SDL INC, S-3/A, 1996-06-25

SDL INC
S-3/A, 1996-06-25
SEMICONDUCTORS & RELATED DEVICES

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<PAGE>

AS FILED WITH THE SECURITIES AND EXCHANGE COMMISSION ON JUNE 25, 1996

REGISTRATION NO. 333-3647
================================================================================
SECURITIES AND EXCHANGE COMMISSION
WASHINGTON, D.C. 20549

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

AMENDMENT NO. 2 TO
FORM S-3
REGISTRATION STATEMENT
UNDER THE SECURITIES ACT OF 1933

---------------
SDL, INC.
(EXACT NAME OF REGISTRANT AS SPECIFIED IN ITS CHARTER)
---------------

DELAWARE 3674 77-0331449
(State or Other (Primary Standard Industrial (I.R.S. Employer
Jurisdiction of Classification Code Number) Identification Number)

80 ROSE ORCHARD WAY
SAN JOSE, CALIFORNIA 95134-1365
(408) 943-9411
(Address and telephone number of principal executive offices and principal
place of business)
---------------

GREGORY C. LINDHOLM, VICE PRESIDENT, FINANCE
SDL, INC.
80 ROSE ORCHARD WAY
SAN JOSE, CALIFORNIA 95134-1365
(408) 943-9411
(Name, Address, and Telephone Number of Agent for Service)

COPIES TO:

William D. Sherman, Esq. Scott C. Dettmer, Esq.
Kevin A. Faulkner, Esq. Margaret E. Nibbi, Esq.
Cori M. Allen, Esq. Douglas T. Sheehy, Esq.
Morrison & Foerster LLP Gunderson Dettmer Stough Villeneuve
755 Page Mill Road Franklin & Hachigian, LLP
Palo Alto, CA 94304-1018 600 Hansen Way
Palo Alto, CA 94304

APPROXIMATE DATE OF COMMENCEMENT OF PROPOSED SALE TO THE PUBLIC: As soon as
practicable after this Registration Statement becomes effective.

If the only securities being registered on this Form are being offered
pursuant to dividend or reinvestment plans, please check the following
box. [_]

If any of the securities being registered on this form are to be offered on
a delayed or continuous basis pursuant to Rule 415 under the Securities Act of
1933, check the following box. [_]

If this Form is filed to register additional securities for an offering
pursuant to Rule 462(b) under the Securities Act, please check the following
box and list the Securities Act registration statement number of the earlier
effective registration statement for the same offering. [_]

If this Form is a post-effective amendment filed pursuant to Rule 462(c)
under the Securities Act, check the following box and list the Securities Act
registration statement number of the earlier effective registration statement
for the same offering. [_]

If delivery of the prospectus is expected to be made pursuant to Rule 434,
please check the following box. [_]

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

THE REGISTRANT HEREBY AMENDS THIS REGISTRATION STATEMENT ON SUCH DATE OR
DATES AS MAY BE NECESSARY TO DELAY ITS EFFECTIVE DATE UNTIL THE REGISTRANT
SHALL FILE A FURTHER AMENDMENT WHICH SPECIFICALLY STATES THAT THIS
REGISTRATION STATEMENT SHALL THEREAFTER BECOME EFFECTIVE IN ACCORDANCE WITH
SECTION 8(a) OF THE SECURITIES ACT OF 1933 OR UNTIL THE REGISTRATION STATEMENT
SHALL BECOME EFFECTIVE ON SUCH DATE AS THE COMMISSION, ACTING PURSUANT TO SAID
SECTION 8(a), MAY DETERMINE.
================================================================================
<PAGE>

++++++++++++++++++++++++++++++++++++++++++++++++++++++++++++++++++++++++++++++++
+INFORMATION CONTAINED HEREIN IS SUBJECT TO COMPLETION OR AMENDMENT. A +
+REGISTRATION STATEMENT RELATING TO THESE SECURITIES HAS BEEN FILED WITH THE +
+SECURITIES AND EXCHANGE COMMISSION. THESE SECURITIES MAY NOT BE SOLD NOR MAY +
+OFFERS TO BUY BE ACCEPTED PRIOR TO THE TIME THE REGISTRATION STATEMENT +
+BECOMES EFFECTIVE. THIS PROSPECTUS SHALL NOT CONSTITUTE AN OFFER TO SELL OR +
+THE SOLICITATION OF AN OFFER TO BUY NOR SHALL THERE BE ANY SALE OF THESE +
+SECURITIES IN ANY STATE IN WHICH SUCH OFFER, SOLICITATION OR SALE WOULD BE +
+UNLAWFUL PRIOR TO REGISTRATION OR QUALIFICATION UNDER THE SECURITIES LAWS OF +
+ANY SUCH STATE. +
++++++++++++++++++++++++++++++++++++++++++++++++++++++++++++++++++++++++++++++++

PROSPECTUS SUBJECT TO COMPLETION, DATED JUNE 25, 1996
JUNE , 1996

1,700,000 SHARES

LOGO

COMMON STOCK

Of the 1,700,000 shares of Common Stock offered hereby, 1,500,000 shares are
being issued and sold by SDL, Inc. (the Company) and 200,000 shares are being
offered by certain stockholders of the Company (the Selling Stockholders). See
"Principal and Selling Stockholders." The Company will not receive any proceeds
from the sale of shares by the Selling Stockholders.

The Common Stock is quoted on the Nasdaq National Market under the Symbol
"SDLI." On June 13, 1996, the last reported sale price of the Common Stock on
the Nasdaq National Market was $30.50 per share. See "Price Range of Common
Stock."

On May 6, 1996, the Company's Board of Directors declared a three-for-two
stock split in the form of a 50% stock dividend which was paid on June 12, 1996
to holders of record on May 15, 1996 (the Stock Split). Beginning on June 13,
1996, price quotations for the Common Stock on the Nasdaq National Market
reflected the Stock Split. All information in this Prospectus reflects the
Stock Split.

SEE "RISK FACTORS," BEGINNING ON PAGE 6, FOR A DISCUSSION OF CERTAIN FACTORS
THAT SHOULD BE CONSIDERED BY PROSPECTIVE PURCHASERS OF THE COMMON STOCK.

THESE SECURITIES HAVE NOT BEEN APPROVED OR DISAPPROVED BY THE SECURITIES
AND EXCHANGE COMMISSION OR ANY STATE SECURITIES COMMISSION NOR HAS THE
SECURITIES AND EXCHANGE COMMISSION OR ANY STATE SECURITIES COMMISSION
PASSED UPON THE ACCURACY OR ADEQUACY OF THIS PROSPECTUS. ANY
REPRESENTATION TO THE CONTRARY IS A CRIMINAL OFFENSE.

- --------------------------------------------------------------------------------
<TABLE>
<CAPTION>
PRICE UNDERWRITING PROCEEDS PROCEEDS TO
TO THE DISCOUNTS AND TO THE THE SELLING
PUBLIC COMMISSIONS(1) COMPANY(2) STOCKHOLDERS
- --------------------------------------------------------------------------------
<S> <C> <C> <C> <C>
Per Share........................ $ $ $ $
Total(3)......................... $ $ $ $
- --------------------------------------------------------------------------------
</TABLE>

(1) The Company and the Selling Stockholders have agreed to indemnify the
Underwriters against certain liabilities, including liabilities under the
Securities Act of 1933, as amended. See "Underwriting."

(2) Before deducting expenses of the offering, estimated at $500,000, payable
by the Company.

(3) The Company has granted the Underwriters an option, exercisable within 30
days of the date hereof, to purchase up to an aggregate of 255,000
additional shares of Common Stock solely to cover over-allotments, if any.
If such option is exercised in full, the total Price to the Public,
Underwriting Discounts and Commissions and Proceeds to the Company will be
$ , $ and $ , respectively. See "Underwriting."

The shares are being offered by the Underwriters when, as and if delivered to
and accepted by the Underwriters and subject to various prior conditions,
including their right to reject orders in whole or in part. It is expected that
delivery of share certificates will be made in New York, New York, on or about
June , 1996.

DONALDSON, LUFKIN & JENRETTE COWEN & COMPANY
SECURITIES CORPORATION
<PAGE>

AVAILABLE INFORMATION

The Company is subject to the informational requirements of the Securities
Exchange Act of 1934, as amended (the Exchange Act), and in accordance
therewith files reports, proxy statements and other information with the
Securities and Exchange Commission (the Commission). Such reports, proxy
statements and other information can be inspected and copied at the public
reference facilities maintained by the Commission at Room 1024, Judiciary
Plaza, 450 Fifth Street, N.W., Washington, D.C. 20549, as well as at the
following regional offices: 14th Floor, Seven World Trade Center, New York,
New York 10048, and 500 West Madison Street, Suite 1400, Chicago, Illinois
60661. Copies of such material can also be obtained from the Public Reference
Section of the Commission at Room 1024, Judiciary Plaza, 450 Fifth Street,
N.W., Washington, D.C. 20549, at prescribed rates. The Company's Common Stock
is traded on the Nasdaq National Market under the symbol SDLI. The foregoing
material also should be available for inspection at the National Association
of Securities Dealers, Inc., 1735 K Street, N.W., Washington, D.C. 20006.

ADDITIONAL INFORMATION

The Company has filed with the Commission under the Securities Act of 1933,
as amended (the Securities Act), a Registration Statement on Form S-3 with
respect to the shares of Common Stock offered hereby, of which this Prospectus
forms a part. This Prospectus omits certain information contained in the
Registration Statement, and reference is made to the Registration Statement,
including the exhibits thereto, for further information with respect to the
Company and the securities offered hereby. Statements contained in this
Prospectus concerning the provisions of such documents are necessarily
summaries of such documents and each such statement is qualified in its
entirety by reference to the copy of the applicable document filed with the
Commission. Copies of the Registration Statement and the exhibits and
schedules thereto may be inspected, without charge, at the offices of the
Commission, or obtained at prescribed rates from the Public Reference Section
of the Commission at 450 Fifth Street, N.W., Washington, D.C. 20549.

INCORPORATION OF CERTAIN DOCUMENTS BY REFERENCE

The following documents filed by the Company with the Commission are hereby
incorporated by reference in this Prospectus:

(1) the Company's Annual Report on Form 10-K for the year ended December
31, 1995, as amended by the Company's Report on Form 10-K/A, as filed with
the Commission on June 13, 1996 and as further amended by the Company's
Report on Form 10-K/A (Amendment No. 2), as filed with the Commission on
June 25, 1996;

(2) the Company's Quarterly Report on Form 10-Q for the quarter ended
March 31, 1996; and

(3) the Company's Report on Form 8-K as filed with the Commission on
December 15, 1995, as amended by the Company's Report on Form 8-K/A, as
filed with the Commission on February 12, 1996.

All reports and other documents filed by the Company pursuant to Section
13(a), 13(c), 14 or 15(d) of the Exchange Act subsequent to the date of this
Prospectus and prior to the termination of this offering (except information
included in any such document in response to Item 402(i), 402(k) or 402(l) of
Regulation S-K) shall be deemed to be incorporated by reference herein and to
be a part hereof from the date of filing of such reports and documents. Any
statement incorporated herein shall be deemed to be modified or superseded for
purposes of this Prospectus to the extent that a statement contained herein or
in any other subsequently filed document which also is or is deemed to be
incorporated by reference herein modifies or supersedes such statement. Any
statement so modified or superseded shall not be deemed, except as so modified
or superseded, to constitute a part of this Prospectus.

The Company hereby undertakes to provide without charge to each person,
including any beneficial owner, to whom a copy of this Prospectus has been
delivered, upon written or oral request of such person, a copy of any or all
of the foregoing documents incorporated herein by reference (other than
exhibits to such documents, unless such exhibits are specifically incorporated
by reference into such documents). Requests for such

2
<PAGE>

documents should be submitted in writing to the Chief Financial Officer of the
Company, at the Company's principal executive offices at 80 Rose Orchard Way,
San Jose, California, 95134-1365 or by telephone at (408) 943-9411.

IN CONNECTION WITH THIS OFFERING, THE UNDERWRITERS MAY OVER-ALLOT OR EFFECT
TRANSACTIONS WHICH STABILIZE OR MAINTAIN THE MARKET PRICE OF THE COMMON STOCK
OF THE COMPANY AT A LEVEL ABOVE THAT WHICH MIGHT OTHERWISE PREVAIL IN THE OPEN
MARKET. SUCH TRANSACTIONS MAY BE EFFECTED ON THE NASDAQ NATIONAL MARKET, IN
THE OVER-THE-COUNTER MARKET, OR OTHERWISE. SUCH STABILIZING, IF COMMENCED, MAY
BE DISCONTINUED AT ANY TIME.

IN CONNECTION WITH THIS OFFERING, THE UNDERWRITERS AND OTHER SELLING GROUP
MEMBERS (IF ANY) MAY ENGAGE IN PASSIVE MARKET MAKING TRANSACTIONS IN THE
COMMON STOCK OF THE COMPANY ON THE NASDAQ NATIONAL MARKET IN ACCORDANCE WITH
RULE 10B-6A UNDER THE SECURITIES EXCHANGE ACT OF 1934. SEE "UNDERWRITING."

SDL(R) is a registered trademark of the Company. This Prospectus contains
other trademarks and service marks of the Company and trademarks of other
entities.

3
<PAGE>

PROSPECTUS SUMMARY

The following summary is qualified in its entirety by the detailed
information and the financial statements, including the notes thereto,
appearing or incorporated by reference elsewhere in this Prospectus. Unless
otherwise indicated, the information in this Prospectus assumes no exercise of
the Underwriters' over-allotment option and has been adjusted to reflect the
three-for-two Stock Split which was paid on June 12, 1996 to stockholders of
record on May 15, 1996. See "Recent Development." Certain of the statements
contained in this Prospectus are forward-looking statements. The Company's
actual results could differ materially from those in such forward-looking
statements. See "Risk Factors."

THE COMPANY

These markets are demanding an advanced light source due to the inherent
performance limitations of electronic solutions or the significant shortcomings
of traditional light source technologies. Such an advanced light source should
be highly reliable, highly efficient, small, rugged, light weight, capable of
being modulated at high speed, focusable, low voltage and capable of generating
the full color spectrum. The Company has developed, or is developing, advanced
semiconductor OEIC and laser light sources which are designed to meet these
requirements.

The Company's semiconductor OEIC and laser products replace traditional
technologies in many applications in the communications, information and light
source replacement markets with light-emitting semiconductor devices that are
generally smaller, cheaper, more reliable, more durable and/or more powerful
than their predecessors. With increased levels of semiconductor-based
optoelectronic integration, the Company miniaturizes and generally reduces the
cost while increasing the functionality of what previously were large, bulky
and expensive components. The Company believes that, like silicon integrated
circuits, advanced semiconductor OEICs will represent an increasing portion of
the electronic or optical system's value.

The Company serves a range of customers in the communications, information
and optics industries. Companies currently utilizing the Company's products
include 3M, Alcatel, AT&T, ATx Telecom Systems (a division of Amoco), Eastman
Kodak, Iridex, Lockheed Martin, Lucent Technologies, NASA, Pioneer, TRW and
Xerox. The Company's backlog increased 56.2% from March 31, 1995 to March 31,
1996.

On November 30, 1995, the Company and its wholly-owned subsidiary SDL Optics,
Inc. (SDL Optics) acquired substantially all of the assets and assumed certain
of the liabilities of Seastar Optics Inc. (Seastar), a British Columbia
corporation and a wholly-owned subsidiary of The Axys Group, Ltd. SDL Optics
designs, manufactures and sells products to the fiber optic communications
markets.

The Company's address is SDL, Inc., 80 Rose Orchard Way, San Jose, California
95134-1365, and its phone number is (408) 943-9411.

4
<PAGE>

THE OFFERING

<TABLE>
<S> <C>
Common Stock offered by the Company........... 1,500,000 shares
Common Stock offered by the Selling
Stockholders............................... 200,000 shares
Common Stock to be outstanding after the
offering..................................... 12,526,661 shares (1)
Use of proceeds............................... Expand manufacturing
facilities, acquire capital
equipment and other general
corporate purposes, including
working capital, as well as
potential acquisitions. See
"Use of Proceeds."
Nasdaq National Market symbol................. SDLI
</TABLE>

RECENT DEVELOPMENT

On May 6, 1996, the Company announced a three-for-two split of its Common
Stock, effected in the form of a 50% stock dividend, which was paid on June 12,
1996 to stockholders of record on May 15, 1996. All share and per share data in
this Prospectus has been adjusted to reflect the Stock Split. Beginning on June
13, 1996, price quotations for the Common Stock on the Nasdaq National Market
reflected the Stock Split. See "Recent Development."

SUMMARY CONSOLIDATED FINANCIAL DATA

<TABLE>
<CAPTION>
THREE MONTHS ENDED
YEAR ENDED DECEMBER 31, MARCH 31,
------------------------------- -------------------
1992 1993 1994 1995 1995 1996
(IN THOUSANDS, EXCEPT PER SHARE DATA)
<S> <C> <C> <C> <C> <C> <C>
CONSOLIDATED STATEMENT OF
OPERATIONS DATA:
Total revenue............ $27,982 $27,702 $33,024 $53,894 $ 10,512 $ 20,422
Gross margin............. 9,442 10,823 13,033 20,504 4,005 7,675
Write-off of purchased
in-process research and
development............. -- -- -- 10,010 -- --
Operating income (loss)
(2)..................... 2,578 4,193 5,678 (1,149) 1,860 3,177
Net income (loss) (2).... $ 489 $ 1,150 $ 2,195 $(2,819) $ 905 $ 2,159
======= ======= ======= ======= ========= =========
Net income (loss) per
share (2)............... $ 0.08 $ 0.15 $ 0.29 $ (0.31) $ 0.11 $ 0.18
======= ======= ======= ======= ========= =========
Shares used in computing
net income (loss) per
share (2)(3)............ 5,992 7,509 7,548 9,228 8,062 12,073
</TABLE>

<TABLE>
<CAPTION>
MARCH 31, 1996
------------------------
ACTUAL AS ADJUSTED (4)
<S> <C> <C>
CONSOLIDATED BALANCE SHEET DATA:
Working capital....................................... $ 25,949 $ 68,912
Total assets.......................................... 58,821 101,784
Deferred acquisition obligations...................... 2,680 2,680
Stockholders' equity.................................. 44,797 87,760
</TABLE>
- --------------------

(1) Excludes, as of March 31, 1996, (i) 2,704,815 shares reserved for issuance
pursuant to the exercise of stock options outstanding as of March 31, 1996
having a weighted average exercise price of $4.56 per share, (ii) 401,416
shares reserved for future issuance under the 1995 Employee Stock Purchase
Plan and (iii) 39,344 shares, issuable at the Company's option on March 31,
1997, to pay a portion of the deferred acquisition obligation at an assumed
price of $30.50 per share. Includes 119,000 shares to be issued upon
exercise of outstanding options and sold in this offering by certain
selling stockholders. See "Management--Stock Plans" and Note 8 of Notes to
Consolidated Financial Statements.

(2) Operating results for the year ended December 31, 1995, include a one-time
write-off of approximately $10 million of purchased in-process research and
development during the fourth quarter in connection with the acquisition of
certain assets and liabilities of Seastar Optics Inc. Excluding this write-
off, the pro forma operating income, net income and net income per share
were $8,861,000, $5,691,000 and $0.53, respectively. Pro forma net income
per share was based on 10,729,500 common and common equivalent shares.
(3) See Note 1 of Notes to Consolidated Financial Statements for a description
of the method used to determine the number of shares used in computing net
income (loss) per share.

(4) Adjusted to reflect the sale of 1,500,000 shares of Common Stock offered by
the Company hereby at an assumed public offering price of $30.50 per share,
after deducting estimated underwriting discounts and commissions and
offering expenses, and the receipt of the net proceeds therefrom.

5
<PAGE>

RISK FACTORS

In addition to other information in this Prospectus, the following risk
factors should be considered carefully by prospective investors in evaluating
the Company and its business before purchasing any of the shares of Common
Stock offered hereby.

The statements contained in this Registration Statement that are not purely
historical are forward looking statements within the meaning of Section 27A of
the Securities Act of 1933 and Section 21E of the Securities Exchange Act of
1934, including statements regarding the Company's expectations, hopes,
beliefs, intentions or strategies regarding the future. Forward looking
statements include: descriptions of the future use of OEICs and light as a
replacement for existing technologies under the headings "Prospectus Summary--
The Company" and "Business--Industry Background;" statements regarding future
products or product development under the heading "Business;" statements
regarding the adequacy of cash resources in "Risk Factors--Future Capital
Requirements" and "Use of Proceeds;" statements regarding future research and
development spending and the Company's product development strategy under the
heading "Business--Research and Development;" statements regarding litigation
currently pending against the Company and the Company's defenses thereto under
the headings "Business--Competition," "Business--Intellectual Property" and
"Business--Legal Proceedings;" and statements regarding the future flexibility
of the Company's manufacturing processes and continuing remodeling of its
manufacturing facilities under the heading "Business--Manufacturing." All
forward looking statements included in this document are based on information
available to the Company on the date hereof, and the Company assumes no
obligation to update any such forward looking statement. It is important to
note that the Company's actual results could differ materially from those in
such forward looking statements. Among the factors that could cause actual
results to differ materially are the factors detailed below. Prospective
purchasers of the Common Stock should consult the risk factors listed from
time to time in the Company's Reports on Form 10-Q, 8-K, 10-K and Annual
Reports to Stockholders.

Manufacturing Risks. The Company relies exclusively on its own production
capability in computer-aided chip and package design, wafer fabrication, wafer
processing, device packaging, hybrid microelectronic packaging, printed
circuit board testing, final assembly and testing of products. Because the
Company manufactures, packages and tests these components, products and
systems at its own facility, and such components, products and systems are not
readily available from other sources, any interruption in manufacturing
resulting from shortages of parts or equipment, fire, natural disaster,
equipment failures or otherwise would have a material adverse effect on the
Company's business and results of operations. In particular, a significant
portion of the Company's production relies or occurs on equipment for which
the Company does not have a backup. In order to alleviate, at least in part,
this situation, the Company is in the process of remodeling its front-end
wafer fabrication facility. This might cause downtime on existing equipment.
Also, there can be no assurance that the new facility and equipment will not
experience start-up and yield problems. In the event of any disruption in
production, the Company's business and results of operations could be
materially adversely affected. Furthermore, the Company has a limited number
of employees dedicated to the operation and maintenance of its equipment, the
loss of whom could affect the Company's ability to effectively operate and
service such equipment. The Company is experiencing, and may in the future
experience, lower than expected production yields on many of its products,
including some of its key product lines. This reduction in yields adversely
affects gross margins and delays component, product and system shipments.
There can be no assurance that the Company will be able to maintain acceptable
manufacturing yields or ship products on time in the future. To the extent the
Company continues to experience lower than expected manufacturing yields or
experiences shipment delays, the Company's business and results of operations
would be materially adversely affected. See "--Dependence on Single Source and
Other Third Party Suppliers."

Multisite Operations; Need to Manage Growth. The Company has on occasion
been unable to manufacture certain products in quantities sufficient to meet
the demand of its existing customer base and of new customers. As a result,
the Company expanded its facilities by relocating its assembly, test and
packaging operations to another building and is in the process of remodeling
its original manufacturing facilities and adding

6
<PAGE>

new manufacturing equipment, and obtaining additional facilities. In addition,
in November 1995, the Company and its subsidiary, SDL Optics, acquired the
business of Seastar, located in Victoria, British Columbia, Canada. Prior to
these developments, the Company had no experience in managing operations in
multiple sites and no assurance can be given that the Company will not
experience unexpected delays, inefficiencies or management problems arising
out of its multisite operations. Such delays or inefficiencies could
materially adversely affect the Company's business and results of operations.

The recent growth in the Company's revenue and expansion in the scope of its
operations has placed a considerable strain on its management, financial,
manufacturing and other resources and has required the Company to implement
and improve a variety of operating, financial and other systems, procedures
and controls. In addition, the Company's Vice President of Manufacturing
recently retired and the Company is presently conducting a search for a
replacement. There can be no assurance that any existing or new systems,
procedures or controls will be adequate to support the Company's operations or
that its systems, procedures and controls will be designed, implemented or
improved in a cost effective and timely manner. Any failure to implement,
improve and expand such systems, procedures and controls in an efficient
manner at a pace consistent with the Company's business could have a material
adverse effect on the Company's business and results of operations.

Control of Manufacturing Process. The manufacture of semiconductor OEIC and
laser components, products and systems such as those sold by the Company is a
highly complex and precise process, requiring production in a highly
controlled and clean environment. Changes in the Company's or its suppliers'
manufacturing processes or the inadvertent use of defective or contaminated
materials by the Company or its suppliers could adversely affect the Company's
ability to achieve acceptable manufacturing yields and product reliability. To
the extent the Company does not achieve such yields or product reliability,
its operating results and customer relationships would be adversely affected.

Technology Agreement. As part of its formation, the Company entered into a
technology agreement with Xerox Corporation (Xerox) and Spectra-Physics, Inc.
(Spectra-Physics) pursuant to which, among other things, SDL granted to
Spectra-Physics and Xerox an irrevocable, royalty-free, worldwide, non-
exclusive license to certain patented and non-patented technology developed by
SDL. In March 1995, Spectra-Physics initiated a lawsuit against the Company in
Santa Clara Superior Court, alleging that the Company was refusing to comply
with its obligations under the Technology Agreement. Spectra-Physics claims
that the Technology Agreement requires the Company to transfer and license to
Spectra-Physics all patented and non-patented technology developed by the
Company during a time period extending from the founding of the Company in
1983 until at least June 1993. Spectra-Physics asserts claims against the
Company for breach of contract, promissory estoppel and fraud.

On June 27, 1995, Spectra-Physics filed a first amended complaint, adding
Opto Power Corporation (Opto Power), an affiliate of Spectra-Physics and a
competitor of the Company, as a plaintiff. Opto Power's claims are based in
part on its assertion that it is entitled to access to the Company's
technology as a third party beneficiary of the Technology Agreement, because
the Agreement is alleged to give Spectra-Physics the right to sublicense its
subsidiaries. Spectra-Physics and Opto Power seek remedies of unspecified
actual damages, punitive damages, specific performance and a declaratory
judgment regarding the parties' rights and duties under the Technology
Agreement.

The Company has answered the first amended complaint denying the plaintiffs'
claims and has filed a cross-complaint seeking declaratory relief regarding
its obligations under the Technology Agreement as well as seeking damages and
injunctive relief on various grounds against Spectra-Physics and Opto Power.
In addition, the Company has named Xerox as an additional cross defendant on
the claim for a declaratory judgment seeking an interpretation of the
Technology Agreement with respect to the treatment of Xerox technical
information. Xerox has filed a cross-complaint against the Company, Spectra-
Physics and Opto Power seeking a declaratory judgment that Spectra-Physics and
Opto Power have no license to, and that the Company may not disclose without
Xerox' consent, Xerox technical information. Xerox also asserts a breach of
contract claim against the Company for the alleged failure to transfer
technology to Xerox pursuant to the Technology Agreement. Xerox seeks
unspecified damages from the Company and specific performance of the
Technology Agreement.

7
<PAGE>

In March 1995, Xerox formally requested transfer of SDL technology under the
Technology Agreement, but advised the Company that, in connection with such
transfer, Xerox currently intends to use the SDL technology for Xerox'
internal research and development, laser printing, image projection and other
activities in the document processing field. Xerox further indicated to the
Company that Xerox did not at that time intend to become a supplier of
products that would be competitive with the Company's current product
offerings. SDL agreed to a limited technology transfer for those purposes. No
assurance can be given, however, that Xerox and such subsidiaries or
affiliates as specified in the Technology Agreement will not in the future
offer products competitive with the Company's products, which products could
include or be based on SDL Technology.

Discovery is currently proceeding for this lawsuit, which is currently
scheduled for trial beginning January 21, 1997. Although the Company believes
that it has meritorious defenses to Spectra-Physics', Opto Power's and Xerox's
claims, there can be no assurance that the Company will achieve a successful
result in this litigation. The litigation has involved and is expected to
continue to involve significant expense to the Company and to divert the
attention of the Company's technical and management personnel, and the outcome
could have a material adverse effect on the Company's business and results of
operations. If the Company does not prevail in such litigation, the Company
could face substantial monetary damages and could be required to license and
to transfer valuable SDL trade secrets and technology to Spectra-Physics and
its subsidiaries, possibly including Opto Power, which is currently
manufacturing optoelectronic devices that currently compete with a number of
the Company's products. Such a result could significantly impair the Company's
competitive advantage in certain technology areas and with respect to a number
of products and could have a material adverse effect on the Company's business
and results of operations.

Risk of Patent Infringement Claims. The semiconductor optoelectronics,
communications, information and laser industry is characterized by frequent
litigation regarding patent and other intellectual property rights. From time
to time the Company has received, and may receive in the future, notice of
claims of infringement of other parties' proprietary rights and licensing
offers to commercialize third party patent rights. To date, one royalty-
bearing license has been acquired. In addition, there can be no assurance that
additional infringement claims (or claims for indemnification resulting from
infringement claims) will not be asserted against the Company, or that
existing claims or any other assertions will not result in an injunction
against the sale of infringing products or otherwise materially adversely
affect the Company's business and results of operations.

In 1985, the Company received correspondence from Rockwell International
Corporation (Rockwell) alleging that a fabrication process used by the Company
infringes a Rockwell patent. Those allegations have led to two lawsuits, which
are currently pending. The first lawsuit was initiated in August 1993, when
Rockwell sued the Federal government in the United States Court of Federal
Claims, alleging infringement of the Rockwell patent with respect to the
contracts the Federal government has had with at least 15 companies, including
the Company (the Government Lawsuit). The Company was not originally named as
a party to the Government Lawsuit. However, the Federal government has
asserted that, if it is held liable to Rockwell for infringement of the
Rockwell patent in connection with some of its contracts with the Company, the
Company will be liable to indemnify the Federal government for a portion of
its liability on those contracts. In August 1995, the Company intervened in
the Government Lawsuit as a third-party defendant.

In May 1995, Rockwell filed suit against the Company in the Northern
District of California, alleging that the Company had infringed and currently
infringes the Rockwell patent in connection with the Company's manufacture and
sale of products to customers other than the Federal government (the Rockwell-
SDL Action). By its complaint, Rockwell seeks a permanent injunction against
the Company enjoining it from infringement of the Rockwell patent, damages in
an unspecified amount for the Company's alleged past infringement of the
patent, treble damages and attorneys' fees. The Company filed an answer to the
complaint on August 18, 1995, alleging that Rockwell's patent is invalid, that
Rockwell's patent is not infringed by the Company, that Rockwell's patent is
unenforceable under the doctrine of inequitable conduct, and that Rockwell's
action is barred by the doctrines of laches and equitable estoppel. On August
11, 1995, the Company filed a motion to stay the Rockwell-SDL Action based
upon the pendency of the Government Lawsuit. The District Court granted

8
<PAGE>

the Company's motion to stay on September 15, 1995. There have been no further
proceedings in the Rockwell-SDL Action.

Since intervening in the Government Lawsuit, the Company has pursued
discovery regarding construction of the Rockwell patent's claims and regarding
the Company's allegation that the Rockwell patent is invalid. Discovery on
these issues is presently scheduled to close on September 30, 1996. In March
1996, Rockwell filed a motion seeking summary judgment that its patent is not
invalid. The Company and the Federal government both filed responses to that
motion and filed cross-motions for summary judgment that the Rockwell patent
is invalid. Rockwell's motion for summary judgment and the Company's and the
Federal government's cross-motions for summary judgment will be considered
together by the court, although no hearing date has been set at this time.
Rockwell's response to SDL's and the Federal government's cross-motions is
currently due July 10, 1996.

The Company believes that it has meritorious defenses to Rockwell's
allegations, including, among others, that the Company's process does not
infringe Rockwell's patent upon which its claim is based and that such patent
is invalid. However, the resolution of intellectual property disputes is often
fact intensive and, therefore, the results are inherently uncertain. There can
be no assurance that Rockwell will not ultimately prevail in this dispute. If
Rockwell were to prevail, it could be awarded substantial monetary damages
and/or an injunction against the sale of infringing products by the Company.
If such an injunction were entered, the Company may seek to obtain a license
to use Rockwell's patent. There can be no assurance, however, that a license
would be available on reasonable terms or at all. The award of monetary
damages against the Company, or the grant of an injunction and failure to
obtain a license to use Rockwell's patent on commercially reasonable terms
could have a material adverse effect on the Company's business and results of
operations. Rockwell is significantly larger than the Company and has
significantly greater resources with which to pursue such litigation. Such
litigation is expected to involve significant expense to the Company and
divert the attention of the Company's technical and management personnel and
could have a material adverse effect on the Company's business and results of
operations.

Dependence on Emerging Applications. The Company's current products serve
many applications in the communications, information and light source
replacement markets. In many cases, the Company's products are substantially
completed, but the customer's product is not yet completed, and the
applications are emerging or are otherwise in new markets. In addition, the
Company and certain of its customers are currently in the process of
developing new products, in various stages of development, testing and
qualification, sometimes in emerging applications or new markets. A
substantial portion of the Company's products addresses markets that are not
now and may never become substantial commercial markets. The Company has
experienced, and is expected to experience, technological and pricing
constraints that may preclude development of markets and fluctuation in
customer orders. No assurances can be given that the Company or its customers
will continue their existing product development efforts, or if continued that
such efforts will be successful, that markets will develop for any of the
Company's or customer's products, that the Company's technology or pricing
will enable such markets to develop, or that the Company's and its customer's
products will not be superseded by other technology or products.

Dependence on Proprietary Technology. The Company's future success and
competitive position is dependent in part upon its proprietary technology, and
the Company relies in part on patent, trade secret, trademark and copyright
law to protect its intellectual property. There can be no assurance that any
of the over 45 patents owned or approximately 100 patents licensed by the
Company will not be invalidated, circumvented, challenged or licensed to
others, that any rights granted thereunder will provide adequate protection or
competitive advantages to the Company or that any of the Company's
approximately four dozen pending or future patent applications will be issued
with the scope of the claims sought by the Company, if at all. Furthermore,
there can be no assurance that others have not developed, or will not develop,
technologies that are similar or superior to the Company's technology,
duplicate the Company's technology or design around the patents owned by the
Company, or patent or assert patents on technology which the Company might use
or intend

9
<PAGE>

to use. In addition, effective copyright and trade secret protection may be
unavailable, limited or not applied for in certain foreign countries. Certain
of the Company's technology is licensed on a non-exclusive basis from Xerox
and other third parties which may license such technology to others, including
competitors of the Company. Under the Technology Agreement, Xerox and Spectra-
Physics, and their subsidiaries or, in the case of Xerox, an affiliate, may
have royalty-free, worldwide license rights to all or some of the Company's
technology. There can be no assurance that steps taken by the Company to
protect its technology will prevent misappropriation of such technology. In
addition, litigation has been necessary and may be necessary in the future to
enforce the Company's patents and other intellectual property rights, to
protect the Company's trade secrets, to determine the validity and scope of
the proprietary rights of others or to defend against claims of infringement
or invalidity. Such litigation has resulted in substantial costs and diversion
of resources and could have a material adverse effect on the Company's
business and results of operations. Moreover, the Company may be required to
participate in interference proceedings to determine the priority of
inventions which could result in substantial cost to the Company. See "--Risk
of Patent Infringement Claims," "--Technology Agreement" and "Business--
Intellectual Property."

Competition. The Company's various markets are highly competitive. The
Company faces current or potential competition from four primary sources: (i)
direct competitors, (ii) potential entrants, (iii) suppliers of potential new
technologies and (iv) suppliers of existing alternative technologies. The
Company offers a range of components, products and systems and has numerous
competitors worldwide in various segments of its markets. As the markets for
the Company's products grow, new competitors have recently emerged and are
likely to continue to do so in the future. The Company also sells products and
services to companies with which it presently competes or in the future may
compete. In most of the Company's product lines, both the Company and
competitors are working to develop new technologies, or improvements and
modifications to existing technologies, which will obsolete present products.
Many of the Company's competitors have significantly greater financial,
technical, manufacturing, marketing, sales and other resources than SDL. In
addition, many of these competitors may be able to respond more quickly to new
or emerging technologies, evolving industry trends and changes in customer
requirements and to devote greater resources to the development, promotion and
sale of their products than the Company. There can be no assurance that the
Company's current or potential competitors have not already or will not in the
future develop or acquire products or technologies comparable or superior to
those developed by the Company, combine or merge to form significant
competitors, or adapt more quickly than the Company to new technologies,
evolving industry trends and changing customer requirements. Increased
competition has resulted and could, in the future, result in price reductions,
reduced margins or loss of market share, any of which could materially and
adversely affect the Company's business and results of operations. There can
be no assurance that the Company will be able to compete successfully against
current and future competitors or that competitive pressures faced by the
Company would not have a material adverse effect on its business and results
of operations. The Company expects that both direct and indirect competition
will increase in the future. Additional competition could have a material
adverse effect on the Company's results of operations through price reductions
and loss of market share. See "--Technology Agreement" and "Business--
Competition."

Dependence Upon Government Programs and Contracts. In 1993, 1994 and 1995,
and the three months ended March 31, 1996, the Company derived approximately
40%, 36%, 45%, and 46%, respectively, of its revenue directly and indirectly
from a variety of Federal government sources. Direct sources included Federal
agencies such as NASA, Advanced Research Projects Agency (ARPA), Air Force,
Navy, Army, Department of Defense (DoD), Department of Commerce (DoC),
National Institute of Standards and Technology (NIST), National Science
Foundation (NSF) and Department of Energy (DoE). Indirect funding includes
standard and custom product sales to, and subcontracts under, customers' prime
contracts and subcontracts with various Federal agencies. The demand for
certain of the Company's services and products is directly related to the
level of funding of government programs. The Company believes that the success
and further development of its business is dependent, in significant part,
upon the continued existence and funding of such programs and upon the
Company's ability to participate in such programs. For example, substantially
all of the Company's research revenue for the three months ended March 31,
1996 and for 1995, 1994 and 1993 was funded by Federal

10
<PAGE>

programs. There can be no assurance that the Federal government will have the
available resources to fund such programs, that such programs will continue to
be funded even if government agencies have available financial resources, or
that the Company will continue to be awarded contracts under such programs.
Most of the Company's Federally-funded programs are subject to renewal every
one or two years, so that continued work by the Company under these programs
in future periods is not assured. Federally-funded programs are subject to
termination for convenience of the government agency, at which point the
Company would be reimbursed for related allowable costs incurred to the
termination date. Federally-funded contracts are subject to audit of pricing
and actual costs incurred which have resulted, and could result in the future,
in price adjustments.

Loss of Eligibility for U.S. Government Small Business Innovative Research
Contracts. Approximately 5% of the Company's 1995 and first quarter 1996
revenue was received through certain U.S. government programs which required
that participants meet specific eligibility requirements. The Company expects
that its growth will result in the Company exceeding the maximum number of
employees allowed under these eligibility requirements before the end of 1996
and that the Company will no longer be able to compete for future research
contract awards under these government programs. Loss of eligibility under
these programs does not disqualify the Company from contracts awarded prior to
the loss of eligibility. Loss of eligibility under these programs could
materially decrease the Company's future revenue and could require increased
internally-funded research and development spending.

Customer Concentration. The Company received 19.0% and 16.9% of its revenue
for 1995 and the three months ended March 31, 1996, respectively, from
Lockheed Martin through several government and commercial programs. Almost all
of the Company's revenue from Lockheed Martin during 1995 and the three months
ended March 31, 1996 was, and during the remainder of 1996 is expected to be,
derived from Federally-funded programs. Most of the Company's Federally-funded
programs are subject to renewal every one or two years and to termination for
convenience of the government agency. The loss of the Company's contracts with
Lockheed Martin could have a material adverse effect on the Company's business
and results of operations. See "--Dependence Upon Government Programs and
Contracts."

Risks of Acquisitions. Although to date the Company has not experienced
significant disruption as a result of the acquisition of Seastar (the
Acquisition), a significant amount of time has been devoted and will continue
to be devoted by Company personnel to the management of the Acquisition, and
there can be no assurance that disruption or other difficulties, such as
departures of employees, will not occur. For example, the President of SDL
Optics, who had been the President of Seastar, recently resigned. The addition
of new products, personnel and technologies places additional burdens on sales
and engineering resources. In particular, as a result of the Acquisition, the
Company must successfully manage the development and sale of a broader range
of products. There can be no assurance that the Company will be able to manage
this process successfully. The Company's strategy involves the acquisition and
integration of additional companies' products, technologies and personnel.
There can be no assurance that the Company will be able to integrate such
products, technologies and personnel successfully.

Dependence on Single Source and Other Third Party Suppliers. The Company
depends on a single or limited number of outside contractors and suppliers for
raw materials, packages and standard components, and to assemble printed
circuit boards. The Company generally purchases these single or limited source
products through standard purchase orders or one year supply agreements and
has no long-term guaranteed supply agreements with such suppliers. The Company
seeks to maintain a sufficient safety stock to overcome short-term shipping
delays or supply interruptions by its suppliers. The Company also endeavors to
maintain ongoing communications with its suppliers to guard against
interruptions in supply and has, to date, generally been able to obtain
sufficient supplies in a timely manner. However, the Company's business and
results of operations have in the past been and could in the future be
adversely affected by a stoppage or delay of supply, substitution of more
expensive or less reliable parts, receipt of defective parts or contaminated
materials, an increase in the price of such supplies or the Company's
inability to obtain reduced pricing from its suppliers in response to
competitive pressures. For example, the Company is currently negotiating with
several suppliers to accelerate

11
<PAGE>

the delivery schedule for parts from the estimated delivery schedules given by
such suppliers and with one other supplier, who had been a sole source of a
particular part, to continue supplying such part. If these suppliers are not
able to accelerate delivery as requested by the Company, the Company's
operating cost may be increased or a portion of the Company's manufacturing
line might be shut down for a period of time, delaying delivery of the
Company's products to its customers and consequently creating customer
dissatisfaction. Any significant interruption in delivery of such parts could
have a material adverse effect on the Company's business and results of
operations.

Customer Order Fluctuations. The Company's product revenue is subject to
fluctuations in customer ordering practices. Occasionally, some of the
Company's customers have ordered more products than they need in a given
period, thereby building up inventory and delaying placement of subsequent
orders until such inventory has been reduced. Also, customers have
occasionally placed large orders which they have subsequently canceled.
Despite cancellation penalties in the Company's sales agreements, such
cancellations can have adverse effects on the Company's business and results
of operations because the Company may have incurred inventory or other
expenses in preparing to fill such orders prior to their cancellation.
Virtually all of the Company's backlog is subject to cancellation.
Cancellation of significant portions of the Company's backlog, or delays in
scheduled delivery dates, could have a material adverse effect on the
Company's business and results of operations.

Potential Adverse Impact of Environmental Regulations. The Company is
subject to a variety of Federal, state and local governmental regulations
related to the storage, use, discharge and disposal of toxic, volatile or
otherwise hazardous or regulated chemicals used in its manufacturing
processes. There can be no assurance that changes in environmental regulations
will not impose the need for additional capital equipment or other
requirements. Further, such regulations could restrict expansion of the
Company's operations. Any failure by the Company to obtain required permits
for, control the use of or adequately restrict the discharge of hazardous or
regulated substances under present or future regulations could subject the
Company to substantial liability, require costly changes in the Company's
manufacturing processes or facilities, or cause its manufacturing operations
to be suspended. Such liability or suspension of manufacturing operations
could have a material adverse effect on the Company's business and results of
operations. The Company has been forced in the past and may be forced in the
future to eliminate certain substances from its manufacturing processes.
Failure to obtain adequate replacements may result in decreased manufacturing
yield, impairment of product reliability, inability to fabricate certain
products or increased manufacturing costs.

Product Liability Risks. Some of the Company's products become critical
components in medical and surgical devices and printing, data storage, data
transmission and communications systems. A malfunction of the Company's
products in any application could result in tort lawsuits based on injuries
resulting from such malfunctions, or in contract damages lawsuits resulting
from high costs of repairing or replacing Company products in applications
such as satellites or fiber cables or due to lost profits for data
transmission down time. Although the Company attempts to reduce the risk of
such losses through warranty disclaimers and liability limitation clauses in
its sales agreements and by maintaining product liability insurance, there can
be no assurance that such warranty disclaimers and liability limitations will
be effective in limiting the Company's liability for any such damages or that
such insurance will be adequate to cover any losses. The personal injury or
lost profits damages could be substantial and could have a material adverse
effect on the Company's business and results of operations.

Rapid and Fundamental Technological Change. The semiconductor
optoelectronics and laser industry is characterized by extensive research and
rapid technological change. The development by others of new or improved
products, processes or technologies have in the past made, and may in the
future make, the Company's current or proposed products obsolete or less
competitive. Although the Company devotes significant efforts and financial
resources to further develop and enhance its existing products, there can be
no assurance that advances in other or alternative technologies will not make
the Company's products obsolete or less competitive. The Company's future
business and results of operations will depend on its ability to enhance its
existing products, develop new products that address the sophisticated needs
of its customers and respond to technological advances and emerging industry
standards and practices.

12
<PAGE>

Distribution Risks. The Company currently uses local distributors in key
industrialized countries and local representatives in smaller markets. In
addition, the Company's sales staff services certain overseas accounts and
large customers directly. Although the Company has formal distribution
contracts with certain of its distributors and representatives, many of the
Company's relationships are currently on an informal basis. Most of the
Company's international distributors and representatives offer only the
Company's products; however, certain distributors offer competing products and
there can be no assurance that additional distributors and representatives
will not also offer products that are competitive with the Company's products.
There can be no assurance that the Company's international distributors and
representatives will enter into formal distribution agreements at all or on
acceptable terms, will not terminate informal or contractual relationships,
will continue to sell the Company's products or that the Company will provide
the distributors and resellers with adequate levels of support. The loss of,
or a significant reduction in revenue through, a significant number of the
Company's international distributors and representatives would have a material
adverse effect on the Company's business and results of operations.

Risk of International Revenue. International revenue accounted for
approximately 23%, 25%, 23% and 17% of the Company's total revenue in 1993,
1994, 1995, and the three month period ended March 31, 1996, respectively.
International revenue carries a number of inherent risks, including reduced
protection for intellectual property rights in some countries, the impact of
recessionary environments in economies outside the United States, generally
longer receivable collection periods, changes in regulatory environments,
tariffs and other potential trade barriers. In addition, certain of the
Company's international revenue is subject to export licensing and approvals
by the DoC or other U.S. governmental agencies. Although to date the Company
has experienced little difficulty in obtaining such licenses or approvals, the
failure to obtain such licenses or approvals or comply with such regulations
in the future could have a material adverse effect on the Company's business
and results of operations.

Need to Hire and Retain Personnel; Dependence on Key Employees. The future
success of the Company is dependent, in part, on its ability to attract,
assimilate and retain additional, including certain key, personnel. The
Company will continue to need a substantial number of additional personnel,
including those with specialized skills, to commercialize its products and
expand all areas of its business in order to continue to grow. The Company
intends to hire a significant number of additional personnel in the remainder
of 1996 and beyond. Competition for such personnel is intense, and there can
be no assurance that the Company will be able to attract, assimilate or retain
additional highly qualified personnel. The Company's future performance also
depends in significant part upon the continued service of its key technical
and senior management personnel. The loss of the services of one or more of
the Company's officers or other key employees could have a material adverse
effect on the Company's business, operating results and financial condition.
While many of the Company's current employees have many years of service with
the Company, there can be no assurance that the Company will be able to retain
its existing personnel. For example, the Company's Vice President of
Manufacturing has recently retired and the Company is presently conducting a
search for a replacement. If the Company is unable to retain and hire
additional and replacement personnel for key technical and management
positions, the Company's business and results of operations could be
materially and adversely affected. See "--Multisite Operations; Need to Manage
Growth."

Future Capital Requirements. The Company is currently devoting substantial
resources to new equipment and facilities, development of new products, cost
reduction and yield improvements. The Company believes that its existing cash
balances, cash flow from operations, available lines of credit and cash
available in the equity markets will be sufficient to fund capital equipment
purchases, acquisitions of complimentary businesses, products or technologies
and to provide adequate working capital through the end of 1997. However,
there can be no assurance that events in the future will not require the
Company to seek additional capital sooner or, if so required, that adequate
capital will be available on terms acceptable to the Company. The timing and
amount of any such capital requirements cannot be precisely determined at this
time and will depend on several factors, including demand for the Company's
products and products under development and changes in its industry. See
"Management's Discussion and Analysis of Financial Condition and Results of
Operations--Liquidity and Capital Resources."

13
<PAGE>

Potential Volatility of Stock Price. Factors such as announcements of
technological innovations, large customer orders, order cancellations or new
products by the Company, its competitors or third parties, as well as
quarterly variations in the Company's actual or anticipated results of
operations, developments in litigation involving the Company and other
factors, may cause the market price of the Company's Common Stock to fluctuate
significantly. Furthermore, the stock market has experienced extreme price and
volume fluctuations, which have particularly affected the market prices of
many high technology companies and which have often been unrelated to the
operating performance of such companies. These broad market fluctuations may
adversely affect the market price of the Company's Common Stock. Many
companies in the semiconductor industry, including the Company, have in the
past year experienced historical highs in the market prices of their stock.
The prices for several of these companies have subsequently decreased
significantly. There can be no assurance that the market price of the
Company's Common Stock will not experience significant fluctuations in the
future, including fluctuations that are unrelated to the Company's
performance.

Sales of Common Stock into the Market. Sales of the Company's Common Stock
in the public market after this offering could materially adversely affect the
market price of the Company's Common Stock. The 1,700,000 shares sold hereby
will be freely transferable without restriction under the Securities Act of
1933, as amended. In addition, shares of Common Stock sold in the Company's
two prior public offerings and shares of unregistered stock and option shares
registered on the Company's Form S-8 Registration Statements held by certain
securityholders of the Company are also eligible for immediate sale in the
public market. The Company's executive officers and directors, who hold an
aggregate of approximately 2,881,887 shares of Common Stock, including option
shares, have also agreed that for a period of ninety days after the date of
this Prospectus, they will not, without the prior written consent of
Donaldson, Lufkin & Jenrette Securities Corporation, offer for sale, sell,
transfer or otherwise dispose of any shares of Common Stock of the Company.
See "Underwriting."

Potential Anti-Takeover Effects of Delaware Law; Possible Issuances of
Preferred Stock. Certain provisions of Delaware law could delay or impede the
removal of incumbent directors and could make more difficult a merger, tender
offer or proxy contest involving the Company, even if such events could be
beneficial, in the short term, to the interests of the stockholders. Such
provisions could limit the price that certain investors might be willing to
pay in the future for shares of the Company's Common Stock. In addition,
shares of preferred stock may be issued by the Board of Directors without
stockholder approval on such terms as the Board may determine. The rights of
the holders of Common Stock will be subject to, and may be adversely affected
by, the rights of the holders of any preferred stock that may be issued in the
future. Moreover, although the ability to issue preferred stock may provide
flexibility in connection with possible acquisitions and other corporate
purposes, such issuance may make it more difficult for a third party to
acquire, or may discourage a third party from acquiring, a majority of the
voting stock of the Company. The Company has no current plans to issue any
shares of preferred stock. See "Description of Capital Stock."

RECENT DEVELOPMENT

On May 6, 1996, the Company announced a three-for-two split of its Common
Stock, which was effected in the form of a 50% stock dividend, paid on June
12, 1996 to stockholders of record on May 15, 1996. Certificates representing
the additional shares were distributed on June 12, 1996 and beginning on June
13, 1996 price quotations for the Common Stock on the Nasdaq National Market
reflect the Stock Split. Share and per share data in this Prospectus have been
adjusted to reflect the Stock Split. The number of shares of Common Stock
issuable upon exercise of outstanding options and the number of shares
reserved for issuance under the Company's current stock incentive plans were
proportionately adjusted to give effect to the Stock Split.

14
<PAGE>

USE OF PROCEEDS

The net proceeds to the Company from the sale of the 1,500,000 shares of
Common Stock being offered by the Company hereby at an assumed public offering
price of $30.50 per share are estimated to be $42,963,000 ($50,351,000 if the
Underwriters' over-allotment option is exercised in full), after deducting the
estimated underwriting discounts and commissions and offering expenses. The
Company will not receive any proceeds from the sale of Common Stock by the
Selling Stockholders.

The net proceeds are expected to be used to expand the Company's
manufacturing facilities, to acquire capital equipment and for general
corporate purposes including working capital. The Company currently estimates
that approximately $6 million of the net proceeds will be used to expand
manufacturing facilities and approximately $16 million of the net proceeds
will be used for acquisition of capital equipment. In addition, the Company
frequently reviews potential acquisition opportunities. Although there are no
current plans with respect to any such transactions, proceeds of the offering
could be used to acquire complementary businesses, products or technologies.
Pending such uses, the net proceeds of this offering will be invested in
short-term, investment-grade, income producing investments.

The Company believes that its current cash balances, cash generated from
operations, its bank line of credit and the net proceeds from the offering
will be sufficient to fund necessary purchases of capital equipment and
facilities expansion, and to provide adequate working capital through 1997.
However, there can be no assurance that events in the future will not require
the Company to seek additional capital sooner or, if so required, that
adequate capital will be available on terms acceptable to the Company.

PRICE RANGE OF COMMON STOCK

The Common Stock of the Company has been traded on the Nasdaq National
Market since the Company's initial public offering on March 16, 1995 at $10.67
per share (the IPO). Prior to the IPO, there was no public market for the
Company's Common Stock. The following table sets forth the range of high and
low closing sale prices for the Common Stock for the periods indicated, as
reported by the Nasdaq National Market, which prices reflect the Stock Split.
See "Recent Development."

<TABLE>
<CAPTION>
PRICE RANGE OF
COMMON STOCK
---------------
HIGH LOW
<S> <C> <C>
Year ended December 31, 1995
First Quarter (from March 16, 1995)....................... $ 19.50 $ 16.33
Second Quarter............................................ 20.00 16.00
Third Quarter............................................. 23.00 18.08
Fourth Quarter............................................ 18.17 13.50
Year ended December 31, 1996
First Quarter............................................. 22.67 15.00
Second Quarter (through June 13, 1996).................... 32.00 19.83
</TABLE>

On June 13, 1996, the closing price of the Company's Common Stock as
reported on the Nasdaq National Market was $30.50 per share. As of April 30,
1996, there were approximately 110 holders of record and 3,400 beneficial
holders of Common Stock.

15
<PAGE>

CAPITALIZATION

The following table sets forth the consolidated capitalization of the
Company at March 31, 1996, and the consolidated capitalization of the Company
as adjusted to give effect to the sale of 1,500,000 shares of Common Stock
offered by the Company hereby at an assumed public offering price of $30.50
per share and the receipt of the estimated net proceeds therefrom. This table
should be read in conjunction with the Company's Financial Statements and
Notes thereto and "Selected Consolidated Financial Data" included or
incorporated elsewhere in this Prospectus.

<TABLE>
<CAPTION>
AS OF MARCH 31,
1996
---------------------
AS
ACTUAL ADJUSTED
(IN THOUSANDS,
EXCEPT SHARE DATA)
<S> <C> <C>
Deferred acquisition obligations(1)...................... $ 2,680 $ 2,680
Stockholders' equity:
Preferred Stock, $0.001 par value; 1,000,000 shares
authorized,
none issued or outstanding............................ -- --
Common Stock, $0.001 par value; 21,000,000 shares au-
thorized(2)........................................... 11 12
Additional paid-in capital (net of treasury shares).... 65,049 108,011
Accumulated deficit.................................... (19,869) (19,869)
Less stockholders' notes receivable and cumulative
translation adjustment................................ (394) (394)
--------- ---------
Total stockholders' equity........................... 44,797 87,760
--------- ---------
Total capitalization..................................... $ 47,477 $ 90,440
========= =========
</TABLE>
- ---------------------
(1) Represents deferred payments due in connection with the acquisition of
Seastar. See Note 2 of Notes to Consolidated Financial Statements.

(2) 10,907,661 shares outstanding Actual; and 12,407,661 shares outstanding As
Adjusted. Excludes options to purchase 2,704,815 shares of Common Stock,
outstanding as of March 31, 1996 having a weighted average exercise price
of $4.56 per share and 401,416 shares reserved for future issuance under
the 1995 Employee Stock Purchase Plan and 39,344 shares, issuable at the
Company's option on March 31, 1997, to pay a portion of the deferred
acquisition obligations at an assumed price of $30.50 per share. See Note
8 of Notes to Consolidated Financial Statements.

16
<PAGE>

SELECTED CONSOLIDATED FINANCIAL DATA

The following consolidated selected financial data of the Company is
qualified by reference to and should be read in conjunction with the
consolidated financial statements of the Company, including the notes thereto,
and Management's Discussion and Analysis of Financial Condition and Results of
Operations included elsewhere herein. The Consolidated Statement of Operations
Data for the three years ended December 31, 1995, and the Consolidated Balance
Sheet Data as of December 31, 1994 and 1995 are derived from the audited
consolidated financial statements included elsewhere in this Prospectus, which
financial statements have been audited by Ernst & Young LLP, independent
auditors, whose report with respect thereto appears elsewhere in this
Prospectus. The Consolidated Balance Sheet Data as of December 31, 1992 and
1993 are derived from financial statements of the Company audited by Ernst &
Young LLP but not included herein. The Consolidated Statement of Operations
Data for the year ended December 31, 1992 have been derived from the unaudited
financial statements of the Company. The Consolidated Statement of Operations
Data for the three-month periods ended March 31, 1995 and 1996 and the
Consolidated Balance Sheet Data as of March 31, 1996 are derived from
unaudited interim financial statements contained elsewhere herein. The
unaudited interim financial statements include all adjustments, consisting
only of normal recurring adjustments, which the Company considers necessary
for a fair presentation of the data. Results of operations for interim periods
are not necessarily indicative of results to be expected for the full fiscal
year.
<TABLE>
<CAPTION>
THREE MONTHS
ENDED
YEARS ENDED DECEMBER 31, MARCH 31,
---------------------------------- -----------------
1992 1993 1994 1995 1995 1996
(IN THOUSANDS, EXCEPT PER SHARE DATA)
<S> <C> <C> <C> <C> <C> <C>
CONSOLIDATED STATEMENT
OF OPERATIONS DATA:
Total revenue:
Product revenue........ $ 24,317 $22,176 $27,597 $45,277 $ 8,652 $17,348
Research revenue....... 3,665 5,526 5,427 8,617 1,860 3,074
-------- ------- ------- ------- ------- -------
Total revenue.......... 27,982 27,702 33,024 53,894 10,512 20,422
Cost of revenue:
Cost of product
revenue............... 15,870 12,749 15,790 26,871 5,097 10,505
Cost of research
revenue............... 2,670 4,130 4,201 6,519 1,410 2,242
-------- ------- ------- ------- ------- -------
Total cost of revenue.. 18,540 16,879 19,991 33,390 6,507 12,747
-------- ------- ------- ------- ------- -------
Gross margin........... 9,442 10,823 13,033 20,504 4,005 7,675
Operating expenses:
Research and
development........... 2,130 3,047 2,781 3,994 724 1,687
Selling, general and
administrative........ 4,734 3,583 4,574 7,649 1,421 2,650
In-process research and
development........... -- -- -- 10,010 -- --
Amortization of
purchased intangibles. -- -- -- -- -- 161
-------- ------- ------- ------- ------- -------
Total operating
expenses.............. 6,864 6,630 7,355 21,653 2,145 4,498
-------- ------- ------- ------- ------- -------
Operating income
(loss)(1)............. 2,578 4,193 5,678 (1,149) 1,860 3,177
Interest (income)
expense, net........... 1,095 2,356 2,079 (118) 424 (145)
-------- ------- ------- ------- ------- -------
Income (loss) before
income taxes(1)....... 1,483 1,837 3,599 (1,031) 1,436 3,322
Provision for income
taxes.................. 994 687 1,404 1,788 531 1,163
-------- ------- ------- ------- ------- -------
Net income (loss)(1)... $ 489 $ 1,150 $ 2,195 $(2,819) $ 905 $ 2,159
======== ======= ======= ======= ======= =======
Net income (loss) per
share(1).............. $ 0.08 $ 0.15 $ 0.29 $ (0.31) $ 0.11 $ 0.18
======== ======= ======= ======= ======= =======
Shares used in computing
net income (loss) per
share(1)(2)............ 5,992 7,509 7,548 9,228 8,062 12,073
<CAPTION>
DECEMBER 31,
---------------------------------- MARCH 31,
1992 1993 1994 1995 1996
<S> <C> <C> <C> <C> <C> <C>
CONSOLIDATED BALANCE
SHEET DATA:
Working capital......... $ 6,540 $ 6,425 $ 5,556 $22,649 $25,949
Total assets............ 19,216 19,612 23,799 56,643 58,821
Long-term debt (less
current portion)....... 26,266 24,821 22,519 -- --
Convertible redeemable
preferred stock and
stockholders' equity
(net capital
deficiency)............ (11,537) (9,994) (7,724) 40,500 44,797
</TABLE>
- ---------------------

(1) Operating results for the year ended December 31, 1995, includes a one-
time write-off of approximately $10 million of purchased in-process
research and development during the fourth quarter in connection with the
acquisition of certain assets and liabilities of Seastar. Excluding this
write-off, the pro forma operating income, net income and net income per
share was $8,861,000, $5,691,000 and $0.53, respectively. Pro forma net
income per share was based on 10,729,500 common and common equivalent
shares.
(2) See Note 1 of Notes to Consolidated Financial Statements for a description
of the method used to determine the number of shares being used in
computing net income (loss) per share.

17
<PAGE>

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

INTRODUCTION

SDL designs, manufactures and markets semiconductor optoelectronic
integrated circuits (OEICs), high power semiconductor lasers and related
products. The Company's revenue consists of product and research revenue. The
Company's product revenue is primarily derived from the sale of standard and
customized products to a variety of customers, in volumes ranging from single
products sold to numerous organizations to high unit volumes sold to certain
original equipment manufacturer (OEM) customers. As a result, product gross
margins tend to fluctuate based on the mix of products sold in any reported
period. From the original products introduced in 1984, the Company has
expanded its product offering to over 200 standard products in addition to
providing custom design and packaging for OEM customers. OEM customers often
fund the design or customization as well as the manufacturing and testing of
their volume products. The primary applications for the Company's products
include telecommunications, CATV, satellite communications, printing, medical,
data storage, sensor, defense, materials processing and scientific markets.

The Company's research revenue is derived from customer-funded research
programs. The Company's research and engineering staff, which currently
includes over 40 Ph.D.s, provides state-of-the-art research and proof-of-
concept prototypes over a broad range of semiconductor OEIC and laser
technologies. The Company has been issued over 45 U.S. patents and has over
four dozen U.S. patent applications pending. Customer-funded research revenue
is typically based on material and labor costs incurred, plus coverage for
overhead and operating expenses, and in most cases, an additional profit
component. Cost-based pricing has generally resulted in lower gross margins
for research revenue than for product revenue. The Company typically retains
rights to the technology developed under customer-funded research programs and
therefore is able to leverage these programs to continue to broaden its
product and technology offerings. All internally-funded research and
development costs are expensed in the period incurred.

On November 30, 1995, the Company and its subsidiary, SDL Optics, acquired
substantially all of the assets of and assumed certain liabilities of Seastar,
which was accounted for under the purchase method of accounting. SDL Optics'
operating results are included in the accompanying consolidated financial
statements since that date.

Certain of the statements contained in this Management's Discussion and
Analysis of Financial Condition and Results of Operations may be forward-
looking statements regarding the Company's business, operations and prospects.
The Company's actual results could differ materially from those in such
forward-looking statements. See "Risk Factors."

18
<PAGE>

RESULTS OF OPERATIONS

The following table sets forth certain consolidated statement of operations
data expressed as a percentage of total revenues for the periods indicated.

<TABLE>
<CAPTION>
THREE MONTHS
ENDED
YEAR ENDED DECEMBER 31, MARCH 31,
------------------------- --------------
1993 1994 1995 1995 1996
<S> <C> <C> <C> <C> <C>
Total revenue:
Product revenue.................. 80.1% 83.6% 84.0% 82.3% 84.9%
Research revenue................. 19.9 16.4 16.0 17.7 15.1
------- ------- ------- ------ ------
Total revenue.................. 100.0 100.0 100.0 100.0 100.0
Cost of revenue:
Cost of product revenue (1)...... 57.5 57.2 59.3 58.9 60.6
Cost of research revenue (1)..... 74.7 77.4 75.7 75.8 72.9
Total cost of revenue.......... 60.9 60.5 62.0 61.9 62.4
------- ------- ------- ------ ------
Gross margin................... 39.1 39.5 38.0 38.1 37.6
Operating expenses:
Research and development......... 11.0 8.4 7.4 6.9 8.2
Selling, general and
administrative.................. 12.9 13.9 14.2 13.5 13.0
In-process research and
development..................... -- -- 18.5 -- --
Amortization of purchased
intangibles..................... -- -- -- -- 0.8
------- ------- ------- ------ ------
Total operating expenses....... 23.9 22.3 40.1 20.4 22.0
------- ------- ------- ------ ------
Operating income (loss)........ 15.2 17.2 (2.1) 17.7 15.6
Interest (income) expense, net..... 8.5 6.3 (0.2) 4.0 (0.7)
------- ------- ------- ------ ------
Income (loss) before income taxes.. 6.7 10.9 (1.9) 13.7 16.3
Provision for income taxes......... 2.5 4.3 3.3 5.1 5.7
------- ------- ------- ------ ------
Net income (loss).................. 4.2% 6.6% (5.2)% 8.6% 10.6%
======= ======= ======= ====== ======
</TABLE>
- ---------------------
(1) Cost of product revenue and cost of research revenue are stated as
percentages of product revenue and research revenue, respectively.

THREE MONTHS ENDED MARCH 31, 1996 COMPARED TO THREE MONTHS ENDED MARCH 31,
1995

Total Revenue. Total revenue for the quarter ended March 31, 1996 increased
94.3% to $20.4 million compared to $10.5 million in the corresponding 1995
quarter and increased 21.7% compared to total revenue for the quarter ended
December 31, 1995. This increase was driven by demand for the Company's
semiconductor lasers and optoelectronic solutions, revenue from SDL Optics,
which was acquired in the fourth quarter of 1995 and, to a lesser extent,
research revenue growth. Information-based products within the fiber-based
telecommunications, satellite communications, printing, medical and industrial
markets continued to represent approximately 70% of the Company's March 31,
1996 product revenue. The balance represented products for the light
replacement markets. Research revenue continued to grow as compared to both
the corresponding prior year quarter and the December 31, 1995 quarter, but at
a slower rate than that of product revenue. For the three months ended
March 31, 1996, research revenue represented 15.1% of total revenue as
compared to 17.7% for the three months ended March 31, 1995.

International revenue increased by 33.8% for the first quarter of 1996
compared to the March 1995 quarter. However, international revenue as a
percentage of total revenue for the three months ended March 31, 1996
decreased to 17.2% compared to 25.0% for the corresponding 1995 quarter. This
decline was primarily due to the large percentage of SDL Optics' revenue
within the domestic communications markets.

19
<PAGE>

The Company received 16.9% and 15.6% of its revenue for the three month
periods ended March 31, 1996 and 1995, respectively, from Lockheed Martin.
This compares to 23.0% of total revenue for the three month period ending
December 31, 1995. Continued demand for the Company's fiber-based products
during the first quarter of 1996 contributed to the percentage decline in
total revenue derived from Lockheed Martin. There can be no assurances that
the application markets for SDL's products will grow in future periods at
historical percentage rates. Further, there can be no assurance that the
Company will be able to increase or maintain its market share in the future or
to sustain historical growth rates.

Gross Margin. Total gross margin for the three months ended March 31, 1996
improved to 37.6% as compared to 36.6% for the quarter ended December 31,
1995, but remained relatively constant when compared to the three months ended
March 31, 1995. Influencing this gross margin improvement was the combination
of increased higher-margin product revenue and relatively flat cost-
reimbursable revenue during the first quarter of 1996 as compared to the
December 1995 quarter. However, product gross margins continued to be impacted
primarily by a product customization program for Lockheed Martin.

The Company's gross margin can be affected by a number of factors, including
product mix, pricing pressures and product yield. Generally, the cost of newer
products tends to be higher as a percentage of product revenue than that of
more mature, higher volume products. In addition, the cost of research revenue
is significantly higher as a percentage of revenue, as research revenue is
typically based on costs incurred rather than market pricing. As a result of
these factors, gross margin fluctuations are difficult to predict and there
can be no assurance that the Company will maintain gross margins at current
levels in future periods.

Research and Development. The Company's future results depend, to a
considerable extent, on its ability to maintain a competitive advantage in the
products it provides. For this reason, SDL believes it is critical to continue
to make investments in research and development to ensure the flow of
innovative, productive, high-quality products. The Company's total research
and development activities consist of customer-funded research programs and
internally-funded research and development. Increased research revenue,
together with increased spending on new product development projects, cost
reduction, reliability improvement and the acquisition of the SDL Optics
business resulted in the growth in total research and development activities
during the three months ended March 31, 1996 to $3.9 million as compared to
$2.1 million for the first quarter of 1995. As a percentage of total revenue,
the total of customer-funded cost of research revenue and internally-funded
research and development decreased to 19.2% for the three months ended March
31, 1996 from 20.3% for the corresponding 1995 quarter. The high relative
growth in total revenue for the reported periods is the primary reason for the
decreased ratio of total Company research and development activities on a
year-over-year basis. Accordingly, the level of research and development may
vary based on future levels of customer-funded research and development.

Selling, General and Administrative. The increase of selling, general and
administrative expense for the three months ended March 31, 1996 as compared
to the March 1995 quarter resulted primarily from the continuing expansion of
the Company's business, headcount increases, on-going litigation expense, and
to a lesser extent, the acquisition of SDL Optics. When litigation expenses
are excluded selling, general and administrative decreased as a percentage of
total revenue. The Company expects that selling, general and administrative
expenses will continue to increase to support the Company's current and
expected future volumes of business. However, there can be no assurances that
current selling, general and administrative levels as a percentage of total
revenue are indicative of future selling, general and administrative as a
percentage of total revenue. For the next several quarters, the Company
expects that litigation expense may increase above the level recorded during
the most recent three month period.

Interest (Income) Expense, Net. The Company recorded net interest income for
the first quarter of 1996 compared to net interest expense for the
corresponding three month period of 1995 due to the repayment of the
outstanding subordinated and bank debt, effective with the Company's March
1995 initial public stock offering.

20
<PAGE>

Provision for Income Taxes. The annualized estimated effective tax rate was
35.0% and 37.0% for the three month periods ended March 31, 1996 and 1995,
respectively. The reduction in the effective tax rate is attributable to the
benefits of the Company's foreign sales corporation and tax exempt income, as
well as a reduction in the valuation allowance.

1995 COMPARED TO 1994

Total Revenue. The Company's total revenue increased 63.2% to $53.9 million
in 1995 compared to $33.0 million in 1994. This increase was driven by a
strong demand for the Company's semiconductor laser and optoelectronic
solutions in fiber-based telecommunications, satellite communications,
printing, medical and industrial markets. Information-based products
represented approximately 70% of the Company's total 1995 revenue. The balance
represented products for light replacement markets. New product introductions,
improvements within existing products and expansion of the markets in which
SDL participates were the primary reasons for the growth in information-based
product revenue. While research revenue grew at a slightly lower rate than
product revenue, 58.8% compared to 64.1%, research revenue remained at
approximately 16% of total revenue based on the addition of several major
research programs during 1995.

International revenue increased by 45.2% during 1995 compared to 1994.
International revenue accounted for 22.6% and 25.4% of 1995 and 1994 total
revenue, respectively. There can be no assurances that the application markets
for SDL's products will grow in future periods at historical percentage rates.
Further, there can be no assurance that the Company will be able to increase
or maintain its market share in the future or to sustain historical growth
rates.

Of the Company's 1995 revenue, 19.0% was received from Lockheed Martin
through several government and commercial programs. Most of the Company's
revenue from this customer during 1995 was, and during 1996 is expected to be,
derived from Federally funded programs, which are subject to renewal every one
or two years and to termination for convenience of the government agency. The
loss of the Company's contracts with Lockheed Martin could have an adverse
effect on the Company's results of operations.

Approximately 5% of the Company's 1995 revenue was received through certain
Federal government programs which required that participants meet specific
eligibility requirements. During 1996, the Company expects that its growth
will result in the Company exceeding the maximum number of employees allowed
under these eligibility requirements before the end of 1996 and that the
Company will no longer be able to compete for future research contract awards
under these government programs. Loss of eligibility under these programs does
not disqualify the Company from contracts awarded prior to the loss of
eligibility. Loss of eligibility under these programs could materially
decrease the Company's future revenue and could require increased internally
funded research and development spending.

The Company derived approximately 45% of its 1995 revenue directly or
indirectly from a variety of Federal government sources. The demand for
certain of the Company's services and products is directly related to the
level of funding of government programs. The Company believes that the success
and further development of its business is dependent upon the Company's
ability to participate in such programs. For example, substantially all of the
Company's research revenue for 1995 was funded by Federal programs. There can
be no assurance that such programs will continue to be funded even if
government agencies have available financial resources or that the Company
will continue to be awarded contracts under such programs. See "Risk Factors--
Dependence upon Government Programs and Contracts," "Risk Factors--Loss of
Eligibility for U.S. Government Small Business Innovative Research Contracts"
and "Risk Factors--Customer Concentration."

Gross Margin. Gross margin as a percentage of total revenue was 38.0% in
1995 compared to 39.5% in 1994. Lower product gross margins offset the slight
increase in research gross margins in 1995 compared to the prior year period.
1995 gross margins declined primarily due to a higher percentage of cost
reimbursable revenue, which includes a product customization program for
Lockheed Martin.

21
<PAGE>

Research and Development. Total research and development activities
decreased as a percentage of total revenue for 1995 from 1994 due to the
increase of total revenue. During 1995, the total of customer-funded cost of
research revenue and internally-funded research and development grew 50.6% to
$10.5 million. As compared to total revenue, the total of customer-funded cost
of research revenue and internally-funded research and development decreased
to 19.5% for 1995 from 21.1% for 1994. The level of research and development
may vary based on future levels of customer-funded research and development.

Selling, General and Administrative. Selling, general and administrative
expense for 1995 compared to 1994 increased primarily to support the Company's
growth and litigation costs. When litigation expense is excluded, selling,
general and administrative expense as a percentage of total revenue decreased
due to revenue growth exceeding the growth in selling, general and
administrative expense.

In-process Research and Development. The acquisition of SDL Optics resulted
in a $10.0 million one-time write-off of purchased in-process research and
development during the fourth quarter of 1995.

Interest (Income) Expense, Net. The Company recorded net interest income
during 1995 compared to net interest expense during 1994 due primarily to the
repayment of the outstanding subordinated and bank debt balances, effective
with the Company's March 1995 initial public stock offering.

Provision for Income Taxes. The effective tax rate for 1995 differs
substantially from prior years due to the one-time write-off of in-process
research and development from the acquisition of SDL Optics, which is not
currently tax-deductible. Excluding the impact of the one-time write-off, the
Company's effective tax rate for 1995 was reduced to 37.0% from 39.0% in 1994
primarily due to increased benefits of state tax credits and tax-exempt
interest income, offset by reduced benefits from the Company's foreign sales
corporation.

A valuation allowance has been established in 1995 to offset a portion of
the deferred tax asset attributable to the write-off of in-process research
and development. Due to the extended period over which this tax benefit may be
recognized, sufficient uncertainty exists regarding the realizability of a
portion of this asset, and accordingly, a valuation allowance has been
established.

1994 COMPARED TO 1993

Total Revenue. Total revenue increased 19.2% during 1994 to $33.0 million as
compared to 1993. Product revenue for 1994 increased 24.4% to $27.6 million,
while research revenue remained relatively unchanged as compared to that of
the prior year. Approximately 60% of the increase in product revenue was due
to increased OEM product sales. No customer accounted for 10% or more of
revenue during 1994 or 1993. See "Risk Factors--Dependence Upon Government
Programs and Contracts" and "Risk Factors--Customer Concentration."

International revenues increased 31.3% for 1994 compared to 1993.
International revenue represented approximately 25% of total revenue for 1994
as compared to approximately 23% for 1993.

Gross Margin. Cost of product revenue increased to $15.8 million in 1994
primarily due to product revenue increasing 24.4% during 1994. However,
product gross margin remained constant as a percentage of product revenue at
approximately 43% for both 1994 and 1993. Research gross margin decreased to
22.6% in 1994 from 25.3% in the prior year. This decrease was due to
additional reserves related to potential changes in estimated reimbursable
costs.

Research and Development. Internally-funded research and development
decreased to 8.4% of total revenue for 1994 from 11.0% of total revenue for
1993. The high percentage level of investment in 1993 reflects the
implementation of the strategic program initiated by the Company in 1993 to
more rapidly broaden its product base.

Selling, General and Administrative. Selling, general and administrative
expenses increased to 13.9% of total revenue for 1994 from 12.9% of total
revenue for 1993. This increase was principally attributable to

22
<PAGE>

increased marketing expense to promote new products and infrastructure expense
to support the substantial increase in new orders received in 1994.

Interest (Income) Expense, Net. Net interest expense decreased to $2.1
million during 1994 from $2.4 million during 1993 primarily due to a decrease
in total debt outstanding, as well as a decrease in the weighted average
interest rate.

Provision for Income Taxes. The effective tax rates for 1994 and 1993 were
39.0% and 37.4%, respectively. The increased effective tax rate in 1994 is
attributable to a relatively smaller favorable impact from the Company's
foreign sales corporation. Effective January 1, 1993, the Company changed its
method of accounting for income taxes from the deferred method to the
liability method required by Statement of Financial Accounting Standards No.
109 (FAS 109). As permitted by FAS 109, the Company has elected not to restate
the financial statements of any prior years. The cumulative effect of adopting
FAS 109 was not material.

23
<PAGE>

QUARTERLY RESULTS OF OPERATIONS

The following tables set forth certain unaudited quarterly financial data
for the four quarters of 1994 and 1995 and the first quarter of 1996. The
Company believes that all necessary adjustments, consisting only of normal
recurring adjustments, have been included in the amounts below to present
fairly the selected quarterly information when read in conjunction with the
Consolidated Financial Statements and the Notes thereto included elsewhere
herein. The results of operations for any quarter are not necessarily
indicative of results that may be expected for any future period or for the
entire year.

<TABLE>
<CAPTION>
QUARTER ENDED
---------------------------------------------------------------------------------
1994 1995
---------------------------------- ----------------------------------- 1996
MAR. 31 JUNE 30 SEPT. 30 DEC. 31 MAR. 31 JUNE 30 SEPT. 30 DEC. 31 MAR. 31
(IN THOUSANDS)
<S> <C> <C> <C> <C> <C> <C> <C> <C> <C>
Total revenue:
Product revenue........ $6,302 $6,456 $6,995 $7,844 $8,652 $10,411 $11,727 $14,487 $17,348
Research revenue....... 1,296 1,323 1,257 1,551 1,860 2,103 2,357 2,297 3,074
------ ------ ------ ------ ------ ------- ------- ------- -------
Total revenue........ 7,598 7,779 8,252 9,395 10,512 12,514 14,084 16,784 20,422
Cost of revenue:
Cost of product reve-
nue................... 3,548 3,675 4,109 4,458 5,097 6,138 6,865 8,771 10,505
Cost of research reve-
nue................... 867 954 1,067 1,313 1,410 1,489 1,756 1,864 2,242
------ ------ ------ ------ ------ ------- ------- ------- -------
Total cost of reve-
nue................. 4,415 4,629 5,176 5,771 6,507 7,627 8,621 10,635 12,747
------ ------ ------ ------ ------ ------- ------- ------- -------
Gross margin......... 3,183 3,150 3,076 3,624 4,005 4,887 5,463 6,149 7,675
Operating expenses:
Research and develop-
ment.................. 874 651 611 645 724 953 993 1,324 1,687
Selling, general and
administrative........ 1,060 1,209 1,087 1,218 1,421 1,871 2,134 2,223 2,650
In-process research
and development....... -- -- -- -- -- -- -- 10,010 --
Amortization of pur-
chased intangibles.... -- -- -- -- -- -- -- -- 161
------ ------ ------ ------ ------ ------- ------- ------- -------
Total operating ex-
penses.............. 1,934 1,860 1,698 1,863 2,145 2,824 3,127 13,557 4,498
------ ------ ------ ------ ------ ------- ------- ------- -------
Operating income
(loss).............. 1,249 1,290 1,378 1,761 1,860 2,063 2,336 (7,408) 3,177
Interest (income) ex-
pense, net............. 559 552 511 457 424 (112) (219) (211) (145)
------ ------ ------ ------ ------ ------- ------- ------- -------
Income (loss) before in-
come taxes............. 690 738 867 1,304 1,436 2,175 2,555 (7,197) 3,322
Provision (benefit) for
income taxes........... 269 288 338 509 531 805 945 (493) 1,163
------ ------ ------ ------ ------ ------- ------- ------- -------
Net income (loss)....... $ 421 $ 450 $ 529 $ 795 $ 905 $ 1,370 $ 1,610 $(6,704) $ 2,159
====== ====== ====== ====== ====== ======= ======= ======= =======
<CAPTION>
AS A PERCENTAGE OF TOTAL REVENUE
---------------------------------------------------------------------------------
<S> <C> <C> <C> <C> <C> <C> <C> <C> <C>
Total revenue:
Product revenue........ 82.9% 83.0% 84.8% 83.5% 82.3% 83.2% 83.3% 86.3% 84.9%
Research revenue....... 17.1 17.0 15.2 16.5 17.7 16.8 16.7 13.7 15.1
------ ------ ------ ------ ------ ------- ------- ------- -------
Total revenue........ 100.0 100.0 100.0 100.0 100.0 100.0 100.0 100.0 100.0
Cost of revenue:
Cost of product reve-
nue (1)............... 56.3 56.9 58.7 56.8 58.9 59.0 58.5 60.5 60.6
Cost of research reve-
nue (1)............... 66.9 72.1 84.9 84.7 75.8 70.8 74.5 81.1 72.9
Total cost of reve-
nue................. 58.1 59.5 62.7 61.4 61.9 60.9 61.2 63.4 62.4
------ ------ ------ ------ ------ ------- ------- ------- -------
Gross margin......... 41.9 40.5 37.3 38.6 38.1 39.1 38.8 36.6 37.6
Operating expenses:
Research and develop-
ment.................. 11.5 8.4 7.4 6.9 6.9 7.6 7.1 7.9 8.2
Selling, general and
administrative........ 14.0 15.5 13.2 13.0 13.5 15.0 15.2 13.2 13.0
In-process research
and development....... -- -- -- -- -- -- -- 59.6 --
Amortization of pur-
chased intangibles.... -- -- -- -- -- -- -- -- 0.8
------ ------ ------ ------ ------ ------- ------- ------- -------
Total operating ex-
penses.............. 25.5 23.9 20.6 19.9 20.4 22.6 22.3 80.7 22.0
------ ------ ------ ------ ------ ------- ------- ------- -------
Operating income
(loss).............. 16.4 16.6 16.7 18.7 17.7 16.5 16.5 (44.1) 15.6
Interest (income) ex-
pense, net............. 7.4 7.1 6.2 4.9 4.0 (0.9) (1.6) (1.3) (0.7)
------ ------ ------ ------ ------ ------- ------- ------- -------
Income (loss) before in-
come taxes............. 9.0 9.5 10.5 13.8 13.7 17.4 18.1 (42.8) 16.3
Provision (benefit) for
income taxes........... 3.5 3.7 4.1 5.4 5.1 6.5 6.7 (2.9) 5.7
------ ------ ------ ------ ------ ------- ------- ------- -------
Net income (loss)....... 5.5% 5.8% 6.4% 8.4% 8.6% 10.9% 11.4% (39.9)% 10.6%
====== ====== ====== ====== ====== ======= ======= ======= =======
</TABLE>
- -------------------
(1) Cost of product revenue and cost of research revenue are stated as
percentages of product revenue and research revenue, respectively.

24
<PAGE>

The Company's total revenue has increased steadily on a quarterly basis
during the nine quarter period ended March 31, 1996, principally due to
increased demand for both standard and custom products. Customer-funded
research revenue has also increased due to the addition of numerous programs.

Cost of revenue fluctuated between 58.1% and 63.4% for the nine quarters
ended March 31, 1996, but the Company believes that such quarterly
fluctuations do not reflect any significant trend.

Research and development expenses have fluctuated over the past nine
quarters between 6.9% and 11.5% of total revenues.

Selling, general and administrative expenses have generally fluctuated
between 13.0% and 15.5% of total revenues during the last nine quarters. These
fluctuations were primarily due to the timing of increased marketing efforts
relative to product introductions, major trade shows, customer proposal
preparation activities, professional fees, travel, advertising and litigation
expenses in 1996.

Net interest expense declined in absolute dollars and as a percentage of
total revenue through March 1995 due to both a decrease in total debt
outstanding as well as a decrease in the weighted average interest rate, in
part owing to current payment of interest on subordinated notes issued in
connection with a 1992 recapitalization of the Company. Substantially all of
the Company's debt was repaid in full in March 1995 with a portion of the
proceeds of the IPO. As a result, the Company began generating net interest
income in the quarter ended June 30, 1995.

LIQUIDITY AND CAPITAL RESOURCES

Since 1992, the Company has financed its operations primarily through cash
generated by operating activities and a portion of the proceeds from the sale
of equity securities. For the three months ended March 31, 1996, net cash from
operations of $3.4 million was provided by increased net income and non-cash
adjustments for depreciation and amortization, the reduction of trade
receivable days sales outstanding and the income tax benefit received from the
exercise of employee stock options which was offset slightly by increased
inventory and trade payables.

Cash used for investing activities is attributable to capital expenditures,
certain acquisitions and purchases of short-term investments. For the three
months ended March 31, 1996, the Company spent $2.1 million for planned
facilities expansion and capital equipment purchases, and made a $1.5 million
payment pursuant to its remaining obligation for the acquisition of SDL
Optics. The Company currently expects to spend approximately $12 million for
capital equipment purchases and leasehold improvements during 1996. As a
result of operating, investing and financing activities, the Company increased
cash, cash equivalents and short-term investments to $11.4 million at March
31, 1996 as compared to $11.3 million at December 31, 1995.

As of March 31, 1996, the Company's principal sources of liquidity included
cash, cash equivalents, short-term investments and an $8.0 million secured
line of credit, which expires in January 1997. Any borrowings under this line
would be limited to 80% of eligible accounts receivable, as defined in the
credit agreement (approximately $6.5 million of borrowings were available
under the line at March 31, 1996), and bear interest at the bank's prime rate
(8.25% at March 31, 1996). The credit agreement contains affirmative and
negative covenants and, among other things, requires the Company to maintain
certain financial ratios and restricts the ability to pay cash dividends. The
financial ratio requirements are as follows: (i) a minimum quick ratio of 1.5
to 1.0, (ii) a minimum tangible net worth of $38.0 million (increased by 100%
of any new equity and by 75% of quarterly profits since January 1996) and
(iii) a maximum debt to tangible net worth ratio of 1.0 to 1.0. In addition,
the Company is required to be profitable on an annual basis and in at least
three quarters of each fiscal year. At December 31, 1995, the Company was in
default of the financial covenant requirement for annual profitability as a
result of the one-time write-off of in-process research and development in
connection with the acquisition of Seastar. Subsequent to December 31, 1995,
the covenant violation was waived by the bank.

25
<PAGE>

The Company has future cash requirements to complete its acquisition of the
SDL Optics business of (i) $1.5 million payable on March 31, 1997, for which
the Company was contingently liable for a letter of credit at March 31, 1996
and (ii) $1.2 million in cash or common stock of the Company (at the Company's
option) on March 31, 1997.

The Company believes that current cash balances, cash generated from
operations, credit available under the bank line of credit and proceeds of
this offering will be sufficient to fund capital equipment purchases,
acquisitions of complimentary businesses, products or technologies and working
capital requirements at least through 1997. However, there can be no
assurances that events in the future will not require the Company to seek
additional capital sooner or, if so required, that adequate capital will be
available on terms acceptable to the Company.

26
<PAGE>

BUSINESS

SDL is a leading designer, manufacturer and marketer of semiconductor
optoelectronic integrated circuits (OEICs) and high power semiconductor
lasers. The Company believes its leadership position is demonstrated by the
Company's numerous awards for product technology and design, substantial
market share and significant breadth of product offerings. The Company
pioneered the design of, and commercially developed, the first OEIC containing
multiple semiconductor lasers. Semiconductor OEICs integrate two or more
semiconductor lasers or other optical or electronic elements onto a single
chip. Semiconductor OEICs are revolutionizing the type and number of
applications that can be served by optoelectronics. The Company's products
replace traditional technologies in the electronics and optics industries with
light-emitting semiconductor devices that are generally smaller, cheaper, more
reliable, more durable and/or more powerful than their predecessors. The
Company has over 200 standard and custom products, as well as systems, which
are used in a diversity of markets such as cable television (CATV),
telecommunications, satellite communications, printing, medical, data storage,
consumer electronics, sensor, defense, materials processing and scientific
markets. SDL's wholly-owned subsidiary, SDL Optics, designs, manufactures and
sells semiconductor products for the fiber optic communications markets. The
Company is also currently being funded to develop or customize products in
certain existing markets, as well as local area network (LAN), display and
entertainment markets. SDL's customers include 3M, Alcatel, AT&T, ATx Telecom
Systems (a division of Amoco), Eastman Kodak, Iridex, Lockheed Martin, Lucent
Technologies, NASA, Pioneer, TRW and Xerox.

INDUSTRY BACKGROUND

The communications and information industries have historically relied on
electricity for the transmission, display, storage, processing and generation
of information. A significant portion of transmission of information, such as
telephone or CATV signals, is still accomplished by sending electrical signals
through coaxial cables or twisted pair copper wires. Data storage is often
performed by electromagnetic writing on magnetic tape or disc. Display of
information is commonly achieved by impinging electrons onto a phosphorescent
screen in a cathode ray tube (CRT).

Although these functions historically have been accomplished electronically,
electronic solutions are subject to inherent performance limitations. For
example, transmission of information via copper wires or coaxial cables is
limited to short distances by the capacitance of the wire transmission medium,
is characterized by limited data transfer rates, and is subject to electronic
noise and signal interference. Recording information on magnetic media is
limited by the medium's size and storage density. CRT displays are heavy,
bulky and fragile. Today, communications and information markets are demanding
faster data transmission, greater storage density and lighter, more durable
displays.

To overcome the limitations of electronic information transmission, storage
and display, the communications and information industries are utilizing
advanced light source and laser technologies. Light generally can carry more
information at less expense and greater speed, and can store more information
in a given space with greater precision. New forms of display are more
reliable, smaller, lighter and more efficient. Enabled by the development of
advanced light source and laser technology, light is beginning to replace
electronic devices in communications and information industries.

Light is also providing advances in other industries. Laser light is used in
materials processing, welding and heat treatment, in surgical devices, and in
environmental sensors. Laser welding and cutting can speed production lines.
Laser surgery has been found to reduce bleeding and shorten recovery times.
Laser satellite sensors use light to probe the earth's atmosphere for holes in
the ozone layer and global atmospheric pollutants.

Light for these markets has traditionally been supplied by solid state or
gas lasers, light emitting diodes (LEDs) and incandescent lamps. Solid state
lasers are specialized glass or crystals typically illuminated by a high-
intensity incandescent lamp. Solid state and gas lasers are used in surgical
devices and materials processing.

27
<PAGE>

LEDs serve to display information and to illuminate. Incandescent lamps are
used to illuminate liquid crystal displays. Significant shortcomings exist,
however, with most of the traditional technology available for laser, LED and
incandescent lamp applications. Solid state lasers are limited by their
dependence on inefficient and unreliable incandescent lamps. Gas lasers are
large, expensive, inefficient and fragile. LEDs generally have low power
output and cannot be tightly focused. Incandescent lamps are fragile,
inefficient and have relatively short operating lives.

These markets demand an advanced light source; however, different
applications require different light source properties. For example, the most
important properties for CATV applications are high speed modulation,
reliability and high power. In LANs, the most important properties are high
speed modulation, reliability and low cost. Displays require small,
lightweight, reliable, efficient and multicolor light sources. Materials
processing requires high power, focusability and reliability. Data storage
applications require focusability, low cost, small size, light weight and
reliability. Such an advanced light source should therefore be highly
reliable, highly efficient, small, rugged, light weight, capable of being
modulated at high speed, focusable, low voltage and capable of generating the
full color spectrum.

THE SDL SOLUTION

Using its advanced semiconductor OEIC technology, the Company designs and
manufactures products to overcome the limitations of traditional electronic
and optical technology. With increased levels of semiconductor-based
optoelectronic integration, the Company miniaturizes and generally reduces the
cost while increasing the functionality of what previously were large, bulky
and expensive components. The Company believes that, just like silicon
integrated circuits, advanced semiconductor OEICs will represent an increasing
portion of the electronic or optical system's value. Semiconductor OEICs have
the potential to effectively meet many of the market needs for an advanced
light source.

A semiconductor OEIC integrates two or more semiconductor lasers or other
optical or electronic elements such as lenses, light detectors, mirrors, light
modulators, switches and light amplifiers onto a single chip. Semiconductor
OEICs and lasers are built in semiconductor crystals. They can be
miniaturized, allowing lasers to be made as small as a grain of salt.
Semiconductor lasers are now widely used in electronic and optical systems
such as compact audio disk players and laser printers. In many applications,
semiconductor OEICs and lasers offer advantages over traditional light
sources, as demonstrated in the table below.

Properties of Light Sources

<TABLE>
<CAPTION>
SMALL
HIGH SIZE/
AVERAGE LOW HIGH SPEED MULTI- LOW LIGHT-
INTEGRATABLE RELIABLE POWER FOCUSABLE VOLTAGE MODULATION EFFICIENT COLORS COST WEIGHT
- -------------------------------------------------------------------------------------------------------------
<S> <C> <C> <C> <C> <C> <C> <C> <C> <C> <C>
Semiconductor
OEICs/Lasers X X X X X X X X X
- -------------------------------------------------------------------------------------------------------------
LEDs X X X X X X
- -------------------------------------------------------------------------------------------------------------
Gas Lasers X X X
- -------------------------------------------------------------------------------------------------------------
Solid State Lasers X X X
- -------------------------------------------------------------------------------------------------------------
Incandescent Lamps X X X X X
</TABLE>

As with silicon integrated circuits, SDL's advanced semiconductor OEICs and
lasers provide functionality that cannot be achieved with conventional
electronic or optical components. In the communications and information
markets, the Company's products improve the transmission, storage and display
of information by replacing electronic technology. Also, the Company's
products replace traditional light sources in applications such as materials
processing, surgical lasers, environmental sensors, and defense and scientific
uses. The Company is seeking to achieve additional technological advances that
would create new applications for semiconductor OEICs, such as all-optical
satellite communications, all-optical switching of light from fiber to

28
<PAGE>

fiber in a fiber-optic transmission system, and generation of red, green and
blue light on a single semiconductor chip for miniature display systems.

COMPANY STRATEGY

The Company's objectives are to replace functions currently performed
electronically with advanced semiconductor OEIC light sources and to
substitute semiconductor OEICs and lasers for traditional light sources. Key
elements of the Company's strategy include:

Expand Technology Leadership. Through substantial investment in research and
development, the Company seeks to expand its leadership position in various
technologies. The Company funds a majority of its research and development
programs with revenue received from customers in connection with the design
and development of specific products and research programs. SDL intends to
continue using customer funding to support both long-term research and near-
term custom product development. The Company will pursue patents aggressively
for any newly-created technologies, adding to its current U.S. portfolio of
over 45 patents and over four dozen pending patent applications.

Cultivate Customers in High Growth Markets. The Company focuses on what it
perceives as the highest potential growth markets. As a result, the Company
has experienced a substantial increase in orders resulting in a 56.2% increase
in its backlog from March 31, 1995 to March 31, 1996. The Company works
closely with customers in potential high-growth markets early in the design
stage to optimize the performance of the Company's products in customer
systems. For example, the Company's Business Communications Unit focuses on
specific customer needs in the CATV, telecommunications, satellite
communications and LAN markets.

Pursue Forward Integration of Product Line. The Company is pursuing
increased vertical integration and value-added systems products. The Company
has recently added communications, medical, industrial and chemical-sensor
systems and subsystems to its product portfolio. The Company is also
integrating more advanced optoelectronics and optical systems and subsystems
onto a chip with more advanced packaging. The acquisition of SDL Optics in
November 1995 further illustrates the Company's strategy to pursue value-added
vertical integration in the communications field. Additionally, in 1996, the
Company started its Business Development Unit to more actively pursue vertical
integration through acquisitions and new system level product introductions.
The Company believes vertical integration provides the Company with higher
performance products for its customers while maintaining a cost advantage over
its competitors.

Leverage Advanced Manufacturing Capability. The Company will seek to
capitalize on its advanced semiconductor manufacturing capability by: (i)
aggressively pricing volume products to encourage the development of new high-
volume markets and the rapid growth of existing markets, (ii) increasing
factory volume by producing a broad range of products and (iii) investing
research and development funding in manufacturing cost reduction, yield
improvement and increased factory automation. The Company believes that low
manufacturing costs will be a key to its long-term success.

Expand Worldwide Markets. The Company has established an enhanced
international marketing infrastructure, including new distributors in Europe
and the Pacific Rim. International revenue in 1995 increased 45.2% as compared
to that of 1994. The Company intends to continue emphasizing its international
marketing activities, where the Company believes many promising markets are
located.

PRODUCTS

The Company produces over 200 standard products and develops custom products
for specific customer applications. SDL's products include: (i) "single mode"
semiconductor OEICs, lasers and fiber optic modules, (ii) "multimode"
semiconductor OEICs, lasers and fiber optic packages and (iii) systems
incorporating or interfacing with the Company's semiconductor OEIC, laser and
fiber optic products. Prices for the Company's products range from a few
dollars to tens of thousands of dollars.

29
<PAGE>

SINGLE MODE PRODUCTS

"Single mode" refers to the ability of the semiconductor OEIC or laser to
focus the light it generates to a tiny spot (known as a diffraction limited
spot) approximately 100 times smaller than the diameter of a human hair.
Diffraction limited spots have a dimension of approximately the wavelength of
such light. Single mode products allow greater voice and data rates to be
transmitted over single mode optical fiber. Such single mode fiber
communication products are manufactured by SDL Optics. Single mode products
also allow data storage on and retrieval from regions the size of the laser's
diffraction limited spot. The next generation of this technology is expected
to allow greater amounts of information to be stored in an even smaller
physical space. Currently, such products primarily use infrared lasers,
emitting at a wavelength of approximately 780 nanometers (nm). Using a single
mode blue laser emitting at a wavelength of 430 nm would allow the storage and
retrieval of approximately four times more information in the same space. A
red laser operating at 630 nm would allow storage and retrieval of
approximately two times the data of an infrared laser or half the data of a
blue laser.

MULTIMODE PRODUCTS

In contrast to single mode products, "multimode products" cannot be focused
to diffraction limited spots. Rather, multimode products generally emit higher
power light within a narrow spectrum and can be sufficiently focused or
delivered through multimode optical fibers to allow replacement of traditional
lasers, LEDs and high intensity incandescent lamps in certain applications. By
integrating large numbers of multimode lasers on a single chip or coupling
light into multimode fibers, multimode products can achieve effective power
output comparable to all but the highest power gas lasers. Since the Company's
multimode products are generally more reliable, smaller, lower voltage, more
efficient, higher power and/or lower cost than traditional light sources,
multimode products are used in applications such as laser surgery, printing,
materials processing and pumping of solid state lasers for use in
telecommunication and CATV transmitters, laser sensors, materials processing,
defense and scientific applications.

FIBER COUPLED PRODUCTS

Light from both single mode and multimode products is often coupled into a
transparent single mode or multimode optical fiber, respectively, prior to
sale to a customer application. The recent acquisition of SDL Optics allows
SDL to sell single mode fiber coupled products in addition to the multimode
fiber coupled products sold previously. New single mode fiber coupled products
made by SDL Optics include the 980 nm pump module for excitation of optical
fiber amplifiers and a high power 1.5 micron laser transmitter module for CATV
transmission systems.

SYSTEM PRODUCTS

In addition to producing semiconductor OEICs and lasers, the Company
manufactures electronic systems which provide control, power and interface
functions for its semiconductor OEICs, lasers and fiber optic products. The
Company presently markets fourteen such systems. A recently introduced fiber
LAN transmitter/receiver system offers 1.2 gigabit per second transmission
over a wider range of environmental conditions than any other product known to
the Company. Eight additional systems are sold primarily to scientific and
engineering development laboratory users who do not wish to provide their own
electronic control units. The Company produces three different fiber coupled
optical power delivery systems. These fiber-optic power delivery systems are
designed to be used in laser surgery, materials processing, marking, scribing,
soldering and pumping of solid state lasers. The Company also produces a line
of high-power, wavelength tunable and wavelength stabilized products designed
for scientific, pollution sensing, medical and chemical monitoring
applications.

The following table lists several applications for the Company's products,
the type of SDL product used in the application and the dates the product was
introduced or most recently updated. The Company is continually updating and
customizing its products to meet specific customer needs.

30
<PAGE>

Applications for SDL Products

<TABLE>
<CAPTION>
INTRODUCTION OR
REPRESENTATIVE APPLICATIONS PRODUCT DESCRIPTION LATEST UPDATE
-----------------------------------------------------------------------------------------------------
S <S> <C> <C>
I CATV Transmitter at 1.5 micron High power, fiber coupled 1996
N -----------------------------------------------------------------------------------------------------
G Optical Amplifier for 1.5 micron CATV and High power, fiber coupled 1996
L Telephone Networks
E -----------------------------------------------------------------------------------------------------
Satellite-to-Satellite Data Link High power, infrared 1995
M -----------------------------------------------------------------------------------------------------
O Color, High Resolution, and Black & White Prints Red, infrared, arrays 1995
D -----------------------------------------------------------------------------------------------------
E Read/Write Computer Data Storage; Write to Infrared, red 1995
PhotoCD
-----------------------------------------------------------------------------------------------------
Pollution Sensor; Gas Sensor; Atomic Clock Single frequency 1996
Excitation
-----------------------------------------------------------------------------------------------------
Generation of Blue, Green and Red Light for High power infrared and red 1995
Displays, Printing
-----------------------------------------------------------------------------------------------------
Move/Sort Biological Cells with Light High power 1996
-----------------------------------------------------------------------------------------------------
Laser Pointers Red, low cost 1995
-----------------------------------------------------------------------------------------------------
-----------------------------------------------------------------------------------------------------
Satellite Communications Beacon High power, infrared 1995
-----------------------------------------------------------------------------------------------------
Solid State Laser Transmitter for CATV and High power, infrared 1995
Telecommunications
M -----------------------------------------------------------------------------------------------------
U High Power Optical Amplifiers for CATV and High power, infrared 1995
L Telephone Networks
T -----------------------------------------------------------------------------------------------------
I Excitation of Solid State Lasers for Cutting, High power, fiber coupled 1995
M Soldering, Welding, Drilling, Marking
O -----------------------------------------------------------------------------------------------------
D Color Proofing/Publishing High power, fiber coupled 1995
E -----------------------------------------------------------------------------------------------------
Illumination High power red, infrared 1995
-----------------------------------------------------------------------------------------------------
Tissue Welding, Suturing; Diabetic Retinopathy Infrared, red 1995
Treatment; Glaucoma Treatment, Eye Surgery,
Cancer Treatment
-----------------------------------------------------------------------------------------------------
Laser Radar/Pollution Sensing/Astronomy High power, infrared 1995
-----------------------------------------------------------------------------------------------------
-----------------------------------------------------------------------------------------------------
High Speed Data Transmission in Extreme Ruggedized LAN transceiver 1996
Temperatures
-----------------------------------------------------------------------------------------------------
Real-time Chemical Analysis High power, wavelength stabilized 1996
-----------------------------------------------------------------------------------------------------
General Surgery; Prostate Surgery High power, fiber coupled 1995
-----------------------------------------------------------------------------------------------------
Materials Processing, Soldering, Marking High power, fiber coupled 1995
S -----------------------------------------------------------------------------------------------------
Y Scientific Instrument, Sensors, Pollution High power, wavelength tunable 1996
S Monitoring
T -----------------------------------------------------------------------------------------------------
E Scientific Laboratory Power Supplies 8 models, 1-150 Amps 1995
M -----------------------------------------------------------------------------------------------------
Excitation of Solid State Lasers High power, fiber coupled 1995
-----------------------------------------------------------------------------------------------------
</TABLE>

USTOMER APPLICATIONS

The Company's products serve many applications in the communications,
information and light source replacement markets. A description of specific
examples of applications of the Company's current and developmental products
follows. Except for "Early Stage and Developmental Products," the following
examples of the Company's products are substantially completed. In certain
cases, the customer's product is not yet completed. In many cases, the
applications for the Company's and the customer's products are emerging or are
otherwise in new markets. No assurances can be given that the Company or its
customers will continue their development efforts, that markets will develop
for such products, that such products will be completed or will not be
superseded by other technology or that these products will achieve any degree
of market acceptance. See "Risk Factors--Dependence on Emerging Applications."

COMMUNICATIONS

. Telecommunications Amplifiers. SDL Optics provides single mode 980 nm fiber
coupled pump modules to provide power for 1.5 micron fiber amplifiers.
Fiber amplifiers are used to directly amplify weak digital light pulses in
the fiber optic telecommunication backbone network, thereby replacing
electronic

31
<PAGE>

repeaters. In comparison to electronic repeaters, optical amplifiers can
amplify at higher data rates, can amplify many signals at the same time
(wavelength division multiplexing) and can be spaced farther apart than
electronic repeaters. As announced by AT&T, a single fiber can carry as
much as 32 times more information using an optical amplifier system
relative to electronic repeaters. This saves the cost of installing 31
more fibers to achieve the same data or voice transmission throughput.
Since amplifiers represent a small percentage of the cost of installing a
fiber optic line, telecommunication providers are rapidly adding capacity
through use of this technology.

. CATV Amplifiers. CATV providers are replacing coaxial transmission trunk
lines with 1.5 micron optical fiber systems which can use optical
amplifiers. In this case, the optical amplifiers are often used to supply
high light power levels in order that the more powerful light signals can
be split and delivered to over 10 times more sites or nodes. The optical
amplifier system is also compatible with 2-way interactive communication.

. CATV Transmitter. A high power wavelength stabilized transmitter laser
module operating at 1.5 micron was introduced by the Company in February
1996. This unit delivers 50% more power to the CATV headend transmitter
and light modulator than currently competitive products known to the
Company. This added power allows an increase in the number of nodes
served, an increase in the transmission distance and in certain cases
eliminates the need for optical amplifiers entirely. This is the
Company's first such transmitter product offering for the CATV market.

. Local Area Network. In February 1996, the Company formally introduced its
first complete transmitter receiver fiber optic system. The system
operates at 1.2 Gb/sec and is compatible with standard emitter coupled
logic (ECL) electronics. The system is the first known high speed LAN to
operate reliably over a temperature range of -40(degrees)C to
125(degrees)C. Such a temperature range is required on most ships,
airplanes and other environmentally sensitive applications. The system is
much lighter weight, can transmit over longer distances and has a low
radar reflection compared to coaxial cable systems.

PRINTING AND PUBLISHING

. Color Proofing. Eastman Kodak's "Approval" color proofing system utilizes
the Company's semiconductor OEIC products. This system creates 14" by 17"
ultra high quality glossy proofs at 1800 dots per inch resolution from
digital input. Using SDL's product, color, resolution, tint and format
can be adjusted prior to a publisher's approval for volume offset
printing and publishing. This printing process produces instant proofs
without wet chemical processing, reducing the environmental concerns
associated with wet chemical processing.

MEDICAL

. Eye Surgery. Iridex uses the Company's multimode products to replace
traditional gas lasers in treating diabetic retinopathy, an eye condition
where retinal blood vessels bleed as a result of diabetes, causing
blindness. The Iridex system is used to cauterize the blood vessels to
reduce bleeding. Unlike gas lasers, the Company's product offers Iridex a
lower cost source which is small, reliable and compatible with a standard
120 volt outlet. The Company's low voltage and low power consumption OEIC
allows these products to be battery powered, enabling application in
developing countries.

MATERIALS PROCESSING

. Drilling, Cutting and Welding. Precision Laser Machining Consortium, a
group of 20 members and affiliated companies, including General Motors,
Ford and Chrysler, uses the Company's semiconductor lasers to create next
generation machine tool capability. By using high power kilowatt-level
arrays of the Company's semiconductor lasers to create efficient, high
intensity, reliable solid state lasers, consortium members are designing
products to significantly improve their welding, drilling and cutting
accuracy and productivity.

32
<PAGE>

DATA STORAGE/PLAYBACK

. Recording. Eastman Kodak uses the Company's infrared and red single mode
lasers for the recording and reading of digital information. The
Company's infrared lasers are used to record information on Eastman
Kodak's PhotoCDs, which store high-resolution color photographs. SDL's
red single mode lasers are used to read and write data on Eastman Kodak's
14" diameter optical Mass Storage System. The Company's red lasers allow
higher data storage density to be achieved. Compared with traditional
laser sources used for reading information in compact audio disc players,
SDL's high power red and infrared lasers allow recording as well as
reading of data while achieving long operating life and low optical
noise.

SENSORS

. Chemical Analysis. In 1996, the Company introduced a single mode high
power wavelength stabilized laser for use in chemical analysis systems.
This laser system is designed to replace gas lasers that are over 10
times larger, require over 100 times more power and are significantly
more costly than the Company's product. This product can be utilized for
real time high sensitivity chemical analysis as opposed to current batch
sampling and remote location testing methods. Examples of potential
applications include monitoring of production line chemical processes and
administration of anesthetics. This is the Company's first laser system
product to address the chemical sensor market.

EARLY STAGE AND DEVELOPMENTAL PRODUCTS

. CATV Amplifiers. In February 1996, the Company introduced a prototype 980 nm
pump module which delivers up to 5 times more power than the Company's
standard pump module. Amplifiers operating at 1.5 micron powered by this
source could be split into up to 5 times more nodes compared to conventional
amplified signals. Furthermore, this high power pump module emitting at 1015
nm can also be used to power a new generation of 1.3 micron fiber
amplifiers. These amplifiers are significant because most of the CATV
installed fiber infrastructure operates at 1.3 micron. The Company's new
high power product enables 1.3 micron amplifiers to have sufficient
amplification to service more nodes, potentially allow a significant
capacity increase by using wavelength division multiplexing and could be
made compatible with 2-way interactive communication.

. Video Disc. The Company is developing a blue laser, designed to be used
in high-density video disc players, which would allow a full-length two-
hour movie to be stored on a five inch disc with higher resolution than
developmental video disc systems based on red lasers. The Company is also
attempting to develop a red laser with sufficient power and reliability
to be used for recording information on an optical disc and is designed
to be used in systems that could replace VCRs.

. Holographic Data Storage. In 1995, the Company received an industry award
for the introduction of the world's highest power single mode visible
semiconductor laser. As an example of one application, this laser is
being utilized in an experimental holographic data storage system having
a capacity of one trillion bits or more and a data throughput rate of at
least one billion bits per second. This capacity is 12 times greater than
today's largest magnetic disk hard drives and the data recording and
reading times are 10 times faster than those available today from
magnetic storage systems.

. Displays. The Company is being funded to develop red, green and blue
laser sources for use in full-color displays. These sources are designed
to have sufficient light intensity to be fully visible in a large screen
theater display format or to be sufficiently small and efficient to be
used in a flat-panel or head-mounted display.

SALES AND MARKETING

The Company sells its standard products through direct sales in North
America, and representatives and distributors throughout the rest of the
world. In addition to its direct sales and marketing staff, the Company's

33
<PAGE>

senior management and technical staff market custom products to OEMs around
the world and to U.S. government agencies.

The Company supports its sales and marketing efforts by actively participating
in electro-optics and communications trade shows and conferences. The Company
seeks to increase the market visibility of its products by serving with
customers on technical and organizing committees for such conferences and trade
shows, presenting technical papers at such conferences and publishing in
technical and trade journals. The Company distributes new product announcements
and literature through direct mailings as well as advertising in trade journals.

DOMESTIC SALES AND MARKETING

The Company's sales and marketing staff, senior management and technical staff
work closely with potential OEM customers to provide optoelectronic solutions
for its customers' problems. The sales cycle begins by understanding the
customer's requirements and then attempting to match them with the most optimal
solution. Typically, the Company will first try to match the customer's
requirements to an existing product or a modification of an existing product.
Such modifications often involve changing a physical or electrical
specification, developing a new package or changing the wavelength of the
product. In some cases, the modification is costly enough that the Company
charges the customer a non-recurring engineering fee. The Company will produce
prototype customized devices and aid the customer in fitting the customized
device to the requirement. When the OEM customer's evaluation is successful,
which may take several years and several custom device iterations, negotiations
regarding volume, delivery and price take place. The Company believes that the
high level of marketing, management and engineering support involved in this
process is beneficial in developing competitive differentiation and long-term
relationships with its customers.

INTERNATIONAL SALES AND MARKETING

The Company markets its products internationally primarily through separate
local distributors in key industrialized countries and local representatives in
smaller markets. In addition, the Company's sales and marketing staff services
certain international house accounts and large OEM customers directly. The
Company intends to continue to expand its international marketing efforts. There
can be no assurance that the Company's future international marketing efforts
will continue to be as successful as the Company's past efforts, or that the
increased level of international orders received in the recent past will be
sustained in the future.

The Company's international distributors and representatives are generally
operating under letter agreements or contracts that allow for termination by
either party upon 90 days' notice. The Company has formal contracts with some of
its international distributors and representatives but has not yet obtained a
signed contract with each party. There can be no assurance that the remaining
distributors and representatives will enter into agreements at all or on terms
that are favorable to the Company. There can be no assurance that any
distributors and representatives will not terminate any formal or informal
agreement, or that the Company would be able to find an acceptable replacement
distributor or representative on acceptable terms. See "Risk Factors--
Distribution Risks."

34
<PAGE>

CUSTOMERS

The following is a representative list of the Company's customers.

COMMUNICATIONS DATA STORAGE PRINTING
Alcatel Eastman Kodak 3M
ANT Bosch Matsushita Creo Products
AT&T NSIC (IBM, Rockwell, GTE) Eastman Kodak
ATx Telecom Systems Pioneer Fuji Xerox
Harmonic Lightwaves Xerox
MATERIALS PROCESSING

Japan Space Agency Fibertek DEFENSE
Lockheed Martin Lightwave Electronics ARPA
Lucent Technologies TRW U.S. Air Force
NASA U.S. Navy
NEC

MEDICAL

Northern Telecom Cell Robotics SCIENTIFIC
Oki Electric Coherent Coherent
Siemens Iridex Continuum
Uniphase Nidek

SENSORS
Chromex
Coherent Technologies

The Company received over 19% of its 1995 revenue and expects to receive over
10% of its 1996 revenue from Lockheed Martin, through several government and
commercial programs, primarily in the satellite communications market. Almost
all of the Company's revenues from Lockheed Martin during 1995 was and during
1996 is expected to be derived from Federally-funded programs. See "Risk
Factors--Dependence Upon Government Programs and Contracts" and "Risk Factors--
Customer Concentration."

TECHNOLOGY

The Company's leadership in developing and delivering certain semiconductor
OEICs, lasers and systems is based upon the Company's expertise in the
technologies set forth below. The Company has a significant portfolio of
proprietary technology, and has been issued over 45 U.S. patents and has over
four dozen U.S. patent applications pending. In addition, the Company has a
royalty-free, non-exclusive license to approximately 100 Xerox U.S. patents
related to optoelectronics and lasers.

The word "laser" is an acronym for "light amplification by stimulated
emission of radiation." Light amplification in semiconductors occurs when
electric current is injected at high density into a small portion of the
semiconductor chip. Stimulated emission occurs when the light generated by the
current is partially reflected by mirrors, further stimulating the production
of light. At a threshold level of current, light radiates at high efficiency.
Semiconductor lasers are believed to be the smallest, most efficient laser or
light source known today.

ADVANCED SEMICONDUCTOR OEIC AND LASER DESIGNS

The Company has developed advanced application specific semiconductor OEIC
and laser designs. Specifically, the Company believes that it has developed
single mode chip designs that emit five times higher optical power levels than
any other commercial single mode laser. The Company's most powerful multimode
OEIC contains the equivalent of 1,000 semiconductor lasers. Two-dimensional
arrays of these multimode OEICs are currently available at 5,000 watts of peak
power and 1,400 watts of average power from a four centimeter by four
centimeter array.

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<PAGE>

ADVANCED SEMICONDUCTOR MANUFACTURING TECHNOLOGY

The Company's semiconductor products and custom chips are based on the
elements indium, aluminum, gallium, arsenic and phosphorous. These elements
form compound semiconductors such as indium phosphide and gallium aluminum
arsenide. The composition ratio of these elements determines the wavelength of
light generated. Semiconductor OEIC and laser designs are processed via
photomasking, etching, implantation, metallization and other techniques
commonly used in the silicon integrated circuit industry. The Company has
modified and adapted these techniques to its own manufacturing processes, and
protects these modifications as proprietary information.

MICROELECTRONIC PACKAGING

The Company provides its customers with a variety of microelectronic
packages. Package options include photodetectors for monitoring light output
power, thermoelectric coolers for controlling the ambient temperature within
the package, and optical fibers for low loss light transmission. Heat removal
is a key packaging aspect for the Company's high power products. The Company
has developed patented techniques for efficiently removing heat from the
light-producing region of the chip.

Maintaining the brightness and intensity of the semiconductor OEIC or laser
is important in many applications. For example, the Company couples light from
micron sized lasers into micron sized optical fibers by tightly aligning the
laser and the fiber, thereby maintaining brightness. The Company has developed
miniaturized "optical bench" technology, consisting of the laser chip or
multi-element laser array and an arrangement to rigidly hold a single fiber or
an array of optical fibers while maintaining alignments of less than one
micron. The optical bench is integrated inside a hermetically sealed package
to provide freedom from adverse environmental gases and water vapor.

SPACE QUALIFICATION/RELIABILITY

The Company has developed high-reliability device and packaging capability
and a quality assurance system that has been certified by satellite systems
companies for use in space. The Company believes that few of its competitors
have similar space-qualified optoelectronic device and packaging capability,
providing the Company with an advantage over many of its competitors in
satellite markets. The Company believes that the space qualification of
certain of its products demonstrates to customers in other markets where
reliability is key to system performance, such as telecommunications, that the
Company's products are highly reliable, providing product differentiation and
a competitive advantage in those markets.

RESEARCH AND DEVELOPMENT

Research and development in the semiconductor OEIC and laser industry is
characterized primarily by design and product engineering that enables new
functionality or improved performance. The Company's ability to successfully
compete will be substantially dependent on its ability to design, develop and
introduce on a timely basis new product offerings. The Company also focuses on
reducing the cost of existing manufacturing processes, developing new process
capabilities and adding new features to existing products.

In 1993, 1994, 1995 and the three months ended March 31, 1996, the Company
spent approximately $3.0 million, $2.8 million, $4.0 million and $1.7 million,
respectively, on internally-funded research and development. The Company
expects that it will continue to spend substantial funds on research and
development activities.

The Company receives research and development funding from Fortune 500
companies, major international corporations, smaller domestic and
international companies, and multiple U.S. government agencies. Under such
programs, the Company may bill the customer for a fixed non-recurring
engineering charge or may bill for actual burdened costs. On many of these
programs, the Company teams with its customers or suppliers to present a
vertically integrated system solution. Certain of these programs also require
research and development cost-sharing by the Company.

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<PAGE>

The Company's product development strategy emphasizes a broad line of
standard products that are based on customer input and requests, as well as
custom product design. The Company often develops new products at the
customer's system-design stage in order to optimize compatibility with the
customer's system and to better ensure market acceptance.

The Company has successfully introduced what it believes to be leading edge
products. Over a twelve-year period, the Company received 20 new product
awards from the three leading industry trade journals, more such awards over
that time period than any other company in the industry. There can be no
assurance that the Company will succeed in identifying new product
opportunities, or in developing and bringing to market any such new products,
or that the Company will be able to respond effectively to technological
advances by others. There also can be no assurance that the Company's new
products will be accepted by the Company's end markets. Moreover, the end
markets for the Company's new standard products are subject to rapid
technological change and there can be no assurance that, as such markets
change, the Company's product offerings will remain current. See "Risk
Factors--Competition" and "Risk Factors--Rapid and Fundamental Technological
Change."

The Company is developing or has demonstrated a variety of prototype chip
designs including: (i) the integration onto a single chip of optical frequency
converters (called "frequency doublers") with semiconductor lasers allowing
the generation of red, green and blue light from infrared lasers, (ii) a two-
dimensional one square centimeter chip emitting 50 watts of average power from
a 1,500 element array of surface emitting lasers and (iii) lasers integrated
onto a single chip with optical elements such as lenses, thereby miniaturizing
and ruggedizing optical elements that previously were fragile and required
precise alignment.

The chart below describes some of the Company's recently awarded research
development and customization programs, as well as some existing programs.

Representative Externally-Funded Product Development/Customization Programs

<TABLE>
<CAPTION>
CUSTOMER OR
PROGRAM APPLICATION PROGRAM START DEVELOPMENT PARTNER
- ------------------------------------------------------------------------------------------------------------------
- ------------------------------------------------------------------------------------------------------------------
<S> <C> <C> <C>
Pump Module Upgrade Fiber Optic Amplifier February 1996 AT&T
- ------------------------------------------------------------------------------------------------------------------
High Power Printer Laser Color Printing November 1995 Eastman Kodak
- ------------------------------------------------------------------------------------------------------------------
Holographic Data Storage Mass Computer Memory October 1995 NSIC
- ------------------------------------------------------------------------------------------------------------------
Blue Semiconductor Laser Data Storage, Displays, Printing May 1995 Hewlett-Packard, Xerox
- ------------------------------------------------------------------------------------------------------------------
Satellite Transmitter Japanese Optical Communications Satellite November 1994 NEC, NASDA
- ------------------------------------------------------------------------------------------------------------------
All Optical Switch High Speed ATM Random Access September 1994 Optivision
Switch Between 8 Input and 8 Output Fibers
- ------------------------------------------------------------------------------------------------------------------
LAN Transmitter Data Communications, FDDI, Fast Ethernet August 1994 Hewlett-Packard, AMP, Dupont
- ------------------------------------------------------------------------------------------------------------------
Red, Green, Blue Array Printing, Data Storage, Displays September 1992 Xerox
</TABLE>

MANUFACTURING

The Company's manufacturing operations are located at the Company's
headquarters in San Jose, California, at a nearby facility in Santa Clara,
California and in Victoria, British Columbia, Canada. The Company's
manufacturing operation is vertically integrated and has capabilities in
computer-aided chip and package design, wafer fabrication, wafer processing,
device packaging, hybrid microelectronic packaging, printed circuit board
testing, and final assembly and testing. Many of the functions within the
Company's manufacturing operation are computer monitored or controlled, which
enhances reliability and yield. The Company employs flexible manufacturing
techniques, allowing the Company to switch readily, reliably and efficiently
from one product to another. The Company believes that its flexible
manufacturing capability differentiates it from its competitors.

37
<PAGE>

The Company's semiconductor OEICs and lasers are fabricated using many
proprietary processes and customized manufacturing equipment. Therefore,
almost all steps in the manufacturing of the semiconductor OEICs are performed
by the Company. Any interruption in manufacturing resulting from shortages of
parts or equipment, earthquake, fire, equipment failures or otherwise could
have a material adverse effect on the Company's business and results of
operations. In particular, a significant portion of the Company's production
relies or occurs on equipment for which the Company does not have a backup.
See "Risk Factors--Manufacturing Risks," "Risk Factors--Multisite Operations;
Need to Manage Growth" and "Risk Factors--Control of Manufacturing Process."
Outside contractors and suppliers are used to supply raw materials, packages
and standard components, and to assemble printed circuit boards. The Company
depends on single or a limited number of suppliers. The Company generally
purchases these single or limited source products through standard purchase
orders or one year supply agreements and has no long-term guaranteed supply
agreements with such suppliers. The Company seeks to maintain a sufficient
safety stock to overcome shipping delays or supply interruptions by its
suppliers. The Company also endeavors to maintain ongoing communications with
its suppliers to guard against interruptions in supply and has, to date,
generally (although not always) been able to obtain sufficient supplies in a
timely manner. Operating results have been in the past and could be in the
future adversely affected by a stoppage or delay of supply, substitution of
more expensive or less reliable alternate parts, receipt of defective parts or
contaminated materials, an increase in the pricing of such supplies, or the
Company's inability to obtain reduced pricing from its suppliers in response
to competitive pressures. See "Risk Factors--Dependence on Single Source and
Other Third Party Suppliers."

The Company has on occasion been unable to manufacture certain products in
quantities sufficient to meet the demand of its existing customer base and of
new customers. As a result, the Company expanded its facilities by relocating
its assembly, test and packaging operations to another building and is in the
process of remodeling its original manufacturing facilities, adding new
manufacturing equipment and obtaining additional facilities. In addition, in
November 1995, the Company and its subsidiary, SDL Optics, acquired the
business of Seastar, located in Victoria, British Columbia, Canada. Prior to
these developments, the Company had no experience in managing operations in
multiple sites and no assurance can be given that the Company will not
experience unexpected delays, inefficiencies or management problems arising
out of its multisite operations. Such delays or inefficiencies could
materially adversely affect the Company's business and results of operations.
The Company is experiencing, and may in the future experience, lower than
expected production yields on many of its products, including some of its key
product lines. This reduction in yields adversely affects gross margins and
delays component, product and system shipments. There can be no assurance that
the Company will be able to achieve acceptable manufacturing yields or ship
products on time in the future. See "Risk Factors--Manufacturing Risks" and
"Risk Factors--Multisite Operations; Need to Manage Growth."

ENVIRONMENTAL REGULATIONS

The Company is subject to a variety of federal, state and local laws and
regulations concerning the storage, use, discharge and disposal of toxic,
volatile, or otherwise hazardous or regulated chemicals or materials used in
its manufacturing processes. Further, the Company is subject to other safety,
labeling and training regulations as required by local, state and federal law.
The Company has established an environmental and safety compliance program to
meet the objectives of applicable federal, state and local laws. This
compliance program is administered by the environmental and safety department
of the Company and includes monitoring, measuring and reporting compliance,
establishing safety programs and training Company personnel in environmental
and safety matters. There can be no assurance that changes in regulations and
laws will not have an adverse economic effect on the Company. Further, such
regulations could restrict the Company's ability to expand its operations. Any
failure by the Company to obtain required permits or operate within
regulations for, control the use of, or adequately restrict the discharge of
hazardous or regulated substances or materials under present or future
regulations could subject the Company to substantial liability, require costly
changes in the Company's manufacturing processes or facilities or cause its
operations to be suspended. See "Risk Factors--Potential Adverse Impact of
Environmental Regulations."

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<PAGE>

BACKLOG

As of March 31, 1996, the Company's total backlog was $37.8 million, as
compared to $24.2 million at March 31, 1995. This increase is primarily due to
orders placed during 1995. The Company's backlog includes all purchase orders
that have been received and accepted. Orders constituting the Company's
backlog are generally subject to delivery rescheduling, price renegotiations
and cancellation at the option of the buyer without significant penalty. A
significant portion of the Company's business, in line with that of much of
the semiconductor industry, is characterized by short lead-time orders and
quick delivery schedules.

COMPETITION

The Company's various markets are highly competitive. The Company faces
current or potential competition from four primary sources: (i) direct
competitors, (ii) potential entrants, (iii) suppliers of potential new
technologies and (iv) suppliers of existing alternative technologies.

The Company offers a range of components, products and systems, and has
numerous competitors worldwide in various segments of its markets. In high
power laser and light source replacement markets, its direct competitors
include Opto Power and Sony. In its single mode laser markets, its competitors
include Sanyo and Philips among others. In its fiber amplifier pump market,
IBM is the Company's primary competitor, with other competitors emerging, some
of which are licensing technology from IBM. SDL Optics has multiple
competitors in its single mode pump module product lines, including Lasertron,
which is also licensing IBM chip technology. In 1995, several new start-ups
began shipping products in these markets. The Company often competes with
David Sarnoff Research Laboratories, among others, for research contract
funding. The Company also sells its products to current competitors and
companies with the capability of becoming competitors. If the markets for the
Company's products continue to grow, new competitors are likely to emerge and
present competitors may increase their market share.

Potential new technologies may emerge to compete with the Company's
products. For example, the Company is attempting to develop blue semiconductor
lasers based on gallium nitride technology. Blue semiconductor lasers have
been demonstrated based on an alternative technology, which the Company is not
presently pursuing. Although such alternative technology has, to date,
exhibited poor reliability, rapid advances in that technology could render
obsolete any gallium nitride based lasers developed by the Company.
Additionally, many other companies around the world are working to develop or
have developed blue gallium nitride lasers. In most of the Company's product
lines, both the Company and competitors are working to develop new
technologies, or improvements and modifications to existing technologies,
which will obsolete present products. There can be no assurances that the
Company will continue its development efforts, or that such efforts, if
continued, will be successful. In addition, there can be no assurances that
markets will develop for any such products, or that any such products would be
competitive with other technologies or products that may be developed by
others.

The Company also competes with alternate existing technologies. For example,
the Company makes semiconductor laser products for powering CATV and
telecommunications optical amplifiers. These optical amplifiers compete with
electronic repeaters which utilize semiconductor laser transmitters and photo-
sensitive receivers.

Many of the Company's competitors have significantly greater financial,
technical, manufacturing, marketing, sales and other resources than SDL. In
addition, many of these competitors may be able to respond more quickly to new
or emerging technologies, evolving industry trends and changes in customer
requirements and to devote greater resources to the development, promotion and
sale of their products than the Company. There can be no assurance that the
Company's current or potential competitors do not already have or will not
develop or acquire products comparable or superior to those developed by the
Company, combine or merge to form significant competitors, or adapt more
quickly than the Company to new technologies, evolving industry trends and
changing customer requirements. Increased competition has resulted and could,
in the future, result in

39
<PAGE>

price reductions, reduced margins or loss of market share, any of which could
materially and adversely affect the Company's business and results of
operations. There can be no assurance that the Company will be able to compete
successfully against current and future competitors or that competitive
pressures faced by the Company would not have a material adverse effect on its
business and results of operations. The Company expects that both direct and
indirect competition will increase in the future. Additional competition could
adversely affect the Company's results of operations through price reductions
and loss of market share. In addition, the Company is currently involved in
litigation with Spectra-Physics and Opto Power regarding rights to certain SDL
technology. If the Company does not prevail in such litigation, the Company
could face monetary damages and could be required to transfer and license
valuable SDL trade secrets and technology to Spectra-Physics and its
subsidiaries, possibly including Opto Power, which is currently manufacturing
optoelectronic devices that compete with a number of the Company's products.
Such a result could significantly impair the Company's competitive advantage
in a number of technology areas and with respect to a number of products and
could have a material adverse effect on the Company's business and results of
operations. See "Risk Factors--Technology Agreement," "Risk Factors--
Competition" and "--Legal Proceedings."

INTELLECTUAL PROPERTY

The Company has been a leader in the development of new technologies in the
optoelectronics field and as such, has actively sought to patent its
inventions. The Company frequently reviews its inventions and attempts to
determine which inventions will provide substantial differentiation between
the Company's products and those of its competitors. In certain cases, the
Company may also choose to keep an invention or a process as a trade secret.
Trade secrets are routinely employed in the Company's manufacturing processes.
The Company has entered into non-disclosure agreements to protect its
proprietary technology with its employees and consultants, and in some
instances with its suppliers and customers.

To date, the Company has been issued over 45 U.S. patents on devices,
processes, packages and systems. No patent has less than seven years of life
remaining before expiration and the average remaining life is approximately 12
years. Approximately four dozen additional patent applications are pending.
The Company also has a royalty-free license to approximately 100 Xerox U.S.
patents. It also has one royalty-bearing license from a third party.
Management believes that the breadth of its issued and pending patents and
licenses will allow the Company to compete effectively in its present and
future businesses. However, because of rapid technological developments in the
communications, electronics, optics and semiconductor industries and the broad
and rapidly developing patent coverage, the patent position of any
manufacturer, including the Company, is subject to uncertainties and may
involve complex legal and factual issues. Consequently, although the Company
holds certain patents, is licensed under other patents and is currently
prosecuting additional patent applications, there can be no assurance that
patents will issue from any pending applications or that claims allowed by any
existing or future patents issued or licensed to the Company will not be
challenged, invalidated, or circumvented, or that any rights granted
thereunder will provide adequate protection to the Company. Moreover, the
Company may be required to participate in interference proceedings to
determine the priority of inventions, which could result in substantial cost
to the Company. See "Risk Factors--Dependence on Proprietary Technology."

Due to collaborative efforts with others, some of the Company's pending
patent applications are filed under undivided joint ownership. Approximately
fourteen of the Company's issued inventions were developed under Federal
government funding and contain a provision for a non-exclusive, royalty-free
license for Federal government use.

The Company participates in a number of research or product development
consortia in which the Company has agreed to grant other partners or consortia
members, along with the Federal government, non-exclusive license to
technologies developed with consortia funding. Some of these cross-license
grants are royalty-free while others provide for market rate license fees. In
certain situations, these consortia require the Company to invest its own
research and development funds to match Federal government funds. The
inventions of the Company and other consortia or team members made with
matching research and development funds are also

40
<PAGE>

often subject to such cross-license grant provisions. Joint inventions made in
such collaborations are normally jointly owned.

The Company has registered the name SDL and its logo with the U.S. Patent
and Trademark Office as trademarks.

As part of its formation, the Company entered into the Technology Agreement
with Spectra-Physics and Xerox pursuant to which, among other things, SDL
granted to Spectra-Physics and Xerox an irrevocable, royalty-free, worldwide,
non-exclusive license to patented and non-patented technology developed by
SDL. Spectra-Physics and Opto Power have filed suit against SDL seeking, among
other things, to enforce claims to SDL patented and non-patented technology
developed through at least June 1993. If the Company does not prevail in such
litigation, the Company could face significant monetary damages and could be
required to transfer and license valuable SDL trade secrets and technology to
Spectra-Physics and its subsidiaries, possibly including Opto Power, which is
currently manufacturing optoelectronic devices and systems that currently
compete with a number of the Company's products. See "Risk Factors--Technology
Agreement" and "--Legal Proceedings."

In March 1995, Xerox formally requested transfer of SDL technology under the
Technology Agreement, but advised the Company that, in connection with such
transfer, Xerox currently intends to use the SDL technology for Xerox'
internal research and development, laser printing, image projection and other
activities in the document processing field. Xerox further indicated to the
Company that Xerox did not currently intend to become a supplier of products
that would be competitive with the Company's current product offerings. SDL
agreed to a limited technology transfer for those purposes. Xerox subsequently
asserted a breach of contract claim against the Company in December 1995
claiming unspecified damages and seeking specific performance of the
Technology Agreement. No assurance can be given, however, that Xerox and such
subsidiaries or affiliates as specified in the Technology Agreement will not
in the future offer products competitive with the Company's products, which
products could include or be based on SDL Technology.

LEGAL PROCEEDINGS

As part of its formation, the Company entered into a technology agreement
(the Technology Agreement) with Xerox Corporation (Xerox) and Spectra-Physics,
Inc. (Spectra-Physics) pursuant to which, among other things, SDL granted to
Spectra-Physics and Xerox an irrevocable, royalty-free, worldwide, non-
exclusive license to certain patented and non-patented technology developed by
SDL. In March 1995, Spectra-Physics initiated a lawsuit against the Company in
Santa Clara Superior Court, alleging that the Company was refusing to comply
with its obligations under the Technology Agreement. Spectra-Physics claims
that the Technology Agreement requires the Company to transfer and license to
Spectra-Physics all patented and non-patented technology developed by the
Company during a time period extending from the founding of the Company in
1983 until at least June 1993. Spectra-Physics asserts causes of action
against the Company for breach of contract, promissory estoppel and fraud.

41
<PAGE>

that Spectra-Physics and Opto Power have no licenses to, and that the Company
may not disclose without Xerox' consent, Xerox technical information. Xerox
also asserts a breach of contract claim against the Company for the alleged
failure to transfer technology to Xerox pursuant to the Technology Agreement.
Xerox seeks unspecified damages from the Company and specific performance of
the Technology Agreement.

Discovery is currently proceeding for this lawsuit, which is currently
scheduled for trial beginning January 21, 1997. Although the Company believes
that it has meritorious defenses to Spectra-Physics', Opto Power's and Xerox's
claims, there can be no assurance that the Company will achieve a successful
result in this litigation. The litigation has involved and is expected to
continue to involve significant expense to the Company and to divert the
attention of the Company's technical and management personnel, and the outcome
could have a material adverse effect on the Company's business and results of
operations. If the Company does not prevail in such litigation, the Company
could face substantial monetary damages and could be required to license and
to transfer valuable SDL trade secrets and technology to Spectra-Physics and
its subsidiaries, possibly including Opto Power, which is currently
manufacturing optoelectronic devices that compete with a number of the
Company's products. Such a result could significantly impair the Company's
competitive advantage in certain technology areas and with respect to a number
of products and could have a material adverse effect on the Company's business
and results of operations.

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<PAGE>

Discovery on these issues is presently scheduled to close on September 30,
1996. In March 1996 Rockwell filed a motion seeking summary judgment that its
patent is not invalid. The Company and the Federal government both filed
responses to that motion and filed cross-motions for summary judgment that the
patent is invalid. Rockwell's motion for summary judgment and the Company's
and the Federal government's cross-motions for summary judgment will be
considered together by the Court, although no hearing date has been set at
this time. Rockwell's response to SDL's and the Federal government's cross-
motions is currently due on July 10.

EMPLOYEES

As of March 31, 1996, the Company employed 441 persons, including 279 in
manufacturing, 106 in engineering, research and development, 19 in sales and
marketing, and 37 in general and administrative capacity. The Company also
employs, from time to time, a number of temporary employees and consultants on
a contract basis. As of March 31, 1996, the Company employed 42 such persons.
None of the Company's employees is represented by a labor union. The Company
has not experienced any work stoppages and considers its relations with its
employees to be good. See "Risk Factors--Need to Hire and Retain Personnel;
Dependence on Key Employees."

FACILITIES

The Company leases two adjacent buildings comprising approximately 64,000
square feet of office and manufacturing space in San Jose, California. These
facilities serve as the Company's headquarters and include manufacturing,
marketing, research, engineering and administrative functions. The present
leases expire in November 1996. The Company has renewal options to extend
these leases through November 2016.

In January 1995 and May 1996, the Company leased an additional 50,000 and
10,000 square feet, respectively, of manufacturing, office and warehouse space
in Santa Clara, California, approximately three miles from its headquarters.
These leases expire in March 2002 and May 1999, respectively. The Company has
renewal options to extend the January 1995 lease through 2017 and recently
exercised an option for an adjacent additional 50,000 square feet. SDL Optics
leases 21,000 square feet of manufacturing and office space, and adjacent
parking space, in Saanichton, British Columbia, Canada. These facilities serve
as SDL Optics' headquarters and include manufacturing, marketing, research,
engineering and administrative functions. The present leases expire in August
1998. SDL Optics has two one-year renewal options under each lease and an
option to purchase the manufacturing and office space during the initial or
renewal term of the lease for that facility.

43
<PAGE>

MANAGEMENT

EXECUTIVE OFFICERS AND DIRECTORS

The executive officers and directors of the Company and their ages as of the
date of this Prospectus are as follows:

<TABLE>
<CAPTION>
NAME AGE POSITION
<S> <C> <C>
Donald R. Scifres....... 49 Chairman of the Board, Chief Executive Officer and President
John P. Melton.......... 60 Vice President, Business Operations, Secretary and Director
Gregory C. Lindholm..... 45 Vice President, Finance, Chief Financial Officer and Treasurer
Richard R. Craig........ 40 Vice President, Communications Business Unit
John G. Endriz.......... 54 Vice President, Engineering
David S. Evans.......... 61 Vice President, Marketing & Sales
Elizabeth A. Gurklys.... 35 Vice President, Human Resources
Thomas L. Koch.......... 40 Vice President, Research & Development
David F. Welch.......... 35 Vice President, Business Development
Keith B. Geeslin (1).... 43 Director
Anthony B. Holbrook (1). 56 Director
Mark B. Myers (2)....... 57 Director
Frederic N. Schwettmann Director
(2).................... 56
</TABLE>
- ---------------------
(1) Member of Audit Committee.
(2) Member of Compensation Committee.

Dr. Scifres has been President, Chief Executive Officer and a member of the
Board of Directors of the Company since its inception in June 1983. In
connection with a recapitalization of the Company in 1992 (the
Recapitalization), Dr. Scifres became Chairman of the Board. Upon completing
his Ph.D. in 1972, Dr. Scifres joined Xerox Palo Alto Research Center.
Dr. Scifres earned a bachelor's degree in electrical engineering from Purdue
University in 1968, and a master's degree and doctorate in electrical
engineering from the University of Illinois in 1970 and 1972, respectively.
Dr. Scifres is a Fellow of the Institute of Electrical and Electronic Engineers
and the Optical Society of America, holds over 100 U.S. patents and has won
several industry awards, including awards for commercialization of
semiconductor OEIC and laser technology.

Mr. Melton joined the Company as a consultant in 1987 and became Manager,
Business Operations of the Company in 1988. In connection with the
Recapitalization, Mr. Melton's title was changed to Vice President, Business
Operations and Mr. Melton became a Director of the Company. Mr. Melton is also
Chairman of SDL Optics. Mr. Melton earned a bachelor's degree in chemistry from
the University of Oklahoma in 1958, and an M.B.A. degree from Stanford
University in 1963.

Mr. Lindholm joined the Company in September 1985 as Controller and
Treasurer. In connection with the Recapitalization, Mr. Lindholm's title was
changed to Vice President, Finance and Chief Financial Officer. Mr. Lindholm
received a B.A. degree in business administration from California State
University, Fullerton in 1975.

Dr. Craig joined the Company in September 1989 as Senior Staff Engineer in
the Engineering Department. He was appointed Communications Business Unit
Director upon creation of the unit in August 1994, and became Vice President,
Communications Business Unit in March 1995. Dr. Craig is also the President of
SDL Optics. Dr. Craig received a B.S. degree in physics from the University of
California, Berkeley in 1978 and a Ph.D. in electrical engineering from the
University of California, Los Angeles in 1985.

Dr. Endriz joined the Company in February 1988 as Engineering Manager. In
connection with the Recapitalization, Dr. Endriz's title was changed to Vice
President, Engineering. Dr. Endriz received an M.S. degree in electrical
engineering from the Massachusetts Institute of Technology in 1965 and a Ph.D.
in electrical engineering from Stanford University in 1970.

44
<PAGE>

Mr. Evans joined the Company in June 1984 as Manager, Marketing and Sales.
In connection with the Recapitalization, Mr. Evans' title was changed to Vice
President, Marketing and Sales. Prior to joining the Company, Mr. Evans was
employed by Spectra-Physics from 1966 to 1984, serving as International Sales
Manager, responsible for worldwide sales and support activities for Spectra-
Physics' Laser Products Division.

Ms. Gurklys initially joined the Company in April 1990 as Human Resources
Representative. From March 1995 to June 1995, she was Human Resources Manager
of Quasar Engineering, Inc., an architectural design company. In July 1995,
Ms. Gurklys rejoined the Company as Director of Human Resources and became
Vice President, Human Resources in January 1996. Ms. Gurklys received a B.A.
degree in administrative studies from York University in 1989.

Dr. Koch joined the Company in February 1996 as Vice President of Research &
Development. From October 1989 to January 1996, he managed the research in
optoelectronic technology at Lucent Technologies, Inc., formerly AT&T Bell
Laboratories-Telecommunications. Dr. Koch received a B.A. degree in physics
from Princeton University in 1977 and a Ph.D. in applied physics from The
California Institute of Technology in 1982. Dr. Koch has received industry
awards for development of optical communication related technologies.

Dr. Welch joined the Company in January 1985 as a member of the technical
staff. In January 1991, he became Manager of the Research Department. In
connection with the Recapitalization, Dr. Welch's title was changed to Vice
President, Research & Development. Dr. Welch's title has recently changed to
Vice President--Business Development. Dr. Welch received a B.S. degree in
electrical engineering from the University of Delaware in 1981 and a Ph.D. in
electrical engineering from Cornell University in 1985. Dr. Welch received the
Outstanding Young Scientist Award from the Optical Society of America in 1994
for his contributions to the commercialization of semiconductor OEICs and
lasers.

Mr. Geeslin has been a Director of the Company since July 1992. Mr. Geeslin
is Senior Vice President of The Sprout Group, where he has been employed since
1984. In addition, he is a direct or indirect general or limited partner of a
series of investment funds associated with The Sprout Group, a division of DLJ
Capital Corporation, a subsidiary of Donaldson, Lufkin & Jenrette, Inc. Mr.
Geeslin is also a director of Actel Corporation, Norand Corporation and
several privately held companies. Mr. Geeslin received a B.S.E.E. degree from
Stanford University in 1975, an M.A. degree in Philosophy, Politics and
Economics from Oxford in 1977, and an M.S. degree in engineering-economic
systems from Stanford in 1978.

Mr. Holbrook has been a Director of the Company since December 1995. Mr.
Holbrook has served as a director and Vice Chairman of Advanced Micro Devices
since August 1994. Mr. Holbrook joined AMD in 1973 as Managing Director of
computer interface and linear circuits. He served in a number of executive
capacities and in 1982 was named Executive Vice President and Chief Operating
Officer. In 1986, Mr. Holbrook was appointed President and Chief Operating
Officer, positions he held until May 1, 1989, at which time he was named Chief
Technical Officer. Mr. Holbrook retired in August 1994. Prior to joining AMD,
Mr. Holbrook held engineering management positions with Fairchild
Semiconductor and Computer Micro Technology Corporation.

Dr. Myers has been a Director of the Company since December 1992. Dr. Myers
is Senior Vice President, Corporate Research and Technology of Xerox
Corporation, responsible for worldwide research and technology. Since joining
Xerox in 1964, Dr. Myers has held several research and engineering positions.
He was named Vice President and Manager of the Webster Research Center in
1984. He was elected Corporate Vice President in May 1989 and was named to his
current position in February 1992. Dr. Myers earned a B.S. degree in geology
and physics from Earlham College, Richmond, Indiana, in 1960 and a Ph.D. in
material sciences from Pennsylvania State University in 1964.

45
<PAGE>

Dr. Schwettmann was appointed a member of the Board in October 1994. Dr.
Schwettmann has served as President, Chief Operating Officer and Director of
Read-Rite Corporation since May 1993. Dr. Schwettmann has held positions as
Chairman of the Advisory Committee for Integrated Systems at Stanford
University, member of the Board of the Applied Technology Institute for
Microelectronics and member of the Board of SEMATECH. He currently serves on
the Board of Actel Corporation. Prior to joining Read-Rite, Dr. Schwettmann
worked with Hewlett-Packard Company from 1976 to 1993, his most recent position
being Vice President and General Manager of the Circuit Technology Group. Dr.
Schwettmann received his B.Ch.E. degree from The City College of New York in
1961, his M.Ch.E. degree from New York University in 1964, and his Ph.D.Ch.E.
degree from The City University of New York in 1969.

46
<PAGE>

PRINCIPAL AND SELLING STOCKHOLDERS

The following table sets forth certain information known to the Company with
respect to beneficial ownership of the Company's Common Stock as of June 1,
1996 and as adjusted to reflect the sale of shares offered pursuant to this
Prospectus, by (a) each stockholder known by the Company to be the beneficial
owner of more than five percent of the Company's Common Stock, (b) each
Director, (c) certain executive officers and (d) all current executive
officers and directors as a group. The following table reflects the Stock
Split. See "Recent Development."
<TABLE>
<CAPTION>
NUMBER OF SHARES NUMBER OF SHARES
BENEFICIALLY OWNED BENEFICIALLY OWNED
PRIOR TO OFFERING(1) NUMBER AFTER OFFERING(2)
5% BENEFICIAL OWNERS, DIRECTORS AND -----------------------OF SHARES ---------------------
EXECUTIVE OFFICERS NUMBER PERCENT OFFERED NUMBER PERCENT
<S> <C> <C> <C> <C> <C>
Donald R. Scifres(2)(3)... 1,273,999 11.0 36,000 1,237,999 9.8
Keystone Small Growth
Fund(4).................. 750,000 6.8 0 750,000 6.0
JP Morgan & Co., Inc.(5).. 560,805 5.1 0 560,805 4.5
David S. Evans(2)......... 243,554 2.2 31,500 212,054 1.7
Hsing H. Kung(2).......... 238,280 2.1 45,000 193,280 1.5
David F. Welch(2)(6)...... 153,768 1.4 27,500 126,268 1.0
John P. Melton(2)(7)...... 152,652 1.4 18,000 134,652 1.1
Gregory C. Lindholm(2)(8). 137,288 1.2 22,500 114,788 *
John G. Endriz(2)......... 95,790 * 12,000 83,790 *
Richard R. Craig(2)....... 62,506 * 7,500 55,006 *
Keith B. Geeslin(2)....... 22,107 * 0 22,107 *
Mark B. Myers(2).......... 10,700 * 0 10,700 *
Frederic N.
Schwettmann(2)........... 10,700 * 0 10,700 *
Elizabeth A. Gurklys...... 10,071 * 0 10,071 *
Anthony B. Holbrook....... 0 * 0 0 *
All executive officers and
directors as a group
(14 persons)............. 2,173,135 18.1 155,000 2,018,135 15.0
</TABLE>
- ---------------------
* Less than 1%.
(1) To the Company's knowledge, except as set forth in the footnotes to this
table and subject to applicable community property laws, each person named
in the table has sole voting and investment power with respect to the
shares set forth opposite such person's name.

(2) Includes options exercisable during the sixty-day period following June 1,
1996, in the following amounts: Dr. Scifres, 481,585 shares; Mr. Evans,
161,255 shares; Dr. Kung, 91,187 shares; Dr. Welch, 57,973 shares;
Mr. Melton, 42,008 shares; Mr. Lindholm, 32,062; Dr. Endriz, 50,175
shares; Dr. Craig, 56,971; Mr. Geeslin, 10,700 shares; Dr. Myers, 10,700
shares; Dr. Schwettmann, 10,700 shares; and all executive officers and
directors as a group, 914,129 shares.

(3) Includes 524,914 shares held by The Donald R. and Carol D. Scifres
Revocable Living Trust and 19,890 shares held by each of Dr. Scifres' five
dependent children. Dr. Scifres' address is c/o SDL, Inc., 80 Rose Orchard
Way, San Jose, California 95134.

(4) Keystone Small Growth Fund's address is 200 Berkeley Street, Boston,
Massachusetts 02116. James R. McCall, President of Keystone Investment
Management Company, shares voting control over shares held by Keystone
Small Growth Fund. Such information is based on a Schedule 13G filed by
such stockholder with the Securities and Exchange Commission and reflects
stock held as of December 31, 1995.

(5) JP Morgan & Co., Inc.'s address is 60 Wall Street, New York, New York
10260. Such information is based on a Schedule 13G filed by such
stockholder with the Securities and Exchange Commission and reflects stock
held as of December 31, 1995.

(6) Includes 2,485 shares held by David F. Welch and Heidi A. Welch, Trustees
F/A/O The Welch Charitable Remainder Uni Trust DTD 10/17/95.

(7) Includes 110,644 shares held by John Phillip Melton and Eve Wood Melton or
successor(s), as trustees of the Melton Family Trust DTD 8/6/92.

(8) Includes 105,226 shares held by Gregory C. Lindholm and Laurie D. Lindholm
co-trustees under the Lindholm Trust Agreement DTD 11/1/95.

47
<PAGE>

DESCRIPTION OF CAPITAL STOCK

The Company is authorized to issue up to 21,000,000 shares of Common Stock,
$0.001 par value per share, and 1,000,000 shares of Preferred Stock, $0.001 par
value per share.

COMMON STOCK

The holders of Common Stock are entitled to one vote for each share held of
record on all matters submitted to a vote of the stockholders. Holders of
Common Stock have cumulative voting rights in the election of directors.
Subject to preferences that may be granted to any then outstanding Preferred
Stock, holders of Common Stock are entitled to receive ratably such dividends
as may be declared by the Board of Directors out of funds legally available
therefor. In the event of a liquidation, dissolution or winding up of the
Company, holders of Common Stock are entitled to share ratably in all assets of
the Company remaining after payment of liabilities and the liquidation of any
then outstanding Preferred Stock. Holders of Common Stock have no preemptive or
other subscription or conversion rights. There are no redemption or sinking
fund provisions applicable to the Common Stock. All outstanding shares of
Common Stock are, and all shares of Common Stock to be outstanding upon
completion of the offering will be, validly issued, fully paid and
nonassessable. See "Risk Factors--Potential Volatility of Stock Price."

PREFERRED STOCK

The Board of Directors has the authority, without further action by the
stockholders, to issue up to 1,000,000 shares of Preferred Stock in one or more
series and to fix the rights, preferences, privileges and restrictions thereof,
including dividend rights, conversion rights, voting rights, terms of
redemption, liquidation preferences, sinking fund terms and the number of
shares constituting any series or the designation of such series, without any
further vote or action by stockholders. The issuance of Preferred Stock could
adversely affect the voting power of holders of Common Stock and the likelihood
that such holders will receive dividend payments and payments upon liquidation
and could have the effect of delaying, deferring or preventing a change in
control of the Company. The Company has no present plan to issue any shares of
Preferred Stock.

DELAWARE LAW AND CERTAIN CHARTER PROVISIONS

Certain provisions of Delaware law and the Company's Restated Certificate of
Incorporation (the Certificate) could make more difficult the acquisition of
the Company by means of a tender offer, a proxy contest or otherwise and the
removal of incumbent officers and directors. These provisions are expected to
discourage certain types of coercive takeover practices and inadequate takeover
bids and to encourage persons seeking to acquire control of the Company to
negotiate first with the Company.

DELAWARE STATUTE

The Company is subject to the provisions of Delaware General Corporation Law
Section 203 (the Delaware Statute). In general, the Delaware Statute prohibits
certain business combinations between a publicly-held Delaware corporation,
such as the Company, and any "interested stockholder" for a period of three
years after the date on which the latter became an interested stockholder
unless the business combination is approved in a prescribed manner. A "business
combination" includes a merger, asset sale or other transaction resulting in
financial benefit to the interested stockholder. An "interested stockholder" is
a person who, together with affiliates and associates, owns (or within three
years prior, did own) 15% or more of the corporation's outstanding voting
stock.

CLASSIFIED BOARD OF DIRECTORS

The Certificate provides that, so long as the Board of Directors consists of
more than two directors, the Board of Directors will be divided into three
classes of directors serving staggered three-year terms. As a result,

48
<PAGE>

approximately one-third of the Company's Board of Directors will be elected
each year. In addition, the Certificate provides for cumulative voting in the
election of directors, allowing the election of a director at each election by
holders representing a large minority of shares.

ADVANCE NOTICE FOR RAISING BUSINESS OR MAKING NOMINATIONS AT MEETINGS

The Certificate establishes an advance notice procedure for bringing business
before an annual meeting of stockholders and for nominating (other than by or
at the direction of the Board of Directors) candidates for election as
directors at an annual meeting or a special meeting called for the purpose of
electing directors. To be timely, notice of nominations or other business to be
brought before an annual meeting must be received by the Secretary of the
Company not earlier than 90 nor later than 60 days prior to the first
anniversary of the preceding year's annual meeting or, if the date of the
annual meeting is advanced by more than 30 days or delayed by more than 60 days
from such anniversary, such notice must be received not earlier than 90 days
prior to such annual meeting and not later than the later of (1) the 60th day
prior to the annual meeting or (2) the 10th day following the date on which
notice of the date of the annual meeting was mailed or public disclosure
thereof was made, whichever occurs first. Similar advance notice requirements
are applicable to nominations to be brought before a special meeting called for
the purpose of electing directors.

OTHER CHARTER PROVISIONS

The Certificate provides that in determining whether to take or refrain from
taking corporate action on any matter, the Board of Directors may take into
account the interests of customers, employees and other constituencies of the
Company and its subsidiaries, including the effect upon communities in which
the Company and its subsidiaries do business, and may consider long-term as
well as short-term interests of the Company and its stockholders, in addition
to any other considerations which the Board of Directors may lawfully take into
account.

49
<PAGE>

UNDERWRITING

Subject to the terms and conditions set forth in an underwriting agreement
(Underwriting Agreement), the Underwriters named below have severally agreed
to purchase from the Company and the Selling Stockholders an aggregate of
1,700,000 shares of Common Stock. The number of shares of Common Stock that
each underwriter has agreed to purchase is set forth opposite its name below:

<TABLE>
<CAPTION>
NUMBER OF
NAME SHARES
<S> <C>
Donaldson, Lufkin & Jenrette Securities Corporation.............
Cowen & Company.................................................
---------
Total....................................................... 1,700,000
=========
</TABLE>

The Underwriting Agreement provides that the obligation of the several
Underwriters to purchase shares of Common Stock are subject to the approval of
certain legal matters by counsel and to certain other conditions. If any of
the shares of Common Stock are purchased by the Underwriters pursuant to the
Underwriting Agreement, all such shares of Common Stock (other than the shares
of Common Stock covered by the over-allotment option described below) must be
so purchased.

The Company and the Selling Stockholders have agreed to indemnify the
Underwriters against certain liabilities, including liabilities under the
Securities Act, or to contribute to payments that the Underwriters may be
required to make in respect thereof.

The Company and the Selling Stockholders have been advised by the
Underwriters that they propose to offer the Common Stock to the public
initially at the price to the public set forth on the cover page of this
Prospectus and to certain dealers (who may include the Underwriters) at such
price less a concession not to exceed $ per share. The Underwriters may
allow, and such dealers may reallow, discounts not in excess of $ per share
to the other Underwriter and certain other dealers.

The Company has granted to the Underwriters an option to purchase up to an
aggregate of 255,000 additional shares of Common Stock at the public offering
price less underwriting discounts and commissions solely to cover over-
allotments. Such option may be exercised at any time until 30 days after the
date of this Prospectus. To the extent that the Underwriters exercise such
option, each of the Underwriters will be committed, subject to certain
conditions, to purchase a number of option shares proportionate to such
Underwriter's initial commitment as indicated in the preceding table.

The Company, the Selling Stockholders and all directors and executive
officers of the Company have agreed that, without the prior written consent of
Donaldson, Lufkin & Jenrette Securities Corporation, they will not, directly
or indirectly, offer, sell, contract to sell, grant any option to purchase or
otherwise dispose of any Common Stock or any securities convertible into or
exercisable or exchangeable for such Common Stock or in any other manner
transfer all or a portion of the economic consequences associated with
ownership of any such Common Stock, except to the Underwriters pursuant to the
Underwriting Agreement, until ninety days following the date of this
Prospectus.

Keith B. Geeslin, a Director of the Company, is Senior Vice President of The
Sprout Group and a direct or indirect general or limited partner of a series
of funds associated with The Sprout Group. The Sprout Group is a division of
DLJ Capital Corporation. DLJ Capital Corporation and Donaldson, Lufkin &
Jenrette Securities Corporation are each wholly-owned subsidiaries of
Donaldson, Lufkin & Jenrette, Inc. The Equitable Life Assurance Society of the
United States and The Equitable Variable Life Insurance Co., companies
affiliated with Donaldson, Lufkin & Jenrette, Inc., hold 95,767 shares of the
Company's Common Stock.

50
<PAGE>

In connection with this offering, the Underwriters and selling group members
(if any) who are qualifying registered market makers on Nasdaq may engage in
passive market making transactions in the Common Stock on the Nasdaq National
Market in accordance with Rule 10b-6A under the Securities Exchange Act of
1934 during the two business day period before commencement of sales in this
offering. The passive market making transactions must comply with applicable
price and volume limits and be identified as such. In general, a passive
market maker may display its bid at a price not in excess of the highest
independent bid for the security. If all independent bids are lowered below
the passive market maker's bid, however, such bid must then be lowered when
certain purchase limits are exceeded. Net purchases by a passive market maker
on each day are generally limited to a specified percentage of the passive
market making average daily trading volume in the Common Stock during a price
period and must be discontinued when such limit is reached. Passive market
making may stabilize the market price of the Common Stock at a level above
that which might otherwise prevail and, if commenced, may be discontinued at
any time.

LEGAL MATTERS

The validity of the Common Stock offered hereby will be passed upon for the
Company by Morrison & Foerster, Palo Alto, California. Certain legal matters
in connection with the offering will be passed upon for the Underwriters by
Gunderson Dettmer Stough Villeneuve Franklin & Hachigian, LLP, Palo Alto,
California.

EXPERTS

The consolidated financial statements of SDL, Inc. as of December 31, 1994
and 1995 and for the years ended December 31, 1993, 1994 and 1995, appearing
or incorporated by reference in this Prospectus and the Registration Statement
have been audited by Ernst & Young LLP, independent auditors, as set forth in
their report thereon appearing or incorporated by reference elsewhere herein
and in the Registration Statement, and are included in reliance upon such
report given upon the authority of such firm as experts in accounting and
auditing.

The financial statements of Seastar Optics Inc. as of March 31, 1994 and
1995 and for the years ended March 31, 1993, 1994 and 1995, incorporated by
reference in this Prospectus and the Registration Statement have been audited
by Ernst & Young, independent auditors, as set forth in their report thereon,
incorporated by reference elsewhere herein, and are included in reliance upon
such report given upon the authority of such firm as experts in accounting and
auditing.

51
<PAGE>

SDL, INC.
INDEX TO CONSOLIDATED FINANCIAL STATEMENTS

<TABLE>
<CAPTION>
PAGE
<S> <C>
Report of Ernst & Young LLP, Independent Auditors......................... F-3
Financial Statements:
Consolidated Balance Sheets at December 31, 1994 and 1995................. F-4
Consolidated Statements of Operations for the Years Ended December 31,
1993, 1994 and 1995...................................................... F-6
Consolidated Statements of Convertible Redeemable Preferred Stock and
Stockholders' Equity
(Net Capital Deficiency)................................................. F-7
Consolidated Statements of Cash Flows..................................... F-8
Notes to Consolidated Financial Statements................................ F-9
Index to Interim Consolidated Financial Statements........................ F-20
</TABLE>

F-1
<PAGE>

[THIS PAGE INTENTIONALLY LEFT BLANK]

F-2
<PAGE>

REPORT OF ERNST & YOUNG LLP, INDEPENDENT AUDITORS

The Board of Directors and Stockholders
SDL, Inc.

We have audited the accompanying consolidated balance sheets of SDL, Inc. as
of December 31, 1995 and 1994, and the related consolidated statements of
operations, convertible redeemable preferred stock and stockholders' equity
(net capital deficiency), and cash flows for each of the three years in the
period ended December 31, 1995. These financial statements are the
responsibility of the Company's management. Our responsibility is to express
an opinion on these financial statements based on our audits.

We conducted our audits in accordance with generally accepted auditing
standards. Those standards require that we plan and perform the audit to
obtain reasonable assurance about whether the financial statements are free of
material misstatement. An audit includes examining, on a test basis, evidence
supporting the amounts and disclosures in the financial statements. An audit
also includes assessing the accounting principles used and significant
estimates made by management, as well as evaluating the overall financial
statement presentation. We believe that our audits provide a reasonable basis
for our opinion.

In our opinion, the consolidated financial statements referred to above
present fairly, in all material respects, the financial position of SDL, Inc.
at December 31, 1995 and 1994, and the consolidated results of its operations
and its cash flows for each of the three years in the period ended December
31, 1995, in conformity with generally accepted accounting principles.

Ernst & Young LLP

San Jose, California
January 26, 1996, except for Note 12 as to which the date is June 12, 1996

F-3
<PAGE>

SDL, INC.
CONSOLIDATED BALANCE SHEETS

<TABLE>
<CAPTION>
AS OF DECEMBER 31,
-------------------
1995 1994
(IN THOUSANDS,
EXCEPT SHARE DATA)
<S> <C> <C>
ASSETS
Current assets:
Cash and cash equivalents............................... $ 2,793 $ 632
Short-term investments.................................. 8,515 --
Accounts receivable, net................................ 13,535 7,964
Inventories............................................. 9,006 3,466
Deferred income taxes................................... 989 1,098
Prepaid expenses and other current assets............... 502 397
------- -------
Total current assets...................................... 35,340 13,557
------- -------
Property and equipment, net............................... 16,470 9,746
Purchased intangibles, net................................ 2,766 --
Deferred income tax....................................... 1,840 358
Other assets.............................................. 227 138

------- -------
Total assets.............................................. $56,643 $23,799
======= =======
</TABLE>

See accompanying notes.

F-4
<PAGE>

SDL, INC.
BALANCE SHEETS

<TABLE>
<CAPTION>
AS OF DECEMBER 31,
---------------------
1995 1994
(IN THOUSANDS,
EXCEPT SHARE DATA)
<S> <C> <C>
LIABILITIES, CONVERTIBLE REDEEMABLE PREFERRED STOCK, AND
STOCKHOLDERS' EQUITY (NET CAPITAL DEFICIENCY)
Current liabilities:
Accounts payable...................................... $ 6,257 $ 2,931
Accrued payroll and related expenses.................. 1,990 1,290
Income taxes payable.................................. -- 571
Accrued warranty...................................... 442 369
Accrued interest...................................... -- 452
Unearned revenue...................................... 972 443
Acquisition obligations............................... 1,592 --
Other accrued liabilities............................. 1,438 292
Current portion of long-term debt..................... -- 1,653
------- -------
Total current liabilities............................... 12,691 8,001
------- -------
Long-term debt, less current portion.................... -- 22,519
Deferred acquisition obligations........................ 2,680 --
Other long-term liabilities............................. 772 1,003
Commitments and contingencies........................... -- --
Convertible redeemable preferred stock:
Series A, $0.001 par value:
Authorized shares--300,000; issued and outstanding
shares--none and 271,078 at December 31, 1995 and
1994, respectively................................. -- 10,888
Less preferred stockholders' notes receivable....... -- (343)
------- -------
-- 10,545
Stockholders' equity (net capital deficiency):
Preferred stock, $0.001 par value:
Authorized shares--1,000,000; none issued and
outstanding........................................ -- --
Common stock, $0.001 par value:
Authorized shares--21,000,000; issued and
outstanding shares--10,628,115 and 4,477,846 at
December 31, 1995 and 1994, respectively........... 11 4
Treasury stock........................................ (33) --
Additional paid-in capital............................ 63,034 1,482
Accumulated deficit, $26.3 million relating to the
repurchase of common stock in 1992 and $5.8 million
relating to a Recapitalization in 1992............... (22,028) (19,209)
Cumulative translation adjustment..................... (6) --
------- -------
40,978 (17,723)
------- -------
Less common stockholders' notes receivable............ (478) (546)
------- -------
Total stockholders' equity (net capital deficiency)..... 40,500 (18,269)
------- -------
Total liabilities, convertible redeemable preferred
stock, and stockholders' equity (net capital
deficiency)............................................ $56,643 $23,799
======= =======
</TABLE>

See accompanying notes.

F-5
<PAGE>

SDL, INC.
CONSOLIDATED STATEMENTS OF OPERATIONS

<TABLE>
<CAPTION>
YEARS ENDED DECEMBER 31,
---------------------------
1995 1994 1993
(IN THOUSANDS, EXCEPT PER
SHARE DATA)
<S> <C> <C> <C>
Revenue:
Product revenue.................................. $45,277 $ 27,597 $ 22,176
Research revenue................................. 8,617 5,427 5,526
-------- -------- --------
53,894 33,024 27,702
Cost of revenue:
Cost of product revenue.......................... 26,871 15,790 12,749
Cost of research revenue......................... 6,519 4,201 4,130
-------- -------- --------
Gross margin....................................... 20,504 13,033 10,823
Operating expenses:
Research and development......................... 3,994 2,781 3,047
Selling, general and administrative.............. 7,649 4,574 3,583
In-process research and development.............. 10,010 -- --
-------- -------- --------
Operating income (loss)............................ (1,149) 5,678 4,193
Interest (income) expense, net..................... (118) 2,079 2,356
-------- -------- --------
Income (loss) before income taxes.................. (1,031) 3,599 1,837
Provision for income taxes......................... 1,788 1,404 687
-------- -------- --------
Net income (loss).................................. $ (2,819) $ 2,195 $ 1,150
-------- -------- --------
Net income (loss) per share........................ $ (0.31) $ 0.29 $ 0.15
======== ======== ========
Shares used in computing net income (loss) per
share............................................. 9,228 7,548 7,509
======== ======== ========
Pro forma net loss, see Note 1..................... $ (2,573) -- --
======== ======== ========
Pro forma net loss per share....................... $ (0.26) -- --
======== ======== ========
Shares used in computing pro forma net loss per
share............................................. 9,968 -- --
======== ======== ========
</TABLE>

See accompanying notes.

F-6
<PAGE>

SDL, INC.
CONSOLIDATED STATEMENTS OF CONVERTIBLE REDEEMABLE PREFERRED STOCK AND
STOCKHOLDERS' EQUITY (NET CAPITAL DEFICIENCY)

<TABLE>
<CAPTION>
CONVERTIBLE REDEEMABLE PREFERRED STOCK STOCKHOLDERS' EQUITY (NET CAPITAL DEFICIENCY)
---------------------------------------- -------------------------------------------------
PREFERRED STOCK STOCKHOLDERS' COMMON STOCK ADDITIONAL
----------------- NOTES ----------------- TREASURY PAID-IN ACCUMULATED
SHARES AMOUNT RECEIVABLE TOTAL SHARES AMOUNT STOCK CAPITAL DEFICIT
(IN THOUSANDS, EXCEPT SHARE DATA)
<S> <C> <C> <C> <C> <C> <C> <C> <C> <C>
BALANCE AT
JANUARY 1, 1993.. 233,266 $10,140 $ (69) $10,071 4,441,820 $ 4 -- $ 1,488 $(22,554)
Issuance of
stock pursuant
to employee
stock option
plans........... 6,746 50 (40) 10 6,018 -- -- 2 --
Compensation on
stock options... -- 388 -- 388 -- -- -- -- --
Redemption
expenses........ -- -- -- -- -- -- -- (8) --
Repayments on
stockholders'
notes
receivable...... -- -- 1 1 -- -- -- -- --
Net income...... -- -- -- -- -- -- -- -- 1,150
-------- ------- ----- ------- --------- --- ---- ------- --------
BALANCE AT
DECEMBER 31,
1993............. 240,012 10,578 (108) 10,470 4,447,838 4 -- 1,482 (21,404)
Issuance of
stock pursuant
to employee
stock option
plans........... 31,066 310 (271) 39 32,610 -- -- 11 --
Compensation on
stock options... -- -- -- -- -- -- -- 1 --
Payments on
stockholders'
notes
receivable...... -- -- 36 36 -- -- -- -- --
Repurchase of
common stock.... -- -- -- -- (2,601) -- -- (12) --
Net income...... -- -- -- -- -- -- -- -- 2,195
-------- ------- ----- ------- --------- --- ---- ------- --------
BALANCE AT
DECEMBER 31,
1994............. 271,078 10,888 (343) 10,545 4,477,847 4 -- 1,482 (19,209)
Issuance of
stock pursuant
to employee
stock option
plans........... 550 8 (5) 3 566,793 1 -- 795 --
Conversion of
preferred stock
to common stock. (271,628) (10,896) 346 (10,550) 1,385,302 2 -- 10,894 --
Proceeds from
issuance of
common stock
(less offering
expenses of
$1,441)......... -- -- -- -- 4,200,000 4 -- 47,378 --
Repurchase of
common stock.... -- -- -- -- (1,827) -- (33) -- --
Payments on
stockholders'
notes
receivable...... -- -- 2 2 -- -- -- -- --
Income tax
benefit from
exercise of
employee stock
options......... -- -- -- -- -- -- -- 2,485 --
Net loss........ -- -- -- -- -- -- -- -- (2,819)
Translation
adjustment...... -- -- -- -- -- -- -- -- --
-------- ------- ----- ------- --------- --- ---- ------- --------
BALANCE AT
DECEMBER 31,
1995............. -- $ -- $ -- $ -- 10,628,115 $11 $(33) $63,034 $(22,028)
======== ======= ===== ======= ========= === ==== ======= ========
<CAPTION>
STOCKHOLDERS' EQUITY (NET CAPITAL DEFICIENCY)
-------------------------------------------------

TOTAL
STOCKHOLDERS'
CUMULATIVE STOCKHOLDERS' EQUITY (NET
TRANSLATION NOTES CAPITAL
ADJUSTMENT RECEIVABLE DEFICIENCY)

BALANCE AT -- $(546) $(21,608)
JANUARY 1, 1993..
Issuance of
stock pursuant
to employee
stock option -- -- 2
plans...........
Compensation on -- -- --
stock options...
Redemption -- -- (8)
expenses........
Repayments on
stockholders'
notes -- -- --
receivable...... -- -- 1,150
Net income...... --- ----- --------

BALANCE AT
DECEMBER 31, -- (546) (20,464)
1993.............
Issuance of
stock pursuant
to employee
stock option -- -- 11
plans...........
Compensation on -- -- 1
stock options...
Payments on
stockholders'
notes -- -- --
receivable......
Repurchase of -- -- (12)
common stock.... -- -- 2,195
Net income...... --- ----- --------

BALANCE AT
DECEMBER 31, -- (546) (18,269)
1994.............
Issuance of
stock pursuant
to employee
stock option -- (54) 742
plans...........
Conversion of
preferred stock -- (346) 10,550
to common stock.
Proceeds from
issuance of
common stock
(less offering
expenses of -- -- 47,382
$1,441).........
Repurchase of -- -- (33)
common stock....
Payments on
stockholders'
notes -- 468 468
receivable......
Income tax
benefit from
exercise of
employee stock -- -- 2,485
options......... -- -- (2,819)
Net loss........
Translation (6) -- (6)
adjustment...... --- ----- --------

BALANCE AT
DECEMBER 31, $(6) $(478) $ 40,500
1995............. === ===== ========

</TABLE>

See accompanying notes.

F-7
<PAGE>

SDL, INC.
CONSOLIDATED STATEMENTS OF CASH FLOWS

<TABLE>
<CAPTION>
YEARS ENDED DECEMBER 31,
--------------------------
1995 1994 1993
(IN THOUSANDS)
<S> <C> <C> <C>
OPERATING ACTIVITIES:
Net income (loss)................................. $ (2,819) $ 2,195 $ 1,150
Adjustments to reconcile net income (loss) to net
cash provided by operating activities:
Depreciation and amortization.................... 2,840 2,365 2,247
In-process research and development.............. 10,010 -- --
Deferred income taxes............................ (1,373) (112) (357)
Deferred rent.................................... (84) (55) (82)
Compensation on stock options.................... -- 1 388
Accrued interest on subordinated notes........... (452) 1,421 2,050
Changes in operating assets and liabilities:
Accounts receivable............................ (4,245) (2,194) 250
Inventories.................................... (3,610) (199) (691)
Accounts payable............................... 2,672 1,001 60
Income taxes payable........................... 1,914 (69) 585
Accrued payroll and related expenses........... 620 729 10
Accrued warranty............................... -- (21) (30)
Unearned revenue............................... 529 138 (250)
Other accrued liabilities...................... 999 391 51
Other.......................................... (123) (164) 92
-------- ------- -------
Total adjustments................................. 9,697 3,232 4,323
-------- ------- -------
Net cash provided by operating activities......... 6,878 5,427 5,473
INVESTING ACTIVITIES:
Acquisition of property and equipment, net........ (8,518) (3,617) (2,185)
Purchase of short-term investments................ (50,815) -- --
Sale of short-term investments.................... 42,300 -- --
Acquisition of Seastar Optics..................... (12,076) -- --
-------- ------- -------
Net cash used in investing activities............. (29,109) (3,617) (2,185)
FINANCING ACTIVITIES:
Proceeds from issuance of long-term debt.......... -- 2,784 --
Payments of long-term debt........................ (2,592) (4,402) (3,495)
Payments of subordinated debt..................... (21,580) -- --
Proceeds from issuance of common stock............ 47,382 -- --
Repurchase of common stock........................ (33) (12) (8)
Issuance of stock pursuant to employee stock
plans............................................ 745 50 12
Payments on stockholders' notes receivable........ 470 36 1
-------- ------- -------
Net cash provided by (used in) financing activi-
ties............................................. 24,392 (1,544) (3,490)
-------- ------- -------
Net increase (decrease) in cash and cash equiva-
lents............................................ 2,161 266 (202)
Cash and cash equivalents at beginning of period.. 632 366 568
-------- ------- -------
Cash and cash equivalents at end of period........ $ 2,793 $ 632 $ 366
======== ======= =======
SUPPLEMENTAL DISCLOSURES OF CASH FLOW INFORMATION
Cash paid for income taxes........................ $ 1,362 $ 1,614 $ 621
Cash received from income taxes refunded.......... $ -- $ 14 $ 160
Cash paid for interest............................ $ 927 $ 709 $ 363
SUPPLEMENTAL DISCLOSURES OF NON-CASH ACTIVITIES
Conversion of convertible redeemable preferred
stock to common stock............................ $ 10,896 $ -- $ --
Stock issued for stockholders' notes receivable... $ 59 $ 271 $ 40
Subordinated notes converted to senior notes...... $ -- $ -- $ 4,000
</TABLE>

See accompanying notes.

F-8
<PAGE>

SDL, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

NOTE 1. ORGANIZATION AND SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES

Organization. The Company designs, manufactures and markets semiconductor
optoelectronic integrated circuits (OEICs), high-power semiconductor lasers
and related products. The Company's revenue is derived from: (i) the sale of
standard and customized products to a diverse worldwide customer base
utilizing various market applications and, (ii) customer-funded research
programs principally through various government agencies.

SDL, Inc. (the Company), previously Spectra Diode Laboratories, Inc., was
incorporated on March 28, 1983. On April 3, 1993, the Company reincorporated
in the state of Delaware and changed its name to SDL, Inc. The reincorporation
has been retroactively reflected in the financial statements and notes.

Basis of Presentation. The Company's fiscal year ends on December 31. The
Company utilizes a four-four-five quarterly cycle; as a result, a fiscal
quarter may not end on the same day as the calendar quarter. For convenience
of presentation, the accompanying financial statements of the Company have
been shown as ending on the last day of the calendar quarter.

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 expense during the
reporting period. Actual results could differ from those estimates.

Cash and Cash Equivalents. The Company considers all highly liquid
investments with original maturities of three months or less when purchased to
be cash equivalents.

Short-term Investments. Effective January 1, 1995, the Company adopted
Statement of Financial Accounting Standards (SFAS) No. 115, "Accounting for
Certain Investments in Debt and Equity Securities." In accordance with the
Statement, prior period financial statements have not been restated to reflect
the change in accounting principle. The cumulative effect as of January 1,
1995 of the adoption of SFAS No. 115 did not have a material effect on the
Company's financial condition or results of operations.

The Company has classified its entire investment portfolio as available-for-
sale. Available-for-sale securities are stated at fair market value. The
amortized cost of debt securities is adjusted for amortization of premiums and
accretion of discounts to maturity. Such amortization is included in interest
income. Realized gains and losses are included in other (income) expense. The
cost of securities sold is based on the specific identification method.

Inventories. Inventories are stated at the lower of cost (first-in, first-
out basis) or market. The market value is based upon estimated net realizable
value.

Equipment and Leasehold Improvements. Property and equipment are stated at
cost. Equipment and fixtures are depreciated using the straight-line method
over estimated useful lives ranging from two to eight years. Leasehold
improvements are amortized using the straight-line method over the shorter of
the estimated useful lives or the remaining lease terms.

In 1995, the Financial Accounting Standards Board released the Statement of
Financial Accounting Standards No. 121 (SFAS 121), "Accounting for the
Impairment of Long-Lived Assets and for Long-Lived Assets to be Disposed of."
SFAS 121 requires recognition of impairment of long-lived assets in the event
the net book value of such assets exceeds the future undiscounted cash flows
attributable to such assets. SFAS 121 is effective for fiscal years beginning
after December 15, 1995. Adoption of SFAS 121 is not expected to have a
material impact on the Company's financial position or results of operations.

F-9
<PAGE>

SDL, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(CONTINUED)

Revenue Recognition. Revenue recognition is based on the terms of the
underlying sales agreements (purchase orders or contracts). Revenue for
product sales is recognized upon shipment. Revenue for costs incurred plus
specified fee contracts is recognized on the percentage-of-completion method.
Revenue for fixed price milestone contracts is recognized upon the completion
of the milestone. Customers entering into long-term contracts with the Company
include the U.S. government, prime or subcontractors for which the U.S.
government may be the end customer, and other domestic and international end-
users.

CONCENTRATIONS

Customer--The Company received approximately 19 percent of its 1995 revenue
from Lockheed Martin through several government and commercial programs.
Almost all of the Company's revenue from this customer during 1995 and 1996 is
expected to be derived from Federally-funded programs. Most of the Company's
Federally-funded programs are subject to renewal every one or two years and to
termination for convenience of the government agency. The loss of the
Company's contracts with Lockheed Martin, or other major customers, could have
an adverse effect on the Company's results of operations. No customers
accounted for more than 10 percent of net revenue during the years ended
December 31, 1994 and 1993. Individual customers include commercial companies
and government agencies.

Dependence Upon Government Programs and Contracts--In 1995, 1994 and 1993,
the Company derived approximately 45 percent, 36 percent and 40 percent
respectively, of its revenue directly and indirectly from a variety of Federal
government sources. The demand for certain of the Company's services and
products is directly related to the level of funding of government programs.
The Company believes that the success and further development of its business
is dependent, in significant part, upon the continued existence and funding of
such programs and upon the Company's ability to participate in such programs.
For example, substantially all of the Company's research revenue for 1995,
1994 and 1993 was funded by Federal programs. There can be no assurance that
such programs will continue to be funded even if government agencies have
available financial resources or that the Company will continue to be awarded
contracts under such programs.

Approximately 5% of the Company's 1995 revenue was received through certain
Federal government programs which required that participants meet specific
eligibility requirements. During 1996, the Company expects that its growth
will result in the Company exceeding the maximum number of employees allowed
under these eligibility requirements and that the Company will no longer be
able to compete for future research contract awards under these government
programs. Loss of eligibility under these programs does not disqualify the
Company from contracts awarded prior to the loss of eligibility. Loss of
eligibility under these programs could materially decrease the Company's
future revenue and could require increased internally funded research and
development spending.

Dependence on Single Source and Other Third Party Suppliers--The Company
depends on a single or limited number of outside contractors and suppliers for
raw materials, packages and standard components, and to assemble printed
circuit boards. The Company generally purchases these single or limited source
products through standard purchase orders or one year supply agreements and
has no long-term guaranteed supply agreements with such suppliers. While the
Company seeks to maintain a sufficient safety stock of such products and also
endeavors to maintain ongoing communications with its suppliers to guard
against interruptions or cessation of supply, the Company's business and
results of operations have in the past been and could in the future be
adversely affected by a stoppage or delay of supply, substitution of more
expensive or less reliable products, receipt of defective parts or
contaminated materials, an increase in the price of such supplies or the
Company's inability to obtain reduced pricing from its suppliers in response
to competitive pressures.

Credit Risk--The Company performs ongoing credit evaluations of its
customers' financial condition and generally requires no collateral from its
customers. The Company maintains reserves for potential credit losses.

F-10
<PAGE>

SDL, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(CONTINUED)
Although such losses have been within management's expectations to date, there
can be no assurance that such reserves will continue to be adequate.

Principal Business and Export Sales. The Company's operations are conducted
in one principal line of business, the development, manufacture, and sale of
semiconductor optoelectronic integrated circuits, semiconductor lasers and
related products.

All sales to international customers constitute export sales and are
denominated in U.S. dollars. Export sales to Europe totaled approximately $4.3
million, $4.2 million and $4.2 million for the years ended December 31, 1995,
1994 and 1993, respectively. Export sales to the Pacific Rim and Canada
totaled approximately $7.9 million, $4.2 million and $2.2 million for the
years ended December 31, 1995, 1994 and 1993, respectively.

Net Income (Loss) Per Share. Except as noted below, net income per share is
computed using the weighted average number of shares of common stock
outstanding and dilutive common equivalent shares from convertible redeemable
preferred stock (using the as-if-converted method) and from stock options
(using the modified treasury stock method). Pursuant to the Securities and
Exchange Commission regulations, options granted by the Company at prices
below the actual offering price during the twelve month period prior to the
initial public offering have been included in the calculation of common and
common equivalent shares as if they were outstanding for all periods presented
(using the treasury stock method and the initial public offering price).

Net loss per share for the year ended December 31, 1995 is computed using
the weighted average number of shares of common stock outstanding.

Unaudited Pro Forma Net Loss Per Share. Pro forma net loss per share,
computed as described above for net loss per share, includes adjustments
giving effect to the reduction of interest expense, net of income tax effect,
attributable to the repayment of outstanding indebtedness as of January 1,
1995 with a portion of the proceeds from the issuance of stock as described in
Note 8.

Foreign Currency Translation. The functional currency of the Company's
foreign subsidiary is the U.S. dollar. Subsidiary financial statements are
remeasured into U.S. dollars for consolidation. Foreign currency transaction
gains and losses are included in other (income) expense and were immaterial
for all periods presented.

Accounting for Stock-Based Compensation. The Company accounts for its stock
option plans and the Employee Stock Purchase Plan in accordance with
provisions of the Accounting Principles Board's Opinion No. 25 (APB 25),
"Accounting for Stock Issued to Employees." In 1995, the Financial Accounting
Standards Board released the Statement of Financial Accounting Standard No.
123 (SFAS 123), "Accounting for Stock-Based Compensation." SFAS 123 provides
an alternative to APB 25 and is effective for fiscal years beginning after
December 15, 1995. The Company expects to continue to account for its employee
stock plans in accordance with the provisions of APB 25. Accordingly, SFAS 123
is not expected to have any material impact on the Company's financial
position or results of operations.

Change in Method of Accounting for Income Taxes. Effective January 1, 1993,
the Company adopted Statement of Financial Accounting Standards No. 109 (FAS
109), "Accounting for Income Taxes." Under FAS 109, the liability method is
used in accounting for income taxes. Prior to the adoption of FAS 109, income
tax expense was determined using the deferred method. As permitted by FAS 109,
the Company has elected not to restate the financial statements of any prior
years. The effect of the change on income taxes for the year ended December
31, 1993 and the cumulative effect of the change were not material.

NOTE 2. ACQUISITION OF SEASTAR OPTICS INC.

On November 30, 1995, the Company acquired certain assets and assumed
certain liabilities of Seastar Optics Inc. (Seastar), a British Columbia
corporation and a wholly-owned subsidiary of The Axys Group Ltd.

F-11
<PAGE>

SDL, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(CONTINUED)
The assets acquired consisted of accounts receivable, inventory, equipment,
research and development in process, patents and other intellectual property
rights, and all other tangible and intangible assets used by Seastar in the
operation of its business. The transaction has been accounted for under the
purchase method of accounting. The results of operations for Seastar for the
month of December 1995 are included in the Company's consolidated statement of
operations for the year ended December 31, 1995.

The purchase price consisted of (i) cash in the amount of $12.1 million paid
at closing, (ii) a letter of credit in the face amount of $1.5 million placed
into escrow at the closing, (iii) $1.1 million, as adjusted, payable upon
completion of an audit of the assets transferred, (iv) $1.2 million payable in
cash or stock of the Company (at the Company's option) on March 31, 1997 and
(v) the value of assumed liabilities. Acquisition and other costs totaled $0.5
million. All amounts are stated in U.S. dollars.

The allocation of the purchase price, based upon an independent valuation,
is as follows (in thousands):

<TABLE>
<S> <C>
Net tangible assets acquired...................................... $ 3,520
In-process research and development............................... $10,010
Purchased technology, assembled workforce and customer base....... $ 1,910
Goodwill.......................................................... $ 910
</TABLE>

Goodwill and other purchased intangibles are being amortized using the
straight-line method over three to seven years.

Unaudited pro forma combined results of operations, assuming the transaction
took place on January 1, 1995 and January 1, 1994 for the years ended December
31, 1995 and December 31, 1994, respectively, are as follows:

<TABLE>
<CAPTION>
YEARS ENDED DECEMBER 31,
-------------------------
1995 1994
(IN THOUSANDS, EXCEPT PER
SHARE DATA)
<S> <C> <C>
Revenue.......................................... $ 60,325 $ 38,741
Operating income................................. $ 7,616 $ 4,909
Net income....................................... $ 4,833 $ 1,062
Net income per share............................. $ 0.53 $ 0.14
</TABLE>

The one-time write-off of in-process research and development is excluded
from the pro forma combined results of operations as it represents a
nonrecurring item. The pro forma combined results of operations for the year
ended December 31, 1994 combine the historical results of operations for the
Company for the fiscal year ended December 31, 1994 with the historical
results of operations for Seastar for the fiscal year ended March 31, 1995.
Accordingly, Seastar results of operations for the three month period ended
March 31, 1995, including revenues of $3.0 million and net income of $0.4
million are included in the pro forma combined results of operations for both
of the years ended December 31, 1995 and 1994.

The carrying amount of net assets at December 31, 1995 is $0.8 million.

NOTE 3. SHORT-TERM INVESTMENTS

Short-term investments consist of the following (in thousands):

<TABLE>
<CAPTION>
AS OF DECEMBER 31,
-------------------
1995 1994
<S> <C> <C>
Tax-exempt auction rate preferred stock............... $ 7,000 $ --
Municipal bonds....................................... 1,515 --
---------- --------
$ 8,515 $ --
========== ========
</TABLE>

F-12
<PAGE>

SDL, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(CONTINUED)

Municipal bonds mature within one to eight months.

Both realized and unrealized gains and losses on the sale of available-for-
sale securities were immaterial for the year ended December 31, 1995.

NOTE 4. BALANCE SHEET COMPONENTS

Accounts receivable consist of the following (in thousands):

<TABLE>
<CAPTION>
AS OF DECEMBER 31,
--------------------
1995 1994
<S> <C> <C>
Trade receivables..................................... $ 9,872 $ 6,669
Receivables under long-term contracts:
Billed.............................................. 2,632 640
Unbilled costs and estimated earnings............... 1,516 863
--------- --------
14,020 8,172
Allowances.......................................... (485) (208)
--------- --------
$ 13,535 $ 7,964
========= ========
</TABLE>

Receivables under long-term contracts include advance billings of
approximately $0.5 million, $0.1 million and $0.1 million at December 31,
1995, 1994 and 1993, respectively.

Inventories consist of the following (in thousands):

<TABLE>
<CAPTION>
AS OF DECEMBER 31,
-------------------
1995 1994
<S> <C> <C>
Raw materials.......................................... $ 4,151 $ 1,548
Work-in-process........................................ 4,855 1,918
--------- ---------
$ 9,006 $ 3,466
========= =========
</TABLE>

No significant amounts of finished goods or work-in-process related to long-
term contracts are maintained.

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

<TABLE>
<CAPTION>
AS OF DECEMBER 31,
-------------------
1995 1994
<S> <C> <C>
Machinery and equipment............................... $ 20,807 $ 15,876
Leasehold improvements................................ 5,209 2,619
Furniture and fixtures................................ 646 313
Construction-in-progress.............................. 3,310 1,763
--------- ---------
29,972 20,571
Less accumulated depreciation and amortization........ 13,502 10,825
--------- ---------
$ 16,470 $ 9,746
========= =========
</TABLE>

Purchased intangibles consist of the following (in thousands):

<TABLE>
<CAPTION>
AS OF DECEMBER 31,
------------------
1995 1994
<S> <C> <C>
Goodwill............................................... $ 910 $ --
Other purchased intangibles............................ 1,910 --
--------- --------
2,820 --
Less accumulated amortization.......................... 54 --
--------- --------
$ 2,766 $ --
========= ========
</TABLE>

F-13
<PAGE>

SDL, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(CONTINUED)
NOTE 5. COSTS AND ESTIMATED EARNINGS ON LONG-TERM CONTRACTS

The following is a summary of research and product contract activity related
to uncompleted long-term contracts from the inception of the contracts (in
thousands):

<TABLE>
<CAPTION>
AS OF DECEMBER 31,
-------------------
1995 1994
<S> <C> <C>
Costs incurred on uncompleted long-term contracts..... $ 41,460 $ 31,012
Estimated earnings.................................... 2,533 2,139
--------- ---------
Revenue recognized on uncompleted long-term contracts. 43,993 33,151
Less billings to date................................. 42,477 32,288
--------- ---------
Unbilled costs and estimated earnings................. $ 1,516 $ 863
========= =========
</TABLE>

The above balances are included in accounts receivable in the accompanying
balance sheets as described in Note 2. Unbilled costs and estimated earnings
on uncompleted long-term contracts are generally billable in the subsequent
year.

Approximately $19.7 million, $7.7 million and $9.7 million of revenue
recognized on long-term contracts is included in total revenues for the years
ended December 31, 1995, 1994 and 1993, respectively.

Pursuant to the retainage provisions in certain long-term contracts, a
specified portion of billed receivables do not become due and payable until
completion of a final audit by the Defense Contract Audit Agency. Such
retainage amounts are included in other assets in the accompanying balance
sheets.

NOTE 6. LONG-TERM DEBT

Long-term debt consists of the following (in thousands):

<TABLE>
<CAPTION>
AS OF DECEMBER 31,
-------------------
1995 1994
<S> <C> <C>
Subordinated notes:
Principal balance................................... $ -- $ 17,724
Deferred interest added to principal balance........ -- 3,856
-------- ----------
-- 21,580
Notes payable to bank:
Revolving line of credit............................ -- 1,086
Term loan........................................... -- 1,506
-------- ----------
-- 24,172
Less current portion.................................. -- 1,653
-------- ----------
$ -- $ 22,519
======== ==========
</TABLE>

The subordinated notes were payable to seven stockholders and bore interest
at 8 percent per annum. These notes were secured by all of the assets of the
Company but were subordinated to the notes payable to a bank and restricted
the payment of dividends. These notes were repaid in conjunction with the
Company's initial public stock offering in March 1995.

F-14
<PAGE>

SDL, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(CONTINUED)

The term loan was payable in thirty-six equal monthly installments of
principal, plus interest at the bank's prime rate plus .25 percent per annum
(8.75 percent at December 31, 1994) through July 1, 1997, and was repaid in
conjunction with the Company's initial public stock offering in March 1995.

The Company has a credit agreement with a bank, which provides for a
revolving line of credit of $8.0 million, with an expiration date of January
1997.

Borrowings under the revolving line of credit bear interest at the bank's
prime rate per annum (8.5 percent at December 31, 1995), and the line of
credit requires a commitment fee of .125 percent per annum on the committed
line of credit. The weighted average interest rate was 9.75 percent and 8.73
percent for the years ended December 31, 1995 and 1994, respectively. At
December 31, 1995, the Company was contingently liable for an outstanding
letter of credit in the amount of $1.5 million relating to the acquisition of
Seastar, secured by the revolving line of credit. At December 31, 1995,
approximately $6.5 million of the revolving line of credit remains available
for future borrowings.

Outstanding borrowings under the credit agreement are secured by all of the
Company's assets. The credit agreement contains affirmative and negative
covenants and will, among other things, require the Company to maintain
minimum levels of working capital, tangible net worth and cash flow, limit net
losses in specified periods, limit the Company's ability to incur additional
debt, pay cash dividends or to purchase or sell certain assets; and restricts
certain acquisitions, mergers, consolidations or similar transactions. At
December 31, 1995, the Company was in default of the financial covenant
requirement for annual profitability as a result of the one-time write-off of
in-process research and development in connection with the acquisition of
Seastar. Subsequent to December 31, 1995, the covenant violation was waived by
the bank.

The Company incurred interest expense of $0.5 million, $2.2 million and $2.5
million for the years ended December 31, 1995, 1994 and 1993, respectively.

NOTE 7. INCOME TAXES

The provision for income taxes consists of the following (in thousands):

<TABLE>
<CAPTION>
YEARS ENDED DECEMBER 31,
-----------------------------
1995 1994 1993
<S> <C> <C> <C>
Current:
Federal.................................... $ 2,853 $ 1,185 $ 781
State...................................... 308 331 211
--------- -------- -------
3,161 1,516 992
Deferred:
Federal.................................... (1,180) (111) (241)
State...................................... (193) (1) (64)
--------- -------- -------
(1,373) (112) (305)
--------- -------- -------
$ 1,788 $ 1,404 $ 687
========= ======== =======
</TABLE>

The tax benefits resulting from the exercise of nonqualified stock options
and the disqualifying disposition of shares acquired under the Company's stock
option and employee stock purchase plans reduced taxes currently payable as
shown above by $2.5 million in 1995. Such benefits were credited to additional
paid-in capital.

F-15
<PAGE>

SDL, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(CONTINUED)

The difference between the provision for income taxes and the amount
computed by applying the Federal statutory income tax rate (35%) to income
before taxes is explained below (in thousands):

<TABLE>
<CAPTION>
YEARS ENDED DECEMBER 31,
---------------------------
1995 1994 1993
<S> <C> <C> <C>
Tax at Federal statutory rate.................. $ (361) $ 1,260 $ 643
State income tax, net of Federal tax benefit... (192) 215 96
Change in valuation allowance.................. 2,402 -- --
Tax-exempt interest income..................... (148) -- --
Benefit of foreign sales corporation........... (8) (63) (52)
Other.......................................... 95 (8) --
-------- -------- ------
Provision for income taxes..................... $ 1,788 $ 1,404 $ 687
======== ======== ======
</TABLE>

Significant components of the Company's deferred tax assets and liabilities
are as follows (in thousands):

<TABLE>
<CAPTION>
DECEMBER 31,
---------------
1995 1994
<S> <C> <C>
Deferred tax assets:
Reserves and other accrued expenses, not yet deductible
for tax............................................... $ 1,095 $ 620
Stock option compensation.............................. -- 978
Inventory valuation accounts........................... 692 301
Intangible assets...................................... 3,984 --
Other.................................................. 171 106
------- ------
Total deferred tax assets.............................. 5,942 2,005
------- ------
Valuation allowance.................................... (2,402) --
------- ------
Net deferred tax asset................................. 3,540 2,005
Deferred tax liabilities:
Depreciation........................................... (616) (517)
Other.................................................. (95) (32)
------- ------
Total deferred tax liabilities......................... (711) (549)
------- ------
Net deferred tax assets.................................. $ 2,829 $1,456
======= ======
</TABLE>

A valuation allowance has been established in 1995 to offset a portion of
the deferred tax asset attributable to the write-off of purchased research and
development. Due to the extended period over which this tax benefit may be
recognized, sufficient uncertainty exists regarding the realizability of a
portion of these assets and, accordingly, a valuation allowance has been
established.

NOTE 8. CONVERTIBLE REDEEMABLE PREFERRED STOCK AND STOCKHOLDERS' EQUITY (NET
CAPITAL DEFICIENCY)

Convertible Redeemable Preferred Stock. Each share of convertible redeemable
preferred stock (Preferred Stock) has the respective rights, preferences,
privileges, and restrictions set forth below:

Preferred stockholders are entitled to noncumulative dividends, when and if
declared by the Board of Directors, payable quarterly, at the amount per share
computed based on the greater of either $2.00 per share per annum or an amount
equal to that paid on any other outstanding share of the Company's stock on an
as if converted basis.

F-16
<PAGE>

SDL, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(CONTINUED)
The preferred stockholders are entitled to receive, prior and in preference
to any distribution of the Company's assets to the holders of common stock, an
amount equal to the sum of $32.35 for each outstanding share of preferred
stock plus any declared but unpaid dividends on such shares. After all
preferred stockholders receive their liquidation preference, the common
stockholders are entitled to $0.51 per share. In the event that the Company's
funds are insufficient to permit such payment to all holders of a specific
class of stock, a ratable distribution of the available funds among the
stockholders in such group shall occur. If after all such distributions
Company assets remain, such assets are to be distributed ratably to preferred
and common stockholders based on the number of shares of common stock held by
each, assuming conversion of all preferred stock.

Each preferred stockholder shall have the right to one vote for each share
of common stock to which such preferred stock could then be converted. Such
holder has full voting rights and powers equal to the voting rights and powers
of the common stockholders. Concurrent with the Company's initial public
offering, each outstanding share of convertible redeemable preferred stock was
converted into 3.4 shares of common stock.

Common Stock Offerings. On March 15, 1995, the Company issued 3,600,000
shares of common stock in conjunction with its initial public offering at a
per share price of $10.67. Net proceeds to the Company amounted to
approximately $34.8 million. Of the net proceeds, approximately $21.6 million
and $2.4 million were used to repay the entire principal amount outstanding
under the Company's subordinated notes due 1997, and the Company's bank line
of credit and term loan, respectively. Concurrent with the offering, a 5.1-
for-1 split of the Company's common stock was authorized and each outstanding
share of convertible redeemable preferred stock converted into 5.1 shares of
common stock.

On August 1, 1995, the Company issued 600,000 shares of common stock in a
follow-on public stock offering at a per share price of $23.00 resulting in
net proceeds to the Company of approximately $12.6 million.

1984 Incentive Stock Option Plan. The 1984 Option Plan provided for the
granting of options to purchase up to 448,380 shares of the Company's
preferred stock (convertible into 1,659,492 shares of Common Stock) to
officers and key employees of the Company at exercise prices of not less than
fair value on the date of grant as determined by a committee of the Board of
Directors. Options granted are immediately exercisable; however, unexercised
options and shares purchased upon the exercise of the options are subject to
vesting over a four-year period. Shares that are not vested at the date of
termination of employment may be repurchased by the Company at the original
exercise price. Concurrent with the Company's common stock offering, all
outstanding options under the 1984 Option Plan were converted into options to
purchase 5.1 shares of common stock. No further options will be granted under
the 1984 Option Plan.

The Company recognized compensation expense of approximately $0.4 million
for the year ended December 31, 1993 relating to the conversion of the
outstanding common stock options to preferred stock options at the original
option price in connection with a recapitalization and the extension of
certain expired stock options. The compensation expense recognized represents
the difference between the fair value and the existing exercise price of each
option share. These expenses were amortized over the remaining vesting period.

1992 Stock Option Plan. The 1992 Stock Option Plan provides for the granting
of incentive stock options and nonqualified options to purchase up to
4,558,125 shares of the Company's common stock to officers and key employees
at exercise prices of not less than fair value on the date of grant as
determined by a committee of the Board of Directors. Options granted are
immediately exercisable; however, unexercised options and shares purchased
upon the exercise of the options are subject to vesting over a one- to five-
year period. Shares that are not vested at the date of termination of
employment may be repurchased by the Company at the original exercise price.
No further options will be granted under the 1992 Stock Option Plan.

F-17
<PAGE>

SDL, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(CONTINUED)

1995 Stock Option Plan. The Company's 1995 Stock Option Plan was approved by
the Board of Directors in January 1995 and by the stockholders in February
1995. The purposes of the 1995 Option Plan are to give the Company's employees
and others who perform substantial services to the Company incentive, through
ownership of the Company's common stock, to continue in service to the
Company, and to help the Company compete effectively with other enterprises
for the services of qualified individuals. The 1995 Stock Option Plan permits
the grant of incentive stock options to employees, including officers and
Directors who are employees, and the award of nonqualified stock options to
the Company's employees, officers, Directors, independent contractors, and
consultants. Options granted under the 1995 Stock Option Plan are subject to
vesting over a one- to five-year period and must generally be exercised by the
optionee during the period of employment or service with the Company or within
a specified period following termination of employment or service.

Information with respect to all stock options is summarized as follows:

<TABLE>
<CAPTION>
OUTSTANDING OPTIONS
-----------------------------------
AVAILABLE NUMBER PRICE
FOR GRANT OF SHARES PER SHARE
<S> <C> <C> <C>
Balance at January 1, 1993............ 423,672 2,864,946 $0.34--$ 4.90
Options granted..................... (98,302) 98,302 $1.47--$ 3.53
Options canceled.................... 45,012 (45,012) $0.34--$ 4.90
Options exercised................... -- (40,421) $0.34--$ 4.90
Option authorization canceled....... (1,866) --
-------- ---------
Balance at December 31, 1993.......... 368,516 2,877,815 $0.34--$ 4.90
Options granted..................... (159,722) 159,722 $3.53--$ 5.10
Options canceled.................... 54,413 (54,413) $0.34--$ 3.53
Options exercised................... -- (191,046) $0.34--$ 1.96
-------- ---------
Balance at December 31, 1994.......... 263,207 2,792,078 $0.34--$ 4.90
Shares authorized................... 712,500 --
Options granted..................... (663,339) 663,339 $6.08--$23.00
Options canceled.................... 73,539 (73,539) $0.34--$19.50
Options exercised................... -- (521,015) $0.34--$ 5.10
Option authorization canceled....... (255,557) --
-------- ---------
Balance at December 31, 1995.......... 130,350 2,860,863 $0.34--$23.00
======== =========
</TABLE>

Options to purchase 1,729,619, 1,765,392 and 1,415,465 shares were vested at
December 31, 1995, 1994 and 1993, respectively.

The Company has reserved 2,916,213 shares of common stock for future
issuance under its Stock Option Plans as of December 31, 1995. On January 1,
1996, an additional 531,375 shares became available for grant in accordance
with provisions within the 1995 Stock Option Plan.

Employee Stock Purchase Plan. To provide employees with an opportunity to
purchase common stock of the Company through payroll deductions, the Company
established the 1995 Employee Stock Purchase Plan (the 1995 ESPP) and
initially reserved 450,000 shares of common stock for issuance to
participants. Under this plan, the Company's employees, subject to certain
restrictions, may purchase shares of common stock at the lesser of 85 percent
of the fair market value at either the beginning of each two-year offering
period or the end of each six-month purchase period within the two year
offering period. As of December 31, 1995, 48,584 shares have been issued under
the 1995 ESPP and 401,416 shares were reserved for future issuance.

F-18
<PAGE>

SDL, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(CONTINUED)

Stockholders' Notes Receivable. Certain exercises of preferred and common
stock options occurred in conjunction with the issuance of full-recourse
stockholders' notes receivable. The notes issued for preferred stock bear
interest between 5 percent and 9 percent per annum with annual interest
payments. The principal on the notes is due five years after issuance between
1996 and 2000. The notes issued for common stock bear interest between 6
percent and 8 percent with interest and principal due between 1997 and 2000.

NOTE 9. COMMITMENTS

The Company leases all of its facilities and certain equipment under
operating leases. The operating facilities leases contain renewal options. The
future minimum rental payments as of December 31, 1995 under operating leases
are as follows (in thousands):

<TABLE>
<S> <C>
1996.............................................................. $1,281
1997.............................................................. $ 652
1998.............................................................. $ 595
1999.............................................................. $ 507
2000 and thereafter............................................... $1,194
</TABLE>

Rental expense was approximately $1.0 million, $0.7 million and $0.6 million
for the years ended December 31, 1995, 1994 and 1993, respectively.

NOTE 10. CONTINGENCIES

In 1985, Rockwell International Corporation (Rockwell) asserted, and in 1995
filed suit against the Company alleging that a Company fabrication process
infringed certain Rockwell patent rights. Rockwell is seeking to permanently
enjoin the Company from infringing Rockwell's alleged patent rights and is
seeking unspecified actual and treble damages plus costs. The Company has
answered Rockwell's complaint asserting that Rockwell's patent is invalid, not
infringed, unenforceable and barred by laches and estoppel. In addition, the
Federal government, which is a defendant in a suit brought by Rockwell
relating to certain of the same alleged patent rights, asserted that the
Company will be liable to indemnify the Federal government for certain of
Rockwell's claims. The Company has intervened in Rockwell's suit against the
Federal government.

In 1995, Spectra-Physics, Inc. (Spectra) and others filed suit against the
Company alleging that the Company was refusing to comply with its alleged
obligations to transfer and license Company technology to them. These parties
are seeking declaratory relief, specific performance and unspecified actual
and punitive damages. The Company has answered these claims denying them and
has cross-complained against Spectra and certain others seeking declaratory
relief, damages and injunctive relief.

The Company is vigorously contesting these claims. Although the outcome of
these matters cannot be determined at this time, management does not believe
that their outcome will have a material adverse effect on the Company's
financial position, results of operations and cash flows and has made no
provisions for the ultimate outcome of these matters in its financial
statements. However, based on future developments, the Company's estimate of
the outcome of these matters could change in the near term.

NOTE 11. EMPLOYEE BENEFIT PLAN

In 1990, the Company established the SDL, Inc. Profit Sharing and Saving
Plus Plan (the Plan) that covers substantially all full-time employees and is
qualified under Sections 401(a) and 401(k) of the Internal Revenue Code.
Participants may defer up to 10 percent of their pre-tax earnings (up to the
Internal Revenue Service limit) as well as up to 5 percent of their after-tax
earnings. The Company matches 50 percent of employee contributions up to a
maximum of 5 percent of the participants' pre-tax earnings. The participants'
as well as the Company's matching contributions are fully vested. Company
contributions to the Plan were approximately $0.3 million, $0.2 million and
$0.2 million for the years ended December 31, 1995, 1994 and 1993,
respectively.

NOTE 12. SUBSEQUENT EVENT

In May 1996, the Board of Directors authorized a three-for-two split of its
Common Stock, effected in the form of a 50% stock dividend, which was paid on
June 12, 1996 to stockholders of record on May 15, 1996. All share and per
share data in these financial statements have been retroactively adjusted to
reflect the Stock Split.

F-19
<PAGE>

SDL, INC.
INDEX TO INTERIM CONSOLIDATED FINANCIAL STATEMENTS

<TABLE>
<CAPTION>
PAGE
----
<S> <C>
Condensed Consolidated Balance Sheets at March 31, 1996 (unaudited) and
December 31, 1995........................................................ F-21
Condensed Consolidated Statements of Income for the Three Months Ended
March 31, 1996 and 1995 (unaudited)...................................... F-22
Condensed Consolidated Statements of Cash Flows for the Three Months Ended
March 31, 1996 and 1995 (unaudited)...................................... F-23
Notes to Condensed Consolidated Financial Statements (unaudited).......... F-24
</TABLE>

F-20
<PAGE>

SDL, INC.
CONDENSED CONSOLIDATED BALANCE SHEETS

<TABLE>
<CAPTION>
MARCH 31, DECEMBER 31,
1996 1995
(UNAUDITED) (1)
(IN THOUSANDS--EXCEPT
SHARE DATA)
<S> <C> <C>
ASSETS
Current assets:
Cash and cash equivalents........................... $ 2,426 $ 2,793
Short-term investments.............................. 9,015 8,515
Accounts receivable, net............................ 12,294 13,535
Inventories......................................... 10,552 9,006
Deferred income taxes............................... 1,129 989
Prepaid expenses and other current assets........... 1,125 502
-------- --------
Total current assets.............................. 36,541 35,340
Property and equipment, net........................... 17,588 16,470
Purchased intangibles, net............................ 2,605 2,766
Deferred income taxes................................. 1,840 1,840
Other assets.......................................... 247 227
-------- --------
$ 58,821 $ 56,643
======== ========
LIABILITIES AND STOCKHOLDERS' EQUITY
Current liabilities:
Accounts payable.................................... $ 5,121 $ 6,257
Accrued payroll and related expenses................ 2,398 1,990
Accrued warranty.................................... 432 442
Unearned revenue.................................... 935 972
Acquisition obligations............................. 102 1,592
Other accrued liabilities........................... 1,604 1,438
-------- --------
Total current liabilities......................... 10,592 12,691
Deferred acquisition obligations...................... 2,680 2,680
Other long-term liabilities........................... 752 772
Stockholders' equity:
Common stock, $0.001 par value, 21,000,000 shares
authorized; 10,907,661 outstanding (10,628,115 at
December 31, 1995)................................. 11 11
Treasury stock...................................... (33) (33)
Additional paid-in-capital.......................... 65,082 63,034
Accumulated deficit ($32,084 relating to the
repurchase of common stock and recapitalization in
1992).............................................. (19,869) (22,028)
Cumulative translation adjustment................... (7) (6)
-------- --------
45,184 40,978
Less: common stockholders' notes receivable......... (387) (478)
-------- --------
Total stockholders' equity............................ 44,797 40,500
-------- --------
$ 58,821 $ 56,643
======== ========
</TABLE>

- ---------------------
(1) The balance sheet at December 31, 1995 has been derived from the audited
financial statements at that date.

See accompanying notes.

F-21
<PAGE>

SDL, INC.
CONDENSED CONSOLIDATED STATEMENTS OF INCOME

<TABLE>
<CAPTION>
THREE MONTHS ENDED
MARCH 31,
--------------------------
1996 1995
(IN THOUSANDS, EXCEPT PER
SHARE DATA--UNAUDITED)
<S> <C> <C>
Total revenue:
Product revenue................................... $ 17,348 $ 8,652
Research revenue.................................. 3,074 1,860
------------ ------------
20,422 10,512
Cost of revenue:
Cost of product revenue........................... 10,505 5,097
Cost of research revenue.......................... 2,242 1,410
------------ ------------
Gross margin........................................ 7,675 4,005
Operating expenses:
Research and development.......................... 1,687 724
Selling, general and administrative............... 2,650 1,421
Amortization of purchased intangibles............. 161 --
------------ ------------
Operating income.................................... 3,177 1,860
Interest (income) expense, net...................... (145) 424
------------ ------------
Income before income taxes.......................... 3,322 1,436
Provision for income taxes.......................... 1,163 531
------------ ------------
Net income.......................................... $ 2,159 $ 905
============ ============
Net income per share................................ $ 0.18 $ 0.11
============ ============
Shares used in computing net income per share....... 12,074 8,063
============ ============
</TABLE>

See accompanying notes.

F-22
<PAGE>

SDL, INC.
CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS

<TABLE>
<CAPTION>
THREE MONTHS ENDED
MARCH 31,
-------------------
1996 1995
(IN THOUSANDS--
UNAUDITED)
<S> <C> <C>
OPERATING ACTIVITIES:
Net income............................................... $ 2,159 $ 905
Adjustments to reconcile net income to net cash provided
by operating activities:
Depreciation and amortization.......................... 1,100 618
Deferred income taxes.................................. (140) 136
Accrued interest....................................... -- (452)
Deferred rent.......................................... (20) --
Changes in operating assets and liabilities:
Accounts receivable.................................. 1,241 (757)
Inventories.......................................... (1,546) (402)
Accounts payable..................................... (1,136) 1,203
Income taxes payable................................. 1,588 126
Accrued payroll and related expenses................. 408 212
Accrued warranty..................................... (10) --
Unearned revenue..................................... (37) 641
Other accrued liabilities............................ 166 193
Other................................................ (332) (160)
-------- ---------
Total adjustments........................................ 1,282 1,358
-------- ---------
Net cash provided by operating activities................ 3,441 2,263
INVESTING ACTIVITIES
Acquisition of property and equipment, net............... (2,057) (1,350)
Payments of acquisition obligations...................... (1,490) --
Purchase of short-term investments, net.................. (500) (10,300)
-------- ---------
Net cash used in investing activities.................... (4,047) (11,650)
FINANCING ACTIVITIES
Payments of bank debt.................................... -- (2,592)
Payments of subordinated debt............................ -- (21,580)
Proceeds from issuance of common stock................... -- 34,776
Purchase of treasury stock............................... -- (22)
Issuance of stock pursuant to employee stock plans....... 148 33
Payments on stockholders' notes receivable............... 91 2
-------- ---------
Net cash provided by financing activities................ 239 10,617
-------- ---------
Net increase (decrease) in cash and cash equivalents..... (367) 1,230
Cash and cash equivalents at beginning of period......... 2,793 632
-------- ---------
Cash and cash equivalents at end of period............... $ 2,426 $ 1,862
======== =========
Supplemental disclosures of cash flow information
Cash paid (received) for income taxes.................... $ (400) $ 265
Cash paid for interest................................... $ -- $ 894
SUPPLEMENTAL DISCLOSURES OF NONCASH ACTIVITIES
Conversion of convertible redeemable preferred stock to
common stock............................................ $ -- $ 10,888
Stock issued for stockholders' notes receivable.......... $ -- $ 34
</TABLE>

See accompanying notes.

F-23
<PAGE>

SDL, INC.
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED)
MARCH 31, 1996

1. BASIS OF PRESENTATION

The accompanying unaudited condensed consolidated financial statements have
been prepared in accordance with generally accepted accounting principles for
interim financial information and with the instructions to Form 10-Q and
Article 10 of Regulation S-X. Accordingly, they do not include all of the
information and footnotes required by generally accepted accounting principles
for complete financial statements. In the opinion of management, all
adjustments (consisting only of normal recurring accruals) considered
necessary for a fair presentation have been included. Operating results for
the three-month period ended March 31, 1996 are not necessarily indicative of
the results that may be expected for the year ended December 31, 1996. For
further information, refer to the consolidated financial statements and
footnotes thereto included in the Registrant Company's annual report on Form
10-K for the year ended December 31, 1995.

The consolidated financial statements include the accounts of SDL, Inc. and
its wholly owned subsidiary SDL Optics. Intercompany accounts and transactions
have been eliminated in consolidation.

The functional currency of the Company's foreign subsidiary is the U.S.
dollar. Subsidiary financial statements are remeasured into U.S. dollars for
consolidation. Foreign currency transaction gains and losses are included in
other (income) expense and were immaterial for all periods presented.

2. NET INCOME PER SHARE

Net income per share is computed using the weighted average number of shares
of common stock outstanding and dilutive common equivalent shares from stock
options (using the treasury stock method).

3. SHORT-TERM INVESTMENTS

Available for sale short-term investments consist of the following (in
thousands):

<TABLE>
<CAPTION>
MARCH 31, DECEMBER 31,
1996 1995
<S> <C> <C>
Tax-exempt auction rate preferred stocks............ $7,500 $7,000
Municipal bonds..................................... 1,515 1,515
------ ------
$9,015 $8,515
====== ======
</TABLE>

Tax-exempt auction rate preferred stock contains contractual maturities of
less than one year.

Municipal bonds mature within one to eight months.

Both realized and unrealized gains and losses on the sale of available-for-
sale securities were immaterial for the quarter ended March 31, 1996.

4. INVENTORIES

The components of inventories consist of the following (in thousands):

<TABLE>
<CAPTION>
MARCH 31, DECEMBER 31,
1996 1995
<S> <C> <C>
Raw materials....................................... $ 4,403 $4,151
Work in process..................................... 6,149 4,855
------- ------
$10,552 $9,006
======= ======
</TABLE>

No significant amounts of finished goods are maintained.

F-24
<PAGE>

SDL, INC.
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED)--(CONTINUED)

5. COSTS AND ESTIMATED EARNINGS ON LONG-TERM CONTRACTS

The following is a summary of research and product contract activity related
to uncompleted long-term contracts from the inception of the contracts (in
thousands):

<TABLE>
<CAPTION>
MARCH 31, DECEMBER 31,
1996 1995
<S> <C> <C>
Costs incurred on uncompleted long-term contracts.. $48,885 $41,460
Estimated earnings................................. 3,207 2,533
------- -------
Revenue recognized on uncompleted long-term
contracts......................................... 52,092 43,993
Less billings to date.............................. 50,917 42,477
------- -------
Unbilled costs and estimated earnings.............. $ 1,175 $ 1,516
======= =======
</TABLE>

The above balances are included in accounts receivable in the accompanying
balance sheets. Unbilled costs and estimated earnings on uncompleted long-term
contracts are generally billable in the subsequent year.

Approximately $5.8 million and $4.0 million of revenue recognized on long-
term contracts is included in total revenue for the three month periods ended
March 31, 1996 and 1995, respectively.

6. CONTINGENCIES

In 1985, Rockwell International Corporation (Rockwell) asserted, and in 1995
filed suit against the Company alleging that a Company fabrication process
infringed certain Rockwell patent rights. Rockwell is seeking to permanently
enjoin the Company from infringing Rockwell's alleged patent rights and is
seeking unspecified actual and treble damages plus costs. The Company has
answered Rockwell's complaint asserting that Rockwell's patent is invalid, not
infringed, unenforceable and barred by laches and estoppel. In addition the
Federal government, which is a defendant in a suit brought by Rockwell
relating to certain of the same alleged patent rights, asserted that the
Company may be liable to indemnify the Federal government for certain of
Rockwell's claims. The Company has intervened in Rockwell's suit against the
Federal government.

The Company is vigorously contesting these claims. Although the outcome of
these matters cannot be determined at this time, management believes that it
has meritorious defenses to such claims and is defending against them
vigorously.

F-25
<PAGE>

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

NO DEALER, SALESPERSON OR OTHER PERSON HAS BEEN AUTHORIZED TO GIVE ANY IN-
FORMATION OR TO MAKE ANY REPRESENTATIONS NOT CONTAINED IN THIS PROSPECTUS IN
CONNECTION WITH THE OFFERING COVERED BY THIS PROSPECTUS. IF GIVEN OR MADE,
SUCH INFORMATION OR REPRESENTATIONS MUST NOT BE RELIED UPON AS HAVING BEEN AU-
THORIZED BY THE COMPANY, ANY SELLING STOCKHOLDER OR ANY UNDERWRITER. THIS PRO-
SPECTUS DOES NOT CONSTITUTE AN OFFER TO SELL, OR A SOLICITATION OF AN OFFER TO
BUY, COMMON STOCK IN ANY JURISDICTION TO ANY PERSON TO WHOM IT IS UNLAWFUL TO
MAKE SUCH AN OFFER OR SOLICITATION IN SUCH JURISDICTION. NEITHER THE DELIVERY
OF THIS PROSPECTUS NOR ANY SALE MADE HEREUNDER SHALL, UNDER ANY CIRCUMSTANCES,
CREATE ANY IMPLICATION THAT THE INFORMATION CONTAINED HEREIN IS CORRECT AS OF
ANY TIME SUBSEQUENT TO THE DATE HEREOF OR THAT THERE HAS BEEN NO CHANGE IN THE
AFFAIRS OF THE COMPANY SINCE THE DATE HEREOF.

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

TABLE OF CONTENTS

<TABLE>
<CAPTION>
PAGE
<S> <C>
Available Information..................................................... 2
Additional Information.................................................... 2
Incorporation of Certain Documents by Reference........................... 2
Prospectus Summary........................................................ 4
Risk Factors.............................................................. 6
Recent Development........................................................ 14
Use of Proceeds........................................................... 15
Price Range of Common Stock............................................... 15
Capitalization............................................................ 16
Selected Consolidated Financial Data...................................... 17
Management's Discussion and Analysis of Financial Condition and Results of
Operations............................................................... 18
Business.................................................................. 27
Management................................................................ 44
Principal and Selling Stockholders........................................ 47
Description of Capital Stock.............................................. 48
Underwriting.............................................................. 50
Legal Matters............................................................. 51
Experts................................................................... 51
Index to Consolidated Financial Statements................................ F-1
</TABLE>

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

1,700,000 SHARES

[LOGO OF SDL APPEARS HERE]

COMMON STOCK

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

PROSPECTUS

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

DONALDSON, LUFKIN & JENRETTE
SECURITIES CORPORATION
COWEN & COMPANY

JUNE , 1996

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

PART II

INFORMATION NOT REQUIRED IN PROSPECTUS

ITEM 14. OTHER EXPENSES OF ISSUANCE AND DISTRIBUTION

The expenses to be paid by the Registrant in connection with the
distribution of the securities being registered, other than underwriting
discounts and commissions, are as follows:

<TABLE>
<CAPTION>
AMOUNT*
--------
<S> <C>
Securities and Exchange Commission Filing Fee................... $ 17,997
NASD Filing Fee................................................. 5,719
Nasdaq National Market Listing Fee.............................. 17,500
Accounting Fees and Expenses.................................... 100,000
Blue Sky Fees and Expenses...................................... 10,000
Legal Fees and Expenses......................................... 150,000
Custodian, Transfer Agent and Registrar Fees and Expenses....... 10,000
Printing Expenses............................................... 70,000
Miscellaneous Expenses.......................................... 118,784
--------
Total....................................................... $500,000
========
</TABLE>
- --------
* All amounts are estimates except the SEC filing fee, the NASD filing fee
and the Nasdaq National Market listing fee.

ITEM 15. INDEMNIFICATION OF DIRECTORS AND OFFICERS

Under Section 145 of the General Corporation Law of the State of Delaware,
the Registrant has broad powers to indemnify its directors and officers
against liabilities they may incur in such capacities, including liabilities
under the Securities Act of 1933, as amended (the Securities Act). The
Registrant's Bylaws also provide for mandatory indemnification of its
directors and executive officers, and permissive indemnification of its
employees and agents, to the fullest extent permissible under Delaware law.

The Registrant's Certificate of Incorporation provides that the liability of
its directors for monetary damages shall be eliminated to the fullest extent
permissible under Delaware law. Pursuant to Delaware law, this includes
elimination of liability for monetary damages for breach of the directors'
fiduciary duty of care to the Registrant and its stockholders. These
provisions do not eliminate the directors' duty of care and, in appropriate
circumstances, equitable remedies such as injunctive or other forms of non-
monetary relief will remain available under Delaware law. In addition, each
director will continue to be subject to liability for breach of the director's
duty of loyalty to the Registrant, for acts or omissions not in good faith or
involving intentional misconduct, for knowing violations of law, for any
transaction from which the director derived an improper personal benefit, and
for payment of dividends or approval of stock repurchases or redemptions that
are unlawful under Delaware law. The provision also does not affect a
director's responsibilities under any other laws, such as the federal
securities laws or state or federal environmental laws.

The Registrant has entered into agreements with its directors and certain of
its executive officers that require the Registrant to indemnify such persons
against expenses, judgments, fines, settlements and other amounts actually and
reasonably incurred (including expenses of a derivative action) in connection
with any proceeding, whether actual or threatened, to which any such person
may be made a party by reason of the fact that such person is or was a
director or officer of the Registrant or any of its affiliated enterprises,
provided such person acted in good faith and in a manner such person
reasonably believed to be in or not opposed to the best interests of the
Registrant and, with respect to any criminal proceeding, had no reasonable
cause to believe his or her conduct was unlawful. The indemnification
agreements also set forth certain procedures that will apply in the event of a
claim for indemnification thereunder.

II-1
<PAGE>

The Registrant has obtained a policy of directors' and officers' liability
insurance that insures the Company's directors and officers against the cost
of defense, settlement or payment of a judgment under certain circumstances.

The Underwriting Agreement filed as Exhibit 1.1 to this Registration
Statement provides for indemnification by the Underwriters of the Registrant
and its officers and directors for certain liabilities arising under the
Securities Act or otherwise.

ITEM 16. EXHIBITS AND FINANCIAL STATEMENT SCHEDULES

(a) EXHIBITS

The exhibits are as set forth in the Exhibit Index.

(b) FINANCIAL STATEMENT SCHEDULES

Schedule II--Valuation and Qualifying Accounts

Schedules other than those listed above have been omitted since they are not
required or are not applicable or the required information is shown in the
financial statements or related notes. Columns omitted from schedules filed
have been omitted since the information is not applicable.

ITEM 17. UNDERTAKINGS

Insofar as indemnification for liabilities arising under the Securities Act
may be permitted to directors, officers and controlling persons of the
Registrant pursuant to the foregoing provisions, or otherwise, the Registrant
has been advised that in the opinion of the Securities and Exchange Commission
such indemnification is against public policy as expressed in the Act and is,
therefore, unenforceable. In the event that a claim for indemnification
against such liabilities (other than the payment by the Registrant of expenses
incurred or paid by a director, officer or controlling person of the
Registrant in the successful defense of any action, suit or proceeding) is
asserted by such director, officer or controlling person in connection with
the securities being registered, the Registrant will, unless in the opinion of
its counsel the matter has been settled by controlling precedent, submit to a
court of appropriate jurisdiction the question whether such indemnification by
it is against public policy as expressed in the Act and will be governed by
the final adjudication of such issue.

The Registrant hereby undertakes that:

(1) For purposes of determining any liability under the Securities Act of
1933, the information omitted from the form of prospectus filed as part of
this Registration Statement in reliance upon Rule 430A and contained in a
form of prospectus filed by the Registrant pursuant to Rule 424(b)(1) or
(4) or 497(h) under the Securities Act shall be deemed to be part of this
Registration Statement as of the time it was declared effective.

(2) For the purpose of determining any liability under the Securities Act
of 1933, each post-effective amendment that contains a form of prospectus
shall be deemed to be a new registration statement relating to the
securities offered therein, and the offering of such securities at that
time shall be deemed to be the initial bona fide offering thereof.

(3) The undersigned registrant hereby undertakes that, for purposes of
determining any liability under the Securities Act of 1933, each filing of
the registrant's annual report pursuant to Section 13(a) or 15(d) of the
Securities Exchange Act of 1934 (and, where applicable, each filing of an
employee benefit plan's annual report pursuant to Section 15(d) of the
Securities Exchange Act of 1934) that is incorporated by reference in the
registration statement shall be deemed to be a new registration statement
relating to the securities offered therein, and the offering of such
securities at that time shall be deemed to be the initial bona fide
offering thereof.

II-2
<PAGE>

SIGNATURES

PURSUANT TO THE REQUIREMENTS OF THE SECURITIES ACT OF 1933, THE REGISTRANT
BELIEVES THAT IT HAS REASONABLE GROUNDS TO BELIEVE THAT IT MEETS ALL THE
REQUIREMENTS FOR FILING A REGISTRATION STATEMENT ON FORM S-3 AND HAS DULY
CAUSED THIS AMENDMENT NO. 2 TO REGISTRATION STATEMENT TO BE SIGNED ON ITS
BEHALF BY THE UNDERSIGNED, THEREUNTO DULY AUTHORIZED, IN THE CITY OF SAN JOSE,
STATE OF CALIFORNIA ON THE 24TH DAY OF JUNE, 1996.

SDL, Inc.

By: /s/ Donald R. Scifres*
-----------------------------------
Donald R. Scifres
Chairman of the Board, Chief
Executive Officer and President

PURSUANT TO THE REQUIREMENTS OF THE SECURITIES ACT OF 1933, THIS AMENDMENT
TO REGISTRATION STATEMENT HAS BEEN SIGNED BY THE FOLLOWING PERSONS IN THE
CAPACITIES AND ON THE DATES INDICATED:

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

<S> <C> <C>
/s/ Donald R. Scifres* Chairman of the Board, Chief June 24, 1996
____________________________________ Executive Officer and
Donald R. Scifres President
(Principal Executive
Officer)

/s/ Gregory C. Lindholm Vice President, Finance and June 24, 1996
____________________________________ Chief Financial Officer
Gregory C. Lindholm (Principal Financial and
Accounting Officer)

/s/ John P. Melton* Director June 24, 1996
____________________________________
John P. Melton

/s/ Keith B. Geeslin* Director June 24, 1996
____________________________________
Keith B. Geeslin

/s/ Anthony B. Holbrook* Director June 24, 1996
____________________________________
Anthony B. Holbrook

/s/ Mark B. Myers* Director June 24, 1996
____________________________________
Mark B. Myers

/s/ Frederic N. Schwettmann* Director June 24, 1996
____________________________________
Frederic N. Schwettmann
</TABLE>

*By: /s/
Gregory C. Lindholm
- -------------------------------
Gregory C. Lindholm,
Attorney-in-fact

II-3
<PAGE>

EXHIBIT 23.2

CONSENT OF ERNST & YOUNG LLP, INDEPENDENT AUDITORS

We consent to the reference to our firm under the captions "Experts" and
"Selected Consolidated Financial Data" in Amendment No. 2 to the Registration
Statement (Form S-3 No. 333-3647) and related Prospectus of SDL, Inc. for the
registration of 1,955,000 shares of its common stock and to the inclusion
and/or incorporation by reference therein of our reports dated January 26,
1996 (except for Note 12 as to which the date is June 12, 1996) with respect
to the consolidated financial statements and schedule of SDL, Inc. included in
its Annual Report (Form 10-K) for the year ended December 31, 1995, filed with
the Securities and Exchange Commission.

ERNST & YOUNG LLP

San Jose, California

June 24, 1996

II-4
<PAGE>

EXHIBIT 23.3

CONSENT OF ERNST & YOUNG, INDEPENDENT AUDITORS

We consent to the reference to our firm under the caption "Experts" in
Amendment No. 2 to the Registration Statement (Form S-3 No. 333-3647) and
related Prospectus of SDL, Inc. for the registration of 1,955,000 shares of its
common stock and to the incorporation by reference therein of our report dated
January 26, 1996 with respect to the financial statements of Seastar Optics
Inc. included in the Form 8-K/A of SDL, Inc. filed on February 9, 1996 with the
Securities and Exchange Commission.

Victoria, Canada June 24, 1996 Ernst & Young

II-5
<PAGE>

EXHIBIT INDEX

<TABLE>
<CAPTION>
SEQUENTIALLY
EXHIBIT NUMBERED
NUMBER DOCUMENT PAGE
------- -------- ------------
<C> <S> <C>
1.1* Form of Underwriting Agreement.
4.1* Investor Rights Agreement, as amended between certain
investors and stockholders listed therein and the
Registrant, dated July 17, 1992 (incorporated by ref-
erence to the indicated exhibit to the Company's Reg-
istration Statement on Form S-1 (Registration No.
33-87752)).
5.1* Opinion of Morrison & Foerster.
23.1* Consent of Morrison & Foerster. Reference is made to
Exhibit 5.1.
23.2 Consent of Ernst & Young LLP, independent auditors.
Reference is made to Page II-4.
23.3 Consent of Ernst & Young, independent auditors. Ref-
erence is made to Page II-5.
24.1* Powers of Attorney.
</TABLE>
- ---------------------
* Previously filed.