COM21 INC, 10-Q, 1998-08-05

COM21 INC
10-Q, 1998-08-05
COMPUTER PROGRAMMING, DATA PROCESSING, ETC.

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UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
WASHINGTON, D.C. 20549

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

FORM 10-Q
------------------------

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

FOR THE QUARTERLY PERIOD ENDED JUNE 30, 1998

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

FOR THE TRANSITION PERIOD FROM
--------------- TO
--------------- .

COMMISSION FILE NUMBER: 000-2409

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COM21, INC.
(EXACT NAME OF REGISTRANT AS SPECIFIED IN ITS CHARTER)

<TABLE>
<S> <C>
DELAWARE 94-3201698
(STATE OR OTHER JURISDICTION OF (IRS EMPLOYER IDENTIFICATION NO.)
INCORPORATION OR ORGANIZATION)
</TABLE>

750 TASMAN DRIVE
MILPITAS, CALIFORNIA 95035
(408) 953-9100
(ADDRESS, INCLUDING ZIP CODE, AND TELEPHONE NUMBER, INCLUDING AREA CODE, OF THE
REGISTRANT'S PRINCIPAL EXECUTIVE OFFICES)

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

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

The number of outstanding shares of the registrant's Common Stock, $0.001
par value, was 18,524,205 as of June 30, 1998.

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COM21, INC.

INDEX

<TABLE>
<CAPTION>
PAGE
----
<S> <C>
PART I: FINANCIAL INFORMATION
Item 1. Financial Statements
Condensed Balance Sheets -- June 30, 1998 and
December 31, 1997......................................... 3
Condensed Statements of Operations -- Three and Six
Month periods ended June 30, 1998 and 1997.......... 4
Statements of Cash Flows -- Six Months Ended June
30, 1998 and 1997................................... 5
Notes to Financial Statements..................... 6
Item 2. Management's Discussion and Analysis of Financial
Condition and Results of Operations....................... 9

PART II: OTHER INFORMATION
Item 1. Legal Proceedings................................... 25
Item 2. Changes in Securities and Use of Proceeds........... 25
Item 3. Defaults Upon Senior Securities..................... 26
Item 4. Submission of Matters to a Vote of Security
Holders................................................... 26
Item 5. Other Information................................... 26
Item 6. Exhibits and Reports on Form 8-K.................... 26
Signatures.......................................... 27
Exhibit Index
</TABLE>

2
<PAGE> 3

This report contains certain forward-looking statements that involve risks
and uncertainties, including statements regarding the Company's strategy,
financial performance and revenue sources. The Company's actual results could
differ materially from the results anticipated in these forward-looking
statements as a result of certain factors set forth under "Management's
Discussion and Analysis of Financial Condition and Results of Operations--Risk
Factors" and elsewhere in this report.

PART I: FINANCIAL INFORMATION

ITEM 1. FINANCIAL STATEMENTS

COM21, INC.

CONDENSED BALANCE SHEETS
(IN THOUSANDS, EXCEPT SHARE AND PAR VALUE AMOUNTS)
(UNAUDITED)

ASSETS

<TABLE>
<CAPTION>
JUNE 30, DECEMBER 31,
1998 1997
-------- ------------
<S> <C> <C>
Current assets:
Cash and cash equivalents................................. $ 68,383 $ 17,950
Accounts receivable (net of allowance of $440 and $121 at
June 1998 and December 1997, respectively)............. 5,724 5,036
Inventories............................................... 2,889 2,643
Prepaid expenses and other................................ 1,022 430
-------- --------
Total current assets.............................. 78,018 26,059
Investments................................................. 5,030 --
Property and equipment, net................................. 5,160 5,311
Other assets................................................ 202 203
-------- --------
Total assets...................................... $ 88,410 $ 31,573
======== ========
LIABILITIES AND STOCKHOLDERS' EQUITY
Current liabilities:
Accounts payable.......................................... $ 4,292 $ 2,832
Accrued compensation and related benefits................. 948 871
Deferred revenue.......................................... 1,141 1,004
Other current liabilities................................. 1,409 619
Current portion of capital lease and debt obligations..... 1,305 1,210
-------- --------
Total current liabilities......................... 9,095 6,536
Deferred rent............................................... 270 246
Non-current portion of capital lease obligations............ 1,196 1,320
Debt obligations............................................ 103 188
-------- --------
Total liabilities................................. 10,664 8,290
-------- --------
Stockholders' equity:
Convertible preferred stock:
Series A-G; $0.001 par value; 5,000,000 shares and
22,000,000 shares authorized at June 30, 1998 and
December 31, 1997, respectively; none and 9,957,604
issued and outstanding at June 30, 1998 and December
31, 1997, respectively................................ -- 10
Common stock, $0.001 par value, 40,000,000 shares and
35,000,000 shares authorized at June 30, 1998 and
December 31, 1997, respectively; 18,524,205 and
2,772,139 issued and outstanding at June 30, 1998 and
December 31, 1997, respectively....................... 19 3
Additional paid-in capital............................. 121,593 58,722
Deferred stock compensation............................ (99) (116)
Accumulated deficit.................................... (43,767) (35,336)
-------- --------
Total stockholders' equity........................ 77,746 23,283
-------- --------
Total liabilities and stockholders' equity........ $ 88,410 $ 31,573
======== ========
</TABLE>

See notes to financial statements.
3
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COM21, INC.

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

<TABLE>
<CAPTION>
THREE MONTHS ENDED SIX MONTHS ENDED
JUNE 30, JUNE 30,
------------------ ------------------
1998 1997 1998 1997
------- ------- ------- -------
<S> <C> <C> <C> <C>
Revenues:
Product revenues.................................. $ 8,711 $ 2,878 $15,731 $ 2,878
License fees -- related party..................... -- -- -- 500
------- ------- ------- -------
Total revenues...................................... 8,711 2,878 15,731 3,378
Cost of product revenues............................ 5,778 1,520 10,454 1,520
------- ------- ------- -------
Gross profit........................................ 2,933 1,358 5,277 1,858
------- ------- ------- -------

Operating expenses:
Research and development.......................... 4,392 3,041 8,670 6,169
Sales and marketing............................... 2,304 1,145 4,107 2,015
General and administrative........................ 815 405 1,395 772
------- ------- ------- -------
Total operating expenses.................. 7,511 4,591 14,172 8,956

Loss from operations................................ (4,578) (3,233) (8,895) (7,098)
Total other income (expense)........................ 379 (18) 473 19
------- ------- ------- -------
Loss before income taxes............................ (4,199) (3,251) (8,422) (7,079)
Provision for income taxes.......................... -- 12 9 12
------- ------- ------- -------
Net loss............................................ $(4,199) $(3,263) $(8,431) $(7,091)
======= ======= ======= =======
Net loss per share, basic and diluted............... $ (0.28) $ (0.36) $ (0.61) $ (0.79)
======= ======= ======= =======
Shares used in computation, basic and diluted....... 14,989 8,963 13,722 8,936
======= ======= ======= =======
</TABLE>

See notes to financial statements.
4
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COM21, INC.

STATEMENTS OF CASH FLOWS
(IN THOUSANDS)
(UNAUDITED)

<TABLE>
<CAPTION>
SIX MONTHS ENDED
JUNE 30,
------------------
1998 1997
------- -------
<S> <C> <C>
CASH USED IN OPERATING ACTIVITIES:
Net loss.................................................. $(8,431) $(7,091)
Adjustments to reconcile net loss to net cash used in
operating activities:
Depreciation and amortization.......................... 1,623 843
Deferred rent.......................................... 24 115
Changes in operating assets and liabilities:
Accounts receivable.................................. (688) (1,458)
Inventories.......................................... (246) (1,862)
Prepaid expenses and other........................... (377) (137)
Other assets......................................... 1 (14)
Accounts payable..................................... 1,460 709
Accrued compensation and related benefits............ 77 138
Deferred revenue..................................... 137 37
Other current liabilities............................ 790 91
------- -------
Net cash used in operating activities.................. (5,630) (8,629)
------- -------
CASH USED IN INVESTING ACTIVITIES:
Purchases of long term investments........................ (5,030) --
Purchases of property and equipment....................... (1,001) (563)
------- -------
(6,031) (563)
------- -------
CASH FLOWS FROM FINANCING ACTIVITIES:
Proceeds from issuance of common stock, net............... 62,877 110
Proceeds from issuance of debt obligations................ -- 2,100
Repayments under capital lease obligations................ (536) (349)
Repayments on debt obligations............................ (247) (63)
------- -------
Net cash provided by financing activities................... 62,094 1,798
------- -------

Net change in cash and cash equivalents..................... 50,433 (7,394)
Cash and cash equivalents at beginning of period............ 17,950 12,427
------- -------
Cash and cash equivalents at end of period.................. $68,383 $ 5,033
======= =======
NONCASH INVESTING AND FINANCING ACTIVITIES:
Property and equipment acquired under capital lease....... $ 454 $ 544
======= =======
Deferred stock compensation............................... $ - $ 40
======= =======
Assets acquired through lease financing................... $ 215 $ --
======= =======
SUPPLEMENTAL CASH FLOW INFORMATION:
Cash paid for income taxes................................ $ 9 $ 12
======= =======
Cash paid for interest.................................... $ 177 $ 161
======= =======
</TABLE>

See notes to financial statements.
5
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COM21, INC.

NOTES TO CONDENSED FINANCIAL STATEMENTS
JUNE 30, 1998
(UNAUDITED)

1. BUSINESS AND SIGNIFICANT ACCOUNTING POLICIES

Business -- Com21, Inc. (the "Company") was incorporated in Delaware in
June 1992. The Company designs, develops, markets and sells value-added,
high-speed communications solutions for the broadband access market. During
1997, the Company exited the development stage for financial reporting purposes
as it completed its initial product development activities and commenced
shipping product.

Unaudited Interim Financial Statements -- The accompanying unaudited
financial statements have been prepared by the Company pursuant to the rules and
regulations of the Securities and Exchange Commission. Certain information and
footnote disclosures normally included in financial statements prepared in
accordance with generally accepted accounting principles have been condensed or
omitted pursuant to such rules and regulations. In the opinion of management,
these unaudited consolidated financial statements include all adjustments
necessary for a fair presentation of the Company's financial position as of June
30, 1998, the results of operations for the three and six months ended June 30,
1998 and 1997 and cash flows for the six months ended June 30, 1998 and 1997.

The results of operations for the three and six months ended June 30, 1998
may not necessarily be indicative of the results to be expected for the fiscal
year ending December 31, 1998. These financial statements should be read in
conjunction with the consolidated financial statements and the accompanying
notes included in the Company's Registration Statement on Form S-1 (No.
333-48107), including the related prospectus dated May 21, 1998 as filed with
the SEC.

Net Loss Per Share -- In the fourth quarter of 1997, the Company adopted
the SFAS No. 128, "Earnings Per Share" which requires a dual presentation of
basic and diluted earnings per share ("EPS"). Basic EPS excludes dilution and is
computed by dividing net income attributable to common shareholders by the
weighted average of common shares outstanding for the period. In addition, all
outstanding shares of preferred stock that were converted to shares of common
stock in the initial public offering are included in the computation of
outstanding common shares even when the effect is anti-dilutive. Diluted EPS
reflects the potential dilution that could occur if securities or other
contracts to issue common stock (warrants to purchase convertible preferred
stock and common stock options using the treasury stock method) were exercised
or converted into common stock. Potential common shares in the diluted EPS
computation are excluded in net loss periods as their effect would be
antidilutive. EPS for all periods have been computed in accordance with SFAS No.
128.

Recently Adopted Accounting Standards -- In the first quarter of 1998, the
Company adopted SFAS No. 130, "Reporting Comprehensive Income" requiring an
enterprise to report, by major components and as a single total, the change in
net assets during the period from nonowner sources. For the periods presented,
net loss and comprehensive loss were the same.

2. INVESTMENTS

The Company invests certain of its excess cash in debt instruments of the
U.S. government and its agencies, and of high quality corporate issuers. All
highly liquid instruments with an original maturity of three months or less are
considered cash equivalents; those with original maturities greater than three
months are considered short-term investments and those with maturities greater
than twelve months from the balance sheet date are considered long-term
investments. The Company classifies investment securities in accordance with
SFAS No. 115, "Accounting for Certain Investments in Debt and Equity
Securities."

At June 30, 1998 the Company's investments were all classified as
available-for-sale and consisted primarily of obligations of the U.S. government
($30,421,000) and U.S. corporate securities ($33,737,000).

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COM21, INC.

NOTES TO CONDENSED FINANCIAL STATEMENTS (CONTINUED)
JUNE 30, 1998
(UNAUDITED)

As of June 30, 1998, $5,030,000 of the Company's investments are due between one
and five years. Unrealized gains and losses during the period were not material.

3. INVENTORIES

Inventories consist of:

<TABLE>
<CAPTION>
JUNE 30, DECEMBER 31,
1998 1997
-------- ------------
(IN THOUSANDS)
<S> <C> <C>
Raw materials and sub-assemblies....................... $ 546 $ 633
Work-in-process........................................ 1,098 980
Finished goods......................................... 1,245 1,030
------ ------
$2,889 $2,643
====== ======
</TABLE>

4. STOCKHOLDERS' EQUITY

In May, 1998, the Company completed its initial public stock offering and
issued 5,750,000 shares (including 750,000 shares issued in connection with the
exercise of the underwriters' allotment option) of its Common Stock to the
public at a price of $12.00 per share. The Company received net proceeds of
approximately $62.8 million in cash. As of the closing date of the offering, all
of the convertible preferred stock outstanding was converted into an aggregate
of 9,957,604 shares of common stock.

5. LITIGATION

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COM21, INC.

NOTES TO CONDENSED FINANCIAL STATEMENTS (CONTINUED)
JUNE 30, 1998
(UNAUDITED)

litigation matter are inherently uncertain. In the event of an adverse result in
the Hybrid litigation, or in any other litigation with third parties that could
arise in the future with respect to intellectual property rights relevant to the
Company's products, the Company could be required to pay substantial damages,
including treble damages if the Company is held to have willfully infringed, to
cease the manufacture, use and sale of infringing products, to expend
significant resources to develop non-infringing technology, or to obtain
licenses to the infringing technology. There can be no assurance that licenses
will be available from Hybrid, or any other third party that asserts
intellectual property claims against the Company, on commercially reasonable
terms, or at all. In addition, litigation frequently involves substantial
expenditures and can require significant management attention, even if the
Company ultimately prevails. Accordingly, there can be no assurance that the
Hybrid matter will not have a material adverse effect on the Company's business,
operating results and financial condition. Because of the early stage of this
litigation, and because Hybrid has sought unspecified damages, neither the
ultimate outcome of this litigation nor any costs and payments resulting from
the litigation or any settlement can presently be determined. Accordingly, no
provision for any loss which may result from the Hybrid litigation has been
recorded in the accompanying financial statements.

8
<PAGE> 9

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

Certain statements in this discussion and analysis, including statements
regarding the Company's strategy, financial performance and revenue sources, are
forward-looking statements based on current expectations and entail various
risks and uncertainties that could cause actual results to differ materially
from those expressed in such forward-looking statements. The Company's actual
results could differ materially from the results anticipated in these
forward-looking statements as a result of certain factors set forth under "Risk
Factors" and elsewhere in this report. Readers are urged to carefully review and
consider the various disclosures made by the Company in this report and in the
Company's other reports filed with the SEC, including the Company's Registration
Statement on Form S-1 (No. 333-48107) and the related prospectus dated May 21,
1998 as filed with the SEC, that attempt to advise interested parties of certain
risks and factors that may affect the Company's business. Readers are cautioned
not to place undue reliance on these forward-looking statements to reflect
events or circumstances occurring after the date hereof. The following
discussion should be read in conjunction with the Company's financial statements
and notes thereto.

OVERVIEW

Com21, Inc. (the "Company" or "Com21") designs, develops, markets and sells
value-added, high-speed communications solutions for the broadband access
market. The Company's ComUNITY Access system enables cable operators to provide
high-speed, cost-effective Internet access to corporate telecommuter, small
office/home office ("SOHO") and residential users in the U.S. and
internationally, and enables them to address the distinct price, performance,
security and other needs of these different end-user groups. Com21's products
include headend equipment, subscriber cable modems, network management software
and noise containment technologies.

The Company was incorporated in June 1992. From inception through April
1997, the Company's operating activities related primarily to establishing a
research and development organization, testing prototype designs, building
application-specific integrated circuit ("ASIC") design infrastructure,
commencing the staffing of marketing, sales and field service and technical
support organizations and establishing manufacturing relationships. Since the
Company's first customer shipment in April 1997, the Company has also focused on
commencing trials with cable operators, developing customer relationships,
marketing the Com21 brand, investing in field service and customer support,
continuing to develop new products and technologies and to enhance existing
products. Since inception, the Company has incurred significant losses and, as
of June 30, 1998, had an accumulated deficit of $43.8 million. See "Risk
Factors -- Limited Operating History; History of Losses; No Assurance of
Profitability."

The Company's revenues consist primarily of sales of headend equipment,
cable modems and, to a lesser extent, the licensing of network management
software. The Company recognizes revenue upon commercial shipment of its
products. As the cable operators that purchase the Company's products make
data-over-cable services broadly available to their customers, the Company
expects its product mix to shift more heavily toward sales of cable modems.
Pursuant to a Technology License and Reseller Agreement with 3Com (the "3Com
Agreement"), the Company received certain non-refundable technology fees in the
quarters ended June 30, 1996 and March 31, 1997. In addition, the terms of the
3Com Agreement provide that, until December 31, 1998, 3Com is obligated to pay a
per unit royalty fee on sales by 3Com of the first 100,000 cable modems
incorporating the Company's technology. 3Com prepaid $1.0 million of this
obligation in April 1996, and the Company recorded this payment as deferred
revenue. The Company will earn such revenues on the earlier of (i) the sale of
the Company's cable modems by 3Com or (ii) at the expiration of the royalty
period on December 31, 1998. Through June 30, 1998 an aggregate of approximately
$1.5 million has been recognized as technology licensing fees and royalties
pursuant to this agreement.

To date, gross margin on sales of headend and related equipment and
software licenses has been significantly higher than gross margin on sales of
cable modems. The Company expects to experience decreasing average selling
prices of its cable modems due to greater competition and price sensitivity of
cable

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modem sales particularly as interoperable MCNS/DOCSIS-compliant products become
widely available from multiple vendors.

Com21 tests and assembles the ComCONTROLLER headend equipment in the
Company's facility in Milpitas, California. Com21 outsources turnkey
manufacturing of the ComPORT cable modem to Celestica, a contract manufacturer
located in Toronto, Canada. The Company has taken, and continues to take, steps
to reduce the manufacturing costs of its cable modem products by consolidating
functionality and component parts into ASICs, making them easier to manufacture,
using parts the Company believes will be sold in high volume by a number of
vendors. The Company is also working with Celestica to facilitate more efficient
manufacturing of the Company's cable modems and to enable Com21 to benefit from
Celestica's volume purchasing capability. However, there can be no assurance
that such cost-reduction efforts will be successful. See "Risk Factors -- Need
to Reduce Cost of Modems" and "Risk Factors -- Limited Manufacturing Experience;
Dependence on Third Party Manufacturing."

Research and development expenses consist principally of salaries and
related personnel expenses, consultant fees and prototype expenses related to
the design, development, testing and enhancement of headend equipment, cable
modems and network management software. As of June 30, 1998, all research and
development costs had been expensed as incurred. The Company believes that
continued investment in research and development is critical to attaining its
strategic product and cost reduction objectives and, as a result, expects these
expenses to increase in absolute dollars in the future. Sales and marketing
expenses consist of salaries and related expenses for personnel engaged in
marketing, sales and field service support functions, as well as trade show and
promotional expenditures. The Company intends to pursue sales and marketing
campaigns aggressively and therefore expects these expenses to increase
significantly in absolute dollars in the future. In addition, the Company
expects that it may be required to devote resources to the development of a
retail or other end user sales channel, which would also result in an increase
in sales and marketing expenses. General and administrative expenses consist
primarily of salaries and related expenses for executive, accounting and
administrative personnel, recruiting expenses, professional fees and other
general corporate expenses. The Company expects general and administrative
expenses to increase in absolute dollars as the Company incurs legal costs
related to its defense of the Hybrid litigation, adds personnel and incurs
additional costs related to the growth of its business and operation as a public
company. One of the Company's challenges to future success is its ability to
attract and retain qualified personnel which is partly dependent on the
compensation package the Company can offer these personnel. An important
component of the compensation package offered by the Company is the grant of
stock options. See "Risk Factors -- Dependence on Key Personnel and Hiring of
Additional Personnel."

The Company relies on its systems, applications and devices in operating
and monitoring all major aspects of its business, including its financial
systems. The Company also relies, directly or indirectly, on the external
systems of business enterprises such as customers and suppliers. Despite the
Company's efforts to address the year 2000 impact on its internal systems, the
Company has not fully identified such impact or whether it can resolve such
impact without disruption of its business or without incurring significant
expense. Based on the information currently available, the Company believes that
the costs associated with the year 2000 issue, and the consequences of
incomplete or untimely resolution of the year 2000 issue, will not have a
material adverse effect on the Company's business, operating results and
financial condition in any given year. In addition, even if the internal systems
of the Company are not materially affected by the year 2000 issue, the Company's
business, operating results and financial condition could be materially
adversely affected through disruption in the operation of the enterprises with
which the Company interacts. See "Risk Factors -- Year 2000 Compliance."

The Company did not commence product shipments until April 1997, and, as a
result, has a limited operating history upon which investors may evaluate the
Company and its prospects. The Company has incurred net losses since its
inception and expects to continue to operate at a loss through at least fiscal
1999. As of June 30, 1998, the Company had an accumulated deficit of
approximately $43.8 million. Because the market for the Company's products is
new and evolving, the Company cannot accurately predict the future growth rate,
if any, or the ultimate size of the data-over-cable market. To achieve
profitable operations on a continuing basis, the Company must successfully
design, develop, test, manufacture, introduce, market and
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<PAGE> 11

distribute its products on a broad commercial basis. There can be no assurance
that the Company will ever achieve profitability. The Company's ability to
generate future revenues will depend on a number of factors, many of which are
beyond the Company's control. Such factors include the rate at which cable
operators upgrade their cable infrastructures, the ability of the Company and
cable operators to coordinate timely and effective marketing campaigns with the
availability of such upgrades, the success of the cable operators in marketing
data-over-cable services and the Company's modems to subscribers, the prices
that the cable operators set for data transmission installation service and the
installation of subscriber site equipment, and the rate at which the cable
operators can complete the installations required to initiate service for new
subscribers. As a result of the foregoing factors, the Company is unable to
forecast its revenues or the rate at which the Company's systems will be adopted
by cable operators with any degree of accuracy. Accordingly, there can be no
assurance that the Company will ever achieve, or be able to sustain,
profitability. See "Risk Factors -- Limited Operating History; History of
Losses; No Assurance of Profitability."

From time to time, third parties, including competitors of the Company,
have asserted patent, copyright and other intellectual property rights to
technologies that are important to the Company. In 1997 the Company received a
written notice from Hybrid in which Hybrid claimed to have patent rights in
certain cable modem technology and requested that the Company review its own
products in light of Hybrid's alleged patent rights. In January 1998, Hybrid
filed an action against the Company in the U.S. District Court for the Eastern
District of Virginia, accusing the Company of willfully infringing the Hybrid
patents, among other claims. Subsequently, the Company filed suit for
declaratory relief against Hybrid in the U.S. District Court for the Northern
District of California asserting that it does not infringe the Hybrid patents
and that the Hybrid patents are invalid. The Company then filed a motion in the
Virginia District Court to transfer the action filed by Hybrid to the Northern
District of California, and that motion was granted and the actions were
consolidated in the Northern District of California on April 29, 1998. Hybrid's
January, 1998 complaint seeks injunctive relief and unspecified damages, among
other relief. Hybrid's complaint also identifies a pending application for
reissuance of the 304 patent to broaden the scope of its claims, which the U.S.
Patent and Trademark Office has allowed for reissuance with respect to certain
claims, and states that once the reissue application is issued, it will be
substituted for the 304 patent in the action. On April 21, 1998, the 304 patent
was reissued; however, to date Hybrid has not moved to amend its complaint.
Formal discovery commenced on July 17, 1998. The Company has received opinions
of its patent counsel that the claims of the Hybrid patents are either invalid
or not infringed by the Company's products. However, there can be no assurance
that some or all of the Company's products will not ultimately be determined to
infringe the Hybrid patents, and the Company anticipates that Hybrid will
continue to pursue litigation with respect to these claims. The results of any
litigation matter are inherently uncertain. In the event of an adverse result in
the Hybrid litigation, the Company could be required to pay substantial damages,
including treble damages if the Company is held to have willfully infringed, to
cease the manufacture, use and sale of infringing products, to expend
significant resources to develop non-infringing technology, or to obtain
licenses to the infringing technology. There can be no assurance that licenses
will be available from Hybrid on commercially reasonable terms, or at all. In
addition, litigation frequently involves substantial expenditures and can
require significant management attention, even if the Company ultimately
prevails. In addition, Celestica, a contract manufacturer for the Company, has
been named in the suit and the Company has agreed to indemnify Celestica for
costs related to this litigation. Accordingly, there can be no assurance that
the Hybrid matter will not have a material adverse effect on the Company's
business, operating results and financial condition.

Because of the early stage of this litigation and because Hybrid has sought
unspecified damages, neither the ultimate outcome of this litigation nor any
costs and payments resulting from the litigation or any settlement can presently
be determined. Accordingly, no provision for any loss which may result from the
Hybrid litigation has been recorded in the accompanying financial statements.
See "Risk Factors -- Patents and Proprietary Rights; Patent Litigation" and Note
5 of Notes to Financial Statements.

RESULTS OF OPERATIONS

Total Revenues -- Total revenues increased 203% from $2.9 million in the
second quarter of 1997 to $8.7 million in the second quarter of 1998, and
increased 366% from $3.4 million for the first six months of

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<PAGE> 12

1997 to $15.7 million for the first six months of 1998. The growth in total
revenues during both periods was primarily a result of increasing unit sales of
ComPORT cable modems and ComCONTROLLER headend equipment. During the quarter
ended June 30, 1998 international sales accounted for 47% of total revenues,
decreasing from the 70% of international sales in the second quarter of 1997.
This decrease was primarily due to a greater proportional increase in sales to
large domestic cable companies.

Gross Margins -- Gross margins decreased from 47.2% in the second quarter
of 1997 to 33.7% in the second quarter of 1998, and decreased from 55.0% for the
first six months of 1997 to 33.5% for the six months of 1998. The decrease is
due primarily to a shift in product mix from the higher margin ComCONTROLLER
headend equipment to the lower margin ComPORT cable modems. During the second
quarter, the Company continued its cable modem cost reduction program to improve
its gross margins on sales of cable modems in subsequent quarters. The Company
expects that the benefits obtained as a result of this cost reduction program
will be partially offset by decreases in the average sales price of cable
modems.

Research and Development -- Research and development expenses increased 44%
from $3.0 million in the second quarter of 1997 to $4.4 million in the second
quarter of 1998, and increased 41% from $6.2 million for the first six months of
1997 to $8.7 million for the first six months of 1998. The increase was
attributable to higher costs related primarily to increased personnel and
equipment related costs.

Sales and Marketing -- Sales and marketing expenses increased 101% from
$1.1 million in the second quarter of 1997 to $2.3 million in the second quarter
of 1998, and increased 104% from $2.0 million for the first six months of 1997
to $4.1 million for the first six months of 1998. The increase was attributable
to higher costs associated with increased personnel, commissions on sales,
consulting and more trade advertising and promotion.

General and Administrative -- General and administrative expenses increased
101% from $405,000 in the second quarter of 1997 to $815,000 in the second
quarter of 1998, and increased 81% from $772,000 for the first six months of
1997 to $1.4 million for the first six months of 1998. The increase was
attributable to higher legal expenses, increased salary costs and higher
consulting costs.

Total Other Income (Expense) -- Total other income (expense) increased from
($18,000) in the second quarter of 1997 to $379,000 in the second quarter of
1998, and increased from $19,000 for the first six months of 1997 to $473,000
for the first six months of 1998. The increase was attributable to earnings on
higher cash balances available during the first six months of 1998, particularly
the second quarter.

LIQUIDITY AND CAPITAL RESOURCES

At June 30, 1998 the Company's cash and cash equivalents were $68.4
million, compared to $18.0 million at December 31, 1997. On May 21, 1998, the
Company completed an initial public offering of 5,750,000 shares of common stock
at a price of $12.00 per share. The net proceeds to the Company from the
offering were approximately $62.8 million.

Net cash used in operating activities of $5.6 million for the six months
ended June 30, 1998 was attributable primarily to a net loss of $8.4 million
during the period and the increase in total accounts receivable of $688,000,
offset in part by $1.6 million of depreciation and amortization, a total
increase of $1.5 million in accounts payable and a total increase of $790,000 in
other current liabilities.

Net cash used in investing activities was $6.0 million for the first six
months ended June 30, 1998, and consisted of purchases of long-term investments
of $5.0 million with an average maturity of 480 days and purchases of property
and equipment of $1.0 million.

Cash flows provided by financing activities of $62.1 million for the six
months ended June 30, 1998 consisted of net proceeds of approximately $62.9
million from the issuance of common stock, offset in part by $783,000 of
repayments on debt and lease obligations.

At June 30, 1998, the Company had $68.4 million of cash and cash
equivalents. In addition, the Company had a $5.0 million line of credit subject
to borrowing base requirements. To date, the Company has not drawn upon its line
of credit. Other than capital lease commitments, the Company has no material
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commitments for capital expenditures. However, the Company anticipates it may
increase its capital expenditures and may increase lease commitments consistent
with anticipated growth in operations, infrastructure and personnel. The Company
intends to establish sales offices and lease additional space, which will
require it to commit to additional lease obligations, purchase equipment and
install leasehold improvements.

The Company believes that the current cash and cash equivalents, will be
sufficient to meet its anticipated cash requirements for the next twelve months,
although the Company may seek to raise additional capital during that time
period. The sale of additional equity or convertible debt securities could
result in additional dilution to the Company's stockholders. There can be no
assurance that financing will be available in amounts or on terms acceptable to
the Company, if at all. See "Risk Factors -- Potential Need for Additional
Capital."

RISK FACTORS

Limited Operating History; History of Losses; No Assurance of
Profitability -- The Company did not commence product shipments until April
1997, and, as a result, has a limited operating history upon which investors may
evaluate the Company and its prospects. The Company has incurred net losses
since its inception and expects to continue to operate at a loss through at
least fiscal 1999. As of June 30, 1998, the Company had an accumulated deficit
of approximately $43.8 million. Because the market for the Company's products is
new and evolving, the Company cannot accurately predict the future growth rate,
if any, or the ultimate size of the data-over-cable market. To achieve
profitable operations on a continuing basis, the Company must successfully
design, develop, test, manufacture, introduce, market and distribute its
products on a broad commercial basis. There can be no assurance that the Company
will ever achieve profitability. The Company's ability to generate future
revenues will depend on a number of factors, many of which are beyond the
Company's control. Such factors include the rate at which cable operators
upgrade their cable infrastructures, the ability of the Company and cable
operators to coordinate timely and effective marketing campaigns with the
availability of such upgrades, the success of the cable operators in marketing
data-over-cable services and the Company's modems to subscribers, the prices
that the cable operators set for data transmission installation service and the
installation of subscriber site equipment, and the rate at which the cable
operators can complete the installations required to initiate service for new
subscribers. As a result of the foregoing factors, the Company is unable to
forecast its revenues or the rate at which the Company's systems will be adopted
by cable operators with any degree of accuracy. Accordingly, there can be no
assurance that the Company will ever achieve, or be able to sustain,
profitability.

Competing Technologies and Evolving Industry Standards -- The market for
high-speed data transmission services is characterized by several competing
technologies that offer alternative solutions. Competitive technologies include
telco-related wireline technologies that utilize telephone copper twisted-pair
wiring, such as Integrated Services Digital Network ("ISDN") and digital
subscriber line ("DSL") implementations, as well as wireless technologies such
as local multipoint distribution service ("LMDS"), multichannel multipoint
distribution service ("MMDS") and direct broadcast satellite ("DBS"). In
addition, new modulation technologies, such as the synchronous code division
multiple access ("S-CDMA") technology being developed by one of the Company's
competitors, may become commercially available to address upstream noise in
cable plants. Significant market acceptance of alternative solutions for
high-speed data transmission could decrease the demand for the Company's
products if such alternatives are viewed as providing faster access, greater
reliability, increased cost-effectiveness or other advantages over cable
solutions. Because of the ubiquity of the telephone network infrastructure,
competition from telco-related solutions is expected to be intense. There can be
no assurance that cable modem technology will compete effectively against
wireline or wireless technologies in the market for high bandwidth access in the
local loop.

The Company's headend equipment and cable modem products currently are not
interoperable with the headend equipment and modems of other suppliers of
broadband Internet access products, other than certain cable modems manufactured
by 3Com Corporation ("3Com"). As a result, potential customers who wish to
purchase broadband Internet access products from multiple suppliers may be
reluctant to purchase the Company's products. The emergence or evolution of
industry standards, either through adoption by official standards committees or
widespread use by cable operators or telcos, could require the Company to
redesign
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<PAGE> 14

its products. The Company's products are not currently in full compliance with
the standards and developing specifications proposed by Digital Audio Video
Interactive Council and Digital and Video Broadcast Organization ("DAVIC/DVB"),
MCNS including the Data Over Cable Service/Interoperability Specification
(DOCSIS), Institute of Electrical and Electronics Engineers, Inc. ("IEEE") or
Internet Engineering Task Force ("IETF"), and other relevant standards bodies.
The Company expects the MCNS/DOCSIS standard to achieve substantial market
acceptance, and the Company is currently developing MCNS/DOCSIS-compliant
products. If such standards become widespread and the Company's products are not
in compliance, the Company's customers and potential customers may refuse to
purchase the Company's products, which would materially adversely affect its
business, operating results and financial condition. Moreover, different
implementations of the same specification could potentially slow deployment of
the Company's products if such different implementations cause the Company's
products to fail to become interoperable with other companies' products. The
anticipated widespread adoption of the MCNS/DOCSIS standard is likely to cause
increased price competition and further, such adoption could result in lower
sales of headend products and licensing of the network management software by
the Company. Any such increased price competition or reduction in sales of
headend products would result in downward pressure on the Company's gross
margin, which could have a material adverse effect on the Company's business,
operating results and financial condition.

The rapid development of new competing technologies and standards increases
the risk that current or new competitors could develop products that would
reduce the competitiveness of the Company's products. Market acceptance of new
technologies or the failure of the Company to develop and introduce new products
or enhancements directed at new industry standards could have a material adverse
effect on the Company's business, operating results and financial condition.

Potential Fluctuations in Operating Results -- The Company's operating
results are likely to fluctuate significantly in the future on a quarterly and
annual basis as a result of a variety of factors, many of which are beyond the
Company's control. Factors that will influence the Company's operating results
include: (i) the Company's ability to retain existing cable operator customers,
to attract new customers at a steady rate, to maintain customer satisfaction and
to obtain significant orders; (ii) the announcement or introduction of new
services and products by the Company and its competitors and the timely
introduction of MCNS/DOCSIS-compliant products by the Company; (iii) the
Company's ability to manage inventory and fulfillment operations; (iv) the
timing of upgrades of cable plants to hybrid fiber-coaxial ("HFC") and the
ability and willingness of cable operators to deploy cable modems and offer
either one-way or two-way data transmission service; (v) the Company's product
mix; (vi) price competition or pricing changes in the Internet, cable and
telecommunication industries, pricing of the Company's products and its ability
to reduce to the costs of its products over time; (vii) the level of use of the
Internet as a replacement for private wide area networks; (viii) the Company's
ability to develop new products in a timely and cost-effective manner; (ix) the
amount and timing of operating costs and capital expenditures relating to
expansion of the Company's business; operating results and infrastructure; (x)
governmental regulation; and (xi) general economic conditions and economic
conditions specific to the cable and electronic data transmission industries.
For the quarter ended June 30, 1998 approximately 46% of revenue was recognized
in the last month of the quarter. A significant portion of the Company's
expenses are fixed in advance based in large part on future revenue forecasts.
If revenues are below expectations in any given period, the adverse impact of
such a shortfall may be magnified by the Company's inability to adjust spending
to compensate for the shortfall. Therefore, a shortfall in revenues from those
expected would have a material adverse effect on the Company's business,
operating results and financial condition. In addition, the Company plans to
increase operating expenses to fund additional sales and marketing, research and
development and general and administrative activities. To the extent that these
expenses are not accompanied by an increase in revenues, the Company's business,
operating results and financial condition would be materially adversely
affected.

The Company anticipates that it will experience decreases in the average
selling price of its cable modem products and that it may experience declines in
the average selling prices of its other products. Any price decline that is not
offset by a decline in the cost of the product could have an adverse effect on
the Company's gross margin. The sales mix of the Company's headend equipment and
modems also affects its gross margin.

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<PAGE> 15

The Company's modems have a lower gross margin than does the Company's headend
equipment. The Company anticipates that its sales mix will be increasingly
weighted toward modems in the foreseeable future, as headends become more
broadly deployed and as MCNS/DOCSIS-compliant products are deployed by cable
operators. As a result, the Company expects to experience continued downward
price pressure on its gross margin in part offset by cost reduction programs.
Due to all of the foregoing factors, it is likely that the Company's operating
results in one or more future periods will fail to meet or exceed the
expectations of securities analysts or investors. In such event, the trading
price of the Common Stock would likely be materially adversely affected.

Early Stage of Market for Cable Modems; Unproven Acceptance of the
Company's Products -- The Company's success will depend on the timely adoption
of its products by cable operators and end-users. The market for the Company's
products has only recently begun to develop, is rapidly evolving and is
characterized by an increasing number of market entrants that have introduced or
developed, or are in the process of introducing or developing, cable modem
systems, including headend equipment, cable modems and system management
software, that compete with the Company's products. Critical issues concerning
the use of cable modems, including security, reliability, cost, ease of
deployment and administration, and quality of service, remain largely unresolved
and may adversely affect the Company's growth and the market acceptance of its
products. Because the market for the Company's products is new and evolving, the
Company cannot accurately predict the future growth rate, if any, or the
ultimate size of the cable modem market. If the market fails to develop, or
develops more slowly than expected, the Company's business, operating results
and financial condition would be materially adversely affected. Some cable
operators will, prior to purchasing the Company's products, require that their
internal technical personnel or their internet data service provider certify the
Company's products for integration into their systems. There can be no assurance
that certification of the Company's products will occur in a timely manner, if
at all, or that the Company, in order for its products to be certified will not
have to make significant modifications to its products. Failure to become
certified could render the Company unable to deploy its products in timely
manner, or at all, with one or more cable operators. Any or all of these
possibilities could have a material adverse effect on the Company's business,
operating results and financial condition. There can be no assurance that the
market for cable modems will develop as the Company anticipates, or that the
Company will be able to compete with new entrants to the market should the
market develop. There can be no assurance that the Company's products will
achieve acceptance in their markets, and the failure of the Company's products
to achieve such market acceptance would have a material adverse effect upon the
Company's business, operating results and financial condition.

Dependence on Cable Operators -- The Company depends on cable operators to
purchase its headend equipment and cable modems and to market data transmission
service to end-users. Cable operators have a limited number of programming
channels over which they can offer services, and there can be no assurance that
they will choose to provide data transmission services to their subscribers.
Even if a cable operator chooses to provide data transmission services, there
can be no assurance that it would choose the Company's products. The future
success of services providing data transmission over cable will depend, in large
part, upon the ability of cable systems to support two-way communications. While
many cable operators are in the process of upgrading, or have announced their
intention to upgrade, their cable infrastructures to HFC to provide increased
quality and speed of transmission and, in certain cases, two-way transmission
capabilities, many cable operators, particularly cable operators in the U.S.,
have delayed their planned upgrades. Cable operators have limited experience
with such upgrades, and investments in upgrades place a significant strain on
the financial, managerial, operational and other resources of the cable
operators, most of which are already highly leveraged and face intense
competition from telephone companies, satellite television and broadband
wireless system operators. Cable operators may not have the capital required to
upgrade their infrastructure or to offer new services that require substantial
start-up costs. As a result, it is uncertain whether cable operators will
upgrade to HFC or whether they will offer additional services, such as Internet
access in the near term, or at all. After installation, the Company will be
highly dependent on cable operators to continue to maintain their cable
infrastructure in such a manner that the Company's products will operate at a
consistently high performance level and reliable environment. Accordingly, the
success and future growth of the Company's business will be subject to economic
and other factors affecting the cable television industry generally,
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<PAGE> 16

particularly the industry's ability to continue to finance the substantial
capital expenditures necessary to use the Company's products effectively.

Whenever cable operators wish to upgrade their cable plants from coaxial
cable to HFC, they are required to obtain certain city and county permits. There
can be no assurance that such permits will be obtained, or even if they are
obtained, that they will be obtained in a timely and cost-effective manner.
Further, cable operators must periodically renew their franchises with city or
county governments. As a condition of obtaining such renewal, the cable operator
may have to meet certain conditions imposed by the issuing jurisdiction. Meeting
such conditions may cause the cable operator to delay upgrades or the
implementation of data over cable services. The failure of cable operators to
complete these upgrades or implement these services in a timely and satisfactory
manner, or at all, would adversely affect the market for the Company's products.
Although the Company's commercial success depends on the successful and timely
completion of these infrastructure upgrades, cable operators are under no
obligation to upgrade systems or to roll out, market or promote the Company's
products. Any failure to upgrade or delay in upgrading could have a material
adverse effect on the Company's business, operating results and financial
condition.

Competition -- The markets for the Company's products are intensely
competitive, rapidly evolving and subject to rapid technological change. The
principal competitive factors in this market include, or are likely to include,
product performance and features, reliability, technical support and service,
relationships with cable system operators and systems integrators, compliance
with industry standards, compatibility with the products of other suppliers,
sales and distribution interoperability, strength of brand name, price,
long-term cost of ownership to cable operators and general industry and economic
conditions. Many of the Company's current and potential competitors have longer
operating histories, greater name recognition and significantly greater
financial, technical, marketing and distribution resources than the Company.
Such competitors may undertake more extensive marketing campaigns, adopt more
aggressive pricing policies and devote substantially more resources to
developing new products than the Company. There can be no assurance that the
Company will be able to compete successfully against current or future
competitors or that competitive pressures faced by the Company will not
materially adversely affect the Company's business, operating results and
financial condition. In response to changes in the competitive environment, the
Company may make certain pricing, service, marketing or other strategic
decisions that could have a material adverse effect on the Company's business,
operating results or financial condition. There can be no assurance that the
Company's competitors will not develop enhancements to, or future generations
of, products that will offer price or performance superior to that of the
Company's products. The Company believes that the broad adoption of MCNS/ DOCSIS
will cause increased competition, which is likely to negatively affect the
Company's gross margin. There can be no assurance that competitors will not more
quickly develop MCNS/DOCSIS-compliant products than the Company. Current
customers of the Company that move to the MCNS/DOCSIS platform could choose
alternative cable modem suppliers or choose to purchase MCNS/DOCSIS-compliant
cable modems from multiple suppliers. Such competition could materially
adversely affect the Company's business, operating results and financial
condition.

The Company's current and potential competitors include 3Com, Cisco, the
LANcity division of Bay Networks, Inc., Hybrid Networks, Inc. ("Hybrid"),
General Instrument Corporation, Motorola, Inc., Terayon Communication Systems
and Zenith Electronics Corporation. Some of these competitors have existing
relationships with many of the Company's prospective customers. There can be no
assurance that the Company will establish relationships with cable operators who
have existing relationships with those competitors, and failure to establish
such relationships could have a material adverse effect on the Company's
business, operating results and financial condition. In addition, the Company
anticipates that some large consumer electronics companies, such as Matsushita
Electronic Industrial Co., Ltd. (which markets products under the brand name
Panasonic), Sony Corp., Thomson Consumer Electronics International S.A. and
Toshiba America, Inc., will likely introduce competitive cable modem products in
the future. As the MCNS/ DOCSIS specification is adopted for the North American
market, the distribution of cable modems may move into the retail channel. If
this occurs, the large consumer electronics companies could gain a competitive
advantage, due to their well-established retail distribution capabilities. There
can be no assurance that the Company will be able to compete successfully
against current or future competitors or that competitive

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<PAGE> 17

pressures faced by the Company will not have a material adverse effect on the
Company's business, operating results and financial condition.

Lengthy Sales Cycle -- The sale of the Company's products typically
involves a significant technical evaluation and commitment of capital and other
resources by cable operators, with delays frequently associated with cable
operators' internal procedures to approve large capital expenditures, to
engineer deployment of new technologies within their networks and to test and
accept new technologies that affect key operations. For these and other reasons,
the sales cycle associated with the Company's products is typically lengthy,
generally lasting six to twelve months, and is subject to a number of
significant risks, including cable operators' budgetary constraints and internal
acceptance reviews, that are beyond the Company's control. The announcement and
project product introduction of MCNS/DOCSIS-compliant products have already
affected sales cycles, as most domestic cable operators have chosen to delay
large scale deployment of cable modems until MCNS/DOCSIS-compliant products are
available. Because of the lengthy sales cycle, if deployments forecasted for a
specific cable operator for a particular period are not realized in that period,
the Company's operating results for that period could be materially adversely
affected.

Need to Reduce Cost of Modems -- Certain of the Company's competitors
currently offer modems at prices lower than those of the Company's modems.
Market acceptance of the Company's products, and the Company's future success,
will depend in significant part on the cost of its modems. The Company expects
that as headend equipment becomes more widely deployed, the price of modems and
other products will decline. In particular, Company believes that the adoption
of industry standards such as MCNS/DOCSIS will cause increased price competition
for cable modems. However, there can be no assurance that the Company will be
able to continually reduce the cost of its modems sufficiently to enable it to
compete with other cable modem suppliers. If the Company is unable to reduce the
cost of its cable modems, its gross margin and profitability would be adversely
affected. In order to address ongoing competitive and pricing pressures, the
Company will have to reduce the cost of manufacturing its cable modems. The
Company is dependent on its manufacturers to secure components at favorable
prices, and there can be no assurance that additional volume purchase or
manufacturing arrangements will be available to the Company on terms that the
Company considers acceptable, if at all. To the extent that the Company enters
into a high-volume or long-term purchase or supply arrangement and subsequently
decides that it cannot use the products or services provided for in the
agreement, the Company's business, operating results and financial condition
could be materially adversely affected.

Patents and Proprietary Rights; Patent Litigation -- The Company relies on
a combination of patent, copyright and trademark laws, and on trade secrets and
confidentiality provisions and other contractual provisions to protect its
proprietary rights. These measures afford only limited protection. The Company
currently has five issued U.S. patents and several pending patent applications.
There can be no assurance that the Company's means of protecting its proprietary
rights in the U.S. or abroad will be adequate or that competitors will not
independently develop similar technologies. The Company's future success will
depend in part on its ability to protect its proprietary rights to the
technologies used in its principal products. Despite the Company's efforts to
protect its proprietary rights, unauthorized parties may attempt to copy aspects
of the Company's products or to obtain and use trade secrets or other
information that the Company regards as proprietary. In addition, the laws of
some foreign countries do not protect the Company's proprietary rights as fully
as do the laws of the U.S. There can be no assurance that any issued patent will
preserve the Company's proprietary position, or that competitors or others will
not develop technologies similar to or superior to the Company's technology.
Failure of the Company to enforce and protect its intellectual property rights
could have a material adverse effect on the Company's business, operating
results and financial condition.

From time to time, third parties, including competitors of the Company,
have asserted patent, copyright and other intellectual property rights to
technologies that are important to the Company. The Company expects that it will
increasingly be subject to infringement claims as the number of products and
competitors in the cable modem market grows and the functionality of products
overlaps. In this regard, in 1997 the Company received a written notice from
Hybrid in which Hybrid claimed to have patent rights in certain cable modem
technology and requested that the Company review its own products in light of
Hybrid's alleged patent rights to U.S. Patent No. 5,586,121 (the "121 patent")
issued on December 17, 1996 and entitled
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<PAGE> 18

"Asymmetric Hybrid Access System and Method" and U.S. Patent No. 5,347,304 (the
"304 patent") issued on September 13, 1994 and entitled "Remote Link Adapter for
Use in TV Broadcast Data Transmission Systems" (collectively, the "Hybrid
patents"). The Company informed Hybrid that it believes that the Company's
products do not infringe any valid claim of the Hybrid patents. In January 1998,
Hybrid filed an action against the Company in the U.S. District Court for the
Eastern District of Virginia, accusing the Company of willfully infringing the
Hybrid patents, among other claims. Subsequently, the Company filed suit for
declaratory relief against Hybrid in the U.S. District Court for the Northern
District of California asserting that it does not infringe the Hybrid patents
and that the Hybrid patents are invalid. The Company then filed a motion in the
Virginia District Court to transfer the action filed by Hybrid to the Northern
District of California, and that motion was granted and the actions were
consolidated in the Northern District of California on April 29, 1998. Hybrid's
January, 1998 complaint seeks injunctive relief and unspecified damages, among
other relief. Hybrid's complaint also identifies a pending application for
reissuance of the 304 patent to broaden the scope of its claims, which the U.S.
Patent and Trademark Office has allowed for reissuance with respect to certain
claims, and states that once the reissue application is issued, it will be
substituted for the 304 patent in the action. On April 21, 1998, the 304 patent
was reissued; however, to date Hybrid has not moved to amend its complaint.
Formal discovery commenced on July 17, 1998. The Company has received opinions
of its patent counsel that the claims of the Hybrid patents, including the
claims set forth in Hybrid's 304 patent as reissued, are either invalid or not
infringed by the Company's products. However, there can be no assurance that
some or all of the Company's products will not ultimately be determined to
infringe the Hybrid patents, including the 304 patent as reissued, and the
Company anticipates that Hybrid will continue to pursue litigation with respect
to these claims. The results of any litigation matter are inherently uncertain.
In the event of an adverse result in the Hybrid litigation, or in any other
litigation with third parties that could arise in the future with respect to
intellectual property rights relevant to the Company's products, the Company
could be required to pay substantial damages, including treble damages if the
Company is held to have willfully infringed, to cease the manufacture, use and
sale of infringing products, to expend significant resources to develop
non-infringing technology, or to obtain licenses to the infringing technology.
There can be no assurance that licenses will be available from Hybrid, or any
other third party that asserts intellectual property claims against the Company,
on commercially reasonable terms, or at all. In addition, litigation frequently
involves substantial expenditures and can require significant management
attention, even if the Company ultimately prevails. In addition, Celestica, a
contract manufacturer for the Company, has been named in the suit and the
Company has agreed to indemnify Celestica for costs related to this litigation.
Accordingly, there can be no assurance that the Hybrid matter, or any other
infringement claim or litigation against or by the Company, will not have a
material adverse effect on the Company's business, operating results and
financial condition.

Because of the early stage of this litigation, and because Hybrid has
sought unspecified damages, neither the ultimate outcome of this litigation nor
any costs and payments resulting from the litigation or any settlement can
presently be determined. Accordingly, no provision for any loss which may result
from the Hybrid litigation has been recorded in the accompanying financial
statements.

Management of Growth -- To fully exploit the market for its products and
services, the Company must rapidly execute its sales strategy and develop new
and enhanced products while managing anticipated growth by implementing
effective planning and operating processes. To manage its anticipated growth,
the Company must, among other things, continue to implement and improve its
operational, financial and management information systems, hire and train
additional qualified personnel, continue to expand and upgrade core technologies
and effectively manage multiple relationships with various customers, suppliers
and other third parties. The Company may in the future experience difficulties
meeting the demand for its products and services. The installation and use of
the Company's products requires training. If the Company is unable to provide
training and support for its products, the implementation process will be longer
and customer satisfaction may be lower. There can be no assurance that the
Company's systems, procedures or controls will be adequate to support the
Company's operations or that the Company's management will be able to achieve
the rapid execution necessary to exploit fully the market for the Company's
products and services. Any failure of the Company to manage its growth
effectively could have a material adverse effect on the Company's business,
operating results and financial condition.
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Dependence on Key Personnel and Hiring of Additional Personnel -- The
Company's future success will depend to a significant extent on the ability of
its management to operate effectively, both individually and as a group. Given
the Company's early stage of development, the Company is dependent on its
ability to retain and motivate high quality personnel, in addition to attracting
new personnel. Competition for qualified personnel in the cable networking
equipment and telecommunications industries is intense, and there can be no
assurance that the Company will be successful in attracting and retaining such
personnel. The Company believes that there may be only a limited number of
persons with the requisite skills to serve in those positions and it may become
increasingly difficult to hire such persons. The Company is seeking to hire
additional skilled engineers for research and development, who are in short
supply. The Company's business, operating results and financial condition could
be adversely affected if it encounters delays in hiring additional engineers.
Competitors and others have in the past and may in the future attempt to recruit
the Company's employees. The Company does not have employment contracts with any
of its key personnel, nor does it maintain key person life insurance on its key
personnel. The loss of the services of any of the key personnel, the inability
to attract or retain qualified personnel in the future or delays in hiring
required personnel, particularly engineers, could have a material adverse effect
on the Company's business, operating results and financial condition.

Dependence Upon Strategic Relationships -- The Company's business strategy
relies to a significant extent on its strategic relationships with other
companies. These relationships include software license arrangements with third
party vendors pursuant to which the Company incorporates software into its
network management system, as well as marketing arrangements with Philips and
Siemens. Further, in developing an MCNS/DOCSIS-compliant modem the Company is
working with Cisco to ensure the interoperability of this modem with Cisco's
previously announced MCNS/DOCSIS-compliant Universal Broadband Router. There can
be no assurance that these relationships will be successful or that the Company
will continue to maintain or develop strategic relationships or to replace
strategic partners in the event any such relationships were terminated or that
licenses between the Company and any third party will be renewed or extended at
their expiration dates. The Company's failure to renew or extend a key license
or maintain any strategic relationship could materially and adversely affect the
Company's business, operating results and financial condition.

Limited Manufacturing Experience; Dependence on Third-Party
Manufacturing -- The Company relies on contract manufacturers for the
manufacture of certain of its products. In particular, the Company relies upon
CMC Industries, Inc. ("CMC") for the manufacture of printed circuit assemblies
for its headend products and upon Celestica for the manufacture of its modems.
The Company maintains only a limited in-house manufacturing capability for final
assembly, testing and integration of headend products. The Company's future
success will depend, in significant part, on its ability to manufacture, or have
others manufacture, cost-effectively and in volumes sufficient to meet customer
demand. There are a number of risks associated with the Company's dependence
upon third party manufacturers, including, but not limited to, reduced control
over delivery schedules, quality assurance, manufacturing yields and costs, the
potential lack of adequate capacity during periods of excess demand, limited
warranties on products supplied to the Company, increases in prices and the
potential misappropriation of the Company's intellectual property. A
manufacturing disruption could impact the production of the Company's products
for a substantial period of time, which could have a material adverse effect on
the Company's business, operating results and financial condition. The Company
has no long-term contracts or arrangements with any of its vendors that
guarantee the availability of product, the continuation of particular payment
terms or the extension of credit limits. There can be no assurance that the
Company will not experience manufacturing or supply problems in the future from
any of its manufacturers. While to date the Company has not experienced any such
manufacturing supply problems, any such difficulties, if experienced in the
future, could have a material adverse effect on the Company's business,
operating results and financial condition.

In addition, Celestica is a foreign corporation, and the Company may
increase its use of foreign manufacturers in the future. Any foreign or domestic
regulations regarding foreign exports and imports, trade barriers and tariffs
currently in place or imposed in the future could materially and adversely
affect the Company's ability to obtain modems. Because lead times for some
materials needed to produce modems and headend equipment can be between eight
and 26 weeks, the Company may not be able to meet the demand for its products,
which could adversely affect the Company's ability to support cable operators'
expansion of

19
<PAGE> 20

cable modem service to cable operators' customers. The Company has had only
limited experience manufacturing and arranging for the manufacture of its
products, and there can be no assurance that the Company or any manufacturer of
the Company's products will be successful in increasing its manufacturing
volume. The Company may need to procure additional manufacturing facilities and
equipment, adopt new inventory controls and procedures, substantially increase
its personnel and revise its quality assurance and testing practices, and there
can be no assurance that any of these efforts will be successful.

Sole-Sourced Components and Dependency on Key Suppliers -- Certain parts,
components and equipment used in the Company's products are obtained from sole
sources of supply. The Company has designed its headend equipment to incorporate
a radio frequency modulation chip from one specific vendor, transmit/ receive
components from another and the Asynchronous Transfer Mode ("ATM") headend
switch from still another. Additional sole-sourced parts may be incorporated
into the Company's headend equipment in the future. The Company anticipates
entering into long-term supply contracts to ensure sources of supply for various
components necessary to manufacture the Company's products. However, if the
Company fails to able to obtain components in sufficient quantities when
required, this failure could have an adverse impact on the Company's operating
results and financial condition. The Company's suppliers also sell products to
the Company's competitors. There can be no assurance that the Company's
suppliers will not enter into exclusive arrangements with the Company's
competitors, stop selling their products or components to the Company at
commercially reasonable prices or refuse to sell their products or components to
the Company at any price. The Company's inability to obtain sufficient
quantities of sole-sourced components, or to develop alternative sources for
components and/or products would have a material adverse effect on the Company's
business, operating result and financial condition. The Company relies on
Stanford Telecommunications, Inc. and Broadcom Corp., suppliers of demodulation
components; Atmel Corporation, the fabricator of the Company's semiconductor
devices; Virata Limited, formerly Advanced Telecommunications Modules Limited
(ATML), a supplier of ATM switches; and Hewlett-Packard Company, Wind River
Systems supplier of embedded software and Objectivity, Inc., supplier of object
database. If any of these manufacturers delay or halt production of any of the
Company's products such failure could have a material adverse effect on the
Company's business, operating results and financial condition.

Customer Concentration -- The Company's customer base is highly
concentrated. A relatively small number of customers has accounted for a
significant portion of the Company's revenues to date, and the Company expects
that this trend will continue for the foreseeable future. In 1997 and the six
months ended June 30, 1998, the top six customers comprised 66% and 84% of the
Company's total revenues, respectively. Further, in 1997, revenues attributable
to Philips, 3Com and Siemens accounted for 21%, 16% and 12% of total revenues,
respectively. In the six months ended June 30, 1998, revenues attributable to
TCI, Siemens, Philips and Cablecom Holding AG ("Cablecom") for 33%, 16%, 14% and
10% of total revenues, respectively. The Company expects that its largest
customers in future periods could be different from its largest customers in
prior periods due to a variety of factors, including customers' deployment
schedules and budget considerations. Because a limited number of cable operators
account for a majority of the Company's prospective customers, the Company's
future success will depend upon its ability to establish and maintain
relationships with these companies. Any reduction or delay in sales of the
Company's products to any of these current significant customers could have a
material adverse effect on the Company's business, operating results and
financial condition. There can be no assurance that the Company will retain
these current accounts or that it will be able to obtain additional accounts.
Both in the U.S. and internationally, a substantial majority of homes passed are
controlled by a relatively small number of cable operators. The loss of one or
more of the Company's customers or the inability of the Company to successfully
develop relationships with additional significant cable operators could have a
material adverse effect on the Company's business, operating results and
financial condition.

Risks Associated with New Product Development -- The market for cable modem
systems and products is characterized by rapidly changing technologies and short
product life cycles. The Company's future success will depend in large part upon
the Company's ability to identify and respond to emerging technological trends
in the market, develop and maintain competitive products, enhance its products
by adding innovative features that differentiate its products from those of its
competitors, bring products to market on a timely basis at

20
<PAGE> 21

competitive prices and respond effectively to new technological changes or new
product announcements by others. There can be no assurance that product
development and enhancements will not take longer than planned, or that having
to rework portions of the effort will not delay the date of the targeted
delivery of future products. There can be no assurance that the Company's design
and introduction schedules for new products or additions or enhancements to its
existing and future products will be met. The Company's future success will
depend in part upon its ability to enhance its existing products and to develop
and introduce, on a timely basis, new products and features that meet changing
customer requirements and emerging industry standards. In particular, as the
MCNS/DOCSIS specification is emerging for the North American market with
potential deployment internationally and the Company's success in penetrating
this market will depend on its ability to successfully develop, introduce in a
timely manner and market MCNS/DOCSIS-compliant products. In making new product
decisions, the Company must anticipate well in advance future demand for product
features and performance characteristics, as well as available supporting
technologies, manufacturing capacity, industry standards and competitive product
offerings. The technical innovations required for the Company to remain
competitive are inherently complex, require long development cycles and are
dependent in some cases on sole source suppliers. The Company will be required
to continue to invest in research and development in order to attempt to
maintain and enhance its existing technologies and products, and there can be no
assurance that it will have the funds available to do so, or that such
investments will serve the needs of customers or be compatible with changing
technological requirements or standards. Much of such expenses must be incurred
before the technical feasibility or commercial viability can be ascertained.
There can be no assurance that revenues from future products or product
enhancements will be sufficient to recover the development costs associated with
such products or enhancements.

Need to Develop Additional Distribution Channels -- The Company presently
focuses on selling its products to cable operators and systems integrators. The
Company believes that much of the North American cable modem market may shift to
a retail distribution model. Accordingly, the Company anticipates that it will
shift a greater amount of focus to selling its modems directly to retail
distributors and end users. Thus, it will need to focus its efforts on
developing new distribution channels for its products. There can be no assurance
that the Company will be able to develop such additional distribution channels,
or that, if the Company does establish additional channels, it will have the
capital required or the ability to hire the additional personnel necessary to
foster and enhance such distribution channels. In addition, there can be no
assurance that the Company can form relationships with retail distributors to
establish such a channel. Failure by the Company to establish such channels
could have a material adverse affect on the Company's business, operating
results and financial condition. To the extent that large consumer electronics
companies enter the cable modem market, their well established retail
distribution capabilities would provide them with a significant competitive
advantage.

Risks Associated with International Markets -- In 1997 and the six months
ended June 30, 1998, revenues attributable to international customers accounted
for 64% and 48% of total revenues, respectively. The Company expects that a
significant portion of its sales will continue to be concentrated in
international markets for the foreseeable future. The Company intends to expand
operations in the international markets that it serves currently and to enter
new international markets, which will demand management attention and financial
commitment. There can be no assurance that the Company will successfully expand
its international operations. In addition, a successful expansion by the Company
of its international operations and sales in certain markets will require the
Company to develop relationships with international systems integrators and
distributors. There can be no assurance that the Company will identify, attract
or retain suitable international systems integrators or distributors or, that if
such parties are identified, that successful relationships will result. Further,
to increase revenues in international markets, the Company will need to continue
to establish foreign operations, to hire additional personnel to run such
operations and maintain good relations with its foreign systems integrators and
distributors. To the extent that the Company is unable to successfully do so,
the Company's growth in international sales will be limited. The failure to
expand international sales could have a material adverse effect on the Company's
business, operating results and financial condition.

If other countries begin to regulate the cable modem industry more heavily
or introduce standards or specifications with which the Company's products do
not comply, the Company will be unable to offer

21
<PAGE> 22

products in those countries until its products comply with such standards or
specifications and the Company may have to incur substantial cost in order to
comply with such standards or specifications. For instance, should the DAVIC/DVB
standards for ATM-based digital video be established internationally, the
Company will be required to conform its cable modems in order to compete.
Further, many countries do not have regulations for installation of cable modem
systems or for upgrading existing cable operating systems to accommodate the
Company's products. Whether the Company currently operates in such a country or
enters into the market in a country where no such regulations exist, there can
be no assurance that such regulations will not be proposed at any time, and if
imposed, that they would not place limitations on that country's cable
operators' ability to upgrade to support the Company's products. There can be no
assurance that the cable operators in such countries would be able to comply
with such regulations, or that compliance with such regulations would not
require a long, costly process.

The Company's international sales to date have been denominated in U.S.
dollars. The Company does not currently engage in any foreign currency hedging
transactions. A decrease in the value of foreign currencies relative to the U.S.
dollar could make the Company's products more expensive in international
markets. In addition to currency fluctuation risks, international operations
entail a number of risks not typically present in domestic operations. Such
risks include: changes in regulatory requirements; costs and risks of deploying
systems in foreign countries; availability of suitable export financing; timing
and availability of export licenses; tariffs and other trade-barriers; political
and economic instability; difficulties in staffing and managing foreign
operations; potentially adverse tax consequences; the burden of complying with a
wide variety of complex foreign laws and treaties; difficulties in managing
distributors; difficulties in obtaining governmental approvals for products; and
the possibility of difficult accounts receivable collections. Distributors'
customer purchase agreements may be governed by foreign laws which may differ
significantly from laws of the U.S. The Company is also subject to the risks
associated with the imposition of legislation and regulations relating to the
import or export of high technology products. The Company cannot predict whether
quotas, duties, taxes or other charges or restrictions upon the importation or
exportation of the Company's products will be implemented by the U.S. or other
countries, leading to a reduction in sales and profitability in that country.
Future international activity may result in sales dominated by foreign
currencies. Gains and losses on the conversion to U.S. dollars of accounts
receivable, accounts payable and other monetary assets and liabilities arising
from international operations may contribute to fluctuations in the Company's
operating results. Any of these factors could materially and adversely affect
the Company's business, operating results and financial condition.

Risks Associated with Regulation of Information Security Products -- The
Company's products make use of encryption, and are therefore subject to export
restrictions administered by the U.S. Department of Commerce, which permit the
export of encryption products only with the required level of export license.
The Company may therefore be at a disadvantage in competing for international
sales compared to companies located outside the U.S. that are not subject to
such restrictions. International customers may be unwilling to purchase the
Company's products that are eligible for export due to perceptions that such
products are inferior to those marketed within the U.S., may contain
undocumented features which undermine the products' security architecture, or
are required to incorporate security features which are unacceptable to the
customer. Although the Company has been granted all currently required U.S.
export licenses, there can be no assurance that the Company will continue to be
able to secure such licenses in a timely manner in the future, or at all. In
certain foreign countries, the Company's distributors are required to secure
licenses or formal permission before products that incorporate encryption
features can be imported. There can be no assurance the Company's distributors
will make the effort, or be successful in the effort, to obtain the necessary
licenses or permission to import the Company's products into certain countries.
The regime of export administration, and resulting regulations in the U.S. are
in a stage of transition due to political controversy concerning their purposes
and legality. Consequently, the uncertainty concerning the interpretation and
application of such regulations may unduly delay or prevent the export of
Company's products, leading to a loss of revenues and market position.

Recent legislative proposals have indicated the possibility that the
Company's products sold for use within the U.S. may be required to incorporate
certain features to assist law enforcement agencies in recovering

22
<PAGE> 23

suspect communications. If such proposals are enacted into law, the Company may
be obligated to incur significant expense in complying with such regulations. In
addition, the market opportunities and customer acceptance of the Company's
products could be adversely affected by the Company's compliance with such laws,
leading to a commensurate loss of revenues and market share.

Year 2000 Compliance -- Many existing computer systems and applications,
and other control devices, use only two digits to identify a year in the date
code field, and were not designed to account for the upcoming change in the
century. As a result, such systems and applications could fail or create
erroneous results unless corrected so that they can process data related to the
year 2000. The Company relies on its systems, applications and devices in
operating and monitoring all major aspects of its business, including financial
systems (such as general ledger, accounts payable and accounts receivable
modules), customer services, infrastructure, embedded computer chips, networks
and telecommunications equipment and end products. The Company also relies,
directly and indirectly, on external systems of business enterprises such as
customers, suppliers, creditors, financial organizations, and of governmental
entities, both domestic and international, for accurate exchange of data.
Despite the Company's efforts to address the year 2000 impact on its internal
systems, the Company has not fully identified such impact or whether it can
resolve such impact without disruption of its business or without incurring
significant expense. Based on the information currently available, the Company
believes that the costs associated with the year 2000 issue, and the
consequences of incomplete or untimely resolution of the year 2000 issue, will
not have a material adverse effect on its business, operating results and
financial condition in any given year. In addition, even if the internal systems
of the Company are not materially affected by the year 2000 issue, the Company
could be materially adversely affected through disruption in the operation of
the enterprises with which the Company interacts.

Risks of Product Defects, Product Returns and Product Liability -- Products
as complex as those offered by the Company frequently contain undetected errors,
defects or failures, especially when first introduced or when new products are
released. In the past, such errors have occurred in the Company's products and
there can be no assurance that errors will not be found in the Company's current
and future products. The occurrence of such errors, defects or failures could
result in delays in installation, product returns and other losses to the
Company or to its cable operators or end-users. Such occurrence could also
result in the loss of or delay in market acceptance of the Company's products,
which could have a material adverse effect on the Company's business, operating
results and financial condition. With respect to any new products introduced,
the Company would have limited experience with the problems that could arise
with such products. Although the Company has not experienced any product
liability claims to date, the sale and support of the Company's products entails
the risk of such claims. A successful product liability claim brought against
the Company could have a material adverse effect on the Company's business,
operating results and financial condition.

Government Regulations -- The Company's products are subject to the
regulations of the Federal Communications Commission (the "FCC") and other
federal and state communications regulatory agencies. Changes in the regulatory
environment relating to the Internet connectivity market, including regulatory
changes that, directly or indirectly, affect telecommunications costs, limit
usage of subscriber-related information or increase the likelihood or scope of
competition from telecommunications companies, could affect the prices at which
cable operators sell their services and thus indirectly impact the Company. In
addition, the Company cannot predict the impact, if any, that future regulation
or regulatory changes might have on its business. Regulation of cable television
rates may affect the speed at which the cable operators upgrade their cable
infrastructures to two-way HFC. Changes in current or future laws or regulations
which negatively impact the Company's products and technologies, in the U.S. or
elsewhere, could materially and adversely affect the Company's business,
operating results and financial condition.

Dependence on the Internet -- The Company's products will depend in part
upon the increased use of the Internet by corporate telecommuters, SOHOs and
residential consumer users. Businesses are increasingly using the Internet,
intranets and extranets, not only for communication within and outside the firm,
but also to create cost-effective, secure data connections known as virtual
private networks ("VPNs") between corporate sites or remote locations. Critical
issues concerning the commercial use of the Internet, such as ease of access,
security, reliability, cost and quality of service, remain unresolved and may
affect the growth of Internet use, especially in the business and consumer
markets targeted by the Company. Despite growing interest in the
23
<PAGE> 24

commercial possibilities for the Internet, many businesses have been deterred
from adopting Internet-based data communications systems for a number of
reasons, including inconsistent quality of service, lack of availability of
cost-effective, high-speed service, a limited number of local access points for
corporate users, inability to integrate business applications on the Internet,
the need to deal with multiple and frequently incompatible vendors, inadequate
protection of the confidentiality of stored data and information moving across
the Internet and a lack of tools to simplify Internet access and use. There can
be no assurance that such issues can be resolved and that such concerns can be
alleviated. Failure of the Internet community to address and resolve such
problems, to develop or to develop more slowly than expected could have a
material adverse affect on the Company's business, operating results and
financial condition.

Potential Need for Additional Capital -- The Company currently anticipates
that the proceeds of its initial public offering, together with its existing
cash balances and available line of credit and cash flow expected to be
generated from future operations, will be sufficient to meet the Company's
liquidity needs for the next twelve months. However, the Company may need to
raise additional funds if its estimates of revenues, working capital and/or
capital expenditure requirements change or prove inaccurate or in order for the
Company to respond to unforeseen technological or marketing hurdles or to take
advantage of unanticipated opportunities. In addition, the Company expects to
review potential acquisitions or additions to its product line that would
complement its existing product offerings or enhance its technical capabilities.
While the Company has no current agreements or negotiations underway with
respect to any such acquisition, any future transaction of this nature could
require potentially significant amounts of capital. There can be no assurance
that any such funds will be available at the time or times needed, or available
on terms acceptable to the Company. If adequate funds are not available, or are
not available on acceptable terms, the Company may not be able to take advantage
of market opportunities, to develop new products or otherwise respond to
competitive pressures. Such inability could have a material adverse effect on
the Company's business, operating results and financial condition

Volatility of Stock Price -- The trading price of the Company's Common
Stock could be subject to wide fluctuations in response to quarter to quarter
variations in results of operations, announcements of technological innovations
or new products by the Company or its competitors, general conditions in the
telecommunications and data communications equipment markets, changes in
earnings estimates or buy/sell recommendations by analysts or other events or
factors. In addition, the public stock markets have experienced extreme price
and trading volume volatility, particularly in high technology sectors of the
market. This volatility has significantly affected the market prices of
securities of many technology companies for reasons frequently unrelated to the
operating performance.

24
<PAGE> 25

PART II: OTHER INFORMATION

ITEM 1. LEGAL PROCEEDINGS

In 1997 the Company received a written notice from Hybrid Networks, Inc.
("Hybrid") in which Hybrid claimed to have patent rights in certain cable modem
technology and requested that the Company review its own products in light of
Hybrid's alleged patent rights to U.S. Patent No. 5,586,121 (the "121 patent")
issued on December 17, 1996 and entitled "Asymmetric Hybrid Access System and
Method" and U.S. Patent No. 5,347,304 (the "304 patent") issued on September 13,
1994 and entitled "Remote Link Adapter for Use in TV Broadcast Data Transmission
Systems" (collectively, the "Hybrid patents"). The Company informed Hybrid that
it believes that the Company's products do not infringe any valid claim of the
Hybrid patents. In January 1998, Hybrid filed an action against the Company in
the U.S. District Court for the Eastern District of Virginia, accusing the
Company of willfully infringing the Hybrid patents, among other claims.
Subsequently, the Company filed suit for declaratory relief against Hybrid in
the U.S. District Court for the Northern District of California asserting that
it does not infringe the Hybrid patents and that the Hybrid patents are invalid.
The Company then filed a motion in the Virginia District Court to transfer the
action filed by Hybrid to the Northern District of California, and that motion
was granted and the actions were consolidated in the Northern District of
California on April 29, 1998. Hybrid's January, 1998 complaint seeks injunctive
relief and unspecified damages, among other relief. Hybrid's complaint also
identifies a pending application for reissuance of the 304 patent to broaden the
scope of its claims, which the U.S. Patent and Trademark Office has allowed for
reissuance with respect to certain claims, and states that once the reissue
application is issued, it will be substituted for the 304 patent in the action.
On April 21, 1998, the 304 patent was reissued; however, to date Hybrid has not
moved to amend its complaint. Formal discovery commenced on July 17, 1998. The
Company has received opinions of its patent counsel that the claims of the
Hybrid patents, including the claims set forth in Hybrid's 304 patent as
reissued, are either invalid or not infringed by the Company's products.
However, there can be no assurance that some or all of the Company's products
will not ultimately be determined to infringe the Hybrid patents, including the
304 patent as reissued, and the Company anticipates that Hybrid will continue to
pursue litigation with respect to these claims. The results of any litigation
matter are inherently uncertain. In the event of an adverse result in the Hybrid
litigation, or in any other litigation with third parties that could arise in
the future with respect to intellectual property rights relevant to the
Company's products, the Company could be required to pay substantial damages,
including treble damages if the Company is held to have willfully infringed, to
cease the manufacture, use and sale of infringing products, to expend
significant resources to develop non-infringing technology, or to obtain
licenses to the infringing technology. There can be no assurance that licenses
will be available from Hybrid, or any other third party that asserts
intellectual property claims against the Company, on commercially reasonable
terms, or at all. In addition, litigation frequently involves substantial
expenditures and can require significant management attention, even if the
Company ultimately prevails. In addition, Celestica, a contract manufacturer for
the Company, has been named in the suit and the Company has agreed to indemnify
Celestica for costs related to this litigation. Accordingly, there can be no
assurance that the Hybrid matter will not have a material adverse effect on the
Company's business, operating results and financial condition. Because of the
early stage of this litigation, and because Hybrid has sought unspecified
damages, neither the ultimate outcome of this litigation nor any costs and
payments resulting from the litigation or any settlement can presently be
determined. Accordingly, no provision for any loss which may result from the
Hybrid litigation has been recorded in the accompanying financial statements.

ITEM 2. CHANGES IN SECURITIES AND USE OF PROCEEDS

(c) Sales of Unregistered Securities. During the three months ended June
30, 1998, following the exercise of options to purchase shares of Common Stock
that had been granted under the Company's 1995 Stock Option Plan by 12
employees, the Company issued an aggregate of 25,271 shares of Common Stock for
an aggregate purchase price of $37,886. All sales of Common Stock made by the
Company pursuant to the exercise of stock options were made pursuant to the
exemption from the registration requirements of the Securities Act afforded by
Rule 701 promulgated under the Securities Act.

25
<PAGE> 26

(d) Use of Proceeds from Sales of Registered Securities. On May 21, 1998,
the Company completed an initial public offering of its Common Stock, $0.001 par
value. The managing underwriters in the Offering were Deutsche Bank Securities
formerly Deutsche Morgan Grenfell, Inc., Merrill Lynch & Co. and Dain Rauscher
Wessels (the "Underwriters"). The shares of Common Stock sold in the Offering
were registered under the Securities Act of 1933, as amended, on a Registration
Statement on Form S-1 (the "Registration Statement") (Reg. No. 333-48107) that
was declared effective by the SEC on May 21, 1998. The Offering commenced on May
22, 1998 after all 5,000,000 shares of Common Stock registered under the
Registration Statement were sold at a price of $12.00 per share. The
Underwriters exercised an overallotment option of 750,000 shares on May 29,
1998. All 750,000 overallotment shares were sold at a price of $12.00 per share.
The aggregate price of the Offering amount registered was $69,000,000. In
connection with the Offering, the Company paid an aggregate of $4,830,000 in
underwriting discounts and commissions to the Underwriters. In addition, the
following table sets forth an estimate of all expenses incurred in connection
with the Offering, other than underwriting discounts and commissions. All
amounts shown are estimated except for the registration fees of the SEC and the
National Association of Securities Dealers, Inc. ("NASD").

<TABLE>
<S> <C>
SEC Registration fee........................................ $ 20,355
NASD filing fee............................................. 5,560
Nasdaq National Market listing fee.......................... 95,000
Printing and engraving expenses............................. 300,000
Legal fees and expenses..................................... 515,000
Accounting fees and expenses................................ 425,000
Blue Sky fees and expenses.................................. 5,000
Transfer Agent and Registrar fees........................... 2,500
Miscellaneous............................................... 10,585
----------
Total............................................. 1,379,000
</TABLE>

After deducting the underwriting discounts and commissions and the
estimated Offering expenses described above, the Company received net proceeds
from the Offering of approximately $62,791,000. As of June 30, 1998, the Company
has used the net proceeds from its initial public offering of Common Stock of
the Company to invest in short-term and long-term, interest bearing, investment
grade securities and has used its existing cash balances to fund the general
operations of the Company. The proceeds will be used for general corporate
purposes, including working capital and product development. A portion of the
net proceeds may also be used to acquire or invest in complementary business or
products or to obtain the right to use complementary technologies. The Company
has no agreements or commitments with respect to any such acquisition or
investments and the Company is not currently engaged in any material
negotiations with respect to any such transaction. None of the Company's net
proceeds of the Offering were paid directly or indirectly to any director,
officer, general partner of the Company or their associates, persons owning 10%
or more of any class of equity securities of the Company, or an affiliate of the
Company.

ITEM 3. DEFAULTS UPON SENIOR SECURITIES

None

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

None

ITEM 5. OTHER INFORMATION

None

26
<PAGE> 27

ITEM 6. EXHIBITS AND REPORTS ON FORM 8-K.

(a) Exhibits

<TABLE>
<CAPTION>
EXHIBIT
NUMBER DESCRIPTION
------- -----------
<C> <S>
27.1 Financial Data Schedule
</TABLE>

(b) Reports on Form 8-K

None

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

COM21, INC.

By: /s/ DAVID L. ROBERTSON
------------------------------------
David L. Robertson
Chief Financial Officer
Vice President, Finance

Date:

27
<PAGE> 28

COM21, INC.

EXHIBIT INDEX

<TABLE>
<CAPTION>
NO. EXHIBIT PAGE
--- ------- ----
<C> <S> <C>
27.1 Financial Data Schedule..................................... 33
</TABLE>

<ARTICLE> 5
<MULTIPLIER> 1,000

<S> <C>
<PERIOD-TYPE> 6-MOS
<FISCAL-YEAR-END> DEC-31-1998
<PERIOD-START> JAN-01-1998
<PERIOD-END> JUN-30-1998
<CASH> 68,383
<SECURITIES> 5,030
<RECEIVABLES> 6,164
<ALLOWANCES> 440
<INVENTORY> 2,889
<CURRENT-ASSETS> 78,018
<PP&E> 10,054
<DEPRECIATION> 4,894
<TOTAL-ASSETS> 88,410
<CURRENT-LIABILITIES> 9,095
<BONDS> 0
0
0
<COMMON> 19
<OTHER-SE> 77,727
<TOTAL-LIABILITY-AND-EQUITY> 88,410
<SALES> 15,731
<TOTAL-REVENUES> 15,731
<CGS> 10,454
<TOTAL-COSTS> 24,626
<OTHER-EXPENSES> 0
<LOSS-PROVISION> 0
<INTEREST-EXPENSE> 167
<INCOME-PRETAX> (8,422)
<INCOME-TAX> 9
<INCOME-CONTINUING> (8,431)
<DISCONTINUED> 0
<EXTRAORDINARY> 0
<CHANGES> 0
<NET-INCOME> (8,431)
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</TABLE>