NASSDA CORP - 10-Q Quarterly Report

UNITED STATES
SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

FORM 10-Q

(Mark One)

ý		QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934

		For the quarterly period ended June 30, 2004

		or

o		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: 000-33291

NASSDA CORPORATION

(Exact name of registrant as specified in its charter)

Delaware		77-0494462
(State or other jurisdiction of incorporation or organization)		(I.R.S. Employer Identification Number)

2650 San Tomas Expressway, Santa Clara, CA		95051
(Address of principal executive offices)		(Zip Code)

Registrant’s telephone number, including area code: (408) 562-9168

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 ý No o

Indicate by check mark if the registrant is an accelerated filer (as defined in Rule 12b-2 of the Securities Exchange Act of 1934, as amended).

Yes ý No o

At July 27, 2004, 26,944,369 shares of common stock of the registrant were outstanding.

NASSDA CORPORATION
INDEX

PART I.	FINANCIAL INFORMATION

Item 1.	Financial Statements

	Condensed Consolidated Balance Sheets

	Condensed Consolidated Income Statements

	Condensed Consolidated Statements of Cash Flows

	Notes to Condensed Consolidated Financial Statements

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

Item 3.	Quantitative and Qualitative Disclosures About Market Risk

Item 4.	Controls and Procedures

PART II.	OTHER INFORMATION

Item 1.	Legal Proceedings

Item 6.	Exhibits and Reports on Form 8-K

SIGNATURES

PART I – FINANCIAL INFORMATION

ITEM 1: FINANCIAL STATEMENTS

NASSDA CORPORATION

CONDENSED CONSOLIDATED BALANCE SHEETS

(in thousands, except share data)

	June 30, 2004			September 30, 2003 (1)
	(unaudited)
Assets:
Current assets:
Cash and cash equivalents	$	57,558		$	53,145
Short-term investments	42,296			39,020
Accounts receivable, net of allowances of $82 and $92 at June 30, 2004 and September 30, 2003, respectively	2,045			1,874
Prepaid expenses and other current assets	1,247			996
Deferred income taxes	3,010			2,568
Total current assets	106,156			97,603
Property and equipment, net	512			704
Other assets	1,035			1,165
Total assets	$	107,703		$	99,472
Liabilities and Stockholders’ Equity:
Current liabilities:
Accounts payable	$	1,777		$	230
Accrued liabilities	6,744			7,682
Deferred revenue	11,155			8,982
Total current liabilities	19,676			16,894
Deferred revenue	622			849
Other long-term liabilities	60			64
Total liabilities	20,358			17,807
Stockholders’ equity:
Common stock, par value $0.001: 110,000,000 shares authorized; 26,922,248 and 25,999,439 shares outstanding at June 30, 2004 and September 30, 2003, respectively	27			26
Additional paid-in capital	73,002			70,343
Deferred stock-based compensation	(401		)	(1,117		)
Accumulated other comprehensive loss	(90		)	(4		)
Retained earnings	14,807			12,417
Total stockholders’ equity	87,345			81,665
Total liabilities and stockholders’ equity	$	107,703		$	99,472

(1) Derived from the audited consolidated balance sheet of Nassda Corporation as of September 30, 2003.

See accompanying notes to the condensed consolidated financial statements.

NASSDA CORPORATION

CONDENSED CONSOLIDATED INCOME STATEMENTS

(in thousands, except per share data)

	Three Months Ended June 30,					Nine Months Ended June 30,
	2004		2003			2004			2003
	(unaudited)
Revenue:
Product	$	2,643	$	1,892		$	7,217		$	9,735
Subscription	5,793		3,558			15,790			10,749
Maintenance	2,519		2,058			7,462			6,158
Total revenue	10,955		7,508			30,469			26,642
Cost of revenue:
Product	49		69			214			198
Subscription	108		90			317			260
Maintenance	268		211			753			609
Total cost of revenue	425		370			1,284			1,067
Gross profit	10,530		7,138			29,185			25,575
Operating expenses:
Research and development	2,419		1,968			6,461			5,203
Sales and marketing	3,245		2,659			8,585			8,408
General and administrative	3,735		2,457			11,132			7,335
Stock-based compensation*	189		229			631			725
Total operating expenses	9,588		7,313			26,809			21,671
Income (loss) from operations	942		(175		)	2,376			3,904
Interest income	253		222			731			746
Other income (expense), net	1		11			(19		)	(19		)
Income before taxes	1,196		58			3,088			4,631
Provision for (benefit from) income taxes	130		(138		)	698			1,390
Net income	$	1,066	$	196		$	2,390		$	3,241
Earnings per share:
Basic	$	0.04	$	0.01		$	0.09		$	0.13
Diluted	$	0.04	$	0.01		$	0.08		$	0.11
Shares used in computing earnings per share:
Basic	26,666		25,326			26,291			24,859
Diluted	28,959		28,546			29,107			28,652
*Stock-based compensation includes:
Research and development	$	83	$	103		$	277		$	317
Sales and marketing	52		67			184			233
General and administrative	54		59			170			175
Total	$	189	$	229		$	631		$	725

See accompanying notes to condensed consolidated financial statements.

NASSDA CORPORATION

CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS

(in thousands)

	Nine Months Ended June 30,
	2004			2003
	(unaudited)
Operating activities
Net income	$	2,390		$	3,241
Adjustments to reconcile net income to net cash provided by operating activities:
Depreciation	354			400
Stock-based compensation	631			725
Deferred income taxes	(312		)	(859		)
Provision for bad debt	(10		)	—
Changes in operating assets and liabilities:
Accounts receivable	(161		)	1,212
Prepaid expenses and other assets	(251		)	(573		)
Accounts payable	1,547			20
Accrued liabilities	(226		)	536
Deferred revenue	1,946			3,956
Long-term liabilities	(4		)	(10		)
Net cash provided by operating activities	5,904			8,648

Investing activities
Purchase of short-term investments	(40,314		)	(44,578		)
Proceeds from maturity of short-term investments	36,952			50,378
Purchases of property and equipment	(162		)	(452		)
Net cash provided by (used in) investing activities	(3,524		)	5,348

Financing activities
Proceeds from issuance of common stock	2,033			2,197
Net cash provided by financing activities	2,033			2,197
Increase in cash and cash equivalents	4,413			16,193
Cash and cash equivalents, beginning of period	53,145			43,157
Cash and cash equivalents, end of period	$	57,558		$	59,350

Supplemental disclosure of cash flow information
Cash paid for income taxes	$	580		$	72

Supplemental schedule of non-cash activities
Unrealized gain/(loss) on short-term investments	$	(86	)	$	7

Deferred stock-based compensation (reversal)	$	(85	)	$	(135	)
Income tax benefit from employee stock transactions	$	712		$	115

See accompanying notes to condensed consolidated financial statements.

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

1. Basis of Presentation

The Company

Nassda Corporation was incorporated in California in August 1998 to provide full-chip circuit simulation and analysis software for the design and verification of complex nanometer-scale semiconductors. We reincorporated in the State of Delaware in September 2001. Our fiscal year ends on September 30.

Condensed Consolidated Financial Statements

The interim condensed consolidated financial statements included herein have been prepared by Nassda Corporation, without audit pursuant to the rules and regulations of the Securities and Exchange Commission (“SEC”). Certain information and footnote disclosures normally included in annual financial statements prepared in accordance with accounting principles generally accepted in the United States of America have been condensed or omitted. The interim consolidated financial statements reflect, in the opinion of management, all adjustments necessary (consisting only of normal recurring adjustments) to present a fair statement of results for the interim periods presented. The operating results for any interim period are not necessarily indicative of the results that may be expected for the fiscal year ending September 30, 2004. The accompanying condensed consolidated financial statements should be read in conjunction with the consolidated financial statements and notes included in our Annual Report on Form 10-K for the fiscal year ended September 30, 2003.

Use of Estimates

The preparation of consolidated financial statements in accordance with accounting principles generally accepted in the United States of America requires our management to make estimates and assumptions that affect the reported amounts of assets and liabilities at the date of the interim condensed consolidated financial statements and the reported amounts of revenues and expenses during the reporting periods. Such estimates include, but are not limited to, revenue recognition and allowances, accrued liabilities, deferred revenue, loss contingencies and accounting for income taxes. Actual results could differ from these estimates.

Critical Accounting Policies

Revenue Recognition

We recognize revenue in accordance with the provisions of American Institute of Certified Public Accountants Statement of Position 97-2 (“SOP 97-2”), Software Revenue Recognition. The application of SOP 97-2 requires judgment, including whether a software arrangement includes multiple elements, and if so, whether vendor-specific objective evidence (“VSOE”) of fair value exists for each of those elements. When certain elements of an arrangement are delivered at different times, the ability to identify VSOE for those undelivered elements could materially impact the amount of earned and unearned revenue.

We recognize and report revenue in three separate categories: product revenue, subscription revenue and maintenance revenue. Product revenue is derived from perpetual license fees. Subscription revenue is derived from time-based license fees, which include maintenance during the license period. We recognize product revenue and subscription revenue when all of the following conditions are met:

• a written purchase order, license agreement or other contract has been executed;

• the product and the production license key have been delivered;

• user acceptance periods, if any, have expired;

• the license fee is fixed or determinable; and

• collection of the fee is probable.

VSOE exists for maintenance on perpetual licenses based on renewal rates. Our customers generally purchase the first year of maintenance when they purchase a perpetual license, so we use the residual method to determine the allocation of revenue to the license portion of multiple element arrangements involving perpetual licenses. Because we bundle both the license and maintenance into our agreements for time-based licenses for the entire term, VSOE does not exist for each element of the arrangement. Therefore, we recognize subscription revenue from time-based licenses ratably over the period of the license. Maintenance revenue is derived from the annual maintenance contracts that are purchased by perpetual licensees. We generally recognize revenue from maintenance ratably over the maintenance period, which is typically one year.

For sales made through our distributors, we recognize revenue when the software has been sold to the end users and all other revenue recognition criteria have been met. When the distributor is the primary obligor in the arrangement and has latitude in establishing prices and credit risk, we record revenue based on amounts invoiced to the distributor (rather than the amount invoiced by the distributor to the end users). When we are the primary obligor in the arrangement and have latitude in establishing price and credit risk, we record revenue based on amounts invoiced to the end customer (with the related commissions paid to the distributors reported as sales and marketing expense).

Future changes in accounting pronouncements, including those affecting revenue recognition, could require us to change our methods of revenue recognition. These changes could cause us to defer revenue from current periods to subsequent periods or accelerate recognition of deferred revenue to current periods.

Allowance for Doubtful Accounts

We maintain an allowance for doubtful accounts based on our estimate of probable losses inherent in the outstanding accounts receivable balance. We determine the allowance based on known troubled accounts, historical experience and other currently available evidence. If the financial condition of our customers were to deteriorate, resulting in an impairment of their ability to make payments, additional allowances may be required.

Sales Commission Accrual and Expenses

Sales commissions are earned by our sales force for each order received, shipped and collected. Based on our policies, sales commissions are paid upon booking and collection. Commission rates increase as the sales person achieves a certain percentage of his or her annual quota. We determine an estimated average annual commission rate during the first three fiscal quarters for purposes of accruing commissions. We adjust the balance of the commission accrual and the actual commission expense at the end of each fiscal year based on each sales person’s actual commission rates.

Contingent Liabilities

We are subject to several legal proceedings and claims, the outcomes of which are subject to uncertainty (see Note 7). Statement of Financial Accounting Standards (SFAS) No. 5, Accounting for Contingencies, requires that an estimated loss from a loss contingency should be accrued by a charge to income if it is probable that an asset has been impaired or a liability has been incurred and the amount of the loss can be reasonably evaluated, taking into account the degree of probability of an unfavorable outcome and the ability to make a reasonable estimate of the amount of loss, among other factors. Changes in these factors could materially impact our financial position or our results of operations. We regularly evaluate current information available to us to determine whether such accruals should be recorded. To date, we have not accrued any loss contingencies.

2. Earnings Per Share

Basic earnings per share (“EPS”) is computed by dividing net income by the weighted average common shares outstanding of the period. Diluted EPS reflects the potential dilution that would occur if securities or other contracts to issue common stock were exercised or converted into common stock.

During the three and nine months ended June 30, 2004 and 2003, we had securities outstanding that could potentially dilute basic earnings per share in the future, but these securities were excluded in the computation of diluted earnings per share in such periods as their effect would have been antidilutive. At June 30, 2004 and 2003, weighted average options to purchase 3.8 million and 2.3 million shares of common stock with a weighted average exercise price of $8.37 and $9.53, respectively, were excluded from the diluted net income per share computation.

The following table is a reconciliation of the numerators and denominators used in computing basic and diluted earnings per share (in thousands, except per share data):

	Three Months Ended June 30,						Nine Months Ended June 30,
	2004			2003			2004			2003
Net income (numerator):	$	1,066		$	196		$	2,390		$	3,241
Shares (denominator):
Weighted average common shares outstanding	26,736			25,723			26,429			25,459
Weighted average common shares subject to repurchase	(70		)	(397		)	(138		)	(600		)
Shares used in basic computation	26,666			25,326			26,291			24,859
Weighted average common shares subject to repurchase	70			397			138			600
Common shares issuable upon exercise of stock options (treasury stock method)	2,223			2,823			2,678			3,193
Shares used in diluted computation	28,959			28,546			29,107			28,652
Basic earnings per share	$	0.04		$	0.01		$	0.09		$	0.13
Diluted earnings per share	$	0.04		$	0.01		$	0.08		$	0.11

3. Comprehensive Income

The components of comprehensive income, net of tax, were as follows (in thousands):

	Three Months Ended June 30,					Nine Months Ended June 30,
	2004			2003		2004			2003
Net income	$	1,066		$	196	$	2,390		$	3,241
Unrealized gain (loss) on investments	(90		)	3		(86		)	7
Comprehensive Income	$	976		$	199	$	2,304		$	3,248

4. Bonuses and Management Compensation

During fiscal 2001, we accrued bonuses of $3.7 million earned by our employees for their services in fiscal 2001. We paid approximately $2.0 million of these bonuses during fiscal 2002, with the majority of the amount paid in the first quarter of fiscal 2002. In the first quarter of fiscal 2003, we paid $1.2 million of these bonuses with the remainder paid ratably over the balance of fiscal 2003. These bonuses had been fully paid as of September 30, 2003. In addition, our executive officers orally agreed that they would not receive their base salaries in fiscal 2002 and fiscal 2003.

During fiscal 2002, we accrued bonuses of $760,000 earned by our employees for their services in fiscal 2002. In the first fiscal quarter of fiscal 2003, we paid $252,000 of these bonuses, with the remainder paid ratably through the first quarter of fiscal 2004. These bonuses had been fully paid as of October 31, 2003.

In fiscal 2003, we accrued bonuses of $900,000 earned by our employees for their services in fiscal 2003. These bonuses were paid in December 2003. We also accrued bonuses of $865,000 earned by our employees for their services for the nine months ended June 30, 2004. In October 2003, the compensation committee of our board of directors reinstated the salaries of our executive officers and we expect to pay base salaries totaling approximately $743,000 to these officers in fiscal 2004. As a result of our significant bonus accruals in prior years and the foregone salaries in fiscal 2002 and fiscal 2003, our compensation expense in fiscal 2004 may not be consistent with compensation expense in prior years.

5. Lease Commitments

We lease our facilities under various noncancelable operating leases. In December 2002, we entered into a three-year operating lease for our current headquarters located in Santa Clara, California, which began in February 2003 and will expire in March 2006. These noncancelable operating leases began expiring in October 2003. Rent expense was $600,000 in fiscal 2002, $784,000 in fiscal 2003 and $558,000 for the nine months ended June 30, 2004. As of September 30, 2003, the aggregate future noncancelable minimum rentals or operating leases are as follows (in thousands):

Year Ending September 30,
2004	$	585
2005	529
2006	252
	$	1,366

6. Stock-based Awards

We account for our stock-based awards to employees using the intrinsic value method in accordance with Accounting Principles Board Opinion No. 25, “Accounting for Stock Issued to Employees,” and all of its related interpretations. Accordingly, compensation expense has been recognized in the consolidated financial statements for employee stock arrangements to the extent the fair value of the underlying common stock exceeds the exercise price of the stock options at the date of grant. Deferred stock-based compensation of $2.5 million and $1.8 million was recorded during fiscal 2001 and fiscal 2000, respectively, for the excess of the fair value of the common stock underlying the options at the grant date over the exercise price of the options. These amounts are being amortized on a straight-line basis over the vesting period, generally four years. Amortization of deferred stock-based compensation related to employee grants was $631,000 and $725,000 for the nine months ended June 30, 2004 and 2003, respectively.

We account for stock-based awards to non-employees in accordance with the provisions of SFAS No. 123, “Accounting for Stock-Based Compensation.” Accordingly, we recognize the fair value for non-employee awards as stock compensation expense over the vesting terms of the awards. There were no stock-based awards to non-employees or amortization of stock compensation expenses recognized previously for non-employees during the nine months ended June 30, 2004 and 2003.

SFAS No. 148 amends the disclosure requirements of SFAS No. 123 to require prominent disclosures in both annual and interim financial statements about the method of accounting for stock-based employee compensation and the effect of the method used on reported results. With the adoption of SFAS No. 148, we are required to disclose pro forma information regarding option grants made to our employees based on specified valuation techniques that produce estimated compensation charges. Our calculations are based on a single option valuation approach and forfeitures are recognized as they occur. The fair value of options at the date of grant was estimated using the minimal value method through the date of our initial public offering in December 2001, and the Black-Scholes option pricing model for options granted thereafter, with the following weighted-average assumptions:

	Three Months Ended June 30,				Nine Months Ended June 30,
	2004		2003		2004		2003
Stock Option Plans:
Risk-free interest rate	3.28	%	2.62	%	3.19	%	2.85	%
Expected volatility	78	%	85	%	78	%	92	%
Expected life (in years)	4.5		4.5		4.5		4.5
Expected dividend	0.0	%	0.0	%	0.0	%	0.0	%

Employee Stock Purchase Plan:
Risk-free interest rate	1.11	%	1.10	%	1.04	%	1.25	%
Expected volatility	76	%	85	%	76	%	92	%
Expected life (in years)	2.0		2.0		2.0		2.0
Expected dividend	0.0	%	0.0	%	0.0	%	0.0	%

If the computed minimum values of our stock-based awards to employees had been amortized to expense over the period of the awards as specified under SFAS No. 123, our pro forma net loss, basic earnings (loss) per share and diluted income (loss) per share under SFAS No. 123 (as compared to such items as reported) would have been as follows (in thousands, except per share amounts):

	Three Months Ended June 30,						Nine Months Ended June 30,
	2004			2003			2004			2003
Net income as reported	$	1,066		$	196		$	2,390		$	3,241
Add: stock based employee compensation expense included in reported net income, net of taxes	209			30			571			426
Less: stock-based employee compensation expense determined under fair value based method, net of taxes	(1,776		)	(1,210		)	(4,443		)	(3,900		)
Pro forma net loss	$	(501	)	$	(984	)	$	(1,482	)	$	(233	)
Basic earnings (loss) per share:
As reported	$	0.04		$	0.01		$	0.09		$	0.13
Pro forma	$	(0.02	)	$	(0.04	)	$	(0.06	)	$	(0.01	)
Diluted earnings (loss) per share:
As reported	$	0.04		$	0.01		$	0.08		$	0.11
Pro forma	$	(0.02	)	$	(0.04	)	$	(0.06	)	$	(0.01	)

7. Contingencies

Legal Proceedings

Synopsys has filed claims against us in state and federal courts. These claims are based on the alleged facts and circumstances relating to the departure of our five founders from their employment at Synopsys, the founding of our company and the development and sale of HSIM and our other products. Each of our founders and Dr. Sang S. Wang, our Chief Executive Officer, became an employee of Synopsys when Synopsys acquired EPIC Design Technology in February 1997. Dr. Wang resigned from Synopsys in March 1998 and served as a consultant to Synopsys until June 1998. Dr. An-Chang Deng, our President, and our four other founders resigned from Synopsys at approximately the same time in August 1998 and became employees of our company immediately thereafter. Dr. Wang became an employee of our company in April 1999. None of Drs. Wang or Deng or our four other founders was subject to a noncompetition agreement with Synopsys at any time.

have filed an answer denying Synopsys’ allegations. In August 2003, Synopsys filed several motions for terminating sanctions against us, which were heard in January 2004. In June 2004 the Court ruled on Synopsys’ motions for terminating sanctions. The Discovery Referee vacated the orders of January 2003 that created the rebuttable presumptions in favor of Synopsys, but issued new orders that are favorable to Synopsys and not favorable to us and the individual defendants. These orders limit our defenses regarding the timing and the development of the initial HSIM source code and the evidence that we and the remaining individual defendants can present at trial. For purposes of trial, among other things, the orders established as facts that: (i) the first 60,000 lines of source code of HSIM and all the ideas and concepts reflected therein, to the extent they were not publicly known, were copied or derived from Synopsys’ source code or other Synopsys’ materials while the individual defendants were employed by Synopsys and (ii) we and the individual defendants acted in concert to intentionally alter, destroy, lose or misplace items requested in discovery and conceal evidence. These orders also struck the answer of one individual defendant, Jeh-Fu Tuan. The Discovery Referee denied Synopsys’ request to strike our answers and the answers of the remaining individual defendants. Synopsys has requested unspecified damages of at least $25 million, an injunction, a constructive trust on unspecified intellectual property belonging to us and other relief. Further, in September 2003, Synopsys notified us that it reserves the right to seek up to $80 million in punitive damages with respect to claims for which punitive damages are allowed under California Civil Code Section 3294, and up to $50 million in punitive damages with respect to the trade secret claims under California Civil Code Section 3426.3(c). This action is currently in discovery. The court has set the case for trial beginning on January 18, 2005.

We disagree with the Discovery Referee’s orders and believe that we have meritorious defenses to Synopsys’ allegations and claims. We intend to continue to defend ourselves vigorously and the trial judge or jury can reach its own conclusions regarding Synopsys’ claims based upon the evidence presented at trial. However, because of the inherent uncertainty of litigation in general, and the fact that the discovery related to this litigation is ongoing, we cannot assure you that we will ultimately prevail. Should Synopsys ultimately succeed in the prosecution of its claims, we could be permanently enjoined from selling our software and deriving related maintenance revenue. In addition, we could be required to pay substantial monetary damages to Synopsys. Further, we could be enjoined preliminarily from selling our software during the course of the litigation. Litigation such as the suit Synopsys has brought against us can take years to resolve and can be expensive to defend. Although the final outcome of the litigation may not occur for some time, the parties periodically conduct evidence gathering, meet to discuss the status of the litigation and file motions and other requests for the court to act. The results of these periodic activities, particularly the court’s decisions on current pending and future motions, could have the effect of determining the ultimate outcome of the litigation, either for or against us, prior to a trial on the merits, or strengthen or weaken our ability to assert claims and defenses. For example, in November 2001, the court denied a motion brought by Synopsys for injunctive relief that, if granted, could have prevented us from selling our products. If any of Synopsys’ motions ultimately prevail, our ability to defend ourselves against the claims brought against us in this litigation could be severely limited. It is possible that our relationships with our customers will be seriously harmed in the future as a result of the Synopsys litigation. Accordingly, an adverse judgment, if entered in favor of any Synopsys claim, could seriously harm our business, financial position and results of operations and cause our stock price to decline substantially. In addition, the Synopsys allegations and claims, even if ultimately determined to be without merit, could be time consuming to defend, result in costly litigation, divert our management’s attention and resources, cause product shipment delays or require us to enter into royalty or license agreements. These royalty or license agreements may not be available on terms acceptable to us, if at all, and the prosecution of the Synopsys allegations and claims could significantly harm our business, financial position and results of operations and cause our stock price to decline substantially.

In May 2001, Synopsys filed a complaint in the United States District Court, Northern District of California, San Jose division (Case No. CO1-20423 PVT) against us, alleging that our HSIM software

infringes U.S. Patent No. 5,878,053 entitled “Hierarchical Power Network Simulation and Analysis tool for reliability testing of Deep Submicron IC Designs” (the “053 patent”), which is purportedly assigned to Synopsys. Since the case began, Synopsys has also alleged that our subsequently released HSIM 2.0 and LEXSIM products, infringe the 053 patent. Synopsys has requested relief including damages from $4.1 million to $13.7 million and an injunction. Synopsys has also requested that any damage award be trebled for alleged willful infringement. In June 2001, we filed an answer to the complaint denying infringement of a valid, enforceable patent and asserting counterclaims. We have since amended our counterclaims. Our current counterclaims allege that, among other things, the 053 patent is invalid, unenforceable and not infringed and that Synopsys has violated federal antitrust and state unfair competition laws.

From time to time, the court has ruled on summary judgment motions in the case. In May 2002, the court granted summary judgment in favor of Synopsys on our invalidity defenses and counterclaims, concluding that they were barred by the doctrine of assignor estoppel. The court denied Synopsys’ motion with respect to our unenforceability defense and counterclaim. In November 2002, the court issued an order granting summary judgment in favor of Synopsys on certain antitrust counterclaims based on the doctrine of assignor estoppel. However, the court declined to rule on Synopsys’ motion with respect to our other antitrust and unfair competition counterclaims. In addition, the court issued a ruling construing the claims of the 053 patent in August 2002.

In September 2002, the U.S. Patent and Trademark Office granted our request for ex parte reexamination of the 053 patent based on prior art not previously considered by the Patent Office. We have moved to stay the federal litigation pending the outcome of the reexamination and the court granted our motion in December 2002. During the reexamination of the 053 patent, the Patent Office may determine that the subject matter in the patent is patentable as originally claimed, that the subject matter is patentable if the claims are modified or that the subject matter is not patentable. We cannot predict what the result of the reexamination procedure will be or how long it will take to complete.

Activity on several other summary judgment motions has been suspended because the court stayed the federal litigation. In November 2002, Synopsys filed three motions for summary judgment. The first motion asked the court to enter judgment before trial that Nassda’s products infringe the 053 patent. The second motion asked the court to rule before trial against us on our defense that the 053 patent is unenforceable because Synopsys committed inequitable conduct in obtaining the patent. We submitted oppositions to both of these motions. Synopsys’ third motion asked the court to rule before trial against us on our remaining antitrust counterclaims. Because of the court’s prior rulings against us on our other antitrust counterclaims, we did not oppose this motion. In November 2002, we also filed a summary judgment motion, which asked the court to enter judgment before trial that our products do not infringe the 053 patent. Synopsys opposed this motion. The court issued its order staying the federal litigation before the parties’ reply briefs were due.

particularity. We opposed Synopsys’ motions. In October 2003, the court denied Synopsys’ motion to dismiss and strike the invalidity and unenforceability defenses and counterclaims and granted Synopsys’ motion to strike the laches, patent misuse and unclean hands defenses with leave to amend the pleadings. In March 2004, Synopsys filed a motion for partial summary judgment on the ground that we are barred from contesting the validity and enforceability of the 898 Patent based on the doctrine of assignor estoppel. In April 2004, the Court ruled that we are barred under the doctrine of assignor estoppel from asserting the 898 Patent is invalid or unenforceable by virtue of pre-assignment inequitable conduct. The court issued a ruling construing the claims of the 898 patent in July 2004. The court has set the case for trial beginning on April 25, 2005.

We believe that we have meritorious defenses to Synopsys’ claims and intend to defend ourselves vigorously. However, because of the high degree of complexity of the intellectual property at issue, the inherent uncertainties of litigation in general and the preliminary nature of this litigation, we cannot assure you that we will ultimately prevail. Should Synopsys ultimately succeed in the prosecution of its claims, we could be permanently enjoined from selling our software and deriving related maintenance revenue. In addition, we may be required to pay substantial monetary damages to Synopsys. Further, we could be enjoined preliminarily from selling our software during the course of the litigation. Litigation such as the suit Synopsys has brought against us can take years to resolve and can be expensive to defend. The court’s decisions on current pending and future motions could have the effect of determining the ultimate outcome of the litigation prior to a trial on the merits, or strengthen or weaken our ability to assert claims and defenses. It is possible that our relationships with our customers will be seriously harmed in the future as a result of the Synopsys litigation. Accordingly, an adverse judgment, if entered on any Synopsys claim, could seriously harm our business, financial position and results of operations and cause our stock price to decline substantially. In addition, the Synopsys allegations and claims, even if ultimately determined to be without merit, could be time consuming to defend, result in costly litigation, divert our management’s attention and resources, cause product shipment delays or require us to enter into royalty or license agreements. These royalty or license agreements may not be available on terms acceptable to us, if at all, and the prosecution of the Synopsys allegations and claims could significantly harm our business, financial position and results of operations and cause our stock price to decline substantially. For instance, in January 2003 and June 2004, we reported certain negative rulings issued by the discovery referee with regard to the state litigation between us and Synopsys. As a result, the stock price of our common stock was adversely impacted.

In July 2004, we and certain of our officers and directors were named in a securities class action lawsuit filed in the United States District Court for the Northern District of California. The complaint asserts claims against our company, Sang S. Wang, An-Chang Deng, Tammy Shu-Hua Liu and Yen-Son Huang on behalf of a putative class of persons who purchased our stock between December 13, 2001 and June 11, 2004. The class action alleges that the named defendants violated certain provisions of the Securities Exchange Act of 1934 by making materially false and misleading representations in press releases and financial statements filed with the SEC relating to our financial results. The complaint’s allegations derive largely from allegations contained in the Synopsys trade secret litigation currently pending in California State Superior Court. The case is in the preliminary stages, and it is not possible for us to quantify the impact, if any, on our company. An unfavorable outcome in this case could have a material adverse effect on our business, financial condition, results of operations and cash flow. In addition, the expense of defending any litigation may be costly and divert our attention from the day-to-day operations of the business.

No amount has been accrued for any loss contingencies, which may result from the resolution of the above lawsuits filed against us, as the outcome of the matters is too uncertain to predict.

Other Contingencies

We from time to time enter into certain types of contracts that require us to indemnify parties against third party claims. These contracts primarily relate to: (i) certain agreements with our officers, directors and employees and third parties, under which we may be required to indemnify such persons for liabilities arising out of their duties to us and (ii) agreements under which we indemnify customers and partners for claims arising from intellectual property infringement.

The terms of such obligations vary. Because the obligated amounts of these types of agreements often are not explicitly stated, the overall maximum amount of the obligations cannot be reasonably estimated. Historically, we have not been obligated to make any significant payments for these obligations other than those in connection with defending our directors, officers and employees in the Synopsys litigation and derivative complaint, and no liabilities were recorded for these obligations on our balance sheet as of June 30, 2004.

In general, we provide our customers a 90-day limited warranty in connection with the licensing of our software that the software will perform substantially in accordance with our documentation. We do not maintain a general warranty reserve for estimated costs at the time revenue is recognized due to our extensive quality testing of the software. To date, we have incurred minimal costs related to this limited warranty obligation.

Our standard software license and maintenance agreements include an infringement indemnification provision for claims from third parties related to our intellectual property. The agreements generally limit the scope of the available remedies in a variety of industry-standard methods, including but not limited to a right to control the defense or settlement of any claim, procure the right for continued usage and replace or modify the infringing products to make them non-infringing. Such indemnification provisions are accounted for in accordance with SFAS No. 5. To date, we have not incurred any costs related to any claims under such indemnification provisions.

8. Recent Accounting Pronouncements

The Financial Accounting Standards Board (“FASB”) issued Interpretation 46 (“FIN 46”), Consolidation of Variable Interest Entities in January 2003, and a revised interpretation of FIN 46 (“FIN 46-R”). FIN 46 requires certain variable interest entities (“VIEs”) to be consolidated by the primary beneficiary of the entity if the equity investors in the entity do not have the characteristics of a controlling financial interest or sufficient equity at risk for the entity to finance its activities without additional subordinated financial support from other parties. The provisions of FIN 46 are effective immediately for all arrangements entered into after January 31, 2003. We have not invested in any entities that we believe are variable interest entities for which we are the primary beneficiary. The adoption of FIN 46-R had no impact on our financial position, results of operations or cash flows.

In May 2003, the FASB issued SFAS No. 150, Accounting for Certain Financial Instruments with Characteristics of both Liabilities and Equity, which requires that certain financial instruments be presented as liabilities that were previously presented as equity or as temporary equity. Such instruments include mandatory redeemable preferred and common stock, and certain options and warrants. SFAS No. 150 is effective for financial instruments entered into or modified after May 31, 2003 and was effective at the beginning of the first interim period beginning after June 15, 2003. In November 2003, the FASB issued FASB Staff Position (“FSP”) No. 150-3, Effective Date, Disclosures, and Transition for Mandatorily Redeemable Financial Instruments of Certain Nonpublic Entities and Certain Mandatorily Redeemable Noncontrolling Interests under SFAS No. 150, which defers the effective date for various provisions of SFAS

No. 150. The Company believes that it has properly classified and measured in its balance sheets and disclosed in its interim consolidated financial statements certain financial instruments with characteristics of both liabilities and equity.

In November 2003, the Emerging Issues Task Force (“EITF”) reached an interim consensus on Issue 03-01, “The Meaning of Other-Than-Temporary Impairment and its Application to Certain Investment,” to require additional disclosure requirements for securities classified as available-for-sale or held-to-maturity for fiscal years ending after December 15, 2003. In March 2004, the EITF reached a final consensus on this Issue and provided additional guidance in determining whether investment securities have an impairment which should be considered other-than-temporary in reporting periods after June 15, 2004. The adoption of this Issue had no impact on our financial position, results of operations or cash flows.

MANAGEMENT’S DISCUSSION AND ANALYSIS OF
FINANCIAL CONDITION AND RESULTS OF OPERATIONS

This Quarterly Report on Form 10-Q contains forward-looking statements within the meaning of Section 27A of the Securities Act of 1933 and Section 21E of the Securities Exchange Act of 1934. These statements relate to future events or our future financial performance and involve known and unknown risks, uncertainties and other factors that may cause our or our industry’s actual results, levels of activity, performance or achievements to be materially different from any future results, levels of activity, performance or achievements expressed or implied by the forward-looking statements. In some cases you can identify forward-looking statements by terminology such as “may,” “will,” “should,” “expects,” “plans,” “anticipates,” “believes,” “estimates,” “predicts,” “potential,” “continue” or the negative of these terms or other comparable terminology. These statements are only predictions and you should not place undue reliance on these statements. Actual events or results may differ materially. In evaluating these statements, you should specifically consider various factors including those discussed in “Factors Affecting Future Operating Results” below.

Although we believe that the expectations reflected in our forward-looking statements are reasonable, we cannot guarantee future results, levels of activity, performance or achievements. Moreover, neither we nor any other person assumes responsibility for the accuracy and completeness of these statements. We are under no duty to update any of the forward-looking statements after the date of this Quarterly Report on Form 10-Q to conform our prior statements to actual results, as a result of new information or otherwise.

Overview

We are a leading provider of full-chip circuit simulation and analysis software for the design and verification of complex semiconductors. Our customers use our software to reduce time-to-market and achieve first silicon success by simulating complex designs rapidly and accurately. We released our first product, HSIM, in July 1999 and began recognizing revenue from HSIM in the three months ended September 30, 1999. In February 2002, with the release of HSIM 2.0, we also introduced two new options, CircuitCheck and Cadence Analog Artist Integration, which are sold as separate options. We released our second major product, LEXSIM, in May 2002, and our third product, CRITIC, in December 2002. In April 2003, we released HSIM 3.0 with a new digital co-simulation interface option, and in May 2003, we released on a limited basis our fourth product, HANEX.

In April 2004, we released the HSIM^plus platform for the comprehensive simulation and analysis of high-performance analog, mixed-signal, memory and system-on-chip designs including important post-layout effects. The platform, based on version 5.0 of our HSIM hierarchical simulator and combined with the reconfigured LEXSIM, provides a suite of analyses for ICs manufactured in 130 nanometer processes and below. These analyses address major concerns of nanometer IC designers including reliability of power and signal networks, the timing impact of dynamic voltage drop in power networks, dynamic crosstalk noise due to coupling capacitance and MOSFET device reliability.

Current Economic Environment

The general economic environment has been challenging over the last three years as the semiconductor industry experienced a prolonged economic downturn. As a result, research and development capital budgets have been reduced substantially and at the same time, the numbers of design starts and potential users have decreased due to budget cuts and layoffs. The electronic design automation (“EDA”) industry has endured this difficult period by providing flexible license structures and payment terms, such as

time-based licenses with installment payments, competitive pricing, bundling/packaging of suites of tools and continuing to consolidate, especially large EDA vendors. As a relatively small company in the EDA industry offering a limited number of products as compared to the large EDA vendors who offer products for the whole design flow, we have had to compete by creating leading technology and solutions, providing high levels of customer support, remaining flexible in licensing structure and payment terms and offering substantial discounts which lower our average selling prices. More recently, there have been some improvements in the global economy and the semiconductor industry. However, we have not experienced any material changes in our customers’ purchasing behavior and continue to believe that our customers will continue to spend conservatively in the second half of calendar 2004 with tight control on their research and development budgets.

For the second half of calendar 2004, we expect to continue to experience longer sales cycles, pressure on average selling prices, flexible licensing structures and extended payment terms. Nonetheless, we intend to maintain our focus on increasing the adoption of our newer products, enhancing and executing our major account strategies in order to increase market penetration, expanding our worldwide organization cautiously while providing first class customer support and controlling costs.

Our fiscal year ends on September 30. Throughout this report we refer to the fiscal year ended September 30, 2003 as fiscal 2003, the fiscal year ending September 30, 2004 as fiscal 2004 and so on.

Sources of Revenue

We derive all of our revenue from software licensing and maintenance fees. To date, we have derived substantially all of this revenue from the licensing and support of HSIM. Even though, as a percent of total orders received, sales of other products other than HSIM have increased for the nine months ended June 30, 2004 as compared to the same period in fiscal 2003, we do not expect these other products to account for any meaningful percentage of our total revenue until fiscal 2005. Our software does not require customization and generally does not require on-site implementation services. As a result, we have not generated any professional service or consulting revenue. We do not consider backlog to be a meaningful measure of future revenue because our customers can generally cancel orders without penalty.

Product Revenue — Perpetual Licenses

Perpetual license customers pay a one-time license fee and are entitled to use the software as long as they desire. To receive support, periodic updates and new enhancements from us, perpetual license customers must purchase maintenance contracts. Prior to fiscal 2003, we generated the majority of our total revenue from perpetual licenses. As more customers have been purchasing time-based licenses, product revenue as a percent of total revenue has decreased and accounted for only 24.1% and 23.7% of our total revenue for the three and nine months ended June 30, 2004, respectively, as compared to 25.2% and 36.5% of our total revenue for the three and nine months ended June 30, 2003, respectively. We expect that over time product revenue will continue to decrease as a percent of our total revenue.

Subscription Revenue — Time-Based Licenses

Our time-based licenses give the customer the right to use our software for a fixed period of time, typically one to three years, and include maintenance. Time-based licenses can be renewed for one or more years. At times, customers may also acquire additional licenses for a shorter term, typically multiples of one-month licenses, to be used when they reach certain stages of the design process in conjunction with their other time-based or perpetual licenses. These shorter term licenses are sold primarily to help customers with their peak usage demands. To date, revenue from these shorter term licenses has not been significant. An

increasing proportion of our total revenue is derived from time-based licenses, as more of our large customers initially subscribe to time-based licenses, renew their expired time-based licenses or subscribe to additional time-based licenses. In today’s challenging economic environment, some of the customers who had purchased perpetual licenses previously and new customers are also choosing to purchase time-based licenses due to their flexible licensing and payment terms and we expect this trend to continue.

Maintenance Revenue

Our perpetual license customers typically purchase maintenance contracts and renew them annually. Customers who purchase maintenance receive support, updates and enhancements when we make them available to our general installed base. We anticipate that as an increasing proportion of our future licenses come from time-based licenses, maintenance revenue may decrease as a percent of total revenue. Maintenance revenue may also fluctuate from quarter to quarter due to the timing of annual renewals.

Quarterly Fluctuations

Our revenue for the fiscal quarters ended March 31, 2003 and June 30, 2003 decreased sequentially but has recovered in part and rose in each of the last four quarters, including the quarter ended June 30, 2004. We believe the prolonged economic slowdown and seasonal factors in our business have caused and will continue to cause both the total revenue and each of its components to fluctuate from quarter to quarter. Our customers and prospective customers are controlling their spending in order to conserve capital and maintain or increase profitability, which causes extended sales cycles, smaller number of license purchases or decreased or canceled budgets and decreasing average selling prices. Other seasonal factors include the mix between perpetual and time-based licenses, timing of the renewals of time-based licenses and maintenance, and payment terms, which may impact the timing of revenue recognition. Further, commissions represent a significant portion of our sales force compensation, which is structured to encourage sales closures prior to fiscal year end. As a result, we expect that sales efforts will intensify in the fourth fiscal quarter, which could result in our order receipts and revenue being lower in the first half of the subsequent fiscal year.

Deferred Revenue

Time-based licenses and maintenance that are invoiced in advance and are either paid or due are included in deferred revenue and generally recognized ratably over the contract period on a straight line basis. Deferred revenue also consists of deferred perpetual license fees for which all of the revenue recognition criteria have not been met. Deferred revenue fluctuates depending on the timing of perpetual licenses meeting all the revenue recognition criteria, as well as the number, subscription period, payment terms, and timing of renewals of time-based licenses and maintenance contracts. Deferred revenue expected to be recognized beyond one year from the balance sheet date is classified as long-term deferred revenue.

Operating Expenses

Since our inception in August 1998, we have incurred substantial costs to develop our technology and products, recruit and train personnel for our engineering, sales and marketing and technical support departments and establish an administrative organization. We anticipate that our operating expenses will increase in the future as we fund more research and development projects, increase our sales and marketing operations both domestically and internationally, develop new sales channels, broaden our technical support and improve our operational and financial systems. In fiscal 2002, fiscal 2003 and the nine months ended June 30, 2004, legal fees and other expenses related to our litigation with Synopsys were $5.6 million, $7.8 million and $8.5 million, respectively. We expect the cost of the Synopsys litigation to increase as we continue to defend ourselves vigorously and the lawsuits move toward trial. Additionally, we also expect

costs related to being a public company, such as directors’ and officers’ liability insurance, compliance with corporate governance rules adopted by The Nasdaq Stock Market and the Securities and Exchange Commission, professional fees and various filing fees to increase our general and administrative expenses. We believe that our operating expenses will continue to grow in absolute dollars in future periods although the rate of growth in expenses from period to period may vary. We expect, however, that as a percent of revenue, operating expenses will fluctuate from quarter to quarter depending primarily upon the rate of growth in revenue. We will need to generate significant revenue in the future to maintain profitability.

To increase market share in international locations and better serve our customers, we plan to further expand our international operations selectively. As a result of these investments in our international operations, we may experience an increase in cost of sales and other operating expenses disproportionate to revenue from those operations.

In fiscal 2003, we accrued bonuses of an aggregate of $900,000 earned by our employees for their services in fiscal 2003. These bonuses were paid in full as of December 31, 2003. We also accrued bonuses of $865,000 earned by our employees for their services for the nine months ended June 30, 2004. In addition, our executive officers orally agreed that they would not receive their base salaries in fiscal 2002 and fiscal 2003. In October 2003, the compensation committee of our board of directors reinstated the salaries of our executive officers and we expect to pay base salaries totaling approximately $743,000 to these officers in fiscal 2004. As a result of our significant bonus accruals in prior years and the foregone salaries in fiscal 2002 and fiscal 2003, our compensation expense in fiscal 2004 may not be consistent with compensation expense in prior years and compensation expense in prior years may not be indicative of future periods.

Stock-Based Compensation

We did not record any deferred stock-based compensation in fiscal 2002, fiscal 2003 or in the nine months ended June 30, 2004. We have been amortizing stock-based compensation recorded previously over the vesting period of the related options, which is generally four years. We amortized $1.0 million and $955,000 of stock-based compensation in fiscal 2002 and fiscal 2003, respectively. During the three and nine months ended June 30, 2004, we recognized aggregate stock-based compensation expense of approximately $189,000 and $631,000, respectively. We expect aggregate stock-based compensation expense of approximately $166,000 during the remainder of fiscal 2004 and approximately $235,000 during fiscal 2005.

Foreign Currency Transactions

Our revenue is generally denominated in United States dollars; however, our operating expenses in international locations are denominated in local currencies. Historically, our exposure to foreign exchange fluctuations has been minimal; however, as our international sales and operations expand, we anticipate that our exposure to risks associated with foreign currency fluctuations will increase.

Critical Accounting Policies

Revenue Recognition

• a written purchase order, license agreement or other contract has been executed;

• the product and the production license key have been delivered;

• user acceptance periods, if any, have expired;

• the license fee is fixed or determinable; and

• collection of the fee is probable.

For sales made through all distributors, we recognize revenue when the software has been sold to the end users and all other revenue recognition criteria have been met. When the distributor is the primary obligor in the arrangement and has latitude in establishing prices and credit risk, we record revenue based on amounts invoiced to the distributor (rather than the amount invoiced by the distributor to the end users). When we are the primary obligor in the arrangement and have latitude in establishing price and credit risk, we record revenue based on amounts invoiced to the end customer (with the related commissions paid to the distributors reported as sales and marketing expense).

Allowance for Doubtful Accounts

We maintain an allowance for doubtful accounts based on management’s best estimate of probable losses inherent in the outstanding accounts receivable balance. Management determines the allowance based on known troubled accounts, historical experience and other currently available evidence. If the financial condition of our customers were to deteriorate, resulting in an impairment of their ability to make payments, additional allowances may be required.

Sales Commission Accrual and Expenses

We adjust the balance of the commission accrual and the actual commission expense at the end of each fiscal year based on each sales person’s actual commission rates.

Contingent Liabilities

We are subject to several legal proceedings and claims, the outcomes of which are subject to significant uncertainty. Statement of Financial Accounting Standards (SFAS) No. 5, Accounting for Contingencies, requires that an estimated loss from a loss contingency should be accrued by a charge to income if it is probable that an asset has been impaired or a liability has been incurred and the amount of the loss can be reasonably evaluated, taking into account the degree of probability of an unfavorable outcome and the ability to make a reasonable estimate of the amount of loss, among other factors. Changes in these factors could materially impact our financial position or our results of operations. We regularly evaluate current information available to us to determine whether such accruals should be recorded. To date, we have not accrued any loss contingencies.

Results of Operations

The following table sets forth the results of our operations expressed as a percent of total revenue. Our historical operating results are not necessarily indicative of the results for any future period.

	Three Months Ended June 30,				Nine Months Ended June 30,
	2004		2003		2004		2003
Revenue:
Product	24.1	%	25.2	%	23.7	%	36.5	%
Subscription	52.9		47.4		51.8		40.4
Maintenance	23.0		27.4		24.5		23.1
Total revenue	100.0		100.0		100.0		100.0
Cost of revenue:
Product	0.5		0.9		0.7		0.7
Subscription	1.0		1.2		1.0		1.0
Maintenance	2.4		2.8		2.5		2.3
Total cost of revenue	3.9		4.9		4.2		4.0
Gross profit	96.1		95.1		95.8		96.0
Operating expenses:
Research and development	22.1		26.2		21.2		19.5
Sales and marketing	29.6		35.4		28.2		31.6
General and administrative	34.1		32.7		36.5		27.5
Stock-based compensation	1.7		3.1		2.1		2.7
Total operating expenses	87.5		97.4		88.0		81.3
Income (loss) from operations	8.6		(2.3	)	7.8		14.7
Interest income	2.3		3.0		2.4		2.8
Other income (expense), net	0.0		0.1		(0.1	)	(0.1	)
Income before taxes	10.9		0.8		10.1		17.4
Provision for (benefit from) income taxes	1.2		(1.8	)	2.3		5.2
Net income	9.7	%	2.6	%	7.8	%	12.2	%

Three and Nine Months Ended June 30, 2004

Revenue

Total Revenue. Our revenue consists of product, subscription and maintenance revenue. Total revenue increased by 45.9%, or $3.5 million, to $11.0 million in the three months ended June 30, 2004 from $7.5 million for the three months ended June 30, 2003, and increased by 14.4%, or $3.9 million, to $30.5 million for the nine months ended June 30, 2004 from $26.6 million for the nine months ended June 30, 2003. The increases were primarily attributable to an increase in our end user base, resulting in substantial growth in subscription and maintenance revenue.

Revenue from sales outside of North America accounted for 31.9% and 36.0% of total revenue for the three months ended June 30, 2004 and 2003, respectively, and 36.9% and 38.0% of total revenue for the nine months ended June 30, 2004 and 2003, respectively. The percent of total revenue from outside of North America decreased due to domestic revenue growing at a faster rate than revenue from outside of North America, particularly from major accounts. Revenue from Japan was 13.7% and 13.1% of our total revenue in the three months ended June 30, 2004 and 2003, respectively, and 17.1% and 14.1% of total revenue for the nine months ended June 30, 2004 and 2003, respectively. No other country outside North America accounted for more than 10% of our total revenue in any of these periods. We expect that revenue from sales outside of North America will continue to account for a significant portion of our total revenue in the future.

Marubeni Solutions, our exclusive distributor for Japan, accounted for approximately 13.7% and 13.1% of our total revenue for the three months ended June 30, 2004 and 2003, respectively, and 17.1% and 14.1% of total revenue for the nine months ended June 30, 2004 and 2003, respectively. Broadcom Corporation accounted for approximately 11.5% of our total revenue for the nine months ended June 30, 2003. No other direct customer or distributor accounted for more than 10% of our total revenue during any of these periods.

Deferred revenue includes perpetual license fees for which all of the revenue recognition criteria have not been met, time-based license fees that have been invoiced and due for which we recognize revenue ratably over the term of the license period and maintenance fees on perpetual licenses for which we also recognized revenue ratably over the term of the maintenance period. Our total short term and long term deferred revenue increased to $11.8 million as of June 30, 2004 from $9.8 million as of September 30, 2003 and from $10.0 million as of June 30, 2003. We expect deferred revenue to fluctuate from quarter to quarter due to the number of additional time-based license purchases, the timing of renewals of time-based licenses and maintenance and their respective payment terms. Additionally, deferred revenue may not increase if more customers prefer quarterly payments for time-based licenses and maintenance.

Product Revenue. Product revenue increased by 39.7%, or $751,000, to $2.6 million for the three months ended June 30, 2004 from $1.9 million for the three months ended June 30, 2003 due to additional sales of perpetual licenses to major accounts. Product revenue decreased by 25.9%, or $2.5 million, to $7.2 million for the nine months ended June 30, 2004 from $9.7 million for the nine months ended June 30, 2003. This decrease was primarily due to more customers, particularly major accounts, purchasing time-based licenses as compared to perpetual licenses. As a percent of total revenue, product revenue decreased to 24.1% for the three months ended June 30, 2004 from 25.2% for the three months ended June 30, 2003, and decreased to 23.7% for the nine months ended June 30, 2004 from 36.5% for the nine months ended June 30, 2003, as the sales of perpetual licenses was outpaced by growth in the sales of time-based licenses.

Subscription Revenue. Subscription revenue increased by 62.8%, or $2.2 million, to $5.8 million for the three months ended June 30, 2004 from $3.6 million for the three months ended June 30, 2003, and

increased by 46.9%, or $5.1 million, to $15.8 million for the nine months ended June 30, 2004 from $10.7 million for the nine months ended June 30, 2003. The increases were primarily due to new customers purchasing time-based licenses, as well as existing customers purchasing additional time-based licenses and renewing their expired time-based licenses. As a percent of total revenue, subscription revenue rose to 52.9% for the three months ended June 30, 2004 from 47.4% for the three months ended June 30, 2003, and rose to 51.8% for the nine months ended June 30, 2004 from 40.4% for the nine months ended June 30, 2003. We expect time-based licenses to account for an increasing proportion of total revenue in the future.

Maintenance Revenue. Maintenance revenue increased by 22.4%, or $461,000, to $2.5 million for the three months ended June 30, 2004 from $2.1 million for the three months ended June 30, 2003, and increased by 21.2%, or $1.3 million, to $7.5 million for the nine months ended June 30, 2004 from $6.2 million for the nine months ended June 30, 2003. The increases in maintenance revenue were due to the increase in the number of perpetual licenses in the installed base. As a percent of total revenue, maintenance revenue decreased to 23.0% for the three months ended June 30, 2004 from 27.4% for the three months ended June 30, 2003, and increased to 24.5% for the nine months ended June 30, 2004 from 23.1% for the nine months ended June 30, 2003. We expect maintenance revenue to vary as a percent of total revenue based on the growth rate of product revenue relative to subscription revenue and the number of customers renewing annual maintenance. If maintenance revenue increases as a percent of total revenue, our gross profit as a percent of total revenue, or gross margin, may decrease because of lower margins on maintenance revenue than product revenue due to incremental maintenance support costs.

Cost of Revenue

Cost of Product Revenue. Cost of product revenue consists primarily of royalties due from us to third parties under original equipment manufacturer arrangements. We incur only minimal costs to deliver our software as the product and documentation are primarily sent electronically. Our cost of product revenue decreased by 29.0%, or $20,000, to $49,000 for the three months ended June 30, 2004 from $69,000 for the three months ended June 30, 2003. Cost of product revenue increased by 8.1% or $16,000, to $214,000 for the nine months ended June 30, 2004 from $198,000 for the nine months ended June 30, 2003, due to an increase in the sublicensing of third-party products. As a percent of total revenue, the cost of product revenue decreased to 0.5% for the three months ended June 30, 2004 from 0.9% for the three months ended June 30, 2004, and remained flat at 0.7% for the nine months ended June 30, 2004 and 2003. We expect the cost of product revenue as a percent of total revenue to continue to vary based on the sales of third-party products.

Cost of Subscription Revenue. Cost of subscription revenue consists primarily of personnel and allocated overhead expenses for support of time-based licenses. Our cost of subscription revenue increased by 20.0%, or $18,000, to $108,000 for the three months ended June 30, 2004 from $90,000 for the three months ended June 30, 2003, and increased by 21.9%, or $57,000, to $317,000 for the nine months ended June 30, 2004 from $260,000 for the nine months ended June 30, 2003. The increases in cost of subscription revenue were primarily due to the increase in personnel and other costs associated with the support of a larger number of time-based licenses. As a percent of total revenue, the cost of subscription revenue decreased slightly to 1.0% for the three months ended June 30, 2004 from 1.2% for the three months ended June 30, 2003, and remained flat at 1.0% for the nine months ended June 30, 2004 and 2003. We expect the absolute dollar amount of the cost of subscription revenue to increase over the next 12 months.

Cost of Maintenance Revenue. Cost of maintenance revenue consists primarily of personnel and other expenses related to providing maintenance support to our customers who purchase perpetual licenses. Our cost of maintenance revenue increased by 27.0%, or $57,000, to $268,000 for the three months ended June 30, 2004 from $211,000 for the three months ended June 30, 2003, and increased by 23.6%, or $144,000, to $753,000 for the nine months ended June 30, 2004 from $609,000 for the nine months ended

June 30, 2003. The increases in cost of maintenance revenue were primarily due to increased hiring of dedicated support personnel to provide support to a growing installed user base. As a percent of total revenue, the cost of maintenance revenue decreased slightly to 2.4% for the three months ended June 30, 2004 from 2.8% for the three months ended June 30, 2003, and increased slightly to 2.5% for the nine months ended June 30, 2004 from 2.3% for the nine months ended June 30, 2003. The increase in the cost of maintenance revenue was primarily due to the additional resources required in supporting an increasing number of perpetual licensees. We expect that the absolute dollar amount of cost of maintenance revenue will grow in the next 12 months as we continue to increase support for our growing base of domestic and international customers.

Operating Expenses

Research and Development. Research and development expenses consist of engineering costs to develop new products, enhance existing products and perform quality assurance activities. Our research and development expenses increased by 22.9%, or $451,000, to $2.4 million for the three months ended June 30, 2004 from $2.0 million for the three months ended June 30, 2003, and increased by 24.2%, or $1.3 million, to $6.5 million for the nine months ended June 30, 2004 from $5.2 million for the nine months ended June 30, 2003. The increases in research and development expenses were primarily due to the hiring of additional research and development personnel. Research and development headcount increased to 49 at June 30, 2004 from 43 at June 30, 2003. As a percent of total revenue, research and development expenses decreased to 22.1% in the three months ended June 30, 2004 from 26.2% in the three months ended June 30, 2003 due to the growth rate of total revenue outpacing the growth rate of research and development expenses, and increased to 21.2% in the nine months ended June 30, 2004 from 19.5% in the nine months ended June 30, 2003. We anticipate that research and development expenses will continue to increase in absolute dollars in the future.

Sales and Marketing. Sales and marketing expenses consist primarily of salaries, commissions, travel, promotional and advertising costs. Our sales and marketing expenses increased by 22.0%, or $586,000, to $3.2 million for the three months ended June 30, 2004 from $2.7 million for the three months ended June 30, 2003, and increased by 2.1%, or $177,000, to $8.6 million for the nine months ended June 30, 2004 from $8.4 million for the nine months ended June 30, 2003. These increases were primarily due to higher distributor and sales commissions as a result of increases in total revenue. Sales and marketing headcount increased to 48 at June 30, 2004 from 47 at June 30, 2003. As a percent of total revenue, sales and marketing expenses decreased to 29.6% in the three months ended June 30, 2004 from 35.4% in the three months ended June 30, 2003, and decreased to 28.2% in the nine months ended June 30, 2004 from 31.6% in the nine months ended June 30, 2003. We expect that sales and marketing expenses will increase in absolute dollars in future periods as we further expand our global sales and support organization.

General and Administrative. General and administrative expenses include corporate, finance, human resource, administrative, legal and consulting expenses. Our general and administrative expenses increased by 52.0%, or $1.2 million, to $3.7 million for the three months ended June 30, 2004 from $2.5 million for the three months ended June 30, 2003, and increased by 51.8%, or $3.8 million, to $11.1 million for the nine months ended June 30, 2004 from $7.3 million for the nine months ended June 30, 2003. As a percent of total revenue, general and administrative expenses increased to 34.1% for the three months ended June 30, 2004 from 32.7% for the three months ended June 30, 2003, and increased to 36.5% for the nine months ended June 30, 2004 from 27.5% for the nine months ended June 30, 2003. The increases in general and administrative expenses were primarily due to legal fees related to our litigation with Synopsys. Legal fees related to our litigation with Synopsys increased by 60.0%, or $1.0 million, to $2.7 million for the three months ended June 30, 2004 from $1.7 million for the three months ended June 30, 2003, and increased by 63.1%, or $3.3 million, to $8.5 million for the nine months ended June 30, 2004 from $5.2 million for the

nine months ended June 30, 2003. General and administrative headcount increased to 13 at June 30, 2004 from 11 at June 30, 2003. We expect that general and administrative expenses will continue to increase in absolute dollars to support the growth of our future operations, as well as from increased legal fees, liability insurance and the costs of public company compliance reporting.

Stock-Based Compensation. Stock-based compensation expense decreased by 17.5%, or $40,000, to $189,000 for the three months ended June 30, 2004 from $229,000 for the three months ended June 30, 2003, and decreased by 13.0%, or $94,000, to $631,000 for the nine months ended June 30, 2004 from $725,000 for the nine months ended June 30, 2003. As a percent of total revenue, stock-based compensation expense decreased to 1.7% for the three months ended June 30, 2004 from 3.1% for the three months ended June 30, 2003, and decreased to 2.1% for the nine months ended June 30, 2004 from 2.7% for the nine months ended June 30, 2003 due to increases in revenue.

Interest Income

Interest income increased by 14.0%, or $31,000, to $253,000 for the three months ended June 30, 2004 from $222,000 for the three months ended June 30, 2003, and decreased by 2.0%, or $15,000, to $731,000 for the nine months ended June 30, 2004 from $746,000 for the nine months ended June 30, 2003. As a percent of total revenue, interest income decreased to 2.3% for the three months ended June 30, 2004 from 3.0% for the three months ended June 30, 2003, and decreased to 2.4% for the nine months ended June 30, 2004 from 2.8% for the nine months ended June 30, 2003.

Other Expense, Net

Our other expense, net remained relatively small and was immaterial for the three and nine months ended June 30, 2004 and 2003.

Income Taxes

Based on current estimates, we project that our effective tax rate for fiscal 2004 will be approximately 22.6%. The effective tax rate that we projected in prior quarters was 30.0%. The decrease was caused primarily by the lowered projected annual income for fiscal 2004 and the adjustments made to the fiscal 2003 tax accrual based on the tax returns filed in June 2004. This resulted in a lower tax accrual for the quarter ended June 30, 2004, with an effective tax rate of approximately 10.9%.

The research tax credit provision in Section 41 of the Internal Revenue Code of 1986, as amended, expired on June 30, 2004. If the research credit is extended by Congress, our effective tax rate for fiscal 2004 may change. Any extension of the credit will be taken into account in the quarter in which such legislation is enacted.

Liquidity and Capital Resources

As of June 30, 2004, we had cash, cash equivalents and short-term investments of $99.9 million and working capital of $86.5 million.

Net cash provided by operating activities was $5.9 million for the nine months ended June 30, 2004 and $8.6 million for the nine months ended June 30, 2003. Net cash provided by operating activities for the nine months ended June 30, 2004 resulted primarily from net income and increases in accounts payable and deferred revenue, partially offset by a decrease in accrued liabilities and increase in prepaid expenses and other assets. Net cash provided by operating activities for the nine months ended June 30, 2003 resulted

primarily from net income, increases in deferred revenue and accrued liabilities and a decrease in accounts receivable, partially offset by increases in prepaid expenses and other current assets.

Net cash used in investing activities was $3.5 million for the nine months ended June 30, 2004 primarily related to the purchases of short-term investment securities. Net cash provided by investing activities was $5.3 million for the nine months ended June 30, 2003 primarily related to the net proceeds from maturity of short-term investment securities and partially offset by purchases of property and equipment.

Net cash provided by financing activities was $2.0 million and $2.2 million for the nine months ended June 30, 2004 and 2003, respectively, consisting primarily of proceeds generated by stock option exercises and the employee stock purchase plan during both periods.

Capital expenditures were approximately $162,000 for the nine months ended June 30, 2004 and $452,000 for the nine months ended June 30, 2003. Our capital expenditures consisted of purchases of computer equipment, software and office furniture and fixtures. We expect to invest approximately $100,000 in the remainder of fiscal 2004 for similar assets.

As of June 30, 2004, we had no borrowings, lines of credit, outstanding equipment leases or lease lines.

We intend to continue to invest heavily in the development of new products and enhancements to existing products. We also intend to increase our sales and marketing operations. Our future liquidity and capital requirements will depend on numerous factors, including:

• the amount and timing of orders and their respective payment terms;

• the extent to which our existing and new products gain market acceptance;

• the extent to which customers continue to renew time-based licenses and maintenance;

• the cost and timing of expansion of product research and development efforts, including such efforts outside North America, and the success of these development efforts;

• the cost and timing of expansion of sales and marketing activities, including such activities outside North America;

• the cost of litigation and damages when and if awarded; and

• available borrowings under future credit arrangements, if any.

We believe that our current cash and investment balances and any cash generated from operations, will be sufficient to meet our operating and capital requirements for at least the next 12 months. However, it is possible that we may require additional financing within this period. We have no current plans, and we are not currently negotiating to obtain additional financing. The factors described above will affect our future capital requirements and the adequacy of our available funds. In addition, even if we raise sufficient funds to meet our anticipated cash needs during the next 12 months, we may need to raise additional funds beyond this time. We may be required to raise those funds through public or private financings, strategic relationships or other arrangements. We cannot assure you that such funding, if needed, will be available on terms attractive to us, or at all. Furthermore, any additional equity financing may be dilutive to stockholders, and debt

financing, if available, may involve restrictive covenants. If we fail to raise capital as and when needed, our failure could have a negative impact on our ability to pursue our business strategy and maintain profitability.

Lease Commitments

Year Ending September 30,
2004	$	585
2005	529
2006	252
	$	1,366

Recent Accounting Pronouncements

The Financial Accounting Standards Board (“FASB”) issued FASB Interpretation 46 (“FIN 46”), Consolidation of Variable Interest Entities in January 2003, and a revised interpretation of FIN 46 (“FIN46-R”). FIN 46 requires certain variable interest entities (“VIEs”) to be consolidated by the primary beneficiary of the entity if the equity investors in the entity do not have the characteristics of a controlling financial interest or sufficient equity at risk for the entity to finance its activities without additional subordinated financial support from other parties. The provisions of FIN 46 are effective immediately for all arrangements entered into after January 31, 2003. We have not invested in any entities that we believe are variable interest entities for which we are the primary beneficiary. The adoption of FIN46-R had no impact on our financial position, results of operations or cash flows.

In November 2003, the Emerging Issues Task Force (“EITF”) reached an interim consensus on Issue 03-01, “The Meaning of Other-Than-Temporary Impairment and its Application to Certain Investment” to require additional disclosure requirements for securities classified as available-for-sale or held-to-maturity for fiscal years ending after December 15, 2003. In March 2004, the EITF reached a final consensus on this Issue and provided additional guidance in determining whether investment securities have an impairment which should be considered other-than-temporary in reporting periods after June 15, 2004. The adoption of this Issue had no impact on our financial position, results of operations or cash flows.

Non-Audit Services of Independent Auditors

Our Audit Committee of the Board of Directors did not approve any non-audit services to be performed by our independent auditors, Deloitte & Touche LLP, during the three months ended June 30, 2004.

Factors Affecting Future Results

We have relied and expect to continue to rely on HSIM for a substantial majority of our revenue, and a decline in sales of licenses for HSIM could cause our revenue to decline.

Historically, we have derived substantially all of our revenue from HSIM. We believe HSIM is the first hierarchical simulator that meets the circuit verification challenges of complex nanometer semiconductors. We expect that the revenue from this product will continue to account for a substantial majority of our revenue for at least the remainder of fiscal 2004 and fiscal 2005. The electronic design automation software market, including the market for hierarchical simulator software, is characterized by rapid technological change, frequent new product introductions, uncertain product life cycles and evolving industry standards. If our competitors introduce new products, special bundling and/or offer aggressive pricing that compete with HSIM, our revenue could decline materially and our results of operations could be harmed. For instance, in fiscal 2003 and the first three fiscal quarters of 2004, certain competitors were offering extremely competitive prices either by substantial discounting or bundling their products which resulted in a longer sales cycle for HSIM or delays by prospective customers in making their purchasing decisions. Since we expect HSIM to continue to account for a substantial majority of our revenue for at least the remainder of fiscal 2004 and fiscal 2005, any factors adversely affecting the pricing of our licenses of or demand for HSIM, including competition or technological change, could cause our revenue to decline materially and our business to suffer.

Our revenue would decline substantially if our existing customers do not purchase additional licenses or renew existing time-based licenses and maintenance from us.

We rely on additional perpetual and time-based license revenue from our existing customers, as well as annual maintenance renewals for our perpetual licenses and renewals of our time-based licenses when they expire. Even if we are successful in generating revenue from our software to new customers, if our existing customers do not purchase additional licenses of our software or renew their expired time-based licenses or annual maintenance for perpetual licenses, we would experience a substantial decline in revenue. Through fiscal 2002, 2003 and the first three quarters of fiscal 2004, our revenue from perpetual licenses as a percent of total revenue has continued to decrease as a result of more customers’ preference to purchase time-based licenses, lower demand and average selling prices due to much tighter budgets. Revenue from time-based licenses and maintenance has increased steadily over the last two years and we expect it to continue to increase. For instance, for the nine months ended June 30, 2004, 76.3% of our total revenue was derived from time-based licenses and maintenance as compared to 63.5% for the nine months ended June 30, 2003. As more of our revenue is attributable to time-based licenses, our revenue could decline materially if our customers do not renew their existing time-based licenses or purchase additional time-based licenses.

We are currently a defendant in three lawsuits brought by Synopsys. The prosecution of these lawsuits could have a substantial negative impact on our business. Should Synopsys prevail, we may be required to pay substantial monetary damages or be prevented from selling our software.

founders and Dr. Sang S. Wang, our Chief Executive Officer, became an employee of Synopsys when Synopsys acquired EPIC Design Technology in February 1997. Dr. Wang resigned from Synopsys in March 1998 and served as a consultant to Synopsys until June 1998. Dr. An-Chang Deng, our President, and our four other founders resigned from Synopsys at approximately the same time in August 1998 and became employees of our company immediately thereafter. Dr. Wang became an employee of our company in April 1999. None of Drs. Wang or Deng or our four other founders was subject to a noncompetition agreement with Synopsys at any time.

In February 2000, Synopsys filed a complaint in the Superior Court of the State of California in the County of Santa Clara (Case No. CV787950) against us and Dr. Deng, our President. The complaint alleged breach of contract, breach of fiduciary trust, diversion of corporate opportunity and constructive trust. In September 2001, Synopsys filed its second amended complaint, which added claims of inducing/aiding and abetting breach of fiduciary duty, including/aiding and abetting diversion of corporate opportunity, misappropriation of trade secrets, civil conspiracy, breach of confidence and unfair competition, and added as individual defendants Dr. Wang and our four other founders. In September 2002, Synopsys filed a supplemental second amended complaint that contained supplemental allegations but added no new claims or parties. In January 2003, the discovery referee issued orders creating rebuttable presumptions in favor of Synopsys on certain evidentiary issues to sanction us for erasure of certain computer files requested in discovery by Synopsys. These rulings meant that we must prove at trial that we did not take or use Synopsys’ source code or other confidential information, rather than the usual requirement that Synopsys provide such proof in the first instance. We filed a motion for reconsideration of this order and in March 2003, the court denied our motion, concluding that it was barred on procedural grounds. In January 2003, Synopsys filed a third amended complaint, which contained supplemental allegations but added no new claims or parties. We have filed an answer denying Synopsys’ allegations. In August 2003, Synopsys filed several motions for terminating sanctions against us, which were heard in January 2004. In June 2004, the Court ruled on Synopsys’ motions for terminating sanctions. The Discovery Referee vacated the orders of January 2003 that created the rebuttable presumptions in favor of Synopsys, but issued new orders that are favorable to Synopsys and not favorable to us and the individual defendants. These orders limit our defenses regarding the timing and the development of the initial HSIM source code and the evidence that we and the remaining individual defendants can present at trial. For purposes of trial, among other things, the orders established as facts that: (i) the first 60,000 lines of source code of HSIM and all the ideas and concepts reflected therein, to the extent they were not publicly known, were copied or derived from Synopsys’ source code or other Synopsys’ materials while the individual defendants were employed by Synopsys and (ii) we and the individual defendants acted in concert to intentionally alter, destroy, lose or misplace items requested in discovery and conceal evidence. These orders also struck the answer of one individual defendant, Jeh-Fu Tuan. The Discovery Referee denied Synopsys’ request to strike our answers and the answers of the remaining individual defendants. Synopsys has requested unspecified damages of at least $25 million, an injunction, a constructive trust on unspecified intellectual property belonging to us and other relief. Further, in September 2003, Synopsys notified us that it reserves the right to seek up to $80 million in punitive damages with respect to claims for which punitive damages are allowed under California Civil Code Section 3294, and up to $50 million in punitive damages with respect to the trade secret claims under California Civil Code Section 3426.3(c). This action is currently in discovery. The court has set the case for trial beginning on January 18, 2005.

deriving related maintenance revenue. In addition, we could be required to pay substantial monetary damages to Synopsys. Further, we could be enjoined preliminarily from selling our software during the course of the litigation. Litigation such as the suit Synopsys has brought against us can take years to resolve and can be expensive to defend. Although the final outcome of the litigation may not occur for some time, the parties periodically conduct evidence gathering, meet to discuss the status of the litigation and file motions and other requests for the court to act. The results of these periodic activities, particularly the court’s decisions on current pending and future motions, could have the effect of determining the ultimate outcome of the litigation, either for or against us, prior to a trial on the merits, or strengthen or weaken our ability to assert claims and defenses. For example, in November 2001, the court denied a motion brought by Synopsys for injunctive relief that, if granted, could have prevented us from selling our products. If any of Synopsys’ motions ultimately prevail, our ability to defend ourselves against the claims brought against us in this litigation could be severely limited. It is possible that our relationships with our customers will be seriously harmed in the future as a result of the Synopsys litigation. Accordingly, an adverse judgment, if entered in favor of any Synopsys claim, could seriously harm our business, financial position and results of operations and cause our stock price to decline substantially. In addition, the Synopsys allegations and claims, even if ultimately determined to be without merit, could be time consuming to defend, result in costly litigation, divert our management’s attention and resources, cause product shipment delays or require us to enter into royalty or license agreements. These royalty or license agreements may not be available on terms acceptable to us, if at all, and the prosecution of the Synopsys allegations and claims could significantly harm our business, financial position and results of operations and cause our stock price to decline substantially.

In May 2001, Synopsys filed a complaint in the United States District Court, Northern District of California, San Jose division (Case No. CO1-20423 PVT) against us, alleging that our HSIM software infringes U.S. Patent No. 5,878,053 entitled “Hierarchical Power Network Simulation and Analysis tool for reliability testing of Deep Submicron IC Designs” (the “053 patent”), which is purportedly assigned to Synopsys. Since the case began, Synopsys has also alleged that our subsequently released HSIM 2.0 and LEXSIM products, infringe the 053 patent. Synopsys has requested relief including damages from $4.1 million to $13.7 million and an injunction. Synopsys has also requested that any damage award be trebled for alleged willful infringement. In June 2001, we filed an answer to the complaint denying infringement of a valid, enforceable patent and asserting counterclaims. We have since amended our counterclaims. Our current counterclaims allege that, among other things, the 053 patent is invalid, unenforceable and not infringed and that Synopsys has violated federal antitrust and state unfair competition laws.

In June 2003, Synopsys filed a second complaint in the United States District Court, Northern District of California, San Francisco Division (Case No. C03-2664 RS) against us, alleging that the our products, including but not limited to HSIM and HANEX software products, infringe Synopsys U.S. Patent No. 6,249,898 entitled “Methods and Systems for Reliability Analysis of CMOS VLSI Circuits Based on Stage Partitioning and Node Activities” (the “898 Patent”). In July 2003, we filed an answer denying that we infringe the 898 Patent and asserting as defenses that the 898 Patent is invalid and unenforceable. We also brought a declaratory judgment counterclaim seeking judgment that the 898 Patent is not infringed by us and that the 898 Patent is invalid and unenforceable. In August 2003, Synopsys filed a motion to dismiss these defenses and counterclaims on the ground that we are barred from contesting the validity and enforceability of the 898 Patent based on the doctrine of assignor estoppel. Synopsys’ motion also sought to strike our defenses of laches, patent misuse and unclean hands on the ground that we had not pleaded them with sufficient particularity. We opposed Synopsys’ motions. In October 2003, the court denied Synopsys’ motion to dismiss and strike the invalidity and unenforceability defenses and counterclaims and granted Synopsys’ motion to strike the laches, patent misuse and unclean hands defenses with leave to amend the pleadings. In March 2004, Synopsys filed a motion for partial summary judgment on the ground that we are barred from contesting the validity and enforceability of the 898 Patent based on the doctrine of assignor estoppel. In April 2004, the Court ruled that we are barred under the doctrine of assignor estoppel from asserting the 898 Patent is invalid or unenforceable by virtue of pre-assignment inequitable conduct. The court issued a ruling construing the claims of the 898 patent in July 2004. The court has set the case for trial beginning on April 25, 2005.

operations and cause our stock price to decline substantially. For instance, in January 2003 and June 2004, we reported certain negative rulings issued by the discovery referee with regard to the state litigation between us and Synopsys. As a result, the stock price of our common stock was adversely impacted.

If semiconductor design and manufacturing companies continue to experience recession or other conditions which impact their operating budgets, they may delay or cancel purchases of our software, which would reduce our revenues and cause our business to suffer.

The primary customers for our software are semiconductor design and manufacturing companies. Any significant downturn in our customers’ markets, or domestic and global conditions, which result in the reduction of research and development budgets or the delay of software purchases, would likely result in a decline in demand for our software and services and could harm our business. Since early 2000, the semiconductor industry had experienced a substantial decline in order volume and revenue and that downturn had continued until the second half of 2003 when semiconductor companies experienced some slow recovery in orders and end-users market demand. Even though some semiconductor companies’ revenue and profitability have increased over the last several quarters, we have not seen and do not expect to see in the near future any material changes in our customers’ purchasing behavior or substantially increased budgets. This could result in our customers delaying or canceling the purchase of our software. Any of these occurrences could have a significant impact on our operating results, revenues and costs and may cause the market price of our common stock to decline or become more volatile. For example, we experienced a substantial change in customers’ purchasing behavior during the three months ended March 31, 2003 due to the prolonged economic downturn and concerns for their own financial stability. Consequently, as a cost-cutting measure, customers either suspended or reduced their capital budgets dramatically, which adversely affected our revenue. In addition, we were unable to meet revenue and earnings expectations for the quarter ended March 31, 2003 and had to lower our revenue and earnings guidance for the quarter ended June 30, 2003 and fiscal 2003. As a result, the market price of our common stock was negatively impacted.

In addition, the markets for semiconductor products are cyclical. For example, in recent years certain Asian countries have experienced significant economic difficulties, including currency devaluation and instability, business failures and a depressed business environment. These difficulties have triggered a significant downturn in the semiconductor market, resulting in reduced budgets for semiconductor design tools, which, in turn, has negatively impacted us. We cannot predict what impact the recent prolonged economic slowdown or the slow recovery, and in particular, the semiconductor industry, will have on our business, but it may result in fewer purchases of licenses of our software, substitution to our lower priced configurations by customers who previously licensed our higher priced configurations or nonrenewal of time-based licenses or maintenance. If our customers’ budgets do not increase with the slow recovery, the current

slow recovery does not continue or the economic slowdown returns, we may not meet our revenue expectations for the fourth quarter of fiscal 2004 or fiscal 2004.

Because many of our current competitors have greater resources than we do and pre-existing relationships with our potential customers, we might not be able to achieve sufficient market penetration to sustain profitability or gain additional market share.

We face significant competition from larger companies that market suites of electronic design automation products that address all or almost all steps in the semiconductor design process. Many of these competitors have substantially greater financial, customer support, technical and marketing resources, larger customer bases, longer operating histories, greater name recognition and more established relationships in the industry than we do. We cannot be sure that we will have the resources or expertise to compete successfully in the future. If we are unable to gain additional market share due to their pre-existing relationships with our potential customers, our operating results could be harmed.

Our software is used to simulate and analyze complex nanometer-scale semiconductor designs. Our competitors in the electronics design automation industry who offer products that are used for other segments of the semiconductor design process often bundle their products together to offer discounts on products competitive with those we offer, making those products extremely attractive for our customers or potential customers to use. In addition, based on our experience, these competitors may not support our effort to integrate our software into their existing software. These competitors include such companies as Cadence Design Systems, Inc., Synopsys and Mentor Graphics Corporation. Since these competitors offer a more comprehensive range of products than we do, they are often able to respond more quickly or price more effectively to take advantage of new or changing opportunities and respond to new technologies and customer requirements. We cannot assure you that we will be able to compete successfully in such environments. If we lose such opportunities to our competitors, our results of operations could be harmed significantly.

Our business depends on continued demand for complex nanometer-scale semiconductors and the electronic equipment that incorporate them.

Our software is used to design complex nanometer-scale semiconductors that are an integral part of portable consumer electronics, networking equipment, wireless communications equipment, multimedia devices and personal computers. As a result, if the demand for these devices and businesses of the manufacturers of these products do not continue to grow, our revenue and business will suffer. Demand for portable consumer electronics may decrease if mobile phone, electronic mail or Internet use declines, the cost of those services increases or consumers fail to adopt latest generation portable electronics. Potential consumers of portable consumer electronics may use or modify existing equipment and never adopt next generation portable consumer electronics. Demand for other complex electronic equipment, such as networking equipment, may decrease if service providers do not experience subscriber growth or defer network build outs or other capital spending.

Purchases of licenses of our software are largely dependent upon the commencement of new design projects by semiconductor manufacturers and their customers, the number of design engineers and the increasing complexity of designs. Since late 2000, the semiconductor industry has experienced a sharp decline in orders and revenue and many companies have reduced the number of design engineers and/or design projects. The outlook for the electronics industry is uncertain and we cannot predict whether the current slow recovery will continue or the downturn will return. Many semiconductor manufacturers and vendors of products incorporating semiconductors had announced earnings shortfalls and employee layoffs and we have not seen meaningful recovery in the job market.

Budget cuts have impacted the number of orders we receive from our customers and our customers in general have been seeking larger discounts and extended payment terms or purchasing time-based licenses in lieu of more costly perpetual licenses. We believe our customers’ and potential customers’ internal budgets have been and will continue to be subject to heightened scrutiny and the time required to receive budgetary approvals has lengthened. We cannot predict whether purchases of licenses of our software will be further deferred due to budget constraints or whether the number of complex nanometer-scale semiconductor design starts by our customers will be slower or decline even further.

If we lose any of our key personnel, our ability to manage our business and continue our growth would be negatively impacted.

Our future success depends in part on our ability to enhance our existing products and achieve market acceptance of new, innovative products and technologies. Our software and technologies are complex and to successfully implement our business strategy and manage our business, an in depth understanding of circuit design and the physical behavior of complex nanometer-scale semiconductors is required. We depend substantially on the expertise of Sang S. Wang, our Chairman and Chief Executive Officer, and our existing engineering personnel, especially An-Chang Deng, our President, and our other founders. We do not have long-term employment agreements with our founders and the loss of the services of any of our key employees could adversely affect our business and slow our product development process. We do not maintain key person life insurance on any of our employees.

If we do not continue to expand our sales force and customer service and support organization, our revenue may not grow.

Approximately 74.1% and 76.8% of our total revenue for the nine months ended June 30, 2004 and 2003, respectively, was from our direct sales efforts. Our software requires sophisticated sales efforts by experienced and knowledgeable personnel. Competition for these individuals is intense due to the limited number of people available with the necessary sales experience and technical understanding of electronic design automation products. Hiring customer service and support personnel is also very competitive in our industry due to the limited number of people available with the necessary technical skills. Our sales and support staff consisted of 46 persons as of June 30, 2004. If we are unable to successfully train and integrate sales and support personnel and continue to identify, hire, train and retain new qualified individuals, our revenue may not grow.

If we are unable to attract and retain qualified research and development personnel, our business will suffer.

There is a limited number of qualified software engineer and research and development personnel with the necessary experience and understanding of complex nanometer-scale semiconductor design products in the San Francisco Bay Area, where our primary facility is located. The scarcity of qualified persons may cause us to incur higher compensation costs or require us to provide larger stock option grants. We have a small research and development facility in Taiwan, out of which five of our engineers currently operate, to broaden the pool of software engineers from which we can recruit. We cannot assure you that this strategy will help us satisfy our need for qualified personnel. Further, we may encounter other difficulties with managing geographically separate research and development activities. If we fail to attract, motivate and retain engineers and research and development personnel, we may be unable to develop or enhance our software, meet the demands of our customers in a timely manner or remain competitive and our business would suffer.

Because we rely on distributors for a large portion of our revenue, our revenue could decline if our existing distributors do not continue to purchase software licenses from us or represent us in those markets.

A majority of our sales outside North America and Europe are conducted through distributors. Sales by our distributors accounted for approximately 25.9% and 23.2% of our total revenue in the nine months ended June 30, 2004 and 2003, respectively. We rely on Marubeni Solutions as the exclusive distributor of our software in Japan. Sales to Marubeni Solutions accounted for 17.0% and 14.1% of our total revenue in the nine months ended June 30, 2004 and 2003, respectively. We cannot be certain that we will be able to attract distributors that market our software effectively or provide timely and cost effective user support and service. Further, our agreements with our distributors do not obligate the distributor to purchase any amount of licenses of our software or sell licenses of our software. Consequently, one or more of our distributors may not continue to represent our software or devote a sufficient amount of effort and resources to selling our licenses of software in their territories. We may from time to time be forced to terminate relationships with distributors who do not maintain an appropriate level of sales. We may also decide to sell our software in a particular territory directly and terminate relationships with a particular distributor. As a result, our sales in a given territory may decrease substantially or cease until a suitable replacement distributor can be found or we are able to establish or provide adequate sales and support efforts for that territory. Even if we are successful in selling licenses of our software through new distributors, the rate of growth of our total revenue could be harmed if our existing distributors do not continue to sell licenses of our software.

If we fail to adequately match our expenses to anticipated revenue in any given quarter, our operating results could fall below market expectations and cause the price of our stock to decline.

Because of the prolonged economic downturn, extended sales cycle, seasonal fluctuations in our business, cyclicality of the semiconductor industry and the rapidly evolving market for complex nanometer-scale semiconductors, our ability to accurately forecast our quarterly revenue is limited. As a result, it is difficult to predict the revenue we will recognize in any given quarter.

We expect to experience seasonal fluctuations in our revenue due to:

• financial stability and outlook of our customers;

• capital budgeting and purchasing cycles of our customers;

• economic incentives for our sales force;

• lengthening of the sales cycle due to limited resources as a result of layoffs by our customers, longer approval process, summer holidays, particularly in Europe and Japan (which is also affected by budgeting cycles);

• the number of orders received for perpetual licenses versus time-based licenses; and

• the special terms and conditions in the orders received which may cause revenue deferral under our revenue recognition policies.

Commissions represent a significant portion of our sales force compensation, which is structured to encourage sales closures prior to fiscal year end. As a result, we expect that sales efforts will intensify in the fourth fiscal quarter, which could result in our order receipts and revenue being flat or slightly lower in the first and second quarters of the subsequent fiscal year.

It is difficult for us to evaluate the degree to which these factors may reduce our sales because our revenue growth historically had masked the impact of these factors. In addition, most of our costs are relatively fixed in the short term and our business may not grow rapidly enough to absorb the costs of our personnel and facilities. As a result, we may be unable to reduce our expenses to avoid or minimize the negative impact on our quarterly operating results if anticipated revenue is not realized. For example, for the three months ended March 31, 2003, our revenue and earnings fell short of our previous guidance and market expectation and we revised our guidance for the quarter ended June 30, 2003 and fiscal 2003 to project much lower revenue and earnings than previously given, which negatively impacted the trading price of our common stock. Although we were able to achieve revenue and earnings results that met the revised guidance for the remaining quarters of fiscal 2003 and the first three quarters of fiscal 2004, we did not see any meaningful improvements in our customers’ spending pattern with the slow recovery and our outlook continues to be cautious. Additionally, due to the expected increase in legal fees related to the defense of the litigation between us and Synopsys as the trial dates approach, we revised and lowered the earnings guidance for the fourth quarter of fiscal 2004. These trends could materially affect our quarter to quarter operating results, which could negatively impact our stock price.

We may not succeed in creating market acceptance for CRITIC, HANEX and HSIM^plus platform and its related post-layout options, and our operating results may decline as a result.

We released our second major product, LEXSIM, in May 2002, our third product, CRITIC, in December 2002, our fourth product, HANEX, in May 2003 and reconfigured LEXSIM into post-layout options for the new HSIM^plus platform in May 2004. To date, these products and options other than HSIM have accounted for only an immaterial portion of our revenue. Even though we do not expect any product or option other than HSIM to account for a meaningful percentage of our total revenue until fiscal 2005, our future growth and profitability could be affected by our ability to increase sales of our other products and options. Furthermore, marketing new products and options requires significant additional expenses and resources. If we fail to market them successfully, our profitability may decline.

If we fail to enhance our circuit simulation and analysis software and develop and introduce new circuit simulation and analysis software on a timely basis, we may not be able to address the needs of our customers, our technology may become obsolete and our results of operations may be harmed.

The electronic design automation software market is characterized by rapid technological change, frequent new product introductions and enhancements, uncertain product life cycles, changes in user demands and evolving industry standards. The introduction of software embodying new technologies and the emergence of new industry standards can render existing software in the semiconductor design industry obsolete and unmarketable. For instance, if customers widely adopt new engineering languages to describe their semiconductor designs and our software fails to support those languages adequately, demand for our software will suffer. To be successful, we must devote a substantial amount of our resources to enhance our software, keep pace with changes within our industry and develop and market new technologies. If our enhanced products or our future products and technologies do not achieve market acceptance, we may not be able to maintain our market share or recoup our development costs. As a result, our operating results would be harmed.

Our sales cycle is unpredictable and may be more than six months, so we may fail to adequately match our expenses to anticipated revenue in any given period or meet market expectations.

Our sales cycle, or the period between our initial contact with a potential customer and the customer’s purchase of a license of our software, generally ranges from three to six months but may be longer, particularly in the current challenging economic and business conditions. We cannot predict the exact length

of our sales cycle, which at times has exceeded six months. The unpredictability of our sales cycle makes it difficult to plan our expenses and forecast our results of operations for any given period. If we do not correctly predict the timing of our customers’ purchases, the amount of revenue we recognize in a given quarter could be negatively impacted, which could harm our operating results. Our sales cycle may lengthen because of several factors, including:

• competition from other electronic design automation software vendors;

• limited and decreased capital spending due to weakness in the semiconductor industry and customers’ uncertainty about economic recovery;

• concerns regarding the on-going legal proceedings between us and Synopsys;

• long technical evaluation periods and validation periods for the integration of our software with our potential customers’ existing semiconductor design flow;

• the significant investment of resources required by customers to purchase and integrate our software into their design flow, particularly customers with large semiconductor design organizations;

• limited access to key decision makers of potential customers to authorize the adoption of our software;

• budget cycles of our customers which affect the timing of purchases; and

• delay of purchases due to product combination announcements or planned introductions of new products by our competitors or us.

If we were to experience a delay in receipt of orders for our products, it could harm our ability to meet our forecasts or investors’ expectations for a given quarter and ultimately result in the decrease of our stock price. Further, if our sales cycle unexpectedly lengthens in general, it would adversely affect the timing of our revenue recognition, which could cause us not to meet market expectations and cause our stock price to suffer. For instance, for the three months ended March 31, 2003 and June 30, 2003, our revenue decreased as compared to the previous quarters because we experienced substantially reduced capital budgets and longer sales cycles, which negatively impacted our ability to receive orders and recognize revenue.

Our expansion into international markets will result in higher personnel costs or distributor commissions and could reduce our operating margins.

In order to penetrate international markets further, we must either expand the number of distributors who sell licenses of our software or increase our direct international sales presence. As we increase our direct international sales presence, our sales efforts may be delayed as we begin our local sales activities and we may incur higher personnel costs that may not result in additional revenue. These costs and the time to establish a local sales presence could harm our operating results. We may not realize corresponding growth in operating margins from growth in international sales due to the higher costs of these sales. We have increased our sales and support resources in Europe over the last two years and have established offices in England, France, Germany, India, Israel and Singapore. However, the expected returns on those investments have not been realized, primarily due to the economic slowdown. To date, we have relied primarily on international distributors in Asia and have only a very small direct sales force in Taiwan, Singapore and India. Even if we expand our direct and indirect international selling efforts, our efforts may not create or increase

international market demand for our software or generate revenue sufficient to recoup the cost of this expansion.

If we experience losses in the future, the market price of our common stock could decline.

Although we had net income for the past four fiscal years, we may incur losses in the future. In order to fund our growth and implement our strategies, we must continue to increase our investment in research and development, sales and marketing and other operations. As a result, we will need to generate significant revenue to maintain profitability. If we do not maintain profitability, the market price of our common stock may decline, perhaps substantially.

We anticipate that our expenses will increase substantially in the next 12 months as we:

• continue to defend ourselves vigorously against the three lawsuits brought by Synopsys.

• increase our sales and marketing activities, particularly by expanding our direct sales force;

• continue to increase the size and number of locations of our support organization;

• continue to invest in research and development to enhance our existing products and technologies and develop new circuit simulation and analysis products; and

• implement additional internal systems, develop additional infrastructure and hire additional management to keep pace with our growth.

Any failure to significantly increase our revenue as we implement our strategies would also harm our ability to maintain profitability and could negatively impact the market price of our common stock.

If we are not able to preserve the value of our software’s intellectual property, our business will suffer.

Our software is differentiated from that of our competitors by our internally developed technology. If we fail to protect our intellectual property, other vendors could sell circuit simulation and analysis software with capabilities similar to ours, and this could reduce demand for our software. We protect our intellectual property through a combination of copyright, patent, trade secret and trademark laws. We have a patent program and to date have filed two patent applications, one of which was issued by the U.S. Patent and Trademark Office in June 2003. We generally enter into confidentiality or license agreements with our employees, consultants, customers, corporate partners and prospective customers and partners, and generally seek to control access to our intellectual property and the distribution of our software, documentation and other proprietary information. However, we believe that these measures afford only limited protection. Others may develop technologies that are similar or superior to our technology or design around the copyrights and trade secrets we own. Unauthorized parties may attempt to copy or otherwise obtain and use our software or technology. Policing unauthorized use of our software is difficult and expensive, and we cannot be certain that the steps we have taken will prevent misappropriation of our technology, particularly in foreign countries where the laws may not protect our proprietary rights as fully as those in the United States. If our means of protecting our proprietary rights is inadequate or ineffective, our business may be severely harmed.

A protracted infringement claim or a significant damage award would adversely impact our operating results.

Substantial litigation and threats of litigation regarding intellectual property rights exist in our industry. We expect that circuit simulation and analysis design software may be increasingly subject to third-party infringement claims as the number of competitors in our industry segment grows and the functionality of products in different industry segments overlaps. We are not aware of any valid proprietary rights of third parties that our software infringes. We are currently a defendant in three lawsuits brought by Synopsys. Additional third parties other than Synopsys may claim that we infringe their intellectual property rights. Any claims, with or without merit, could:

• be time consuming to defend;

• result in costly litigation and/or damage awards;

• divert our management’s attention and resources;

• cause customers to cancel or delay orders;

• cause product shipment delays; or

• require us to seek to enter into royalty or licensing agreements.

These royalty or licensing agreements may not be available on terms acceptable to us, if at all. A successful claim of product infringement against us or our failure to license the infringed or similar technology could adversely affect our business. We would not be able to sell licenses of the impacted software without exposing ourselves to litigation risk and damages or we may be required to redevelop the software which may not meet customers’ requirements and incur significant additional expense. We may also lose market share. Because we expect to derive a substantial majority of our revenue from HSIM for at least the remainder of fiscal 2004 and fiscal 2005, anything that would limit our ability to license HSIM would harm our business.

Any potential dispute involving our intellectual property could include our customers and strategic partners, which could trigger our indemnification obligations with them and result in substantial expense.

In any potential dispute involving our intellectual property, our customers and strategic partners could also become the target of litigation. This could trigger our technical support and indemnification obligations in our license agreements, which could result in substantial expense to us. In addition to the time and expense required for us to supply such support or indemnification to our customers and strategic partners, any such litigation could severely disrupt or shut down the business of our customers and strategic partners, which in turn could hurt our relations with our customers and strategic partners, result in potential claims for damages and cause licenses for our software to decrease substantially.

Significant errors in our software, our inability to correct errors or the failure of our software to conform to specifications could result in our customers demanding refunds from us or asserting claims for damages against us.

Because our circuit simulation and analysis software is complex, our software could fail to perform as anticipated. Further, significant errors in our software may be found in the future or errors may not be corrected satisfactorily for our customers. The detection of any significant errors may result in:

• product liability claims or damage awards;

• the loss of or delay in market acceptance and sales of our software;

• injury to our reputation and hindered market acceptance of our software;

• diversion of development resources from new software to fix errors in existing software;

• costs of corrective actions or returns of defective software;

• reduction in maintenance or time-based license renewal rates; or

• delays in shipping dates for our software.

We have warranted that our software will operate substantially in accordance with our user documentation. If our software fails to conform to these specifications, customers could demand a refund for the purchase price or assert and collect on claims for damages.

Moreover, because our software is used in connection with other vendors’ products that are used to design complex nanometer-scale semiconductors, significant liability claims may be asserted against us if our software does not work properly individually or with other vendors’ products. Our agreements with customers typically contain provisions intended to limit our exposure to liability claims. However, these limitations may not preclude all potential claims and we have only minimal insurance against such liabilities. Regardless of their merit, liability claims could require us to spend significant time and expense in litigation and divert management’s attention from other business pursuits. If successful, a product liability claim could require us to pay significant damages. Any claims, whether or not successful, could seriously damage our reputation and our business.

Because our strategy to expand our international operations is subject to uncertainties, we may not be able to enter new markets outside North America or generate a significant level of revenue or profit margins from those markets.

Customers outside North America accounted for 36.9% and 38.0% of our total revenue in the nine months ended June 30, 2004 and 2003, respectively. We plan to increase our international sales activities, but we have limited resources and experience marketing and directly licensing our software internationally.

We have direct sales offices in France, Germany, India, Israel, Singapore and Taiwan, and rely primarily on indirect sales in Asia. Although our sales contracts provide for payment for our software licenses in United States dollars, our expenses incurred in foreign locations are generally denominated in the applicable local currency. To date we have not undertaken any foreign currency hedging transactions, and as a result, our future expense levels from international operations may be unpredictable due to exchange rate fluctuations. Our international operations are subject to other risks, including:

• the impact of recessions in economies outside North America;

• difficulties and costs of staffing and managing foreign operations;

• foreign currency fluctuations;

• reduced protection for intellectual property rights in some countries;

• changes in import or export duties, quotas or controls, which could prevent us from shipping our software into markets outside North America;

• greater difficulty in accounts receivable collection and longer collection periods;

• unexpected changes in regulatory requirements;

• proper maintenance of corporate formalities by our foreign subsidiaries;

• potentially adverse tax consequences, including the impact of expiry of tax holidays; and

• political and economic instability.

We intend to pursue strategic relationships but these efforts could substantially divert management attention and resources.

In order to establish strategic relationships with semiconductor technology leaders and leading electronic design automation tool providers, we may need to expend significant resources and will need to commit a significant amount of management time and attention, with no guarantee of success. We may be unable to establish key industry strategic relationships if any of the following occur:

• potential industry partners become concerned about our ability to protect their intellectual property;

• potential industry partners develop their own solutions to address circuit simulation and analysis of complex nanometer-scale semiconductors;

• our competitors establish relationships with industry partners with which we seek to establish a relationship;

• potential industry partners attempt to restrict our ability to enter into relationships with their competitors; or

• potential leading electronic design automation tool provider partners develop or acquire competitive products.

We have only recently entered into our current strategic relationships. These relationships may not continue or be successful. We also may be unable to find additional industry partners that are suitable.

We may not be able to expand our proprietary technologies if we do not make acquisitions or investments or fail to successfully integrate the acquired companies with our business.

To expand our proprietary technologies, we may acquire or make investments in complementary businesses, technologies or products if appropriate opportunities arise. We may be unable to identify suitable acquisition or investment candidates at reasonable prices or on reasonable terms, or complete future acquisitions or investments, any of which could slow our growth strategy. We may have difficulty integrating the products, personnel, culture, ideologies or technologies of any acquisitions we might make. These difficulties could disrupt our ongoing business, distract our management and employees and increase our expenses. In addition, the key personnel of the acquired company may decide not to work for us and if our customers are uncertain about our ability to operate on a combined basis, they could delay or cancel orders for

our software. Furthermore, we may have to incur debt or issue equity securities to pay for any future acquisition, the issuance of which would be dilutive to our existing stockholders. We also could have difficulty in assimilating the acquired company’s or division’s personnel and operations, which could negatively affect our operating results.

The markets for complex nanometer-scale semiconductors are evolving rapidly and if these markets do not develop and expand as we anticipate, the demand for our software and our revenue would decline.

We expect that a substantial majority of our revenue will continue to come from sales of HSIM at least for the remainder of fiscal 2004 and fiscal 2005. We depend on the growing use of circuit simulation and analysis software to design complex nanometer-scale semiconductors for use in portable consumer electronics, networking equipment and other applications. The market for complex nanometer-scale semiconductors may not grow if customers choose to use other types of semiconductors that might be more affordable or available with shorter time-to-market schedules. This could cause electronic equipment manufacturers to limit the number of new complex nanometer-scale semiconductors they design and would reduce their need for our software. If demand for our software were to decline, we may choose to lower the prices of our software or we may sell fewer licenses and have lower maintenance renewal rates. In addition, if equipment manufacturers do not widely adopt the use of complex nanometer-scale semiconductors or if there is a wide acceptance of alternative semiconductors that provide enhanced capabilities, the market price of our stock could decline due to our lower operating results or investors’ assessment that the growth potential for licenses of our software is limited.

The markets for complex nanometer-scale semiconductors are evolving rapidly and we cannot predict their potential sizes or future growth rates. Our success in generating revenue in these evolving markets will depend on, among other things, our ability to:

• educate potential customers about the benefits of complex nanometer-scale semiconductors and the use of our software to design them;

• establish and maintain relationships with leading semiconductor manufacturers, electronic equipment designers, portable consumer electronic manufacturers, networking equipment and other electronics companies;

• utilize our research and development efforts to anticipate and adapt to evolving markets; and

• predict and base our software on technology that ultimately becomes industry standard.

We face competition from internally developed semiconductor design software and if our customers elect to continue to use internally designed tools, our business may suffer.

We face significant competition from internal design software groups of semiconductor manufacturers. These internal groups compete with us for access to potential customers’ circuit simulation and analysis software budgets and may eventually compete with us to supply circuit simulation and analysis software to other semiconductor manufacturers. We cannot assure you that internal groups will not expand their internally designed tools to compete directly with ours or actively sell their internally designed tools to other semiconductor manufacturers or, if they do, that we will be able to compete against them successfully.

Our revenue could be reduced if large electronic design automation companies make acquisitions in order to utilize their extensive distribution capabilities with our competitors’ products.

Large electronic design automation vendors, such as Cadence, Mentor Graphics or Synopsys, may acquire or establish cooperative relationships with our other current competitors, including private companies. For example, in February 2004, Synopsys acquired Accelerant Networks, a provider of technology for high-speed serial interfaces and Analog Design Automation, Inc., a provider of automated circuit optimization solutions for analog, mixed-signal and custom integrated circuits. Because large electronic design automation vendors have significant financial and organizational resources, they may be able to further penetrate our markets by leveraging the technology and expertise of smaller companies and utilizing their own extensive distribution channels. We expect that the electronic design automation product industry will continue to consolidate. For example, Cadence completed its acquisition of Verplex Systems, Inc., a provider of formal verification electronic design software, in August 2003 and Q Design Automation, Inc., a provider of solutions for migrating and optimizing IC layout, in January 2004. Mentor Graphics, Inc. also announced in June 2004 that it entered into an agreement to acquire 0-In Design Automation, Inc., a provider of assertion-based and formal verification solutions. It is possible that new competitors or alliances among competitors may emerge and rapidly acquire significant market share, which would harm our business and financial prospects.

We may not be able to compete effectively if our software is delayed or does not incorporate new required features.

Our future success depends on our ability to enhance existing software, develop and introduce new products, satisfy user requirements, meet industry standards and achieve market acceptance. We may not successfully identify new product opportunities or develop and bring new products to market in a timely and cost effective manner. Significant delays in our new software releases or significant problems or delays in enhancing existing products to keep pace with new design techniques for complex nanometer-scale semiconductors could seriously damage our business. We have, from time to time, experienced delays in the scheduled introduction of new and enhanced software and we may experience similar delays in the future. For example, in early 2001 we experienced delays in the development of a new product, which caused us to revise our expected release date for this product by several months. More recently, we have also delayed the release of another product in order to allow for an extended beta testing period and experienced much slower market acceptance of our new products than expected. We cannot assure you that we will not experience additional difficulties that could delay or prevent the successful development, introduction and marketing of this software or that our new software and product enhancements will achieve market acceptance. If we are unable to develop, introduce and successfully market new or enhanced software in a timely manner in response to changing market conditions or customer requirements, our business, operating results and financial condition may be harmed.

We may sell fewer licenses of our products if other vendors’ products are no longer compatible with ours.

Our ability to sell licenses of our software depends in part on the compatibility of our software with other vendors’ software and hardware products. These vendors may change their products so that they will no longer be compatible with our software. If that were to happen, our business and future operating results would suffer if we were no longer able to offer commercially viable or competitive products.

We do not have a consulting staff, and our revenue may suffer if customers demand extensive consulting or other support services.

Our software is designed to be deployed quickly and easily by our customers and to require limited support from us. Many of our competitors offer extensive consulting services in addition to circuit simulation and analysis products. If we introduce software that requires extensive consulting services for specific designs, or if our customers wish to purchase a broad spectrum of software and services that includes extensive consulting services from a single vendor, we would be required to change our business model and cost structure to provide consulting services. Specifically, we would be required to hire and train consultants or outsource the required consulting services. If these events were to occur, our future gross margin would likely suffer because of the added expense of hiring and retaining consulting personnel.

Our common stock is subject to substantial price and volume fluctuations due to a number of factors, many of which are beyond our control, and those fluctuations and limited trading volumes may prevent our stockholders from reselling our common stock at a profit.

The securities markets have experienced extreme price and volume fluctuations recently and the market prices of the securities of technology companies have been especially volatile. This market volatility, as well as general economic or political conditions and any negative information related to the litigation between us and Synopsys, could reduce the market price of our common stock regardless of our operating performance. In addition, our operating results could be below the expectations of investment analysts and investors and, in response, the market price of our common stock may decrease significantly and prevent investors from reselling their shares of our common stock at or above the price at which they purchased the shares. Due to a majority of the outstanding common stock being owned by our founders and employees, we have limited day-to-day trading volumes, which may also cause our stock prices to experience higher volatility and prevent our stockholders from selling our common stock at a profit. For example, in April 2003 we reported our financial results for the three months ended March 31, 2003, which were below previous guidance and market expectations. Additionally, in January 2003 and June 2004, we reported certain negative rulings issued by the discovery referee with regard to the state litigation between us and Synopsys. As a result of each of these events, the stock price of our common stock was adversely impacted.

Our growth could place a significant strain on our management systems and resources and we may be unable to effectively control our costs and implement our business strategies as a result.

Our total number of employees was 110 as of June 30, 2004, and we expect our headcount to increase significantly over the next 24 months. Our productivity and the quality of our software may be adversely affected if we do not integrate, train and motivate our new employees quickly and effectively and manage our resources efficiently. We also cannot be sure that our revenue will continue to grow at a sufficient rate to absorb the costs associated with the increased personnel.

We expect that any future growth we experience will continue to place a significant strain on our management, systems and resources. To manage the anticipated growth of our operations, we will be required to:

• hire, train, manage and retain additional qualified personnel, especially software engineers and sales staff;

• improve existing and implement new operational, financial and management information controls, reporting systems and procedures;

• maintain a high level of customer service and support; and

• establish relationships with additional corporate partners and maintain our existing relationships.

ITEM 3. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK

We develop products primarily in the United States and sell those products primarily in North America, Europe and Japan. Our revenue for sales outside of North America was approximately 31.9% in the three months ended June 30, 2004, 36.0% in the three months ended June 30, 2003, 36.9% in the nine months ended June 30, 2004 and 38.0% in the nine months ended June 30, 2003. As a result, our financial results could be affected by factors such as changes in foreign currency exchange rates or weak economic conditions in foreign markets. As all of our sales are currently made in United States dollars, a strengthening of the United States dollar could make our software less competitive in foreign markets.

Our interest income is sensitive to changes in the general level of United States interest rates, particularly since the majority of our investments are in short-term instruments. The fair value of fixed rate securities may be adversely impacted because of changes in short-term interest rates and credit ratings. Therefore, our future interest income may be negatively affected by changes in interest rates or we may suffer principal losses if we were to sell securities that have declined in value because of changes in interest rates or issuer credit ratings. A sensitivity analysis assuming a hypothetical 10% movement in interest rates applied to our cash equivalent and short-term investments balances at June 30, 2004 would change interest income by approximately $110,000 on an annual basis. However, due to the nature of our short-term investments, we have concluded that we do not have material market risk exposure. We do not hold or issue derivatives, derivative commodity instruments or other financial instruments for trading or speculative purposes.

We invest funds in excess of current operating requirements in:

• obligations of the United States government and its agencies;

• investment grade state and local government obligations;

• securities of United States corporations rated A1 or P1 by Standard & Poors’ or Moody’s equivalents; and/or

• money market funds, deposits or notes issued or guaranteed by United States and non-United States commercial banks meeting certain credit rating and net worth requirements with maturities of less than one year.

As of June 30, 2004, our cash, cash equivalents and short-term investments consisted primarily of demand deposits, money market funds and corporate notes held by large institutions in the United States and agency securities of the United States government and state municipalities.

ITEM 4. CONTROLS AND PROCEDURES

(a) Evaluation of disclosure controls and procedures.

We have carried out an evaluation, under the supervision and with the participation of our management, including our Chief Executive Officer and our Chief Financial Officer, of the effectiveness of the design and operation of our disclosure controls and procedures (as defined in Rules 13a-15(e) and 15d-15(e) under the Exchange Act) as of the end of the period covered by this Quarterly Report. Based upon that

evaluation, our Chief Executive Officer and our Chief Financial Officer concluded that our disclosure controls and procedures are effective to ensure that material information required to be disclosed by us in the reports that we file or submit under the Exchange Act is recorded, processed, summarized and reported within the time periods specified in the Securities and Exchange Commission rules and forms.

(b) Changes in internal controls.

There were no significant changes in our internal control over financial reporting during the period covered by this Quarterly Report that materially affected our internal control over financial reporting.

PART II - OTHER INFORMATION

ITEM 1. Legal Proceedings

Litigation

Synopsys has filed claims against us in state and federal court. These claims are based on the alleged facts and circumstances relating to the departure of our five founders from their employment at Synopsys, the founding of our company and the development and sale of HSIM and our other products. Each of our founders and Dr. Sang S. Wang, our Chief Executive Officer, became an employee of Synopsys when Synopsys acquired EPIC Design Technology in February 1997. Dr. Wang resigned from Synopsys in March 1998 and served as a consultant to Synopsys until June 1998. Dr. An-Chang Deng, our President, and our four other founders resigned from Synopsys at approximately the same time in August 1998 and became employees of our company immediately thereafter. Dr. Wang became an employee of our company in April 1999. None of Drs. Wang or Deng or our four other founders was subject to a noncompetition agreement with Synopsys at any time.

3294, and up to $50 million in punitive damages with respect to the trade secret claims under California Civil Code Section 3426.3(c). This action is currently in discovery. The court has set the case for trial beginning on January 18, 2005.

We disagree with the Discover Referee’s orders and believe that we have meritorious defenses to Synopsys’ allegations and claims. We intend to continue to defend ourselves vigorously and the trial judge or jury can reach its own conclusions regarding Synopsys’ claims based upon the evidence presented at trial. However, because of the inherent uncertainty of litigation in general, and the fact that the discovery related to this litigation is ongoing, we cannot assure you that we will ultimately prevail. Should Synopsys ultimately succeed in the prosecution of its claims, we could be permanently enjoined from selling our software and deriving related maintenance revenue. In addition, we could be required to pay substantial monetary damages to Synopsys. Further, we could be enjoined preliminarily from selling our software during the course of the litigation. Litigation such as the suit Synopsys has brought against us can take years to resolve and can be expensive to defend. Although the final outcome of the litigation may not occur for some time, the parties periodically conduct evidence gathering, meet to discuss the status of the litigation and file motions and other requests for the court to act. The results of these periodic activities, particularly the court’s decisions on current pending and future motions, could have the effect of determining the ultimate outcome of the litigation, either for or against us, prior to a trial on the merits, or strengthen or weaken our ability to assert claims and defenses. For example, in November 2001, the court denied a motion brought by Synopsys for injunctive relief that, if granted, could have prevented us from selling our products. If any of Synopsys’ motions ultimately prevail, our ability to defend ourselves against the claims brought against us in this litigation could be severely limited. It is possible that our relationships with our customers will be seriously harmed in the future as a result of the Synopsys litigation. Accordingly, an adverse judgment, if entered in favor of any Synopsys claim, could seriously harm our business, financial position and results of operations and cause our stock price to decline substantially. In addition, the Synopsys allegations and claims, even if ultimately determined to be without merit, could be time consuming to defend, result in costly litigation, divert our management’s attention and resources, cause product shipment delays or require us to enter into royalty or license agreements. These royalty or license agreements may not be available on terms acceptable to us, if at all, and the prosecution of the Synopsys allegations and claims could significantly harm our business, financial position and results of operations and cause our stock price to decline substantially.

and unfair competition counterclaims. In addition, the court issued a ruling construing the claims of the 053 patent in August 2002.

Synopsys has brought against us can take years to resolve and can be expensive to defend. The court’s decisions on current pending and future motions could have the effect of determining the ultimate outcome of the litigation prior to a trial on the merits, or strengthen or weaken our ability to assert claims and defenses. It is possible that our relationships with our customers will be seriously harmed in the future as a result of the Synopsys litigation. Accordingly, an adverse judgment, if entered on any Synopsys claim, could seriously harm our business, financial position and results of operations and cause our stock price to decline substantially. In addition, the Synopsys allegations and claims, even if ultimately determined to be without merit, could be time consuming to defend, result in costly litigation, divert our management’s attention and resources, cause product shipment delays or require us to enter into royalty or license agreements. These royalty or license agreements may not be available on terms acceptable to us, if at all, and the prosecution of the Synopsys allegations and claims could significantly harm our business, financial position and results of operations and cause our stock price to decline substantially. For instance, in January 2003 and June 2004, we reported certain negative rulings issued by the discovery referee with regard to the state litigation between us and Synopsys. As a result, the stock price of our common stock was adversely impacted.

ITEM 6. EXHIBITS AND REPORTS ON FORM 8-K

(a)	Exhibits

	Exhibit 31	Certifications of Chief Executive Officer and Chief Financial Officer pursuant to Section 302 of the Sarbanes-Oxley Act of 2002

	Exhibit 32	Certifications of Chief Executive Officer and Chief Financial Officer pursuant to Section 906 of the Sarbanes-Oxley Act of 2002

(b)	Reports on Form 8-K

We furnished (not filed) two current reports on Form 8-K on April 14, 2004 in connection with our earnings release and the amendment and restatement of our Code of Ethics for Principal Executive and Senior Financial Officers.

SIGNATURES

Pursuant to the requirements of the Securities and Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned thereunto duly authorized.

	NASSDA CORPORATION

July 30, 2004

	By:	/s/ Sang S. Wang
		Sang S. Wang
		Chief Executive Officer and Chairman (Principal Executive Officer)

	By:	/s/ Tammy S. Liu
		Tammy S. Liu
		Vice President of Finance and Administration and Chief Financial Officer (Principal Financial and Accounting Officer)