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UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

WASHINGTON, D.C. 20549

FORM 10-Q

(MARK ONE)

FOR THE QUARTERLY PERIOD ENDED JANUARY 31, 2005

OR

FOR THE TRANSITION PERIOD FROM              TO             

COMMISSION FILE NUMBER: 000-30362

CROSSROADS SYSTEMS, INC.

(EXACT NAME OF REGISTRANT AS SPECIFIED IN ITS CHARTER)

8300 NORTH MOPAC EXPRESSWAY

AUSTIN, TEXAS 78759

(Address of Registrant’s principal executive offices, including zip code.)

(512) 349-0300

(Registrant’s telephone number, including area code)

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

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

As of March 15, 2005 Registrant had outstanding 26,115,649 shares of common stock, par value $0.001 per share.

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CROSSROADS SYSTEMS, INC. AND SUBSIDIARIES

FORM 10-Q

QUARTER ENDED JANUARY 31, 2005

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PART I - FINANCIAL INFORMATION

ITEM 1. FINANCIAL STATEMENTS

CROSSROADS SYSTEMS, INC. AND SUBSIDIARIES

CONDENSED CONSOLIDATED BALANCE SHEETS

(UNAUDITED)

(IN THOUSANDS, EXCEPT SHARE DATA)

See accompanying notes to unaudited condensed consolidated financial statements.

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CROSSROADS SYSTEMS, INC. AND SUBSIDIARIES

CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS

(UNAUDITED)

(IN THOUSANDS, EXCEPT SHARE AND PER SHARE DATA)

See accompanying notes to unaudited condensed consolidated financial statements.

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CROSSROADS SYSTEMS, INC. AND SUBSIDIARIES

CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS

(UNAUDITED)

(IN THOUSANDS)

See accompanying notes to unaudited condensed consolidated financial statements.

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CROSSROADS SYSTEMS, INC. AND SUBSIDIARIES

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

(UNAUDITED)

1. BASIS OF PRESENTATION AND SIGNIFICANT ACCOUNTING POLICIES

The accompanying condensed consolidated financial statements include the accounts of Crossroads Systems, Inc. (Crossroads or the Company) and its wholly-owned subsidiaries. Headquartered in Austin, Texas, Crossroads, a Delaware corporation, is a leading global provider of connectivity for storage networking solutions. Crossroads sells its products and services primarily to leading storage system and server original equipment manufacturers, distributors, system integrators and storage service providers. The Company continues to consolidate the balance sheet, statements of operations and cash flows of NexQL Corporation (NexQL), a variable interest entity (VIE). The Company defines its operations as two distinct businesses: device controllers and network solution appliances.

The accompanying financial data as of January 31, 2005 and for the three months ended January 31, 2004 and 2005, have been prepared by the Company, without audit, pursuant to the rules and regulations of the Securities and Exchange Commission (the SEC). Certain information and footnote disclosures normally included in financial statements prepared in accordance with generally accepted accounting principles have been condensed or omitted pursuant to the SEC’s rules and regulations. These unaudited financial statements should be read in conjunction with the audited financial statements and related notes for the year ended October 31, 2004, included in our Annual Report on Form 10-K.

The preparation of the condensed consolidated financial statements in conformity with generally accepted accounting principles requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities at the date of the condensed consolidated financial statements and the reported amounts of revenue and expenses during the reporting periods. Actual results could differ from those estimates and such differences may be material to the condensed consolidated financial statements. Certain amounts in prior periods may have been reclassified to conform to the current presentation.

Revenue Recognition

Product revenue is recognized when persuasive evidence of an arrangement exists, delivery has occurred, the price is fixed or determinable, collectibility is probable and the risk of loss has passed to the customer. Revenue from product sales to customers that do not have rights of return, including product sales to original equipment manufacturers (OEMs) and certain distributors, Value Added Resellers (VARs) and system integrators, are recognized upon shipment or when title transfers. Sales and cost of sales related to customers that have rights of return are deferred and subsequently recognized upon sell-through to end-users.

Royalty and other revenue includes revenue from the licensing of intellectual property (IP), royalty payments from Hewlett-Packard (HP) and sales of service contracts. IP licensing arrangements can differ, but typically consist of upfront non-refundable fees including payments relating to past and future sales of licensee products. Once a license agreement is signed, delivery of the license has occurred and there are no remaining obligations outstanding, the Company records revenue from upfront nonrefundable IP license arrangements. License arrangements can also include a royalty stream that is recognized quarterly based on reports from the licensee. Revenue from royalty payments from HP is recognized monthly based on reports from HP and quarterly from other IP licensees. Support only includes telephone support and correction of errors. Service revenue is recognized ratably over the service period.

Consolidation of Variable Interest Entities

Financial Accounting Standards Board (FASB) Interpretation No. 46, “Consolidation of Variable Interest Entities” (FIN 46), was issued in January 2003. FIN 46 requires that if an entity is the primary beneficiary of a variable interest entity, the assets, liabilities, and results of operations of the variable interest entity should be included in the consolidated financial statements of the entity. FASB Interpretation No. 46(R), “Consolidation of Variable Interest Entities” (FIN 46(R)), was issued in December 2003. The Company adopted FIN 46(R) effective April 30, 2004, and consolidated NexQL in its reported financial results. For additional information regarding NexQL see Note 6 of our Annual Report on Form 10-K.

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CROSSROADS SYSTEMS, INC. AND SUBSIDIARIES

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

(UNAUDITED)

Deferred Revenue

NexQL entered into a Master Reseller Agreement (Agreement) on July 30, 2004 with a reseller in Europe. Subject to the terms of the Agreement, NexQL has assigned specific customer accounts exclusively to the reseller for an initial fee of $50,000. In August 2004, NexQL delivered product simulators to the reseller and has collected $950,000 for the simulators and $50,000 for the Agreement. Crossroads will recognize revenue when persuasive evidence of an arrangement exists, delivery has occurred and the fee is fixed or determinable. Securities and Exchange Commission Staff Accounting Bulletin No. 104-”Revenue Recognition” requires the Company to be able to estimate returns and warranty expenses prior to recognizing revenue. Since NexQL has no history selling their products, we are not able to estimate returns and warranty expense at this time. Revenue from sales of products prior to the time we are able to estimate returns and warranty expense will be deferred. As of January 31, 2005 the entire $1.0 million remained deferred.

Purchased Intangible Assets

Purchased intangible assets are amortized over their useful economic life and periodically tested for impairment in accordance with SFAS No. 142, “Goodwill and Other Intangible Assets.” The Company performs impairment tests on an annual basis.

The Company intends to evaluate the useful economic life of this intangible annually and will record an impairment charge as necessary. When an evaluation is required, the estimated future undiscounted cash flows associated with this asset will be compared to the carrying amount to determine if a write-down to fair market value or discounted cash flow value is required.

Stock-Based Compensation

As of January 31, 2005, the Company has one employee stock-based compensation plan, which is described more fully in Note 12 of our Annual Report on Form 10-K. Stock-based compensation is recognized using the intrinsic value method prescribed in Accounting Principles Board Opinion No. 25, “Accounting for Stock Issued to Employees,” and related interpretations. Accordingly, compensation cost for stock options is measured as the excess, if any, of the fair value of the Company’s stock at the date of grant over the amount an employee must pay to acquire the stock amortized over the vesting period.

The Company allocates stock-based compensation to specific line items within the condensed consolidated statements of operations based on the classification of the employees who receive the benefit. Stock-based compensation was recorded as follows (in thousands):

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CROSSROADS SYSTEMS, INC. AND SUBSIDIARIES

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

(UNAUDITED)

The following table illustrates the effect on net loss and loss per share if the Company had applied the fair value recognition provisions of Financial Accounting Standards Board Statement No. 123, “Accounting for Stock-Based Compensation,” as amended by SFAS No. 148, “Accounting for Stock-Based Compensation - Transition and Disclosure,” to employee stock-based compensation (in thousands, except share data):

2. INVENTORIES

Inventories, net consist of the following (in thousands):

3. CONCENTRATIONS

Financial instruments that potentially expose the Company to concentrations of credit risk consist primarily of cash and cash equivalents, short-term investments and accounts receivable. The Company invests only in high credit quality short-term debt instruments.

The Company’s sales are primarily concentrated in the United States and are primarily derived from sales to OEMs in the computer storage and server industry. Revenue is concentrated with several major customers. The loss of a major customer, a change of suppliers or a significant technological change in the industry could affect operating results adversely. The Company performs credit evaluations of its customers and generally does not require collateral on accounts receivable balances and provides allowances for potential credit losses, product sales returns and other allowances. The Company has not experienced material credit losses in any of the periods presented.

The Company relies on a limited number of contract manufacturers to provide manufacturing services for its products. The inability of any contract manufacturer or supplier to fulfill supply requirements could materially impact future operating results. Additionally, the Company’s supplier arrangement for the production of certain vital components of its storage routers is concentrated with a small number of key suppliers.

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CROSSROADS SYSTEMS, INC. AND SUBSIDIARIES

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

(UNAUDITED)

The percentage of sales to significant customers was as follows:

The level of sales to any customer may vary from quarter to quarter. However, the Company expects that significant customer concentration, particularly to our two major customers, will continue for the foreseeable future. The loss of any one of these customers, or a decrease in the level of sales to any one of these customers, could have a material adverse impact on the Company’s financial condition or results of operations.

4. BUSINESS COMBINATIONS

Purchase Acquisition

During the fourth quarter of fiscal 2004, the Company completed an asset acquisition of Teracruz, Inc. (Teracruz), to add application acceleration and monitoring technology. The acquisition was accounted for as a purchase transaction. For additional information regarding the asset acquisition of Teracruz, Inc. see Note 6 of our Annual Report on Form 10-K.

The purchase price of the transaction was allocated to the acquired assets based on their estimated fair values as of the date of the acquisition, including identifiable intangible assets. The allocation is subject to change as additional information is received.

The following table presents details of the purchased intangible assets acquired during fiscal 2004 as part of the Teracruz asset acquisition and represents the balance at January 31, 2005 (in thousands, except number of years):

The future amortization expense for the next three years is as follows (in thousands):

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CROSSROADS SYSTEMS, INC. AND SUBSIDIARIES

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

(UNAUDITED)

NEXQL

During the first fiscal quarter of 2004, the Company entered into a strategic relationship with NexQL, a privately-held development stage enterprise in the data management industry. Pursuant to certain agreements with NexQL, the Company may provide NexQL with up to $1.5 million under a loan facility, over a discretionary time period, and will make an equity investment of $1.0 million. As of January 31, 2005 the Company had invested $1.0 million in NexQL and loaned approximately $1.2 million to NexQL. The Company has agreed in principle to amend the existing agreements with NexQL, subject to the completion and execution of definitive documents. See Note 8 Commitments and Contingencies – NexQL Commitment. The investment in NexQL has inherent risk as the markets for the technologies or products of NexQL are in the early stages of development and may never materialize.

In January 2003, the FASB issued FASB Interpretation No. 46 (FIN 46), “Consolidation of Variable Interest Entities, an Interpretation of ARB No. 51” which addresses consolidation by business enterprises of VIEs either: (1) that do not have sufficient equity investment at risk to permit the entity to finance its activities without additional subordinated financial support, or (2) in which the equity investors lack an essential characteristic of a controlling financial interest. In December 2003, the FASB completed deliberations of proposed modifications to FIN 46 (Revised Interpretations) resulting in multiple effective dates based on the nature as well as the creation date of the VIE. VIEs created after January 31, 2003, but prior to January 1, 2004, may be accounted for either based on the original interpretation or the Revised Interpretations. However, the Revised Interpretations must be applied no later than the second quarter of fiscal year 2004. VIEs created after January 1, 2004 must be accounted for under the Revised Interpretations.

As a result of the Revised Interpretations, under FIN 46R rules, the operating results of NexQL were accounted for on the equity method for the three months ended January 31, 2004 and the six months ended April 30, 2004. The company began consolidating the statements of operations and cash flows of NexQL beginning May 1, 2004, the beginning of the Company’s third fiscal quarter of 2004.

Management believes that recognition of additional liabilities as a result of consolidating NexQL does not result in any incremental increase in the level of claims on the general assets of the Company and its other subsidiaries, rather, the additional liabilities represent claims against the additional assets recognized by the Company as a result of the consolidation. Conversely, the additional assets recognized as a result of consolidating NexQL do not represent additional assets of the Company that could be used to satisfy claims by the creditors of the Company and its other subsidiaries.

Crossroads did not record any amounts as revenue related to NexQL for the three months ended January 31, 2004 or 2005. Net operating expenses and net loss attributable to NexQL for the three months ended January 31, 2004 and 2005 were approximately $0.3 million and $0.7 million, respectively. Overall results were significantly impacted as a result of our investment in NexQL and adoption of FIN 46R.

5. SEGMENT INFORMATION

Under SFAS No. 131, “Disclosures about Segments of an Enterprise and Related Information,” the Company operates in two reportable industry segments: device controllers and network solution appliances. The Chief Executive Officer is the Company’s Chief Operating Decision Maker (CODM), as defined by SFAS No. 131. The CODM evaluates resource allocation decisions and operational performance based upon product type. For the three months ended 2005, the network solution appliances segment is comprised of NexQL and the assets acquired from Teracruz. The Company did not operate in reportable industry segments during the three months ended January 31, 2004.

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CROSSROADS SYSTEMS, INC. AND SUBSIDIARIES

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

(UNAUDITED)

The following presents selected financial information for the three months ended January 31, 2005 by product type (in thousands):

6. BUSINESS RESTRUCTURING EXPENSES AND ASSET IMPAIRMENT

In May 2002, the Company completed a restructuring plan that reduced its workforce by approximately 25%, or 40 people (primarily in the sales, marketing and general and administrative areas), to scale down its infrastructure and to consolidate operations.

Components of business restructuring expenses and the remaining restructuring accruals as of January 31, 2005 are as follows (in thousands):

The entire accrual amount relates to remaining payments to be made for lease abandonment losses. In March 2003, the Company entered into an agreement to sublease a portion of its abandoned facilities. The anticipated rent payments from this sublease are approximately $0.5 million through January 2006. A second agreement to sublease a portion of its abandoned properties was signed in May 2003. The anticipated rent payments from the second sublease are approximately $0.1 million through January 2006.

In total, the Company has reduced its restructuring accrual by approximately $0.2 million during the three months ended January 31, 2005, principally for rent payments to be received over the next twelve months of the remaining sublease terms. As the Company entered into the last twelve months of these subleases, the Company will no longer reduce the restructuring accrual for rent payments to be received, though the Company continues to assess recoverability of these sublease payments on a quarterly basis.

The Company has substantially completed its restructuring efforts initiated in conjunction with the restructuring announcement made during fiscal 2002; however, there can be no assurance that future restructuring efforts will not be necessary.

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CROSSROADS SYSTEMS, INC. AND SUBSIDIARIES

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

(UNAUDITED)

7. LINE OF CREDIT

The Company carries a line of credit with its bank. The committed revolving line provides for an advance of up to $3.0 million with a borrowing base of 80% of eligible accounts receivable. The line of credit will mature on June 14, 2005. As of October 31, 2004 and January 31, 2005, there were no borrowings outstanding under this revolving line of credit.

8. COMMITMENTS AND CONTINGENCIES

OPERATING LEASES

The Company leases office space and equipment under long-term operating lease agreements that expire on various dates through July 31, 2007. In conjunction with entering into a lease agreement for its headquarters, the Company signed an unconditional, irrevocable letter of credit with a bank for $100,000, which is secured by the $3.0 million line of credit. Future minimum lease payments under all non-cancelable operating leases as of January 31, 2005 were approximately $2.8 million. In addition to base rent on its facilities lease, many of the operating lease agreements require that the Company pay a proportional share of the respective facilities’ operating expenses.

GUARANTEES AND PRODUCT WARRANTIES

FIN 45, “Guarantor’s Accounting and Disclosure Requirements for Guarantees, Including Indirect Guarantees of Indebtedness of Others,” requires that upon issuance of a guarantee, the guarantor must disclose and recognize a liability for the fair value of the obligation it assumes under that guarantee.

The disclosure requirements of FIN 45 are applicable to the Company’s product warranty liability and certain guarantees issued before December 31, 2002. The Company’s guarantees issued before December 31, 2002, which would have been disclosed in accordance with the disclosure requirements of FIN 45, were not material.

It is the Company’s policy to repair or replace products that have been authorized for repair or replacement by the Company’s customers. The Company maintains a reserve for the estimated costs of such repairs or replacements and adjusts the reserve based on historical sales volumes as well as actual costs incurred. The Company warrants products for a period from 12 to 39 months following the sale of its products.

Activity in the accrued warranty costs during the nine months ended January 31, 2004 and 2005 was as follows (in thousands):

LEGAL PROCEEDINGS

Intellectual Property Litigation

On October 17, 2003, the Company filed a lawsuit against Dot Hill Systems, Inc. (Dot Hill) alleging that Dot Hill has infringed two of the Company’s patents, U.S. Patent No. 5,941,972 (the ’972 Patent) and U.S. Patent No. 6,425,035 (the ‘035 Patent), with some of Dot Hill’s products. Subsequently, Dot Hill filed an answer denying infringement and

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CROSSROADS SYSTEMS, INC. AND SUBSIDIARIES

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

(UNAUDITED)

alleging the ‘972 and ‘035 Patents are invalid and unenforceable. Dot Hill had filed a third-party complaint against FalconStor, Inc. (FalconStor), seeking indemnification for certain of Dot Hill’s products at issue in the litigation. In response, FalconStor had also denied infringement and alleged the ‘972 and ‘035 Patents are invalid and unenforceable. On August 18, 2004, FalconStor and Crossroads settled their claims against one another. The settlement included an upfront license fee from FalconStor to Crossroads and a cross-license of patents between the parties. In the continuing litigation against Dot Hill, Crossroads plans to vigorously defend its patents against all counterclaims.

Securities Class Action Litigation

The Company and several of its officers and directors were named as defendants in several class action lawsuits filed in the United States District Court for the Western District of Texas. The plaintiffs in the actions purport to represent purchasers of the Company’s common stock during various periods ranging from January 25, 2000 through August 24, 2000. On February 24, 2003, the Court entered a final judgment in the defendants’ favor. Plaintiff’s appealed to the United States Court of Appeals for the Fifth Circuit. On April 14, 2004, the Fifth Circuit issued an opinion, which affirmed in part and vacated in part the district court’s ruling. The remaining claims were remanded to the district court. On May 12, 2004, the Fifth Circuit denied plaintiff’s request for panel rehearing. In December 2004, the Company reached an agreement in principle to settle this litigation. The shareholder class will receive a total payment of $4.35 million. Of that amount, the Company’s directors-and-officers insurance carriers agreed to pay $3.35 million and the Company agreed to pay $1.0 million. On February 14, 2005, the Court entered into an order preliminarily approving the settlement, certifying the class for settlement purposes and providing for notice. The Court has set a hearing on the settlement on July 11, 2005. As of January 31, 2005, the Company has accrued $1.0 million related to the proposed settlement of our consolidated securities class action suit. Any changes in threatened or pending litigation could result in revisions to the Company’s estimates of the potential liability and could materially impact the results of operations and financial position.

Other

From time to time, the Company may be involved in litigation relating to claims arising out of its ordinary course of business. Management believes that, other than the matters described above, there are no claims or actions pending or threatened against the Company, the ultimate disposition of which would have a material impact on the Company’s financial position, results of operations or cash flows.

EMPLOYMENT CONTRACTS

The Company has entered into an Employment Agreement with its President and Chief Executive Officer. The CEO is employed on an “at will” basis and may be terminated at any time, with or without cause.

The Company also entered into Severance Benefit Plans with some executive officers. Pursuant to the terms of these plans, to the extent these executive officers are terminated prior to a change of control involving the Company (i) they will receive a cash payment equal to one month of salary for each quarter of service they have provided to the Company, up to a maximum of twelve months salary and (ii) the vesting of all options held by such executive officer will accelerate by a period of one year.

NEXQL COMMITMENT

In December 2003, the Company entered into a strategic agreement with NexQL, a development stage company, in which, among other things, Crossroads agreed to provide a total of up to $2.5 million in debt and equity financing to NexQL. These funding obligations were satisfied in February 2005. One of these agreements granted the Company an exclusive right, but not an obligation, to purchase NexQL. If the Company chooses to exercise this right, the purchase would be subject to various conditions, including the amount and type of consideration. Depending upon the structure of the purchase, one condition could be the need to obtain Crossroads’ stockholder approval. The exclusive right to purchase NexQL will lapse at various times after NexQL completes certain milestones. The Company has agreed in principle to amend the existing agreements with NexQL, subject to the completion and execution of definitive documents. The material terms of the relationship will be:

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CROSSROADS SYSTEMS, INC. AND SUBSIDIARIES

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

(UNAUDITED)

9. NET LOSS PER SHARE

In accordance with SFAS No. 128, “Earnings Per Share,” basic and diluted net loss per share is computed by dividing the loss to common stockholders by the weighted average number of common shares outstanding for the period, less shares subject to repurchase. Diluted loss per share is equivalent to basic loss per share because all common stock equivalents are antidilutive for all periods presented.

Common stock equivalents consist of outstanding stock options. The total number of outstanding stock options excluded from the calculations of diluted net loss per common share was 4,905,571 and 5,109,364 as of January 31, 2004 and 2005, respectively.

10. SUBSEQUENT EVENTS

On February 15, 2005, the Company appointed Valerie H. Savage, 48, as its Interim Chief Financial Officer, to serve pursuant to the terms of a consulting agreement. Ms. Savage will also serve as the Company’s principal financial officer and principal accounting officer.

On February 16, 2005, the Company’s Audit Committee engaged Helin, Donovan, Trubee & Wilkinson, LLP (HDT&W) to serve as its independent public accountants and dismissed the Company’s former independent accountants, KPMG LLP. The change in auditors was effective February 17, 2005. HDT&W will audit the Company’s financial statements for the fiscal year ending October 31, 2005.

On March 10, 2005, the Company’s board of directors approved a restructuring plan to reduce the Company’s workforce by approximately 20 percent throughout the company to streamline operations and re-align resources with the Company’s current strategy in targeted growth areas. The Company will recognize a charge in its second fiscal quarter as a result of this restructuring plan.

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ITEM 2. MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS

This Quarterly Report on Form 10-Q contains forward-looking statements within the meaning of Section 27A of the Securities Act of 1933, as amended, and Section 21E of the Securities Exchange Act of 1934, as amended. All statements other than historical or current facts, including, without limitation, statements about our business strategy, plans and objectives of management and our future prospects, are forward-looking statements. Although we believe that the expectations reflected in such forward-looking statements are reasonable, such forward-looking statements are subject to risks and uncertainties that could cause actual results to differ materially from these expectations. Such risks and uncertainties include, without limitation, the following:

These risks and uncertainties are beyond our control and, in many cases, we cannot predict the risks and uncertainties that could cause our actual results to differ materially from those indicated by the forward-looking statements. When used in this document, the words “believes,” “plans,” “expects,” “anticipates,” “intends,” “continue,” “may,” “will,” “could,” “should,” “future,” “potential,” “estimate,” or the negative of such terms and similar expressions as they relate to us or our management are intended to identify forward-looking statements.

The following discussion should be read in conjunction with, and is qualified in its entirety by, the condensed consolidated financial statements and notes thereto included above in Item 1 of this Quarterly Report and the condensed consolidated financial statements and notes thereto and Management’s Discussion and Analysis of Financial Condition and Results of Operations in our Form 10-K filed with the SEC on January 26, 2005. Historical results and percentage relationships among any amounts in the financial statements are not necessarily indicative of trends in operating results for any future periods.

OVERVIEW

We are a leading provider of enterprise data routing solutions for open system storage area networks, or SANs, based on our market share of storage routers shipped. By using our storage routers to serve as the interconnect between SANs and the other devices in a computer network, organizations are able to more effectively and efficiently store, manage and ensure the integrity and availability of their data. Specifically, when used in SANs our storage routers:

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Our objective is to maintain our position as a leading provider of storage routing solutions while also growing the company with new technologies. Our vision is to bring intelligent, focused solutions to the marketplace that solve specific customer problems in the area of data access, use and storage. By providing special purposed network controllers and network solutions appliances, we believe that we can achieve our vision of delivering solutions that provide “Intelligence At The Edge.” “Intelligence At The Edge” defines our approach to maximizing storage resource understanding, utilization and management through the delivery of value-add software features and functionality between storage devices and the network through specifically purposed devices that reside within the network and have a complete view of the application servers and the storage systems. This vision will require us to transform ourself from a tape device networking interface provider focusing primarily on hardware to a networking solutions company that incorporates software on specifically purposed hardware solutions.

To date, we have sold our products primarily to original equipment manufacturers, or OEMs, of servers and storage systems. These computer equipment manufacturers sell our storage routers to end-user organizations for use in their SANs. We also sell our storage routers through companies that distribute, resell or integrate our storage routers as part of a complete SAN solution.

On a product basis, sales have shifted to our fifth generation of products, the 6000 and 10000, and to our embedded line of products. Additionally, as storage networking continues to mature as an industry, we have seen a trend towards simplification of networking components and management. The impact of this trend on our business has been the push for, and subsequent ramp up of, embedded routers being shipped with tape libraries.

In March 2005, we introduced our StrongBox family of products that deliver a set of intelligent appliances designed to operate together supporting enterprise-wide auditing, security, and analysis as well as performance monitoring, with no impact on network or application performance. To date, we have appliances installed for evaluation purposes only. At the present time, we are considering multiple options to distribute these appliances including through distributors, through sales integrators and direct sales under a subscription-based model.

Our financial results depend on our ability and the ability of our OEM partners to predict and to respond to industry-wide trends. While the quantity of online data continues to grow, the price of storage and storage networking hardware continues to decline. Data growth is outpacing information technology, or IT, spending growth. Companies are migrating towards modular, scalable systems rather than large, fixed frame systems. Companies are looking for storage systems with data management, software to help simplify data storage and reduce the total cost of ownership. Due to these changes, we believe the basic protocol to protocol conversion bridge business on which our historical operations are based is declining due to:

With this challenge in mind, we began focusing on an “Intelligence At The Edge” strategy in early 2004. This strategy is designed to translate our technology leadership in fibre channel to SCSI (FC-SCSI) connectivity and expand it by developing solutions targeted at the fibre channel to SAN (FC-SAN), internet protocol to SAN (IP-SAN), and local area network (LAN) environments.

Another trend significant to our business and financial results is the decline of our business through our distribution channel. We recognize that bridge products have a short life cycle. Eventually, the technology will either adopt the bridge into its central solution, which we are seeing in our OEM opportunities, or the technology will evolve such that the bridging function is no longer required. We are approaching the end of the bridging product life cycle. As such, we have sought to offset the impact of this waning revenue stream by transforming the basic bridge into a storage controller for tape much like a disk/RAID controller does for disk.

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Our reliance on OEMs, as opposed to sales through distributors or VARs, poses a challenge in visibility for revenue growth as we are subject to their product delivery schedules. This limited visibility is the primary reason it was important to restructure our storage business. In March 2005, our board of directors approved a restructuring plan to reduce its workforce by approximately 20 percent, or 23 people throughout the company, to scale down our infrastructure and to reduce the size of our storage segment’s operations. We will recognize a charge in the second fiscal quarter as a result of this restructuring plan.

CRITICAL ACCOUNTING POLICIES AND ESTIMATES

Management’s Discussion and Analysis of Financial Condition and Results of Operations is based upon our condensed consolidated financial statements, which have been prepared in accordance with accounting principles generally accepted in the United States. The preparation of these financial statements requires management to make estimates and judgments that affect the reported amounts of assets, liabilities, revenue and expenses, and related disclosure of contingent assets and liabilities. On an ongoing basis, we evaluate our estimates, including those related to revenue recognition, deferred taxes, investment in privately-held company and consolidation, warranty obligations, excess and obsolete inventories, allowance for doubtful accounts, facility lease abandonment losses associated with our restructuring, valuation of intangibles and litigation. We base our estimates on historical experience and on various other assumptions that are believed to be reasonable under the circumstances, the results of which form the basis for making judgments about the carrying values of assets and liabilities that are not readily apparent from other sources. Actual results may differ from these estimates under different assumptions or conditions.

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

Revenue recognition. With respect to sales of our products to OEMs, we recognize product revenue when persuasive evidence of an arrangement exists, delivery has occurred, the price is fixed or determinable, collectibility is probable and risk of loss has passed to the OEM. Product sales to distributors, VARs and system integrators who do not have return rights are recognized upon shipment. To the extent that we sell products to distributors, VARs and system integrators that have rights of return, we defer revenue and the related cost of revenue associated with such sales and recognize these amounts when that customer sells our products to its customers. Judgments and estimates must be made and used in connection with the revenue recognized in any given accounting period. Material differences may result in the amount and timing of our revenue, in any given accounting period, if our management alters the method by which they derive such judgments or estimates.

Royalty and other revenue includes licensing of intellectual property (IP), royalty payments and sales of service contracts. IP licensing arrangements typically consist of upfront nonrefundable fees, including payments related to past sales of licensed products or payments related to a paid-up license in which the licensee makes a single payment for a lifetime patent license. Once a license agreement is signed, delivery of the license has occurred and there are no remaining obligations outstanding, we record revenue from upfront nonrefundable IP license fees. License

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arrangements can also include a royalty stream that is recognized quarterly based on reports from the licensee. Revenue from royalty payments from HP is recognized monthly based on reports from HP and quarterly from other IP licensees. Service revenue is recognized ratably over the service period.

Deferred taxes. In preparing our financial statements, we are required to estimate our income tax obligations. This process involves estimating our actual tax exposure together with assessing temporary differences resulting from differing treatment of items for tax and accounting purposes. These differences result in deferred tax assets and liabilities, which are included within our balance sheet. We must then assess the likelihood that our deferred tax assets will be recovered from future taxable income and, to the extent we believe that recovery is not likely, we must establish a valuation allowance. If we change this valuation allowance in a period, we must include an expense or benefit within the tax provision in our statement of operations.

Judgment is required in determining our deferred tax assets and liabilities and our valuation allowance recorded against our net deferred tax assets. In assessing the potential realization of deferred tax assets, we consider whether it is more likely than not that some portion or all of the deferred tax assets will be realized. The ultimate realization of deferred tax assets is dependent upon us attaining future taxable income during the period in which our deferred tax assets are recoverable. Due to uncertainty surrounding our ability to generate taxable income in the future, we have determined that it is more likely than not that we will not be able to utilize any of the benefits of our deferred tax assets, including net operating loss carry forwards, before they expire. Therefore, we have provided a 100% valuation allowance on our deferred tax assets, and our net deferred tax assets as of January 31, 2005 is zero.

Investment in privately-held company and consolidation. We assess the impairment of investments whenever events or changes in circumstances indicate that the carrying value may not be recoverable. Factors considered important which could trigger an impairment review include: (i) inherent risk of investment due to stage of development, (ii) underperformance relative to projected future operating results, and (iii) changes in the strategy of business. When we determine that the carrying value of an investment may not be recoverable, an impairment charge is recorded.

As of January 31, 2005, we had a minority equity interest in NexQL of approximately 25% and we held one of four of NexQL’s board of director seats. Currently, NexQL has a negative equity position. If we are required to consolidate our financial results with NexQL in the future, any additional losses will impact our consolidated statement of operations. The factors used to determine how we will account for our interest in NexQL in the future makes it difficult for us to assess the impact of NexQL on our financial results in future periods.

Warranty obligations. We provide for the estimated cost of product warranties at the time revenue is recognized. These estimates are developed based on historical information. While we engage in extensive product quality programs and processes, including actively monitoring and evaluating the quality of our component suppliers, our warranty obligation is affected by product failure rates, material usage and service delivery costs incurred in correcting a product failure. Should actual product failure rates, material usage or service delivery costs differ from our estimates, revisions to the estimated warranty liability would be required.

Excess and obsolete inventory. We write-down our inventory for estimated obsolescence or unmarketable inventory based on the difference between the cost of inventory and the estimated market value derived by assumptions about future demand and market conditions. If actual demand and/or market conditions are less favorable than those projected by management, additional inventory write-downs may be required.

Allowance for doubtful accounts. We assess the collectibility of outstanding customer invoices and in doing such, we maintain an allowance for estimated losses resulting from the non-collection of customer receivables. In estimating this allowance, we consider factors such as:

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Actual customer collections could differ from our estimates. For example, 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.

Facility lease abandonment losses. We vacated excess leased facilities as a result of the restructuring plan we completed during fiscal 2002. We estimated costs of vacating these leased facilities, including estimated costs to sublease, based on market information and trend analysis. Any sublease payments received by us are recorded as a reduction to this accrual based on the specified sublease terms. Actual results may differ from these estimates in the near term, and such differences could be material to our financial statements.

Valuation of purchased intangible assets. We record intangible assets when we acquire companies. The cost of the acquisition is allocated to the assets and liabilities acquired, including identifiable intangible assets, with the remaining amount being classified as goodwill, if applicable. Identifiable intangible assets are amortized over time, while in-process research and development is recorded as a charge on the date of acquisition and goodwill is capitalized, subject to periodic review for impairment. The allocation of the acquisition cost to identifiable intangible assets requires extensive use of estimates and assumptions, including estimates of future cash flows expected to be generated by the acquired assets. Should conditions be different than management’s current assessment, material write-downs of the fair value of intangible assets may be required. We periodically review the estimated remaining useful lives of our intangible assets. A reduction in the estimate of remaining useful life could result in accelerated amortization expense or a write-down in future periods. As such, any future write-downs of the assets would adversely affect our gross and operating margins.

Litigation. We evaluate contingent liabilities, including pending or threatened litigation in accordance with SFAS No. 5, “Accounting for Contingencies” and record accruals when the outcome of these matters is deemed probable and the liability is reasonably estimable. We make these assessments based upon the facts and circumstances, and in some instances based in part upon the advice of outside legal counsel. As of January 31, 2005, we have accrued $1.0 million related to the proposed settlement of our consolidated securities class action suit. Any changes in threatened or pending litigation could result in revisions to our estimates of the potential liability and could materially impact our results of operations and financial position.

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RESULTS OF OPERATIONS

Our net loss for the three months ended January 31, 2004 and 2005 were $1.0 million and $3.0 million, respectively. Both a decrease in sales to EMC and our investment in NexQL had a significant impact on our current net loss. Compared to the three months ended January 31, 2004, sales to EMC decreased approximately $1.0 million during the three months ended January 31, 2005. Net operating expenses and net loss attributable to NexQL for the three months ended January 31, 2004 and 2005 were approximately $0.3 million and $0.7 million, respectively.

The following table sets forth, for the periods indicated, a year-over-year comparison of the key components of our revenue, costs of revenue and gross profit:

TOTAL REVENUE

Total revenue consists of product revenue and royalty revenue. Compared to the three months ended January 31, 2004, current royalty and other revenue remained relatively flat; however, product revenue decreased approximately 49%.

A significant portion of our revenue is concentrated among a limited number of OEM customers. For the three months ended January 31, 2005, two customers represented 54.7% and 31.3%, respectively, of total revenue for a combined total of 86% of total revenue. We expect that a significant portion of our future revenue will continue to come from sales of products to a limited number of customers. Therefore, the loss of, or a decrease in the level of sales to, any one of these customers could seriously harm our financial condition and results of operations.

Product Revenue

Product revenue consists of sales of our storage router and ServerAttach lines of products. Our product revenue is primarily generated from sales to our OEM partners who then sell our products to end-user customers. During the three months ended January 31, 2005, the decrease in product revenue is primarily due to a significant reduction in revenue from our OEM customers due to what we believe is a shift in the industry toward more comprehensive storage solutions. During fiscal 2004, we experienced a decrease in product revenue as a result of our transition to a royalty model for embedded products with HP. We do not anticipate that product revenue will increase until we are able to introduce new solutions to our OEMs and gain market acceptance of our new StrongBox family of products.

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Royalty and Other Revenue

Royalty and other revenue consists of revenue from the licensing of IP, royalty payments from HP and sales of service contracts. IP licensing arrangements typically consist of upfront nonrefundable fees. These fees are collected as consideration for either past or future sales of licensee products. When a license agreement is signed, delivery of the license has occurred and there are no remaining obligations outstanding, we record revenue from upfront nonrefundable IP licensing arrangements. License arrangements can also include a royalty stream that is recognized quarterly based on reports from the licensee. Revenue from royalty payments from HP is recognized monthly based on reports from HP and quarterly from other IP licensees. Service revenue is recognized ratably over the service period.

Royalty and other revenue for the three months ended January 31, 2005 remained relatively flat as compared to the comparable period in fiscal 2004 as we did not generate additional license revenue or release any new royalty based products with HP. We are currently collaborating with HP to develop and release new royalty based products in the latter half of fiscal 2005.

Given the nature of patent license agreements, the timing of license revenue is difficult to forecast and therefore is expected to cause fluctuations in royalty and other revenue. Our potential to generate patent license revenue in the future will be largely dependent upon our ability to identify and successfully pursue additional, potential licensees.

Gross Profit

Gross profit is total revenue less total cost of revenue. Total gross profit was 65% for the three months ended January 31, 2004 and 2005. Total gross profit decreased for the three months ended January 31, 2005 as compared to the same period in fiscal 2004 due to lower product revenue. Gross profit percentage was the same for both periods as a result of product mix, including the positive effect of royalty revenue, and the absence of license revenue in both periods.

Cost of product revenue consists primarily of contract manufacturing costs, material costs, manufacturing overhead, third party software licenses, warranty costs and stock-based compensation. Cost of product revenue decreased 35% for the three months ended January 31, 2005 as compared to the comparable period in fiscal 2004. The decrease in cost of product revenue was attributable to decreases in demand from our OEMs. We expect cost of product revenue to fluctuate based on the introduction of new products, changes in product mix and other fluctuations in the components of cost of product revenue.

We expect to introduce new products throughout fiscal 2005. As new or enhanced products are introduced, we must successfully manage the transition from older products to avoid excessive levels of older product inventories, and ensure that sufficient supplies of new products can be delivered to meet customer demands. Our revenue and gross profit margin will be adversely affected if we fail to successfully manage the introductions of these new products.

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OPERATING EXPENSES

Sales and Marketing Expenses

Sales and marketing expenses consist primarily of salaries, commissions, travel, tradeshow and advertising programs, other promotional activities and stock-based compensation expenses. The following table sets forth, for the periods indicated, a year-over-year comparison of the key components of our sales and marketing expenses:

Sales and marketing expenses decreased during the three months ended January 31, 2005, as compared to the same period in fiscal 2004, primarily due to decreased compensation expense resulting from a smaller sales force. During the three months ended January 31, 2005, we retained sales personnel necessary to support our product strategy in fiscal 2005. Although we decreased expenses with our March 2005 restructuring, we anticipate that sales and marketing expenses may increase as we plan to launch new products during fiscal 2005.

As a result of consolidation of NexQL’s results, we also absorbed approximately $40,000 of NexQL sales and marketing expenses for the three months ended January 31, 2005, primarily for compensation and tradeshow related costs. If NexQL’s results continue to be consolidated, we anticipate that sales and marketing expenses related to NexQL would increase in the future with further product introduction and development.

Research and Development Expenses

Research and development expenses consist primarily of salaries and other personnel-related costs, product development costs and stock-based compensation expenses. The following sets forth, for the periods indicated, a year-over-year comparison of the key components of our research and development expenses:

Research and development expenses increased for the three months ended January 31, 2005, as compared to the same period in fiscal 2004, due to increased compensation expense to support the development and testing of new products to be introduced in fiscal 2005. Although we decreased expenses with our March 2005 restructuring, we anticipate that research and development expenses may increase as we continue the development of our StrongBox family of products and expand our product offerings during fiscal 2005.

As a result of consolidation of NexQL’s results, we also absorbed approximately $0.6 million of NexQL research and development expenses for the three months ended January 31, 2005, primarily for compensation and prototype related costs. If NexQL’s results continue to be consolidated, we anticipate that research and development costs related to NexQL would increase as they continue to progress through various product development stages.

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General and Administrative Expenses

General and administrative expenses consist primarily of salaries and other personnel-related costs, costs of our administrative, executive and information technology departments, as well as legal and accounting, insurance and stock-based compensation expenses. The following table sets forth, for the periods indicated, a year-over-year comparison of the key components of our general and administrative expenses:

The decrease in general and administrative expenses for the three months ended January 31, 2005, as compared to the same period in fiscal 2004, was primarily due to a decrease in professional fees. We anticipate that general and administrative expenses may decrease throughout the remainder of fiscal 2005 as we have outsourced our human resources activities, restructured our workforce and changed our auditors in an effort to reduce general and administrative costs.

As a result of consolidation of NexQL’s results, we also absorbed approximately $32,000 of NexQL general and administrative expenses for the three months ended January 31, 2005, primarily for compensation, legal and insurance related costs. If NexQL’s results continue to be consolidated, we anticipate that general and administrative costs related to NexQL would increase as the development company continues to mature.

NexQL

During the first fiscal quarter of 2004, we entered into a strategic relationship with NexQL, a privately-held development stage company. Pursuant to certain agreements with NexQL, we have invested $1.0 million to purchase NexQL common stock and have provided NexQL with an additional $1.5 million under a loan facility. Through January 31, 2005 we have loaned NexQL approximately $1.2 million. We also have an exclusive right, but not an obligation, to purchase NexQL. If we choose to exercise this right, the purchase would be subject to various conditions, including the amount and type of consideration. Depending upon the structure of the purchase, one condition could be the need for us to obtain stockholder approval. The exclusive right to purchase NexQL will lapse at various times after NexQL completes certain milestones.

We have agreed in principle to amend the existing agreements with NexQL, subject to the completion and execution of definitive documents. The material terms of the relationship will be:

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In connection with the adoption of the Revised Interpretations of FIN 46 (FIN 46R), we concluded that NexQL is a VIE and that we are the primary beneficiary. Under FIN 46R transition rules, the operating results of NexQL were accounted for on the equity method for the three months ended January 31, 2004 and the six months ended April 30, 2004. The Company consolidated the statements of operations and cash flows of NexQL beginning May 1, 2004, the beginning of our third fiscal quarter of 2004.

Crossroads did not record any amounts as revenue related to NexQL for the three months ended January 31, 2004 or 2005. Net operating expenses and net loss attributable to NexQL for the three months ended January 31, 2004 and 2005 were approximately $0.3 million and $0.7 million, respectively. Our overall results were significantly impacted as a result of our investment in NexQL and adoption of FIN 46R. NexQL entered into a Master Reseller Agreement on January 30, 2004 with a reseller in Europe. Subject to the terms of the reseller agreement, NexQL has assigned specific customer accounts exclusively to the reseller for an initial fee of $50,000. In August 2004, NexQL delivered product simulators to the reseller and has collected $950,000 for the simulators and $50,000 for the reseller agreement. Crossroads will recognize revenue when persuasive evidence of an arrangement exists, delivery has occurred, the fee is fixed or determinable and collection is probable. SEC Staff Accounting Bulletin No. 104, -”Revenue Recognition” requires us to be able to estimate returns and warranty expenses prior to recognizing revenue. Since NexQL has no history selling their products, we are not able to estimate returns and warranty expense. Revenue from sales of products prior to the time we are able to estimate returns and warranty expense will be deferred. As of January 31, 2005 we continued to defer the entire $1.0 million.

In accordance with the equity method, as described above, we monitored our investment in NexQL for impairment during the first two quarters of fiscal 2004 and made appropriate reductions in its carrying value and recorded an impairment charge based on the financial condition and near-term prospects of NexQL. These impairment charges are included in the caption, NexQL research and development, in the consolidated statement of operations. The impairment charge, including our percentage of losses on our investment in NexQL, was approximately $0.3 million for the three months ended January 31, 2004. Our investment in NexQL has inherent risk as the markets for the technologies or products of NexQL are in the early stages of development and may never materialize. Effective April 30, 2004, we began consolidating NexQL in accordance with FIN 46R and as a result potential additional losses from NexQL have and may continue to impact our consolidated statement of operations, which could cause substantial fluctuations in our financial results.

Business Restructuring Expenses and Asset Impairment

In May 2002, we completed a restructuring plan that reduced our workforce by approximately 25%, or 40 people (primarily in the sales, marketing and general and administrative areas), to scale down our infrastructure and to consolidate our operations.

Components of business restructuring expenses and the remaining restructuring accruals as of January 31, 2005 are as follows (in thousands):

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In March 2003, we entered into an agreement to sublease a portion of our abandoned facilities. The anticipated rent payments from this sublease are approximately $0.5 million through January 2006. In addition, we signed another agreement to sublease a portion of our abandoned facilities during the third fiscal quarter of 2003. The anticipated rent payments from this sublease are approximately $0.1 million through January 2006.

In total, we reduced our restructuring accrual by approximately $0.2 million during the three months ended January 31, 2005, principally for rent payments to be received over the next twelve months of both sublease terms. As we entered into the last twelve months of these subleases, we will no longer reduce the restructuring accrual for rent payments to be received, though we continue to assess recoverability of these sublease payments on a quarterly basis.

In March, 2005, we announced plans to further restructure our organization by reducing our workforce 23 employees, or approximately 20%. As this restructuring occurred following our first fiscal quarter, the financial impact of this latest restructuring effort is not represented in this Quarterly Report as the details will be discussed more fully in our quarterly report for the second fiscal quarter of 2005.

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LIQUIDITY AND CAPITAL RESOURCES

The following table presents selected financial statistics and information related to our liquidity and capital resources (dollars in thousands):

Our principal sources of liquidity at January 31, 2005 consisted of $9.4 million in cash and cash equivalents and $16.2 million in short-term investments.

In June 2004, we renewed our line of credit with Silicon Valley Bank. The committed revolving line is an advance of up to $3.0 million with a borrowing base of 80% of eligible accounts receivable. The line of credit contains provisions that prohibit the payment of cash dividends and require the maintenance of specified levels of tangible net worth and certain financial performance covenants measured on a monthly basis. The line of credit matures in June 2005. As of January 31, 2005, there were no borrowings outstanding under the revolving line of credit and no term loans outstanding.

Cash utilized by operating activities for the three months ended January 31, 2005 was approximately $2.7 million. This utilization of cash for operating activities is primarily due to decreased product revenue and additional funding provided to NexQL. During the three months ended January 31, 2005, we funded NexQL approximately $0.9 million and our product gross margin decreased 63%, or approximately $1.6 million, as compared with the comparable period in fiscal 2004.

Cash utilized by investing activities was approximately $2.0 million during the three months ended January 31, 2005, primarily due to the timing of short-term investment transactions and the maturity of held-to-maturity investments, net of purchases. Our investment policy related to debt instruments places greater emphasis on the safeguarding of cash and requires investment in high quality short-term securities. Capital expenditures were approximately $0.4 million and reflect our investments in computer equipment, software, test equipment, software development tools and leasehold improvements, all of which were required to support the ongoing research and development in our technologies and expansion of our product offerings. We anticipate additional capital expenditures during the remainder of fiscal 2005, primarily to support our ongoing product development efforts.

Cash provided by financing activities was approximately $0.1 million for the three months ended January 31, 2005 as a result of approximately $0.2 million in stock option exercises less the decrease in our book overdrafts of approximately $0.1 million, due to the timing of vendor payments.

We have funded our operations to date primarily through product sales, sales of preferred stock and our initial public offering, resulting in aggregate gross proceeds to us of $98.2 million.

As of January 31, 2005, we had no long-term debt. We believe our existing cash and short-term investment balances and our credit facilities will be sufficient to meet our capital requirements beyond the next 12 months. However, we could be required or could elect to seek additional funding prior to that time. Our future capital requirements will depend on many factors, including the rate of revenue growth, the timing and extent of spending to support product development efforts, acquisition of companies, products or technologies, the timing of introductions of new products and enhancements to existing products, the amount of cash used to fund our stock repurchase program, and market acceptance of our products. In fiscal 2004, we entered into a technology development agreement with NexQL Corporation for the joint development of advanced data management solutions. During the term of this and other strategic agreements, we provided debt and equity funding of approximately $2.5 million to

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NexQL, and have agreed in principle to extend up to an additional $2.0 million in secured, convertible debt funding. In total, we have funded $2.5 million to NexQL as of the date of this Quarterly Report. Additionally, we may enter into additional strategic arrangements or acquisitions in the future that could require us to seek additional equity or debt financing. We cannot assure that additional equity or debt financing, if required, will be available to us on acceptable terms, or at all.

CONTRACTUAL CASH OBLIGATIONS AND COMMITMENTS

We lease office space and equipment under long-term operating lease agreements that expire on various dates through July 2007.

In April 2000, we relocated our headquarters in accordance with an agreement to lease approximately 63,500 square feet of administrative office space in Austin, Texas. During fiscal 2004, we renegotiated the terms of our lease to relinquish approximately 4,700 square feet of office space. The term of the lease agreement is approximately six years, from April 1, 2000 through April 15, 2006, and represents a lease commitment of approximately $1.8 million per year through the lease term. In conjunction with entering into the lease agreement, we signed an unconditional, irrevocable letter of credit with a bank for $100,000, which is secured by a $3.0 million line of credit.

Our final assembly and test facility of approximately 15,550 square feet also is located in Austin, Texas. The lease agreement on this facility expires in April 2006.

Pursuant to the terms of our acquisition of Teracruz, Inc. assets on October 29, 2004, we assumed a lease of approximately 3,919 square feet in Huntsville, Alabama that expires in July 2007. This facility is currently being used for engineering purposes.

The following summarizes our contractual cash obligations as of January 31, 2005 (in thousands):

RECENT ACCOUNTING PRONOUNCEMENTS

In December 2004, FASB issued Statement No. 123 (R), Share-Based Payment, which establishes accounting standards for transactions in which an entity receives employee services in exchange for (a) equity instruments of the entity or (b) liabilities that are based on the fair value of the entity’s equity instruments or that may be settled by the issuance of equity instruments. Effective in the fourth quarter of 2005, SFAS 123(R) will require us to recognize the grant-date fair value of stock options and equity based compensation issued to employees in the statement of operations. The statement also requires that such transactions be accounted for using the fair –value-based method, thereby eliminating use of the intrinsic value method of accounting in APB No. 25, Accounting for Stock Issued to Employees, which was permitted under Statement 123, as originally issued. We currently are evaluating the impact of Statement 123 (R) on our financial condition and results of operations.

In November 2004, the FASB issued Statement No. 151, Inventory Costs, to amend the guidance in Chapter 4, Inventory Pricing, of FASB Accounting Research Bulletin No. 43, Restatement and Revision of Accounting Research Bulletins, which will become effective for the Company in fiscal year 2006. Statement 151 clarifies the accounting

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for abnormal amounts of idle facility expense, freight, handling costs, and wasted material (spoilage). The Statement requires that those items be recognized as current-period charges. Additionally, Statement 151 requires that allocation of fixed production overhead to the costs of conversion be based on the normal capacity of the production facilities. We do not currently believe that Statement 151 will have a significant impact on our financial condition and results of operations.

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ADDITIONAL FACTORS THAT MAY AFFECT FUTURE RESULTS

In addition to the other information in this Quarterly Report on Form 10-Q, the following factors should be considered in evaluating Crossroads and our business. These factors include, but are not limited to the factors listed below. Additional risks and uncertainties that we are unaware of or that we currently deem immaterial also may become important factors that affect us. This document is qualified in its entirety by these risk factors.

If any of the following risks actually occur, they could materially harm our business, financial condition or results of operations. In that case, the market price of our common stock could decline.

We have incurred significant losses and negative cash flow, we expect future losses and we may never be profitable or maintain a consistent positive cash flow position.

We have incurred significant losses in every fiscal quarter since fiscal 1996 and expect to continue to incur losses in the future. As of January 31, 2005, we had an accumulated deficit of $156.9 million. We cannot be certain that we will be able to generate sufficient revenue to achieve profitability or become consistently cash flow positive. Although we restructured our organization in 2002, to significantly reduce our expense structure, we still expect to incur significant sales and marketing, research and development and general and administrative expenses and, as a result, we expect to continue to incur losses. We expect fluctuations in our cash flow position to continue in future quarters throughout fiscal 2005.

We have experienced and expect to continue to experience significant period-to-period fluctuations in our revenue and operating results, which makes our financial results difficult to predict and may result in volatility in our stock price.

We have experienced and expect to continue to experience significant period-to-period fluctuations in our revenue and operating results due to a number of factors, and any such variations and factors may cause our stock price to fluctuate. Accordingly, you should not rely on the results of any past quarterly or annual periods as an indication of our future performance. It is likely that in some future period our operating results will be below the expectations of public market analysts or investors. If this occurs, our stock price may drop, perhaps significantly.

Factors, some of which are beyond our control, could cause our quarterly results to fluctuate, including:

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In addition, potential and existing OEM customers often place initial orders for our products for purposes of qualification and testing. As a result, we may report an increase in sales or a commencement of sales of a product in a quarter that will not be followed by similar sales in subsequent quarters as OEMs conduct qualification and testing. This order pattern could lead to fluctuations in quarterly revenue and gross profits.

We are introducing a new family of products that represents a fundamental shift in our strategic direction which entails significant risk. If we are unable to successfully develop these new products, if these new markets fail to develop to the extent and as quickly as we expect, or if we are not successful in this strategic shift, our business will be materially and adversely affected.

We have recently announced our “Intelligence At The Edge” approach to maximizing storage resource understanding, utilization and management through the delivery of new features and functionality between storage devices and the network. The result of this new approach is our Network Solution Appliance Family of products which we plan to introduce in fiscal 2005. This new approach entails significant risks, such as new markets and new competition, and represents a fundamental shift in our business. If we are not successful in implementing this new strategy, our business will be materially and adversely affected.

We believe that our new Network Solution Appliance Family of products may require a distribution model significantly different from our traditional OEM and distribution channel business, and we may not be successful in the execution of this new strategy, including hiring a sales team to support a direct sales model.

Historically, our storage routing business has relied upon key OEM and distribution channels, and, as such, we have had limited direct contact with the end users of our products. We believe that our new Network Solution Appliance family of products will require, provide an opportunity for, direct interface with the end user, in addition to continuing to leverage our existing and new OEM relationships and channel partners. We are unable to determine the exact mix of direct sales versus indirect sales (through OEM and distribution channels), and we currently do not have a direct sales force. We believe that the hiring and training of a direct sales team will be critical to the success of this family of products in the marketplace we have limited experience in this area. If we are not successful in defining and executing the appropriate distribution model for this family of products, or in hiring and training a direct sales team that can execute our strategy, the future prospects for our business will be materially and adversely affected.

We believe the protocol-to-protocol conversion bridge business, the basis of our current products, is declining.

We believe our current business, the protocol to protocol conversion bridge business, is challenged and declining due to:

The protocol-to-protocol conversion bridge business is the basis for our current business and our current products. If this business is unable to overcome these challenges, revenue from sales of our current products may be stagnant or decrease. Due to our belief that our current business model is challenged, we are attempting to transform ourselves into a networking solutions company. If we are unable to successfully complete this transformation, our business will be materially and adversely affected.

Global economic conditions may continue to negatively impact us and the price of our common stock.

The macroeconomic environment and capital spending on information technology in the past three fiscal years resulted in continued uncertainty in our revenue expectations. The operating results of our business depend on the overall demand for storage area network products. Because our sales are primarily to major OEM customers whose businesses fluctuate with general economic and business conditions, continued soft demand for storage area network products caused by budgetary constraints has resulted in decreased revenue. We may be especially prone to this as a

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result of the relatively high percentage of revenue we have historically derived from the high-tech industry, which has been more adversely impacted by the economic environment. In particular, continuing economic uncertainty has resulted in a general reduction in information technology spending. This reduction in information technology spending has helped lead to a decline in our growth rates compared to historical trends. Customers may continue to defer or reconsider purchasing products if they continue to experience a lack of growth in their business or if the general economy fails to significantly improve, resulting in a continued decrease in our product revenue.

The storage technology market is characterized by rapid technological evolution, and our success depends on our ability to develop new products.

The market for our products is characterized by rapidly changing technology and evolving industry standards and is highly competitive with respect to timely innovation. The introduction of new products embodying new or alternative technology or the emergence of new industry standards could render our existing products obsolete or unmarketable. Our future success will depend in part on our ability to anticipate changes in technology, to gain access to such technology for incorporation into our products and to develop new and enhanced products on a timely and cost-effective basis. Risks inherent in the development and introduction of new products include:

We have also entered into a strategic relationship with NexQL for the joint development of advanced data management solutions. This relationship may not result in additional products that obtain market acceptance.

In addition, we must be able to maintain the compatibility of our products with future device technologies, and we must rely on producers of new device technologies to achieve and sustain market acceptance of those technologies. Development schedules for high-technology products are subject to uncertainty, and we may not meet our product development schedules. If we are unable, for technological or other reasons, to develop products in a timely manner or if the products or product enhancements that we develop do not achieve market acceptance, our business will be harmed.

Failure to manage our business effectively could seriously harm our business, financial condition and prospects.

Our ability to successfully implement our business plan, develop and offer products, and manage our business in a rapidly evolving market requires a comprehensive and effective planning and management process. We continue to change the scope of our operations, including managing our headcount appropriately. Changes in our business, headcount, organizational structure and relationships with customers and other third parties has placed, and will continue to place, a significant strain on our management systems and resources. Our failure to continue to improve upon our operational, managerial and financial controls, reporting systems, and internal control procedures, and our failure to continue to train and manage our work force, could seriously harm our business and financial results.

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An adverse decision in the various securities class action lawsuits filed against us may have a material adverse effect on our business and financial performance.

We, and several of our officers and directors, were named as defendants in several class action lawsuits filed in the United States District Court for the Western District of Texas. The plaintiffs in the actions purport to represent purchasers of our common stock during various periods ranging from January 25, 2000 through August 24, 2000. On February 24, 2003, the Court entered a final judgment in the defendant’s favor. Plaintiff’s appealed to the United States Court of Appeals for the Fifth Circuit. On April 14, 2004, the Fifth Circuit issued an opinion, which affirmed in part and vacated in part the district court’s ruling. The remaining claims were remanded to the district court. On May 12, 2004, the Fifth Circuit denied plaintiff’s request for panel rehearing. In December 2004, we reached an agreement in principle to settle this litigation. The shareholder class will receive a total payment of $4.35 million. Of that amount, our directors-and-officers insurance carriers agreed to pay $3.35 million and we agreed to pay $1.0 million. On February 14, 2005, the Court entered an order preliminarily approving the settlement, certifying the class for settlement purposes and providing for notice to class members. The Court has set a hearing on the settlement on July 11, 2005.

Our business is dependent on the storage area network market, which is unpredictable, and if this market does not expand as we anticipate, our business will suffer.

Substantially all of our current and many of our proposed future products are used exclusively in SANs and, therefore, our business is dependent on the SAN market. Accordingly, the widespread adoption of SANs for use in organizations’ computing systems is critical to our future success. Most of the organizations that would be likely to purchase our products have invested substantial resources in their existing computing and data storage systems and, as a result, may be reluctant or slow to adopt a new approach like SANs, particularly in the current economic environment. SANs are often implemented in connection with the deployment of new storage systems and servers. Therefore, our future success is also substantially dependent on the market for new storage systems and servers. Furthermore, the ability of the different components used in a SAN to function effectively, or interoperate, with each other when placed in a computing system has not yet been achieved on a widespread basis. Until greater interoperability is achieved, customers may be reluctant to deploy SANs. Our success in generating revenue in the emerging SAN market will depend on, among other things, our ability to:

We have limited product offerings and our success depends on our ability to develop in a timely manner new and enhanced products that achieve market acceptance.

We currently have a limited number of products that we sell in commercial quantities. Our future growth and competitiveness will depend greatly on the market acceptance of our product lines, including the storage routers and the ServerAttach line of products. We have received revenue from the sale of our storage routers and ServerAttach lines of products; however, the market acceptance of our ServerAttach line of products sold through the channel remains uncertain. If the ServerAttach line of products does not achieve sufficient market acceptance, our future growth prospects could be seriously harmed. Moreover, even if we are able to develop and commercially introduce new products and enhancements, these new products or enhancements may not achieve market acceptance.

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Factors that may affect the market acceptance of our products, some of which are beyond our control, include the following:

We depend on a limited number of customers for the vast majority of our revenue. The loss of or significant reduction in orders from any key customers would significantly reduce our revenue and would substantially harm our future results of operations.

In fiscal 2003, 2004, and the three months ended January 31, 2005, 75%, 84% and 86% of our total revenues, respectively, were derived from OEM customers with more than ten percent of our total sales. In fiscal 2004, HP, StorageTek and EMC represented 48%, 21% and 15% of our total revenue, respectively. Although we added EMC to our list of significant OEM customers for fiscal 2004, our operating results now and in the foreseeable future will continue to depend on sales to a limited number of OEM customers. Therefore, the loss of any of our key OEM customers, or a significant reduction in sales to any one of them, would significantly reduce our revenue.

Our OEM customers require our products to undergo a lengthy and expensive qualification process that does not assure product sales.

Prior to offering our products for sale, our OEM customers require that each of our products undergo an extensive qualification process, which involves interoperability testing of our product in the OEM’s system as well as rigorous reliability testing. This qualification process may continue for a year or longer. However, qualification of a product by an OEM does not assure any sales of the product to the OEM. Despite this uncertainty, we devote substantial resources, including sales, marketing and management efforts, toward qualifying our products with OEMs in anticipation of future sales opportunities. If we are unsuccessful or delayed in qualifying any products with an OEM, such failure or delay would preclude or delay sales of that product to the OEM, which may impede our ability to grow our business.

Demand for our current products depends significantly upon the need to interconnect small computer system interface (SCSI) tape storage systems with Fibre Channel SANs, and we expect to face competition from manufacturers of tape storage systems that incorporate Fibre Channel interfaces into their products.

In traditional computer networks, system backup is accomplished by transferring data from applications and databases over the servers used in the network to tape drives or other media where the data is safely stored. Tape storage devices generally rely on a SCSI connection to interface with the network in receiving and transmitting data. Our routers enable these SCSI-based storage devices to interface with the Fibre Channel-based components of the SAN. Because our routers allow communication between SCSI storage devices and a Fibre Channel SAN, organizations are able to affect their backup processes over the SAN rather than through the computer network, enabling the servers of the network to remain available for other computing purposes. We currently derive the majority of our revenue from sales of storage routers that are used to connect SCSI-based tape storage systems with SANs. The introduction of tape storage systems that incorporate Fibre Channel interfaces would enable tape storage devices to communicate directly with SANs, without using storage routers. We are aware that a number of manufacturers of storage systems, including several of our current customers, are developing tape storage systems with embedded Fibre Channel interfaces, with products expected to be introduced to market in the near future. If these or other manufacturers are successful in introducing Fibre Channel-based storage systems, demand for our current storage router products would be materially reduced and our revenue would decline.

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Our research and development efforts are focused on utilizing emerging technologies and standards and any delay or abandonment of efforts to develop these technologies or standards, by industry participants, or failure of these technologies or standards to achieve market acceptance, could compromise our competitive position.

Our products are intended to complement other SAN products to improve the performance of computer networks by addressing the input/output bottlenecks that have emerged between the storage systems and the servers within a computing system. We have devoted and expect to continue to devote significant resources to developing products based on emerging technologies and standards that reduce input/output bottlenecks, such as internet SCSI (iSCSI). A number of large companies in the computer hardware and software industries are actively involved in the development of new technologies and standards that we expect to incorporate in our new products. Should any of these companies delay or abandon their efforts to develop commercially available products based on these new technologies and standards, our research and development efforts with respect to such technologies and standards likely would have no appreciable value. In addition, if we do not correctly anticipate new technologies and standards, or if our products based on these new technologies and standards fail to achieve market acceptance, our competitors may be better able to address market demand than would we. Furthermore, if markets for these new technologies and standards develop later than we anticipate, or do not develop at all, demand for our products that are currently in development would suffer, resulting in less revenue for these products than we currently anticipate.

Uncertainties involving sales and demand forecasts for our products could negatively affect our business.

We have limited ability to forecast the demand for our products. In preparing sales and demand forecasts, we rely largely on input from our distribution partners. If our distribution partners are unable to accurately forecast demand, or we fail to effectively communicate with our distribution partners about end-user demand or other time sensitive information, sales and demand forecasts may not reflect the most accurate, up-to-date information. Because we make business decisions based on our sales and demand forecasts, if these forecasts are inaccurate, our business and financial results could be negatively impacted. Furthermore, we may not be able to identify these forecast differences until late in our fiscal quarter. Consequently, we may not be able to make adjustments to our business model without negatively impacting our business and results of operations.

We are subject to increased inventory risks and costs because we manufacture products in advance of binding commitments from our customers to purchase our products.

In order to assure availability of our products for some of our largest OEM customers, we manufacture products in advance of purchase orders from these customers based on forecasts provided by them. However, these forecasts do not represent binding purchase commitments and we do not recognize revenue for such products until the product is shipped and risk of loss has passed to the OEM. As a result, we incur inventory and manufacturing costs in advance of anticipated revenue. Because demand for our products may not materialize, this product delivery method subjects us to increased risks of high inventory carrying costs and increased obsolescence and may increase our operating costs.

The loss of our primary contract manufacturers, or the failure to forecast demand accurately for our products or to manage our relationship with our primary contract manufacturers successfully, would negatively impact our ability to manufacture and sell our products.

We rely on a limited number of contract manufacturers, primarily Solectron and Celestica, to assemble the printed circuit board for our current shipping programs, including our 6000 and 10000 and ServerAttach line of products. We generally place orders for products with Solectron and Celestica approximately four months prior to the anticipated delivery date, with order volumes based on forecasts of demand from our customers. Accordingly, if we inaccurately forecast demand for our products, we may be unable to obtain adequate manufacturing capacity from Solectron or Celestica to meet our customers’ delivery requirements, or we may accumulate excess inventories. We have on occasion in the past been unable to adequately respond to unexpected increases in customer purchase orders, and therefore were unable to benefit from this incremental demand. Solectron and Celestica have not provided assurance to us that adequate capacity will be available to us within the time required to meet additional demand for our products.

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Our plans to introduce new products and product enhancements to market require coordination across our suppliers and manufacturers which exposes us to risks of delay or poor execution from a variety of sources.

We have recently introduced new products and product enhancements, which requires that we coordinate our efforts with those of our component suppliers and our contract manufacturers to rapidly achieve volume production. If we should fail to effectively manage our relationships with our component suppliers, our contract manufacturers and other manufacturers of our products or if any of our suppliers or our manufacturers experience delays, disruptions, capacity constraints or quality control problems in their manufacturing operations, our ability to ship products to our customers could be delayed, and our competitive position and reputation could be harmed. Qualifying a new component supplier or contract manufacturer and commencing volume production can be expensive and time consuming. If we are required to change or choose to change suppliers, we may lose revenue and damage our customer relationships.

We depend on sole source and limited source suppliers for certain key components, and if we are unable to buy these components on a timely basis, our delayed ability to deliver our products to our customers may result in reduced revenue and lost sales.

We purchase Fibre Channel application specific integrated circuits and other key components for our products from sole or limited sources. To date, most of our component purchases have been made in limited volumes. As a result, if our suppliers receive excess demand for their products, we likely will receive a low priority for order fulfillment, as large volume customers will use our suppliers’ available capacity. If we are delayed in acquiring components for our products, the manufacture and shipment of our products will also be delayed, which will reduce our revenue and may result in lost sales. We generally use a rolling nine-month forecast of our future product sales to determine our component requirements. Lead times for ordering materials and components vary significantly and depend on factors such as specific supplier requirements, contract terms and current market demand for such components. If we overestimate our component requirements, we may have excess inventory which would increase our costs. If we underestimate our component requirements, we may have inadequate inventory that would delay our manufacturing and render us unable to deliver products to customers on a scheduled delivery date. We also may experience shortages of certain components from time to time, which also could delay our manufacturing. Manufacturing delays could negatively impact our ability to sell our products and damage our customer relationships.

Competition within our markets may reduce sales of our products and reduce our market share.

The market for SAN products generally, and storage routers in particular, is increasingly competitive. We anticipate that the market for our products will continually evolve and will be subject to rapid technological change. We currently face direct competition primarily from ADIC and ATTO. In addition, other OEM customers could develop products or technologies internally, or by entering into strategic relationships with or acquiring other existing SAN product providers that would replace their need for our products and would become a source of competition. We may face competition in the future from OEMs, including our customers and potential customers, local area network router manufacturers, storage system industry suppliers, including manufacturers and vendors of other SAN products or entire SAN systems, and innovative start-up companies. For example, manufacturers of Fibre Channel switches or directors could seek to include router functionality within their SAN products that would obviate the need for our storage routers. As the market for SAN products grows, we also may face competition from traditional networking companies and other manufacturers of networking products. These networking companies may enter the storage router market by introducing their own products or by entering into strategic relationships with or acquiring other existing SAN product providers. This could introduce additional competition in our markets, especially, if one of our OEMs begins to manufacture our higher end storage routers. While we do not currently face significant direct competition for our ServerAttach products, we anticipate we will see increased competition as this market develops.

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We are a relatively small company with limited resources compared to some of our current and potential competitors.

Some of our current and potential competitors have longer operating histories, significantly greater resources, broader name recognition and a larger installed base of customers than Crossroads. As a result, these competitors may have greater credibility with our existing and potential customers. They also may be able to adopt more aggressive pricing policies and devote greater resources to the development, promotion and sale of their products than we can to ours, which would allow them to respond more quickly than us to new or emerging technologies or changes in customer requirements. In addition, some of our current and potential competitors have already established supplier or joint development relationships with decision makers at our current or potential customers. These competitors may be able to leverage their existing relationships to discourage these customers from purchasing products from us or to persuade them to replace our products with their products. Increased competition could decrease our prices, reduce our sales, lower our margin, or decrease our market share. These and other competitive pressures may prevent us from competing successfully against current or future competitors, and may materially harm our business.

We have licensed our storage router technology to a key customer, which may enable this customer to compete with us.

In November 2002, we amended our existing licensing agreement with HP. Pursuant to this amendment we have outsourced the manufacturing of our embedded routers to HP. As a result, we do not incur the inventory and overhead costs of the hardware, and we will receive a royalty from HP for licensing our technology, which will result in less aggregate revenue for us. However, even though total revenue from the sale of our embedded routers will be less in the future, our arrangement will have a positive impact on gross margin. We believe this agreement will allow us to leverage the strengths of both companies, including HP’s economies of scale in manufacturing and systems integration expertise and our software, value-added applications and intellectual property. We have been working under this new agreement since the fiscal second quarter of 2003. HP has vastly greater resources and distribution capabilities than we do, and therefore, it could establish market acceptance in a relatively short time frame for any competitive products that it may introduce using our licensed technologies, which, in turn, would reduce demand for our products from HP and could reduce demand for our products from other customers.

Unit prices of our products decrease over time, and if we cannot increase our sales volumes and develop new, higher margin products, our revenue will decline.

As storage networking continues to mature as an industry, we have seen a trend towards simplification of devices. The impact of this trend on our business has been the push for, and subsequent ramp of embedded routers being shipped with tape libraries. These embedded routers are lower cost than the stand-alone box routers and this lower cost is passed on to our OEM customers. As our mix shifts from box routers to embedded routers, we will see a reduction in average price per unit and revenue will decline if volume does not increase. To date, some of our agreements with OEM customers, including our largest customer, provide for quarterly reductions in pricing on a product-by-product basis, with the actual discount determined according to the volume potential expected from the customer, the OEM’s customer base, the credibility the OEM may bring to our solution, additional technology the OEM may help us incorporate with our product, and other Crossroads products the OEM supports. Notwithstanding, the decreases in our average selling prices of our older generation products generally have been partially offset by higher average selling prices for our newer products, as well as sales to distributors and system integrators where price decreases are not generally required. Nonetheless, we could experience declines in our average unit selling prices for our products in the future, especially if our newer products do not receive broad market acceptance. In addition, declines in our average selling prices may be more pronounced should we encounter significant pricing pressures from increased competition within the storage router market.

Our products are complex and may contain undetected software or hardware errors that could lead to an increase in our costs or a reduction in our revenue.

Networking products such as ours may contain undetected software or hardware errors when first introduced or as new versions are released. Our products are complex and errors have been found in the past and may be found from time to time in the future. In addition, our products include components from a number of third-party vendors. We rely on the quality testing of these vendors to ensure the adequate operation of their products. Because our products are manufactured with a number of components supplied by various third-party sources, should problems occur in the operation or performance of our products, it may be difficult to identify the source. In addition, our products are

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deployed within SANs from a variety of vendors. Therefore, the occurrence of hardware and software errors, whether caused by our or another vendor’s SAN products, could adversely affect sales of our products. Furthermore, defects may not be discovered until our products are already deployed in the SAN. These errors also could cause us to incur significant warranty, diagnostic and repair costs, divert the attention of our engineering personnel from our product development efforts and cause significant customer relations and business reputation problems.

We depend on our key personnel to manage our business effectively in a rapidly changing market, and if we are unable to retain our current personnel and hire additional personnel, our ability to sell our products could be harmed.

We believe our future success will depend in large part upon our ability to attract and retain highly skilled managerial, engineering and sales and marketing personnel. Moreover, we maintain a limited staff of executive management and are highly dependent on those individuals, in particular Rob Sims, our chief executive officer, to provide continuity in the execution of our growth plans. The loss of the services of any of our key employees or key management would harm our business. Additionally, our inability to attract or retain qualified personnel in the future or any delays in hiring required personnel, particularly engineers and sales personnel, could delay the development and introduction of, and negatively impact our ability to sell, our products. The recent decline in our stock price has resulted in a substantial number of “underwater” stock options, which may cause certain of our employees to seek employment elsewhere as a result of this decreased financial incentive. In addition, the recently announced reduction in our workforce may adversely affect the morale among our remaining employees, which may further adversely affect our ability to retain or attract qualified employees. If we are unable to retain the personnel we currently employ, or if we are unable to quickly replace departing employees, our operations and new product development may suffer.

We may be unable to protect our intellectual property, which would negatively affect our ability to compete.

Our products rely on our proprietary technology, and we expect that future technological advancements made by us will be critical to sustain market acceptance of our products. Therefore, we believe that the protection of our intellectual property rights is and will continue to be important to the success of our business. We rely on a combination of patent, copyright, trademark and trade secret laws and restrictions on disclosure to protect our intellectual property rights. We also enter into confidentiality or license agreements with our employees, consultants and business partners, and control access to and distribution of our software, documentation and other proprietary information. Despite these efforts, unauthorized parties may attempt to copy or otherwise obtain and use our products or technology. Monitoring unauthorized use of our products is difficult, and we cannot be certain that the steps we have taken will prevent unauthorized use of our technology, particularly in foreign countries where applicable laws may not protect our proprietary rights as fully as in the United States.

Our efforts to protect our intellectual property may cause us to become involved in costly and lengthy litigation, which could seriously harm our business.

In recent years, there has been significant litigation in the United States involving patents, trademarks and other intellectual property rights. From time to time, we receive letters from various industry participants alleging infringement of patents, trademarks or misappropriation of trade secrets or from customers requesting indemnification for claims brought against them by third parties. The exploratory nature of these inquiries has become relatively common in the semiconductor industry. We typically respond when appropriate and as advised by legal counsel. We have been involved in litigation to protect our intellectual property rights in the past and may become involved in such litigation again in the future. For example, in November 2003 we filed a lawsuit against Dot Hill Systems alleging that they infringed two of our patents. In December 2003 Dot Hill denied infringement and alleged that two of our patents were invalid and unenforceable. In 2000, we filed a lawsuit against Pathlight Technology alleging that they had infringed one of our patents. Pathlight was subsequently acquired by ADIC and in June 2001 ADIC paid us $15.0 million in settlement of this lawsuit. In the future, we may become involved in additional litigation to defend allegations of infringement asserted by others, both directly and indirectly as a result of certain industry-standard indemnities we may offer to our customers. Legal proceedings could subject us to significant liability for damages or invalidate our intellectual property rights. Any litigation, regardless of its outcome, would likely be time consuming and expensive to resolve and would divert management’s time and attention. Any potential intellectual property litigation against us could force us to take specific actions, including:

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