NASSDA CORP - 10-Q Quarterly Report

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 and Exchange Act of 1934 during the preceding 12 months (or for shorter period that the registrant was required to file such reports); and (2) has been subject to such filing requirements for the past 90 days. Yes x No ¨

Indicate by check mark whether the registrant is an accelerated filer (as defined in Rule 12b-2 of the Securities Exchange Act of 1934, as amended). Yes x No ¨

At July 31, 2003, 25,912,987 shares of common stock of the Registrant were outstanding.

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, 2003. 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, 2002.

The preparation of 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 financial statements and the reported amounts of revenues and expenses during the reporting period. Actual results could differ from these estimates.

We commenced our initial public offering in which we sold five million shares of common stock at $11.00 per share in December 2001. The net proceeds we received from this offering after deducting underwriting discounts and offering expenses were approximately $49.6 million. All outstanding shares of preferred stock were automatically converted into common stock on a share for share basis immediately prior to the first closing of the sale of our comment stock in the initial public offering. Our common stock began trading on the Nasdaq National Market on December 13, 2001.

In January 2002, the underwriters of our initial public offering exercised their over-allotment option to purchase an additional 750,000 shares of common stock at $11.00 per share. The net proceeds we received pursuant to this over-allotment option after deducting underwriting discounts were approximately $7.6 million.

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, 2003 and 2002, 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, 2003 and 2002, weighted average options to purchase 2.3 million and 38,000 shares of common

stock with a weighted average exercise price of $9.53 and $16.96 per share, 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):

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

During fiscal 2001, we accrued bonuses of $3.7 million earned by our employees. 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 three quarters of fiscal 2003, we paid $1.6 million of these bonuses with the remainder to be paid ratably over the last quarter of fiscal 2003. Employees whose employment by us terminates prior to the applicable payment date will receive the undistributed amounts on December 15, 2005. As of June 30, 2003, approximately $2,000 of these bonuses was classified as a long-term liability.

During fiscal 2002, we accrued bonuses of $760,000 earned by our employees. We anticipate that approximately $709,000 of these bonuses will be paid during fiscal 2003 and the remaining $51,000 will be paid during the first quarter of fiscal 2004. In the first three fiscal quarters of fiscal 2003, we paid $557,000 of these bonuses, with the remainder to be paid ratably over the last quarter of fiscal 2003 and the first quarter of 2004. As of June 30, 2003, none of these bonuses was classified as a long-term liability. Employees

whose employment by us terminates prior to the applicable payment date will receive the undistributed amounts on December 15, 2006.

During the three months ended June 30, 2003, we accrued bonuses of $325,000 earned by our employees for services during that period. We anticipate that these bonuses will be paid during the first quarter of fiscal 2004.

In addition, our executive officers orally agreed that they would not receive their base salaries in fiscal 2002 and fiscal 2003. The total base salaries earned by these executive officers in fiscal 2001 were approximately $539,000. As a result of our significant bonus accruals in fiscal 2001 and fiscal 2002 and the foregone salaries in fiscal 2002 and fiscal 2003, our compensation expense in fiscal 2004 may not be consistent with compensation expense in fiscal 2001, fiscal 2002 or fiscal 2003.

We lease our facilities under various noncancelable operating leases, which expired beginning in February 2003. Rent expense was $365,000 in fiscal 2001 and $600,000 in fiscal 2002. As of September 30, 2002, the aggregate future noncancelable minimum rentals or operating leases are as follows (in thousands):

In December 2002, we entered into a three-year operating lease beginning in February 2003. The lease is for our primary business operation. The future minimum lease obligations related to this lease are $982,000.

We account for our stock-based awards to employees using the intrinsic value method in accordance with Accounting Principles Board No. 25, “Accounting for Stock Issued to Employees,” and its related interpretations. Accordingly, compensation expense has been recognized in the 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 compensation related to employee grants was $725,000 and $756,000 for the nine months ended June 30, 2003 and 2002, respectively.

We account for stock-based awards to non-employees in accordance with the provisions of Statement of Financial Accounting Standards (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, 2003 and 2002.

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 for fiscal 2000, fiscal 2001 and 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:

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 income (loss), basic income (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):

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.

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 mean 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. However, none of these rulings resolves any of the claims made by Synopsys in the case and the trial judge or jury can reach their own conclusions based upon the evidence presented at trial. 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. This action is currently in discovery. 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. A trial date has not yet been set.

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 Synopsys 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”). 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.

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”). On July 31, 2003, we filed an answer to the complaint denying infringement of a valid, enforceable patent and asserting counterclaims alleging that the 898 Patent is invalid, unenforceable and not infringed.

We believe 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.

On July 1, 2003, a purported derivative complaint was filed against us and our directors in the United States District Court for the Northern District of California. This complaint alleged violations of California Corporations Code Section 25402, breach of fiduciary duty, waste of corporate assets and unjust enrichment based generally on the facts and circumstances alleged in the Synopsys litigations. The complaint seeks an unspecified amount of damages. The case is still in the preliminary stages, and it is not possible for us to quantify the extent of our potential liability, if any. 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 management’s attention from the day-to-day operations of our business.

We from time to time enter into certain types of contracts that contingently 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. Generally, a maximum obligation is not explicitly stated. 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 significant payments for these obligations, and no liabilities have been recorded for these obligations on our balance sheet as of June 30, 2003.

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 a right to 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.

In October 2001, the Financial Accounting Standards Board (FASB) issued SFAS No. 144, Accounting for the Impairment or Disposal of Long-Lived Assets, or SFAS No. 144, which addresses financial accounting and reporting for the impairment or disposal of long-lived assets. SFAS No. 144 supersedes SFAS No. 121, Accounting for the Impairment of Long-Lived Assets and for Assets to Be Disposed of. We adopted SFAS No. 144 for fiscal 2003 beginning October 1, 2002. The adoption of SFAS No. 144 had no impact on our financial position, results of operations or cash flows.

In December 2002, the FASB issued SFAS No. 148, “Accounting for Stock-Based Compensation – Transition and Disclosure.” SFAS No. 148 amends SFAS No. 123, “Accounting for Stock-Based Compensation,” to provide alternative methods of transition for a voluntary change to the fair value based method of accounting for stock-based employee compensation. In addition, 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. SFAS No. 148 is effective for fiscal years ending after December 15, 2002. We adopted the disclosure provisions of SFAS No. 148 for the quarterly period beginning on January 1, 2003. We do not expect to change to the fair value based method of accounting for stock-based employee

compensation; therefore, the adoption of SFAS No. 148 is not expected to have an impact on our financial position, results of operation or cash flows.

In January 2003, the FASB issued FASB Interpretation 46 (FIN 46), “Consolidation of Variable Interest Entities.” FIN 46 clarifies the application of Accounting Research Bulletin 51, “Consolidated Financial Statements,” for certain entities that do not have sufficient equity at risk to finance their activities without additional subordinated financial support from other parties or in which equity investors do not have the characteristics of a controlling financial interest (“variable interest entities”). Variable interest entities within the scope of FIN 46 will be required to be consolidated by their primary beneficiary. The primary beneficiary of a variable interest entity is determined to be the party that absorbs a majority of the entity’s expected losses, receives a majority of its expected returns, or both. FIN 46 applies immediately to variable interest entities created after January 31, 2003, and to variable interest entities in which an enterprise obtains an interest after that date. It applies in the first fiscal year or interim period beginning after June 15, 2003 to variable interest entities in which an enterprise holds a variable interest that it acquired before February 1, 2003. We are in the process of determining what impact, if any, the adoption of the provisions of FIN 46 will have upon our financial condition or results of operations, but do not expect that FIN 46 will have a material impact on our financial condition or results of operations.

In April 2003, the FASB issued SFAS No. 149, “Amendment of Statement 133 on Derivative Instruments and Hedging Activities” (SFAS No. 149). SFAS No. 149 amends and clarifies financial accounting and reporting for derivative instruments, including certain derivative instruments embedded in other contracts, and for hedging activities under SFAS No. 133, “Accounting for Derivative Instruments and Hedging Activities.” SFAS No. 149 amends SFAS No. 133 for decisions made as part of the Derivatives Implementation Group process and in connection with implementation issues raised in relation to the application of the definition of a derivative. SFAS 149 is effective for contracts entered into or modified after June 30, 2003. We do not expect the requirements of SFAS No. 149 to have a material impact on our financial position or results of operations.

In May 2003, the FASB issued SFAS No. 150, “Accounting for Certain Financial Instruments with Characteristics of both Liabilities and Equity” (SFAS No. 150), 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 is generally effective at the beginning of the first interim period beginning after June 15, 2003. We do not expect the requirements of SFAS No. 150 to have a material impact on our financial position or results of operations.

This Quarterly Report on Form 10-Q, including the sections titled “Management’s Discussion and Analysis of Financial Condition and Results of Operations” and “Litigation,” contains forward-looking statements. 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. Forward looking statements include, but are not limited to: the statements under “Overview––Quarterly Fluctuations” regarding the impact of quarterly fluctuations of revenues on us; the statements under “Overview––Revenue Recognition” regarding the recognition of future revenue from the sale of our products; the statements in the second paragraph under “Results of Operations––Revenue” regarding international sales as a percentage of total revenue; the statements under “Results of Operations—Research and Development” regarding the hiring of new personnel; the statement under “Results of Operations—General and Administrative” regarding the increases in expenditure due to legal fees; the statements in the last paragraph under “Liquidity and Capital Resources” concerning the anticipated spending for capital additions for the remainder of fiscal 2003, the sufficiency of our available resources to meet cash requirements and the factors which will determine our future cash requirements; and the statements in “Factors Affecting Future Operating Results.” 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.

We are a leading provider of full-chip circuit simulation and analysis software for the design and verification of complex nanometer-scale semiconductors. We believe that our initial product, HSIM, is the industry’s first hierarchical simulator that meets the circuit verification challenges of today’s integrated circuit designs, and we believe our second product, LEXSIM, is the leading electronic design automation tool able to simulate the nanometer effects of both the power network and signal interconnects for complex integrated circuits, or ICs, with millions of transistors. In December 2002, we also released our third product, CRITIC, which we believe is the first design automation tool able to automatically provide accurate analysis of nanometer effects on critical signal paths and clock networks for complex, high-performance digital ICs comprised of millions of gates and developed with customer-owned tooling flows. In April 2003, we released version 3.0 of HSIM with many new enhancements and a new digital co-simulation interface option. In May 2003, we also announced the limited customer release of our fourth product, HANEX, which we believe to be the first hybrid analysis tool to automatically identify critical paths, including the impact of crosstalk effects on signal timing for custom complementary metal-oxide semiconductor digital designs with millions of elements.

Our fiscal year ends on September 30. Throughout this report we refer to the fiscal year ended September 30, 2002 as fiscal 2002, the fiscal year ending September 30, 2003 as fiscal 2003 and so on.

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. We do not expect LEXSIM, CRITIC or HANEX to account for any meaningful percentage of our total revenue until fiscal 2004. 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.

Historically, we had 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 been decreasing and accounted for only 25.2% of our total revenue for the three months ended June 30, 2003. We expect that over time product revenue will not continue to represent a majority of our revenue. 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.

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 require 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 who initially subscribe to time-based licenses renew those licenses or subscribe to additional time-based licenses. In today’s challenging economic environment, other customers are also choosing to purchase time-based licenses due to their flexible licensing and payment terms and we expect this trend to continue.

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.

Through the fiscal quarter ended December 31, 2002, we achieved 13 quarters of sequential revenue growth. However, our revenue for the fiscal quarters ended March 31, 2003 and June 30, 2003 decreased sequentially. 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 the components to fluctuate from quarter to quarter. Our customers and prospective customers are controlling their spending even more in order to conserve capital and return to 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 revenue being lower in the first quarter of the subsequent fiscal year.

Time-based licenses and maintenance that are invoiced in advance and are either paid or due are included in deferred revenue and 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.

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 substantially 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. Our increased operating expenses will result primarily from higher headcount in all areas, and we expect our headcount to double over the next 18 to 24 months. In fiscal 2001, fiscal 2002 and the nine months ended June 30, 2003, legal fees and other expenses related to our litigation with Synopsys were $1.0 million, $5.6 million and $5.2 million, respectively. We also 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’ liabilities insurance, professional fees and various filing fees to increase our general and administrative expenses. We believe that our operating expenses will 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 2002, we accrued bonuses of an aggregate of $760,000 earned by our employees for their services in fiscal 2002. These bonuses will be paid over time on specified schedules. We paid $152,000 and $557,000 of these bonuses during the three and nine months ended June 30, 2003, respectively. If an

employee who provided services to us in fiscal 2002 is not employed by us on the scheduled date of a given bonus payment, we will pay the amounts due to that employee on December 15, 2006. During the three months ended June 30, 2003, we accrued bonuses of $325,000 earned by our employees for services during the quarter then ended. We anticipate that these bonuses will be paid during the first quarter of fiscal 2004. In addition, our executive officers have orally agreed that they will not receive their base salaries in fiscal 2003. As a result of our significant bonus accruals in fiscal 2001 and fiscal 2002 and the foregone salaries in fiscal 2002 and fiscal 2003, our compensation expense in fiscal 2004 may not be consistent with that in fiscal 2001, fiscal 2002 or fiscal 2003.

We recorded deferred stock-based compensation of $2.5 million in connection with stock option grants in fiscal 2001 and did not record any deferred stock-based compensation in fiscal 2002 or in the nine months ended June 30, 2003. We have been amortizing this stock-based compensation over the vesting period of the related options, which is generally four years. We amortized $2.4 million and $1.0 million of stock-based compensation in fiscal 2001 and fiscal 2002, respectively. During the three and nine months ended June 30, 2003, we recognized aggregate stock-based compensation expense of approximately $229,000 and $725,000, respectively. We expect aggregate stock-based compensation expense of approximately $229,000 during the remainder of fiscal 2003, approximately $842,000 during fiscal 2004 and approximately $275,000 during fiscal 2005.

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.

We recognize revenue in accordance with the provisions of American Institute of Certified Public Accountants Statement of Position 97-2, Software Revenue Recognition, as amended.

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 and includes maintenance during the license period. We recognize product revenue and subscription revenue when all of the following conditions are met:

Vendor specific objective evidence 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, vendor specific objective evidence 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.

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.

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 commissions are earned and paid to our sales force for each order received, shipped and collected. Based on our policies, we pay a portion of the sales commissions based on both bookings and collections and the commission rate varies depending on each sales person’s ability to attain his or her annual quota. 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’s accrual and the actual commission expense at the end of each fiscal year based on each sales person’s actual commission rates.

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.

Total Revenue. Our revenue consists of product, subscription and maintenance revenue. Total revenue decreased by 15.8%, or $1.4 million, to $7.5 million in the three months ended June 30, 2003 from $8.9 million for the three months ended June 30, 2002. The decline in total revenue stemmed from a shift toward time-based licenses as customers purchased fewer perpetual license and lower demand due to much tighter budgets. Total revenue increased by 10.8%, or $2.6 million, to $26.6 million for the nine months ended June 30, 2003 from $24.0 million for the nine months ended June 30, 2002 due to an increase in our end user base, resulting in substantial growth in subscription and maintenance revenue, partially offset by decreases in additional perpetual license sales.

Revenue from sales outside of North America accounted for 36.0% and 28.2% of total revenue for the three months ended June 30, 2003 and 2002, respectively, and 38.0% and 39.2% of total revenue for the nine months ended June 30, 2003 and 2002, respectively. The percent of total revenue from outside of North America increased for the three months ended June 30, 2003 as compared to the same period in 2002 due to domestic revenue growing at a slower rate than revenue from outside of North America. Revenue from Japan was 13.1% and 10.8% of our total revenue in the three months ended June 30, 2003 and 2002, respectively, and 14.1% and 19.5% of total revenue for the nine months ended June 30, 2003 and 2002, 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 13.1% and 10.8% of our total revenue for the three months ended June 30, 2003 and 2002, respectively, and 14.1% and 19.5% of total revenue for the nine months ended June 30, 2003 and 2002, respectively. Broadcom Corporation accounted for approximately 11.5% of our total revenue for the nine months ended June 30, 2003 and 10.3% of our total revenue for the three months ended June 30, 2002. Micron Technology, Inc. accounted for approximately 17.8% of our total revenue for the three months ended June 30, 2002. 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 are not been met, time-based license fees that have been invoiced and for which we recognize revenue ratably over the term of the license period, and maintenance fees on perpetual licenses for which we also recognize revenue ratably over the term of the maintenance period. Our total short-term and long-term deferred revenue increased to $10.0 million as of June 30, 2003 from $6.1 million as of September 30, 2002 and from $7.5 million as of March 31, 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. Deferred revenue may not increase if more customers prefer quarterly payments for time-based licenses and maintenance.

Product Revenue. Product revenue decreased by 62.2%, or $3.1 million, to $1.9 million for the three months ended June 30, 2003 from $5.0 million for the three months ended June 30, 2002, and decreased by 30.1%, or $4.2 million, to $9.7 million for the nine months ended June 30, 2003 from $13.9 million for the nine months ended June 30, 2002. These decreases were primarily due to more customers, particularly major accounts, purchasing time-based licenses as compared to perpetual licenses and lower customer demand due to tighter budgets in a prolonged economic downturn. As a percent of total revenue, product revenue decreased to 25.2% for the three months ended June 30, 2003 from 56.0% for the three months ended June 30, 2002 and decreased to 36.5% for the nine months ended June 30, 2003 from 57.9% for the nine months ended June 30, 2002, as the sales of perpetual licenses was outpaced by growth in the sales of time-based licenses.

Subscription Revenue. Subscription revenue increased by 35.7%, or $936,000, to $3.6 million for the three months ended June 30, 2003 from $2.6 million for the three months ended June 30, 2002, and increased by 61.3%, or $4.1 million, to $10.7 million for the nine months ended June 30, 2003 from $6.6 million for the nine months ended June 30, 2002. 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 47.4% for the three months ended June 30, 2003 from 29.4% for the three months ended June 30, 2002 and rose to 40.4% for the nine months ended June 30, 2003 from 27.7% for the nine months ended June 30, 2002. We expect time-based licenses to account for an increasing proportion of total revenue in the future.

Maintenance Revenue. Maintenance revenue increased by 58.2%, or $757,000, to $2.1 million for the three months ended June 30, 2003 from $1.3 million for the three months ended June 30, 2002 and increased by 78.3%, or $2.7 million, to $6.2 million for the nine months ended June 30, 2003 from $3.5 million for the nine months ended June 30, 2002. 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 increased to 27.4% for the three months ended June 30, 2003 from 14.6% for the three months ended June 30, 2002 and increased to 23.1% for the nine months ended June 30, 2003 from 14.4% for the nine months ended June 30, 2002. 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 proportion of customers with perpetual licenses 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 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 increased by 213.6%, or $47,000, to $69,000 for the three months ended June 30, 2003 from $22,000 for the three months ended June 30, 2002 and increased by 26.1%, or $41,000, to $198,000 for the nine months ended June 30, 2003 from $157,000 for the nine months ended June 30, 2002, due to an increase in the sublicensing of third-party products. As a percent of total revenue, the cost of product revenue increased to 0.9% for the three months ended June 30, 2003 from 0.2% for the three months ended June 30, 2002 and remained constant at 0.7% for the nine months ended June 30, 2003 and 2002. 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 21.6%, or $16,000, to $90,000 for the three months ended June 30, 2003 from $74,000 for the three months ended June 30, 2002 and increased by 36.1% or $69,000, to $260,000 for the nine months ended June 30, 2003 from $191,000 for the nine months ended June 30, 2002. 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 increased to 1.2% for the three months ended June 30, 2003 from 0.8% for the three months ended June 30, 2002 and increased to 1.0% for the nine months ended June 30, 2003 from 0.8% for the nine months ended June 30, 2002. 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 21.3%, or $37,000, to $211,000 for the three months ended June 30, 2003 from $174,000 for the three months ended June 30, 2002 and increased by 25.1%, or $122,000, to $609,000 for the nine months ended June 30, 2003 from $487,000 for the nine months ended June 30, 2002. 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 increased to 2.8% for the three months ended June 30, 2003 from 2.0% for the three months ended June 30, 2002 and increased to 2.3% for the nine months ended June 30, 2003 from 2.0% for the nine months ended June 30, 2002. The increase in the cost of maintenance revenue as a percent of total 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.

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 57.7%, or $720,000, to $2.0 million for the three months ended June 30, 2003 from $1.3 million for the three months ended June 30, 2002 and increased by 35.7%, or $1.4 million, to $5.2 million for the nine months ended June 30, 2003 from $3.8 million for the nine months ended June 30, 2002. The increases in research and development expenses were primarily due to the hiring of additional research and development personnel, partially offset by decreases in bonuses. Research and development headcount increased to 43 at June 30, 2003 from 35 at June 30, 2002. As a percent of total revenue, research and development expenses increased to 26.2% in the three months ended June 30, 2003 from 14.0% in the three months ended June 30, 2002 and increased to 19.5% in the nine months ended June 30, 2003 from 16.0% in the nine months ended June 30, 2002. 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 9.7%, or $235,000, to $2.7 million for the three months ended June 30, 2003 from $2.4 million for the three months ended June 30, 2002 and increased by 23.0%, or $1.6 million, to $8.4 million for the nine months ended June 30, 2003 from $6.8 million for the nine months ended June 30, 2002. The absolute dollar increases in sales and marketing expenses were primarily due to the hiring of additional sales, application engineering, and marketing personnel, which increased to 47 at June 30, 2003 from 44 at June 30, 2002, and, to a lesser extent, increased travel, trade show and other marketing activities and the expansion of our sales offices. As a percent of total revenue, sales and marketing expenses increased to 35.4% in the three months ended June 30, 2003 from 27.2% in the three months ended June 30, 2002 and increased to 31.6% in the nine months ended June 30, 2003 from 28.4% in the nine months ended June 30, 2002. We expect that sales and marketing expenses will continue to increase in absolute dollars in future periods as we further expand our global sales and support organization.

General and Administrative. General and administrative expenses represent corporate, finance, human resource, administrative, legal and consulting expenses. Our general and administrative expenses increased by 17.8%, or $372,000, to $2.5 million for the three months ended June 30, 2003 from $2.1 million for the three months ended June 30, 2002 and increased by 30.8%, or $1.7 million, to $7.3 million for the nine months ended June 30, 2003 from $5.6 million for the nine months ended June 30, 2002. As a percent of total revenue, general and administrative expenses increased to 32.7% for the three months ended June 30, 2003 from 23.4% for the three months ended June 30, 2002 and increased to 27.5% for the nine months ended June 30, 2003 from 23.3% for the nine months ended June 30, 2002. The increases in general and administrative expenses were primarily due to legal fees, cost of public company compliance reporting and liability insurance. General and administrative headcount increased to 11 at June 30, 2003 from 10 at June 30, 2002. 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 9.1%, or $23,000, to $229,000 for the three months ended June 30, 2003 from $252,000 for the three months ended June 30, 2002 and decreased by 4.1%, or $31,000, to $725,000 for the nine months ended June 30, 2003 from $756,000 for the nine months ended June 30, 2002. As a percent of total revenue, stock-based compensation expense increased to 3.1% for the three months ended June 30, 2003 from 2.8% for the three months ended June 30,

2002, but decreased to 2.7% for the nine months ended June 30, 2003 from 3.1% for the nine months ended June 30, 2002 due to decreases in revenue.

Interest income decreased by 30.6%, or $98,000, to $222,000 for the three months ended June 30, 2003 from $320,000 for the three months ended June 30, 2002 due to lower interest rates. Interest income increased by 13.7%, or $90,000, to $745,000 for the nine months ended June 30, 2003 from $655,000 for the nine months ended June 30, 2002 due to profitability and positive cash flow, which increased our cash balances and resulted in increased interest income, despite lower interest rates. As a percent of total revenue, interest income decreased to 3.0% for the three months ended June 30, 2003 from 3.6% for the three months ended June 30, 2002 but increased to 2.8% for the nine months ended June 30, 2003 from 2.7% for the nine months ended June 30, 2002.

Our other income (expense), net remained relatively small and was immaterial for the three and nine months ended June 30, 2003 and 2002.

Income tax benefit (provision) as a percent of income before taxes was a benefit of 237.9% for the three months ended June 30, 2003 as compared to a provision of 38.3% for the three months ended June 30, 2002. Income tax provision as a percent of income before taxes was 30.0% for the nine months ended June 30, 2003 as compared to 37.8% for the nine months ended June 30, 2002. The decrease in the effective tax rate from the prior year was primarily due to increased permanent tax differences, as pre-tax income for fiscal 2003 is expected to be lower than fiscal 2002. In addition, we have experienced more tax benefits during fiscal 2003 as compared to fiscal 2002 related to exercises of stock options for which stock-based compensation has been recorded.

Since inception, we have financed our operations primarily through private sales of preferred stock for aggregate proceeds of $525,000 in September 1998 and $1.5 million in May 1999. We have also financed our operations through the sale of common stock to employees and cash generated from profits. In December 2001 and January 2002, we sold 5,750,000 shares of common stock in connection with our initial public offering at $11.00 per share. Total net proceeds after deducting underwriting discounts and offering expenses were approximately $57.2 million.

As of June 30, 2003, we had cash, cash equivalents and short-term investments of $88.9 million and working capital of $80.0 million.

Net cash provided by operating activities was $8.6 million for the nine months ended June 30, 2003 and $5.5 million for the nine months ended June 30, 2002. 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 provided by operating activities for the nine months ended June 30, 2002 resulted primarily from net income and increases in accrued liabilities and deferred revenue, offset by decreases in long term liabilities and increases in accounts receivable.

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 used in investing activities was $20.0 million for the nine months ended June 30, 2002, primarily related to the purchases of short-term investment securities and purchases of property and equipment.

Net cash provided by financing activities was $2.2 million for the nine months ended June 30, 2003 and $57.4 million for the nine months ended June 30, 2002. For the nine months ended June 30, 2003, net cash provided by financing activities was from proceeds generated by stock option exercises and the employees stock purchase plan. For the nine months ended June 30, 2002, net cash provided by financing activities was primarily from the net proceeds of the sale of five million shares of common stock in our December 2001 initial public offering and an additional 750,000 shares in January 2002 pursuant to the exercise of the over-allotment option by our underwriters.

Capital expenditures were approximately $452,000 for the nine months ended June 30, 2003 and $222,000 for the nine months ended June 30, 2002. Our capital expenditures consisted of purchases of computer equipment, software and office furniture and fixtures. We expect to invest approximately $100,000 during the remainder of fiscal 2003 for similar assets.

As of June 30, 2003, 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:

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 18 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 18 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.

In December 2002, we entered into a three-year operating lease, which began in February 2003. The lease is for our primary business operation. The future minimum lease obligations related to this lease are $982,000.

In October 2001, the FASB issued SFAS No. 144, Accounting for the Impairment or Disposal of Long-Lived Assets, which addresses financial accounting and reporting for the impairment or disposal of long-lived assets. SFAS No. 144 supersedes SFAS No. 121, Accounting for the Impairment of Long-Lived Assets and for Assets to Be Disposed of. We adopted SFAS No. 144 for fiscal 2003 beginning October 1, 2002. The adoption of SFAS No. 144 had no impact on our financial position, results of operations or cash flows.

In December 2002, the FASB issued SFAS No. 148, “Accounting for Stock-Based Compensation – Transition and Disclosure.” SFAS No. 148 amends SFAS No. 123, “Accounting for Stock-Based Compensation,” to provide alternative methods of transition for a voluntary change to the fair value based method of accounting for stock-based employee compensation. In addition, 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. SFAS No. 148 is effective for fiscal years ending after December 15, 2002. We intend to adopt the disclosure provisions of SFAS No. 148 for the quarterly period beginning on January 1, 2003. We do not expect to change to the fair value based method of accounting for stock-based employee compensation; therefore, the adoption of SFAS No. 148 is not expected to have an impact on our financial position, results of operation or cash flows.

expected losses, receives a majority of its expected returns, or both. FIN 46 applies immediately to variable interest entities created after January 31, 2003, and to variable interest entities in which an enterprise obtains an interest after that date. It applies in the first fiscal year or interim period beginning after June 15, 2003 to variable interest entities in which an enterprise holds a variable interest that it acquired before February 1, 2003. We are in the process of determining what impact, if any, the adoption of the provisions of FIN 46 will have upon our financial condition or results of operations, but do not expect that this statement will have a material impact on our financial condition or results of operations.

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 substantially all of our revenue for at least the next 12 months. 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 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 the first three quarters of fiscal 2003, 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 substantially all of our revenue in the remainder of fiscal 2003 and fiscal 2004, 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 renewal 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 for our software, renew their annual maintenance for perpetual licenses or renew their time-based licenses when they expire, we would experience a decline in revenue. For the first three quarters of fiscal 2003, our revenue from perpetual licenses has been decreasing as a result of more customers’ preference to purchase time-based licenses and lower demand due to much tighter budgets. Revenue from time-based licenses and maintenance has increased steadily over the last 12 months and we expect it to continue to increase. For instance, for the three months ended June 30, 2003, 74.8% of our total revenue was derived from time-based licenses and maintenance as compared to 44.0% for the three months ended June 30, 2002. As more of our revenue is attributed to time-based licenses, our revenue could decline materially if our customers do not renew their existing time-based licenses or purchase additional licenses.

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 has experienced a substantial decline in order volume and revenue and that downturn has continued. 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, revenue 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’ 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. 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. More recently, certain Asian countries have also experience difficulties from concerns about and the impact of closures due to SARS. These difficulties have triggered a significant downturn in the semiconductor market, resulting in reduced budgets for chip design tools, which, in turn, has negatively impacted us. We cannot predict what impact the prolonged economic slowdown 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 the current economic slowdown continues, we may not meet our revenue expectations for upcoming quarters.

We are currently a defendant in three lawsuits brought by Synopsys and a derivative complaint. 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.

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.

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.

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 will be negatively impacted.

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, 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., Mentor Graphics Corporation and Synopsys. 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 how long the current downturn will last. Many semiconductor manufacturers and vendors of products incorporating semiconductors continue to announce earnings shortfalls and employee layoffs.

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. Further, four of our executive officers have agreed to work without receiving salary during fiscal 2002 and 2003. If any or all of these executive officers must be replaced, we would incur unexpected expenses relating to the payment of salaries to the replacement executive officers during fiscal 2003.

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

Approximately 76.8% of our total revenue in the nine months ended June 30, 2003, 72.1% of our total revenue in fiscal 2002 and 61.2% of our total revenue in fiscal 2001 were 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 45 persons as of June 30, 2003. 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 are 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 salary costs or require us to provide larger stock option grants. We have a small research and development facility in Taiwan, out of which four 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 or meet the demands of our customers in a timely manner 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 market our software.

A majority of our sales outside North America and Europe are conducted through distributors. Sales by our distributors accounted for approximately 23.2% of our total revenue in the nine months ended June 30, 2003, 27.9% of our total revenue in fiscal 2002 and 38.8% of our total revenue in fiscal 2001. We rely on Marubeni Solutions Corp. as the exclusive distributor of our software in Japan. Sales to Marubeni Solutions accounted for 14.1% of our total revenue in the nine months ended June 30, 2003, 15.0% of our accounts receivable at June 30, 2003, 19.4% of our total revenue in fiscal 2002 and 23.0% of our accounts receivable at September 30, 2002. 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 provide exclusive distribution rights, but 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, 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.

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 revenue being flat or slightly lower in the first quarter 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 three months ended June 30, 2003, we did not see any meaningful improvements in our customers’ spending pattern and our outlook continues to be cautious. 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 LEXSIM, CRITIC and HANEX, 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 and our fourth product, HANEX, in May 2003. To date, LEXSIM, CRITIC and HANEX have accounted for only an immaterial portion of our revenues. Even though we do not expect LEXSIM, CRITIC or HANEX to account for a meaningful percentage of our total revenue until fiscal 2004, our future growth and profitability could be affected by our ability to increase sales of these new products. Furthermore, marketing new products 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 HSIM, 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 economic downturn. 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:

If we were to experience a delay in our orders, 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 June 30, 2003 and March 31, 2003, our revenue decreased as compared to the previous quarters because we experienced longer sales cycles, which negatively impacted our ability to received 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 France, Germany, United Kingdom and Israel. 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 recently begun to employ direct sales personnel in 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 15 quarters, with substantially lower net income for the last two fiscal quarters, we may incur losses in the future. In order to fund our operations 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:

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 and corporate 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:

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 and incur significant additional expense. Because we expect to derive substantially all of our revenue from HSIM in fiscal 2003 and fiscal 2004, 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 and cause licenses for our software to decrease.

Significant errors in our software 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, errors in our software may be found in the future. The detection of any significant errors may result in:

We have warranted that our software will operate 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 from those markets.

Customers outside North America accounted for 38.0% of our total revenue in the nine months ended June 30, 2003, 42.0% of our total revenue in fiscal 2002 and 51.0% of our total revenue in fiscal 2001. We plan to increase our international sales activities, but we have limited experience marketing and directly licensing our software internationally.

We have sales offices in France, Germany, Israel and the United Kingdom, and primarily rely 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:

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:

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 in the remainder of fiscal 2003 and fiscal 2004. 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:

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 Design Systems, Mentor Graphics or Synopsys, may acquire or establish cooperative relationships with our other current competitors, including private companies. For example, Synopsys acquired Avant! Corporation, a provider of a wide range of electronic design automation products, in June 2002, Numerical Technologies, Inc., a provider of sub-wavelength lithography-enabling technology, in February 2003, and InnoLogic Systems, Inc., a provider of memory and full-custom equivalence checking technology, in June 2003. 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, Mentor Graphics completed a cash tender offer for IKOS Systems, Inc., a functional verification company, in March 2002, and for Innoveda, Inc., an electronic design automation company, in May 2002. Additionally, Cadence Design Systems completed its acquisition of Plato Design Systems, Inc., a design technology company, in April 2002, Simplex Solutions, a provider of software

and services for the design and verification of integrated circuits, in June 2002, Celestry Design Technologies, Inc., a provider of silicon modeling and circuit simulation tools, in January 2003, and Get2Chip, Inc., a provider of advanced nanometer-scale synthesis technology, in April 2003 and entered into a definitive agreement to acquire Verplex Systems, Inc., a provider of formal verification electronic design software, in July 2003. 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. 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 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, 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. 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. As a result, 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 increased from 89 as of June 30, 2002 to 101 as of June 30, 2003. 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:

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 36.0% in the three months ended June 30, 2003, 28.2% in the three months ended June 30, 2002, 38.0% in the nine months ended June 30, 2003 and 39.2% in the nine months ended June 30, 2002. 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. We expect that our interest

income will be negatively affected by recent declines in short-term interest rates. A sensitivity analysis assuming a hypothetical 10% movement in interest rates applied to our cash equivalent and short-term investments balances at June 30, 2003 would change interest income by approximately $90,000 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 invest funds in excess of current operating requirements in short-term tax exempt and taxable instruments that meet high credit quality standards, as specified in our investment policy. The policy also limits the amount of credit exposure to any one issue, issuer or type of instrument. As of June 30, 2003, our cash, cash equivalents and short-term investments primarily consisted of the following instruments:

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. It should be noted, however, that the design of any system of controls is based in part upon certain assumptions about the likelihood of future events, and there can be no assurance that any design will succeed in achieving its stated goals under all potential future conditions, regardless of how remote.

There were no changes in our internal control over financial reporting during the period covered by this Quarterly Report that had materially affected, or is reasonably likely to materially affect, our internal control over financial reporting.

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.

We believe that we have meritorious defenses to Synopsys’ allegations and claims and we intend to continue to defend ourselves vigorously. 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.

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.


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.

The Company filed current reports on Form 8-K on April 2, 2003 and April 16, 2003 in connection with its earnings releases.

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.

		PAGE NO.
PART I.	FINANCIAL INFORMATION

Item 1.	Financial Statements	3

	Condensed Consolidated Balance Sheets	3

	Condensed Consolidated Income Statements	4

	Condensed Consolidated Statements of Cash Flows	5

	Notes to Condensed Consolidated Financial Statements	6-14

Item 2.	Management’s Discussion and Analysis of Financial Condition and Results of Operations	15

Item 3.	Quantitative and Qualitative Disclosures About Market Risk	43

Item 4.	Controls and Procedures	44

PART II.	OTHER INFORMATION

Item 1.	Legal Proceedings	44-47

Item 6.	Exhibits and Reports on Form 8-K	47

SIGNATURES		49

	June 30, 2003			September 30, 2002 (1)
	(unaudited)
Assets:
Current assets:
Cash and cash equivalents	$	59,350		$	43,157
Short-term investments		29,509			35,295
Accounts receivable, net of allowances of $92 and $87 at June 30, 2003 and September 30, 2002, respectively		2,944			4,156
Prepaid expenses and other current assets		1,125			553
Deferred income taxes		2,716			2,050

Total current assets		95,644			85,211
Property and equipment, net		836			784
Other assets		916			727

Total assets	$	97,396		$	86,722

Liabilities and Stockholders’ Equity:
Current liabilities:
Accounts payable	$	575		$	555
Accrued liabilities		6,030			6,994
Deferred revenue		9,061			6,065

Total current liabilities		15,666			13,614
Deferred revenue		960			—
Long-term liabilities		44			54

Total liabilities		16,670			13,668

Stockholders’ equity:
Common stock, par value $0.001: 110,000,000 shares authorized; 25,892,119 and 24,935,036 shares outstanding at June 30, 2003 and September 30, 2002, respectively		26			25
Additional paid-in capital		69,939			66,378
Deferred stock-based compensation		(1,346	)		(2,208	)
Accumulated other comprehensive income		13			6
Retained earnings		12,094			8,853

Total stockholders’ equity		80,726			73,054

Total liabilities and stockholders’ equity	$	97,396		$	86,722

	Three Months Ended June 30,						Nine Months Ended June 30,
	2003			2002			2003			2002
	(unaudited)
Revenue:
Product	$	1,892		$	4,999		$	9,735		$	13,920
Subscription		3,558			2,622			10,749			6,662
Maintenance		2,058			1,301			6,158			3,453

Total revenue		7,508			8,922			26,642			24,035

Cost of revenue:
Product		69			22			198			157
Subscription		90			74			260			191
Maintenance		211			174			609			487

Total cost of revenue		370			270			1,067			835

Gross profit		7,138			8,652			25,575			23,200

Operating expenses:
Research and development		1,968			1,248			5,203			3,833
Sales and marketing		2,659			2,424			8,408			6,834
General and administrative		2,457			2,085			7,335			5,607
Stock-based compensation*		229			252			725			756

Total operating expenses		7,313			6,009			21,671			17,030

Income (loss) from operations		(175	)		2,643			3,904			6,170
Interest income		222			320			746			655
Other income (expense), net		11			(1	)		(19	)		(6	)

Income before taxes		58			2,962			4,631			6,819
Income tax benefit (provision)		138			(1,133	)		(1,390	)		(2,577	)

Net income	$	196		$	1,829		$	3,241		$	4,242

Earnings per share:
Basic	$	0.01		$	0.08		$	0.13		$	0.22

Diluted	$	0.01		$	0.06		$	0.11		$	0.15

Shares used in computing earnings per share:
Basic		25,326			22,962			24,859			18,922

Diluted		28,546			29,375			28,652			27,432

*Stock-based compensation includes:
Research and development	$	103		$	107		$	317		$	321
Sales and marketing		67			87			233			261
General and administrative		59			58			175			174

Total	$	229		$	252		$	725		$	756

	Nine Months Ended June 30,
	2003			2002
	(unaudited)
Operating activities
Net income	$	3,241		$	4,242
Adjustments to reconcile net income to net cash provided by operating activities:
Depreciation		400			309
Stock-based compensation		725			756
Deferred income taxes		(859	)		(303	)
Changes in operating assets and liabilities:
Accounts receivable		1,212			(2,364	)
Prepaid expenses and other current assets		(572	)		136
Accounts payable		20			313
Accrued liabilities		536			2,650
Deferred revenue		3,956			1,334
Long-term liabilities		(10	)		(1,554	)

Net cash provided by operating activities		8,649			5,519

Investing activities
Purchase of short-term investments		(44,578	)		(71,902	)
Proceeds from maturity of short-term investments		50,378			52,124
Purchases of property and equipment		(452	)		(222	)
Other assets		(1	)		41

Net cash provided by (used in) investing activities		5,347			(19,959	)

Financing activities
Proceeds from issuance of common stock		2,197			57,545
Repurchase of common stock		—			(168	)

Net cash provided by financing activities		2,197			57,377

Increase in cash and cash equivalents		16,193			42,937
Cash and cash equivalents, beginning of period		43,157			5,655

Cash and cash equivalents, end of period	$	59,350		$	48,592

Supplemental disclosure of cash flow information
Cash paid for income taxes	$	72		$	1,485

Supplemental schedule of noncash activities
Unrealized (gain)/loss on short-term investments	$	(7	)	$	8

Deferred stock-based compensation (reversal)	$	(135	)	$	(189	)

	Three Months Ended June 30,						Nine Months Ended June 30,
	2003			2002			2003			2002
Net income (numerator):	$	196		$	1,829		$	3,241		$	4,242

Shares (denominator):
Weighted average common shares outstanding		25,723			24,627			25,459			21,147
Weighted average common shares subject to repurchase		(397	)		(1,665	)		(600	)		(2,225	)

Shares used in basic computation		25,326			22,962			24,859			18,922
Weighted average common shares subject to repurchase		397			1,665			600			2,225
Common shares issuable upon exercise of stock options (treasury stock method)		2,823			4,748			3,193			4,545
Convertible preferred stock		—			—			—			1,740

Shares used in diluted computation		28,546			29,375			28,652			27,432

Basic earnings per share	$	0.01		$	0.08		$	0.13		$	0.22

Diluted earnings per share	$	0.01		$	0.06		$	0.11		$	0.15

	Three Months Ended June 30,				Nine Months Ended June 30,
	2003		2002		2003		2002
Net income	$	196	$	1,829	$	3,241	$	4,242
Unrealized gain/ (loss) on investments		3		38		7		(8	)

Comprehensive Income	$	199	$	1,867	$	3,248	$	4,234

	Three Months Ended June 30,				Nine Months Ended June 30,
	2003		2002		2003		2002
Stock Option Plans:
Risk-free interest rate	2.62	%	4.00	%	2.85	%	4.00	%

Expected volatility	85	%	70	%	92	%	70	%

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	1.10	%	1.86	%	1.25	%	1.86	%

Expected volatility	85	%	70	%	92	%	70	%

Expected life (in years)	2.0		2.0		2.0		2.0

Expected dividend	0.0	%	0.0	%	0.0	%	0.0	%

	Three Months Ended June 30,						Nine Months Ended June 30,
	2003			2002			2003			2002
Net income as reported	$	196		$	1,829		$	3,241		$	4,242
Add: stock based employee compensation expense included in reported net income, net of taxes		30			252			426			756
Less: stock-based employee compensation expense determined under fair value based method, net of taxes		(1,210	)		(995	)		(3,900	)		(2.408	)

Pro forma net income (loss)	$	(984	)	$	1,086		$	(233	)	$	2,590

Basic earnings per share:
As reported	$	0.01		$	0.08		$	0.13		$	0.22

Pro forma	$	(0.04	)	$	0.05		$	(0.01	)	$	0.14

Diluted earnings per share:
As reported	$	0.01		$	0.06		$	0.11		$	0.15

Pro forma	$	(0.04	)	$	0.04		$	(0.01	)	$	0.09

Date: August 4, 2003	NASSDA CORPORATION

	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)

Year Ending September 30,
2003	$	417
2004		16
2005		2

	$	435

	Three Months Ended June 30,				Nine Months Ended June 30,
	2003		2002		2003		2002
Revenue:
Product	25.2	%	56.0	%	36.5	%	57.9	%
Subscription	47.4		29.4		40.4		27.7
Maintenance	27.4		14.6		23.1		14.4

Total revenue	100.0		100.0		100.0		100.0

Cost of revenue:
Product	0.9		0.2		0.7		0.7
Subscription	1.2		0.8		1.0		0.8
Maintenance	2.8		2.0		2.3		2.0

Total cost of revenue	4.9		3.0		4.0		3.5

Gross profit	95.1		97.0		96.0		96.5

Operating expenses:
Research and development	26.2		14.0		19.5		16.0
Sales and marketing	35.4		27.2		31.6		28.4
General and administrative	32.7		23.4		27.5		23.3
Stock-based compensation	3.1		2.8		2.7		3.1

Total operating expenses	97.4		67.4		81.3		70.8

Income (loss) from operations	(2.3	)	29.6		14.7		25.7
Interest income	3.0		3.6		2.8		2.7
Other income (expense), net	0.1		—		(0.1	)	—

Income before taxes	0.8		33.2		17.4		28.4
Income tax benefit (provision)	1.8		(12.7	)	(5.2	)	(10.8	)

Net income	2.6	%	20.5	%	12.2	%	17.6	%

Year Ending September 30,
2003	$	417
2004		16
2005		2

	$	435