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UNITED STATES SECURITIES AND EXCHANGE COMMISSION

Form 10-K

Commission file number 000-27969

Immersion Corporation

(408) 467-1900

Securities registered pursuant to Section 12(b) of the Act:

Securities registered pursuant to Section 12(g) of the Act:

      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 þ          No o

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

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

      The aggregate market value of the registrant’s common stock held by non-affiliates of the registrant on June 30, 2003, the last business day of the registrant’s most recently completed second fiscal quarter, was $22,586,824 (based on the closing sales price of the registrant’s common stock on that date). Shares of the registrant’s common stock held by each officer and director and each person whom owns 5% or more of the outstanding common stock of the registrant have been excluded in that such persons may be deemed to be affiliates. This determination of affiliate status is not necessarily a conclusive determination for other purposes. Number of shares of common stock outstanding at March 10, 2004: 20,899,651.

DOCUMENTS INCORPORATED BY REFERENCE

      Portions of the definitive Proxy Statements for the 2004 Annual Meeting are incorporated by reference into Part III hereof.

IMMERSION CORPORATION

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PART I

      In addition to historical information, this Annual Report on Form 10-K contains forward-looking statements within the meaning of Section 27A of the Securities Act of 1933, as amended, and Section 21E of the Securities Exchange Act of 1934, as amended. These forward-looking statements involve many risks and uncertainties, including those identified in the section of this report entitled “Risk Factors,” which could cause actual results to differ from those discussed in the forward-looking statements. Forward-looking statements in this report are identified by words such as “believes,” “anticipates,” “expects,” “intends,” “may,” “will” and other similar expressions. However, these words are not the only way we identify forward-looking statements. In addition, any statements, which refer to expectations, projections or other characterizations of future events or circumstances, are forward-looking statements. Our forward-looking statements include our projections about our business under Item 1, “Business,” and our statements regarding our future financial performance, which are contained in Item 7, “Management’s Discussion and Analysis of Financial Condition and Results of Operations.” We caution you not to place undue reliance on these forward-looking statements, which speak only as of the date of this report, and we undertake no obligation to release the results of any revisions to these forward-looking statements which could occur after the filing of this report. You are urged to review carefully and consider our various disclosures, in this report and in our other reports filed with the SEC that attempt to advise you of the risks and factors that may affect our business.

Overview

      We are a leading provider of haptic technology that brings the sense of feel or touch to a wide variety of markets. We develop, manufacture, license and support a wide range of hardware and software technologies that let users interact with digital devices using their sense of touch. We focus on four application areas — consumer, computing and entertainment; industrial and automotive; three-dimensional and professional products; and medical simulation. We manage these application areas under two operating and reportable segments: 1) Immersion Computing, Entertainment and Industrial, and 2) Immersion Medical.

      In markets where our touch technology is a small piece of a larger system (such as cellular phones, consumer gaming peripherals and automotive interfaces), we license our technologies to third party manufacturers who integrate our technology into their products and resell it under their own brand names. In other markets, where our touch technology is a complete system (like medical simulation systems and three-dimensional and professional products), we manufacture and sell products under our own Immersion brand name, through direct sales, distributors and value added resellers. In all market areas, we also engage in development projects for third parties and government agencies from time to time.

      Our objective is to proliferate our TouchSense® technologies across markets, platforms and applications so that touch and feel become as common as color, graphics and sound in modern user interfaces. Immersion and its wholly owned subsidiaries hold more than 210 issued patents and more than 240 pending patent applications worldwide, covering various aspects of hardware and software technologies.

Haptics — The Science of Touch Simulation

      Haptics refers to the sense of touch. Although the word haptics may be new to many people, everyone uses their sense of touch when interacting with their immediate environment. Haptic feedback is part of any motor action, for example, typing on a keyboard, using a mouse, biting an apple, sculpting, writing and giving a hug.

      The haptic sensory system has two components: tactile sensing and kinesthetic sensing. Tactile sensing refers to an awareness of the stimulation of the skin. Kinesthetic sensing refers to an awareness of body parts and their position and movement (with eyes closed, we know the positions of our limbs), as well as muscle tension. Unlike vision and hearing that are mainly input systems for the human observer, the haptic system is bi-directional. You use your sense of touch to both feel (take in information) and manipulate (have an effect on something). Many activities including reading Braille and playing the piano provide haptic feedback during motor task.

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      In the world of computers, haptic feedback, also known as force feedback, refers to the physical forces created by input/output devices to stimulate the sense of touch. These forces are made by actuators, usually motors, which in their simplest form are built into peripheral devices (such as joysticks, steering wheels and gamepads). They can also be designed into more sophisticated interfaces designed for industrial, medical, automotive or scientific applications. Under digital control, touch-enabled peripheral devices can impart to users physical sensations like rough textures, smooth surfaces, viscous liquids, compliant springs, jarring vibrations, heavy masses and rumbling engines.

      As a user uses a touch-enabled device, such as a joystick, motors within the device apply computer-modulated forces that resist, assist and enhance the manipulations. These forces are generated based on mathematical models that simulate the desired sensations. For example, when simulating the feel of a rigid wall with a force feedback joystick, motors within the joystick apply forces that simulate the feel of encountering the wall. As the user moves the joystick to penetrate the wall, the motors apply a force that resists the penetration. The harder the user pushes, the harder the motors push back. The end result is a sensation that feels like a physical encounter with an obstacle.

      The mathematical models that control the motors may be simple modulating forces based on a function of time, such as jolts and vibrations, or may be more complex forces such as surfaces, textures, springs and liquids. Complex sensations can be created by combining a number of simpler sensations. For example, a series of simulated surfaces can be combined to give the seamless feel of a complex object like a sports car. Textures can be added to these complex surfaces so that the windshield of the sports car feels smooth and its tires feel rubbery.

Industry Background

      Historically, haptic systems were first used in applications like military flight simulators. As early as in the 1960s, combat pilots honed their flight skills in training simulators that replicated the feel of flying actual planes. Motors and actuators pushed, pulled, and shook the flight yoke, throttle, rudder pedals, and cockpit shell, reproducing many of the tactile and kinesthetic cues of real flight. Though advanced for their time, these systems were limited by the then available technology and were therefore relatively crude and low fidelity by today’s standards. They also cost at least hundreds of thousands, if not millions, of dollars and therefore were not within the grasp of consumers or even most businesses.

      By the late 1970s and early 1980s, computing power reached the point where rich color graphics and high quality audio were possible. Computers evolved from primitive command-prompt, text-based systems on monochrome display monitors to powerful systems capable of rendering colorful pictures, charts, and animations and playing music and sound effects. These advancements in turn bred entirely new businesses in the late 1980s and early 1990s.

      To the consumer, the multimedia revolution changed things, like flight simulation from a professional pilot-only activity to a PC-based hobby for millions of private pilots and aspiring pilots. The graphics and sound these hobbyists/gamers experienced at home was far superior to what the combat pilots experienced in the 1960s.

      The multimedia revolution also made the medical simulation business possible. By the 1990s, high-end Silicon Graphics workstations enabled parts of the human anatomy to be displayed with never-before-possible realism. Companies were founded to harness this new technology and turn it into safer and more effective teaching aids for medical personnel. The interactive nature of a multimedia computer workstation-based medical curriculum was far superior to traditional medical textbooks and without the shortcomings and/or excessive cost of animals, cadavers, and live patients.

      However, the multimedia revolution also highlighted a shortcoming in the products of the medical simulation market: even though the graphics and animations looked incredibly realistic, graphics and sound could not possibly convey to a physician what it actually feels like to break through a venal wall with a catheter needle or what it feels like to cut through the tissue surrounding a gall bladder with a scalpel. In the case of flight simulation, graphics and sound could not possibly convey to a hobbyist what it actually feels like to fight the flight yoke or flight stick out of a steep dive or through a sharply banked turn. Only hands-on experience provided this critical component of learning.

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      So by the mid 1990s, these new industrial and consumer multimedia products were in need of haptic technology that could provide that missing “hands-on” experience, bringing the critical sense of touch back into the experience. Immersion was founded in 1993 to provide just that. By combining 1) the basic concepts that were used in the military flight simulators of the 1960s, 2) state-of-the-art advancements in robotic controls, 3) advancements in the understanding of how the human sense of touch works, and 4) advancements in computing power, Immersion was able to significantly reduce the cost and size of haptic solutions while simultaneously increasing the quality of the simulated sensations. Immersion’s early products were used in the world’s first consumer force feedback peripherals for video computer games as flight sticks and steering wheels. These products not only looked and sounded like the real thing, but also felt like the real thing. And for the first time, sophisticated medical simulators offered medical professionals the ability to train, practice and enhance their surgical and other procedural skills in a way never before possible.

      Continued advancements in size, power and cost reductions have pushed the adoption of haptics even further into those industries as well as into new ones. Immersion’s TouchSense technology is now widespread in gamepads, joysticks, and steering wheels for Sony’s PlayStation2, Microsoft’s Xbox, Nintendo’s GameCube, and the PC and Apple Macintosh. Hundreds of Immersion Medical simulators have been deployed at hospitals and medical schools throughout the United States and abroad. Immersion’s haptic technology is also now used by designers from Boeing, GM, and Toyota and by researchers from NASA, Stanford, and MIT. And automobiles from BMW, Rolls Royce, and Volkswagen now use programmable haptic controls powered by Immersion technology.

      Today, computing power continues to march forward and push multimedia capabilities into new areas like cell phones and industrial controls, thereby creating even more exciting opportunities for Immersion’s haptic technology.

Our Solution

      Our goal is to change the way people interact with digital devices by adding the sense of touch to a digital world. Our touch technologies give users a more complete, intuitive experience. Used in diverse applications — computer gaming, business productivity, medical simulation, automotive controls, and mobile communication, — and implemented in a wide range of devices — joysticks, medical interface devices, automobile controls, gloves, gamepads and cellular phones.

      Our hardware and software technologies work together to enable devices to present touch sensations. Our patented designs include specialized hardware elements such as motors, control electronics and mechanisms, which are incorporated into common computer peripheral devices, such as gamepads and joysticks, or more complex devices, such as endoscopic surgical simulators. Driven by software algorithms, these hardware elements direct tactile sensations corresponding to on-screen events to the user’s hand.

      When designed into our licensees’ products our haptic technologies enable:

      Enhanced Simulation and Training Applications. Some computer applications, such as those that simulate product prototypes must be realistic to be effective. To save time and expense in product design, Immersion customers use our 3D whole-hand sensing glove technologies, which, together with our software products, allow for real-time, three-dimensional object manipulation. For medical procedures, the medical community has started to enhance traditional medical training and education with simulation systems to improve skills and educate health professionals worldwide. Our medical simulation systems provide tactile feedback that simulates what a doctor would feel when performing an actual procedure. These include systems teaching laparoscopic, endovascular and endoscopic surgeries and catheter insertion.

      Presenting Information through the Sense of Touch. It is difficult to communicate physical properties such as texture, compliance, weight and friction through only words, pictures or sound. Our technologies allow people to use their sense of touch to perceive these physical properties in a way that is instantly understandable and intuitively accessible. Our technologies significantly improve the ability of software to communicate to users the physical features of a product, the physical properties of a medical procedure and the physical response of an object in a simulated gaming environment.

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      Increased Satisfaction and Enjoyment. By engaging the user’s sense of touch, our technologies have the potential of reducing distractions and cognitive loads. Also, they have the potential of providing a richer machine-to-man experience. Finally, it will make a variety of consumer hardware and software applications more interesting, engaging and satisfying.

      We offer our licensees our expertise to help them design touch into their products quickly and inexpensively. This takes the form of turn-key engineering, authoring tools, an application programming interface, and the wide use of industry standards:

      Turn-key Engineering. We offer technical, engineering and design assistance that allows our licensees to incorporate our touch-enabling technologies into their interface products at a reasonable cost and in a reasonable time frame. This allows them to get to market quickly by using our years of haptic development expertise. We offer product development solutions, technology transfer, component sourcing and other engineering services.

      Authoring Tools. We supply authoring tools that let software developers quickly design and incorporate custom touch sensations into their own applications. Authoring tools allow designers to create, modify, experience and save or restore haptic sensations for a haptic device. The tools are the equivalent of a computer-aided design application for haptics. Our authoring tools support vibro-tactile haptic devices (such as cellular phone and gaming devices), as well as kinesthetic haptic devices (such as rotary devices and joysticks). Various haptic effect parameters can be defined and modified, and the result immediately experienced. Our authoring tools run on mainstream operating systems, such as Microsoft Windows. Our authoring tools support archiving features and may include an automatic code generator for easy porting of the created effects into the target application.

      Application Programming Interface (API). Our API provides an extensive haptic generation capability. This allows designers and programmers to focus on adding haptic effects to their applications instead of struggling with the mechanics of programming real-time algorithms and handling communications between computers and devices. Our haptic APIs are device independent (for example, they work with scroll wheels, rotary knobs, 2D joysticks, etc.) to allow flexibility and reusability.

      Compatible with Industry Standards. We have designed our hardware and software technologies offered to our consumer licensees to be compatible with hardware and software standards. Our consumer technologies operate across multiple platforms and comply with such standards as DirectX, Microsoft’s entertainment application programming interface and, Universal Serial Bus (USB) a standard connector interface. Our application programming interfaces are supported on Windows and Macintosh platforms and are capable of being ported onto cellular phone operating systems. Software plug-ins are available so that programmers can easily add TouchSense technology into their applications. Our non-consumer software technology has been designed to be platform independent. We are supporting many operating systems including VxWorks and Linux and many communication protocols including CAN bus and serial.

Strategy

      Our goal is to make the sense of touch as common as color graphics and sound in the interface between people and machines. We will do so by expanding our TouchSense technologies across markets, platforms and applications. We intend to maintain and enhance our position as a leading provider of touch-enabling technology by employing the following strategies:

      Pursue Royalty-Based Licensing Model for High Volume Applications of our Technologies. We believe that the most effective way to proliferate our touch-enabling technologies, where touch is a small part of a larger system, is to embed them in high volume applications, (such as computer peripherals, cellular phones and automotive controls,) and license our intellectual property. We have licensed our intellectual property to numerous manufacturers of joysticks, gamepads and steering wheels and we have licensed our intellectual property to a manufacturer of cell phones, all of which are targeted at consumers. In addition, our technology has been licensed to automotive manufacturers and automotive parts suppliers for use in the controls of automobiles. We intend to expand the number and scope of our licensing relationships in the future.

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      Pursue Product Sales in Lower-Volume Applications through Multiple Channels. For lower-volume emerging applications of our technologies, such as medical simulation systems and three-dimensional and professional products, our primary strategy is to manufacture and sell products through direct sales, distributors and value added resellers. Our Immersion Medical division currently sells medical simulation devices that simulate intravenous catheterization, endovascular interventions, and laparoscopic and endoscopic procedures. The Immersion Computing, Entertainment and Industrial division sells three-dimensional and professional products which consist primarily of computer digitizing products, including the MicroScribe® G2 digitizer and specialized whole-hand sensing gloves and software, such as the CyberGlove® electronic glove, CyberGrasp® system and CyberForce® armature that permit simulated interaction with three-dimensional environments.

      Secure Licensees in New Markets for Touch-Enabling Technology. We believe that our touch-enabling technology can be used in virtually all areas of computing and communication. We initially focused on computer gaming applications for personal computers and dedicated game consoles, an area in which we have experienced acceptance of our technologies by key licensees. We have broadened our focus to include additional applications, such as automotive controls, cellular phones and medical simulation devices.

      Facilitate Our Licensees’ Development of Touch-Enabled Products. We will continue to devote significant resources to facilitate the development of touch-enabled products by our licensees. We offer design packages that include sample hardware, software, firmware and related documentation, and offer our technical expertise on a consulting basis. We will continue to invest in research and development to improve our technologies, with particular emphasis on reducing the cost of consumer touch-enabled products and expanding the breadth of our medical simulation product offerings.

      Expand Software Support for Our Touch-Enabling Technology. In addition to licensing our intellectual property to computer peripheral device manufacturers and supporting their product development efforts, we have focused on expanding software support for our touch-enabling technology. Our authoring tools support vibro-tactile haptic devices (such as cellular phones and gaming devices) as well as kinesthetic haptic devices (such as rotary devices and joysticks). Various effect parameters can be defined and modified, and the result is immediately experienced. Our API provides an extensive haptic generation capability and allows the designers and programmers to focus on enabling their target applications with haptic effects instead of struggling with the mechanics of programming the real-time algorithms and handling the communication between computers and devices.

      Expand Market Awareness. We promote adoption of our touch-enabling technology by increasing market awareness among peripheral device manufacturers, software developers and consumers. As part of our license agreements, we require our licensees to use our trademarks and logos to create brand awareness among consumers. We also devote significant resources to promote our brands, through advertising, trade shows and other marketing avenues.

      Develop and Protect Touch-Enabling Technology. Our success depends on our ability to license and commercialize our intellectual property and to continue to expand our intellectual property portfolio, which currently includes more than 210 issued patents and more than 240 pending patent applications worldwide. We devote substantial resources to research and development and are engaged in projects focused on expanding the scope and application of our technologies. We have also secured technology by acquisition. We intend to continue to invest in technology development and potential acquisitions and to protect our intellectual property rights. On February 11, 2002, we filed a complaint against Microsoft Corporation, and both Sony Computer Entertainment, Inc., and Sony Computer Entertainment of America, Inc. (collectively, “Sony Computer Entertainment”) in the U.S. District Court for the Northern District Court of California alleging infringement of U.S. Patent Nos. 5,889,672 and 6,275,213. The case was assigned to United States District Judge Claudia Wilken. On April 4, 2002, Sony Computer Entertainment and Microsoft answered the complaint by denying the material allegations and alleging counterclaims, seeking a judicial declaration that the asserted patents were invalid, unenforceable, or not infringed. Under the counterclaims, the defendants are also seeking damages for attorneys’ fees. The process of discovery and exchanging information and documents on infringement, invalidity, and damages, is ongoing. On October 8, 2002, we filed an amended complaint, withdrawing the claim under the ‘672 patent and adding claims under a new patent, U.S. Patent No. 6,424,333.

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      On October 10, 2002, the Court entered an Amended Case Management Order that set, among other dates in the case, April 25, 2003 for a hearing to construe the claims of the asserted patents and April 5, 2004 for the start of trial. On October 28, 2002, Sony Computer Entertainment and Microsoft answered the amended complaint and alleged similar counterclaims for declaratory relief that the asserted patents are invalid, unenforceable, or not infringed. On March 21, 2003, Sony Computer Entertainment filed a motion for summary judgment of non-infringement. At our request, the Court ordered this motion stricken, without prejudice to its being refiled at a later date, after the Court rules on claim construction. On April 25, 2003, the Court held the scheduled claim construction hearing. On July 9, 2003, the Court issued an Order Modifying Case Management Order that reset certain scheduled dates in the case, including setting April 12, 2004 as the start of trial. On October 2, 2003, the Court issued its Claim Construction Order construing certain terms of the patents asserted in the lawsuit. On January 16, 2004, Sony Computer Entertainment filed a motion for summary judgment of invalidity and that Sony Computer Entertainment Inc. should be dismissed as a party. We filed a motion for summary judgment seeking to dismiss Sony’s defenses that the asserted patents are unenforceable. On February 27, 2004, the Court held a hearing on these motions. On March 2, 2004, the Court issued a written ruling on the summary judgment motions. The Court denied Sony’s motion for summary judgment of invalidity. The Court granted all but one of Immersion’s motions and dismissed several Sony defenses. On March 23, 2004 the court rescheduled the trial from April 12, 2004 to April 19, 2004.

      On July 28, 2003, we announced that we had settled our legal differences with Microsoft and we and Microsoft agreed to dismiss all claims and counterclaims relating to this matter as well as assume financial responsibility for our respective legal costs with respect to the lawsuit between Immersion and Microsoft. We continue to pursue our claims of infringement against Sony Computer Entertainment. In the event we settle our lawsuit with Sony Computer Entertainment, we will have certain obligations to pay certain sums to Microsoft as described in Note 9 to our consolidated financial statements. If Sony Computer Entertainment were successful in its counterclaims and our patents were deemed invalid and unenforceable, the assets relating to the patents that were deemed invalid would be impaired and we may be required to pay Sony Computer Entertainment’s attorneys fees. The case is scheduled to go to trial in April 2004.

      Due to the inherent uncertainties of litigation, we cannot accurately predict the ultimate outcome of the litigation. We anticipate that the litigation will continue to be costly, and there can be no assurance that we will be able to recover the costs we incur in connection with the litigation.

Market Applications

      While we believe that our technologies are broadly applicable, we are currently focusing our marketing and business development activities on the following target application areas:

      Consumer, Computing and Entertainment. We initially licensed our intellectual property for touch-enabling technologies for consumer gaming peripherals in 1996, under the I-FORCE trademark. We have transitioned our branding to the TouchSense trademark, which extends beyond gaming to all aspects and applications of our haptics-related products and services. We have licensed our TouchSense intellectual property to Microsoft for use in its products and to Apple for use in its Macintosh operating system. We have also licensed our TouchSense intellectual property to over 20 gaming peripheral manufacturers and distributors, including Logitech, Microsoft, and Mad Catz, to bring haptics to the PC, Macintosh, Nintendo GameCube, Microsoft Xbox, and Sony PlayStation 2 platforms. We have recently developed new technologies that will allow us to target cell phones and handheld devices. In December of 2003 we signed a multi-year, worldwide license agreement that allows Samsung to pursue the use of our high-fidelity haptic technology in its cell phones. This agreement grants Samsung rights to Immersion’s TouchSense technology as well as rights to Immersion’s haptic authoring tools for Samsung’s cell phones.

      Medical Simulation. We have developed numerous technologies that can be used for medical training and simulation. By enabling computers to deliver touch sensations to users, our technologies can support realistic simulations that are effective in teaching medical students, doctors and health professionals what it feels like to perform a given procedure. The use of our simulators allows healthcare providers to practice procedures in an environment that poses no risks to patients, where mistakes have no dire consequences and where animal or

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      Industrial and Automotive. In recent years there has been a proliferation of automotive sub-systems, which are directly accessed by drivers and passengers. These include AM, FM and XM radio, CD, route navigation, DVD systems, telephone and climate control systems. As a result, there has been an increase in the number of physical control devices in the automotive cockpit. Our TouchSense knob technology allows the controls of multiple systems using a single controller that — creates a different feel for each system. This allows the driver to identify by feel which system is being controlled. The result is a simpler car layout. We have licensed our automotive control knob technology to BMW, which has incorporated the TouchSense control knob in its 7 Series, and in some models of its 5 Series and 6 Series, starting in 2003. We are also conducting various funded development efforts and providing tools and evaluation licenses to several other major automobile manufacturers and suppliers who have expressed interest in touch-enabled automobile controls.

      Three-Dimensional and Professional Products. Our three-dimensional and professional products allow users to capture three-dimensional computer models directly from physical objects. These products include the MicroScribe G2 product line, which contains sensor and microprocessor technologies that allow users to digitize physical objects simply by tracing their contours with a stylus. Third-party software records the three-dimensional geometry of the object and reproduces it on the screen as a three-dimensional computer model. The MicroScribe G2 product line is designed to support the needs of game developers, engineers, animators, filmmakers, industrial designers and other professionals who need to create realistic three-dimensional computer images quickly and easily.

      Other 3D products include our CyberGlove, CyberGrasp and CyberForce line of gloves and touch-enabled interaction hardware and our VirtualHand® three-dimensional interaction software. Used together the CyberGloves and VirtualHand software simulate the manipulation of objects in three-dimensional environments. Our CyberGlove line of whole-hand sensing gloves and three-dimensional software products are used in research applications and in high-end simulation, mechanical computer-aided design, visualization and motion-capture applications to improve the product development process.

      In addition to these 3D products, we manufacture and sell specialized professional products such as computer peripherals that are not touch-enabled, but incorporate related advanced computer peripheral technologies. These specialized peripherals include the Softmouse, a high performance, non-touch-enabled mouse optimized for use in geographic information systems and mapmaking, and PinPoint, a stereotactic arm used to enable image-guided biopsies and radiation therapy.

Technologies and Products

      Technology Licensing. We currently license our intellectual property to manufacturers that produce devices incorporating our touch-enabling technologies. In general, our licenses permit manufacturers to produce only a particular category of product within a specified field of use. Our licensing model includes an up-front license fee and/or a per-unit royalty paid by the manufacturer that is a percentage of the wholesale selling price of the touch-enabled product. In addition, our licensees generally have branding obligations. The prominent display of the TouchSense logo on retail packaging generates customer awareness for our technologies.

      Consumer, Computing and Entertainment Products. We license our intellectual property to manufacturers and distributors that incorporate our touch-enabling technologies into various computer peripheral devices targeted at the PC and game console platforms. Currently, there are consumer PC joysticks sold using TouchSense technology, including the Wingman Force 3D from Logitech; the Cyborg 3D Force, ST330 and 3D Rumble Joystick from Saitek; the Fox 2 Pro Joystick and Top Gun Afterburner Force Feedback Joystick from ThrustMaster; and the Destroyer Aftershock from Gravis. There are also PC steering wheel gaming peripherals licensed under the TouchSense brand, including the Wingman Formula Force GP and the MOMO Force from Logitech; the NASCAR Pro Force Feedback Racing Wheel and the F1 Force Feedback Racing Wheel from Guillemot; and the R440 Force Feedback Wheel from Saitek. There are PC gamepads sold using TouchSense

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      In the video game console peripheral market, Immersion has licensed its patents for use in more than 50 spinning mass tactile feedback devices from various manufacturers including Mad Catz, Logitech, Intec, NYKO, Saitek, Thrustmaster and SpectraVideo. These products are designed to work with one or more video game consoles including the XBox from Microsoft, the PlayStation and PlayStation 2 from Sony, the GameCube, N64, and GameBoy from Nintendo, and the DreamCast from Sega.

      Recently we have expanded the scope of our Consumer, Computing and Entertainment Products division and licensed our technology to Samsung for incorporation into its cell phones.

      Medical Products. We have five medical simulation product lines: our CathSim® Vascular Access Simulator, which simulates intravenous catheterization; our AccuTouch® Endoscopy Simulator, which simulates endoscopy procedures; our AccuTouch Endovascular Simulator, which simulates endovascular interventions; our Laparoscopic simulation hardware that can be integrated with third-party software for surgical procedure simulation; and our AccuTouch Rigid Endoscopy Simulator, which simulates such procedures as hysteroscopy. These devices are used for training and educational purposes that enable health professionals to feel simulations of the sensations experienced during medical procedures, such as encountering an unexpected obstruction in an artery. All these products are comprised of a hardware system, an interface device and software modules. We sell the hardware systems for between $6,000 and $40,000. We design each product line to maximize the number of procedures that can be simulated with minimal additional customer hardware investment. These systems then enable potential additional sales of software to the installed base of hardware systems. The relatively low price of our software modules provides an opportunity for repeat sales. We currently have over 25 various software modules available that replicate such medical procedures as intravenous catheterization, peripherally inserted central catheters (“PICC”), bronchoscopy, colonoscopy, cardiac pacing modules, coronary angioplasty and hysteroscopy.

      Medtronic, a leading medical device company, accounts for a large portion of our medical simulation product revenues as well as development contract revenues. A reduction in sales to Medtronic, a reduction in development work, or a decision not to renew existing licenses by Medtronic may reduce our total revenue. For the year ended December 31, 2003 Medtronic accounted for 18% of our total revenues

      Industrial and Automotive Controls. We have developed TouchSense technology appropriate for use in automobile controls. We have licensed this technology to automobile manufacturers and automobile component suppliers. BMW was the first automobile manufacturer to license our TouchSense knob technology for use in the dashboard controls of its 2002 7 Series sedan model. BMW has also launched the 2003 Rolls Royce and the 2004 5 Series and 6 Series, all with our technology. We have also formed a strategic relationship with ALPS Electronics, a leading automotive component supplier, as part of a strategy to speed adoption of our TouchSense technologies across the automotive industry. Volkswagen included our technology in its high-end Phaeton sedan. We are also working with other major automobile manufacturers, who have expressed interest in touch-enabled automobile controls.

      Three-Dimensional and Professional Products. The Microscribe G2 products are a family of 3D digitizers that allow users to create accurate 3D computer models by tracing over the contours of a physical object. The three primary markets for the MicroScribe G2 digitizer are graphic arts, CAD/ CAM and 3D-positioning/ OEM, with CAD/ CAM being the largest and fastest growing of those markets.

      We manufacture and sell the CyberGlove system, a fully instrumented glove that accurately measures the movement of a user’s hand and, used in conjunction with our software, maps the movement to a graphical hand on the computer screen. Users can “reach in and grab” digital objects similar to physical objects. The CyberTouch^TM system is a CyberGlove product with a vibro-tactile feedback option that provides users with tactile cues when they manipulate digital objects. The CyberGrasp system is an option for the CyberGlove product that adds force-feedback to the fingertips. With a CyberGrasp system, users can actually feel the 3D graphical objects being manipulated on the screen. The CyberForce product is an enhanced, grounded force-

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      Our software products for our whole-hand interfaces include VirtualHand Software Development Kit (SDK), VirtualHand Extension to WorldToolKit, and VirtualHand for V5. VirtualHand SDK is a software toolkit that helps users integrate our whole-hand glove-based interface products into specific applications. VirtualHand Extension to WorldToolKit integrates VirtualHand SDK into a well-established virtual-world building product from Sense8. VirtualHand for V5 leverages our relationship with Dassault Systemes by bringing our glove-based products directly into the CATIA V5 and ENOVIA V5 environments, allowing for real-time interaction with digital prototypes for the evaluation of ergonomics, assembly and maintainability of products. Multiple digital design iterations can replace the need for physical prototypes, reducing costs and time to market.

Sales, Marketing And Support

      Our sales, distribution and support structure varies by market. In the PC and video console gaming and mobility markets, we establish licensing relationships through our business development efforts. In Automotive, we use a worldwide direct sales force targeting OEMs and tier 1 suppliers. With respect to medical simulation, we employ a direct sales force that markets simulation systems to hospitals, health management organizations, colleges and universities, nursing schools, medical schools, emergency medical technician training programs, the military and other organizations involved in procedural medicine. We have seven regional medical sales representatives in the United States and two sales representatives in Europe. The MicroScribe G2 desktop digitizers, along with first and third-party hardware accessories and companion software, are sold through an international network of over 50 resellers including CNC Services, ID8 Media, and International Technology Transfer Corporation. Major OEMs include NOMOS Corporation. In addition to direct sales, our whole-hand interaction products are distributed, sold and supported by a growing worldwide network of over 20 international and domestic resellers including Nissho Electronics, Immersion S.A. and Engineering Systems Technologies. We have strategic relationships or contracts with leading 3D CAD/ CAM and interaction companies, including Dassault Systemes, a worldwide leader in product lifecycle management software.

      Our sales force is also augmented through co-marketing arrangements. As part of our strategy to increase our visibility and promote our touch-enabling technology, our license agreements generally require our licensees to display the TouchSense logos on licensed products they distribute. With respect to intellectual property licensing, we have focused our marketing activities on developing relationships with potential licensees and on participating with existing licensees in their marketing and sales efforts. To generate awareness of our technologies and our licensees’ products, we participate in industry trade shows, maintain ongoing contact with industry press and provide product information over our Web site.

      A focus of our marketing efforts in certain markets is to promote the adoption of our touch-enabling technology by software developers to facilitate the implementation of touch sensations into software applications. We have developed the Immersion TouchSense Developer Toolkit, which contains our software authoring tools, as well as documentation, tutorials and software files containing sample touch sensations. Our software support staff also works closely with developers to assist them in developing compelling touch-enabled applications.

      We believe that it is important to increase awareness of our touch-enabling technology among potential customers and, in some markets, the end users. To generate increased awareness and sales leads, we execute marketing campaigns specific to each market. These campaigns for a specific market may include public relations programs, Internet marketing, advertising, trade shows, and/or public speaking at industry events.

      Our sales and marketing expenses were $7.8 million in 2003, an increase of $200,000 over 2002 spending. We have budgeted further increases for 2004 as we expect our Sales, Marketing and Support expenses to increase over time as we expand our technology offerings and seek to increase market penetration.

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Research And Development

      Our success depends on our ability to invent, improve and reduce the costs of our technologies in a timely manner and to interact with our licensees who are integrating our technologies into theirs.

      Immersion Engineering. We have assembled a team of highly skilled engineers who possess experience in the disciplines required for touch-enabling technology development, including mechanical engineering, electrical engineering, firmware, control system, computer science and content development including medical doctors and 3D and automotive applications.

      Licensee Interaction. In order to increase the successful integration and adoption of our technology in a licensee’s product, we need to ensure clear communication between Immersion and our customers. Therefore, all collaborative development efforts are structured using a four-phase approach including a Product Definition phase, a Concept Development phase, a Detail Design phase and a Production Design phase. At the conclusion of each phase, a review meeting is held with the team members from Immersion and the partner company to examine what was discovered and the conclusions that were reached during that portion of the project. These reviews provide an excellent opportunity to reassess the project direction and product viability prior to entering subsequent phases. The continuation of Immersion’s development effort is contingent upon successful completion of prior phases. This method ensures that the customer’s financial risk is minimized and assures that project deliverables remain consistent with the goals established in the Product Definition phase.

      Our research and development efforts have been focused on technology development, including hardware, software and designs. We have entered into numerous contracts with corporations and government agencies that help fund advanced research and development. Our government contracts permit us to retain ownership of the technology developed under the contracts, provided that we provide the applicable government agency a license to use the technology for non-commercial purposes.

      Our research and development expenses were $7.0 million in 2003, an increase of $549,000 over 2002 spending, and we have budgeted further increases in 2004 to support our development contract efforts and advance our core technology.

Competition

      With respect to touch-enabled consumer products, we are aware of several companies that claim to possess force feedback technology applicable to the consumer market, but we are not aware that any of these companies or their licensees have introduced touch-enabled products. In addition, we are aware of several companies that currently market unlicensed force feedback products in the consumer markets. We are engaged in litigation with one of these companies, Sony Computer Entertainment, over infringement of our patents. Several companies also currently market force feedback products to nonconsumer markets and could shift their focus to the consumer market. In addition, our licensees may develop products that compete with products employing our touch-enabling technology but are based on alternative technologies or develop technologies that are similar or superior to our technologies, duplicate our technologies or design around our patents. Many of our licensees, including Microsoft, Logitech, and other potential competitors have greater financial and technical resources upon which to draw in attempting to develop computer peripheral technologies that do not make use of our touch-enabling technology.

      Our failure to obtain or maintain adequate protection for our intellectual property rights for any reason could hurt our competitive position. There is no guarantee that patents will be issued from the patent applications that we have filed or may file. Our issued patents may be challenged, invalidated or circumvented, and claims of our patents may not be of sufficient scope or strength or issued in the proper geographic regions, to provide meaningful protection or any commercial advantage.

      Our competitive position is partially dependent on the competitive positions of our licensees that pay a per-unit royalty. Our licensees’ markets are highly competitive. We believe that the principal competitive factors in our licensees’ markets include price, performance, user-centric design, ease of use, quality and timeliness of products, as well as the manufacturer’s responsiveness, capacity, technical abilities, established customer

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      There are several companies that currently sell high-end simulation products that compete with our Immersion Medical Division’s products, including Simbionix, Mentice and Medical Simulation Corporation. The principal bases for competition in these markets are technological sophistication and price. We believe we compete favorably on these bases.

      Another company, SensAble Technologies, currently sells high-end 3D sculpting and design products that employ haptics. We believe that SensAble’s products compete on some level with our 3D Interaction products.

Intellectual Property

      We believe that intellectual property protection is crucial to our business. We rely on a combination of patents, copyrights, trade secrets, trademarks, employee and third-party nondisclosure agreements and licensing arrangements to protect our intellectual property.

      Immersion and its wholly owned subsidiaries hold more than 210 issued patents and more than 240 pending patent applications in the U.S. and abroad covering various aspects of our hardware and software technologies. Our current U.S. patents begin to expire starting in 2007.

      Where we feel it is appropriate, we will engage the legal system to protect our intellectual property rights as we have done in our complaint against Sony Computer Entertainment. Due to the inherent uncertainties of litigation, we cannot accurately predict the ultimate outcome of this litigation. We anticipate that this litigation will continue to be costly, and there can be no assurance that we will be able to recover the costs we incur in connection with the litigation.

Available Information

      It is Immersion’s policy to make all of our filings with the Securities and Exchange Commission (“SEC”), including without limitation our annual report on Form 10-K, quarterly reports on Form 10-Q, and current reports on Form 8-K, available free of charge on our Web Site, www.immersion.com, on the day of filing.

Employees

      As of December 31, 2003, we had 126 full-time and 6 part-time employees, including 52 in research and development, 37 in sales and marketing and 43 in legal, finance, administration and operations. As of that date, we also had 2 independent contractors. None of our employees are represented by a labor union, and we consider our employee relations to be positive.

Executive Officers

      The following table sets forth information regarding our executive officers as of March 26, 2004:

      Mr. Victor Viegas has served as our President, Chief Executive Officer, Chief Financial Officer, and Director since October 2002, having served as President, Chief Financial Officer and Chief Operating Officer from February 2002. From August 1999 until February 2002, Mr. Viegas served as our Chief Financial Officer and Vice President, Finance. From June 1996 to August 1999, he served as Vice President, Finance and Administration and Chief Financial Officer of Macrovision Corporation, a developer and licensor of video and

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      Mr. Dexter C. Tight, Jr. joined Immersion in November 2003 as our Vice President and General Manager of our Industrial Business Group. He is responsible for Immersion’s Industrial Businesses, which are focused on touch feedback for automotive and industrial controls and includes all of Immersion’s 3D digitizing and 3D interactive products. Mr. Tight has spent over 25 years working in high technology Silicon Valley companies in marketing and sales, senior management and product development. Prior to joining Immersion, he was the Chief Executive Officer and founder of Edge Capital Access, an investment banking firm. Before that, he was Vice President Marketing and Sales at Diablo Research, an outsourced engineering company. He has held a number of senior marketing positions at Raychem, Metcal, Pyramid and Spectra Physics. He holds a bachelor’s degree in physics from Denison University, a master’s degree in mechanical engineering from Stanford University and an MBA from Stanford Graduate School of Business.

      Mr. Richard Vogel joined Immersion in March 2004 as Senior Vice President and General Manager of our wholly owned subsidiary, Immersion Medical, in Gaithersburg, Maryland. He is responsible for our Medical Training and Simulation Business. Previously, Mr. Vogel has held Chief Executive Officer, President, Chief Operation Officer and general manager positions at a variety of medical device, durable medical equipment, and capital equipment companies. Over his 25-year career, he has profitably grown medical start-ups as well as the medical businesses of public companies such as Kinetic Concepts, Inc. and American Cyanamid. Mr. Vogel holds a Bachelor of Arts degree from Middlebury College in Vermont and a Master of Business Administration degree from Harvard Business School. He speaks five languages and has extensive international experience including assignments in various locations in Europe and South America.

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RISK FACTORS

      You should carefully consider the following risks and uncertainties, as well as other information in this report and our SEC filings, before you invest in our common stock. Investing in our common stock involves risk. If any of the following risks or uncertainties actually occur, our business, financial condition or results of operations could be materially adversely affected. The following risks and uncertainties are not the only ones facing us. Additional risks and uncertainties of which we are unaware or which we currently believe are immaterial could also materially adversely affect our business, financial condition or results of operations. In any case, the trading price of our common stock could decline, and you could lose all or part of your investment. See also, “Forward-Looking Statements discussion in Management’s Discussion and Analysis of Financial Condition and Results of Operation.”

Factors that May Affect Future Results

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

	•	protect and enforce our intellectual property, including the costs of our litigation against Sony Computer Entertainment;
	•	continue to develop our technologies;
	•	attempt to expand the market for touch-enabled products;
	•	increase our sales efforts; and
	•	pursue strategic relationships.

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

      On February 11, 2002, we filed a complaint against Microsoft Corporation, Sony Computer Entertainment, Inc., and Sony Computer Entertainment of America, Inc. in the U.S. District Court for the Northern District Court of California alleging infringement of U.S. Patent Nos. 5,889,672 and 6,275,213. The case was assigned to United States District Judge Claudia Wilken. On April 4, 2002, Sony Computer Entertainment and Microsoft answered the complaint by denying the material allegations and alleging counterclaims seeking a judicial declaration that the asserted patents were invalid, unenforceable, or not infringed. Under the counterclaims, the defendants are also seeking damages for attorneys’ fees. The process of discovery and exchanging information and documents on infringement, invalidity, and damages, is ongoing. On October 8, 2002, we filed an amended complaint, withdrawing the claim under the ‘672 patent and adding claims under a new patent, U.S. Patent No. 6,424,333.

      On October 10, 2002, the Court entered an Amended Case Management Order that set, among other dates in the case, April 25, 2003 for a hearing to construe the claims of the asserted patents and April 5, 2004 for the start of trial. On October 28, 2002, Sony Computer Entertainment and Microsoft answered the amended complaint and alleged similar counterclaims for declaratory relief that the asserted patents are invalid, unenforceable, or not infringed. On March 21, 2003, Sony Computer Entertainment filed a motion for summary judgment of non-infringement. At Immersion’s request, the Court ordered this motion stricken, without prejudice to its being refiled at a later date after the Court rules on claim construction. On April 25, 2003, the Court held the scheduled claim construction hearing. On July 9, 2003, the Court issued an Order Modifying Case Management Order that reset certain scheduled dates in the case, including setting April 12, 2004 as the start of trial. On October 2, 2003,

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      On July 28, 2003, we announced that we had settled our legal differences with Microsoft and we and Microsoft agreed to dismiss all claims and counterclaims relating to this matter as well as assume financial responsibility for our respective legal costs with respect to the lawsuit between Immersion and Microsoft. We continue to pursue our claims of infringement against Sony Computer Entertainment. In the event we settle our lawsuit with Sony Computer Entertainment, we will be obligated to pay certain sums to Microsoft as described in Note 9 to our consolidated financial statements. If Sony Computer Entertainment were successful in its counterclaims and our patents were deemed invalid and unenforceable, the assets relating to the patents that were deemed invalid would be impaired and we may be required to pay Sony Computer Entertainment’s attorneys fees. The case is scheduled to go to trial in April 2004.

      Due to the inherent uncertainties of litigation, we cannot accurately predict the ultimate outcome of the litigation. We anticipate that the litigation will continue to be costly, and there can be no assurance that we will be able to recover the costs we incur in connection with the litigation. We expense litigation costs as incurred and only accrue for costs that have been incurred but not paid to the vendor as of the financial statement date. The litigation has diverted, and is likely to continue to divert, the efforts and attention of some of our key management and personnel. As a result, until such time as it is resolved, the litigation could adversely affect our business. Further, any unfavorable outcome could adversely affect our business.

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

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

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

      These factors include:

	•	the establishment or loss of licensing relationships;
	•	the timing of payments under fixed and/or up-front license agreements;
	•	the timing of our expenses, including costs related to litigation, acquisitions of technologies or businesses;

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	•	the timing of introductions of new products and product enhancements by us, our licensees or their competitors;
	•	our ability to develop and improve our technologies;
	•	our ability to attract, integrate and retain qualified personnel; and
	•	seasonality in the demand for our licensees’ products.

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

      Our revenue growth is significantly dependent on our ability to enter into new licensing arrangements. Our failure to enter into new licensing arrangements will cause our operating results to suffer. We face numerous risks in obtaining new licenses on terms consistent with our business objectives and in maintaining, expanding and supporting our relationships with our current licensees. These risks include:

	•	the lengthy and expensive process of building a relationship with potential licensees;
	•	the fact that we may compete with the internal design teams of existing and potential licensees;
	•	difficulties in persuading consumer product manufacturers to work with us, to rely on us for critical technology and to disclose to us proprietary product development and other strategies;
	•	if we are not successful in the litigation with Sony, not only might we have a difficult time signing up new gaming licensees, we also risk losing our existing licensees as well;
	•	difficulties in convincing car companies to sign a license agreement with us when they will need to purchase components from one of their vendors who may or may not yet be able to meet the car companies’ stringent quality and parts availability standards;
	•	difficulties in persuading existing and potential licensees to bear the development costs necessary to incorporate our technologies into their products; and
	•	challenges in demonstrating the compelling value of our technologies in new applications like cell phones and automobiles.

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

      We have entered into, and will continue to enter into, agreements pursuant to which our licensees are granted rights under our technology and intellectual property. These rights may be granted in certain fields of use, or with respect to certain market sectors or product categories, and may include exclusive rights or sublicensing rights. The license terms and restrictions in our agreements, including but not limited to field of use definitions, market sector and product category definitions, and sublicensing and exclusivity terms, shall collectively be referred to as “License Provisions.”

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      Due to the continuing evolution of market sectors, product categories and licensee business models, and to the compromises inherent in the drafting and negotiation of License Provisions, our licensees may, at some time during the term of their agreements with us, interpret License Provisions in their agreements in a way that is different to our interpretation of such License Provisions, or in a way that is in conflict with the rights that we have granted to other licensees. Such interpretations by our licensees may lead to (a) claims that we have granted rights to one licensee which are inconsistent with the rights that we have granted to another licensee, and/or (b) claims by one licensee against another licensee that may result in our incurring indemnification or other obligations or liabilities.

      In addition, after entering into an agreement it is possible that markets and/or products, or legal and/or regulatory environments, will evolve in a manner that was not foreseen or was not foreseeable at the time the agreement was entered into. As a consequence, in the agreement we may have granted rights that will preclude or restrict our exploitation of potentially lucrative new opportunities that arise after the execution of the agreement.

      Our largest royalty stream from the auto industry is from BMW for its iDrive controller. Press reviews of this system have been largely negative and critical of the system’s complexity. While this negative press is not our fault, it may mean limited sales of BMW’s cars, and could ultimately lead to their abandoning the system, which could reduce or eliminate the related royalties.

      Under the terms of our present agreement with Microsoft, Microsoft receives a royalty-free, perpetual, irrevocable license to Immersion’s worldwide portfolio of patents. This license permits Microsoft to make, use and sell hardware, software and services, excluding specified products, covered by Immersion’s patents. Immersion also granted to Microsoft a limited right, under Immersion’s patents relating to touch technology, to sublicense specified rights, excluding rights to excluded products and peripheral devices, to third party customers of Microsoft’s or Microsoft’s subsidiaries’ operating systems (other than Sony Corporation, Sony Computer Entertainment, Inc., Sony Computer Entertainment of America, Inc., and their subsidiaries). In exchange, for the grant of these rights and the rights included in a separate Sublicense Agreement, Microsoft paid Immersion a one-time payment of $20.0 million. We will not receive any further revenues or royalties from Microsoft under our current agreement with Microsoft. Microsoft has a significant share of the market for touch-enabled gaming computer peripherals and is pursuing other consumer markets such as cell phones and PDAs. Microsoft has significantly greater financial, sales and marketing resources, as well as greater name recognition and a larger customer base, than our other licensees. In the event that Microsoft increases its share of these markets, our royalty revenue from other licensees in these market segments might decline.

      In February 2003, we entered into an agreement with Medtronic, a leading medical device company, in which Medtronic was granted a right of first negotiation. The right of first negotiation applies to any agreement, which we refer to as a “Proposed Agreement,” under which we would grant a third party rights to use specified Immersion intellectual property in specified fields of use. Under the terms of the right of first negotiation, we must notify Medtronic if we have received a written offer from a third party to enter into a Proposed Agreement, or if we are seeking to find a third party to enter into a Proposed Agreement. Medtronic has the exclusive right, for a period of forty days, to negotiate with us regarding the material terms of the Proposed Agreement. If during such forty-day period, Medtronic and Immersion fail to reach agreement in principle upon the material terms of the Proposed Agreement, then we will have twelve months after the expiration of such forty day period to enter into an agreement with the applicable third party, provided that the terms of such agreement are in the aggregate more favorable to Immersion than the offer presented by Medtronic or the terms under which we initially sought to find a third party to enter into the Proposed Agreement. The right of first negotiation ceases to apply to any

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      For the years ended December 31, 2003, 2002 and 2001 we derived 18%, 10% and 9%, respectively, of our total revenue from Medtronic. If our royalty and license revenue or product sales to Medtronic decline, and/or Medtronic reduces the development activities we perform, then our total revenue may decline. In addition, under our recent agreements with Medtronic, monies advanced by Medtronic are subject to refund provisions under certain circumstances. These circumstances have not arisen to date, but we cannot predict whether these circumstances will arise in the future.

      Mad Catz accounts for a significant portion of our total revenue. For the year ended December 31, 2003 our revenue from Mad Catz increased as compared to 2002. For the years ended December 31, 2003, 2002 and 2001 we derived 7%, 6% and 2%, respectively of our total revenue from Mad Catz. We expect that a significant portion of our total revenue will continue to be derived from Mad Catz. If Mad Catz fails to achieve anticipated sales volumes for its computer peripheral products that incorporate our technologies, our total revenue may decline.

      Logitech has in the past and may in the future account for a significant portion of our revenue. For the year ended December 31, 2003 our revenue from Logitech declined from 2002. For the years ended December 31, 2003, 2002 and 2001 we derived from Logitech 5%, 8% and 14%, respectively of our total revenue. We expect that a significant portion of our total revenue will continue to be derived from Logitech. If Logitech fails to achieve anticipated sales volumes for its computer peripheral products that incorporate our technologies, our total revenue may decline.

      Should any unanticipated circumstances arise which significantly increase our cash or capital requirements we may elect to or need to raise additional capital in order to ensure a sufficient supply of cash for such events or future periods. Our plans to raise additional capital may include possible customer prepayments of certain royalty obligations in exchange for a royalty discount and/or other negotiated concessions, entering into new license agreements that require up-front license payments, and through debt or equity financing. We have taken measures to control our costs and will continue to monitor these efforts. We cannot be certain that additional financing will be available to us on favorable terms when required, or at all. Changes in equity markets over the past three years have adversely affected the ability of companies to raise equity financing and have adversely affected the markets for financing for companies with a history of losses such as ours. Additional financing may require us to issue additional shares of our common or preferred stock such that our existing stockholders may experience substantial dilution.

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      Our medical simulation products, such as our AccuTouch Endoscopy Simulator, the AccuTouch Endovascular Simulator and our Laparoscopic Surgical Workstation^TM, have only recently begun to be used by hospitals and medical schools to train healthcare professionals. As a result, many of these medical institutions do not budget for such simulation devices. To increase sales of our simulation devices, we must, in addition to convincing medical institution personnel of the utility of the devices, persuade them to include a significant expenditure for the devices in their budgets. If these medical institutions are unwilling to budget for simulation devices or reduce their budgets as a result of the economic slowdown, cost-containment pressures or other factors, we may not be able to increase sales of medical simulators at a satisfactory rate. As a result of the terrorist attacks against the United States on September 11, 2001 and the continuing threat of terrorist acts, hospitals may have assigned priority in their capital expenditure budgets to equipment that will enable them to respond more effectively to catastrophic emergencies, and federal, state and local governments may have delayed certain funding for medical and educational institutions, in which case purchases of medical simulators may have been deferred. If we are unable to increase sales of our medical simulation products, our results of operations and financial condition may be adversely affected. We believe that medical device companies may also decrease their expenditures in corporate research and development budgets and this may adversely affect our contract and development revenue generated by the medical segment.

      A key part of our business strategy is to license our intellectual property to companies that manufacture and sell products incorporating our touch-enabling technologies. Sales of those products generate royalty and license revenue for us. For the years ended December 31, 2003, 2002 and 2001, 30%, 26% and 28% of our total revenues were royalty and license revenues. However, we do not control or influence the manufacture, quality control, promotion, distribution or pricing of products that are manufactured and sold by our licensees. In addition, we generally do not have commitments from our licensees that they will continue to use our technology in future products. As a result, products incorporating our technologies may not be brought to market, meet quality control standards, achieve commercial acceptance or generate meaningful royalty revenue for us. For us to generate royalty revenue, licensees that pay us per-unit royalties must manufacture and distribute products incorporating our touch-enabling technologies in a timely fashion and generate consumer demand through marketing and other promotional activities. Products incorporating our touch-enabling technologies are generally difficult to design and manufacture which may cause product introduction delays or quality control problems. If our licensees fail to stimulate and capitalize upon market demand for products that generate royalties for us, or if products are recalled because of quality control problems, our revenues will not grow and could decline.

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

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

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

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

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

      We have acquired patents from third parties and also license some technologies from third parties. We must rely upon the owners of the patents or the technologies for information on the origin and ownership of the acquired or licensed technologies. As a result, our exposure to infringement claims may increase. We generally obtain representations as to the origin and ownership of acquired or licensed technology and indemnification to cover any breach of these representations. However, representations may not be accurate and indemnification may not provide adequate compensation for breach of the representations. Intellectual property claims against our

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      Our business depends on generating revenues by licensing our intellectual property rights and by selling products that incorporate our technologies. If we are not able to protect and enforce those rights, our ability to obtain future licenses or maintain current licenses and royalty revenue could be impaired. In addition, if a court were to limit the scope of, declare unenforceable or invalidate any of our patents, current licensees may refuse to make royalty payments or may themselves choose to challenge one or more of our patents. Also it is possible that:

	•	our pending patent applications may not result in the issuance of patents;
	•	our patents may not be broad enough to protect our proprietary rights; and
	•	effective patent protection may not be available in every country in which our licensees do business.

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

	•	laws and contractual restrictions may not be sufficient to prevent misappropriation of our technologies or deter others from developing similar technologies; and
	•	policing unauthorized use of our products and trademarks would be difficult, expensive and time-consuming, particularly overseas.

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

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

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

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

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

      If the medical simulation market develops as we anticipate, we will probably have a greater number of competitors and may have competition in product lines where we have previously enjoyed sole supplier status. Increased competition may result in the reduction of our market share and/or cause us to reduce our selling prices which may result in a decline in our revenue.

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

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

	•	we fail to develop new technologies;
	•	the technologies we develop infringe on existing non-Immersion patents;
	•	our new technologies fail to gain market acceptance; or
	•	our current products become obsolete.

      We have one supplier for some of our custom medical simulators. Any disruption in the manufacturing process from our sole supplier could adversely affect our ability to deliver our products, ensure quality

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

      The product development process for automobiles is very lengthy, sometimes longer than four years. We do not earn per unit royalty revenue on our automotive technologies unless, and until, automobiles featuring our technologies are shipped to customers, which may not occur until several years after we enter into an agreement with an automobile manufacturer. Throughout the product development process, we face the risk that an automobile manufacturer or supplier may delay the incorporation of, or choose not to incorporate, our technologies into its automobiles, making it difficult for us to predict the per unit automotive royalties we may receive, if any. After the product launches, our royalties still depend on market acceptance of the vehicle, which is likely to be determined by many factors beyond our control.

      Our ability to develop and deploy our technologies and to sustain our revenue growth depends upon the continued service of our management and other key personnel, many of whom would be difficult to replace. Management and other key employees may voluntarily terminate their employment with us at any time upon short notice. The loss of management or key personnel could delay product development cycles or otherwise harm our business.

      We believe that our future success will also depend largely on our ability to attract, integrate and retain sales, support, marketing and research and development personnel. Competition for such personnel is intense, and we may not be successful in attracting, integrating and retaining such personnel. Given the protracted nature of if, how and when we collect royalties on new design contracts, it may be difficult to craft compensation plans that will attract and retain the level of salesmanship needed to secure these contracts. Some of our executive officers and key employees hold stock options with exercise prices considerably above the current market price of our common stock. Each of these factors may impair our ability to retain the services of our executive officers and key employees. Our technologies are complex and we rely upon the continued service of our existing engineering personnel to support licensees, enhance existing technology and develop new technologies.

      We have, and had in the past, and may have in the future, stockholders who retain greater than 10%, or in some cases greater than 20%, of our outstanding stock. Acting together, these stockholders would be able to exercise significant influence over matters that our stockholders vote upon, including the election of directors and mergers or other business combinations, which could have the effect of delaying or preventing a third party from acquiring control over or merging with us. Further, if any individuals in this group elect to sell a significant portion or all of their holdings of our common stock, the trading price of our common stock could experience volatility.

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

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

      Our facilities could be subject to a catastrophic loss such as fire, flood, earthquake, power outage or terrorist activity. California has experienced problems with its power supply in recent years. As a result, we have experienced utility cost increases and may experience unexpected interruptions in our power supply that could have a material adverse effect on our sales, results of operations and financial condition. In addition, a substantial portion of our research and development activities, manufacturing, our corporate headquarters and other critical business operations are located near major earthquake faults in San Jose, California, an area with a history of seismic events. Any such loss at our facilities could disrupt our operations, delay production, shipments and revenue and result in large expenses to repair and replace the facility. While we believe that we maintain insurance sufficient to cover most long-term potential losses at our facilities, our existing insurance may not be adequate for all possible losses.

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

      As part of our business strategy, we have in the past acquired, and may in the future acquire, businesses or intellectual property that we feel could complement our business, enhance our technical capabilities or increase

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	•	unanticipated costs associated with the acquisitions;
	•	use of substantial portions of our available cash to consummate the acquisitions;
	•	diversion of management’s attention from other business concerns;
	•	difficulties in assimilation of acquired personnel or operations; and
	•	potential intellectual property infringement claims related to newly acquired product lines.

      Any acquisitions, even if successfully completed, might not generate significant additional revenue or provide any benefit to our business.

      We are involved in legal proceedings relating to a class action lawsuit filed on November 9, 2001. In re Immersion Corporation Initial Public Offering Securities Litigation, No. Civ. 01-9975 (S.D.N.Y.), related to In re Initial Public Offering Securities Litigation, No. 21 MC 92 (S.D.N.Y.). The named defendants are the Company and three of its current or former officers or directors (the “Immersion Defendants”), and certain underwriters of the Company’s November 12, 1999 initial public offering (“IPO”). Subsequently, two of the individual defendants stipulated to a dismissal without prejudice.

      The operative amended complaint is brought on purported behalf of all persons who purchased the common stock of the Company from the date of the IPO through December 6, 2000. It alleges liability under Sections 11 and 15 of the Securities Act of 1933 and Sections 10(b) and 20(a) of the Securities Exchange Act of 1934, on the grounds that the registration statement for the IPO did not disclose that: (1) the underwriters agreed to allow certain customers to purchase shares in the IPO in exchange for excess commissions to be paid to the underwriters; and (2) the underwriters arranged for certain customers to purchase additional shares in the aftermarket at predetermined prices. The complaint also appears to allege that false or misleading analyst reports were issued. The complaint does not claim any specific amount of damages.

      Similar allegations were made in other lawsuits challenging over 300 other initial public offerings and follow-on offerings conducted in 1999 and 2000. The cases were consolidated for pretrial purposes. On February 19, 2003, the Court ruled on all defendants’ motions to dismiss. The motion was denied as to claims under the Securities Act of 1933 in the case involving the Company, as well as in all other cases (except for 10 cases). The motion was denied as to the claim under Section 10(b) as to the Company, on the basis that the complaint alleged that the Company had made acquisition(s) following the IPO. The motion was granted as to the claim under Section 10(b), but denied as to the claim under Section 20(a), as to the remaining individual defendant.

      We have decided to accept a settlement proposal presented to all issuer defendants. In this settlement, plaintiffs will dismiss and release all claims against the Immersion Defendants, in exchange for a contingent payment by the insurance companies collectively responsible for insuring the issuers in all of the IPO cases, and for the assignment or surrender of certain claims we may have against the underwriters. The Immersion Defendants will not be required to make any cash payments in the settlement, unless the pro rata amount paid by the insurers in the settlement exceeds the amount of the insurance coverage, a circumstance which we believe is remote. The settlement will require approval of the Court, which cannot be assured, after class members are given the opportunity to object to the settlement or opt out of the settlement.

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      To maintain the listing of our common stock on the Nasdaq National Market, we are required to comply with one of two sets of maintenance criteria for continued listing. Under the first set of criteria, among other things, we must maintain stockholders’ equity of at least $10 million, the market value of our “publicly held” common stock (excluding shares held by our affiliates) must be at least $5 million, and the minimum bid price for our common stock must be at least $1.00 per share. Under the second set of criteria, among other things, the market value of our common stock must be at least $50 million or we must have both $50 million in assets and $50 million in revenues, the market value of our “publicly held” shares must be at least $15 million, and the minimum bid price for our common stock must be at least $1.00 per share. As of December 31, 2003, our most recent balance sheet date, we had a deficit in stockholders’ equity, and therefore would not have been in compliance with the first set of listing criteria as of that date. Although we were in compliance with the second set of criteria, should the price of our common stock decline to the point where the aggregate value of our outstanding common stock falls below $50 million, the value of our “publicly held” shares falls below $15 million, or the bid price of our common stock falls below $1.00 per share, our shares could be delisted from the Nasdaq National Market. If we are unable to comply with the applicable criteria and our common stock is delisted from the Nasdaq National Market, it would likely be more difficult to effect trades and to determine the market price of our common stock. In addition, delisting of our common stock could materially affect the market price and liquidity of our common stock and our future ability to raise necessary capital.

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

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

      We lease a facility in San Jose, California of approximately 48,000 square feet, which serves as our corporate headquarters and includes our sales, marketing, administration, research and development, manufacturing and distribution functions for the Immersion Computing, Entertainment and Industrial operating segment. Products produced in San Jose include our MicroScribe G2 digitizer, our CyberGlove line of whole-hand sensing gloves and three-dimensional software products, and several of our professional and industrial products, including the Softmouse, various arcade products and automotive demo knobs. The lease for this property was to expire in June 2005, during March 2004 the lease was extended to June 30, 2010.

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      We lease a facility in Montreal, Quebec, Canada of approximately 5,500 square feet, for our subsidiary, Immersion Canada, Inc. The facility is used for administration and research and development functions. Two leases, covering subdivisions of the property, expire in September 2005.

      We lease a facility in Gaithersburg, Maryland of approximately 18,900 square feet, for Immersion Medical. The facility is used for sales, marketing, administration, research and development, manufacturing and distribution functions. Products assembled and distributed in Gaithersburg include four medical simulators: the CathSim Vascular Access Simulator, the AccuTouch Endoscopy Simulator, and the AccuTouch Endovascular Simulator and the Laparoscopy Simulator. The lease for this property expires in May 2009.

      Overall, the rent paid, including operating expenses, property taxes, and assessments, is currently approximately $143,000 per month and is subject to annual adjustment. We believe that our existing facilities are adequate to meet our current needs.

      We are involved in legal proceedings relating to a class action lawsuit filed on November 9, 2001. In re Immersion Corporation Initial Public Offering Securities Litigation, No. Civ. 01-9975 (S.D.N.Y.), related to In re Initial Public Offering Securities Litigation, No. 21 MC 92 (S.D.N.Y.). The named defendants are the Company and three of its current or former officers or directors (the “Immersion Defendants”), and certain underwriters of the Company’s November 12, 1999 initial public offering (“IPO”). Subsequently, two of the individual defendants stipulated to a dismissal without prejudice.

      The operative amended complaint is brought on purported behalf of all persons who purchased the common stock of the Company from the date of the IPO through December 6, 2000. It alleges liability under Sections 11 and 15 of the Securities Act of 1933 and Sections 10(b) and 20(a) of the Securities Exchange Act of 1934, on the grounds that the registration statement for the IPO did not disclose that: (1) the underwriters agreed to allow certain customers to purchase shares in the IPO in exchange for excess commissions to be paid to the underwriters; and (2) the underwriters arranged for certain customers to purchase additional shares in the aftermarket at predetermined prices. The complaint also appears to allege that false or misleading analyst reports were issued. The complaint does not claim any specific amount of damages.

      Similar allegations were made in other lawsuits challenging over 300 other initial public offerings and follow-on offerings conducted in 1999 and 2000. The cases were consolidated for pretrial purposes. On February 19, 2003, the Court ruled on all defendants’ motions to dismiss. The motion was denied as to claims under the Securities Act of 1933 in the case involving the Company, as well as in all other cases (except for 10 cases). The motion was denied as to the claim under Section 10(b) as to the Company, on the basis that the complaint alleged that the Company had made acquisition(s) following the IPO. The motion was granted as to the claim under Section 10(b), but denied as to the claim under Section 20(a), as to the remaining individual defendant.

      We have decided to accept a settlement proposal presented to all issuer defendants. In this settlement, plaintiffs will dismiss and release all claims against the Immersion Defendants, in exchange for a contingent payment by the insurance companies collectively responsible for insuring the issuers in all of the IPO cases, and for the assignment or surrender of certain claims we may have against the underwriters. The Immersion Defendants will not be required to make any cash payments in the settlement, unless the pro rata amount paid by the insurers in the settlement exceeds the amount of the insurance coverage, a circumstance which we believe is remote. The settlement will require approval of the Court, which cannot be assured, after class members are given the opportunity to object to the settlement or opt out of the settlement.

      On February 11, 2002, we filed a complaint against Microsoft Corporation, Sony Computer Entertainment, Inc., and Sony Computer Entertainment of America, Inc. in the U.S. District Court for the Northern District

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      On October 10, 2002, the Court entered an Amended Case Management Order that set, among other dates in the case, April 25, 2003 for a hearing to construe the claims of the asserted patents and April 5, 2004 for the start of trial. On October 28, 2002, Sony Computer Entertainment and Microsoft answered the amended complaint and alleged similar counterclaims for declaratory relief that the asserted patents are invalid, unenforceable, or not infringed. On March 21, 2003, Sony Computer Entertainment filed a motion for summary judgment of non-infringement. At our request, the Court ordered this motion stricken, without prejudice to its being refiled at a later date after the Court rules on claim construction. On April 25, 2003, the Court held the scheduled claim construction hearing. On July 9, 2003, the Court issued an Order Modifying Case Management Order that reset certain scheduled dates in the case, including setting April 12, 2004 as the start of trial. On October 2, 2003, the Court issued its Claim Construction Order construing certain terms of the patents asserted in the lawsuit. On January 16, 2004, Sony Computer Entertainment filed a motion for summary judgment of invalidity and that Sony Computer Entertainment Inc. should be dismissed as a party. We filed a motion for summary judgment seeking to dismiss Sony’s defenses that the asserted patents are unenforceable. On February 27, 2004, the Court held a hearing on these motions. On March 2, 2004, the Court issued a written ruling on the summary judgment motions. The Court denied Sony’s motion for summary judgment of invalidity. The Court granted all but one of Immersion’s motions and dismissed several Sony defenses. On March 23, 2004 the court rescheduled the trial from April 12, 2004 to April 19, 2004.

      On July 28, 2003, we announced that we had settled our legal differences with Microsoft and we and Microsoft agreed to dismiss all claims and counterclaims relating to this matter as well as assume financial responsibility for our respective legal costs with respect to the lawsuit between Immersion and Microsoft. We continue to pursue our claims of infringement against Sony Computer Entertainment. In the event we settle our lawsuit with Sony Computer Entertainment, we will be obligated to pay certain sums to Microsoft as described in Note 9 to our consolidated financial statements. If Sony Computer Entertainment was successful in its counterclaims and our patents were deemed invalid and unenforceable, the assets relating to the patents that were deemed invalid would be impaired. For Sony Computer Entertainment to be awarded damages for attorneys’ fees the court would have to rule that we acted with willful disregard and did not perform a proper investigation. We currently believe it is remote that a loss may be or has been incurred related to the counterclaims of Sony Computer Entertainment. The case is scheduled to go to trial in April 2004.

      Due to the inherent uncertainties of litigation, we cannot accurately predict the ultimate outcome of the litigation. We anticipate that the litigation will continue to be costly, and there can be no assurance that we will be able to recover the costs we incur in connection with the litigation. We expense litigation costs as incurred and only accrue for costs that have been incurred but not paid to the vendor as of the financial statement date. The litigation has diverted, and is likely to continue to divert, the efforts and attention of some of our key management and personnel. As a result, until such time as it is resolved, the litigation could adversely affect our business. Further, any unfavorable outcome could adversely affect our business.

      No matters were submitted to a vote of security holders in the fourth quarter of fiscal 2003.

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PART II

      Our common stock is traded on the Nasdaq National Market under the symbol “IMMR.” The following table sets forth, for the periods indicated, the high and low sales prices for our common stock on such market.

      On March 10, 2004, the closing price was $8.57 and there were 171 stockholders of record.

Dividend Policy

      We have never declared or paid any cash dividends on our common stock or other securities and we do not anticipate paying cash dividends in the foreseeable future. The Company currently intends to retain any earnings to fund future growth, product development, and operations.

      The following financial data is qualified in its entirety by, and should be read in conjunction with, “Management’s Discussion and Analysis of Financial Condition and Results of Operations” and the consolidated financial statements and notes thereto included elsewhere in this Annual Report on Form 10-K.

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      The following discussion should be read in conjunction with the consolidated financial statements and notes thereto.

      This Management’s Discussion and Analysis of Financial Condition and Results of Operations includes forward-looking statements within the meaning of Section 27A of the Securities Act of 1933, as amended, and Section 21E of the Securities Exchange Act of 1934, as amended. The forward-looking statements involve risks and uncertainties. Forward-looking statements are identified by words such as “anticipates,” “believes,” “expects,” “intends,” “may,” “will” and other similar expressions. However, these words are not the only way we identify forward-looking statements. In addition, any statements, which refer to expectations, projections or other characterizations of future events or circumstances, are forward-looking statements. Actual results could differ materially from those projected in the forward-looking statements as a result of a number of factors, including those set forth in Item 1, those described elsewhere in this report and those described in our other reports filed with the SEC. We caution you not to place undue reliance on these forward-looking statements, which speak only as of the date of this report, and we undertake no obligation to release the results of any revisions to these forward-looking statements which could occur after the filing of this report.

Critical Accounting Policies and Estimates

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

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

      We recognize revenues in accordance with applicable accounting standards including Staff Accounting Bulletin (“SAB”) No. 104, “Revenue Recognition,” Emerging Issues Task Force (“EITF”) Issue No. 00-21, “Accounting for Revenue Arrangements with Multiple Deliverables” and the American Institute of Certified Public Accountants’ (the “AICPA”) Statement of Position (“SOP”) 97-2, “Software Revenue Recognition,” as amended. Revenue is recognized when persuasive evidence of an arrangement exists, delivery has occurred or service has been rendered, the fee is fixed and determinable, and collectibility is probable. We derive our revenues from three principle sources: royalty and license fees, product sales, and development contracts. We recognize royalty and license revenue based on royalty reports or related information received from the licensee as well as time-based licenses of our intellectual property portfolio. Up-front payments under license agreements are

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      We generally license and recognize revenue from our licensees under the above license models or a combination thereof. Individual contracts may have characteristics that do not fall within a specific license model or may have characteristics of a combination of license models. Under those circumstances, we recognize revenue in accordance with SAB No. 104, EITF No. 00-21 and SOP 97-2, as amended, to guide the accounting treatment for each individual contract. If the information received from our licensees regarding royalties is incorrect or inaccurate, it could adversely affect revenue in future periods. To date all information received from our licensees has caused no material reduction in future period revenues. We recognize revenues from product sales when the product is shipped provided collection is determined to be probable and no significant obligation remains. We sell the majority of our products with warranties ranging from three to twenty-four months. We record the estimated warranty costs during the quarter the revenue is recognized. Historically, warranty-related costs and related accruals have not been significant. We offer a general right of return on the MicroScribe G2 product line for 14 days after purchase. We recognize revenue at the time of shipment of a MicroScribe system and provide an accrual for potential returns based on historical experience. No other general right of return is offered on our products. Development contract revenues are recognized under the cost-to-cost percentage-of-completion accounting method based on physical completion of the work to be performed. Losses on contracts are recognized when determined. Revisions in estimates are reflected in the period in which the conditions become known. Our revenue recognition policies are significant because our revenue is a key component of our results of operations. In addition, our revenue recognition determines the timing of certain expenses, such as commissions and royalties. Revenue results are difficult to predict, and any shortfall in revenue or delay in recognizing revenue could cause our operating results to vary significantly from quarter to quarter and could result in greater or future operating losses.

      We have executed a series of agreements with Microsoft Corporation as described in Note 9 to our consolidated financial statements that provide for settlement of our lawsuit against Microsoft as well as various licensing, sublicensing and financing arrangements. We have accounted for the proceeds received under the agreements as a long-term customer advance based on certain provisions that would result in payment of funds to Microsoft.

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

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

      We have acquired patents and other intangibles. Our business acquisitions typically result in goodwill and other intangible assets. In addition, we capitalize the external legal and filing fees associated with patents and trademarks. We assess the recoverability of our goodwill and other intangible assets and we must make assumptions regarding estimated future cash flows and other factors to determine the fair value of the respective assets that affect our consolidated financial statements. If these estimates or related assumptions change in the future, we may be required to record impairment charges for these assets. We amortize our intangible assets related to patents and trademarks, once they issue, over their estimated useful lives, generally 10 years. Future changes in the estimated useful life could affect the amount of future period amortization expense that we will incur. During 2003, we capitalized external costs associated with patents and trademarks of $1.6 million and our amortization expense for the same period was $102,000.

      The above listing is not intended to be a comprehensive list of all of our accounting policies. In many cases, the accounting treatment of a particular transaction is specifically dictated by generally accepted accounting principles in the United States of America, with no need for management’s judgment in their application. There are also areas in which management’s judgment in selecting any available alternative would not produce a materially different result. See our consolidated financial statements included elsewhere in this Annual Report which contains accounting policies and other disclosures required by GAAP.

Results of Operations

      During 2003, we achieved several significant milestones. We advanced penetration into our core markets and succeeded at gaining market acceptance of new haptics-based solutions. In addition,

	•	Our medical business was profitable for the full year, driven largely by $3.2 million in licensing and development revenues associated with agreements signed with Medtronic.
	•	We signed a multiyear licensing agreement with Samsung, enabling this cell phone innovator to deliver a new generation of phones that include Immersion’s TouchSense touch feedback technology.
	•	We have programs in production or development with four of the top 10 automotive OEMs spanning Europe, Asia, and North America and three of the world’s most prestigious brands.
	•	We achieved a successful outcome to our litigation with Microsoft.
	•	Our intellectual property portfolio continued to grow, and we continued to pursue our patent infringement litigation with Sony Computer Entertainment.

      During 2003 we experienced a decline in medical product sales mainly due to the cautious economic environment and its impact on our customer’s ability to secure capital funding for such purchases. Furthermore, our royalty and license revenues were negatively impacted by the decline in the PC gaming market, in part due to the trend away from PC gaming towards console gaming. During 2003, we continued to pursue our litigation against Sony Computer Entertainment which diverted, and is likely to continue to divert, the efforts and attention of some of our key management and personnel. We incurred significant costs, $7.0 million associated with the litigation during the year, as our litigation expenses increased by $5.1 million from 2002. We anticipate that the litigation will continue to be costly, and there can be no assurance that we will be able to recover the costs we incur in connection with the litigation. The case is scheduled to go to trial in April 2004.

      In 2004, we expect to see continued growth in our business segments as our technology gains further acceptance. However, our success could be limited by several factors, including the timely release of our new products or our licensees’ products, continued market acceptance of our products and technology, the introduction of new products by existing or new competitors and the cost of ongoing litigation. For a further discussion of these and other risk factors, see the section titled “Factors That May Affect Future Results.”

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      The following table sets forth our statement of operations data as a percentage of total revenues.

Comparison of Years Ended December 31, 2003, 2002, and 2001

      Total Revenue. Our total revenues for the year ended December 31, 2003 were flat compared to the year ended December 31, 2002. While the overall revenue did not increase, the revenue mix did change from 2002 to 2003.

      Royalty and license revenue. Royalty and license revenue is comprised of royalties earned on sales by our TouchSense licensees and license fees charged for our intellectual property portfolio. Royalty and license revenue increased $857,000 or 16% from 2002 to 2003. The increase in royalty and license revenue is a combination of an increase in medical royalty and licensee fees of $1.5 million and an increase in automotive royalties of $237,000, offset by a decrease in gaming royalties of $899,000. The significant increase in royalty and license revenue from our medical licensees is primarily due to license revenue of $1.9 million recognized on our license and development agreements with Medtronic. During the fourth quarter, we achieved the second of

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      Product sales. Product sales decreased by $1.3 million or 12% from 2002 to 2003. The decrease in product sales is mainly due to a $1.6 million decrease in the volume of medical products sales offset in part by an increase in the volume of 3D and professional product sales. Medical product sales consist of sales of our virtual reality medical simulators in the vascular, endoscopic, endovascular, and laparoscopic product lines. Many of our customers rely on grant monies to purchase our medical simulation devices. During this economic downturn, our customers have had difficulties in securing these funding sources and hence our medical product sales, primarily in the intravenous catheterization and endoscopic surgical simulator lines have declined.

      Development contract and other revenue. Development contract and other revenue is comprised of revenue on commercial and government contracts. Development contract and other revenue increased $399,000 or 9% from 2002 to 2003. The increase in this category is attributable to an increase of $733,000 in government contracts offset by a decrease in commercial contracts in the medical and automotive sectors in the amount of $334,000. While the commercial sector has experienced decreased development contract spending due to declining research and development budgets, the government has increased spending related to military and security needs.

      Total Revenue. Our total revenues for the year ended December 31, 2002 increased by $1.0 million or 5% to $20.2 million from $19.2 million in 2001.

      Royalty and license revenue. Royalty and license revenue decreased by $131,000 or 2% from 2001 to 2002. Royalties from our gaming licensees decreased by $953,000 due to the decline in sales of general computing and PC gaming peripheral devices as well as delayed product introductions from some of our licensees. The decrease in gaming royalties was offset by an increase of $401,000 in automotive royalties and license fees and an increase of $421,000 in medical royalty and license revenue due in part from signing new automotive and medical license agreements during 2002.

      Product sales. Product sales for the period ended increased by $363,000 or 4% from 2001 to 2002. The increase in product sales is primarily due to a $2.0 million increase in the volume of sales of our medical products as compared to 2001 offset by decreased microprocessor sales of $907,000 and decreased 3D products sales of $306,000. Demand for medical products increased across all product lines, and in particular the endoscopy simulator. The decline in our microprocessor sales is based on a decision to decrease the sales effort related to this low margin product line as well as reduced volume requirements from our licensees who use this microprocessor solution. Sale of our 3D products such as our MicroScribe G2 digitizer and our line of whole-hand interface devices decreased in 2002 from 2001 mainly due to delays in purchasing decisions by customers affected by the current economic slowdown.

      Development contract and other revenue. Development contract and other revenue increased by $771,000 or 22% during fiscal 2002 as compared to fiscal 2001 due to securing new commercial and government development contracts in the medical field.

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      Our cost of product sales consists primarily of materials, labor and overhead. There is no cost of sales associated with royalty and license revenue or development contract revenue. The cost of product sales decreased by $605,000 or 10% from 2002 to 2003 due to a combination of decreased product sales, decreased royalty costs, decreased price and production variances and decreased overhead costs, offset by increased inventory write offs for excess and obsolete inventory. Product sales decreased by 12% from 2002 to 2003 but direct material and labor costs only decreased by $134,000 or 4% due to a reduction in sales of our higher margin products such as our medical simulators, causing an unfavorable product mix. Royalty costs decreased by $274,000 from 2002 to 2003 due in part to the elimination of royalties on our MicroScribe G2 product line due to the settlement agreement reached with MicroScribe LLC in 2002. In addition there were cost savings from decreased price and production variances of $249,000 and decreased overhead costs of $33,000 during fiscal 2003 as compared to fiscal 2002. These cost savings were offset by inventory write offs for excess and obsolete inventory of $197,000 due to design revisions made to products to improve product quality.

      The cost of product sales decreased by $193,000 or 3% from 2001 to 2002 due to a combination of favorable product mix, decreased inventory write-downs, and decreased royalties offset by increased price and production variances and increased overhead costs. Product sales volume increased by 4% from 2001 to 2002 but direct material and labor costs decreased by $194,000 or 5% due to the reduction in sales of our lower margin products such as our microprocessors causing a favorable product mix and reduced direct costs. Inventory write-downs decreased by $151,000 largely due to a write-down taken during fiscal 2001 for our LightScribe product line. Royalty costs decreased by $52,000 from 2001 to 2002 due to the elimination of royalties due on our MicroScribe G2 product line after June of 2002. These cost savings were offset by increased price and production variances of $133,000 and increased overhead costs of $80,000 during fiscal 2002 as compared to fiscal 2001.

      Sales and Marketing. Our sales and marketing expenses are comprised primarily of employee headcount and related compensation and benefits, advertising, trade shows, brochures, market development funds, travel and an allocation of facilities costs. Sales and marketing expenses increased by $198,000 or 3% in 2003 compared to 2002. The increase in expense was attributable to increased sales and marketing focus on medical and cell phone market opportunities as well as upgrading our corporate marketing function, offset by decreased spending in collateral and advertising which we were able to leverage from prior period investments and decreased bad debt expense. In 2003, we increased headcount and related compensation, benefits and overhead by $99,000, increased professional consulting and license fees by $92,000 and increased travel by $251,000 to support the sales and marketing efforts noted above. Offsetting this, we reduced advertising, market development funds, Web site development and corporate identity by $101,000 leveraging investments in those categories from prior periods and we reduced bad debt expense by $166,000. During the later half of 2003 and the beginning of 2004, we reorganized and redeployed our sales and marketing teams to capitalize on our leading technology and progress with strategic customers in order to better execute our market development and our sales strategy. We hired a

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      Sales and marketing expenses decreased by $2.3 million or 23% in 2002 compared to 2001. The reduction in expenses was attributable to our continued cost cutting measures and leverage of prior period investments in sales and marketing. In 2002, we reduced advertising, market development funds, Web site development and corporate identity by $1.1 million. In addition we reduced expenses associated with headcount and related overhead costs by $819,000 due to decreased headcount. The remaining cost reduction is associated with reduced travel expenses of $149,000 and reduced office and supplies expenses of $133,000.

      Research and Development. Our research and development expenses are comprised primarily of employee headcount and related compensation and benefits, consulting fees, costs of acquired technology, tooling and supplies and an allocation of facilities costs. Research and development expenses increased to $7.0 million in 2003 compared to $6.5 million in 2002. The increase of $549,000 or 8% increase from the prior fiscal year was primarily due to increased salary, benefit and related overhead costs of $262,000 related to upgrading our engineering talent and relocation costs related to moving our vice president of engineering, from Montreal, Quebec to San Jose, California. Other factors causing this increase in expenses were increased outside professional services and license fees of $164,000 and increased supplies and materials of $87,000. We believe that continued investment in research and development is critical to our future success, and we expect these expenses may increase in absolute dollars in the future periods but decrease as a percentage of revenue.

      Research and development expenses decreased to $6.5 million in 2002 compared to $7.5 million in 2001. The decrease of $1.0 million or 14% reduction from the prior fiscal year was primarily due to reduced headcount and related overhead costs of $693,000 and reduced outside professional services of $389,000.

      General and Administrative. Our general and administrative expenses are comprised primarily of employee headcount and related compensation and benefits, legal and professional fees, office supplies, recruiting, travel and an allocation of facilities costs. General and administrative expenses increased to $12.5 million in 2003 compared to $8.1 million in 2002. The increase of $4.4 million or 55% is primarily attributable to increased legal and professional fees of $4.7 million, mostly related to the litigation against both Sony Computer Entertainment and Microsoft, offset by decreased personnel and related overhead costs of $121,000 and public company expenses of $78,000. We expect that the dollar amount of general and administrative expenses will increase in the future as we incur additional costs related to these legal matters and compliance costs associated with Sarbanes-Oxley and new Nasdaq listing requirements among others.

      General and administrative expenses increased to $8.1 million in 2002 compared to $7.7 million in 2001. The increase of $370,000 or 5% is primarily attributable to increased legal and professional fees of $1.5 million, mostly related to the litigation against us and litigation against both Sony Computer Entertainment and Microsoft, offset by decreased personnel and related overhead costs of $1.1 million due in part to the elimination of some executive management positions.

      Amortization of Intangibles and Deferred Stock Compensation. Amortization of intangibles and deferred stock compensation decreased by $628,000 or 20% from 2002 to 2003. The decrease is mainly attributable to intangible amortization that decreased by $211,000 as some intangible assets reached full amortization and a decrease in deferred stock compensation expense of $417,000 due to the expiration of certain option vesting periods.

      Amortization of intangibles and deferred stock compensation decreased by $2.1 million or 41% from 2001 to 2002. The decrease is mainly attributable to $1.4 million of goodwill amortization incurred during 2001 prior to the adoption of Statement of Financial Accounting Standard (“SFAS”) No. 142, “Goodwill and Other Intangible Assets.” SFAS No. 142 provides that goodwill and intangible assets with indefinite lives not be amortized but tested at least annually for impairment, and therefore no goodwill amortization was recorded during fiscal 2002. Intangible amortization decreased by $516,000 as some intangible assets reached full

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      Impairment of Goodwill. Impairment of goodwill decreased $3.8 million or a 100% decrease from 2002 to 2003. During the fourth quarter of 2002, in accordance with SFAS No. 142, an impairment test was performed on goodwill in conjunction with the annual forecasting process. Based on that analysis, it was determined that goodwill was impaired and a $3.8 million impairment loss was recognized during 2002.

      Other Charges. Other charges decreased $397,000 or a 100% decrease from 2002 to 2003. The costs in 2002 primarily consisted of severance benefits paid as a result of the reduction in force of twelve employees in 2002. Employees from manufacturing, sales and marketing, research and development and general and administrative were included in the reduction in force. We did not incur any additional charges related to the aforementioned reduction in force.

      For fiscal year 2002, other charges increased $173,000 or 77% from 2001 to 2002. The $224,000 of costs incurred in 2001 mainly consists of $199,000 in severance benefits paid as part of a reduction in force of eighteen employees in 2001 and $25,000 of accounting and legal charges, relating to the merger that occurred in the prior fiscal year. Employees from sales and marketing, research and development and general and administrative were included in the reduction in force. We did not incur any additional charges related to the 2001 reduction in force.

      Interest and Other Income. Interest and other income, consists primarily of interest income, dividend income and capital gains from cash and cash equivalents and short-term investments. Interest and other income declined by $180,000 and $782,000 for the year ended December 31, 2003 and 2002, respectively. The decline is primarily due to reduced cash, cash equivalents and short-term investments invested for the period due to cash used in operating and investing activities as well as reduced yields on investments.

      Interest Expense. Interest expense consists primarily of interest expense on notes payable and capital leases. The decrease in interest expense from 2002 to 2003 and from 2001 to 2002 is related to the maturity and subsequent payment of certain notes payable in 2002 and 2003.

      Other Expense. Other expense consists primarily of impairment losses on our investments in privately held companies and accretion and dividend expense on our long-term customer advance from Microsoft. Other expense was $2.0 million in 2003, $1.2 million in 2002 and $4.5 million in 2001. Other expense in 2003 consisted primarily of a noncash impairment loss due to the write off of our investment in a technology application developer, There, Inc., in the amount of $1.0 million. We review our cost-method investments on a quarterly basis to determine if there has been an other-than-temporary decline in the investment’s value based on our estimate of their net realizable value taking into account the companies’ respective business prospects, financial condition and ability to raise third party financing. The impairment loss was based on There, Inc.’s continued decline in financial condition, uncertain future revenue streams and inability to raise adequate third-party financing. In addition to the impairment loss, other expense for 2003 included accretion of payments which may be due Microsoft of $867,000 and dividend expense on our Series A Redeemable Convertible Preferred Stock (“Series A Preferred Stock”) of $183,000 as further discussed in Note 9 to the consolidated financial statements. Other expense in 2002 consisted primarily of our noncash impairment loss due to the write down of our investment in an early stage technology company, Geometrix, Inc in the amount of $1.2 million. The impairment loss was based on Geometrix’s continued decline in financial condition and uncertain future revenue streams, as well as Geometrix’s inability to raise third-party financing. During 2001 other expense primarily consisted of our noncash impairment loss of $4.3 million due to the write down of our investment in End Points, Inc. and Geometrix, Inc. and $239,000 of interest due to us from our investment in Geometrix, Inc.

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      Provision for Income taxes. For the year ended 2003, we recorded a provision for income taxes of $154,000 on a pre-tax loss of $16.8 million, yielding an effective tax rate of (0.9%). The provision for income tax was based on federal alternative minimum income tax due on taxable income primarily the result of the $20 million license fee paid by Microsoft during 2003. This rate differs from the statutory rate primarily due to the recording of a full valuation allowance of $31.3 million against deferred tax assets. For the year ended 2002, we recorded no provision for income taxes on a pre-tax loss of $16.5 million yielding an effective tax rate of 0%. This rate differs from the statutory rate primarily due to the recording of a full valuation allowance of $25.2 million against net deferred tax assets.

Segment Results for the Years Ended December 31, 2003, 2002, and 2001 are as follows:

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

		Fiscal 2003 Compared to Fiscal 2002

      Immersion Computing, Entertainment and Industrial segment. Revenues from the Immersion Computing, Entertainment and Industrial segment decreased $696,000, or 6% for the year ended December 31, 2003 compared to the year ended December 31, 2002. The decrease is mainly due to decreased royalty and license revenue from our gaming licensees due to a general weakness in PC gaming market. Net loss for the year ended December 31, 2003 increased by $2.3 million or 16% as compared to the year ended December 31, 2002. The increase was primarily attributable to decreased gross margin of $763,000, increased legal and professional fees of $4.9 million, increased other expense of $1.1 million offset by decreased impairment of goodwill of $3.8 million and decreased amortization of intangibles and deferred stock compensation of $595,000. The decrease in gross margin is mainly due to the decrease in revenue. Increased legal and professional fees are primarily related to the litigation against both Sony Computer Entertainment and Microsoft. Other expense increased due to the accretion of amounts that may be due to Microsoft of $867,000 and dividend expense on our Series A Preferred Stock of $183,000. We did not incur an impairment loss on goodwill during fiscal 2003.

      Immersion Medical segment. Revenues from Immersion Medical increased $1.5 million or 19% for the year ended December 31, 2003, compared to the year ended December 31, 2002. The increase is primarily due to

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      Immersion Computing, Entertainment and Industrial segment. Revenues from the Immersion Computing, Entertainment and Industrial segment decreased $1.6 million, or 11% for the year ended December 31, 2002 compared to the year ended December 31, 2001. The decrease is mainly due to decreased product sales namely our microprocessors and decreased royalty revenue related to our gaming licensees. Net loss for the year ended December 31, 2002 decreased by $1.5 million or 9% as compared to the year ended December 31, 2001. The decrease was primarily attributable to reduced sales and marketing expenses of $2.0 million, reduced amortization of intangibles and deferred stock compensation of $2.4 million, and reduced other expense of $3.3 million offset by impairment of goodwill of $3.8 million, increased general and administrative expenses of $1.2 million and reduced interest and other income of $902,000.

      Immersion Medical segment. Revenues from Immersion Medical increased $2.9 million or 58% for the year ended December 31, 2002, compared to the year ended December 31, 2001. The increase is primarily due to a $1.5 million increase in product sales and $1.2 million in development contract revenue. Net loss for the year ended December 31, 2002 decreased by $3.8 million or 70% compared to the year ended December 31, 2001. Net loss for the year ended December 31, 2002 decreased mainly due to increased gross profit of $2.0 million due to increased product sales and development contract revenue, a decrease in research and development of $593,000 and a reduction in general and administrative expenses of $866,000.

Liquidity and Capital Resources

      Our cash, cash equivalents, and short-term investments consist primarily of money market funds and highly liquid debt instruments. All of our cash equivalents and short-term investments are classified as available-for-sale under the provisions of SFAS No. 115, “Accounting for Certain Investments in Debt and Equity Securities.” The securities are stated at market value with unrealized gains and losses reported as a component of accumulated other comprehensive income (loss) within stockholders’ equity (deficit).

      At December 31, 2003 our cash and cash equivalents totaled $21.7 million, up $13.0 million from $8.7 million at December 31, 2002.

      During the year ended December 31, 2003, we entered into agreements with Microsoft providing for certain license rights under our patents, the settling of our lawsuit and providing for an investment in our new Series A Preferred Stock; as a result, our cash position increased by $26.0 million. Pursuant to the license agreement, we granted Microsoft a worldwide royalty-free, irrevocable license in exchange for $20.0 million. Under the terms of the Series A Redeemable Convertible Preferred Stock purchase agreement, Microsoft purchased 2,185,792 shares of Preferred Stock for $2.745 each, an aggregate purchase price of $6.0 million. The Preferred Stock accrues cumulative dividends at a rate of 7% per year, payable in cash or additional shares of Preferred Stock and can be

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      Net cash used in operating activities during the fiscal year 2003 was $12.6 million, a change of $14.1 million from the $1.5 million provided during the comparable period during fiscal year 2002. Cash used in operations during the year ended December 31, 2003 comprised primarily of a $17.0 million net loss offset by noncash charges and credits of $5.6 million, including $1.0 million in depreciation, $2.5 million in amortization of intangibles and deferred stock compensation, $1.1 million in dividend expense and accretion on our Series A Preferred Stock and $1.0 million related to the write down of a cost-method investment in There, Inc. Cash used in operations during fiscal 2003 was also impacted by a decrease of $1.3 million due to a change in accounts receivable mainly due to $1.0 million that became due from Medtronic near year end, a decrease of $722,000 due to a change in deferred revenue and customer advances, mainly due to amortization of prepaid royalties, a decrease of $207,000 due to a change in accounts payable offset by an increase of $933,000 due to a change in accrued compensation and other current liabilities due to the timing of certain payments and increased litigation expenses related to our litigation against Sony Computer Entertainment. Net cash provided in operating activities during the fiscal year 2002 was $1.5 million, a change of $13.9 million from the $12.4 million used during the comparable period during fiscal year 2001. Cash provided by operations during the year ended December 31, 2002 comprised primarily of a $16.5 million net loss offset by noncash charges and credits of $9.8 million, including $3.8 million impairment of goodwill, $3.1 million in amortization of intangibles and deferred stock compensation, $1.3 million in depreciation and $1.2 million related to the write down of a cost-method investment in Geometrix, Inc. Cash provided by operations during fiscal 2002 was also impacted by an increase of $7.1 million due to a change in deferred revenue and customer advances, an increase due to a change of $450,000 in prepaid and other current assets, an increase of $421,000 due to a change in accounts payable, and an increase of $237,000 due to a change in accrued compensation and other current liabilities. The significant increase in deferred revenue and customer advances was primarily the result of a $5.0 million upfront payment by one licensee pursuant to the terms of a royalty and license agreement and a $2.5 million increase in customer advances due to a prepayment from another licensee. Subsequent to December 31, 2002, $500,000 of the prepayment was returned to the licensee upon reaching final terms of the prepayment agreement. Net cash used in operating activities during 2001 was $12.4 million, primarily attributable to a net loss of $21.7 million offset by noncash charges and credits of $11.7 million, including amortization of intangibles and deferred stock compensation of $5.3 million and the write down of our cost-method investments in EndPoints, Inc. and Geometrix, Inc. of $4.3 million and interest charges on a loan of $239,000. Cash used in operations during fiscal 2001 was also impacted by a decrease of $343,000 due to a change in prepaid expenses and other current assets, a decrease of $344,000 due to a change in accounts receivable, a decrease of $1.0 million due to a change in accounts payable and a decrease of $430,000 due to a change in accrued compensation and other current liabilities. The decrease in accounts payable and other current liabilities is primarily due to reduced spending during 2001 as a result of cost reduction programs.

      Net cash used in investing activities during the fiscal year 2003 was $2.0 million, as opposed to the $1.5 million provided by investing activities during fiscal year 2002, a change of $3.5 million. Net cash used in investing activities during the period consisted of a $1.6 million increase in other assets, primarily due to capitalization of external patent filing and application costs and $441,000 used to purchase capital equipment. Net cash provided by investing activities during 2002 was $1.5 million, as opposed to the $1.3 million used by investing activities during fiscal year 2001, a change of $2.8 million. Net cash provided by investing activities during the period consisted of $2.6 million sale of short-term investments, offset by $442,000 used to purchase capital equipment and an increase of $566,000 in other assets for the capitalization of external patent filing and application costs. Net cash used by investing activities for 2001 was $1.3 million and was made of $3.4 million of sales and maturities of short-term investments, offset by short-term investment purchases of $3.6 million, $612,000 used to purchase property and equipment for our corporate facilities and information technology infrastructure and an increase of $481,000 in other assets for the capitalization of external patent filing and application costs.

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      Net cash provided by financing activities during fiscal year 2003 was $26.8 million compared to $4.7 million used during fiscal year 2002, or a $31.5 million change from prior year. The increase was primarily due to $26.0 million received from Microsoft as discussed in Note 9 to the consolidated financial statements, and issuances of common stock and exercise of stock options in the amount of $893,000. Net cash used in financing activities during 2002 was $4.7 million compared to $660,000 provided during fiscal year 2001, or a $5.3 million change from prior year. Net cash used in financing activities included payments of $5.0 million on notes payable and capital leases including $4.4 million on our convertible note payable to Medtronic, offset by issuances of common stock and exercise of stock options and warrants of $369,000. In 2001, net cash provided by financing activities was $660,000, and was primarily attributable to the net proceeds from the exercise of stock options and issuance of stock of $763,000, offset by payment on capital leases of $120,000.

      We believe that our cash and cash equivalents will be sufficient to meet our working capital needs and our continued litigation costs for the next twelve months. We have taken measures to control our costs and will continue to monitor these efforts. We do, however, expect our legal costs to increase during 2004 as a result of our lawsuit against Sony Computer Entertainment. We anticipate that capital expenditures for the year ended December 31, 2004 will total approximately $750,000 in connection with anticipated upgrades to operations and infrastructure. Dividends accrue on our Series A Preferred Stock at a rate of 7% per annum; we may elect to pay these dividends in cash which would require a cash payment of $420,000 annually. To the extent we raise additional capital through debt or equity financing, this could result in substantial dilution for our stockholders. If we acquire one or more businesses, patents or products, our cash or capital requirements could increase substantially. In the event of such an acquisition or should any unanticipated circumstances arise which significantly increase our capital requirements, we may elect to raise additional capital through debt or equity financing. Although we expect to be able to raise additional capital, there is no assurance that such additional capital will be available on terms acceptable to us, if at all. In addition, pursuant to the Certificate of Designation of the Powers, Preferences and Rights of Series A Redeemable Convertible Preferred Stock, if the closing price for our common stock exceeds an amount equal to the sum of $6.8625 plus any dividends in the form of additional shares of Series A Preferred Stock that remain unpaid plus any accrued but unpaid cash dividends per share (the “Accretive Value”) for thirty consecutive trading days, at our election we may redeem all (and not less than all) of the shares of Series A Preferred Stock (a “Company Redemption”), at a redemption price equal to 125% of the then Accretive Value (the “Redemption Price”), payable in cash in immediately available funds to an account designated by the holder of the Series A Preferred Stock. Our stock traded on the Nasdaq National Market from January 30, 2004 to March 12, 2004 in an amount in excess of two and one half times the Accretive Value. As a result, we have the option to send notice to the holder of our Series A Preferred Stock informing it of our intention to enact a Company Redemption. We calculate a Company Redemption would utilize approximately $7.5 million in cash if the holder did not convert the Series A Preferred Stock into common stock prior to the effective date of the Company Redemption. We have not yet made a decision whether to exercise redemption rights.

      In addition, events may occur during the next year that may require us to redeem our outstanding Series A Preferred Stock. The holder of our Series A Preferred Stock will be entitled to receive a multiple of the original purchase price upon the occurrence of the following events: (i) a sale of all or substantially all of our assets or intellectual property, (ii) a merger or acquisition where our stockholders hold less than fifty percent of the voting power of the combined company, (iii) with certain exceptions, the withdrawal from or dismissal of our lawsuit against Sony Computer Entertainment with or without prejudice before a settlement or judicial resolution of the lawsuit by us, (iv) the sale of the lawsuit to Sony Computer Entertainment or its affiliates, (v) the sale or transfer of the patents which are the subject of the lawsuit to Sony Computer Entertainment or its affiliates before the settlement or judicial resolution of the lawsuit, (vi) Microsoft negotiates a settlement with Sony Computer Entertainment on terms that are within previously agreed upon parameters, and requests that we settle the lawsuit based upon those terms, but we decline to do so, or (vii) we settle the lawsuit for proceeds within certain parameters. The holder of our Series A Preferred Stock may also elect to trigger a redemption and receive a multiple of the original purchase price should there be a change in any twelve month period of two or more of our incumbent directors that are not eligible for reelection in that year or any expansion in the number of the incumbent directors of our Board above nine. A settlement with Sony Computer Entertainment in an amount less

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      Under our agreements with the holder of our Series A Preferred Stock, we agreed to file, at our expense, with the Securities and Exchange Commission (the “Commission”), a shelf registration statement on Form S-3 covering the resale of shares of our common stock issued to the holder of the Series A Preferred Stock upon conversion of such Series A Preferred Stock and the common stock issuable upon the conversion of any debentures issued to the holder. There is a monthly penalty (equal to $45,000) for the failure to file or update this registration statement on Form S-3, failure to deliver our response letter to the Commission within 15 days of receipt, obtain the effectiveness of the registration statement within 180 days after filing, to fail to maintain the effectiveness of the registration statement, or for the suspension of trading under the registration statement on Form S-3 for more than 90 days in any six-month period. As we did not obtain the effectiveness of the registration statement by March 6, 2004, we have not satisfied our obligation to do so within 180 days after filing. On March 18, 2004, Microsoft waived its right to receive penalties for this failure to timely register their shares, as well as its right to receive dividends that would otherwise accrue after the registration statement becomes effective. In exchange, we agreed that Microsoft shall have the right to convert its shares of Series A Preferred Stock into common stock in advance of any decision by us to redeem such shares of Series A Preferred Stock. We also agreed to continue to work diligently towards obtaining the effectiveness of the registration statement.

Summary Disclosures About Contractual Obligations and Commercial Commitments

      The following table reflects a summary of our contractual cash obligations and other commercial commitments as of December 31, 2003 (in thousands):

      On July 28, 2003 Microsoft purchased 2,185,792 shares of our Series A Preferred Stock for $2.745 each, an aggregate purchase price of $6.0 million. Series A Preferred Stock accrues cumulative dividends at a rate of 7% per year, payable in cash or additional shares of Series A Preferred Stock semi-annually in arrears on July 25 and January 25 of each year commencing on January 25, 2004 and ending on July 25, 2008. The Series A Preferred Stock can be redeemed at the request of the holder for twice the original purchase price plus any dividends in the form of additional shares that remain unpaid and any accrued but unpaid cash dividends per share on or after July 25, 2006. In addition as discussed above, certain other events, including a settlement of the lawsuit with Sony Computer Entertainment, could result in redemption of the Series A Preferred Stock prior to July 25, 2006 for an amount up to $15.0 million as adjusted for cumulative dividends. In connection with our series of agreements with Microsoft executed in July 2003, we are also obligated to pay Microsoft certain amounts based on a settlement of the Sony Computer Entertainment litigation (see Note 9 to the consolidated financial statements.)

Recent Accounting Pronouncements

      In November 2002, the EITF reached a consensus on Issue No. 00-21 “Accounting for Revenue Arrangements with Multiple Deliverables.” The EITF concluded that revenue arrangements with multiple elements should be divided into separate units of accounting if the deliverables in the arrangement have value to the customer on a standalone basis, if there is objective and reliable evidence of fair value of the undelivered elements, and as long as there are no rights of return or additional performance guarantees by the Company. The provisions of EITF Issue No. 00-21 are applicable to agreements entered into in fiscal periods beginning after June 15, 2003. The adoption of EITF No. 00-21 did not have a material impact on our financial position, results of operations or cash flows.

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      In December 2002, the FASB issued SFAS No. 148, “Accounting for Stock-Based Compensation — Transition and Disclosure.” The statement amends SFAS No. 123, “Accounting for Stock-Based Compensation,” to provide alternative methods of transition for a voluntary change to the fair value based method of accounting for stock-based employee compensation. In addition, this statement amends the disclosures in both annual and interim financial statements about the method of accounting for stock-based employee compensation and the effect of the method used on reported results. We adopted the disclosure provisions of SFAS No. 148 at December 31, 2002.

      The Financial Accounting Standards Board (“FASB”) issued Interpretation No. 46 (“FIN 46”), “Consolidation of Variable Interest Entities,” in January 2003, and a revised interpretation of FIN 46 (“FIN 46-R”) in December 2003. FIN 46 requires certain variable interest entities (“VIEs”) to be consolidated by the primary beneficiary of the entity if the equity investors in the entity do not have the characteristics of a controlling financial interest or do not have sufficient equity at risk for the entity to finance its activities without additional subordinated financial support from other parties. The provisions of FIN 46 are effective immediately for all arrangements entered into after January 31, 2003. Since January 31, 2003, we have not invested in any entities we believe are variable interest entities for which we are the primary beneficiary. For all arrangements entered into after January 31, 2003, we are required to continue to apply FIN 46 through the end of the first quarter of fiscal 2004. We are required to adopt the provisions of FIN 46-R for those arrangements in the second quarter of fiscal 2004. For arrangements entered into prior to February 1, 2003, we are required to adopt the provisions of FIN 46-R in the second quarter of fiscal 2004. We do not expect the adoption of FIN 46-R to have an impact on our financial position, results of operations or cash flows.

      In May 2003, the FASB issued SFAS No. 150, “Accounting for Certain Financial Instruments with Characteristics of both Liabilities and Equity,” which requires that certain financial instruments be presented as liabilities that were previously presented as equity or as temporary equity. Such instruments include mandatory redeemable preferred and common stock, and certain options and warrants. SFAS No. 150 is effective for financial instruments entered into or modified after May 31, 2003 and was effective at the beginning of the first interim period beginning after June 15, 2003. In November 2003, the FASB issued FASB Staff Position (“FSP”) No. 150-3, “Effective Date, Disclosures, and Transition for Mandatorily Redeemable Financial Instruments of Certain Nonpublic Entities and Certain Mandatorily Redeemable Noncontrolling Interests under SFAS No. 150,” which defers the effective date for various provisions of SFAS No. 150. We believe that we have properly classified and measured in our balance sheets and disclosed in our interim consolidated financial statements both characteristics of both liabilities and equity appropriately. While not required by SFAS No. 150, we have classified the Series A Preferred Stock as a liability rather than between total liabilities and stockholders’ equity (deficit).

      In December 2003 the SEC issued SAB 104, “Revenue Recognition.” SAB 104 updates portions of existing interpretative guidance in order to make this guidance consistent with current authoritative accounting and auditing guidance and SEC rules and regulations. The adoption of SAB 104 did not have a material effect on our consolidated financial statements.

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

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

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IMMERSION CORPORATION

INDEX TO CONSOLIDATED FINANCIAL STATEMENTS

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INDEPENDENT AUDITORS’ REPORT

      To the Board of Directors and Stockholders of Immersion Corporation:

      We have audited the accompanying consolidated balance sheets of Immersion Corporation (the “Company”) as of December 31, 2003 and 2002, and the related consolidated statements of operations, stockholders’ equity (deficit), and cash flows for each of the three years in the period ended December 31, 2003. Our audits also included the consolidated financial statement schedule listed in Item 15 (a) 2. These consolidated financial statements and the consolidated financial statement schedule are the responsibility of the Company’s management. Our responsibility is to express an opinion on the consolidated financial statements and the consolidated financial statement schedule based on our audits.

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

      In our opinion, such consolidated financial statements present fairly, in all material respects, the financial position of Immersion Corporation at December 31, 2003 and 2002, and the results of its operations and its cash flows for each of the three years in the period ended December 31, 2003 in conformity with accounting principles generally accepted in the United States of America. Also, in our opinion, such financial statement schedule, when considered in relation to the basic consolidated financial statements taken as a whole, presents fairly in all material respects the information set therein.

      As discussed in Note 5 to the consolidated financial statements, in 2002 the Company changed its method of accounting for goodwill and other intangible assets to conform to Statement of Financial Accounting Standards No. 142, “Goodwill and Other Intangible Assets.”

DELOITTE & TOUCHE LLP

San Jose, California

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IMMERSION CORPORATION

CONSOLIDATED BALANCE SHEETS