VA LINUX SYSTEMS INC - 10-K Annual Report

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

FORM 10-K

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

FOR THE FISCAL YEAR ENDED JULY 28, 2001

OR

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

FOR THE TRANSITION PERIOD FROM TO .

COMMISSION FILE NUMBER: 000-28369

VA LINUX SYSTEMS, INC.
(Exact name of Registrant as specified in its charter)

DELAWARE 77-0399299
(State or other jurisdiction of (I.R.S. Employer
incorporation or organization) Identification No.)

47071 BAYSIDE PARKWAY, FREMONT, CALIFORNIA, 94538
(Address, including zip code, of principal executive offices)

(510) 687-7000
(Registrant's telephone number, including area code)

SECURITIES REGISTERED PURSUANT TO SECTION 12(G) OF THE ACT:
COMMON STOCK, $0.001 PAR VALUE
(Title of Class)

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

Indicate by check mark 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 10K or any amendment to this
Form 10-K. [ ]

As of September 30, 2001, there were 53,742,284 shares of the Registrant's
Common Stock outstanding. The aggregate market value of the Common Stock held by
non-affiliates of the Registrant as of September 28, 2001 (based on the closing
price for the Common Stock on the Nasdaq National Market for such date) was
approximately $42,075,370. Shares of common stock held by each of our officers
and directors and by each person or group who owns 5% or more of our outstanding
common stock have been excluded in that such persons or groups may be deemed to
be our affiliate. This determination of affiliate status is not necessarily a
conclusive determination for other purposes.

DOCUMENTS INCORPORATED BY REFERENCE

Specified portions of the Registrant's definitive Proxy Statement to be
issued in conjunction with Registrant's Annual Meeting of Stockholders are
incorporated by reference into Part III of this Form 10-K.
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PART I

Item 1 Business.................................................... 4
Overview................................................. 4
Company Background....................................... 4
The SourceForge Solution................................. 5
Sales, Marketing, and Customers.......................... 6
Competition.............................................. 7
Seasonality.............................................. 8
Backlog.................................................. 8
Intellectual Property Rights............................. 8
Employees................................................ 8
Segments................................................. 8
Item 2 Properties.................................................. 8
Item 3 Legal Proceedings........................................... 9
Item 4 Submission of Matters to a Vote of Security Holders......... 9

PART II

Item 5 Market for the Registrant's Common Stock and Related
Stockholder Matters......................................... 9
Item 6 Selected Financial Data..................................... 10
Item 7 Management's Discussion and Analysis of Financial Condition
and Results of Operations................................... 11
Item 7A Quantitative and Qualitative Disclosures About Market
Risk........................................................ 28
Item 8 Financial Statements and Supplementary Data................. 29
Item 9 Changes in and Disagreements with Accountants on Accounting
and Financial Disclosure.................................... 55

PART III

Item 10 Directors and Executive Officers of the Registrant.......... 55
Item 11 Executive Compensation...................................... 55
Item 12 Security Ownership of Certain Beneficial Owners and
Management.................................................. 55
Item 13 Certain Relationships and Related Transactions.............. 55

PART IV

Item 14 Exhibits, Financial Statement Schedules, and Reports on Form
8-K......................................................... 55

Signatures............................................................. 56

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PART I

ITEM 1. BUSINESS

SPECIAL NOTE REGARDING FORWARD-LOOKING STATEMENTS

This Form 10-K contains forward-looking statements that involve risks and
uncertainties. Words such as "expects," "believes," "in our view," and
variations of such words and similar expressions are intended to identify such
forward looking statements, which include, but are not limited to, statements
regarding our expectations and beliefs regarding future revenue growth, gross
margins, financial performance and results of operations, technological trends
in, and emergence of, collaborative software development, the future
functionality, business potential, demand for, efficiencies created by and
adoption of SourceForge(TM), management's strategy, plans and objectives for
future operations, the impact of our restructuring, reductions in force and new
business model on our operating expenses and the amount of cash utilized by
operations each quarter, our intentions and strategies regarding customers and
customer relationships, our intent to continue to invest significant resources
in software development, our intent to develop long-term relationships and
strategic alliances, competition, competitors, the bases of competition and our
ability to compete, liquidity and capital resources. Actual results may differ
materially from those projected in such forward-looking statements. The
following business description should be read in conjunction with the Risk
Factors contained in the section of this Form 10-K entitled "Management's
Discussion and Analysis of Financial Condition and Results of Operations." We
undertake no obligation to update forward-looking statements to reflect events
or circumstances occurring after the date of this Form 10-K.

OVERVIEW

This past fiscal year we have evolved into an application software company
by exiting our business related to hardware, professional services and Linux
software engineering services. We made this strategic decision in order to allow
us to focus on our SourceForge collaborative software development (CSD)
platform, comprised of SourceForge Enterprise Edition and SourceForge Portal
Edition.

SourceForge Enterprise Edition is designed for today's research and
development (R&D) and information technology (IT) organizations. We believe it
helps companies maximize developer productivity, capture and manage corporate
intellectual property, and reduce development costs by addressing common
software development challenges. Whether enterprise companies are building
applications for internal use or software for sale, we expect that such
companies are likely to face the challenges of distributed development, non-
integrated and incomplete tool sets, duplication of effort, developer turnover
and loss of intellectual property, and burdensome administrative overhead.
SourceForge Enterprise Edition is designed to help address these challenges.

Developer relations groups in leading technology companies use SourceForge
Portal Edition to create Internet sites that allow internal and external
developers to collaborate. SourceForge Portal Edition is designed to make it
easy for hardware and software companies to support third-party developers with
information, tools and other resources, and to facilitate application
development for their platforms.

SOURCEFORGE, OSDN, VA LINUX SYSTEMS and the VA logo, SLASHDOT, THINKGEEK
and FRESHMEAT, are trademarks, trade names or service marks that we use. We have
applied for federal trademark registration for these marks. This Form 10-K
contains other trademarks and trade names of other individuals and companies.

COMPANY BACKGROUND

We were incorporated in January 1995 in California as VA Research, Inc. In
June 1999 we changed our name to VA Linux Systems, Inc., and in December 1999 we
reincorporated in Delaware. In December 1999, we sold 4,400,000 shares of common
stock to the public in our initial public offering. Our principal executive
offices are located at 47071 Bayside Parkway, Fremont, California, 94538, and
our telephone number is (510) 687-7000. Our corporate web site is located at
valinux.com.
---------------------

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From incorporation in January 1995 until the end of fiscal 1998, we grew
very modestly. From July 31, 1998 though the first quarter of fiscal 2001, we
experienced significant growth as a leading provider of Linux-based solutions,
integrating systems, software and services. Commensurate with strong growth, we
invested in hiring personnel with Linux expertise, growing our direct sales
force, acquiring companies, and expanding our operations, customer support and
administration infrastructure. We outsourced our manufacturing, but provided
support through our internal organization.

Increasing demand from customers in the Internet Infrastructure and
"dot-com" markets fueled our growth through the first quarter of fiscal 2001.
Thereafter, the market for our systems products and professional services
declined significantly due in large part to the general economic downturn, which
resulted in downturns in, and reduced availability of capital for, our Internet
Infrastructure and "dot-com" customers. This decline had a significant negative
effect on our sales, margins and operating losses. We endeavored to market our
products to larger "enterprise" customers, but were unable to make sufficient
progress to build a sustainable business in the midst of a slowing economy and
fierce competition from incumbent hardware vendors that were moving into the
Linux market.

Rather than continue with a business model that was not going to enable us
to achieve profitability and would significantly decrease our cash levels, on
June 27, 2001, we announced our strategic decision to exit the systems business
and pursue our application software business. As a result, we eliminated our
manufacturing organization, except for a small number of employees handling
certain continuing obligations to systems customers, primarily in the area of
hardware service and support. Subsequent to our fiscal year end of July 28,
2001, we made a strategic decision to exit the professional services and Linux
software engineering services fields in order to focus solely on SourceForge. By
exiting these businesses we preserved our cash through significant cost
reductions. Essentially, we have changed our business strategy and devoted our
resources to develop and market the SourceForge CSD platform. SourceForge is a
relatively new product and further development and enhancements are expected in
the future. Revenue levels will be very modest as we begin this new business and
we expect revenues to grow gradually as SourceForge gains acceptance in the
market.

An important marketing element of our SourceForge strategy is OSDN, the
Open Source Development Network. OSDN is a suite of web properties targeting the
IT and open source development communities. It includes the SourceForge.net
site, the largest reference for SourceForge. SourceForge benefits from OSDN
through product advertising on the web sites, sales leads from users of
SourceForge.net and the credibility derived from SourceForge.net as a reference
site. Advertising, sponsorship and e-commerce revenue generated by OSDN is
expected to represent the majority of our consolidated revenue in the near term
and we expect it to decline as a percentage of total revenue over time as our
revenue from SourceForge increases.

THE SOURCEFORGE SOLUTION

In focusing on SourceForge, we see the opportunity to address a major shift
in software engineering. Software engineering has changed significantly in
recent years, and we believe software engineering tools and processes have not
evolved to keep pace with that change. Many traditional software development
tools and methodologies were based on an assumption that software development
occurs under one roof and that development teams always stay the same. This is
no longer the case for many companies. We believe that our target market -- R&D
and IT organizations in Global 2000 companies face major challenges in managing
software development: increased turnover, remote developers and development
teams, duplicative development efforts, piecemeal deployment of different
development tools that are incomplete or not integrated, all of which results in
excessive administrative time. We believe SourceForge Enterprise Edition will
help our customers solve these problems, while cutting costs.

SOURCEFORGE ENTERPRISE EDITION

Following the December 1999 launch of SourceForge.net, Global 2000
companies began approaching us asking if they could buy their own internal
SourceForge to manage their software development. That is now the focus of our
business. OSDN's SourceForge.net web site is now the world's largest reference
implementa-

5

tion of the SourceForge CSD platform, supporting more than 27,000 software
projects and more than 270,000 users.

We believe SourceForge gives us an opportunity to enter a new market in
collaborative software development (CSD), which we believe does not have an
entrenched competitor. In our view, CSD has the potential to do for R&D and IT
organizations what enterprise resource planning (ERP) and customer relationship
management (CRM) have done for manufacturing and sales organizations. We provide
an environment that interoperates with and enhances existing development tools.
SourceForge does not replace existing tools but improves the efficiency of
existing software development efforts.

We believe SourceForge Enterprise Edition provides a comprehensive solution
to many of the software development problems facing our targeted customers. It
is an Internet-based CSD platform that enables distributed development teams to
communicate and captures their code development and interaction. Because
SourceForge Enterprise Edition creates a Web-based central point of access to
source code, it creates visibility of software projects across development
tools, groups, and geographies within a company and enables collaboration. As a
highly modular platform, SourceForge Enterprise Edition can integrate with
customers' existing development tools rather than trying to replace them.
Because it provides a standard set of tools and resources, SourceForge
Enterprise Edition reduces ramp-up time for new developers and enables companies
to standardize their development organization. Finally, because SourceForge
Enterprise Edition provides comprehensive reporting and search features, it
makes it possible for developers and managers to spend less time reporting and
more time developing.

SOURCEFORGE PORTAL EDITION

Developer relations groups in leading technology companies use SourceForge
Portal Edition to create Internet sites that allow internal and external
developers to collaborate. SourceForge Portal Edition makes it easy for hardware
and software companies to support third-party developers with information, tools
and other resources, and to facilitate application development for their
platforms.

We expect that our new business model, focused on application software
rather than hardware, will significantly reduce our operating expenses and the
amount of cash used by operations each quarter. We believe this will allow us to
build a successful software company using existing resources.

SALES, MARKETING, AND CUSTOMERS

SOURCEFORGE

SourceForge Enterprise Edition is our key product. Installed behind
corporate firewalls, SourceForge helps R&D and IT organizations cut costs and
develop better software more efficiently by providing an infrastructure for
collaboration.

Since the inception of our SourceForge.net site, potential customers have
expressed interest in a commercial version of SourceForge that they can use
internally, behind their firewalls, to enable collaborative software development
in their enterprises.

The target market for SourceForge is R&D and IT organizations within Global
2000 companies, a customer segment that comprised only a small percentage of our
exited systems business. We market and sell our products (software, consulting,
maintenance and support, and training) directly through our SourceForge field
sales organization, on the Internet at valinux.com and on our various OSDN web
sites. Our direct sales organization includes a telesales operation to augment
our direct sales presence.

By creating the SourceForge CSD platform, we believe we have an opportunity
to move to a business model that includes a subscription-based, deferred revenue
stream, as well as some business based on perpetual license fees. Each
SourceForge contract type and revenue recognition model will be based on
negotiation of individual contracts. SourceForge has a complete customer service
and support organization. This organization provides support installation for
software usage, updates and system administration issues.

6

Customer service and support are typically provided as part of the SourceForge
contract to ensure the productivity of end users. We also release periodic bug
or security fix updates and version upgrades.

We believe that the success of SourceForge will depend partly on our
ability to enhance the product to meet the needs of a rapidly evolving
marketplace and increasingly sophisticated and demanding customers. We intend to
extend and strengthen our CSD platform by expanding partnerships, enhancing
existing and adding additional features and offering higher levels of
integration. During fiscal 2002, we plan to add additional popular collaborative
development tool set applications to the SourceForge platform. These tool set
applications are sold by firms competing in related markets. Engineering
enhancements to SourceForge will be necessary to support integration with the
SourceForge platform. Although we primarily develop SourceForge technology
internally, we may, based on timing and cost considerations, acquire
technologies or products from third parties. Therefore, we have devoted our
entire research and development budget to the goal of improving SourceForge to
better serve the CSD market.

For the fiscal year ended July 28, 2001, one customer accounted for
approximately 25% of net revenues and for the fiscal year ended July 28, 2000,
one customer accounted for approximately 18% of net revenues.

OSDN

We own and manage several web sites that are widely used by the IT and open
source development communities. OSDN receives more than 120 million page views
and more than 5.2 million unique visitors per month. SourceForge Enterprise
Edition and SourceForge Portal Edition benefit from OSDN in a variety of ways.
OSDN reaches software developers, providing advertising for SourceForge and
acting as a sales tool for the SourceForge platform. The OSDN site
SourceForge.net is the largest reference model for potential SourceForge
customers and provides further sales leads. Following is a list of OSDN sites:

- sourceforge.net is our flagship web site and development center. As of
October 15, 2001, SourceForge is the development home for more than
27,000 open source projects and has more than 270,000 registered
developers. We believe that this represents more than two thirds of the
known open source projects in the world.

- slashdot.org is our most popular site. A "village pub" for the open
source community, Slashdot carries news and interactive commentary on
topics of interest to the community.

- freshmeat.net is the world's leading open source index and is the most
popular update notification service for open source developers.

- linux.com contains news, links and articles of interest to open source
community members. Its focus is on corporate Linux usage, customization
and support.

- themes.org is a repository of desktop themes. Desktop themes are
background images, icons and other graphic customizations for the window
systems used in Linux and popular Unix operating systems.

- thinkgeek.com is an e-commerce site, providing online sale of a variety
of retail products of interest to the developer community.

COMPETITION

We believe SourceForge gives us an opportunity to enter the new CSD market,
a market without an entrenched competitor. However, we face competition from
software development tools and processes developed internally by customers,
including ad hoc integrations of platforms based on open source code. There are
also many entrenched competitors in closely related markets who could choose to
focus on the CSD market. Such competition could arise from, among others,
Collab.net, Rational Software Corporation, IBM Corporation, Starbase
Corporation, Merant plc, Microsoft Corporation, Oracle Corporation, as well as

7

numerous other public and privately held software application development and
tools suppliers. Many of these potential competitors are likely to have
substantial competitive advantages including:

- greater resources that can be devoted to the development, promotion and
sale of their products;

- more established sales forces and channels;

- greater software development experience; and

- greater name recognition.

To be competitive, we must respond promptly and effectively to the
challenges of technological change, evolving standards and our competitors'
innovations by continuing to enhance our products and grow our sales and
professional services organizations. Any pricing pressures or loss of potential
customers resulting from our failure to compete effectively would reduce our
revenues.

SEASONALITY

During the past two years, our revenues have not been significantly
impacted by seasonality. It is not yet clear whether our new business model
focusing on the SourceForge platform will be subject to seasonal fluctuations.

BACKLOG

We have operated historically with little or no backlog. Our backlog at
July 28, 2001 related to received systems orders, which were shipped in the
subsequent quarter. We anticipate no further backlog related to systems
business. Going forward, we may have backlog related to deferred revenue on
SourceForge contracts. The backlog levels cannot be accurately forecasted at
present due to our lack of history in our new business model focusing on the
SourceForge platform.

INTELLECTUAL PROPERTY RIGHTS

SourceForge Enterprise Edition and SourceForge Portal Edition incorporate
both proprietary software code and open source code. We protect our property
through a combination of copyright, trademark, patent, and trade-secret laws,
employee and third-party nondisclosure agreements, and other methods of
protection.

EMPLOYEES

We believe our success will depend in part on our continued ability to
attract and retain highly qualified personnel in a competitive market for
experienced and talented software engineers and sales and marketing personnel.
Our employees are not represented by any collective bargaining organization, we
have never experienced a work stoppage and we believe that our relations with
our employees are good. As of July 28, 2001, our employee base totaled 286. Due
to subsequent reductions in our work force in connection with our decision to
exit additional lines of business, and related cost-cutting actions, our
employee base totaled 209 as of September 30, 2001, including 62 in operations,
52 in sales, marketing and customer support, 34 in research and development and
61 in finance and administration.

SEGMENTS

Information regarding our previous two operating segments over the last
fiscal year is set forth in Note 11 of the Notes to the Consolidated Financial
Statements. For the year beginning July 29, 2001, the Company will operate as
one business segment, providing application software products and related OSDN
products.

ITEM 2. PROPERTIES

In September 2000, we relocated our corporate headquarters to Fremont,
California from Sunnyvale, California. Our Fremont facility consists of
approximately 140,000 square feet, which is occupied pursuant to a lease that
expires in May 2010. We have subleased approximately 52,000 square feet of our
Fremont facility

8

pursuant to an agreement that expires in 2002. We have also subleased our
Sunnyvale facility pursuant to an agreement that expires in 2005, upon the
expiration of our lease with the landlord.

ITEM 3. LEGAL PROCEEDINGS

Starting on January 12, 2001, we and two of our officers were named as
defendants in purported securities class-action lawsuits filed in the United
States District Court, Southern District of New York (the "Actions"). The first
of the Actions is captioned Macaroon v. VA Linux Systems, Inc. et al., No. 01
CIV. 0242. The Court has since consolidated the Actions, appointed a lead
plaintiff and approved lead plaintiffs' selection of lead counsel. Lead
plaintiff has filed a consolidated complaint ("Complaint") with the Court. The
Complaint alleges claims against us, two of our officers, and/or Credit Suisse
First Boston ("CSFB"), the lead underwriter of our December 9, 1999 initial
public offering, under Sections 11 and 15 of the Securities Act of 1933, as
amended. The Complaint also alleges claims solely against CSFB under Section
12(2) of the Securities Act of 1933 and Section 10(b) of the Securities Exchange
Act of 1934, as amended. We believe that the claims against us and our two
officers are without legal merit and intend to defend them vigorously. On August
8, 2001, all pending cases against all underwriters and issuers were reassigned
to Honorable Shira A. Scheindlin, U.S. District Court Judge, Southern District
of New York. The time for defendants to move to dismiss the Complaint is
presently adjourned pending further instruction from Judge Scheindlin.

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

Not applicable.

PART II

ITEM 5. MARKET FOR THE REGISTRANT'S COMMON STOCK AND RELATED STOCKHOLDER MATTERS

The common stock of VA Linux Systems, Inc. is traded in the NASDAQ National
Market System under the symbol LNUX. As of October 8, 2001, there were 54,187
holders of record of VA Linux common stock. We have declared no cash dividends
since our inception and do not expect to pay any dividends in the foreseeable
future. The quarterly high and low closing sales price, as reported by Nasdaq,
of VA Linux common stock since the initial public offering on December 9, 1999
are as follows:

The foregoing reflects interdealer prices without retail markup, markdown,
or commissions and may not necessarily reflect actual transactions.

During our last fiscal year, we issued 2,012,580 shares of our common stock
upon the exercise of stock grants under our 1998 Stock Plan. The shares were
issued pursuant to an exemption either by reason of Section 4(2) or Rule 701
under the Securities Act of 1933. These sales were made without general
solicitation or advertising. For purposes of qualifying for such exemptions,
each purchaser either was an accredited investor, a sophisticated investor
(either alone or through its representative) or a natural person satisfying the
requirements of Rule 701, with access to all relevant information necessary to
make an investment decision.

9

ITEM 6. SELECTED FINANCIAL DATA

You should read the selected financial data set forth below in conjunction
with "Management's Discussion and Analysis of Financial Condition and Results of
Operations" and our financial statements and the related notes included
elsewhere in this Form 10-K. The statement of operations data for the years
ended July 28, 2001 and 2000 and July 31, 1999 and the balance sheet data as of
July 28, 2001 and 2000 are derived from, and are qualified by reference to, the
audited financial statements and related notes appearing elsewhere in this Form
10-K. The statement of operations data for the years ended July 31, 1998 and
1997 and the balance sheet data as of July 31, 1999, 1998 and 1997 are derived
from audited financial statements not appearing in this Form 10-K. Historical
results are not necessarily indicative of results that may be expected for any
future period.

SUMMARY FINANCIAL INFORMATION
(IN THOUSANDS, EXCEPT PER SHARE DATA)

10

ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS
OF OPERATIONS

The following discussion and analysis should be read in conjunction with
"Selected Financial Data" and our financial statements and the related notes
included elsewhere in this Form 10-K. This discussion contains forward-looking
statements that involve risks and uncertainties. Our actual results could differ
materially from those anticipated in the forward-looking statements as a result
of certain factors including the risks discussed in "Risk Factors" and elsewhere
in this Form 10-K. See Part I -- Item 1 -- "Special Note Regarding Forward
Looking Statements."

OVERVIEW

From incorporation in January 1995 until the end of fiscal 1998, we grew
very modestly. From July 31, 1998 though the first quarter of fiscal 2001, we
experienced significant growth as a leading provider of Linux-based solutions,
integrating systems, software and services. Commensurate with strong growth, we
invested in hiring personnel with Linux expertise, growing our direct sales
force, acquiring companies, and expanding our operations, customer support and
administration infrastructure. We outsourced our manufacturing, but provided
support through our internal organization.

Increasing demand from customers in the Internet Infrastructure and
"dot-com" markets fueled our growth through the first quarter of fiscal 2001.
Thereafter, the market for our systems products and professional services
declined significantly due in large part to the general economic downturn, which
resulted in downturns in, and reduced availability of capital for, our Internet
Infrastructure and "dot-com" customers. This decline had a significant negative
effect on our sales, margins and operating losses. We endeavored to market our
products to larger "enterprise" customers, but were unable to make sufficient
progress to build a sustainable business in the midst of a slowing economy and
fierce competition from incumbent hardware vendors that were moving into the
Linux market.

Rather than continue with a business model that was not going to enable us
to achieve profitability and would significantly decrease our cash levels, on
June 27, 2001 we announced our strategic decision to exit the systems business
and pursue our application software business. As a result, we eliminated our
manufacturing organization, except for a small number of employees handling
certain continuing obligations to systems customers, primarily in the area of
hardware service and support. Subsequent to our fiscal year end of July 28,
2001, we made a strategic decision to exit the professional services and Linux
software engineering services fields in order to focus solely on SourceForge. By
exiting these businesses we preserved our cash through significant cost
reductions. We expect to report an additional restructuring charge in the first
quarter of fiscal 2002 to account for the costs associated with this
restructuring decision.

We have changed our business strategy and restructured the Company to be in
the application software business and devoted our resources to develop and
market the SourceForge CSD platform. SourceForge is a relatively new product and
additional development and enhancements are expected in the future. An important
marketing element of our SourceForge strategy is OSDN, a suite of web properties
targeting the IT and open source development communities. It includes the
SourceForge.net site, the largest reference for SourceForge. OSDN benefits
SourceForge through product advertising on the web sites, sales leads from users
of SoureceForge.net and the credibility derived from SourceForge.net as a
reference site.

SourceForge Enterprise Edition is designed for today's R&D and IT
organizations. We believe it helps companies maximize developer productivity,
capture and manage corporate intellectual property, and reduce development costs
by addressing common software development challenges. Whether companies are
building applications for internal use or software for sale, we believe that
they face the challenges of distributed development, non-integrated and
incomplete tool sets, duplication of effort, and administrative overhead.
SourceForge enterprise Edition is designed to help address these challenges.

The SourceForge commercial products are SourceForge Enterprise Edition and
SourceForge Portal Edition. Developer relations groups in leading technology
companies use SourceForge Portal Edition to create Internet sites that allow
internal and external developers to collaborate. SourceForge Portal Edition
makes it

11

easy for hardware and software companies to support third-party developers with
information, tools and other resources, and to facilitate application
development for their platforms.

We expect that revenue levels for our SourceForge software platform will be
very modest as we begin business as an application software company. In the
near-term we expect revenues generated by OSDN from the sale of advertising,
sponsorships and e-commerce to represent the majority of our consolidated
revenues. However, we expect revenues from OSDN to decline as a percentage of
total revenue over time as the revenue from SourceForge increases as it gains
acceptance in the market.

RESULTS OF OPERATIONS

The following table sets forth for the years indicated certain financial
data as a percentage of net revenue:

NET REVENUES

We had two reportable business segments for revenue during fiscal 2001:
Systems and Services, and OSDN. We allocated our resources and evaluated
performance of our separate segments based on revenue. Effective July 29, 2001,
as a result of our decision to exit the systems business in the fourth quarter
of fiscal 2001, we will operate as one business segment.

Our overall net revenues increased by $14.6 million, or 12.1%, from $120.3
million in fiscal 2000 to $134.9 million in fiscal 2001. During fiscal 2001, our
Systems and Services business segment accounted for $120.2 million or 89.1% of
net revenues and our OSDN business segment accounted for $14.7 million or 10.9%
of net revenues. Net revenues for the Systems and Services business segment
increased by $2.0 million, or 1.7%, from $118.2 million in fiscal 2000 to $120.2
million in fiscal 2001. This marginal increase in our Systems and Services
business was primarily due to a small increase in net revenues from services
offset by a decline in demand for our server products from the Internet
infrastructure market. Net revenues for our

12

OSDN business segment increased $12.6 million, or 605.5%, from $2.1 million in
fiscal 2000 to $14.7 million in fiscal 2001. This significant percentage
increase in net revenues for our OSDN business segment was primarily due to
incurring a full year's worth of net revenues for our OSDN business segment in
fiscal 2001 as compared to the period from June 7, 2000 to July 28, 2000 in
fiscal 2000. The increase in our OSDN net revenues was also partially offset by
a decrease in demand in the second half of fiscal 2001 for our web advertising
offerings. We believe our overall net revenues will significantly decline for
the fiscal year 2002 due to our strategic decision to exit from the systems and
services business and our focus on the application software business.

Our overall net revenues increased by $102.6 million, or 579.3%, from $17.7
million in fiscal 1999 to $120.3 million in fiscal 2000. Net revenues increased
primarily due to the high demand for our web based server products and the
introduction of our 1U and 2U server products in the third and second quarters
of fiscal 2000, respectively. We derived all of our fiscal 1999 net revenues
from sales of our systems and in fiscal 2000 sales of our systems were
approximately 95% of net revenue. In fiscal 2000, we derived approximately 71%
of our net revenues from sales to companies in the Internet infrastructure
market.

Export sales for fiscal 2001, 2000, and 1999 were not material.

COST OF REVENUES

Cost of revenues increased $55.9 million, or 57.0%, from $98.2 million in
fiscal 2000 to $154.1 million in fiscal 2001. Gross margin decreased (as a
percent of net revenues) from 18.4% in fiscal 2000 to a negative 14.2% in fiscal
2001. The decline in gross margin was mostly due to charges from the write-off
of excess inventory caused by lower demand for our server products and our
decision to exit the systems business, charges from lower of cost or market
adjustments to inventory, selling price reductions on our server products due to
competitive pricing pressure, lower sales volume in the second half of fiscal
2001, and increased investments in professional service while partially offset
by an increase in gross profit from the OSDN business segment.

Cost of revenues increased $80.4 million, or 452.6%, from $17.8 million in
fiscal 1999 to $98.2 million in fiscal 2000. Gross margin increased (as a
percent of net revenues) from a negative 0.3% in fiscal 1999, to 18.4% in fiscal
2000. This increase was primarily due to increased sales volume from our server
products, reductions in component costs, improved manufacturing efficiencies as
a result of outsourcing our manufacturing to a third party, and the introduction
of new products.

SALES AND MARKETING EXPENSES

Sales and marketing expenses consist primarily of salaries, commissions and
related expenses for personnel engaged in marketing, sales and sales support
functions, as well as costs associated with trade shows, advertising and
promotional activities.

Sales and marketing expenses increased $10.5 million, or 35.6%, from $29.5
million in fiscal 2000 to $40.0 million in fiscal 2001. Sales and marketing
expenses (as a percent of net revenues) increased from 24.5% in fiscal 2000 to
29.6% in fiscal 2001. The increase in absolute dollars was due to incurring a
full year's worth of expenses from our sales and marketing organizations from
our OSDN business segment, and the expansion of our sales and marketing
organizations in Europe and Japan. We believe our sales and marketing expenses
will decrease in absolute dollars for fiscal year 2002 due to changes made to
our organization related to our strategic decisions to exit our systems and
services business and pursue the application software business.

Sales and marketing expenses increased $24.3 million, or 468.8%, from $5.2
million in fiscal 1999 to $29.5 million in fiscal 2000. Sales and marketing
expenses (as a percent of net revenues) decreased from 29.3% in fiscal 1999 to
24.5% in fiscal 2000. The increase in absolute dollars was due to an increase in
sales and marketing personnel, tradeshow and branding expenses, and increased
commission expenses resulting from higher revenue.

13

RESEARCH AND DEVELOPMENT EXPENSES

Research and development expenses consist primarily of salaries and related
expenses for software and former hardware engineers and cost of material for
prototyping and testing units. We expense all of our research and development
costs as they are incurred.

Research and development expenses increased $5.6 million, or 45.3%, from
$12.4 million in fiscal 2000 to $18.0 million in fiscal 2001. Research and
development (as a percent of net revenues) increased from 10.3% in fiscal 2000
to 13.3% in fiscal 2001. The increase in absolute dollars was mostly due to an
increased investment in cost relating to research and development personnel,
partially offset by decreased material spending for new product development. We
expect research and development expenses to decrease in absolute dollars for
fiscal 2002 due to changes made to our organization related to our strategic
decisions to exit our systems and services business and pursue the application
software business.

Research and development expenses increased $9.2 million, or 287.7%, from
$3.2 million in fiscal 1999 to $12.4 million in fiscal 2000. Research and
development expenses (as a percent of net revenues) decreased from 18.0% in
fiscal 1999 to 10.3% in fiscal 2000. The increase in absolute dollars was due to
an increase in research and development personnel and increased material
spending for new product development as a result of higher revenues.

GENERAL AND ADMINISTRATIVE EXPENSES

General and administrative expenses increased $13.0 million, or 145.0%,
from $9.0 million in fiscal 2000 to $22.0 million in fiscal 2001. General and
administrative expenses (as a percent of net revenues) increased from 7.5% in
fiscal 2000 to 16.3% in fiscal 2001. The increase in absolute dollars was due to
an increase in expenses for administrative personnel and support costs relating
to increased operations from our OSDN business segment and international
operations. We expect general and administrative expenses to decrease in
absolute dollars for fiscal year 2002 due to changes made to our organization
related to our strategic decisions to exit our systems and services business and
pursue the application software business.

General and administrative expenses increased $5.2 million, or 137.0%, from
$3.8 million in fiscal 1999 to $9.0 million in fiscal 2000. General and
administrative expenses (as a percent of net revenues) decreased from 21.4% in
fiscal 1999 to 7.5% in fiscal 2000. The increase in absolute dollars was due to
an increase in administrative personnel and increased expenses relating to the
support of our increased operations.

RESTRUCTURING COSTS AND OTHER SPECIAL CHARGES

During February 2001, in response to the general slowdown in the economy,
we adopted a plan to reduce operating costs. In connection with these actions,
we recorded a restructuring charge of approximately $43.4 million in the third
quarter of fiscal 2001. The principle actions of the plan involved the closure
of our San Diego facility and the exit from our managed services business. Of
the $43.4 million restructuring charge, $33.8 million related to the
acceleration of deferred stock compensation that was originally contingent on
future employment by three employees of TruSolutions and one employee of Life,
companies acquired in March 2000 and September 2000, respectively. We terminated
these four employees as part of the restructuring and, as part of each
employee's severance arrangement, we released all of their stock that we held in
escrow. In addition, as part of the plan to exit from our managed services
business, we sold Brave New Worlds, Inc. ("BNW"), a company acquired in
September 2000, for minimal proceeds and recorded severance charges related to
six employees of BNW. As part of these six employees' severance agreements, we
released a portion of their stock that we had held in escrow. Further, we
recorded $1.7 million for workforce reduction. This $1.7 million charge
consisted of severance, acceleration of stock options, and other related costs
attributable to 43 employees, who were primarily from our domestic hardware
systems business that were terminated as part of the February 2001 plan. Of the
remaining $7.9 million restructuring charge, $1.7 million was for excess
facilities related primarily to non-cancelable leases (payments, unless we
sublet, will continue until fiscal 2010) or other costs and the abandonment or
disposal of property and equipment, and $6.2 million was for the impairment of
goodwill and purchased intangibles as there are no future cash flows expected
from the managed services business that are being exited pursuant to the
restructuring plan. The
14

results of operations relating to the managed services business were not
material to the consolidated results of operations.

In addition to the above, we recorded a $3.4 million charge in connection
with our plan to exit our managed service business and closure of our San Diego
facility. We classified this $3.4 million restructuring charge as cost of
revenues in the statement of operations. Of the $3.4 million, we recorded $0.2
million for workforce reduction, which consisted of severance and other related
costs attributable to 19 employees from our domestic systems business and nine
employees from our managed services business. Of the remaining $3.2 million,
$2.9 million related to a write down of inventory from the closing of our San
Diego facility, and $0.3 million related to other restructuring costs related to
the exit of our managed service business.

In June 2001, we adopted a plan to exit the systems business, which we
accounted for in the fourth quarter ended July 28, 2001. We decided to exit our
systems business to reduce operating losses and improve cash flow. We recorded a
restructuring charge of $70.1 million in the fourth quarter of fiscal 2001
related to our plan to exit our systems business. Of the $70.1 million, $53.5
million related to the impairment of goodwill and purchased intangibles,
resulting from our expectation that we will receive no significant future cash
flows from the systems business. $6.6 million of the $70.1 million charge
related to excess facilities primarily from non-cancelable lease payments which,
unless we sublet, will continue until fiscal 2010, $3.2 million related to a
workforce reduction consisting of severance, acceleration of stock options, and
other related costs attributable to 84 employees primarily from our systems
business, and $6.8 million related to other restructuring charges related to the
exit from the systems business. The accrual for non-cancelable lease payments
includes management's estimates of the time expected to sublet the facilities
and estimates of sublease income. These estimates are subject to change based on
actual events.

In addition to the above, we recorded a $10.5 million charge in connection
with the exit of the systems business included in cost of revenues in the
statement of operations. Of the $10.5 million, we recorded $7.6 million for
excess inventory charges arising from the exit from the systems business, $0.4
million for a workforce reduction, which consisted of severance, and other
related costs attributable to 64 former employees from our systems business, and
the remaining $2.5 million for other restructuring costs.

15

All our restructuring activities are expected to be complete by January
2002, except that cash payments for non-cancelable leases will be made over the
respective lease terms as noted above. Below is a summary of the restructuring
charges in operating expenses (in thousands):

Net revenues for the systems business were $110.7 million, $114.3 million
and $17.7 million for fiscal 2001, 2000, and 1999, respectively.

AMORTIZATION OF DEFERRED STOCK COMPENSATION

In connection with the grant of certain stock options to employees during
fiscal 2000 and 1999, we recorded deferred stock compensation within
stockholders' equity of approximately $37.8 million, representing the difference
between the estimated fair value of the common stock for accounting purposes and
the option exercise price of these options at the date of grant. The deferred
stock compensation expense is being amortized on an accelerated basis over the
vesting period of the individual award, generally four years. The method is in
accordance with Financial Accounting Standards Board Interpretation No. 28. The
amortization expense relates to options awarded to employees in all operating
expense categories. The amortization of deferred compensation has not been
separately allocated to these categories. The amount of deferred compensation
expense to be recorded in future periods could decrease if options for which
accrued but unvested compensation has been recorded are forfeited. In connection
with the acquisitions of TruSolutions, Precision Insight and NetAttach, we
recorded $113.1 million of deferred stock compensation during fiscal 2000. In
connection with the acquisitions of BNW and Life BVBA ("Life"), we recorded $6.8
million of deferred stock compensation during fiscal 2001. We recorded
amortization of deferred stock compensation of $61.3 million, $39.5 million and
$2.3 million for the years ended July 28, 2001 and 2000 and July 31, 1999,
respectively. In addition, in connection with the restructuring discussed above,
expense of approximately $35.7 million related to the acceleration of deferred
stock compensation has been recorded for the year ended July 28, 2001 and has
been included in restructuring costs and other special charges in the statements
of operations.

16

AMORTIZATION OF GOODWILL AND INTANGIBLES AND IMPAIRMENT OF LONG-LIVED ASSETS

In connection with the acquisitions of BNW, Life and certain intangibles of
Alabanza Corporation ("Alabanza") and Lavaca Systems Inc. ("Lavaca"), we
recorded $10.6 million of goodwill and intangibles during fiscal 2001. In
connection with the acquisitions of TruSolutions, Inc., Precision Insight, Inc.,
NetAttach, Inc., and OSDN (previously Andover.Net), we recorded $381.3 million
of goodwill and intangibles during fiscal 2000. We amortized $97.9 million and
$18.2 million of goodwill and intangibles in fiscal 2001 and 2000, respectively.
In connection with our restructuring plans in fiscal 2001, we have written off
goodwill and intangibles associated with BNW, Life, Alabanza and TruSolutions in
the amount of $59.7 million as we have exited from these lines of business and
there are no expected future cash flows.

We periodically evaluate the carrying amount of our long-lived assets and
apply the provisions of Statement of Financial Accounting Standards ("SFAS") No.
121, "Accounting for the Impairment of Long-Lived Assets and for Long-Lived
Assets to be Disposed of." SFAS No. 121 requires that long-lived assets and
certain identifiable intangibles to be held and used or disposed of by an entity
be reviewed for impairment whenever events or changes in circumstances indicate
that the carrying amount of an asset may not be recoverable.

We performed an assessment of the carrying value of our long-lived assets
to be held and used including significant amounts of goodwill and other
intangible assets recorded in connection with our OSDN acquisition. We performed
the assessment pursuant to SFAS No. 121 due to the significant slowdown in the
economy affecting our current operations and our expected future sales, as well
as the general decline of technology valuations. The conclusion of that
assessment was that the decline in market conditions within our industry was
significant and other than temporary. As a result, we recorded during the fourth
quarter of fiscal 2001 a charge of $160.0 million to reduce goodwill and other
intangible assets associated with the acquisition of OSDN, based on the amount
by which the carrying value of these assets exceeded their fair value. The
charge is included in the caption "Impairment of long-lived assets" in the
statements of operations. Fair value was determined based on discounted future
cash flows.

As of July 28, 2001, we have remaining goodwill and intangibles of $56.7
million. In July 2001, the Financial Accounting Standards Board ("FASB") issued
SFAS No. 142, "Goodwill and Other Intangible Assets." Under SFAS No. 142,
goodwill and intangible assets with indefinite lives are not amortized but are
subject to at least an annual assessment for impairment applying a fair-value
based test. Upon adoption of SFAS No. 142 on July 29, 2001, we will no longer
amortize goodwill, thereby eliminating annual goodwill amortization of
approximately $8.6 million. We expect amortization of intangible assets in
fiscal 2002 to be approximately $13.9 million. We are currently reviewing
remaining goodwill and intangible assets to determine whether recent economic
events and the impact of adopting this standard have resulted in impairment.

WRITE-OFF OF IN-PROCESS RESEARCH AND DEVELOPMENT

The value assigned to purchased in-process research and development in
fiscal 2000 related to the acquisitions of TruSolutions, Inc. and Andover.Net,
Inc. ("Andover" or "OSDN"), and was based on the income method prepared by an
independent third party and was determined by identifying research projects in
areas for which technological feasibility had not been established and no future
alternative uses existed.

TruSolutions' in-process research projects included the research and
development associated with the 1/2U, 1U, 2U, and 4U server products. The value
of in-process research and development was determined by estimating the costs to
develop the purchased in-process technology into commercially viable products,
estimating the resulting net cash flows from such projects and discounting the
net cash flows back to their present value. The discount rate included a
risk-adjusted discount rate to take into account the uncertainty surrounding the
successful development of the purchased in-process technology. The risk-adjusted
discount rate applied to the projects' cash flows was 45% for the in-process
technology. We believe that the estimated in-process technology amounts
represent fair value and do not exceed the amount a third party would pay for
the projects. The valuation included cash inflows from in-process technology
through 2003 with revenues commencing in 2000 for the 1U, 2U and 4U servers, and
in 2001 for the 1/2U server. Where appropriate, we
17

allocated anticipated cash flows from an in-process research and development
project to reflect contributions of the core technology. At the time of the
merger, TruSolutions' remaining tasks that were substantially incomplete
included: developing additional server features as well as proving out the
in-process products' electrical designs, testing for compatibility with other
systems common in server farms, and testing for Linux performance. Finally,
TruSolutions needed to conduct shock, vibration and performance testing. As of
July 28, 2001, we do not expect to incur any additional charges related to these
projects.

Andover's in-process research projects included next-generation web site
management tools, online web applications, and other technologies that will
support our vast network of web sites. The value of in-process research and
development was determined by estimating the costs to develop the purchased
in-process technology into commercially viable products, estimating the
resulting net cash flows from such projects and discounting the net cash flows
back to their present value. The discount rate included a risk-adjusted discount
rate to take into account the uncertainty surrounding the successful development
of the purchased in-process technology. The risk-adjusted discount rate applied
to the projects' cash flows was 30% for the in-process technology. We believed
that the estimated in-process technology amounts represented fair value and did
not exceed the amount a third party would pay for the projects.

The valuation included cash inflows from in-process technology through 2005
with revenues commencing in 2001. Where appropriate, we allocated anticipated
cash flows from an in-process research and development project to reflect
contributions of the core technology. At the time of the merger, Andover's
remaining tasks that were substantially incomplete included certain planning,
designing, coding, prototyping, and testing activities that are necessary to
establish that the developmental technologies can be produced to meet their
design specifications including functional, technical, and economic performance
requirements. As of July 28, 2001, we do not expect to incur any additional
charges related to these projects.

INTEREST AND OTHER INCOME, NET

Interest and other income, net includes income from our cash investments
net of other expenses. We had net interest and other income of approximately
$6.5 million in fiscal 2001, $5.6 million in fiscal 2000, and $19,000 in fiscal
1999. The increase from fiscal 2000 to fiscal 2001 was primarily due to
offsetting the appropriate amount of operating loss for our Japan joint venture
operations to the minority shareholders and the incremental increase in interest
income earned from our short-term investments, partially offset by the payment
of various state taxes.

The increase in interest in other income from fiscal 1999 to fiscal 2000
was primarily due to an increase in interest income earned on proceeds from our
initial public offering in December 1999.

INCOME TAXES

As of July 28, 2001, we had $145.3 million of federal and $39.3 million of
state net operating loss carryforwards for tax reporting purposes available to
offset future taxable income. The federal and state net operating loss
carryforwards expire at various dates through 2021 and 2006, respectively, to
the extent that they are not utilized. We have not recognized any benefit from
these net operating loss carryforwards because of uncertainty surrounding their
realization. The amount of net operating losses that we can utilize is limited
under tax regulations because we have experienced a cumulative stock ownership
change of more than 50% over the last three years.

PREFERRED STOCK DIVIDEND

During the quarter ended October 29, 1999, we recorded a preferred stock
dividend of $4.9 million representing the value of the beneficial conversion
feature on the issuance of convertible preferred stock in September 1999. The
beneficial conversion feature was calculated at the commitment date based on the
difference between the conversion price of $3.86 per share and the estimated
fair value of the common stock at that date. The amount of the beneficial
conversion feature was limited to the amount of the gross proceeds received from
the issuance of convertible preferred stock. The excess of the beneficial
conversion feature over the gross proceeds received was $4.2 million. No
dividends were recorded in fiscal 2001.
18

LIQUIDITY AND CAPITAL RESOURCES

Cash and cash equivalents decreased $63.5 million from $123.8 million at
July 28, 2000 to $60.3 million at July 28, 2001. Working capital decreased by
$107.9 million from $171.7 million at July 28, 2000 to $63.8 million at July 28,
2001 primarily due to using our cash and short-term investments to support our
operating activities. We used cash in operating activities of $81.6 million and
$24.6 million in fiscal 2001 and fiscal 2000, respectively. The increase in net
cash used in operating activities was primarily due to the increase in operating
losses, an increase in inventories and a decrease in accounts payable, offset by
the impairment of long-lived assets, non-cash restructuring expenses,
depreciation and amortization, amortization of deferred stock compensation,
provisions for excess and obsolete inventory, a decrease in accounts receivable,
and an increase in other long-term liabilities.

Cash and cash equivalents increased $105.1 million from $18.7 million at
July 31, 1999 to $123.8 million at July 28, 2000. This increase is primarily a
result of our initial public offering of common stock in December 1999, which
generated net proceeds of $138.7 million and the cash we assumed from our
acquisition of Andover as a result of their initial public offering of common
stock in December 1999, which generated net proceeds of $77.4 million. We used
$10.2 million of cash in operating activities in fiscal 1999 and $24.6 million
in fiscal 2000. This increase in cash used was primarily due to increases in
operating losses and accounts receivable, offset by depreciation, amortization
of stock compensation, increases in accounts payable, write-off of in-process
research and development, and lower inventories.

Investing activities provided cash of $17.9 million in fiscal 2001. The
sale of short-term investments provided $29.8 million and the net cash from
acquisitions provided $4.6 million, offset by the purchase of property and
equipment of $14.7 million for furniture and fixtures for the Fremont
headquarters facilities and computer equipment purchases and the purchase of
intangibles of $1.9 million primarily for certain assets acquired from Alabanza
and Lavaca.

We used cash in investing activities of $13.2 million in fiscal 2000 due to
purchases of short-term investments of $52.4 million, capital equipment of $7.6
million, offset by the net amount of cash acquired as a result of acquisitions
of $46.9 million. We used cash in investing activities of $2.3 million in fiscal
1999 due to purchases of computer equipment and other fixed assets.

Our financing activities provided cash of $1.6 million in fiscal 2001,
generated from the proceeds of our issuance of common stock from employee stock
option exercises, partially offset by payments on notes payables and capital
lease obligations. Financing activities provided cash of $143.0 million in
fiscal 2000, generated from the proceeds of our issuance of common stock with
our initial public offering in December 1999 and the sale of convertible
preferred stock in September 1999, partially offset by payments on notes
payables and capital lease obligations. Financing activities provided cash of
$31.0 million in fiscal 1999, resulting almost entirely from the net proceeds
from the issuance of convertible preferred stock.

In February 1999, we entered into a loan and security agreement with a bank
for maximum borrowings of $10,000,000 under a revolving line of credit ("Line of
Credit") and $500,000 under an equipment loan ("Equipment Loan"). The interest
rate for both the Line of Credit and the Equipment Loan is the bank's base rate
plus 0.75% (7.5% at July 28, 2001). The amount available for borrowing under the
Line of Credit is limited to the committed revolving line, less any outstanding
letters of credit issued under the Line of Credit, which is not to exceed
$5,000,000. The amount available for borrowing under the Equipment Loan can only
be utilized to acquire equipment that the bank approves. As of July 28, 2001, we
had no borrowings outstanding under the Line of Credit and $208,333 outstanding
under the Equipment Loan, of which $166,667 is current and $41,666 is
non-current. The Equipment Loan and Line of Credit require that we maintain
certain financial and non-financial ratios and covenants. As of July 28, 2001,
we complied with all of such ratios and covenants.

As of July 28, 2001, we had outstanding letters of credit issued under the
Line of Credit of approximately $2,300,000, primarily related to the corporate
facility lease.

19

During fiscal 2001, we established letters of credit of approximately $4.0
million used to collateralize the delivery of customer parts from a single
supplier. As of July 28, 2001, we had approximately $0.6 million of restricted
cash outstanding on the letters of credit.

Our future liquidity and capital requirements will depend upon numerous
factors, including the costs associated with the expansion of our sales and
marketing activities and product development efforts, the level and timing of
product and service revenues, the amount of working capital required, and the
level of fixed asset investment required. We believe that the net proceeds from
our initial public offering, together with our current cash and investment
balances and any cash generated from current or future debt financing, will be
sufficient to meet our operating and capital requirements for at least the next
12 months. However, we may require additional financing within this period,
particularly if we elect to acquire complementary businesses or technologies.
The factors described in this paragraph will affect our future capital
requirements and the adequacy of our available funds. As a result, we may be
required to raise additional funds through the sale of equity or convertible
debt or other arrangements. Furthermore, any additional equity financing may be
dilutive to stockholders, and debt financing, if available, may involve
restrictive covenants. Our inability to raise capital when needed could
seriously harm our business.

RECENT ACCOUNTING PRONOUNCEMENTS

In June 1998, the FASB issued SFAS No. 133 "Accounting for Derivative
Instruments and Hedging Activities." SFAS No. 133 establishes accounting and
reporting standards requiring that every derivative instrument be recorded in
the balance sheet as either an asset or liability measured at its fair value.
SFAS No. 133, as amended, is effective for fiscal years beginning after June 15,
2000. We adopted SFAS No. 133 on July 29, 2000 and this adoption did not have a
material effect on our financial position or results of operations.

In December 1999, the Securities and Exchange Commission ("SEC") issued
Staff Accounting Bulletin ("SAB") No. 101, "Revenue Recognition in Financial
Statements". In June 2000, the SEC deferred the adoption date for SAB No. 101
until our fourth quarter ended July 28, 2001. SAB No. 101 summarizes certain
areas of the Staff's views in applying generally accepted accounting principles
to revenue recognition in financial statements. We adopted SAB No. 101 in May
2001 and this adoption did not have a material effect on our financial position
or results of operations.

In June 2001, the FASB issued SFAS No. 141, "Accounting for Business
Combinations." This statement requires the purchase method of accounting be used
for all business combinations initiated after June 30, 2001, and establishes
specific criteria for the recognition of intangible assets separately from
goodwill. The Company will follow the requirements of this statement for
business acquisitions made after June 30, 2001.

In June 2001, the FASB issued SFAS No. 142, "Goodwill and Other Intangible
Assets." Under SFAS No. 142, goodwill and intangible assets with an indefinite
life are not amortized. Instead of amortizing goodwill and intangible assets
deemed to have an indefinite life, the statement requires a test for impairment
to be performed annually, or immediately if conditions indicate that such an
impairment could exist. The amortization period of intangible assets with finite
lives will no longer be limited to forty years. This statement is effective for
fiscal years beginning after December 15, 2001, and permits early adoption for
fiscal years beginning after March 15, 2001. The Company adopted SFAS No. 142 on
July 29, 2001. As a result of adopting SFAS No. 142, the Company will stop
amortizing goodwill of approximately $8.6 million per year. We are currently
reviewing remaining goodwill and intangible assets to determine whether recent
economic events and the impact of adopting this standard have resulted in
impairment.

FACTORS THAT MAY AFFECT FUTURE RESULTS

Investors should carefully consider the risks described below before making
an investment decision. The trading price of our common stock could decline due
to any of these risks and investors may lose all or part of their investment. In
assessing these risks, investors should also refer to the other information
contained or incorporated by reference in this Annual Report on Form 10-K
including our consolidated financial statements and related notes.
20

RISKS RELATED TO COMPETITION WITHIN OUR INDUSTRY

BECAUSE THE MARKET FOR OUR PRODUCTS IS NEW, WE DO NOT KNOW WHETHER EXISTING
AND POTENTIAL CUSTOMERS WILL LICENSE OUR PRODUCTS IN SUFFICIENT QUANTITY FOR US
TO ACHIEVE PROFITABILITY. The market for collaborative software development
(CSD) is new and rapidly evolving. Our future growth and financial performance
will depend on broad market acceptance of our CSD platform. The number of
software developers using our products is still relatively small. We expect that
we will continue to need intensive marketing and sales efforts to educate
prospective clients about the uses and benefits of our products. Various factors
could inhibit the growth of the market and market acceptance of our CSD
platform. In particular, potential customers may be unwilling to make the
significant capital investment needed to license our products and retrain their
software developers to develop software using our CSD platform. Many of our
customers have licensed only small quantities of our products, and these or new
customers may decide not to broadly implement or license additional copies of
our products. We cannot be certain that a viable market for our products will
emerge, or if it does emerge, that it will be sustainable.

WE ARE CONCENTRATING OUR EFFORTS SOLELY ON THE SALES OF OUR SOURCEFORGE
PRODUCT, SO IF THIS PRODUCT DOES NOT ACHIEVE MARKET ACCEPTANCE WE ARE LIKELY TO
EXPERIENCE LARGER LOSSES. We are directing nearly all of our product
development efforts to the on-going development of SourceForge. The failure to
achieve widespread market acceptance of SourceForge on a timely basis would
adversely affect our business and operating results. The success of our
SourceForge CSD platform is difficult to predict because CSD represents a new
area of business for the computer software industry. There can be no assurance
that we will be successful in marketing, upgrading and supporting our
SourceForge products. Our failure to do so could adversely affect our business
and operating results.

IF WE DO NOT DEVELOP AND ENHANCE SOURCEFORGE TO KEEP PACE WITH
TECHNOLOGICAL, MARKET, AND INDUSTRY CHANGES, OUR REVENUES MAY DECLINE. Rapid
technological advances, changes in customer requirements, and frequent new
product introductions and enhancements characterize the software development
industry. If we fail to anticipate or respond adequately to technology
developments, industry standards, or practices and customer requirements, or if
we experience any significant delays in product development, introduction, or
integration, our products may become obsolete or unmarketable, our ability to
compete may be impaired, and our revenues may decline. We must respond rapidly
to developments related to hardware platforms, operating systems, and software
development tools. These developments will require us to make substantial
product-development investments.

IF WE DO NOT EFFECTIVELY COMPETE WITH NEW AND EXISTING COMPETITORS, OUR
REVENUES AND OPERATING MARGINS WILL DECLINE. We believe that the newly emerging
CSD market is fragmented, subject to rapid change and highly sensitive to new
product introductions and marketing efforts by industry participants.
Competition in related markets is intense. If our products gain market
acceptance, we expect the competition to rapidly intensify as new competitors
enter the CSD market. Our potential competitors include entrenched companies in
closely related markets who may choose to enter and focus on the CSD market.
Although we do not believe that we presently have an entrenched competitor, we
expect competition to intensify in the future if the market for CSD platforms
continues to expand. Many of these potential competitors are much larger than we
are and may have significantly more resources and more experience. Our potential
competitors include providers of software and related services as well as
providers of hosted application services. Our potential competitors vary in
size, scope of services offered and platforms supported. Many of our competitors
have longer operating histories and greater financial, technical, sales and
marketing resources than we do. We cannot guarantee that we will be able to
compete successfully against current and future competitors or that competitive
pressures will not result in price reductions, reduced operating margins and
loss of market share, any one of which could seriously harm our business.

21

We believe our continued success will become increasingly dependent on our
ability to:

- support multiple platforms, including Linux, commercial UNIX and
Microsoft Windows;

- use the latest technologies to continue to support Web-based development;
and

- continually support the rapidly changing standards, tools and
technologies used in the development of Web-based applications as well as
off-the-shelf products.

Because individual product sales often lead to a broader customer relationship,
our products must be able to successfully compete with and complement numerous
competitors' current and potential offerings. Moreover, we may be forced to
compete with our strategic partners, and potential strategic partners, and this
may adversely impact our relationship with an individual partner or a number of
partners.

IF WE FAIL TO ATTRACT AND RETAIN LARGER CORPORATE AND ENTERPRISE-LEVEL
CUSTOMERS, OUR REVENUES WILL DECLINE SUBSTANTIALLY. We face competition from
different sources, and we must compete effectively against other current and
future competitors to retain and expand our customer base. We have focused our
sales and marketing efforts upon larger corporate and enterprise-level
customers. This strategy may fail to generate sufficient revenue to offset the
substantial demands that this strategy will place on our business, in particular
the longer sales cycles, higher levels of service and support and volume pricing
and terms that larger corporate and enterprise accounts often demand.

Rather than license SourceForge, our target customers may develop their
software development tools and processes internally, including ad hoc
integrations of CSD platforms based on open source code. A failure to
successfully obtain revenues from large corporate or enterprise-level customers
will materially and adversely affect our operations.

IF WE ARE UNABLE TO PROVIDE HIGH-QUALITY CUSTOMER SUPPORT AND SERVICES, WE
WILL NOT MEET THE NEEDS OF OUR CUSTOMERS. For our business to succeed, we must
effectively market our software solutions. If our customer support organization
does not meet the needs or expectations of customers, we face an increased risk
that customers will purchase software from other providers.

INCREASED UTILIZATION AND COSTS OF OUR TECHNICAL SUPPORT SERVICES MAY
ADVERSELY AFFECT OUR FINANCIAL RESULTS. Like many companies in the software
industry, technical support costs will likely comprise a significant portion of
our operating costs and expenses. Over the short term, we may be unable to
respond to fluctuations in customer demand for support services. We also may be
unable to modify the format of our support services to compete with changes in
support services provided by competitors. Further, customer demand for these
services could cause increases in the costs of providing such services and
adversely affect our operating results.

RISKS RELATED TO OUR FINANCIAL RESULTS

IT IS DIFFICULT TO EVALUATE OUR BUSINESS BECAUSE WE HAVE A LIMITED HISTORY
OPERATING AS A PROVIDER OF OUR CSD PLATFORM. We have a relatively brief
operating history as a provider of our CSD platform. As a result, our historical
financial information is of limited value in projecting future operating
results. On June 27, 2001, we exited our hardware business. Subsequent to our
fiscal year end of July 28, 2001 we made the strategic decision to exit the
professional services and Linux software engineering services fields to focus
solely on SourceForge. These changes required us to adjust our business
processes and make a number of significant personnel changes, including changes
and additions to our engineering and management teams. Therefore, in evaluating
our business you must consider the risks and difficulties frequently encountered
by early stage companies in new and rapidly evolving markets, including those
discussed within this "Factors That May Affect Future Results" and in
"Management's Discussion and Analysis of Financial Condition and Results of
Operations."

IF WE FAIL TO ADEQUATELY MONITOR AND MINIMIZE OUR USE OF EXISTING CASH AND
CREDIT FACILITIES, WE MAY NEED SUBSTANTIAL ADDITIONAL CAPITAL TO FUND CONTINUED
OPERATIONS IN FISCAL 2003. Since becoming a public company, we have experienced
negative
22

cash flow from operations and expect to experience negative cash flow from
operations for at least the foreseeable future. Unless we monitor and minimize
the level of use of our existing cash, cash equivalents, short-term investments
and credit facilities, we may require substantial additional capital to fund
continued operations into fiscal 2003. We believe that our existing cash
balances and credit facilities will be adequate to fund our operations for the
next twelve (12) months, although there can be no assurances in this regard. We
may require additional funding within this time frame, and there can be no
assurances that this additional funding, if needed, will be available on terms
acceptable to us, or at all. It is possible that we may require additional
financing within this period, particularly if the general economic downturn
continues to negatively affect revenues, or if we elect to acquire complementary
businesses or technologies. The factors described in this paragraph, and other
factors that may arise subsequently, will affect our future capital requirements
and the adequacy of our available funds. As a result, we may be required to
raise additional funds through public financing facilities, strategic
relationships or other arrangements. Any additional equity financing may be
dilutive to our stockholders. Debt financing, if available, may involve
restrictive covenants on our operations and financial condition. Our inability
to raise capital when needed could seriously harm our business.

BECAUSE WE HAVE A LIMITED OPERATING HISTORY WITH OUR NEW SOURCEFORGE
PRODUCT, WE MAY NOT ACCURATELY FORECAST OUR SALES AND REVENUES, WHICH WILL CAUSE
QUARTERLY FLUCTUATIONS IN OUR NET REVENUES AND RESULTS OF OPERATIONS AND MAY
RESULT IN VOLATILITY IN OUR STOCK PRICE. Our ability to accurately forecast our
quarterly sales and revenue is made difficult by our limited operating history
with our new business direction and the general economic downturn. In addition,
most of our operating costs are fixed and based on our revenue expectations.
Therefore, if we have a shortfall in revenues, we may be unable to reduce our
expenses quickly enough to avoid lower quarterly operating results. During
fiscal 1999, we hired 138 employees, moved into significantly larger facilities
and substantially increased our operating expenses. Throughout fiscal 2000, we
continued to add a significant number of new employees. In early fiscal 2001, we
again relocated to larger facilities. In February, June and August 2001, we
substantially reduced our workforce such that as of September 30, 2001 we had
209 employees. Nevertheless, despite these reductions in our workforce, our
business may fail to grow rapidly enough to offset our operating expenses. As a
result, our quarterly operating results could fluctuate, and such fluctuation
could adversely affect the market price of our common stock. Our quarterly net
revenues and results of operations may vary significantly in the future due to a
number of additional factors, many of which are outside of our control. The
primary factors that may cause our quarterly net revenues and results of
operations to fluctuate include the following:

- economic conditions generally and in the specific industries in which our
customers operate;

- demand for and market acceptance of our software and services;

- reductions in the sales price of our software or software offered by our
competitors;

- our ability to develop, introduce and market new versions of our software
and product enhancements that meet customer requirements in a timely
manner.

Accordingly, you should not rely on the results of any past periods as an
indication of our future performance. It is likely that in some future periods,
our operating results may be below expectations of public market analysts or
investors. If this occurs, the price of our common stock may drop.

FAILURE TO MAINTAIN OR INCREASE OUR GROSS MARGIN WILL HARM OUR RESULTS OF
OPERATIONS. Our gross margin may be adversely affected by decreases in the
average selling prices of our software or increased costs of providing service
and customer support. If we are unable to offset a decrease in the average
selling prices of our existing products by developing and introducing products
and services with higher margins or by reducing our product and development
costs, our gross margin will suffer.

For more information related to our costs associated with software
development and our gross margin, see "Management's Discussion and Analysis of
Financial Conditions and Results of Operations -- Results of Operations."

23

We from time to time makes internal estimates as to future operating
results, which are used for various purposes, including establishing reserves
and spending levels and allocations. Should our operating results fall short of
our internal estimates, or the other bases for our reserves adversely change,
our gross margin will suffer as we increase reserves or take other appropriate
actions.

SIGNIFICANT UNANTICIPATED FLUCTUATIONS IN OUR QUARTERLY REVENUES AND
OPERATING RESULTS MAY CAUSE US NOT TO MEET SECURITIES ANALYSTS' OR INVESTORS'
EXPECTATIONS AND MAY RESULT IN A DECLINE IN THE PRICES OF OUR COMMON STOCK. Our
net revenues and operating results are difficult to predict and may fluctuate
significantly from quarter to quarter. If our revenues, operating results,
earnings, or future projections are below the levels expected by securities
analysts, the price of our common stock is likely to decline.

Factors that may cause quarterly fluctuations in our operating results
include, but are not limited to:

- the discretionary nature of our customers' purchase and budget cycles;

- difficulty predicting the size and timing of customer orders;

- long sales cycles;

- seasonal variations in operating results;

- introduction or enhancement of our products or our competitors' products;

- changes in our pricing policies or the pricing policies of our
competitors;

- an increase in our operating costs;

- whether we are able to expand our sales and marketing programs;

- the mix of our products and services sold;

- the level of sales incentives for our direct sales force;

- the mix of our domestic and international sales;

- unfavorable economic conditions in the technology industry;

- decreased spending on technology due to adverse economic conditions;

- fluctuations in foreign currency exchange rates;

- changes in accounting pronouncements applicable to us;

- the timing of announcements and releases of new or enhanced versions of
our products and product upgrades;

- the introduction of competitive products by existing or new competitors;

- end-of-period buying patterns of foreign and domestic software markets;
and

- the market's transition between new releases of operating systems.

In addition to the foregoing factors, the risk of quarterly fluctuations is
increased by the fact that many enterprise customers negotiate site licenses
near the end of each quarter. In part, this is because enterprise customers are
able, or believe that they are able, to negotiate lower prices and more
favorable terms at that time. Our reliance on a large portion of revenue
occurring at the end of the quarter and the increase in the dollar value of
transactions that occur at the end of a quarter can result in increased
uncertainty relating to quarterly revenues. Due to this end-of-period buying
pattern, forecasts may not be achieved, either because expected sales do not
occur or because they occur at lower prices or on terms that are less favorable
to us. In addition, these factors increase the chances that our results could
diverge from the expectations of investors and analysts.

24

In addition, the timing of our product revenues is difficult to predict
because our sales cycles vary substantially from customer to customer. We base
our operating expenses on our expectations regarding future revenue levels. As a
result, if total revenues for a particular quarter are below our expectations,
we could not proportionately reduce operating expenses for that quarter.
Therefore, a revenue shortfall would have a disproportionate effect on our
operating results for that quarter. In addition, because our service revenues
are largely correlated with our license revenues, a decline in license revenues
could also cause a decline in our service revenues in the same quarter or
subsequent quarters.

WE HAVE A HISTORY OF LOSSES AND EXPECT TO CONTINUE TO INCUR NET LOSSES FOR
THE FORESEEABLE FUTURE. We incurred a loss of $290.1 million for our fiscal
fourth quarter ended July 28, 2001, primarily due to the general economic
slowdown, and we had an accumulated deficit of $634.9 million as of July 28,
2001. We expect to continue to incur significant product development, sales and
marketing and administrative expenses. In addition, we are investing
considerable resources in our Internet operations. We do not expect to generate
sufficient revenues to achieve profitability and, therefore, we expect to
continue to incur net losses for at least the foreseeable future. If we do
achieve profitability, we may not be able to sustain it. Failure to become and
remain profitable may materially and adversely affect the market price of our
common stock and our ability to raise capital and continue operations.

FUTURE GUIDELINES AND INTERPRETATIONS REGARDING SOFTWARE REVENUE
RECOGNITION COULD HAVE A MATERIAL IMPACT ON OUR BUSINESS. In October 1997, the
American Institute of Certified Public Accountants ("AICPA") issued Statement of
Position ("SOP") No. 97-2, "Software Revenue Recognition" which superceded SOP
No. 91-1. SOP No. 97-2, as amended by SOP No. 98-4 and SOP No. 98-9, provides
guidance on applying generally accepted accounting principles for software
revenue recognition transactions. In December 1999, the SEC issued SAB No. 101,
"Revenue Recognition in Financial Statements," which provides further revenue
recognition guidance. We adopted SAB No. 101, as amended, in the fourth quarter
of fiscal 2001 as required. The adoption of SAB No. 101 did not have a material
effect on our consolidated financial position, results of operations or cash
flows. The accounting profession continues to review certain provisions of SOP
No. 97-2 and SAB No. 101 with the objective of providing additional guidance on
implementing its provisions. Depending upon the outcome of these reviews and the
issuance of implementation guidelines and interpretations, we may be required to
change its revenue recognition policies and business practices and such changes
could have a material adverse effect on our business, results of operations or
financial position.

RISKS RELATED TO INTELLECTUAL PROPERTY

WE ARE VULNERABLE TO CLAIMS THAT OUR PRODUCTS INFRINGE THIRD-PARTY
INTELLECTUAL PROPERTY RIGHTS. ANY RESULTING CLAIMS AGAINST US COULD BE COSTLY TO
DEFEND OR SUBJECT US TO SIGNIFICANT DAMAGES. From time to time we receive
notices from third parties claiming infringement by our products of third party
patent and other intellectual property rights. We expect that our software
products will increasingly be subject to infringement claims as the number of
products and competitors in our industry segments grows and the functionality of
products in different industry segments overlaps. In addition, we may receive
patent infringement claims as companies increasingly seek to patent their
software, especially in light of recent developments in the law that extend the
ability to patent software. Our developers may fail to perform patent searches
and may therefore unwittingly infringe third-party patent rights. We cannot
prevent current or future patent holders or other owners of intellectual
property from suing us and others seeking monetary damages or an injunction
against shipment of our software offerings. A patent holder may deny us a
license or force us to pay royalties. In either event, our operating results
could be seriously harmed. In addition, employees hired from competitors might
utilize proprietary and trade secret information from their former employers
without our knowledge, even though our employment agreements and policies
clearly prohibit such practices.

Any litigation regarding our intellectual property, with or without merit,
could be costly and time consuming to defend, divert the attention of our
management and key personnel from our business operations and cause product
shipment delays. Claims of intellectual property infringement may require us to
enter into royalty and licensing agreements that may not be available on terms
acceptable to us, or at all. In addition,
25

parties making claims against us may be able to obtain injunctive or other
equitable relief that could effectively block our ability to sell our products
in the United States and abroad and could result in an award of substantial
damages against us. Defense of any lawsuit or failure to obtain any required
license could delay shipment of our products and increase our costs. If a
successful claim is made against us and the we fail to develop or license a
substitute technology, our business, results of operations, financial condition
or cash flows could be immediately and materially adversely affected.

IF WE FAIL TO ADEQUATELY PROTECT OUR INTELLECTUAL PROPERTY RIGHTS,
COMPETITORS MAY USE OUR TECHNOLOGY AND TRADEMARKS, WHICH COULD WEAKEN OUR
COMPETITIVE POSITION, REDUCE OUR REVENUES, AND INCREASE OUR COSTS. We rely on a
combination of copyright, trademark, patent, and trade-secret laws, employee and
third-party nondisclosure agreements, and other arrangements to protect our
proprietary rights. Despite these precautions, it may be possible for
unauthorized third parties to copy our products or obtain and use information
that we regard as proprietary to create products that compete against ours. Some
license provisions protecting against unauthorized use, copying, transfer, and
disclosure of our licensed programs may be unenforceable under the laws of
certain jurisdictions and foreign countries.

In addition, the laws of some countries do not protect proprietary rights
to the same extent as do the laws of the United States. To the extent that we
increase our international activities, our exposure to unauthorized copying and
use of our products and proprietary information will increase. We do not
currently plan to increase the current level of our international activity.

Our collection of trademarks is important to our business. The protective
steps we take or have taken may be inadequate to deter misappropriation of our
trademark rights. We have filed applications for registration of some of our
trademarks in the United States and internationally. Effective trademark
protection may not be available in every country in which we offer or intend to
offer our products and services. Failure to protect our trademark rights
adequately could damage our brand identity and impair our ability to compete
effectively. Furthermore, defending or enforcing our trademark rights could
result in the expenditure of significant financial and managerial resources.

The scope of United States patent protection in the software industry is
not well defined and will evolve as the United States Patent and Trademark
Office grants additional patents. Because patent applications in the United
States are not publicly disclosed until the patent is issued, applications may
have been filed that would relate to our products.

Our success depends significantly upon our proprietary technology. Despite
our efforts to protect our proprietary technology, it may be possible for
unauthorized third parties to copy certain portions of our products or to
reverse engineer or otherwise obtain and use our proprietary information. We do
not have any software patents, and existing copyright laws afford only limited
protection. In addition, we cannot be certain that others will not develop
substantially equivalent or superseding proprietary technology, or that
equivalent products will not be marketed in competition with our products,
thereby substantially reducing the value of our proprietary rights. We cannot
assure you that we will develop proprietary products or technologies that are
patentable, that any patent, if issued, would provide us with any competitive
advantages or would not be challenged by third parties, or that the patents of
others will not adversely affect our ability to do business. Litigation may be
necessary to protect our proprietary technology. This litigation may be
time-consuming and expensive.

PROMOTIONAL PRODUCT VERSIONS MAY ADVERSELY IMPACT OUR ACTUAL PRODUCT
SALES. Our marketing strategy relies in part on making elements of our
technology available for no charge or at a very low price. This strategy is
designed to expose our products to a broader customer base than to our
historical customer base and to encourage potential customers to purchase an
upgrade or other full priced products from us.

We may not be able to introduce enhancements to our full-price products or
versions of our products with intermediate functionality at a rate necessary to
adequately differentiate them from the promotional versions, which could reduce
sales of our products.

26

WE MAY BE SUBJECT TO CLAIMS AS A RESULT OF INFORMATION PUBLISHED ON, POSTED
ON OR ACCESSIBLE FROM OUR INTERNET SITES. We may be subject to claims of
defamation, negligence, copyright or trademark infringement (including
contributory infringement) or other claims relating to the information contained
on our Internet sites, whether written by third parties or us. These types of
claims have been brought against online services in the past and can be costly
to defend regardless of the merit of the lawsuit. Although recent federal
legislation protects online services from some claims when third parties write
the material, this protection is limited. Furthermore, the law in this area
remains in flux and varies from state to state. We receive notification from
time to time of potential claims, but have not been named as a party to
litigation involving such claims. While no formal complaints have been filed
against us to date, our business could be seriously harmed if one were asserted.

OTHER RISKS RELATED TO OUR BUSINESS

FUTURE REVENUE GROWTH DEPENDS ON OUR ABILITY TO HIRE AND RETAIN QUALIFIED
PERSONNEL. During late fiscal 2001 and early fiscal 2002, we hired a
significant number of software development, sales and marketing personnel.
Competition for these individuals is intense, and we may not be able to attract,
assimilate or retain highly qualified personnel. Our future success and ability
to grow our revenue also depend upon the continued service of our executive
officers and other key engineering, sales, marketing and support personnel.
Competition for qualified personnel in our industry and in the San Francisco Bay
Area, as well as the other geographic markets in which we recruit, is intense
and characterized by increasing salaries, which may increase our operating
expenses or hinder our ability to recruit qualified candidates.

IF WE ARE UNABLE TO IMPLEMENT APPROPRIATE SYSTEMS, PROCEDURES AND CONTROLS,
WE MAY NOT BE ABLE TO SUCCESSFULLY OFFER OUR SERVICES AND GROW OUR SOFTWARE
BUSINESS. Our ability to successfully offer our services and grow our software
business requires an effective planning and management process. In the past
twenty-four months we have implemented or updated our operations and financial
systems, procedures and controls, including the implementation of an enterprise
resource planning. Our systems will continue to require additional modifications
and improvements to respond to current and future changes in our business. Our
key personnel have limited experience managing this type of fluctuation in
operations. If we cannot grow our software business, and manage that growth
effectively, or if we fail to timely implement appropriate internal systems,
procedures, controls and necessary modifications and improvements to these
systems, our business will suffer.

27

ITEM 7A. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK

The primary objective of our investment activities is to preserve principal
while at the same time maximizing the income we receive from our investments
without significantly increasing risk. Some of the securities that we have
invested in may be subject to market risk. This means that a change in
prevailing interest rates may cause the principal amount of the investment to
fluctuate. For example, if we hold a security that was issued with a fixed
interest rate at the then-prevailing rate and the prevailing interest rate later
rises, the principal amount of our investment will probably decline. To minimize
this risk, we maintain a portfolio of cash equivalents and short-term
investments in a variety of securities, including commercial paper, money market
funds and government and non-government debt securities. In general, money
market funds are not subject to market risk because the interest paid on such
funds fluctuates with the prevailing interest rate.

The following table presents the amounts of our cash equivalents and
short-term investments that are subject to market risk and weighted-average
interest rates, categorized by expected maturity dates, as of July 28, 2001.
This table does not include money market funds because those funds are not
subject to market risk.

We have operated primarily in the United States, and virtually all sales
have been made in U.S. dollars. Accordingly, we have not had any material
exposure to foreign currency rate fluctuations.

28

ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA

TABLE OF CONTENTS

All other schedules are omitted because they are not applicable, not
required, or because the required information is included in the consolidated
financial statements or notes thereto.

29

REPORT OF INDEPENDENT PUBLIC ACCOUNTANTS

To The Board of Directors and Stockholders of
VA Linux Systems, Inc.:

We have audited the accompanying consolidated balance sheets of VA Linux
Systems, Inc. (a Delaware corporation) as of July 28, 2001 and 2000, and the
related consolidated statements of operations, stockholders' equity and cash
flows for each of the three years in the period ended July 28, 2001. These
financial statements are the responsibility of the Company's management. Our
responsibility is to express an opinion on these financial statements based on
our audits.

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

In our opinion, the financial statements referred to above present fairly,
in all material respects, the financial position of VA Linux Systems, Inc. as of
July 28, 2001 and 2000, and the results of its operations and its cash flows for
each of the three years in the period ended July 28, 2001, in conformity with
accounting principles generally accepted in the United States.

Our audit was made for the purpose of forming an opinion on the basic
financial statements taken as a whole. The schedule listed in Item 14(a)2 is
presented for purposes of complying with the Securities and Exchange
Commission's rules and is not part of the basic financial statements. This
schedule has been subjected to the auditing procedures applied in the audit of
the basic financial statements and, in our opinion, fairly states in all
material respects the financial data required to be set forth therein in
relation to the basic financial statements taken as a whole.

ARTHUR ANDERSEN LLP

San Jose, California
August 22, 2001

30

VA LINUX SYSTEMS, INC.

CONSOLIDATED BALANCE SHEETS
(IN THOUSANDS, EXCEPT SHARE INFORMATION)

The accompanying notes are an integral part of these financial statements.
31

VA LINUX SYSTEMS, INC.

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

The accompanying notes are an integral part of these financial statements.
32

VA LINUX SYSTEMS, INC.

CONSOLIDATED STATEMENTS OF STOCKHOLDERS' EQUITY
(IN THOUSANDS)

The accompanying notes are an integral part of these financial statements.
33

VA LINUX SYSTEMS, INC.

CONSOLIDATED STATEMENTS OF CASH FLOWS
(IN THOUSANDS)

The accompanying notes are an integral part of these financial statements.
34

VA LINUX SYSTEMS, INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

1. ORGANIZATION AND OPERATIONS OF THE COMPANY:

VA Linux, Inc. ("VA Linux" or the "Company") was incorporated in January
1995 in California as VA Research, Inc. In June 1999, the Company's name was
changed to VA Linux Systems, Inc. and in December 1999 reincorporated in
Delaware. In December 1999, the Company sold 4,400,000 shares of common stock to
the public in its initial public offering.

From inception through June 27, 2001, the Company was a provider of
Linux-based computer systems and services, Internet infrastructure and Open
Source Software Services and OSDN, the Open Source Development Network.

On June 27, 2001 the Company announced its decision to exit the systems
business and pursue the application software business. Subsequent to its fiscal
year end of July 28, 2001, the Company made the decision to exit the
professional services and Linux software engineering services fields in order to
focus solely on its SourceForge collaborative software development platforms.

The Company operates on a 52-53 week year ending the Saturday before July
31. Prior to the quarter ended January 27, 2001, the last day of each fiscal
quarter and year end was Friday. This change did not have a material impact on
the results of operations for the year ended July 28, 2001, or to prior periods.

The Company is subject to certain risks, including without limitation,
risks relating to fluctuating operating results, customer and market acceptance
of new products, dependence on new products, rapid technological change,
litigation, dependence on growth in the computer software market, management of
international operations, product concentration, changing product mix,
competition, reliance on a limited number of suppliers, equity investments and
acquisitions, management of our operations in light of reduced demand for our
products, dependence on proprietary technology, intellectual property rights,
dependence on key personnel, volatility of stock price, shares eligible for
future sale, effect of certain anti-takeover provisions and dilution and
dependence on a continuous power supply.

2. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES:

USE OF ESTIMATES

The preparation of financial statements in conformity with accounting
principles generally accepted in the United States requires management to make
estimates and assumptions that affect the reported amounts of assets and
liabilities and disclosure of contingent assets and liabilities at the date of
the financial statements and the reported amounts of revenues and expenses
during the period. Significant estimates made by the Company include reserves
for inventory and accounts receivable, amortization periods for intangible
assets and goodwill and depreciation lives. Actual results could differ from
those estimates.

PRINCIPLES OF CONSOLIDATION

These consolidated financial statements include the accounts of VA Linux
Systems, Inc. and its wholly and majority owned subsidiaries. All significant
intercompany accounts and transactions have been eliminated in consolidation. In
September, 2000, the Company acquired 68% of the outstanding shares of common
stock of VA Linux KK (Japan) for a cash purchase price of approximately $6.9
million. The minority interest in the results of operations for VA Linux KK have
not been material to date and have been recorded in other income in the
accompanying statements of operations. The minority interest of VA Linux KK is
reflected separately in the balance sheet outside of stockholders' equity.

FOREIGN CURRENCY TRANSLATION

The functional currency of a foreign operation is deemed to be the
country's local currency. Consequently, balance sheet accounts are translated
into U.S. dollars at exchange rates prevailing at balance sheet
35

VA LINUX SYSTEMS, INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)

dates. Revenue and expenses are translated into U.S. dollars at average rates
for the period. Gains and losses resulting from translation are accumulated as a
component of stockholders' equity.

CASH, CASH EQUIVALENTS AND SHORT-TERM INVESTMENTS

The Company considers all highly liquid investments with an original
maturity of three months or less to be cash equivalents. Cash and cash
equivalents consist principally of cash deposited in money market and checking
accounts.

The Company accounts for its investments under the provisions of Statement
of Financial Accounting Standards ("SFAS") No. 115, "Accounting for Certain
Investments in Debt and Equity Securities." Investments in highly liquid
financial instruments with original maturities greater than three months but
less than one year are classified as short-term investments. All short-term
investments are deemed by management to be available-for-sale and are reported
at fair value with net unrealized gains (losses) reported, net of tax, as other
comprehensive loss in stockholders' equity. To date the unrealized gains
(losses) have not been material. The fair value of the Company's
available-for-sale securities is based on quoted market prices at the balance
sheet dates.

Cash equivalents and short-term investments are all due within one year and
consist of the following (in thousands):

RESTRICTED CASH

During fiscal 2001, the Company established letters of credit of
approximately $4.0 million used to collateralize the delivery of customer parts
from a single supplier. As of July 28, 2001, the Company had approximately $0.6
million of restricted cash outstanding on the letters of credit.

INVENTORIES

Inventories are stated at the lower of cost or market, using the first-in
first-out method, and are comprised of materials. Inventories consist of the
following (in thousands):

Provisions, when required, are made to reduce excess and obsolete
inventories to their estimated net realizable values. Due to competitive
pressures and technological innovation, it is possible that estimates of net
realizable value could change.

36

VA LINUX SYSTEMS, INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)

PROPERTY AND EQUIPMENT

Property and equipment are stated at cost and are depreciated using the
straight-line method over the estimated useful lives (two to five years) of the
assets. Leasehold improvements are amortized over the corresponding lease term.
Property and equipment consist of the following (in thousands):

GOODWILL AND INTANGIBLES

Goodwill and intangibles are amortized on a straight-line basis over three
to five years. Goodwill and intangibles consist of the following:

IMPAIRMENT OF LONG-LIVED ASSETS

The Company continually evaluates whether events and circumstances have
occurred that indicate the remaining estimated useful lives of long-lived assets
may warrant revision or that the remaining balance of long-lived assets may not
be recoverable in accordance with SFAS No. 121, "Accounting for Impairment of
Long-Lived Assets and for Long-Lived Assets to be Disposed of." When factors
indicate that long-lived assets should be evaluated for possible impairment, the
Company uses an estimate of the related undiscounted future cash flows over the
remaining life of the long-lived assets in measuring whether they are
recoverable. If the estimated undiscounted future cash flows exceed the carrying
value of the asset, a loss is recorded as the excess of the assets carrying
value over fair value. Long-lived assets and certain identifiable intangible
assets to be disposed of are reported at the lower of carrying amount or fair
value less costs to sell. See Note 3 for details on impairment charges
recognized during fiscal 2001.

REVENUE RECOGNITION

The Company's revenue recognition policy follows SEC Staff Accounting
Bulletin ("SAB") No. 101, "Revenue Recognition in Financial Statements."
Specifically, product revenues from the sale of Linux-based servers, components,
and desktop computers are recognized when persuasive evidence of an arrangement
exists, delivery has occurred, the sales price is fixed and determinable, and
collectibility is probable. In general, revenue is recognized upon shipment of
the goods. The Company generally does not grant to its customers any

37

VA LINUX SYSTEMS, INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)

rights to return products. The Company provides allowances for warranty costs at
the time of shipment. Revenues from customer support services, including on-site
maintenance and technical support, are recognized pro-rata over the term of the
related service agreement. Revenues from professional service contracts are
recognized as revenue upon completion of the project, or using the percentage of
completion method of the project where project costs can be reasonably
estimated. Any payments received prior to revenue recognition are recorded as
deferred revenue. For the years ended July 28, 2001 and 2000 and July 31, 1999,
revenues from customer support services and professional service contracts were
not material.

Advertising revenues are derived from the sale of advertising space on the
Company's various websites. Advertising revenues are recognized over the period
in which the advertisements are displayed, provided that no significant
obligations remain and collection of the receivable is probable. The Company's
obligations typically include guarantees of a minimum number of "impressions"
(times that an advertisement is viewed by users of the Company's online services
over a specified period of time). To the extent that minimum guaranteed
impressions are not met, the Company does not recognize the corresponding
revenues until the guaranteed impressions are achieved.

STOCK-BASED COMPENSATION

SFAS No. 123, "Accounting for Stock-Based Compensation" permits the use of
either a fair value based method or the method defined in Accounting Principles
Board ("APB") Opinion No. 25, "Accounting for Stock Issued to Employees" to
account for stock-based compensation arrangements. Companies that elect to
employ the valuation method provided in APB No. 25 are required to disclose the
pro forma net income (loss) that would have resulted from the use of the fair
value based method. The Company has elected to continue to determine the value
of stock-based compensation arrangements under the provisions of APB No. 25 and,
accordingly, it has included the pro forma disclosures required under SFAS No.
123 in the notes to the financial statements (see Note 9).

The value of options, stock purchase rights and stock exchanged for
services rendered or assets acquired are valued using the Black-Scholes option
pricing model. To calculate the expense or asset value, the Company uses either
the fair value of the consideration received or the fair value of the equity
instruments issued, whichever is more reliably measurable.

SOFTWARE DEVELOPMENT COSTS

In accordance with SFAS No. 86, "Accounting for the Cost of Computer
Software to be Sold, Leased, or Otherwise Marketed," development costs incurred
in the research and development of new software products are expensed as
incurred until technological feasibility in the form of a working model has been
established. To date, the Company's software development has been completed
concurrent with the establishment of technological feasibility and, accordingly,
all software development costs have been charged to research and development
expense in the accompanying statements of operations.

COMPUTATION OF PER SHARE AMOUNTS

Basic net loss per common share and diluted net loss per common share are
presented in conformity with SFAS No. 128, "Earnings Per Share" for all periods
presented.

In accordance with SFAS No. 128, basic net loss per common share has been
calculated using the weighted-average number of shares of common stock
outstanding during the period, less shares subject to repurchase. For the years
ended July 28, 2001 and 2000 and July 31, 1999, the Company has excluded all
convertible preferred stock and outstanding stock options from the calculation
of diluted net loss per common share because all such securities are
antidilutive for those periods. The total number of shares excluded from

38

VA LINUX SYSTEMS, INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)

the calculations of diluted net loss per common share were 4,104,969, 14,514,563
and 25,320,000 for the years ended July 28, 2001 and 2000 and July 31, 1999,
respectively.

The following table presents the calculation of basic and diluted net loss
per share (in thousands, except per share data):

COMPREHENSIVE INCOME (LOSS)

In June 1997, the Financial Accounting Standards Board ("FASB") issued SFAS
No. 130, "Reporting Comprehensive Income," which establishes standards for
reporting and presentation of comprehensive income. Comprehensive income (loss)
is comprised of net income (loss) and other non-owner changes in stockholders'
equity, including foreign currency translation gains or loss and unrealized
gains or losses on available-for sale marketable securities. For the year ended
July 28, 2001, foreign currency translation losses, net were approximately $1.5
million, and unrealized gains, net were approximately $12,000 resulting in a
comprehensive loss of $526.7 million. For the years ended July 28, 2000 and July
31, 1999, comprehensive income (loss) approximated net income (loss).

RECENT ACCOUNTING PRONOUNCEMENTS

In June 1998, the FASB issued SFAS No. 133 "Accounting for Derivative
Instruments and Hedging Activities." SFAS No. 133 establishes accounting and
reporting standards requiring that every derivative instrument be recorded in
the balance sheet as either an asset or liability measured at its fair value.
SFAS No. 133, as amended, is effective for fiscal years beginning after June 15,
2000. The Company adopted SFAS No. 133 on July 29, 2000 and this adoption did
not have a material effect on the financial position or results of operations.

In December 1999, the SEC issued SAB No. 101, "Revenue Recognition in
Financial Statements." In June 2000, the SEC deferred the adoption date for SAB
No. 101 until the Company's fourth quarter ended July 28, 2001. SAB No. 101
summarizes certain areas of the Staff's views in applying generally accepted
accounting principles to revenue recognition in financial statements. The
Company adopted SAB No. 101 in May 2001 and this adoption did not have a
material effect on the financial position or results of operations.

In June 2001, the FASB issued SFAS No. 141, "Accounting for Business
Combinations." This statement requires the purchase method of accounting be used
for all business combinations initiated after June 30, 2001, and establishes
specific criteria for the recognition of intangible assets separately from
goodwill. The Company will follow the requirements of this statement for
business acquisitions made after June 30, 2001.

In June 2001, the FASB issued SFAS No. 142, "Goodwill and Other Intangible
Assets." Under SFAS No. 142, goodwill and intangible assets with an indefinite
life are not amortized. Instead of amortizing goodwill and intangible assets
deemed to have an indefinite life, the statement requires a test for impairment
to be performed annually, or immediately if conditions indicate that such an
impairment could exist. The

39

VA LINUX SYSTEMS, INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)

amortization period of intangible assets with finite lives will no longer be
limited to forty years. This statement is effective for fiscal years beginning
after December 15, 2001, and permits early adoption for fiscal years beginning
after March 15, 2001. The Company adopted SFAS No. 142 on July 29, 2001. As a
result of adopting SFAS No. 142, the Company will stop recording amortization of
goodwill of approximately $8.6 million per year. The Company is currently
reviewing remaining goodwill and intangible assets to determine whether recent
economic events and the impact of adopting this standard have resulted in
impairment.

SUPPLIER CONCENTRATION

In fiscal 2001 and 2000, the Company was dependent on a single contract
manufacturer for substantially all of its manufacturing and supply chain
management, including component procurement and inventory management for its
systems and services segment (see Note 11). The contract manufacturer was also
an investor in the Company.

CONCENTRATIONS OF CREDIT RISK AND SIGNIFICANT CUSTOMERS

Financial instruments that potentially subject the Company to
concentrations of credit risk consist primarily of trade receivables. The
Company provides credit, in the normal course of business, to a number of
companies and performs ongoing credit evaluations of its customers. As of July
28, 2001, approximately 24% of gross accounts receivables were concentrated with
one customer. As of July 28, 2000, approximately 28% of gross accounts
receivables were concentrated with one customer. For the fiscal year ended July
28, 2001, one customer accounted for approximately 25% of net revenues. For the
fiscal year ended July 28, 2000, one customer accounted for approximately 18% of
net revenues. No customer accounted for more than 10% of net revenues in fiscal
1999.

RECLASSIFICATIONS

Certain prior year amounts have been reclassified to conform to current
year presentation.

3. ACQUISITIONS AND DIVESTITURES

During the years ended July 28, 2001 and 2000, the Company completed a
number of acquisitions accounted for using the purchase method. The consolidated
financial statements include the operating results of each business from the
date of acquisition. The value assigned to purchased in-process research and
development, based on the income method prepared by an independent third party,
was determined by identifying research projects in areas for which technological
feasibility had not been established and no future alternative uses existed.
Amounts allocated to goodwill and purchased intangible assets are amortized on a
straight-line basis over three to five years.

BRAVE NEW WORLDS, INC.

On September 26, 2000, in an acquisition accounted for under the purchase
method of accounting, VA Linux acquired all of the outstanding shares of BNW for
approximately $2.5 million. The consideration included approximately 35,000
shares of VA Linux common stock valued at $1.7 million and cash of approximately
$750,000. The purchase agreement contained additional payments to be made in
common stock that were solely contingent upon the continued employment of
certain key employees for a period of four years. Maximum future payments
contingent on employment of the key employees was to be $4.8 million in stock
(approximately 97,000 shares) and was payable after 12 months, 24 months, 36
months and 48 months. The contingent payments were accounted for as compensation
expense on a pro rata basis over the term of the employment condition and not as
purchase price. Upon consummation of the acquisition, VA Linux established an
escrow for these contingent payments. The disclosures of the allocation of
purchase price and
40

VA LINUX SYSTEMS, INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)

pro forma data have been omitted as the amounts are not material. In February
2001, in response to the general slowdown in the economy, the Company adopted a
plan to reduce operating costs. The plan involved the divestiture of the managed
services business, including the recently acquired BNW. Charges were recorded to
write down the net book value of the BNW net assets acquired to the Company's
estimate of proceeds to be received on the sale of the business, which was
estimated to be nominal. In addition, compensation expense of $1.4 million was
recorded for the acceleration of a portion of the contingent consideration
related to severance arrangements made with terminated BNW employees. The sale
of BNW was completed on June 10, 2001 for minimal proceeds. The charges
associated with this divestiture have been recorded as restructuring costs and
other special charges in the statement of operations (see Note 4).

LIFE BVBA

On September 29, 2000, in an acquisition accounted for under the purchase
method of accounting, VA Linux acquired all of the outstanding shares of Life
for approximately $860,000. The consideration included approximately 14,000
shares of VA Linux common stock valued at $660,000 and cash of approximately
$200,000. The purchase agreement contained additional payments to be made in
common stock that were solely contingent upon the continued employment of
certain key employees for a period of four years. Maximum future payments
contingent on employment of the key employees were capped at $2.0 million in
stock (approximately 43,000 shares) and was originally payable after 12 months,
24 months, 36 months and 48 months. Upon consummation of the acquisition, VA
Linux established an escrow for these contingent payments. The disclosures of
the allocation of purchase price and pro forma data have been omitted as the
amounts are not material. In February 2001, in response to the general slowdown
in the economy, the Company adopted a plan to reduce operating costs. The plan
involved the divestiture of the managed services business, including the
recently acquired Life. The sale of Life was completed on April 25, 2001 for
minimal proceeds. In addition, compensation expense of $1.3 million was recorded
for the acceleration of the contingent consideration related to severance
arrangements made with terminated Life employees. The charges associated with
this divestiture have been recorded as restructuring costs and other special
charges in the statement of operations (see Note 4).

TRUSOLUTIONS, INC.

On March 28, 2000, in an acquisition accounted for under the purchase
method of accounting, VA Linux acquired all of the outstanding shares of
TruSolutions, Inc. ("TruSolutions") for approximately $72.9 million (including
acquisition costs of approximately $400,000). The consideration included 767,000
shares of VA Linux common stock valued at $56.7 million, cash of approximately
$10 million and the assumption of outstanding options to purchase TruSolutions
common stock valued at $5.8 million. The purchase agreement contained additional
payments to be made in common stock that were solely contingent upon the
continued employment of certain key employees for a period of three years.
Maximum future payments, contingent on employment of the key employees, was
$96.3 million payable in stock (approximately 1,303,000 shares) and was
originally payable after 12 months, 24 months and 36 months (approximately
501,000 shares, 501,000 shares and 301,000 shares, respectively). The contingent
payments were to be accounted for as compensation expense over the term of the
employment condition and not as part of the purchase price. The purchase price
of $72.9 million was allocated as follows: $62.2 million to goodwill, $7.7
million to other intangible assets, $4.0 million to in-process research and
development and the remainder to other assets and liabilities.

TruSolutions' in-process research projects included the research and
development associated with the 1/2U, 1U, 2U, and 4U server products. The value
of in-process research and development was determined by estimating the costs to
develop the purchased in-process technology into commercially viable products,
estimating the resulting net cash flows from such projects and discounting the
net cash flows back to their present value. The discount rate included a
risk-adjusted discount rate to take into account the uncertainty surrounding the
successful development of the purchased in-process technology. The risk-adjusted
discount
41

VA LINUX SYSTEMS, INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)

rate applied to the projects' cash flows was 45% for the in-process technology.
The Company believes that the estimated in-process technology amounts represent
fair value and do not exceed the amount a third party would pay for the
projects. The valuation included cash inflows from in-process technology through
2003 with revenues commencing in 2000 for the 1U, 2U and 4U servers, and in 2001
for the 1/2U server. Where appropriate, the Company allocated anticipated cash
flows from an in-process research and development project to reflect
contributions of the core technology. At the time of the merger, TruSolutions'
remaining tasks that were substantially incomplete included: developing
additional server features as well as proving out the in-process products'
electrical designs, testing for compatibility with other systems common in
server farms, and testing for Linux performance. Finally, TruSolutions needed to
conduct shock, vibration and performance testing. The Company estimated that it
would cost approximately $400,000 to complete the projects with significant
remaining development efforts. As of July 28, 2001, the Company does not expect
to incur any additional charges related to these projects.

In February 2001, in response to the general slowdown in the economy, the
Company adopted a plan to reduce operating costs. The plan included charges
related to the closure of TruSolution's sole facility located in San Diego. In
addition, compensation expense of $33.3 million was recorded for the
acceleration of the contingent consideration related to severance arrangements
with terminated TruSolutions' employees. These charges were recorded as
restructuring costs and other special charges in the statements of operations
(see Note 4). In June 2001, the Company adopted a plan to exit the systems
business. As a result, the net book value of goodwill and intangible assets of
$50.6 million related to the TruSolutions acquisition was written down to zero
as there are no future cash flows expected from this business pursuant to the
completion of the restructuring plan (see Note 4).

NETATTACH, INC.

On April 5, 2000, in an acquisition accounted for under the purchase method
of accounting, VA Linux acquired all of the outstanding shares of NetAttach,
Inc. ("NetAttach") for approximately $37.4 million (including acquisition costs
of approximately $300,000). The purchase price included 396,000 shares of VA
Linux common stock valued at $24.6 million, cash of $10.0 million and the
assumption of outstanding options valued at $2.5 million. The purchase agreement
also contained additional payments to be made in common stock. These payments
were solely contingent upon the continued employment of certain key employees
for a period of two years. Maximum future payments, contingent on employment of
the key employees, are $5.4 million payable in stock (approximately 86,000
shares of VA Linux common stock) and are payable on the two-year anniversary
date of the merger. The contingent payments are accounted for as compensation
expense over the term of the employment condition and not as part of the
purchase price. The total purchase price of $37.4 million was allocated as
follows: $33.1 million to goodwill, $4.8 million to other intangible assets and
the remainder to other assets and liabilities. As part of the NetAttach
acquisition, the Company assumed certain warrant agreements in association with
the purchase. The fair market value of the warrants was not material. All
warrants have been converted into common stock.

Subsequent to July 28, 2001, the Company made the decision to exit the
Network Attached Storage (NAS) business and will record restructuring and other
special charges related to this decision in the first quarter of fiscal 2002.

PRECISION INSIGHT, INC.

On April 14, 2000, in an acquisition accounted for under the purchase
method of accounting, VA Linux acquired all of the outstanding shares of
Precision Insight, Inc. ("Precision Insight") for approximately $4.1 million.
The consideration included approximately 32,000 shares of VA Linux common stock
valued at $2.3 million and cash of approximately $1.8 million. The purchase
agreement contained additional payments to be made in common stock that were
solely contingent upon the continued employment of certain key

42

VA LINUX SYSTEMS, INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)

employees for a period of four years. Maximum future payments, contingent on
employment of the key employees, was $11.5 million in stock (approximately
157,000 shares of VA Linux common stock) and were originally payable after 24
months, 36 months and 48 months (approximately 52,300 shares each year). The
contingent payments were to be accounted for as compensation expense over the
term of the employment condition and not as purchase price. The disclosures of
the allocation of purchase price and pro forma data have not been disclosed as
the amounts are not material.

Subsequent to our July 28, 2001, the Company made the decision to exit the
professional services business and will record restructuring and other special
charges related to this decision in the first quarter of fiscal 2002.

OSDN

On June 7, 2000, in an acquisition accounted for under the purchase method
of accounting, VA Linux acquired all of the outstanding shares of OSDN (formerly
known as Andover.Net, Inc.) for approximately $342.0 million (including
acquisition costs of approximately $5.0 million). The purchase price included
6,986,000 shares of VA Linux common stock valued at $315.0 million and the
assumption of outstanding options to purchase VA Linux common stock valued at
approximately $22.0 million. The purchase price was allocated as follows: $229.7
million to goodwill, $38.4 million to other intangible assets, $5.0 million to
in-process research and development and the remainder to other assets and
liabilities.

OSDN's in-process research projects included next-generation web site
management tools, online web applications, and other technologies that will
support the Company's vast network of web sites. The value of in-process
research and development was determined by estimating the costs to develop the
purchased in-process technology into commercially viable products, estimating
the resulting net cash flows from such projects and discounting the net cash
flows back to their present value. The discount rate included a risk-adjusted
discount rate to take into account the uncertainty surrounding the successful
development of the purchased in-process technology. The risk-adjusted discount
rate applied to the projects' cash flows was 30% for the in-process technology.
The Company believed that the estimated in-process technology amounts
represented fair value and did not exceed the amount a third party would pay for
the projects.

The valuation included cash inflows from in-process technology through 2005
with revenues commencing in 2001. Where appropriate, the Company allocated
anticipated cash flows from an in-process research and development project to
reflect contributions of the core technology. At the time of the merger, OSDN's
remaining tasks that were substantially incomplete included certain planning,
designing, coding, prototyping, and testing activities that are necessary to
establish that the developmental technologies can be produced to meet their
design specifications including functional, technical, and economic performance
requirements. The Company estimated that it would cost approximately $1,000,000
to complete the projects with significant remaining development efforts. As of
July 28, 2001, the Company does not expect to incur any additional charges
related to these projects.

In the fourth quarter of fiscal 2001, the Company performed an assessment
of the carrying value of the Company's long-lived assets to be held and used
including significant amounts of goodwill and other intangible assets recorded
in connection with its acquisition of OSDN. The assessment was performed
pursuant to SFAS No. 121 due to the significant slowdown in the economy
affecting both the Company's current operations and expected future sales, as
well as the general decline of technology valuations. The conclusion of that
assessment was that the decline in market conditions within the Company's
industry was significant and other than temporary. As a result, the Company
recorded during the fourth quarter of fiscal 2001, a charge of $160.0 million to
reduce goodwill associated with the acquisition of OSDN, based on the amount by
which the carrying value of these assets exceeded their fair value. The charge
is included in the caption "Impairment of long-lived assets" in the statements
of operations. Fair value was determined based on discounted future cash flows.
43

VA LINUX SYSTEMS, INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)

The following unaudited pro forma information represents the results of
operations of VA Linux, NetAttach, TruSolutions and OSDN as if the acquisitions
had been consummated as of the beginning of the periods presented. The pro forma
information does not purport to be indicative of what would have occurred had
the acquisitions been made as of those dates or of results that may occur in the
future. The information below does not include $9.0 million of purchased
in-process research and development that was expensed at the time of the
acquisitions of TruSolutions and OSDN. The unaudited pro forma information is as
follows (in thousands, except per share data):

HELP DESK FACILITY

On November 27, 2000, VA Linux acquired certain assets of Alabanza
Corporation ("Alabanza") for approximately $3.6 million. The consideration
included 224,090 shares of VA Linux common stock valued at $2.6 million and cash
of approximately $950,000. The agreement contained no additional contingent
payments, options or commitments. In February 2001, in response to the general
slowdown in the economy, the Company adopted a plan to reduce operating costs.
In connection with these actions, the plan involved the divestiture of our
managed services business, including the help desk facility recently acquired
from Alabanza. Charges were recorded to write down the net book value of
intangible assets to the Company's estimate of proceeds to be received on the
sale of the assets, which was estimated to be nominal. The divestiture of
Alabanza was completed on July 10, 2001 for minimal proceeds. The charges
associated with this divestiture have been recorded as restructuring costs and
other special charges in the statements of operations (see Note 4).

SOFTWARE TECHNOLOGY

On December 7, 2000, VA Linux acquired certain assets of Lavaca Systems
Corporation ("Lavaca") for approximately $3.6 million. The consideration
included 306,122 shares of VA Linux common stock valued at $2.6 million and cash
of approximately $1.0 million. The agreement contained no additional contingent
payments, options or commitments. Purchased intangible assets included
intellectual property and technology related to specific software applications
of approximately $3.6 million. During the fourth quarter of fiscal 2001, charges
were recorded to write down the net book value of intangible assets to the
Company's estimate of proceeds to be received on the sale of the assets. All
assets held for disposal do not have an expected material fair value. The
charges associated with this write-down have been recorded as restructuring
costs and other special charges in the statements of operations (see Note 4).

4. RESTRUCTURING COSTS AND OTHER SPECIAL CHARGES

During February 2001, in response to the general slowdown in the economy,
the Company adopted a plan to reduce operating costs. In connection with these
actions, a restructuring charge of approximately $43.4 million was recorded in
the third quarter of fiscal 2001. The principle actions of the plan involved the
closure of the San Diego facility and the exit from the Company's managed
services business. Of the $43.4 million, $33.8 million related to the
acceleration of deferred stock compensation that was originally contingent on
future employment by three employees of TruSolutions and one employee of Life,
companies acquired in March 2000 and September 2000, respectively. These
employees were terminated as part of the

44

VA LINUX SYSTEMS, INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)

restructuring and all stock held in escrow was released to them as part of their
severance agreements. In addition, as part of the plan to exit from the
Company's managed services business, the Company sold BNW, a company acquired in
September 2000, for minimal proceeds. In addition, the Company recorded
severance charges related to six employees of BNW. As part of their severance
agreements, a portion of stock held in escrow was released to them. A further
$1.7 million was recorded for workforce reduction, consisting of severance,
acceleration of stock options, and other related costs attributable to 43
employees, primarily from the Company's domestic systems business that were
terminated as part of the February 2001 plan. The remaining $7.9 million was for
$1.7 million of excess facilities related primarily to non-cancelable lease
payments, unless sublet by the Company, will continue until fiscal 2010 or other
costs and the abandonment or disposal of property and equipment, and $6.2
million was for the impairment of goodwill and purchased intangibles as there
are no future cash flows expected from the managed services business that are
being exited pursuant to the restructuring plan. The results of operations
relating to the Managed Services business were not material to the consolidated
results of operations.

In addition to the above, the Company recorded $3.4 million in connection
with these restructuring charges, which has been classified as cost of revenues
in the statement of operations. Of the $3.4 million, $0.2 million was recorded
for workforce reduction, consisting of severance and other related costs
attributable to 19 employees from our domestic systems business and nine
employees from the managed services business. Of the remaining $3.2 million,
$2.9 million related to a write down of inventory from the closing of the San
Diego facility, and $0.3 million related to other restructuring costs.

In June 2001, the Company adopted an additional plan to exit the systems
business that was accounted for in the fourth quarter ended July 28, 2001. The
decision to exit the systems business was based upon reducing operating losses
and improving cash flow. The $70.1 million of charges recorded in the fourth
quarter of fiscal 2001 consist of $53.5 million related to the impairment of
goodwill and purchased intangibles, as no significant future cash flows are
expected from the systems business and the remaining $16.6 million was for $6.6
million of excess facilities related primarily to non-cancelable lease payments
which, unless sublet by the Company, will continue until fiscal 2010, $3.2
million for a workforce reduction consisting of severance, acceleration of stock
options, and other related costs attributable to 84 employees primarily from our
systems business, and $6.8 million for other restructuring charges related to
the exit from the systems business. The accrual for non-cancelable lease
payments includes management's estimates of the time taken to sublet the
facilities and estimates of sublease income. These estimates are subject to
change based on actual events.

In addition to the above, the Company recorded $10.5 million of charges in
connection with the exit of the systems business, which has been classified as
cost of revenues in the statements of operations. Of the $10.5 million, $7.6
million was related to excess inventory charges arising from the exit from the
systems business, $0.4 million was recorded for a workforce reduction consisting
of severance, and other related costs attributable to 64 former employees from
the Company's systems business, and the remaining $2.5 million related to other
restructuring costs.

45

VA LINUX SYSTEMS, INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)

All activities are expected to be complete by January 2002, except that
cash payments for non-cancelable leases will be made over the respective lease
terms as noted above. Below is a summary of the restructuring charges in
operating expenses (in thousands):

Net revenues for the systems business were $110,700,000, $114,300,000 and
$17,700,000 for fiscal 2001, 2000, and 1999, respectively.

5. OTHER OBLIGATIONS

CAPITAL LEASE

VA Linux KK (Japan) entered into a capital lease in fiscal 2001 for certain
equipment. The balance outstanding as of July 28, 2001 is approximately $590,000
and has been recorded as current portion of notes payable in the balance sheet.

OSDN NOTES PAYABLE

As part of the OSDN acquisition, the Company assumed three note payable
agreements (the "Notes") with an employee of OSDN. The Notes bore interest rates
of 9.0% to 9.75% totaling $2,043,000 and were to mature through fiscal year
2003. As of July 28, 2001, the remaining principal maturities under the note
payables of $922,000 are currently due and have been recorded as accrued
compensation in the accompanying balance sheet.

6. LINE OF CREDIT AND EQUIPMENT LOAN

In February 1999, the Company entered into a loan and security agreement
with a bank which was last amended in August 2001 for maximum borrowings of
$10,000,000 under a revolving line of credit ("Line of Credit") and $500,000
under an equipment loan ("Equipment Loan"). The interest rate for both the Line
of

46

VA LINUX SYSTEMS, INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)

Credit and the Equipment Loan is the bank's base rate plus 0.75% (7.5% at July
28, 2001). The amount available for borrowing under the Line of Credit is
limited to the committed revolving line, less any outstanding letters of credit
issued under the Line of Credit, which is not to exceed $5,000,000. The amount
available for borrowing under the Equipment Loan can only be utilized to acquire
equipment that the bank approves. As of July 28, 2001, the Company had no
borrowings outstanding under the Line of Credit and $208,333 outstanding under
the Equipment Loan, of which $166,667 is current and $41,666 is non-current. The
Equipment Loan and Line of Credit require that the Company maintain certain
financial and non-financial ratios and covenants. As of July 28, 2001, the
Company was in compliance with all of the ratios and covenants.

As of July 28, 2001, the Company has outstanding letters of credit issued
under the Line of Credit of approximately $2,300,000, primarily related to
securing the corporate facility lease in Fremont, California.

During fiscal 2001, we established letters of credit of approximately $4.0
million used to collateralize the delivery of customer parts from a single
supplier. As of July 28, 2001, we had approximately $0.6 million of restricted
cash outstanding on the letters of credit.

7. COMMITMENTS AND CONTINGENCIES

The Company leases its facilities under operating leases that expire at
various dates through 2010. As part of the acquisitions, the Company also
assumed various non-cancelable office equipment leases, which expire through
November 2002. Future minimum lease payments under non-cancelable operating
leases, net of sublease income, as of July 28, 2001 are as follows (in
thousands):

Effective June 1, 2000, the Company entered into a ten-year lease agreement
for a new corporate facility.

Rent expense for the years ended July 28, 2001 and 2000 and July 31, 1999
was approximately $13,601,000, $2,163,000 and $344,000, respectively. $8,300,000
of the rent expense for the year ended July 28, 2001 was attributable to an
estimate of the loss related to idle facilities, which has been recorded as
restructuring costs and other special charges in the statements of operations.

In January 2001, the Company and two of its officers were named as
defendants in purported securities class-action lawsuits filed in the United
States District Court, Southern District of New York (the "Actions"). The first
of the Actions is captioned Macaroon v. VA Linux Systems, Inc. et al., No. 01
CIV. 0242. The Court has since consolidated the Actions, appointed a lead
plaintiff and approved lead plaintiffs' selection of lead counsel. Lead
plaintiff has filed a consolidated complaint ("Complaint") with the Court. The
Complaint alleges claims against the Company, two of the Company's officers,
and/or Credit Suisse First Boston ("CSFB"), the lead underwriter of the
Company's December 9, 1999 initial public offering, under Sections 11 and 15 of
the Securities Act of 1933, as amended. The Complaint also alleges claims solely
against CSFB under Section 12(2) of the Securities Act of 1933 and Section 10(b)
of the

47

VA LINUX SYSTEMS, INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)

Securities Exchange Act of 1934, as amended. The Company believes that the
claims against it and its two officers are without legal merit and intends to
defend them vigorously.

8. RETIREMENT SAVINGS PLAN

The Company maintains an employee savings and retirement plan, which is
intended to be qualified under Section 401(k) of the Internal Revenue Code and
is available to substantially all full-time employees of the Company. The plan
provides for tax deferred salary deductions and after-tax employee
contributions. Contributions include employee salary deferral contributions and
discretionary employer contributions. To date, there have been no employer
discretionary contributions.

9. COMMON STOCK

In October 1999, the Company's board of directors approved the
reincorporation into Delaware by way of a merger with a newly-formed Delaware
subsidiary in connection with the Company's IPO. In conjunction with the IPO,
the Company issued 4,400,000 shares of common stock with an initial public
offering price of $30.00 per share. Upon closing of the initial public offering,
all of the outstanding shares of convertible preferred stock were automatically
converted into 19,921,322 shares of common stock. In addition, the underwriters
exercised their option to purchase 660,000 additional shares to cover the
over-allotments of shares at the $30.00 per share offering price. The IPO raised
approximately $141,000,000 after underwriting fees and $139,000,000 after all
other direct costs. In fiscal 2001, the Company repurchased 41,114 shares of
common stock for approximately $4,000 and cancelled 63,386 shares, which has
been recorded as treasury stock in the balance sheet and statement of
stockholders' equity.

As of July 28, 2001 there were 54,118,703 shares of common stock issued and
outstanding. VA Linux is authorized to issue 250,000,000 shares of common stock,
$0.001 par value.

As of July 28, 2001, the Company had reserved shares of its common stock
for future issuance as follows:

1998 Stock Option Plan and Assumed Plans.................... 18,149,530
1999 Director Option Plan................................... 750,000
1999 Employee Stock Purchase Plan........................... 1,373,396
----------
20,272,926
==========

STOCK REPURCHASE AGREEMENTS

In connection with the exercise of options pursuant to the Company's Stock
Option Plan, employees entered into restricted stock purchase agreements with
the Company. Under the terms of these agreements, the Company has a right to
repurchase any unvested shares at the original exercise price of the shares upon
termination of the employee. The repurchase right lapses ratably over the
vesting term of the original option grant. As of July 28, 2001, 922,744 shares
were subject to repurchase by the Company.

STOCK OPTION PLAN

In fiscal 1997, the Company adopted and the board of directors approved the
1996 Stock Option Plan ("1996 Plan"), under which a total of 4,650,000 shares
were reserved for issuance. The 1996 Plan permitted options to be granted to
employees, consultants and directors to purchase shares of the Company's common
stock at a price determined by the board of directors. The Company granted
4,650,000 options under the 1996 Plan during fiscal 1997 and 1998. In fiscal
1998, the Company granted options to purchase 4,026,000 shares of common stock
outside of the 1996 Plan at an exercise price of $0.02 per share. In October
1998, the Company cancelled all stock options outstanding under the 1996 Plan
and the 4,026,000 options that had been issued in

48

VA LINUX SYSTEMS, INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)

fiscal 1998 outside of the 1996 Plan. The cancelled options were replaced with
options under the 1998 Stock Plan ("1998 Plan") that had vesting and exercise
prices consistent with the terms of the cancelled options. The 1996 Plan was
terminated in October 1998.

In fiscal 1999, the Company adopted and the board of directors approved the
1998 Plan. The number of shares reserved for issuance under the 1998 Plan was
29,800,432 as of July 28, 2001. Under the 1998 Plan, the board of directors may
grant to employees and consultants options and/or stock purchase rights to
purchase the Company's common stock at terms and prices determined by the board
of directors. The Plan will terminate in 2008. Nonqualified options granted
under the 1998 Plan must be issued at a price equal to at least 85% of the fair
market value of the Company's common stock at the date of grant. All options may
be exercised at any time within 10 years of the date of grant or within three
months of termination of employment, or such shorter time as may be provided in
the stock option agreement, and vest over a vesting schedule determined by the
board of directors.

The Company's 1999 Directors Option Plan (the "Directors' Plan") was
adopted by the Company's board of directors in October 1999. A total of 750,000
shares of common stock have been reserved for issuance under the Directors'
Plan, subject to an annual increase of the lesser of 250,000 shares, 0.5% of the
then outstanding common stock or an amount determined by the board of directors.
Through July 28, 2001, 130,000 options have been granted under the Directors'
Plan. Under the Directors' Plan, options will be granted when a non-employee
director joins the board of directors following the IPO and at each annual
meeting where the director continues to serve on the board of directors. The
Directors' Plan establishes an automatic grant of 40,000 shares of common stock
to each non-employee director who is elected after the completion of the IPO.
The Directors' Plan also provides that upon the date of each annual
stockholders' meeting, each non-employee director who has been a member of the
board of directors for at least six months prior to the date of the
stockholders' meeting will receive automatic annual grants of options to acquire
10,000 shares of common stock. Each automatic grant will have an exercise price
per share equal to the fair market value of the common stock at the date of
grant and vest monthly and become fully vested one year after the date of grant.
Each automatic grant will have a term of ten years. In the event of a merger
with another corporation or the sale of substantially all of its assets, each
non-employee director's outstanding option will become fully vested and
exercisable. Options granted under the Directors' Plan must be exercised within
3 months of the end of the non-employee director's tenure as a member of the
board of directors, or within 12 months after a non-employee director's
termination by death or disability, provided that the option does not terminate
by its terms earlier. Unless terminated sooner, the Directors' Plan terminates
automatically in 2009.

The Company has assumed certain option plans and the underlying options of
companies which the Company has acquired (the "Assumed Plans"). Options under
the Assumed Plans have been converted into the Company's options and adjusted to
effect the appropriate conversion ratio as specified by the applicable
acquisition agreement, but are otherwise administered in accordance with the
terms of the Assumed Plans. Options under the Assumed Plans generally vest over
four years and expire ten years from the date of grant. No additional options
will be granted under the Assumed Plans.

49

VA LINUX SYSTEMS, INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)

A summary of the option activity under all of the stock option plans for
the three years ended July 28, 2001 follows:

During fiscal 1999, the Company also granted to non-employees options and
stock purchase rights to acquire 268,332 shares of common stock outside of the
1998 Plan at a weighted average exercise price of $0.15 and a weighted average
fair value of $0.57. These equity instruments were either granted in exchange
for certain assets, including certain Internet properties and rights, or for
consulting services rendered. During fiscal 2000 and 1999, 185,000 and 83,332
options and stock purchase rights, with weighted average exercise prices of
$0.09 and $0.26, were exercised respectively. As of July 28, 2001, there were no
options or stock

50

VA LINUX SYSTEMS, INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)

purchase rights granted outside of the 1998 Plan outstanding. The compensation
expense recorded in connection with these grants was not material.

EMPLOYEE STOCK PURCHASE PLAN

The board of directors adopted the Company's 1999 Employee Stock Purchase
Plan ("ESPP") in October 1999. As of July 28, 2001, the Company had 1,373,396
shares of the common stock reserved for issuance under the ESPP, subject to an
annual increase of the lesser of 500,000 shares, 1% of the then outstanding
common stock or an amount determined by the board of directors. The plan allows
employees to purchase shares of common stock at a 15% discount. Through July 28,
2001, the Company issued 126,604 shares to its employees under the ESPP.

The Company accounts for stock options issued to employees under APB
Opinion No. 25 whereby the difference between the exercise price and the fair
value at the date of grant is recognized as compensation expense. Had
compensation expense been determined consistent with SFAS No. 123, net loss
would have increased to the following pro forma amounts (in thousands except per
share data):

The weighted average fair value of options granted during fiscal 2001, 2000
and 1999 was $6.52, $10.28 and $0.03, respectively. Pursuant to the provisions
of SFAS No. 123, the compensation cost associated with options granted in fiscal
2001, 2000 and 1999 were estimated on the grant date using the Black-Scholes
model and the following assumptions:

DEFERRED STOCK COMPENSATION

In connection with the grant of certain stock options to employees during
fiscal 2000 and 1999, the Company recorded deferred stock compensation within
stockholders' equity of approximately $37,800,000, representing the difference
between the estimated fair value of the common stock for accounting purposes and
the option exercise price of these options at the date of grant. The deferred
stock compensation expense is being amortized on an accelerated basis over the
vesting period of the individual award, generally four years. The method is in
accordance with FASB Interpretation No. 28. The amortization expense relates to
options awarded to employees in all operating expense categories. The
amortization of deferred compensation has not been separately allocated to these
categories. The amount of deferred compensation expense to be recorded in future
periods could decrease if options for which accrued but unvested compensation
has been recorded are forfeited. In connection with the acquisitions of
TruSolutions, Precision Insight and NetAttach, the Company recorded $113.1
million of deferred stock compensation during fiscal 2000. In connection with
the acquisitions of Brave New Worlds, Inc. and Life BVBA, the Company recorded
$6.8 million of deferred stock
51

VA LINUX SYSTEMS, INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)

compensation during fiscal 2001. The Company recorded amortization of deferred
stock compensation of $61.3 million, $39.5 million and $2.3 million for the
years ended July 28, 2001 and 2000 and July 31, 1999, respectively. In addition,
in connection with the restructuring discussed in Note 4, expense of
approximately $35.7 million related to the acceleration of deferred stock
compensation has been recorded for the year ended July 28, 2001 and has been
included in restructuring costs and other special charges in the statements of
operations.

10. INCOME TAXES

The Company accounts for income taxes in accordance with SFAS No. 109,
"Accounting for Income Taxes". Due to the Company's loss position in fiscal
2001, 2000 and 1999, there was no provision for income taxes for the years ended
July 28, 2001 and 2000 and July 31, 1999. A valuation allowance has been
recorded for the total deferred tax assets as a result of uncertainties
regarding realization of the assets based on the lack of consistent
profitability to date and the uncertainty of future profitability.

The components of the net deferred tax assets are as follows (in
thousands):

As of July 28, 2001, the Company has net operating loss carryforwards of
approximately $175.1 million to offset future federal taxable income, which
expires at various dates through the year 2020. This amount includes
approximately $12.5 million of net operating loss carryforwards from the
acquisition of OSDN. The deferred tax assets related to the acquisition of OSDN,
approximately $5.6 million as of June 7, 2000, if and when realized, will be
used to reduce the amount of goodwill and intangibles recorded at the date of
acquisition. The Company also has California net operating loss carryforwards of
approximately $48.7 million to offset future California taxable income, which
expire at various dates through 2011. The net operating loss carryforwards also
include approximately $21.0 million resulting from employee exercises of
non-qualified stock options or disqualifying dispositions, the tax benefits of
which, when realized, will be recorded as an addition to additional paid-in
capital rather than a reduction of the provision for income taxes. The operating
loss carryforwards to be used in future years is limited in accordance with the
provisions of the Tax Reform Act of 1986 as the Company has experienced a
cumulative stock ownership change of more than 50% over the last three years.
The net operating loss carryforwards stated above are reflective of various
federal and state tax limitations.

11. SEGMENT AND GEOGRAPHIC INFORMATION

SFAS No. 131, "Disclosures about Segments of an Enterprise and Related
Information", establishes standards for reporting information regarding
operating segments in annual financial statements and requires selected
information for those segments to be presented in interim financial reports
issued to stockholders. SFAS No. 131 also establishes standards for related
disclosures about products and services and geographic areas. Operating segments
are identified as components of an enterprise about which separate discrete
financial information is available for evaluation by the chief operating
decision-maker, or decision-making group, in making decisions how to allocate
resources and assess performance. The Company's chief decision-maker, as defined
under SFAS No. 131, are the Chief Executive Officer and the executive team. For
the

52

VA LINUX SYSTEMS, INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)

period up to the acquisition of Andover.Net on June 7, 2000, VA Linux operated
as one operating segment, the provision of Linux-based systems and services
referred to as Systems and Services. From June 7, 2000 through June 27, 2001, VA
Linux viewed the operations of Andover.Net, or the OSDN, as a second segment. On
June 27, 2001, the Company announced its decision to exit the hardware systems
business. Subsequent to the Company's fiscal year end of July 28, 2001, a
decision was made to exit the professional services and Linux software
engineering services, which had been part of the Company's Systems and Services
business segment, in order to solely focus on SourceForge. Significant cost
reduction actions accompanied the exiting of these businesses which will help to
preserve the Company's cash (see Note 4). Consequently, for the year beginning
July 29, 2001, the Company will operate as one business segment, providing
application software products and related OSDN services.

The Systems and Services segment consisted of a broad line of Linux systems
and open source services, including system architecture design and integration,
development of open source software and managed services. The OSDN segment helps
people develop, distribute and discuss open source software development. Through
June 27, 2001, the Company's chief decision-maker allocated resources to and
evaluated the performance of its segments based on each segment's revenue rather
than profit or other similar measure. The accounting policies of each segment
are the same as those described in the summary of significant accounting
policies. For the years ended July 28, 2001 and July 28, 2000, revenue from the
Systems and Services segment was $120.2 million and $118.2 million,
respectively. For the years ended July 28, 2001 and July 28, 2000, revenue from
OSDN was $14.7 million and $2.1 million, respectively. There have been no
intersegment sales or transfers.

Cash, cash equivalents and short-term investments are maintained by the
Company's corporate headquarters, which were included in the systems and
services business. Total assets of OSDN as of July 28, 2001 and 2000, excluding
cash, cash equivalents, short-term investments and goodwill and other
intangibles, which are evaluated by the chief decision-maker on a consolidated
basis, were not material in relation to consolidated total assets. Similarly,
excluding non-cash expenses such as amortization of deferred stock compensation,
amortization of goodwill and intangible assets and impairment of long-lived
assets, operating loss and net loss for the years ended July 28, 2001 and 2000
of OSDN are not material in relation to consolidated results.

The Company marketed its products in the United States through its direct
sales force. Revenues for each of the years ended July 28, 2001 and 2000 and
July 31, 1999 were primarily generated from sales to end users in the United
States.

12. SUBSEQUENT EVENTS (UNAUDITED)

In September 2001, the Company amended its loan and security agreement with
a bank. In accordance with the amended agreement, the committed revolving line
of credit was reduced from $10,000,000 to $7,500,000. The amount available for
borrowing is not to exceed the committed revolving line, less any outstanding
letters of credit issued under the line of credit, which is not to exceed
$3,000,000. If the sum of outstanding advances plus the face amount of all
outstanding letters of credit exceeds $4,000,000, then advances are not to
exceed the lesser of (i) the committed revolving line or (ii) 70% of eligible
accounts receivables, minus in each case the face amount of all outstanding
letters of credit. Borrowings under the amended agreement mature in April 30,
2002.

On September 9, 2001, the Company made a strategic decision to exit the
professional services and Linux software engineering services fields.

53

VA LINUX SYSTEMS, INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)

13. QUARTERLY FINANCIAL DATA (UNAUDITED)

54

ITEM 9. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND
FINANCIAL DISCLOSURE

Not applicable.

PART III

ITEM 10. DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANT

The information called for by this item is incorporated by reference to the
sections entitled "Certain Beneficial Owners" and "Security Ownership of
Directors and Executive Officers" in the Proxy Statement.

ITEM 11. EXECUTIVE COMPENSATION

The information called for by this item is incorporated by reference to the
section entitled "Compensation of Directors and Executive Officers" in the Proxy
Statement.

ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT

The information called for by this item is incorporated by reference to the
sections entitled "Certain Beneficial Owners" and "Security Ownership of
Directors and Executive Officers" in the Proxy Statement.

ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS

The information called for by this item is incorporated by reference to the
sections entitled "Certain Relationships and Related Transactions" in the Proxy
Statement.

PART IV

ITEM 14. EXHIBITS, FINANCIAL STATEMENT SCHEDULES, AND REPORTS ON FORM 8-K

(a) The following documents are filed as part of this report:

1. All Financial Statements:

See the Consolidated Financial Statements and notes thereto in Item 8
above.

2. Schedule II -- Valuation and Qualifying Accounts are filed as part
of this Form 10-K.

3. Exhibits:

See the Exhibit Index.

(b) Reports on Form 8-K.

(i) Report on Form 8-K dated June 8, 2001, containing a May 22, 2001
news release announcing the Registrant's financial results for its third
fiscal quarter ended April 28, 2001.

(ii) Report on Form 8-K dated July 6, 2001, containing a June 27, 2001
news release announcing that the Registrant was adopting a new strategy
focusing on application software, as well as significant restructuring
steps designed to improve cash flow and reduce operating losses. As part of
this strategy, Registrant announced it would discontinue its systems
hardware business and make significant reductions in staffing levels.

55

SIGNATURES

Pursuant to the requirements of Section 13 or 15(d) of the Securities
Exchange Act of 1934, the Registrant has duly caused this report to be signed on
its behalf by the undersigned, thereunto duly authorized.

VA LINUX SYSTEMS, INC.

By: /s/ LARRY M. AUGUSTIN
------------------------------------
Larry M. Augustin
Chief Executive Officer and Chairman
of the Board of Directors

Date: October 19, 2001

POWER OF ATTORNEY

KNOW ALL PERSONS BY THESE PRESENTS, that each person whose signature
appears below hereby constitutes and appoints Larry M. Augustin and Todd B.
Schull, and each of them, his true and lawful attorneys-in-fact, each with full
power of substitution, for him and all capacities, to sign any amendments to
this report on Form 10-K and to file the same, with exhibits thereto and other
documents in connection therewith, with the Securities and Exchange Commission
and does hereby ratify and confirm all that each of said attorneys-in-fact or
their substitute or substitutes may do or cause to be done by virtue hereof.

Pursuant to the requirement of the Securities Exchange Act of 1934, this
report has been signed below by the following persons on behalf of the
Registrant and in the capacities and on the dates indicated.

56

VA LINUX SYSTEMS, INC.

SCHEDULE II -- VALUATION AND QUALIFYING ACCOUNTS

57

EXHIBIT INDEX

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

+ Confidential treatment has been requested by the Registrant as to
certain portions of this exhibit. The omitted portions have been
separately filed with the Commission.

* Incorporated by reference to the corresponding exhibit of Registrant's
form S-1 and the amendment thereto (Commission registration no.
333-88687).

** Incorporated by reference to the corresponding exhibit of Registrant's
form S-4 and the amendment thereto (Commission registration no.
333-35704).

*** Incorporated by reference from Exhibit 10.16 of Registrant's form S-1
and the amendments thereto (Commission registration no. 333-88687).

**** Incorporated by reference from Exhibit 10.18 of Registrant's Quarterly
Report on Form 10-Q for the period ended January 28, 2000 filed on March
13, 2000 (Commission file number 000-28369).

***** Incorporated by reference from Exhibit 10.1 of Registrant's Quarterly
Report on Form 10-Q for the period ended January 27, 2001 filed on March
12, 2000 (Commission file number 000-28369).

****** Incorporated by reference from Exhibit 10.2 of Registrant's Quarterly
Report on Form 10-Q for the period ended January 27, 2001 filed on March
12, 2000 (Commission file number 000-28369).

******* Incorporated by reference from Exhibit 10.14 of Registrant's Annual
Report on Form 10-K for the period ended June 28, 2000 filed on October
26, 2000 (Commission file number 000-28369).

58