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

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

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<PAGE> 1

SECURITIES AND EXCHANGE COMMISSION
WASHINGTON, D.C. 20549

FORM 10-Q

(MARK ONE)

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

FOR THE QUARTERLY PERIOD ENDED SEPTEMBER 30, 2000

[ ] TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITITIES
EXCHANGE ACT OF 19343

FOR THE TRANSITION PERIOD FROM _________ TO _________

COMMISSION FILE NUMBER: 000-26541

GADZOOX NETWORKS, INC.
(EXACT NAME OF REGISTRANT AS SPECIFIED IN ITS CHARTER)

<TABLE>
<S> <C>
DELAWARE 77-0308899
(STATE OR OTHER JURISDICTION (I.R.S. EMPLOYER
OF INCORPORATION OR ORGANIZATION) IDENTIFICATION NO.)
</TABLE>

5850 HELLYER AVENUE
SAN JOSE, CA 95138
(408) 360-4950
(ADDRESS, INCLUDING ZIP CODE, OR REGISTRANT'S
PRINCIPAL EXECUTIVE OFFICES AND TELEPHONE
NUMBER, INCLUDING AREA CODE)

Indicate by check mark whether the Registrant (1) has filed all reports required
to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during
the preceding 12 months (or for such shorter period that the Registrant was
required to file such reports), and (2) has been subject to such filing
requirements for the past 90 days.

Yes [X] No [ ]

The number of shares outstanding of the Registrant's Common Stock on September
30, 2000 was 27,978,590 shares.

Page 1 of 37 pages.

<PAGE> 2

GADZOOX NETWORKS, INC.

FORM 10-Q
QUARTER ENDED SEPTEMBER 30, 2000

INDEX

<TABLE>
<CAPTION>
Page
----
<S> <C> <C>
PART I - FINANCIAL INFORMATION

Item 1. Financial Statements

Condensed Balance Sheets as of September 30, 2000 and March 31, 2000

Condensed Statements of Operations for the Three Months and Six
Months Ended September 30, 2000 and 1999

Condensed Statements of Cash Flows for the Six Months Ended
September 30, 2000 and 1999

Notes to Condensed Financial Statements

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

Item 3. Quantitative and Qualitative Disclosures About Market Risks

PART II - OTHER INFORMATION

Item 1. Legal Proceedings

Item 2. Changes in Securities and Use of Proceeds

Item 3. Defaults Upon Senior Securities

Item 4. Submission of Matters to a Vote of Security Holders

Item 5. Other Information

Item 6. Exhibits and Reports on Form 8-K
</TABLE>

SIGNATURES

THIS FORM 10-Q contains forward-looking statements that relate to future
events or our future performance such as future product development and
deployment including development and deployment of the Geminix router, the
Axxess Network Storage Pool product, a fibre channel fabric backbone switch and
other future products, prospects for profitability, percentage of revenues
derived from products, our investment in research and development, sales and
marketing and general and administrative activities and the evolution of SAN
capabilities and the market for SAN products. In certain cases you can identify
forward-looking statements by terminology such as "may," "will," "should,"
"expects," "plans," "anticipates," "believes," "estimates," "predicts,"
"intends," "potential" or "continue" or the negative of such terms or other
comparable terminology. Our actual results could differ materially from those

Page 2 of 37 pages.

<PAGE> 3

anticipated in these forward-looking statements as a result of various factors,
including but not limited to market acceptance of our new products and the speed
at which customers adopt current and new products for SANs; the ability and
willingness of our distribution channel partners to sell our products; growth
rates of the market segment within which we participate; our ability to develop,
introduce, ship and support new products; our ability to meet future capital
requirements; competition in our industry and the timing of new technology and
product introductions and the ability to retain and hire skilled personnel. We
assume no obligation to update any such forward-looking statements.

Page 3 of 37 pages.

<PAGE> 4

PART I - FINANCIAL INFORMATION

ITEM 1. FINANCIAL STATEMENTS

GADZOOX NETWORKS, INC.

CONDENSED BALANCE SHEETS
(IN THOUSANDS)

<TABLE>
<CAPTION>
September 30, March 31,
2000 2000
------------- ---------
(unaudited)
<S> <C> <C>
ASSETS
Current assets:
Cash and cash equivalents .................... $ 10,775 $ 42,830
Short-term investments ....................... 30,695 30,619
Accounts receivable, net ..................... 7,225 14,131
Inventories .................................. 9,034 6,665
Prepaid expenses and other current assets .... 2,933 2,464
-------- --------
Total current assets ................... 60,662 96,709
Property and equipment, net ..................... 7,551 6,495
Goodwill ........................................ 18,869 --
Other assets .................................... 1,517 292
-------- --------
$ 88,598 $103,496
======== ========

LIABILITIES AND STOCKHOLDERS' EQUITY
Current liabilities:
Current portion of note payable ............... $ 33 $ 3,248
Current portion of capital lease obligations .. 1,257 1,545
Accounts payable .............................. 6,202 7,079
Compensation related accruals ................. 1,625 1,534
Other accrued liabilities ..................... 4,569 2,008
-------- --------
Total current liabilities .............. 13,686 15,414
Capital lease obligations, net of current portion 767 1,292
-------- --------
Total liabilities ...................... 14,453 16,706
-------- --------

Stockholders' equity:
Common stock .................................. 139 134
Additional paid-in capital .................... 152,300 127,251
Deferred compensation ......................... (780) (1,140)
Accumulated deficit ........................... (77,514) (39,455)
-------- --------
Total stockholders' equity ............. 74,145 86,790
-------- --------
$ 88,598 $103,496
======== ========
</TABLE>

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

Page 4 of 37 pages.

<PAGE> 5

GADZOOX NETWORKS, INC.

CONDENSED STATEMENTS OF OPERATIONS
(IN THOUSANDS, EXCEPT PER SHARE DATA)
(UNAUDITED)

<TABLE>
<CAPTION>
Three Months Ended Six Months Ended
----------------------- -----------------------
Sept. 30, Sept. 30, Sept. 30, Sept. 30,
2000 1999 2000 1999
-------- -------- -------- --------
<S> <C> <C> <C> <C>
Net revenues ................................. $ 7,219 $ 11,081 $ 16,221 $ 20,292
Cost of revenues ............................. 13,616 6,325 18,839 11,740
-------- -------- -------- --------
Gross margin ............................... (6,397) 4,756 (2,618) 8,552
-------- -------- -------- --------

Operating expenses:
Research and development ................... 8,641 4,540 14,160 8,458
Sales and marketing ........................ 5,989 1,914 11,715 3,802
General and administrative ................. 2,344 866 3,829 1,629
In-process research & development .......... -- -- 4,900 --
Amortization of goodwill & intangible assets 1,048 -- 2,096 --
Amortization of deferred compensation ...... 169 321 337 643
-------- -------- -------- --------
Total operating expenses ................. 18,191 7,641 37,037 14,532
-------- -------- -------- --------
Loss from operations ......................... (24,588) (2,885) (39,655) (5,980)

Total other income, net ...................... 710 936 1,595 795
-------- -------- -------- --------

Net loss ..................................... $(23,878) $ (1,949) $(38,060) $ (5,185)
======== ======== ======== ========

Basic net loss per share ..................... $ (0.86) $ (0.09) $ (1.38) $ (0.39)
======== ======== ======== ========

Weighted average shares used in computing
basic net loss per share.................... 27,782 21,199 27,608 13,455
======== ======== ======== ========

Pro forma basic net loss per share ........... $ (0.86) $ (0.08) $ (1.38) $ (0.24)
======== ======== ======== ========

Weighted average shares used in computing
pro forma basic net loss per share ......... 27,782 24,222 27,608 21,891
======== ======== ======== ========
</TABLE>

The condensed notes are an integral part
to these condensed financial statements.

Page 5 of 37 pages.

<PAGE> 6

GADZOOX NETWORKS, INC.

CONDENSED STATEMENTS OF CASH FLOWS
(IN THOUSANDS)
(UNAUDITED)

<TABLE>
<CAPTION>
Six Months Ended
September 30,
-----------------------
2000 1999
-------- --------
<S> <C> <C>
Cash Flows from Operating Activities:
Net loss ............................................. $(38,060) $ (5,185)
Adjustments to reconcile net loss to
net cash used in operating activities:
Depreciation and amortization ...................... 1,623 1,169
Amortization of goodwill ........................... 2,096 --
In-process research & development .................. 4,900 --
Amortization of deferred compensation .............. 337 643
Accelerated vesting of stock options ............... 293 --
Inventory reserves ................................. 6,732 --
Accrued interest ................................... 27 319
Changes in operating assets and liabilities;
net of assets acquired:
Accounts receivable .............................. 6,906 (2,836)
Inventories ...................................... (9,101) 585
Prepaid expenses and other assets ................ (675) (364)
Accounts payable and other accrued liabilities ... 914 (18)
-------- --------
Net cash used in operating activities .......... (24,008) (5,687)
-------- --------

Cash Flows from Investing Activities:
Purchases of property and equipment .................. (2,595) (654)
Purchases of investments ............................. (1,000) --
Net cash used in the acquisition of SmartSAN,
net of cash acquired .............................. (1,167) --
Purchase of available for sale investments ........... (76) (47,793)
-------- --------
Net cash used for investing activities ......... (4,838) (48,477)
-------- --------

Cash Flows from Financing Activities:
Payments on note payable ............................. (3,555) (182)
Payments on capital lease obligations ................ (813) (570)
Proceeds from issuance of common stock to employees... 1,159 392
Proceeds from issuance of common stock in the
initial public offering ............................ -- 84,525
Offering costs relating to the issuance of
common stock ....................................... -- (7,030)
-------- --------
Net cash used for financing activities ........ (3,209) 77,135
-------- --------
Net decrease in cash and cash equivalents .............. (32,055) 23,001
Cash and cash equivalents at beginning of period ....... 42,830 12,202
-------- --------
Cash and cash equivalents at end of period ............. $ 10,775 $ 35,203
======== ========

Supplemental Cash Flow Information:
Cash paid for interest ................................. $ 157 $ 118
======== ========
Property and equipment acquired under capital
lease obligations ................................... $ -- $ 676
======== ========
Partial conversion of convertible note to
common stock ........................................ $ -- $ 9,617
======== ========
Conversion of convertible preferred stock into
common stock ........................................ $ -- $ 34,129
======== ========
</TABLE>

The condensed notes are an integral part
to these condensed financial statements.

Page 6 of 37 pages.

<PAGE> 7

GADZOOX NETWORKS, INC.

NOTES TO CONDENSED FINANCIAL STATEMENTS
(Information for the three and six months ended
September 30, 2000 is unaudited)

1. BASIS OF PRESENTATION

The condensed financial statements included herein have been prepared by
Gadzoox Networks, Inc. ("Gadzoox") without audit, pursuant to the rules and
regulations of the Securities and Exchange Commission. Certain information and
footnote disclosures normally included in financial statements prepared in
accordance with generally accepted accounting principles have been condensed or
omitted pursuant to such rules and regulations. In the opinion of management,
the disclosures are adequate to make the information not misleading. The
condensed balance sheet as of March 31, 2000 has been derived from the audited
financial statements as of that date, but does not include all disclosures
required by generally accepted accounting principles. These financial statements
and notes should be read in conjunction with the audited financial statements
and notes thereto, included in Gadzoox' Annual Report on Form 10-K for the
fiscal year ended March 31, 2000, filed with the Securities and Exchange
Commission on June 29, 2000, and as amended on July 31, 2000.

In the opinion of management, the unaudited condensed financial statements
reflect all adjustments, consisting only of normal recurring adjustments,
necessary for a fair presentation of financial position, results of operations
and cash flows for the periods indicated. The results of operations for the
three and six months ended September 30, 2000, are not necessarily indicative of
the results that may be expected for future quarters or the fiscal year ending
March 31, 2001.

2. ACQUISITION OF SMARTSAN SYSTEMS, INC.

On April 5, 2000, in an acquisition accounted for under the purchase method
of accounting, Gadzoox acquired all of the outstanding shares of SmartSAN
Systems, Inc., a California corporation ("SmartSAN"). Gadzoox acquired SmartSAN
by issuing 239,433 shares of its common stock in exchange for 100% of the
outstanding stock of SmartSAN and has agreed to issue 108,376 additional shares
pursuant to the exercise of SmartSAN stock options outstanding at the time of
the acquisition. Total consideration was as follows:

<TABLE>
<S> <C>
Value of stock issued and options assumed $ 23,625,000
Merger and other related costs paid in cash 1,169,000
------------
Total consideration $ 24,794,000
============
</TABLE>

The allocation of the total consideration to the fair value of acquired
assets and liabilities is as follows:

<TABLE>
<S> <C>
Fair value of net assets acquired and liabilities assumed $ (1,071,000)
Goodwill 20,965,000
In-process research and development 4,900,000
------------
$ 24,794,000
============
</TABLE>

At the time of the acquisition, Gadzoox expensed approximately $4,900,000
of purchased in-process research and development costs. Other purchased
intangible assets, including goodwill, developed technology and other intangible
assets of approximately $20,965,000 are being amortized over their estimated
useful lives of five years on a straight-line basis. For the quarter ended and
six months ended

Page 7 of 37 pages.

<PAGE> 8

September 30, 2000, Gadzoox amortized approximately $1,048,000 and $2,096,000 of
goodwill and intangible assets, respectively.

The $4,900,000 expensed as in-process research and development costs
represented approximately 20% of the purchase price and was attributed and
supported by an analysis that identified revenue and costs on a
project-by-project basis. The value assigned to purchased in-process technology,
based on a discounted cash flow method, was determined by identifying research
projects in areas for which technological feasibility has not been established.
As of the acquisition date, in-process projects consisted of the Geminix router
and two other router products. The value of in-process research and development
was determined by estimating the costs to develop the purchased in-process
technology into commercially viable products, estimating the resulting net cash
flows from such projects and discounting the net cash flows back to their
present value. The discount rate includes a risk-adjusted discount rate to take
into account the uncertainty surrounding the successful development of the
purchased in-process technology and the completeness of each product at the time
of the acquisition. The discount rate used was 35%. The percentage complete
calculations for all products were estimated based on research and development
expenses incurred to date and management's estimates of remaining development
costs, which do not differ materially from historical amounts. At the date of
acquisition, the Geminix router and two other products under development at the
time of the acquisition were determined to be 80%, 65% and 25% complete,
respectively.

3. NET LOSS PER SHARE

Basic and diluted net loss per share are presented in conformity with
Statement of Financial Accounting Standards No. 128, "Earnings Per Share,"
("SFAS No. 128") for all periods presented. In accordance with the Securities
and Exchange Commission Staff Accounting Bulletin No. 98, common stock and
convertible preferred stock issued or granted for nominal consideration prior to
the anticipated effective date of an initial public offering must be included in
the calculation of basic and diluted net loss per share as if such stock has
been outstanding for all periods presented. To date, Gadzoox has not had any
issuances or grants for nominal consideration.

In accordance with SFAS No. 128, basic net loss per share has been computed
using the weighted-average number of shares of common stock outstanding during
the period, less shares subject to repurchase. Pro forma basic net loss per
share has been computed as described above and assuming the conversion of
convertible preferred stock into an equivalent number of common shares, as if
the shares had converted on the dates of their issuance.

Page 8 of 37 pages.

<PAGE> 9

The following table presents the calculation of basic and pro forma basic
net loss per share (in thousands, except per share data):

<TABLE>
<CAPTION>
Three Months Ended Six Months Ended
----------------------- -----------------------
Sept. 30, Sept. 30, Sept. 30, Sept. 30,
2000 1999 2000 1999
-------- -------- -------- --------
(unaudited) (unaudited)
<S> <C> <C> <C> <C>
Net loss ............................... $(23,878) $ (1,949) $(38,060) $ (5,185)
======== ======== ======== ========
Basic:
Weighted average shares of common stock
outstanding .......................... 27,782 21,434 27,608 13,740
Less: Weighted average shares of common
stock subject to repurchase .......... -- (235) -- (285)
-------- -------- -------- --------
Weighted average shares used in
computing basic net loss per share ... 27,782 21,199 27,608 13,455
======== ======== ======== ========

Basic net loss per share ............... $ (0.86) $ (0.09) $ (1.38) $ (0.39)
======== ======== ======== ========

Pro forma:
Net loss ............................... $(23,878) $ (1,949) $(38,060) $ (5,185)
======== ======== ======== ========

Shares used above ...................... 27,782 21,199 27,608 13,455
Pro forma adjustment to reflect weighted
average effect of assumed conversion
of convertible preferred stock ....... -- 3,023 -- 8,436
-------- -------- -------- --------
Weighted average shares used in
computing pro forma basic net
loss per shares ...................... 27,782 24,222 27,608 21,891
======== ======== ======== ========

Pro forma basic net loss per share ..... $ (0.86) $ (0.08) $ (1.38) $ (0.24)
======== ======== ======== ========
</TABLE>

4. CASH AND CASH EQUIVALENTS AND SHORT-TERM INVESTMENTS

All highly liquid investment securities with original maturities of three
months or less are considered cash equivalents. Available for sale investments
not intended to be held to maturity with original maturities of more than three
months are considered short-term investments. Management determines the
appropriate classification of investments in debt and equity securities at the
time of purchase. All of Gadzoox' investments are classified as available for
sale. At September 30, 2000, Gadzoox held $10.8 and $30.7 million in cash and
cash equivalents and short-term investments, respectively. All investments are
stated at fair market value.

Page 9 of 37 pages.

<PAGE> 10

5. INVENTORIES

Inventories are stated at the lower of cost or market, on a first in, first
out method. Inventories consist of the following (in thousands):

<TABLE>
<CAPTION>
September 30, March 31,
2000 2000
------------- ---------
(unaudited)
<S> <C> <C>
Raw materials .......... $5,455 $3,582
Work-in-progress ....... 606 58
Finished Goods ......... 2,973 3,025
------ ------
$9,034 $6,665
====== ======
</TABLE>

6. CONVERTIBLE NOTE

In September 1998, Gadzoox entered into a $15,000,000 convertible note
purchase agreement (the "Agreement") with Seagate Technology, Inc. ("Seagate").
The Agreement provides that Seagate purchase up to $15.0 million of convertible
subordinated promissory notes (the "Convertible Notes"), bearing simple interest
on the unpaid principal balance at a rate equal to 5.75% per annum with
principal and interest maturing September 2001. At the sole option of the
Company, the Company may require that any portion or all of the outstanding
balance of principal and interest on the Convertible Note converts into shares
of Series G preferred stock at a price of $7.65 per share. Accrued interest is
converted prior to any principal owing under the Convertible Note. In the event
of a default, as defined in the Agreement, Seagate may declare all outstanding
interest and principal immediately due and payable in cash. Gadzoox may, upon 30
days written notice to Seagate, prepay the Convertible Note in whole or in part.

For the period from October 1998 through June 30, 2000, a total $12.8
million of principal and accrued interest was converted into 1,668,722 shares of
common stock in three separate transactions.

On July 31, 2000, the Company repaid, in full, the outstanding principal
and accrued interest under the loan of approximately $3.1 million in cash. As a
result of the repayment, the Company reclassified the amount of the convertible
note at March 31, 2000, of $3.1 million from long-term liabilities to short-term
liabilities.

7. LEGAL PROCEEDINGS

From time to time, Gadzoox may become involved in various lawsuits and
legal proceedings which arise in the ordinary course of business. In May 1999, a
former employee filed a complaint against Gadzoox and in September 2000 the
plaintiff and Gadzoox settled this lawsuit out of court. This settlement did not
have a material adverse affect on Gadzoox' financial condition or results of
operations during the three months ended September 30, 2000. Litigation is
subject to inherent uncertainties, and an adverse result in other matters could
arise from time to time that may harm Gadzoox' business and financial condition
and results of operations.

8. COMMON STOCK

Page 10 of 37 pages.

<PAGE> 11

1999 EMPLOYEE STOCK PURCHASE PLAN

In May 1999, the Board of Directors approved the adoption of Gadzoox' 1999
Employee Stock Purchase Plan (the "Stock Purchase Plan"). The stockholders
approved the Stock Purchase Plan on June 19, 1999. A total of 150,000 shares of
common stock were initially reserved for issuance under the Stock Purchase Plan.
The number of shares reserved for issuance under the Stock Purchase Plan are
subject to annual increases to be added on the first day of Gadzoox' fiscal
year, beginning in 2000, and equal to the lesser of (a) 250,000 shares, (b) 0.5%
of the outstanding shares on such date, or (c) a lesser amount determined by the
Board of Directors. Accordingly, in April 2000, an additional 250,000 shares of
Common Stock were automatically reserved for issuance under the Stock Purchase
Plan. The Stock Purchase Plan allows eligible employees to purchase shares of
common stock through payroll deductions at 85% of the fair market value of the
common stock. As of September 30, 2000, 93,562 shares had been purchased from
the Stock Purchase Plan.

1993 STOCK OPTION PLAN

In May 1999, the Board of Directors approved and adopted an Amended and
Restated 1993 Stock Option Plan (the "Amended Plan"). The Amended Plan was
approved by the stockholders on June 19, 1999 and was effective upon the closing
of Gadzoox' initial public offering on July 20, 1999. Under the Amended Plan,
the number of shares authorized for issuance increased to 8,180,000. The number
of shares reserved for issuance under the Amended Plan is subject to annual
increases to be added on the first day of Gadzoox' fiscal year, and equal to the
lesser of (a) 1,500,000 shares, (b) 1% of the outstanding shares on such date,
or (c) a lesser amount determined by the Board of Directors. Accordingly, in
April 2000, an additional 1,342,092 shares of Common Stock were automatically
reserved for issuance under the Amended Plan. In April 2000, the Board of
Directors authorized an increase in the number of shares reserved for issuance
under the Amended Plan by 1,400,000 shares and in October 2000, the stockholders
of the Company approved this increase.

1999 DIRECTOR STOCK OPTION PLAN

In May 1999, the Board of Directors approved the adoption of the 1999
Director Stock Option Plan (the "Director Plan"). The stockholders approved the
Director Plan on June 19, 1999. The Director Plan provides for the automatic
grant of 5,000 shares of common stock to each non-employee director on the later
of the date of adoption of the Director Plan or the date on which such person
first becomes a director (the "Initial Grant"). After the Initial Grant, the
non-employee director will receive automatic annual grants of 2,500 shares of
common stock. All shares granted under the Director Plan are 100% vested at the
grant date and expire upon the earlier of three years or the resignation of the
director from the Board of Directors. A total of 50,000 shares of common stock
were initially reserved for issuance under the Director Plan. The number of
shares reserved for issuance under the Director Plan is subject to annual
increases, sufficient to bring the number of shares available for future
issuance to 50,000 shares. Accordingly, in April 2000, an additional 25,000
shares of Common Stock were automatically reserved for issuance under the
Director Plan. As of September 30, 2000, options to acquire 33,020 shares of
common stock were outstanding under the Director Plan.

2000 NONSTATUTORY STOCK OPTION PLAN

In June 2000, the Board of Directors approved the adoption of the 2000
Nonstatutory Stock Option Plan (the "NSO Plan"). The number of shares reserved
for issuance under this Plan was 1,600,000. The NSO Plan is designed to issue
stock option grants to only non-officer employees. Options shall vest at a rate
of 1/48th each month for existing employees, subject to the optionee's continued
employment with the Company, and for new employees 1/4th shall vest on the first
anniversary date of the grant with the

Page 11 of 37 pages.

<PAGE> 12

remainder vesting ratably at 1/48th per month. In August 2000, an additional
700,000 shares of Common stock were reserved under the Nonstatutory Stock Option
Plan.

9. BUSINESS SEGMENTS

During the year ended March 31, 2000, Gadzoox adopted Statement of
Financial Accounting Standards No. 131 "Disclosures About Segments of an
Enterprise and Related Information ("SFAS No. 131") which requires a new basis
of determining reportable business segments, i.e., the management approach. This
approach requires that business segment information used by management to assess
performance and manage company resources be the source for information
disclosure. On this basis, Gadzoox is organized and operates as one business
segment, the development, manufacture, marketing and sales of hubs, switches,
routers and managed storage systems for storage area networks.

10. FACILITY LEASE AGREEMENTS

In May 2000, Gadzoox entered into a facility lease agreement with its
current facility lessor to lease an additional 73,000 square feet in a building
to be erected next to its current headquarter facilities. The triple-net lease
expires on November 30, 2005 and provides for an initial monthly square foot
rental rate of $2.00. In addition, the Board of Directors authorized the
issuance of warrants to the lessor to purchase 50,000 shares of common stock at
$26.375 per share.

In June 2000, Gadzoox entered into an eighteen-month facility lease of
approximately 7,800 square feet in a neighboring facility. The monthly full
service lease provides for monthly square foot rental rate of $3.75.

11. EQUITY INVESTMENT IN STRATEGIC PARTNER

In May 2000, Gadzoox purchased 49,164 shares of Series C Preferred Stock of
DataCore Software Corporation, a privately held strategic partner, at $20.34 per
share for a total investment of approximately $1.0 million.

Page 12 of 37 pages.

<PAGE> 13

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

The following information should be read in conjunction with the condensed
interim financial statements and the notes thereto included in Item 1 of this
Quarterly Report and with Management's Discussion and Analysis of Financial
Condition and Results of Operations contained in Gadzoox' Annual Report on Form
10-K filed with the Securities and Exchange Commission on June 29, 2000, and as
amended on July 31, 2000.

FORWARD-LOOKING INFORMATION IS SUBJECT TO RISK AND UNCERTAINTY

This discussion contains forward-looking statements that relate to future
events or our future performance such as future product development and
deployment including development and deployment of the Geminix router, the
Axxess Network Storage Pool product, a fibre channel fabric backbone switch and
other future products, prospects for profitability, percentage of revenues
derived from products, our investment in research and development, sales and
marketing and general and administrative activities and the evolution of SAN
capabilities and the market for SAN products. In certain cases you can identify
forward-looking statements by terminology such as "may," "will," "should,"
"expects," "plans," "anticipates," "believes," "estimates," "predicts,"
"intends," "potential" or "continue" or the negative of such terms or other
comparable terminology. Our actual results could differ materially from those
anticipated in these forward-looking statements as a result of various factors,
including but not limited to market acceptance of our new products and the speed
at which customers adopt current and new products for SANs; the ability and
willingness of our distribution channel partners to sell our products; growth
rates of the market segment within which we participate; our ability to develop,
introduce, ship and support new products; our ability to meet future capital
requirements; competition in our industry and the timing of new technology and
product introductions and the ability to retain and hire skilled personnel. We
assume no obligation to update any such forward-looking statements.

COMPANY OVERVIEW

We are a leading provider of hardware and software products for storage
area networks, or "SANs". Our SAN hub, switch, router and network storage pool
products are designed to leverage the capabilities of fibre channel technology
to enable companies to better manage the growth in mission-critical data by
overcoming the limitation of traditional captive storage architecture. We sell
our SAN products primarily through leading original equipment manufacturers
("OEMs"), including Hewlett-Packard Company, Compaq Computer Corporation and
Data General Corporation. We also sell our products through distribution channel
partners.

We were founded in April 1992 and initially developed electronic test
equipment. Since October 1995, we have focused on developing fibre channel
network products that address the needs of the SAN market. In fiscal 1997, we
sold our patent rights to the electronic test equipment. Prior to fiscal 1998,
our operating activities related primarily to increasing our research and
development capabilities, designing and developing hardware and software
products which we currently sell and staffing our administrative, marketing and
sales organizations. Since our inception, we have incurred significant losses,
and as of September 30, 2000, we had an accumulated deficit of $74.5 million and
our net loss for the quarter ended September 30, 2000, was approximately $23.9
million. We have not achieved profitability on a quarterly or annual basis and
anticipate that we will incur net losses for the foreseeable future. We expect
to continue to incur significant sales and marketing, product development and
administrative expenses, and as a result, we need to generate significant net
revenues to achieve and maintain profitability. For the past

Page 13 of 37 pages.

<PAGE> 14

two quarters, revenues have decreased and we can provide no assurances that they
will increase in the near future or at all.

<TABLE>
<S> <C>
Value of stock issued and options assumed $23,625,000
Merger and other related costs paid in cash 1,169,000
-----------
Total Consideration $24,794,000
===========
</TABLE>

The allocation of the total consideration to the fair value of acquired
assets and liabilities is as follows:

<TABLE>
<S> <C>
Fair value of net assets acquired and liabilities assumed $(1,071,000)
Goodwill 20,965,000
In-process research and development 4,900,000
-----------
$24,794,000
===========
</TABLE>

We currently derive substantially all of our net revenues from sales of a
limited number of products. During fiscal 2000, substantially all of our net
revenues were derived from sales of our hub and switch products. We commenced
commercial shipment of our Capellix 3000 switch products during the quarter
ended December 31, 1999 and commenced commercial shipment of our Capellix 2000
switch products in the fiscal quarter ended March 31, 2000. During the fiscal
quarter ended June 30, 2000, we derived initial revenues from our Geminix router
product. We expect that as we continue to sell our Capellix switch products and
our router and network storage pool products, our hub revenues will decrease as
an overall percentage of our total net revenues in fiscal 2001. We may not be
successful in our efforts to diversify our product base or complete the
development of our fibre channel fabric backbone switch and other products under
development. Also, we may not be successful in the adoption of new products.
Additionally, even if our customers adopt our Capellix, Geminix and newer
products, we can not assure you that our net revenues will increase.

We depend on a few key customers. In fiscal 2000, approximately 72% of our
net revenues came from four customers with sales to Hewlett-Packard, Compaq
Computer Corporation, Bell Microproducts, Inc. and Tokyo Electron Limited, each
accounting for more than 10% of our net revenues. For the six months ended
September 30, 2000, approximately 85% of our net revenues came from two
customers with approximately 46% from Hewlett Packard Company and 39% from
Compaq Computer Corporation.

We record product net revenues upon shipment and provide an allowance for
product returns based on management's estimates or, if sales are to a new
distributor or reseller, the Company recognizes revenue when sell through
information has been received from the customer. Allowances for estimated sales
returns are provided at the time of revenue recognition. Our past product return
experience may not be indicative of future product return rates.

Page 14 of 37 pages.

<PAGE> 15

Our contracts with our distribution channel partners generally contain
additional provisions for stock rotation, which provide for a right of return of
10% to 15% of the value of purchases during the prior three months, to be offset
with an immediately deliverable order in an amount equal to or greater than the
stock to be rotated. We provide reserves for stock rotations. Our past stock
rotation experience may not be indicative of future stock rotation rates.

Our gross margins are 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 timing and size of customer orders and product implementations,
new product introductions both by us and by our competitors, changes in our
pricing policies and those of our competitors, component costs and the volume
manufacturing pricing we are able to obtain from our contract manufacturer and
other factors.

For the quarter ended September 30, 2000, Gadzoox recorded an increase in
inventory reserve of $9.1 million for production cancellation penalties and
excess inventory that was manufactured in reliance on the Company's earlier
internal sales forcasts. As a result, gross margins were (89%) and (16%) of net
sales for the three and six months ended September 30, 2000, respectively,
compared to gross margins of 43% and 42% for the corresponding three and six
month periods of fiscal year 2000.

Although we enter into general sales contracts with our customers, none of
our customers are obligated to purchase any amount of our products pursuant to
these contracts. We rely on our customers to submit purchase orders for specific
quantities of our products. All of our sales contracts contain provisions
regarding the following:

- products and pricing;

- order dates, rescheduling and cancellations;

- warranties and repair procedures; and

- marketing and/or sales support and training obligations.

Our OEM contracts generally contain additional provisions regarding product
technical specifications, labeling and boxing instructions and other
customization instructions. Several of our OEM sales contracts contain favored
pricing provisions as well as confidentiality provisions. Two of our OEM sales
contracts provide the OEM the right to manufacture our product in the event of a
material default we are unable to cure within a specified time period.

We currently outsource substantially our entire product manufacturing to
Sanmina Corporation, a third-party manufacturer and manufacture our products in
two of their locations in the United States. Our agreement with Sanmina
Corporation provides for two months of rolling purchase orders and rolling
forecasts for nine months immediately following the purchase order period.
Purchase prices are negotiable throughout the three-year contract period. We are
liable for materials that Sanmina Corporation purchases on our behalf that we
cannot use, cannot be cancelled before receipt or are unique parts otherwise
unusable by Sanmina Corporation. The agreement restricts our ability to
reschedule orders and allows us to cancel existing orders subject to penalties
of up to the total purchase price. Sanmina Corporation provides warranties on
workmanship and pass-through warranties on component parts. Sanmina Corporation
purchases most of the key components used to manufacture our products. Gadzoox
obtains some of these key components, such as our application specific
integrated circuits, or ASICs, from sole sources and other components, such as
optical transceivers. If we inaccurately forecast demand for our products,
Sanmina Corporation may be unable to provide us with adequate manufacturing
capacity. In addition, Sanmina Corporation may not be able to obtain adequate
supplies of components to meet our customers' delivery requirements.
Alternatively, Sanmina Corporation may accumulate excess inventory for our
account. In

Page 15 of 37 pages.

<PAGE> 16

order to reduce the cost of sales, during the quarter ended September 30, 1999,
we relocated substantially all of our manufacturing operations from Sanmina
Corporation's manufacturing facility in Santa Clara, California to its
manufacturing facility in Guntersville, Alabama. Additionally, in July 2000 we
entered into an agreement with another contract manufacturing partner to
manufacture our products in Thailand and, for a lower volume of products, to
manufacture in San Jose, California. The relocation of certain of our
manufacturing facilities is time consuming and expensive and there can be no
assurance that these moves will not disrupt the manufacturing of our products.
Such disruptions could cause us to lose net revenues and damage our customer
relationships.

Page 16 of 37 pages.

<PAGE> 17

QUARTERLY RESULTS OF OPERATIONS

The following table presents our operating results for the three and six
month periods ended September 30, 2000 and 1999 as a percentage of net revenues
represented by selected items from the unaudited Condensed Consolidated
Statements of Operations. This table should be read in conjunction with the
Condensed Consolidated Financial Statements included elsewhere herein.

<TABLE>
<CAPTION>
Three Months Ended Six Months Ended
--------------------- ---------------------
Sept. 30, Sept. 30, Sept. 30, Sept. 30,
2000 1999 2000 1999
--------- --------- --------- ---------
<S> <C> <C> <C> <C>
Net revenues ................................... 100 % 100 % 100 % 100 %
Cost of revenues ............................... 189 57 116 58
---- ---- ---- ----
Gross margin ................................. (89) 43 (16) 42
---- ---- ---- ----
Operating expenses:
Research and development ..................... 120 41 87 42
Sales and marketing .......................... 83 17 72 19
General and administrative ................... 32 8 24 8
In-process research & development ............ -- -- 30 --
Amortization of goodwill & intangible assets... 15 -- 13 --
Amortization of deferred compensation ......... 2 3 2 3
---- ---- ---- ----
Total operating expenses ................... 252 69 228 72
---- ---- ---- ----
Loss from operations ........................... (341) (26) (244) (30)

Total other income (expense), net .............. 10 8 10 4
---- ---- ---- ----
Net Loss .............................. (331)% (18)% (234)% (26)%
==== ==== ==== ====
</TABLE>

Net Revenues

Net revenues for the three months ended September 30, 2000, decreased by
approximately $3.9 million or 35% to $7.2 million compared to net revenues of
$11.1 million in the same period in fiscal 1999. Net revenues for the six months
ended September 30, 2000, decreased by approximately $4.1 million or 20% to
$16.2 million from $20.3 million in the same period of fiscal 1999. For the
quarter ended September 30, 2000, approximately 31%, 41% and 15% of our net
revenues came from sales to Hewlett-Packard Company, Compaq Computer Corporation
and Wyle Systems. For the quarter ended September 30, 1999, approximately 45% of
our net revenues came from sales to Hewlett-Packard Company and approximately
17% of our net revenues came from sales to Compaq Computer Corporation. We
expect a majority of our net revenues in the foreseeable future to be derived
from a limited number of customers.

The primary reason for the decline in net revenues was the
slower-than-planned adoption of our Capellix fibre channel switch which
translated into a decrease in orders from our distribution channel partners due
to decreased sell-through to end-user customers. This decrease in sell-through
resulted in a corresponding decrease in net revenues of approximately $7.9
million, or 52%, for the quarter ended September 30, 2000, compared to net
revenues for the quarter ended March 31, 2000. For the quarter ended September
30, 2000, 70% of our net revenues came from sales to OEM customers as compared
to 71% of net revenues represented by sales to OEM customers during the quarter
ended September 30, 1999. Although we have taken several actions to improve the
ability of our distribution channel partners to sell our products to end-users,
we cannot assure you that demand for our products through the distribution

Page 17 of 37 pages.

<PAGE> 18

channel will increase. If we are unable to effectively leverage sales through
our distribution channel partners, our net revenues may continue to decline and
our business could be harmed. International sales represented 32% and 30% of our
net revenues for the quarter ended September 30, 2000 and September 30, 1999,
respectively.

Gross Margin

Gross margin decreased 235% to ($6.4) million for the quarter ended
September 30, 1999, down from $4.8 million for the quarter ended September 30,
1999. For the six months ended September 30, 2000, gross margin decreased by
131% to ($2.6) million, down from $8.6 million for the six months ended
September 30, 1999. The decrease in gross margin is primarily due to an increase
in inventory reserve of $9.1 million for production cancellation penalties and
excess inventory that was manufactured in reliance on the Company's earlier
internal sales forcasts. Also contributing to the decrease in gross margin to a
much lesser degree is lower sales volumes to distribution channel partners, for
which gross margins are typically higher than for OEM customers, and the mix of
products sold, some of which derive higher gross margins.

Research and Development Expenses

Research and development expenses consist primarily of salaries and related
personnel costs, fees paid to consultants and outside service providers,
material costs for prototype and test units and other expenses related to the
design, development, testing and enhancements of our products. We expense our
research and development costs as they are incurred.

Research and development expenses increased by 90% to $8.6 million for the
quarter ended September 30, 2000, up from $4.5 million for the quarter ended
September 30, 1999. For the six months ended September 30, 2000, research and
development expenses increased by 67% to $14.2 million from $8.5 million in to
the same period in fiscal 1999. These increases are primarily due to the hiring
of additional research and development personnel, including the addition of our
strategic research and development team and our two ASIC development teams, and
the cost of development of the Capellix switch product and other future
products. 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 continue to increase in
absolute dollars.

Sales and Marketing Expenses

Sales and marketing expenses consist primarily of salaries, commissions and
other related expenses for personnel engaged in marketing, sales and customer
engineering support functions, as well as costs associated with trade shows,
promotional activities, travel expenses and other related expenses.

Sales and marketing expenses increased by 213% to $6.0 million during the
quarter ended September 30, 2000, up from $1.9 million for the quarter ended
September 30, 1999. For the six months ended September 30, 2000, sales and
marketing expenses increased by 208% to $11.7 million from $3.8 million for the
same period in fiscal 1999. The increases are primarily attributable to
increased staffing, the cost of supporting OEM customers, providing sales
support for distribution customers through Gadzoox Associates in Networking
("GAIN") program, comprehensive sales tools, in-depth training and other
marketing and sales activities.

Page 18 of 37 pages.

<PAGE> 19

We intend to continue to significantly expand our sales and marketing
operations and efforts, both domestically and internationally, in order to
increase market awareness and to generate additional sales of our products.
However, we cannot be certain that any increased expenditures will result in
higher net revenues. In addition, we believe our future success depends upon
establishing additional successful relationships with a variety of channel
partners. We believe that continued investment in sales and marketing is
critical to our success and expect these expenses to continue to increase in
absolute dollars in the future.

General and Administrative Expenses

General and administrative expenses consist primarily of salaries and
related expenses for executive, finance, accounting, information technology,
facilities and human resources, recruiting expenses, professional fees and costs
associated with expanding our information systems.

General and administrative expenses increased by 171% to $2.3 million for
the quarter ended September 30, 2000, up from $0.9 million for the quarter ended
September 30, 1999. For the six months ended September 30, 2000, general and
administrative expenses increased by 135% to $3.8 million from $1.6 million in
the same period in fiscal 1999. These increases are primarily attributable to
increases in personnel, additional expenses incurred related to the growth of
our business, expansion of our facilities and information infrastructure and our
operation as a public company.

We expect general and administrative expenses to continue to increase in
absolute dollars as we add personnel and incur additional costs related to the
growth of our business, expansion of our information infrastructure and our
operation as a public company.

In-process Research and Development Costs

As a result of our acquisition of SmartSAN in April 2000, we expensed
approximately $4.9 million as in-process research and development costs which
represented approximately 20% of the purchase price and was attributed and
supported by an analysis that identified revenue and costs on a
project-by-project basis.

The value assigned to purchased in-process technology, based on a
discounted cash flow method, was determined by identifying research projects in
areas for which technological feasibility has not been established. As of the
acquisition date, in-process projects consisted of the Geminix router and two
other router products. The value of in-process research and development was
determined by estimating the costs to develop the purchased in-process
technology into commercially viable products, estimating the resulting net cash
flows from such projects and discounting the net cash flows back to their
present value. The discount rate includes a risk-adjusted discount rate to take
into account the uncertainty surrounding the successful development of the
purchased in-process technology and the completeness of each product at the time
of the acquisition. The discount rate used was 35%. The percentage complete
calculations for all products were estimated based on research and development
expenses incurred to date and management's estimates of remaining development
costs which do not differ materially from historical amounts. At the date of
acquisition, the Geminix router and two other products under development at the
time of the acquisition were determined to be 80%, 65% and 25% complete,
respectively.

Amortization of Goodwill and Intangible Assets

Page 19 of 37 pages.

<PAGE> 20

As a result of our acquisition of SmartSAN in April 2000, purchased
intangible assets, including goodwill, developed technology and other intangible
assets of approximately $21.0 million are being amortized over their estimated
useful lives of five years on a straight-line basis. For the quarter and six
months ended September 30, 2000, Gadzoox amortized approximately $1.0 million
and $2.1 million, respectively, of goodwill and intangible.

Amortization of Deferred Compensation

In connection with the grant of stock options to employees, we recorded
deferred compensation within stockholders' equity of approximately $3.0 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 amortization of deferred compensation of
approximately $0.2 million and $0.3 million for the quarters ended September 30,
2000 and 1999, respectively. For the six months ended September 30, 2000
compared to September 30, 1999, we amortized deferred compensation of
approximately $0.3 million and $0.6 million, respectively. The amortization
expense relates to options awarded to employees in all operating expense
categories. The amount of deferred compensation expense to be recorded in future
periods could decrease if options for which accrued but unvested compensation
has been recorded are forfeited.

Other Income (Expense), net

Interest income, net of interest expense related to our debt and lease
obligations, includes income from our cash and cash equivalents and short-term
investments, net of expenses related to our financing obligations.

Interest income, net of interest expense, totaled $0.7 million for the
quarter ended September 30, 2000. For the quarter ended September 30, 1999,
interest expense, net of interest income, totaled $0.9 million. This decrease is
primarily due to lower interest income earned from investment of the proceeds
received from the issuance of common stock from our initial public offering in
July 1999 due to cash used by the Company for operating, investing and financing
activities. For the six months ended September 30, 2000, interest income, net of
interest expense totaled $1.6 million compared to interest expense net of
interest income of $0.8 million for the same period in 1999.

Liquidity and Capital Resources

Since inception, we have financed our operations primarily through private
sales of convertible preferred stock, the issuance of a convertible note,
equipment financing and proceeds from our initial public offering.

For the six months ended September 30, 2000, we used $24.0 million in cash
for operations compared to $5.7 million for the same period in 1999. This
represents a increase of 321% and is primarily due to an increase in our net
loss to $38.1 million in the six months ended September 30, 2000 compared to our
net loss of $5.2 million for the same period in fiscal 1999. The increase in our
net loss is primarily due to a decline in net revenue and to a one-time reserve
of $9.1 million for production cancellation penalties and excess inventory that
was manufactured in reliance on the Company's earlier internal sales forcasts, a
one-time charge of approximately $4.9 million for in-process research and
development costs and the amortization of goodwill of approximately $2.1
million, both in connection with our acquisition of SmartSAN in April 2000.

Page 20 of 37 pages.

<PAGE> 21

For the six months ended September 30, 2000, Gadzoox used $2.6 million in
cash from investing activities to acquire property and equipment compared to
$0.7 million used in the same period in 1999. In May 2000, we purchased 49,164
shares of Series C Preferred Stock of DataCore Software Corporation, a privately
held strategic partner, at $20.34 per share for a total investment of
approximately $1,000,000. For the six months ended September 30, 2000, we used
approximately $1.2 million in cash for the acquisition of SmartSAN.

In July 2000, we repaid approximately $3.1 million of principal and accrued
interest on our note payable to Seagate. Accordingly, at March 31, 2000, the
Company reclassified the amount of the convertible note from long-term
liabilities to short-term liabilities.

For the six months ended September 30, 2000, cash used by financing
activities was $3.2 million. Cash provided by financing activities was $77.1
million for the six months ended September 30, 1999, and the primary source of
cash generation was from the sale of common stock in our initial public
offering.

For the six months ended September 30, 2000, we did not acquire any
equipment under capitalized leases. For the six months ended September 30, 1999,
we acquired $0.7 million in equipment under capitalized leases. At September 30,
2000, we had $2.0 million in outstanding capitalized lease obligations.

Cash, cash equivalents and short-term investments totaled $41.5 million at
September 30, 2000, down from $73.4 million at March 31, 2000. This decrease is
primarily due to the cash used in operations of $24.0 million. This decrease was
partially offset by cash raised from the exercise of employee stock options and
the stock purchase made under the Employee Stock Purchase Plan in July 2000.

Our capital requirements depend on numerous factors, including market
acceptance of our products, the resources we devote to developing, marketing,
selling and supporting our products, the timing and expense associated with
expanding our distribution channels, and other factors. We expect to devote
substantial capital resources to continue our research and development efforts,
to hire and expand our sales, support, marketing and product development
organizations, to expand marketing programs, to establish additional facilities
worldwide and for other general corporate activities. We believe that our
existing cash balances, credit facilities and cash generated from future
operations will be sufficient to fund our operations for at least the next 12
months. However, we may require additional financing within this time frame and
there can be no assurances that this additional funding, if needed, will be
available on terms acceptable to us, if at all.

Page 21 of 37 pages.

<PAGE> 22

RISK FACTORS

You should carefully consider the following risk factors and all other
information contained in this Form 10-Q for the quarter ended September 30,
2000. Risks and uncertainties, in addition to those we describe below, that are
not presently known to us, or that we currently believe are immaterial may also
impair our business operations. If any of the following risks occurs, our
business, operating results and financial condition could be seriously harmed.
In addition, the trading price of our common stock could decline due to the
occurrence of any of these risks. See also page 2 of this document for
discussion of forward-looking statements.

WE HAVE INCURRED SIGNIFICANT LOSSES IN EVERY FISCAL YEAR AND FISCAL QUARTER
SINCE OUR INCEPTION AND MAY NEVER BECOME PROFITABLE.

We have incurred significant losses since inception and expect to continue
to incur losses on both a quarterly and annual basis for the foreseeable future.
As of September 30, 2000, our accumulated deficit was $77.5 million and we
expect to incur significant product development, sales and marketing and
administrative expenses and, as a result, we will need to generate increased net
revenues to achieve profitability. Further, even if we achieve profitability,
given the competition in, and the evolving nature of the storage area networking
market, we may not be able to sustain or increase profitability on a quarterly
or annual basis.

DUE TO OUR LIMITED OPERATING HISTORY, WE MAY HAVE DIFFICULTY ACCURATELY
PREDICTING REVENUES FOR FUTURE PERIODS AND APPROPRIATELY BUDGETING FOR EXPENSES,
AND, BECAUSE MOST OF OUR EXPENSES ARE FIXED IN THE SHORT-TERM, WE MAY NOT BE
ABLE TO DECREASE OUR EXPENSES IN A TIMELY MANNER TO OFFSET ANY UNEXPECTED
SHORTFALL IN REVENUES.

We have generated net revenues for less than six years and, thus, we have
only a short history from which to predict future net revenues. This limited
operating experience, combined with the rapidly evolving nature of the SAN
market in which we sell our products, reduces our ability to accurately forecast
our quarterly and annual revenue. Further, we plan our operating expenses based
primarily on these revenue projections. Because most of our expenses are fixed
in the short-term or incurred in advance of anticipated revenue, we may not be
able to decrease our expenses in a timely manner to offset any unexpected
shortfall in revenue. For example, during the six months ended September 30,
2000, orders from our distribution channel partners were significantly lower
than expected due to decreased sell-through to end-user customers which resulted
in a corresponding decrease in net revenues of approximately $7.9 million, for
the quarter ended September 30, 2000 or 52% compared to net revenues for the
quarter ended March 31, 2000. Also, in July 1998, Digital Equipment Corporation
cancelled orders for our Bitstrip product, which resulted in a corresponding
decrease in net revenues. If a similar situation were to occur in the future, we
may incur additional unexpected losses which could seriously harm our business.
For further financial information relating to our business, see "Notes to
Condensed Financial Statements" and "Management's Discussion and Analysis of
Financial Condition and Results of Operations."

WE HAVE A HISTORY OF QUARTERLY AND ANNUAL FLUCTUATIONS IN OUR NET REVENUES AND
OPERATING RESULTS, AND EXPECT THESE FLUCTUATIONS TO CONTINUE, WHICH MAY RESULT
IN VOLATILITY IN OUR STOCK PRICE.

Our quarterly and annual net revenues and operating results have varied
significantly in the past and are likely to vary significantly in the future due
to a number of factors, many of which are outside of our

Page 22 of 37 pages.

<PAGE> 23

control. The primary factors that may cause our quarterly net revenues and
operating results to fluctuate include the following:

o fluctuations in demand for our products and services;

o the ability and willingness of our distribution channel partners to
sell our products;

o the timing of customer orders and product implementations,
particularly large orders from our customers;

o our ability to develop, introduce, ship and support new products
product enhancements;

o the rate of adoption of SANs as an alternative to existing data
storage and management systems;

o announcements and new product introductions by our competitors and
deferrals of customer orders in anticipation of new products, services
or product enhancements introduced by us or our competitors;

o decreases in the prices at which we can sell our products;

o our ability to obtain sufficient supplies of components, including
sole or limited source components, at expected prices;

o the mix of our hub and switch products sold and the mix of
distribution channels through which they are sold;

o increases in the prices of the components we purchase;

o our ability to maintain quality manufacturing standards for our
products;

o competitive technology developments which may decrease the demand for
products based on the technology we utilize;

o our ability to maintain, increase or quickly decrease the contract
production of our products; and

o the mix of our hubs, switches, routers, software and other products
sold and the mix of distribution channels through which they are sold.

Accordingly, you should not rely on the results of any past periods as an
indication of our future performance. It is likely that in future periods, our
operating results may be below expectations of public market analysts or
investors. If this occurs, our stock price may drop. For example, net revenues
for the quarter ended September 30, 2000 were 52% lower than net revenues for
the quarter ended March 31, 2000, as a result of a decline in orders from our
distribution channel partners.

IF OUR DISTRIBUTION CHANNEL PARTNERS ARE UNABLE OR UNWILLING TO RESELL OUR
PRODUCTS, OUR NET REVENUES WILL DECREASE AND OUR BUSINESS WILL BE HARMED.

During fiscal 2000, 35% of our net revenues were derived from sales to
distribution channel partners. During the six months ended September 30, 2000,
approximately 10% of our net revenues were derived from sales to distribution
channel partners. Our OEM customers have demonstrated the ability to resell our

Page 23 of 37 pages.

<PAGE> 24

SAN products due, in part, to the length of time they have been involved in the
SAN marketplace and the strength of their internal technical, sales and
marketing structures. Our distribution channel partners have participated in the
SAN market for a shorter period of time and often do not have trained technical,
sales and marketing staff. As a result, they are not as well positioned as our
OEM customers to provide full solution sales. Additionally, distribution channel
partners may not be able to effectively compete with OEMs. For example, net
revenues for the quarter ended September 30, 2000, were 52% lower than net
revenues for the quarter ended March 31, 2000, as a result of a decline in
orders from our distribution channel partners due to slower than expected
sell-through to end-user customers. Although we have taken several actions to
improve our distribution channel partners' abilities to sell our products to
end-users, we can not assure you that demand for our products through the
distribution channel will increase. If we are unable to effectively leverage
sales through our distribution channel partners, our net revenues may continue
to decline, and our business could be harmed. The inability or unwillingness of
our distribution channel partners to resell SAN networking equipment, including
full SAN solutions, would significantly reduce our net revenues which would harm
our business.

BECAUSE WE DEPEND ON A FEW KEY ORIGINAL EQUIPMENT MANUFACTURER CUSTOMERS, THE
LOSS OF ANY OF THESE CUSTOMERS COULD SIGNIFICANTLY REDUCE OUR NET REVENUES.

We depend on a few key OEM and distribution channel partners. In fiscal
2000, approximately 72% of our net revenues came from four customers with sales
to Hewlett-Packard Company, Compaq Computer Corporation, Bell Microproducts,
Inc. and Tokyo Electron Limited, each accounting for 10% or more of our net
revenues. For the six months ended September 30, 2000, approximately 46% of our
net revenues came from sales to Hewlett-Packard Company and 39% of our net
revenues came from Compaq Computer Corporation. Although we intend to expand our
distribution and original equipment manufacture customer bases, we anticipate
that our operating results will continue to depend on sales to a relatively
small number of customers. None of our current customers have any minimum
purchase obligations, and they may stop placing orders with us at any time,
regardless of any forecast they may have previously provided. The loss of any of
our key customers, or a significant reduction in sales to those customers, could
significantly reduce our net revenues. For example, net revenues for the quarter
ended September 30, 2000, were 52% less than net revenues for the quarter ended
March 31, 2000, as a result of a decline in orders from our distribution channel
partners due to slower than expected sell-through to end-user customers. As
another example, in July 1998, Digital Equipment Corporation cancelled orders
for our Bitstrip product, and in December 1998, Hewlett-Packard Company
unexpectedly reduced orders for our Gibraltar 10-port product. Digital Equipment
Corporation's order cancellation resulted in a reduction of anticipated net
revenues by approximately 12% for the fiscal year ended March 31, 1999.

OUR RELIANCE ON OEM CUSTOMERS AND DISTRIBUTION CHANNEL PARTNERS AND THE LENGTHY
PROCESS REQUIRED TO ADD THESE PARTNERS MAY IMPEDE THE GROWTH OF OUR NET
REVENUES.

We rely on OEM customers and distribution channel partners to distribute
and sell our products. As a result, our success depends substantially on (1) our
ability to initiate, manage and expand our relationships with significant OEM
customers, (2) our ability to attract distribution channel partners that are
able and willing to sell our products and (3) the sales efforts of these OEM
customers and distribution channel partners. Our OEM customers typically conduct
significant evaluation, testing, implementation and acceptance procedures before
they begin to market and sell new technologies, including our products. Based on
our experience with our larger OEM customers, this evaluation process is lengthy
and has historically been as long as nine months. This process is also complex
and may require significant sales, marketing and management efforts on our part.
The complexity of this process increases if we must qualify our products with
multiple customers at the same time. In addition, once our products have been
qualified, the length of the sales cycle of each of our OEM customers may vary
depending upon whether our products

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are being bundled with another product or are being sold as an option or add-on.
Sales to distribution channel partners may also require lengthy sales and
marketing cycles. Additionally, as a result of lower than expected net revenues
from our distribution channel partners, we have taken several actions to improve
sell-through at the end-user level. As a result, we may expend significant
resources in developing partner relationships before recognizing any revenue. We
may not be able to manage and expand our relationships with OEM customers and
distribution channel partners successfully and they may be unwilling or unable
to market our products successfully. Moreover, our agreements with OEM customers
and distribution channel partners have no minimum purchase commitments. Our
failure to manage and expand our relationships with OEM customers and
distribution channel partners or their failure or unwillingness to market our
products could substantially reduce our net revenues and seriously harm our
business.

OUR BUSINESS MAY BE HARMED BY CLASS ACTION LITIGATION DUE TO STOCK PRICE
VOLATILITY.

In the past, securities class action litigation often has been brought
against a company due to volatility in the market price of its securities. The
market price of our securities has been volatile in the past and may be volatile
in the future. Therefore, we may in the future be the target of securities
litigation. Securities litigation could result in substantial costs and divert
management's attention and resources.

IF WE ARE UNABLE TO MEET OUR FUTURE CAPITAL REQUIREMENTS, WE MAY BE UNABLE TO
DEVELOP OR ENHANCE OUR PRODUCTS, TAKE ADVANTAGE OF FUTURE OPPORTUNITIES OR
RESPOND TO COMPETITIVE PRESSURES OR UNANTICIPATED REQUIREMENTS, EACH OF WHICH
WOULD MATERIALLY HARM OUR BUSINESS.

We believe that our existing cash balances, credit facilities and cash flow
expected to be generated from future operations, will be sufficient to meet our
capital requirements at least through the next 12 months. However, we may be
required, or could elect, to seek additional funding prior to that time. In the
event we are required to raise additional funds we may not be able to do so on
favorable terms, if at all. Further, if we issue new equity securities,
stockholders may experience additional dilution or the new equity securities may
have rights, preferences or privileges senior to those of existing holders of
common stock. If we cannot raise funds on acceptable terms, we may be unable to
develop or enhance our products, take advantage of future opportunities or
respond to competitive pressures or unanticipated requirements. For additional
information on our anticipated future capital requirements, see "Management's
Discussion and Analysis of Financial Condition and Results of Operations --
Liquidity and Capital Resources."

THE SAN MARKET IN WHICH WE COMPETE IS NEW AND UNPREDICTABLE, AND IF THIS MARKET
DOES NOT DEVELOP AND EXPAND AS WE ANTICIPATE, OUR BUSINESS WILL SUFFER.

The market for SANs and related hub and switch products has only recently
begun to develop and is rapidly evolving. Because the SAN market is new, it is
difficult to predict its potential size or future growth rate. Our products are
used exclusively in SANs. Accordingly, widespread adoption of SANs as an
integral part of data-intensive enterprise computing environments is critical to
our future success. Potential end-user customers who have invested substantial
resources in their existing data storage and management systems may be reluctant
or slow to adopt a new approach, like SANs. The speed at which customers adopt
current and new products for SANs is highly unpredictable. Our success in
generating net revenues in this emerging market will depend on, among other
things, our ability to:

o educate potential OEM customers, distribution channel partners and end
users about the benefits of SANs, as well as hub, switch, router and
network storage pool technologies;

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<PAGE> 26

o maintain and enhance our relationships with our OEM customers and
channel partners;

o predict and base our products on standards which ultimately become
industry standards; and

o predict and deliver new and innovative products demanded by the
storage area marketplace.

In addition, SANs are often implemented in connection with deployment of
new storage systems and servers. Accordingly, our future success is also
substantially dependent on the market for new storage systems and servers.

WE HAVE LIMITED PRODUCT OFFERINGS AND OUR BUSINESS MAY SUFFER IF DEMAND FOR ANY
OF THESE PRODUCTS DECLINES OR FAILS TO DEVELOP AS WE EXPECT.

We derive a substantial portion of our net revenues from a limited number
of products. Specifically, in fiscal 2000 and for the six months ended September
30, 2000, the majority of our net revenues were derived from our hub and switch
products. We expect that net revenues from our hub and switch products will
continue to account for a substantial portion of our total net revenues for the
foreseeable future. There is no assurance that our Geminix and Axxess products,
as well as other products currently under development or that will be developed,
will be adopted by end-users or our OEM or distribution channel partners or that
significant net revenues would be derived if adopted. As a result, for the
foreseeable future, we will continue to be subject to the risk of a significant
decrease in net revenues if demand for our hub and switch products decline.
Therefore, continued market acceptance of our hub, switch, router and Axxess
products is critical to our future success. Factors that may affect the market
acceptance of our products, some of which are beyond our control, include the
following:

o growth and changing requirements of the SAN and hub and switch product
markets;

o availability, price, quality and performance of competing products and
technologies;

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

o successful development of our relationships with existing and
potential OEM customers and distribution channel partners.

OUR BUSINESS WILL SUFFER IF WE FAIL TO DEVELOP AND SUCCESSFULLY INTRODUCE NEW
AND ENHANCED PRODUCTS THAT MEET THE CHANGING NEEDS OF OUR CUSTOMERS.

Our future success depends upon our ability to address the rapidly changing
SAN market including changes in relevant industry standards and the changing
needs of our customers by developing and introducing high-quality,
technologically-progressive, cost-effective products, product enhancements and
services on a timely basis. In May 1999, we announced the launch of our Capellix
switch and commenced initial shipments in September 1999. Additionally, we
commercially shipped our Geminix product and introduced our Axxess product
during the quarter ended June 30, 2000, and we expect to release our fibre
channel backbone switch and another router product later in fiscal 2001. Our
future net revenue growth will be dependent on the success of these and other
new products, and we may not be able to develop and introduce these or other new
products successfully in the time frame we expect. Further, we cannot be certain
of the demand for, and market acceptance of, these and other new products. In
addition, we must

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successfully manage the introduction of new or enhanced products to minimize
disruption in our customers' ordering patterns, avoid excessive levels of older
product inventories and ensure that adequate supplies of new products can be
delivered to meet our customers' demands. Our net revenues may be reduced if we
fail to develop product enhancements, if we fail to introduce new products, if
we do not successfully manage inventories of our older products or if any new
products or product enhancements that we develop and introduce are not broadly
accepted.

COMPETING TECHNOLOGES MAY EMERGE AND WE MAY FAIL TO ADOPT NEW TECHNOLOGIES ON A
TIMELY BASIS. FAILURE TO UTILIZE NEW TECHNOLOGIES MAY DECREASE THE DEMAND FOR
OUR PRODUCTS.

The technology being deployed today in most SAN products is FC-AL or FC-SW.
During the last fiscal year, the development of competing technologies, such as
Ethernet IP has been discussed by the technical community. If we are unable to
identify new technologies in a timely manner and efficiently utilize such new
technologies in our product developments, the demand for our current products
may decrease significantly and rapidly, which would harm our business.

WE WILL BE UNABLE TO MANUFACTURE OR SELL OUR PRODUCTS IF OUR SOLE CONTRACT
MANUFACTURER IS UNABLE TO MEET OUR MANUFACTURING NEEDS.

Sanmina Corporation, a third-party manufacturer for numerous companies,
manufactures all of our products at its Guntersville, Alabama facility. Sanmina
Corporation is not obligated to supply products to us for any specific period,
or in any specific quantity, except as may be provided in a particular purchase
order which has been accepted by Sanmina Corporation. If Sanmina Corporation
experiences delays, disruptions, capacity constraints or quality control
problems in its manufacturing operations, then product shipments to our
customers could be delayed, which would negatively impact our net revenues and
our competitive position and reputation. Further, our business would be harmed
if we fail to effectively manage the manufacture of our products. We generally
place orders with Sanmina Corporation at least two months prior to scheduled
delivery of products to our customers. Accordingly, if we inaccurately forecast
demand for our products, we may be unable to obtain adequate manufacturing
capacity from Sanmina Corporation or adequate quantities of components to meet
our customers' delivery requirements or we may accumulate excess inventories. In
the future, we intend to work with additional new contract manufacturers that
can potentially manufacture our higher volume products at lower costs in foreign
locations. We could experience difficulties and disruptions in the manufacture
of our products while we transition to new facilities. Manufacturing disruptions
could prevent us from achieving timely delivery of products and could result in
lost net revenues. Additionally, we must coordinate our efforts with those of
our suppliers and Sanmina Corporation, and our other new third party
manufacturers, to rapidly achieve volume production. Although we have not
experienced supply problems with Sanmina Corporation, we have experienced delays
in product deliveries from one of our former contract manufacturers. Moreover,
we may in the future need to find additional contract manufacturers that can
manufacture our products in higher volume and at lower costs. We may not find a
contract manufacturer that meets our needs. Additionally, qualifying a new
contract manufacturer and commencing volume production is expensive and time
consuming. If we are required or choose to change contract manufacturers, we may
lose net revenues and our customer relationships may suffer.

BECAUSE WE DEPEND ON SOLE SOURCE AND LIMITED SOURCE SUPPLIERS FOR KEY
COMPONENTS, WE ARE SUSCEPTIBLE TO SUPPLY SHORTAGES THAT COULD ADVERSELY AFFECT
OUR OPERATING RESULTS.

We depend upon a single source for each type of our application-specific
integrated circuits, or ASICs, and limited sources of supply for several key
components, including, but not limited to, power supplies, chassis and optical
transceivers. We have in the past experienced and may in the future experience

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shortages of, or difficulties in acquiring, these components. Because we rely on
Sanmina Corporation, and now our newer contract manufacturer, to procure
components required for the manufacture of our products, Sanmina Corporation may
suffer component shortages. If we or our contract manufacturing partners are
unable to buy these components, we will not be able to manufacture our products
on a timely basis which would harm our business.

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, such as, specific supplier
requirements, contract terms and current market demand for such 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 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.

OUR OPERATING RESULTS MAY SUFFER BECAUSE OF COMPETITION IN THE SAN MARKET, AS
WELL AS ADDITIONAL COMPETITION FROM DATA NETWORKING COMPANIES AND ENTERPRISE
SOFTWARE DEVELOPERS.

The market for our SAN hub, switch and router products is competitive, and
is likely to become even more competitive. In the SAN market, our current
competitors include Ancor Communications, Inc., Atto Brocade Communications
Systems, Inc., Chaparral Network Storage, Inc., Cornerstone, Emulex Corporation,
McData Corporation, Pathlight and Vixel Corporation, , and. In addition to these
companies, we expect new SAN competitors to emerge. In the future, we may also
compete against data networking companies which may develop SAN products.
Furthermore, although we currently offer products that complement the software
products offered by Legato Systems, Inc. and Veritas Software Corporation, they
and other enterprise software developers may in the future compete with us. We
also compete with providers of data storage solutions that employ traditional
storage technologies, including small computer system interface-based technology
such as Adaptec, Inc., LSI Logic Corporation and QLogic Corporation. Increased
competition could result in pricing pressures, reduced sales, reduced margins,
reduced profits, reduced market share or the failure of our products to achieve
or maintain market acceptance. Some of our competitors and potential competitors
have longer operating histories, greater name recognition, access to larger
customer bases, more established distribution channels or substantially greater
resources than we have. As a result, they may be able to respond more quickly
than we can to new or changing opportunities, technologies, standards or
customer requirements. Moreover, we have only recently begun to offer SAN
switch, router and Axxess products. Therefore, we may not be able to compete
successfully in the SAN switch product market.

IF WE CANNOT INCREASE OUR SALES VOLUMES, REDUCE OUR COSTS OR INTRODUCE HIGHER
MARGIN PRODUCTS TO OFFSET REDUCTIONS IN THE AVERAGE UNIT PRICE OF OUR PRODUCTS,
OUR OPERATING RESULTS MAY SUFFER.

We anticipate that as products in the storage area market become more
commoditized, the average unit price of our products will continue to decline in
the future in response to changes in product mix, competitive pricing pressures,
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 net revenues will decline. In addition, to
maintain our gross margins, we must continue to reduce the

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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 with higher margins. If we cannot maintain our gross margins, our
business could be seriously harmed, particularly if the average selling price of
our products decreases significantly.

OUR PRODUCTS ARE COMPLEX AND MAY CONTAIN UNDETECTED SOFTWARE OR HARDWARE ERRORS,
WHICH COULD LEAD TO AN INCREASE IN OUR COSTS OR A REDUCTION IN OUR NET REVENUES.

Networking products frequently contain undetected software or hardware
errors when first introduced or as new versions are released. Our products are
complex and we have from time to time found errors in existing products, and we
may from time to time find errors in our existing, new or enhanced products. In
addition, our products are combined with products from other vendors. As a
result, should problems occur, it may be difficult to identify the source of the
problem. The occurrence of hardware and software errors, whether caused by our
or other vendors' SAN products, could adversely affect sales of our products,
cause us to incur significant warranty and repair costs, divert the attention of
our engineering personnel from our product development efforts and cause
significant customer relationship problems.

IF WE DO NOT HIRE, RETAIN AND INTEGRATE HIGHLY SKILLED MANAGERIAL, ENGINEERING,
SALES, MARKETING, FINANCE AND OPERATIONS PERSONNEL, OUR BUSINESS MAY SUFFER.

Our success depends to a significant degree upon the continued
contributions of our key personnel in engineering, sales, marketing, finance and
operations, many of whom would be difficult to replace. We do not maintain key
person life insurance on most of our key personnel and do not have employment
contracts with any of our key personnel. The loss of the services of any of our
key personnel could have a negative impact on our business. We also believe that
our success depends to a significant extent on the ability of our key personnel
to operate effectively, both individually and as a group. Many of our employees
have only recently joined us. If we are unable to integrate new employees in a
timely and cost-effective manner, our operating results may suffer. We believe
our future success will also depend in large part upon our ability to attract
and retain highly skilled managerial, engineering, sales, marketing, finance and
operations personnel. Competition for these people is intense, especially in the
San Francisco Bay area where our operations are headquartered. In particular, we
have experienced difficulty in hiring qualified ASIC, software, system, test and
customer support engineers and we may not be successful in attracting and
retaining individuals to fill these positions. If we are unable to attract or
retain qualified personnel in the future, or if we experience delays in hiring
required personnel, particularly qualified engineers and sales personnel, our
ability to develop, introduce and sell our products could be harmed. In
addition, companies in our industry whose employees accept positions with
competitors frequently claim that their competitors have engaged in unfair
hiring practices. We may be subject to such claims in the future as we seek to
hire qualified personnel. Any claim of this nature could result in material
litigation. We could incur substantial costs in defending ourselves against
these claims, regardless of their merits.

WE HAVE EXPERIENCED A PERIOD OF RAPID GROWTH, AND IF WE ARE NOT ABLE TO
SUCCESSFULLY MANAGE THIS AND FUTURE GROWTH, OUR BUSINESS MAY SUFFER.

We have recently experienced a period of rapid growth. At March 31, 1997,
we had a total of 38 employees, and at September 30, 2000, we had a total of 225
employees. We plan to continue to hire new employees to expand our operations
significantly to pursue existing and potential market opportunities. This growth
will place a significant demand on our management and our operational resources.
In order to manage growth effectively, we must implement and improve our
operational systems, procedures and controls on a timely basis. Our key
personnel have limited experience managing this type of growth. If we cannot
manage growth effectively, our business could suffer.

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BECAUSE OUR INTELLECTUAL PROPERTY IS CRITICAL TO THE SUCCESS OF OUR BUSINESS,
OUR OPERATING RESULTS WOULD SUFFER IF WE ARE UNABLE TO ADEQUATELY PROTECT OUR
INTELLECTUAL PROPERTY.

Because our products rely on proprietary technology and will likely
continue to rely on technological advancements for market acceptance, we believe
that the protection of our intellectual property rights will be critical to the
success of our business. To protect our intellectual property rights, we rely on
a combination of patent, copyright, trademark and trade secret laws and
restrictions on disclosure. We also enter into confidentiality or license
agreements with our employees, consultants and corporate partners, and control
access to and distribution of our software, documentation and other proprietary
information. Despite our efforts to protect our proprietary rights, unauthorized
parties may copy or otherwise obtain and use our products or technology.
Monitoring unauthorized use of our products is difficult and the steps we have
taken may not prevent unauthorized use of our technology, particularly in
foreign countries where the laws may not protect our proprietary rights as fully
as in the United States. If we are unable to protect our intellectual property
from infringement, other companies may be able to use our intellectual property
to offer competitive products at lower prices. We may not be able to effectively
compete against these companies.

WE RELY HEAVILY ON OUR INTELLECTUAL PROPERTY, AND EFFORTS TO PROTECT IT MAY
CAUSE US TO BECOME INVOLVED IN COSTLY AND LENGTHY LITIGATION WHICH COULD
SERIOUSLY HARM OUR BUSINESS.

Although we are not currently involved in any intellectual property
litigation, we may be a party to litigation in the future either to protect our
intellectual property or as a result of an alleged infringement of others'
intellectual property. These claims and any resulting litigation could subject
us to significant liability for damages and could cause our proprietary rights
to be invalidated. Litigation, regardless of the merits of the claim or outcome,
would likely be time-consuming and expensive to resolve and would divert
management time and attention. Any potential intellectual property litigation
could also force us to do one or more of the following:

o stop using the challenged intellectual property or selling our
products or services that incorporate it;

o obtain a license to use the challenged intellectual property or to
sell products or services that incorporate it, which license may not
be available on reasonable terms, or at all; or

o redesign those products or services that are based on or incorporate
the challenged intellectual property.

If we are forced to take any of the foregoing actions, we may be unable to
manufacture and sell our products, and our net revenues would be substantially
reduced.

INDUSTRY STANDARDS AND GOVERNMENT REGULATIONS AFFECTING OUR BUSINESS EVOLVE
RAPIDLY, AND IF WE CANNOT DEVELOP PRODUCTS THAT ARE COMPATIBLE WITH THESE
EVOLVING STANDARDS, OUR BUSINESS WILL SUFFER.

Our products must comply with industry standards. For example, in the
United States, our products must comply with various regulations and standards
defined by the Federal Communications Commission. Internationally, our products
are also required to comply with standards established by authorities in various
countries. Any new products and product enhancements that we introduce in the
future must also meet industry standards at the time they are introduced.
Failure to comply with existing or evolving industry standards or to obtain
timely domestic or foreign regulatory approvals or certificates could

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materially harm our business. Our products comprise only a part of the entire
SAN. All components of the SAN must comply with the same standards in order to
operate efficiently together. We depend on companies that provide other
components of the SAN to support the industry standards as they evolve. Many of
these companies are significantly larger and more influential in effecting
industry standards than we are. Some industry standards may not be widely
adopted or they may not be implemented uniformly, and competing standards may
emerge that may be preferred by OEM customers or end users. If other companies
do not support the same industry standards that we do, or if competing standards
emerge, market acceptance of our products could suffer.

WE PLAN TO INCREASE OUR INTERNATIONAL SALES ACTIVITIES WHICH WILL SUBJECT US TO
ADDITIONAL BUSINESS RISKS.

For the fiscal year ended March 31, 2000, approximately 30% of our net
revenues were from international sales activities, and for the six months ended
September 30, 2000, approximately 31% of our net revenues were from
international sales activities. We plan to continue to increase our
international sales activities. Our international sales will be limited if we
cannot establish relationships with international distributors, establish
additional foreign operations, expand international sales channel management,
hire additional personnel and develop relationships with international service
providers. Even if we are able to successfully continue international
operations, we may not be able to maintain or increase international market
demand for our products. Our international operations are subject to a number of
risks, including:

o multiple protectionist, adverse and changing governmental laws and
regulations;

o reduced or limited protections of intellectual property rights;

o potentially adverse tax consequences resulting from changes in tax
laws; and

o political and economic instability.

To date, none of our international net revenues and costs have been
denominated in foreign currencies. As a result, an increase in the value of the
U.S. dollar relative to foreign currencies could make our products more
expensive and thus less competitive in foreign markets. A portion of our
international net revenues may be denominated in foreign currencies in the
future, which would subject us to risks associated with fluctuations in those
foreign currencies.

WE MAY BECOME INVOLVED IN COSTLY AND TIME-CONSUMING LITIGATION THAT MAY
SUBSTANTIALLY INCREASE OUR COSTS AND THEREBY HARM OUR BUSINESS.

We may from time to time become involved in various lawsuits and legal
proceedings which arise in the ordinary course of our business. For example, In
May 1999, a former employee filed a complaint against Gadzoox and in September
2000 the plaintiff and Gadzoox settled this lawsuit out of court. This
settlement did not have a material adverse affect on Gadzoox' financial
condition or results of operations. Litigation is subject to inherent
uncertainties, and an adverse result in other matters could arise from time to
time that may harm Gadzoox' business and, financial condition and results of
operations.

WE MAY ENGAGE IN FUTURE ACQUISITIONS THAT DILUTE OUR STOCKHOLDERS' EQUITY AND
CAUSE US TO INCUR DEBT OR ASSUME CONTINGENT LIABILITIES.

As part of our strategy, we expect to review opportunities to buy other
businesses or technologies that would complement our current products, expand
the breadth of our market or enhance our technical capabilities, or that may
otherwise offer growth opportunities. For example, in April 2000, we completed

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our acquisition of SmartSAN Systems, Inc. While we have no additional current
agreements or negotiations underway, we may buy businesses, products or
technologies in the future. In the event of any future purchases, we could:

o issue stock that would dilute our current stockholders' percentage
ownership;

o incur debt; and

o assume liabilities.

These purchases could also involve numerous risks, including:

o problems integrating the purchased operations, technologies or
products;

o unanticipated costs;

o diversion of management's attention from our core business;

o adverse effects on existing business relationships with suppliers and
customers;

o risks associated with entering markets in which we have no or limited
prior experience; and

o potential loss of key employees of purchased organizations.

We may not be able to successfully integrate any businesses, products,
technologies or personnel that we might purchase in the future.

OUR PRINCIPAL STOCKHOLDERS HAVE SIGNIFICANT VOTING POWER AND MAY TAKE ACTIONS
THAT MAY NOT BE IN THE BEST INTERESTS OF OUR OTHER STOCKHOLDERS.

As of September 30, 2000, our executive officers and directors and their
affiliates beneficially owned, in the aggregate, approximately 35% of our
outstanding common stock. As a result, these stockholders may be able to
exercise significant control over all matters requiring stockholder approval,
including the election of directors and approval of significant corporate
transactions, which could delay or prevent an outside party from acquiring or
merging with us.

FUTURE SALES OF OUR COMMON STOCK IN THE PUBLIC MARKET MAY DEPRESS OUR STOCK
PRICE.

As of September 30, 2000, our executive officers, directors and their
affiliates beneficially owned, in the aggregate, approximately 35% of our
outstanding common stock, which they are able to sell in the public market.
Sales of a substantial number of shares of our common stock could cause our
stock price to fall. In addition, the sale of these shares could impair our
ability to raise capital through the sale of additional stock.

PROVISIONS IN OUR CHARTER DOCUMENTS AND DELAWARE LAW COULD PREVENT OR DELAY A
CHANGE IN CONTROL OF OUR COMPANY AND MAY REDUCE THE MARKET PRICE OF OUR COMMON
STOCK.

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Provisions of our certificate of incorporation and bylaws may discourage, delay
or prevent a merger or acquisition that a stockholder may consider favorable.
These provisions include:

o authorizing our board of directors to issue preferred stock without
stockholder approval;

o providing for a classified board of directors with staggered,
three-year terms;

o prohibiting cumulative voting in the election of directors;

o requiring super-majority voting to effect significant amendments to
our certificate of incorporation and bylaws;

o limiting the ability of stockholders to call special meetings;

o prohibiting stockholder actions by written consent; and

o establishing advance notice requirements for nominations for election
to the board of directors or for proposing matters that can be acted
on by stockholders at stockholder meetings.

Certain provisions of Delaware law also may discourage, delay or prevent
someone from acquiring or merging with us, which may cause the market price of
our common stock to decline.

ITEM 3. QUANTITATIVE AND QUALITATIVE DISCLOSURE ABOUT MARKET RISKS.

The primary objective of our investment activities is to preserve principal
while at the same time maximizing the income we receive from our investments
without significantly increasing risk. Some of the securities that we may invest
in may be subject to market risk. This means that a change in prevailing
interest rates may cause the principal amount of the investment to fluctuate.
For example, if we hold a security that was issued with a fixed interest rate at
the then-prevailing rate and the prevailing interest rate later rises, the
principal amount of our investment will probably decline. To minimize this risk
in the future, we intend to maintain our portfolio of cash equivalents and
short-term investments in a variety of securities, including commercial paper,
money market funds, government and non-government debt securities. In general,
money market funds are not subject to market risk because the interest paid on
such funds fluctuates with the prevailing interest rate. As of September 30,
2000, all of our investments were in cash equivalents and short-term
investments. See Note 3 of the Notes to the Condensed Financial Statements.

We have operated primarily in the United States and all sales to date have
been made in U.S. dollars. Accordingly, we have not had any material exposure to
foreign currency rate fluctuations.

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PART II - OTHER INFORAMTION

ITEM 1. LEGAL PROCEEDINGS

From time to time, Gadzoox may become involved in various lawsuits and
legal proceedings which arise in the ordinary course of business. For example,
in May 1999, a former employee filed a complaint against Gadzoox. For example,
In May 1999, a former employee filed a complaint against Gadzoox and in
September 2000 the plaintiff and Gadzoox settled this lawsuit out of court. This
settlement did not have a material adverse affect on Gadzoox' financial
condition or results of operations. Litigation is subject to inherent
uncertainties, and an adverse result in other matters could arise from time to
time that may harm Gadzoox' business and, financial condition and results of
operations

ITEM 2. CHANGES IN SECURITIES AND USE OF PROCEEDS

In connection with its initial public offering in July of 1999, Gadzoox
filed a Registration Statements on Form S-1, SEC File No. 333-78029 (the
"Registration Statement"), which was declared effective by the Securities and
Exchange Commission on July 19, 1999. Pursuant to the Registration Statement,
Gadzoox registered 4,025,000 shares of its common stock, par value of $0.005 per
share, including 525,000 shares sold to the underwriters upon the exercise of
their over-allotment option. The aggregate offering price of the shares
registered was $84.5 million, $5.9 million of which was applied toward the
underwriters discounts and commissions. Other expenses related to the offering
were approximately $1.1 million. Gadzoox received net proceeds of approximately
$77.5 million from the sale of common stock in the initial public offering.
Managing underwriters of the offering were Credit Suisse First Boston, Hambrecht
& Quist, and Morgan Keegan & Company, Inc.

Gadzoox invested the proceeds from the offering in short-term investment
grade, interest bearing securities and intends to use the proceeds for working
capital and general corporate purposes, including expenditures for research and
development of new products, sales channel development and other corporate
purposes. In addition, we may use a portion of the net proceeds to acquire
businesses, products or technologies that are complementary to our current or
future business and product lines. The use of proceeds from the offering does
not represent a material change in the use of proceeds described in the
prospectus.

ITEM 3. DEFAULTS UPON SENIOR SECURITIES

None

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

None

ITEM 5. OTHER INFORMATION

None

ITEM 6. EXHIBITS AND REPORTS ON FORM 8-K

(a) Exhibits:

27.1 Financial Data Schedule

(b) Reports on Form 8-K:

Page 34 of 37 pages.

<PAGE> 35

We filed a current report on Form 8-K dated September 7, 2000, to report a
press release announcing lower than expected revenues and to record a reserve
for excess and obsolete inventory for the quarter ended September 30, 2000.

Page 35 of 37 pages.

<PAGE> 36

SIGNATURES

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

Dated: November 13, 2000 GADZOOX NETWORKS, INC.
(Registrant)

/s/ MICHAEL PARIDES
----------------------------------------
MICHAEL PARIDES
President and Chief Executive Officer

/s/ SUSAN A. KOFNOVEC
----------------------------------------
SUSAN A. KOFNOVEC
Corporate Controller

Page 36 of 37 pages.

<PAGE> 37

EXHIBIT INDEX

<TABLE>
<CAPTION>
EXHIBIT
NO. DESCRIPTION
------- -----------
<S> <C>
27.1 Financial Data Schedule
</TABLE>