IMMERSION CORP - 10-Q Quarterly Report

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

FORM 10-Q


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

For the quarterly period ended September 30, 2002


[ ]		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 000-27969

IMMERSION CORPORATION

(Exact Name of Registrant as Specified in its Charter)


Delaware		94-3180138

(State or other jurisdiction of incorporation or organization)		(I.R.S. employer Identification No.)

801 Fox Lane, San Jose, California 95131

(Address of principal executive offices)(Zip Code)

(408) 467-1900

(Registrant’s Telephone Number, including Area Code)

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

Number of shares of Common Stock outstanding at November 6, 2002: 20,133,903.

TABLE OF CONTENTS


PART I FINANCIAL INFORMATION
	ITEM 1. CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
		CONDENSED CONSOLIDATED BALANCE SHEETS
		CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS
		CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS
		NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
	ITEM 2. MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS
	ITEM 3. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK
	ITEM 4. CONTROLS AND PROCEDURES
PART II OTHER INFORMATION
	ITEM 1. LEGAL PROCEEDINGS
	ITEM 6. EXHIBITS AND REPORTS ON FORM 8-K
SIGNATURES
CERTIFICATIONS
EXHIBIT INDEX
EXHIBIT 99.1
EXHIBIT 99.2

IMMERSION CORPORATION

INDEX

Page

PART I

FINANCIAL INFORMATION

Item 1. Financial Statements

Condensed Consolidated Balance Sheets as of September 30, 2002 (Unaudited) and
December 31, 2001
3

Condensed Consolidated Statements of Operations (Unaudited) for the Three Months and Nine
months Ended September 30, 2002 and 2001
4

Condensed Consolidated Statements of Cash Flows (Unaudited) for the Nine Months Ended
September 30, 2002 and 2001
5

Notes to Condensed Consolidated Financial Statements (Unaudited) 6

Item 2. Management’s Discussion and Analysis of Financial Condition and Results of Operations 13

Item 3. Quantitative and Qualitative Disclosures About Market Risk 32

Item 4. Controls and Procedures 33

PART II

OTHER INFORMATION

Item 1. Legal Proceedings 33

Item 6. Exhibits and Reports on Form 8-K 34

SIGNATURES 35

CERTIFICATIONS 36

PART I
FINANCIAL INFORMATION

ITEM 1. CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

IMMERSION CORPORATION
CONDENSED CONSOLIDATED BALANCE SHEETS
(In thousands, except share and per share amounts)

September 30, December 31,

2002 2001 (1)

(Unaudited)

ASSETS

Current assets:

Cash and cash equivalents
$ 8,686 $ 10,381

Short-term investments
— 2,545

Accounts receivable, (net of allowances for doubtful accounts of: 2002, $239; and 2001, $356)
3,880 3,779

Inventories
2,353 1,965

Prepaid expenses and other current assets
435 1,179

Total current assets
15,354 19,849

Property and equipment, net
2,305 2,918

Goodwill, net
3,758 3,676

Purchased intangibles and other assets, net
6,836 8,382

Other investments
1,000 2,200

Total assets
$ 29,253 $ 37,025

LIABILITIES AND STOCKHOLDERS’ EQUITY

Current liabilities:

Accounts payable
$ 840 $ 722

Accrued compensation
773 1,158

Other current liabilities
1,353 587

Deferred revenue and customer advances
1,034 953

Current portion of long-term debt and warrant liability
599 4,519

Current portion of capital lease obligation
22 22

Total current liabilities
4,621 7,961

Long-term debt, less current portion
28 83

Capital lease obligation, less current portion
31 47

Warrant liability
— 120

Long-term deferred revenue, less current portion
4,542 —

Total liabilities
9,222 8,211

Contingencies (Note 8)

Stockholders’ equity:

Common stock — $0.001 par value; 100,000,000 shares authorized; shares issued and outstanding: 2002, 20,133,903 and 2001, 18,973,108
89,450 89,294

Warrants
1,974 1,990

Deferred stock compensation
(1,725 ) (2,956 )

Accumulated other comprehensive loss
(16 ) (19 )

Accumulated deficit
(69,652 ) (59,495 )

Total stockholders’ equity
20,031 28,814

Total liabilities and stockholders’ equity
$ 29,253 $ 37,025

See accompanying Notes to Condensed Consolidated Financial Statements.

(1) The balance sheet at December 31, 2001 has been derived from the audited financial statements at that date but does not include all of the information and footnotes required by generally accepted accounting principles for complete financial statements.

IMMERSION CORPORATION
CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS
(In thousands, except per share amounts)
(Unaudited)

Three Months Ended Nine Months Ended

September 30, September 30,

2002 2001 2002 2001

Revenues:

Royalty revenue
$ 878 $ 1,263 $ 3,745 $ 3,385

Product sales
2,612 2,327 7,831 8,073

Development contracts and other
987 881 3,167 2,610

Total revenues
4,477 4,471 14,743 14,068

Costs and expenses:

Cost of product sales
1,623 1,421 4,387 4,801

Sales and marketing
1,607 2,303 5,533 7,929

Research and development
1,557 1,791 4,848 5,920

General and administrative
2,062 2,116 5,853 5,917

Amortization of intangibles and deferred stock compensation *
748 1,301 2,374 3,953

Other charges
— 100 397 225

Total costs and expenses
7,597 9,032 23,392 28,745

Operating loss
(3,120 ) (4,561 ) (8,649 ) (14,677 )

Interest and other income
20 301 255 1,084

Interest and other expense
(1,332 ) (4,778 ) (1,763 ) (5,185 )

Net loss
$ (4,432 ) $ (9,038 ) $ (10,157 ) $ (18,778 )

Basic and diluted net loss per share
$ (0.22 ) $ (0.48 ) $ (0.51 ) $ (1.01 )

Shares used in calculating basic and diluted net loss per share
20,113 18,785 19,825 18,616

* Amortization of intangibles and deferred stock compensation

Amortization of intangibles
$ 422 $ 923 $ 1,383 $ 2,831

Deferred stock compensation — sales and marketing
3 4 9 7

Deferred stock compensation — research and development
321 334 965 898

Deferred stock compensation — general and administrative
2 40 17 217

Total
$ 748 $ 1,301 $ 2,374 $ 3,953

See accompanying Notes to Condensed Consolidated Financial Statements.

IMMERSION CORPORATION
CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS
(In thousands)
(Unaudited)

Nine Months Ended

September 30,

2002 2001

Cash flows from operating activities:

Net loss
$ (10,157 ) $ (18,778 )

Adjustments to reconcile net loss to net cash provided by (used in) operating activities:

Depreciation and amortization
975 930

Amortization of intangibles
1,383 2,831

Amortization of deferred stock compensation
991 1,122

Amortization of discounts on notes payable
275 338

Fair value adjustment for warrant liability
(89 ) (245 )

Loss on disposal of equipment
19 34

Loss on writedown of investments
1,200 4,539

Noncash compensation expense
14 —

Noncash interest expense
212 234

Changes in operating assets and liabilities:

Accounts receivable
(101 ) (1,781 )

Inventories
(388 ) (311 )

Prepaid expenses and other assets
825 (185 )

Accounts payable
113 (487 )

Accrued liabilities
381 (189 )

Deferred revenue and customer advances
4,623 (372 )

Net cash provided by (used in) operating activities
276 (12,320 )

Cash flows from investing activities:

Purchases of short-term investments
(5 ) (1,020 )

Sales and maturities of short-term investments
2,550 3,381

Purchases of property and equipment
(381 ) (536 )

Net cash provided by investing activities
2,164 1,825

Cash flows from financing activities:

Issuance of common stock
95 295

Exercise of warrants
50 —

Exercise of stock options
222 248

Payments on notes payable and capital leases
(4,509 ) (89 )

Proceeds from shareholder note
— 17

Net cash provided by (used in) financing activities
(4,142 ) 471

Effect of exchange rates on cash and cash equivalents
7 (26 )

Net (decrease) in cash and cash equivalents
(1,695 ) (10,050 )

Cash and cash equivalents:

Beginning of the period
10,381 23,474

End of the period
$ 8,686 $ 13,424

Supplemental disclosure of cash flow information :

Cash paid for taxes
$ — $ 4

Cash paid for interest
$ 978 $ 69

Supplemental disclosure of noncash investing and financing activities:

Change in net unrealized gains from short-term investments
$ — $ 1

See accompanying Notes to Condensed Consolidated Financial Statements.

IMMERSION CORPORATION
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
SEPTEMBER 30, 2002
(Unaudited)

1. SIGNIFICANT ACCOUNTING POLICIES

Basis of Presentation — The accompanying unaudited condensed consolidated financial statements reflect all the normal recurring adjustments which are, in the opinion of management, necessary to present fairly the condensed consolidated financial position, statements of operations and cash flows for the interim periods presented.

The accompanying unaudited condensed consolidated financial statements have been prepared in accordance with the instructions for Form 10-Q and, therefore, do not include all information and footnotes necessary for a complete presentation of the financial position, results of operations, and cash flows, in conformity with accounting principles generally accepted in the United States of America. These unaudited condensed consolidated financial statements should be read in conjunction with the Company’s audited consolidated financial statements included in the Company’s Annual Report on Form 10-K for the fiscal year ended December 31, 2001.

The results of operations for the interim period ended September 30, 2002 are not necessarily indicative of the results to be expected for the full year.

Reclassifications — Certain prior period amounts have been reclassified to conform to the current period presentation. These reclassifications had no material effect on net loss or stockholders’ equity.

Goodwill and Purchased Intangible Assets — In June 2001, the Financial Accounting Standards Board issued SFAS No. 142, Goodwill and Other Intangible Assets. SFAS No. 142 addresses the initial recognition and measurement of intangible assets acquired outside of a business combination and the accounting for goodwill and other intangible assets subsequent to their acquisition. SFAS No. 142 provides that intangible assets with finite useful lives will be amortized and that goodwill and intangible assets with indefinite lives will not be amortized, but rather will be tested at least annually for impairment. The Company adopted SFAS No. 142 effective January 1, 2002 and discontinued the amortization of goodwill.

Under SFAS 142, material amounts of goodwill attributable to each of our reporting units are required to be tested for impairment by comparing the fair value of each reporting unit with its carrying value. These impairment tests are required to be performed at adoption and at least annually thereafter. Prior to June 30, 2002, the Company performed the first of the required impairment tests of goodwill. No impairment loss resulted from the initial goodwill impairment test. On an ongoing basis (absent any impairment indicators), we expect to perform our impairment tests during the fourth quarter, in conjunction with our annual budgeting process. There can be no assurance that future goodwill impairment tests will not result in a charge to earnings.

The following pro forma financial information reflects net income and diluted earnings per share as if goodwill and certain intangibles were not subject to amortization for the three and nine months ended September 30, 2001 (in thousands, except per share amounts):


	Three Months Ended						Nine Months Ended
	September 30, 2001						September 30, 2001

	Net (Loss)			(Loss) per share			Net (Loss)			(Loss) per share

Amounts as reported	$	(9,038	)	$	(0.48	)	$	(18,778	)	$	(1.01	)
Amortization of goodwill and intangibles		419			0.02			1,257			0.07

Pro forma amounts	$	(8,619	)	$	(0.46	)	$	(17,521	)	$	(0.94	)

The carrying amount of goodwill is attributable to the Immersion Computing, Entertainment and Industrial segment.

In connection with adopting SFAS 142, we also reassessed the useful lives and the classification of our identifiable intangible assets and determined that they continued to be appropriate except for acquired workforce of $82,000, which was reclassified into goodwill. The components of our purchased intangibles and other assets are as follows:


	September 30,			December 31,
	2002			2001

	(In thousands)
Purchased patents and technology	$	6,757		$	6,418
Other intangibles		5,748			5,830
Other assets		83			503

Gross purchased intangibles and other assets	$	12,588		$	12,751
Accumulated amortization of purchased patents and technology		(2,382	)		(1,907	)
Accumulated amortization of other intangibles		(3,370	)		(2,462	)

Net purchased intangibles and other assets	$	6,836		$	8,382

Amortization of intangibles during the three and nine months ended September 30, 2002 was $422,000 and $1.4 million respectively. The estimated annual amortization expense for intangible assets as of September 30, 2002 was $1.7 million in 2002, $1.5 million in 2003, $1.3 million in 2004, $1.0 million in 2005, $579,000 in 2006, $498,000 in 2007, and $80,000 in 2008.

Recent Accounting Pronouncements — In June 2001, the FASB issued SFAS No. 143, “Accounting for Asset Retirement Obligations” which applies to contractual obligations associated with the retirement of a tangible long-lived asset that results from the acquisition, construction, or development and/or the normal operation of a long-lived asset. Under this standard, guidance is provided on measuring and recording the liability. We intend to adopt this statement effective January 1, 2003. We do not believe that adoption of this statement will materially impact our financial position, results of operations or cash flows.

Effective January 1, 2002, the Company adopted the provisions of SFAS No. 144, “Accounting for the Impairment or Disposal of Long-Lived Assets.” This Statement establishes a single accounting model for the impairment or disposal of long-lived assets. The adoption of SFAS No. 144 did not have a material impact on the Company’s consolidated financial statements for the three and nine months ended September 30, 2002.

On April 30, 2002, the FASB issued SFAS 145, “Rescission of FASB Statements No. 4, 44, and 64, Amendment of FASB Statement No. 13, and Technical Corrections.” The Statement updates, clarifies and simplifies existing accounting pronouncements. Among other things, SFAS 145 rescinds SFAS 4, which required all gains and losses from extinguishment of debt to be aggregated and, if material, classified as an extraordinary item, net of related income tax effect. As a result, the criteria in Accounting Principles Board Opinion 30 will now be used to classify those gains and losses. The statement is effective on various dates after May 15, 2002. The adoption of SFAS No. 145 did not have an impact on the Company’s consolidated financial statements for the three and nine months ended September 30, 2002.

In June 2002, the FASB issued SFAS 146, “Accounting for Costs Associated with Exit or Disposal Activities,” which addresses accounting for restructuring and similar costs. SFAS 146 supersedes previous accounting guidance, principally Emerging Issues Task Force Issue No. 94-3. The Company will adopt the provisions of SFAS 146 for restructuring activities initiated after December 31, 2002. SFAS 146 requires that the liability for costs associated with an exit or disposal activity be recognized when the liability is incurred. Under issue 94-3, a liability for an exit cost would be recognized at the date of the Company’s commitment to an exit plan. SFAS 146 also establishes that the liability should be measured and recorded at fair value. Accordingly, SFAS 146 may affect the timing of recognizing future restructuring costs as well as the amounts recognized. We do not believe that adoption of SFAS 146 will materially impact our financial position, results of operations or cash flows.

2. INVENTORIES


	September 30,		December 31,
	2002		2001

	(In thousands)
Raw materials and subassemblies	$	1,645	$	1,148
Work in process		159		146
Finished goods		549		671

Total	$	2,353	$	1,965

3. PROPERTY AND EQUIPMENT


	September 30,			December 31,
	2002			2001

	(In thousands)
Computer equipment and purchased software	$	2,000		$	1,982
Machinery and equipment		1,785			1,765
Furniture and fixtures		1,329			1,417
Leasehold improvements		692			698

Total		5,806			5,862
Less accumulated depreciation		(3,501	)		(2,944	)

Property and equipment, net	$	2,305		$	2,918

4. OTHER INVESTMENTS

Other investments are comprised of equity investments in privately-held companies accounted for under the cost method. The Company intends to hold its equity investments for the long term and monitors whether there have been other-than-temporary declines in value of these investments based on management’s estimates of their net realizable value taking into account the companies’ respective financial condition and ability to raise third-party financing. At September 30, 2002 the balance of other investments was $1.0 million, after a write down of $1.2 million during the quarter ended September 30, 2002. At December 31, 2001 the balance of other investments was $2.2 million, after a write down of $4.5 million during the quarter ended September 30, 2001.

5. NET LOSS PER SHARE

The following is a reconciliation of the numerators and denominators used in computing basic and diluted net loss per share (in thousands, except per share amounts):


		Three Months Ended						Nine Months Ended
		September 30,						September 30,

		2002			2001			2002			2001

Numerator:
	Net loss	$	(4,432	)	$	(9,038	)	$	(10,157	)	$	(18,778	)

Denominator:
	Weighted average common shares outstanding		20,113			18,785			19,825			18,637
	Weighted average common shares held in escrow		—			—			—			(21	)

	Shares used in computation, basic and diluted		20,113			18,785			19,825			18,616

Net loss per share, basic and diluted		$	(0.22	)	$	(0.48	)	$	(0.51	)	$	(1.01	)

For the above-mentioned periods, the Company had securities outstanding that could potentially dilute basic earnings per share in the future, but were excluded from the computation of diluted net loss per share in the periods presented since their effect would have been anti-dilutive. These outstanding securities consisted of the following:


	September 30,

	2002		2001

Convertible note payable		—		226,450
Outstanding stock options		7,037,041		8,085,578
Warrants		511,999		523,972

6. COMPREHENSIVE LOSS

The following table sets forth the components of comprehensive loss:


		Three Months Ended						Nine Months Ended
		September 30,						September 30,

		2002			2001			2002			2001

		(In thousands)						(In thousands)
	Net loss	$	(4,432	)	$	(9,038	)	$	(10,157	)	$	(18,778	)
	Foreign currency translation adjustment		(10	)		(1	)		2			(51	)
	Change in unrealized gains on short-term investments		—			—			—			1

Total comprehensive loss		$	(4,442	)	$	(9,039	)	$	(10,155	)	$	(18,828	)

7. SEGMENT INFORMATION, OPERATIONS BY GEOGRAPHIC AREA AND SIGNIFICANT CUSTOMERS

The Company designs, develops, produces, markets and licenses products based on touch-enabling technology. These devices are used in computer entertainment, personal computing, medical and other professional computing applications. The Company has two operating and reportable segments. A description of the types of products and services provided by each operating segment is as follows:

Immersion Computing, Entertainment and Industrial develops and markets TouchSense and force-feedback technology that enables software and hardware developers to bring realism into their computing and entertainment experience and industrial applications. Immersion Medical develops, manufactures, and markets medical simulators that recreate realistic healthcare environments.

The following tables display information about our reportable segments:


		Three Months Ended						Nine Months Ended
		September 30,						September 30,

		2002			2001			2002			2001

		(In thousands)						(In thousands)
Revenues:
	Immersion Computing, Entertainment and Industrial	$	2,496		$	3,334		$	9,193		$	10,316
	Immersion Medical		2,121			1,145			5,753			3,778
	Intersegment eliminations		(140	)		(8	)		(203	)		(26	)

Total		$	4,477		$	4,471		$	14,743		$	14,068

Net Loss:
	Immersion Computing, Entertainment and Industrial	$	(4,240	)	$	(7,323	)	$	(8,439	)	$	(14,373	)
	Immersion Medical		(134	)		(1,713	)		(1,632	)		(4,402	)
	Intersegment eliminations		(58	)		(2	)		(86	)		(3	)

Total		$	(4,432	)	$	(9,038	)	$	(10,157	)	$	(18,778	)


		September 30,			December 31,
		2002			2001

		(In thousands)
Total Assets:
	Immersion Computing, Entertainment and Industrial	$	39,544		$	41,670
	Immersion Medical		3,457			2,990
	Intersegment eliminations		(13,748	)		(7,635	)

Total		$	29,253		$	37,025

The Company operates primarily in the United States and in Canada where it operates through its wholly owned subsidiary, Immersion Canada. Segment assets and expenses relating to the Company’s corporate operations are not allocated but are included in Immersion Computing, Entertainment and Industrial as that is how they are considered for management evaluation purposes. As a result, the segment information may not be indicative of the financial position or results of operations that would have been achieved had these segments operated as unaffiliated entities. Management measures the performance of each segment based on several metrics, including net loss. These results are used, in part, to evaluate the performance of, and allocate resources, to each of the segments.

REVENUE BY REGION

Revenues are broken out geographically by the ship-to location of the customer. Geographic revenue as a percentage of total revenue was as follows:


		Three Months Ended						Nine Months Ended
		September 30,						September 30,

		2002			2001			2002			2001

North America			76	%		71	%		67	%		71	%
Europe			15	%		10	%		16	%		12	%
Far East			9	%		17	%		15	%		16	%
Rest of the world			0	%		2	%		2	%		1	%

	Total		100	%		100	%		100	%		100	%

The Company derived 73% and 71% of its total revenues from the United States for the three months ended September 30, 2002 and 2001 respectively. The Company derived 66% and 69% of its total revenues from the United States for the nine months ended September 30, 2002 and 2001 respectively. Revenues from Japan accounted for 10% of the Company’s total revenues for the nine months ended September 30, 2002. Revenues from other countries represented less than 10% individually for the periods presented.

The majority of the Company’s long-lived assets were located in the United States. Long-lived assets included net property and equipment and long-term investments and other assets. Long-lived assets that were outside the United States constituted less than 10% of the total at September 30, 2002 and December 31, 2001.

SIGNIFICANT CUSTOMERS

Customers comprising 10% or greater of the Company’s net revenues are summarized as follows:


		Three Months Ended						Nine Months Ended
		September 30,						September 30,

		2002			2001			2002			2001

Customer A			*			15	%		*			12	%
Customer B			*			*			11	%		*
Customer C			10	%		*			*			*

	Total		10	%		15	%		11	%		12	%

Revenue derived from customer represented less than 10% for the period.

As of September 30, 2002, customer C accounted for 12% of the Company’s accounts receivables. As of September 30, 2001, customer A accounted for 11% of the Company’s accounts receivables. No other customer accounted for more than 10% of the Company’s accounts receivable for the periods presented.

8. CONTINGENCIES

In re Immersion Corporation

The Company is involved in legal proceedings relating to a class action lawsuit filed on November 9, 2001. The case is now designated as In re Immersion Corporation Initial Public Offering Securities Litigation, No. Civ. 01-9975 (S.D.N.Y.), related to In re Initial Public Offering Securities Litigation, No. 21 MC 92 (S.D.N.Y.). The action was filed in the United States District Court, Southern District of New York, against defendants Immersion Corporation, Louis Rosenberg (former Chief Executive Officer, President and Chairman of the Company), Victor Viegas (current President, Chief Executive Officer and Chief Financial Officer), Bruce Schena (former Chief Technology Officer and Director); and certain underwriters of Immersion’s November 12, 1999 initial public offering. Subsequently, two of the individual

defendants stipulated to a dismissal without prejudice. The case is purportedly brought on behalf of all persons who purchased the Company’s common stock from November 12, 1999 through December 6, 2000.

The lawsuit has been consolidated for pretrial purposes with similar lawsuits relating to more than 300 other initial public offerings conducted in 1999 and 2000 before the Honorable Judge Shira A. Scheindlin. On May 29, 2002, plaintiffs electronically served an amended complaint. The amended complaint alleges violations of Sections 11 and 15 of the Securities Act of 1933 and Sections 10(b) and 20(a) of the Securities Exchange Act of 1934, on the grounds that the prospectus incorporated in the registration statement for the Company’s initial public offering failed to disclose, among other things, that (i) the underwriter had solicited and received excessive and undisclosed commissions from certain investors in exchange for which the underwriter allocated to those investors material portions of the shares of the Company’s stock sold in the offering; and (ii) the underwriter had entered into agreements with customers whereby the underwriter agreed to allocate shares of the Company’s stock sold in the offering to those customers in exchange for which the customers agreed to purchase additional shares of the Company’s stock in the aftermarket at pre-determined prices. The amended complaint appears to allege that false or misleading analyst reports were issued. The amended complaint does not claim any specific amount of damages.

On July 15, 2002, the Company (as well as the other issuers and their affiliated individual defendants) filed a motion to dismiss. The motions were heard on November 1, 2002 and are currently under consideration by the judge. Settlement discussions with the Plaintiffs are being conducted under the auspices of a mediator. The Company is considering a settlement proposal presented by the mediator.

Immersion Corporation vs. Microsoft Corporation, Sony Computer Entertainment Inc. and Sony Computer Entertainment of America, Inc.

On February 11, 2002, we filed a complaint against Microsoft Corporation, Sony Computer Entertainment, Inc., and Sony Computer Entertainment of America, Inc. in the U.S. District Court for the Northern District Court of California alleging infringement of U.S. Patent Nos. 5,889,672 and 6,275,213. The case was assigned to United States District Judge Claudia Wilken. On April 4, 2002, Sony Computer Entertainment and Microsoft answered the complaint by denying the material allegations and alleging counterclaims seeking a judicial declaration that the asserted patents were invalid, unenforceable, or not infringed. The process of discovery and exchanging information and documents on infringement, invalidity, and claim construction, is underway. On October 8, 2002, we filed an amended complaint, withdrawing the claim under the ‘672 patent and adding a claim of infringement of a new patent, U.S. Patent No. 6,424,333. On October 10, 2002, the Court entered an Amended Case Management Order that sets, among other dates in the case, April 18, 2003 for a hearing to construe the claims of the asserted patents and April 5, 2004 for the start of trial. On October 28, 2002, Sony Computer Entertainment and Microsoft answered the amended complaint and alleged similar counterclaims for declaratory relief that the asserted patents are invalid, unenforceable, or not infringed. Due to the inherent uncertainties of litigation, we cannot accurately predict the ultimate outcome of the litigation. We anticipate that the litigation will be costly, and there can be no assurance that we will be able to recover the costs we incur in connection with the litigation. The litigation has diverted, and is likely to continue to divert, the efforts and attention of some of our key management and personnel. As a result, until such time as it is resolved, the litigation could adversely affect our business. Further, any unfavorable outcome could adversely affect our business.

Other Contingencies

The Company’s 70% owned subsidiary, Sky Fitness, has had claims against the Company relating to the Sky Fitness mark and ownership of the Sky Fitness technology. The claims allege that the SkyCYCLE mark infringes a competitor’s mark and that a former employee of the Company violated a noncompete clause within his employment agreement. The Company believes these claims are without merit and would vigorously defend itself if these claims were to progress.

In addition, the Company has received claims from third parties asserting that the Company’s technologies, or those of its licensees, infringe on the other parties’ intellectual property rights. Management believes that these claims are without merit and, with respect to each, has obtained or is in the process of obtaining written non-infringement and/or patent invalidity opinions from outside patent counsel. The Company from time to time is involved in routine legal matters and contractual disputes incidental to its normal operations. In management’s opinion, the resolution of such matters will not have a material adverse effect on the Company’s consolidated financial condition, results of operations or liquidity.

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

This Quarterly Report on Form 10-Q includes forward-looking statements within the meaning of Section 27A of the Securities Act of 1933, as amended, and Section 21E of the Securities Exchange Act of 1934, as amended. The forward-looking statements involve risks and uncertainties. Forward-looking statements are identified by words such as “anticipates”, “believes”, “expects”, “intends”, “may”, “will” and other similar expressions. However, these words are not the only way we identify forward-looking statements. In addition, any statements, which refer to expectations, projections or other characterizations of future events or circumstances are forward-looking statements. Actual results could differ materially from those projected in the forward-looking statements as a result of a number of factors, including those set forth in this Management’s Discussion and Analysis of Financial Condition and Results of Operation and Factors That May Affect Future Results, those described elsewhere in this report and those described in our other reports filed with the SEC. We caution you not to place undue reliance on these forward-looking statements, which speak only as of the date of this report, and we undertake no obligation to release the results of any revisions to these forward-looking statements which could occur after the filing of this report.

OVERVIEW

We develop, manufacture, license and support a wide range of hardware and software technologies that enable users to interact with a multitude of computing and other devices using their sense of touch. We manage our business under two operating and reportable segments: Immersion Computing, Entertainment and Industrial, and Immersion Medical. We focus on four application areas — computing and entertainment, medical simulation, professional and industrial, and three-dimensional capture and interaction. In high volume market areas such as consumer computer peripherals and automotive interfaces, we primarily license our touch-enabling technologies to third party manufacturers. We have licensed our intellectual property to numerous manufacturers of mice, joysticks, knobs, wheels and gamepads targeted at consumers. For lower-volume markets like medical simulation systems and three-dimensional capture and interaction products, our primary strategy is to manufacture and sell products through direct sales, distributors and value added resellers. We sell medical simulation devices used to train and allow health care providers to practice and enhance their skills in a variety of procedures. These devices simulate such procedures as intravenous catheterization, endovascular interventions, and laparoscopic and endoscopic surgical procedures. We also sell three-dimensional capture and interaction products. Our capture products include the MicroScribe G2 desktop digitizer product line and associated software and accessories. Our interaction product line is comprised of specialized whole-hand sensing gloves, armatures and software, including the CyberGlove, CyberGrasp, CyberForce, CyberTouch and VirtualHand software products, that permit simulated interaction with three-dimensional environments. In all market areas, we also engage in development projects for third parties from time to time.

We have entered into numerous contracts with government agencies and corporations since 1993. Government contracts help fund advanced research and development, are typically less than two years in duration, are usually for a fixed price or for our costs plus a fixed fee, and allow the government agency to license the resulting technology for government applications, specifically excluding any commercial activity. Corporate contracts are typically for product development consulting, are for a fixed fee and are also less than two years in duration.

Since inception, we have completed a number of acquisitions of patents and technology. We capitalize the cost of patents and technology and license agreements, except for amounts relating to acquired in-process research and development for which there is no alternative future use. As of September 30, 2002, we had capitalized patents and technology of $4.4 million, net of accumulated amortization of $2.4 million. We are amortizing these patents and technology over the estimated useful life of the technology of nine years.

We currently derive royalty revenue from sales of our licensees’ consumer computer peripheral devices, such as touch-enabled mice and joysticks. We also derive royalty revenue from the inclusion of touch-enabled controls incorporating our technology in automobiles and medical simulators. Our basic licensing model typically includes an up-front license fee and/or a royalty paid by the peripheral or automobile manufacturer that is a percentage of the wholesale selling price of the touch-enabled product. We derive product revenue from a number of sources including sales of our medical simulation hardware devices and from sales of the software modules that are used in conjunction with such devices. Other sources of product revenue include sales of our three-dimensional digitizing products, such as the MicroScribe G2 products, sales of hardware and software for our whole-hand sensing gloves, such as the CyberGlove, and sales of our custom microprocessors, called the Immersion Processors, which are designed for use by our licensees in

their touch-enabled computer peripheral devices. With respect to development projects, most such projects involve assisting our licensees in the development of their touch-enabled products for which we receive fixed payments for product-related deliverables.

We recognize revenues in accordance with applicable accounting standards including the American Institute of Certified Public Accountants’ Statement of Position 97-2, Software Revenue Recognition, as amended. Revenue is recognized when persuasive evidence of an arrangement exists, delivery has occurred or service has been rendered, the fee is fixed and determinable, and collectibility is probable. This generally occurs at the time of shipment for product sales. We recognize fixed-fee contract revenue under the cost-to-cost percentage-of-completion accounting method based on the actual physical completion of work performed and the ratio of costs incurred to total estimated costs to complete the contract. We recognize allowable fees under cost-reimbursement contracts as costs are incurred. Losses on contracts are recognized when determined. Revisions in estimates are reflected in the period in which the conditions become known. We recognize royalty revenue based on royalty reports or related information received from our licensees and time-based licenses of our intellectual property portfolio over the term of the license.

RESULTS OF OPERATIONS FOR THE THREE MONTHS AND NINE MONTHS ENDED SEPTEMBER 30, 2002 AND 2001 ARE AS FOLLOWS:


	September 30,				Change

REVENUES	2002		2001

	($ In thousands)
Three months ended:
Royalty revenue	$	878	$	1,263		(30	)%
Product sales		2,612		2,327		12	%
Development contracts and other		987		881		12	%

Total Revenue	$	4,477	$	4,471		0	%

Nine months ended:
Royalty revenue	$	3,745	$	3,385		11	%
Product sales		7,831		8,073		(3	)%
Development contracts and other		3,167		2,610		21	%

Total Revenue	$	14,743	$	14,068		5	%

Total Revenue. Our total revenue for the third quarter of fiscal 2002 was $4.5 million, flat with the third quarter of fiscal 2001; a decrease in royalty revenue was offset by increases in both product sales and development contract revenues for the period. Royalty revenue for the three months ended September 30, 2002 decreased to $878,000 from $1.3 million for the three months ended September 30, 2001, a decrease of 30%. Royalty revenue is comprised of royalties earned on sales by our TouchSense licensees and license fees charged for our intellectual property portfolio. This decrease is mainly due to delayed new product introductions from some of our gaming licensees this year, as well as an elevated level of new product introductions during the third quarter of 2001. Product sales for the three months ended September 30, 2002 increased by $285,000 or 12% as compared to the three months ended September 30, 2001. The increase in product sales was mainly due to an increase of $757,000 in our medical product sales, offset by a decrease of $319,000 in our microprocessors sales and a decrease of $138,000 for our custom location-based entertainment products as compared with the three months ended September 30, 2001. Medical product sales consist of sales of our virtual reality medical simulators in the vascular, endoscopic, endovascular, and laparoscopic product lines. The increase in medical product sales is primarily the result of an increase in simulator sales in the vascular and laparoscopic product lines during the third quarter of 2002 as compared to the third quarter of 2001. The decline in our microprocessor sales is based on a decision to decrease the sales effort related to this low margin product line as well as reduced volume requirements from our licensees who use this microprocessor solution. Development contract and other revenue is comprised of revenue on commercial and government contracts, which increased by $106,000 during the third quarter of fiscal 2002, as compared to the third quarter of fiscal 2001, due to an increase in

related development activity on existing contracts and on securing new commercial and governmental development contracts.

Our total revenue for the first nine months of fiscal 2002 increased by $675,000 or 5% from the first nine months of fiscal 2001. The increase in royalty revenue of $360,000 or 11% is mainly attributable to an increase in royalties from our automotive and medical licensees and product offerings by those licensees during the first nine months of fiscal 2002. The decrease in product sales for the nine months ended September 30, 2002 of $242,000 or 3% is primarily attributable to a decrease of $713,000 in microprocessor sales, a decrease of $424,000 in our 3D product sales, and a decrease of $306,000 in our custom location-based entertainment products, offset by an increase in medical product sales of $1.2 million. The significant increase in medical product sales is due to increased hardware and software platform offerings and increased markets for this technology. The decline in our microprocessor sales is based on a decision to decrease the sales effort related to this low margin product line as well as reduced volume requirements from our licensees who use this microprocessor solution. Products sold by our 3D group include the MicroScribe G2 product line and products such as the CyberGlove and CyberForce for use in research in computer-aided design, simulation, training and virtual reality applications. The decline in our 3D product sales during the nine months ended September 30, 2002 as compared to the nine months ended September 30, 2001 is mainly the result of the current economic climate causing delayed capital spending by industrial customers. The increase of $557,000 in development contract and other revenue for the first nine months of fiscal 2002 compared to the first nine months of fiscal 2001 is due primarily to an increase in related development activity on commercial and governmental contracts in our medical business.

We categorize our geographic information into four major regions: North America, Europe, Far East, and Rest of the World. In the third quarter of fiscal 2002, revenue generated in North America, Europe, Far East and Rest of the World represented 76%, 15%, 9%, and 0% respectively compared to 71%, 10%, 17%, and 2% respectively, for the third quarter of fiscal 2001. The shift in revenues among regions is mainly due to an increase in medical product sales and development efforts in North America and Europe and a decrease in sales of our microprocessors to licensees in the Far East.

In the first nine months of fiscal 2002, revenue generated in North America, Europe, Far East, and Rest of the World represented 67%, 16%, 15%, and 2% respectively compared to 71%, 12%, 16%, and 1% respectively, for the first nine months of fiscal 2001. The shift in revenues among regions is mainly due to an increase in royalty revenue and medical product sales to Europe and a decrease in location-based entertainment products in North America.


		September 30,						Change

COST OF PRODUCT SALES		2002			2001

		($ In thousands)
Three months ended:
Cost of product sales		$	1,623		$	1,421			14	%
	% of total product revenue		62	%		61	%
Nine months ended:
Cost of product sales		$	4,387		$	4,801			(9	)%
	% of total product revenue		56	%		59	%

Cost of Product Sales. Our cost of product sales consists primarily of materials, labor and overhead. There is no cost of product sales associated with royalty revenue or development contract revenue. Cost of product sales increased by $202,000 or 14% for the three months ended September 30, 2002 as compared to the three months ended September 30, 2001. The $202,000 increase in cost of product sales for the third quarter of 2002 is primarily due to a combination of increased product sales of 12% and an increase in overhead costs of $107,000.

Cost of product sales decreased by $414,000 or 9% for the nine months ended September 30, 2002 as compared to the nine months ended September 30, 2001. The $414,000 decrease in cost of product sales is due to a combination of decreased product sales, a favorable shift in the product mix and a decrease in inventory write downs. For the nine months ended September 30, 2002 compared to the nine months ended September 30, 2001 product sales decreased by

3% and sales of our lower margin products such as our microprocessors decreased contributing to favorable product mix. This favorable mix shift is primarily the reason for the decrease in cost of product sales as a percentage of total product sales to 56% for the nine months ended September 30, 2002 compared to 59% for the nine months ended September 30, 2001. Inventory write downs decreased by $158,000 for the nine months ended September 30, 2002 largely due to the significant write down taken during the nine months ended September 30, 2001 for our LightScribe product line.


		September 30,						Change

OPERATING EXPENSES AND OTHER		2002			2001

		($ In thousands)
Three months ended:
Sales and marketing		$	1,607		$	2,303			(30	)%
	% of total revenue		36	%		52	%
Research and development		$	1,557		$	1,791			(13	)%
	% of total revenue		35	%		40	%
General and administrative		$	2,062		$	2,116			(3	)%
	% of total revenue		46	%		47	%
Amortization of intangibles and deferred stock compensation		$	748		$	1,301			(43	)%
	% of total revenue		17	%		29	%
Other charges		$	—		$	100			(100	)%
	% of total revenue		0	%		2	%

Nine months ended:
Sales and marketing		$	5,533		$	7,929			(30	)%
	% of total revenue		38	%		56	%
Research and development		$	4,848		$	5,920			(18	)%
	% of total revenue		33	%		42	%
General and administrative		$	5,853		$	5,917			(1	)%
	% of total revenue		40	%		42	%
Amortization of intangibles and deferred stock compensation		$	2,374		$	3,953			(40	)%
	% of total revenue		16	%		28	%
Other charges		$	397		$	225			76	%
	% of total revenue		3	%		2	%

Sales and Marketing. Our sales and marketing expenses are comprised primarily of employee headcount and related compensation and benefits, advertising, trade shows, brochures, market development funds, travel and an allocation of facilities costs. Sales and marketing expenses decreased by $696,000 or 30% in the third quarter of fiscal 2002 compared to the comparable period in 2001. The decrease was mainly due to reduced headcount and related compensation, benefits and overhead costs of $214,000, reduced expenses of $241,000 for market development funds, application development, collateral reproduction and advertising, reduced supplies and materials of $53,000, reduced travel expenses of $50,000

and a decrease in bad debt expenses of $144,000. The reduction in marketing expenses reflects our ability to leverage programs and marketing materials initiated in prior periods and continued implementation of cost reductions initiated during 2001 and continued in 2002.

Sales and marketing expenses decreased by $2.4 million or 30% in the first nine months of fiscal 2002 compared to the same period last year. The decrease was mainly due to reduced expenses in market development funds, application development, collateral reproduction, and advertising costs of $1.1 million, a decrease in personnel related costs of $794,000 primarily attributable to a decrease in employee headcount, related compensation, benefits and overhead, reduced travel expenses of $155,000, reduced supplies and materials of $36,000, and a decrease in bad debt expenses of $268,000.

Research and Development. Our research and development expenses are comprised primarily of headcount and related compensation and benefits, consulting fees, tooling and supplies and an allocation of facilities costs. Research and development expenses decreased by $234,000 or 13% in the third quarter of fiscal 2002 compared to the same period in 2001. The decrease was mainly due to a decrease in personnel related costs of $142,000 primarily attributable to a decrease in employee headcount, related compensation, benefits and overhead, a decrease in outside consulting and engineering fees of $48,000 and reduced travel costs of $16,000.

Research and development expenses decreased by $1.1 million or 18% in the first nine months of fiscal 2002 compared to the same period last year. The decrease was mainly due to a decrease in personnel related costs of $665,000 attributable to a decrease in employee headcount, related compensation, benefits and overhead and a decrease in outside consulting and engineering fees of $404,000. We believe that continued investment in our research and development is critical to our future success, as we strive to deliver new products and technologies to the marketplace, and expect that these expenses may increase in absolute dollars in future periods, but decrease as a percentage of total revenues.

General and Administrative. Our general and administrative expenses are comprised primarily of employee headcount and related compensation and benefits, legal and professional fees, office supplies, travel and an allocation of facilities costs. General and administrative expenses decreased by $54,000 or 3% in the third quarter of fiscal 2002 compared to the same period in 2001. The decrease is mainly due to a decrease in personnel related costs of $385,000 attributable to a decrease in employee headcount, related compensation, benefits and overhead, and reduced travel costs of $6,000, offset by an increase in legal and professional fees of $283,000 mostly due to increased litigation costs and an increase of $43,000 of public company expenses. We expect that the dollar amount of general and administrative expenses will increase in the future as we incur additional costs related to the litigation against us and an increase in legal fees due to the litigation against both Sony and Microsoft, as well as additional public company compliance costs.

General and administrative expenses decreased $64,000 or 1% in the first nine months of fiscal 2002 compared to the same period last year. The decrease is primarily attributable to a decrease in personnel related costs of $787,000 due to a decrease in employee headcount, related compensation, benefits and overhead, a decrease in office related expenses of $58,000, and reduced travel costs of $46,000, offset by an increase in legal and professional fees of $758,000 mainly due to increased litigation costs and increased public company expenses of $88,000.

Amortization of Intangibles and Deferred Stock Compensation. Our amortization of intangibles and deferred stock compensation is comprised primarily of patent amortization, goodwill and other intangible amortizations and deferred stock compensation. Amortization of intangibles and deferred stock compensation decreased by $553,000 or 43% in the third quarter of fiscal 2002 compared to the same period in 2001. A decrease of $370,000 is the result of the adoption of SFAS No. 142, Goodwill and Other Intangible Assets beginning January 1, 2002. SFAS No. 142 provides that intangible assets with finite useful lives will be amortized and that goodwill and intangible assets with indefinite lives will not be amortized, but rather will be tested at least annually for impairment. During the second quarter of fiscal 2002 we performed our initial impairment test and no impairment loss resulted from this initial impairment test. Intangible amortization decreased by $131,000 as some intangible assets have reached full amortization and deferred stock compensation expense decreased by $52,000 due to the expiration of certain option vesting periods.

Amortization of intangibles and deferred stock compensation decreased by $1.6 million or 40% in the first nine months of fiscal 2002 compared to the same period last year. A decrease of $1.1 million is the result of the adoption of SFAS 142. Intangible amortization decreased by $350,000 and deferred stock compensation decreased by $131,000 for the nine month period ended September 30, 2002 as compared to the nine month period ended September 30, 2001.

Other Charges. Other charges decreased by $100,000 or 100% in the third quarter of fiscal 2002 as compared to the third quarter of fiscal 2001. During the quarter ended September 30, 2001 we incurred $100,000 related to severance

costs. During the nine months ended September 30, 2002, other charges increased by $172,000 or 76% as compared to the same period in 2001. The increase is due to severance costs incurred during the first quarter of fiscal 2002.

Interest and Other Income. Interest and other income consist primarily of interest income, dividend income and capital gains from cash and cash equivalents and short-term investments. Interest and other income declined by $281,000 in the third quarter of fiscal 2002 compared to the same period in 2001 as a result of reduced cash, cash equivalents and short-term investments invested for the period due to cash used in operating activities, as well as reduced yields on investments due to lower interest rates.

Interest and other income declined by $829,000 in the first nine months of fiscal 2002 compared to the same period last year as a result of reduced cash, cash equivalents and short-term investments invested for the period due to cash used in operating activities as well as reduced yields on investments due to lower interest rates.

Interest and Other Expense. Interest and other expense consist primarily of interest expense on our secured convertible promissory note and other notes payable. Interest and other expense decreased by $3.4 million for the three months and nine months ended September 30, 2002 compared to the three months and nine months ended September 30, 2001. During the quarter ended September 30, 2002 we incurred a non cash write down of $1.2 million of an investment in a privately-held company, conversely during the quarter ended September 30, 2001 we incurred a $4.5 million non cash write down of investments in two privately-held companies.

SEGMENT RESULTS FOR THE THREE MONTHS AND NINE MONTHS ENDED SEPTEMBER 30, 2002 AND 2001 ARE AS FOLLOWS:


		Three Months Ended						Nine Months Ended
		September 30,						September 30,

		2002			2001			2002			2001

		(In thousands)						(In thousands)
Revenues:
	Immersion Computing, Entertainment and Industrial	$	2,496		$	3,334		$	9,193		$	10,316
	Immersion Medical		2,121			1,145			5,753			3,778
	Intersegment eliminations		(140	)		(8	)		(203	)		(26	)

Total		$	4,477		$	4,471		$	14,743		$	14,068

Net Loss:
	Immersion Computing, Entertainment and Industrial	$	(4,240	)	$	(7,323	)	$	(8,439	)	$	(14,373	)
	Immersion Medical		(134	)		(1,713	)		(1,632	)		(4,402	)
	Intersegment eliminations		(58	)		(2	)		(86	)		(3	)

Total		$	(4,432	)	$	(9,038	)	$	(10,157	)	$	(18,778	)

Immersion Computing, Entertainment and Industrial segment. Revenues from the Immersion Computing, Entertainment and Industrial segment decreased by $838,000, or 25% in the third quarter of fiscal year 2002 compared to the same period in 2001. The decrease is mainly due to a decrease in royalty revenues and a decrease in product sales of our microprocessors and custom location-based entertainment products. Net loss for the quarter ended September 30, 2002 decreased by $3.1 million or 42% compared to the same period in 2001. The decrease is mainly due to a reduction of $3.3 million in the write down of certain investments in privately-held companies that occurred in both the third quarter of 2002 and 2001, the cessation of goodwill amortization, and a reduction in expenses for marketing partly offset by a decrease in gross margin due to reduced sales and an increase in legal fees.

Revenues for the first nine months of fiscal 2002 decreased by $1.1 million or 11% as compared to the same period last year for the Immersion Computing, Entertainment and Industrial segment. The decrease in revenue is primarily attributable to a decrease in our microprocessors and 3D product sales, and a decrease in development contract revenue for the nine months ended 2002 compared to the nine months ended in 2001, partially offset by an increase in royalty revenues for the same period. Net loss for the nine months ended September 30, 2002 decreased $5.9 million or 41% compared to the same

period in 2001. The decrease is mainly due to a reduction of $3.3 million in the write down of certain investments in privately-held companies that occurred in both the third quarter of 2002 and 2001, the cessation of goodwill amortization of $1.8 million, decreased compensation, benefits and overhead costs related to reduced headcount and a reduction in expenses for marketing partially offset by an increase in legal fees.

Immersion Medical segment. Revenues from Immersion Medical increased by $976,000 or 85% for the third quarter of fiscal 2002 compared to the same period in 2001. The increase is primarily due to an increase of $571,000 in product sales, an increase of $343,000 in development contract revenue related to new development efforts secured during 2002, and an increase in licensing revenue of $62,000. Net loss for the quarter ended September 30, 2002 decreased by $1.6 million or 92% compared to the same period in 2001. The decrease is primarily attributable to an increase in gross margin of $613,000 related to the increased development contract revenue and product sales, and reduced expenses for compensation, benefits and overhead costs of $618,000 related to reduced headcount, as well as reduced consulting service costs.

Revenues for the first nine months of fiscal 2002 for the Immersion Medical segment increased by $2.0 million or 52% as compared to the same period last year. The increase in revenues is primarily due to an increase of $912,000 in product sales, an increase of $792,000 in development contract revenue related to development contracts entered into during 2002, and an increase of $271,000 in licensing revenue. Net loss for the first nine months of fiscal 2002 decreased by $2.8 million or 63% primarily due to an increase in gross margin of $1.4 million resulting from the increase in all revenue categories, and decreased compensation, benefits and overhead costs of $1.1 million related to reduced headcount, as well as reduced consulting service costs.

LIQUIDITY AND CAPITAL RESOURCES

Our cash, cash equivalents, and short-term investments consist primarily of money market funds and highly liquid debt instruments. All of our cash equivalents and short-term investments are classified as available-for-sale under the provisions of SFAS 115, “Accounting for Certain Investments in Debt and Equity Securities.” The securities are stated at market value with unrealized gains and losses reported as a component of accumulated other comprehensive income (loss) within stockholders’ equity.

At September 30, 2002 our cash, cash equivalents and short-term investments totaled $8.7 million, down $4.2 million from $12.9 million at December 31, 2001.

Net cash provided by operating activities during the first nine months of fiscal 2002 was $276,000, an increase from the $12.3 million of net cash used in operating activities during the comparable period last year. Cash provided by operations during the nine month period ended September 30, 2002 comprised primarily of our $10.2 million net loss offset by noncash charges and credits of $5.0 million, including amortization of intangibles and deferred compensation of $2.4 million and the write down of one of our investments in a privately-held company of $1.2 million, an increase of $4.6 million due to a change in deferred revenue mostly due to prepayments under certain licensing agreements entered into during the first quarter of fiscal 2002, an increase of $825,000 due to a change in prepaid expenses and other assets, an increase of $381,000 due to a change in accrued liabilities, an increase of $113,000 due to a change in accounts payable, offset by a decrease of $388,000 due to a change in inventories, and a decrease of $101,000 due to a change in accounts receivable.

Net cash provided by investing activities during the first nine months of fiscal 2002 was $2.2 million, as opposed to the $1.8 million provided during the same period last year. Net cash provided by investing activities during the period consisted of $2.6 million sale of short-term investments offset by $381,000 used to purchase capital equipment. In order to improve our rate of return on cash and still provide short-term liquidity, we periodically purchase or sell short-term investments, which typically are interest-bearing, investment-grade securities with a maturity of greater than 90 days and less than one year.

Net cash used in financing activities during the first nine months of fiscal 2002 was $4.1 million as compared to the $471,000 provided during the same period last year. Net cash used in financing activities included payments of $4.5 million on notes payable and capital lease including $4.4 million on our convertible note payable with Medtronic, offset by issuances of common stock of $95,000, the exercise of stock options of $222,000, and the exercise of stock warrants of $50,000.

We believe that we will need to raise approximately $5.0 to $10.0 million in additional capital over the next six months to meet our working capital needs and capital expenditure requirements for the next twelve months. Our plans to raise

additional capital include possible customer prepayments of certain royalty obligations in exchange for a royalty discount and/or other negotiated concessions, entering into new license agreements which require up-front license payments and potentially through debt or equity financing. We have taken measures to control our costs and will continue to monitor these efforts. We do, however, expect our legal costs to increase during 2002 and 2003 as a result of our lawsuit against Sony and Microsoft. We anticipate that capital expenditures for the year ended December 31, 2002 will total approximately $600,000 in connection with anticipated upgrades to operations and infrastructure. Our convertible note payable with Medtronic matured on August 10, 2002, and we repaid Medtronic approximately $4.4 million in principal and interest on this note leaving $680,000 of debt on our balance sheet of which approximately $500,000 is payable during the fourth quarter of 2002. To the extent we raise additional capital through debt or equity financing for future operating needs, this could result in substantial dilution for our stockholders. If we acquire one or more businesses or products, our capital requirements could increase substantially. In the event of such an acquisition or should any unanticipated circumstances arise which significantly increase our capital requirements, we may elect to raise additional capital through debt or equity financing. Although we expect to raise additional capital, there is no assurance that necessary additional capital will be available on terms acceptable to us, if at all.

SUMMARY DISCLOSURES ABOUT CONTRACTUAL OBLIGATIONS AND COMMERCIAL COMMITMENTS

The following table presents, at December 31, 2001, our obligations and commitments to make future payments for each of the years listed under various contractual obligations. No material changes have occurred during the nine months ended September 30, 2002. The numbers presented do not include accrued interest under certain debt obligations since December 31, 2001 of $339,000 payable within 2002.

Less than 1 - 3 4 -5 After 5

Contractual Cash Obligations Total 1 Year Years Years Years

(In thousands)

Long-Term Debt
$ 4,602 $ 4,519 $ 83 $ — $ —

Capital Lease Obligations
81 30 51 — —

Operating Leases
5,528 1,195 2,409 1,108 816

Total Contractual Cash Obligations
$ 10,211 $ 5,744 $ 2,543 $ 1,108 $ 816

During the third quarter of fiscal 2002, we repaid $4.4 million of long-term debt, including interest, owed to Medtronic. As a result of this repayment our balance of long-term debt obligations is $627,000 as of September 30, 2002, that includes $599,000 payable prior to September 30, 2003. Included in this amount is a principal only balance of $500,000 payable during the fourth quarter of 2002.

CRITICAL ACCOUNTING POLICIES AND ESTIMATES

Our discussion and analysis of our financial condition and results of operations are based upon our condensed consolidated financial statements, which have been prepared in accordance with accounting principles generally accepted in the United States. The preparation of these condensed consolidated financial statements requires management to make estimates and assumptions that affect the reported amounts of assets, liabilities, revenues, expenses, and related disclosure of contingent assets and liabilities. On an ongoing basis, we evaluate our estimates, including those related to revenue recognition, bad debts, warranty obligations, patents and intangible assets, inventories, contingencies, and litigation. We base our estimates on historical experience and on various other factors that are believed to be reasonable under the circumstances, the results of which form the basis for making judgments about the carrying values of assets and liabilities that are not readily apparent from other sources. Actual results may differ from these estimates.

We believe the following critical accounting policies affect our more significant judgments and estimates used in the preparation of our consolidated financial statements:

We classify all of our cash equivalents and short-term investments that are free of trading restrictions, or become free of trading restrictions within one year, as “available-for-sale.” We carry these investments at fair value, based on quoted market prices, and unrealized gains and losses, net of taxes, are included in accumulated other comprehensive income (loss), which is reflected as a separate component of stockholders’ equity. Realized gains and losses are recognized when incurred on our consolidated statements of operations. We have a policy in place to review our short-term investments on

a regular basis to evaluate whether or not these investments have experienced an other-than-temporary decline in fair value. During the three and nine months ended September 30, 2002, we did not record any impairment losses related to any of our cash equivalents and our short-term investments.

We derive our revenues from three principal sources: royalties, product sales, and development contracts. Royalty revenues are based on royalty reports or related information received from our licensees as well as time-based licenses of our intellectual property portfolio. If this information is incorrect or inaccurate it could adversely affect revenue in future periods. To date all information received from our licensees has caused no material reduction in future period revenues. We recognize revenues from product sales when the product is shipped provided collection is determined to be probable and no significant obligation remains. Development contract revenues are recognized under the cost-to-cost percentage of completion accounting method based on physical completion of the work to be performed and the ratio of costs incurred to total estimated costs to complete the contract. Our revenue recognition policies are significant because revenue is a key component of our results of operations. In addition, our revenue recognition determines the timing of certain expenses, such as commissions and royalties. Revenue results are difficult to predict, and any shortfall in revenue or delay in recognizing revenue could cause our operating results to vary significantly from quarter to quarter and could result in greater or future operating losses.

We maintain allowances for doubtful accounts for estimated losses resulting from our review and assessment of our customers’ ability to make required payments. If the financial condition of our customers were to deteriorate, resulting in an impairment of their ability to make payments, additional allowances might be required. To date such estimated losses have been within our expectations.

We provide for estimated costs of future anticipated product returns and warranty obligations based on historical experience when related revenues are recognized and defer warranty related revenue over the related warranty term.

We have acquired patents and other intangibles. Our business acquisitions have included goodwill and other intangible assets. We assess the recoverability of our goodwill and other intangible assets and we must make assumptions regarding estimated future cash flows and other factors to determine the fair value of the respective assets that affect our consolidated financial statements. If these estimates or related assumptions change in the future, we may be required to record impairment charges for these assets, in addition changes could affect the amount of future period amortization expense that we will incur. In June 2001, the Financial Accounting Standards Board issued SFAS No. 141, Business Combinations and SFAS No. 142, Goodwill and Other Intangible Assets. SFAS No. 141 requires that all business combinations initiated after September 30, 2001 be accounted for under the purchase method and addresses the initial recognition and measurement of goodwill and other intangible assets acquired in a business combination. Business combinations originally accounted for under the pooling of interest method will not be changed. SFAS No. 142 addresses the initial recognition and measurement of intangible assets acquired outside of a business combination and the accounting for goodwill and other intangible assets subsequent to their acquisition. SFAS No. 142 provides that intangible assets with finite useful lives will be amortized and that goodwill and intangible assets with indefinite lives will not be amortized, but rather will be tested at least annually for impairment. We adopted SFAS No. 142 effective January 1, 2002 and discontinued the amortization of goodwill. Prior to June 30, 2002, we performed our first required impairment test of goodwill. No impairment loss resulted from the initial impairment test. On an ongoing basis, we expect to perform our impairment tests during the fourth quarter of each fiscal year. There can be no assurance that future goodwill impairment tests will not result in a charge to earnings.

We write down the cost of inventory for estimated obsolescence or unmarketable inventory equal to the difference between the cost of inventory and the estimated market value based upon assessments about current and future demand and market conditions. If actual market conditions were to be less favorable than those projected by management, additional inventory write-downs could be required.

We hold equity investments in privately-held companies. We intend to hold our equity investments for the long term and will monitor whether there has been other-than-temporary declines in their values based on our estimates of their net realizable value taking into account the companies respective financial condition and ability to raise third-party financing. If the decline in fair value is determined to be other-than-temporary, an impairment loss is recorded and the individual security is written down to a new cost basis. As a result of our review of the fair value of these investments, we recorded an impairment loss of $1.2 million during the third quarter of 2002, and an impairment loss of $4.3 million on these investments and a $239,000 impairment loss on interest receivable on loans on these investments during the third quarter of 2001. The remaining cost basis of these investments on our Consolidated Balance Sheet is $1.0 million. We will monitor the remaining value of these investments, and may determine that there could be other impairment losses in the future. As of September 30, 2002, we determined that the carrying value of these investments at $1.0 million is

appropriate.

RECENT ACCOUNTING PRONOUNCEMENTS

In June 2001, the FASB issued SFAS No. 143, “Accounting for Asset Retirement Obligations” which applies to legal obligations associated with the retirement of a tangible long-lived asset that results from the acquisition, construction, or development and/or the normal operation of a long-lived asset. Under this standard, guidance is provided on measuring and recording the liability. We intend to adopt this statement effective January 1, 2003. We do not believe that adoption of this statement will materially impact our financial position, results of operations or cash flows.

FACTORS THAT MAY AFFECT FUTURE RESULTS

WE WILL NEED ADDITIONAL CAPITAL TO FUND OUR BUSINESS OPERATIONS, AND WE CANNOT BE SURE THAT ADDITIONAL FINANCING WILL BE AVAILABLE.

Since 1997, our cash flow from operations has primarily been negative and we expect to experience negative cash flow from operations at least until the third quarter of 2003. We believe that we will need to raise approximately $5 to $10 million in additional capital over the next six months to meet our working capital needs and capital expenditure requirements for the next twelve months. Our plans to raise additional capital include possible customer prepayments of certain royalty obligations in exchange for a royalty discount and/or other negotiated concessions, entering into new license agreements which require up-front license payments and potentially through debt or equity financing. We have taken measures to control our costs and will continue to monitor these efforts. Prior to the third quarter of 2003, we may experience quarterly periods where we achieve a positive cash flow from operations, however we may not be able to sustain consistent positive cash flow during such time. We cannot be certain that additional financing will be available to us on favorable terms when required, or at all. Changes in equity markets over the past two years have adversely affected the ability of companies to raise equity financing and have adversely affected the markets for financing for companies with a history of losses such as ours. Additional financing may require us to issue additional shares of our common or preferred stock such that our existing stockholders may experience substantial dilution.

THE MARKET FOR TOUCH-ENABLING TECHNOLOGIES AND TOUCH-ENABLED PRODUCTS IS AT AN EARLY STAGE AND IF MARKET DEMAND DOES NOT DEVELOP, WE MAY NOT ACHIEVE OR SUSTAIN REVENUE GROWTH.

The market for our touch-enabling technologies, and our licensees’ touch-enabled products is at an early stage. If we and our licensees are unable to develop demand for touch-enabling technologies and touch-enabled products, we may not achieve or sustain revenue growth. We cannot accurately predict the growth of the markets for these technologies and products, the timing of product introductions or the timing of commercial acceptance of these products. We are currently working to increase the demand for these technologies and products in the following five principal application areas:

• cursor control peripherals, such as touch-enabled mice and trackballs, for use with personal computers;

       •    touch-enabled medical simulators that can be used for training and skills assessment for procedures such as catheterization, bronchoscopy, colonoscopy, sigmoidoscopy and laparoscopic procedures;

       •    touch-enabled peripherals for computer gaming on personal computers and dedicated gaming consoles,

       •    touch-enabled automotive interfaces; and

       •    touch-enabled, whole-hand sensing gloves, such as our CyberForce product.

Even if our touch-enabling technologies and our licensees’ touch-enabled products are ultimately widely adopted, widespread adoption may take a long time to occur. The timing and amount of royalties and product sales that we receive will depend on whether the products marketed achieve widespread adoption and, if so, how rapidly that adoption occurs. We expect that we will need to pursue extensive and expensive marketing and sales efforts to educate prospective licensees and end users about the uses and benefits of our technologies and to persuade software developers to create software that utilizes our technologies.

WE HAD AN ACCUMULATED DEFICIT OF $70 MILLION AS OF SEPTEMBER 30, 2002, HAVE A HISTORY OF LOSSES, WILL EXPERIENCE LOSSES IN THE FUTURE AND MAY NOT ACHIEVE OR MAINTAIN PROFITABILITY.

Since 1997, we have incurred losses in every fiscal quarter. We will need to generate significant revenue to achieve and maintain profitability. We anticipate that our expenses will increase in the foreseeable future as we:

       •    attempt to expand the market for touch-enabled products;

       •    increase our sales efforts;

       •    incur additional expenses related to the operation of businesses we have acquired or will acquire;

       •    continue to develop our technologies;

       •    pursue strategic relationships; and

       •    protect and enforce our intellectual property, including the costs of our litigation against Sony and Microsoft.

If our revenues grow more slowly than we anticipate or if our operating expenses exceed our expectations, we may not achieve or maintain profitability.

OUR CURRENT LITIGATION AGAINST MICROSOFT AND SONY IS EXPENSIVE, DISRUPTIVE AND TIME CONSUMING AND WILL CONTINUE TO BE, AND IF WE ARE NOT SUCCESSFUL, COULD ADVERSELY AFFECT OUR BUSINESS.

IF WE ARE UNABLE TO ENTER INTO NEW LICENSING ARRANGEMENTS WITH OUR EXISTING LICENSEES AND WITH ADDITIONAL THIRD-PARTY MANUFACTURERS FOR OUR TOUCH-ENABLING TECHNOLOGY, OUR ROYALTY REVENUE MAY NOT GROW.

Our revenue growth is significantly dependent on our ability to enter into new licensing arrangements. Our failure to enter into new licensing arrangements will cause our operating results to suffer. We face numerous risks in obtaining new

licenses on terms consistent with our business objectives and in maintaining, expanding and supporting our relationships with our current licensees. These risks include:

       •    the lengthy and expensive process of building a relationship with potential licensees;

       •    the fact that we may compete with the internal design teams of existing and potential licensees;

       •    difficulties in persuading consumer product manufacturers to work with us, to rely on us for critical technology and to disclose to us proprietary product development and other strategies; and

       •    difficulties in persuading existing and potential licensees to bear the development costs necessary to incorporate our technologies into their products.

A substantial majority of our royalty revenue has been derived from the licensing of our portfolio of touch-enabling technologies for personal computer gaming peripherals, such as joysticks and steering wheels. The market for joysticks and steering wheels for use with personal computers is a substantially smaller market than either the mouse market or the dedicated gaming console market and is characterized by declining average selling prices. If we are unable to gain market acceptance beyond the personal computer gaming peripherals market, we may not achieve royalty revenue growth.

LITIGATION REGARDING INTELLECTUAL PROPERTY RIGHTS COULD BE EXPENSIVE, DISRUPTIVE, AND TIME CONSUMING; COULD RESULT IN THE IMPAIRMENT OR LOSS OF PORTIONS OF OUR INTELLECTUAL PROPERTY; AND COULD ADVERSELY AFFECT OUR BUSINESS.

Intellectual property litigation, whether brought by us or by others against us, could result in the expenditure of significant financial resources and the diversion of management’s time and efforts. From time to time, we initiate claims against third parties that we believe infringe our intellectual property rights. We intend to enforce our intellectual property rights vigorously and may initiate litigation against parties that we believe are infringing our intellectual property if we are unable to resolve matters satisfactorily through negotiation. Litigation brought to protect and enforce our intellectual property rights could be costly, time-consuming and distracting to management and could result in the impairment or loss of portions of our intellectual property. In addition, any litigation in which we are accused of infringement may cause product shipment delays, require us to develop non-infringing technology or require us to enter into royalty or license agreements even before the issue of infringement has been decided on the merits. If any litigation were not resolved in our favor, we could become subject to substantial damage claims from third parties and indemnification claims from our licensees. We and our licensees could be enjoined from the continued use of the technology at issue without a royalty or license agreement. Royalty or license agreements, if required, might not be available on acceptable terms, or at all. If a third party claiming infringement against us prevailed and we could not develop non-infringing technology or license the infringed or similar technology on a timely and cost-effective basis, our expenses would increase and our revenues could decrease.

We attempt to avoid infringing known proprietary rights of third parties. However, third parties may hold, or may in the future be issued, patents that could be infringed by our products or technologies. Any of these third parties might make a claim of infringement against us with respect to the products that we manufacture and the technologies that we license. From time to time, we have received letters from companies, several of which have significantly greater financial resources than we do, asserting that some of our technologies, or those of our licensees, infringe their intellectual property rights. Certain of our licensees have received similar letters from these or other companies. Such letters may influence our licensees’ decisions whether to ship products incorporating our technologies. Although none of these matters has resulted in litigation to date, any of these notices, or additional notices that we could receive in the future from these or other companies, could lead to litigation.

Intellectual property claims against us or our licensees, whether or not they have merit, could be time-consuming to defend, cause product shipment delays, require us to pay damages, harm existing license arrangements, or require us or our licensees to cease utilizing the technology unless we can enter into royalty or licensing agreements. Royalty or licensing agreements might not be available on terms acceptable to us or at all. Furthermore, claims could also result in claims from our licensees under the indemnification provisions of their agreements with us.

IF WE FAIL TO PROTECT AND ENFORCE OUR INTELLECTUAL PROPERTY RIGHTS, OUR ABILITY TO LICENSE OUR TECHNOLOGIES AND TO GENERATE REVENUES WOULD BE IMPAIRED.

Our business depends on generating revenues by licensing our intellectual property rights and by selling products that incorporate our technologies. If we are not able to protect and enforce those rights, our ability to obtain future licenses and royalty revenue could be impaired. In addition, if a court were to limit the scope of, declare unenforceable or

invalidate any of our patents, current licensees may refuse to make royalty payments or may themselves choose to challenge one or more of our patents. Also it is possible that:

       •    our pending patent applications may not result in the issuance of patents;

       •    our patents may not be broad enough to protect our proprietary rights; and

       •    effective patent protection may not be available in every country in which our licensees do business.

We also rely on licenses, confidentiality agreements and copyright, trademark and trade secret laws to establish and protect our proprietary rights. It is possible that:

• laws and contractual restrictions may not be sufficient to prevent misappropriation of our technologies or deter others from developing similar technologies; and

• policing unauthorized use of our products and trademarks would be difficult, expensive and time-consuming, particularly overseas.

WE COULD LOSE SOME OR ALL OF THE INVESTMENT THAT WE HAVE MADE IN SEVERAL EARLY STAGE TECHNOLOGY COMPANIES SHOULD THOSE COMPANIES NOT BE SUCCESSFUL IN DEVELOPING THEIR TECHNOLOGIES OR NOT BE ABLE TO OBTAIN ADDITIONAL FINANCING IF AND WHEN NEEDED.

From time to time we have made strategic investments in early stage technology companies that are developing technologies that we believe could complement or enhance our own technologies, if successful. We have made these investments to provide funding for the development of these companies technologies primarily because of the anticipated benefits to Immersion of the availability of these technologies. The prospect of realizing a substantial return on these investments was a secondary, though important, consideration. We wrote down $1.2 million of these investments in the third quarter of 2002, and in the third quarter of 2001 we wrote down $4.3 million of these investments and approximately $239,000 of interest receivable from these companies, and do not expect to realize any return on these amounts. Our remaining investment may not succeed in developing its technology, might be unsuccessful in marketing its technology or products based on its technology or might fail for any number of other reasons, including an inability to obtain additional capital if required to fund operations, including the completion of the development of its technology. In the event that this company in which we have invested fails or does not achieve a level of success that permits us to realize the value of this investment, we could experience a complete or partial loss on some or all of this investment. If we experience additional losses and related write-downs on the carrying value of our remaining investment, it would decrease our assets and increase our losses.

OUR RELATIONSHIP WITH MEDTRONIC, INC., A LEADING MEDICAL DEVICE COMPANY, MAY INTERFERE WITH OUR ABILITY TO ENTER INTO DEVELOPMENT AND LICENSING RELATIONSHIPS WITH MEDTRONIC’S COMPETITORS.

In August 1999, we entered into an agreement with Medtronic, Inc., a leading medical device company, in which Medtronic was given a right of first offer for additional development agreements. Under the terms of the right of first offer, we must notify Medtronic if we have received a written offer, or if we are seeking to find a third party to enter a development agreement to develop a simulation system within a field in which Medtronic is active. If Medtronic is interested in participating in a development agreement with respect to such new simulation system then for a period of thirty days we will negotiate exclusively with Medtronic. If an agreement is not reached within this period, we may enter into an agreement with a third party, provided that the terms of the agreement are more favorable to us than the offer presented by Medtronic. Although the right of first offer has not impeded our ability to interest other medical device companies in our technologies to date, our relationship with Medtronic may impede our ability to enter into development or license agreements with other large medical device companies that compete with Medtronic.

OUR QUARTERLY REVENUES AND OPERATING RESULTS ARE VOLATILE, AND IF OUR FUTURE RESULTS ARE BELOW THE EXPECTATIONS OF PUBLIC MARKET ANALYSTS OR INVESTORS, THE PRICE OF OUR COMMON STOCK IS LIKELY TO DECLINE.

Our revenues and operating results are likely to vary significantly from quarter to quarter due to a number of factors, many of which are outside of our control and any of which could cause the price of our common stock to decline.

These factors include:

• the establishment or loss of licensing relationships;

       •    the timing of payments under fixed and/or up-front license agreements;

       •    the timing of our expenses, including costs related to litigation, acquisitions of technologies or businesses;

       •    the timing of introductions of new products and product enhancements by us, our licensees or their competitors;

       •    our ability to develop and improve our technologies;

       •    our ability to attract, integrate and retain qualified personnel; and

       •    seasonality in the demand for our licensees’ products.

Accordingly, we believe that period-to-period comparisons of our operating results should not be relied upon as an indicator of our future performance. In addition, because a high percentage of our operating expenses are fixed, a shortfall of revenues can cause significant variations in operating results from period to period.

MEDTRONIC ACCOUNTS FOR A LARGE PORTION OF OUR REVENUES AND A REDUCTION IN SALES TO MEDTRONIC, A REDUCTION IN DEVELOPMENT WORK, OR A DECISION NOT TO RENEW EXISTING LICENSES FOR MEDTRONIC MAY REDUCE OUR TOTAL REVENUE.

For the three and nine months ended September 30, 2002 we derived 8% and 11%, respectively, of our total revenues from Medtronic. If our product sales to Medtronic decline, and/or Medtronic reduces the development activities we perform then our total revenues may decline.

LOGITECH ACCOUNTS FOR A LARGE PORTION OF OUR ROYALTY REVENUE AND THE FAILURE OF LOGITECH TO ACHIEVE SALES VOLUMES FOR ITS GAMING AND CURSOR CONTROL PERIPHERAL PRODUCTS THAT INCORPORATE OUR TOUCH-ENABLING TECHNOLOGIES MAY REDUCE OUR ROYALTY REVENUE.

For the quarter ended September 30, 2002, we derived 4% of our total revenues and 23% of our royalty revenue from Logitech, and for the quarter ended September 30, 2001, we derived 15% of our total revenues and 53% of our royalty revenue from Logitech. For the nine months ended September 30, 2002, we derived 7% of our total revenues and 23% of our royalty revenue from Logitech, and for the nine months ended September 30, 2001, we derived 12% of our total revenues and 51% of our royalty revenues from Logitech. We expect that a significant portion of our total revenues will continue to be derived from Logitech. If Logitech fails to achieve anticipated sales volumes for its computer peripheral products that incorporate our technologies, our royalty revenue would be reduced.

THE RECENT SLOWDOWN IN PERSONAL COMPUTER SALES MAY LEAD TO A REDUCTION IN SALES OF OUR LICENSEES’ TOUCH-ENABLED PERIPHERAL PRODUCTS, SUCH AS TOUCH-ENABLED MICE AND JOYSTICKS, WHICH MAY ADVERSELY AFFECT OUR ROYALTY REVENUE.

Over the past year, large personal computer manufacturers have announced slower than anticipated sales of personal computers. This slowdown in personal computer sales may adversely affect sales of our licensees’ royalty bearing, touch-enabled peripheral products, such as touch-enabled mice and joysticks, that are used with personal computers. The slowdown affecting personal computer companies may also make it more difficult to persuade such manufacturers to incorporate more costly touch-enabled mice products into their product lines. The impact of this downturn on our royalty revenue may be more pronounced if a significant cause of this trend is a reduction in the amount that individuals and companies have budgeted for personal computer-related devices, such as touch-enabled mice, rather than saturation of the market for personal computers generally. As a result, our results of operations and financial condition may be adversely affected.

WE MAY BE UNABLE TO INCREASE SALES OF OUR MEDICAL SIMULATION DEVICES IF, AS A RESULT OF THE CURRENT ECONOMIC SLOWDOWN OR OTHER FACTORS, MEDICAL INSTITUTIONS DO NOT BUDGET FOR SUCH DEVICES.

Our medical simulation products, such as our AccuTouch Endoscopy Simulator, the AccuTouch Endovascular Simulator and our Laparoscopic Surgical Workstation, have only recently begun to be used by hospitals and medical schools to train healthcare professionals. As a result, many of these medical institutions do not budget for such simulation devices. To increase sales of our simulation devices, we must, in addition to convincing medical institution personnel of the utility of the devices, persuade them to include a significant expenditure for the devices in their budgets. If these medical institutions are unwilling to budget for simulation devices or reduce their budgets as a result of the economic slowdown, cost-containment pressures or other factors, we may not be able to increase sales of medical simulators at a satisfactory rate. As a result of the terrorist attacks against the United States on September 11, 2001 and the future threat of terrorist acts, hospitals may have assigned priority in their capital expenditure budgets to equipment

that will enable them to respond more effectively to catastrophic emergencies, and federal, state and local governments may have delayed certain fundings for medical and educational institutions, in which case purchases of medical simulators may have been deferred. If we are unable to increase sales of our medical simulation products, our results of operations and financial condition may be adversely affected. We believe that medical device companies may also decrease their expenditures in corporate research and development budgets and this may adversely affect our contract and development revenue generated by the medical segment.

REDUCED SPENDING BY CORPORATE RESEARCH AND DEVELOPMENT DEPARTMENTS MAY ADVERSELY AFFECT SALES OF OUR THREE-DIMENSIONAL CAPTURE AND INTERACTION PRODUCTS.

We believe that the current economic downturn has led to a reduction in corporations’ budgets for research and development in several sectors, including the automotive and aerospace sectors, that use our three-dimensional capture and interaction products. Sales of our three-dimensional capture and interaction products, including our CyberGlove line of whole-hand sensing gloves and our MicroScribe G2 line of three-dimensional digitizers may be adversely affected by these cuts in corporate research and development budgets.

WE HAVE LIMITED DISTRIBUTION CHANNELS AND RESOURCES TO MARKET AND SELL OUR MEDICAL SIMULATION AND THREE-DIMENSIONAL SIMULATION PRODUCTS, AND IF WE ARE UNSUCCESSFUL IN MARKETING AND SELLING THESE PRODUCTS WE MAY NOT ACHIEVE OR SUSTAIN PRODUCT REVENUE GROWTH.

We have limited resources for marketing and selling medical simulation or three-dimensional simulation products either directly or through distributors. To achieve our business objectives we must build a balanced mixture of sales through a direct sales channel and through qualified distribution channels. The success of our efforts to sell medical simulation and three-dimensional simulation products will depend upon our ability to retain and develop a qualified sales force and effective distributor channels. We may not be successful in attracting and retaining the personnel necessary to sell and market our simulation products. A number of our distributors represent small-specialized companies that may not have sufficient capital or human resources to support the complexities of selling and supporting simulation products. There is no assurance that our direct selling efforts will be effective, distributors will market our products successfully or, if our relationships with distributors terminate, we will be able to establish relationships with other distributors on satisfactory terms, if at all. Any disruption in the distribution, sales or marketing network for our simulation products could have a material adverse effect on our product revenues.

VICTOR VIEGAS, OUR PRESIDENT, CHIEF EXECUTIVE OFFICER, CHIEF FINANCIAL OFFICER AND DIRECTOR, RECENTLY BECAME THE CHIEF EXECUTIVE OFFICER AND DIRECTOR OF THE COMPANY AND IF THERE ARE DIFFICULTIES WITH THIS LEADERSHIP TRANSITION IT COULD IMPEDE THE EXECUTION OF OUR BUSINESS STRATEGY

Victor Viegas, our President, Chief Executive Officer, Chief Financial Officer and Director, took over the duties of Chief Executive Officer and Director in October 2002. Our success will depend to a significant extent on Mr. Viegas’ ability to implement a successful strategy, to successfully lead and motivate our employees, and to work effectively with our executive staff and board of directors. If this leadership transition is not successful, our ability to execute our business strategy would be impeded.

WE MAY ENGAGE IN ACQUISITIONS THAT COULD DILUTE STOCKHOLDERS’ INTERESTS, DIVERT MANAGEMENT ATTENTION OR CAUSE INTEGRATION PROBLEMS.

As part of our business strategy, we have in the past acquired, and may in the future acquire, businesses or intellectual property that we feel could complement our business, enhance our technical capabilities or increase our intellectual property portfolio. If we consummate acquisitions through an exchange of our securities, our stockholders could suffer significant dilution. Acquisitions could also create risks for us, including:

       •    unanticipated costs associated with the acquisitions;

       •    use of substantial portions of our available cash to consummate the acquisitions;

       •    diversion of management’s attention from other business concerns;

       •    difficulties in assimilation of acquired personnel or operations; and

       •    potential intellectual property infringement claims related to newly acquired product lines.

Any acquisitions, even if successfully completed, might not generate significant additional revenue or provide any

benefit to our business.

WE MIGHT BE UNABLE TO RETAIN OR RECRUIT NECESSARY PERSONNEL, WHICH COULD SLOW THE DEVELOPMENT AND DEPLOYMENT OF OUR TECHNOLOGIES.

Our ability to develop and deploy our technologies and to sustain our revenue growth depends upon the continued service of our executive officers and other key personnel and upon hiring additional key personnel. A number of employees of our subsidiaries, including several members of these subsidiaries senior management, have departed since the acquisitions were completed. It may not be possible to retain enough key employees of our subsidiaries to operate these businesses effectively.

We may hire additional sales, support, marketing and research and development personnel. We may not be able to attract, assimilate or retain additional highly qualified personnel in the future. Our executive officers and key employees hold stock options with exercise prices considerably above the current market price of our common stock. In addition, merit increases have been suspended for fiscal 2002. Each of these factors may impair our ability to retain the services of our executive officers and key employees. Our technologies are complex and we rely upon the continued service of our existing engineering personnel to support licensees, enhance existing technology and develop new technologies.

WE DO NOT CONTROL OR INFLUENCE OUR LICENSEES’ MANUFACTURING, PROMOTION, DISTRIBUTION OR PRICING OF THEIR PRODUCTS INCORPORATING OUR TOUCH-ENABLING TECHNOLOGIES, UPON WHICH WE ARE DEPENDENT TO GENERATE ROYALTY REVENUE.

A key part of our business strategy is to license our intellectual property to companies that manufacture and sell products incorporating our touch-enabling technologies. Sales of those products generate royalty revenue for us. For the quarters ended September 30, 2002 and 2001, 20% and 28% respectively, of our total revenues were royalty revenues. For the nine months ended September 30, 2002 and 2001, 25% and 24% respectively, of our total revenues were royalty revenues. However, we do not control or influence the manufacture, quality control, promotion, distribution or pricing of products that are manufactured and sold by our licensees. In addition, we generally do not have commitments from our licensees that they will continue to use our technology in future products. As a result, products incorporating our technologies may not be brought to market, meet quality control standards, achieve commercial acceptance or generate meaningful royalty revenue for us. For us to generate royalty revenue, licensees that pay us per-unit royalties must manufacture and distribute products incorporating our touch-enabling technologies in a timely fashion and generate consumer demand through marketing and other promotional activities. Products incorporating our touch-enabling technologies are generally difficult to design and manufacture which may cause product introduction delays or quality control problems. If our licensees fail to stimulate and capitalize upon market demand for products that generate royalties for us, or if products are recalled because of quality control problems, our revenues will not grow and could decline.

Peak demand for products that incorporate our technologies, especially in the computer gaming peripherals market, typically occurs in the third and fourth calendar quarters as a result of increased demand during the year-end holiday season. If our licensees do not ship licensed products in a timely fashion or fail to achieve strong sales in the fourth quarter of the calendar year, we may not receive related royalty revenue.

THE HIGHER COST OF PRODUCTS INCORPORATING OUR TOUCH-ENABLING TECHNOLOGIES MAY INHIBIT OR PREVENT THE WIDESPREAD ADOPTION AND SALE OF PRODUCTS INCORPORATING OUR TECHNOLOGIES.

Personal computer gaming peripherals, computer mice and automotive controls incorporating our touch-enabling technologies are more expensive than similar competitive products that are not touch-enabled. Although major manufacturers, such as Logitech, Microsoft, ALPS Electric Co. and BMW, have licensed our technology, the greater expense of products containing our touch-enabling technologies as compared to non-touch-enabled products may be a significant barrier to the widespread adoption and sale of touch-enabled products.

COMPETITION WITH OUR PRODUCTS AND OUR LICENSEES’ PRODUCTS MAY REDUCE OUR REVENUE.

Rapid technological change, short product life cycles, cyclical market patterns, declining average selling prices and increasing foreign and domestic competition characterize the markets in which we and our licensees’ compete. We believe that competition in these markets will continue to be intense, and that competitive pressures will drive the price of our products and our licensees’ products downward. These price reductions, if not offset by increases in unit sales or productivity, will cause our revenues to decline.

We face competition from unlicensed products as well. Our licensees or other third parties may seek to develop products, which they believe do not require a license under our intellectual property. These potential competitors may have significantly greater financial, technical and marketing resources than we do, and the costs associated with asserting our intellectual property rights against such products and such potential competitors could be significant. Moreover, if such alternative designs were determined by a court not to require a license under our intellectual property rights, competition from such unlicensed products could limit or reduce our revenues.

IF WE ARE UNABLE TO CONTINUALLY IMPROVE, AND REDUCE THE COST OF OUR TECHNOLOGIES, COMPANIES MAY NOT INCORPORATE OUR TECHNOLOGIES INTO THEIR PRODUCTS, WHICH COULD IMPAIR OUR REVENUE GROWTH.

Our ability to achieve revenue growth depends on our continuing ability to improve, and reduce the cost of, our technologies and to introduce these technologies to the marketplace in a timely manner. If our development efforts are not successful or are significantly delayed, companies may not incorporate our technologies into their products and our revenue growth may be impaired.

IF WE FAIL TO DEVELOP NEW OR ENHANCED TECHNOLOGIES FOR NEW APPLICATIONS AND PLATFORMS, WE MAY NOT BE ABLE TO CREATE A MARKET FOR OUR TECHNOLOGIES OR OUR TECHNOLOGIES MAY BECOME OBSOLETE AND OUR ABILITY TO GROW AND OUR RESULTS OF OPERATIONS MIGHT BE HARMED.

Our initiatives to develop new and enhanced technologies and to commercialize these technologies for new applications and new platforms may not be successful. Any new or enhanced technologies may not be favorably received by consumers and could damage our reputation or our brand. Expanding our technology could also require significant additional expenses and strain our management, financial and operational resources. Moreover, technology products generally have relatively short product life cycles and our current products may become obsolete in the future. Our ability to generate revenues will be harmed if we:

       •    fail to develop new technologies;

       •    our new technologies fail to gain market acceptance; or

       •    our current products become obsolete.

BECAUSE PERSONAL COMPUTER PERIPHERAL PRODUCTS THAT INCORPORATE OUR TOUCH-ENABLING TECHNOLOGIES CURRENTLY MUST WORK WITH MICROSOFT’S OPERATING SYSTEM SOFTWARE, OUR COSTS COULD INCREASE AND OUR REVENUES COULD DECLINE IF MICROSOFT MODIFIES ITS OPERATING SYSTEM SOFTWARE.

Our hardware and software technology for personal computer peripheral products that incorporate our touch-enabling technologies is currently compatible with Microsoft’s Windows 98, Windows 2000, Windows Me and Windows XP operating systems software, including DirectX, Microsoft’s entertainment applications programming interface. If Microsoft modifies its operating system, including DirectX, we may need to modify our technologies and this could cause delays in the release of products by our licensees. If Microsoft modifies its software products in ways that limit the use of our other licensees’ products, our costs could be increased and our revenues could decline.

OUR CURRENT CLASS ACTION LAWSUIT COULD BE EXPENSIVE, DISRUPTIVE AND TIME CONSUMING TO DEFEND AGAINST, AND IF WE ARE NOT SUCCESSFUL, COULD ADVERSELY AFFECT OUR BUSINESS.

In re Immersion Corporation

We are involved in legal proceedings relating to a class action lawsuit filed on November 9, 2001. The case is now designated as In re Immersion Corporation Initial Public Offering Securities Litigation, No. Civ. 01-9975 (S.D.N.Y.), related to In re Initial Public Offering Securities Litigation, No. 21 MC 92 (S.D.N.Y.). The action was filed in the United States District Court, Southern District of New York, against defendants Immersion Corporation, Louis Rosenberg (former Chief Executive Officer, President and Chairman of the Company), Victor Viegas (current President, Chief Executive Officer and Chief Financial Officer), Bruce Schena (former Chief Technology Officer and Director); and certain underwriters of Immersion’s November 12, 1999 initial public offering. Subsequently, two of the individual defendants stipulated to a dismissal without prejudice. The case is purportedly brought on behalf of all persons who purchased the Company’s common stock from November 12, 1999 through December 6, 2000.

PRODUCT LIABILITY CLAIMS COULD BE TIME-CONSUMING AND COSTLY TO DEFEND, AND COULD EXPOSE US TO LOSS.

Claims that our products or our licensees’ products have flaws or other defects that lead to personal or other injury are common in the computer peripherals industry and medical fields. If products that we or our licensees sell cause personal injury, financial loss or other injury to our or our licensees’ customers, the customers or our licensees may seek damages or other recovery from us. Any claims against us would be time-consuming, expensive to defend and distracting to management and could result in damages and injure our reputation or the reputation of our licensees or their products. This damage could limit the market for our and our licensees’ products and harm our results of operations.

In the past, manufacturers of peripheral products, such as computer mice and certain gaming products such as joysticks, wheels or gamepads, have been subject to claims alleging that use of their products has caused or contributed to various types of repetitive stress injuries, including carpal tunnel syndrome. We have not experienced any product liability claims to date. Although our license agreements typically contain provisions designed to limit our exposure to product liability claims, existing or future laws or unfavorable judicial decisions could limit or invalidate the provisions.

LEGISLATIVE ACTIONS, HIGHER INSURANCE COST AND POTENTIAL NEW ACCOUNTING PRONOUNCEMENTS ARE LIKELY TO IMPACT OUR FUTURE FINANCIAL POSITION AND RESULTS OF OPERATIONS.

There have been regulatory changes, including the Sarbanes-Oxley Act of 2002, and there may be potential new accounting pronouncements or additional regulatory rulings which will have an impact on our future financial position and results of operations. The Sarbanes-Oxley Act of 2002 and other rule changes as well as proposed legislative initiatives following the Enron bankruptcy are likely to increase general and administrative costs. In addition, insurers are likely to increase premiums as a result of high claims rates over the past year, which we expect will increase our premiums for our various insurance policies. Further, proposed initiatives are expected to result in changes in certain accounting rules, including legislative and other proposals to account for employee stock options as a compensation expense. These and other potential changes could materially increase the expenses we report under generally accepted accounting principles, and adversely affect our operating results.

IF OUR FACILITIES WERE TO EXPERIENCE CATASTROPHIC LOSS, OUR OPERATIONS WOULD BE SERIOUSLY HARMED.

Our facilities could be subject to a catastrophic loss such as fire, flood, earthquake, power outage or terrorist activity. California has experienced problems with its power supply in recent years. As a result, we have experienced utility cost increases and may experience unexpected interruptions in our power supply that could have a material adverse effect on our sales, results of operations and financial condition. In addition, a substantial portion of our research and development activities, manufacturing, our corporate headquarters and other critical business operations are located near major earthquake faults in San Jose, California, an area with a history of seismic events. Any such loss at our facilities could

disrupt our operations, delay production, shipments and revenue and result in large expenses to repair and replace the facility. While we believe that we maintain insurance sufficient to cover most long-term potential losses at our facilities, our existing insurance may not be adequate for all possible losses.

WE HAVE EXPERIENCED RAPID GROWTH AND CHANGE IN OUR BUSINESS, AND OUR FAILURE TO MANAGE THIS AND ANY FUTURE GROWTH COULD HARM OUR BUSINESS.

Any future periods of rapid growth may place significant strains on our managerial, financial, engineering and other resources. The rate of any future expansion, in combination with our complex technologies, may demand an unusually high level of managerial effectiveness in anticipating, planning, coordinating and meeting our operational needs as well as the needs of our licensees.

BECAUSE WE HAVE A FIXED PAYMENT LICENSE WITH MICROSOFT, OUR ROYALTY REVENUE FROM LICENSING JOYSTICKS AND STEERING WHEELS IN THE GAMING MARKET MIGHT DECLINE IF MICROSOFT INCREASES ITS VOLUME OF SALES OF TOUCH-ENABLED JOYSTICKS AND STEERING WHEELS AT THE EXPENSE OF OUR OTHER LICENSEES.

Under the terms of our present agreement with Microsoft, Microsoft receives a perpetual, worldwide, irrevocable, non-exclusive license under our patents for Microsoft’s SideWinder Force Feedback Pro Joystick and its SideWinder Force Feedback Wheel, and for a future replacement version of these specific SideWinder products having essentially similar functional features. Instead of an ongoing royalty on Microsoft’s sales of licensed products, the agreement provided for a payment of $2.35 million, which we recognized in equal monthly increments over a one-year period that ended in mid-July 2000. We will not receive any further revenues or royalties from Microsoft under our current agreement with Microsoft. At the present time, we do not have a license agreement with Microsoft for products other than the SideWinder joystick and steering wheel. Microsoft has a significant share of the market for touch-enabled joysticks and steering wheels for personal computers. Microsoft has significantly greater financial, sales and marketing resources, as well as greater name recognition and a larger customer base, than our other licensees. In the event that Microsoft increases its share of this market, our royalty revenue from other licensees in this market segment might decline.

WE DEPEND ON A SINGLE SUPPLIER TO PRODUCE OUR IMMERSION PROCESSORS AND A SINGLE SUPPLIER TO PRODUCE OUR MEDICAL SIMULATORS AND MAY LOSE CUSTOMERS IF THESE SUPPLIERS DO NOT MEET OUR REQUIREMENTS.

We have one supplier for our custom Immersion Processors and one supplier for our custom medical simulators. The custom Immersion Processors improve the performance and help reduce the cost of computer peripheral products, such as joysticks and mice, incorporating our touch-enabling technologies. We have limited control over delivery schedules, quality assurance, manufacturing capacity, yields, costs and misappropriation of our intellectual property. Although our supplier warrants that microprocessors it supplies to us or to our customers will conform to our specifications and be free from defects in materials and workmanship for a period of one year from delivery, any delays in delivery of the processor, quality problems or cost increases could cause us to lose customers and could damage our relationships with our licensees.

Our custom Immersion Medical simulators improve the performance and training of medical personnel. Any disruption in the manufacturing process from our sole supplier could adversely affect the Company’s ability to deliver our products, ensure quality workmanship and could result in a reduction of the Company’s product sales.

MEDICAL LICENSING AND CERTIFICATION AUTHORITIES MAY NOT ENDORSE OR REQUIRE USE OF OUR TECHNOLOGIES FOR TRAINING PURPOSES, SIGNIFICANTLY SLOWING OR INHIBITING THE MARKET PENETRATION OF OUR MEDICAL SIMULATION TECHNOLOGIES.

Several key medical certification bodies, including the American Board of Internal Medicine (“ABIM”) and the American College of Cardiology (“ACC”), have great influence in endorsing particular medical methodologies, including medical training methodologies, for use by medical professionals. In the event that the ABIM and the ACC, as well as other, similar bodies, do not endorse our medical simulation training products as a training vehicle, market penetration for our products could be significantly and adversely affected.

AUTOMOBILES INCORPORATING OUR TOUCH-ENABLING TECHNOLOGIES ARE SUBJECT TO LENGTHY PRODUCT DEVELOPMENT PERIODS, MAKING IT DIFFICULT TO PREDICT WHEN AND WHETHER WE

WILL RECEIVE PER UNIT AUTOMOTIVE ROYALTIES.

The product development process for automobiles is very lengthy. We do not earn per unit royalty revenue on our automotive technologies unless, and until, automobiles featuring our technologies are shipped to customers, which may not occur until several years after we enter into an agreement with an automobile manufacturer. Throughout the product development process, we face the risk that an automobile manufacturer or supplier may delay the incorporation of, or choose not to incorporate, our technologies into its automobiles, making it difficult for us to predict the per unit automotive royalties we may receive, if any.

OUR STOCK MAY BE VOLATILE.

The stock market has experienced extreme volatility that often has been unrelated or disproportionate to the performance of particular companies. These market fluctuations may cause our stock price to decline regardless of our performance. The market price of our common stock has been, and in the future could be, significantly affected by factors such as: actual or anticipated fluctuations in operating results; announcements of technical innovations; announcements regarding litigation in which we are involved; new products or new contracts; sales or the perception in the market of possible sales of large number of shares of Immersion common stock by insiders or others; changes in securities analysts’ recommendations; changing circumstances regarding competitors or their customers; governmental regulatory action; developments with respect to patents or proprietary rights; inclusion in or exclusion from various stock indices; and general market conditions. In the past, following periods of volatility in the market price of a company’s securities, securities class action litigation has been initiated against that company, such as the suit currently filed against us.

OUR MAJOR STOCKHOLDERS RETAIN SIGNIFICANT CONTROL OVER US, WHICH MAY LEAD TO CONFLICTS WITH OTHER STOCKHOLDERS OVER CORPORATE GOVERNANCE MATTERS AND COULD ALSO AFFECT THE VOLATILITY OF OUR STOCK PRICE.

Certain stockholders hold a substantial amount of our outstanding common stock. Acting together, these stockholders would be able to exercise significant influence over matters that our stockholders vote upon, including the election of directors and mergers or other business combinations, which could have the effect of delaying or preventing a third party from acquiring control over or merging with us. Further, if any individuals in this group elect to sell a significant portion or all of their holdings of our common stock, the trading price of our common stock could experience volatility.

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

Provisions in our certificate of incorporation and bylaws may have the effect of delaying or preventing a change of control or changes in our management. In addition, certain provisions of Delaware law may discourage, delay or prevent someone from acquiring or merging with us. These provisions could limit the price that investors might be willing to pay in the future for shares.

ITEM 3. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK

We have limited exposure to financial market risks, including changes in interest rates. The fair value of our portfolio or related income would not be significantly impacted by a 100 basis point increase or decrease in interest rates due mainly to the short-term nature of the major portion of our investment portfolio. An increase or decrease in interest rates would not significantly increase or decrease interest expense on debt obligations due to the fixed nature of our debt obligations. Our foreign operations are limited in scope and thus we are not materially exposed to foreign currency fluctuations.

We have equity investments in several privately-held companies. We intend to hold our equity investments for the long term and will monitor whether there has been other-than-temporary declines in their values based on management’s estimates of their net realizable value taking into account the companies respective financial condition and ability to raise third-party financing. If the decline in fair value is determined to be other-than-temporary, an impairment loss is recorded and the individual security is written down to a new cost basis. As a result of our review, of the fair value of these investments, we recorded an impairment loss of $1.2 million in the third quarter of 2002, and in the third quarter of 2001 we recorded an impairment loss of $4.3 million on these investments and a $239,000 impairment loss on interest

receivable on loans on these investments. The remaining cost basis of these investments on our Consolidated Balance Sheet is $1.0 million. We will monitor the remaining value of these investments, and may determine that there could be other impairment losses in the future. As of September 30, 2002, management has determined that the carrying value of these investments at $1.0 million is appropriate.

ITEM 4. CONTROLS AND PROCEDURES

(a) Under the supervision and with the participation of our management, including our chairman of the board and our principal executive officer and principal financial officer, we conducted an evaluation of our disclosure controls and procedures, as such term is defined under Rule 13a-14(c) promulgated under the Securities Exchange Act of 1934, as amended (the “Exchange Act”), within 90 days of the filing date of this report. Based on their evaluation, our chairman of the board and our principal executive officer and principal financial officer concluded that our disclosure controls and procedures are effective.

(b) There have been no significant changes (including corrective actions with regard to significant deficiencies or material weaknesses) in our internal controls or in other factors that could significantly affect these controls subsequent to the date of the evaluation referenced in paragraph (a) above.

PART II
OTHER INFORMATION

ITEM 1. LEGAL PROCEEDINGS

In re Immersion Corporation

Immersion Corporation vs. Microsoft Corporation, Sony Computer Entertainment Inc. and Sony Computer Entertainment of America, Inc.

ITEM 6. EXHIBITS AND REPORTS ON FORM 8-K

(a) Exhibits.

The following exhibits are filed herewith:

Exhibit

Number Description

99.1 Certification of Robert O’Malley, Chairman of the Board, Pursuant to 18 U.S.C. Section 1350, as Adopted Pursuant to Section 906 of the Sarbanes-Oxley Act of 2002

99.2 Certification of Victor Viegas, President, Chief Executive Officer, Chief Financial Officer and Director, Pursuant to 18 U.S.C. Section 1350, as Adopted Pursuant to Section 906 of the Sarbanes-Oxley Act of 2002

(b) Reports on Form 8-K

None

SIGNATURES

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.

IMMERSION CORPORATION
Registrant

Date: November 13, 2002 /s/ Robert O’Malley

Robert O’Malley
Chairman of the Board

Date: November 13, 2002 /s/ Victor Viegas

Victor Viegas
President, Chief Executive Officer,
Chief Financial Officer and Director

CERTIFICATIONS

I, Robert O’Malley, certify that:

1. I have reviewed this quarterly report on Form 10-Q of Immersion Corporation;

2. Based on my knowledge, this quarterly report does not contain any untrue statement of a material fact or omit to state a material fact necessary to make the statements made, in light of the circumstances under which such statements were made, not misleading with respect to the period covered by this quarterly report;

3. Based on my knowledge, the financial statements, and other financial information included in this quarterly report, fairly present in all material respects the financial condition, results of operations and cash flows of the registrant as of, and for, the periods presented in this quarterly report;

4. The registrant’s other certifying officers and I are responsible for establishing and maintaining disclosure controls and procedures (as defined in Exchange Act Rules 13a-14 and 15d-14) for the registrant and we have:

a) designed such disclosure controls and procedures to ensure that material information relating to the registrant, including its consolidated subsidiaries, is made known to us by others within those entities, particularly during the period in which this quarterly report is being prepared;

b) evaluated the effectiveness of the registrant’s disclosure controls and procedures as of a date within 90 days prior to the filing date of this quarterly report (the “Evaluation Date”); and

c) presented in this quarterly report our conclusions about the effectiveness of the disclosure controls and procedures based on our evaluation as of the Evaluation Date;

5. The registrant’s other certifying officers and I have disclosed, based on our most recent evaluation, to the registrant’s auditors and the audit committee of registrant’s board of directors (or persons performing the equivalent function):

a) all significant deficiencies in the design or operation of internal controls which could adversely affect the registrant’s ability to record, process, summarize and report financial data and have identified for the registrant’s auditors any material weaknesses in internal controls; and

b) any fraud, whether or not material, that involves management or other employees who have a significant role in the registrant’s internal controls; and

6. The registrant’s other certifying officers and I have indicated in this quarterly report whether or not there were significant changes in internal controls or in other factors that could significantly affect internal controls subsequent to the date of our most recent evaluation, including any corrective actions with regard to significant deficiencies and material weaknesses.

Date: November 13, 2002

/s/ Robert O’Malley

Robert O’Malley
Chairman of the Board

I, Victor Viegas, certify that:

1. I have reviewed this quarterly report on Form 10-Q of Immersion Corporation;

b) evaluated the effectiveness of the registrant’s disclosure controls and procedures as of a date within 90 days prior to the filing date of this quarterly report (the “Evaluation Date”); and

c) presented in this quarterly report our conclusions about the effectiveness of the disclosure controls and procedures based on our evaluation as of the Evaluation Date;

b) any fraud, whether or not material, that involves management or other employees who have a significant role in the registrant’s internal controls; and

Date: November 13, 2002

/s/ Victor Viegas

Victor Viegas
President, Chief Executive Officer,
Chief Financial Officer and Director

EXHIBIT INDEX

Exhibit

Number Description

99.1 Certification of Robert O’Malley, Chairman of the Board, Pursuant to 18 U.S.C. Section 1350, as Adopted Pursuant to Section 906 of the Sarbanes-Oxley Act of 2002

99.2 Certification of Victor Viegas, President, Chief Executive Officer, Chief Financial Officer and Director, Pursuant to 18 U.S.C. Section 1350, as Adopted Pursuant to Section 906 of the Sarbanes-Oxley Act of 2002

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			Page

PART I
FINANCIAL INFORMATION
	Item 1.	Financial Statements
		Condensed Consolidated Balance Sheets as of September 30, 2002 (Unaudited) and December 31, 2001	3
		Condensed Consolidated Statements of Operations (Unaudited) for the Three Months and Nine months Ended September 30, 2002 and 2001	4
		Condensed Consolidated Statements of Cash Flows (Unaudited) for the Nine Months Ended September 30, 2002 and 2001	5
		Notes to Condensed Consolidated Financial Statements (Unaudited)	6
	Item 2.	Management’s Discussion and Analysis of Financial Condition and Results of Operations	13
	Item 3.	Quantitative and Qualitative Disclosures About Market Risk	32
	Item 4.	Controls and Procedures	33
PART II
OTHER INFORMATION
	Item 1.	Legal Proceedings	33
	Item 6.	Exhibits and Reports on Form 8-K	34
	SIGNATURES		35
	CERTIFICATIONS		36


			September 30,			December 31,
			2002			2001 (1)

			(Unaudited)
ASSETS
Current assets:
	Cash and cash equivalents		$	8,686		$	10,381
	Short-term investments			—			2,545
	Accounts receivable, (net of allowances for doubtful accounts of: 2002, $239; and 2001, $356)			3,880			3,779
	Inventories			2,353			1,965
	Prepaid expenses and other current assets			435			1,179

		Total current assets		15,354			19,849
Property and equipment, net				2,305			2,918
Goodwill, net				3,758			3,676
Purchased intangibles and other assets, net				6,836			8,382
Other investments				1,000			2,200

Total assets			$	29,253		$	37,025

LIABILITIES AND STOCKHOLDERS’ EQUITY
Current liabilities:
	Accounts payable		$	840		$	722
	Accrued compensation			773			1,158
	Other current liabilities			1,353			587
	Deferred revenue and customer advances			1,034			953
	Current portion of long-term debt and warrant liability			599			4,519
	Current portion of capital lease obligation			22			22

		Total current liabilities		4,621			7,961
Long-term debt, less current portion				28			83
Capital lease obligation, less current portion				31			47
Warrant liability				—			120
Long-term deferred revenue, less current portion				4,542			—

		Total liabilities		9,222			8,211

Contingencies (Note 8)
Stockholders’ equity:
	Common stock — $0.001 par value; 100,000,000 shares authorized; shares issued and outstanding: 2002, 20,133,903 and 2001, 18,973,108			89,450			89,294
	Warrants			1,974			1,990
	Deferred stock compensation			(1,725	)		(2,956	)
	Accumulated other comprehensive loss			(16	)		(19	)
	Accumulated deficit			(69,652	)		(59,495	)

		Total stockholders’ equity		20,031			28,814

Total liabilities and stockholders’ equity			$	29,253		$	37,025


					Nine Months Ended
					September 30,

					2002			2001

Cash flows from operating activities:
	Net loss				$	(10,157	)	$	(18,778	)
	Adjustments to reconcile net loss to net cash provided by (used in) operating activities:
		Depreciation and amortization				975			930
		Amortization of intangibles				1,383			2,831
		Amortization of deferred stock compensation				991			1,122
		Amortization of discounts on notes payable				275			338
		Fair value adjustment for warrant liability				(89	)		(245	)
		Loss on disposal of equipment				19			34
		Loss on writedown of investments				1,200			4,539
		Noncash compensation expense				14			—
		Noncash interest expense				212			234
		Changes in operating assets and liabilities:
			Accounts receivable			(101	)		(1,781	)
			Inventories			(388	)		(311	)
			Prepaid expenses and other assets			825			(185	)
			Accounts payable			113			(487	)
			Accrued liabilities			381			(189	)
			Deferred revenue and customer advances			4,623			(372	)

				Net cash provided by (used in) operating activities		276			(12,320	)

Cash flows from investing activities:
	Purchases of short-term investments					(5	)		(1,020	)
	Sales and maturities of short-term investments					2,550			3,381
	Purchases of property and equipment					(381	)		(536	)

				Net cash provided by investing activities		2,164			1,825

Cash flows from financing activities:
	Issuance of common stock					95			295
	Exercise of warrants					50			—
	Exercise of stock options					222			248
	Payments on notes payable and capital leases					(4,509	)		(89	)
	Proceeds from shareholder note					—			17

				Net cash provided by (used in) financing activities		(4,142	)		471

Effect of exchange rates on cash and cash equivalents						7			(26	)

Net (decrease) in cash and cash equivalents						(1,695	)		(10,050	)
Cash and cash equivalents:
	Beginning of the period					10,381			23,474

	End of the period				$	8,686		$	13,424

Supplemental disclosure of cash flow information :
	Cash paid for taxes				$	—		$	4

	Cash paid for interest				$	978		$	69

Supplemental disclosure of noncash investing and financing activities:
	Change in net unrealized gains from short-term investments				$	—		$	1


			Less than		1 - 3		4 -5		After 5
Contractual Cash Obligations	Total		1 Year		Years		Years		Years

	(In thousands)
Long-Term Debt	$	4,602	$	4,519	$	83	$	—	$	—
Capital Lease Obligations		81		30		51		—		—
Operating Leases		5,528		1,195		2,409		1,108		816

Total Contractual Cash Obligations	$	10,211	$	5,744	$	2,543	$	1,108	$	816

	•		touch-enabled medical simulators that can be used for training and skills assessment for procedures such as catheterization, bronchoscopy, colonoscopy, sigmoidoscopy and laparoscopic procedures;

	•		touch-enabled peripherals for computer gaming on personal computers and dedicated gaming consoles,

	•		touch-enabled automotive interfaces; and

	•		touch-enabled, whole-hand sensing gloves, such as our CyberForce product.

	•		attempt to expand the market for touch-enabled products;

	•		increase our sales efforts;

	•		incur additional expenses related to the operation of businesses we have acquired or will acquire;

	•		continue to develop our technologies;

	•		pursue strategic relationships; and

	•		protect and enforce our intellectual property, including the costs of our litigation against Sony and Microsoft.

	•		the lengthy and expensive process of building a relationship with potential licensees;

	•		the fact that we may compete with the internal design teams of existing and potential licensees;

	•		difficulties in persuading consumer product manufacturers to work with us, to rely on us for critical technology and to disclose to us proprietary product development and other strategies; and

	•		difficulties in persuading existing and potential licensees to bear the development costs necessary to incorporate our technologies into their products.

	•		our pending patent applications may not result in the issuance of patents;

	•		our patents may not be broad enough to protect our proprietary rights; and

	•		effective patent protection may not be available in every country in which our licensees do business.

	•		laws and contractual restrictions may not be sufficient to prevent misappropriation of our technologies or deter others from developing similar technologies; and

	•		policing unauthorized use of our products and trademarks would be difficult, expensive and time-consuming, particularly overseas.

	•		the timing of payments under fixed and/or up-front license agreements;

	•		the timing of our expenses, including costs related to litigation, acquisitions of technologies or businesses;

	•		the timing of introductions of new products and product enhancements by us, our licensees or their competitors;

	•		our ability to develop and improve our technologies;

	•		our ability to attract, integrate and retain qualified personnel; and

	•		seasonality in the demand for our licensees’ products.

	•		unanticipated costs associated with the acquisitions;

	•		use of substantial portions of our available cash to consummate the acquisitions;

	•		diversion of management’s attention from other business concerns;

	•		difficulties in assimilation of acquired personnel or operations; and

	•		potential intellectual property infringement claims related to newly acquired product lines.

	•		fail to develop new technologies;

	•		our new technologies fail to gain market acceptance; or

	•		our current products become obsolete.


Exhibit
Number		Description

99.1		Certification of Robert O’Malley, Chairman of the Board, Pursuant to 18 U.S.C. Section 1350, as Adopted Pursuant to Section 906 of the Sarbanes-Oxley Act of 2002




99.2		Certification of Victor Viegas, President, Chief Executive Officer, Chief Financial Officer and Director, Pursuant to 18 U.S.C. Section 1350, as Adopted Pursuant to Section 906 of the Sarbanes-Oxley Act of 2002


Exhibit
Number		Description

99.1		Certification of Robert O’Malley, Chairman of the Board, Pursuant to 18 U.S.C. Section 1350, as Adopted Pursuant to Section 906 of the Sarbanes-Oxley Act of 2002




99.2		Certification of Victor Viegas, President, Chief Executive Officer, Chief Financial Officer and Director, Pursuant to 18 U.S.C. Section 1350, as Adopted Pursuant to Section 906 of the Sarbanes-Oxley Act of 2002