UNITED STATES
SECURITIES AND EXCHANGE COMMISSION

FORM 10-Q

For the quarterly period ended March 31, 2004

OR

For the Transition Period from                             to                            .

Commission File Number: 000-27687

BSQUARE CORPORATION

(425) 519-5900
(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 [  ].

Indicate by check mark whether the registrant is an accelerated filer (as defined in Rule 12b-2 of the Exchange Act). Yes [  ] No [X]

As of April 30, 2004, there were 37,900,027 shares of the registrant’s common stock outstanding.

BSQUARE CORPORATION

FORM 10-Q

For the Quarterly Period Ended March 31, 2004

TABLE OF CONTENTS

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PART I. FINANCIAL INFORMATION

Item 1. Financial Statements

BSQUARE CORPORATION
CONDENSED CONSOLIDATED BALANCE SHEETS
(in thousands, except share amounts)

See notes to condensed consolidated financial statements.

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BSQUARE CORPORATION
CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS
(in thousands, except per share data)

See notes to condensed consolidated financial statements.

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BSQUARE CORPORATION
CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS
(in thousands)

See notes to condensed consolidated financial statements.

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BSQUARE CORPORATION
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
March 31, 2004
(unaudited)

1. Summary of Significant Accounting Policies

Basis of Presentation

The accompanying unaudited condensed consolidated financial statements have been prepared by BSQUARE Corporation (the “Company” or “BSQUARE”) pursuant to the rules and regulations of the Securities and Exchange Commission for interim financial reporting and include the accounts of the Company and its subsidiaries. Certain information and footnote disclosures normally included in annual financial statements prepared in accordance with generally accepted accounting principles have been condensed or omitted pursuant to such rules and regulations. In the opinion of the Company, the unaudited financial statements reflect all adjustments, consisting only of normal recurring adjustments, necessary for a fair presentation, in conformity with U.S. generally accepted accounting principles, of the Company’s financial position at March 31, 2004 and its operating results and cash flows for the three months ended March 31, 2004 and 2003. Preparing financial statements requires management to make estimates and assumptions that affect the reported amounts of assets, liabilities, revenue and expenses. Examples include provision for bad debts, valuation of inventory and long-lived assets and deferred revenue. Actual results may differ from these estimates. Interim results are not necessarily indicative of results for a full year. The information included in this Form 10-Q should be read in conjunction with the Company’s financial statements and notes thereto contained in the Company’s annual report on Form 10-K for the year ended December 31, 2003 filed with the Securities and Exchange Commission. Certain reclassifications have been made for consistent presentation.

Stock-Based Compensation

The Company has elected to follow Accounting Principles Board (APB) Opinion No. 25, “Accounting for Stock Issued to Employees,” and related interpretations, in accounting for employee stock options rather than the alternative fair value accounting allowed by Statement of Financial Accounting Standards (SFAS) No. 123, “Accounting for Stock-Based Compensation.” Under APB No. 25, compensation expense related to the Company’s employee stock options is measured based on the intrinsic value of the stock option. SFAS No. 123, amended by SFAS No. 148 “Accounting for Stock-Based-Compensation — Transition and Disclosure,” requires companies that continue to follow APB No. 25 to provide pro forma disclosure of the impact of applying the fair value method of SFAS No. 123. The Company recognizes compensation expense for options granted to non-employees in accordance with the provisions of SFAS No. 123 and the Emerging Issues Task Force consensus Issue 96-18, “Accounting for Equity Instruments that are Issued to Other Than Employees for Acquiring, or in Conjunction with Selling Goods or Services,” which require using the Black-Scholes option pricing model and re-measuring such stock options to the current fair market value as the underlying options vest.

Deferred stock-based compensation consists of amounts recorded when the exercise price of an option is lower than the fair value of the underlying common stock on the date of grant. Deferred stock-based compensation is amortized in accordance with Financial Accounting Standards Board (FASB) Interpretation No. 28, on a graded vesting basis, over the vesting period of the underlying option.

Pro forma information regarding net loss is required by SFAS No. 123 and SFAS No. 148 as if the Company had accounted for its employee stock options under the fair value method. The fair value of the Company’s options was estimated on the date of grant using the Black-Scholes method, with the following weighted average assumptions:

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For purposes of pro forma disclosures, the estimated fair value of the options is amortized to expense over the options’ vesting period. The following table illustrates what net loss would have been had the Company accounted for its stock options under the provisions of SFAS 123 (in thousands, except per share data):

Earnings Per Share

Basic earnings per share is computed using the weighted average number of common shares outstanding during the period, net of shares subject to repurchase, and excludes any dilutive effects of common stock equivalent shares, such as options and warrants (using the treasury stock method) and convertible securities (using the if-converted method). Diluted earnings per share is computed using the weighted average number of common and common stock equivalent shares outstanding during the period; common stock equivalent shares are excluded from the computation if their effect is antidilutive.

As of March 31, 2004 and 2003, there were stock options and warrants outstanding to acquire 5,723,607 and 5,256,769 common shares, respectively, that were excluded from the computation of diluted loss per share, as their effect was antidilutive. If the Company had reported net income, the calculation of per share amounts would have included the dilutive effect of these common stock equivalents using the treasury stock method.

2. Consolidation of Excess Facilities and Restructuring Charge

During the first quarter of 2004, the Company eliminated ten positions in the Power Handheld business, representing 7% of the Company’s remaining workforce. The Company incurred severance of $79,000, paid in April 2004, and $20,000 of related charges. In addition, $30,000 of remaining assets related to the now closed Japan operation was charged to restructuring expense. There were no such charges in the three months ended March 31, 2003.

The following table provides a rollforward of the Company’s accrual for restructuring and related charges (in thousands):

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3. Goodwill and Other Intangible Assets

The Company’s intangible assets subject to amortization consist of the following (in thousands):

Intangible assets subject to amortization are amortized over their estimated useful lives of thirty-six months. Based on the current amount of intangible assets subject to amortization, the estimated amortization expense for the remaining nine months of 2004 is $133 and zero thereafter.

4. Comprehensive Loss

Comprehensive loss is defined as the change in equity of a company during a period from transactions and other events and circumstances, excluding transactions resulting from investments by owners and distributions to owners. The difference between net loss and comprehensive loss for the Company results from foreign currency translation adjustments.

Components of comprehensive loss consist of the following (in thousands):

5. Commitments and Contingencies

Contractual Commitments

The Company’s principal commitments consist of obligations outstanding under operating leases, which expire through 2014. In 2002, the Company agreed to certain early lease termination fees related to its corporate headquarters in Bellevue, Washington of which $856,000, payable in quarterly installments in 2004, remained outstanding at March 31, 2004. In February 2004, the Company signed an amendment to the lease for its current corporate headquarters and simultaneously entered into a ten-year lease for a new corporate headquarters, also located in Bellevue, Washington. The amendment of the current headquarters lease, which is scheduled to terminate on December 31, 2004, provides that no cash lease payments will be made for the remainder of that lease term. Similarly, the new corporate headquarters lease also provides that no cash lease payments will be made during 2004. However, in the event the Company were to default under its new corporate headquarters lease, the landlord has the ability to demand payment for cash payments forgiven in 2004 under both leases. The amount of the forgiven payments that the landlord has the ability to demand payment for reduces over time in accordance with the underlying agreements. The total cash payments forgiven in 2004 is expected to be $3.0 million. The lease agreement for the new corporate headquarters contains a lease escalation clause calling for increased rents during the second half of the lease.

The Company also has lease commitments for office space in Eden Prairie, Minnesota; San Diego, California; and Taipei, Taiwan.

As described above, there are no cash payments due for the existing or new corporate headquarters facility in 2004. The cash payments for non-headquarter leases in the three months ended March 31, 2004 was $62,000. The non-cash expense related to our corporate headquarters in the three months ended March 31, 2004 was $94,000. Rental expense in the three months ended March 31, 2003 was $641,000.

As of March 31, 2004, the Company had $3.6 million pledged as collateral for bank letters of credit issued to a landlord to secure lease obligations, all of which will terminate in 2004. The Company is obligated to issue a letter of credit and deposit restricted cash of $1.2 million in July 2004 under the terms of its new corporate headquarters facility lease. The pledged cash is recorded as restricted cash.

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Contractual commitments at March 31, 2004, are as follows (in thousands):

Legal Proceedings

In summer and early fall 2001, four purported shareholder class action lawsuits were filed in the United States District Court for the Southern District of New York against the Company, certain of its current and former officers and directors (the “Individual Defendants”), and the underwriters of its initial public offering. The suits purport to be class actions filed on behalf of purchasers of the Company’s common stock during the period from October 19, 1999 to December 6, 2000. The complaints against the Company have been consolidated into a single action and a Consolidated Amended Complaint, which was filed on April 19, 2002 and is now the operative complaint.

Plaintiffs allege that the underwriter defendants agreed to allocate stock in the Company’s initial public offering to certain investors in exchange for excessive and undisclosed commissions and agreements by those investors to make additional purchases of stock in the aftermarket at pre-determined prices. Plaintiffs allege that the prospectus for the Company’s initial public offering was false and misleading in violation of the securities laws because it did not disclose these arrangements. The action seeks damages in an unspecified amount.

The action is being coordinated with approximately 300 other nearly identical actions filed against other companies. On July 15, 2002, the Company moved to dismiss all claims against it and the Individual Defendants. On October 9, 2002, the Court dismissed the Individual Defendants from the case without prejudice based upon Stipulations of Dismissal filed by the plaintiffs and the Individual Defendants. On February 19, 2003, the Court denied the motion to dismiss the complaint against the Company. In June 2003, the Company approved a Memorandum of Understanding (“MOU”) and related agreements which set forth the terms of a settlement between the Company, the plaintiff class and the vast majority of the other approximately 300 issuer defendants. Among other provisions, the settlement contemplated by the MOU provides for a release of the Company and the individual defendants for the conduct alleged in the action to be wrongful. The Company would agree to undertake certain responsibilities, including agreeing to assign away, not assert, or release certain potential claims the Company may have against its underwriters. It is anticipated that any potential financial obligation of the Company to plaintiffs pursuant to the terms of the MOU and related agreements will be covered by existing insurance. Therefore, the Company does not expect that the settlement will involve any payment by the Company. The MOU and related agreements are subject to a number of contingencies, including the negotiation of a settlement agreement and its approval by the Court. The Company cannot predict whether or when a settlement will occur or be finalized and are unable at this time to determine whether the outcome of the litigation will have a material impact on its results of operations or financial condition in any future period.

Microsoft Audit

The Company has a Value Added Partner (VAP) agreement with Microsoft, which enables the Company to resell Microsoft Windows Embedded operating systems. The resale of Microsoft Windows Embedded operating systems is a material portion of the Company’s revenue. There are provisions within the VAP agreement that allow for the audit of the Company’s internal records and processes. The Company is currently undergoing an audit of its royalty reporting for the period 1998 through 2003. The impact of the audit, if any, is unknown at this time. However, the final outcome of this audit could have a material adverse impact on the Company’s results of operations and financial condition.

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6. Segment Information

The Company follows the requirements of Statement of Financial Accounting Standards No. 131 (SFAS 131), “Disclosures About Segments of an Enterprise and Related Information.” During 2003, the Company’s chief operating decision makers began reviewing operating results as two segments: software and services sold to smart device makers, and hardware which the Company designs, manufactures and distributes. This represents a change from prior years. All historical amounts have been appropriately restated.

The Company measures operating results of its segments using an internal performance of direct segment operating expenses that includes amortization of intangible assets, impairment of goodwill, restructuring and related charges. All other centrally-incurred operating costs are allocated to segment results. There are no internal revenue transactions between reporting segments.

Software and Services Solutions for Smart Device Makers

The Company provides software and service solutions to smart device makers. Customers include world class original equipment manufacturers (OEMs) original design manufacturers (ODMs), device component suppliers such as silicon vendors (SVs) and peripheral vendors, and enterprises with customized device needs such as retailers or field service organizations and wireless operators that market and distribute connected smart devices.

Smart Device Design and Distribution (Hardware)

The Company designs, manufactures and distributes its own proprietary smart device hardware products, which are sold to wireless network operators and OEMs. The Company’s first hardware product introduction is the Power Handheld, a convergent wireless device.

The method for determining what information to report is based on the way that management organizes the segments within the Company for making operating decisions and assessing financial performance. Information about the Company’s reportable segments is summarized in the following table:

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The following table summarizes information about the Company’s revenue and long-lived asset information by geographic areas:

(1)

Revenue is attributed to countries based on location of customer invoiced.

(2)

Long-lived assets do not include acquired intangible assets or long-term investments.

The Company does not track assets by operating segments. Consequently, it is not practicable to show assets by operating segments.

7. Related Party Transactions

In July 2003, the Company named Donald Bibeault, the President of Bibeault & Associates, as Chairman of the Board of Directors and entered into a consulting agreement. Under this agreement, Mr. Bibeault provides the Company 10 days per month of onsite consulting services. For the three months ended March 31, 2004, the Company incurred expenses of approximately $69,000 under the agreement.

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

From time to time, information provided by us, statements made by our employees or information included in our filings with the Securities and Exchange Commission may contain statements that are “forward-looking statements” involving risks and uncertainties. In particular, statements in “Management’s Discussion and Analysis of Financial Condition and Results of Operations” relating to our revenue, profitability, and sufficiency of capital to meet working capital and capital expenditure requirements may be forward-looking statements. The words “expect,” “anticipate,” “plan,” “believe,” “seek,” “estimate” and similar expressions are intended to identify such forward-looking statements. Such statements are not guarantees of future performance and involve certain risks, uncertainties and assumptions that could cause our future results to differ materially from those expressed in any forward-looking statements made by or on behalf of us. Many such factors are beyond our ability to control or predict. Readers are accordingly cautioned not to place undue reliance on forward-looking statements. We disclaim any intent or obligation to update any forward-looking statements, whether in response to new information or future events or otherwise. Important factors that may cause our actual results to differ from such forward-looking statements include, but are not limited to, the factors discussed elsewhere in this report in the section entitled “Factors That May Affect Future Results.”

Overview

BSQUARE Corporation provides software, professional services and hardware offerings to the smart device marketplace. A smart device is a dedicated purpose computing device that typically has the ability to display information, run an operating system (e.g., Microsoft^® Windows^® CE .NET) and may be connected to a network via a wired or wireless connection. Examples of smart devices that BSQUARE targets include set-top boxes, home gateways, point-of-sale terminals, kiosks, voting machines, gaming platforms, Personal Digital Assistants (PDAs), personal media players and smartphones. We primarily focus on smart devices that utilize embedded versions of the Microsoft Windows family of operating systems, specifically Windows CE .NET, Windows XP Embedded and Windows Mobile™ for Pocket PC and Smartphone.

We have been providing software and professional service solutions to the smart device marketplace since our inception. Our customers include world class OEMs, ODMs, device component suppliers such as silicon vendors (SVs) and peripheral vendors, and enterprises with customized device needs such as retailers and wireless operators that market and distribute connected smart devices. The software and professional services we provide our customers are utilized and deployed throughout various phases of our customers’ device life cycle, including design, development, customization, quality assurance and deployment.

In addition to providing software and service solutions to smart device makers, BSQUARE designs, manufactures and distributes the Power Handheld. The Power Handheld is a convergent wireless device that provides our customers with data capabilities, such as email and internet access, as well as an open platform for integration into enterprise systems, along with voice capabilities, all in a convenient handheld form-factor. As described elsewhere in this document and more fully in our annual report on Form 10-K for the year ended December 31, 2003 filed with the Securities and Exchange Commission, our Board of Directors is currently considering strategic financing options for the Power Handheld business, including a spin-out, sale, strategic partnering, additional financing or a combination thereof. However, there can be no assurance that a strategic option will be available on acceptable terms, if at all. Lacking any acceptable strategic financing option, the Board of Directors will assess the go-forward viability of the Power Handheld business unit given that business unit’s current working capital requirements.

Fiscal 2003 was a year of significant change for BSQUARE. Revenue from the now discontinued Microsoft tools consulting business, which made up 51% and 24% of our service and overall revenue in 2002, respectively, declined to 10% and 3% of our service and overall revenue in 2003, respectively. We do not expect any further significant revenue from the Microsoft tools consulting business in the future. We have been able to replace the decline in Microsoft tools consulting revenue with revenue from other software and service offerings.

Critical Accounting Judgments

The preparation of financial statements in conformity with accounting principles generally accepted in the United States requires estimates and assumptions that affect the reported amounts of assets and liabilities, revenues and expenses and related disclosures of contingent assets and liabilities in the consolidated financial statements and accompanying notes. The SEC has defined a company’s critical accounting policies as those that are most important to the portrayal of the company’s financial condition and results of operations, and which require the company to make its most difficult and subjective judgments, often as a result of the need to make estimates of matters that are inherently uncertain. Based on this definition, we have identified the critical accounting policies and judgments addressed below. We also have other key accounting policies, which involve the use of estimates, judgments and assumptions that are significant to understanding our results. For additional information see Item 8 of Part II, “Financial Statements and Supplementary Data — Note 1 — Description of Business and Accounting Policies”

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contained in our annual report on Form 10-K for the year ended December 31, 2003 filed with the Securities and Exchange Commission. Although we believe that our estimates, assumptions and judgments are reasonable, they are based upon information presently available. Actual results may differ significantly from these estimates under different assumptions, judgments or conditions.

Revenue Recognition

We recognize revenue from software, service and hardware sales when the following four revenue recognition criteria are met: persuasive evidence of an arrangement exists; delivery has occurred or services have been rendered; the selling price is fixed or determinable; and collectibility is reasonably assured. Contracts and customer purchase orders are generally used to determine the existence of an arrangement. Shipping documents and customer acceptance, when applicable, are used to verify delivery. We assess whether the fee is fixed or determinable based on the payment terms associated with the transaction and whether the sales price is subject to refund or adjustment. We assess collectibility based primarily on the creditworthiness of the customer as determined by credit checks and analysis, as well as the customer’s payment history.

We recognize software revenue upon shipment provided that collection is determined to be probable and no significant obligations remain on our part. We also enter into arrangements in which a customer purchases a combination of software licenses, post-contract customer support (“PCS”), and/or professional services. As a result, significant contract interpretation is sometimes required to determine the appropriate accounting, including how the price should be allocated among the deliverable elements if there are multiple elements, whether undelivered elements are essential to the functionality of delivered elements, and when to recognize revenue. PCS, or maintenance, includes rights to upgrades, when and if available, telephone support, updates, and enhancements. Professional services relate to consulting and development services and training. When vendor specific objective evidence (“VSOE”) of fair value exists for all elements in a multiple element arrangement, revenue is allocated to each element based on the relative fair value of each of the elements. VSOE of fair value is established by the price charged when the same element is sold separately. Accordingly, the judgments involved in assessing VSOE have an impact on the recognition of revenue in each period. Changes in the allocation of the sales price between deliverables might impact the timing of revenue recognition, but would not change the total revenue recognized on the contract.

Service revenue from fixed-priced contracts is recognized using the percentage of completion method. Percentage of completion is measured based primarily on input measures such as hours incurred to date compared to total estimated hours to complete, with consideration given to output measures, such as contract milestones, when applicable. We rely on estimates of total expected hours as a measure of performance and cost in order to determine the amount of revenue to be recognized. Revisions to hour and cost estimates are recorded in the period the facts that give rise to the revision become known. Losses on fixed-priced contracts are recognized in the period when they become known. Service revenue from time and materials contracts and training services is recognized as revenue as services are performed.

We recognize revenue from sales of hardware products upon shipment provided that title and risk of loss has been transferred to the customer and provided that product acceptance has occurred, collection is determined to be probable and no significant obligations remain. We record revenue from sales of hardware products net of estimated customer returns.

When elements such as hardware products, software and engineering services are contained in a single arrangement, or in related arrangements with the same customer, we allocate revenue to each element based on its relative fair value, provided that such element meets the criteria for treatment as a separate unit of accounting. In the absence of fair value for a delivered element, we allocate revenue first to the fair value of the undelivered elements and allocate the residual revenue to the delivered elements. In the absence of fair value for an undelivered element, the arrangement is accounted for as a single unit of accounting, resulting in a delay of revenue recognition for the delivered elements until the undelivered elements are fulfilled. As a result, contract interpretations and assessments of fair value are sometimes required to determine the appropriate accounting.

Estimated costs of future warranty claims and claims under indemnification provisions in certain licensing agreements are accrued based on historical experience. If actual costs of claims differ from our estimates, revision to the estimated warranty liability would be required.

We perform ongoing credit evaluations of our customers’ financial condition and generally do not require collateral. We maintain allowances for estimated credit losses.

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Long-Lived Assets

We assess the impairment of our long-lived assets whenever events or changes in circumstances indicate that the carrying value may not be recoverable. Factors we consider, which could trigger an impairment review, include significant underperformance relative to expected historical or projected future operating results and a significant change in the manner of use of the assets or business strategy. When we determine that the carrying value of certain long-lived assets may not be recoverable based upon the existence of one or more of the above indicators of impairment, we then measure any impairment based on a projected discounted cash flow method using a discount rate determined to be commensurate with the risk inherent in our current business. This approach uses our estimates of future market growth, forecasted revenue and other proceeds and costs, expected periods the assets will be utilized and appropriate discount rates.

Taxes

As part of the process of preparing our consolidated financial statements, we are required to estimate income taxes in each of the countries in which we operate. This process involves estimating our current tax exposure together with assessing temporary differences resulting from differing treatment of items for tax and accounting purposes. These differences result in deferred tax assets and liabilities. We must then assess the likelihood that our deferred tax assets will be recovered from future taxable income, and, to the extent we believe that recovery is not likely, we must establish a valuation allowance. To the extent we establish a valuation allowance or increase this allowance in a period, it may result in an expense within the tax provision in the statement of operations. Significant management judgment is required in determining our provision for income taxes, deferred tax assets and liabilities and any valuation allowance recorded against our net deferred tax assets. We have provided a full valuation allowance on deferred tax assets because of our uncertainty regarding their realizability based on our valuation estimates. If we determine that it is more likely than not that the deferred tax assets would be realized, the valuation allowance would be reversed. In order to realize our deferred tax assets, we must be able to generate sufficient taxable income.

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Results of Operations

The following table presents certain financial data as a percentage of total revenue for the three-month periods ended March 31, 2004 and 2003. Our historical operating results are not necessarily indicative of the results for any future periods.

Revenue

Total revenue consists of sales of software and services provided to smart device makers and, to a much lesser extent, revenue from hardware sales. Software revenue consists of resale of third-party software, sales of our proprietary software products and royalties from our software development tool products, debugging tools and applications and smart device reference designs. Service revenue is derived from hardware and software development consulting and engineering services fees, porting contracts, maintenance and support contracts, and fees for customer training. Hardware revenue is derived from the sale of our Power Handheld hardware device.

Total revenue was $11.1 and $8.1 million in the three months ended March 31, 2004 and 2003, respectively, representing an increase of 38%. We experienced increased revenue in all three of our revenue categories, Software, Services and Hardware. The increases in revenue are discussed in detail in the sections below.

Revenue from customers located outside of the United States was $1.8 million and $1.4 million in the three months ended March 31, 2004 and 2003, respectively. These amounts include revenue attributable to our foreign operations, as well as revenue invoiced to foreign customers from our operations located in the United States. The increase in international revenue was primarily due to sales of our Power Handheld to a European customer and increased revenue from our Taiwan operation, offset by a decrease in revenue attributable to our now closed Japan operation. We continue to pursue business opportunities in Japan from both Taiwan and the United States. Total revenue attributable to Japan was $80,000 and $665,000 in the three months ended March 31, 2004 and 2003, respectively.

Software revenue

Software revenue was $7.7 million and $6.1 million in the three months ended March 31, 2004 and 2003, respectively, representing an increase of 26%. The increase was primarily due to increased sales of third-party software products and, to a lesser extent, increased sales of our proprietary SDIO Now! product. As a percentage of software revenue, third-party software revenue was 91% and 93% in the three months ended March 31, 2004 and 2003, respectively. Of those amounts, software revenue associated with the resale of Microsoft embedded operating systems was 98% and 96% in the three months ended March 31, 2004 and 2003, respectively. We expect third-party software sales to continue to be a significant percentage of our software revenue.

Service revenue

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Service revenue was $2.9 million and $2.0 million in the three months ended March 31, 2004 and 2003, respectively, representing an increase of 46%. The increase was due primarily to improvements in our service business, in the areas of pricing and contract management. In addition, we increased the consulting services provided to Microsoft in the first quarter of 2004, representing 15% of our service revenue, compared to 4% in the first quarter of 2003.

Hardware revenue

Hardware revenue was $524,000 in the three months ended March 31, 2004, all of which was generated by sales of our Power Handheld device. There was no hardware revenue in the three months ended March 31, 2003. We expect hardware revenue to continue in the immediate future as we deliver product for current orders. However, expenses and working capital required to support the Power Handheld business are significant and cannot be supported through our existing resources at current operational levels. As mentioned in Part I, Item 1. “Business,” of our Annual Report of Form 10-K for the year ended December 31, 2003, we announced that our Board of Directors had formed a strategic planning committee to explore strategic options for this business. Options we are exploring include a spin-out, sale, strategic partnering, additional financing or a combination thereof. However, there can be no assurance that a strategic option will be available on acceptable terms, if at all. Lacking any acceptable strategic financing option, the Board of Directors will assess the go-forward viability of the Power Handheld business unit given that business unit’s current working capital requirements.

Gross profit

Gross profit is revenue less the cost of revenue, which consists of cost of software, services and hardware revenue. Gross profit was $2.2 million and $777,000 in the three month ended March 31, 2004 and 2003, respectively, representing and increase of 179%. As a percentage of revenue, gross profit was 20% in the three months in March 31, 2004 and 10% in the three months ended March 31, 2003. The increase in gross profit is primarily a result of the increase in our services business, which generates higher margins, somewhat offset by increased software revenue, particularly third-party software revenue, which carries a lower margin and hardware revenue, which had negative gross profit.

Software gross profit

Cost of revenue related to software revenue consists primarily of license fees and royalties for third-party software and the costs of product media, product duplication and manuals. Software gross profit was 21% and 20% in the three months ended March 31, 2004 and 2003, respectively. We expect third-party software sales to continue to be a significant percentage of our software revenue, and therefore, software gross profit to remain relatively low in the foreseeable future.

Service gross profit

Cost of revenue related to service revenue consists primarily of salaries and benefits for our engineers, plus related facilities and depreciation costs. Service gross profit (loss) was 28% and (23)% in the three months ended March 31, 2004 and 2003, respectively. The increase in service gross margin is attributable to improvements in our services business resulting in increased service revenue, improved resource utilization, pricing and contract management. In addition, our facilities costs, a portion of which is included in service cost of revenue, decreased 30% in the three months ended March 31, 2004, as compared to the three months ended March 21, 2003.

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Hardware gross profit

Cost of revenue related to hardware revenue consists primarily of the cost to manufacture the Power Handheld device, cost of operations personnel, amortization of tooling used in the production of the device and royalties for third-party software included within the device. During the first quarter of 2004, certain personnel and other costs previously classified as research and development expense were charged to cost of revenue, coinciding with the first meaningful shipments of the Power Handheld. Hardware gross profit was (47)% in the three months ended March 31, 2004. If sales volume of the Power Handheld device does not increase, we will continue to experience negative gross margins.

Operating expenses

Selling, general and administrative

Selling, general and administrative expenses consist primarily of salaries and benefits for our sales, marketing and administrative personnel and related facilities and depreciation costs.

Selling, general and administrative expenses were $2.7 million and $3.8 million in the three months ended March 31, 2004 and 2003, respectively, representing a decrease of 29%. Selling, general and administrative expenses represented 25% and 47% of our total revenue in the three months ended March 31, 2004 and 2003, respectively. The decrease in selling, general and administrative operating expenses was due primarily to restructuring initiatives that reduced personnel and facilities costs during 2003.

Research and development

Research and development expenses consist primarily of salaries and benefits for software developers, quality assurance personnel, program managers, related facilities and depreciation costs and costs of outside vendors.

Research and development expenses were $1.5 million and $3.1 million in the three months ended March 31, 2004 and 2003, representing a decrease of 52%. As a percentage of total revenue, research and development expenses were 13% and 39% in the three months ended March 31, 2004 and 2003, respectively. Of these amounts, research and development expenses associated with our Power Handheld hardware initiative totaled $1.3 million and $1.5 million in the three months ended March 31, 2004 and 2003, respectively. The decrease in overall research and development expenses in 2004 was primarily due to reductions in our developer workforce targeting proprietary software products as well as reductions in our facilities costs. Specifically, we terminated a number of proprietary products and associated development efforts and, consequently, terminated a number of personnel associated with these products. In addition, during the first quarter of 2004, certain personnel and other costs previously classified as research and development expense were charged to cost of hardware revenue, coinciding with the first meaningful shipments of the Power Handheld.

Amortization of intangible assets

Intangible assets subject to amortization are amortized over their estimated useful lives of thirty-six months. Amortization of intangible assets was $133,000 and $146,000 in the three months ended March 31, 2004 and 2003, respectively. The remaining intangible assets will be fully amortized in the second quarter of 2004.

Impairment of goodwill and other intangible assets

On March 13, 2002, we acquired Infogation Corporation (Infogation) in a purchase transaction valued at approximately $8.7 million. The purchase price was allocated to the fair value of the acquired assets and assumed liabilities based on their fair market values at the date of the acquisition. Due to weaker-than-expected demand for telematics products and services, we subsequently eliminated all our telematics personnel and are no longer actively pursuing telematics work.

In March 2003, $300,000 and 129,729 shares of common stock (together, the “Escrow Consideration”) previously held in an escrow account related to our purchase of Infogation were released to the former owners of Infogation (the “Sellers”). The escrow account was designated for a variety of uncertainties and potential claims related to representations and warranties of the Sellers. The Escrow Consideration related to the purchase of Infogation and, upon its release date, was valued at $435,000 and considered a purchase price adjustment. Because of the 2002 decision to significantly reduce

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telematics personnel and no longer pursue such work, we evaluated this amount and recorded an impairment charge for the entire value of the Escrow Consideration in the first quarter of 2003.

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Restructuring and related charges

Restructuring and related charges represent expenses associated with our efforts to reduce our overall operating costs. During 2004 and 2003, we approved restructuring plans to reduce headcount and eliminate excess facilities, among other things. Restructuring and related charges were $129,000 in the three months ended March 31, 2004. There were no such charges in the three months ended March 31, 2003.

During the first quarter of 2004, we eliminated ten positions in the Power Handheld business, representing 7% of our remaining workforce. We incurred severance of $79,000, paid in April 2004 and $20,000 of related charges. In addition, $30,000 of remaining assets related to the now closed Japanese operations was charged to restructuring expense.

The components of the charges recorded for the three months ended March 31, 2004, and a roll-forward of the restructuring liability are as follows (in thousands):

Other Income, Net

Other income, net was $57,000 and $108,000 in the three months ended March 31, 2004 and 2003, respectively, representing a decrease of 47%. The decrease was due to lower interest income as a result of lower average cash, cash equivalent and short-term investment balances due to the use of cash in operations.

Liquidity and Capital Resources

As of March 31, 2004, we had $15.4 million of cash, cash equivalents, restricted cash, and short-term investments compared to $17.7 million at December 31, 2003. Specifically, we had $11.8 million of unrestricted cash and $3.6 million of restricted cash as of March 31, 2004. Our restricted cash balance relates to securitization of obligations associated with our current corporate headquarters lease. All the restricted cash balance as of March 31, 2004, is expected to become unrestricted during 2004. However, we are obligated to issue a letter of credit and deposit restricted cash of $1.2 million in July 2004 under terms of our new corporate headquarters facility lease. Our working capital at March 31, 2004 was $15.1 million compared to $16.5 million at December 31, 2003, resulting primarily from the decrease in overall cash balances used to fund operating losses.

During the three months ended March 31, 2004, net cash used in operating activities was $2.1 million primarily stemming from our net loss of $2.2 million and the payment of restructuring obligations, offset by depreciation and amortization. During the three months ended March 31, 2003, net cash used in operating activities was $9.6 million primarily due to our net loss of $6.6 million and the payment of restructuring obligations.

Investing activities provided cash of $222,000 in the three months ended March 31, 2004 and $2.1 million in the three months ended March 31, 2003. Investing activities in 2004 included $290,000 provided by maturities of short-term investments and $68,000 used for purchases of capital equipment. Investing activities in 2003 included $2.1 million provided by maturities of short-term investments and $63,000 used for purchases of leasehold improvements and capital equipment.

Financing activities generated $92,000 and $48,000 in the three months ended March 31, 2004 and 2003, respectively, as a result of employees’ exercise of stock options.

In the fourth quarter of 2003 we received our first customer commitments to purchase the Power Handheld device. The design, manufacture and distribution of these devices is a new business for us, and requires substantial levels of working capital to fulfill

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orders. Although we outsource all of our manufacturing, we are nevertheless required to finance such manufacturing and related inventory costs. We are also required to finance the related distribution costs. To date, we have been able to finance our relatively small-scale manufacturing, inventory and distribution expenses internally, and we will continue to do so in the short term. However, expenses and working capital required to support the Power Handheld business are significant and cannot be supported through our existing resources at current operational levels. As mentioned in Part I, Item 1. “Business,” of our Annual Report of Form 10-K for the year ended December 31, 2003, we announced that our Board of Directors had formed a strategic planning committee to explore strategic options for this business. Options we are exploring include a spin-out, sale, strategic partnering, additional financing or a combination thereof. There can be no assurance that a strategic option will be available on acceptable terms, if at all. Certain options including a spin-off, sale or other financing options for this business may be dilutive to existing holders of our common stock. Working capital financing alternatives could involve restrictive covenants, which could impair our ability to engage in certain business transactions. If other financing sources are not available on acceptable terms, or not at all, our ability to continue to manufacture and distribute our Power Handheld devices would be negatively impacted, with a corresponding adverse effect on our future revenue and results of operations. Additionally, lacking any acceptable strategic financing option, the Board of Directors will assess the go-forward viability of the Power Handheld business unit given that business unit’s current working capital requirements.

We have a Value Added Partner (VAP) agreement with Microsoft, which enables us to resell Microsoft Windows Embedded operating systems. There are provisions within the VAP agreement that allow for the audit of our internal records and processes. The resale of Microsoft Windows Embedded operating systems is a material portion of our revenue. We are currently undergoing an audit of our royalty reporting for the period 1998 through 2003. The impact of the audit, if any, is unknown at this time. However, the final outcome of this audit could have a material adverse impact on our results of operations and financial condition.

In the first quarter of 2004, we paid a total of $558,000 in restructuring-related costs. As of March 31, 2004, we had an accrued balance of $974,000 in estimated remaining restructuring-related costs, consisting of $856,000 for early lease termination obligations, $89,000 for severance and related charges and $29,000 for excess facilities primarily related to non-cancelable leases. Substantially all of our remaining accrued restructuring liability will be paid in 2004.

Our other principal commitments consist of obligations outstanding under operating leases, which expire through 2014. In 2002 we agreed to certain early lease termination fees related to our corporate headquarters in Bellevue, Washington, of which $856,000, payable in quarterly installments in 2004, remained outstanding at March 31, 2004. In February 2004, we signed an amendment to the lease for our current corporate headquarters and simultaneously entered into a ten-year lease for a new corporate headquarters, also located in Bellevue, Washington. The amendment of the current headquarters lease, which is scheduled to terminate on December 31, 2004, provides that no cash lease payments will be made for the remainder of that lease term. Similarly, the new corporate headquarters lease also provides that no cash lease payments will be made during 2004. However, in the event that we were to default under our new corporate headquarters lease, the landlord has the ability to demand payment for cash payments forgiven in 2004 under both leases. The total cash payments forgiven in 2004 is expected to be $3.0 million. The amount of the forgiven payments that the landlord has the ability to demand payment for reduces over time in accordance with the underlying agreements.

We also have lease commitments for office space in Eden Prairie, Minnesota; San Diego, California; and Taipei, Taiwan. The annual obligations under all of these leases are detailed in the table below.

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Contractual commitments at March 31, 2004 are as follows (in thousands):

Our total revenue increased 3% in the first quarter of 2004 as compared to the fourth quarter of 2003 and 38% as compared to the first quarter of 2003. However, the Company is not yet profitable and continues to use cash to fund operations. If our revenue remains flat or declines and/or our expenses increase or can not be maintained proportionately, we will continue to experience losses and will be required to use our existing cash to fund operations. We believe that our existing cash, cash equivalents and short-term investments will be sufficient to meet our remaining needs for working capital and capital expenditures for the next 12 months. See “Factors That May Affect Future Results.”

Related Party Transactions

In July 2003, we named Donald Bibeault, the President of Bibeault & Associates, as Chairman of the Board of Directors and entered into a consulting agreement. Under this agreement, Mr. Bibeault provides us 10 days per month of onsite consulting services. For the three months ended March 31, 2004, we incurred expenses of approximately $69,000 under the agreement.

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FACTORS THAT MAY AFFECT FUTURE RESULTS

The following risk factors and other information included in this Quarterly Report should be carefully considered. The risks and uncertainties described below are not the only ones we face. Additional risks and uncertainties not presently known to us or that we currently deem immaterial also may impair our business operations. If any of the following risks occur, our business, financial condition, operating results and cash flows could be materially adversely affected.

If we do not maintain our Value Added Partner agreement with Microsoft, our revenue would decrease and our business would be adversely affected.

We have a Value Added Partner (VAP) agreement with Microsoft which enables us to resell Microsoft Windows Embedded operating systems to our customers in North America. Software sales under this agreement constitute a significant portion of our revenue. For the three months ended March 31, 2004 and 2003, revenue under this agreement constituted 89% of our total software revenue. If our VAP agreement was terminated, our software and service revenue would decrease significantly. Moreover, if our VAP agreement with Microsoft is renewed on less favorable terms, our revenue could decrease, and/or our gross profit from these transactions, which are relatively low, could further decline. Our VAP agreement is renewable annually, and there is no automatic renewal provision in the agreement. Additionally, there are provisions within the VAP agreement that require us to maintain certain internal records and processes for royalty auditing and other reasons. Non-compliance with these requirements could result in the termination of our VAP agreement. BSQUARE is currently undergoing an audit of our royalty reporting for the period 1998 through 2003. The impact of the audit, if any, is unknown at this time. However, the final outcome of this audit could have a material adverse impact on our results of operations and financial condition.

The market for resale of Microsoft Embedded operating systems licenses is highly competitive and the margins are relatively low. If the margins in this business erode, our results will be negatively impacted. In addition this business experiences seasonality.

The gross profit margin on sales of Microsoft Embedded Windows licenses is relatively low. There are three competitors which also sell Embedded Windows licenses to substantially the same customer base in the North American market place, which can create additional downward pressure on gross profit. During the first quarter of 2004 and throughout 2003, our gross profit margin on the resale of Microsoft Embedded operating systems and tools remained relatively flat, but there can be no assurance that gross profits on future sales will not decline. Additionally, Microsoft offers BSQUARE and its competitors largely volume-based rebates which have the effect of increasing our software gross margins. If Microsoft were to reduce or eliminate these rebate programs, our gross margins would be negatively impacted. Finally, the revenue associated with the Microsoft Embedded distribution business is seasonal in nature. Due primarily to customer ordering patterns, revenue generated in the first quarter of each year in this business can generally be expected to be lower than other quarters.

If we do not maintain our favorable relationship with Microsoft, we will have difficulty marketing and selling our software and services and may not receive developer releases of Windows Embedded operating systems and Windows Mobile targeted platforms. As a result, our revenue and operating margins could suffer.

We maintain a strategic marketing relationship with Microsoft. In the event that our relationship with Microsoft were to deteriorate, our efforts to market and sell our software and services to OEMs and others could be adversely affected and our business could be harmed. Microsoft has significant influence over the development plans and buying decisions of OEMs and others utilizing Windows Embedded operating systems and Windows Mobile targeted platforms for smart devices. Microsoft provides referrals of some of those customers to us. Moreover, Microsoft controls the marketing campaigns related to its operating systems. Microsoft’s marketing activities; including trade shows, direct mail campaigns and print advertising, are important to the continued promotion and market acceptance of Windows Embedded operating systems and Windows Mobile targeted platforms, and consequently, to our sale of Windows-based embedded software and services. We must maintain a favorable relationship with Microsoft to continue to participate in its joint marketing activities with them, which includes participating in “partner pavilions” at trade shows, listing our services on Microsoft’s website, and receiving customer referrals. In the event that we are unable to continue our joint marketing efforts with Microsoft, or fail to receive referrals from them, we would be required to devote significant additional resources and incur additional expenses to market software products and services directly to potential customers. In addition, we depend on Microsoft for developer releases of new versions of and upgrades to Windows Embedded and Windows Mobile software in order to facilitate timely development and shipment of our products and services. If we are unable to receive these developer releases, our revenue and profit margins could suffer.

Design, manufacture and distribution of the Power Handheld device has and will continue to require substantial working capital. Our current resources have been determined to be inadequate to properly fund the foreseen requirements of the Power Handheld device and business. We are exploring strategic options with regard to meeting

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these working capital requirements, but, if we are unable to execute on such a strategy successfully, our business could be adversely affected.

In the fourth quarter of 2003 we received our first customer commitments to purchase Power Handheld devices, and our belief is that orders for the device will continue at some level during 2004. The design, manufacture and distribution of these devices is a new business for us, and requires substantial levels of working capital to fulfill orders. Although we outsource all of our manufacturing, we are nevertheless required to finance such manufacturing and related inventory costs through a variety of mechanisms, including letters of credit and cash payments. We are also required to finance the related distribution costs. To date, we have been able to finance our relatively small-scale manufacturing, inventory and distribution expenses internally, and we will continue to do so in the short term. However, expenses and working capital required to support the Power Handheld business are significant and cannot be supported through our existing resources at current operational levels. As mentioned in Part I, Item 1. “Business,” of our Annual Report on Form 10-K for the year ended December 31, 2003, we announced that our Board of Directors had formed a strategic planning committee to explore strategic options for this business. Options we are exploring include a spin-out, sale, strategic partnering, additional financing or a combination thereof. However, there can be no assurance that a strategic option will be available on acceptable terms, if at all. Such options could include a spin-off, sale or other financing options for this business, some of which may be dilutive to existing holders of our common stock. Working capital financing alternatives could involve restrictive covenants, which could impair our ability to engage in certain business transactions. If other financing sources are not available on acceptable terms, or not at all, our ability to continue to manufacture and distribute our Power Handheld devices would be negatively impacted, with a corresponding adverse effect on our future revenue and results of operations. Additionally, lacking any acceptable strategic financing option, the Board of Directors will assess the go-forward viability of the Power Handheld business unit given that business unit’s current working capital requirements.

We are devoting a substantial portion of our resources to our Power Handheld device. The device market is new to us and is subject to many uncertainties. If this initiative is not successful, our potential future revenue and earnings will suffer.

In connection with the cost-reduction efforts described elsewhere in this report, we were forced to make certain product development decisions based on limited information regarding the future demand for those products. There can be no assurance that we decided to pursue the right product offerings to take advantage of future market opportunities. Specifically, in 2003, we made the strategic decision to devote a substantial portion of our research and development and working capital resources toward the design, development, and distribution of our Power Handheld device. We have limited experience in producing or distributing such devices, and there can be no assurance that the Power Handheld device, or the underlying technology, will achieve substantial market acceptance or that it will ultimately prove to be profitable in light of the many uncertainties inherent in designing, manufacturing and introducing a new product to market. These uncertainties include the intense competition found in the market generally for handheld computing devices, the various design, manufacturing and distribution risks involved in producing and marketing a new electronic product, the length of the sales cycle and the variation in customer ordering patterns. In the event that these product development initiatives do not meet our expectations, our potential future revenue and earnings are likely to suffer and we would continue to be dependent on our other sources of revenue, including the revenue generated from our VAP agreement with Microsoft.

If we fail to develop, manufacture and sell products successfully and in a timely manner, including our Power Handheld hardware device, we may not be able to compete effectively and our ability to generate revenue could suffer.

The markets for Windows-based embedded products and services are competitive, new and evolving. As a result, the life cycles of our products and services are difficult to estimate. To be successful, we believe we must continue to enhance our current product line and provide new products and service offerings that appeal to our customers with attractive features, prices and terms. We have experienced delays in enhancements and new product release dates in the past and may be unable to introduce enhancements or new products successfully or in a timely manner in the future. Our business may be harmed if we delay releases of our products and product enhancements or if we fail to accurately anticipate our customers’ needs or technical trends and are unable to introduce new products and service offerings into the market successfully. In addition, our customers may defer or forego purchases of our products if we, Microsoft, our competitors or major hardware, systems or software vendors introduce or announce new products or product enhancements. Problems in acquiring or manufacturing key components of our Power Handheld device (e.g., custom sheet metal parts, batteries, displays or other critical components) may result in delayed or missed deliveries to our customers. Such deferrals, delays or failures to purchase could decrease our revenue and could impact future revenue potential.

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Our marketplace is extremely competitive, which may result in price reductions, lower gross profit margins and loss of market share.

The market for Windows-based software products and services is extremely competitive, as is the market for our Power Handheld device. In addition, competition is intense for the business of the limited number of customers that are capable of building and shipping large quantities of smart devices. Increased competition may result in price reductions, lower gross profit margins and loss of market share, which would harm our business. We face competition from:

	•		Our current and potential customers’ internal research and development departments, which may seek to develop their own proprietary products and solutions;
	•		Professional engineering service firms;
	•		Software and component distributors; and
	•		Hardware manufacturers and others that manufacture and distribute hardware devices targeted at the enterprise marketplace.

As we develop new products, particularly products focused on specific industries, we may begin competing with companies with which we have not previously competed. It is also possible that new competitors will enter the market or that our competitors will form alliances, including alliances with Microsoft, that may enable them to rapidly increase their market share. Microsoft has not agreed to any exclusive arrangement with us, nor has it agreed not to compete with us. Microsoft may decide to bring more of the core development services and expertise that we provide in-house, possibly resulting in reduced service revenue opportunities for us. The barrier to entering the market as a provider or distributor of Windows-based smart device software and services is low. In addition, Microsoft has created marketing programs to encourage systems integrators to work on Windows Embedded operating system products and services. These systems integrators are given substantially the same access by Microsoft to the Windows technology as we are. New competitors may have lower overhead than we do and may be able undercut our pricing. We expect that competition will increase as other established and emerging companies enter the Windows-based smart device market, and as new products and technologies are introduced.

If Microsoft adds features to its Windows operating system or develops products that directly compete with products and services we provide, our revenue could be reduced and our gross profit margins could suffer.

As the developer of Windows, Windows XP Embedded, Windows CE, Windows Mobile for Smartphone and Windows Mobile for PocketPC, Microsoft could add features to its operating systems or could develop products that directly compete with the products and services we provide to our customers. Such features could include, for example, software that competes with our own proprietary software products, driver development tools, faxing, hardware-support packages and quality-assurance tools. The ability of our customers or potential customers to obtain products and services directly from Microsoft that compete with our products and services could harm our business. Even if the standard features of future Microsoft operating system software were more limited than our offerings, a significant number of our customers and potential customers might elect to accept more limited functionality in lieu of purchasing additional software from us. Moreover, the resulting competitive pressures could lead to price reductions for our products and reduce our gross margins.

Microsoft has plans to release a new version of its Windows CE .NET embedded operating system in 2004, incorporating certain of our existing SDIO Now! functionality. This is expected to decrease overall demand for our current SDIO Now! software product and may adversely impact future revenue generated from our proprietary software products.

A portion of our software revenue comes from proprietary software products, most notably our SDIO Now! software product. Microsoft plans on releasing new Windows Embedded operating system versions in 2004 which will incorporate some of our existing SDIO Now! functionality which we believe will decrease overall demand for our current SDIO Now! software product. Our ability to maintain and grow our revenue from our SDIO Now! software product is contingent on the timing of the Microsoft releases and the specific functionality of those offerings. We are currently designing our next generation SDIO software product to complement the functionality expected to be included in upcoming Windows Embedded operating system releases. However, there can be no assurance that our next-generation SDIO products will be as competitive in the marketplace as they are now.

During the three months ended March 31, 2004 and 2003, sales of our proprietary software products comprised 9% and 7% of our software revenue, respectively. These software products carry much higher gross profit margins than third-party software products, which we resell to our customers. Accordingly, Microsoft’s next generation operating system releases incorporating

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SDIO technology may have an adverse impact on revenue and may have a more significant adverse impact on our overall software gross profits.

Our ability to maintain or grow the portion of our software revenue attributable to sales of our proprietary software products is contingent on our ability to bring to market competitive, unique offerings that keep pace with technological changes and needs. If we are not successful in doing so, our business would be harmed.

The amount and percentage of revenue attributable to sales of our proprietary software products has decreased over the last three years due to a more competitive marketplace, changing technological needs and the elimination of certain proprietary software products which were determined to be unprofitable and non-competitive. Our ability to maintain the revenue contribution from proprietary software products, as well as the higher gross profit contribution from these products, is contingent on our ability to enhance the features and functionality of our current proprietary products as well as introduce new products which may not be guaranteed.

If the market for smart devices does not develop or develops more slowly than we expect, our revenue may not develop as anticipated, if at all, and our business would be harmed.

The market for smart devices is emerging and the potential size of this market and the timing of its development are not known. As a result, our profit potential is uncertain and our revenue may not develop as anticipated, if at all. We are dependent upon the broad acceptance by businesses and consumers of a wide variety of smart devices, which will depend on many factors, including:

	•		The development of content and applications for smart devices;
	•		The willingness of large numbers of businesses and consumers to use devices such as smartphones, PDAs and handheld industrial data collectors to perform functions currently carried out manually or by traditional PCs, including inputting and sharing data, communicating among users and connecting to the Internet; and
	•		The evolution of industry standards or the necessary infrastructure that facilitated the distribution of content over the Internet to these devices via wired and wireless telecommunications systems, satellite or cable.

If the market for Windows Embedded operating systems and Windows Mobile targeted platforms fails to develop further, develops more slowly than we expect, or declines, our business and operating results may be materially harmed.

Because a significant portion of our revenue to date has been generated by software products and services dependent on the Windows Embedded operating systems and Windows Mobile targeted platforms, if the market fails to develop further or develops more slowly than we expect, or declines, our business and operating results may be significantly harmed. Market acceptance of Windows Embedded and Windows Mobile will depend on many factors, including:

	•		Microsoft’s development and support of the Windows Embedded and Windows Mobile market. As the developer and primary promoter of Windows CE, Windows XP Embedded, Windows Mobile for Smartphone and Windows Mobile for PocketPC, if Microsoft were to decide to discontinue or lessen its support of these operating systems and platforms, potential customers could select competing operating systems, which could reduce the demand for our Windows Embedded and Windows Mobile software products and services;
	•		The ability of the Microsoft Windows Embedded operating systems and Windows Mobile software to compete against existing and emerging operating systems for the smart device market, including: VxWorks and pSOS from WindRiver Systems Inc., Linux, Symbian, Palm OS from PalmSource, JavaOS from Sun Microsystems, Inc., and other proprietary operating systems. In particular, in the market for handheld devices, Windows Mobile software for Pocket PC and Windows CE face intense competition from PalmSource. In the market for convergent devices, Windows Mobile for Pocket PC Phone Edition and for Smartphone, face competition from the EPOC operating system from Symbian. Windows Embedded operating systems and Windows Mobile for Smartphone may be unsuccessful in capturing a significant share of these two segments of the smart device market, or in maintaining its market share in those other segments of the smart device market on which our business currently focuses, including the markets for point-of-sale devices, gaming devices, medical devices, kiosks, and consumer devices such as television set-top boxes;

•

The acceptance by OEMs and consumers of the mix of features and functions offered by Windows embedded operating systems and Windows Mobile targeted platforms; and

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•

The willingness of software developers to continue to develop and expand the applications that run on Windows Embedded operating systems and Windows Mobile targeted platforms. To the extent that software developers write applications for competing operating systems that are more attractive to smart device users than those available on Windows Embedded operating systems and Windows Mobile targeted platforms, potential purchasers could select competing operating systems over Windows Embedded operating systems and Windows Mobile targeted platforms.

Unexpected delays or announcement of delays by Microsoft of Windows Embedded operating systems and Windows Mobile targeted platforms product releases could adversely affect our revenue.

Unexpected delays or announcement of delays in Microsoft’s delivery schedule for new versions of its Windows Embedded operating systems could cause us to delay our product introductions and impede our ability to complete customer projects on a timely basis. These delays or announcements of delays, by Microsoft could also cause our customers to delay or cancel their project development activities or product introductions, which may have a negative impact on our revenue. Any resulting delays in, or cancellations of, our planned product introductions or in our ability to commence or complete customer projects may adversely affect our revenue and operating results.

The success and profitability of our service offerings targeted at smart device makers is contingent on our ability to differentiate our offerings adequately in the marketplace and defend our billing rate structures against those of competitors, including those using lower-cost offshore resources. If we are unable to do so successfully, our business could be harmed.

We are a leader in providing service solutions to our smart device customers. Our market differentiation is created through several factors, including our deep experience with a variety of smart device platforms and applications. Our differentiation, in part, is contingent on our ability to attract and retain employees with this expertise; significantly all of whom currently are based in the United States. To the extent we are unable to retain critical engineering services talent or our competition is able to deliver the same services by using lower-cost offshore resources, our service revenue and gross profit could be adversely impacted.

The success and profitability of our service engagements is contingent upon our ability to scope and bid engagements profitably. If we are unable to do this, our service revenue and profitability may be significantly adversely impacted.

During 2003, we entered into several fixed-price service engagements that ultimately proved to be less profitable than expected due to a number of factors, including inadequate project scoping, inefficient service delivery and fixed-price contract structures. While we have taken steps to address these inadequacies and risks going forward, there can be no assurance that we will be successful given customer demands, competitive pressures and other factors. If we are unable to adequately scope, bid and deliver on service engagements successfully, our service revenue and gross profit could be negatively impacted.

If we are unable to license key software from third parties, our business could be harmed.

We often integrate third-party software with our proprietary software or hardware to provide products and services for our customers. If our relationships with our third-party vendors were to deteriorate, we might be unable to obtain licenses on commercially reasonable terms, if at all, for newer versions of their software required to maintain compatibility. In the event that we are unable to obtain additional licenses, we would be required to develop this technology internally, which could delay or limit our ability to introduce enhancements or new products or to continue to sell existing products.

Our revenue may flatten or decline, or we may not be able to return to profitability in accordance with our plans.

Our revenue increased 3% in the first quarter of 2004 as compared to the fourth quarter of 2003, increased slightly from 2002 to 2003, declined 39% from 2001 to 2002, and declined 3% from 2000 to 2001. If our revenue remains flat or declines and/or our expenses increase or can not be maintained proportionately, we will continue to experience losses and will be required to use our existing cash to fund operations. In addition, the continuing slowness in the U.S. economy has created economic and consumer uncertainty that has adversely affected our revenue and could continue to do so. We expect that our expenses will continue to be substantial in the foreseeable future, as we continue to develop our technology and refocus our product and service offerings. These efforts may prove more expensive than we currently expect, and we may not succeed in increasing our revenue sufficiently to offset our expenses.

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Non-compliance with certain agreements could have a material adverse impact on our financial position.

In addition to our Microsoft VAP agreement described above, we have entered into agreements with third-parties with respect to which non-compliance could have a material adverse impact on our financial position. Most notable is a new lease entered into in February 2004 for our new corporate headquarters, and an amendment entered into that same time for our current corporate headquarters. Both of these agreements were entered into with the same landlord. Under both of these leases, we are not required to make any cash lease payments during 2004. However, in the event we were to default under our new corporate headquarters lease, the landlord has the ability to demand cash payments forgiven in 2004 under both leases. The total cash payments forgiven in 2004 is expected to be $3.0 million. The amount of the forgiven payments that the landlord has the ability to demand payment for reduces over time in accordance with the underlying agreements.

We rely on a third party to manufacture our Power Handheld device, and our reputation and revenue could be adversely affected if this third party fails to meet their performance obligations.

We outsource all manufacturing of our Power Handheld device to a third party, upon which we depend to produce a sufficient volume of our products in a timely fashion and of satisfactory quality. Were our third party manufacturer to fail to produce quality products on time and in sufficient quantities, our reputation and results of operations could suffer. In addition, we rely on our third party manufacturer to place orders with suppliers for the components they need to manufacture our products. If it fails to place timely and sufficient orders with suppliers, our revenue could suffer. Our Power Handheld device is currently manufactured by a third party manufacturer at its international facilities located in China. The cost, quality and availability of third party manufacturing operations are essential to the successful production and sale of our handheld device. Our reliance on third party manufacturers exposes us to risks that are not in our control, with the potential to negatively impact our revenue or gross profit. For example, another outbreak of Severe Acute Respiratory Syndrome (SARS) in China could result in quarantines or closures of our third party manufacturer or one of its suppliers. In the event of such a quarantine or closure, our ability to deliver the Power Handheld device on a timely basis could be impaired and, as a result, our revenue, expenses and results of operations could be negatively impacted. We do not have manufacturing agreements with our third-party manufacturer. The absence of a manufacturing agreement means that, with little or no notice, our contract manufacturer could refuse to continue to manufacture all or some of the units of our devices that we require, or change the terms under which they manufacture our device products. If this manufacturer were to stop manufacturing our devices, we may be unable to replace the lost manufacturing capacity on a timely basis and our results of operations could be harmed. In addition, if our manufacturer were to change the terms under which they manufacture for us, our manufacturing costs could increase and our gross profit could decrease. We have experienced delays in the manufacturing of our products in the past, and there can be no guarantee that we will not experience delays in the future.

We may be subject to product liability claims that could result in significant costs.

Our license agreements with our customers typically contain provisions designed to limit our exposure to potential product liability claims. It is possible, however, that these provisions may be ineffective under the laws of certain jurisdictions. Although we have not experienced any product liability claims to date, the sale and support of our products and services entail the risk of such claims, and we may be subject to such claims in the future. In addition, to the extent we develop and sell increasingly comprehensive, customized turnkey solutions for our customers, including the Power Handheld and similar devices, we may be increasingly subject to risks of product liability claims. There is a risk that any such claims or liabilities may exceed or fall outside the scope of our insurance coverage, and we may be unable to retain adequate liability insurance in the future. A product liability claim brought against us, whether successful or not, could harm our business and operating results.

Unexpected fluctuations in our operating results could cause our stock price to decline significantly.

Our operating results have fluctuated in the past, and we expect that they will continue to do so. Because our business has shifted over the past two years from a business model based largely on tools consulting for Microsoft to a more broad-based supplier of products and services to smart device makers, we believe that period to period comparisons of our operating results are not meaningful, and you should not rely on such comparisons to predict our future performance. If our operating results fall below the expectations of stock analysts and investors, the price of our common stock may fall. Factors that have in the past and may continue in the future to cause our operating results to fluctuate include those described in this “Risk Factors” section. In addition, our stock price may fluctuate due to conditions unrelated to our operating performance, including general economic conditions in the technology industry and the market for technology stocks.

Our efforts to reduce expenses, including reductions in work force, may not achieve the results we intend and may harm our business.

During 2004 and 2003, we continued our efforts to streamline operations and reduce expenses, including cuts in discretionary spending, reductions in capital expenditures, reductions in our work force and consolidation of certain office locations, including the closure of our Japanese subsidiary. In connection with our cost reduction efforts, we were required to make certain product and product development decisions with limited information regarding the future demand for those products. There can be no assurance that we made the correct decisions to pursue the right product offerings to take advantage of future market opportunities. Furthermore, the implementation of such measures has placed, and may continue to place, a significant strain on our managerial, operational, financial, employee and other resources. Additionally, the restructuring may negatively affect our recruiting and retention of important employees. It is possible that these reductions could impair our marketing, sales and customer support efforts or alter our product development plans. If we experience difficulties in carrying out such measures, our expenses could decrease more slowly than we expect. If we find that our planned reductions do not achieve our objectives, we may need to make additional reductions in our expenses and our work force, or to undertake additional measures.

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The long sales cycle of our products and services makes our revenue susceptible to fluctuations.

Our sales cycle is typically three to nine months because the expense and complexity of our products and services generally require a lengthy customer approval process and may be subject to a number of significant risks over which we have little or no control, including:

	•		Customers’ budgetary constraints and internal acceptance review procedures;
	•		The timing of budget cycles; and
	•		The timing of customers’ competitive evaluation processes.

In addition, to successfully sell our products and services, we frequently must educate our potential customers about the full benefits of our products and services, which can require significant time. If our sales cycle further lengthens unexpectedly, it could adversely affect the timing of our revenue which could cause our quarterly results to fluctuate.

Erosion of the financial condition of our customers could adversely affect our business.

Our business could be adversely affected should the financial condition of our customers erode, given that such erosion could reduce demand from those customers for our products and services or even terminate their relationships with us, and also could enhance the credit risk of those customers. If the global information technology market weakens, the likelihood of the erosion of the financial condition of our customers increases, which could adversely affect the demand for our products and services. While we believe that our allowance for doubtful accounts is adequate, those allowances may not cover actual losses, which could adversely affect our business.

Our software, services and hardware offerings, including the Power Handheld device, could infringe the intellectual property rights of third parties, which could expose us to additional costs and litigation and could adversely affect our ability to sell our products or cause shipment delays or stoppages.

It is difficult to determine whether our products and services infringe third-party intellectual property rights, particularly in a rapidly evolving technological environment in which technologies often overlap and where there may be numerous patent applications pending, many of which are confidential when filed, with regard to similar technologies. If we were to discover that one of our products, or a product based on one of our reference designs, violated a third party’s proprietary rights, we may not be able to obtain a license on commercially reasonable terms, or at all, to continue offering that product. Similarly, third parties may claim that our current or future products and services, infringe their proprietary rights, regardless of merit. Any such claims could increase our costs and harm our business. In certain cases, we have been unable to obtain indemnification against potential claims that the technology we license from third parties infringes the proprietary rights of others. Moreover, any indemnification we do obtain may be limited in scope or amount. Even if we receive broad third-party indemnification, these entities may not have the financial capability to indemnify us in the event of infringement. In addition, in some circumstances we could be required to indemnify our customers for claims made against them that are based on our solutions. There can be no assurance that infringement or invalidity claims related to the products and services we provide or arising from the incorporation by us of third-party technology, and claims for indemnification from our customers resulting from such claims, will not be asserted or prosecuted against us. Some of our competitors, with respect to the products we develop have or are affiliated with, are companies with substantially greater resources than we have and these competitors may be able to sustain the costs of complex intellectual property litigation to a greater degree and for longer periods of time than we could. In addition, we expect that software product developers will be increasingly subject to infringement claims, as the number of products and competitors in the software industry grows and the functionality of products in different industry segments overlap. Such claims, even if not meritorious, could result in the expenditure of significant financial and managerial resources in addition to potential product redevelopment costs and delays. Furthermore, if we were unsuccessful in resolving a patent or other intellectual property infringement action claim against us, we may be prohibited from developing or commercializing certain of our technologies and products unless we obtain a license from the holder of the patent or other intellectual property rights. There can be no assurance that we would be able to obtain any such license on commercially favorable terms, or at all. If such license is not obtained, we would be required to cease these related business operations, which could have a material adverse effect on our business, financial conditions and results of operations.

If we fail to adequately protect our intellectual property rights, competitors may be able to use our technology or trademarks, which could weaken our competitive position, reduce our revenue and increase our costs.

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If we fail to adequately protect our intellectual property, our competitive position could be weakened and our revenue adversely affected. We rely primarily on a combination of patent, copyright, trade secret and trademark laws, confidentiality procedures and contractual provisions to protect our intellectual property. These laws and procedures provide only limited protection. We have applied for a number of patents relating to our engineering work. These patents, if issued, may not provide sufficiently broad protection or they may not prove to be enforceable against alleged infringers. There can be no assurance that any of our pending patents will be granted. Even if granted, these patents may be circumvented or challenged and, if challenged, may be invalidated. Any patents obtained may provide limited or no competitive advantage to us. It is also possible that another party could obtain patents that block our use of some, or all, of our products and services. If that occurred, we would need to obtain a license from the patent holder or design around those patents. The patent holder may or may not choose to make a license available to us at all or on acceptable terms. Similarly, it may not be possible to design around such a blocking patent. In general, there can be no assurance that our efforts to protect our intellectual property rights through patent, copyright, trade secret and trademark laws will be effective to prevent misappropriation of our technology, or to prevent the development and design by others of products or technologies similar to or competitive with those developed by us. We frequently license the source code of our products and the source code results of our services to customers. There can be no assurance that customers with access to our source code will comply with the license terms or that we will discover any violations of the license terms or, in the event of discovery of violations that we will be able to successfully enforce the license terms and/or recover the economic value lost from such violations. To license many of our software products, we rely in part on “shrinkwrap” and “clickwrap” licenses that are not signed by the end user and, therefore, may be unenforceable under the laws of certain jurisdictions. As with other software, our products are susceptible to unauthorized copying and uses that may go undetected, and policing such unauthorized use is difficult. A significant portion of our marks include the word “BSQUARE” or the preface “b.” Other companies use forms of “BSQUARE” or the preface “b” in their marks alone or in combination with other words, and we cannot prevent all such third-party uses. We license certain trademark rights to third parties. Such licensees may not abide by our compliance and quality control guidelines with respect to such trademark rights and may take actions that would harm our business. The computer software market is characterized by frequent and substantial intellectual property litigation, which is often complex and expensive, and involves a significant diversion of resources and uncertainty of outcome. Litigation may be necessary in the future to enforce our intellectual property or to defend against a claim of infringement or invalidity. Litigation could result in substantial costs and the diversion of resources and could harm our business and operating results.

Our software or hardware products or the third-party hardware or software integrated with our products and services may suffer from defects or errors that could impair our ability to sell our products and services.

Software and hardware components as complex as those needed for smart devices frequently contain errors or defects, especially when first introduced or when new versions are released. We have had to delay commercial release of certain versions of our products until problems were corrected, and in some cases have provided product enhancements to correct errors in released products. Some of our contracts require us to repair or replace products that fail to work. To the extent that we repair or replace products our expenses may increase. In addition, it is possible that by the time defects are fixed, the market opportunity may decline which may result in lost revenue. Moreover, to the extent that we provide increasingly comprehensive products and rely on third-party manufacturers and suppliers to manufacture our and our customers’ products, including those related to our Power Handheld device that we distribute, we will be dependent on the ability of third-party manufacturers to correct, identify and prevent manufacturing errors. Errors that are discovered after commercial release could result in loss of revenue or delay in market acceptance, diversion of development resources, damage to our reputation and increased service and warranty costs, all of which could harm our business.

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Our international operations expose us to greater intellectual property, management, collections, regulatory and other risks.

Foreign operations generated approximately 2% and 9% of our total revenue in the three months ended March 31, 2004 and 2003, respectively. Our international operations expose us to a number of risks, including the following:

	•		Greater difficulty in protecting intellectual property due to less stringent foreign intellectual property laws and enforcement policies;
	•		Greater difficulty in managing foreign operations due to the lack of proximity between our headquarters and our foreign operations;
	•		Longer collection cycles than we typically experience in the U.S.;
	•		Unfavorable changes in regulatory practices and tariffs;
	•		Adverse changes in tax laws;
	•		The impact of fluctuating exchange rates between the U.S. dollar and foreign currencies; and
	•		General economic and political conditions in international markets, as a result of such events as the spread of SARS and other illnesses, which may differ from those in the U.S. These risks could have a material adverse effect on the financial and managerial resources required to operate our foreign offices, as well as on our future international revenue, which could harm our business.

We currently have international operations in Taipei, Taiwan.

As we increase the amount of product and service development conducted in non-US locations, potential delays and quality issues may impact our ability to deliver our products and services on-time, potentially impacting our revenue and profitability.

During 2003, we initiated a program to move certain development activities to non-US locations, primarily India, to take advantage of the high-quality, low-cost software development resources found in some developing countries. To date we have limited experience in managing software development done in non-US locations. Moving portions of our development contracts to these locations inherently increases the complexity of managing these programs and may result in delays in introducing new products to market, or delays in completing service projects for our customers, which in turn may impact the amount of revenue we recognize from related products and services and/or could impact the profitability of service engagements employing off-shore resources.

Past acquisitions have proven difficult to integrate, and future acquisitions, if any, could disrupt our business, dilute shareholder value and adversely affect our operating results.

We have acquired the technologies and/or operations of other companies in the past and may acquire or make investments in companies, products, services and technologies in the future. If we fail to properly evaluate, integrate and execute on our acquisitions and investments, our business and prospects may be seriously harmed. In some cases, we have been required to implement reductions in force and office closures in connection with an acquisition, which has resulted in significant costs to us. To successfully complete an acquisition, we must properly evaluate the technology, accurately forecast the financial impact of the transaction, including accounting charges and transaction expenses, integrate and retain personnel, combine potentially different corporate cultures and effectively integrate products and research and development, sales, marketing and support operations. If we fail to do any of these, we may suffer losses and impair relationships with our employees, customers and strategic partners, and our management may be distracted from day-to-day operations. We also may be unable to maintain uniform standards, controls, procedures and policies, and significant demands may be placed on our management and our operations, information services and financial, legal and marketing resources. Finally, acquired businesses sometimes result in unexpected liabilities and contingencies, which could be significant.

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Our senior management has experienced significant turnover and change of job function, which could disrupt our business and operations.

Since June 2003, there have been numerous changes in our senior management team. On June 17, 2003, we announced the departures of James R. Ladd, Senior Vice President of Finance & Operations and Chief Financial Officer, and Kent A. Hellebust, Senior Vice President of Marketing & Product Management. On that same date, we announced that Nogi Asp was promoted from Director of Finance to Vice President of Finance and Chief Financial Officer. On July 24, 2003, we announced that one of our founders, William T. Baxter, resigned as Chairman of the Board and Chief Executive Officer. Mr. Baxter remained as a member of our Board of Directors and our Chief Technology Officer. Subsequently, on January 12, 2004, we announced that Mr. Baxter resigned his position on our Board of Directors and as our Chief Technology Officer. On July 24, 2003 we also announced that Brian T. Crowley, our then Vice President of Product Development, was appointed by our Board of Directors to succeed Mr. Baxter as Chief Executive Officer and to serve on our Board, that Donald D. Bibeault was elected to the position of Chairman of the Board, and that Jeffrey T. Chambers had resigned from our Board of Directors. On December 17, 2003, we announced the hiring of Carey Butler to lead our Professional Engineering Services organization. On January 5, 2004, we announced that Mr. Asp had left the company and that Scott C. Mahan had been appointed as our new Chief Financial Officer.

Because of these recent management departures, additions and changes in roles, our current management team has not worked together in their current positions for a significant length of time and may not be able to work together effectively in these new positions to successfully develop and implement business strategies. In addition, as a result of these management changes, management may need to devote significant attention and resources to preserve and strengthen relationships with employees and customers. Mr. Crowley and Mr. Mahan, in particular, will need to successfully meet the increased internal and external challenges and responsibilities of their new positions. All members of our management team will need to overcome the challenges created by any vacancies in our senior management positions that remain unfilled. If our new management team is unable to develop successful business strategies, achieve our business objectives or maintain effective relationships with employees and customers, our ability to grow our business and successfully meet operational challenges could be impaired.

A small number of our existing shareholders can exert control over us.

Principal shareholders individually holding more than 5% of our common stock together control a majority of our outstanding common stock. As a result, these shareholders, if they act together, could control our management and affairs of the company and all matters requiring shareholder approval, including the election of directors and approval of significant corporate transactions. This concentration of ownership may have the effect of delaying or preventing a change in control of BSQUARE and might affect the market price of our common stock.

It might be difficult for a third party to acquire us even if doing so would be beneficial to our shareholders.

Certain provisions of our articles of incorporation, bylaws and Washington law may discourage, delay or prevent a change in the control of us or a change in our management even if doing so would be beneficial to our shareholders. Our Board of Directors has the authority under our amended and restated articles of incorporation to issue preferred stock with rights superior to the rights of the holders of common stock. As a result, preferred stock could be issued quickly and easily with terms calculated to delay or prevent a change in control of our company or make removal of our management more difficult. In addition, our Board of Directors is divided into three classes. The directors in each class serve for three-year terms, one class being elected each year by our shareholders. This system of electing and removing directors may discourage a third party from making a tender offer or otherwise attempting to obtain control of our company because it generally makes it more difficult for shareholders to replace a majority of our directors. In addition, Chapter 19 of the Washington Business Corporation Act generally prohibits a “target corporation” from engaging in certain significant business transactions with a defined “acquiring person” for a period of five years after the acquisition, unless the transaction or acquisition of shares is approved by a majority of the members of the target corporation’s Board of Directors prior to the time of acquisition. This provision may have the effect of delaying, deterring or preventing a change in control of our company. The existence of these anti-takeover provisions could limit the price that investors might be willing to pay in the future for shares of our common stock.

A continued decline in our stock price could cause us ultimately to be delisted from the NASDAQ National Market.

During the first quarter of 2004 and throughout 2003 and 2002, our common stock has traded at times near or below the $1.00 Nasdaq National Market minimum bid price. In May 2003, we received notification from The Nasdaq Stock Market, advising that we were not in compliance with the Nasdaq National Market’s listing maintenance standards requiring minimum bid price and listed security market value. In September 2003, we received notification from The Nasdaq Stock Market that we regained compliance with the Nasdaq National Market’s listing maintenance standards regarding minimum bid price. If our stock price declines and remains below $1.00 for a period of thirty consecutive trading days, we face the possibility of receiving notification

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from the Listing Qualifications Department of The Nasdaq Stock Market, Inc. indicating that our common stock has not maintained the required minimum bid price for continued quotation on the Nasdaq National Market and is subject to delisting. If our common stock is delisted from trading on the NASDAQ National Market as a result of listing requirement violations and is neither relisted thereon nor listed for trading on the NASDAQ SmallCap Market, trading in our common stock may continue to be conducted on the OTC Bulletin Board or in a non-NASDAQ over-the-counter market, such as the “pink sheets.” Delisting of our common stock from trading on the NASDAQ National Market would adversely affect the price and liquidity of our common stock and could adversely affect our ability to issue additional securities or to secure additional financing. In that event our common stock could also be deemed to be a “penny stock” under the Securities Enforcement and Penny Stock Reform Act of 1990, which would require additional disclosure in connection with trades in the common stock, including the delivery of a disclosure schedule explaining the nature and risks of the penny stock market. Such requirements could further adversely affect the liquidity of our common stock.

Item 3. Quantitative and Qualitative Disclosures About Market Risk.

Interest Rate Risk. We do not hold derivative financial instruments or equity securities in our short-term investment portfolio. Our cash equivalents consist of high-quality securities, as specified in our investment policy guidelines. The policy limits the amount of credit exposure to any one issue to a maximum of 15% and any one issuer to a maximum of 10% of the total portfolio with the exception of treasury securities, commercial paper and money market funds, which are exempt from size limitation. The policy limits all short- term investments to those with maturities of two years or less, with the average maturity being one year or less. These securities are subject to interest rate risk and will decrease in value if interest rates increase.

Foreign Currency Exchange Rate Risk. Currently, the majority of our revenue and expenses is denominated in U.S. dollars, and, as a result, we have not experienced significant foreign exchange gains and losses to date. While we have conducted some transactions in foreign currencies and expect to continue to do so, we do not anticipate that foreign exchange gains or losses will be significant. We have not engaged in foreign currency hedging to date, although we may do so in the future.

Our international business is subject to risks typical of international activity, including, but not limited to, differing economic conditions, changes in political climate, differing tax structures, other regulations and restrictions, and foreign exchange rate volatility. Accordingly, our future results could be materially adversely impacted by changes in these or other factors.

Our exposure to foreign exchange rate fluctuations can vary as the financial results of our foreign subsidiaries are translated into U.S. dollars in consolidation. The effect of foreign exchange rate fluctuations for the year ended December 31, 2003 was not material.

Item 4. Controls and Procedures.

We carried out an evaluation required by the Securities Exchange Act of 1934, under the supervision and with the participation of our senior management, including our principal executive officer and principal financial officer, of the effectiveness of the design and operation of our disclosure controls and procedures as of the end of the period covered by this report. Based on this evaluation, and subject to the disclosure below, our principal executive officer and principal financial officer concluded that our disclosure controls and procedures, as defined in Rules 13a-15(e) and 15d-15(e) under the Securities Exchange Act of 1934, are effective in timely alerting them to material information required to be included in our periodic SEC reports.

Except as discussed below, there has been no change in our internal control over financial reporting during our first fiscal quarter of 2004 that has materially affected, or is reasonably likely to materially affect, our internal control over financial reporting.

As described elsewhere in this report, there are provisions within our VAP agreement with Microsoft Corporation that require us to maintain certain internal records and processes for royalty reporting and license inventory accounting. Non-compliance with these requirements could result in the termination of the VAP agreement. We are currently undergoing an audit of our royalty reporting and inventory accounting for the period 1998 through 2003. The impact of the audit, if any, is unknown at this time. However, the final outcome of this audit could have a material adverse impact on our results of operations and financial condition. In conjunction with the audit and review of our underlying controls and processes, we have strengthened certain controls and processes for royalty reporting and license inventory accounting and are continuing to review these controls and processes to ensure continued compliance with the VAP agreement.

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PART II. OTHER INFORMATION

Item 1. Legal Proceedings

Class Action Securities Suit

In summer and early fall 2001, four purported shareholder class action lawsuits were filed in the United States District Court for the Southern District of New York against us, certain of our current and former officers and directors (the “Individual Defendants”), and the underwriters of our initial public offering. The suits purport to be class actions filed on behalf of purchasers of our common stock during the period from October 19, 1999 to December 6, 2000. The complaints against us have been consolidated into a single action and a Consolidated Amended Complaint, which was filed on April 19, 2002 and is now the operative complaint.

Plaintiffs allege that the underwriter defendants agreed to allocate stock in our initial public offering to certain investors in exchange for excessive and undisclosed commissions and agreements by those investors to make additional purchases of stock in the aftermarket at pre-determined prices. Plaintiffs allege that the prospectus for our initial public offering was false and misleading in violation of the securities laws because it did not disclose these arrangements. The action seeks damages in an unspecified amount.

The action is being coordinated with approximately 300 other nearly identical actions filed against other companies. On July 15, 2002, we moved to dismiss all claims against us and the Individual Defendants. On October 9, 2002, the Court dismissed the Individual Defendants from the case without prejudice based upon Stipulations of Dismissal filed by the plaintiffs and the Individual Defendants. On February 19, 2003, the Court denied the motion to dismiss the complaint against us. In June 2003, we approved a Memorandum of Understanding (“MOU”) and related agreements which set forth the terms of a settlement between us, the plaintiff class and the vast majority of the other approximately 300 issuer defendants. Among other provisions, the settlement contemplated by the MOU provides for a release of us and the individual defendants for the conduct alleged in the action to be wrongful. We would agree to undertake certain responsibilities, including agreeing to assign away, not assert, or release certain potential claims we may have against the underwriters. It is anticipated that any potential financial obligation by us to plaintiffs pursuant to the terms of the MOU and related agreements will be covered by existing insurance. Therefore, we do not expect that the settlement will involve any direct payment by us. The MOU and related agreements are subject to a number of contingencies, including the negotiation of a settlement agreement and its approval by the Court. We cannot predict whether or when a settlement will occur or be finalized and are unable at this time to determine whether the outcome of the litigation will have a material impact on our results of operations or financial condition in any future period.

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

(a) Exhibits

(b) Reports on Form 8-K

     On January 6, 2004, we filed a Current Report on Form 8-K announcing the departure of Nogi Asp from the positions of Vice President of Finance and Chief Financial Officer and the appointment of Scott Mahan to those positions.

     On January 30, 2004, we filed a Current Report on Form 8-K announcing our financial results for the quarter ended December 31, 2003.

     On February 24, 2004, we filed a Current Report on Form 8-K announcing the completion of the last in a series of lease restructurings.

     On March 30, 2004, we filed a Current Report of Form 8-K announcing the filing of our Form 10-K, which included minor adjustments to fourth quarter 2003 results.

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SIGNATURE

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.

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BSQUARE CORPORATION

INDEX TO EXHIBITS

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