SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

Form 10-K

Commission File Number 000-31803

Transmeta Corporation

(Exact name of registrant as specified in its charter)

3990 Freedom Circle, Santa Clara, CA 95054

(Address of Principal Executive Offices, including zip code)

(408) 919-3000

(Registrant’s Telephone Number, including area code)

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

None

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

Common Stock, $0.00001 par value per share

Stock Purchase Rights

      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.     þ

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

      As of June 25, 2004, the aggregate market value of the shares of common stock held by non-affiliates of the Registrant (based on the closing price of $2.26 for the common stock as quoted by the NASDAQ National Market on that date) was approximately $351,200,603.

      As of February 28, 2005, there were 189,821,030 shares of the Registrant’s common stock, $0.00001 par value per share, outstanding. This is the only outstanding class of common stock of the Registrant.

DOCUMENTS INCORPORATED BY REFERENCE

      Portions of the Registrant’s definitive Proxy Statement for its Annual Meeting of Stockholders to be held in 2005 are incorporated by reference into Parts II and III of this report on Form 10-K.

TRANSMETA CORPORATION

FISCAL YEAR 2004 FORM 10-K

INDEX

      We were incorporated in California in March 1995 and reincorporated in Delaware in October 2000. Our principal executive offices are located at 3990 Freedom Circle, Santa Clara, California 95054, and our telephone number at that address is (408) 919-3000. Transmeta®, the Transmeta logo, Crusoe®, the Crusoe logo, Code Morphing®, LongRun®, LongRun2^tm, Efficeon^tm and AntiVirusNX^tm are trademarks of Transmeta Corporation in the United States and other countries. All other trademarks or trade names appearing in this report are the property of their respective owners.

CAUTION REGARDING FORWARD-LOOKING STATEMENTS

      This Report contains forward-looking statements that are based upon our current expectations, estimates and projections about our industry, and that reflect our beliefs and certain assumptions based upon information made available to us at the time of this Report. Words such as “anticipates,” “expects,” “intends,” “plans,” “believes,” “seeks,” “estimates,” “may,” “could,” “will” and variations of these words or similar expressions are intended to identify forward-looking statements. Such statements include, but are not limited to, statements concerning anticipated trends or developments in our business and the markets in which we operate, the competitive nature and anticipated growth of those markets, our expectations for our future performance and the market acceptance of our products, our ability to develop our licensing and services business and our future gross margins, operating expenses and need for additional capital.

      Investors are cautioned that such forward-looking statements are only predictions, which may differ materially from actual results or future events. These statements are not guarantees of future performance and are subject to risks, uncertainties and assumptions that are difficult to predict. Some of the important risk factors that may affect our business, results of operations and financial condition are set out and discussed below in the section entitled “Risks That Could Affect Future Results.” You should carefully consider those risks, in addition to the other information in this Report and in our other filings with the SEC, before deciding to invest in our company or to maintain or change your investment. Investors are cautioned not to place reliance on these forward-looking statements, which reflect management’s analysis only as of the date of this Report. We undertake no obligation to revise or update any forward-looking statement for any reason.

PART I

General

      In March 2005, as we prepare this Annual Report for our 2004 fiscal year, we are simultaneously completing our evaluation of our customers’ requirements for our products and of the economics and competitive conditions in the market for x86-compatible microprocessors. We expect to modify our business model based in part on that evaluation and to announce a related restructuring plan on or about March 31, 2005. We are also currently engaged in discussions with other companies regarding potential strategic alliances for leveraging our microprocessor design and development capabilities, and we believe that the outcome of those discussions might also affect the nature and extent of our restructuring plan.

      From Transmeta’s inception in 1995 through our fiscal year ended December 31, 2004, our business model was focused primarily on designing, developing and selling highly efficient x86-compatible software-based microprocessors. We believe that our microprocessor products deliver a compelling balance of low power consumption, high performance, low cost and small size. These advantages are valuable to a broad range of computing platforms, especially battery-operated mobile devices and applications that need high performance, low power consumption and low heat generation. Such platforms include notebook computers, ultra-personal computers, or UPCs, tablet PCs, thin clients, blade servers and embedded computers. We currently supply our products to a number of the leading companies in the computer industry, such as Fujitsu, Hewlett-Packard, and Sharp. Our products include our Crusoe® and Efficeon^tm families of microprocessors.

      Although we believe that our products deliver a compelling balance of low power consumption, high performance, low cost and small size, we have had negative cash flows and had incurred a cumulative loss aggregating $649.4 million as of December 31, 2004. Accordingly, we have focused increasingly on diversifying our business model by establishing a revenue stream based upon the licensing of certain of our intellectual property and advanced computing and semiconductor technologies developed in the course of Transmeta’s research and development programs. Since March 2004, we have entered into and announced agreements granting licenses to NEC Electronics, Fujitsu Limited and Sony Corporation to use Transmeta’s proprietary LongRun2^tm technologies for power management and transistor leakage control. Those licensing agreements include deliverable-based technology transfer fees, maintenance and service fees, and subsequent royalties on products incorporating the licensed technologies.

      In January 2005, we announced that we are critically evaluating the economics of our microprocessor product business during the first quarter of 2005 and that we intend to modify our business model in 2005 to increase our efforts to license our intellectual property and advanced technologies. We intend to continue our efforts to license our advanced power management technologies to other semiconductor companies, and we are also contemplating licensing our intellectual property and microprocessor and computing technologies to other companies in the future in order to grow our licensing and services revenue. During the first quarter of 2005, as part of our transition to a modified business model, we also began taking action to reduce our operating expenses by discontinuing certain of our products, increasing prices for our products, and changing our terms and conditions of sale, which actions we anticipate will improve the negative gross margins historically associated with our product business. We currently expect that our modified business model will further reduce our historic business focus on product sales, and that we will further reduce operating expenses associated with our product business as part of a restructuring plan, including a reduction of our workforce.

Our Product Business

      Our product business model has historically focused on designing, developing and selling x86-compatible microprocessor products, including products in both our Crusoe® and Efficeon^tm families. Unlike traditional microprocessors that are built entirely with silicon hardware, our microprocessor products utilize our innovative combination of software and hardware technology. A portion of the functionality of our microprocessors is implemented with software that allows the remaining functionality to be implemented in hardware with only a fraction of the number of logic transistors required in a conventional microprocessor. Because of this reduction in the number of logic transistors, our microprocessors consume less power and generate less heat.

      In 2004 we derived product revenue from our sales of Crusoe and Efficeon microprocessor products. In March 2005, as we prepare this Annual Report for our 2004 fiscal year, we are simultaneously completing our evaluation of our customers’ requirements for those products and of the economics and competitive conditions in the market for x86-compatible microprocessors. We have been consulting with our customers and critical suppliers in that evaluation, and we have announced to our customers that we will continue to support their critical product requirements while taking immediate steps to improve our targeted product margins and positively impact our cash flow.

      We announced our first family of microprocessor products in January 2000 under the brand name Crusoe. The Crusoe product family evolved multiple models featuring different performance levels and cost structures. Our current Crusoe models are in the TM5800 series. We introduced the TM5800 in June 2001 and began to derive revenue from TM5800 sales during the fourth quarter of 2001. Our TM5800 processors are manufactured at Taiwan Semiconductor Manufacturing Company, or TSMC, using TSMC’s 130 nanometer CMOS technology.

      During the first quarter of 2005, we have worked with our current and potential customers to take steps to improve Crusoe’s targeted product margins and to positively impact Transmeta’s cash flow. Based on these efforts, we have advised our customers that we plan to discontinue our Crusoe products during 2005. We have provided our Crusoe customers in the first quarter of 2005 an End-of-Life notice on these products and we will continue to work closely with our customers during this transition period.

      In October 2003, we introduced our second family of microprocessors, the Efficeon TM8000 series. Our first Efficeon products were originally manufactured at TSMC, using the TSMC 130 nanometer CMOS manufacturing process that has been used for our Crusoe TM5800 products. In September 2004, we began building a new version of our Efficeon processor, the TM8800 series, using a new 90 nanometer CMOS manufacturing technology at Fujitsu’s 90 nanometer foundry in Akiruno, Japan.

      During the first quarter of 2005, we have taken steps to improve the product margins for our Efficeon products and positively impact our cash flow in our product business. Based upon our review of critical customer needs, we have decided to narrow our Efficeon product line and announced to our customers in the first quarter of 2005 that certain versions of the Efficeon products will be discontinued. These efforts have in some cases resulted in substantial price increases and other favorable changes to our terms and conditions of sale. We expect to continue evaluating the business of designing, developing and selling our Efficeon processors, and we may decide to discontinue some or all of our remaining Efficeon products in 2005 as we refine our modified business model.

Our Licensing and Services Business

      We began licensing certain of our intellectual property and advanced computing and semiconductor technologies in 2003, and we expect to continue building this line of our business in the future. We have derived most of our revenue in this line of business from licensing and services agreements relating to our proprietary LongRun2 technologies for power management and transistor leakage control. Since March 2004, we have entered into and announced agreements granting such licenses to NEC Electronics, Fujitsu Limited and Sony Corporation. Those licensing agreements include deliverable-based technology transfer fees, maintenance and service fees, and subsequent royalties on products incorporating the licensed technologies. We intend to continue our efforts to license our advanced power management technologies to other semiconductor companies, and we are also contemplating licensing our intellectual property and microprocessor and computing technologies to other companies in the future in order to increase our revenue in this line of business.

Customers

      We currently sell our products to a number of the computing industry’s leaders. Based on product revenue for the year ended December 31, 2004, our top two customers were Hewlett Packard and Sharp.

      We have licensed our proprietary LongRun2 and advanced power management technologies to three companies. During the year ended December 31, 2004, we entered into such licensing agreements with NEC Electronics and Fujitsu. In January 2005 we entered into such an agreement with Sony Corporation. We continue to work with other semiconductor companies on the potential for licensing LongRun2 technologies.

Sales and Marketing

      We have traditionally sold our x86 microprocessor products directly to OEMs and through distributors, stocking representatives and manufacturers’ representatives. During the first quarter of 2005, we have evaluated changes required to align our sales and distribution network with the changes we have made or contemplate making to our microprocessor product business model. We have started to consolidate our sales and distribution network by, for example, terminating our agreements with certain distributors, stocking representatives and manufacturers’ representatives, as appropriate, to reflect such changes to our business model.

      We have traditionally employed direct sales personnel, and we currently employ direct sales personnel located in the United States, Japan, Taiwan, Korea and China. Based upon the changes that we have made or contemplate making to our microprocessor product business model, we anticipate reducing our sales and marketing activities and resources worldwide, and we expect to consolidate our direct sales personnel in the United States and in Japan in 2005.

      We also employ field applications engineers who work directly with our customers. We currently have field applications engineers working in our offices in Taiwan, China and Japan, and in two locations in the United States. Our field applications engineers assist our potential customers in selecting, integrating and tuning hardware and software system components that make up the final computer system. We also provide potential customers with reference platform designs, which we believe will enable our customers to achieve easier and faster transitions from the initial prototype designs through final production releases. We believe these reference platform designs also will enhance our targeted customers’ confidence that our products will

meet their market requirements and product introduction schedules. Based upon the changes that we have made or contemplate making to our microprocessor product business model, we anticipate reducing our field applications engineering resources in 2005.

Manufacturing

      We have traditionally used third-party manufacturers for all of our wafer fabrication. By subcontracting our manufacturing, we focus our resources on product design and eliminate the high cost of owning and operating a semiconductor fabrication facility. This fabless business model also allows us to take advantage of the research and development efforts of manufacturers, and permits us to work with those manufacturers that offer the most advanced manufacturing processes and competitive prices.

      We currently use Taiwan Semiconductor Manufacturing Company, or TSMC, to fabricate wafers for our Crusoe microprocessors. We place orders with TSMC on a purchase order basis. We do not have a manufacturing agreement with TSMC that guarantees any particular production capacity or any particular price from TSMC. TSMC may allocate capacity to other companies and reduce deliveries to us on short notice.

      We currently use Fujitsu Limited in Japan to manufacture our 90 nanometer Efficeon TM8000 products. We began volume shipments from this process in the second half of 2004. We have yet to enter into a definitive manufacturing agreement with Fujitsu, and any agreement we may enter into may not provide us with guaranteed production capacity.

      Advanced Semiconductor Engineering, or ASE, performs the initial testing of the silicon wafers that contain our microprocessors. After initial testing, ASE cuts the silicon wafers into individual semiconductors and assembles them into packages. All testing is performed on standard test equipment using proprietary test programs developed by our test engineering group. We periodically inspect the test facilities to ensure that their procedures remain consistent with those required for the assembly of our products. We generally ship our products from a third party fulfillment center in Hong Kong.

      We participate in quality and reliability monitoring through each stage of the production cycle by reviewing data from our wafer fabrication plants and assembly subcontractor. We closely monitor wafer fabrication plant production to enhance product quality and reliability and yield levels.

Competition

      The market for microprocessors is intensely competitive, is subject to rapid technological change and is currently, and has been for many years, dominated by Intel. We face intense and direct competition from Intel, and we face additional competition from Advanced Micro Devices and VIA Technologies, in the market for microprocessors. We expect to continue to face intense competition from these and other competitors in the various microprocessor markets that we target or may target in the future. We believe that competition will be intense in the future in all of the markets in which we compete and may cause price reductions, reduced gross margins and loss of market share, any one of which could significantly reduce our future revenue and increase our losses.

      We compete on the basis of a variety of factors, including:

      Many of our current and potential competitors have longer operating histories, significantly greater financial, technical, product development and marketing resources, greater name recognition, significantly greater influence and leverage in the industry and much larger customer bases than we do. We may not be able to compete effectively against current and potential competitors, especially those with significantly greater resources and market leverage.

      In marketing our microprocessors to OEMs, ODMs and distributors, we depend on third-party companies for the design and manufacture of core-logic chipsets, graphics chips, motherboards, BIOS software and other components. All of these third-party designers and manufacturers produce chipsets, motherboards, BIOS software and other components to support each new generation of Intel’s microprocessors, and Intel has significant leverage over their business opportunities.

      We also expect to face substantial competition in our licensing and services business, in which we have focused primarily on licensing our power management and transistor leakage control technologies. The development of such technologies is an emerging field subject to rapid technological change, and our competition is unknown and could increase. Our LongRun2 technologies are highly proprietary and, though the subject of patents and patents pending, are marketed primarily as trade secrets subject to strict confidentiality protocols. Although we are not aware of any other company having developed, offered or demonstrated any comparable power management or leakage control technologies, we note that most semiconductor companies have internal efforts to reduce transistor leakage and power consumption in current and future semiconductor products. Indeed, all of our current and prospective licensees are larger, technologically sophisticated companies, which generally have significant resources and internal efforts to develop their own technological solutions. We expect to compete against any emerging competition on the basis of several factors, including the following:

Intellectual Property

      Our success depends in part upon our ability to secure and maintain legal protection for the proprietary aspects of our technology and to operate without infringing the proprietary rights of others. We rely on a combination of patents, copyrights, trademarks, trade secret laws and contractual restrictions on disclosure to protect our intellectual property rights. Our intellectual property rights include numerous issued U.S. patents, with expiration dates ranging from 2012 to 2025. We also have a number of patent applications pending in the United States and in other countries. It is possible that no more patents will issue from patent applications that we have filed. Our existing patents and any additional patents that may issue may not provide sufficiently broad protection to protect our proprietary rights. We hold a number of trademarks, including Transmeta, Crusoe, Efficeon, LongRun, LongRun2, Code Morphing, and AntiVirusNX.

      Legal protections afford only limited protection for our technology. Despite our efforts to protect our proprietary rights, unauthorized parties may attempt to copy aspects of our products or to obtain and use information that we regard as proprietary. In addition, the laws of some foreign countries do not protect our proprietary rights to the same extent as do the laws of the United States. Attempts may be made to copy or reverse engineer aspects of our products or to obtain and use information that we regard as proprietary. Accordingly, we may not be able to prevent misappropriation of our technology or deter others from

developing similar technology. Furthermore, policing the unauthorized use of our products or technology is difficult. Leading companies in the semiconductor industry have extensive intellectual property portfolios relating to semiconductor technology. From time to time, third parties, including these leading companies, may assert exclusive patent, copyright, trademark and other intellectual property rights to technologies and related methods that are important to us. We have received, and may in the future receive, communications from third parties asserting patent or other intellectual property rights covering our products. There are currently no such third party claims that we believe to be material. In the future, however, litigation may be necessary to defend against claims of infringement or invalidity, to determine the validity and scope of the proprietary rights of others, to enforce our intellectual property rights, or to protect our trade secrets.

Employees

      At December 31, 2004, we employed 310 people in the United States, Japan, Taiwan, China and Korea. Of these employees, 227 were engaged in research and development, 44 were engaged in sales and marketing and 39 were engaged in general and administrative functions. None of our employees is subject to any collective bargaining agreements.

      In January 2005, we announced that we expect to announce a corporate restructuring on or about March 31, 2005. We expect that our restructuring plan will include a reduction of our workforce. In January 2005 we gave written notice to our employees, pursuant to federal and state Worker Adjustment and Retraining Notification (WARN) Acts and similar statutes applicable in other countries, that we plan to restructure our business operations and, depending upon the outcome of negotiations with third parties for strategic collaborations, we expect to conduct a mass layoff on or about March 31, 2005. We currently expect that our restructuring plan will include a reorganization of our management team and some changes in our executive officers.

      Despite the uncertainty associated with our prospective restructuring and related workforce reduction, we believe that our employee relations are good. We believe that our future success depends in part upon our continued ability to hire and retain qualified personnel.

Available Information

      We make available free of charge on or through our Internet address located at www.transmeta.com our annual report on Form 10-K, quarterly reports on Form 10-Q, current reports on Form 8-K, and amendments to those reports filed or furnished pursuant to Section 13(a) or 15(d) of the Securities Exchange Act of 1934, as amended, as soon as reasonably practicable after we electronically file that material with, or furnish it to, the Securities and Exchange Commission. Materials we file with the SEC may be read and copied at the SEC’s Public Reference Room at 450 Fifth Street, NW, Washington, D.C. 20549. This information may also be obtained by calling the SEC at 1-800-SEC-0330. The SEC also maintains an Internet website that contains reports, proxy and information statements, and other information regarding issuers that file electronically with the SEC at www.sec.gov. We will provide a copy of any of the foregoing documents to stockholders upon request.

      We lease a total of approximately 126,225 square feet of office space in Santa Clara, California, under leases expiring in June 2008. We also lease office space in Taiwan, Japan and China to support our sales and marketing personnel worldwide. As a result of our workforce reduction in the third quarter of fiscal 2002, we vacated approximately 67,730 square feet of office space in Santa Clara, California. During the fourth quarter of fiscal 2003, we reassessed our needs for office space and determined that we will use approximately 20,000 square feet of previously vacated space in 2004. We have listed the vacated excess office space with a real estate broker in an effort to secure subtenants. As of December 31, 2004, approximately 31,100 square feet of vacated office space has been subleased.

      The Company is a party to one consolidated lawsuit. Beginning in June 2001, the Company, certain of its directors and officers, and certain of the underwriters for its initial public offering were named as defendants in three putative shareholder class actions that were consolidated in and by the United States District Court for the Southern District of New York in In re Transmeta Corporation Initial Public Offering Securities Litigation, Case No. 01 CV 6492. The complaints allege that the prospectus issued in connection with the Company’s initial public offering on November 7, 2000 failed to disclose certain alleged actions by the underwriters for that offering, and alleges claims against the Company and several of its officers and directors under Sections 11 and 15 of the Securities Act of 1933, as amended, and under Sections 10(b) and Section 20(a) of the Securities Exchange Act of 1934, as amended. Similar actions have been filed against more than 300 other companies that issued stock in connection with other initial public offerings during 1999-2000. Those cases have been coordinated for pretrial purposes as In re Initial Public Offering Securities Litigation, Master File No. 21 MC 92 (SAS). In July 2002, the Company joined in a coordinated motion to dismiss filed on behalf of multiple issuers and other defendants. In February 2003, the Court granted in part and denied in part the coordinated motion to dismiss, and issued an order regarding the pleading of amended complaints. Plaintiffs subsequently proposed a settlement offer to all issuer defendants, which settlement would provide for payments by issuers’ insurance carriers if plaintiffs fail to recover a certain amount from underwriter defendants. Although the Company and the individual defendants believe that the complaints are without merit and deny any liability, but because they also wish to avoid the continuing waste of management time and expense of litigation, they accepted plaintiffs’ proposal to settle all claims that might have been brought in this action. Our insurance carriers are part of the proposed settlement, and the Company and the individual Transmeta defendants expect that their share of the global settlement will be fully funded by their director and officer liability insurance. Although the Company and the Transmeta defendants have approved the settlement in principle, it remains subject to several procedural conditions, as well as formal approval by the Court. It is possible that the parties may not reach a final written settlement agreement or that the Court may decline to approve the settlement in whole or part. In the event that the parties do not reach agreement on the final settlement, the Company and the Transmeta defendants believe that they have meritorious defenses and intend to defend any remaining action vigorously.

      Not applicable.

PART II

Market Information for Common Stock

      Our common stock began trading on the NASDAQ National Market on November 6, 2000 under the symbol “TMTA”. The following table shows the high and low sale prices reported on the NASDAQ National Market for the periods indicated. The market price of our common stock has been volatile. See “Management’s Discussion and Analysis of Financial Condition and Results of Operations — Risks That Could Affect Future Results.” On February 28, 2005, the closing price of our common stock was $1.05.

Stockholders

      As of February 28, 2005, we had approximately 593 holders of record of our common stock. This does not include the number of persons whose stock is in nominee or “streetname” accounts through brokers.

Dividends

      Transmeta has never declared or paid cash dividends on our common stock. We currently intend to retain all available funds and any future earnings to fund the development and growth of our business and do not anticipate declaring or paying any cash dividends on our common stock in the foreseeable future.

Securities Authorized For Issuance Under Equity Compensation Plans

      The information required by this item is incorporated by reference to the caption “Equity Compensation Plan Information” in our Proxy Statement for our 2004 Annual Meeting.

Recent Sales of Unregistered Securities

      During the year ended December 31, 2004, we issued and sold the following unregistered securities:

      In March 2004, we issued 9,899 shares of common stock to Aisys Corporation upon exercise of a warrant that was granted in March 1999. The exercise price of $3.00 was paid by a net exercise of the warrant through the surrender of shares issuable under the warrant.

      The sales and issuance of securities listed above were determined to be exempt from registration under Section 4(2) of the Securities Act or Regulation D promulgated under the Securities Act as transactions by an issuer not involving a public offering.

      The following table reflects selected unaudited consolidated financial information for Transmeta for the past five fiscal years. We have prepared this information using the historical audited consolidated financial statements of our company for the five years ended December 31, 2004.

      It is important that you read this selected historical financial data with the historical consolidated financial statements and related notes contained in this Report as well as the section of this Report titled “Management’s Discussion and Analysis of Financial Condition and Results of Operations.” These historical results are not necessarily indicative of results to be expected in any future period.

      NOTE: For a more complete understanding of our financial condition and results of operations, and some of the risks that could affect future results, see “Risks That Could Affect Future Results.” This section should also be read in conjunction with the Consolidated Financial Statements and related Notes, which immediately follow this section.

Overview

      In March 2005, as we prepare this Annual Report for our 2004 fiscal year, we are simultaneously completing our evaluation of our customers’ requirements for our products and of the economics and competitive conditions in the market for x86-compatible microprocessors. We expect to modify our business model based in part on that evaluation and to announce a related restructuring plan on or about March 31, 2005. We are also currently engaged in discussions with other companies regarding potential strategic alliances for leveraging our microprocessor design and development capabilities, and we believe that the outcome of those discussions might also affect the nature and extent of our restructuring plan. No assurance can be given that any of these discussions will be concluded successfully. Accordingly, the potential impact of these discussions has not been considered in the preparation of the financial statements presented with this Annual Report.

      From Transmeta’s inception in 1995 through our fiscal year ended December 31, 2004, our business model was focused primarily on designing, developing and selling highly efficient x86-compatible software-based microprocessors. Since introducing our first family of microprocessor products in January 2000, we have derived the majority of our revenue from selling our microprocessor products. Although we believe that our products deliver a compelling balance of low power consumption, high performance, low cost and small size, we have had negative cash flows and had incurred a cumulative loss aggregating $649.4 million as of December 31, 2004. Accordingly, we have diversified our business model to establish a revenue stream based upon the licensing of certain of our intellectual property and advanced computing and semiconductor technologies developed in the course of Transmeta’s research and development programs. Since March 2004, we have entered into and announced agreements granting licenses to NEC Electronics, Fujitsu Limited and Sony Corporation to use Transmeta’s proprietary LongRun2 technologies for power management and transistor leakage control. Those licensing agreements include deliverable-based technology transfer fees, maintenance and service fees, and subsequent royalties on products incorporating the licensed technologies. In January 2005, we announced that we are critically evaluating the economics of our microprocessor product business during the first quarter of 2005 and that we intend to modify our business model in 2005 to increase our efforts to license our intellectual property and advanced technologies. During the first quarter of 2005, we increased our focus on our licensing and services business and initiated actions to improve the negative gross margins associated with our product business. We currently expect that our modified business model will further reduce our historic business focus on product sales, and that we will further reduce operating expenses associated with our product business as part of a restructuring plan, including a reduction of our workforce.

      Our total revenue in fiscal 2004 was $29.4 million, compared to $17.3 million in fiscal 2003. Our total revenue increased primarily due to an increase in license and service revenue of $9.6 million, to $10.7 million in fiscal 2004 from $1.1 million in fiscal 2003. The increase in our license and service revenue can be substantially attributed to an agreement that we entered into during fiscal 2004 to license our advanced power management and transistor leakage control technologies to another company. Additionally, our product revenue increased 15.7% in fiscal 2004 compared to fiscal 2003. The increase in our product revenue can be attributed to increases in net units shipped for the Efficeon products, which was introduced in October 2003 and had a full year of sales in fiscal 2004. We expect our licensing and service revenue to increase in 2005, based on our technology licensing agreements with NEC, Fujitsu and Sony as well as other prospective activity toward our licensing of our intellectual property and proprietary technologies. We expect our product revenue to decline in 2005, based on our announced modification of our business model to focus on intellectual property and technology licensing.

      As a percent of product revenue, our product gross margin was negative 103.8% for fiscal 2004, compared to 0.3% for fiscal 2003. The decrease in our gross margin was primarily attributed to our transition to our new

90 nanometer Efficeon products, pricing pressure, lower than expected sales volumes and higher than expected manufacturing costs. Gross margin in fiscal 2004 was additionally adversely affected by higher inventory and inventory-related charges and an impairment charge on long-lived assets that are used in the manufacturing process. We have historically reported negative cash flows from operations because the gross profit, if any, generated from our product and licensing revenues has not been sufficient to cover our operational cash requirements. Our total operating expenses were $98.0 million in fiscal 2004, compared to $89.5 million in fiscal 2003. Our net loss was $106.8 million in fiscal 2004, compared to $87.6 million in fiscal 2003. The higher net loss in fiscal 2004 was primarily the result of a negative product gross margin, higher operating expenses related to the development and promotion for our Efficeon TM8000 family of microprocessors and an impairment charge on long-lived and other assets. Historically we have incurred significant losses, and as of December 31, 2004, we had an accumulated deficit of $649.4 million. We anticipate improved gross margins in 2005, based on expected growth in our licensing and service revenue, and lower negative gross margins associated with reduced product sales. We expect to reduce our overall operating expenses in 2005 based on our anticipated restructuring of our organization and operations in accordance with our modified business model.

      In January 2004, we received net proceeds of $10.2 million when our underwriters exercised their over-allotment option to purchase an additional 3.75 million shares of our common stock relating to a public offering of our common stock in December 2003. In November 2004, we received net proceeds, after expenses, of $15.4 million related to an issuance of 11.1 million shares of common stock.

      We believe that our existing cash and cash equivalents and short-term investment balances and cash from operations will be sufficient to fund our operations, planned capital and R&D expenditures for the next twelve months on the modified business model that we are currently developing and expect to announce with a related restructuring plan on or about March 31, 2005. We expect that our restructuring plan and related restructuring charge may vary depending upon the outcome of our current discussions with other companies regarding potential strategic alliances for leveraging our microprocessor design and development capabilities.

      For ease of presentation, the accompanying financial information has been shown as of December 31 for all annual financial statement captions. Fiscal year 2004 consisted of 53 weeks an ended on December 31. Fiscal years 2003 and 2002 each consisted of 52 weeks and ended on December 26 and December 27, respectively.

      On February 25, 2005, our Board of Directors resolved to change the fiscal year from one ending on the last Friday in December to a fiscal year ending the last calendar day in December. This change is not deemed a change in fiscal year for purposes of reporting subject to Rule 13a-10 or 15d-10 because our fiscal year 2005 commenced with the end of its fiscal year 2004.

Critical Accounting Policies

      The process of preparing financial statements requires the use of estimates on the part of our management. The estimates used by management are based on our historical experiences combined with management’s understanding of current facts and circumstances. Certain of our accounting policies are considered critical as they are both important to the portrayal of our financial condition and results and require significant or complex judgments on the part of management.

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

      License and Service Revenue Recognition. We enter into technology and trademark license agreements, some of which may contain multiple elements, including technology licenses and support services, or non-standard terms and conditions. As a result, interpretation on these agreements, in accordance with Emerging Issues Task Force (EITF) Issue No. 00-21, “Revenue Arrangements with Multiple Deliverables” and the Securities and Exchange Commission’s Staff Accounting Bulletin No. 104, “Revenue Recognition”, is required to determine the appropriate accounting, including whether deliverables specified in a multiple element arrangement should be treated as separate units of accounting for revenue recognition purposes, and if so, how the price should be allocated among the deliverable elements and when to recognize revenue for each element. We recognize revenue from license agreements when earned, which generally occurs when agreed-upon deliverables are provided, customer acceptance criteria has been met, or milestones are met and accepted by licensees and relative fair values of multiple elements can be determined. Additionally, license, and maintenance and service revenues are recognized if collectibility is reasonably assured and if we are not subject to any future performance obligation. Royalty revenue is recognized upon receipt of royalty payments from customers.

      Estimation of Inventory Valuations. Our inventory valuation policy stipulates that we write-down or write-off our inventory for estimated obsolescence or unmarketable inventory at the end of each reporting period. The amount of the write-down or write-off is equal to the difference between the cost of the inventory and the estimated market value of the inventory based upon reasonable assumptions about future demand and market conditions. If actual market conditions are less favorable than those projected by management, additional inventory write-downs or write-offs may be required. Conversely, if demand for estimated excess or obsolete materials exceeds our original estimates, or the sales prices for previously written down materials are higher than anticipated, our gross margins would benefit to the extent that the associated revenue exceeds the material’s adjusted value. Additionally, as we introduce product enhancements and new products, and improve our manufacturing processes, demand for our existing products in inventory may decrease. Inventory on hand in excess of forecasted demand is not valued. In computing inventory valuation adjustments as a result of lower of cost or market considerations, we review not only the inventory on hand but also inventory in the supply chain pursuant to the non-cancelable purchase orders. If we become aware of factors that indicate that inventory associated with these non-cancelable purchase orders will be sold to customers below its cost, we accrue such loss as an additional cost of revenue and as an additional accrued liability on the balance sheet. At the end of the second quarter of 2001, consistent with this policy, we recorded a charge of $28.1 million primarily to write-off certain older inventory products as a result of an actual decrease of future demand for these older products. Additionally, we made adjustments of $18.5 million and $1.5 million for fiscal 2004 and 2003, respectively. For fiscal 2004 and 2003, the Company’s gross margins included a benefit of $0.6 million and $0.5 million, respectively, resulting from the sale of previously written down inventory.

      Valuation of Long-Lived and Intangible Assets. Our policy for the valuation and impairment of long lived assets stipulates that, whenever events or changes in circumstances indicate that the carrying amount of long-lived assets may not be recoverable, we evaluate our long-lived and intangible assets for impairment. Recoverability of assets to be held and used is determined by comparing the carrying amount of an asset to the future cash flows expected to be generated by the asset. If the carrying amount of an asset exceeds the future cash flows the asset is considered to be impaired and the impairment charge recognized is measured by the amount by which the carrying amount of the asset exceeds the fair value of the asset. During the fourth quarter of 2004, consistent with this policy, we recorded an impairment charge of $4.5 million related to certain long-lived and other assets associated with our product sales. We continue to periodically evaluate our long-lived assets for impairment in accordance with SFAS 144 and acknowledge it is at least possible that such evaluation might result in future adjustments for impairment. Such an impairment might adversely affect our operating results.

      Determining the expected future cash flows requires management to make significant estimates. We base our estimates on assumptions that we believe to be reasonable but that are unpredictable and inherently uncertain. Actual future results may differ from these estimates. If these estimates or their related assumptions change in the future, it could result in lower estimated future cash flows that may not support the current carrying value of these assets, which would require us to record impairment charges for these assets.

      Restructuring Charges. In fiscal 2002, in accordance with EITF Issue No. 94-3, “Liability Recognition for Certain Employee Termination Benefits and Other Costs to Exit an Activity (including Certain Costs Incurred in a Restructuring)”, we accrued for restructuring costs when we made a commitment to a firm exit plan that specifically identified all significant actions to be taken in conjunction with our response to a change in our strategic plan, product demand, increased costs or other environmental factors. As part of the 2002 restructuring plan, we recorded restructuring charges of $10.6 million primarily related to lease costs and equipment write-offs. We recorded restructuring charges of $4.1 million related to a reduction in workforce during the third quarter of fiscal 2002. Our assumptions used in determining the estimation of restructuring expenses include the determination of the period that it will take to sublet our vacated premises, the market price that we would be able to command for the subleased space and the interest rate used to determine the present value of our future lease obligations. Any significant variation in these estimates compared to actual results may have a material impact on our restructuring expenses and our operating results. We reassess the restructuring accruals on a quarterly basis to reflect changes in the costs of the restructuring activities. The most significant variables of our accrued restructuring costs are the period that it will take to sublet our vacated premises and the market price at which we believe that we will be able to sublet our vacated facilities. For example, if it is determined that the rate for which we are able to sublease our vacated space is less than our assumed rate, our restructuring charges could significantly increase as a result. Additionally, if it takes longer than expected to sublease our vacated space, additional restructuring charges may be incurred. When reassessing our estimates, we incorporate the most recently available industry data regarding relevant occupancy and lease cost rates. We have found that these variables are often difficult to predict as there are many uncertainties related to the commercial real estate market in which we are attempting to sublet our vacated facilities. During the fourth quarter of fiscal 2003, we adjusted the balance in our accrued restructuring costs and recorded a recovery of $0.2 million of previously recorded restructuring charges. This adjustment was the result of an update in assumptions regarding the Company’s internal use of previously vacated office space, as well as the anticipated length of time before our vacated facilities are sublet to others. During the third quarter of fiscal 2004, we adjusted the balance in our accrued restructuring costs and recorded a charge of $0.9 million to restructuring charges. This adjustment was the result of an update to certain underlying assumptions regarding the sublease of our vacant facilities in future periods. The assumption had been revised such that we no longer assume that we will be able to sublease our previously vacated space that remained unused as of September 30, 2004.

      Loss Contingencies. We are subject to the possibility of various loss contingencies arising in the normal course of business. In accordance with SFAS No. 5, “Accounting for Contingencies”, we accrue for a loss contingency when it is probable that a liability has been incurred and we can reasonably estimate the amount of loss. We regularly assess current information available to determine whether changes in such accruals are required.

Description of Operating Accounts

      Total Revenue. Total revenue currently consists of product sales, net of returns and allowances, and revenue from licensing and services agreements.

      Gross Margin. Cost of revenue consists of the costs of manufacturing, assembly and testing of our silicon chips, and compensation and associated costs related to manufacturing support, logistics and quality assurance personnel. Cost of revenue may additionally include a component for adjustments to the valuation of certain inventories based on lower demand and average selling prices expected in future periods. Cost of revenue also includes the costs of providing services under the maintenance agreements with the licenses of our power management and other technologies. Gross margin is the percentage derived from dividing gross profit by product revenue. Our gross margin each quarter is affected by a number of factors, including competitive pricing, mix, foundry pricing, yields, production flow costs and speed distribution of our products.

      Research and Development. Research and development expenses consist primarily of salaries and related overhead costs associated with employees engaged in research, design and development activities for products and related technologies, as well as the cost of masks, wafers and other materials and related test services and equipment used in the development process.

      Selling, General & Administrative. Selling, general and administrative expenses consist of salaries and related overhead costs for sales, marketing and administrative personnel and legal and accounting services.

      Restructuring Charges. Restructuring charges resulted from our decision in 2002 to cease development and productization of a previous generation of microprocessors. The restructuring charges consisted primarily of lease costs, employee severance and termination costs, equipment write-offs and other costs.

      Amortization of Patents and Patent Rights. These charges primarily relate to various patents and patent rights acquired from Seiko Epson and others during fiscal 2001.

      Impairment Charge on Long-Lived and Other Assets. The impairment charge on long-lived and other assets was recorded in fiscal 2004 after the emergence of indicators of impairment in the fourth quarter of fiscal 2004 related to the expected negative operating margin related to the Company’s product sales. This led to the recording of an impairment charge for assets for which the carrying amount exceeded their fair value.

      Stock Compensation. There were two components to stock compensation expense during these periods. The first component is the amortization of deferred stock compensation associated with options granted prior to November 2000, net of cancellations. The second component is the application of variable accounting for certain stock option grants. During the fourth quarter of fiscal 2001, we did not enforce the recourse provisions of certain employee notes associated with option exercises. Therefore, we account for all other outstanding notes as if they had terms equivalent to non-recourse notes, even though the terms of these notes were not in fact changed from recourse to non-recourse. As a result, we have and will continue to record adjustments related to variable stock option accounting on the associated stock awards until the notes are paid. This variable stock compensation charge is based on the excess, if any, of the current market price of our stock as of the period-end over the purchase price of the stock award, adjusted for vesting and prior stock compensation expense recognized on the stock award.

      Interest Income and Other, Net and Interest Expense. Interest income and other, net consist of the interest income on our average cash balances over a given period of time. Interest expense is primarily based on the accretion of long-term property lease obligations related to office space that was vacated as part of our 2002 restructuring.

Results of Operations

      Our products are targeted at a broad range of computing platforms, particularly battery-operated mobile devices and applications that need high performance, low power consumption and low heat generation. Such platforms include notebook computers, ultra-personal computers, or UPCs, tablet PCs, thin clients, blade servers and embedded computers. Total revenue, which includes product and license and service revenue, for each computing market, is presented as a percentage of total revenue in the following table:

      Thin client desktop revenues increased with the ramp of Crusoe-based systems. Notebook revenues declined as our TM5800 product line matured and customers transitioned to our TM8000 Efficeon products. Tablet PC’s revenues declined as a result of a product line transition within a major customer account.

      During fiscal 2004 and fiscal 2003, we recognized $10.7 million and $1.1 million of license and service revenue, respectively, related to certain license agreements that we entered into during those years. Most of our license and service revenue in fiscal 2004 derived from our LongRun2 licensing agreement with NEC Electronics. In November 2004, we entered into a licensing agreement with Fujitsu Limited. As of December 31, 2004, we have not recognized revenue associated with this agreement, because we had not completed delivery of all the required deliverables. In January 2005, we also entered into a licensing agreement with Sony Corporation. We continue to explore additional opportunities for licensing our advanced power management technologies to other companies in the integrated circuit industry.

      We have derived the majority of our revenue from a limited number of customers. Additionally, we derive a significant portion of our revenue from customers located in Asia, which subjects us to economic cycles in that region as well as the geographic areas in which they sell their products containing our microprocessors. The following table represents our sales to customers, each of which is located in Asia, that accounted for more than 10% of total revenue for fiscals 2004, 2003 and 2002:

      Total revenue for the comparative periods is summarized in the following table:

      Fiscal 2004 Compared to Fiscal 2003. Total revenue was $29.4 million for fiscal 2004 compared to $17.3 million for fiscal 2003, representing an increase of $12.1 million, or 69.9%. License and service revenue increased $9.6 million, primarily due to the recognition of $9.0 million in technology transfer and license fees and $0.8 million in service revenue pursuant to a technology and professional services agreement executed in March 2004. Product revenue increased $2.5 million, mostly due to revenue from the Efficeon product offset by a decrease in the revenue from the TM5800 product. The Efficeon product, which began shipment in the fourth quarter of fiscal 2003 and represented less than 5% of total fiscal 2003 revenue, had a full year of sales in fiscal 2004 and represented 18.2% of total fiscal 2004 revenue. Pricing pressure on the TM5800 continued to increase as the product has matured and continues to sell into market segments and geographies, such as China and Taiwan, that traditionally demand lower average selling prices, or ASPs.

      Fiscal 2003 Compared to Fiscal 2002. Total revenue was $17.3 million for fiscal 2003 compared to $24.2 million for fiscal 2002, representing a decrease of $6.9 million, or 28.5%. Excluding the effects of a certain sale of previously written down inventory in the third quarter of fiscal 2002, this decline can be attributed to a decrease in average selling prices, or ASPs, of 36.0% from fiscal 2002 to fiscal 2003, partially

offset by an increase in unit volume of 8%. The increase in volume primarily resulted from an increase of our products into the tablet PC and thin client markets and an expansion of our international sales, particularly into China, Hong Kong and Taiwan. See “Gross Margin” section below for further discussion on the effects of decreases in ASPs and increases in volume.

      We experienced pricing pressure on the TM5800 in fiscal 2003 as the product had matured and transitioned into geographies and market segments that traditionally demand lower ASPs. We continued to manufacture the TM5800 as we have begun to migrate the processor into market segments such as the embedded, thin client, and ultra personal computer markets, from which we expect the processor to derive the majority of its future revenue. The Efficeon product was targeted at the high-volume notebook market, which traditionally demands higher ASPs. We started shipping the Efficeon product in the fourth quarter of fiscal 2003. Revenue recognized from sales of this product represented less than 5% of total fiscal 2003 revenue.

      Revenue recognized in fiscal 2003 also included license and service revenue, which was earned in connection with technology and trademark license agreements during the year. Total licensing revenue was $1.1 million for fiscal 2003. Fiscal 2002 did not include any license and service revenues.

      Our product gross margin is comprised of the components displayed in the following table, shown as a percentage of product revenue:

      Fiscal 2004 Compared to Fiscal 2003. Product gross margin was negative 103.8% for fiscal 2004 compared to 0.3% for fiscal 2003.

      As a percent of product revenue, our product costs increased 9.5 percentage points, from 80.8% in fiscal 2003 to 90.3% in fiscal 2004. We experienced higher product costs with the introduction of our 130 nanometer Efficeon TM8000 processors during the first quarter of fiscal 2004. This was followed by the introduction of and transition to our 90 nanometer Efficeon TM8800 processors during the third quarter of fiscal 2004. Our initial production costs of these new products were higher than the ongoing costs of mature products. In addition to overall higher product costs, we experienced downward pressures on our average selling prices, which is used as a component of the denominator in this calculation.

      Gross margin was also adversely affected during both periods by unabsorbed overhead costs as our production-related infrastructure exceeded our needs. For fiscal 2004, these unabsorbed costs were $1.4 million, or 7.5% of product revenue, compared to $2.1 million, or 12.8% of product revenue, for the same period in the prior year. The decrease in unabsorbed overhead costs was due to increased utilization of our manufacturing overhead as we shifted our product mix to the Efficeon TM8000, and as the volume of shipments of our Crusoe TM5800 product increased.

      In fiscal 2004, we recorded inventory-related charges of $17.4 million consisting of charges related to excess quantities and net realizable value of inventory on hand and on non-cancelable purchase orders. Of these charges, $9.0 million was for inventory on hand, primarily related to our Crusoe and 130 nanometer

Efficeon processors. The remaining $8.4 million in charges was for non-cancelable orders for substrates and wafers, primarily related to both our 130 nanometer and 90 nanometer Efficeon processors. In computing inventory valuation adjustments as a result of lower of cost or market considerations, we review the inventory on hand and inventory on order. If we become aware of factors that indicate that inventory associated with these non-cancelable purchase orders will be sold to customers below its cost, we accrue such loss as an additional cost of revenue and as an additional accrued liability on the balance sheet. The Efficeon-related charges for both inventory on hand and on order was the result of the manufacturing costs of these products exceeding the price at which we expect to be able to sell them, as well as lower than expected yields. Additionally, we believe that the initial availability of our first limited production 90 nanometer Efficeon processors in September 2004 had a greater than expected adverse effect on the demand for our 130 nanometer Efficeon microprocessors, and as a result, we recorded inventory-related charges for the 130 nanometer product on hand and on order that are in excess of our anticipated demand for that product.

      Gross margin from our 130 and 90 nanometer parts on hand and on order may have a benefit from future sales only to the extent that the associated revenue exceeds their currently adjusted values. Similarly, our gross margins could be adversely affected if the products are sold at a price lower than their currently estimated market value. The $8.4 million charge in connection with the non-cancelable orders for substrates and wafers mentioned above includes a $3.3 million charge related to a conditional purchase order for a minimum quantity of units for which mandatory yields were lower than expected for the product specification required by the customer. Consequently, we were unable to ship the minimum quantity and therefore have recorded a write down. If we are successful in our current efforts to obtain approval from the customer for a change in the product specifications such that these products will be accepted by the customer, we may record in future periods a benefit to gross margins to the extent that the revenue exceeds their adjusted values.

      In addition to the $17.4 million charges noted above, gross margin in fiscal 2004 was also additionally adversely affected by a $1.1 million charge related to non-cancelable obligations that we had made to a third party suppliers for goods and services from which we do not anticipate seeing any economic benefits.

      Of the $5.4 million and $8.8 million net inventory on hand at December 31, 2004 and December 31, 2003, respectively, $2.4 million and $2.6 million of net inventory, respectively, were adjusted to their net realizable value, which was lower than cost. Accordingly, gross margin may be impacted from future sales of these parts to the extent that the associated revenue exceeds or fails to achieve their currently adjusted values. Benefits to gross margin as a result of products being sold at ASPs in excess of their previously written down values were $0.6 million and $0.5 million for fiscal 2004 and fiscal 2003, respectively.

      During the fourth quarter of 2004, due to the emergence of indicators of impairment, we performed an assessment of our long-lived and other assets. The conclusion of the assessment was that the carrying value of certain assets was in excess of their expected future undiscounted cash flows. As a result, we recorded a $1.9 million charge in cost of revenue to write-off prepaid tools that are used in the manufacturing of our products.

      Fiscal 2003 Compared to Fiscal 2002. Product gross margin was 0.3% for fiscal 2003 compared to 29.4% for fiscal 2002. Our benefits from the sale of previously written down inventory were 2.9% and 7.8% of product revenue in fiscal 2003 and fiscal 2002, respectively. Before taking into consideration such benefits, our cost of product revenue was 102.6% of product revenue for fiscal 2003, and 78.4% of product revenue for fiscal 2002. As a percent of product revenue, our product costs increased 20.5 percentage points, from 60.3% to 80.8%, mostly as a result of a decrease in average selling prices, which is used as a component of the denominator in this calculation. Partially offsetting this decline in average selling prices was a reduced average dollar cost of products sold in fiscal 2003 as compared to fiscal 2002. The reduced average product cost is attributed to reduced costs to manufacture our Crusoe TM5800 product. Additionally, we experienced production difficulties in fiscal 2002 which increased our costs to manufacture product during that period.

      Gross margin was adversely affected during both years by unabsorbed overhead costs as our production-related infrastructure exceeded our needs. For fiscal 2003, these unabsorbed costs were $2.1 million, or 12.8% of product revenue, compared to $1.8 million, or 7.3% of product revenue, for the same period in the prior year.

      In fiscal 2003 and fiscal 2002 our gross margin was adversely affected by adjustments to our inventory valuation in response to lower demand and lower average selling prices expected in future periods for some of our products. For the year ended December 31, 2003, these adjustments totaled $1.5 million, or 9.0% of product revenue compared to $2.6 million, or 10.8% of product revenue for the same period in the prior year. Of the $8.8 million and $10.9 million of inventory on hand at December 31, 2003 and 2002, respectively, $2.6 million and $2.8 million of net inventory, respectively, were stated at net realizable value. Accordingly, gross margin may benefit from future sales of these parts to the extent that the associated revenue exceeds their currently adjusted values. In fiscal 2003, the Company’s gross margin included a benefit of $0.5 million resulting from the sale of previously written down inventory. In fiscal 2002 the Company recognized $0.7 million in gross margin related to the sale of inventory for which the value had been written down in previous periods at amounts in excess of the average selling prices used to record their lower of cost or market valuation. In fiscal 2002 we additionally recorded a benefit to gross margin sold in the amount of $1.2 million related to the reversal of previously accrued inventory-related purchase commitments due to favorable settlements of such purchase commitments.

      Fiscal 2004 Compared to Fiscal 2003. Research and development (R&D) expenses were $52.8 million for fiscal 2004 compared to $48.5 million for fiscal 2003, representing an increase of $4.3 million, or 8.9%. The increase in R&D expenses was due to increased headcount-related expenses of $2.9 million and non-recurring engineering charges of $2.8 million, partially offset by decreased depreciation expenses of $1.4 million. The increased headcount-related and engineering expenses in fiscal 2004 were primarily the result of our increased efforts devoted to the development of the 90 nanometer and 130 nanometer manufacturing technology for our Efficeon TM8000 family of microprocessors, as well as our LongRun2 power management technologies. The decreases in depreciation expenses were primarily due to certain property and equipment being fully depreciated throughout the last fiscal year. We anticipate that our research and development spending in future periods will be invested to further develop our LongRun2 power management and other computing technologies.

      Fiscal 2003 Compared to Fiscal 2002. Research and development expenses were $48.5 million for fiscal 2003 compared to $63.6 million for fiscal 2002, representing a decrease of $15.1 million, or 23.7%. The majority of the decrease for the year can be attributed to our workforce reduction in the third quarter of fiscal 2002, which resulted in lower compensation and benefit costs and consultant fees. We additionally incurred less non-recurring engineering charges in fiscal 2003, in part due to a $1.6 million charge in the second quarter of 2002 for engineering related silicon and mask sets for products that the Company ceased development. The majority of research and development spending in fiscal 2003 was for the Efficeon TM8000 family of microprocessors. We also devoted additional research and development resources towards our next generation 90 nanometer manufacturing technology as well as our LongRun2 power management technology. The remaining portion of the fiscal 2003 research and development expenditure was used for sustaining engineering efforts on our TM5800 microprocessor in fiscal 2003.

      Fiscal 2004 Compared to Fiscal 2003. Selling, general and administrative (SG&A) expenses were $30.9 million for fiscal 2004 compared to $26.2 million for fiscal 2003, representing an increase of $4.7 million, or 17.9%. The increase in SG&A expenses was due to increases in consultant and accounting expenses of $2.5 million, headcount-related expenses of $1.4 million, facilities expenses of $0.8 million, and travel and tradeshow expenses of $0.7 million. The increases in these expenses were partially offset by decreases in insurance expenses of $0.6 million and depreciation expenses of $0.6 million. The increased consultant and accounting expenses were primarily due to costs incurred in relation to efforts to comply with Section 404 “Management’s Internal Controls and Procedures for Financial Reporting” of the Sarbanes Oxley Act of 2002. The increased headcount-related expenses and travel and tradeshow expenses in fiscal 2004 were primarily the result of our continued efforts to hire additional personnel, to expand our presence in the Asia-Pacific market with new offices and to promote awareness of our Efficeon TM8000 processor. The increased

facilities expenses were primarily the result of our increased building occupancy at our offices in Santa Clara. The decrease in depreciation expenses were primarily due to certain property and equipment being fully depreciated throughout the last fiscal year. The decrease in insurance expense was primarily due to the receipt of certain refunds related to overpayment of our estimated insurance premiums.

      Fiscal 2003 Compared to Fiscal 2002. Selling, general and administrative expenses were $26.2 million for fiscal 2003 compared to $29.9 million for fiscal 2002, representing a decrease of $3.7 million, or 12.4%. A significant portion of this decrease was due to lower compensation and benefit costs, consultant fees and recruiting costs related to our reduction in workforce in the third quarter of fiscal 2002. Additionally, as a result of our 2002 restructuring charge, for fiscal 2003 we recorded lower facilities-related charges, including rent and building maintenance costs. These decreases were partly offset by increases in other areas, including higher corporate insurance costs and expenditures for patent protection of our inventions. In fiscal 2003 the primary focus of our marketing expenses was to promote the awareness of our new Efficeon TM8000 processor. In fiscal 2003, we had anticipated on increasing our selling costs as we planned to initiate a marketing alliance program specifically designed and structured to promote our customers’ products, to drive awareness, foster market opportunities, and help generate sales.

      During fiscal 2002, we recorded restructuring charges of $14.7 million. We recorded charges of $10.6 million in the second quarter of fiscal 2002 consisting primarily of lease costs, equipment write-offs and other costs as we identified a number of leased facilities and leased equipment that were no longer required. We recorded severance and termination charges of $4.1 million in the third quarter of fiscal 2002 related to the reduction in workforce. Approximately 195 employees and contractors were terminated on July 18, 2002. Other than future lease payments for our vacated facilities, the majority of our restructuring activities have been completed.

      As a result of our workforce reduction completed in the third quarter of fiscal 2002, we vacated a total of approximately 67,730 square feet of office space in Santa Clara, California. As part of our quarterly reassessment of restructuring accruals, during the fourth quarter of fiscal 2003, we adjusted the accrued restructuring balance as a result of an update in assumptions regarding our internal use of previously vacated office space, as well as the anticipated length of time before vacated facilities are sublet to others. As a result of this update, we adjusted the balance in accrued restructuring costs and recorded a benefit of $0.2 million to restructuring charges.

      During the third quarter of fiscal 2004, we adjusted our accrued restructuring costs as a result of an update to certain underlying assumptions. We had previously anticipated subleasing our vacant facilities in future periods. In view of market conditions, this assumption had been revised such that we no longer assume that we will be able to sublease our previously vacated space that remained unused as of September 30, 2004. As a result of this update in assumptions, we adjusted the accrued restructuring costs and recorded a charge of $0.9 million in restructuring charges. We may need to adjust our restructuring accruals in the future as circumstances change and as we make our quarterly reassessment. See Note 7 in the “Notes to Consolidated Financial Statements” for further discussion of our restructuring charges.

      Amortization charges for fiscal 2004, 2003 and fiscal 2002 relate to various patents and patent rights acquired from Seiko Epson and others during fiscal 2001. See Note 5 and Note 6 in the “Notes to Consolidated Financial Statements” for further discussion of our technology license agreements and patents and patent rights.

      Fiscal 2004 Compared to Fiscal 2003. Amortization of patents and patent rights was $9.2 million for fiscal 2004 compared to $10.5 million for fiscal 2003, representing a decrease of $1.3 million, or 12.4%. This decrease can be attributed to a reduction in payments due under our patents and patent rights and our technology license agreement with IBM, as amended. Amounts due under the agreements decreased $18.5 million, from $23.5 million at December 31, 2003 to $5.0 million at December 31, 2004.

      Fiscal 2003 Compared to Fiscal 2002. Amortization of patents and patent rights was $10.5 million for fiscal 2003 compared to $11.4 million for fiscal 2002, representing a decrease of $0.9 million, or 7.9%. This decrease can be attributed to a reduction in payments due under our patents and patent rights and our technology license agreement with IBM, as amended. Amounts due under the agreements decreased $16.0 million, from $39.5 million at December 31, 2002 to $23.5 million at December 31, 2003.

      During the fourth quarter of 2004, due to the emergence of indicators of impairment, we performed an assessment of our long-lived and other assets. The assessment was performed in connection with our internal policies and pursuant to SFAS 144. The conclusion of the assessment was that the carrying value of certain assets was in excess of their expected future undiscounted cash flows. As a result, we recorded a charge of $2.5 million to write-off such assets based on the amount by which the carrying amount of these assets exceeded their fair value, which was deemed to be zero and was based on the expected future discounted cash flows for the Company’s product sales. The assumptions supporting the estimated future discounted cash flows reflect management’s best estimates and may be affected by future events. The $2.5 million charge related to long-lived and other assets associated with the product business and was comprised of $1.7 million for property and equipment and $0.8 million for software maintenance prepayments.

      Fiscal 2004 Compared to Fiscal 2003. Stock compensation was $1.7 million for fiscal 2004 compared to $4.5 million for fiscal 2003, representing a decrease of $2.8 million. The two components of stock compensation were the amortization of deferred stock compensation and variable stock compensation. Net amortization of deferred stock compensation for fiscal 2004 was $0.7 million compared to $1.8 million for fiscal 2003. This decrease was primarily a result of amortizing the deferred charge on an accelerated method in accordance with our accounting policy. The amortization of the deferred stock compensation, calculated in connection with stock options granted prior to November 2000, was completed in fiscal 2004. Variable stock compensation for fiscal 2004 was $1.0 million, compared to $2.7 million for the same period last year. Variable stock compensation in fiscal 2004 is comprised of expenses of $0.5 million related to adjustments made for certain notes receivable from stockholders that had been fully paid and expenses of $0.5 million primarily related to the higher market price of our common stock at the time of repayment of notes from stockholders. The decrease in the variable stock compensation component in fiscal 2004 compared to fiscal 2003 primarily resulted from a higher repayment amount of notes from which such variable stock accounting is applied, as well as a lower market price of our stock as of December 31, 2004 compared to the same period in the prior year.

      Fiscal 2003 Compared to Fiscal 2002. Stock compensation was $4.5 million for fiscal 2003 compared to $1.8 million for fiscal 2002, representing an increase of $2.7 million. The two components of stock compensation were the amortization of deferred stock compensation and variable stock compensation. Net amortization of deferred stock compensation for fiscal 2003 was $1.8 million compared to $3.6 million for fiscal 2002. This decrease was primarily a result of amortizing the deferred charge on an accelerated method in accordance with our accounting policy, as well as a decrease in the number of outstanding options affecting the compensation charge as a result of cancellations in connection with our reduction in workforce in the third quarter of fiscal 2002. In connection with stock options granted prior to November 2000, we expect to record amortization of deferred stock compensation of $0.7 million in 2004. Variable stock compensation for fiscal 2003 was $2.7 million, compared to a credit of $1.8 million for the same period last year. This charge is based on the excess, if any, of the current market price of our stock as of the period-end over the purchase price of the stock award, adjusted for vesting and prior stock compensation expense recognized on the stock award. The increase in the variable stock compensation component primarily resulted from a higher market price of our stock as of December 31, 2003, compared to the same period in the prior year.

      Fiscal 2004 Compared to Fiscal 2003. Interest income and other, net for fiscal 2004 was $0.8 million compared to $1.4 million compared for fiscal 2003, representing a decrease of $0.6 million, or 42.9%. This decrease was due to lower average invested cash balances during fiscal 2004 as we continued to use cash to fund operations. Interest expense for fiscal 2004 was $0.1 million compared to $0.5 million for fiscal 2003, representing a decrease of $0.4 million, or 80.0%. This decrease was primarily the result of lower average debt balances due to several debt arrangements expiring during fiscal 2003.

      Fiscal 2003 Compared to Fiscal 2002. Interest income and other, net for fiscal 2003 was $1.4 million compared to $5.0 million for fiscal 2002, representing a decrease of $3.6 million, or 72.0%. This decrease was due to lower average invested cash balances during fiscal 2003 as we continued to use cash to fund operations, as well as a decrease in interest rates earned on investments during the period. Interest expense for fiscal 2003 was $0.5 million compared to $0.6 million for fiscal 2002, representing a decrease of $0.1 million, or 16.7%. This decrease was primarily the result of lower average debt balances due to several lease-financing arrangements expiring during 2002, offset by increases in certain accretion expenses related to our facilities lease commitments.

Liquidity and Capital Resources

      We have historically reported negative cash flows from our operations because the gross profit, if any, generated from our product revenues and our license and service revenues has not been sufficient to cover our operating cash requirements. From our inception in 1995 through the end of fiscal year 2004, we incurred a cumulative loss aggregating $649.4 million, which included net losses of $106.8 million in fiscal 2004, $87.6 million in fiscal 2003 and $110.0 million in fiscal 2002, which losses have reduced stockholders’ equity to $58.0 million at December 31, 2004.

      At December 31, 2004, we had $53.7 million in cash, cash equivalents and short-term investments compared to $120.8 million and $129.5 million at December 31, 2003 and December 31, 2002, respectively.

      We believe that our existing cash and cash equivalents and short-term investment balances and cash from operations would not be sufficient to fund our operations, planned capital and R&D expenditures for the next twelve months under the business model that we pursued during and through our fiscal year ended December 31, 2004, which business model was primarily focused on designing, developing and selling software-based x86-compatible microprocessor products.

      Accordingly, and as we announced publicly in January 2005, we are currently evaluating and modifying our business model and developing a related restructuring plan, and we currently expect to announce that modified business model and related restructuring plan on or about March 31, 2005. During the first quarter of 2005, we began to modify our business model to leverage our intellectual property rights and increase our business focus on licensing our advanced power management and other proprietary technologies to other companies. By increasing our focus on our licensing and service business, we hope to increase revenue from our licensing and service activities in 2005 and beyond. During the first quarter of 2005, as part of our transition to a modified business model, we also began taking action to reduce our operating expenses by discontinuing certain of our products, increasing prices for our products, and changing our terms and conditions of sale, which actions we anticipate will improve the negative gross margins historically associated with our product business. We currently expect that our modified business model will further reduce our

historic business focus on product sales, and that we will further reduce operating expenses associated with our product business as part of a restructuring plan. We expect that our restructuring plan will include a reduction of our workforce, and in January 2005 we gave written notice to our employees, pursuant to federal and state Worker Adjustment and Retraining Notification (WARN) Acts and similar statutes applicable in other countries, that we plan to restructure our business operations and to conduct a mass layoff on or about March 31, 2005. Under the currently anticipated restructuring plan, we expect to restructure our operations so as to reduce our overall operating expenses in accordance with a modified business model and, as a result, we believe that our existing cash and cash equivalents and short-term investment balances and cash from operations will be sufficient to fund our operations, planned capital and R&D expenditures for the next twelve months under the modified business model that we are currently developing and expect to announce with a related restructuring plan on or about March 31, 2005. The accompanying financial statements have been prepared assuming that we will continue as a going concern; however, the above conditions raise substantial doubt about our ability to continue as a going concern. The financial statements do not include any adjustments to reflect the possible future effects on the recoverability and classification of assets or the amounts and classifications of liabilities that may result should we be unable to continue as a going concern.

      In addition to the currently expected modifications of our business model referred to above, we are currently engaged in discussions with other companies regarding certain potential strategic alliances that could enable us to leverage our microprocessor design and development capabilities in order to raise operating capital and to improve or enhance our business in other ways. We believe that the outcome of some of those discussions might affect the nature of our restructuring plan and the extent of any related reduction in our workforce. Although it is possible that we might raise additional operating capital or create new prospects by means of one or more strategic alliances with other companies, we have no assurance that we will achieve any such strategic alliance or that any such strategic alliance, if achieved, will prove favorable for us or our business.

      To date, we have financed our operational expenses and working capital requirements primarily with funds that we raised from the sale of our common stock. Although it is possible that we might raise additional capital by means of one or more strategic alliances, or through public or private equity or debt financing, we have no assurance that any additional funds will be available on terms favorable to us or at all.

      Despite these several disclosed contingencies relating to our planned modification of our business model, we believe that our existing cash and cash equivalents and short-term investment balances and cash from operations will be sufficient to fund our operations, planned capital and R&D expenditures for the next twelve months under the modified business model that we are currently developing and expect to announce with a related restructuring plan on or about March 31, 2005.

      Net cash used in operating activities was $77.7 million for the year ended December 31, 2004, compared to $64.5 million for the year ended December 31, 2003 and $93.9 million for the year ended December 31, 2002.

      The cash usage during fiscal 2004 was primarily the result of a net loss of $106.8 million, as well as a $1.7 million cash usage related to the building leasehold cost component of our restructuring charges. This usage in cash was partially offset by the $8.8 million increase in accounts payable and accrued liabilities and the $3.4 million decrease in inventory. The net loss and changes in operating assets and liabilities were partially offset by non-cash charges related to amortization of patents and patent rights of $9.2 million, impairment charges on certain assets of $4.5 million, depreciation of $3.6 million and stock compensation of $1.7 million.

      The cash usage during fiscal 2003 was primarily the result of a net loss of $87.6 million, as well as a $2.5 million net cash drawdown of accrued restructuring charges related to building leasehold costs during the period. This usage in cash was partially offset by the $2.2 million decrease in accounts receivable and the $2.1 million decrease in inventory. The net loss and changes in operating assets and liabilities were partially

offset by non-cash charges related to amortization of patents and patent rights of $10.5 million, depreciation and amortization of $6.0 million, and amortization of deferred stock compensation of $4.5 million.

      Net cash used in investing activities was $11.3 million for the year ended December 31, 2004, compared to net cash provided by investing activities of $49.6 million for the year ended December 31, 2003 and $49.7 million for the year ended December 31, 2002.

      The change in net cash used in investing activities was primarily due to decreased net proceeds from the maturity of available for-for-sale investments, which totaled $9.5 million in fiscal 2004, compared to $66.7 million in fiscal 2003 and $70.5 million in fiscal 2002. Offsetting the net proceeds from the maturity of available-for-sale investments were payments related to the purchase of patents and patent rights and payments to our development partner, which totaled $18.5 million, $16.0 million and $15.0 million for fiscals 2004, 2003 and 2002, respectively. As of December 31, 2004, a payment to our development partner for $5.0 million remains and will be due on June 30, 2006. Additional cash used in investing activities included the purchase of property and equipment, which amounted to $2.3 million, $1.1 million and $5.6 million for fiscals 2004, 2003 and 2002, respectively. Capital equipment purchases increased in fiscal 2004 compared to fiscal 2003 as we invested in our next generation 90 nanometer manufacturing technology and further developed our LongRun2 power management technology.

      Net cash provided by financing activities was $31.5 million for the year ended December 31, 2004, compared to $73.1 million for the year ended December 31, 2003 and $3.1 million for the year ended December 31, 2002.

      Cash provided by financing activities in fiscal 2004 was primarily due to net proceeds from the public offering of common stock. In January 2004, we received $10.2 million when our underwriters exercised their over-allotment option in relation to our December 2003 common stock offering and purchased 3.75 million shares of our common stock. We also received $15.4 million in November 2004 when we completed a public offering of 11.1 million shares of common stock. This compares to $67.5 million in net proceeds received in fiscal 2003 related to the issuance of 25.0 million shares of common stock in December 2003. Additionally, we received $5.3 million in net proceeds from sales of common stock under our employee stock purchase and stock option plans for fiscal 2004, compared to $6.1 million for fiscal 2003 and $4.2 million for fiscal 2002.

      These proceeds from stock issuances were partially offset by payments for debt and capital lease obligations of $0.4 million for fiscal 2004, compared to $0.7 million for fiscal 2003 and $2.7 million for fiscal 2002. The decrease in payments for debt and capital lease obligations was primarily the result of the expiration of these leases in fiscals 2002 and 2003.

      Since our inception, we have financed our operations primarily through sales of equity securities and, to a lesser extent, from lease financing. It is reasonably possible that we may continue to seek financing through these sources of capital as well as other types of financing, including but not limited to debt financing. Additional financing might not be available on terms favorable to us, or at all.

      At December 31, 2004, we had $17.3 million in cash and cash equivalents and $36.4 million in short-term investments. We lease our facilities under non-cancelable operating leases expiring in 2008, and we lease equipment and software under non-cancelable leases with terms ranging from 12 to 36 months.

      As part of our 2002 restructuring plan, we recorded charges primarily for excess facilities costs for which we expect cash expenditures of approximately $5.8 million through June 2008. Of this amount, $5.2 million was recorded on our consolidated balance sheets at December 31, 2004 and $0.6 million will be expensed as interest expense in future periods as the costs are incurred or the requirements to record the costs as a liability

are met. See Note 7 in the “Notes to Consolidated Financial Statements” for further discussion of our restructuring charges.

      At December 31, 2004, we had the following contractual obligations:

      As part of our ongoing business, we do not participate in transactions that generate relationships with unconsolidated entities or financial partnerships, such as entities often referred to as structured finance or special purpose entities (“SPEs”), which would have been established for the purpose of facilitating off-balance sheet arrangements or other contractually narrow or limited purposes. As of December 31, 2004, we are not involved in SPE transactions.

Recent Accounting Pronouncements

      In March 2004, the Financial Accounting Standards Board (FASB) approved the consensus reached on the Emerging Issues Task Force (EITF) Issue No. 03-1, “The Meaning of Other-Than-Temporary Impairment and Its Application to Certain Investments.” EITF 03-1 provides guidance for identifying other-than-temporarily impaired investments. EITF 03-1 also provides new disclosure requirements for investments that are deemed to be temporarily impaired. In September 2004, the FASB issued a FASB Staff Position (FSP) EITF 03-1-1 that delays the effective date of the measurement and recognition guidance in EITF 03-1 until further notice. Once the FASB reaches a final decision on the measurement and recognition provisions, we will evaluate the impact of the adoption of the accounting provisions of EITF 03-1.

      In November 2004, the FASB issued Statement of Financial Accounting Standards (SFAS) 151, “Inventory Costs, an amendment of ARB No. 43, Chapter 4.” SFAS 151 amends ARB No. 43, Chapter 4, to clarify that abnormal amounts of idle facility expense, freight, handling costs and wasted materials (spoilage) should be recognized as current period charges. Additionally, SFAS 151 requires that the allocation of fixed production overheads to the costs of conversion be based on the normal capacity of the production facilities. SFAS 151 is effective for fiscal years beginning after June 15, 2005. The adoption of this pronouncement is not expected to have a material impact on our statements of operations.

      In December 2004, the FASB issued SFAS 123(R), “Share-Based Payment.” SFAS 123(R) requires employee stock options and rights to purchase shares under stock participation plans to be accounted for under the fair value method, and eliminates the ability to account for these instruments under the intrinsic value method prescribed by APB Opinion No. 25, and allowed under the original provisions of SFAS 123. SFAS 123(R) requires the use of an option pricing model for estimating fair value, which is amortized to expense over the service periods. The requirements of SFAS 123(R) are effective for fiscal periods beginning

after June 15, 2005. SFAS 123(R) allows for either prospective recognition of compensation expense or retrospective recognition, which may be back to the original issuance of SFAS 123 or only to interim periods in the year of adoption. We are currently evaluating the impact of the adoption of SFAS 123(R).

      In December 2004, the FASB issued SFAS No. 153, “Exchanges of Nonmonetary Assets, an amendment of APB Opinion No. 29.” SFAS 153 amends APB Opinion No. 29 to eliminate the exception for nonmonetary exchanges of similar productive assets and replaces it with a general exception for exchanges of nonmonetary assets that do not have commercial substance. A nonmonetary exchange has commercial substance if the future cash flows of the entity are expected to change significantly as a result of the exchange. The Company is required to adopt SFAS 153, on a prospective basis, for nonmonetary exchanges beginning after June 15, 2005. The adoption of SFAS No. 153 is not expected to have an impact on our consolidated result of operations.

Risks that Could Affect Future Results

      The factors discussed below are cautionary statements that identify important risk factors that could cause actual results to differ materially from those anticipated in the forward-looking statements in this Form 10-K. If any of the following risks actually occurs, our business, financial condition and results of operations would suffer. In this case, the trading price of our common stock could decline and investors might lose all or part of their investment in our common stock.

We have a history of losses, expect to incur further significant losses and must develop and successfully execute on a modified business model and restructuring plan if we are to sustain our operations.

      We have historically reported negative cash flows from operations because the gross profit, if any, generated from our product revenue and our licensing and service revenue has not been sufficient to cover our operating cash requirements. From our inception through the end of fiscal 2004, we have incurred a cumulative loss aggregating $649.4 million, which includes net losses of $106.8 million in fiscal 2004, $87.6 million in fiscal 2003 and $110.0 million in fiscal 2002, which losses have reduced stockholders’ equity to $58.0 million at December 31, 2004.

      At the end of 2004 we determined that our existing cash and cash equivalents and short-term investment balances and cash from operations would not be sufficient to fund our operations, planned capital and R&D expenditures for the next twelve months under the business model that we pursued during and through the end of 2004, which business model was primarily focused on designing, developing and selling software-based x86-compatible microprocessor products. See “Management’s Discussion and Analysis of Financial Condition and Results of Operations — Liquidity and Capital Resources.” Accordingly, we undertook a critical evaluation of our customers’ requirements for our products and of the economics and competitive conditions in the market for x86-compatible microprocessors, and we announced that we expected to modify our business model based in part on that evaluation and to announce a related restructuring plan on or about March 31, 2005. Although the nature and extent of our restructuring plan may vary depending upon the resolution of pending discussions with other companies regarding potential strategic alliances for leveraging our microprocessor design and development capabilities, we must in any case develop and begin executing on a modified business model in order to permit us to continue to operate for a period that extends at least through December 31, 2005.

We have announced that we are modifying our business model in 2005. We may fail to develop a viable new business model and restructuring plan, and we might fail to execute our restructuring plan or to operate successfully under our modified business model.

      In January 2005 we announced our intent to modify our business model during 2005, for example, by leveraging our intellectual property assets and by focusing on our strategy of licensing our advanced power management and other technologies to other companies. Any modification of our business model entails significant risks and costs, and even if we define a viable new business model, we might not succeed in operating within that model or under our restructuring plan for many reasons. These reasons include the risks that we might not be able to develop viable products or technologies, achieve market acceptance for our

products or technologies, earn adequate revenues from the sale of our products or from our licensing and services business, or achieve profitability. Employee concern about changes in our business model or the effect of such changes on their workloads or continued employment might cause our employees to seek or accept other employment, depriving us of the human and intellectual capital that we need in order to succeed. Because we necessarily lack historical operating and financial results for any modified business model, it will be difficult for us, as well as for investors, to predict or evaluate our business prospects and performance. Our business prospects would need to be considered in light of the uncertainties and difficulties frequently encountered by companies undergoing a business transition or in the early stages of development. The modification of our business model might also create uncertainties and cause our stock price to fall and impair our ability to raise additional capital.

Our anticipated restructuring plan and related reductions in our workforce may adversely affect the morale and performance of our personnel, the rate of attrition among our personnel, our ability to hire new personnel and our ability to conduct our business operations.

      As part of our effort to reduce operating expenses under our modified business model, we expect to announce a financial restructuring and related reduction in our workforce on or about March 31, 2005. Our restructuring plan may include the termination of employment of some or substantially all of our employees and contractors. We currently expect that our restructuring plan will include a reorganization of our management team and some changes in our executive officers. We also expect that our restructuring plan and any related workforce reduction will cause us to incur substantial costs related to severance and other employee-related costs. Our workforce reduction may also subject us to litigation risks and expenses. In addition, our restructuring plan may yield unanticipated consequences, such as attrition beyond our planned reduction in workforce. As a result of these reductions, our ability to respond to unexpected challenges may be impaired and we may be unable to take advantage of new opportunities. In addition, some of the employees who were terminated had specific and valuable knowledge or expertise, the loss of which may adversely affect our operations. Further, the reduction in force may reduce employee morale and may create concern among existing employees about job security, which may lead to increased attrition or turnover. As a result of these factors, our remaining personnel may decide to seek other employment, including opportunities with more established companies or with smaller, private companies, and we may have difficulty attracting new personnel that we might wish to hire in the future.

We might not be able to execute on our modified business model and restructuring plan if we lose key management or technical personnel, on whose knowledge, leadership and technical expertise we rely.

      Our success under our modified business model and restructuring plan will depend heavily upon the contributions of our key management and technical personnel, whose knowledge, leadership and technical expertise would be difficult to replace. Many of these individuals have been with us for several years and have developed specialized knowledge and skills relating to our technology and lines of business. We have recently lost some of our executive management. For instance, Ray Holzworth, our Vice President of Operations since August 2002, left the Company in February 2005. Others have joined us in key management roles only recently. In September 2004, Mark R. Kent joined us as our Chief Financial Officer. All of our executive officers and key personnel are employees at will. We have no employment contracts and do not maintain key person insurance on any of our personnel. We might not be able to execute on our modified business model or restructuring plan if we were to lose the services of any of our key personnel. If any of these individuals were to leave our company unexpectedly, we could face substantial difficulty in hiring qualified successors and could experience a loss in productivity while any such successor develops the necessary training and experience.

We may not be able to raise any more financing, or financing may only be available on terms unfavorable to us or our stockholders.

      Although we believe that our existing cash and cash equivalents and short-term investment balances and cash from operations will be sufficient to fund our operations, planned capital and R&D expenditures for the next twelve months under the modified business model that we are currently developing and expect to

announce with a related restructuring plan on or about March 31, 2005, it is possible that we may need to raise significant additional funds through public or private equity or debt financing in order to continue operations under our modified business model. Further, as we continue to develop new technologies or to enhance our products or service competencies in accordance with our modified business model, we might require more cash to fund our operations. In addition, we may begin to generate positive cash flow from operations later than anticipated or we may never generate positive cash flow from operations. A variety of other business contingencies could contribute to our need for funds in the future, including the need to:

      If we were to raise additional funds through the issuance of equity or convertible debt securities, the percentage ownership of our stockholders would be reduced, and these newly issued securities might have rights, preferences or privileges senior to those of our then-existing stockholders. For example, in order to raise equity financing, we may decide to sell our stock at a discount to our then current trading price, which may have an adverse effect on our future trading price. Additional financing might not be available on terms favorable to us, or at all. If we are unable to raise additional funds or to sustain our operations on a modified business model in the future, then substantial doubt may develop as to our ability to continue to operate our business as a going concern, with substantial adverse effects on the value of our common stock and our ability to raise additional capital. This uncertainty may also create concerns among our current and future customers, vendors and licensees as to whether we will be able to fulfill our obligations or, in the case of customers, fulfill their future product or service needs. As a result, our current and prospective customers, licensees and strategic partners might decide not to do business with us, or only do so on less favorable terms and conditions. Employee concern about the future of the business and their continued prospects for employment may cause employees to seek employment elsewhere, depriving us of the human and intellectual capital we need to be successful.

Our product revenue and our product business may be negatively impacted by modifications to our business model that we have recently implemented or are contemplating.

      During the first quarter of 2005, as part of our transition to a modified business model, we began taking action to reduce our operating expenses by discontinuing certain of our products, increasing prices for our products, and changing our terms and conditions of sale, which actions we anticipate will improve the negative gross margins historically associated with our product business. Accordingly, we have advised our customers that we plan to discontinue production of our Crusoe products during 2005. We have provided our Crusoe customers an End-of-Life notice and we will continue to work closely with our customers during this transition period. Based upon our review of critical customer needs, we have also decided to narrow our Efficeon product line and announced to our customers that certain versions of the Efficeon products will be discontinued. We currently expect that our modified business model will further reduce our historic business focus on product sales, and that we will further reduce operating expenses associated with our product business as part of a restructuring plan, including a reduction of our workforce. The actions that we have taken or contemplate taking likely will result in lost sales as target customers design a competitor’s microprocessor into their product, to replace our own microprocessors. We expect to continue evaluating the business of designing, developing and selling our Efficeon processors, and we may decide to discontinue some or all of our remaining Efficeon products in 2005 as we refine our modified business model.

The success of our licensing and service business depends on maintaining and increasing our LongRun2 licensing revenue.

      Our licensing and service revenue was $10.7 million in fiscal year 2004 and $1.1 million in fiscal year 2003. In 2005, our licensing and service revenue will depend upon revenue that we receive from existing licensing agreements and our entering into new licensing agreements. Our ability to enter into new LongRun2 licensing agreements depends in part upon the adoption of our LongRun2 technology by our licensees and potential licensees and the success of the products incorporating our technology sold by licensees. While we anticipate that we will continue our efforts to license our technology to licensees, we cannot predict the timing or the extent of any future licensing revenue, and recent levels of license revenues may not be indicative of future periods.

We have limited visibility regarding when and to what extent our licensees will use our LongRun2 or other licensed technologies.

      We have not yet earned or received any royalties under any of our LongRun2 licensees. Our receipt of royalties from our LongRun2 licenses depends on our licensees incorporating our technology into their manufacturing and products, their bringing their products to market, and the success of their products. Our licensees are not contractually obligated to manufacture, distribute or sell products using our licensed technologies. Thus, our entry into and our full performance of our obligations under our LongRun2 licensing agreements does not necessarily assure us of any future royalty revenue. Any royalties that we are eligible to receive are based upon our licensees’ use of our licensed technologies and, as a result, we do not have direct access to information that would enable us to forecast the timing and amount of any future royalties. Factors that negatively affect our licensees and their customers could adversely affect our future royalties. The success of our licensees is subject to a number of factors, including:

Because we do not control the business practices of our licensees and their customers, we have little influence on the degree to which our licensees promote our technology.

Our licensing and services revenue cycle is long and unpredictable, which makes it difficult to predict future revenues, which may cause us to miss analysts’ estimates and may result in unexpected changes in our stock price.

      It is difficult to predict accurately our future revenues from either the granting of new licenses or the generation of royalties by our licensees under our existing licenses. In addition, engineering services are dependent upon the varying level of assistance desired by licensees and, therefore, revenue from these services is also difficult to predict. There can be no assurance that we can accurately estimate the amount of resources required to complete projects, or that we will have, or be able to expend, sufficient resources required to complete a project. Furthermore, there can be no assurance that the development schedules of our licensees will not be changed or delayed. Our licensees are not obligated to continue using our licensed technology or to use future generations of our technologies in future manufacturing processes, and therefore our past contract revenue may not be indicative of the amount of such revenue in any future period. All of these factors make it difficult to predict future licensing and service revenue, which may result in us missing analysts’ estimates and may cause unexpected changes in our stock price.

We could encounter a variety of technical and manufacturing problems that could delay or prevent us from satisfying customer demand for Efficeon TM8000 series microprocessors manufactured using a 90 nanometer process.

      We are using Fujitsu Limited to manufacture our 90 nanometer Efficeon TM8000 series microprocessors. Manufacturing on an advanced 90 nanometer CMOS process involves a variety of technical and manufacturing challenges. Fujitsu Limited has limited experience with the 90 nanometer CMOS process and, although we have achieved production of our Efficeon TM8800 product on the Fujitsu Limited 90 nanometer CMOS process, we cannot be sure that Fujitsu Limited’s 90 nanometer foundry will achieve production shipments on our planned schedule or that other manufacturing challenges might later arise. For example, during 2001 and again in 2004, we experienced yield problems as we migrated our products to smaller geometries, which caused increases in our product costs, delays in product availability and diversion of engineering personnel. If we encounter problems with the manufacture of the Efficeon TM8000 series microprocessors using the 90 nanometer process that are more significant or take longer to resolve than we anticipate, our ability to fulfill our customer demand would suffer and we could incur significant expenses.

Our restructuring plan will very likely reduce our resources and ability to pursue opportunities and support customers in emerging markets for our microprocessor products.

      We currently expect that our modification of our business model will further reduce our historical business focus on product sales, and that we will further reduce operating expenses associated with our product business as part of a restructuring plan, including a reduction of our workforce. Our restructuring plan will likely substantially limit our resources and ability to pursue opportunities in emerging markets for which our products are suited, including new classes of computing devices such as UPCs and other unique PC form factors, which require newly developed technologies, extensive development time, and marketing support.

We face intense competition in the x86-compatible microprocessor and power management markets. Many of our competitors are much larger than we are and have significantly greater resources. We may not be able to compete effectively.

      The market for microprocessors is intensely competitive. We may not be able to compete effectively against current and potential competitors, especially those with significantly greater resources and market leverage. Competition may cause price reductions, reduced gross margins and loss of market share, any one of which could significantly reduce our future revenue and increase our losses. For example, we may determine to lower the prices of our products in order to increase or maintain market share, which would likely increase our losses.

      Significant competitors in the x86-compatible microprocessor product market include Intel, Advanced Micro Devices and VIA Technologies. Our current and potential competitors have longer operating histories, significantly greater financial, technical, product development and marketing resources, greater name recognition and significantly larger customer bases than we do. Our competitors may be able to develop products comparable or superior to those we offer, adapt more quickly than we do to new technologies, evolving industry trends and customer requirements, and devote greater resources to the development, promotion and sale of their products than we can. Many of our competitors also have well-established relationships with our existing and prospective customers and suppliers. As a result of these factors, many of our competitors, either alone or with other companies, have significant influence in our target markets that could outweigh any advantage that we may possess. For example, negotiating and maintaining favorable customer and strategic relationships are and will continue to be critical to our business. If our competitors use their influence to negotiate strategic relationships on more favorable terms than we are able to negotiate, or if they structure relationships that impair our ability to form strategic relationships, our competitive position and our business would be substantially damaged.

      In particular, Intel has dominated the market for x86-compatible microprocessors for many years. We may be adversely affected by Intel’s pricing decisions, product mix and introduction schedules, marketing strategies and influence over industry standards and other market participants and the loyalty of consumers to

the Intel brand. We cannot be sure that we can compete effectively against Intel even in the market segments that we intend to target.

      In 2003, Intel introduced a new microprocessor that is focused on the notebook computer market segment and designed to consume less power than its prior microprocessors. We expect that Intel, and potentially other microprocessor companies, will increasingly seek to offer microprocessors specifically targeted at many of the same market segments that we have served and intend to serve, which could adversely affect our ability to compete successfully.

      Furthermore, our competitors may merge or form strategic relationships that might enable them to offer, or bring to market earlier, products that are superior to ours in terms of features, quality, pricing or other factors. We expect additional competition from other established and emerging companies and technologies.

      We also expect to face substantial competition in our licensing and services business, in which we have focused primarily on licensing our power management and transistor leakage control technologies. The development of such technologies is an emerging field subject to rapid technological change, and our competition is unknown and could increase. Our LongRun2 technologies are highly proprietary and, though the subject of patents and patents pending, are marketed primarily as trade secrets subject to strict confidentiality protocols. Although we are not aware of any other company having developed, offered or demonstrated any comparable power management or leakage control technologies, we note that most semiconductor companies have internal efforts to reduce transistor leakage and power consumption in current and future semiconductor products. Indeed, all of our current and prospective licensees are larger, technologically sophisticated companies, which generally have significant resources and internal efforts to develop their own technological solutions.

We may experience manufacturing difficulties that could increase the cost and reduce the supply of our products.

      The fabrication of wafers for our microprocessors is a highly complex and precise process that requires production in a tightly controlled, clean room environment. Minute impurities, difficulties in the fabrication process, defects in the masks used to print circuits on a wafer or other factors can cause numerous die on each wafer to be nonfunctional. The proportion of functional die expressed as a percentage of total die on a wafer is referred to as product “yield.” Semiconductor companies frequently encounter difficulties in achieving expected product yields, particularly when introducing new products. Yield problems may not be identified and resolved until a product has been manufactured and can be analyzed and tested, if ever. As a result, yield problems are often difficult, time-consuming and expensive to correct. We have experienced yield problems in the past, and we may experience yield problems in the future that impair our ability to deliver our products to our customers, increase our costs, adversely affect our margins and divert the efforts of our engineering personnel. Difficulties in achieving the desired yields often occur in the early stages of production of a new product or in the migration of manufacturing processes to smaller geometries. We could experience difficulties in achieving desired yields or other manufacturing problems in the production of our Efficeon TM8000 series products that could delay our ability to deliver Efficeon TM8000 series products, adversely affect our costs and gross margins and harm our reputation. Even with functional die, normal variations in wafer fabrication can cause some die to run faster than others. Variations in speed yield could lead to excess inventory of the slower, less valuable die, a resulting unfavorable impact on gross margins and an insufficient inventory of faster products, depending upon customer demand.

Our lengthy and variable product sales cycles make it difficult for us to predict when and if a design win will result in volume shipments.

      We depend upon other companies designing our microprocessors into their products, which we refer to as design wins. Many of our targeted customers consider the choice of a microprocessor to be a strategic decision. Thus our targeted customers may take a long time to evaluate our products, and many individuals may be involved in the evaluation process. We anticipate that the length of time between our initial contact with a customer and the time when we recognize revenue from that customer will vary. We expect our sales cycles to

range typically from six to 12 months, or more, from the time we achieve a design win to the time the customer begins volume production of products that incorporate our microprocessors. We do not have historical experience selling our products that is sufficient for us to determine accurately how our sales cycles will affect the timing of our revenue. Variations in the length of our sales cycles could cause our revenue to fluctuate widely from period to period. While potential customers are evaluating our products and before they place an order with us, we may incur sales and marketing expenses and expend significant management and engineering resources without any assurance of success. The value of any design win depends upon the commercial success of our customers’ products. If our customers cancel projects or change product plans, we could lose anticipated sales. We can offer no assurance that we will achieve further design wins or that the products for which we achieve design wins will ultimately be introduced or will, if introduced, be commercially successful.

If we fail to forecast demand for our products accurately, we could lose sales and incur inventory losses.

      The demand for our products depends upon many factors and is difficult to forecast. Many shipments of our products may be made near the end of the fiscal quarter, which makes it difficult to estimate demand for our products. Significant unanticipated fluctuations in demand have caused, and in the future could cause, problems in our operations. The lead-time required to fabricate large volumes of wafers is often longer than the lead-time our customers provide to us for delivery of their product requirements. As a result, we have only a limited ability to react to fluctuations in demand for our products, which could cause us to have either too much or too little inventory of a particular product. If demand does not develop as we expect, we could have excess production. Excess production would result in excess inventories of product, which would use cash and could result in inventory write-downs and write-offs. For example, we recorded a $6.8 million inventory-related charge for the third quarter of fiscal 2004. We have limited capability to reduce ongoing production once wafer fabrication has commenced. Conversely, if demand exceeds our expectations, Taiwan Semiconductor Manufacturing Company, or TSMC, or Fujitsu Limited might not be able to fabricate wafers as quickly as we need them. Also, Advanced Semiconductor Engineering, or ASE, might not be able to increase assembly functions in a timely manner. In that event, we would need to increase production and assembly rapidly or find, qualify and begin production and assembly at additional manufacturers or providers of assembly and test services, which may not be possible within a time frame acceptable to our customers. The inability of our product manufacturer or ASE to increase production rapidly enough could cause us to fail to meet customer demand. In addition, rapid increases in production levels to meet unanticipated demand could result in higher costs for manufacturing and other expenses. These higher costs could lower our gross margins.

We currently derive a substantial portion of our product revenue from a small number of customers, and our revenue would decline significantly if any major customer were to cancel, reduce or delay a purchase of our products.

      Our customer base for product sales is highly concentrated. For example, sales to three customers in the aggregate accounted for 72% of total revenue in fiscal 2004. We expect that a small number of customers will continue to account for a significant portion of our revenue. Our future revenue will depend upon the timing and size of future purchase orders, if any, from these customers and new customers and, among other things, the success of our customers in marketing products that incorporate our products, the product requirements of our customers; and the financial and operational success of our customers.

      We expect that our sales to OEM customers will continue to be made on the basis of purchase orders rather than long-term commitments. Many of our customers and potential customers are significantly larger than we are and have sufficient bargaining power to demand changes in terms and conditions of sale. The loss of any major customer, or the delay of significant orders from these customers, could reduce or delay our recognition of revenue.

If our customers are not able to obtain the other components necessary to build their systems, sales of our products could be delayed or cancelled.

      Suppliers of other components incorporated into our customers’ systems may experience shortages, which could reduce the demand for our products. For example, from time to time, the computer and semiconductor industries have experienced shortages of some materials and devices, such as memory components, displays, and storage devices. Our customers could defer or cancel purchases of our products if they are not able to obtain the other components necessary to build their systems.

We rely on an independent foundry that has no obligation to provide us with fixed pricing or production capacity for the fabrication of our wafers, and our business will suffer if we are unable to obtain sufficient production capacity on favorable terms.

      We do not have our own manufacturing facilities and, therefore, must rely on third parties to manufacture our products. We currently rely on TSMC in Taiwan to fabricate the wafers for our current 130 nanometer products, and we rely on Fujitsu Limited in Japan to manufacture our 90 nanometer Efficeon TM8000 series products. We do not have manufacturing contracts with TSMC or Fujitsu Limited, and therefore we cannot be assured that we will have any guaranteed production capacity. These foundries may allocate capacity to other companies’ products while reducing the capacity available to us on short notice. Foundry customers that are larger than we and have greater economic resources, that have long-term agreements with these foundries or that purchase in significantly larger volumes than we may cause these foundries to reallocate capacity to them, decreasing the capacity available to us. In addition, these foundries could, with little or no notice, refuse to continue to fabricate all or some of the wafers that we require. If these foundries were to stop manufacturing for us, we would likely be unable to replace the lost capacity in a timely manner. Transferring to another manufacturer would require a significant amount of time and money. As a result, we could lose potential sales and fail to meet existing obligations to our customers. These foundries could also, with little or no notice, change the terms under which they manufacture for us, which could cause our manufacturing costs to increase substantially.

Our reliance on TSMC and Fujitsu Limited to fabricate our wafers limits our ability to control the production, supply and delivery of our products.

      Our reliance on third-party manufacturers exposes us to a number of risks outside our control, including the following:

We depend on ASE to provide assembly and test services. If ASE were to cease providing services to us in a timely manner and on acceptable terms, our business would suffer.

      We rely on ASE, which is located in Taiwan, for the majority of our assembly and test services. We do not have a contract with ASE for test and assembly services, and we typically procure these services from ASE on a per order basis. ASE could cease to perform all of the services that we require, or could change the terms upon which it performs services for us. If we were required to find and qualify alternative assembly or testing services, we could experience delays in product shipments, increased product costs or a decline in product quality. In addition, as a result of our reliance on ASE, we do not directly control our product delivery schedules. If ASE were not to provide high quality services in a timely manner, our costs could increase, we could experience delays in the delivery of our products and our product quality could suffer.

If our products are not compatible with industry standards, hardware that our customers design into their systems or that is used by end-users or software applications or operating systems for x86-compatible microprocessors, market acceptance of our products and our ability to maintain or increase our revenues would suffer.

      Our products are designed to function as components of a system. If our customers experience system-level incompatibilities between our products and the other components in their systems, we could be required to modify our products to overcome the incompatibilities or delay shipment of our products until the manufacturers of other components modify their products or until our customers select other components. These events would delay purchases of our products, cause orders for our products to be cancelled or result in product returns.

      In addition, to gain and maintain market acceptance, our microprocessors must not have significant incompatibilities with software for x86-compatible microprocessors, and in particular, the Windows operating systems, or hardware used by end-users. Software applications, games or operating systems with machine-specific routines programmed into them can result in specific incompatibilities. If a particular software application, game or operating system is programmed in a manner that makes it unable to respond correctly to our microprocessor, it will appear to users of that software that our microprocessor is not compatible with that software. Software or hardware incompatibilities that are significant or are perceived to be significant could hinder our products from achieving or maintaining market acceptance and impair our ability to increase our revenues.

      In an effort to test and ensure the compatibility of our products with hardware and software for x86-compatible microprocessors, we rely on the cooperation of third-party hardware and software companies, including manufacturers of graphics chips, motherboards, BIOS software and other components. All of these third-party designers and manufacturers produce chipsets, motherboards, BIOS software and other components to support each new generation of Intel’s microprocessors, and Intel has significant leverage over their business opportunities. If these third parties were to cease supporting our microprocessor products, our business would suffer.

Our products may have defects that could damage our reputation, decrease market acceptance of our products, cause us to lose customers and revenue and result in liability to us.

      Highly complex products such as our microprocessors may contain hardware or software defects or bugs for many reasons, including design issues or defective materials or manufacturing processes. Often, these defects and bugs are not detected until after the products have been shipped. If any of our products contains defects, or has reliability, quality or compatibility problems, our reputation might be damaged significantly and customers might be reluctant to buy our products, which could result in the loss of or failure to attract customers. In addition, these defects could interrupt or delay sales. We may have to invest significant capital and other resources to correct these problems. If any of these problems is not found until after we have commenced commercial production of a new product, we might incur substantial additional development costs. If we fail to provide solutions to the problems, such as software patches, we could also incur product recall, repair or replacement costs. These problems might also result in claims against us by our customers or others. In addition, these problems might divert our technical and other resources from other development efforts. Moreover, we would likely lose, or experience a delay in, market acceptance of the affected product or products, and we could lose credibility with our current and prospective customers. This is particularly significant as we are a new entrant to a market dominated by large well-established companies.

If we fail to meet the continued listing requirements of the NASDAQ Stock Market, our common stock could be delisted, which would reduce the liquidity of our stock and would likely result in a further decrease in the trading price of our stock.

      Our common stock is listed on the NASDAQ National Market. The NASDAQ Stock Market’s Marketplace Rules impose requirements for companies listed on the NASDAQ National Market to maintain their listing status. One of these requirements is that we must maintain a minimum closing bid price of

$1.00 per share for our common stock. If we fail to meet this requirement for 30 consecutive business days, the NASDAQ would issue a deficiency notice to us. If we were to receive such a notice, we would then have 90 calendar days to comply, and during this period the minimum closing bid price per share must be above $1.00 per share for 10 consecutive business days during this period to comply. Following this period, we could appeal to NASDAQ for a hearing regarding the determination to delist our common stock from the NASDAQ National Market. If our common stock were to be delisted, holders of our common stock would be less able to purchase or sell shares as quickly and as inexpensively as they have done historically. For instance, failure to obtain listing on another market or exchange may make it more difficult for traders to sell our securities. Broker-dealers may be less willing or able to sell or make a market in our common stock. The loss or discontinuation of our NASDAQ National Market listing may result in a decrease in the trading price of our common stock due to a decrease in liquidity, reduced analyst coverage and less interest by institutions and individuals in investing in our common stock.

If we fail to constitute an independent Board of Directors by the time of our next annual stockholders meeting, our common stock could be delisted, which would reduce the liquidity of our stock and would likely result in a further decrease in the trading price of our stock.

      In order to maintain our NASDAQ continued listing requirements, we also must satisfy the specific requirement that a majority of the members of our Board of Directors are independent, within the meaning of NASDAQ rules, by the time of our next annual meeting of stockholders. We expect that our meeting of stockholders for 2005 will be held in May or June 2005. Our Board of Directors, as currently constituted, would not satisfy this requirement, and we must adjust the membership of our Board of Directors in order to achieve that requirement by the time of our annual meeting of stockholders. If we are unable to meet the Board independence requirement for any reason, our common stock may be delisted. If our common stock were to be delisted, holders of our common stock would be less able to purchase or sell shares as quickly and as inexpensively as they have done historically. For instance, failure to obtain listing on another market or exchange may make it more difficult for traders to sell our securities. Broker-dealers may be less willing or able to sell or make a market in our common stock. Not maintaining a listing on a major stock market may result in a decrease in the trading price of our common stock due to a decrease in liquidity, reduced analyst coverage and less interest by institutions and individuals in investing in our common stock.

We are subject to general economic and market conditions.

      Our business is subject to the effects of general economic conditions in the United States and worldwide and, in particular, market conditions in the semiconductor and computer industries. In 2001, 2002 and through parts of 2003, our operating results were adversely affected by unfavorable global economic conditions and reduced information technology spending, particularly in Japan, where we currently generate a substantial portion of our revenue. These adverse conditions resulted in decreased demand for notebook computers and, as a result, our products, which are components of notebook computers. Further, demand for our products decreases as computer manufacturers seek to manage their component and finished product inventory levels. If the economic conditions in Japan and worldwide do not improve, or worsen, we may continue to experience material adverse effects on our business, operating results and financial condition.

If we do not keep pace with technological change, our products may not be competitive and our revenue and operating results may suffer.

      The semiconductor industry is characterized by rapid technological change, frequent new product introductions and enhancements, and ongoing customer demands for greater performance. In addition, the average selling price of any particular microprocessor product has historically decreased substantially over its life, and we expect that trend to continue. As a result, our products may not be competitive if we fail to introduce new products or product enhancements that meet evolving customer demands. It may be difficult or costly for us, or we may not be able, to enhance existing products to fully meet customer demands, particularly in view of our anticipated restructuring plan.

Advances in battery design, cooling systems and power management systems could adversely affect our ability to achieve widespread market acceptance for our products.

      We believe that our ability to achieve widespread market acceptance for our products will depend in large part on whether potential purchasers of our products believe that the low power usage of our products is a substantial benefit. Advances in battery technology, or energy technologies such as fuel cell technologies, that offer increased battery life and enhanced power capacity, as well as the development and introduction of more advanced cooling systems, may make microprocessor power consumption a less important factor to our customers and potential customers. These developments, or developments in power management systems by third parties, may adversely affect our ability to market and sell our products.

Our products and technologies may infringe the intellectual property rights of others, which may cause us to become subject to expensive litigation, cause us to incur substantial damages, require us to pay significant license fees or prevent us from selling our products.

      Our industry is characterized by the existence of a large number of patents and frequent claims and related litigation regarding patent and other intellectual property rights. We cannot be certain that our products and technologies do not and will not infringe issued patents, patents that may be issued in the future, or other intellectual property rights of others. In addition, leading companies in the semiconductor industry have extensive intellectual property portfolios with respect to semiconductor technology. From time to time, third parties, including these leading companies, may assert exclusive patent, copyright, trademark and other intellectual property rights to technologies and related methods that are important to us. We expect that we may become subject to infringement claims as the number of products and competitors in our target markets grows and the functionality of products overlaps. We have received, and may in the future receive, communications from third parties asserting patent or other intellectual property rights covering our products. Litigation may be necessary in the future to defend against claims of infringement or invalidity, to determine the validity and scope of the proprietary rights of others, to enforce our intellectual property rights, or to protect our trade secrets. We may also be subject to claims from customers for indemnification. Any resulting litigation, regardless of its resolution, could result in substantial costs and diversion of resources.

      If it were determined that our products infringe the intellectual property rights of others, we would need to obtain licenses from these parties or substantially reengineer our products and technologies in order to avoid infringement. We might not be able to obtain the necessary licenses on acceptable terms, or at all, or to reengineer our products and technologies successfully. Moreover, if we are sued for infringement and lose the suit, we could be required to pay substantial damages or be enjoined from licensing or using the infringing products or technology. Any of the foregoing could cause us to incur significant costs and prevent us from selling our products.

Any dispute regarding our intellectual property may require us to indemnify certain licensees, the cost of which could severely hamper our business operations and financial condition.

      In any potential dispute involving our patents or other intellectual property, our licensees could also become the target of litigation. Our LongRun2 license agreements provide limited indemnities. Our indemnification obligations could result in substantial expenses. In addition to the time and expense required for us to supply such indemnification to our licensees, a licensee’s development, marketing and sales of licensed products incorporating our LongRun2 technology could be severely disrupted or shut down as a result of litigation, which in turn could severely hamper our business operations and financial condition.

If we are unable to protect our proprietary rights adequately, our competitors might gain access to our technology and we might not compete successfully in our markets.

      We believe that our success will depend in part upon our proprietary technology. We rely on a combination of patents, copyrights, trademarks, trade secret laws and contractual obligations with employees and third parties to protect our proprietary rights. These legal protections provide only limited protection and may be time consuming and expensive to obtain and enforce. If we fail to protect our proprietary rights

adequately, our competitors might gain access to our technology. As a result, our competitors might offer similar products and we might not be able to compete successfully in our market. Moreover, despite our efforts to protect our proprietary rights, unauthorized parties may copy aspects of our products and obtain and use information that we regard as proprietary. Also, our competitors may independently develop similar, but not infringing, technology, duplicate our products, or design around our patents or our other intellectual property. In addition, other parties may breach confidentiality agreements or other protective contracts with us, and we may not be able to enforce our rights in the event of these breaches. Furthermore, the laws of many foreign countries do not protect our intellectual property rights to the same extent as the laws of the United States. We may be required to spend significant resources to monitor and protect our intellectual property rights.

      Our pending patent and trademark applications may not be approved. Our patents, including any patents that may result from our patent applications, may not provide us with any competitive advantage or may be challenged by third parties. If challenged, our patents might not be upheld or their claims could be narrowed. We may initiate claims or litigation against third parties based on our proprietary rights. Any litigation surrounding our rights could force us to divert important financial and other resources from our business operations.

The evolution of our business could place significant strain on our management systems, infrastructure and other resources, and our business may not succeed if we fail to manage it effectively.

      Our ability to implement our business plan in a rapidly evolving market requires effective planning and management process. Changes in our business plans could place significant strain on our management systems, infrastructure and other resources. In addition, we expect that we will continue to improve our financial and managerial controls and procedures. We will also need to expand, train and manage our workforce worldwide. Furthermore, we expect that we will be required to manage an increasing number of relationships with suppliers, manufacturers, customers and other third parties. If we fail to manage change effectively, our employee-related costs and employee turnover could increase and our business may not succeed.

We have significant international operations, which exposes us to risk and uncertainties.

      We have sold, and in the future we expect to sell, most of our products to customers in Asia. In addition, TSMC and ASE are located in Taiwan, and the Fujitsu Limited foundry we use for our 90 nanometer product is located in Japan. In addition, we generally ship our products from a third-party warehouse facility located in Hong Kong. In attempting to conduct and expand business internationally, we are exposed to various risks that could adversely affect our international operations and, consequently, our operating results, including:

Our operating results are difficult to predict and fluctuate significantly. A failure to meet the expectations of securities analysts or investors could result in a substantial decline in our stock price.

      Our operating results fluctuate significantly from quarter to quarter, and we expect that our operating results will fluctuate significantly in the future as a result of one or more of the risks described in this section or as a result of numerous other factors. You should not rely on quarter-to-quarter comparisons of our results of operations as an indication of our future performance. Our stock price has declined substantially since our stock began trading publicly. If our future operating results fail to meet or exceed the expectations of securities analysts or investors, our stock price would likely decline from current levels.

      A large portion of our expenses, including rent and salaries, is fixed or difficult to reduce. Our expenses are based in part on expectations for our revenue. If our revenue does not meet our expectations, the adverse effect of the revenue shortfall upon our operating results may be acute in light of the fixed nature of our expenses. We often make many shipments of our products at or near the end of the fiscal quarter, which makes it difficult to estimate or adjust our operating activities quickly in response to a shortfall in expected revenue.

We might experience payment disputes for amounts owed to us under our LongRun2 licensing agreements, and this may harm our results of operations.

      The standard terms of our LongRun2 license agreements require our licensees to document the royalties owed to us from the sale of products that incorporate our technology and report this data to us on a quarterly basis. While standard license terms give us the right to audit books and records of our licensees to verify this information, audits can be expensive, time consuming, and potentially detrimental to our ongoing business relationship with our licensees. Our failure to audit our licensees’ books and records may result in us receiving more or less royalty revenues than we are entitled to under the terms of our license agreements. The result of such royalty audits could result in an increase, as a result of a licensee’s underpayment, or decrease, as a result of a licensee’s overpayment, to previously reported royalty revenues. Such adjustments would be recorded in the period they are determined. Any adverse material adjustments resulting from royalty audits or dispute resolutions may result in us missing analyst estimates and causing our stock price to decline. Royalty audits may also trigger disagreements over contract terms with our licensees and such disagreements could hamper customer relations, divert the efforts and attention of our management from normal operations and impact our business operations and financial condition.

The price of our common stock has been volatile and is subject to wide fluctuations.

      The market price of our common stock has been volatile and is likely to remain subject to wide fluctuations in the future. Many factors could cause the market price of our common stock to fluctuate, including:

      In addition, the stock market generally and the market for semiconductor and other technology-related stocks in particular experienced a decline during 2000, 2001 and through 2002, and could decline from current

levels, which could cause the market price of our common stock to fall for reasons not necessarily related to our business, results of operations or financial condition. The market price of our stock also might decline in reaction to events that affect other companies in our industry even if these events do not directly affect us. Accordingly, you may not be able to resell your shares of common stock at or above the price you paid. Securities litigation is often brought against a company following a period of volatility in the market price of its securities, and we have been subject to such litigation in the past. Any such lawsuits in the future will divert management’s attention and resources from other matters, which could also adversely affect our business and the price of our stock.

Our California facilities and the facilities of third parties upon which we rely to provide us critical services are located in regions that are subject to earthquakes and other natural disasters.

      Our California facilities, including our principal executive offices, are located near major earthquake fault lines. If there is a major earthquake or any other natural disaster in a region where one of our facilities is located, our business could be materially and adversely affected. In addition, TSMC, upon which we currently rely to fabricate our wafers, and ASE, upon which we currently rely for the majority of our assembly and test services, are located in Taiwan. Fujitsu Limited, which we expect will fabricate a significant amount of our wafers in the future, is located in Japan. Taiwan and Japan have experienced significant earthquakes and could be subject to additional earthquakes in the future. Any earthquake or other natural disaster in these areas could materially disrupt our manufacturer’s production capabilities and ASE’s assembly and test capabilities and could result in our experiencing a significant delay in delivery, or substantial shortage, of wafers and possibly in higher wafer prices.

Our certificate of incorporation and bylaws, stockholder rights plan and Delaware law contain provisions that could discourage or prevent a takeover, even if an acquisition would be beneficial to our stockholders.

      Provisions of our certificate of incorporation and bylaws, as well as provisions of Delaware law, could make it more difficult for a third party to acquire us, even if doing so would be beneficial to our stockholders. These provisions include:

      In addition, the stockholder rights plan, which we implemented in 2002, and Section 203 of the Delaware General Corporation Law may discourage, delay or prevent a change in control.

Our reported financial results may be adversely affected by changes in accounting principles generally accepted in the United States.

      Generally accepted accounting principles in the United States are subject to interpretation by the Financial Accounting Standards Board (FASB), the American Institute of Certified Public Accountants, the Securities and Exchange Commission (SEC) and various bodies formed to promulgate and interpret appropriate accounting principles. A change in these principles or interpretations could have a significant effect on our reported financial results, and could affect the reporting of transactions completed before the announcement of a change. For example, we currently are not required to record stock-based compensation charges if an employee’s stock option exercise price is equal to or exceeds the deemed fair value of our common stock at the date of grant. However, several companies have recently elected to change their accounting policies and begun to record the fair value of stock options as an expense. The FASB published a pronouncement in December 2004 that would require us to record expense for the fair value of stock options granted. The effective date of the proposed standard is for periods beginning after June 15, 2005. Our future operating expenses may be adversely affected in connection with the issuance of stock options.

We have identified material weaknesses in our internal control over financial reporting, which contributed to our need to amend our financial statements for the second quarter of fiscal 2004.

      In the course of preparing our financial statements for the third quarter of fiscal 2004, material weaknesses, as defined in Public Company Accounting Oversight Board Standard No. 2, were identified in our internal control over financial reporting. Specifically, material weaknesses were identified with respect to our financial statement close process and our contract administration. These material weaknesses contributed to post-closing adjustments and the resulting need to amend our financial statements for the second quarter of fiscal 2004. Our amendment of our previously released financial statements could diminish public confidence in the reliability of our financial statements, which could harm our business and our stock price. In addition, we cannot assure you that we will not in the future identify further material weaknesses or significant deficiencies in our internal control over financial reporting.

      In order to comply with the Sarbanes-Oxley Act of 2002, we are currently completing our system and process evaluation and testing required for our management to assess the effectiveness of our system of internal control over financial reporting as of December 31, 2004, the end of our current fiscal year. In our evaluation, we have identified certain material weaknesses as set forth below in Item 9A. Controls and Procedures. Our independent registered public accounting firm must attest to and report on that assessment by our management. If we fail to complete our evaluation and testing in order to allow for this assessment by our management, or if our independent registered public accounting firm cannot timely attest to our management’s assessment, then we could be subject to regulatory scrutiny and a loss of public confidence in our internal controls, which could harm our business and our publicly traded stock price. Further, if our independent registered public accounting firm are not satisfied with our internal control over financial reporting or with the level at which it is documented, designed, operated or reviewed, they may decline to attest to management’s assessment or may issue a qualified report identifying further material weaknesses in our internal controls. This could result in significant additional expenditures responding to the Section 404 internal control audit, a diversion of management attention and potentially an adverse reaction to our publicly traded stock price.

Changes in securities laws and regulations have increased our costs.

      The Sarbanes-Oxley Act of 2002 has required and will require changes in some of our corporate governance, public disclosure and compliance practices. The Act also requires the SEC to promulgate new rules on a variety of subjects. In addition to final rules and rule proposals already made by the SEC, the National Association of Securities Dealers has adopted revisions to its requirements for companies, such as us, that are listed on the NASDAQ National Market. These developments have increased our legal and financial compliance costs and have made some activities, such as SEC reporting requirements, more difficult. Additionally, we expect these developments to make it more difficult and more expensive for us to obtain director and officer liability insurance, and we may be required to accept reduced coverage or incur

substantially higher costs to obtain coverage. These developments could make it more difficult for us to attract qualified executive officers and attract and retain qualified members of our board of directors, particularly to serve on our audit committee. We are presently evaluating and monitoring regulatory developments and cannot estimate the timing or magnitude of additional costs we may incur as a result.

      Interest Rate Risk. Our cash equivalents and short-term investments are exposed to financial market risk due to fluctuations in interest rates, which may affect our interest income. As of December 31, 2004, our cash equivalents and short-term investments included money market funds and short and medium term corporate bonds and earned interest at an average rate of 2.1%. Due to the relative short-term nature of our investment portfolio, our interest income is vulnerable to sudden changes in market interest rates. We do not use our investment portfolio for trading or other speculative purposes.

      The table below presents principal amounts and related weighted average interest rates by year of maturity for our investment portfolio as of December 31, 2004 (in thousands):

      Foreign Currency Exchange Risk. All of our sales and substantially all of our expenses are denominated in U.S. dollars. As a result, we have relatively little exposure to foreign currency exchange risk. We do not currently enter into forward exchange contracts to hedge exposures denominated in foreign currencies or any other derivative financial instruments for trading or speculative purposes. However, in the event our exposure to foreign currency risk increases, we may choose to hedge those exposures.

INDEX TO CONSOLIDATED FINANCIAL STATEMENTS

The following financial statements are filed as part of this Report:

TRANSMETA CORPORATION

CONSOLIDATED BALANCE SHEETS

(See accompanying notes)

TRANSMETA CORPORATION

CONSOLIDATED STATEMENTS OF OPERATIONS

(See accompanying notes)

TRANSMETA CORPORATION

CONSOLIDATED STATEMENTS OF STOCKHOLDERS’ EQUITY

(See accompanying notes)

TRANSMETA CORPORATION

CONSOLIDATED STATEMENTS OF CASH FLOWS

(See accompanying notes)

TRANSMETA CORPORATION

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

      From Transmeta’s inception in 1995 through its fiscal year ended December 31, 2004, the Company’s business model was focused primarily on designing, developing and selling highly efficient x86-compatible software-based microprocessors. The Company currently supplies its products to a number of the leading companies in the computer industry. The Company has discontinued some of those products during the first quarter of 2005, and it might discontinue more or all of those products during 2005.

      In 2003, the Company initiated efforts to diversify its business model by establishing a revenue stream based upon the licensing of certain of its intellectual property and advanced computing and semiconductor technologies developed in the course of Transmeta’s research and development programs. In 2004, the Company entered into and announced agreements granting licenses to use Transmeta’s proprietary LongRun2^tm technologies for power management and transistor leakage control. Those licensing agreements include deliverable-based technology transfer fees, maintenance and service fees, and subsequent royalties on products incorporating the licensed technologies.

      In January 2005, the Company announced that it is critically evaluating the economics of its microprocessor product business during the first quarter of 2005 and that it intends to modify its business model in 2005 to increase its efforts to license intellectual property and advanced technologies. The Company intends to continue its efforts to license advanced power management technologies to other semiconductor companies, and it is also contemplating licensing its intellectual property and microprocessor and computing technologies to other companies in the future in order to grow its licensing and services revenue.

      Transmeta was incorporated in California as Transmeta Corporation on March 3, 1995. Effective October 26, 2000, Transmeta reincorporated as a Delaware corporation.

      The Company has historically reported negative cash flows from its operations because the gross profit, if any, generated from its product revenues and its license and service revenues has not been sufficient to cover its operating cash requirements. From its inception in 1995 through the end of fiscal year 2004, the Company incurred a cumulative loss aggregating $649.4 million, which included net losses of $106.8 million in fiscal 2004, $87.6 million in fiscal 2003 and $110.0 million in fiscal 2002, which losses have reduced stockholders’ equity to $58.0 million at December 31, 2004. The Company believes that its existing cash and cash equivalents and short-term investment balances and cash from operations would not be sufficient to fund its operations, planned capital and research and development expenditures for the next twelve months under the business model that the Company pursued during and through its fiscal year ended December 31, 2004, which business model was primarily focused on designing, developing and selling software-based x86-compatible microprocessor products.

      Accordingly, and as the Company announced publicly in January 2005, the Company is currently evaluating and modifying its business model and developing a related restructuring plan, and the Company currently expects to announce that modified business model and related restructuring plan on or about March 31, 2005. During the first quarter of 2005, the Company began to modify its business model to leverage its intellectual property rights and increase its business focus on licensing its advanced power management and other proprietary technologies to other companies. By increasing its focus on its licensing and service business, the Company hopes to increase revenue from its licensing and service activities in 2005 and beyond. During the first quarter of 2005, as part of its transition to a modified business model, the Company also began taking action to reduce its operating expenses by discontinuing certain of its products, increasing prices for its products, and changing its terms and conditions of sale, which actions the Company anticipates will improve the negative gross margins historically associated with its product business. The Company currently expects

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that its modified business model will further reduce its historic business focus on product sales, and that the Company will further reduce operating expenses associated with its product business as part of a restructuring plan. The Company expects that its restructuring plan will include a reduction of its workforce, and in January 2005 the Company gave written notice to its employees, pursuant to federal and state Worker Adjustment and Retraining Notification (WARN) Acts and similar statutes applicable in other countries, that the Company plans to restructure its business operations and to conduct a mass layoff on or about March 31, 2005. Under the currently anticipated restructuring plan, the Company expects to restructure its operations so as to reduce its overall operating expenses in accordance with a modified business model and, as a result, the Company believes that its existing cash and cash equivalents and short-term investment balances and cash from operations will be sufficient to fund its operations, planned capital and R&D expenditures for the next twelve months under the modified business model that the Company is currently developing and expects to announce with a related restructuring plan on or about March 31, 2005.

      The accompanying financial statements have been prepared assuming that the Company will continue as a going concern; however, the above conditions raise substantial doubt about the Company’s ability to continue as a going concern. The financial statements do not include any adjustments to reflect the possible future effects on the recoverability and classification of assets or the amounts and classifications of liabilities that may result should the Company be unable to continue as a going concern.

      Transmeta’s fiscal year ends on the last Friday in December. For ease of presentation, the accompanying financial statements have been shown as ending on December 31 and calendar quarter ends for all annual and quarterly financial statement captions. Fiscal year 2004 consisted of 53 weeks and ended on December 31, 2004. Fiscal years 2003 and 2002 consisted of 52 weeks each and ended on December 26 and December 27, respectively.

      On February 25, 2005, the Company’s Board of Directors resolved to change the fiscal year from one ending on the last Friday in December to a fiscal year ending the last calendar day in December. This change is not deemed a change in fiscal year for purposes of reporting subject to Rule 13a-10 or 15d-10 because the Company’s fiscal year 2005 commenced with the end of its fiscal year 2004.

      The accompanying consolidated financial statements include the financial statements of Transmeta and its wholly owned subsidiaries. All significant intercompany balances and transactions have been eliminated in consolidation.

      The preparation of financial statements in accordance with U.S. generally accepted accounting principles requires management to make estimates and assumptions that affect the amounts reported in the financial statements. Actual results could differ from those estimates. The critical accounting policies that require management judgment and estimates include license and service revenue recognition, inventory valuations, long-lived and intangible asset valuations, restructuring charges and loss contingencies.

      Financial instruments that potentially subject the Company to credit risk consist primarily of cash equivalents, short-term investments and accounts receivable. Substantially all of the Company’s cash equivalents are invested in highly liquid money market funds and commercial securities with high-quality

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financial institutions in the United States. Short-term investments consist of U.S. government and commercial bonds and notes. The Company performs ongoing credit evaluations of its customers, maintains an allowance for potential credit losses and does not generally require collateral.

      The Company depends on a single or limited number of outside contractors to fabricate, assemble and test its semiconductor devices. While the Company seeks to maintain a sufficient level of supply and endeavors to maintain ongoing communications with suppliers to guard against interruptions or cessation of supply, business and results of operations could be adversely affected by a stoppage or delay of supply from these vendors.

      The Company recognizes revenue from products sold when persuasive evidence of an arrangement exists, the price is fixed or determinable, delivery has occurred and collectibility is reasonably assured. The Company recognizes revenue for product sales upon transfer of title. Transfer of title for the majority of the Company’s customers occurs upon shipment, as those customers have terms of FOB: shipping point. For those customers that have terms other than FOB: shipping point, transfer of title generally occurs once products have been delivered to the customer or the customer’s freight forwarder. The Company accrues for estimated sales returns, and other allowances at the time of shipment. Certain of the Company’s product sales are made to distributors under agreements allowing for price protection and/or right of return on unsold products. The Company defers recognition of revenue on these sales until the distributors sell the products. The Company may also sell certain products with “End of Life” status to its distributors under special arrangements without price protection or return privileges for which revenue is recognized upon transfer of title, typically upon shipment.

      The Company enters into license agreements, some of which may contain multiple elements, including technology license and support services, or non-standard terms and conditions. As a result, in accordance with Emerging Issues Task Force (EITF) Issue No. 00-21, “Revenue Arrangements with Multiple Deliverables” and the Securities and Exchange Commission’s Staff Accounting Bulletin No. 104, “Revenue Recognition”, significant interpretation on these agreements is sometimes required to determine the appropriate accounting, including whether deliverables specified in a multiple element arrangement should be treated as separate units of accounting for revenue recognition purposes, and if so, how the price should be allocated among the deliverable elements and when to recognize revenue for each element. The Company recognizes revenue from license agreements when earned, which generally occurs when agreed-upon deliverables are provided, or milestones are met and confirmed by licensees and relative fair values of multiple elements can be determined. Additionally, license, and maintenance and service revenues are recognized if collectibility is reasonably assured and if the Company is not subject to any future performance obligation. The Company recognizes revenue from maintenance agreements based on the fair value of such agreements ratably over the period in which such services are rendered. Royalty revenue is recognized upon receipt of royalty payments from customers.

      Shipping and handling costs are expensed as incurred and included in cost of revenue in the Company’s results of operations.

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      Net comprehensive loss includes the Company’s net loss, as well as accumulated comprehensive income/(loss) on available-for-sale investments and foreign currency translation adjustments. Net comprehensive loss for the years ended December 31, 2004, 2003 and 2002, respectively, is as follows:

      Highly liquid debt securities with insignificant interest rate risk and original maturities of three months or less are classified as cash equivalents. Debt securities with maturities greater than three months are available-for-sale and are classified as short-term investments.

      All of Transmeta’s short-term investments were classified as available-for-sale as of the balance sheet dates presented and, accordingly, are reported at fair value with unrealized gains and losses recorded as a component of accumulated other comprehensive income/(loss) in stockholders’ equity. Fair values of cash equivalents approximated original cost due to the short period of time to maturity. The cost of securities sold is based on the specific identification method. Realized gains or losses and declines in value, if any, judged to be other than temporary on available-for-sale securities are reported in interest income or expense.

      The fair values of Transmeta’s cash equivalents, short-term investments, accounts receivable, prepaid expenses and other current assets, and accounts payable and accrued liabilities approximate their carrying values due to the short-term nature of those instruments.

      The fair values of short-term and long-term capital lease obligations are based on interest rates inherent on leasing contracts. The carrying values of these obligations approximate their respective fair values.

      Inventories are stated at the lower of cost (first-in, first-out) or market. Write-downs to reduce the carrying value of excess and obsolete, slow moving and non-usable inventory to net realizable value are charged to cost of revenue. Inventories written down to net realizable value at the close of a fiscal period are not marked up in subsequent periods.

      In computing inventory valuation adjustments as a result of lower of cost or market considerations, the Company reviews not only the inventory on hand but also inventory in the supply chain pursuant to the non-cancelable purchase orders. If the Company becomes aware of factors that indicate that inventory associated with these non-cancelable purchase orders will be sold to customers below its cost, the Company accrues such loss as an additional cost of revenue and as an additional accrued liability on the balance sheet.