, net 172 324
------- -------
Total gross deferred tax assets 1,021 1,010
Less valuation allowance (822) -
------- -------
Net deferred tax assets 199 1,010
Deferred tax liabilities:
Depreciation of property and equipment (199) (68)
------- -------
Total deferred taxes $ - $ 942
------- -------
------- -------
</TABLE>

As of December 31, 1998, the Company had state tax loss carryforwards of
approximately $1,800,000 and federal tax credit carryforwards of
approximately $151,000. The state tax loss carryforwards will expire in 2003,
and the federal tax credit carryforwards will expire in 2018, if not
utilized. Because of the change in ownership provisions of the Internal
Revenue Code, a portion of the Company's net operating loss and tax credit
carryforwards may be subject to annual limitations. The annual limitation
may result in the expiration of net operating loss and tax credit
carryforwards before utilization.

Realization of deferred tax assets is dependent on future earnings, if any,
the timing and the amount of which are uncertain. Accordingly, a valuation
allowance, in an amount equal to the net deferred tax asset as of December
31, 1998 has been established to reflect these uncertainties. The valuation
allowance increased by approximately $822,000 during the fiscal year ended
December 31, 1998. The Company will continue to evaluate the realization of
the deferred tax assets on a quarterly basis.

-39-

<PAGE>

9. EXPORT SALES AND SIGNIFICANT CUSTOMERS

The Company has developed and is marketing a range of video image enhancement
products directed at the consumer/industrial markets and the television
broadcast market.

Product sales to these markets consist of the following (in thousands):

<TABLE>
<CAPTION>
December 31,
1998 1997 1996
-------- -------- -------
<S> <C> <C> <C>
Consumer/industrial $ 10,311 $ 15,199 $10,601
Broadcast 1,209 307 2,025
-------- -------- -------
$ 11,520 $ 15,506 $12,626
-------- -------- -------
-------- -------- -------
</TABLE>

The Company had product sales by region as follows (in thousands):

<TABLE>
<CAPTION>
December 31,
1998 1997 1996
-------- -------- -------
<S> <C> <C> <C>
Revenues to customers:
U.S.A $ 9,241 $ 13,285 $10,612
Asia 1,080 1,182 1,115
Europe 521 345 479
Canada 478 269 200
Latin America and other 200 425 220
-------- -------- -------
$ 11,520 $ 15,506 $12,626
-------- -------- -------
-------- -------- -------
</TABLE>

In 1998, sales to one customer accounted for 10% of total revenues. In 1997,
sales to two customers accounted for 11% of total revenues. In 1996, sales to
one customer accounted for 11% 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 $166,000 in 1998, $147,000 in 1997 and were insignificant during 1996.

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 in April 1999.
Borrowings under the line of credit are collaterized by substantially all of
the Company's tangible assets and contract rights and are limited to a
defined percentage of eligible accounts receivable. In addition, the Company
must satisfy certain financial covenants. Borrowings against the line of
credit bear interest at prime plus 1.5% (equivalent to 9.25% at December 31,
1998). At December 31, 1998, there were no borrowings against the line of
credit.

-40-

<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, 1998 and 1997, and the related consolidated
statements of income, stockholders' equity and cash flows for each of the
three years in the period ended December 31, 1998. Our audits also included
the financial statement schedule listed in the Index as Item 14(a). These
financial statements and schedule are the responsibility of the Company's
management. Our responsibility is to express an opinion on these financial
statements and schedule 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, 1998 and 1997 and the consolidated results of
its operations and its cash flows for each of the three years in the period
ended December 31, 1998, in conformity with generally accepted accounting
principles. Also, in our opinion, the related financial statement schedule,
when considered in relation to the basic financial statements taken as a
whole, present fairly in all material respects the information set forth
therein.

/S/ ERNST & YOUNG LLP

Palo Alto, California
January 25, 1999

-41-

<PAGE>

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, 1999 ("1999 Proxy
Statement"). Information concerning the executive officers of the Registrant
is included in Part I, page 18, of this annual report on Form 10-K.

ITEM 11. EXECUTIVE COMPENSATION.

The section labeled "Executive Compensation" of the 1999 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 1999 Proxy Statement is incorporated herein by reference.

ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS.

The section labeled "Certain Relationships and Related Transactions" of the
1999 Proxy Statement is incorporated herein by reference.

PART IV

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

(a) (1) Financial Statements-see Index to Financial Statements and
Financial Statement Schedules at page 27 of this Form 10-K.
(2) Financial Statement Schedules-see Index to Financial Statements
and Financial Statement Schedules at page 27 of this Form 10-K.
(3) Exhibits-see Exhibit Index at page 45 of this Form 10-K.

(b) Reports on Form 8-K.

No reports on Form 8-K were filed during the last quarter of 1998.

-42-

<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.

FAROUDJA, INC.

By: /S/ GLENN W. MARSCHEL, JR.
--------------------------------------
Glenn W. Marschel, Jr.
PRESIDENT AND CHIEF EXECUTIVE OFFICER
Date: March 29, 1999

KNOW ALL PERSONS BY THESE PRESENTS, that each person whose signature
appears below hereby constitutes and appoints Glenn W. Marschel, Jr. and
Robert A. Sheffield his true and lawful attorneys-in-fact and agents, each
with full power of substitution, for him in his true name, place and stead,
in any and all capacities, to sign this Form 10-K and all amendments hereto,
and to file the same, with exhibits thereto and other documents in connection
therewith, with the Securities and Exchange Commission, granting unto said
attorneys-in-fact and agents full power and authority to do and perform each
and every act and thing requisite and necessary to be done in and about the
premises, as fully to all intents and purposes as he might or could do in
person, hereby ratifying and confirming all that said attorneys-in-fact and
agents, or their substitute or substitutes, may lawfully do or cause to be
done by virtue hereof.

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
- --------- ----- ----
<S> <C> <C>
Chief Executive Officer, President and Director
/S/ GLENN W. MARSCHEL, JR. (Principal Executive Officer) March 29, 1999
- ---------------------------------
Glenn W. Marschel, Jr.

Vice President of Finance and Chief Financial Officer
/S/ ROBERT A. SHEFFIELD (Principal Financial and Accounting Officer) March 29, 1999
- ---------------------------------
Robert A. Sheffield
Chief Technical Officer, Director and Chairman of the
/S/ YVES C. FAROUDJA Executive Committee March 29, 1999
- ---------------------------------
Yves C. Faroudja

/S/ MERV L. ADELSON Director March 29, 1999
- ---------------------------------
Merv L. Adelson

/S/ STUART D. BUCHALTER Director March 29, 1999
- ---------------------------------
Stuart D. Buchalter

/S/ KEVIN B. KIMBERLIN Director March 29, 1999
- ---------------------------------
Kevin B. Kimberlin

/S/ MATTHEW D. MILLER Director March 29, 1999
- ---------------------------------
Matthew D. Miller

/S/ WILLIAM N. SICK Director March 29, 1999
- ---------------------------------
William N. Sick

/S/ WILLIAM J. TURNER Director March 29, 1999
- ---------------------------------
William J. Turner
</TABLE>
-43-

<PAGE>

FAROUDJA, INC.

SCHEDULE II--VALUATION AND QUALIFYING ACCOUNTS

(IN THOUSANDS)

<TABLE>
<CAPTION>
BALANCE AT CHARGED TO CHARGED TO BALANCE
BEGINNING COSTS AND OTHER END OF
OF PERIOD EXPENSES ACCOUNTS DEDUCTIONS(1) PERIOD
---------- ---------- ---------- ------------ -------
<S> <C> <C> <C> <C> <C>
Year ended December 31, 1998 deducted from asset accounts:
Allowance for doubtful accounts ........................... $167 $ 17 $ - $ 48 $136
---------- ---------- ---------- ------------ -------

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 account:
Allowance for doubtful accounts ........................... $ 10 $143 $ - $ 43 $110
---------- ---------- ---------- ------------ -------
</TABLE>

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

-44-

<PAGE>

FAROUDJA, INC.

INDEX TO EXHIBITS

(ITEM 14(c))

<TABLE>
<CAPTION>
EXHIBIT DESCRIPTION
NUMBER -----------
- ------
<S> <C>
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. (1)
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. (2)
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) (3)
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)
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)
10.29 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. (2)
10.31 Loan Modification Agreement, dated April 1, 1998 between the Company
and Silicon Valley Bank (4)
10.32 Amendment to the Company's 1997 Performance Stock Option Plan dated
June 10, 1998.
</TABLE>

-45-

<PAGE>

<TABLE>
<S> <C>
10.33 Letter Agreement, dated June 30, 1998, between the Company and Michael
C. Hoberg.
10.34 Letter Agreement, dated November 30, 1998, between the Company and
Michael J. Moone.
10.35 Letter Agreement, dated January 28, 1999, among the Company and Yves
Faroudja and Isabell Faroudja amending the Registration and
Shareholders' Rights Agreement, dated March 7, 1997, among the Company
and Yves & Isabell Faroudja.
10.36 Letter Agreement, dated January 13, 1999, between the Company and
Nikhil Balram.
21.1 List of the Subsidiaries of the Company. (1)
23 Consent of Ernst & Young LLP, Independent Auditors.
24 Power of Attorney (included on page 43 of this Form 10-K).
27 Financial Data Schedules.
</TABLE>

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

(2) Filed as an exhibit to the Company's Annual Report on Form 10-K for the
year ended December 31, 1997, and incorporated herein by reference.

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

(4) Filed as an exhibit to the Company's Registration Statement on Form S-1,
File No. 333-59901, and incorporated herein by reference.

-46-

<PAGE>

EXHIBIT 10.32
- -------------

Amendment to the Faroudja, Inc. Performance Stock Option Plan, dated
January 2, 1997 and amended on June 13, 1997 (the "1997 Plan"), approved at
the Faroudja, Inc. Annual Meeting of Stockholders on June 10, 1998.

Article III, Paragraph 3.1 of the 1997 Plan is amended and restated in
its entirety, to read as follows:

"3.1 NUMBER OF SHARES: The total number of shares of Common Stock which
are available for granting Options hereunder shall be one million one hundred
and twenty-five thousand (1,125,000) (subject to adjustment as provided below
in Section 3.3 and in Article VII hereof)."

Article III of the 1997 Plan is amended by adding Paragraph 3.4, to read
as follows:

"3.4 LIMITATION ON GRANTS: In no event shall Options be granted to any
Grantee in any one fiscal year to purchase more than an aggregate of 500,000
shares of Common Stock."

<PAGE>

EXHIBIT 10.33
- -------------

June 30, 1998

Mr. Michael Hoberg
8 Bellflower Lane
San Carlos, CA 94070

Dear Mike:

This letter will constitute an agreement between you and Faroudja
Laboratories, Inc. and it's corporate parent, Faroudja, Inc. (collectively,
the "Company") regarding the terms of your continued relationship with the
Company. Effective immediately your status will change and you will become
an advisor to the President. This relationship will continue until January
1, 1999 or the date you secure full-time employment, if earlier (the
"Separation Date"). This agreement is in lieu of any other plan or program
providing severance benefits.

The terms are as follows:

1. You will receive base salary paid in equal semi-monthly installments, net
of normal deductions and withholdings ("Installments") from the date hereof
until the Separation Date.

2. You have already received $3,636.26 (less withholding), as full payment in
lieu of all unused vacation to which you were entitled as of the date of
this Agreement.

3. You will receive continuation of medical and dental insurance benefits
until the Separation Date. These benefits will end as soon as you become
eligible for coverage with another employer. The COBRA period will begin
upon the Separation Date.

4. Your options will continue to vest until the Separation Date. You must
exercise any remaining exercisable options within 30 days after the
Separation Date, or you will not be able to exercise them.

5. You will have access to and exclusive use of the phone number
(408) 617-7217 and the voicemail service associated with such number
until the Separation Date.

<PAGE>

6. Unless otherwise specifically set forth in this agreement, the date of this
Agreement shall be the date of termination of your employment with the
Company and its parent, subsidiaries and affiliates for purposes of all
Company-related plans, agreements and/or benefits in which you participate
or to which you are a party, including without limitation, the vacation
policy, the 401(k) plan, the stock purchase plan, and the bonus plan. All
of your rights upon termination of employment with respect to any of such
plans, agreements and/or benefits shall be as set forth in the provisions
of the governing documents relating thereto.

7. Notwithstanding anything herein to the contrary and without limiting the
Company's rights, if you engage in any activities adverse to the Company's
best interests your right to all remaining payments and benefit coverage's
under this agreement, except as required by law, shall cease immediately.
Activities adverse to the Company's best interests are those a reasonable
man would find to be adverse under the circumstances and include, but are
not limited to (1) public statements or, except as required by law,
statements to customers, suppliers, government agencies or other entities
which statements are critical of the Company or its products, services,
directors, officers or employees; (2) disclosure or utilization in any
manner of Company confidential business, product, engineering and financial
information and inventions, or any other Company confidential information;
and (3) your participation in the solicitation of Company employees either
by yourself or on behalf of a competitor.

8. You agree that you will not make public statements or, except as required
by law, statements to customers, suppliers, government agencies or other
entities which statements are critical of the Company or its products,
services, directors, officers or employees.

9. The Company agrees not to make public statements critical of you or, except
as required by law, any critical statements to customers, suppliers,
government agencies or other entities.

10. You agree that for a period of one (1) year you will not participate in the
solicitation of Company employees, yourself or on behalf of a competitor
without the consent of the Company.

11. You agree to return immediately any Company documents in your possession
containing confidential or trade secret information. You further agree to
promptly advise the Company and take appropriate steps to return such
documents in the event you become aware following your termination of the
existence of any Company documents under your control containing Company
confidential information.

<PAGE>

12. You hereby release and discharge the Company, its subsidiaries, affiliates,
officers, directors, shareholders, employees, and agents (collectively "the
Company and its Affiliates") from any and all actions, liabilities, and
other claims for relief and remuneration whatsoever, with respect to any
act, omission or transaction occurring up to and including the date of this
Agreement, known and unknown, arising out of, or in any way connected with
your employment or former employment at the Company or your separation from
said employment, including, but not limited to, all matters in law, in
equity, in contract, or in tort, or pursuant to statute, including Title
VII of the Civil Rights Act of 1964 or the Age Discrimination in Employment
Act, as amended. This release does not apply to any claims or rights that
may arise after the date this Agreement has been executed or other rights
set forth herein. Notwithstanding anything stated in the foregoing
release, you do not release any claims of contribution or indemnity you
have or may have against the parties released herein with respect to third
party claims made against you as a result of your employment or position
with the Company and its subsidiaries.

13. You hereto expressly waive the benefits of Section 1542 of the Civil Code
of the State of California, which provides as follows:

"A general release does not extend to claims which the creditor does not
know or suspect to exist in his favor at the time of executing the release,
which if known by him must have materially affected his settlement with the
debtor."

14. Except for any act or omission done knowingly and intending that it be
against the best interests of the Company, the Company agrees to indemnify
you and hold you harmless as stated in your Indemnification Agreement
effective as of January 2, 1997, for any losses or expenses incurred by you
or assessed against you arising out of or in connection with your services
as an employee of the Company or one of its subsidiaries to the extent
permitted by the laws of the State of Delaware and the by-laws of the
Company in effect on the date hereof or as such may from time to time be
amended or by any other controlling law. You agree to reasonably assist
the Company in defending against or prosecuting claims, lawsuits and other
actions involving matters within your scope of responsibility while
employed by the Company. The Company will reimburse you for expenses
incurred and pay a reasonable per diem in connection with such assistance.
Reasonable assistance shall not unduly interfere with your other
activities.

15. The Company agrees that it will not file any objection to a claim you make
for unemployment compensation.

<PAGE>

16. By signing this Agreement you acknowledge and state that you have read this
Agreement, that you understand the legal effect and binding nature of this
Agreement, and that you are acting voluntarily and of your own free will in
executing this Agreement. We advise you to consult with an attorney prior
to executing this Agreement, and that you have twenty-one (21) days from
receipt of this Agreement in which to consider entering into this
Agreement. We further advise that you have until seven (7) days following
the execution of this Agreement to revoke this Agreement, in which case
this Agreement shall not become effective or enforceable and all terms of
this Agreement shall become null and void.

17. The parties agree to keep the terms and conditions of this Agreement
confidential except as required by law. Nothing herein shall prevent
confidential conversations with lawyers, accountants or other professional
advisors and family.

18. This is the entire Agreement of the parties and supersedes any prior
agreements or undertakings concerning the subject matter of this Agreement.
It can be modified only by a written agreement signed by the parties.

IN WITNESS WHEREOF, the parties have caused this agreement to be properly
executed as of the date written below.

Faroudja Laboratories, Inc. Michael Hoberg

By: /S/ MICHAEL J. MOONE /S/ MICHAEL C. HOBERG

President and CEO

Dated: 7/22/98 Dated: 7/22/98
----------------------- ----------------------

<PAGE>

EXHIBIT 10.34

CONFIDENTIAL

November 30, 1998

Mr. Michael J. Moone
457 Walsh Road
Atherton, CA 94025

Dear Mike:

This letter will constitute an agreement between you and Faroudja, Inc. and
it's subsidiary, Faroudja Laboratories, Inc. (collectively, the "Company")
regarding the terms of your severance as a result of your resignation from
your director and officer positions with the Company effective as of October
6, 1998 (the "Separation Date"). This severance is in lieu of any other
agreement, plan or program providing severance benefits.

The terms are as follows:

1. You will receive as severance, base salary paid in equal semi-monthly
installments, net of normal deductions and withholdings, for a period of
twelve (12) months (the "Severance Period").

2. Your first payment included $5,387.02 (less withholding) and your next
payment will include an additional $21.63, as full payment in lieu of all
unused vacation to which you were entitled as of the Separation Date.

3. You will receive continuation of medical and dental insurance benefits
during the Severance Period. You will notify the Company if you obtain new
employment during the Severance period. The medical and dental insurance
benefits provided to you by the Company will end as soon as you become
eligible for coverage with another employer. The COBRA period will begin at
the conclusion of the Severance Period. You will also receive continuation
of disability insurance benefits during the Severance Period.

4. You must exercise your 288,463 vested options by July 8, 1999, or you
will not be able to exercise them.

1
<PAGE>

5. You may continue to make contributions under the Company's 401(k) savings
plan through payroll withholdings until the end of 1998, but such
contributions will not be eligible for Company matching contributions.

6. Unless otherwise specifically set forth in this agreement, the Separation
Date shall be the date of termination of your employment with the Company and
its parents, subsidiaries and affiliates for purposes of all Company-related
plans, agreements and/or benefits in which you participate or to which you
are a party, including without limitation, the 401(k) savings plan, bonus
plan, stock purchase plan, stock option plan or stock option agreement. All
of your rights upon termination of employment with respect to any of such
plans, agreements and/or benefits shall be as set forth in the provisions of
the governing documents relating thereto.

7. You will promptly reimburse the Company $11,087.36 for equipment in your
possession purchased by the Company on your behalf and either return the
DV1000 DVD player loaned to you or pay the Company $1,600 for such unit.

8. The Company will not interfere with any arrangement you may have with Rob
Kirkpatrick with respect to the installation of your home theater, provided
that such arrangement does not interfere with Mr. Kirkpatrick's performance
of his Company responsibilities during normal working hours.

9. You agree that you will not make public statements or, except as required
by law, statements to customers, suppliers, government agencies or other
entities which statements are critical of the Company or its products,
services, directors, officers or employees.

10. The Company agrees not to make public statements critical of you or,
except as required by law, any critical statements to customers, suppliers,
government agencies or other entities.

11. You agree that for a period of twelve (12) months from the Separation
Date you will not solicit, or participate in the solicitation of Company
employees, on your own behalf or on behalf of any other enterprise, without
the consent of the Company.

12. You agree that for a period of nine (9) months from the Separation Date
you will not engage or become interested (as owner, lender, stockholder,
partner, director, officer, employee, consultant or otherwise) in any
business that is in competition with the business then conducted by the
Company without the Company's prior written consent, which shall not be
unreasonably withheld. Nothing contained herein shall prohibit your owning
as a passive investment not more than ten percent of the outstanding
securities of any class of any publicly-held company.

13. You acknowledge your obligations under the Employee Proprietary Information
Agreement dated June 24, 1996 to which you are a party. In addition, you agree
to return immediately any Company documents in your possession containing
confidential or trade

<PAGE>

secret information. You further agree to promptly advise the Company and
take appropriate steps to return such documents in the event you become aware
following your termination of the existence of any Company documents under
your control containing Company confidential information.

14. You hereby release and discharge the Company, its subsidiaries,
divisions, affiliates and its officers, directors, shareholders, employees,
and agents (collectively "the Company and its Affiliates") from any and all
actions, liabilities, and other claims for relief and remuneration
whatsoever, with respect to any act, agreement, omission or transaction
occurring up to and including the date of this agreement, known and unknown,
arising out of, or in any way connected with your employment or former
employment at the Company or your separation from said employment, including,
but not limited to, (a) the Employment Agreement dated as of July 8, 1996
between yourself and Faroudja Laboratories, Inc., and (b) all matters in law,
in equity, in contract, or in tort, or pursuant to statute, including Title
VII of the Civil Rights Act of 1964 or the Age Discrimination in Employment
Act, as amended. This release does not apply to any claims or rights that
may arise after the date this agreement has been executed or other rights set
forth herein. Notwithstanding anything stated in the foregoing release, you
do not release any claims of contribution or indemnity you have or may have
against the parties released herein with respect to third party claims made
against you as a result of your employment or position with the Company and
its subsidiaries.

15. You hereby expressly waive the benefits of Section 1542 of the Civil
Code of the State of California, which provides as follows:

16. The Company hereby releases and discharges you from any and all actions,
liabilities, and other claims for relief and remuneration whatsoever, with
respect to any act, agreement, omission or transaction occurring up to and
including the date of this agreement, known to the Company on the date hereof
(with no duty of inquiry), arising out of, or in any way connected with your
employment or former employment at the Company or your separation from said
employment. This release does not apply to any claims or rights that may
arise after the date this agreement is executed or other rights set forth
herein.

17. Except for any act or omission done knowingly and intending that it be
against the best interests of the Company, the Company agrees to indemnify you
and hold you harmless from any losses or expenses incurred by you or assessed
against you arising out of or in connection with your services as an employee of
the Company or one of its subsidiaries to the extent permitted by the laws of
the State of Delaware and the by-laws of the Company in effect on the date
hereof or as such may from time to time be amended or by any other controlling
law. You agree to reasonably assist the Company in defending against or
prosecuting claims, lawsuits and other actions involving matters

<PAGE>

within your scope of responsibility while employed by the Company. The
Company will reimburse you for expenses incurred and pay a reasonable per
diem in connection with such assistance. Reasonable assistance shall not
unduly interfere with your other activities.

18. The Company agrees that it will not file any objection to a claim you
make for unemployment compensation.

19. In the event of any litigation between the parties relating to the
enforcement of this agreement, the prevailing party shall be entitled to
reasonable attorneys' fees and costs.

20. By signing the agreement you acknowledge and state that you have read
this agreement, that you understand the legal effect and binding nature of
this agreement, and that you are acting voluntarily and of your own free will
in executing this agreement. We advise you to consult with an attorney prior
to executing this agreement, and that you have twenty-one (21) days from
receipt of this agreement in which to consider entering into this agreement.
We further advise that you have until seven (7) days following the execution
of this agreement to revoke this agreement, in which case this agreement
shall not become effective or enforceable and all terms of this agreement
shall become null and void.

21. The parties agree to keep the terms and conditions of this agreement
confidential except as required by law. Nothing herein shall prevent
confidential conversations with lawyers, accountants or other professional
advisors and family.

22. This is the entire agreement of the parties and supersedes any prior
agreements or undertakings concerning the subject matter of this agreement.
It can be modified only by a written agreement signed by the parties.

IN WITNESS WHEREOF, the parties have caused this agreement to be
executed as of the date written below.

Faroudja, Inc. Michael J. Moone

By: /S/KENNETH S. BOSCHWITZ /S/ MICHAEL J. MOONE

Its: VP BUS DEVEL & GEN'L COUNSEL Dated: 12/15/98

Dated: 12/18/98

<PAGE>
EXHIBIT 10.35
- -------------

CONFIDENTIAL
- ------------

VIA FACSIMILE
- -------------

January 28, 1999

Greg L. Pickrell, Esq.
Coudert Brothers
530 Lytton Avenue
Suite 300
Palo Alto, CA 94301

Dear Greg:

I am writing to follow up on our discussions regarding the issues raised in
your July 30, 1998 letter regarding the registration rights of Yves Faroudja
and Isabell Faroudja under the Registration and Shareholders Rights Agreement
dated March 7, 1997 (the "Agreement") and Yves Faroudja's Warrant to Purchase
Shares of Faroudja, Inc. Common Stock dated January 20, 1997 (the "Warrant").
The registration rights under the Agreement and the Warrant are referred to
collectively in this letter as the "Registration Rights." This dialog results
from the Faroudja, Inc. (the "Company") Registration Statement on Form S-1
which was declared effective on August 12, 1998 (the "Registration
Statement") and the right and opportunity of Mr. and Mrs. Faroudja to
exercise their Registration Rights and participate therein.

Our most recent discussion involved your comments on my November 11, 1998
letter responding to your July 30, 1998 letter. As expressed in my letter and
our conversations, the Company wishes to resolve this matter amicably. In
furtherance of that objective, a revised proposal follows.

If the Faroudjas wish to register the securities they could have included in the
Registration Statement through the exercise of their rights under the Agreement,
or if Mr. Faroudja wishes to register the securities he could have registered in
the Registration Statement through the exercise of his rights under the Warrant,
the Company is willing to use its reasonable efforts, on one occasion, to
register, at the Company's expense, the offer and sale of such

<PAGE>

Greg L. Pickrell, Esq.
January 28, 1999
Page 2

securities under the Securities Act of 1933, as amended, as soon as possible
following a written request for such registration.

Such a filing would, however, be subject to the following conditions:

(i) registration on Form S-3 (or an equivalent SEC form) is available for
the securities in question;

(ii) the transaction or transactions in which such securities would be sold
occurs over a period of not more than ninety (90) days following the
effective date of the registration statement; and

(iii) the filing of a registration statement would not be seriously
detrimental to the Company in the good faith judgment of the Board of
Directors of the Company.

If the Board of Directors determines that filing a registration statement
would be seriously detrimental to the Company, the Company would have the
right to defer such filing (x) for up to 120 days after receipt of the
request, or (y) if the Company is engaged or has fixed plans to engage in a
registered public offering as to which the Registration Rights could be
exercised, the Company may defer such filing for a period beginning 60 days
prior to the initial filing with the SEC of the registration statement
relating to such offering, and ending not more than 90 days after the
effective date of such registration statement. The Company may defer such
filing for the period described in (x) or (y), but not both. If the Company
exercises its right to defer the filing of a registration statement because
it is engaged or has fixed plans to engage in a registered public offering,
the Faroudjas may elect to include in such offering shares as to which the
Registration Rights were exercised, unless the Board of Directors determines
that inclusion of all or part of such shares would be seriously detrimental
to the Company or the success of the offering. Any shares not included in
such offering would continue to be entitled to the registration rights set
forth in this paragraph or any other applicable Registration Rights. The
rights described herein shall have no effect on the Faroudja's existing
Registration Rights.

I have enclosed two signed copies of this letter. If Mr. and Mrs. Faroudja
are satisfied with this proposal, please have each of them sign and date both
copies of this letter in the space provided below. One executed copy should
be

<PAGE>

Greg L. Pickrell, Esq.
January 28, 1999
Page 3

retained for the Faroudja's files and the other copy should be returned to
me. This letter, countersigned by Mr. and Mrs. Faroudja, shall be deemed to
amend the Agreement and the Warrant.

Please do not hesitate to call me at 408.617.7257 if you have any further
questions or comments.

Yours truly,

/S/ KENNETH S. BOSCHWITZ

Kenneth S. Boschwitz, Vice President
Business Development & General Counsel

cc: Mr. Yves Faroudja
Stuart D. Buchalter, Esq.

Agreed and Accepted:

/S/ YVES C. FAROUDJA /S/ ISABELL FAROUDJA
- -------------------------- -------------------------
Yves C. Faroudja Isabell Faroudja

2-25-99 2-25-99
- ------- -------
Date Date

<PAGE>

EXHIBIT 10.36
- -------------

January 13, 1999

Mr. Nikhil Balram, Ph.D.
387 Foxborough Drive
Mountain View, CA 94041

Dear Nikhil:

Speaking for all of us here at Faroudja Laboratories, Inc., I am very pleased
to offer you the position of Vice President of Advanced Technology. This
position reports to the CEO. The terms of Faroudja Laboratories' offer are
set forth below:

RESPONSIBILITIES: In the capacity of Vice President of Advanced Technology you
will have the following responsibilities:
- - Coordinate the creation, writing and implementation of Faroudja
Laboratories strategic plan.
- - Lead the development of the technical direction and business justification
for the company to enter new volume markets, including LCD and other pixel
displays, PC's and projection displays.
- - Be the Product Manager for the "chip" business including analysis to
identify target markets and products.
- - Lead in forming alliances, partnerships and relationships in the new IC and
display business.
- - Extend and leverage the Faroudja brand name.
- - Represent the company in appropriate forums and committees.
- - Aid in the sales development of our new IC products.
- - Be a protege of Yves Faroudja; learn the Home Theater and Broadcast
business and picture presentation and demonstration art from him.
- - Other responsibilities as required.

SALARY: Your initial salary will be $150,000.00 annually. Payroll is
processed twice a month.

BENEFITS: Faroudja Laboratories has an excellent benefits package including
medical insurance, dental coverage, 401(k) program with company matching
contributions, and long term disability. As a full-time employee, you will be
eligible for all benefits described in the enclosed Faroudja Laboratories
Employee Benefits Summary.

EQUITY: A stock option of 125,000 shares will be recommended to the Board of
Directors of Faroudja, Inc. on your behalf. The options will vest over a
period of four years and have an exercise price based upon the fair market
value of the underlying shares at the time of approval by the Board of
Directors.

<PAGE>

BONUS: You will be eligible to earn an annual bonus. Payment of this bonus
is discretionary and will be based upon a combination of Company and
individual performance factors. Your bonus target is 20% of base salary.
The company must achieve at least 90% of target NOI for the year. Personal
goals must be achieved; a plan will be established each year. The bonus is
payable at year end.

SEVERANCE: In the event that your employment with Faroudja is terminated
within the first twelve months by the Company without cause, you will be
entitled to salary continuance for twelve months from your start date in
accordance with regular payroll practices upon your execution of a general
release, prepared by the Company, of all claims you may have against the
Company. Your stock options will continue to vest during the salary
continuation period, and will be subject in all respects to the Company's
applicable option plan.

Faroudja Laboratories prohibits the solicitation of intellectual property of
other companies. Also, in accepting this offer letter by signing below, you
confirm that you are not subject to any agreement with your present or former
employers (e.g. non-compete agreements) that would prohibit your acceptance
of this offer or your performance of any of the responsibilities defined in
this offer or contemplated in the future during your employment with Faroudja
Laboratories.

Employment with Faroudja Laboratories is at-will and may be terminated by
either party at any time, with or without cause.

This offer will remain valid until January 19, 1999. You will be required to
show proof of eligibility to work in the US when employment with us begins.
As evidence of your acceptance, please sign below and return this letter to
Gayle Holmlund in Human Resources. The enclosed copy is for your records.

Nikhil, we are eager to have you join us as a member of the Faroudja
Laboratories team, and are looking forward to receiving your positive
response as soon as possible.

If you have any questions, please do not hesitate to call me.

Sincerely,

/S/ GLENN W. MARSCHEL, JR.

Glenn W. Marschel, Jr.
President and Chief Executive Officer

Enclosures

Agreed and Accepted: /S/ NIKHIL BALRAM Date: 1/18/99
-------------------

Anticipated Start Date: January 28, 1999

<PAGE>

EXHIBIT 23

CONSENT OF ERNST & YOUNG LLP, INDEPENDENT AUDITORS

We consent to the incorporation by reference in the Registration Statement
(Forms S-8 No. 333-50811), pertaining to the 1995 Stock Option Plan, the 1997
Performance Stock Option Plan, the 1997 Non-Employee Directors Option Plan
and the 1997 Amended Employee Stock Purchase Plan of Faroudja, Inc., of our
report dated January 25, 1999, with respect to the financial statements and
schedule of Faroudja, Inc. included in this Annual Report (Form 10-K) for the
year ended December 31, 1998.

/S/ ERNST & YOUNG LLP

Palo Alto, California
March 29, 1999

-47-

<PAGE>
<ARTICLE> 5
<LEGEND>
THIS SCHEDULE CONTAINS SUMMARY FINANCIAL INFORMATION EXTRACTED FROM THE
FINANCIAL STATEMENTS INCLUDED IN ITEM 8 OF THE COMPANY'S FORM 10-K FOR THE YEAR
ENDED DECEMBER 31, 1998, AND IS QUALIFIED IN ITS ENTIRETY BY REFERENCE TO SUCH
FINANCIAL STATEMENTS.
</LEGEND>
<MULTIPLIER> 1,000

<S> <C>
<PERIOD-TYPE> YEAR
<FISCAL-YEAR-END> DEC-31-1998
<PERIOD-START> JAN-01-1998
<PERIOD-END> DEC-31-1998
<CASH> 20,419
<SECURITIES> 0
<RECEIVABLES> 1,764
<ALLOWANCES> 136
<INVENTORY> 3,348
<CURRENT-ASSETS> 26,710
<PP&E> 1,778
<DEPRECIATION> 2,581
<TOTAL-ASSETS> 28,721
<CURRENT-LIABILITIES> 2,223
<BONDS> 0
0
0
<COMMON> 12
<OTHER-SE> 26,486
<TOTAL-LIABILITY-AND-EQUITY> 28,721
<SALES> 11,520
<TOTAL-REVENUES> 12,270
<CGS> 5,499
<TOTAL-COSTS> 5,499
<OTHER-EXPENSES> 4,822
<LOSS-PROVISION> 0
<INTEREST-EXPENSE> 0
<INCOME-PRETAX> (3,926)
<INCOME-TAX> (457)
<INCOME-CONTINUING> 0
<DISCONTINUED> 0
<EXTRAORDINARY> 0
<CHANGES> 0
<NET-INCOME> (3,469)
<EPS-PRIMARY> (0.29)
<EPS-DILUTED> (0.29)

</TABLE>