COBALT NETWORKS INC, 10-Q, 2000-11-13

COBALT NETWORKS INC
10-Q, 2000-11-13
ELECTRONIC COMPONENTS & ACCESSORIES

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SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

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FORM 10-Q

[X] QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES AND
EXCHANGE ACT OF 1934

For the quarterly period ended September 29, 2000

[_] TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES AND
EXCHANGE ACT OF 1934

For the transition period from to

Commission file number: 000-24360

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COBALT NETWORKS, INC.

(Exact name of registrant as specified in its charter)

Delaware 77-0440751
(State or other jurisdiction (I.R.S. Employer
of incorporation or organization) Identification Number)

555 Ellis Street, Mountain View, CA 94043
(Address of Principal Executive Offices) (Zip Code)

Registrant's telephone number, including area code: (650) 623-2500

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

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 and Exchange Act of 1934
during the preceding 12 months (or for 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 [_]

As of September 29, 2000, 30,314,000 shares of common stock of the Registrant
were outstanding.

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<PAGE>

COBALT NETWORKS, INC.

<TABLE>
<S> <C>
PART I--FINANCIAL INFORMATION............................................ 3

ITEM 1. FINANCIAL STATEMENTS (unaudited)................................ 3

CONDENSED CONSOLIDATED BALANCE SHEET................................... 3

CONDENSED CONSOLIDATED STATEMENT OF OPERATIONS......................... 4

CONDENSED CONSOLIDATED STATEMENT OF CASH FLOWS......................... 5

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS................... 6

ITEM 2. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND
RESULTS OF OPERATIONS.................................................. 11

ITEM 3. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK...... 27

PART II--OTHER INFORMATION............................................... 28

ITEM 1. LEGAL PROCEEDINGS............................................... 28

ITEM 2. CHANGES IN SECURITIES AND USE OF PROCEEDS....................... 28

ITEM 6. EXHIBITS AND REPORTS ON FORM 8-K................................ 28
</TABLE>
<PAGE>

PART I--FINANCIAL INFORMATION

Item 1. Financial Statements

CONDENSED CONSOLIDATED BALANCE SHEET
(in thousands) (unaudited)

<TABLE>
<CAPTION>
September 29, December 31,
2000 1999(1)
-------- -----------
<S> <C> <C>
ASSETS
Current assets:
Cash and cash equivalents................................ $ 37,155 $141,777
Short-term investments................................... 76,810 --
Accounts receivable, net of allowance.................... 10,352 5,846
Sales-type leases receivable............................. 1,993 --
Inventories.............................................. 600 714
Other current assets..................................... 3,606 1,835
-------- --------
Total current assets.................................... 130,516 150,172
Property and equipment, net............................... 3,156 1,685
Long-term sales-type leases receivables................... 1,955 --
Long-term investments..................................... 14,700 --
Goodwill and intangible assets............................ 81,190 --
-------- --------
Total assets............................................ $231,517 $151,857
======== ========

LIABILITIES AND STOCKHOLDERS' EQUITY
Current liabilities:
Notes payable, current................................... $ 48 $ 44
Accounts payable......................................... 20,503 15,101
Accrued liabilities...................................... 11,628 4,611
Deferred margin on distributor inventory................. 2,211 1,305
-------- --------
Total current liabilities............................... 34,390 21,061
Notes payable............................................. 4 40
-------- --------
Total liabilities....................................... 34,394 21,101
-------- --------
Stockholders' equity:
Preferred Stock.......................................... -- --
Common Stock............................................. 30 28
Additional paid-in capital............................... 258,347 174,462
Unearned stock compensation.............................. (3,153) (6,444)
Notes receivable from stockholders....................... (418) (450)
Accumulated deficit...................................... (57,683) (36,840)
-------- --------
Total stockholders' equity............................... 197,123 130,756
-------- --------
Total liabilities and stockholders' equity............... $231,517 $151,857
======== ========
</TABLE>

--------
(1) The information in this column is derived from the Company's audited
financial statements for the year ended December 31, 1999.
See Notes to Condensed Consolidated Financial Statements
<PAGE>

COBALT NETWORKS, INC.

CONDENSED CONSOLIDATED STATEMENT OF OPERATIONS
(in thousands, except per share amounts) (unaudited)

Three months ended Nine months ended
--------------------- --------------------
Sept. 29, Oct. 1, Sept. 29 Oct. 1,
2000 1999 2000 1999
--------- ------- --------- --------
<S> <C> <C> <C> <C>
Net revenues................................... $ 20,370 $ 6,186 $ 48,645 $ 13,849
Cost of revenues............................... 9,939 3,873 25,232 9,029
-------- ------- -------- --------
Gross profit................................ 10,431 2,313 23,413 4,820
-------- ------- -------- --------
Operating expenses:
Research and development...................... 3,299 1,566 7,312 4,337
Sales and marketing........................... 7,209 3,973 18,804 10,246
General and administrative.................... 2,409 1,170 6,018 2,624
Amortization of stock
compensation................................. 858 1,256 3,291 1,509
Amortization of goodwill and other
intangible assets............................ 7,018 -- 9,782 --
In-process research and
development.................................. -- -- 830 --
Merger-related charges........................ 4,008 -- 4,008 --
-------- ------- -------- --------
Total operating expenses.................... 24,801 7,965 50,045 18,716
-------- ------- -------- --------
Loss from operations........................... (14,370) (5,652) (26,632) (13,896)
Interest income (expense), net................. 2,131 282 5,789 282
Other expense.................................. (108) -- (108)
-------- ------- -------- --------
Net loss....................................... (12,239) (5,478) (20,843) (13,722)
Accretion of preferred stock to
redemption value............................... -- (139) -- (1,330)
-------- ------- -------- --------
Net loss attributable to holders of
common stock................................... $(12,239) $(5,617) $(20,843) $(15,052)
======== ======= ======== ========
Net loss attributable to holders of
common stock per share:
Basic and diluted............................. $ (.42) $ (1.48) $ (.74) $ (4.31)
======== ======= ======== ========
Basic and diluted weighted average
shares outstanding............................. 29,473 3,804 28,349 3,491
======== ======= ======== ========
</TABLE>

See Notes to Condensed Consolidated Financial Statements
<PAGE>

COBALT NETWORKS, INC.
CONDENSED CONSOLIDATED STATEMENT OF CASH FLOWS

(in thousands) (unaudited)

<TABLE>
<CAPTION>
Nine months ended
----------------------
Sept. 29, October 1,
2000 1999
-------- ----------
<S> <C> <C>
Cash flows from operating activities:
Net loss...................................................... $ (20,843) $(13,722)
Adjustments to reconcile net loss to net cash used in
operating activities:
Depreciation................................................. 750 594
Purchase of in-process research and development.............. 830 --
Amortization of goodwill and other intangible assets......... 9,782 --
Stock compensation........................................... 3,291 346
Amortization of stock compensation........................... -- 1,163
Non-cash interest (income) expense........................... (18) 130
Other non-cash expense....................................... -- 108
Changes in assets and liabilities:
Accounts receivable......................................... (4,216) (3,167)
Sales-type leases receivable................................ (3,948) --
Inventories................................................. 114 (124)
Other current assets........................................ (1,511) (134)
Accounts payable............................................ 3,642 3,733
Accrued liabilities......................................... 5,546 2,132
Deferred margin on distributor inventory.................... 906 567
--------- --------
Net cash used in operating activities...................... (5,675) (8,374)
--------- --------
Cash flows used in investing activities:
Acquisition of property and equipment......................... (1,913) (871)
Cash used in business combinations (net of cash acquired)..... (6,483) --
Purchases of short-term investments........................... (76,810) --
Purchase of long-term investments............................. (14,700) --
Loan to stockholder........................................... -- (500)
--------- --------
Net cash used in investing activities...................... (99,906) (1,371)
--------- --------
Cash flows from financing activities:
Proceeds from issuance of Mandatorily Redeemable
Convertible Preferred Stock, net.............................. -- 29,705
Proceeds from exercise of stock options, net.................. 941 58
Principal payments on line of credit.......................... -- (600)
Principal payments on notes payable........................... (32) (28)
Proceeds from notes receivable from stockholders.............. 50 --
Proceeds from borrowings under convertible promissory
notes......................................................... -- 4,250
--------- --------
Net cash provided by financing activities.................. 959 33,385
--------- --------
Net increase (decrease) in cash and cash equivalents.......... (104,622) 23,640
Cash and cash equivalents at beginning of period.............. 141,777 2,090
--------- --------
Cash and cash equivalents at end of period.................... $ 37,155 $ 25,730
========= ========
</TABLE>
See Notes to Condensed Consolidated Financial Statements
<PAGE>

COBALT NETWORKS, INC.

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

1. Interim Results

The interim unaudited condensed consolidated financial statements of Cobalt
Networks, Inc. (the "Company") are prepared in conformity with generally
accepted accounting principles. Such principles are applied on a basis
consistent with the audited financial information contained in the Company's
Annual Report on Form 10-K for the year ended December 31, 1999 filed with the
Securities and Exchange Commission on March 30, 2000. The financial statements
included herein has been prepared by management, without audit by independent
accountants who do not express an opinion thereon, and should be read in
conjunction with the audited financial statements contained in the Company's
Annual Report on Form 10-K for the fiscal year ended December 31, 1999. The
condensed consolidated balance sheet as of December 31, 1999, has been derived
from, but does not include all the disclosures contained in, the audited
financial statements for the year ended December 31, 1999. The information
furnished includes all adjustments, consisting only of normal recurring
adjustments, that are, in the opinion of management, necessary for a fair
presentation of results for the interim periods. Certain information or footnote
disclosure normally included in financial statements prepared in accordance with
generally accepted accounting principles has been condensed or omitted pursuant
to the rules and regulations of the Securities and Exchange Commission.

The interim results are not necessarily indicative of the results of operations
for the full year ending December 29, 2000 or for any other future period.

2. Reclassifications

Certain prior period amounts have been reclassified to the current period
presentation.

3. Long-term investments

The Company has equity investments in private companies. These investments are
included in "Long-term investments" in the Company's balance sheet and are
carried at cost. The Company monitors these investments for impairment and makes
appropriate reductions in carrying value when necessary.
<PAGE>

COBALT NETWORKS, INC.

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS--(Continued)

4. Balance Sheet Components (in thousands):

<TABLE>
<CAPTION>
September 29, December 31,
2000 1999
-------- --------
<S> <C> <C>
Inventories:
Finished goods........................... $ 212 $ 517
Raw materials............................ 388 197
------- ------
Total................................... $ 600 $ 714
======= ======

Property and equipment:
Computer equipment....................... $ 2,513 $1,337
Office equipment and fixtures............ 1,190 619
Leasehold improvements................... 959 485
------- ------
4,662 2,441
Less: Accumulated depreciation........... (1,506) (756)
------- ------
$ 3,156 $1,685
======= ======

Accrued liabilities:
Employee benefits........................ $ 4,592 $1,539
Reserve for sales returns................ 1,983 1,817
Warranty................................. 1,534 885
Other.................................... 3,519 370
------- ------
$11,628 $4,611
======= ======
</TABLE>

5. Acquisition of Chili!Soft, Inc.

Effective May 23, 2000, the Company acquired Chili!Soft, Inc. ("Chili!Soft") a
provider of software solution for platform-independent Active Server Pages (ASP)
("the Acquisition"). An aggregate of approximately 1,150,000 shares of Cobalt
Common Stock were issuable pursuant to the Acquisition, including options in
purchase approximately 226,000 shares of Cobalt Common Stock issuable in
connection with the exercise of options to purchase Chili!Soft Common Stock that
Cobalt assumed in connection with the Acquisition.

The Company accounted for the Acquisition as a purchase business combination.
The consolidated financial statements include the results of operations of
Chili!Soft commencing on May 24, 2000. The total purchase price has been
calculated as follows (in thousands):

<TABLE>
<S> <C>
Market value of 924,000 shares of common stock issued........... $60,112
Fair value of options assumed................................... 14,647
Cash advances to acquisition prior to May 23, 2000.............. 2,350
Direct acquisition costs........................................ 1,232
-------
Total purchase price.......................................... $78,341
=======
</TABLE>

The total purchase price has been allocated to tangible and intangible assets
acquired and liabilities assumed on the basis of their respective fair values on
the acquisition date. The fair value of intangible assets was determined using
a combination of methods, including estimates based on risk-based or risk-
adjusted income approach for acquired in-process research and development,
completed technology and non-compete agreement, and on a cost replacement
approach for acquired work force. This valuation was determined by an
independent appraiser.

The allocation of the purchase price to assets acquired and liabilities assumed
is presented in the table that follows (in thousands):

<TABLE>
<S> <C>
Developed technology............................................ $ 1,790
In-process research and development............................. 830
Non compete agreement........................................... 2,250
Workforce....................................................... 2,210
Goodwill........................................................ 72,347
Net liabilities assumed.......................................... (1,088)
-------
Total purchase price.......................................... $78,341
=======
</TABLE>

Amounts allocated to the non-compete agreements and workforce are being
amortized over their estimates useful lives of 3 and 2 years, respectively.
Amounts allocated to existing technology and goodwill are being amortized over
their estimated useful lives of 3 years.

In addition, the Company recorded a $830,000 charge for in-process research and
development related to in-process technology for projects that, as of the date
of the acquisition, had not yet reached technological feasibility and had no
alternative future use. The value of these projects was determined by
estimating the resulting net cash flows from the sale of the products resulting
from the completion of the projects, reduced by the portion of the revenue
attributable to core technology and the percentage completion of the project.
The resulting cash flows were then discounted back to their present value at
appropriate discount rates. Cash flows related to the in-process research and
development were discounted at 30%.

The in-process research and development relates to the development of
Chili!Soft's Active Server Pages which were under development as of the
acquisition date. Research and development costs to bring the products from the
acquired company to technological feasibility are estimated to total
approximately $1.0 million. The Company anticipates the development will be
completed between nine and fifteen months.

Developed technology is technology that is being used in existing products of
the business and is distinguished from in process technology because it has
achieved technological feasibility. Core technology represents fundamental
technology and advances that are the basis for the Company's developed and
in-process products. New and in-process products may leverage core technology
in different degrees depending on the extent of incorporation of new, previously
undeveloped technologies.

The nature of the efforts to develop the purchased in-process research and
development into commercially viable products principally relates to the
completion of all planning, designing, prototyping and testing activities that
are necessary to establish that the product can be produced to meet its design
specification, features and technical performance requirements. The resulting
net cash flows from such products are based one estimates of revenue, cost of
revenue, research and development costs, sales and marketing costs, and income
taxes from such projects.

It is reasonably possible that the development of this technology could fail
because of either prohibitive cost, inability to perform the required efforts
to complete the technology or other factors outside of the Company's control
such as a change in the market for the resulting developed products. In
addition, at such time that the project is completed it is reasonably possible
that the completed product does not receive market acceptance or that we are
unable to produce and market the product cost effectively.

The following unaudited pro forma net revenues, net loss per share data for the
nine months ended September 29, 2000 and October 1, 1999 are based on the
respective historical financial statements of the Company and Chili!Soft. The
pro forma data reflects the consolidated results of operations as if the
Acquisition with Chili!Soft occurred at the beginning of each of the periods
indicated and includes the amortization of the resulting goodwill and other
intangible assets. The pro forma financial data presented are not necessarily
indicative of the Company's results of operations that might have occurred had
the transaction been completed at the beginning of the periods specified, and do
not purport to represent what the Company's consolidated results of operations
might be for any future period.

<TABLE>
<CAPTION>
Nine Months Ended
-----------------
September 29, October 1,
2000 1999
---- ----
<S> <C> <C>
Pro forma net revenue ............................ $ 49,188 $ 14,662
Pro forma loss from operations.................... $(58,746) $(43,857)
Pro forma net loss attributable to holder
of common stock................................. $(52,961) $(45,000)
Pro forma basic and diluted net loss per share
attributable to holders of common stock......... $ (1.84) $ (10.19)
Pro forma shares used in basic and diluted net
loss per share calculation...................... $ 28,839 $ 4,415

</TABLE>

6. Acquisition of Progressive Systems, Inc.

On August 28, 2000 the Company acquired all of the outstanding stock and rights
to acquire capital stock of Progressive Systems, Inc ("Progressive") in exchange
for a combination of the Company's common stock and cash totaling $10.9 million.
An aggregate of 162,484 shares of the Company's common stock were issued and
$3.2 million in cash was paid pursuant to this acquisition. In addition, the
Company assumed certain liabilities and incurred certain direct costs of the
acquisition which resulted in an aggregate purchase price of $12.3 million.

The Company accounted for the transaction as a purchase business combination.
The consolidated financial statements include the results of operations of
Progressive commencing on August 29, 2000. The total purchase price has been
calculated as follows (in thousands):

Market value of 162,484 shares of common stock issued.......... $ 7,409
Cash payment related to terms of acquisition................... 3,176
Direct acquisition costs....................................... 308
-------
Total purchase price......................................... $10,893
=======
<PAGE>

COBALT NETWORKS, INC.

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS--(Continued)

The total purchase price has been allocated to assets acquired and liabilities
assumed on the basis of their respective fair values on the acquisition date.
Amounts allocated to goodwill are being amortized over their estimated useful
lives of 3 years. The allocation of the purchase price to assets acquired and
liabilities assumed is presented in the table that follows (in thousands):

Goodwill....................................................... $12,394
Net liabilities assumed........................................ (1,501)
-------
Total purchase price......................................... $10,893
=======

The following unaudited pro forma net revenues, net loss and net loss per share
data for the nine months ended September 29, 2000 and October 1, 1999 are based
on the respective historical financial statements of the Company and
Progressive. The pro forma data reflects the consolidated results of operations
as if the Acquisition with Progressive occurred at the beginning of each of the
periods indicated and includes the amortization of the resulting goodwill and
other intangible assets. The pro forma financial data presented are not
necessarily indicative of the Company's results of operations that might have
occurred had the transaction been completed at the beginning of the periods
specified, and do not purport to represent what the Company's consolidated
results of operations might be for any future period.

<TABLE>
<CAPTION>
Nine Months Ended
-----------------------
September 29, October 1,
2000 1999
-------- --------
<S> <C> <C>
Pro forma net revenue.................................. $ 49,165 $ 14,335
Pro forma loss from operations......................... $(30,522) $(17,096)
Pro forma net loss attributable to holders of common
stock................................................. $(24,745) $(18,252)
Pro forma basic and diluted net loss per share
attributable to holders of common stock............... $ (.87) $ (5.00)
Pro forma shares used in basic and diluted net loss per
share calculation..................................... 28,456 3,653
</TABLE>

7. Net Loss Per Share

The Company computes net loss per share in accordance with Statement of
Financial Accounting Standards ("SFAS") No. 128, "Earnings per Share" and SEC
Staff Accounting Bulletin ("SAB") No. 98. Under the provisions of SFAS No. 128
and SAB No. 98, basic net loss per share is computed by dividing the net loss
available to holders of Common Stock for the period by the weighted average
number of shares of Common Stock outstanding during the period. Weighted average
shares exclude shares of Common Stock subject to repurchase by the Company
("restricted shares"). Diluted net loss per share is computed by dividing the
net loss available to holders of Common Stock for the period by the weighted
average number of shares of Common Stock and Potential Common Stock outstanding
during the period, if dilutive. Because the inclusion of Potential Common Stock
would be anti-dilutive, diluted net loss per share is the same as basic net loss
per share. Potential Common Stock includes unvested restricted shares of Common
Stock and incremental shares of Common Stock issuable upon the exercise of stock
options and warrants and upon conversion of Series A and B Mandatorily
Redeemable Convertible Preferred Stock (with respect to the three and nine
months ended September 29, 2000).
<PAGE>

COBALT NETWORKS, INC.

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS--(Continued)

The following table sets forth the computation of basic and diluted net loss per
share for the periods indicated (in thousands, except per share data):
<TABLE>
<CAPTION>

Three Months Ended Nine Months Ended
---------------------- -----------------------
Sept. 29, Oct. 1 Sept. 29, Oct. 1
2000 1999 2000 1999
--------- -------- --------- --------
<S> <C> <C> <C> <C>
Numerator:
Net loss attributable to holders of
Common Stock..................................... $(12,239) $(5,617) $(20,843) $(15,052)
======== ======= ======== ========
Denominator:
Weighted average shares outstanding............... 30,023 5,042 29,067 4,903
Weighted average shares of Common
Stock subject to repurchase...................... (550) (1,238) (718) (1,412)
-------- ------- -------- --------
Denominator for basic and diluted
calculation...................................... 29,473 3,804 28,349 3,491
======== ======= ======== ========
Basic and diluted net loss per share
attributable to holders of Common
Stock............................................ $ (.42) $ (1.48) $ (.74) $ (4.31)
======== ======= ======== =======
</TABLE>

The effects of options to purchase 5,663,929 and 3,275,000 shares of Common
Stock at an average exercise price of $18.27 and $1.79 per share as of September
29, 2000 and October 1, 1999, respectively; warrants to purchase 189,000 shares
of Preferred Stock at an average exercise price of $2.22 per share, and warrants
to purchase 243,000 shares of Common Stock at an average exercise price of $3.70
at October 1, 1999; and 17,179,000 shares of Mandatorily Redeemable Convertible
Preferred Stock at October 1, 1999, have not been included in the computation of
diluted net loss per share as their effect would have been anti-dilutive.

8. New Accounting Pronouncements

In December 1999, the staff of the Securities and Exchange Commission issued SAB
101, "Revenue Recognition," which outlines the basic criteria that must be met
to recognize revenue and provides guidance for presentation of revenue and for
disclosure related to revenue recognition policies in financial statements filed
with Securities and Exchange Commission. The effective date of this
pronouncement is the fourth quarter of the fiscal year beginning after December
15, 1999. We believe that adopting SAB 101 will not have a material impact on
our financial position and results of operations.

In March 2000 the Financial Accounting Standards Board ("FASB") issued FASB
Interpretation No. 44 ("FIN 44") Accounting for Certain Transactions involving
Stock Compensation an interpretation of APB Opinion No. 25. FIN 44 clarifies the
application of Opinion 25 for (a) the definition of employee for purposes of
applying Opinion 25, (b) the criteria for determining whether a plan qualifies
as a noncompensatory plan, (c) the accounting consequence of various
modifications to the terms of a previously fixed stock option or award, and (d)
the accounting for an exchange of stock compensation awards in a business
combination.

FIN 44 is effective July 1, 2000, but certain provisions cover specific events
that occur after either December 15, 1999 or January 12, 2000. The adoption of
the provisions of FIN 44 did not have a material effect on the financial
position or results of the Company.

In June 1998, the FASB issued SFAS No. 133 "Accounting for Derivative
Instruments and Hedging Activities." SFAS No. 133 establishes methods of
accounting for derivative financial instruments and hedging activities related
to those instruments as well as other hedging activities. In July 1999, the FASB
issued SFAS No. 137, "Accounting for Derivative Instruments and Hedging
Activities--Deferral of the Effective Date of FASB Statement No. 133." SFAS No.
137 deferred the effect of SFAS No. 133 until fiscal year beginning after June
15, 2000. We will adopt SFAS No. 133 in 2001. To date, we have not engaged in
derivative or hedging activities. We are unable to predict the impact of
adopting SFAS No 133 if we were to engage in derivative and hedging activities
in the future.
<PAGE>

COBALT NETWORKS, INC.

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS--(Continued)

9. Litigation and Other Events

In June 2000, the Company filed suit against NetMachines, Inc., in the U.S.
District Court for the Northern District of California, claiming that the use of
the name RedRak for its server products constitutes trademark infringement of
the Company's registered RaQ trademark for computer hardware products, which
includes servers. The Company intends to pursue this matter vigorously but is
unable to provide an evaluation of the probability of a favorable or unfavorable
outcome. The Company believes, based on currently available information, the
resolution of this matter will not have a material effect on its financial
position, results of operations or cash flows.

10. Segment information

During each period presented, the Company operated in a single business segment,
primarily in the United States, Japan and Europe.

11. Comprehensive Income

To date, the Company has not had any transactions that are required to be
reported in comprehensive income (loss) as compared to its reported net loss.

12. Merger with Sun Microsystems, Inc.

On September 18, 2000, the Company entered into a definitive agreement to merge
with Sun Microsystems, Inc. ("Sun"), a leading provider of products, services
and support solutions for building and maintaining networking computing
environments. Under the terms of the definitive agreement, each outstanding
share of the Company's common stock and each outstanding stock option will be
converted into the right to receive 0.50 shares of Sun common stock. The
transaction is expected to be accounted for as a purchase business combination
and is expected to close by December 31, 2000. The closing of the Sun
transaction is subject to a number of conditions including approval by the
Company's stockholders and regulatory approvals, including approvals under the
Hart-Scott Rodino Antitrust Improvements Act of 1976, as amended.
<PAGE>

Item 2. Management's Discussion and Analysis of Financial Condition and Results
of Operations

Certain statements in this "Management's Discussion and Analysis of Financial
Condition and Results of Operations" are forward looking statements. These
statements relate to future events or our future financial performance and
involve known and unknown risks, uncertainties and other factors that may cause
our or our industry's actual results, levels of activity, performance or
achievements to be materially different from any future results, levels of
activity, performance or achievements expressed or implied by the forward-
looking statements. These risks and other factors include those listed under
"Factors Affecting Future Operating Results" and elsewhere in this quarterly
report on Form 10-Q. In some cases, you can identify forward-looking statements
by terminology such as "may", "will", "should", "expects", "plans",
"anticipates", "believes", "estimates", "predicts", "potential", "continue" or
the negative of these terms or other comparable terminology. These statements
are only predictions. Actual events or results may differ materially. In
evaluating these statements, you should specifically consider various factors,
including the risks outlined under "Factors Affecting Future Operating Results".
These factors may cause our actual results to differ materially from any
forward-looking statement.

Overview

Since our inception in 1996, we have incurred substantial costs to develop our
technology and products, to recruit and train personnel for our engineering,
sales and marketing and technical support departments, and to establish an
administrative organization. As a result, we had an accumulated deficit of $57.7
million as of September 29, 2000. We anticipate that our operating expenses will
increase substantially in the future as we increase our sales and marketing
operations, develop new channels, fund greater levels of research and
development, broaden our technical support and improve our operational and
financial systems. Accordingly, we will need to generate significant revenues to
achieve profitability. In addition, our limited operating history makes it
difficult for us to predict future operating results and, accordingly, there can
be no assurance that we will sustain revenue growth or achieve profitability in
future quarters.

We currently derive substantially all of our net revenues from sales of a
limited number of products. In the three months ended September 29, 2000 and
October 1, 1999, respectively, 92% and 87% of our net revenues were derived from
sales of our Cobalt RaQ and Cobalt Qube products. Although we began selling our
Cobalt Cache products in 1998 and Cobalt NAS products in 1999, we expect that a
substantial majority of our revenues in 2000 will continue to be generated from
sales of our Cobalt Qube and Cobalt RaQ products.

We sell our products directly through our sales force and indirectly through
channel partners that include distributors, resellers and system integrators.
Indirect sales are a majority of our total sales and account for substantially
all of our sales outside of the United States. In the three months ended
September 29, 2000 and October 1, 1999, respectively, 61% and 15% of our net
revenues were from direct sales. In the three months ended September 29, 2000,
approximately 14% of our net revenues came from sales to one customer. The
increase in direct sales as a percentage of net revenues is due to focused
efforts by our direct sales force. Direct sales in absolute dollars rose to
$12.4 million in the three months ended September 29, 2000 from $928,000 in the
three months ended October 1, 1999.

Indirect sales were 39% and 85% of our net revenues in the three months ended
September 29, 2000 and October 1, 1999, respectively. In the three months ended
October 1, 1999, approximately 19% of our net revenues came from sales to Nissho
Electronics. While we are seeking to diversify our customer base and expand the
portion of our net revenues which is derived from sales through various
channels, we anticipate that our operating results will continue to depend on
volume sales to a relatively small number of channel partners.

For direct sales and sales to resellers and system integrators, we record
revenues upon shipment. We recognize revenues on sales to distributors at the
time products are sold through to end-users. As a result, we defer recognition
of gross profit, captioned on our balance sheet as "deferred margin on
distributor inventory" until we record the revenues and cost of revenues on a
sell-through basis. Revenues from service obligations are deferred and
recognized on a straight-line basis over the contractual period.

Our customers and distributors are generally able to cancel their orders at any
time prior to shipment without penalty. In addition, Cobalt is typically able to
fulfill a majority of orders in less than seven days. Consequently, backlog
measured on any given day is not a meaningful predictor of our prospects in the
ensuing weeks and months.

We provide allowances for estimated sales returns and warranty costs at the time
of revenue recognition based on our historical results. To date, our actual
sales returns and warranty expenditures have each been approximately 5% or less
of net revenues in any quarter. However, our past product return and warranty
experience may not be indicative of future product return rates and warranty
costs.
<PAGE>

Although we enter into general sales contracts with our channel partners, none
of our channel partners is obligated to purchase any amount of our products
pursuant to these contracts. We rely on our channel partners to submit purchase
orders for specific quantities of our products.

Our gross profit is affected by:

. fluctuations in demand for our products;

. the mix of products sold;

. the mix of sales channels through which our products are sold;

. the mix of sales within and outside North America;

. the timing and size of customer orders;

. new product introductions by us and our competitors;

. changes in our pricing policies;

. changes in component costs; and

. the volume manufacturing prices we are able to obtain from our contract
manufacturers.

We recorded unearned stock compensation on our balance sheet of $8.9 million in
connection with stock options granted to our employees between July 1, 1998 and
October 1, 1999. We are amortizing this stock compensation over the vesting
period of the related options. During the nine months ended September 29, 2000,
we amortized $3.3 million of stock compensation. During the remainder of 2000,
we expect to amortize stock compensation of $ 623,000. We then expect aggregate
per quarter stock compensation amortization of between $533,000 and $318,000
during 2001, between $262,000 and $116,000 during 2002 and between $78,000 and
$10,000 during 2003. The amount of stock compensation expense to be recorded in
future periods could decrease in the event of the forfeiture of options for
which accrued but unvested compensation has been recorded.

Prior to April 26, 1999, our net loss attributable to holders of common stock
includes accretion charges to increase over time the carrying amount of our
mandatorily redeemable convertible preferred stock to the amount we would be
required to pay if the preferred stock were to be redeemed. As of April 26,
1999, we ceased recording these charges because we changed the terms of the
preferred stock to limit the redemption amount to its original issue price plus
accrued dividends.

We had 265 employees as of September 29, 2000, a substantial increase from 127
employees as of October 1, 1999. This rapid growth has placed significant
demands on our management and operational resources. In order to manage our
growth effectively, we must implement and improve our operational systems,
procedures and controls on a timely basis. We could experience a decline in our
revenues and operating results if:

. our total revenues do not increase relative to our operating expenses;

. our management systems do not expand to meet increasing demands;

. we fail to attract, assimilate and retain qualified personnel, or

. our management otherwise fails to manage our expansion effectively.

Until January 1, 1999, we operated on calendar fiscal quarters and a fiscal year
ended December 31. Beginning in 1999, we began to operate on thirteen week
fiscal quarters ending on a Friday. Therefore, in 2000 our fiscal quarters end
on March 31, June 30, September 29 and December 29.

Recent Developments

On September 18, 2000, we announced that we had entered into a definitive
agreement with Sun Microsystems, Inc., ("Sun"), pursuant to which Sun will
acquire our Company and our stockholders will receive one-half shares of Sun's
common stock for every share of our common stock they hold. The Sun transaction
is expected to close during the quarter ending December 29, 2000 but is subject
to a number of conditions including the approval of our stockholders and various
regulatory approvals and clearances including those under the Hart-Scott Rodino
Antitrust Improvements Act of 1976, as amended.
<PAGE>

Results of Operations--Three and Nine Months Ended September 29, 2000 and
October 1, 1999

Net Revenues

Net revenues for the three months ended September 29, 2000 were $20.4 million,
an increase of $14.2 million, or 229%, over the $6.2 million in the three months
ended October 1, 1999. For the nine months ended September 29, 2000, net
revenues were $48.6 million, an increase of $34.8 million, or 251% over the
$13.8 million in the nine months ended October 1, 1999. These increases were
primarily the result of an increase in sales to new and existing customers of
our Cobalt Qube and Cobalt RaQ product lines. We expect that the majority of our
revenues in the future may continue to be generated from sales of our Cobalt
Qube and Cobalt RaQ products.

Net revenues from sales to international customers increased to $7.8 million, or
38% of net revenues, in the three months ended September 29, 2000 from $3.9
million, or 62% of net revenues, in the three months ended October 1, 1999. For
the nine months ended September 29, 2000 and October 1, 1999, net revenues from
sales to international customers accounted for 42% and 59% of our net revenues,
respectively. The increase in absolute dollars of international revenues was due
to the expansion of our operations in Japan, Europe and other countries. One
factor relating to the increase in net revenues from sales outside the United
States was our introduction of various local language user interfaces including
those in Japanese, German, French and Chinese. Our net revenues from sales
outside the United States were primarily valued in U.S. dollars. The effect of
foreign exchange fluctuations did not have a significant impact on our results.

Cost of Revenues and Gross Profit

Cost of revenues includes technology license fees, manufacturing costs,
manufacturing personnel expenses, packaging and shipping costs and warranty
expenses. Cost of revenues increased to $9.9 million for the three months ended
September 29, 2000 from $3.9 million for the three months ended October 1, 1999.
Cost of revenues for the nine months ended September 29, 2000, increased to
$25.2 million from $9.0 million for the nine months ended October 1, 1999. We
have outsourced our manufacturing and repair operations. Accordingly, in the
three months ended September 29, 2000 approximately 74% and in the three months
ended October 1, 1999 approximately 75% of our cost of revenues consisted of
payments to our contract manufacturers. The cost of revenues as a percentage of
net revenues for the three months ended September 29, 2000 and October 1, 1999
were 49% and 63%, respectively. For the nine months ended September 29, 2000 and
October 1, 1999, the cost of net revenues as a percentage of net revenues were
52% and 65%, respectively. The decrease in cost of revenues as a percentage of
net revenues is attributable to the continued focus on our manufacturing
operations and economies of scale.

Gross profit for the three months ended September 29, 2000 was $10.4 million, an
increase of $8.1 million, or 351%, as compared to the $2.3 million in the three
months ended October 1, 1999. Gross profit as a percentage of net revenues for
the three months ended September 29, 2000 and October 1,1999 was 51% and 37%,
respectively. Gross profit for the nine months ended September 29, 2000 were
$23.4 million, an increase of $18.6 million, or 386%, as compared to the $4.8
million in the nine months ended October 1, 1999. Gross profit as a percentage
of net revenues for the nine months ended September 29, 2000 and October 1, 1999
was 48% and 35%, respectively. The increase in gross profit was primarily due to
increased sales volume and the introduction of new products with higher gross
margins. We believe that the rate of growth of the increase in gross profit will
not be sustainable in future quarters.

Research and Development

Research and development expenses consist primarily of salaries and related
expenses for personnel engaged in research and development including the
development of application and server management software, material costs for
prototype and test units and other expenses related to the design, development,
testing and enhancements of our products. Due to the quick turn around time of
new product introduction, we expense all research and development costs as they
are incurred. Research and development expenses increased to $3.3 million in the
three months ended September 29, 2000 from $1.6 million in the three months
ended October 1, 1999. For the nine months ended September 29, 2000, research
and development expenses were $7.3 million, an increase of 69% over the $4.3
million in the nine months ended October 1, 1999. The increase resulted from
hiring additional research and development personnel. We believe that a
significant level of investment in product research and development is required
to remain competitive. Accordingly, we expect to continue to devote substantial
resources to product research and development such that research and development
expenses will increase in absolute dollars but may continue to fluctuate as a
percentage of net revenues.
<PAGE>

Sales and Marketing

Sales and marketing expenses consist primarily of salaries, commissions and
related expenses for personnel engaged in marketing, sales and customer support
functions, as well as costs associated with trade shows, promotional activities,
advertising and public relations. Sales and marketing expenses increased to $7.2
million in the three months ended September 29, 2000 from $4.0 million in the
three months ended October 1, 1999. For the nine months ended September 29,
2000, sales and marketing expenses were $18.8 million, an increase of 84% over
the $10.2 million in the nine months ended October 1, 1999. The increase in
sales and marketing expenses was due to the expansion of our sales and marketing
efforts, including our branding campaign, advertising and tradeshows, and hiring
additional sales and marketing personnel. We intend to expand our sales and
marketing operations and efforts substantially, both domestically and
internationally, in order to increase market awareness and to generate sales of
our products. Accordingly, we expect our sales and marketing expenses to
increase in absolute dollars but may continue to fluctuate as a percentage of
net revenues.

General and Administrative

General and administrative expenses consist primarily of salaries and related
expenses for executive, finance, accounting, information technology, human
resources personnel, recruiting expenses, professional fees and costs associated
with expanding our information systems. General and administrative expenses
increased to $2.4 million in the three months ended September 29, 2000 from $1.2
million in the three months ended October 1, 1999. For the nine months ended
September 29, 2000, general and administrative expenses were $6.0 million, an
increase of 129% over the $2.6 million in the nine months ended October 1, 1999.
The increase was due to hiring additional administrative personnel and increased
costs associated with the expansion of our facilities and information
infrastructure. We expect these expenses to increase in absolute dollars but may
continue to fluctuate as a percentage of net revenues as we add personnel and
incur additional costs related to the growth of our business and the expansion
of our information infrastructure.

Amortization of Stock Compensation

In connection with the grant of stock options to employees for the period from
July 1, 1998 to October 1, 1999, we recorded unearned stock compensation within
stockholders' equity of approximately $8.9 million, representing the difference
between the estimated fair value of the common stock for accounting purposes and
the option exercise price of these options at the date of grant. We recorded
$858,000 of stock compensation amortization during the three months ended
September 29, 2000 and $1.3 million of stock compensation amortization in the
three months ended October 1, 1999. For the nine months ended September 29,
2000, we recorded $3.3 million of stock compensation amortization and $1.5
million in the nine months ended October 1, 1999. The amount of stock
compensation expense to be recorded in future periods could decrease if options
for which accrued but unvested compensation has been recorded are forfeited.

Amortization of Goodwill and Other Intangible Assets

In the three and nine months ended September 29, 2000, we recorded $7.0 million
and $9.8 million, respectively, for the amortization of goodwill and intangibles
related to the acquisitions of Chili!Soft, Inc. in May 2000 ("Chili!Soft") and
Progressive Systems, Inc. in August 2000. The details for the basis and expected
amortization period are specified in Notes 5 and 6 to the financial statements.

In-Process Research and Development

In the three and nine months ended September 29, 2000, we charged a total of
$830,000 for in-process research and development. This research and development
was acquired as part of the acquisition of Chili!Soft. The amount allocated to
in-process research and development was determined through established valuation
techniques.

The development of this technology may fail because of prohibitive cost,
inability to perform the required efforts to complete the technology or other
factors outside our control such as changes in the market for the resulting
developed products. In addition, at such time that the project is completed, the
completed products may not receive market acceptance or we may be unable to
produce and market the products cost effectively.

Merger-related charges

The company has incurred $4.0 million of merger costs related to the proposed
acquistion by Sun Microsystems, Inc., these costs have been expensed as
incurred.
<PAGE>

Interest Income (Expense), Net

Interest income (expense), net includes income from our cash investments net of
expenses related to our debt and lease financing obligations. We had net
interest income of $2.1 million and $174,000 in the three months ended September
29, 2000 and October 1, 1999, respectively. For the nine months ended September
29, 2000, we recorded net interest income of $5.8 million and $174,000 in the
nine months ended October 1, 1999. The growth in net interest income was
primarily due to an increase in interest income earned on proceeds from our
initial public offering of common stock.

Liquidity and Capital Resources

Since inception, we have financed our operations primarily through private sales
of mandatorily redeemable convertible preferred stock, proceeds from our initial
public offering of common stock, the issuance of convertible notes, equipment
financings and net revenues generated from product sales. As of September 29,
2000, we had cash and cash equivalents of $37.2 million, short-term investments
of $76.8 million, an accumulated deficit of $57.7 million and working capital of
$96.1 million.

Our operating activities used cash of $5.7 million in the nine months ended
September 29, 2000 and $8.4 million in the nine months ended October 1, 1999.
Cash used in operating activities during the nine months ended September 29,
2000 was attributable to a net loss of $20.8 million, and increases in accounts
receivable of $4.2 million, and an increase in sales-type leases receivable of
$3.9 million, and increases in other current assets of $1.5 million but was
offset in part by increases in accrued liabilities of $5.5 million, increases in
accounts payable of $3.6 million, increase in depreciation, amortization of
stock compensation, acquired intangibles and other non-cash expenses aggregating
$14.6 million. Cash used in operating activities for the nine months ended
October 1, 1999 was primarily attributable to net losses of $13.7 million. In
the nine months ended October 1, 1999, cash used in operating activities was
also attributable to increases in accounts receivable and inventories of $3.2
million and $124,000, respectively, offset in part by increases in accounts
payable of $3.7 million, accrued expenses of $2.1 million and deferred margin
of $567,000.

Our investing activities used cash of $99.9 million in the nine months ended
September 29, 2000 and $1.4 million in the nine months ended October 1, 1999.
Cash used in investing activities for the nine months ended September 29, 2000
was primarily attributable to purchases of short-term investments and the
acquisitions of Chili!Soft and Progressive. The cash used in investing
activities in the nine months ended October 1, 1999 reflects purchases of
computer equipment and other fixed assets.

Our financing activities provided cash of $1.0 million in the nine months ended
September 29, 2000 and $33.4 million in the nine months ended October 1, 1999.
The increases in the nine months ended September 29, 2000 resulted primarily
from the net proceeds from the issuances of common stock to our employees upon
the exercise of stock options. Cash provided from financing activities in the
nine months ended October 1, 1999 resulted from the net proceeds from the
issuance of mandatorily redeemable convertible preferred stock and convertible
promissory notes, borrowings under bank lines of credit and advances from a
related party.

From inception, we have made capital expenditures of $4.8 million to support our
research and development, sales and marketing and administrative activities. We
expect to have capital expenditures of approximately $2.2 million for the next
twelve months. We also anticipate that our capital expenditures will increase
over the next several years as we expand our facilities and acquire equipment to
support expansion of our sales and marketing and research and development
activities.

We intend to continue to invest heavily in the development of new products and
enhancements to our existing products. Our future liquidity and capital
requirements will depend upon numerous factors, including:

. the costs and timing of expansion of sales and marketing activities;

. the costs and timing of expansion of product development efforts and the
success of these development efforts;

. the extent to which our existing and new products gain market acceptance;

. the costs involved in maintaining and enforcing intellectual property rights;

. market developments;

. available borrowings under line of credit arrangements; and

. other factors.
<PAGE>

We believe that our current cash and investment balances and any cash generated
from operations and future debt financing will be sufficient to meet our
operating and capital requirements for at least the next 12 months. However, it
is possible that we may require additional financing within this period. We have
no current plans, and we are not currently negotiating, to obtain additional
financing. The factors described above will affect our future capital
requirements and the adequacy of our available funds. In addition, even if we
raise sufficient funds to meet our anticipated cash needs during the next 12
months, we may need to raise additional funds beyond this time. We may be
required to raise those funds through public or private financings, strategic
relationships or other arrangements. We cannot assure that such funding, if
needed, will be available at attractive terms, or at all. Furthermore, any
additional equity financing may be dilutive to stockholders, and debt financing,
if available, may involve restrictive covenants. If we fail to raise capital
when needed, our failure could have a negative impact on our ability to pursue
our business strategy and achieve and maintain profitability.

Recent Accounting Pronouncements

In December 1999, the staff of the Securities and Exchange Commission issued
Staff Accounting Bulletin ("SAB") 101, "Revenue Recognition," which outlines the
basic criteria that must be met to recognize revenue and provides guidance for
presentation of revenue and for disclosure related to revenue recognition
policies in financial statements filed with Securities and Exchange Commission.
The effective date of this pronouncement is the fourth quarter of the fiscal
year beginning after December 15, 1999. We believe that adopting SAB 101 will
not have a material impact on our financial position and results of operations.

FIN 44 is effective July 1, 2000, but certain provisions cover specific
events that occur after either December 15, 1999 or January 12, 2000. The
adoption of the provisions of FIN 44 did not have a material effect on the
financial position or results of the Company.

Factors That May Affect Future Operating Results

Risks Related to the Merger

You will receive 0.50 shares of Sun common stock for each of your shares of our
common stock, regardless of any changes in market value of our common stock or
Sun common stock.

Upon completion of the merger, each share of our common stock will be converted
into the right to receive 0.50 shares of Sun common stock (subject to adjustment
to reflect the effect of any stock split, stock dividend, recapitalization,
reclassification or the like on Sun or our common stock). There will be no
adjustment to this exchange ratio based upon changes in the market price of
either Sun common stock or our common stock, and we are not permitted to
withdraw from the merger or resolicit the vote of our stockholders solely
because of changes in the market price of Sun common stock or our common stock.
Accordingly, the dollar value of Sun common stock you will receive upon
completion of the merger will depend on the market value of Sun common stock at
the time of completion of the merger, which may be different than the market
value of Sun common stock at September 18, 2000. Because the market price of
Sun common stock may increase or decrease before the completion of the merger,
you are urged to obtain current market quotations. The merger may not be
completed immediately following our stockholder meeting, if all regulatory
approvals have not yet been obtained or if other closing conditions have not
been satisfied or waived. We cannot assure you that the value of the Sun common
stock you will receive in the merger will not decline prior to or after the
merger.
<PAGE>

Customer and employee uncertainty related to the merger could harm our company.

Our customers may, in response to the announcement or consummation of the
merger, delay or defer purchasing decisions. Any delay or deferral in
purchasing decisions by our customers could adversely affect the business of the
combined company. Similarly, our employees may experience uncertainty about
their future role with the combined company until or after strategies with
regard to our company are announced or executed by Sun. This may adversely
affect our ability to attract and retain key management, marketing and technical
personnel.

We expect to incur significant costs associated with the merger.

We estimate that we will incur direct transaction costs of approximately $16
million in connection with the merger, which will be expensed in the quarter
that the merger is completed. We believe the combined entity may incur charges
to operations, which are not currently reasonably estimable, in the quarter in
which the merger is completed or the following quarters, to reflect costs
associated with integrating the two companies. There can be no assurance that
the combined company will not incur additional material charges in subsequent
quarters to reflect additional costs associated with the merger.

The price of Sun common stock may be affected by factors different from those
affecting the price of our common stock.

When the merger is completed, holders of our common stock will become holders of
Sun common stock. Sun's business differs from ours and Sun's results of
operations, as well as the price of Sun common stock, may be affected by factors
different from those affecting our results of operations and the price of our
common stock.

We may be unable to obtain the required regulatory approvals for completing the
merger.

As a condition to the obligations of Sun and us to complete the merger, the
waiting period under the Hart-Scott-Rodino Antitrust Improvements Act of 1976
must have expired or been terminated. We have made required filings under the
Hart-Scott-Rodino Act with the Department of Justice and the Federal Trade
Commission. There can be no assurance that the waiting period under the Hart-
Scott-Rodino Act will be permitted to expire or be terminated at all or without
materially adverse restrictions or conditions that would have an adverse effect
on us. In addition, the merger may be subject to various foreign antitrust
laws, some of which may require us to make filings with foreign antitrust
authorities. We may be required to agree to various operating restrictions,
before or after receipt of stockholder approval, in order to obtain the
necessary authorizations and approvals of the merger or to assure that
governmental authorities do not seek to block the merger. We do not expect to
seek any additional stockholder approval for any decision by us or Sun, after
the special meeting of our stockholders, to agree to any terms and conditions
necessary to resolve any regulatory objections to the merger, and we will not
seek stockholder approval unless such stockholder approval is required to
approve such terms and conditions under applicable law. Notwithstanding any
agreements regarding operating restrictions that may be required under
applicable law or by governmental authorities, under the terms of the merger
agreement, Sun is not required to accept any material restrictions on its
business in order to complete the merger and may refuse to complete the merger
if any material restrictions are required by governmental authorities as a
condition to approving the merger. Even if regulatory approvals are obtained,
any federal, state or foreign governmental entity or any private person may
challenge the merger at any time before or after its completion.

If the merger is not completed, our stock prices and future business and
operations could be adversely affected.

If the merger is not completed, we may be subject to the following material
risks, among others:
. we may be required to pay Sun a termination fee of $59 million;
. the option to purchase approximately 6,036,386 shares of our common stock
that we granted to Sun may become exercisable and, if exercised, will result
in a substantial decrease in the percentage of our outstanding common stock
currently held by our stockholders, may depress our stock price and may make
another business combination involving our company more difficult;
. Sun could require us to purchase the option or shares of our common stock it
acquired under the option, resulting in significant additional costs to us;
. the price of our common stock may decline to the extent that the current
market price of our common stock reflects a market assumption that the merger
will be completed; and
. our costs related to the merger, such as legal, accounting and some of the
fees of our financial advisor, must be paid even if the merger is not
completed.

Further, if the merger agreement is terminated and our board of directors
determines to seek another merger or business combination, we may not be able to
find a partner willing to pay an equivalent or more attractive price than that
which would be paid in the merger.

In addition, while the merger agreement is in effect and subject to certain
limited exceptions, we are generally prohibited from soliciting, initiating or
knowingly encouraging or entering into extraordinary transactions, such as a
merger, sale of assets or other business combination with any party other than
Sun.
<PAGE>

We face risks from our ongoing operations.

In addition to the risks related to the Sun transaction, we face other risks
related to our ongoing business operations. We compete in the server appliance
industry, and there are a number of factors that, in the past, have affected all
of the companies in our industry, including us. Many of these factors may also
impact our business in the future. These risks include the following:

We only began selling our products in March of 1998 and, as a result, you may
have difficulty evaluating our business and operating results.

Our company was founded in October 1996, and we did not begin selling our
products until March 1998. You should consider the risks and difficulties we may
encounter as an early stage company in the new and rapidly evolving server
appliance market. Our limited historical financial performance may make it
difficult for you to evaluate the success of our business to date and to assess
its future viability. We cannot be certain that our business strategy will be
successful.

We have a history of losses and may experience losses in the future, which could
result in the market price of our common stock declining.

Since our inception, we have incurred significant net losses including net
losses of $12.2 million in the three months ended September 29, 2000 and $5.6
million in the three months ended October 1, 1999. In addition, we had an
accumulated deficit of $57.7 million as of September 29, 2000.

We expect to continue to incur significant product development, sales and
marketing and administrative expenses. As a result, we will need to generate
significant revenues to achieve profitability. We cannot be certain that we will
achieve profitability in the future or, if we achieve profitability, to sustain
it. If we do not achieve and maintain profitability, the market price for our
common stock may decline, perhaps substantially.

We anticipate that our expenses will increase substantially in the next 12
months as we:

. increase our direct sales and marketing activities, particularly by expanding
our direct sales forces;

. develop our technology, expand our existing product lines and create and
market additional server appliance products;

. make additional investments to develop our brand;

. expand our distribution and reseller channels;

. pursue original equipment manufacturing relationships; and

. implement additional internal systems, develop additional infrastructure and
hire additional management to keep pace with our growth.

Any failure to significantly increase our revenues as we implement our product
and distribution strategies would also harm our ability to achieve and maintain
profitability and could negatively impact the market price of our common stock.

We may not be able to sustain our current revenue growth rates, which could
cause our stock price to decline.

Although our revenues grew rapidly in the three months ended September 29, 2000,
we do not believe that we will maintain this rate of revenue growth because we
started from a small base of revenue, and it is difficult to maintain high
percentage increases over a larger revenue base. In addition, growing
competition, the incremental manner in which customers implement server
appliances and our inexperience in selling our products to small- to medium-
sized organizations could also affect our revenue growth. Any significant
decrease in our rate of revenue growth would likely result in a decrease in our
stock price.

Because our ability to accurately forecast our quarterly sales is limited, our
costs are relatively fixed in the short term and we expect our business to be
affected by seasonality, our quarterly operating results and our stock price may
fluctuate.

Because of our limited operating history and the new and rapidly evolving market
for our server appliances, our ability to accurately forecast our quarterly
sales is limited, which makes it difficult to predict the quarterly revenues
that we will recognize. In addition, we cannot forecast operating expenses based
on historical results, and most of our costs are for personnel and facilities,
which are relatively fixed in the short term. If we have a shortfall in revenues
in relation to our expenses, we may be
<PAGE>

unable to reduce our expenses quickly enough to avoid lower quarterly operating
results. We do not know whether our business will grow rapidly enough to absorb
the costs of these employees and facilities. As a result, our quarterly
operating results could fluctuate, and such fluctuation could adversely affect
the market price of our common stock.

In addition, we expect to experience seasonality in the sales of our products.
For example, we expect that sales may decline during summer months, particularly
in Asian and European markets. We generally anticipate sales to be lower in our
first fiscal quarter due to patterns in the capital budgeting and purchasing
cycles of our current and prospective customers. These seasonal variations in
our sales may lead to fluctuations in our quarterly operating results. It is
difficult for us to evaluate the degree to which this seasonality may affect our
business because our growth may have largely overshadowed this seasonality in
recent periods.

We have relied and expect to continue to rely on sales of our Cobalt Qube and
Cobalt RaQ products for our revenues, and a decline in sales of these products
could cause our revenues to fall.

Historically, we have derived substantially all of our revenues from sales of
our Cobalt Qube and Cobalt RaQ products. During the three months ended September
29, 2000 and October 1, 1999, sales of Cobalt RaQ and Cobalt Qube products
accounted for approximately 92% and 87% of our total revenues. We expect that
these products will continue to account for a large portion of our total
revenues for at least the next two fiscal years. Any factors adversely affecting
the pricing of or demand for our Cobalt Qube and Cobalt RaQ products, including
competition or technological change, could cause our revenues to decline and our
business to suffer. Factors that may affect the market acceptance of our
products, some of which are beyond our control, include the following:

. the growth and changing requirements of the server appliance market;

. the performance, quality, price and total cost of ownership of our products;

. the availability, price, quality and performance of competing products and
technologies; and

. the successful development of our relationships with original equipment
manufacturer customers and existing and potential channel partners.

We may not succeed in developing and marketing new server appliance products,
and our operating results may decline as a result.

We are developing additional server appliance products that use the Linux
operating system, particularly for use by web hosting and application service
providers. Developing new products that meet the needs of web hosting and
application service providers requires significant additional expenses and
development resources. If we fail to successfully develop and market new
products, our operating results will decline.

We introduced our caching products in July 1998 and network attached storage
products in May 1999. To date, these products have accounted for only a limited
portion of our revenues. However, our future growth and profitability could be
affected by our ability to increase sales of our caching and network attached
storage products.

If we experience any increase in the length of our sales cycle, our quarterly
operating results could become more unpredictable and our stock price may
decline as a result.

We experience sales cycles ranging from three weeks to four months for our
products depending on the identity of the end user and whether the sale is
direct or indirect. If we experience any increase in the length of our sales
cycle, our quarterly operating results could become more unpredictable and our
stock price could decline as a result. Sales of our Cobalt Qube products are
generally limited to one unit per end user and do not involve a lengthy
evaluation cycle, if any. We rely heavily for sales of this product on indirect
selling, where our product is recommended by a reseller or distributor. If the
sales cycle for our Cobalt Qube products becomes longer, our revenues could
become less predictable. Our Cobalt RaQ and Cobalt Cache products are generally
sold to customers who evaluate the products before committing to purchase them.
In addition, for these products, a typical customer may purchase a small number
of units and then incrementally increase the size of the installation over time.
If customers were to implement enterprise-wide evaluation programs or purchase
products for the entire organization at once, our sales cycle could lengthen and
our revenues could be erratic from quarter to quarter.

If we cannot increase our sales volumes, reduce our costs or introduce higher
margin products to offset anticipated reductions in the average unit price of
our products, our operating results may suffer.

We have not experienced an overall decrease in the average selling prices of our
products. However, we anticipate that as products in the server appliance market
become more commoditized, the average unit price of our products may decrease in
the
<PAGE>

future. The average unit price of our products may also decrease in response to
changes in product mix, competitive pricing pressures, and new product
introductions by us or our competitors or other factors. If we are unable to
offset the anticipated decrease in our average selling prices by increasing our
sales volumes, our revenues will decline. Changes in the mix of our sales,
including the mix between higher margin Cobalt RaQ products and somewhat lower
margin Cobalt Qube products, could adversely affect our operating results for
future quarters. In addition, our margins could be affected if we invest
additional resources in our lower margin Cobalt NAS products. To maintain our
gross margins, we also must continue to reduce the manufacturing cost of our
products. Further, as average unit prices of our current products decline, we
must develop and introduce new products and product enhancements that sell at
higher margins.

Our business is dependent on the adoption of server appliances and a decrease in
their rate of adoption could cause the market price for our common stock to
decline.

We expect that substantially all of our revenues will continue to come from
sales of our server appliance products. As a result, we depend on the growing
use of server appliances to perform discrete tasks for corporate and internet-
based networks. If the role of server appliances does not increase as we
anticipate, or if it in any way decreases, our revenues would decline. We
believe that our expectations for the growth of the server appliance market may
not be fulfilled if customers continue to use general purpose servers. The role
of our server appliances could, for example, be limited if general purpose
servers become better at performing the functions currently being performed by
our server appliances or are offered at a lower cost. This could force us to
lower the prices of our products or result in fewer sales of our products. In
addition, if corporate information technology organizations do not accept Linux-
based operating systems, or if there is a wide acceptance of alternative
operating systems that provide enhanced capabilities, the market price of our
stock could decline due to our lower operating results or investors' assessment
that the growth potential for sales of our products is limited.

The server appliance market for web hosting and application service providers in
which we compete is new and unpredictable, and if this market does not develop
and expand as we anticipate, or if our clients are consolidated into larger
organizations which may not be as receptive to our products, our revenues may
not grow.

The market for server appliance products, particularly those for use primarily
by web hosting and application service providers-companies that provide
internet, intranet, extranet and application hosting services to others- has
only recently begun to develop and is evolving rapidly. Because this market is
new, we cannot predict its potential size or future growth rate. Our revenues
may not continue to grow and the market price for our common stock could decline
if the server appliance market does not grow rapidly over a number of years.

Small- to medium-sized organizations may not accept server appliances because
they are less likely to be early adopters of new technologies due to their need
for minimal service disruptions. As a result, we believe the rates of adoption
of server appliances for small- to medium-sized organizations are unpredictable.
Our success in generating net revenues in this emerging market will depend on,
among other things, our ability to:

. educate potential end users, original equipment manufacturers and channel
partners about the benefits of server appliances;

. establish and maintain relationships with leading original equipment
manufacturers and maintain and enhance our relationships with our other
channel partners; and

. predict and base our products on technology that ultimately becomes industry
standard.

Our Cobalt RaQ products are used primarily by web hosting and application
service providers. Recently, consolidation has begun to occur in the web hosting
and application service provider market, and many large web hosting and
application service providers are acquiring the smaller and the regional
companies. For example, NTT acquired Verio in 2000. Large web hosting and
application service providers that provide hosting services may not be as
receptive to our products because their buying programs are more likely to be
based on established, proprietary operating systems and general purpose servers.
In addition, we expect that internet service providers that specialize in
providing internet access and non-hosting services to consumers will not be
substantial purchasers of our products.

Because our products use Linux as their operating system, the failure of Linux
developers to enhance and develop the Linux kernel could impair our ability to
release major product upgrades and maintain market share.

We may not be able to release major upgrades of our Cobalt Qube, Cobalt RaQ,
Cobalt Cache and Cobalt NAS products on a timely basis because our products use
Linux as their operating system. The heart of Linux, the Linux kernel, is
maintained by third parties. Linus Torvalds, the original developer of the Linux
kernel, and a small group of independent engineers are primarily responsible for
the development and evolution of the Linux kernel. If this group of developers
fails to further develop the Linux kernel or if Mr. Torvalds or other prominent
Linux developers were to no longer work on the Linux kernel, we would have to
either rely on another party to further develop the kernel or develop it
ourselves. To date we have optimized our Linux-based
<PAGE>

operating system based on a version of Red Hat Linux, which we have licensed for
a nominal price. If we were unable to access Red Hat Linux, or Red Hat Linux
were to become substantially more expensive to obtain, we would be required to
spend additional time to obtain a tested, recognized version of the Linux kernel
from another source or develop our own operating system internally. We cannot
predict whether enhancements to the kernel would be available from reliable
alternative sources. We could be forced to rely to a greater extent on our own
development efforts, which would increase our development expenses and might
delay our product release and upgrade schedules. In addition, any failure on the
part of the kernel developers to further develop and enhance the kernel could
stifle the development of additional Linux-based applications for use with our
products.

We may not succeed if Linux fragments and application developers do not develop
software for our products.

Our products utilize a version of the Red Hat Linux operating system that we
have optimized for our server appliances. If Linux becomes a proprietary
operating system model, like UNIX or Windows NT, and our products do not use the
predominant Linux operating system, we may not be able to encourage third party
developers to write software applications for use with our products. If this
were to occur, our sales might be limited and our revenues could suffer.

We may be unable to manufacture the targeted volume of our products, or any
products at all, if our outside manufacturers are unable to meet our
manufacturing needs because we have no internal manufacturing capacity.

We rely on contract manufacturers to produce our products. In the future, we
anticipate that we may engage with additional contract manufacturing partners to
manufacture our products in higher volume and at lower costs. We may not find
outside manufacturers that will meet our needs. Additionally, qualifying a new
outside manufacturer and commencing volume production are expensive and time
consuming. If we are required or choose to change or add outside manufacturers,
we may lose sales and our customer relationships may suffer.

We may experience transitional problems if we switch outside manufacturers,
including delays and quality control issues that could cause us to lose sales
and impair our ability to achieve profitability.

Prior to August 1999, almost all of our products were manufactured by a single
manufacturer, which also provided supply chain management for our products'
components. We experienced problems in having our products manufactured by this
contractor in a timely fashion in part due to the increase in our volume
requirements. In response to these problems, in August 1999 we switched the
majority of our manufacturing to SMTC Corp. Although we believe that SMTC will
continue to support our manufacturing requirements, they are only obligated to
supply quantities based on our forecasts, and may cancel their manufacturing
obligations to us upon 90 days notice. If SMTC experiences delays, disruptions,
capacity constraints or quality control certain problems in its manufacturing
operations, product shipments to our customers could be delayed, which would
negatively impact our net revenues, competitive position and reputation.

In July 2000, we engaged with Solectron to provide additional manufacturing
capabilities. Any transition of existing products to Solectron, or introduction
of new products at Solectron, could possibly result in disruption of supply to
our customers.

We may experience production delays or disruptions if we relocate our
manufacturing to offshore facilities, which could result in lost revenues.

We anticipate that we may relocate some of our manufacturing operations to
offshore manufacturing facilities during 2001. We could experience difficulties
and disruptions in the manufacture of our products while we transition to an
off-shore facility. Manufacturing disruption could prevent us from achieving
timely delivery of products and could result in lost revenues.

Because we depend on sole source and limited source suppliers for key
components, we are susceptible to supply shortages that could prevent us from
shipping customer orders on time, if at all, and result in lost sales.

We depend upon single source suppliers for our industry standard processors and
power supplies and our custom printed circuit boards, chassis and sheet metal
parts. We also depend on limited sources to supply several other industry
standard components. We have in the past experienced and may in the future
experience shortages of, or difficulties in acquiring, these components. If we
are unable to buy these components, we will not be able to manufacture our
products on a timely basis or deliver our products to our customers.

Because we order components and materials based on rolling forecasts, we may
overestimate or underestimate our component and material requirements, which
could increase our costs or prevent us from meeting customer demand.

We use rolling forecasts based on anticipated product orders to determine our
component requirements. Lead times for materials and components that we order
vary significantly and depend on factors including specific supplier
requirements, contract terms and current market demand for those components. As
a result, our component requirement forecasts may not be accurate. If we
overestimate our component requirements, we may have excess inventory, which
would increase our costs. If we underestimate
<PAGE>

our component requirements, we may have inadequate inventory, which could
interrupt our manufacturing and delay delivery of our products to our customers.
Any of these occurrences would negatively impact our business and operating
results.

Because we rely on channel partners to sell a majority of our products, our
revenues could decline substantially if our existing channel partners do not
continue to purchase products from us.

We rely on our channel partners who are distributors, such as Ingram Micro and
Tech Data, resellers and system integrators to sell a majority of our products
in the United States. A substantial majority of our sales outside of the United
States are through other channel partners, and we rely on Nissho Electronics to
sell a majority of our products in Japan. Sales to distributors accounted for
39% of our net revenues in the three months ended September 29, 2000 and 85% of
our net revenues in the three months ended October 1, 1999. There has been a
decrease in our utilization of channel partners due to focused efforts by our
direct sales force. If we fail to sell our products through our existing
channel partners, we would experience a material decline in revenues. Even if we
are successful in selling our products through new channel partners, the rate of
growth of our net revenues could be materially and adversely affected if our
existing channel partners do not continue to sell a substantial number of our
products. We cannot be certain that we will be able to attract channel partners
that market our products effectively or provide timely and cost-effective
customer support and service. None of our current channel partners are obligated
to continue selling our products. We cannot be certain that any channel partner
will continue to represent our products or that our channel partners will devote
a sufficient amount of effort and resources to selling our products in their
territories.

We may incur significant costs to promote our brand that may not result in the
desired brand recognition by customers or increased sales.

We believe that we need a strong brand to compete successfully. In order to
attract and retain customers, we believe that our brand must be recognized and
viewed favorably by end user customers. Although we intend to advertise and
promote our brand, we cannot be certain that these strategies will be
successful. If we are unable to design and implement effective marketing
campaigns or otherwise fail to promote and maintain our brand, our sales could
decline. Our business may also suffer if we incur excessive expenses in an
attempt to promote and maintain our brand without a corresponding increase in
revenues.

We need to expand our direct and indirect sales channels, and if we fail to do
so, our growth could be limited.

In order to increase market awareness and sales of our products, we will need to
substantially expand our direct and indirect sales operations, both domestically
and internationally. If we fail in this endeavor, our growth will be limited. To
date, we have relied primarily on our direct sales force to generate demand for
our products by regional and national web hosting and application service
providers. Our products require a sophisticated sales effort targeted at our
prospective customers' information technology departments. We have recently
expanded our direct sales force and plan to hire additional sales personnel.
Competition for qualified sales people is intense, and we might not be able to
hire the quality and number of sales people we require.

Our expansion to international markets will result in higher personnel costs and
could reduce our operating margins due to the higher costs of international
sales.

We must expand the number of channel partners who sell our products or our
direct international sales presence to significantly increase our international
sales. We may incur higher personnel costs by hiring direct sales staff that may
not result in an increase in our revenues. We may not realize corresponding
increases in operating margins from increases in international sales, due to the
higher costs of these sales. Our sales outside of the United States represented
38% of our net revenues in the three months ended September 29, 2000 and 62% of
our net revenues in the three months ended October 1, 1999. To date, we have
relied primarily on international channel partners and have only recently begun
to employ direct sales staff outside of the United States. Even if we are able
to successfully expand our direct and indirect international selling efforts, we
cannot be certain that we will be able to create or increase international
market demand for our products.

If we are unable to expand our customer service and support organization, we may
not be able to retain our existing customers and attract new customers.

We currently have a small customer service and support organization and will
need to increase our staff to support new customers and the expanding needs of
our existing customers. If we are unable to expand our customer service and
support organization, we may not be able to retain our existing customers and
attract new customers. Hiring customer service and support personnel is very
competitive in our industry due to the limited number of people available with
the necessary technical skills and understanding of the Linux operating
environment.

We do not have a consulting staff, and our revenues may suffer if customers
demand extensive consulting or other support services.
<PAGE>

Our products are designed to require little or no support from us and to be
deployed quickly and easily by our customers. Many of our competitors offer
extensive consulting services in addition to server appliance products. If we
introduced a product that required extensive consulting services for
installation and use or if our customers wanted to purchase from a single vendor
a menu of items that included extensive consulting services, we would be
required to change our business model. We would be required to hire and train
consultants, outsource the consulting services or enter into a joint venture
with another company that could provide those services. If these events were to
occur, our future profits would likely suffer because customers would choose
another vendor or we would incur the added expense of hiring and retaining
consulting personnel.

We may not be able to effectively compete against providers of general purpose
servers or limited purpose servers as a result of their greater financial
resources and brand awareness.

In the market for server appliances, we face significant competition from larger
companies who market general purpose servers or limited purpose servers and have
greater financial resources and name recognition than we do. We believe that
Compaq, Dell, Gateway, Hewlett-Packard, IBM, Sun Microsystems, VA Linux or other
server manufacturers, each of which is also currently competing with us by
manufacturing and selling general purpose servers or limited purpose servers,
could also introduce server products that include the functionality that we
currently provide in our products at lower prices. If these vendors provide
lower cost server appliances that perform comparable functions to our products
coupled with the broader applications of their existing product lines, our
products could become obsolete. Even if the functionality of the standard
features of these products is equivalent to ours, we face a substantial risk
that a significant number of customers would elect to pay a premium for similar
functionality rather than purchase products from a less well-known vendor.

We may face competition in the future from established companies that have only
recently entered the server appliance market, such as Intel, Novell or Oracle or
from emerging software companies. Barriers to entry in the server appliance
market are relatively low. Increased competition may negatively affect our
business and future operating results by leading to price reductions, higher
selling expenses or a reduction in our market share.

Our revenues could be reduced if general purpose server manufacturers make
acquisitions in order to join their extensive distribution capabilities with our
smaller competitors' products.

Compaq, Dell, Gateway, Hewlett-Packard, IBM, Sun Microsystems, VA Linux, and
other server manufacturers may not only develop their own server appliance
solutions, but they may also acquire or establish cooperative relationships with
our other current competitors, including smaller private companies. Because
general purpose server manufacturers have significant financial and
organizational resources available, they may be able to quickly penetrate the
server appliance market by leveraging the technology and expertise of smaller
companies and utilizing their own extensive distribution channels. We expect
that the server appliance industry will continue to consolidate. For example,
Whistle Communications was acquired by IBM. It is possible that new competitors
or alliances among competitors may emerge and rapidly acquire significant market
share.

We may sell fewer products if other vendors' products are no longer compatible
with ours or other vendors bundle their products with those of our competitors
and sell them at lower prices.

Our ability to sell our products depends in part on the compatibility of our
products with other vendors' software and hardware products. Developers of these
products may change their products so that they will no longer be compatible
with our products. These other vendors may also decide to bundle their products
with other server appliances for promotional purposes and discount the sales
price of the bundle. If that were to happen, our business and future operating
results could suffer if we were no longer able to offer commercially viable
products. Server appliance products are subject to rapid technological change
due to changing operating system software and network hardware and software
configurations, and our products could be rendered obsolete by new technologies.

The server appliance market is characterized by rapid technological change,
frequent new product introductions and enhancements, uncertain product life
cycles, changes in customer demands and evolving industry standards. Our
products could be rendered obsolete if products based on new technologies are
introduced or new industry standards emerge. For example, sales of our products
may be limited if customers widely adopt Windows NT-based server appliances, and
our products, which do not currently operate on the Windows NT platform, fail to
provide comparable functionality.

Computer networks in which servers perform functions for other computers, such
as a personal computer on an employee's desk, are inherently complex. As a
result, we cannot accurately estimate the life cycles of our server appliance
products. New products and product enhancements can require long development and
testing periods, which requires us to hire and retain increasingly scarce,
technically competent personnel. Significant delays in new product releases or
significant problems in installing or implementing new products could seriously
damage our business. We have, on occasion, experienced delays in the scheduled
introduction of new and enhanced products and cannot be certain that we will
avoid similar delays in the future.
<PAGE>

Our future success depends upon our ability to enhance existing products,
develop and introduce new products, satisfy customer requirements and achieve
market acceptance. We cannot be certain that we will successfully identify new
product opportunities and develop and bring new products to market in a timely
and cost-effective manner.

We may not be able to preserve the value of our products' intellectual property
because we do not have any patents and other vendors could challenge our other
intellectual property rights.

Our products are differentiated from those of our competitors by our internally
developed technology that is incorporated into our products. If we fail to
protect our intellectual property, other vendors could sell products with
features similar to ours, and this could reduce demand for our products. We
protect our intellectual property through a combination of copyright, trade
secret and trademark laws. We have only recently commenced a patent program and
to date have only filed two patent applications. We generally enter into
confidentiality or license agreements with our employees, consultants and
corporate partners, and generally control access to our intellectual property
and the distribution of our server appliances, integrated software,
documentation and other proprietary information. We believe that such measures
afford only limited protection. Others may develop technologies that are similar
or superior to our technology or design around the copyrights and trade secrets
we own. Despite our efforts to protect our proprietary rights, unauthorized
parties may attempt to copy or otherwise obtain and use our products or
technology. Policing unauthorized use of our products is difficult, and we
cannot be certain that the steps we have taken will prevent misappropriation of
our technology, particularly in foreign countries where the laws may not protect
our proprietary rights as fully as those in the United States. Our means of
protecting our proprietary rights may be inadequate.

We have invested substantial resources in developing our products and our brand,
and our operating results would suffer if we were subject to a protracted
infringement claim or one with a significant damages award.

Substantial litigation regarding intellectual property rights and brand names
exists in our industry. We expect that server appliance products may be
increasingly subject to third-party infringement claims as the number of
competitors in our industry segment grows and the functionality of products in
different industry segments overlaps. We are not aware that our products employ
technology that infringes any proprietary rights of third parties. However,
third parties may claim that we infringe their intellectual property rights. Any
claims, with or without merit, could:

. be time consuming to defend;

. result in costly litigation;

. divert our management's attention and resources;

. cause product shipment delays; or

. require us to enter into royalty or licensing agreements.

These royalty or licensing agreements may not be available on terms acceptable
to us, if at all. A successful claim of product infringement against us or our
failure or inability to license the infringed or similar technology could
adversely affect our business because we would not be able to sell the impacted
product without redeveloping it or incurring significant additional expenses.

If we were named in an infringement suit in the future, we could be forced to
pay significant monetary damages, a royalty for continuing use of the
intellectual property or trademark or be barred from using certain technologies
or product names altogether. This could result in us losing brand equity.

Our recent growth has placed a significant strain on our management systems and
resources and we may be unable to effectively control our costs and implement
our business strategies as a result.

We continue to increase the scope of our operations and have grown our headcount
substantially. As of September 29, 2000 we had a total of 265 employees, and as
of October 1, 1999, we had a total of 127 employees. Our productivity and the
quality of our products may be adversely affected if we do not integrate and
train our new employees quickly and effectively. We also cannot be sure that our
revenues will continue to grow at a sufficient rate to absorb the costs
associated with a larger overall headcount, as well as recruiting- related
expenses.

This growth has placed, and we expect that any future growth we experience will
continue to place, a significant strain on our management, systems and
resources. To manage the anticipated growth of our operations, we may be
required to:

. improve existing and implement new operational, financial and management
information controls, reporting systems and procedures;
<PAGE>

. hire, train and manage additional qualified personnel; and

. establish relationships with additional suppliers and partners while
maintaining our existing relationships.

We conduct direct sales activities in Japan, the United Kingdom, Germany and the
Netherlands and indirect sales activities in Asia, elsewhere in Europe and
Latin America. Our international operations are subject to other inherent risks,
including:

. the impact of recessions in economies outside the United States;

. greater difficulty in accounts receivable collection and longer collection
periods;

. unexpected changes in regulatory requirements;

. difficulties and costs of staffing and managing foreign operations;

. reduced protection for intellectual property rights in some countries;

. potentially adverse tax consequences; and

. political and economic instability.

Acquisition related accounting charges will reduce our profits or increase our
net losses.

We may continue our expansion into complementary businesses through internal
growth as well as acquisitions. We expect that we will continue to incur
substantial expenses as we acquire other businesses including charges for the
write-off of in-process research and development. Our operating results have
fluctuated in the past and may fluctuate in the future because of the timing of
such write-offs. For example, we incurred a charge to operations in the nine
months ended September 29, 2000 of $830,000 for the write-off of in-process
research and development related to our acquisition of Chili!Soft and we will
experience ongoing charges related to that acquisition for amortization of
goodwill and intangibles currently amounting to approximately $6.6 million per
quarter.

Any acquisitions that we undertake could be difficult to integrate, disrupt our
business, dilute stockholder value or harm our operating results.

We may make investments in complementary businesses, products or technologies.
If we buy a company, we may have difficulty in assimilating that company's
personnel and operations. In addition, the key personnel of the acquired company
may decide not to work for us. If we make other types of acquisitions, we could
have difficulty in assimilating the acquired technology or products into our
operations. These difficulties could disrupt our ongoing business, distract our
management and employees and increase our expenses. We also expect that we would
incur substantial expenses if we acquired other businesses or technologies. Any
acquisition could result in our incurring additional debt, contingent
liabilities or amortization expenses related to goodwill and other intangible
assets, any of which could harm our profits. Furthermore, we may incur debt or
issue equity securities to pay for any future acquisitions. If we issue
additional equity securities, our stockholders could experience dilution.

We rely on the services of our founders and other key personnel, and those
persons' knowledge of our business and technical expertise would be difficult to
replace.

Our products and technologies are complex and we are substantially dependent
upon the continued service of our existing engineering personnel, and especially
Stephen DeWitt, our President and Chief Executive Officer, and Vivek Mehra, our
Chief Technology Officer and one of our founders. The loss of any of our key
employees could adversely affect our business and slow our product development
processes. Although we maintain key person life insurance policies on our key
employees, the amount of this insurance may be inadequate to compensate us for
their loss.

Errors in our products or the failure of our products to conform to
specifications could result in our customers demanding refunds from us or
asserting claims for damages against us.

Because our server appliance products are complex, they could contain errors or
bugs that can be detected at any point in a product's life cycle. In the past we
have discovered errors in some of our products and have experienced delays in
the shipment of our products during the period required to correct these errors.
These delays have principally related to new product releases. To date none of
these delays has materially affected our business. While we continually test our
products for errors and work with customers through our customer support
services to identify and correct bugs in our software and other product
problems, errors
<PAGE>

in our products may be found in the future. Although many of these errors may
prove to be immaterial, any of these errors could be significant. Detection of
any significant errors may result in:

. the loss of or delay in market acceptance and sales of our products;

. diversion of development resources;

. injury to our reputation; or

. increased maintenance and warranty costs.

These problems could harm our business and future operating results. Product
errors or delays could be material, including any product errors or delays
associated with the introduction of new products or the versions of our products
that support operating systems other than Linux. Occasionally, we have warranted
that our products will operate in accordance with specified customer
requirements. If our products fail to conform to these specifications, customers
could demand a refund for the purchase price or assert claims for damages.

Moreover, because our products are used in connection with critical distributed
computing systems services, we may receive significant liability claims if our
products do not work properly. Our agreements with customers typically contain
provisions intended to limit our exposure to liability claims. However, these
limitations may not preclude all potential claims. Liability claims could
require us to spend significant time and money in litigation or to pay
significant damages. Any such claims, whether or not successful, could seriously
damage our reputation and our business.

Our stock has been and will likely continue to be subject to substantial price
and volume fluctuations due to a number of factors, many of which will be beyond
our control, which may prevent our stockholders from reselling our common stock
at a profit.

The securities markets have experienced significant price and volume
fluctuations in the past and the market prices of the securities of technology
companies have been especially volatile. This market volatility, as well as
general economic, market or political conditions, could reduce the market price
of our common stock in spite of our operating performance. In addition, our
operating results could be below the expectations of public market analysts and
investors, and in response the market price of our common stock could decrease
significantly. The market price of our common stock ranged from a low of $22 to
a high of $172 during the period from November 5, 1999 to September 29, 2000.
Investors may be unable to resell their shares of our common stock for a profit.
In the past, companies that have experienced volatility in the market price of
their stock have been the object of securities class action litigation. If we
were the object of securities class action litigation, it could result in
substantial costs and a diversion of management's attention and resources.

The provisions of our charter documents may inhibit potential acquisition bids
that a stockholder may believe are desirable, and the market price of our common
stock may be reduced as a result.

Our board of directors has the authority to issue up to 10,000,000 shares of
preferred stock at any time. The board of directors can fix the price, rights,
preferences, privileges and restrictions of the preferred stock without any
further vote or action by our stockholders. The issuance of shares of preferred
stock may delay or prevent a change in control transaction. As a result, the
market price of our common stock and the voting and other rights of our
stockholders may be adversely affected. The issuance of preferred stock may
result in the loss of voting control to other stockholders. We have no current
plans to issue any shares of preferred stock.

Our charter documents contain anti-takeover devices including:

. the election of only one of the three classes of directors each year;

. the limitation of the ability of our stockholders to remove directors without
cause;

. the elimination of the right of stockholders to act by written consent;

. the elimination of the right of stockholders to call a special meeting of
stockholders; and

. a requirement of advance notice to nominate directors or submit proposals for
consideration at stockholder meetings.

These provisions could discourage potential acquisition proposals and could
delay or prevent a change in control transaction. They could also have the
effect of discouraging others from making tender offers for our common stock. As
a result, these provisions may prevent the market price of our common stock from
increasing substantially in response to actual or rumored takeover attempts.
These provisions may also prevent changes in our management.
<PAGE>

Delaware law may inhibit potential acquisition bids; this may adversely affect
the market price of our common stock, discourage merger offers and prevent
changes in our management.

Section 203 of the Delaware General Corporation Law may inhibit potential
acquisition bids for our company. We are subject to the antitakeover provision
of the Delaware General Corporation Law, which regulates corporate acquisitions.
Under Delaware law, a corporation may opt out of the antitakeover provisions. We
have not and do not intend to opt out of the antitakeover provisions of Delaware
Law.

Item 3. Quantitative and Qualitative Disclosures About Market Risk

We do not engage in any foreign currency hedging transactions and therefore, do
not believe we are subject to exchange rate risk. Our exposure to market risk
for changes in interest rates relates primarily to our cash and cash
equivalents. We are subject to fluctuating interest rates that may impact,
adversely or otherwise, our results of operations or cash flows for our cash and
cash equivalents.

As of September 29, 2000, we had short-term investments of $76.8 million. These
short-term investments consist of highly liquid investments with original
maturities at the date of purchase between three and nine months. These
investments are subject to interest rate risk and will decrease in value if
market interest rates increase. An immediate 10% change in interest rates would
be immaterial to our financial condition or results of operations. Because we
have the ability to hold these investments until maturity we would not expect
any significant decline in value of our investments caused by market interest
rate changes. Declines in interest rates over time will, however, reduce our
interest income.
<PAGE>

PART II--OTHER INFORMATION

Item 1. Legal Proceedings.

In June 2000, the Company filed suit against NetMachines, Inc., in the U.S.
District Court for the Northern District of California, claiming that the use of
the name RedRak for its server products constitutes trademark infringement of
the Company's registered RaQ trademark for computer hardware products, which
includes servers. The Company intends to pursue this matter vigorously but is
unable to provide an evaluation of the probability of a favorable outcome or
unfavorable outcome. The Company believes, based on currently available
information, the resolution of this matter will not have a material effect on
its financial position, results of operations or cash flows.

Item 2. Changes in Securities and Use of Proceeds.

With respect to the requirements of Item 701(f) of Regulation S-K regarding the
reporting of use of proceeds, pursuant to the information required to be
reported by Item 701(f)(4)(viii), Cobalt used net proceeds in the amounts noted
for the stated purposes since its December 31, 1999 Annual Report on Form 10-K:
purchase and installation of machinery and equipment--$1,913,000 and working
capital--$96.1 million.

Item 6. Exhibits and Reports on Form 8-k.

(a) Exhibits:

27.1 Financial Data Schedule.

(b) Reports on Form 8-K. We filed the following current reports on Form 8-K
during the three months ended September 29, 2000:

. Form 8-K/A dated as of August 7, 2000 regarding our acquisition of
Chili!Soft, Inc.

. Form 8-K dated as of September 20, 2000 regarding the execution of a
definitive agreement and plan of reorganization with Sun Microsystems, Inc.

. Form 8-K dated as of September 29, 2000 for the purpose of filing certain
forms of agreement and the agreement and plan of reorganization dated
September 18, 2000 with Sun Microsystems, Inc.
<PAGE>

SIGNATURES

Pursuant to the requirements of the Securities Exchange Act of 1934, as amended,
the Registrant has duly caused this report to be signed on its behalf by the
undersigned, thereunto duly authorized.

Cobalt Networks, Inc.

Date November 13, 2000

/s/ Stephen W. DeWitt
-----------------------------------------
Stephen W. DeWitt
President and Chief Executive
Officer
(Principal Executive Officer)

/s/ Kenton D. Chow
-----------------------------------------
Kenton D. Chow
Vice President of Finance and
Chief Financial Officer
(Principal Financial and
Accounting Officer)