DIGITAL LINK CORP, 10-K, 1999-03-29

DIGITAL LINK CORP
10-K, 1999-03-29
COMPUTER COMMUNICATIONS EQUIPMENT

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UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
Washington, D.C. 20549
----------------------

FORM 10-K

|X| ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES
EXCHANGE ACT OF 1934
For the fiscal year ended December 31, 1998

|_| TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES
EXCHANGE ACT OF 1934
For the transition period from to

Commission File Number: 0-23110

DIGITAL LINK CORPORATION
(Exact name of registrant as specified in its charter)

California 77-0067742
(State or other jurisdiction of (IRS Employer
incorporation or organization) Identification Number)

217 Humboldt Court 94089
Sunnyvale, CA (Zip Code)
(Address of principal executive offices)

Registrant's telephone number, including area code: (408) 745-6200

Securities registered pursuant to Section 12(b) of the Act: None

Securities registered pursuant to Section 12(g) of the Act: Common Stock,
no par value
(Title of class)

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

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

The aggregate market value of the voting stock held by non-affiliates of the
registrant as of March 26, 1999, was approximately $29,134,358.

The number of shares outstanding of the registrant's Common Stock as of March
26, 1999, was 8,127,622 shares.

DOCUMENTS INCORPORATED BY REFERENCE:
Portions of the definitive proxy statement (the "Definitive Proxy Statement") to
be filed with the Securities and Exchange Commission relative to the Company's
annual meeting of shareholders to be held June 7, 1999 are incorporated by
reference in Part III of this Form 10-K.

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<PAGE>

DIGITAL LINK CORPORATION

ANNUAL REPORT ON FORM 10-K

For the Year Ended December 31, 1998

TABLE OF CONTENTS

Form 10-K
Item No. Name of Item Page
-------- ------------ ----

PART I
- ------
Item 1. Business.......................................................... 3
Item 2. Properties........................................................ 10
Item 3. Legal Proceedings................................................. 11
Item 4. Submission of Matters to a Vote of Security Holders............... 11

PART II
- -------
Item 5. Market for Registrant's Common Equity and Related Stockholder
Matters...................................................... 12
Item 6. Selected Financial Data........................................... 12
Item 7. Management's Discussion and Analysis of Financial Condition and
Results of Operations........................................ 13
Item 7A. Quantitative and Qualitative Disclosures About Market Risk........ 25
Item 8. Financial Statements and Supplementary Data....................... 26
Item 9. Changes in and Disagreements with Accountants on Accounting and
Financial Disclosure.............................................. 47

PART III
- --------
Item 10. Directors and Executive Officers of the Registrant................ 47
Item 11. Executive Compensation............................................ 47
Item 12. Security Ownership of Certain Beneficial Owners and Management.... 47
Item 13. Certain Relationships and Related Transactions.................... 47

PART IV
- -------
Item 14. Exhibits, Financial Statement Schedules, and Reports on Form 8-K.. 48

Signatures................................................... 50

<PAGE>

PART I
ITEM 1. BUSINESS

Except for the historical statements contained herein, this Form 10-K
contains forward-looking statements within the meaning of Section 27A of the
Securities Act of 1933, as amended (the "Securities Act") and Section 21E of the
Securities Exchange Act of 1934, as amended (the "Exchange Act"). These
forward-looking statements involve a number of risks, known and unknown, and
uncertainties, such as the loss of, or difference in actual from anticipated
levels of purchases from, the Company's major customers, the impact of
competitive products and pricing, the ability to retain and attract key
personnel and other risks which are described throughout this Form 10-K,
including under the sections titled "Products and Technology," "Customers and
End Users," "Research and Development," "Manufacturing," "Competition,"
"Intellectual Property and Other Proprietary Rights" and "Employees" in Item 1
hereof and within "Management's Discussion and Analysis of Financial Condition
and Results of Operations," including under the title "Other Factors That May
Affect Future Operating Results," in Item 7 of this Form 10-K. The actual
results that the Company achieves may differ materially from any forward-looking
statements due to such risks and uncertainties.
When used in this Form 10-K words such as "believes," "anticipates,"
"expects," "intends," and similar expressions are intended to identify
forward-looking statements, but are not the exclusive means of identifying such
statements. Readers are urged to carefully review and consider the various
disclosures made by the Company in this report and in the Company's reports
filed with the Securities and Exchange Commission that attempt to advise
interested parties of the risks and factors that may affect the Company's
business.
Due to all the foregoing factors, the Company believes that
period-to-period comparisons of its results of operations are not necessarily
meaningful and should not be relied upon as an indication of future performance.
Similarly, past performances are not necessarily indicative of future results.
It is possible, in some future quarters, the Company's operating results will be
below the expectations of stock market analysts and investors. In such event,
the price of the Company's Common Stock would likely be materially adversely
affected. Consequently, the purchase or holding of the Company's Common Stock
involves an extremely high degree of risk.

Overview

The Company designs, manufactures, markets and supports a broad range of
digital wide-area network ("WAN") access products for global networks. The
Company's products are used by service providers as infrastructure equipment and
by business enterprises for connectivity to WAN services, such as leased lines,
frame relay, Internet Protocol ("IP"), Switched Multimegabit Data Service
("SMDS"), Asynchronous Transfer Mode ("ATM") and Digital Subscriber Line
("DSL"). The Company's products allow local area network ("LAN")-based
internetworking devices, such as routers and switches, to access WANs and also
integrate data with digitized voice and video traffic for more efficient line
utilization. Digital Link's products are used both in the customer premise
equipment ("CPE") environment and in the networks of interexchange carriers
("IXCs"), Internet service providers ("ISPs") and telephone companies. The
Company believes it is a leader in the WAN access products market because of its
broad range of products and its diverse sales channels. The Company markets and
sells its products in North America, Europe, South America and Asia primarily
through its direct sales force, value-added resellers ("VARs") and original
equipment manufacturers ("OEMs").
The Company was incorporated in California in 1985. Its principal executive
offices are located at 217 Humboldt Court, Sunnyvale, California 94089 and its
web site is http://www.dl.com. Information included on the Company's web site
does not constitute part of this Form 10-K.

<PAGE>

Industry Background

The growing reliance on enterprise-wide networks to facilitate the sharing
of information has created an environment in which the linkage of multiple LANs
over wide area networks is critical to daily operations. Two types of WANs have
developed to satisfy internetworking needs: private WANs, which are generally
based on dedicated leased lines; and public WANs, which are based on centralized
switching networks that route data to the proper destination. In private WANs,
the functions of switching, routing and multiplexing are performed on the
organization's premises utilizing customer-owned equipment and dedicated lines
leased from telephone companies and IXCs. As an alternative to private WANs,
telephone companies, ISPs and IXCs offer public WAN services. Companies that
provide products for connecting LAN-based data networks to WANs could support
both private and public WANs, including public WANs based on frame relay, SMDS,
ATM and DSL technologies.
In order for LANs to be interconnected to WANs, an interface is required to
condition LAN-based data to a format appropriate for transmission over WANs. The
Company believes equipment providers addressing the WAN access market must
develop product solutions flexible enough to respond to the changing standards
and network requirements associated with emerging WAN technologies.

Products and Technology

The Company's principal products offer 56/64Kbps, T1/E1, nxT1/E1 and T3/E3
access to public and private WANs using Internet, Frame relay, SMDS, ATM and DSL
technology. The Company's products range from simple desktop or rack-mounted
units for smaller sites to intelligent multi-processor systems that support
multiple lines and integrate data with digitized voice and video for larger and
more complex sites. Enterprises use these products to enable internetworking
equipment such as routers and switches to access WANs. The Company's products
may also be used within the networks of telephone companies, ISPs and IXCs to
provide access to their backbone networks. The list prices of the Company's
products generally range from $300 to $15,000.
The Company's WAN access products are classified as Digital Service
Units/Channel Service Units ("DSUs/CSUs"), access multiplexers and inverse
multiplexers. The Company's DSUs/CSUs generally provide the interface between a
single data port and a single WAN line, and its access multiplexers are used to
multiplex multiple data, voice or video ports over one or more WAN lines.
Digital Link's inverse multiplexers break down high-speed data from a single
source for transmission over multiple T1 WAN lines.
The Company introduced its first T1 access products in 1985. In 1993, the
Company introduced the second generation of its T1/E1 access products with
certain enhanced features. Known as the Encore product line, these products
provide interfaces to Ethernet and Token Ring LAN-based data traffic from
internetworking devices and connects them to dedicated or Frame relay-based
56Kbps and T1/E1 lines. In 1998, the Company released T1 and 56/64Kbps access
products that include improved network management capabilities such as in-band
management and integrated performance monitoring ("IPM"). These products, in
conjunction with Digital Link WANview or NetScout Systems, Inc. network
management system, have allowed the Company to market a comprehensive enterprise
management solution.
In 1993, the Company introduced the DL3800 T1 inverse multiplexer in
response to marketplace demand for a method of transporting information at data
rates faster than T1 without the expense and availability issues associated with
T3 lines. The DL3800 accepts data from a single high-speed data device and
prepares it for transmission over as many as eight T1 lines. In June 1996, the
Company introduced an international version of its inverse multiplexer product
line.
The Company introduced its first T3 access products in 1990. The Company's
T3/E3 DSUs and multiplexers include the DL3100 T3/E3 Access Multiplexer which
connects networking equipment to T3/E3 lines and is available with single or
multiple ports. In May 1995, the Company introduced the DL3900 multiplexer shelf
that allows customers to reduce the shelf space needed when installing multiple
inverse multiplexers in the same location. It houses both T1 and inverse
multiplexer modules and T3 access multiplexer modules to provide connectivity
between central and DL3100 or DL3800 units at remote sites.
The Company also offers SMDS and ATM access products. In 1991, the Company
began shipping the DL200, which is a DSU/CSU used to access public SMDS networks
that operate over T1/E1 lines. In 1992, the Company began shipping the DL3200,
which is a DSU used to access public SMDS and ATM networks that operate over
T3/E3 lines.
In support of the ATM infrastructure and to complement the large capacity
ATM switches necessary for such an infrastructure, the Company had developed its
DL7100 product (formerly known as the W/ATM GateWay Product ) to connect non-ATM
traffic and slower speed ATM traffic to these high-speed ATM switches. The
DL7100 was a high-capacity system that multiplexes and switches voice, data,
video, low-speed cell and Frame relay for ATM transmissions. In September 1997,
the Company acquired certain assets of Performance Telecom Corporation
("Performance Telecom"). Performance Telecom developed asymmetrical, symmetrical
and rate-adaptive DSL products. With the DSL technology acquired from
Performance Telecom, the Company developed a DSL interface for the DL7100. In
April 1998, the Company entered into an Asset Sale Agreement (the "Agreement")
with Semaphore Communications Corporation ("Semaphore"). Semaphore developed
security management and virtual private network ("VPN") products for
Internet/intranet and Frame relay applications. In September 1998, the Company
discontinued development on the DL7100 and Semaphore product lines. The decision
to terminate these projects was in response to slower than expected development
of the DL7100 DSL and VPN markets.
The Company believes that network reliability and management are among the
most important factors considered by users when selecting a network equipment
supplier. In order to maximize network reliability, the Company has built
monitoring and diagnostic tools into all of its products. In addition, the
Company offers access products with Simple Network Management Protocol ("SNMP"),
a standards-based network management system, in-band management and IPM. SNMP
provides a set of processes and procedures to manage all elements of a network,
allowing a user to manage and control the entire network with one management
system. In-band management and IPM are management solutions used to improve
network management.
The Company also provides an SNMP-based graphical user interface in its
WANview technology solutions. WANview network management systems help service
providers achieve high levels of service, increased network efficiency and
reliability for improved operations because they can configure, maintain and
test the Company's products. The Company's Management Access Processor ("MAP")
allows customers to manage Digital Link products via a direct Ethernet LAN
interface. This cost-effective interface provides a management access
alternative independent of routers or terminal servers.
The markets for the Company's products are characterized by rapid
technological advances, product obsolescence, changes in customer requirements
and evolving regulatory requirements and industry standards. The Company's
future prospects will depend in part on its ability to enhance the functionality
of its existing WAN access products in a timely manner and to identify, develop
and achieve market acceptance of new products that address new technologies and
meet customer needs in the WAN access market. Any failure by the Company to
anticipate or to respond adequately to competitive solutions, technological
developments in its industry, changes in customer requirements, or changes in
regulatory requirements or industry standards, or any significant delays in the
development, introduction or shipment of products, could have a material adverse
affect on the Company's business and operating results. There can be no
assurance that the Company's product development efforts will result in
commercially successful products or that product delays will not result in
missed market opportunities. In addition, customers could refrain from
purchasing the Company's existing products in anticipation of new product
introductions by the Company or its competitors. New products could also render
certain of the Company's existing products obsolete. Either of these events
could materially adversely affect the Company's business and operating results.
See "Management's Discussion and Analysis of Financial Condition and Results of
Operations -- Other Factors That May Affect Future Operating Results -- Company
Must Respond to Technological Change" in Item 7 of this Form 10-K.

Customers and End Users

Digital Link's customers and end users are diverse and represent many
industries. End users of private WANs that incorporate the Company's access
products, as well as telephone companies, ISPs and IXCs that either incorporate
the Company's products within their public networks or purchase the Company's
access products for resale to end users, include major interexchange carriers,
the Regional Bell Operating Companies ("RBOCs"), major domestic and
international carriers, industrial, electronics and other companies and
governments, universities and utilities.
The Company sells a majority of its products to a relatively limited number
of telephone companies, VARs, OEMs and end users. In 1998, 1997 and 1996, net
sales to MCI represented approximately 11%, 20% and 13%, respectively, of the
Company's net sales. In addition, net sales to Cisco Systems, Inc. during 1998
were 10% of the Company's net sales and net sales to BBN Planet Corporation
during 1996 were 13% of the Company's net sales. There can be no assurance that
the Company's current customers will continue to place orders with the Company
or that the Company will be able to obtain orders from new customers. The loss
of, or difference in actual from anticipated levels of purchases from, the
Company's major customers have in the past adversely affected the Company's
operating results and could continue to do so in the future. A significant
portion of the Company's business is derived from substantial orders placed by
large end users and telephone companies, and the timing of such orders,
including the completion of the build out of carrier and network service
providers' infrastructures, could cause material fluctuations in the Company's
business and operating results. For example, in the fourth quarter of 1997 and
in the second quarter of 1998, the Company had lower operating results than
expected due in part to a weaker than expected demand from certain domestic
carrier customers, including MCI. Other factors that may cause fluctuations in
the Company's operating results include, but are not limited to, the timing of
new product announcements and introductions by the Company and its competitors,
market acceptance of new or enhanced versions of the Company's products, changes
in the product mix sold toward narrowband products that yield lower gross
margins, seasonal capital spending patterns of large domestic customers, changes
in sales volumes through the Company's distribution channels, availability and
cost of components from the Company's suppliers and economic conditions
generally or in various geographic areas. In addition, the Company's expense
levels are based in part on its expectations of future revenue. The Company
operates with limited order backlog, and a substantial majority of its revenues
in each quarter result from orders booked in that quarter. If revenue levels are
below expectations, the Company may be unable to adjust spending in a timely
manner which would adversely affect operating results. A significant portion of
the Company's business is very price competitive, which has in the past and will
in the future require the Company to lower its prices, resulting in fluctuations
in the Company's business and operating results. See "Management's Discussion
and Analysis of Financial Condition and Results of Operations -- Results of
Operations -- Net Sales," " -- Quarterly Consolidated Results of Operations" and
" -- Other Factors That May Affect Future Operating Results -- Operating Results
May Fluctuate; Absence of Significant Backlog" in Item 7 of this Form 10-K.

<PAGE>

Sales and Marketing

The Company primarily markets its products worldwide directly to IXCs,
ISPs, large end users and RBOCs and indirectly primarily through a network of
VARs and OEMs to accommodate specific markets and customer support requirements.
The Company's sales force focuses on (i) U.S. end users, VARS and ISPs, (ii)
U.S. & Canadian IXCs and telephone companies ("carriers") and (iii)
international customers. Each of these focus areas include one or more
field-based system engineers to provide technical sales support. In addition,
the Digital Link sales organization receives support from various groups within
the Company such as the marketing department, which is responsible, among other
things, for product marketing, customer service, and marketing communications.

U.S. End Users, VAR and ISPs

Sales to U.S. end users are generally made through the Company's direct
sales force and indirectly through VARs. Thus, the U.S. end users sales group is
primarily responsible for developing and maintaining relationships with selected
end users and for supporting the sales activities of its VARs. The Company's
agreements with its VARs generally have terms of 12 months, are subject to
renewal by mutual agreement and provide for discounts from the Company's list
prices for products based on the expected annual sales volumes and require the
Company to provide sales and application engineering support. The U.S. end user
sales group operates through the Company's headquarters in Sunnyvale, California
and seven other sales offices.

Carriers

Digital Link's carrier sales force focuses on developing and maintaining
relationships with carriers in the U.S. and Canada and on understanding the
network deployment strategies of these carriers. Products sold to carriers may
be used (i) within a carrier's network in conjunction with the provision of
their services, (ii) for resale in conjunction with a carrier's provision of
services to an end user, or (iii) to satisfy the needs of a carrier's internal
management information systems, where the carrier is an end user of the
products. The Company has entered into agreements with certain carriers in the
United States and Canada to purchase its products. However, these agreements do
not obligate the carriers to purchase any minimum quantity of the Company's
products.

International Customers

Sales to international customers are primarily made through OEMs, the
Company's direct sales force and selected VARs. International VARs authorized to
sell the Company's products are located in several countries within Europe,
South America and Asia. Support for the Company's products sold internationally
is provided by the Company or its authorized VARs. The Company currently has
international sales offices in the United Kingdom and Germany.

Customer Support

The Company believes that a high level of continuing service and support is
integral to its objective of developing and maintaining long-term relationships
with its customers. The Company's customer support personnel are responsible for
servicing the Company's products and provide installation, technical training
and post-sales support. The Company's products generally have a warranty of at
least 2 years and some CPE products have lifetime warranties. The Company offers
free telephone support during normal business hours. The Company also offers
customers the option of entering into a maintenance and support contract that
can include telephone support seven days a week and 24 hours a day, emergency
replacement programs and on-site support. Internationally, the Company provides
customer support either directly or through full service VARs.

Research and Development

The Company's research and development efforts are focused on developing
new products, core technologies and enhancements to existing products. The
Company's product development activities are based on customer requirements,
marketplace needs and active participation by the Company in industry standards
groups and forums.
In 1998, 1997 and 1996 the Company's research and development expenditures
were $12.6 million, $11.0 million and $10.1 million, which represented 23.0%,
16.7% and 19.4%, respectively, of net sales. In addition, the Company incurred a
charge for purchased research and development of $2.3 million in 1998 in
connection with its acquisition of Semaphore Communications and $3.7 million in
1997 in connection with its acquisition of Performance Telecom. The Company's
research and development efforts in 1998 primarily focused on the continued
development of the Company's DL7100 product, including a DSL interface, on the
expansion of its Encore product family by introducing new products and new
features, and development of the Semaphore security products. In September 1998,
the Company discontinued development on the DL7100 and Semaphore product lines.
The decisions to terminate these projects were in response to slower than
expected development in the DL7100 DSL and VPN markets. During 1999, the Company
expects that it will continue to devote research and development resources to
the development of new products, features and management systems within its WAN
access business. The Company considers its research and development efforts to
be vital to its future success and anticipates that research and development
expenditures, as a percentage of net sales, will remain significant for the
foreseeable future. See "Management's Discussion and Analysis of Financial
Condition and Results of Operations -- Results of Operations -- Research and
Development" and "--Purchased Research and Development and Restructuring
Charges" in Item 7 of this Form 10-K.
As referenced above, the Company's product development activities
frequently address new WAN services and applications based on emerging
technologies. The Company believes this strategy has often resulted in early
market penetration for products based on these technologies. However, industry
standards and requirements are more likely to change in new markets, which can
adversely impact the Company's business and operating results. Moreover,
technology and implementation approaches selected by the Company may be rendered
obsolete by such changes, and a new market may not become widespread. See
"Management's Discussion and Analysis of Financial Condition and Results of
Operations -- Other Factors That May Affect Future Operating Results -- Company
Must Respond to Technological Change" in Item 7 of this Form 10-K.
The Company's success will depend upon its ability to develop new products
that achieve market acceptance and to provide enhancements to existing products
as required by the Company's customers and the communications marketplace. In
order to meet the challenges of rapidly changing technologies and services and
new industry standards that can render obsolete the Company's products, the
Company has invested and expects to continue to invest substantial resources in
the development of new products and technologies. The Company may in the future
develop products with which the Company has only limited experience and/or that
are targeted at emerging market segments. There can be no assurance that the
Company's product development efforts will result in commercially successful
products or that product delays will not result in missed market opportunities.

As of December 31, 1998, the Company's research and development staff
consisted of 56 employees, of whom 53 were engineers, and approximately
one-third of such engineers were engaged principally in the development of
software content. The Company believes its ability to attract and retain
qualified development personnel is essential to the success of its development
programs. The market for such personnel is highly competitive, and the Company's
development activities could be adversely affected if the Company is
unsuccessful in attracting and retaining skilled technical personnel.

Manufacturing

The Company's manufacturing operations consist primarily of component
procurement and final assembly, test and quality control of subassemblies and
systems. The Company uses local third party contractors to manufacture and
assemble printed circuit boards. The manufacturing process enables the Company
to configure the hardware and software in combinations to meet a wide variety of
customer requirements. The Company performs "burn-in" procedures and functional
tests, as well as comprehensive inspections to assure the quality and
reliability of its products.
The Company's product designs are proprietary but generally incorporate
industry standard hardware components. However, certain semiconductor devices
and components and subassemblies are presently available only from single
sources. Certain other components are presently available or acquired only from
a limited number of sources. To date, the Company has been able to obtain
adequate supplies of these components, as well as subassemblies from third party
contractors, in a timely manner from existing sources or, when necessary, from
alternative sources, or to redesign its products to accommodate an alternative
component. The inability to obtain sufficient sole or limited source components
or subassemblies as required in the future, or to develop alternative sources or
redesign its products if and as required in the future, could result in delays
or reductions in product shipments. Any such occurrence could materially
adversely affect the Company's business and operating results or damage customer
relationships.

Competition

The market for the Company's products is highly competitive. Many of the
Company's customers purchase products from both the Company and the Company's
competitors. The Company currently competes primarily with Adtran, Inc.
("Adtran"), Kentrox Industries, Inc., a subsidiary of ADC Telecommunications,
Inc. ("Kentrox"), Larscom Inc. ("Larscom"), Paradyne Corporation ("Paradyne"),
Verilink Corporation ("Verilink") and Visual Networks, Inc. ("Visual Networks").
Many of the Company's current and potential competitors have greater financial,
research and development, intellectual property, marketing and other resources
than those of the Company and have broader product lines and longer standing
relationships with customers than the Company. The Company expects competition
to increase in the future from existing competitors and from other companies
that may enter the Company's existing or future markets. In addition, the
Company faces competition from suppliers of internetworking equipment, such as
routers, and telephone equipment, such as switches, which are including a direct
WAN interface in certain of their products. An increased reliance by customers
on such suppliers for WAN access would reduce demand for the Company's products.
Any such reduced demand would have a material adverse effect on the Company's
business and operating results. As discussed above, increased competition has
also placed increasing pressures on the pricing of the Company's products, which
has resulted in lower operating results. The Company anticipates that this
pricing pressure will continue for the foreseeable future. See "Management's
Discussion and Analysis of Financial Condition and Results of Operations --
Results of Operations -- Net Sales" and "-- Gross Profit" in Item 7 of this Form
10-K. The Company believes that its ability to compete successfully depends on a
number of factors both within and outside of its control, including, but not
limited to, price; announcements by the Company and its competitors; rapid
development of new products and features; product quality and performance;
experienced sales, marketing and service organizations; and evolving industry
standards. There can be no assurance that the Company will be able to continue
to compete successfully with its existing competitors or that it will be able to
compete successfully with new competitors.

Intellectual Property and Other Proprietary Rights

The telecommunications industry is characterized by the existence of a
large number of patents and frequent litigation based on allegations of patent
infringement. For example, the Company has been contacted by two separate
parties who have expressed their belief that certain of the Company's products
may infringe upon patents held by it. The third parties have suggested on such
occasions that the Company acquire a license to such patents. See "Management's
Discussion and Analysis of Financial Condition and Results of Operations --
Other Factors That May Affect Future Operating Results -- Risk of Third Party
Claims of Infringement," in Item 7 of this Form 10-K.
The Company treats its software and hardware designs as proprietary and
relies primarily on a combination of copyrights, trademark and trade secret
laws, and employee and third party nondisclosure agreements, to protect its
proprietary information. There can be no assurance that the contractual
obligations to maintain the confidentiality of the Company's trade secrets or
proprietary information will not be breached by employees, consultants, advisors
or others, or that the Company's trade secrets or proprietary technology will
not otherwise become known or be independently developed by competitors. The
Company has one patent with the U.S. Patent and Trademark office for certain ATM
technology that expires in September 2011. However, there can be no assurance
that such patent will prove to be important in the Company's product development
efforts. Certain technologies used in the Company's products are licensed from
third parties on a non-exclusive basis.

Employees

As of December 31, 1998, the Company had 208 employees, of whom 56 were
primarily engaged in research and development, 83 in sales, marketing and
administration, 8 in customer support and 61 in manufacturing. In addition, from
time to time, Digital Link employs contract labor to assist with its short-term
personnel needs. The Company believes that its future success will depend in
large part upon the continued contributions of members of the Company's senior
management and other key personnel, and upon its ability to attract and retain
highly skilled managerial, engineering, sales, marketing and operations
personnel, the competition for whom is intense. Certain of the Company's key
management personnel have only recently joined the Company, and certain
personnel have only limited experience in the Company's industry. For example,
in March 1998, Kent Bossange, was promoted to Vice President, Marketing, in
December 1998, Lana Vaysburd was hired as Vice President, Engineering and in
March 1999, Sherman Silverman was hired as Vice President, Sales and Marketing,
Worldwide. In addition, in March 1998 Vinita Gupta was reappointed as the
Company's interim President and Chief Executive Officer, which position she
accepted on a full-time basis in January 1999. The current availability of
qualified sales and engineering personnel is quite limited, and competition
among companies for such personnel is intense. The Company is currently
attempting to hire a number of sales and engineering personnel and has
experienced delays in filling such positions. There can be no assurance that the
Company will be successful in attracting and retaining skilled personnel to hold
these important positions. The Company expects to continue to experience growth
in the number of its employees, resulting in increased responsibilities for the
Company's management. The Company's employees are not represented by any
collective bargaining organization, and the Company has never experienced a work
stoppage. The Company believes that its employee relations are good.

ITEM 2. PROPERTIES

The Company leases its 60,030 square foot principal facility, which is
located in Sunnyvale, California, pursuant to a lease that expires in October
2003. Digital Link also leases 11,500 square feet of space in Rochester, New
York, as a research and development facility. The Company maintains sales
operations in North America in Oak Brook, Illinois; Ann Arbor, Michigan; St.
Charles, Missouri; Carrollton, Texas; Houston, Texas; Irving, Texas; and
Toronto, Ontario. In Europe, the Company leases a facility near Stuttgart,
Germany. The Company believes that its existing facilities are adequate to meet
its current needs and that suitable additional or alternative space will be
available in the future on commercially reasonable terms. See Note 3 of Notes to
Consolidated Financial Statements.

ITEM 3. LEGAL PROCEEDINGS

In April 1996, a class action complaint was filed against the Company and
certain of its officers and directors in Santa Clara Superior Court of the State
of California, alleging violations of the California Corporations Code and
California Civil Code. In October 1996, a similar parallel lawsuit was filed in
the United States District Court for the Northern District of California
alleging violations of federal securities laws. See "Management's Discussion and
Analysis of Financial Condition and Results of Operations -- Other Factors That
May Affect Future Operating Results -- Legal Proceedings," in Item 7 of this
Form 10-K.

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

Not Applicable.

<PAGE>

PART II

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

The Common Stock of the Company began trading in the over-the-counter
market on the Nasdaq National Market on February 1, 1994 under the symbol
"DLNK." The following table sets forth the high and low closing prices for the
Company's Common Stock as reported on the Nasdaq National Market for each
quarterly period since January 1, 1997. These prices reflect inter-dealer
prices, without retail mark-up, markdown or commission, and may not necessarily
represent actual transactions.

1998 1997
High Low High Low
---- --- ---- ---
1st Quarter....... $12.50 $9.50 $24.25 $12.50
2nd Quarter....... $11.13 $6.75 $21.75 $13.75
3rd Quarter....... $7.75 $3.75 $27.38 $18.88
4th Quarter....... $5.69 $3.22 $26.25 $9.41

As of December 31, 1998 there were 146 holders of record of the Company's
Common Stock and approximately 1,200 beneficial owners.
The Company has never declared or paid any cash dividends on its capital
stock. The Company currently intends to retain any future earnings for use in
its business and, therefore, does not anticipate paying any cash dividends in
the foreseeable future.

ITEM 6. SELECTED FINANCIAL DATA

The following selected consolidated financial data should be read in
conjunction with the consolidated financial statements and the notes thereto
included elsewhere herein. The consolidated statement of operations data for the
years ended December 31, 1998, 1997 and 1996, and the consolidated balance sheet
data at December 31, 1998 and 1997 are derived from, and are qualified by
reference to, the audited consolidated financial statements included elsewhere
in this report and should be read in conjunction with those financial statements
and the notes thereto. The consolidated statement of operations data for the
years ended December 31, 1995 and 1994 and the consolidated balance sheet data
at December 31, 1996, 1995 and 1994 are derived from audited financial
statements not included in this report.

<PAGE>

<TABLE>

Year Ended December 31,
-----------------------

(in thousands, except per share data) 1998 1997 1996 1995 1994
-------- -------- -------- -------- --------

Statement of Operations Data:
<S> <C> <C> <C> <C> <C>
Net sales .................................... $ 54,627 $ 66,008 $ 52,078 $ 44,344 $ 35,222
Cost of sales ................................ 31,442 29,078 21,457 16,769 11,927
-------- -------- -------- -------- --------
Gross profit ......................... 23,185 36,930 30,621 27,575 23,295
-------- -------- -------- -------- --------

Expenses:
Research and development ................ 12,580 11,005 10,120 8,922 7,300
Selling, general and administrative ..... 18,716 22,019 16,150 13,958 10,514
Purchased research & development
and restructuring charges(1)
4,805 3,651 -- -- --
-------- -------- -------- -------- --------
Total expenses ....................... 36,101 36,675 26,270 22,880 17,814
-------- -------- -------- -------- --------
Operating income (loss) .............. (12,916) 255 4,351 4,695 5,481
Other income ................................. 2,196 2,524 2,495 2,281 1,098
-------- -------- -------- -------- --------
Income (loss) before provision
(benefit) for income taxes ........... (10,720) 2,779 6,846 6,976 6,579
Provision (benefit) for income taxes ......... (4,248) 847 2,149 2,162 2,171
-------- -------- -------- -------- --------
Net income (loss) .................... $ (6,472) $ 1,932 $ 4,697 $ 4,814 $ 4,408
======== ======== ======== ======== ========
Earnings per share (basic)
- --------------------------
Net income (loss) per share .................. $ (0.71) $ 0.21 $ 0.52 $ 0.55 $ 0.55
======== ======== ======== ======== ========
Shares used in computing per share amounts
9,176 9,249 9,107 8,783 7,976
======== ======== ======== ======== ========
Earnings per share (diluted)
- ----------------------------
Net income (loss) per share .................. $ (0.71) $ 0.20 $ 0.50 $ 0.51 $ 0.48
======== ======== ======== ======== ========
Shares used in computing per share amounts
9,176 9,600 9,478 9,467 9,113
======== ======== ======== ======== ========

</TABLE>

Year Ended December 31,
----------------------------------------------------------------------
(in thousands) 1998 1997 1996 1995 1994
---- ---- ---- ---- ----
<S> <C> <C> <C> <C> <C>
Balance Sheet Data:
Cash, cash equivalents and
marketable securities...... $34,730 $42,429 $44,048 $37,609 $31,688
Working capital................ 22,135 28,901 28,523 27,483 23,352
Total assets................... 54,906 66,056 62,733 54,755 46,829
Total shareholders' equity..... 45,366 57,334 53,802 47,773 40,211

</TABLE>

(1) See Notes 8 and 9 of Notes to Consolidated Financial Statements for an
explanation of these changes.

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

Overview

<PAGE>

Results of Operations

The following table sets forth statement of operations data as a percentage
of net sales for the years ended December 31, 1998, 1997 and 1996:

<TABLE>

Year Ended December 31,
---------------------------------------------
1998 1997 1996
---- ---- ----
<S> <C> <C> <C>
Net sales.......................................... 100.0% 100.0% 100.0%
Cost of sales...................................... 57.6 44.1 41.2
---------- ---------- ----------
Gross profit............................... 42.4 55.9 58.8
---------- ---------- ----------

Expenses:
Research and development...................... 23.0 16.7 19.4
Selling, general and administrative........... 34.2 33.3 31.0
Purchased research and development
and restructuring charges .................... 8.8 5.5 0
---------- ---------- ----------
Total expenses............................. 66.0 55.5 50.4
---------- ---------- ----------
Operating income (loss) ................... (23.6) 0.4 8.4
Other income....................................... 4.0 3.8 4.8
---------- ---------- ----------
Income (loss) before provision (benefit)
for income taxes........................... (19.6) 4.2 13.2
Provision (benefit) for income taxes............... (7.8) 1.3 4.1
----------- ---------- ----------
Net income (loss) ......................... (11.8)% 2.9% 9.1%
============ ========== ==========
</TABLE>

Net Sales

Net sales decreased 17% to $54.6 million in 1998 from $66.0 million in
1997. This decrease in net sales was primarily attributable to a decrease in
unit sales of broadband (i.e., transmission rates in excess of T1/E1) products,
as a result of lower sales to certain domestic carrier customers, including MCI,
and a decrease in the average selling prices on certain broadband products as a
result of price reductions made in 1998 and 1997. Net sales increased 27% to
$66.0 million in 1997 from $52.1 million in 1996. The increase in 1997 was
primarily attributable to an increase in unit sales of broadband products and to
a lesser extent, an increase in unit sales of narrowband (i.e., transmission
rates up to T1/E1) products. This increase was offset in part by decreased
average selling prices on certain narrowband and broadband products as a result
of price reductions made in the first half of 1997.
In 1998, narrowband sales in absolute dollars decreased by 6% and increased
as a percentage of net sales to 63% as compared to 60% in 1997. Broadband sales
decreased in absolute dollars by 31% and decreased as a percentage of net sales
to 37% in 1998 as compared to 40% in 1997. The changes in narrowband sales and
broadband sales as a percentage of net sales were primarily due to lower sales
of broadband products to certain domestic carrier customers, including MCI. In
1997, narrowband sales in absolute dollars increased by 15% and decreased as a
percentage of net sales to 55% as compared to 61% in 1996. Broadband sales
increased in absolute dollars by 45% and increased as a percentage of net sales
to 45% in 1997 as compared to 39% in 1996. The changes in narrowband sales and
broadband sales as a percentage of net sales from 1996 to 1997 was primarily a
result of higher broadband sales to certain domestic carrier customers and ISPs.
International sales (including sales in Canada) represented approximately
22%, 17% and 17% of net sales in 1998, 1997 and 1996, respectively. The increase
in 1998 as compared to 1997 was due to sales of the products developed by
Semaphore Communications Corporation ("Semaphore") acquired by the Company in
connection with the acquisition of Semaphore in April 1998. The increase in net
sales relating to the Semaphore product will not continue in 1999 as the Company
has discontinued sales of the Semaphore products. International sales are
subject to inherent risks, including difficulties in homologating products in
other countries, difficulties in staffing and managing foreign operations,
greater difficulty in accounts receivable collection, unexpected changes in
regulatory requirements and tariffs, and potentially adverse tax consequences,
which may in the future contribute to fluctuations in the Company's business and
operating results.
In 1998, 1997 and 1996, net sales to MCI represented approximately 11%, 20%
and 13%, respectively, of the Company's net sales. In addition, net sales to
Cisco Systems, Inc. during 1998 were 10% of the Company's net sales and net
sales to BBN Planet Corporation during 1996 were 13% of the Company's net sales.
A significant portion of the Company's business is derived from substantial
orders placed by large end users and telephone companies. Therefore, the level
of demand from, and the timing of orders from, such customers could cause
material fluctuations in the Company's business and operating results. For
example, in the fourth quarter of 1997 and in the second quarter of 1998, the
Company experienced a shortfall in revenues as compared to its expectations,
which was due primarily to lower than expected revenues from certain domestic
carriers, including MCI.

Gross Profit

Gross profit decreased by 37% in 1998 to $23.2 million from $36.9
million for 1997. Gross margin decreased to 42.4% of net sales in 1998 as
compared to 55.9% in 1997. These decreases are primarily a result of decreased
sales volume, and to a lesser extent, to a result of the restructuring charges
related to the termination of the Company's DL7100 and VPN product lines that
were included as a component of cost of sales. These charges amounted to
approximately $3.2 million in the third quarter of 1998 as discussed under
"Purchased Research and Development and Restructuring Charges" below. These
charges were primarily related to the write-down of inventory and warranty
reserves due to the discontinuation or de-emphasis of certain product lines.
Gross profit increased 21% to $36.9 million in 1997 from $30.6 million in
1996. Gross margin decreased to 55.9% of net sales in 1997 as compared to 58.8%
in 1996. This decrease in gross margin was primarily due to the above referenced
price reductions, which were somewhat offset by a shift in the mix of products
sold to include more broadband products, which generally have higher gross
margins than narrowband products.
Gross profits may vary significantly from quarter to quarter depending on
many factors including competitive pricing pressures and changes in the mix of
products sold. A significant portion of the Company's business is very price
competitive, which has in the past and will in the future require the Company to
lower its prices, resulting in fluctuations in the Company's business and
operating results. The Company anticipates that this pricing pressure will
continue for the foreseeable future. In addition, the mix of products sold may
change to include a higher percentage of narrowband products which generally
have lower gross margins and would therefore adversely affect the Company's
overall gross profits.

Research and Development

The primary types of expenses included in research and development ("R&D")
expenses are personnel, consulting, prototype materials and professional
services. R&D expenses increased 14% to $12.6 million in 1998 from $11.0 million
in 1997. The absolute dollar increase in 1998 is attributable to higher
personnel-related expenses including personnel-related expense associated with
the acquisition of Semaphore in the second quarter of 1998. As a percentage of
net sales, R&D expenses were 23.0% in 1998 as compared to 16.7% in 1997. The
increase in R&D expenses as a percentage of net sales is due primarily to lower
sales volumes during 1998. R&D expenses increased 9% to $11.0 million in 1997
from $10.1 million in 1996. This increase was primarily attributable to
personnel related expenses offset by a decrease in consulting fees related to
the Company's DL7100 product. As a percentage of net sales, R&D expenses were
16.7% in 1997 as compared to 19.4% in 1996. The decrease as a percentage of net
sales was primarily the result of operating efficiencies from higher sales
volume during the period. The Company anticipates that its R&D expenses for 1999
will decrease in absolute dollars from the levels experienced in 1998 as a
result of the Company's restructuring related to the termination of the DL7100
and VPN developments. However, actual results could vary from the foregoing
forward-looking statement due to, among other factors set forth or referenced in
"Other Factors That May Affect Future Operating Results" below, the Company's
ability to develop and achieve market acceptance of new products and hire new
personnel during 1999.
All of the Company's R&D expenditures to date have been expensed as
incurred. In the future, the Company may be required to capitalize a portion of
its software development costs pursuant to Statement of Financial Accounting
Standards No. 86, "Accounting for Costs of Computer Software to be Sold, Leased
or Otherwise Marketed."

Selling, General and Administrative

The primary types of expenses included in selling, general and
administrative ("SG&A") expenses are personnel, advertising, other promotional,
and travel and entertainment. SG&A expenses decreased 15% in 1998 to $18.7
million from $22.0 million in 1997. This decrease is primarily attributable to
lower personnel related expenses and consulting expenses in 1998. SG&A expenses
increased 36% in 1997 to $22.0 million from $16.2 million in 1996. This increase
was primarily attributable to higher personnel related expenses and consulting
expenses. As a percentage of net sales, SG&A expenses increased to 34.3% for
1998 as compared to 33.4% for 1997. This increase in SG&A expenses as a
percentage of net sales was primarily a result of lower sales volumes during
1998. As a percentage of net sales, SG&A expenses increased to 33.4% for 1997 as
compared to 31.0% for the prior year. This increase as a percentage of net sales
was primarily a result of a higher rate of growth in personnel related expenses
compared to the rate of growth in net sales over the same period. The Company
has in the past hired more of its SG&A personnel and incurred increased expenses
related to trade shows and other promotional activities during the first half of
the year. Accordingly, SG&A expenses as a percentage of net sales are generally
higher during the first half of the year. However, any decrease in such expenses
as a percentage of net sales in the second half of the year are subject to,
among other factors set forth or referenced in "Net Sales" above and "Other
Factors That May Affect Future Operating Results" below, the Company's ability
to accelerate or defer operating expenses and achieve revenue levels during such
periods.

Purchased Research and Development and Restructuring Charges

The Company incurred an expense of $2.3 million related to purchased
research and development for which technological feasibility had not been
achieved in the second quarter of 1998 related to the acquisition of Semaphore.
Such in-process technology was valued, along with other acquired assets, using a
discounted cash flow analysis with separate cash flow projections for existing
and in-process technology. The value of in-process technology for which
technological feasibility had not been established and for which there was no
alternative use was expensed upon acquisition in accordance with Financial
Accounting Standards ("FAS") No. 2, "Accounting for Research and Development
Costs." See Note 7 of Notes to Financial Statements.
The Company incurred an expense of $3.7 million related to purchased
research and development for which technological feasibility had not been
achieved in the third quarter of 1997 in connection with its acquisition of
certain assets and in-process technology for $5 million in cash from Performance
Telecom. Such in-process technology was valued, along with other acquired
assets, using a discounted cash flow analysis with separate cash flow
projections for existing and in-process technology. The value of in-process
technology for which technological feasibility had not been established and for
which there was no alternative use was expensed upon acquisition in accordance
with FAS No. 2. This technology was designed to enable network service providers
to offer applications such as Internet access, interactive video services,
remote data access and multimedia applications at multi-megabit-per-second
speeds over standard voice-grade copper lines.
The Company incurred an expense of $2.5 million in the third quarter of
1998 related to the termination of its DL7100 and VPN product lines, including
termination of 25 project employees and abandonment of a leased facility. Since
the products included use of, or planned integration of, technologies and other
assets acquired through the Company's acquisitions of Semaphore and Performance
Telecom, the Company also evaluated those acquired assets, which had no
alternative future use, for realizability. The restructuring expense of $2.5
million consisted primarily of severance costs of $500,000, legal and lease
commitment costs of $500,000 and the write-off of goodwill and fixed assets of
$1.5 million related to the aforementioned acquisitions. In addition to these
costs the Company reflected $3.2 million of restructuring related costs in cost
of sales for inventory write-downs and warranty reserves.
All 25 project employees were notified of their termination severance
benefits by September 30, 1998 and 84% of these benefits were actually paid by
the end of December 1998. The Company's leased facility was exited in the first
quarter of 1999. Remaining accrued restructuring charges amounted to $1.2
million as of December 31, 1998, primarily for legal product claims and warranty
expenses associated with the termination of the aforementioned product lines.

Other Income

Other income includes primarily interest income. Other income decreased 13%
to $2.2 million in 1998 from $2.5 million in 1997. This decrease was primarily
due to lower interest income as a result of lower interest rates and lower cash
balances. Other income remained flat at $2.5 million in 1997 as compared to
1996.

Provision (Benefit) for Income Taxes

The Company's effective rate increased to 40% for 1998 compared to 30.5% in
1997. This increase is due primarily to the higher rate available assuming a
carry-back of current year losses compared to the effective tax rate applicable
if the Company were profitable. The Company's effective tax rate decreased to
30.5% in 1997 compared to 31.4% in 1996. This decrease is due primarily to
increases in foreign sales corporation tax benefits and nontaxable municipal
interest. The Company has not provided a valuation allowance on the deferred tax
assets as those amounts can be realized through carryback to prior years when
the Company paid income taxes or are expected to be realized from future
operations based upon the Company's history of profitable operations.

Quarterly Consolidated Results of Operations

The following table sets forth certain unaudited quarterly financial
information for each of the Company's last eight quarters. The Company believes
this information reflects all adjustments, consisting only of normal recurring
adjustments, that the Company's management considers necessary for a fair
representation of this information in accordance with generally accepted
accounting principles. Quarterly results are not necessarily indicative of
future results of operations.

<PAGE>

<TABLE>

Quarter Ended
---------- ---------- ---------- ---------- ---------- ---------- ---------- ----------
Mar. 31, June 30, Sept. 30, Dec. 31, Mar. 31, June 30, Sept. 30, Dec. 31,
1997 1997 1997 1997 1998 1998 1998 1998
(in thousands, except per share --------- --------- --------- --------- --------- --------- --------- ----------
data)
<S> <C> <C> <C> <C> <C> <C> <C> <C>
Net sales...................... $ 16,038 $ 17,033 $ 18,529 $14,408 $ 14,519 $ 12,797 $ 13,271 $14,040
Cost of sales.................. 6,816 6,856 7,948 7,458 7,204 6,830 10,168 7,240
-------- -------- -------- ------- -------- -------- -------- -------
Gross profit.............. 9,222 10,177 10,581 6,950 7,315 5,967 3,103 6,800
-------- -------- -------- ------- -------- -------- -------- -------
Expenses:
Research and development.... 3,032 2,594 2,603 2,776 2,822 3,567 3,856 2,335
Selling, general and
administrative................. 4,916 5,768 5,858 5,477 5,023 4,965 4,413 4,315
Purchased research & development
and restructuring charges...... 0 0 3,651 0 0 2,299 2,506 0
-------- ------- -------- -------- -------- ------- -------- ------
Total expenses............ 7,948 8,362 12,112 8,253 7,845 10,831 10,775 6,650
-------- ------- -------- -------- -------- ------- ------- -------
Operating income.......... 1,274 1,815 (1,531) (1,303) (530) (4,864) (7,672) 150

Other income................... 641 638 646 599 601 466 551 578
-------- -------- -------- ---------- -------- -------- -------- -------
Income before provision
(benefit) for income taxes. 1,915 2,453 (885) (704) 71 (4,398) (7,121) 728

Provision (benefit) for income taxes 583 748 (270) (214) 22 (1,712) (2,848) 290
-------- -------- ------------------------------ ---------- ---------- -------
Net income (loss)......... $ 1,332 $ 1,705 $ (615) $ (490) $ 49 $ (2,686) $ (4,273) $ 438
========= ======= ========= ========== ======== ========= ========= ========
Earnings per share (basic)
- --------------------------
Net income (loss) per share.... $ 0.14 $ 0.19 $ (0.07) $ (0.05) $ (0.01) $ (0.29) $ (0.47) $ 0.05
======= ======= ========== ========== ======== ========= ========= =======
Shares used in computing per share
amounts..................... 9,190 9,188 9,240 9,375 9,383 9,422 9,129 8,776
======= ======= ======= ======= ======== ======= ======= =======
Earnings per share (diluted)
- ----------------------------
Net income (loss) per share.... $ 0.14 $ 0.18 $ (0.07) $ (0.05) $ (0.01) $ (0.29) $ (0.47) $ 0.05
======= ======= ========== ======== ======== ======== ========== ========
Shares used in computing per share
amounts..................... 9,577 9,506 9,240 9,375 9,436 9,422 9,129 8,937
======= ======= ======= ======= ======= ======= ======= =======

</TABLE>

The Company acquired certain assets of Performance Telecom in September
1997, incurring a one-time charge of $3.7 million for purchased research and
development. This created a net loss in the third quarter of 1997.
A significant portion of the Company's business is derived from substantial
orders placed by large end-users and telephone companies. The timing of such
orders can, in general, cause material fluctuations in the Company's operating
results and was of particular significance in the fourth quarter of 1997 and in
the second quarter of 1998 where weaker than expected demand from certain
domestic carrier customers together with expense levels geared in expectation of
higher revenue levels combined to unfavorably impact the Company's net income.
The Company acquired certain assets of Semaphore Corporation in April 1998,
incurring a one-time charge of $2.3 million for purchased research and
development. This charge, in conjunction with weaker than expected demand from
certain carrier customers referenced above, resulted in a net loss for the
second quarter of 1998.
The Company incurred costs of $5.7 million in the third quarter of 1998
related to the termination of its DL7100 and VPN product lines, of which (i)
$2.5 million was included as operating expense under restructuring charges for
severance costs, costs associated with the write-off of fixed assets and legal
and lease commitment costs and (ii) $3.2 million was included in cost of sales
for inventory write-downs and warranty reserves for the discontinued product
lines.
The Company has in the past hired more of its SG&A personnel primarily
within the sales and marketing organizations, and incurred increased expenses
related to trade shows and other promotional activities, during the first half
of the year.
A significant portion of the Company's business is very price competitive,
which has in the past and will in the future require the Company to lower its
prices, resulting in fluctuations in the Company's business and operating
results. For example, periodically throughout 1996, 1997 and 1998, the Company
reduced the prices on some of its access products to address competitive pricing
pressures, which adversely affected the Company's gross margins during those
periods. The Company anticipates that this increased pricing pressure will
continue for the foreseeable future. In addition, the mix of products sold may
continue to change to include a higher percentage of narrowband products that
generally have lower gross margins. This would adversely affect the Company's
overall gross margins. Other factors that may cause fluctuations in the
Company's operating results include the timing of new product announcements and
introductions by the Company and its competitors, market acceptance of new or
enhanced versions of the Company's products, changes in the product mix sold
toward narrowband products that yield lower gross margins, seasonal capital
spending patterns of large domestic customers, changes in sales volumes through
the Company's distribution channels, availability and cost of components from
the Company's suppliers and economic conditions generally or in various
geographic areas. In addition, the Company's expense levels are based, in part,
on its expectations of future revenue. The Company typically operates with
limited order backlog, and a substantial majority of its revenues in each
quarter result from orders booked in that quarter. If revenue levels are below
expectations, the Company may be unable to adjust spending in a timely manner,
which would adversely affect operating results.

Liquidity and Capital Resources

The Company's working capital decreased to $22.1 million at December 31,
1998 from $28.9 million at December 31, 1997 and $28.5 million at December 31,
1996. The Company's cash, cash equivalents and long and short-term marketable
securities decreased to $34.7 million at December 31, 1998 from $42.4 million at
December 31, 1997 and $44.0 million at December 31, 1996. The decline in cash,
cash equivalents and long and short-term marketable securities at the end of
1998 is primarily due to the Company's net loss in 1998 and to significant
repurchases of Company shares when compared with 1997. The Company paid $5
million for certain assets of Performance Telecom in the third quarter of 1997,
accounting for much of the decline in cash, cash equivalents and long and
short-term marketable securities at the end of 1997 when compared with the end
of 1996.
Net cash provided by operating activities was $2.9 million, $5.8 million
and $6.4 million in 1998, 1997 and 1996, respectively. The decline in net cash
provided by operating activities from 1997 to 1998 was due to the net loss and
to the income tax refunds receivable in 1998 but not collectible until 1999,
offset partially by a decrease in inventories. In 1997, net cash provided by
operating activities was primarily a result of net income and a reduction in
receivables offset by increased inventories. In 1996, net cash provided by
operating activities was primarily a result of net income, a decrease in
accounts receivable and an increase in accounts payable and accrued payroll and
other accrued expenses, offset to some extent by increased inventories. To date,
the Company has not experienced any material inventory obsolescence as a result
of new product development, but there can be no assurance that future product
development efforts will not render Company products obsolete.
Net cash provided by investing activities was $3.6 million in 1998, versus
net cash used in investing activities of $5.3 million and $7.8 million in 1997
and 1996, respectively. 1998 was $8.9 million more positive than 1997 due in the
main to net proceeds from marketable securities in 1998 versus 1997 and to the
acquisition of Performance Telecom assets for cash in 1997. 1997 was $2.5
million more positive than 1996 despite the acquisition of Performance Telecom
assets and the increase in purchases of capital equipment, due to a net inflow
from marketable securities in 1997 versus a net outflow in 1996. Leasehold
improvements and capital equipment additions were $2.1 million in 1998, $2.3
million in 1997 and $1.3 million in 1996.
Net cash used in financing activities amounted to $8.7 million in 1998 as
compared to $10,000 in 1997 and to net cash provided by financing activities of
$812,000 in 1996. The use of cash in financing activities in 1998 and 1997 was
due primarily to the Company's repurchase of $9.4 million and $2.4 million,
respectively, of its Common Stock, offset by the proceeds from the exercise of
stock options and employee stock purchases.
In October 1996, the Company's Board of Directors announced the
authorization for the Company to repurchase up to 500,000 shares of common stock
for cash from time to time at market prices and as market and business
conditions warrant, in open market, negotiated or block transactions, at which
time the stock will be retired. The Board authorized additional repurchases of
up to 1,000,000 shares in May 1998 and 500,000 shares in December 1998. No time
limit was set for completion of the repurchase programs. The Company purchased
1,372,000 shares of common stock in 1998 and 142,000 shares in 1997 under this
program at a cost of $9,364,000 and $2,422,000 for 1998 and 1997, respectively.
The Company believes that existing cash and cash flows from operations will
be sufficient to meet its anticipated cash requirements for working capital and
capital expenditures for at least the next 12 months.

IMPACT OF RECENT ACCOUNTING PRONOUNCEMENTS

In March 1998, the American Institute of Certified Public Accountants
("AICPA") issued Statement of Position 98-1 ("SOP 98-1"), "Accounting for the
Costs of Computer Software Developed or Obtained for Internal Use." This
standard requires companies to capitalize qualifying computer software costs
which are incurred during the application development stage and amortize them
over the software's estimated useful life. SOP 98-1 is effective for fiscal
years beginning after December 15, 1998. The Company is currently evaluating the
impact of SOP 98-1 on its financial statements and related disclosures.
In April 1998, the AICPA issued Statement of Position 98-5 ("SOP 98-5"),
"Reporting on the Costs of Start-Up Activities." This standard requires
companies to expense the costs of start-up activities and organization costs as
incurred. In general, SOP 98-5 is effective for fiscal years beginning after
December 15, 1998. The Company believes the adoption of SOP 98-5 will not have a
material impact on its results of operations.
In June 1998, the Financial Accounting Standards Board issued Statement of
Financial Accounting Standards No. 133 ("SFAS 133"), "Accounting for Derivative
Instruments and Hedging Activities." SFAS 133 establishes new standards of
accounting and reporting for derivative instruments and hedging activities. SFAS
133 requires that all derivatives be recognized at fair value in the statement
of financial position, and that the corresponding gains or losses be reported
either in the statement of operations or as a component of comprehensive income,
depending on the type of hedging relationship that exists. SFAS 133 will be
effective for fiscal years beginning after June 15, 1999. The Company does not
currently hold derivative instruments or engage in hedging activities.

OTHER FACTORS THAT MAY AFFECT FUTURE OPERATING RESULTS

In addition to the factors set forth above in this "Management's Discussion
and Analysis of Financial Condition and Results of Operations," there are a
number of other factors that may affect the Company's future operating results.
Most of the following discussion consists of forward-looking statements and
accompanying risks.

Operating Results May Fluctuate; Absence of Significant Backlog

The loss of, or difference in actual from anticipated levels of purchases
from, the Company's major customers have in the past adversely affected the
Company and could in the future adversely affect operating results. A
significant portion of the Company's business is derived from substantial orders
placed by large end users and telephone companies. The timing of such orders,
including the completion of the build out of carrier and network service
providers' infrastructures, could cause material fluctuations in the Company's
business and operating results. For example, in the fourth quarter of 1997 and
in the second quarter of 1998, the Company had lower operating results than
expected due in part to a weaker than expected demand from certain domestic
carrier customers, including MCI. In addition, none of the Company's customers
are contractually obligated to purchase any quantity of products in any
particular period, and product sales to major customers have varied widely from
quarter to quarter and year to year. There can be no assurance that the
Company's current customers will continue to place orders with the Company, that
orders from existing customers will continue at the levels of previous periods
or that the Company will be able to obtain orders from new customers. Other
factors that may cause fluctuations in the Company's operating results include,
but are not limited to, the timing of new product announcements and
introductions by the Company and its competitors, market acceptance of new or
enhanced versions of the Company's products, changes in the product mix sold
toward narrowband products that yield lower gross margins, seasonal capital
spending patterns of large domestic customers, changes in sales volumes through
the Company's distribution channels, availability and cost of components from
the Company's suppliers and economic conditions generally or in various
geographic areas. In addition, the Company's expense levels are based in part on
its expectations of future revenue. The Company operates with limited order
backlog, and a substantial majority of its revenues in each quarter result from
orders booked in that quarter. If revenue levels are below expectations, the
Company may be unable to adjust spending in a timely manner which would
adversely affect operating results.

Market for the Company's Products is Highly Competitive

The market for the Company's products is highly competitive. The Company
expects competition to increase in the future from existing competitors and from
other companies that may enter the Company's existing or future markets. In
addition, the Company faces competition from suppliers of internetworking
equipment, such as routers, and telephone equipment, such as switches, which are
including a direct WAN interface in certain of their products. An increased
reliance by customers on such suppliers for WAN access would reduce demand for
the Company's products. This would have a material adverse affect on the
Company's business and operating results. As discussed above, increased
competition has also placed increasing pressures on the pricing of the Company's
products, which has resulted in lower operating results. The Company anticipates
that this pricing pressure will continue for the foreseeable future.

Company Must Respond to Technological Change

The Company's future prospects will depend in part on its ability to
enhance the functionality of its existing WAN access products in a timely
manner. It will also depend on the Company's ability to identify, develop and
achieve market acceptance of new products that address new technologies and meet
customer needs in the WAN access market. Any failure by the Company to
anticipate or to respond adequately to competitive solutions, technological
developments in its industry, changes in customer requirements, or changes in
regulatory requirements or industry standards, or any significant delays in the
development, introduction or shipment of products, could have a material adverse
effect on the Company's business and operating results. There can be no
assurance that the Company's product development efforts will result in
commercially successful products or that product delays will not result in
missed market opportunities. In addition, customers could refrain from
purchasing the Company's existing products in anticipation of new product
introductions by the Company or its competitors. New products could also render
certain of the Company's existing products obsolete. Either of these events
could materially adversely affect the Company's business and operating results.

<PAGE>

Company Depends on Key Personnel

The Company believes that its future success will depend in large part upon
the continued contributions of members of the Company's senior management and
other key personnel, and upon its ability to attract and retain highly skilled
managerial, engineering, sales, marketing and operations personnel, the
competition for whom is intense. Certain of the Company's key management
personnel have only recently joined the Company and certain personnel have only
limited experience in the Company's industry. For example, in March 1998, Kent
Bossange, was promoted to Vice President, Marketing, in December 1998, Lana
Vaysburd was hired as Vice President, Engineering and in March 1999, Sherman
Silverman was hired as Vice President, Sales and Marketing, Worldwide. In
addition, in March 1998 Vinita Gupta was reappointed as the Company's interim
President and Chief Executive Officer, which position she accepted on a
full-time basis in January 1999. The current availability of qualified sales and
engineering personnel is quite limited, and competition among companies for such
personnel is intense. The Company is currently attempting to hire a number of
sales and engineering personnel and has experienced delays in filling such
positions. There can be no assurance that the Company will be successful in
attracting and retaining skilled personnel to hold these important positions.

Year 2000 Compliance

The Company utilizes management information systems and software technology
that may be affected by Year 2000 issues throughout its businesses. During 1998,
the Company began to implement plans for certain of its internal operating
systems to ensure these systems continue to meet its internal and external
requirements. The Year 2000 compliance efforts will encompass:
All Digital Link products. The cost of this effort will be
approximately $250,000 and will be financed through working
capital and the use of internal engineering resources.
All Digital Link major operational systems (including ASK
MANMAN, databases, spreadsheets, word processing, and CAD). The
cost of these initiatives will be approximately $150,000. The
Company has contracted with a third party to perform the MANMAN
compliance work and will use a combination of consultants and
internal resources to address the compliance issues with other
internal operational systems.
The remaining initiatives to address vendor and customer compliance are
estimated to be complete by the end of June 1999. In addition, the Company has
developed questionnaires and contacted key suppliers and customers regarding
their Year 2000 compliance to determine any impact on its operations. In
general, the Company's suppliers and customers have advised it that they have
developed or are in the process of developing plans to address Year 2000 issues.
The Company will continue to monitor and evaluate the progress of its suppliers
and customers on this critical matter. The Company is also reviewing its
non-information technology systems to determine the extent of any changes that
may be necessary and believes that there will be minimal changes necessary for
compliance.
To date, the Company has incurred approximately $250,000 in expenses
related to Year 2000 compliance of its products and internal operating systems.
The Company has achieved approximately 95% of its products Year 2000 compliance
and plans to have the remaining products compliant by April 1999. Currently, in
excess of 50% of the internal operating systems are Year 2000 compliant. The
Company plans to implement Year 2000 compliance to the remaining portion by July
1999.
Based on the progress the Company has made in addressing its Year 2000
issues and the Company's plan and timeline to complete its compliance program,
the Company does not foresee significant risks associated with its Year 2000
compliance at this time. As the Company's plan is to address its significant
Year 2000 issues prior to being affected by them, it has not developed a
comprehensive contingency plan. However, if the Company identifies significant
risks related to its Year 2000 compliance or its progress deviates from the
anticipated timeline, the Company will develop contingency plans as deemed
necessary at that time.

Legal Proceedings

In April 1996, a class action complaint was filed against the Company and
certain of its officers and directors in the Santa Clara Superior Court of the
State of California, alleging violations of the California Corporations Code and
California Civil Code. In October 1996, a similar parallel lawsuit against the
Company and the same individuals was filed in the United States District Court
for the Northern District of California alleging violations of the federal
securities laws. The class period in both of these lawsuits runs from September
12, 1994 through December 29, 1995, and both complaints allege that the
defendants concealed and/or misrepresented material adverse information about
the Company and that the individual defendants sold shares of the Company's
stock based upon material nonpublic information. The complaints seek unspecified
monetary damages.
In the state court action, the court granted three prior motions to dismiss
filed by the Company and the individuals, in each case granting plaintiff leave
to amend his complaint. The court denied the motion to dismiss the most recent,
third amended complaint. Discovery to date has been limited in the state court
action, and the Superior Court has not set a trial date.
In the parallel Federal proceedings, the Court on September 11, 1997
granted the Company's motion to dismiss the federal complaint with leave to
amend, and plaintiff has filed an amended complaint. The Company has moved to
dismiss the amended complaint, the hearing on which is scheduled to take place
in April or May of 1999. There has been no discovery in the federal action, and
no trial date has been set.
The Company believes that both actions are without merit and intends to
defend both actions vigorously. However, litigation is subject to inherent
uncertainties and, thus, there can be no assurance that these lawsuits will be
resolved favorably to the Company or that they will not have a material adverse
affect on the Company's financial condition and results of operations. No
provision for any liability that may result upon adjudication has been made in
the accompanying financial statements.

Risk of Third Party Claims of Infringement

The telecommunications industry is characterized by the existence of a
large number of patents and frequent litigation based on allegations of patent
infringement. For example, a third party has, on several occasions, expressed
its belief that certain of the Company's products, including its DSU/CSUs, may
infringe upon patents held by it. The third party has suggested on such
occasions that the Company acquire a license to such patents. The Company
believes that a license, to the extent required, will be available; however, no
assurance can be given that the terms of any offered license would be favorable
to the Company. Should a license be unavailable, the Company could be required
to discontinue the sale of or to redesign certain of its products. In addition,
Larscom, a competitor of the Company, has continued to express its belief that
the Company's inverse multiplexer products may infringe a patent jointly owned
by Larscom and a third party and has suggested that the Company acquire a
license to the patent. The Company does not believe that there is merit to
Larscom's claim. Management, after review and consultation with counsel,
believes that the ultimate resolution of both these allegations is uncertain and
there can be no assurance that these assertions will be resolved without costly
litigation or in a manner that is not adverse to the Company. While the Company
has accrued certain amounts deemed probable for these matters in prior years, it
is currently unable to estimate the ultimate range of loss regarding these
matters. Therefore, it is reasonably possible that the ultimate resolution of
these matters could result in payments in excess of, or less than, the amounts
accrued in the accompanying financial statements and require royalty payments in
the future which could adversely impact gross margins and results of operations
in any one period.
There can be no assurance that other third parties will not assert
infringement claims against the Company in the future, that any such claims will
not result in costly litigation or that the Company will prevail in any such
litigation or be able to license any valid and infringed patents from third
parties on commercially reasonable terms.

Possible Adverse Changes in Future Market Price

The risks outlined herein are difficult for the Company to forecast, and
these or other factors can materially affect the Company's operating results and
stock price for one quarter or a series of quarters. Further, in recent years
the stock market has experienced extreme price and volume fluctuations that have
particularly affected the market prices of securities of many high technology
companies, for reasons frequently unrelated to the operating performance of the
specific companies. These fluctuations, as well as general economic, political
and market conditions, may materially adversely affect the market price of the
Company's common stock.

ITEM 7A. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK

The Company has limited exposure to financial market risks, including
changes in interest rates. The Company does not use derivative financial
instruments in its investment portfolio. The Company's investment portfolio is
generally comprised of municipal government securities that mature within three
years. The Company places investments in instruments that meet high credit
quality standards. These securities are subject to interest rate risk, and could
decline in value if interest rates increase. Due to the duration and
conservative nature of the Company's investment portfolio, the Company does not
expect any material loss with respect to its investment portfolio. The Company
does not have any significant foreign operations and thus is not materially
exposed to foreign currency fluctuations. The Company does not currently hedge
against foreign currency rate fluctuations.

<PAGE>

ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA

The quarterly supplementary data is included as part of Item 7,
"Management's Discussion and Analysis of Financial Condition and Results of
Operations." The financial statements required by this item are set forth below.

INDEX TO CONSOLIDATED FINANCIAL STATEMENTS
Page

Report of Independent Accountants ........................................ 27

Consolidated Financial Statements:

Consolidated Balance Sheets as of December 31, 1998 and 1997 ......... 28

Consolidated Statements of Operations and Comprehensive Income (Loss)
for each of the three years in the period ended December 31, 1998..... 29

Consolidated Statements of Shareholders' Equity for each of the three
years in the period ended December 31, 1998 .......................... 30

Consolidated Statements of Cash Flows for each of the three years in
the period ended December 31, 1998 .................................. 31

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

<PAGE>

REPORT OF INDEPENDENT ACCOUNTANTS

To the Board of Directors and Shareholders
Digital Link Corporation and Subsidiaries:

In our opinion, the consolidated financial statements listed in the index
appearing under Item 8 present fairly, in all material respects, the financial
position of Digital Link Corporation and its Subsidiaries at December 31, 1998
and 1997, and the results of their operations and their cash flows for each of
the three years in the period ended December 31, 1998, in conformity with
generally accepted accounting principles. In addition, in our opinion, the
financial statement schedule listed in the index appearing under Item 14(a) (2),
presents fairly, in all material respects, the information set forth therein
when read in conjunction with the related consolidated statements. These
financial statements and the financial statement schedule are the responsibility
of Company's management; our responsibility is to express an opinion on these
financial statements and the financial statement schedule based on our audits.
We conducted our audits of these statements in accordance with generally
accepted auditing standards which require that we plan and perform the audit to
obtain reasonable assurance about whether the financial statements are free of
material misstatement. An audit includes examining, on a test basis, evidence
supporting the amounts and disclosures in the financial statements, assessing
the accounting principles used and significant estimates made by management, and
evaluating the overall financial statement presentation. We believe that our
audits provide a reasonable basis for the opinion expressed above.

/s/ PricewaterhouseCoopers LLP

San Jose, California
January 19, 1999

<PAGE>

<TABLE>

DIGITAL LINK CORPORATION AND SUBSIDIARIES
CONSOLIDATED BALANCE SHEETS
(in thousands, except share data)

ASSETS

December 31,
------------
1998 1997
---- ----

Current assets:
<S> <C> <C>
Cash and cash equivalents ...................................... $ 296 $ 2,504
Short-term marketable securities ............................... 15,738 18,026
Accounts receivable, less allowance for doubtful accounts of
$540 in 1998 and $517 in 1997 .................................. 4,767 5,193
Inventories, net ............................................... 4,306 8,163
Prepaid and other current assets ............................... 998 1,433
Income taxes receivable ........................................ 2,501 --
Deferred income taxes .......................................... 3,069 2,304
------- -------
Total current assets .................................. 31,675 37,623

Property and equipment, net ............................................. 2,582 3,325
Long-term marketable securities ......................................... 18,696 21,899
Deferred income taxes ................................................... 1,560 2,062
Other assets ............................................................ 393 1,147
------- -------
Total assets ................................. $54,906 $66,056
======= =======

LIABILITIES AND SHAREHOLDERS' EQUITY

Current liabilities:
Accounts payable ............................................... $ 2,365 $ 2,407
Accrued payroll and related expense ............................ 2,168 2,344
Other accrued expenses ......................................... 4,764 3,785
Income taxes payable ........................................... 243 186
------- -------
Total current liabilities ............................. 9,540 8,722

Commitments and contingencies (Note 3)
Shareholders' equity:
Preferred stock, no par value:
Authorized: 5,000,000 shares;
Issued and outstanding: none in 1998 and 1997
Common stock, no par value:
Authorized: 25,000,000 shares;
Issued and outstanding: 8,490,472 shares in 1998 and
9,427,306 shares in 1997 .................................. 33,311 34,609
Accumulated other comprehensive income ......................... 52 107
Retained earnings .............................................. 12,003 22,618
------- -------
Total shareholders' equity ............................ 45,366 57,334
------- -------

Total liabilities and shareholders' equity ... $54,906 $66,056
======= =======
</TABLE>

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

<PAGE>

<TABLE>

DIGITAL LINK CORPORATION AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF OPERATIONS AND COMPREHENSIVE INCOME (LOSS)
(in thousands, except per share data)

Year Ended December 31,
-----------------------
1998 1997 1996
---- ---- ----

<S> <C> <C> <C>
Net sales ......................................... $ 54,627 $ 66,008 $ 52,078
Cost of sales ..................................... 31,442 29,078 21,457
-------- -------- --------
Gross profit ............................... 23,185 36,930 30,621
-------- -------- --------

Expenses:
Research and development ...................... 12,580 11,005 10,120
Selling, general and administrative ........... 18,716 22,019 16,150
Purchased research and development and ........ 4,805 3,651 --
-------- -------- --------
restructuring charges
Total expenses ............................. 36,101 36,675 26,270
-------- -------- --------
Operating income (loss) .................... (12,916) 255 4,351
Other income ...................................... 2,196 2,524 2,495
-------- -------- --------
Income (loss) before provision (benefit) for (10,720) 2,779 6,846
income taxes
Provision (benefit) for income taxes .............. (4,248) 847 2,149
-------- -------- --------
Net income (loss) .......................... (6,472) 1,932 4,697
Other comprehensive income (loss) net of tax:
Unrealized losses on securities ............... (55) (150) (298)
-------- -------- --------
Comprehensive income (loss) ................ $ (6,527) $ 1,782 $ 4,399
======== ======== ========
Earnings per share (basic)
- --------------------------
Net income (loss) per share ....................... $ (0.71) $ 0.21 $ 0.52
======== ======== ========
Shares used in computing per share amounts ........ 9,176 9,249 9,107
======== ======== ========
Earnings per share (diluted)
- ----------------------------
Net income (loss) per share ....................... $ (0.71) $ 0.20 $ 0.50
======== ======== ========
Shares used in computing per share amounts ........ 9,176 9,600 9,478
======== ======== ========
</TABLE>

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

<PAGE>

<TABLE>

DIGITAL LINK CORPORATION AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF SHAREHOLDERS' EQUITY
(in thousands)

Accumulated
Other
Common Stock Comprehensive Retained
Shares Amounts Income Earnings Total
-------------------------------------------------------------
<S> <C> <C> <C> <C> <C>
Balances, December 31, 1995 ................. 9,000 $ 29,283 $ 555 $ 17,935 $ 47,773
Issuance of common stock in
connection with:
Stock option plan ..................... 199 546 -- -- 546
Stock purchase plan ................... 19 266 -- -- 266
Tax benefit related to disqualifying
dispositions from exercise of stock
options ............................... -- 818 -- -- 818
Unrealized loss on marketable
securities ............................ -- -- (298) -- (298)
Net income .............................. -- -- -- 4,697 4,697
-------- -------- -------- -------- --------
Balances, December 31, 1996 ................. 9,218 30,913 257 22,632 53,802
Issuance of common stock in
connection with:
Stock option plan ..................... 311 1,885 -- -- 1,885
Stock purchase plan ................... 40 527 -- -- 527
Repurchase of common stock .............. (142) (476) -- (1,946) (2,422)
Tax benefit related to disqualifying
dispositions from exercise of stock
options ............................... -- 1,760 -- -- 1,760
Unrealized loss on marketable
securities ............................ -- -- (150) -- (150)
Net income .............................. -- -- -- 1,932 1,932
-------- -------- -------- -------- --------
Balances, December 31, 1997 ................. 9,427 34,609 107 22,618 57,334
Issuance of common stock in
connection with:
Stock option plan ..................... 21 48 -- -- 48
Stock purchase plan ................... 123 661 -- -- 661
Repurchase of common stock .............. (1,372) (5,221) -- (4,143) (9,364)
Tax benefit related to disqualifying
dispositions from exercise of stock
options ............................... -- 14 -- -- 14
Acquisition of Semaphore Corp. .......... 291 3,200 -- -- 3,200
Unrealized loss on marketable
securities ............................ -- -- (55) -- (55)
Net loss ................................ -- -- -- (6,472) (6,472)
-------- -------- -------- -------- --------
Balances, December 31, 1998 ................. 8,490 $ 33,311 $ 52 $ 12,003 $ 45,366
======== ======== ======== ======== ========

</TABLE>

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

<PAGE>

<TABLE>

DIGITAL LINK CORPORATION AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF CASH FLOWS
(in thousands)

Year Ended December 31,
1998 1997 1996
---- ---- ----
Cash flows from operating activities:
<S> <C> <C> <C>
Net income (loss) ................................................. $ (6,472) $ 1,932 $ 4,697
Adjustments to reconcile net income (loss) to net cash flows
provided by operating activities:
Depreciation and amortization .................................. 3,359 1,224 752
Restructuring charges .......................................... 1,240 -- --
Amortization of goodwill ....................................... 664 28 --
Provision (reduction in allowance) for doubtful accounts ....... 27 66 (383)
Provision (reduction in allowance) for excess and obsolete
inventories ................................................ 3,045 555 457
R&D write-off on acquisition ................................... 2,299 3,651 --
Deferred income taxes .......................................... (263) (1,663) (482)
Changes in assets and liabilities:
Accounts receivable ......................................... 600 1,686 1,583
Inventories ................................................. 1,260 (2,315) (1,774)
Prepaid and other current assets ............................ 700 (284) (402)
Accounts payable ............................................ (42) 107 1,136
Accrued payroll and related expenses and other accrued ...... (1,057) 421 700
expenses
Income taxes (receivable) payable ........................... (2,430) 405 114
-------- -------- --------
Net cash flows provided by operating activities ......... 2,930 5,813 6,398
-------- -------- --------

Cash flows from investing activities:
Purchases of marketable securities ................................ (47,434) (22,740) (34,915)
Maturities of marketable securities ............................... 52,870 24,670 24,391
Sales of marketable securities .................................... -- -- 4,008
Acquisition of Performance Telecom Corporation assets ............. -- (5,000) --
Acquisition of Semaphore Corporation assets ....................... 182 -- --
Acquisition of property and equipment ............................. (2,101) (2,272) (1,290)
-------- -------- --------
Net cash flows provided by (used in) investing activities 3,517 (5,342) (7,806)
-------- -------- --------

Cash flows from financing activities:
Proceeds from exercise of stock options and employee stock
purchases .................................................. 709 2,412 812
Repurchase of common stock ........................................ (9,364) (2,422) --
-------- -------- --------
Net cash flows provided by (used in) financing activities (8,655) (10) 812
-------- -------- --------
Net increase (decrease) in cash and cash
equivalents ........................................ (2,208) 461 (596)

Cash and cash equivalents at beginning of year ....................... 2,504 2,043 2,639
-------- -------- --------

Cash and cash equivalents at end of year ............................. $ 296 $ 2,504 $ 2,043
======== ======== ========

Supplemental disclosure of cash flow information:
Cash paid during the year for income taxes ........................ $ 168 $ 2,377 $ 1,727
-------- -------- --------
Cash received during the year for income taxes .................... $ 1,911 $ 85 $ 27
======== ======== ========

Supplemental schedule of noncash investing and financing activities:
Unrealized gain (loss) on securities carried at market ............ $ 55 $ (150) $ (298)
======== ======== ========
Tax benefit related to disqualifying dispositions from exercise of
stock options .............................................. $ 14 $ 1,760 $ 818
======== ======== ========
Acquisition of Semaphore Corporation assets for stock ............. $ 3,200 $ -- $ --
======== ======== ========

</TABLE>

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

<PAGE>

DIGITAL LINK CORPORATION AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

1. Business and Summary of Significant Accounting Policies:

Basis of Consolidation:

The consolidated financial statements include the accounts of Digital Link
Corporation and its wholly owned subsidiaries (the "Company"). All significant
intercompany balances and transactions have been eliminated.

Cash, Cash Equivalents and Marketable Securities:

The Company considers all highly liquid investments with maturities of
three months or less at the time of purchase and money market funds to be cash
equivalents. The Company has deposited its cash and money market funds at one
major bank and two investment firms. Cash equivalents are stated at cost plus
accrued interest, which approximates market.
All marketable securities are deemed by management to be available for sale
and are reported at fair value with net unrealized gains or losses reported as a
separate component in shareholders' equity. Realized gains and losses on the
sale of marketable securities are computed on the specific identification basis.
Available for sale marketable securities with maturities less than one year from
the balance sheet date are classified as current and those with maturities
greater than one year from the balance sheet date are classified as long-term.

Revenue Recognition:

Product revenues are recognized upon shipment of the product if remaining
obligations are insignificant and collections of the resulting receivable is
probable. The Company records estimated product returns and accrues for future
warranty costs, anticipated retroactive price adjustments and insignificant
vendor obligations at the time of product shipment. Warranty costs to date
generally have not been significant. Maintenance and support revenues, which are
not significant, are recognized over the terms of the related agreements.

Inventories:

Inventories are stated at the lower of cost (determined on a first-in,
first-out basis) or market.

Property and Equipment:

Property and equipment is stated at cost. Effective January 1, 1996, the
Company adopted the straight-line method of depreciation for all property and
equipment placed in service after that date. Property and equipment placed in
service prior to January 1, 1996 continues to be depreciated using the
double-declining balance method. Furniture and fixtures are depreciated over
five years, leasehold improvements over the lesser of five years or the lease
term and all other assets over three years. When property and equipment are
retired or otherwise disposed of, the cost and related accumulated depreciation
are removed from the accounts and the resulting gain or loss is included in
income.
The Company periodically assesses the recoverability of assets by
determining whether the amortization of the asset balance over its remaining
life can be recovered through undiscounted future operating cash flows. The
amount of impairment, if any, is measured as the amount by which the net book
value exceeds the fair value of the asset.

Fair Value:

The fair value of cash equivalents and marketable securities is disclosed
in relevant notes to the financial statements. For all other financial
instruments, the carrying amount approximates fair value.

Concentration of Credit Risk:

Financial instruments which potentially subject the Company to
concentration of credit risk consist principally of investments in marketable
securities and accounts receivable.
The Company currently places its investments with three high credit
qualified financial institutions. With respect to accounts receivable, the
Company's customer base is dispersed across many different geographic areas.
While its customers are dispersed across many industries, a substantial portion
of its sales are to Internet service providers and domestic carriers. The
Company performs ongoing credit evaluations of its customers, generally does not
require collateral and maintains an allowance for potential credit losses. At
December 31, 1998, there were six customers with balances individually in excess
of 5% of total accounts receivable versus three customers at December 31, 1997.
Jointly, these customers accounted for 58% of total accounts receivable at
December 31, 1998 versus 23% at December 31, 1997.

Use of Estimates:

The preparation of financial statements in conformity with generally
accepted accounting principles requires management to make estimates and
assumptions that affect the reported amounts of assets and liabilities and
disclosure of contingent assets and liabilities at the date of the financial
statements and the reported amounts of revenue and expenses during the reporting
period. Actual results could differ from these estimates.

Comprehensive Income (Loss):

The Company adopted Statement of Financial Accounting Standards No. 130
("SFAS 130"), "Accounting for Comprehensive Income," during the fiscal year
ended 1998. This statement establishes standards for reporting and display of
comprehensive income and its components (including revenues, expenses, gains and
losses) in a full set of general-purpose financial statements. The Company's
unrealized losses on investments represent the only component of comprehensive
income (loss) which is excluded from net income (loss) for 1998 and prior years.
The Company's comprehensive income (loss) has been presented in the consolidated
financial statements. The tax effects allocated to the unrealized losses on
investments are as follows:

<PAGE>

Before-Tax Tax Benefit Net of Tax
Amount ----------- Amount
------ ------
(in thousands)
1998
Unrealized losses on
securities ......... $ (91) $ 36 $ (55)
----- ----- -----
1997
Unrealized losses on
securities ......... $(216) $ 66 $(150)
----- ----- -----
1996
Unrealized losses on
securities ......... $(433) $ 135 $(298)
----- ----- -----

Computation of Net Income per Share:

Basic and diluted earnings per share is computed in accordance with the
Statement of Financial Accounting Standards No. 128 ("SFAS No. 128"). The
weighted average shares used in the computations for 1998, 1997 and 1996, were
9,176,000, 9,249,000 and 9,107,000, respectively.

1998 1997 1996
---- ---- ----
Basic
- -----
Weighted-average common shares outstanding
for the period ............................ 9,176 9,249 9,107
------- ------- -----
Shares used in computing per share amounts ..... 9,176 9,249 9,107
------- ------- -------
Net income (loss) .............................. ($6,472) $ 1,932 $ 4,697
======= ======= =======

Net income (loss) per share .................... ($ 0.71) $ 0.21 $ 0.52
======= ======= =======

1998 1997 1996
---- ---- ----
Diluted
- -------
Weighted-average common shares outstanding
for the period ............................ 9,176 9,249 9,107
Common equivalent shares from conversion of
stock options under treasury stock method . -- 351 371
------- ------- -------
Shares used in computing per share amounts ..... 9,176 9,600 9,478
------- ------- -------
Net income (loss) ..............................($6,472) $ 1,932 $ 4,697
======= ======= =======

Net income (loss) per share ....................($ 0.71) $ 0.20 $ 0.50
======= ======= =======

A total of 1,587,000 common equivalent shares have been excluded from the
calculation in 1998, as their effect would have been anti-dilutive.

Advertising Costs:

Costs related to advertising and promotion of products is charged to
advertising expense as incurred. Advertising expense was $1,193,000, $1,750,000
and $1,408,000 for 1998, 1997 and 1996, respectively.

Research and Development Costs:

Costs related to research, design and development of products are charged
to research and development expenses as incurred. Software development costs are
capitalized beginning when a product's technological feasibility has been
established and ending when a product is available for general release to
customers provided that research and development activities for the related
hardware portion of the product have been completed. Generally, the Company's
products include hardware and software components that are developed
concurrently. As a result, the Company has not capitalized any software
development costs since such costs have not been significant.

Foreign Currency Translation:

The Company's foreign subsidiaries use the United States dollar as their
functional currency. Resulting foreign transaction gains and losses, which have
been insignificant, are included in the results of operations.

Accounting for Income Taxes:

The Company's provision for income taxes comprises its estimated tax
liability currently payable and the change in its deferred income taxes.
Deferred tax assets and liabilities are determined based on differences between
financial reporting and tax bases of assets and liabilities and are measured
using the enacted tax rates and laws that will be in effect when the differences
are expected to reverse.

Stock-Based Compensation:

The Company accounts for employee stock options under APB Opinion No. 25,
"Accounting for Stock Issued to Employees," and provides pro forma disclosure in
Note 4 to the financial statements as if the measurement provisions of SFAS No.
123 ("SFAS 123") "Accounting for Stock-Based Compensation," had been adopted.

Recent Pronouncements:

<PAGE>

2. Balance Sheet Detail:

Marketable Securities:

December 31,
1998 1997
---- ----
(in thousands)

Market Market
Cost Value Cost Value
---- ----- ---- -----
Debt securities:
U.S. government corporations and
agencies ...................... $24,766 $24,763 $24,689 $24,679
Commercial paper ................... 5,556 5,555 -- --
State and municipal securities ..... 4,060 4,116 15,129 15,246
------- ------- ------- -------
$34,382 $34,434 $39,818 $39,925
======= ======= ======= =======

Gross unrealized gains and unrealized losses for marketable securities were
$63,000 and $11,000, respectively at December 31, 1998 and $136,000 and $29,000,
respectively, at December 31, 1997.
At December 31, 1998, scheduled maturities of marketable securities within
one year were $15,738,000 (cost $15,688,000) and for one year to five years were
$18,696,000 (cost $18,694,000).

Inventories, net:

December 31,
------------
1998 1997
---- ----
(in thousands)

Raw materials ..................... $1,349 $2,952
Work in progress .................. 1,456 2,275
Finished goods .................... 1,501 2,936
------ ------
$4,306 $8,163
====== ======

The Company's products are concentrated in a single segment in the
telecommunications industry that is highly competitive and rapidly changing.
Significant technological changes in the industry segment could affect operating
results adversely. The Company's inventories include high technology parts and
components that may be specialized in nature or subject to rapid technological
obsolescence. While the Company has programs to minimize the required
inventories on hand and considers technological obsolescence in estimating the
required allowance to reduce recorded amounts to market values, such estimates
could change in the future. In addition, certain semiconductor devices and
components and subassemblies are presently available only from single sources,
and certain other components are presently available or acquired only from a
limited number of sources.

<PAGE>

Property and Equipment, net:

December 31,
------------
1998 1997
---- ----
(in thousands)

Manufacturing and development equipment .........$ 10,859 $ 9,328
Furniture and fixtures .......................... 608 520
Leasehold improvements .......................... 325 215
-------- --------
11,792 10,063
-------- --------
Less accumulated depreciation and amortization .. (9,210) (6,738)
-------- --------
$ 2,582 $ 3,325
======== ========

Other Accrued Expenses:

December 31,
1998 1997
---- ----
(in thousands)

Product warranty ........................... 853 $1,029
Professional fees .......................... 213 209
Restructuring charges ...................... 1,240 --
Co-op advertising .......................... 293 107
Other ...................................... 2,165 2,440
------ ------
$4,764 $3,785
====== ======

3. Commitments and Contingencies:

Commitments:

The Company leases its headquarters facility under an operating lease.
Under the terms of the lease agreement, the Company is responsible for
insurance, maintenance and property taxes.

Future minimum lease payments under the lease are as follows at December
31, 1998 (in thousands):

1999 $1,072
2000 1,126
2001 1,182
2002 1,241
2003 1,019
-----
Total minimum lease payments $5,640
======

Rent expense was $1,540,000, $883,000 and $619,000 for 1998, 1997 and 1996,
respectively.

Contingencies:

Certain third parties have expressed their belief that certain of the
Company's products may infringe patents held by them and have suggested that the
Company acquire licenses to such patents. The Company believes that licenses, to
the extent required, will be available; however, no assurance can be given that
the terms of any offered licenses would be favorable to the Company. Management,
after review and consultation with counsel, believes that the ultimate
resolution of these matters is uncertain and there can be no assurance that
these assertions will be resolved without costly litigation or in a manner that
is not adverse to the Company. While the Company has accrued approximately
$550,000 for these matters deemed probable in prior years, it is currently
unable to estimate the ultimate range of loss regarding these matters.
Therefore, it is reasonably possible that the ultimate resolution of these
matters could result in final settlement that could exceed or be less than the
amount accrued. Adjustment to amounts accrued will take place in the period in
which such matters are resolved.

In April 1996, a class action complaint was filed against the Company and
certain of its officers and directors in the Santa Clara Superior Court of the
State of California, alleging violations of the California Corporations Code and
California Civil Code. In October 1996, a similar parallel lawsuit against the
Company and the same individuals was filed in the United States District Court
for the Northern District of California alleging violations of the federal
securities laws. The class period in both of these lawsuits runs from September
12, 1994 through December 29, 1995, and both complaints allege that the
defendants concealed and/or misrepresented material adverse information about
the Company and that the individual defendants sold shares of the Company's
stock based upon material nonpublic information. The complaints seek unspecified
monetary damages. Discovery to date has been limited in the state court action,
and the Superior Court has not set a trial date.
In the parallel Federal proceedings, the Court on September 11, 1997
granted the Company's motion to dismiss the federal complaint with leave to
amend, and plaintiff has filed an amended complaint. The Company has moved to
dismiss the amended complaint, the hearing on which is currently scheduled to
take place on March 26, 1999. There has been no discovery in the federal action,
and no trial date has been set.
The Company believes that both actions are without merit and intends to
defend both actions vigorously. However, litigation is subject to inherent
uncertainties and, thus, there can be no assurance that these lawsuits will be
resolved favorably to the Company or that they will not have a material adverse
effect on the Company's financial condition and results of operations. No
provision for any liability that may result upon adjudication has been made in
the accompanying financial statements.

4. Shareholders' Equity:

Stock Option Plan:

The Company has a 1992 Equity Incentive Plan ("Plan"), which succeeds the
Company's prior plan. All outstanding stock options issued under the prior plan
will continue to be governed by the terms and conditions of that plan, but no
additional stock options will be granted under that prior plan. During 1995, an
additional 500,000 shares were authorized for grant or sale to employees,
officers, directors and consultants of the Company under the Plan. During 1997,
an additional 800,000 shares were authorized for grant or sale to employees,
officers, directors and consultants of the Company under the Plan. The Plan
expires ten years after its adoption.
Options granted under the Plan may be either incentive stock options or
nonqualified stock options, as designated by the Board of Directors. The Plan
provides that the exercise price of options granted must be no less than the
fair market value of the Company's common stock at the date of grant. The Board
of Directors also has the authority to set exercise dates (no longer than ten
years from the date of grant), payment terms and other provisions for each
grant. Generally, options granted under the Plan through October 31, 1995 become
exercisable annually as to 20% and options granted on or after October 31, 1995
become exercisable as to 25% of the shares one year after the first vesting date
and thereafter with respect to an additional 2.084% at the end of each
succeeding month.
The Plan also provides for the award of common stock based on performance
and the sale of restricted stock to eligible persons at the fair market value of
the common stock of the Company at the date of sale or at discounts of up to
15%, as determined by the Board of Directors. All restricted stock awards under
this Plan are subject to a repurchase option that expires over a five year
period at the original issuance price. As of December 31, 1998, no restricted
stock awards have been issued under the Plan.

Directors Stock Option Plan:

In October 1994, the Company adopted the 1994 Directors Stock Option Plan
(the "Directors Plan"). The Company has reserved 200,000 shares of Common Stock
for issuance to directors of the Company who are not employees of the Company.
The Directors Plan expires ten years after its adoption.
Options granted under the Directors Plan are nonqualified stock options.
The Directors Plan provides that the exercise price of options granted shall be
the fair market value of the Company's common stock at the date of grant.
Options granted under the Directors Plan become exercisable ratably over four
years. The maximum term of these options granted is ten years from the date of
grant.

Activity under the Plan and the Directors Plan during 1998, 1997 and 1996
is as follows:
<TABLE>
<CAPTION>
(in thousands, except per share amounts)
Outstanding Options
------------------------------------------------------------------------
Weighted
Shares Number Price Average
available of per Aggregate Exercise
for grant Shares Share Price Price
------------------------------------------------------------------------

<S> <C> <C> <C> <C> <C>
Balances, December 31, 1995 . 1,091 1,462 $0.60-$28.25 $15,813 $ 10.82
Options granted .......... (984) 984 $10.125-$23.25 15,302 $ 15.55
Options exercised ........ -- (199) $0.60-$21.75 (546) $ 2.74
Options cancelled ........ 425 (425) $0.83-$28.25 (6,079) $ 14.30
------- -------- ---------
Balances, December 31, 1996 . 532 1,822 $0.83-$28.25 24,490 $ 13.45
Additional shares reserved 800 -- -- -- --
Options granted .......... (540) 540 $13.25-$25.75 9,637 $ 17.86
Options exercised ........ -- (311) $12.50-$27.375 (1,885) $ 6.06
Options cancelled ........ 434 (434) $1.00-$28.25 (6,029) $ 13.91
------- -------- ---------
Balances, December 31, 1997 . 1,226 1,617 $1.00-$28.25 26,213 $ 16.23
Options granted .......... (2,710) 2,710 $3.22-$12.38 19,051 $ 7.03
Options exercised ........ -- (21) $6.13-$12.13 (48) $ 2.25
Options cancelled ........ 2,718 (2,719) $3.22-$28.25 (37,402) $ 13.76
------- -------- ---------
Balances, December 31, 1998 . 1,234 1,587 $1.33-$28.25 $ 7,814 $ 4.94
======= ======== =========
</TABLE>

The weighted-average fair value of those options granted in 1998, 1997 and 1996
was $5.21, $11.63 and $8.47, respectively. Options to purchase 163,000 shares,
481,000 shares and 350,000 shares were exercisable with a weighted-average
exercise price of $12.71, $14.65 and $8.88, at December 31, 1998, 1997 and 1996,
respectively.

On January 21, 1998, the Compensation Committee of the Board of Directors
adopted a plan for repricing of stock options under which all current officers
and employees (other than the Company's chief executive officer) who had
outstanding options that were granted under the Plan on or after November 1,
1995 (the "Options"), had the right to reprice such options. With respect to
each officer of the Company, the exercise price of each option was determined as
of the closing price of the Company's common stock on February 9, 1998 with four
year vesting beginning again on February 9, 1998 and thereafter otherwise to the
same terms as the original stock options being amended. With respect to all
other employees of the Company, the exercise price of each amended option was
determined to be the closing price of the Company's common stock on February 9,
1998, no change was made in the vesting schedule. However, the amended options
were not available for exercise until February 9, 1999.
On September 25, 1998, the Compensation Committee of the Board of Directors
adopted a plan for repricing of stock options under which all current officers
and employees who had outstanding options that were granted under the Plan with
an exercise price greater than the closing price of the Company's common stock
on October 19, 1998 could be amended. With respect to all employees, the
exercise price of each option was determined to be the closing price of the
Company's common stock on October 19, 1998. The vesting schedule was amended to
a three year vesting period beginning on October 19, 1998 with the options not
being available for exercise until October 19, 1999. The number of shares
subject to the amended options that were originally granted prior to November 1,
1995 was reduced to twenty-five (25%) of the number of unexercised shares
subject to the original grant with any remaining shares being forfeited.

The following table summarizes information with respect to stock options
outstanding at December 31, 1998:

<TABLE>

<CAPTION>
(number of options in thousands)
Options Outstanding Options Exercisable
---------------------------------------------------------------------------
Weighted
Number Average Number Weighted
Outstanding at Remaining Weighted Exercisable at Average
December 31, Contractual Average December 31, Exercise
Range of Exercise Price 1998 Life (years) Exercise Price 1998 Price
- ----------------------- -------------- ------------ -------------- ------------- ---------

Employee Stock Purchase Plan:

In December 1993, the Company established the 1993 Employee Stock Purchase
Plan (the "Purchase Plan") under which 300,000 shares of Common Stock have been
reserved for issuance. Under the Purchase Plan, an eligible employee may
purchase shares of Common Stock from the Company through payroll deductions of
up to 10% of his or her base compensation and commissions, at a price per share
equal to 85% of the lesser of the fair market value of the Company's Common
Stock as of the first day or last day of each six-month offering period under
the Purchase Plan. The Company sold 122,700 shares, 40,000 shares and 19,000
shares to employees in 1998, 1997 and 1996, respectively. The weighted-average
fair value of those purchase rights granted in 1998, 1997 and 1996 was $5.45,
$6.02 and $5.66, respectively.

<PAGE>

Pro Forma Stock-Based Compensation:

The Company accounts for the fair value of its grants under the Plan, the
Directors Plan and the Purchase Plan in accordance with APB 25. Accordingly, no
compensation expense has been recognized for these plans. Had compensation
expense been determined based on the fair value at the grant dates for awards
under these plans consistent with the method of SFAS 123, the Company's net
income (loss) would have been adjusted to the pro forma amounts indicated below:

(Amounts in thousands, except per share data)

1998 1997 1996
---- ---- ----

Net income (loss)
As reported.................... ($6,472) $1,932 $4,697
Pro forma...................... ($8,713) $ (338) $3,771
Earnings per share (Basic)
As reported.................... ($0.71) $ 0.21 $0.52
Pro forma...................... ($0.95) $(0.04) $0.41
Earnings per share (Diluted)
As reported.................... ($0.71) $ 0.20 $0.50
Pro forma...................... ($0.95) $(0.04) $0.40

The fair value of each option is estimated on the date of grant using a
type of Black-Scholes option-pricing model with the following weighted-average
assumptions used for grants under the Plan and the Directors Plan in 1998, 1997
and 1996:

1998 1997 1996
---- ---- ----

Dividend yield 0.00% 0.00% 0.00%
Expected life of option 4.54 years 4.50 years 4.50 years
Risk-free interest rate 5.09% 5.74% 6.05%
Expected volatility 99% 80% 60%

The Company has also estimated the fair value for the purchase rights
issued under the Purchase Plan using the Black-Scholes option-pricing model with
the following assumptions for grants in 1998, 1997 and 1996:

1998 1997 1996
---- ---- ----

Dividend yield 0.00% 0.00% 0.00%
Expected life of option 0.50 years 0.50 years 0.50 years
Risk-free interest rate 4.88% 5.80% 5.34%
Expected volatility 80% 80% 60%

The above pro forma disclosures are not likely to be representative of the
effects on reported net income for future years.

5. Segments, Significant Customers, Suppliers and Foreign Revenues:

The Company has adopted the Financial Accounting Standards Board's
Statement of Financial Accounting Standards No. 131 ("SFAS 131"), "Disclosures
about Segments of an Enterprise and Related Information." SFAS 131 supersedes
Statement of Financial Accounting Standards No. 14 ("SFAS 14"), "Financial
Reporting for Segments of a Business Enterprise." SFAS 131 changes current
practice under SFAS 14 by establishing a new framework on which to base segment
reporting and also requires interim reporting of segment information.
The Company operates in a single industry segment encompassing the design,
development, manufacture, marketing and support of high-speed digital access
products for wide area networks worldwide. Management uses one measurement of
profitability and does not disaggregate its business for internal reporting. The
Company markets and sells its products primarily in North America, Europe, South
America and Asia, through a direct sales force, VARs and OEMs. In 1998, sales to
one customer accounted for 11% of net sales and sales to another customer
accounted for 10% of net sales. In 1997, sales to one customer accounted for 20%
of net sales. In 1996, sales to two customers each accounted for 13% of net
sales. The loss of any one or more of the Company's major customers could
materially adversely affect the Company's business and operating results.
The Company's product designs are proprietary but generally incorporate
industry standard hardware components. However, certain semiconductor devices
and components and subassemblies are presently available only from single
sources, and certain other components are presently available or acquired only
from a limited number of sources. To date, the Company has been able to obtain
adequate supplies of these components, as well as subassemblies from third party
contractors, in a timely manner from existing sources or, when necessary, from
alternative sources. The inability to obtain sufficient sole or limited source
components or subassemblies as required in the future, or to develop alternative
sources or redesign its products if and as required in the future, could result
in delays or reductions in product shipments. Any such occurrence could
materially adversely affect the Company's business and operating results or
damage customer relationships.

Outside of Europe, no geographic segment had sales in excess of 10% of
total sales.

Revenue Long Lived Assets
------- -----------------
(in thousands)
December 31, 1998
United States ......................... $42,901 $ 2,972
Europe ................................ 6,595 3
Other International ................... 5,131 --
------- -------
Total ................................. $54,627 $ 2,975
======= =======

December 31, 1997
United States ......................... $54,655 $ 4,449
Europe ................................ 5,888 23
Other International ................... 5,465 --
------- -------
Total ................................. $66,008 $ 4,472
======= =======

December 31, 1996
United States ......................... $43,412 $ 2,421
Europe ................................ 4,142 20
Other International ................... 4,524 --
------- -------
Total ................................. $52,078 $ 2,441
======= =======

6. Employee Benefit Plan:

The Company has a 401(k) profit sharing plan for its full time employees
who have attained the age of 21. Eligible employees may make voluntary
contributions to the Plan up to 18% of their annual compensation. The Company
makes a matching contribution equal to 50% of each employee's contributions. In
applying this matching contribution, however, only contributions up to 6% of the
employee's compensation will be considered. For 1998, 1997 and 1996, the Company
contributed $421,000, $356,000 and $191,000, respectively.

7. Income Taxes (Benefit):

The provision (benefit) for income taxes comprises:

1998 1997 1996
---- ---- ----
(in thousands)

Current:
Federal $(3,745) $2,246 $2,376
State (240) 390 135
-------- ------ ------
(3,985) 2,636 2,511

Deferred:
Federal (221) (1,613) (295)
State (42) (176) (67)
-------- ------- -------
(263) (1,789) (362)
-------- ------- -------
$(4,248) $ 847 $2,149
======== ======= =======

The difference between the actual tax provision (benefit) and the amount
obtained by applying the U.S. Federal statutory rate to income (loss) before
provision for income taxes (benefit) is as follows:

1998 1997 1996
---- ---- ----

Tax provision (benefit) at federal statutory rate (34.0%) 34.0% 34.0%
State taxes, net of federal tax benefit ......... (5.2) 6.6 5.4
Nontaxable municipal interest ................... (1.2) (6.3) (2.1)
Foreign sales corporation ....................... (0.5) (2.5) (0.6)
Research and development tax credit ............. -- (3.2) (6.3)
Other ........................................... 1.3 1.9 1.0
----- ----- -----
(39.6%) 30.5% 31.4%
===== ===== =====

<PAGE>

The components of the deferred tax asset are as follows:

December 31,
------------
1998 1997
---- ----
(in thousands)

Deferred tax assets:
Allowance for doubtful accounts receivable ....... $ 210 $ 203
Allowance for excess and obsolete inventories .... 640 885
Depreciation ..................................... 345 379
Amortization of purchased research and
development .................................... 1,317 1,216
Accrual for warranty, royalties and other ........ 1,859 1,483
Other ............................................ 258 200
------ ------
Total deferred tax assets .................... $4,629 $4,366
====== ======

The Company has not provided a valuation allowance on the deferred tax
assets as those amounts can be realized through carryback to prior years when
the Company paid income taxes or are expected to be realized from future
operations based upon the Company's history of profitable operations.

8. Acquisitions:

The Company incurred an expense of $2.3 million related to purchased
research and development for which technological feasibility had not been
achieved in the second quarter of 1998 related to the acquisition of Semaphore.
Such in-process technology was valued, along with other acquired assets, using a
discounted cash flow analysis with separate cash flow projections for existing
and in-process technology. The value of in-process technology for which
technological feasibility had not been established and for which there was no
alternative use was expensed upon acquisition in accordance with Financial
Accounting Standards ("FAS") No. 2, "Accounting for Research and Development
Costs".
The Company incurred an expense of $3.7 million related to purchased
research and development for which technological feasibility had not been
achieved in the third quarter of 1997 in connection with its acquisition of
certain assets and in-process technology for $5 million in cash from Performance
Telecom. Such in-process technology was valued, along with other acquired
assets, using a discounted cash flow analysis with separate cash flow
projections for existing and in-process technology. The value of in-process
technology for which technological feasibility had not been established and for
which there was no alternative use was expensed upon acquisition in accordance
with Financial Accounting Standard No. 2, "Accounting for Research and
Development Costs." This technology was designed to enable network service
providers to offer applications such as Internet access, interactive video
services, remote data access and multimedia applications at
multi-megabit-per-second speeds over standard voice-grade copper lines.
The results attributable to the acquisition of the assets of Performance
Telecom and Semaphore have been consolidated with the Company's results since
September 30, 1997 and April 3, 1998, respectively.
The following unaudited pro forma condensed combined results of operations
information has been presented to give effect to the purchase of the Semaphore
assets as if such transaction had occurred at the beginning of each of the
periods presented. The historical results of operations have been adjusted to
reflect additional depreciation and amortization expense based on the value
allocated to assets acquired in the purchase. In-process research and
development costs in the amount of $2,299,000, which were written off
immediately after the purchase was completed, have been included in the results
of both periods presented. The pro forma results of operations information is
presented for informational purposes only and is not necessarily indicative of
the operating results that would have occurred had the acquisition been
consummated as of the beginning of the periods presented, nor is it indicative
of future operating results.

Unaudited Pro Forma Condensed Combined Results of Operations
(amounts in thousands except per share data)

Twelve Months Ended December 31,
1998 1997
---- ----

Revenue ................................. $ 55,113 $ 69,992
Net loss ................................ (7,857) (3,345)
Earnings per share (Basic)
Net loss per share ................. (0.83) (0.35)
Shares used in per share calculation 9,467(1) 9,540(1)
Earnings per share (Diluted)
Net loss per share ................. (0.83) (0.35)
Shares used in per share calculation 9,467(1) 9,540(1)

(1) Shares used in the per share calculation reflect Digital Link shares issued
to Semaphore as if they were outstanding from the beginning of each period
presented and existing Digital Link shares.

Shares used in pro forma earnings per share basic and diluted calculations for
the twelve months ended December 31, 1998 are as follows (in thousands):

Digital Link shares issued in asset acquisition 291(2)
Existing Digital Link shares 9,176
-----
9,467
-----

Share used in pro forma earnings per share basic and diluted calculations for
the twelve months ended December 31, 1997 are as follows (in thousands):

Digital Link shares issued in asset acquisition 291(2)
Existing Digital Link shares 9,249
-----
9,540
-----

(2) The number of shares issued was determined by dividing $3,200 by the
volume-weighted average price per share (as reported by Bloomberg Financial
Services) at which Digital Link's common stock traded on the five business days
immediately preceding the execution of the Asset Sale Agreement by the parties.

9. Restructuring Charges:

The Company incurred an expense of $2.5 million in the third quarter of
1998 related to the termination of its DL7100 and VPN product lines, including
termination of 25 project employees, abandonment of a leased facility and
related fixed assets. Since the products included use of, or planned integration
of, technologies and other assets acquired through the Company's acquisitions of
Semaphore and Performance Telecom, the Company also evaluated those acquired
assets, which had no alternative future use, for realizability. The
restructuring expense of $2.5 million consisted primarily of severance costs of
$500,000, legal and lease commitment costs of $500,000 and the write-off of
goodwill and fixed assets of $1.5 million related to the aforementioned
acquisitions. In addition to these costs the Company reflected $3.2 million of
restructuring related costs in cost of sales for inventory write-downs and
warranty reserves.
All 25 project employees were notified of their termination severance
benefits by September 30, 1998 and 84% of these benefits were actually paid by
the end of December 1998. The Company's leased facility was exited in the first
quarter of 1999. Remaining accrued restructuring charges amounted to $1.2
million as of December 31, 1998, primarily for legal product claims and warranty
expenses associated with the termination of the aforementioned product lines.

10. Subsequent Event:

During the period from January 1, 1999 through March 12, 1999, the Company
repurchased on the open market a total of 334,700 shares of common stock at
prices ranging from $4.81 to $8.25 a share. This stock has subsequently been
retired.

<PAGE>

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

Not Applicable

PART III

ITEM 10. DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANT

Information required by this Item is incorporated by reference from the
sections titled "Nominees" under "Proposal No. 1 - Election of Directors,"
"Executive Officers" and "Section 16(a) Beneficial Ownership Reporting
Compliance" from the Definitive Proxy Statement to be filed with the Securities
and Exchange Commission relative to the Company's annual meeting of shareholders
to be held on or about June 7, 1999 (the "Definitive Proxy Statement").

ITEM 11. EXECUTIVE COMPENSATION

Information required by this Item is incorporated by reference from the
sections titled "Director Compensation" under "Proposal No. 1 - Election of
Directors" and "Executive Compensation" from the Definitive Proxy Statement.

ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND
MANAGEMENT

Information required by this Item is incorporated by reference from
"Security Ownership of Certain Beneficial Owners and Management" from the
Definitive Proxy Statement.

ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS

Information required by this Item is incorporated by reference from
"Certain Transactions" from the Definitive Proxy Statement.

<PAGE>

PART IV

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

The following financial statements and schedules are filed as part of this
report:

Page
(a)1. Financial Statements

See index in Part II, Item 8........................... 26

(a)2. and (d) Financial Statement Schedules

Schedule II - Valuation and Qualifying Accounts........ 51

All schedules not listed above are omitted because they are not applicable
or the required information is included in the financial statements or notes
thereto.

(a)3. and (c) Exhibits

2.01 Asset Sale Agreement between Registrant and Semaphore
Communications Corporation dated April 3, 1998. (9)
3.01 Registrant's Amended and Restated Articles of Incorporation
filed on February 7, 1994. (1) 3.02 Registrant's Certificate of
Correction of Amended and Restated Articles of Incorporation
filed on April 7, 1994. (1)
3.03 Registrant's Bylaws, as amended. (2)
4.01 Form of Specimen Certificate for Registrant's Common Stock. (3)
4.02 Registration Rights Agreement among Registrant, Vinita Gupta,
Summit Ventures L.P., SV Eurofund C.V. and Summit Investors, L.P.
dated December 23, 1987 and certain exhibits thereto. (3)
4.03 Registration Rights Agreement between Registrant and Semaphore
Communications Corporation dated April 3, 1998. (9)
+10.01 Registrant's 1986 Stock Option Plan, as amended. (3)
+10.02 Form of Agreement for Registrant's 1986 Stock Option Plan. (1)
+10.03 Registrant's 1986 Stock Purchase Plan. (3)
+10.04 Form of Agreement for Registrant's 1986 Stock Purchase Plan, as
amended. (1)
+10.05 Registrant's 1992 Equity Incentive Plan, as amended. (8)
+10.06 Form of Agreement for Registrant's 1992 Equity Incentive Plan,
as amended. (1)
+10.07 Registrant's 1993 Employee Stock Purchase Plan. (3)
+10.08 Registrant's 1994 Directors Stock Option Plan. (1)
+10.09 Form of Agreement for Registrant's 1994 Directors Stock Option
Plan. (1)
10.10 Form of Indemnity Agreement entered into with each of
Registrant's directors. (3)
10.11 Lease Agreement between Registrant and John Hancock Mutual Life
Insurance Company dated June 17, 1992. (3)

<PAGE>

10.12 Form of Patent License Agreement between Registrant and QPSX
Communications Ltd. dated December 1993. (3)
10.13* Software License Agreement between Registrant and Epilogue
Technology Corporation dated January 20, 1992. (3)
10.14 Stockholder Agreement among Registrant, Vinita Gupta, Narendra
Gupta, Summit Ventures, L.P., SV Eurofund C.V. and Summit
Investors, L.P. dated December 23, 1987. (3)
10.22 Separation Agreement between Registrant and Jack A. Musgrove
dated March 16, 1998. (10)
10.23 Executive Retention and Severance Agreement dated
December 14, 1999.

21.01 List of Subsidiaries. (3)
23.01 Consent of Independent Accountants
27.01 Financial Data Schedule
- -----
* Confidential treatment has been obtained with respect to portions
of this exhibit.
(1) Filed as an exhibit to Registrant's Form 10-K for the year ended
December 31, 1994 and incorporated herein by reference.
(2) Filed as an exhibit to Registrant's Registration Statement on
Form S-8 (No. 33-95176) filed on July 31, 1995 and incorporated
herein by reference.
(3) Filed as an exhibit to Registrant's Form S-1 Registration
Statement (File No. 33-72642), which was declared effective
January 31, 1994, and incorporated herein by reference.
(4) Filed as an exhibit to Registrant's Form 10-Q (File No. 0-23110)
for the quarter ended June 30, 1995 and incorporated herein by
reference.
(5) Filed as an exhibit to Registrant's Form 10-K (File No. 0-23110)
for the year ended December 31, 1995 and incorporated herein by
reference.
(6) Filed as an exhibit to Registrant's Form 10-Q (File No. 0-23110)
for the quarter ended September 30, 1996 and incorporated herein
by reference.
(7) Filed as an exhibit to Registrant's Form 10-K (File No. 0-23110)
for the year ended December 31, 1996 and incorporated herein by
reference.
(8) Filed as an exhibit to Registrant's Registration Statement on
Form S-8 (No. 333-27855) filed on May 27, 1997 and incorporated
herein by reference.
(9) Filed as an exhibit to Registrant's Form 8-K (File No. 0-23110)
filed on April 17, 1998 and incorporated herein by reference.
(10) Filed as an exhibit to Registrant's Form 10-Q (File No. 0-23110)
for the quarter ended March 31, 1998 and incorporated herein by
reference.
+ Management contract or compensatory plan required to be filed as
an exhibit to this Form 10-K.

(b) Reports on Form 8-K

No reports on Form 8-K were filed during the last quarter
of the period covered by this report.

<PAGE>

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

DIGITAL LINK CORPORATION

March 26, 1999 By: /s/ Stanley E. Kazmierczak
----------------------------------
Stanley E. Kazmierczak
Chief Financial Officer

Each person whose signature appears below constitutes and appoints Vinita
Gupta and Stanley E. Kazmierczak, jointly and severally, his or her true and
lawful attorneys-in-fact, each with the power of substitution, for him or her in
any and all capacities, to sign amendments to this Report on Form 10-K, and to
file the same, with all exhibits thereto and other documents in connection
therewith, with the Securities and Exchange Commission, hereby ratifying and
confirming all that said attorneys-in-fact, or his or her substitute or
substitutes, may do or cause to be done by virtue hereof.
Pursuant to the requirements of the Securities Exchange Act of 1934, this
Report has been signed below by the following person on behalf of the Registrant
and in the capacities and on the dates indicated.

<TABLE>

Signature Title Date
--------- ----- ----
<S> <C> <C>

Chairperson of the Board, Chief Executive
/s/ Vinita Gupta Officer and President March 26, 1999
- ------------------------------- (Principal Executive Officer)
Vinita Gupta

Chief Financial Officer
and Vice President, Finance
and Operations
(Principal Financial and
/s/ Stanley E. Kazmierczak Accounting Officer) March 26, 1999
- -------------------------------
Stanley E. Kazmierczak

/s/ Richard C. Alberding Director March 26, 1999
- -------------------------------
Richard C. Alberding

/s/ Louis Golm Director March 26, 1999
- ------------------------------
Louis Golm

/s/ Narendra K. Gupta Director March 26, 1999
- -------------------------------
Narendra K. Gupta

/s/ Stephen Von Rump Director March 26, 1999
- -------------------------------
Stephen Von Rump

</TABLE>

<PAGE>

SCHEDULE II

DIGITAL LINK CORPORATION

VALUATION AND QUALIFYING ACCOUNTS
For the Years Ended December 31, 1996, 1997 and 1998(Amounts in thousands)

<TABLE>

Balance at Charged to Deductions Balance at
Beginning of Costs and -------------------- End of
Description the Period Expenses Description Amount the Period
----------- ------------- ---------------- -------------- --------- -------------
<S> <C> <C> <C> <C> <C>
Balances for the year ended December 31, 1996:
Allowance for doubtful accounts receivable....... $ 895 -- (b) 383
(a) 47 $ 465
Allowance for excess and obsolete inventories.... $ 844 457 (a) 167 $1,134

Balances for the year ended December 31, 1997
Allowance for doubtful accounts receivable ...... $ 465 66 (a) 14 $ 517
Allowance for excess and obsolete inventories ... $1,134 555 (a) (23) $1,712

Balances for the year ended December 31, 1998:
Allowances for doubtful accounts receivable ..... $ 517 27 (a) 4 $ 540
Allowances for excess and obsolete inventories .. $1,712 3,045 (a) 3,217 $1,540

</TABLE>

(a) Write-offs & adjustments

(b) Credit to selling, general and administrative expenses

Exhibit 10.23

DIGITAL LINK CORPORATION
EXECUTIVE RETENTION AND SEVERANCE AGREEMENT

Effective December 14, 1998

This Executive Retention and Severance Agreement (the "Agreement") is made and
entered into as of the date written above (the "Effective Date"), by and between

Digital Link Corporation, a California corporation (the "Company")

and

- ------------------------------- ("Executive")

residing at -------------------------------

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

RECITALS

A. Executive is ------------------------------- of the Company and possesses
valuable knowledge of the Company, its business and operations and the markets
in which the Company competes.

B. The Company draws upon the knowledge, experience and objective advice of
Executive in order to manage its business for the benefit of the Company's
stockholders.

C. The Company recognizes that if there occurred a change of control or other
event that could substantially change the nature and structure of the Company,
the resulting uncertainty regarding the consequences of such an event could
adversely affect the Company's ability to attract, retain and motivate its key
employees, including Executive.

D. The Company and Executive desire to enter into this Agreement in order (1) to
encourage Executive to continue to devote Executive's full attention and
dedication to the success of the Company, and (2) to provide specified
compensation and benefits to Executive in the event of a Termination Upon Change
of Control, pursuant to the terms of this Agreement.

THE COMPANY AND EXECUTIVE AGREE AS FOLLOWS:

1. GENERAL

1.1 Purpose. The purpose of this Agreement is to provide specified
compensation and benefits to an Executive in the event of a Termination Upon
Change of Control.

1.2 No employment agreement. This Agreement does not obligate the
Company to continue to employ an Executive for any specific period of time, or
in any specific role or geographic location. Subject to the terms of any
applicable written employment agreement between Company and an Executive,
Company may assign an Executive to other duties, and either an Executive or
Company may terminate an Executive's employment at any time for any reason.

1.3 Defined terms. Capitalized team used in this Agreement shall have
the meanings set forth in Section 4, unless the context clearly requires a
different meaning.

2. TERMINATION UPON CHANGE OF CONTROL

2.1 Basic severance compensation. In the event of an Executive's
Termination Upon Change of Control, an Executive shall be entitled to the basic
severance compensation described below.

2.1.1 All salary and accrued vacation earned through the date
of an Executive's termination shall be paid to Executive.

2.1.2 Within ten (10) days of submission of proper expense
reports by an Executive, the Company shall reimburse an Executive for all
expenses reasonably and necessarily incurred by an Executive in connection with
the business of the Company prior to an Executive's termination of employment.

2.1.3 An Executive shall receive the benefits, if any, under
the Company's 401(k) Plan, nonqualified deferred compensation plan, employee
stock purchase plan and other Company benefit plans to which an Executive may be
entitled pursuant to the terms of such plans.

2.2 Executive cash severance benefits. In the event of an Executive's
Termination Upon Change of Control, an Executive shall be entitled to the
additional executive severance benefits described below.

2.2.1 Prorated bonus payment. An Executive shall receive his
target bonus or incentive payment for the year in which termination occurs, pro
rated through the date of termination and less applicable withholding, paid
within thirty (30) days of termination of employment.

2.2.2 Cash severance payment. Executive shall receive a lump
sum payment in the amount of 100% of an Executive's Target Annual Earnings, less
applicable federal and state withholding, paid within thirty (30) days of
termination of employment.

<PAGE>

2.3 Stock option acceleration.

2.3.1 Acceleration following Change of Control. All
unvested outstanding stock options granted and
restricted stock issued by the Company to Executive
prior to the Change of Control will have their
vesting accelerated so as to be __% vested on the
date of Change of Control.

2.3.2 Acceleration upon non-assumption in a Change of
Control. If there is a Change of Control transaction
in which outstanding stock options granted and
restricted stock issued by the Company prior to the
transaction are not fully assumed by the Successor,
or replaced by fully equivalent substitute options
or restricted stock, then (1) all such options and
restricted stock shall have their vesting fully
accelerated to be 100% vested prior to the effective
date of the Change of Control and (2) the Company
shall provide reasonable prior written notice to an
Executive of (a) the date such unexercised options
will terminate and (b) the period during which an
Executive may exercise the fully vested options.
Alternatively, the Company may elect to deliver to
an Executive on the effective date of the Change of
Control a cash payment equal to the difference
between (i) the aggregate exercise price of an
Executive's unexercised options or restricted stock,
whether vested or unvested, and (ii) the value of
the consideration deliverable for an equivalent
number of shares as a result of the Change of
Control transaction.

2.4 Extended medical and dental benefits.

2.4.1 Benefit continuation for twelve months. An Executive
shall receive continued provision of the Company's standard employee medical and
welfare benefit coverages, as elected by an Executive and in effect immediately
prior to the Change of Control, for twelve (12) months following the date of
termination.

2.4.2 Continued medical coverage for U.S. residents.
Thereafter, if an Executive resides in the United States, an Executive shall be
entitled to elect continued medical and dental insurance coverage in accordance
with the applicable provisions of U.S. federal law (COBRA). If such coverage
included an Executive's dependents immediately prior to the date of termination,
such dependents also shall be covered at Company expense during the extension
period. For purposes of title X of the Consolidated Budget Reconciliation Act of
1985 ("COBRA"), the date of the "qualifying event" for an Executive and his
dependents shall be the date upon which the Company-paid coverage terminates.

2.4.3 Termination upon coverage under another Plan.
Notwithstanding the preceding provisions of this Section 2.4, in the event an
Executive becomes covered as a primary insured (that is, not as a beneficiary
under a spouse's or partner's plan) under another employer's group health plan
during the period provided for herein, an Executive promptly shall inform the
Company and the Company shall cease provision of continued group health
insurance for an Executive and any dependents.

3. FEDERAL EXCISE TAX UNDER IRC SECTION 280G

3.1 Adjustment of excess payments payable to an Executive. If (1) any
amounts payable to an Executive under this Agreement are characterized as excess
parachute payments pursuant to Section 4999 of the Internal Revenue Code, and
(2) an Executive thereby would be subject to any United States federal excise
tax due to that characterization, then (3) an Executive may elect, in
Executive's sole discretion, to reduce the amounts payable under this Plan or to
have any portion of applicable options or restricted stock not vest in order to
avoid any "excess parachute payment" under Section 280G(b)(1) of the Internal
Revenue Code of 1986.

3.2 Determination by independent public accountants. Unless the Company
and an Executive otherwise agree in writing, any determination required under
this Section 3 shall be made in writing by independent public accountants agreed
to by the Company and an Executive (the "Accountants"), whose determination
shall be conclusive and binding upon an Executive and the Company for all
purposes. For purposes of making the calculations required by this Section 3,
the Accountants may rely on reasonable, good faith interpretations concerning
the application of Sections 280G and 4999 of the Code. The Company and an
Executive shall furnish to the Accountants such information and documents as the
Accountants may reasonably request in order to make the required determinations.
The Company shall bear all fees and expenses the Accountants may reasonably
charge in connection with the services contemplated by this Section 3.

4. DEFINITIONS

4.1 Capitalized terms defined. Capitalized terms used in this Agreement
shall have the meanings set forth in this Section 4, unless the context clearly
requires a different meaning.

4.2 "Cause" means:

(a) theft; a material act of dishonesty or fraud; intentional
falsification of any employment or Company records; or the commission of any
criminal act which impairs an Executive's ability to perform appropriate
employment duties under this Agreement;

(b) improper disclosure or use of the Company's confidential,
business or proprietary information by an Executive;

(c) an Executive's conviction (including any plea of guilty or
nolo contendere) for a crime involving moral turpitude causing material harm to
the reputation and standing of the Company, as determined by the Company in good
faith; or

(d) gross negligence or willful misconduct in the performance
of an Executive's assigned duties (but not mere unsatisfactory performance).

4.3 "Change of Control" means:

(a) any "person" (as such term is used in Sections 13(d) and
14(d) of the Securities Exchange Act of 1934, as amended (the "Exchanged Act")),
other than a current employee in service on the Effective Date or a trustee or
other fiduciary holding securities of the Company under the employee benefit
plan of the Company, becomes the "beneficial owner" (as defined in Rule 13d-3
promulgated under the Exchange Act), directly or indirectly, of securities of
the Company representing more than 50% of (A) the outstanding shares of common
stock of the Company or (B) the combined voting power of the Company's
then-outstanding securities;

(b) the Company is party to a merger or consolidation which
results in the holders of voting securities of the Company outstanding
immediately prior thereto failing to continue to represent (either by remaining
outstanding or by being converted into voting securities of the surviving
entity) more than 50% of the combined voting power of the voting securities of
the Company or such surviving entity outstanding immediately after such merger
or consolidation;

(c) the sale or disposition of all or substantially all of the
Company's assets (or consummation of any transaction having similar effect);

(d) there occurs a change in the composition of the Board of
Directors of the Company within a six month period, as a result of which fewer
than a majority of the directors are Incumbent Directors; or

(e) the dissolution of liquidation of the Company.

4.4 "Company" shall mean Digital Link Corporation and, following a
Change of Control, any Successor that agrees to assume, or otherwise becomes
bound to by operation of law, all the terms and provisions of this Agreement.

4.5 "Effective Date" means (1) December 14, 1998 or (2) such later
date as an Executive first became an officer of the Company.

4.6 "Executive" shall mean each person elected to the Board of
Directors to serve as an officer of the Company, and such additional individuals
as may be designated thereafter by the Board of Directors.

4.7 "Good Reason" means the occurrence of any of the following
conditions following a Change of Control, without an Executive's informed
written consent, which condition(s) remain(s) in effect ten (10) days after
written notice to the Company from an Executive of such condition(s):

(a) a material decrease in an Executive's base salary or
target bonus amounts;

(b) the relocation of an Executive's work place for the
Company to a location more than 50 miles from the location of the work place
prior to the Change of Control;

(c) assignment to responsibilities or duties that are not a
Substantive Functional Equivalent (as defined in this Agreement or in an
Agreement) of the position which an Executive occupied prior to the Change of
Control; or

(d) any material breach of an Agreement by the Company.

4.8 "Incumbent Director" shall mean a director who either (1) is a
director of the Company as of the Effective Date of this Agreement, or (2) is
elected, or nominated for election, to the Board of Directors of the Company
with the affirmative votes of at least a majority of the Incumbent Directors at
the time of such election or nomination, but (3) was not elected or nominated in
connection with an actual or threatened proxy contest relating to the election
of directors to the Company.

4.9 "Permanent Disability" means that:

(a) an Executive has been incapacitated by bodily injury,
illness or disease so as to be prevented thereby from engaging in the
performance of an Executive's duties;

(b) such total incapacity shall have continued for a period of
six consecutive months; and

(c) such incapacity will, in the opinion of a qualified
physician, be permanent and continuous during the remainder of the Executive's
life.

4.10 "Substantive Functional Equivalent" means an employment position
occupied after a Change of Control that:

(a) is in a substantive area of competence (such as,
accounting; engineering management; executive management; finance; human
resources; marketing, sales and service; operations and manufacturing; etc.)
that is consistent with an Executive's experience and not materially different
from the position occupied prior to the Change of Control;

(b) requires an Executive to serve in a role and perform
duties that are functionally equivalent to those performed prior to the Change
of Control;

(c) does not otherwise constitute a material, adverse change
in an Executive's responsibilities or duties, as measured against an Executive's
responsibilities or duties prior to the Change of Control, causing it to be of
materially lesser rank or responsibility;

(d) if prior to the Change of Control an Executive was
identified as an officer of the Company for purposes of the rules promulgated
under Section 16 of the Securities Exchange Act of 1934, identifies an Executive
as a Section 16 officer of a publicly traded Successor having net assets and
annual revenues no less than those of the Company prior to the Change of
Control; and

(e) if prior to the Change of Control an Executive was
identified as an officer of the Company, for purposes of the rules promulgated
under Section 16 of the Securities Exchange Act of 1934, requires an Executive
to report directly to an executive officer, committee or board of the Successor
that is no less senior than an Executive officer, committee or board, as the
case may be, to whom an Executive reported at the Company prior to the Change of
Control.

4.12 "Successor" means the Company as defined above and any successor
or assign to substantially all of its business and/or assets.

4.13 "Target Annual Earnings" means the sum of annual base salary plus
100% of annual bonus or incentive pay. If different sums would result from
calculations as of (a) the date thirty (30) days prior to the date that the
Company publicly announces it is conducting negotiations leading to a Change of
Control, (b) the date on which a Change of Control occurs or (c) the date of an
Executive's Termination Upon Change of Control, then Target Annual Earnings
shall be determined by the calculation as of the specified date that yields the
highest value.

4.14 "Termination Upon Change of Control" means:

(a) any termination of the employment of an Executive by the
Company without Cause during the period commencing thirty (30) days prior to the
earlier of (1) the date that the Company first publicly announces it is
conducting negotiations leading to a Change of Control, or (2) the date that the
Company enters into a definitive agreement that would result in a Change of
Control (even though still subject to approval by the Company's stockholders and
other conditions and contingencies); and ending on the date which is six (6)
months after the Change of Control; or

(b) any resignation by an Executive for Good Reason within six
(6) months after the occurrence of any Change of Control; but

"Termination Upon Change of Control" shall not include any termination of the
employment of an Executive (1) by the Company for Cause; (2) by the Company as a
result of the Permanent Disability of an Executive; (3) as a result of the death
of an Executive; or (4) as a result of the voluntary termination of employment
by an Executive for reasons other than Good Reason.

5. EXCLUSIVE REMEDY

5.1 Sole remedy for Termination Upon Change of Control. The payments
and benefits provided in Section 2 shall constitute an Executive's sole and
exclusive remedy for any alleged injury or other damages arising out of the
cessation of the employment relationship between an Executive and the Company in
the event of an Executive's Termination Upon Change of Control.

5.2 No other benefits payable. An Executive shall be entitled to no
other compensation, benefits, or other payments from the Company as a result of
any termination of employment with respect to which the payments and/or benefits
described in Sections 2 and 3 have been provided to an Executive, except as
expressly set forth in this Agreement or, subject to the provisions of Sections
10 and 13, in a duly executed employment agreement between Company and an
Executive.
5.3 Release of claims. The Company may condition payment of the cash
severance benefits described in Section 2.2 of this Agreement and the stock
option acceleration described in Section 2.3 upon the delivery by an Executive
of a signed release of claims in a form reasonably satisfactory to the Company;
provided, however, that an Executive shall not be required to release any rights
an Executive may have to be indemnified by the Company.

6. PROPRIETARY AND CONFIDENTIAL INFORMATION

An Executive agrees to continue to abide by the terms and conditions of the
Company's confidential and/or proprietary rights agreement between an Executive
and the Company.

7. NON-SOLICITATION

7.1 Agreement not to solicit. If Company performs its obligations to
deliver the severance benefits set forth in Section 2 of this Agreement, then
for a period of one (1) year after an Executive's Termination Upon Change of
Control, an Executive will not, directly or indirectly, solicit the services or
business of or in any other manner persuade any employee, distributor, vendor,
representative or customer of the Company to discontinue that person's or
entity's relationship with or to the Company.

7.2 Other agreements not superseded. This provision shall not supersede
or limit the terms, including more restrictive terms, of any other agreement by
an Executive to refrain from competition with or from soliciting the employees
or customers of Company.

8. ARBITRATION

8.1 Disputes subject to arbitration. Any claims dispute or controversy
arising out of this Agreement, the interpretation, validity or enforceability of
this Agreement or the alleged breach thereof shall be submitted by the parties
to binding arbitration by the American Arbitration Association; provided,
however, that (1) the arbitrator shall have no authority to make any ruling or
judgment that would confer any rights with respect to the trade secrets,
confidential and proprietary information or other intellectual property of the
Company upon an Executive or any third party; and (2) this arbitration provision
shall not preclude the Company from seeking legal and equitable relief from any
court having jurisdiction with respect to any disputes or claims relating to or
arising out of the misuse or misappropriation of the Company's intellectual
property. Judgment may be entered on the award of the arbitrator in any court
having jurisdiction.

8.2 Site of arbitration. The site of the arbitration proceeding shall
be, at an Executive's election, either (1) Santa Clara County, California or (2)
if an Executive's primary assigned work place prior to the Change of Control was
not in California, a mutually agreed site located within 25 miles of that work
place.

8.3 Cost and expenses borne by Company. All costs and expenses of
arbitration or litigation, including but not limited to reasonable attorneys
fees and other costs reasonably incurred by an Executive, shall be paid by the
Company. Notwithstanding the foregoing, if an Executive initiates the
arbitration or litigation, and the finder of fact finds that an Executive's
claims were totally without merit or frivolous, then an Executive shall be
responsible for his own attorneys' fees.

9. INTERPRETATION

This Agreement shall be interpreted in accordance with and governed by the laws
of the State of California as applied to contracts entered into and entirely to
be performed within that state.

10. CONFLICT IN BENEFITS; NONCUMULATION OF BENEFITS

10.1 Effect of Plan. This Agreement shall supersede all prior
arrangements, whether written or oral, and understandings regarding the subject
matter of this Agreement and shall be the exclusive agreement for the
determination of any payments and accelerated option vesting due upon an
Executive's Termination Upon Change of Control, except as provided in Sections
10.2, 10.3 and 13.

10.2 No limitation of regular benefit plans. This Agreement is not
intended to and shall not affect, limit or terminate any plans, programs, or
arrangements of the Company that are regularly made available to a significant
number of employees or officers of the Company, including without limitation the
Company's stock option plans.

10.3 Noncumulation of cash benefits. An Executive may not cumulate cash
severance payments and excise tax reimbursement benefits under both this
Agreement and another agreement. If an Executive has any other binding written
agreement with the Company which provides that upon a Change of Control or
termination of employment an Executive shall receive one or more of the benefits
described in Section 2.2 of this Agreement (i.e., the payment of cash
compensation or prorated bonus, post-termination consulting and adjustments or
payments relating to federal excise tax), then with respect to each such benefit
the amount payable under this Agreement shall be reduced by the corresponding
amount paid or payable under such other agreements.

11. SUCCESSORS AND ASSIGNS

11.1 Successors of the Company. The Company will require any successor
or assign (whether direct or indirect, by purchase, merger, consolidation or
otherwise) to all or substantially all of the business and/or assets of the
Company, expressly, absolutely and unconditionally to assume and agree to
satisfy the terms of this Agreement in the same manner and to the same extent
that the Company would be required to perform it if no such succession or
assignment had taken place. Failure of the Company to obtain such agreement
shall be a material breach of this Agreement.

11.2 Acknowledgment by Company. If after a Change of Control the
Company (or any Successor) fails to reasonably confirm that it has performed the
obligation described in Section 11.1 within ten (10) days after written notice
from an Executive, an Executive shall be entitled to terminate his employment
with the Company for Good Reason, and to receive the benefits provided under
this Agreement in the event of Termination Upon Change of Control.

11.3 Heirs and representatives of an Executive. This Agreement shall
inure to the benefit of and be enforceable by an Executive's personal and legal
representatives, executors, administrator, successors, heirs, distributes,
devises and legatees.

12. NO REPRESENTATIONS

Executive acknowledges that in entering into this Agreement, Executive is not
relying and has not relied on any promise, representation or statement made by
or on behalf of the Company which is not set forth in this Agreement.

13. MODIFICATION AND AMENDMENT

This Agreement may be modified, amended or superseded only by a supplemental
written agreement signed with the same, formality as this Agreement by Executive
and by the Company. However, the noncumulation of benefits provision of section
10.3 shall apply to any subsequent agreement, unless (1) such provision is
explicitly disclaimed in the subsequent agreement, and (2) the subsequent
agreement has been authorized by the Company's Board of Directors or a committee
thereof.

14. VALIDITY

14.1 Invalid provisions. If any one or more of the provisions (or any
part thereof) of this Agreement shall be held invalid, illegal or unenforceable
in any respect, the validity, legality and enforceability of the remaining
provisions (or any part thereof) shall not in any way be affected or impaired
thereby.

14.2 Execution by two Company executive officers or directors. This
Agreement and any modifications or amendments shall require the signatures of
two executive officers or members of the Board of Directors of the Company.

14.3 Certain business combinations. In the event it is determined by
the Company's Board of Directors (the "Board"), upon consultation with the
Company's management and the Company's independent auditors, that the
enforcement of any provision of this agreement would preclude accounting for any
proposed business combination of the Company involving a Change of Control as a
pooling of interests, and the Board otherwise desires to approve such a proposed
business transaction which requires as a condition to the closing of such
transaction that it be accounted for as a pooling of interests, then any such
provision of this Agreement shall be null and void.

14.4 Consultation with legal and financial advisors. Executive
acknowledges that this Agreement confers significant legal rights, and may also
involve the waiver of rights under other agreements; that Company has encouraged
Executive to consult with Executive's personal legal and financial advisers; and
that Executive has had adequate time to consult with Executive's advisers before
signing this Agreement.

SIGNATURES

The parties have executed this Agreement, intending to be legally bound as of
the Effective Date.

EXECUTIVE

- ----------------------------------
Executive's signature
Printed name:
-------------

DIGITAL LINK CORPORATION

By: ------------------------------
Printed name: Vinita Gupta
Title: President and Chief Executive Officer

By: ------------------------------
Printed name: Stanley E. Kazmierczak
Title: Vice President, Finance and Operations
and Chief Financial Officer

<PAGE>

In March 1999, the Company and the Employees listed below signed this
Agreement. In Section 2.3.1 of this Agreement, the percentage included for each
Employee is also listed below.

Executive Accelerated Vesting

Kent Bossange 50%
Vinita Gupta 100%
Stan Kazmierczak 100%
Dianne Mastilock 50%
Joe Santos 50%
Sherman Silverman 50%
Frank Thomas 50%
Lana Vaysburd 50%

Exhibit 23.01

CONSENT OF INDEPENDENT ACCOUNTANTS

We consent to the incorporation by reference in the registration statements
of Digital Link Corporation and Subsidiaries on Form S-8 (File Nos. 33-74666,
33-95176 and 333-27855) of our report dated January 19, 1999, on our audits of
the consolidated financial statements and financial statement schedule of
Digital Link Corporation and Subsidiaries as of December 31, 1998 and 1997, and
for the years ended December 31, 1998, 1997 and 1996 which reports are included
in this Annual Report on Form 10-K.

/s/ PricewaterhouseCoopers LLP

San Jose, California
March 24, 1999

<ARTICLE> 5
<LEGEND>
This schedule contains summary financial information extracted from the
consolidated balance sheet, consolidated statement of operations and
consolidated statement of cash flows included in the Company's Form 10-K for the
period ending December 31, 1998, and is qualified in its entirety by reference
to such financial statements.
</LEGEND>
<CIK> 0000810467
<NAME> Digital Link Corporation
<MULTIPLIER> 1,000

<S> <C>
<PERIOD-TYPE> 12-MOS
<FISCAL-YEAR-END> DEC-31-1998
<PERIOD-START> JAN-01-1998
<PERIOD-END> DEC-31-1998
<CASH> 296
<SECURITIES> 15,738
<RECEIVABLES> 4,767
<ALLOWANCES> 540
<INVENTORY> 4,306
<CURRENT-ASSETS> 31,675
<PP&E> 11,792
<DEPRECIATION> 9,210
<TOTAL-ASSETS> 54,906
<CURRENT-LIABILITIES> 9,540
<BONDS> 0
0
0
<COMMON> 33,311
<OTHER-SE> 12,055
<TOTAL-LIABILITY-AND-EQUITY> 54,906
<SALES> 54,627
<TOTAL-REVENUES> 54,627
<CGS> 31,442
<TOTAL-COSTS> 67,543
<OTHER-EXPENSES> (2,196)
<LOSS-PROVISION> 0
<INTEREST-EXPENSE> 0
<INCOME-PRETAX> (10,720)
<INCOME-TAX> (4,248)
<INCOME-CONTINUING> (6,472)
<DISCONTINUED> 0
<EXTRAORDINARY> 0
<CHANGES> 0
<NET-INCOME> (6,472)
<EPS-PRIMARY> (0.71)
<EPS-DILUTED> (0.71)

</TABLE>