MAGMA DESIGN AUTOMATION INC - 10-K Annual Report

(Address, including zip code, and telephone number, including area code, of the registrant’s principal executive offices)

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

Indicate by check mark if disclosure of delinquent filers pursuant to Item 405 of Regulation S-K is not contained herein, and will not be contained, to the best of the registrant’s knowledge, in definitive proxy or information statements incorporated by reference in Part III of this Form 10-K or any amendment to this Form 10-K. ¨

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

The aggregate market value of the registrant’s common stock held by non-affiliates of the registrant, based upon the closing sale price of the Common Stock on September 30, 2004 as reported on the Nasdaq National Market, was $493,818,743. This calculation does not reflect a determination that certain persons are affiliates of the Registrant for any other purpose.

As of May 31, 2005 Registrant had outstanding 33,588,468 shares of Common Stock, $0.0001 par value.

Portions of the Registrant’s proxy statement to be delivered to the stockholders in connection with Registrant’s 2005 Annual Meeting of Stockholders to be held on August 30, 2005, are incorporated by reference into Part III of this Form 10-K. The Registrant’s proxy statement is required to be filed within 120 days after the Registrant’s fiscal year end.

Magma, Blast Fusion, Blast Noise, QuickCap, SiliconSmart and FixedTiming are registered trademarks, and ArchEvaluator, Blast RTL, Blast Power, Blast Plan, Blast Rail, Blast Create, Blast FPGA, Quartz Time, Blast DFT, Quartz, Quartz Formal, Quartz SSTA, Quartz DRC, Quartz LVS, Blast Yield, “The Fastest Path from RTL to Silicon,” “Signoff in the Loop,” and PALACE are trademarks, of Magma Design Automation. All other product and company names are trademarks and registered trademarks of their respective companies.

Magma Design Automation, Inc. provides electronic design automation, or EDA, software products and related services. Our software enables chip designers to reduce the time it takes to design and produce complex integrated circuits used in the communications, computing, consumer electronics, networking and semiconductor industries. Our products comprise a complete digital integrated solution for the chip development cycle, from initial design through physical implementation.

Our software products allow chip designers to meet critical time-to-market objectives, improve chip performance and handle chip designs involving millions of components. Our flagship Blast family of products and our Quartz family of sign-off and verification tools combine into one integrated chip design and verification flow, from what traditionally had been separate logic design, physical design, and analysis and sign-off processes. This integrated flow significantly reduces design iterations, allowing our customers to accelerate the time it takes to design and produce deep submicron integrated circuits.

We provide consulting, training and services to help our customers more rapidly adopt our technology. We also provide post-contract support, or maintenance, for our products.

The trend toward deep submicron and system-on-chip designs has driven demand for improved electronic design automation software that enables the efficient design and implementation of these complex chips. Limitations in traditional electronic design automation technology could slow the adoption of deep submicron processes due to the difficulty in implementing designs at these small feature sizes. Historically, electronic design automation companies developed software for use by separate engineering groups to address either the front-end chip design or back-end chip implementation processes.

In the front-end design process, the chip design is conceptualized and written as a register transfer level computer program, or RTL file, that describes the required functionality of the chip. For large chips, the design is often divided into a number of individual blocks, each with its own associated RTL file. This is often done because of capacity limitations in existing electronic design automation tools. The designer also develops constraints for the design that are used to describe the desired timing performance of the chip. Finally, a target library is specified that contains detailed information about the basic functional building blocks, or logic gates, that will be used in the design. This library is typically provided by the semiconductor vendor or a third-party library vendor. The next step is to run the RTL files through synthesis software that generates a netlist. The netlist describes the circuit in terms of logic gates selected from the target library and connected such that the functionality specified in the RTL files is realized. The synthesis software also performs optimizations to attempt to meet the timing constraints specified by the designer.

A critical objective of chip design is to minimize total circuit delay, which is comprised of gate delay and wire delay. Front-end software was initially developed when the gate delay, or the time it takes for an electrical signal to travel through a logic gate, was the most significant component of total circuit delay. Wire delay, or the time it takes for a signal to travel through a wire connecting two or more gates, was negligible and designers could use simple estimates and still meet targeted circuit speeds.

In the back-end implementation process, physical design software is used to transform the netlist generated by the front-end process into a physical layout of the chip. The resulting physical layout is usually output in a binary file format, commonly referred to as GDSII, that is used to generate the photomasks used to manufacture the integrated circuit. The two primary functions provided by traditional physical design software are placement and routing. Placement determines the optimal physical location for the logic gates on the integrated circuit. After placement is completed, routing connects the logic gates with wires to achieve the desired circuit

functionality. After the layout is completed, the final step in the back-end process is to run timing analysis to verify that the chip will run at the desired circuit speed. If circuit speeds are slower than the speeds reported by the synthesis software, the design must often be iterated back through the synthesis step in an attempt to improve the timing. Since each timing closure iteration cycle can take one or more weeks, successive iterations of the design process can significantly lengthen the time it takes to design and produce new chips.

The trend toward deep submicron technology has rendered traditionally separate front-end and back-end electronic design automation processes less effective for rapid, cost-effective and reliable chip designs. As integrated circuits have increased in complexity and feature sizes have dropped, the problems faced by chip designers have changed. Wire delay now accounts for the majority of total circuit delay and has become the most significant factor in circuit performance for deep submicron technologies. Front-end estimates of wire delay may vary considerably from actual wire delays measured in the final layout. As a result, the front-end timing might meet the design requirements, but the final layout timing at the completion of the back-end process may be unacceptable, requiring time-consuming iterations back through the front-end process.

Deep submicron process technologies bring additional complexities to the design and implementation process that can cause chip failures. These include signal integrity problems such as electrical interference from wires in close proximity, commonly referred to as crosstalk or noise, that can affect both circuit performance and functionality. Using existing design flows and software, designers must contend with analyzing and fixing these problems manually after the layout is completed. These adjustments often change the chip timing and further contribute to the timing closure problem.

These deep submicron challenges make it difficult to efficiently design chips using separate front-end and back-end processes. Semiconductor manufacturers and electronic products companies are currently seeking alternatives to older generation electronic design automation software to shorten design time, improve circuit speed, and handle larger chip designs. As a result, a significant opportunity exists for a new electronic design automation approach to chip design that can enable the design of more complex deep submicron integrated circuits, improve performance, and significantly reduce the time it takes to design and produce next-generation electronic products.

The important technical foundations for our software products are found within our patented FixedTiming^® methodology, our unified data model architecture, platform logic synthesis, interconnect synthesis, physical verification, design-for-manufacturability (“DFM”) and silicon signoff (known to us as our “Signoff in the Loop^™” flow), which allow our customers to reduce the number of iterations that are often required in conventional integrated circuit (“IC”) design processes.

Magma’s fast, high-capacity logic synthesis provides a common front-end to all IC implementation platforms including programmable (“FPGA”), standard cell application specific integrated circuit (“ASIC”) and structured ASIC. A single RTL representation of the design is synthesized to technology-independent netlist and taken through architecture-specific mapping and physical synthesis to accurately predict the area, performance, power, testability and routability during physical implementation. The automated Design-for-Test (“DFT”) logic generation and insertion at this stage also improves planning for failure analysis and yield management through built-in self test (“BIST”) and memory repair features of the underlying manufacturing process. The measure of difficulty for implementing the netlist at this early stage is provided in terms of gain distribution (also called Early Silicon Performance, or ESP report), enabling the designer to correct the RTL or missing timing constraints. Blast Create^™, Blast Create SA, Blast FPGA^™ and Blast DFT products use this underlying technology.

Our patented FixedTiming methodology allows us to reduce the timing closure iterations that are often required between the front-end and back-end processes in conventional integrated circuit design flows. These timing closure iterations are necessitated by the fact that the final circuit timing cannot be accurately calculated until the physical layout is completed. In deep submicron integrated circuits, timing performance is primarily determined by the physical layout of the wiring that connects the logic gates to achieve the desired circuit functionality. Timing that is estimated during the front-end process is often not realized in the final layout, and the design team must iterate between the front-end and back-end processes, modifying the design in an attempt to reach the desired timing performance. Our FixedTiming methodology is designed to predict circuit speeds prior to detailed physical design. We then use a series of design refinements during physical design to achieve a final timing that is very close to the predicted circuit speed. This approach reduces the need for timing closure iterations that exist in conventional flows and can significantly reduce the time it takes to design and produce deep submicron integrated circuits.

Conventional electronic design automation flows are typically based on a collection of software programs that have their own associated data models, often resulting in cumbersome design flows. We believe that we are the only electronic design automation vendor that offers a complete integrated circuit design implementation flow based on a unified data model. Our unified data model architecture is a key enabler for our FixedTiming methodology, our ability to deliver automated signal integrity detection and correction, integrated power analysis and Signoff in the Loop. The unified data model contains all the logical and physical information about the design and is resident in core memory during execution. The various functional elements of our software such as the implementation engines for synthesis, placement and routing, and our analysis software for timing, RC and delay extraction, power, and signal integrity, all operate directly on this data model. Because the data model is concurrently available to all the engines and analysis software, it makes it possible to analyze the design and make rapid tradeoff decisions during the physical design process, thereby reducing design iterations.

Interconnect Synthesis is a recent addition to Magma’s IC implementation design flow. With Interconnect Synthesis, optimization for timing, crosstalk, on-chip variation (“OCV”), power and yield are performed in the routing phase, rather than relying on logic optimization during logic synthesis as has historically been done. Optimization in logic synthesis alone was insufficient as wireload models started failing at 0.18 micron and below. At 90 nanometers and below, wire delay and the effect of their neighbors contribute to almost all deep-submicron effects. Accordingly, optimization has to be done as wires are assigned to tracks and are being routed. This move to combine optimization and routing requires a new flow with a new approach—Interconnect Synthesis. We believe we are currently the only IC implementation vendor to enable the above-referenced advanced optimization techniques during the routing phase.

Every completed physical layout must be analyzed and manipulated before final manufacturing. This process—commonly called physical verification—has increased in complexity and importance as manufacturing technology has moved from 130 nanometers to 90 nanometers, and now to 65 nanometers. Moreover, new physical phenomena at these manufacturing nodes—including optical proximity (“OPC”) and chemical-mechanical-polishing (“CMP”) effects—have introduced the need for new design-for-manufacturing technologies.

Magma has introduced a new product line to address these challenges, with technologies resulting from Magma’s acquisition of Mojave Design. This includes Quartz DRC^™ and Quartz LVS^™, physical verification tools designed specifically to address the challenges at 90 nanometers and 65 nanometers. They are architected to do a full-chip design rule check for any design, at any node, in two hours or less. This is up to an order of magnitude faster than conventional solutions, which typically leverage a small number of CPUs—usually less

than four—to perform full chip physical verification. Using such an approach limits the scalability of the solution—that is, as chip sizes increase, and as design rule complexity increases from process node to process node, there is no way to keep constant, or reduce the total turnaround time.

In contrast, Quartz DRC and Quartz LVS have been architected to be highly scalable. By using techniques that enable fine-grain parallelism, Quartz DRC and Quartz LVS are able to use a large number (up to 100) separate Linux machines on a standard computer network. This ability to do distributed processing on a standard Linux machine provides the ability to linearly increase the speed of processing—increasing the number of processors by 2x increases the speed by 2x, for design rule checking. This scalability is essential to achieving a fast turnaround time of two hours or less.

Magma has a strong position for design-for-manufacturability—as it offers both a leading physical design system, and also a leading physical verification system. Magma is leveraging the Mojave technology, and developing future products, including OPC-aware software that will be used both during design, and during manufacturing.

Design teams have traditionally relied upon one set of tools for implementation and another set for signoff analysis. While this separation enables an advantageous tradeoff with respect to accuracy versus runtime, it also requires corrective iteration loops when discrepancies are found during signoff analysis. With the increased analysis challenges posed for analysis tools by 90- and 65-nanometer processes, such as combining noise analysis with on-chip variation, or OCV, across ever-increasing process corners and operating modes, the use of separate point signoff tools becomes a primary bottleneck in the drive to improve design cycle time. Magma’s “Signoff in the Loop” flow breaks the signoff iteration bottleneck by making signoff-level analysis directly available during the implementation flow. The capabilities of Quartz RC^™ are augmented by the integration of QuickCap technology into the extractor. QuickCap is the industry golden standard for reference parasitic extraction. The inclusion of this technology into a full-chip extractor enables users to attain the highest possible accuracy for the most timing critical nets on a chip.

Similar to the conventional design flow, our design flow starts by reading in technology libraries and constraint files. The following diagram illustrates our integrated design flow and where our products fit within this design flow.

Blast Create, first shipped in April 2003, is a key component of Magma’s RTL-to-GDSII IC design solution. It enables logic designers to synthesize, visualize, evaluate and improve the quality of their RTL code, design constraints, testability requirements and floorplan. The physical netlist generated by Blast Create provides a clean handoff between RTL designer and layout engineer, eliminating back-to-front iterations necessary for timing closure in conventional flows.

Blast Fusion^™, first shipped in April 1999, is our physical design software that shortens the time it takes to design and produce deep submicron integrated circuits. The Blast Fusion flow starts by reading in the netlist, target library and design constraints. The netlist is optimized for circuit performance taking into account placement information that specifies the location of the gates in the chip layout. At the conclusion of this step, Blast Fusion generates a report that predicts the final timing performance that is achievable in the completed chip layout. In the final step, detailed physical design, Blast Fusion generates the final chip layout by performing the routing of wires that are needed to connect the gates into the desired circuit configuration and meet the timing performance requirements.

Blast Fusion is intended for use by chip design teams and other groups whose responsibility it is to take a design from netlist to completed chip layout. In the conventional ASIC design flow, front-end designers use synthesis software to translate and optimize their RTL files into a netlist that is then handed off to the ASIC or semiconductor vendor or separate layout design group for physical design using Blast Fusion. Sales of Blast Fusion account for the majority of our revenue.

Blast Noise^®, first shipped in September 2000, is our noise detection and correction product. Interference, or noise from wires in close proximity to each other, can decrease chip performance or cause chip failure, particularly at 0.18 micron and below. Blast Noise works with Blast Fusion to actively detect potential noise problems and correct them during the physical design process.

Blast Plan^™, first shipped in September 2001, delivers hierarchical design planning capabilities for use in implementing complex integrated circuit and system-on-chip designs. In a hierarchical design methodology, a chip design is partitioned into blocks that are designed and implemented individually and then later assembled to create the entire chip. Blast Plan works with Blast Fusion and Blast Create to streamline the hierarchical planning and design of large chips and system-on-chips within a single environment.

Blast Plan^™ Pro, first shipped in November 2002, combines the hierarchical design planning capabilities of Blast Plan with design exploration and early problem detection. Blast Plan Pro uses the same analysis engines as Magma’s implementation system, thus providing a direct path to IC implementation using Blast Fusion.

Blast Rail^™, first shipped in May 2003, provides IC designers with integrated power analysis and planning, voltage-drop analysis, voltage-drop-induced delay analysis, and electromigration analysis on rail wires and vias. These features enable designers to maintain power integrity in their designs. Blast Rail is fully integrated with Magma’s RTL-to-GDSII implementation flow to enable a correct-by-construction rail design solution. Blast Rail^{^™} NX is our enhanced version of Blast Rail which recently started to ship.

Blast Power^™, launched in May 2004, is the industry’s first and only integrated power management and power minimization solution from RTL to GDSII. Blast Power is available as an option to Magma’s Blast Create and Blast Fusion implementation system, enabling Magma to offer a low-power design methodology that includes embedded power, timing, and rail analysis and power minimization techniques. With Blast Power, Magma users will be able to make power-vs-timing and power-vs-area tradeoffs throughout the RTL-to-GDSII flow—without having to export design data out of the Magma system. This tight integration of power optimization and management into the implementation process will enable users to deliver lower power and more cost-effective development cycles than point tool flows.

In June 2003 Magma acquired Aplus Design Technologies, Inc. (“Aplus”), a leader in physical synthesis and architecture analysis. Aplus products include PALACE^™, a physical synthesis tool for programmable

devices (“FPGAs”), and ArchEvaluator^™, an architectural analysis tool. With the addition of these products to our product portfolio, we now offer implementation and physical design for cell-based, programmable and structured ASIC designs. Our customers are increasingly using structured ASIC designs, which enable a combination of cell-based and programmable logic, to reduce manufacturing costs.

PALACE, which first shipped in July 2001, is a fully automated physical synthesis tool for programmable logic devices. PALACE combines FPGA architecture-specific synthesis and mapping technologies with FPGA physical layout using a unified single data model throughout the synthesis process. PALACE offers an average of 15% better timing compared to best available FPGA synthesis solutions. PALACE supports all the popular FPGA architectures from Xilinx, Altera, Actel, and QuickLogic and it closely interfaces with FPGA vendor physical design tools.

ArchEvaluator^™, which first shipped June 2000, is the only commercial EDA tool that enables the programmable or Structured ASIC architecture designers to discover new synthesis-friendly architectures with the best performance and density advantages. ArchEvaluator is able to evaluate a wide scope of architecture parameters.

Blast FPGA^™, made available in March 2005, is a unified RTL to FPGA tool that combines RTL synthesis technology from Blast Create and physical synthesis technology from PALACE within a single data model.

BLAST FPGA includes features such as an intuitive graphical user interface designed specific for FPGA designers, RTL and schematic views and cross probes, and embedded timing analysis. Blast FPGA offers an average of 20% better timing and 10% better area utilization compared to best available FPGA synthesis solutions. Blast FPGA also enables an easy FPGA migration to Structured ASIC or cell based ASIC within the same unified synthesis environment.

Blast Create^™ SA, made available in December 2004, is a comprehensive front end design tool that enables synthesis, and partitioning of RTL description of the design into cell-based blocks and programmable blocks.

Similarly, Blast Fusion^™ SA, made available in December 2004, is a complete physical design solution for programmable, cell-based or structured ASIC designs.

With the acquisition of Random Logic Corporation in October 2003, we acquired a capacitance extractor called QuickCap^®, long considered the industry’s leading parasitic extraction technology, and QuickInd^™, an inductance extractor based on the same core architecture as QuickCap. QuickCap is a highly accurate 3D-field solver used in parameter extraction and rules generation, library cell extraction, critical cell analysis, and critical net analysis. QuickCap^® NX, made available in February 2005, is an enhanced version of the QuickCap tool, targeted to address specific design challenges that occur in 90-nanometer and smaller process technologies.

In April 2004, we announced the availability of Quartz^™ Formal, a new formal verification product based on Boolean logic equivalence checking technology licensed from International Business Machines Corporation. Quartz Formal joins QuickCap in Magma’s suite of software products for signoff in integrated circuit design.

Our acquisition of Silicon Metrics Corporation in October 2003, forming our Silicon Correlation Division, has allowed Magma to provide highly accurate models and characterization of various intellectual property (“IP”) blocks in nanometer designs. IP vendors, library developers, and COT design teams rely on software models to accurately represent the electrical behavior of circuits implemented with advanced process technologies. To meet the needs of these customers, Silicon Correlation Division’s SiliconSmart^™ products provide robust timing, power, and signal integrity models in a variety of industry standard formats. When used with popular construction and verification tools, these models offer silicon predictability and designer productivity. As a result, SiliconSmart models help customers shorten design cycles and improve chip performance.

We continue to integrate into our design flow certain verification and design for manufacturability (“DFM”) technologies that we acquired by way of our April 2004 merger with Mojave, Inc. We expect our development efforts to result in an ability to design ICs that are more manufacturable, and with inherently better yield, than those designed by flows that do not incorporate DFM capability. Magma believes that by incorporating DFM into IC implementation, Magma will be well positioned to address the next generation of designs at 65 nanometers and below. Our Quartz DRC^™ and Quartz LVS^™ products described below, resulted from the Mojave merger, and, will soon be in general release.

On April 4, 2005, we announced the availability of our next generation of design software, the result of our recent 18-month-long “Cobra” development initiative. The products resulting from the Cobra project include both new products and enhanced capabilities to existing Magma software described above, such as Blast Create, Blast Fusion, Blast Noise and Blast Plan Pro. We believe that these products will significantly expand the design options available to our customers as they do more design work at 90 and 65 nanometers. A key element of the Cobra development initiative is integration of timing, noise, power, test and yield signoff into the implementation flow, thereby reducing design cycles.

Products resulting from the Cobra development initiative are currently in limited release with a number of our customers, with general releases expected to begin on or about June 2005. Blast DFT described below was made available for general release in April 2005. The Cobra development initiative has expanded the Company’s portfolio with the new products described below:

Quartz RC^™: Provides signoff-quality parasitic extraction and can operate as either a standalone tool or integrated with the Blast Fusion system, where it underlies the “Signoff in the Loop” flow.

Quartz Time^™: Combines the proven static timer in Blast Fusion with advanced timing capabilities to create a standalone signoff timing system.

Blast Fusion^® QT: Provides advanced capabilities that enable “Signoff in the Loop” timing analysis with concurrent optimization. This product provides designers access to a signoff timing analysis engine within the implementation flow, eliminating the need to iterate with external signoff tools.

Blast DFT^™: Our new test synthesis product. This design-for-test automation product includes advanced built-in-self-test (“BIST”) capabilities for logic and memory, including built-in self-repair capabilities.

Quartz SSTA^™: Provides a parametric yield analysis capability for the design, providing parametric extraction and statistical timing analysis simultaneously.

Quartz DRC^™ and Quartz LVS^™: Targeted to provide the fastest turnaround time of any physical verification tools, with a goal of performing full chip design rule check (“DRC”) in less than 2 hours.

Blast Plan^™ FX: Provides automated hierarchical design capabilities for taking a complete hierarchical chip from RTL to GDSII in a deterministic, repeatable fashion throughout the design cycle.

Blast Yield^™: A comprehensive design-for-yield (“DFY”) solution it incorporates multiple techniques to optimize the design for parametric and functional yield—both cell and wire yield—without compromising timing or area.

We provide consulting, training and chip design services to help our customers more rapidly adopt our technology. Design services include assisting our customers on complex chip design challenges and providing services ranging from the design and implementation of specific blocks to complete chip designs, including the

delivery of the final chip layout, ready for release to manufacturing. We also provide post-contract support, or maintenance, for our products.

We license our software products to semiconductor manufacturers and electronic products companies around the world. Our customers include Broadcom, Infineon, NEC, Nokia, Renesas Technology, Texas Instruments, Toshiba and Vitesse. In fiscal 2005, Texas Instruments was our largest customer and accounted for 16% of our total revenue.

As of March 31, 2005, we had greater than $325.0 million in backlog, which we define as non-cancelable contractual commitments by our customers through purchase orders or contracts. Approximately 9% of the backlog is variable based on volume of usage of our products by the customers, approximately 7% includes specific future deliverables, and approximately 13% is recognized in revenue on a cash receipts basis. We have estimated variable usage, for the purposes of determining our backlog, based on information from customers’ forecasts available at the contract execution date. It is possible that customers from whom we expect to derive revenue from backlog will default and as a result we may not be able to recognize expected revenue from backlog.

Our license revenue in any given quarter depends on the volume of short term licenses shipped during the quarter and the amount of long term, ratable and cash receipts revenue from deferred revenue that is recognized out of backlog and recognized on orders received during the quarter. We set our revenue targets for any given period based in part, upon an assumption that we will achieve a certain level of orders and a certain license mix of short term licenses. The precise mix of orders is subject to substantial fluctuation in any given quarter or multiple quarter periods, and the actual mix of licenses sold affects the revenue we recognize in the period. If we achieve the target level of total orders but are unable to achieve our target license mix, we may not meet our revenue targets (if we deliver more-than-expected long term or ratable licenses) or may exceed them (if we deliver more-than-expected short term licenses).

Unbilled accounts receivable represent revenue that has been recognized in advance of contractual invoicing to the customer. We typically generate invoices 45 days in advance of contractual due dates, and we invoice the entire amount of the unbilled accounts receivable within one year from the contract inception. As of March 31, 2005 and March 31, 2004, unbilled accounts receivable were approximately $14.1 million and $14.9 million, respectively. These amounts were included in accounts receivable on our consolidated balance sheets for these periods.

We generated 43% of our total revenue from sales outside the United States for fiscal 2005, compared to 48% in fiscal 2004. Additional disclosure regarding financial information on geographic areas is included in Note 11 of our Consolidated Financial Statements in Item 8 of this Annual Report.

We license our products primarily through a direct sales force focused primarily on the industry leaders in the communications, computing, consumer electronics, networking and semiconductor industries. We have North

American sales offices in California, Massachusetts, North Carolina, Pennsylvania, Texas, Washington and Canada. Internationally, we have European offices in Germany, France and the United Kingdom, an office in Israel and Asian offices in China, India, Japan, Korea and Taiwan. Our direct sales force is supported by a larger group of field application engineers that work closely with the customers’ technical chip design professionals.

As of March 31, 2005, we had 272 employees in our marketing, sales and technical sales support organizations. We intend to continue to expand our sales and field application engineering personnel on a worldwide basis.

The electronic design automation industry is highly competitive and characterized by technological change, evolving standards, and price erosion. Major competitive factors in the market we address include technical innovation, product features and performance, level of integration, reliability, price, total system cost, reduction in design cycle time, customer support and reputation.

We currently compete with companies that hold dominant shares in the electronic design automation market. In particular, Cadence Design Systems, Inc. and Synopsys, Inc. are continuing to broaden their product lines to provide an integrated design flow. Each of these companies has a longer operating history and significantly greater financial, technical and marketing resources, as well as greater name recognition and larger installed customer bases than we do. These companies also have established relationships with our current and potential customers and can devote substantial resources aimed at preventing us from establishing or enhancing our customer relationships. Our competitors are better able to offer aggressive discounts on their products, a practice that they often employ. Our competitors offer a more comprehensive range of products than we do; for example, we do not offer logic simulation, full-feature custom layout editing, analog, or mixed signal products, which can sometimes be an impediment to our winning a particular customer order. In addition, our industry has traditionally viewed acquisitions as an effective strategy for growth in products and market share and our competitors’ greater cash resources and higher market capitalization may give them a relative advantage over us in buying companies with promising new chip design products or companies that may be too large for us to acquire without a strain on our resources. Further consolidation in the electronic design automation market could result in an increasingly competitive environment. Competitive pressures may prevent us from increasing market share or require us to reduce the price of products and services, which could harm our business. To execute our business strategy successfully, we must continue to increase our sales worldwide. If we fail to do so in a timely manner or at all, we may not be able to gain market share and our business and operating results could suffer.

Also, a variety of small companies continue to emerge, developing and introducing new products. Any of these companies could become a significant competitor in the future. We also compete with the internal chip design automation development groups of our existing and potential customers. Therefore, these customers may not require, or may be reluctant to purchase, products offered by independent vendors.

Our competitors may develop or acquire new products or technologies that have the potential to replace our existing or new product offerings. The introduction of these new or additional products by competitors may cause potential customers to defer purchases of our products. If we fail to compete successfully, we will not gain market share and our business will fail.

We devote a substantial portion of our resources to developing new products and enhancing our existing products, conducting product testing and quality assurance testing, improving our core technology and strengthening our technological expertise in the electronic design automation market. Our research and development expenditures for fiscal 2005, 2004 and 2003 were $41.7 million, $26.1 million and $18.7 million, respectively. There have not been any customer-sponsored research activities since the inception of the Company.

As of March 31, 2005, our research and development group consisted of 241 employees. We have engineering centers in California and Texas and in China, India, the Netherlands and Korea. Our engineers are focused in the areas of product development, advanced research, product engineering and design services. Our product development group develops our common core technology and is responsible for ensuring that each product fits into this common architecture. Our advanced research group works independently from our product development group to assess and develop new technologies to meet the evolving needs of integrated circuit design automation. Our product engineering group is primarily focused on product releases and customization. Our design services group is specifically focused on, and assists in completing, customer designs for commercial applications.

Currently, we hold, directly or indirectly, more than twenty issued patents. Patent protection affords only limited protection for our technology. Our patents will expire on various dates between April 2018 and June 2022. We do not know if our patent applications or any future patent application will result in a patent being issued with the scope of the claims we seek, if at all, or whether any patents we may receive will be challenged or invalidated. Rights that may be granted under our patent applications that may issue in the future may not provide us competitive advantages. Further, patent protection in foreign jurisdictions where we may need this protection may be limited or unavailable.

It is difficult to monitor unauthorized use of technology, particularly in foreign countries where the laws may not protect our proprietary rights as fully as in the United States. In addition, our competitors may independently develop technology similar to ours. We will continue to assess appropriate occasions for seeking patent and other intellectual property protections for those aspects of our technology that we believe constitute innovations providing significant competitive advantages.

Our success depends in part upon our rights in proprietary software technology. We have patent applications pending for some of our proprietary software technology. We rely on a combination of copyright, trade secret, trademark and contractual protection to establish and protect our proprietary rights that are not protected by patents, and we enter into confidentiality agreements with those of our employees and consultants involved in product development. We routinely require our employees, customers and potential business partners to enter into confidentiality and nondisclosure agreements before we will disclose any sensitive aspects of our products, technology or business plans. We require employees to agree to surrender to us any proprietary information, inventions or other intellectual property they generate or come to possess while employed by us. Despite our efforts to protect our proprietary rights through confidentiality and license agreements, unauthorized parties may attempt to copy or otherwise obtain and use our products or technology. These precautions may not prevent misappropriation or infringement of our intellectual property.

Third parties may infringe or misappropriate our copyrights, trademarks and similar proprietary rights. Many of our contracts contain provisions indemnifying our customers from third-party intellectual property infringement claims. On September 17, 2004, Synopsys, Inc. filed suit for patent infringement against us, and, other parties may assert infringement claims against us and/or our customers. Our products may be found by a court to infringe issued patents that may relate to our products. In addition, because patent applications in the United States are not publicly disclosed until the patent is issued, applications may have been filed that relate to our software products. We may be subject to legal proceedings and claims from time to time in the ordinary course of our business, including claims of alleged infringement of the trademarks and other intellectual property rights of third parties. Intellectual property litigation is expensive and time consuming and could divert management’s attention away from running our business. If there is a successful claim of infringement, we may be ordered to pay substantial monetary damages, we may be prevented from distributing some of our products, and/or we may be required to develop non-infringing technology or enter into royalty or license agreements. These royalty or license agreements, if required, may not be available on acceptable terms, if at all. Our failure to develop non-infringing technology or license the proprietary rights on a timely basis would harm our business.

As of March 31, 2005, we had 582 full-time employees, including 241 in research and development, 272 in sales and marketing and 69 in general and administrative. None of our employees are covered by collective bargaining agreements. We believe our relations with our employees are good.

We were incorporated in Delaware in 1997. Our principal executive offices are located at 5460 Bayfront Plaza, Santa Clara, California 95054 and our telephone number is (408) 565-7500. Our common stock is traded on the Nasdaq National Market under the ticker symbol LAVA. Our Web site address is www.magma-da.com. The information in our Web site is not incorporated by reference into this annual report. Through a link on the Investor Relations section of our web site, we make available our annual report on Form 10-K, quarterly reports on Form 10-Q, current reports on Form 8-K, and any amendments to those reports filed or furnished pursuant to Section 13(a) or 15(d) of the Securities Exchange Act of 1934 as soon as reasonably practicable after they are filed with, or furnished to, the Securities and Exchange Commission. Our 2005 annual meeting will be held on August 30, 2005 at the law offices of Fenwick & West LLP in Mountain View, California.

Our corporate headquarters are located in Santa Clara, California, where we occupy approximately 130,000 square feet under a lease expiring on July 31, 2010. We have North American sales offices in California, Massachusetts, North Carolina, Pennsylvania, Texas, Washington and Canada. Internationally, we have European offices in Germany, the Netherlands, France and the United Kingdom, we have offices in Israel, and Asian offices in China, India, Japan, Korea and Taiwan. We believe our current facilities are adequate to support our current and near-term operations. However, if we need additional space, adequate space may not be available on commercially reasonable terms or at all.

Synopsys, Inc. v. Magma Design Automation, Inc., Civil Action No. C04-03923 (“MMC”), United States District Court, Northern District of California. In this action, filed September 17, 2004, Synopsys has sued the Company for alleged infringement of U.S. Patent Nos. 6,378,114 (“the ‘114 Patent”), 6,453,446 (“the ‘446 Patent”), and 6,725,438 (“the ‘438 Patent”). The patents-in-suit relate to methods for designing integrated circuits. The Complaint seeks unspecified monetary damages, injunctive relief, trebling of damages, fees and costs, and the imposition of a constructive trust for the benefit of Synopsys over any profits, revenues or other benefits allegedly obtained by the Company as a result of its alleged infringement of the patents-in-suit.

On October 21, 2004, the Company filed its answer and counterclaims (“Answer”) to the Complaint. On November 10, 2004, Synopsys filed motions to strike and dismiss certain affirmative defenses and counterclaims in the Answer. On November 24, 2004, Magma filed an Amended Answer and Counterclaims (“Amended Answer”). By order dated November 29, 2004, the Court denied Synopsys’ motions as moot in light of the Amended Answer. On December 10, 2004, Synopsys moved to strike and dismiss certain affirmative defenses and counterclaims in the Amended Answer. By order dated January 20, 2005, the Court denied in part and granted in part Synopsys’ motion. In its pretrial preparation order dated January 21, 2005, the Court set forth a schedule for the case which, among other things, sets trial for April 24, 2006. Discovery is ongoing.

On February 3, 2005, Synopsys filed its Reply to the Amended Answer. On March 17, 2005, Synopsys filed a First Amended Complaint, which asserts seven causes of action against the Company and/or Lukas van Ginneken: (1) patent infringement (against both defendants), (2) breach of contract (against van Ginneken), (3) inducing breach of contract (against the Company), (4) fraud (against the Company), (5) conversion (against both defendants), (6) unjust enrichment/constructive trust (against both defendants), and (7) unfair competition (against both defendants).

On April 1, 2005, the Company filed a motion to dismiss the third through seventh causes of action. This motion was granted in part and denied in part by order dated May 18, 2005. On April 11, 2005, Synopsys voluntarily dismissed van Ginneken from the lawsuit and filed against the Company a motion for partial summary judgment establishing unfair competition and a motion for partial summary judgment based on the doctrine of assignor estoppel. On June 7, 2005, Synopsys filed a Second Amended Complaint asserting six causes of action against the Company: (1) patent infringement, (2) inducing breach of contract/interference with contractual relations, (3) fraud, (4) conversion, (5) unjust enrichment/constructive trust/quasi-contract, and (6) unfair competition. The Second Amended Complaint seeks injunctive relief, declaratory relief, at least $100 million in damages, trebling of damages, punitive damages, fees and costs, and the imposition of a constructive trust for the benefit of Synopsys over any profits, royalties and other benefits allegedly obtained by the Company as a result of its alleged use of Synopsys’s alleged inventions.

On June 10, 2005, Magma filed an opposition to Synopsys’s assignor estoppel motion, an opposition and cross-motion for summary judgment with respect to Synopsys’s unfair competition motion, and a motion for summary judgment as to the Second through Sixth Causes of Action in the Second Amended Complaint. Synopsys’s motions are scheduled to be heard on July 8, 2005 and Magma’s motions are scheduled to be heard on July 15, 2005.

The Company intends to vigorously defend against the claims asserted by Synopsys and to fully enforce its rights against Synopsys. However, the results of any litigation are inherently uncertain and the Company can not assure that it will be able to successfully defend against the Complaint. A favorable outcome for Synopsys could have a material adverse effect on the Company’s financial position, results of operations or cash flows. The Company is currently unable to assess the extent of damages and/or other relief, if any, that could be awarded to Synopsys, therefore, no contingent liability has been recorded as of March 31, 2005.

On June 13, 2005, a putative shareholder class action lawsuit captioned The Cornelia I. Crowell GST Trust vs. Magma Design Automation, Inc., Rajeev Madhavan, Gregory C. Walker and Roy E. Jewell., No. C 05 02394, was filed in U.S. District Court, Northern District of California. The complaint alleges that defendants failed to disclose information regarding the risk of Magma infringing intellectual property rights of Synopsys, Inc., in violation of Section 10(b) of the Securities Exchange Act of 1934 and Rule 10b-5 thereunder, and prays for unspecified damages. The Company is currently unable to assess the possible range or extent of damages and/or other relief, if any, that could be awarded to the shareholder class, therefore, no contingent liability has been recorded at March 31, 2005. The ultimate resolution of this matter or other third party assertions could have a material adverse effect on the Company’s financial position, results of operations and cash flows.

In addition to the above, from time to time, the Company is involved in disputes that arise in the ordinary course of business. The number and significance of these disputes is increasing as the Company’s business expands and it grows larger. Any claims against the Company, whether meritorious or not, could be time consuming, result in costly litigation, require significant amounts of management time and result in the diversion of significant operational resources. As a result, these disputes could harm the Company’s business, financial condition, results of operations or cash flows.

Pursuant to General Instruction G(3) of Form 10-K, the information regarding our executive officers required by Item 401(b) of Regulation S-K is listed below.

The following table provides the names, offices, and ages of each of our executive officers as of May 31, 2005:

Rajeev Madhavan has served as our Chief Executive Officer and Chairman of the Board of Directors since our inception in April 1997. Mr. Madhavan served as our President from our inception until May 2001. Prior to co-founding Magma, from July 1994 until February 1997, Mr. Madhavan founded and served as the President and Chief Executive Officer of Ambit Design Systems, Inc., an electronic design automation software company, later acquired by Cadence Design Systems, Inc., an electronic design automation software company.

Roy E. Jewell has served as our President since May 2001 and as one of our directors since July 2001. Mr. Jewell has served as our Chief Operating Officer since March 2001. From March 1999 to September 2000, Mr. Jewell served as the Chief Executive Officer at a company he co-founded, Clarisay, Inc., a supplier of surface acoustic wave filters. From January 1998 to March 1999, Mr. Jewell was a member of the CEO Staff at Avant! Corporation, a provider of software products for integrated circuit designs. From July 1992 to January 1998, Mr. Jewell was the President and Chief Executive Officer of Technology Modeling Associates, Inc. or TMA, subsequently acquired by Avant! Corporation. Prior to that time, Mr. Jewell served in various marketing positions at TMA.

Gregory C. Walker has served as our Chief Financial Officer and Vice President—Finance since August 2002, and as our Senior Vice President—Finance since September 2002. From April 1999 to April 2002 he served as Chief Financial Officer, and most recently as interim Chief Executive Officer, for Accrue Software, Inc., a leading provider of customer relationship management products. From October 1997 to March 1999, Mr. Walker was Chief Financial Officer at Duet Technologies, Inc., a provider of semiconductor design services and software. From January 1997 through September 1997, Mr. Walker served as Chief Financial Officer of NeTpower, Inc., a manufacturer of work stations and servers. From December 1990 to January 1997, Mr. Walker served as Treasurer, Vice President of Finance and acting Chief Financial Officer, successively, at Synopsys, Inc., a supplier of electronic design automation solutions for the global electronic market. Prior to working at Synopsys, Mr. Walker held various positions in financial operations at Xerox Corporation and IBM Corporation.

Saeid Ghafouri has served as our Senior Vice President, Worldwide Field Operations since September 2002. From September 1999 to September 2002 Mr. Ghafouri was President and Chief Executive Officer of Empact Software, Inc., an enterprise software company. He served as President and Chief Executive Officer of an electronic design automation company, interHDL, which was acquired by Avant! Corporation, from April 1998 to September 1999. Prior to that Mr. Ghafouri served in various management positions between June 1996 and April 1998 at Synopsys, Inc., most recently as Vice President—Business Development for library products. He spent eight years with Cadence Design Systems Inc., between March 1986 and May 1994, where he served in various positions in Sales, Marketing and Applications Engineering.

Hamid Savoj co-founded our company and has served as our Senior Vice President, Product Development since September 2002. Before that he served as our Vice President, Product Development since July 2000. Between April 1997 and July 2000 he served as Magma’s principal engineer. From April 1994 to April 1997 Mr. Savoj was a senior member of the consulting staff at Cadence Design Systems.

ITEM 5. MARKET FOR REGISTRANT’S COMMON EQUITY, RELATED STOCKHOLDER MATTERS AND ISSUER PURCHASES OF EQUITY SECURITIES

Our common stock is traded on the Nasdaq National Market under the symbol “LAVA”. Public trading commenced on November 20, 2001. Prior to that, there was no public market for our common stock. The following table sets forth, for the periods indicated, the high and low per share sale prices of our common stock, as reported by the Nasdaq National Market on its consolidated transaction reporting system.

As of May 31, 2005, there were 339 holders of record (not including beneficial holders of stock held in street names) of our common stock.

We have not declared or paid cash dividends on our common stock and do not anticipate paying any cash dividends in the foreseeable future. We expect to retain future earnings, if any, to fund the development and growth of our business. Our Board of Directors will determine future dividends, if any.

On April 29, 2004, during our first quarter of fiscal 2005, we issued a total of 607,554 shares of our common stock in connection with our acquisition of Mojave, Inc. pursuant to a definitive agreement signed on February 23, 2004. In addition to the initial merger consideration we may issue contingent consideration of up to $115.0 million, half in stock and half in cash, based on product orders over a period ending March 31, 2009, but such payments are contingent on the achievement of certain technology milestones. These securities were issued in reliance upon the exemption from the registration requirements of the Securities Act of 1933 provided by Section 3(a)(10) thereof.

We repurchased no shares of our common stock during the fourth quarter of fiscal 2005.

The following selected consolidated financial data are qualified by reference to, and should be read in conjunction with, “Management’s Discussion and Analysis of Financial Condition and Results of Operations” and the Consolidated Financial Statements and related Notes included in Item 8 of this Report. The selected consolidated balance sheet data as of March 31, 2005 and 2004 and selected consolidated statements of operations data for the years ended March 31, 2005, 2004 and 2003, are derived from our audited consolidated financial statements included elsewhere in this Report. The selected consolidated balance sheet data as of March 31, 2003, 2002 and 2001 and the selected consolidated statements of operations data for the years ended March 31, 2002 and 2001 were derived from audited consolidated financial statements not included in this Report. Our historical results are not necessarily indicative of our future results.

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

This Management’s Discussion and Analysis of Financial Condition and Results of Operation section should be read in conjunction with “Selected Consolidated Financial Data” and our condensed consolidated financial statements and results appearing elsewhere in this report. Throughout this section, we make forward-looking statements within the meaning of Section 27A of the Securities Act of 1933 and Section 21E of the Securities Exchange Act of 1934. You can often identify these and other forward looking statements by terms such as “becoming,” “may,” “will,” “should,” “predicts,” “potential,” “continue,” “anticipates,” “believes,” “estimates,” “seeks,” “expects,” “plans,” “intends,” or comparable terminology. These forward-looking statements include, but are not limited to, our expectations about revenue and various operating expenses. Although we believe that the expectations reflected in these forward-looking statements are reasonable, and we have based these expectations on our beliefs and assumptions, such expectations may prove to be incorrect. Our actual results of operations and financial performance could differ significantly from those expressed in or implied by our forward-looking statements. Factors that could cause or contribute to such differences include, but are not limited to: competition in the EDA market; Magma’s ability to integrate acquired businesses and technologies; potentially higher-than-anticipated costs of litigation; potentially higher-than-anticipated costs of compliance with regulatory requirements, including those relating to internal control over financial reporting; any delay of customer orders or failure of customers to renew licenses; weaker-than-anticipated sales of Magma’s products and services; weakness in the semiconductor or electronic systems industries; the ability to manage expanding operations; the ability to attract and retain the key management and technical personnel needed to operate Magma successfully; the ability to continue to deliver competitive products to customers; and changes in accounting rules.

Magma Design Automation provides electronic design automation (“EDA”) software products and related services. Our software enables chip designers to reduce the time it takes to design and produce complex integrated circuits used in the communications, computing, consumer electronics, networking and semiconductor industries. Our products are used in all major phases of the chip development cycle, from initial design through physical implementation. Our focus is on software used to design the most technologically advanced integrated circuits, specifically those with minimum feature sizes of 0.13 micron and smaller. See “Item 1, Business” for a more complete description of our business.

As an EDA software provider, we generate substantially all our revenue from the semiconductor and electronics industries. Our customers typically fund purchases of our software and services out of their research and development budgets. As a result, our revenue is heavily influenced by our customers’ long-term business outlook and willingness to invest in new chip designs.

Beginning in late calendar 2000, the semiconductor industry entered its steepest and longest downturn of the past 20 years, with industry sales dropping significantly from late 2000 to early 2002. As a result, our customers have focused on controlling costs and reducing risk, lowering research and development (“R&D”) expenditures,

cutting back on design starts, purchasing from fewer suppliers, requiring more favorable pricing and payment terms from suppliers, and pursuing consolidation within their own industry. Further, during this downturn, many start-up semiconductor design companies failed or were acquired, and the pace of investment in new companies declined. While the semiconductor industry experienced a moderate recovery in 2003, our customers have remained cautious. It is not yet clear when improved demand in our own customers’ electronics end markets will result in significantly increased R&D spending or design starts, and corresponding spending on EDA tools.

To support our customers, we have focused on providing the most technologically advanced products to address each step in the integrated circuit (“IC”) design process, as well as integrating these products into broad platforms, and expanding our product offerings. Our goal is to be the EDA technology supplier of choice for our customers as they pursue longer-term, broader and more flexible relationships with fewer suppliers.

Despite the condition of the semiconductor industry described above, we were able to achieve the following during fiscal 2005:

We have acquired companies and purchased technologies that enable us to expand into new markets. We believe that these acquisitions are a significant factor in Magma being able to compete successfully in the EDA industry and we expect to make similar acquisitions in the future. These acquisitions increased our headcount and increased our research and development and sales and marketing expenses. Acquisitions may decrease our liquidity in the short term if earnout milestones are achieved and we must pay contingent cash consideration under the terms of some of these acquisitions.

On April 16, 2004, we acquired Lemmatis, Inc. (“Lemmatis”), a privately-held developer of formal verification technology. Pursuant to the merger agreement, we paid the stockholders of Lemmatis initial consideration of approximately $0.6 million in cash, less $60,000 which we withheld to secure the indemnification obligations of the Lemmatis stockholders. In addition to the initial merger consideration, we may pay up to an additional $1.4 million contingent upon the achievement of certain technology milestones set forth in the merger agreement. As of March 31, 2005, we have paid $0.6 million of contingent consideration in connection with achievement of technology milestones.

On April 29, 2004, we completed the acquisition of Mojave, Inc. (“Mojave”), a privately-held developer of advanced technology for integrated circuit manufacturability and verification. The acquisition of Mojave allows Magma to more comprehensively address its customers’ needs of designing and verifying semiconductors that are manufacturable with desirable yield and performance. Manufacturability is a key design parameter as semiconductor process technology moves to sub-90nm geometries. The total initial purchase price of the Mojave acquisition was approximately $25.1 million and the transaction was accounted for as an asset purchase transaction. We acquired all of the outstanding common stock of Mojave in exchange for initial consideration of $24.2 million, which consisted of 607,554 shares of Magma common stock valued at $11.8 million and $12.4 million in cash. In addition to the initial merger consideration, we agreed to pay contingent consideration of up to $115.0 million, half in stock and half in cash, based on product orders over a period ending March 31, 2009, but such payments are contingent on the achievement of certain technology milestones. We did not assume any stock options or warrants. No contingent consideration yet has been earned or paid for milestone achievement as of March 31, 2005.

On December 22, 2004, we acquired Fortis Systems, Inc. (“Fortis”), a privately-held developer of optical proximity correction and lithography simulation technology. Pursuant to the merger agreement, we paid the stockholders of Fortis initial consideration of approximately $0.5 million in cash, less $50,000 which we withheld to secure the indemnification obligations of the Fortis stockholders. In addition to the initial merger consideration, we may pay up to an additional $1.0 million contingent upon the achievement of certain technology milestones set forth in the merger agreement. No contingent consideration yet was earned or paid for milestone achievement as of March 31, 2005.

During fiscal 2005, a total of $20.4 million of contingent cash consideration was earned on the achievement of certain technology milestones as outlined in various prior asset purchase agreements with Silicon Metrics, Sycon, Aplus, PDAT, SiliconCraft and Lemmatis, of which $3.2 million will be paid in the first quarter of fiscal 2006.

In preparing our financial statements, we make estimates, assumptions and judgments that can have a significant impact on our revenue, operating income or loss and net income or loss, as well as on the value of certain assets and liabilities on our balance sheet. We believe that the estimates, assumptions and judgments involved in the accounting policies described below have the most significant potential impact on our financial statements, so we consider these to be our critical accounting policies. We consider the following accounting policies related to revenue recognition, allowance for doubtful accounts, investments, asset purchases and business combinations, income taxes and valuation of long-lived assets to be our most critical policies due to the estimation processes involved in each.

We recognize revenue in accordance with Statement of Position (“SOP”) 97-2, as modified by SOP 98-9, which generally requires revenue earned on software arrangements involving multiple elements (such as software products, upgrades, enhancements, maintenance, installation and training) to be allocated to each element based on the relative fair values of the elements. The fair value of an element must be based on evidence that is specific to us. If evidence of fair value does not exist for each element of a license arrangement and maintenance is the only undelivered element, then all revenue for the license arrangement is recognized over the term of the agreement. If evidence of fair value does exist for the elements that have not been delivered, but does not exist for one or more delivered elements, then revenue is recognized using the residual method, under which recognition of revenue for the undelivered elements is deferred and the residual license fee is recognized as revenue immediately.

Our revenue recognition policy is detailed in Note 1 of the Notes to Consolidated Financial Statements on Form 10-K for the year ended March 31, 2005. Management has made significant judgments related to revenue recognition; specifically, in connection with each transaction involving our products (referred to as an

“arrangement” in the accounting literature) we must evaluate whether our fee is “fixed or determinable” and we must assess whether “collectibility is probable”. These judgments are discussed below.

The fee is fixed or determinable. With respect to each arrangement, we must make a judgment as to whether the arrangement fee is fixed or determinable. If the fee is fixed or determinable, then revenue is recognized upon delivery of software (assuming other revenue recognition criteria are met). If the fee is not fixed or determinable, then the revenue recognized in each period (subject to application of other revenue recognition criteria) will be the lesser of the aggregate of amounts due and payable or the amount of the arrangement fee that would have been recognized if the fees were being recognized ratably.

Except in cases where we grant extended payment terms to a specific customer, we have determined that our fees are fixed or determinable at the inception of our arrangements based on the following:

In order for an arrangement to be considered fixed or determinable, 100% of the arrangement fee must be due within one year or less from the order date. We have a history of collecting fees on such arrangements according to contractual terms. Arrangements with payment terms extending beyond 12 months are considered not to be fixed or determinable.

Collectibility is probable. In order to recognize revenue, we must make a judgment about the collectibility of the arrangement fee. Our judgment of the collectibility is applied on a customer-by-customer basis pursuant to our credit review policy. We typically sell to customers for which there is a history of successful collection. New customers are subjected to a credit review process, which evaluates the customers’ financial positions and ability to pay. If it is determined from the outset of an arrangement that collectibility is not probable based upon our credit review process, revenue is recognized on a cash receipts basis (as each payment is collected).

We derive license revenue primarily from licenses of our design and implementation software and, to a much lesser extent, from licenses of our analysis and verification products. We license our products under time-based and perpetual licenses.

We recognize license revenue after the execution of a license agreement and the delivery of the product to the customer, provided that there are no uncertainties surrounding the product acceptance, fees are fixed or determinable, collection is probable and there are no remaining obligations other than maintenance. For licenses where we have vendor-specific objective evidence of fair value (“VSOE,”) for maintenance, we recognize license revenue using the residual method. For these licenses, license revenue is recognized in the period in which the license agreement is executed assuming all other revenue recognition criteria are met. For licenses where we have no VSOE for maintenance, we recognize license revenue ratably over the maintenance period, or if extended payment terms exist, based on the amounts due and payable.

For transactions in which we bundle maintenance for the entire license term into a time-based license agreement, no VSOE of fair value exists for each element of the arrangement. For these agreements, where the only undelivered element is maintenance, we recognize revenue ratably over the contract term. If an arrangement involves extended payment terms—that is, where payment for less than 100% of the license, services and initial post contract support is due within one year of the contract date—we recognize revenue to the extent of the lesser of the portion of the amount due and payable or the ratable portion of the entire fee.

For our perpetual licenses and some time-based license arrangements, we unbundle maintenance by including maintenance for up to first year of the license term, with maintenance thereafter renewable by the

customer at the substantive rates stated in their agreements with us. In these unbundled licenses, the aggregate renewal period is greater than or equal to the initial maintenance period. The stated rate for maintenance renewal in these contracts is VSOE of the fair value of maintenance in both our unbundled time-based and perpetual licenses. Where the only undelivered element is maintenance, we recognize license revenue using the residual method. If an arrangement involves extended payment terms, revenue recognized using the residual method is limited to amounts due and payable.

If we were to change any of these assumptions or judgments, it could cause a material increase or decrease in the amount of revenue that we report in a particular period. Amounts invoiced relating to arrangements where revenue cannot be recognized are reflected on our balance sheet as deferred revenue and recognized over time as the applicable revenue recognition criteria are satisfied.

We derive services revenue primarily from consulting and training for our software products and from maintenance fees for our products. Most of our license agreements include maintenance, generally for a one-year period, renewable annually. Services revenue from maintenance arrangements is recognized on a straight-line basis over the maintenance term. Because we have VSOE of fair value for consulting and training services, revenue is recognized as these services are performed or completed. Our consulting and training services are generally not essential to the functionality of the software. Our products are fully functional upon delivery of the product. Additional factors considered in determining whether the revenue should be accounted for separately include, but are not limited to: degree of risk, availability of services from other vendors, timing of payments and impact of milestones or acceptance criteria on our ability to recognize the software license fee.

Unbilled accounts receivable represent revenue that has been recognized in advance of being invoiced to the customer. In all cases, the revenue and unbilled receivables are for contracts which are non-cancelable, there are no contingencies and where the customer has taken delivery of both the software and the encryption key required to operate the software. We typically generate invoices 45 days in advance of contractual due dates, and we invoice the entire amount of the unbilled accounts receivable within one year from the contract inception.

We maintain allowances for doubtful accounts for estimated losses resulting from the inability of our customers to make required payments. We regularly review the adequacy of our accounts receivable allowance after considering the size of the accounts receivable balance, each customer’s expected ability to pay and our collection history with each customer. We review significant invoices that are past due to determine if an allowance is appropriate using the factors described above. We also monitor our accounts receivable for concentration in any one customer, industry or geographic region.

As of March 31, 2005, one customer accounted for approximately 10% of total receivables. The allowance for doubtful accounts represents our best estimate, but changes in circumstances relating to accounts receivable may result in a requirement for additional allowances in the future. If actual losses are significantly greater than the allowance we have established, that would increase our general and administrative expenses and reported net loss. Conversely, if actual credit losses are significantly less than our allowance, this would decrease our general and administrative expenses and our reported net income would increase.

We are required to allocate the purchase price of acquired assets and business combinations to the tangible and intangible assets acquired, liabilities assumed, as well as in-process research and development based on their estimated fair values. Such a valuation requires management to make significant estimates and assumptions, especially with respect to intangible assets.

Critical estimates in valuing certain of the intangible assets include but are not limited to: future expected cash flows from license sales, maintenance agreements, consulting contracts, customer contracts, acquired workforce and acquired developed technologies and patents; expected costs to develop the in-process research and development into commercially viable products and estimated cash flows from the projects when completed; the acquired company’s brand awareness and market position, as well as assumptions about the period of time the acquired brand will continue to be used in the combined company’s product portfolio; and discount rates. Management’s estimates of fair value are based upon assumptions believed to be reasonable, but which are inherently uncertain and unpredictable. Assumptions may be incomplete or inaccurate, and unanticipated events and circumstances may occur.

Other estimates associated with the accounting for these acquisitions may change as additional information becomes available regarding the assets acquired and liabilities assumed resulting in changes in the purchase price allocation.

Our long-lived assets include goodwill and other intangible assets. Statement of Financial Accounting Standards No. 142, “Goodwill and Other Intangible Assets,” requires that goodwill be tested for impairment at the reporting unit level (operating segment or one level below an operating segment) on an annual basis and between annual tests in certain circumstances. Application of the goodwill impairment test requires judgment, including the identification of reporting units, assigning assets and liabilities to reporting units, assigning goodwill to reporting unit, and determining the fair value of the reporting unit. We have determined that we have one reporting unit (see Note 6 of the Notes to the Consolidated Financial Statements under Item 8 of this report). Significant judgments required to estimate the fair value of a reporting unit include estimating future cash flows, determining appropriate discount rates and other assumptions. Changes in these estimates and assumptions could materially affect the determination of fair value for the reporting unit. Any impairment losses recorded in the future could have a material adverse impact on our financial condition and results of operations.

Statement of Financial Accounting Standards No. 144, “Accounting for the Impairment or Disposal of Long-Lived Assets,” requires that we record an impairment charge on finite-lived intangibles or long-lived assets to be held and used when we determine that the carrying value of intangible assets and long-lived assets may not be recoverable. Based on the existence of one or more indicators of impairment, we measure any impairment of intangibles or long-lived assets based on a projected discounted cash flow method using a discount rate determined by our management to be commensurate with the risk inherent in our business model. Our estimates of cash flows require significant judgment based on our historical results and anticipated results and are subject to many factors.

We account for income taxes in accordance with SFAS 109, “Accounting for Income Taxes.” Significant judgment is required in determining our provision for income taxes. In the ordinary course of business, there are many transactions and calculations where the ultimate tax outcome is uncertain. The amount of income taxes we pay could be subject to audits by federal, state, and foreign tax authorities, which could result in proposed assessments. Although we believe that our estimates are reasonable, no assurance can be given that the final outcome of these tax matters will not be different than that which is reflected in our historical income tax provisions.

We assess the likelihood that our net deferred tax assets will be recovered from future taxable income and to the extent we believe that recovery is not likely, we establish a valuation allowance. We consider all available positive and negative evidence including our past operating results, the existence of cumulative losses in the most recent fiscal years, future taxable income, and ongoing prudent and feasible tax planning strategies in assessing

the amount of the valuation allowance. The Company will continue to evaluate the realizability of the deferred tax assets on a quarterly basis. Future reversals or increases to our valuation allowance could have a significant impact on our future earnings.

Our strategic equity investments consist of preferred stock and convertible notes that are convertible into preferred or common stock of several privately-held companies. As of March 31, 2005, none of the notes have been converted. The carrying value of our portfolio of strategic equity investments in non-marketable equity securities (privately-held companies) totaled $2.3 million at March 31, 2005. Our ability to recover our investments in private, non-marketable equity securities and to earn a return on these investments is primarily dependent on how successfully these companies are able to execute on their business plans and how well their products are accepted, as well as their ability to obtain additional capital funding to continue operations. In the current equity market environment, their ability to obtain additional funding as well as to take advantage of liquidity events, such as initial public offerings, mergers and private sales, may be significantly constrained.

Under our accounting policy, the carrying value of a non-marketable investment is the amount paid for the investment unless it has been determined to be other than temporarily impaired, in which case we write the investment down to its estimated fair value. We review all of our investments periodically for impairment; however, for non-marketable equity securities, the fair value analysis requires significant judgment. This analysis includes assessment of each investee’s financial condition, the business outlook for its products and technology, its projected results and cash flows, the likelihood of obtaining subsequent rounds of financing and the impact of any relevant contractual equity preferences held by us or others. If an investee obtains additional funding at a valuation lower than our carrying amount, we presume that the investment is other than temporarily impaired, unless specific facts and circumstances indicate otherwise, such as when we hold contractual rights that give us a preference over the rights of other investors. As the equity markets have declined significantly over the past few years, we have experienced substantial impairments in our portfolio of non-marketable equity securities. If equity market conditions do not improve, as companies within our portfolio attempt to raise additional funds, the funds may not be available to them, or they may receive lower valuations, with more onerous investment terms than in previous financings, and the investments will likely become impaired. However, we are not able to determine at the present time which specific investments are likely to be impaired in the future, or the extent or timing of individual impairments. We recorded impairment charges related to these non-marketable equity investments of $0.8 million and $1.2 million during fiscal 2005 and 2004, respectively.

Revenue consists of licenses revenue and services revenue. License revenue consists of fees for time-based or perpetual licenses of our products. Services revenue consists of fees for services, such as post-contract customer support (“PCS”), customer training and consulting. We recognize revenue based on the specific terms and conditions of the license contracts with our customer for our products and services as described in detail above in our “Critical Accounting Policies and Estimates.” For management reporting and analysis purposes we classify our revenue into the following four categories:

We classify our license arrangements as either bundled or unbundled. Bundled license contracts include maintenance with the license fee and do not include optional maintenance periods. Unbundled license contracts have separate maintenance fees and include optional maintenance periods.

We use this classification of license revenue to provide greater insight into the reporting and monitoring of trends in the components of our revenue and to assist us in managing our business. It is important to note that the characterization of an individual contract may change over time. For example, a contract originally characterized as Ratable may be redefined as Cash Receipts if that customer has difficulty in making payments in a timely fashion. In cases where a contract has been re-characterized for management reporting purposes, prior periods are not restated to reflect that change.

Bundled and Unbundled Licenses: Ratable. For bundled time-based licenses, we recognize license revenue ratably over the contract term, or as customer payments become due and payable, if less. The revenue for these bundled arrangements for both license and maintenance is classified as license revenue in our statement of operations. For unbundled time-based with a term of less than 15 months, we recognize license revenue ratably over the license term, or as customer payments become due and payable, if earlier. For management reporting and analysis purposes, we refer to both these types of licenses generally as “Ratable” and we generally refer to all time-based licenses recognized on a ratable basis as “Long Term,” independent of the actual length of term of the license.

We classify unbundled perpetual or time-based licenses with a term of fifteen months or greater based on the payment term structure, as “Due and Payable,” “Cash Receipts” or “Perpetual”:

Unbundled Licenses: Due and Payable/Time-Based licenses with long term payments. For unbundled time-based licenses where the payment terms extend greater than one year from the arrangement effective date, we recognize license revenue on a due and payable basis and we recognize maintenance and services revenue ratably over the maintenance term. For management reporting and analysis purposes, we refer to this type of license generally as “Due and Payable/Long Term Time-Based Licenses.”

Unbundled Licenses: Cash Receipts. We recognize revenue from customers who have not met our predetermined credit criteria on a cash receipts basis to the extent that revenue has otherwise been earned. Such customers generally order short-term time based licenses or separate annual maintenance. We recognize license revenue as we receive cash payments from these customers. Maintenance is recognized ratably over the maintenance term after the customer has remitted payment. For management reporting and analysis purposes, we refer to this type of license revenue as “Cash Receipts.”

Unbundled Licenses: “Turns”/Perpetual License or Time-Based licenses with short-term payments. For unbundled time-based and perpetual licenses, we recognize license revenue upon shipment as long as the payment terms require the customer to pay 100% of the license fee and the initial period of PCS within one year from the agreement date and payments are generally linear. We recognize maintenance revenue ratably over the maintenance term. In all of these cases, the contracts are non-cancelable, and the customer has taken delivery of both the software and the encryption key required to operate the software. For management reporting and analysis purposes, we refer to this type of license generally as “Turns,” where the license is either perpetual or time-based.

Our license revenue in any given quarter depends upon the mix and volume of perpetual or short term licenses ordered during the quarter and the amount of long-term ratable or due and payable, and cash receipts license revenue recognized during the quarter. In general, we refer to license revenue recognized from perpetual or time based licenses during the quarter as “Up-front” or “Turns” revenue, for management reporting and analysis purposes. All other types of revenue are generally referred to as revenue from backlog. We set our revenue targets for any given period based, in part, upon an assumption that we will achieve a certain level of orders and a certain mix of short term licenses. The precise mix of orders fluctuates substantially from period to period and affects the revenue we recognize in the period. If we achieve our target level of total orders but are unable to achieve our target license mix, we may not meet our revenue targets (if we have more-than-expected long term licenses) or may exceed them (if we have more-than-expected short term or perpetual licenses). If we achieve the target license mix but the overall level of orders is below the target level, then we may not meet our revenue targets as described in the risk factors below.

Table below sets forth the fluctuations in revenue, cost of revenue and gross profit from fiscal 2004 to fiscal 2005 and from fiscal 2003 to fiscal 2004 (in thousands, except percentage data):

Table sets forth the fluctuations in geographic distribution of revenue from fiscal 2004 to fiscal 2005 and from fiscal 2003 to fiscal 2004 below (in thousands, except percentage data):

License revenue increased in fiscal 2004 due to large orders executed in North America, Europe and Japan. These orders came from sales to new customers, the number of which increased by more than 100% from the prior year, future proliferation into our customers’ design groups and the addition of new products, principally Blast Fusion APX. During fiscal 2004 we added more than 60 new customers. Two customers each accounted for more than 10 percent of the full year revenue, combining for a total of 24 percent. License revenue as a percentage of revenue slightly increased in fiscal 2004 as compared to fiscal 2003.

Cost of revenue includes personnel and related costs to provide product support, consulting services and training. Cost of revenue also includes software production costs, product packaging, documentation, amortization of acquired developed technology and other intangible assets, and amortization of deferred stock-based compensation. Management allocates these expenses to cost of upfront licenses, cost of time-based licenses and cost of services, based on orders booked within a given quarter. Accordingly, the costs allocated to upfront licenses, time-based licenses and services are heavily dependent on the mix of software orders received during any given period.

The table below (in thousands, except percentage data) sets forth the fluctuations in operating expenses from fiscal 2004 to fiscal 2005 and from fiscal 2003 to fiscal 2004:

Research and development expense increased in fiscal 2004 compared to fiscal 2003 primarily due to an increase in payroll related expenses of $4.2 million as we more than doubled our research and development headcount through direct hiring as well as business acquisitions during fiscal 2004. The remainder of the increase was caused by increases in common expenses (e.g., facility related expenses) of $3.9 million and software maintenance costs of $0.3 million, both of which were caused by the headcount increase. These increases were offset by a decrease in professional service fees of $1.3 million in fiscal 2004 as we utilized more internal resources to conduct our internal research and development projects. The remainder of the fluctuation in research and development expenses between fiscal 2003 and fiscal 2004 was accounted for by other individually insignificant items.

We expect our research and development expenses in fiscal 2006 to increase as a percentage of revenue compared to the amount in fiscal 2005, attributable to increased compensation costs.

We expect that our sales and marketing expenses in fiscal 2006 will increase moderately, while declining as a percentage of revenue compared with the amount in fiscal 2005 as our sales and marketing headcount will remain at approximately the same level.

We expect our general and administrative expenses to increase in fiscal 2006 compared to 2005 as we continue to see the impact of legal expenses related to patent litigation with Synopsys and professional services related to compliance with the requirements of the Sarbanes-Oxley Act of 2002.

The table below (in thousands, except percentage data) sets forth the fluctuations in other items from fiscal 2004 to fiscal 2005 and from fiscal 2003 to fiscal 2004:

We are in a net deferred tax asset position, for which a full valuation allowance has been recorded. We will continue to provide a valuation allowance on our net deferred tax assets until it becomes more likely than not that the deferred tax assets will be realizable. The Company will continue to evaluate the realizability of the deferred tax assets on a quarterly basis.

In the event of a future change in ownership, as defined under federal and state tax laws, our net operating loss and tax credit carryfowards may be subject to an annual limitation. The annual limitations may result in an increase to our current income tax provision and/or the expiration of the net operating loss and tax credit carryforwards before realization.

During the fourth quarter of fiscal 2005, we reclassified auction rate securities of $55.1 million and $58.4 million as of March 31, 2004 and 2003, respectively, from Cash and cash equivalents to Short-term investments on our Consolidated Balance Sheets. We have reclassified the purchases and sales of these auction rate securities in our Consolidated Statements of Cash Flows, which decreased our cash used in investing activities by $3.4 million for the year ended March 31, 2004 and increased cash used in investing activities by $58.5 million for the year ended March 31, 2003.

Our cash, cash equivalents, short-term investments and long-term marketable securities, excluding restricted cash, were (a) approximately $135.5 million at March 31, 2005, a decrease of $15.3 million or 10% from March 31, 2004; and (b) $150.8 million at March 31, 2004, an increase of $55.1 million, or 58% from March 31, 2003. These changes primarily reflect cash generated from operations, proceeds from issuance of convertible notes and stock issuances, which in fiscal 2005 were more than offset by cash used for asset purchases, repurchase of common stock, purchase of equity investments and for capital investments. Our investment portfolio consists of high-grade fixed-income securities diversified among corporate, US agency and municipal issuers with maturities of two years or less. A portion of the portfolio is allocated to auction rate securities which provide liquidity at par every 28 days with underlying longer-term maturities.

On July 28, 2004, we announced that our Board of Directors authorized Magma to repurchase up to 1,000,000 shares of common stock. The repurchase was completed in the second quarter of fiscal 2005 and we used approximately $16.6 million to repurchase 1,000,000 shares of common stock. The repurchased shares are to be used for Magma’s 2004 Employment Inducement Award Plan.

On April 13, 2005, we announced that our Board of Directors authorized Magma to repurchase up to two million shares of our common stock. The stock repurchase program was completed in May 2005. We used approximately $16.0 million to repurchase 2.0 million shares of common stock. The repurchased shares are to be used for general corporate purposes.

On December 22, 2004, we acquired Fortis Systems, Inc. (“Fortis”), a developer of optical proximity correction and lithography simulation technology, for cash consideration of approximately $0.5 million, less $50,000 withheld to secure indemnification obligations. In addition, we may pay up to an additional $1.0 million upon the achievement of technology milestones set forth in the acquisition agreement. As of March 31, 2005, no contingent consideration has been paid under the agreement because the milestones have not yet been achieved.

On April 29, 2004, we completed the acquisition of Mojave, Inc. (“Mojave”), a privately held developer of advanced technology for integrated circuit manufacturability and verification. The acquisition of Mojave will allow Magma to more comprehensively address its customers’ needs of designing and verifying semiconductors

that are manufacturable with desirable yield and performance. Manufacturability is a key design parameter as semiconductor process technology moves to sub-90nm geometries. The total initial purchase price of the Mojave acquisition was approximately $25.1 million and the transaction has been accounted for as an asset purchase transaction. We acquired all of the outstanding common stock of Mojave in exchange for initial consideration of $24.2 million, which consisted of $12.4 million in cash and 607,554 shares of Magma common stock valued at $11.8 million. In addition to the initial merger consideration, we agreed to pay contingent consideration of up to $115.0 million, half in stock and half in cash, based on product orders over a period ending March 31, 2009, but such payments are contingent on the achievement of certain technology milestones. As of March 31, 2005, no contingent consideration has been paid under the agreement because the milestones have not yet been achieved.

On April 16, 2004, we acquired Lemmatis, Inc. (“Lemmatis”), a developer of formal verification technology, for cash consideration of approximately $0.6 million, less $60,000 withheld to secure indemnification obligations. In addition, we may pay up to an additional $1.4 million contingent upon the achievement of technology milestones set forth in the acquisition agreement. As of March 31, 2005, we have paid $0.6 million of such contingent consideration for the milestones that have been achieved under the agreement.

On May 22, 2003, we issued $150.0 million principal amount of our Zero Coupon Convertible Subordinated Notes due May 15, 2008 (the “Notes”) resulting in net proceeds to us of approximately $145.1 million. The Notes do not bear coupon interest and are convertible into shares of our common stock at an initial conversion price of $22.86 per share, for an aggregate of approximately 6.56 million shares. The Notes are subordinated to our existing and future senior indebtedness and effectively subordinated to all indebtedness and other liabilities of our subsidiaries. We may not redeem the Notes prior to their maturity date. In order to minimize the dilutive effect from the issuance of the Notes, we undertook the following additional transactions concurrent with the issuance of the Notes:

In early May 2005, we repurchased, in privately negotiated transactions, $44.5 million face amount (or approximately 30 percent of the total) of these notes at an average discount to face value of approximately 22 percent. We spent an aggregate of approximately $34.8 million on the repurchase. The repurchase leaves approximately $105.5 million aggregate principal amount of convertible subordinated notes outstanding. At the same time we terminated a portion (approximately 30 percent) of the hedging arrangements.

Net cash provided by operating activities was increased by $12.4 million to $37.1 million in fiscal 2005 compared to fiscal 2004. The increase was primarily due to a $39.5 million increase in cash from customers and a $6.4 million change in prepaid and other assets balances. Prepaid and other assets decreased by $1.5 million in

fiscal 2005 and increased by $4.9 million in fiscal 2004. These increases were partially offset by a $30.5 million increase in costs and operating expenses and a $2.6 million increase in payments associated with accounts payable and accrued liabilities. The increase in cash from customers was primarily due to growth in revenue and strong cash collection during fiscal 2005 compared to fiscal 2004. The decrease in prepaid expenses was primarily caused by decreases in prepaid commission expense and prepaid software maintenance expense. Prepaid commission decreased during fiscal 2005 primarily due to orders recorded in fiscal 2003 of approximately $100.0 million for which we paid advance commissions but where the entire order value has not been recognized as revenue in fiscal 2003. The advance commission balance decreases during years after fiscal 2003 as these orders are recognized as revenue in subsequent periods. The payment of accrued liabilities during fiscal 2005 was primarily related to a payout of accrued bonuses during the period.

Net cash provided by operating activities was $24.8 million for the year ended March 31, 2004. Cash was provided by net income adjusted for non-cash related items and changes in working capital including increases in accounts payable, accrued liabilities and deferred revenue. The increases in accounts payable and accrued liabilities are primarily due to the growth in our operations including headcount. Our headcount increased by 86% in fiscal 2004. Cash was also provided by an increase in other-long term liabilities, which primarily represented deferred rent related to the new lease agreement signed in fiscal 2004 for our headquarters facility. These increases were offset by cash used for changes in working capital including increases in accounts receivable, prepaid expenses and other current assets. Accounts receivable increased due to the timing of installment billings to customers. The increase in prepaid expenses and other current assets is primarily due to increases in prepaid commission and prepaid maintenance related to a licensed technology, which was obtained in March 2004. Prepaid commission increased during fiscal 2004 primarily due to orders recorded by us in fiscal 2003 of approximately $100.0 million for which we paid advance commissions but the entire order value has not been recognized as revenue as of March 31, 2004.

Net cash provided by operating activities was $3.0 million for the year ended March 31, 2003. For the year ended March 31, 2003 net cash provided by operating activities was primarily due to net income of $3.1 million and non-cash items of $4.9 million of depreciation and amortization, $4.8 million of amortization of stock-based compensation, $0.6 million of provision for doubtful accounts, and $0.6 million related to loss on write-down of investments. These increases were offset by changes in accounts receivable, prepaids and other current assets, accounts payable, deferred revenue, accrued expenses, other assets, other long-term liabilities and accounts payable.

Net cash used in investing activities was $27.7 million in fiscal 2005. In order to broaden our product offerings and to incorporate certain key technologies into our existing products, we used a total of $13.2 million in cash, net of cash acquired, to complete the Mojave, Lemmatis, Fortis and other asset purchase transactions during fiscal 2005. We also made earnout payments totaling $17.8 million on milestone payments relating to prior asset purchases. In addition, we made net investments of $1.3 million in several privately held technology companies for business and strategic purposes. We may make additional strategic equity investments in the future by using our cash and cash equivalents and investments. We had a net purchase of $17.3 million of marketable securities as we invested our excess cash resources. In fiscal 2005 we acquired property and equipment totaling $12.7 million. The property and equipment expenditures were primarily for purchases of computer equipment and research and development tools to support our growing operations. We expect to make capital expenditures of approximately $10.0 million for fiscal 2006. These capital expenditures will be used to support selling and marketing and product development activities. We will use our cash and cash equivalents and investments to fund these purchases.

Net cash used in investing activities was $140.7 million in fiscal 2004. We used cash to complete 4 business combination and 4 asset purchase transactions during fiscal 2004 in order to broaden our product offerings and to incorporate certain key technologies into our existing products and paid a total of $78.6 million in cash, net of

cash acquired. In connection with two of these transactions, we maintain restricted cash of $2.7 million to secure certain indemnification obligations. We also made equity investments of $2.1 million in several privately held technology companies for business and strategic purposes. We had a net purchase of $44.0 million of short and long-term investments as we invested the proceeds received from our convertible subordinated notes offering completed in May 2003. During fiscal 2004, we acquired property and equipment totaling $13.7 million.

Net cash used in investing activities was $80.1 million in fiscal 2003. Of the cash used in investing activities in fiscal 2003, $75.9 million was used for net purchase of short-term and long-term investments, $3.2 million was used for purchase of property and equipment and $1.0 million was for purchases of equity investments.

Net cash used in financing activities was $6.4 million in fiscal 2005. The sole source of cash was $10.4 million of cash received from the exercise of stock options and shares purchased under the employee stock purchase plan during the period. We used $16.6 million to repurchase 1,000,000 shares of common stock on the open market, as authorized by the board of directors in July 2004.

Net cash provided by financing activities was $127.0 million in fiscal 2004. The primary source of cash was the net proceeds received from issuance of convertible subordinated notes (the “Debt Offering”) of $145.1 million. In connection with the Debt Offering, we also issued a warrant exercisable for shares of our common stock to a bank and received additional cash proceeds of $35.9 million, while we paid $56.2 million in cash for entering into a bond hedge contract with the same bank. Other sources of cash included $24.1 million of cash received from the exercise of stock options and shares purchased under the employee stock purchase plan and $0.2 million of repayment received for the notes receivable from stockholders. These cash inflows were offset by our $2.1 million repayment of notes payable to a bank and our repurchase of 1.1 million shares of our common stock for $20.0 million in order to minimize the dilutive effect of the Debt offering.

Net cash provided by financing activities was $5.0 million in fiscal 2003, which primarily consisted of proceeds from issuance of common stock of $4.9 million.

We believe that our existing cash and cash equivalents and short-term investments will be sufficient to meet our anticipated operating and working capital expenditure requirements in the ordinary course of business for at least the next 12 months. If we require additional capital resources to grow our business internally or to acquire complementary technologies and businesses at any time in the future, we may use cash or need to sell additional equity or debt securities. The sale of additional equity or convertible debt securities may result in more dilution to our existing stockholders. Financing arrangements may not be available to us, or may not be available in amounts or on terms acceptable to us.

Our acquisition agreements related to certain business combination and asset purchase transactions obligate us to pay certain contingent cash compensation based on continued employment and meeting certain revenue or project milestones. Total cash contingent compensation that could be paid under our acquisition agreements assuming all contingencies are met is $59.7 million as of March 31, 2005.

As of March 31, 2005, our principal commitments consisted of operating leases, the future amount of which was $13.5 million through fiscal 2011 for office facilities, and repayment of the convertible subordinated notes of $150.0 million due in fiscal 2009. Although we have no material commitments for capital expenditures, we anticipate a substantial increase in our capital expenditures and lease commitments with our anticipated growth in operations, infrastructure, and personnel.

The following summarizes our significant contractual obligations at March 31, 2005, and the effect such obligations are expected to have on our liquidity and cash flows in future periods (in millions):

Purchase obligations represent an estimate of all open purchase orders and contractual obligations in the course of business for which we have not received the goods or services as of March 31, 2005. Although open purchase orders are considered enforceable and legally binding, the terms generally allow us the option to cancel, reschedule and adjust our requirements based on our business needs prior to the delivery of goods or performance of services.

In addition to the enforceable and legally binding obligations quantified in the table above, we have other obligations for goods and services entered into in the normal course of business. These obligations, however, either are not enforceable or legally binding or are subject to change based on our business decisions.

As of March 31, 2005, we did not have any significant “off-balance-sheet arrangements,” as defined in Item 303(a)(4)(ii) of Regulation S-K.

We enter into standard license agreements in the ordinary course of business. Pursuant to these agreements, we agree to indemnify our customers for losses suffered or incurred by them as a result of any patent, copyright, or other intellectual property infringement claim by any third party with respect to our products. These indemnification obligations have perpetual terms. Our normal business practice is to limit the maximum amount of indemnification to the amount received from the customer. On occasion, the maximum amount of indemnification we may be required to make may exceed its normal business practices. We estimate the fair value of its indemnification obligations as insignificant, based on our historical experience concerning product and patent infringement claims. Accordingly, we have no liabilities recorded for indemnification under these agreements as of March 31, 2005.

We have agreements whereby our officers and directors are indemnified for certain events or occurrences while the officer or director is, or was, serving at our request in such capacity. The maximum potential amount of future payments we could be required to make under these indemnification agreements is unlimited; however, we have a directors and officers insurance policy that reduces our exposure and enables us to recover a portion of future amounts paid. As a result of our insurance policy coverage, we believe the estimated fair value of these indemnification agreements is minimal. Accordingly, no liabilities have been recorded for these agreements as of March 31, 2005.

In connection with recent business acquisitions, we agreed to assume, or cause our subsidiaries to assume, indemnification obligations to the officers and directors of acquired companies.

We offer our customers a warranty that our products will conform to the documentation provided with the products. To date, there have been no payments or material costs incurred related to fulfilling these warranty obligations. Accordingly, we have no liabilities recorded for these warranties as of March 31, 2005. We assess the need for a warranty accrual on a quarterly basis, and there can be no guarantee that a warranty accrual will not become necessary in the future.

FACTORS THAT MAY AFFECT OUR BUSINESS AND FUTURE RESULTS OF OPERATIONS AND FINANCIAL CONDITION

Our business faces many risks. The risks described below may not be the only risks we face. Additional risks that we do not yet know of or that we currently think are immaterial may also impair our business operations. If any of the events or circumstances described in the following risks actually occur, our business, financial condition or results of operations could suffer, and the trading price of our common stock could decline.

Our limited operating history makes it difficult to evaluate our business and prospects.

We were incorporated in April 1997 and introduced our first principal software product, Blast Fusion, in April 1999. We have a limited history of generating revenue from our software products, and the revenue and income potential of our business and market is still unproven. As a result of our short operating history, we have limited financial data that can be used to evaluate our business. We have only been profitable for eight of the last twelve fiscal quarters, and we were not profitable prior to fiscal 2003. Our software products represent a new approach to the challenges presented in the electronic design automation market, which to date has been dominated by established companies with longer operating histories. Key markets within the electronic design automation industry may fail to adopt our proprietary technologies and software products. Any evaluation of our business and our prospects must be considered in light of our limited operating history and the risks and uncertainties often encountered by relatively young companies.

We have a history of losses prior to fiscal 2003 and have an accumulated deficit of approximately $115.6 million as of March 31, 2005; if we do not increase profitability, the public trading price of our stock would be likely to decline.

We had an accumulated deficit of approximately $115.6 million as of March 31, 2005. Although we achieved profitability in fiscal 2003 and fiscal 2004, we incurred losses in prior years and for the year ended March 31, 2005. If we incur new losses, or do not increase profitability at a level expected by securities analysts or investors, the market price of our common stock is likely to decline. If we incur net losses, we may not be able to maintain or increase our number of employees or our investment in capital equipment, sales, marketing, and research and development programs, and we may not be able to continue to operate.

Our quarterly results are difficult to predict, and if we miss quarterly financial expectations, our stock price could decline.

Our quarterly revenue and operating results are difficult to predict, and fluctuate from quarter to quarter. It is likely that our operating results in some periods will be below investor expectations. If this happens, the market price of our common stock is likely to decline. Fluctuations in our future quarterly operating results may be caused by many factors, including:

We currently face a patent infringement suit brought by Synopsys, Inc., and we may face additional intellectual property infringement claims or other claims against us or our customers that could be costly to defend and result in our loss of significant rights.

On September 17, 2004, Synopsys, Inc., filed suit against us for patent infringement (please see the discussion in “Item 3—Legal Proceedings” for further detail), and in the future other parties may assert intellectual property infringement claims against us or our customers. We have also acquired or may hereafter acquire software as a result of our past or future acquisitions, and we may be subject to claims that such software infringes the intellectual property rights of third parties.

Our products may be found to infringe intellectual property rights of third parties, including third-party patents. In addition, many of our contracts contain provisions in which we agree to indemnify our customers from third-party intellectual property infringement claims that are brought against them based on their use of our products. Also, we may be unaware of filed patent applications that relate to our software products. We believe the patent portfolios of our competitors are far larger than ours, and this may increase the risk that they may sue us for patent infringement and may limit our ability to counterclaim for patent infringement or settle through patent cross-licenses.

Due to intellectual property litigation, including the Synopsys litigation, we could lose critical proprietary rights and incur substantial unexpected operating costs. Intellectual property litigation is expensive and time-consuming and could divert management’s attention from our business. If there is a successful claim of infringement, we may be ordered to pay substantial monetary damages (including punitive damages), we may be prevented from distributing all or some of our products, and we may be required to develop non-infringing technology or enter into royalty or license agreements, which may not be available on acceptable terms, if at all. Our failure to develop non-infringing technologies or license the proprietary rights on a timely basis would harm our business.

In addition, we are often involved in or threatened with commercial litigation unrelated to intellectual property infringement claims and in labor litigation, and we may acquire companies that are actively engaged in such litigation.

We may not be successful in defending some or all claims that may be brought against us. Regardless of the outcome, litigation can result in substantial expense and could divert the efforts of our management and technical personnel from our business. Furthermore, publicly announced developments in litigation that are perceived to be adverse to us could cause our stock price to decline sharply and suddenly, which could result in securities litigation against us.

We may not be able to hire and/or retain the number of qualified personnel required for our business, particularly engineering personnel, which would harm the development and sales of our products and limit our ability to grow.

Competition in our industry for senior management, technical, sales, marketing and other key personnel is intense. If we are unable to retain our existing personnel, or attract and train additional qualified personnel, our growth may be limited due to a lack of capacity to develop and market our products.

In particular, we continue to experience difficulty in hiring and retaining skilled engineers with appropriate qualifications to support our growth strategy. Our success depends on our ability to identify, hire, train and retain qualified engineering personnel with experience in integrated circuit design. Specifically, we need to continue to attract and retain field application engineers to work with our direct sales force to technically qualify new sales opportunities and perform design work to demonstrate our products’ capabilities to customers during the benchmark evaluation process. Competition for qualified engineers is intense, particularly in Silicon Valley where our headquarters is located.

Retaining our employees has become more challenging due to the decline in our stock price over the past several years. Many of the stock options held by our employees have an exercise price that is significantly higher than the current trading price of our stock, and these “underwater” options do not serve their purpose as incentives for our employees to remain with Magma. Although, as discussed below, we are attempting to address this problem in part by implementing a stock option exchange program that will allow eligible employees to exchange existing underwater options for options exercisable for a smaller number of shares at the current trading price, we cannot guarantee that this program will be approved by our stockholders. In addition, the increased volatility of our stock price due to the pendency of, and developments in, the Synopsys litigation may affect employee morale. If we lose the services of a significant number of our employees and/or if we cannot hire additional employees, we will be unable to increase our sales or implement or maintain our growth strategy.

Our success is highly dependent on the technical, sales, marketing and managerial contributions of key individuals, and we may be unable to recruit and retain these personnel.

We depend on our senior executives and certain key research and development and sales and marketing personnel, who are critical to our business. We do not have long-term employment agreements with our key employees, and we do not maintain any key person life insurance policies. Furthermore, our larger competitors may be able to offer more generous compensation packages to executives and key employees, and therefore we risk losing key personnel to those competitors. If we lose the services of any of our key personnel, our product development processes and sales efforts could be slowed. We may also incur increased operating expenses and be required to divert the attention of our senior executives to search for their replacements. The integration of our new executives or any new personnel could disrupt our ongoing operations.

Customer payment defaults may cause us to be unable to recognize revenue from backlog, and changes in the type of orders comprising backlog could affect the proportion of revenue recognized from backlog each quarter, which could have a material adverse effect on our financial condition and results of operations and on investor expectations.

A portion of our revenue backlog is variable based on volume of usage of our products by the customers or includes specific future deliverables or is recognized in revenue on a cash receipts basis. Management has estimated variable usage based on customers’ forecasts, but there can be no assurance that these estimates will be realized. In addition, it is possible that customers from whom we expect to derive revenue from backlog will default and as a result we may not be able to recognize expected revenue from backlog. If a customer defaults and fails to pay amounts owed, or if the level of defaults increases, our bad debt expense is likely to increase. Any material payment default by our customers could have a material adverse effect on our financial condition and results of operations.

Our lengthy and unpredictable sales cycle, and the large size of some orders, makes it difficult for us to forecast revenue and increases the magnitude of quarterly fluctuations, which could harm our stock price.

Customers for our software products typically commit significant resources to evaluate available software. The complexity of our products requires us to spend substantial time and effort to assist potential customers in evaluating our software and in benchmarking it against our competition. As the complexity of the products we sell increases, we expect the sales cycle to lengthen. In addition, potential customers may be limited in their current spending by existing time-based licenses with their legacy vendors. In these cases, customers delay a significant new commitment to our software until the term of the existing license has expired. Also, because our products

require a significant investment of time and cost by our customers, we must target those individuals within the customer’s organization who are able to make these decisions on behalf of their companies. These individuals tend to be senior management in an organization, typically at the vice president level. We may face difficulty identifying and establishing contact with such individuals. Even after initial acceptance, the negotiation and documentation processes can be lengthy. Our sales cycle typically ranges between three and nine months, but can be longer. Any delay in completing sales in a particular quarter could cause our operating results to fall below expectations.

We rely on a small number of customers for a significant portion of our revenue, and our revenue could decline due to delays of customer orders or the failure of existing customers to renew licenses or if we are unable to maintain or develop relationships with current or potential customers.

Our business depends on sales to a small number of customers. In fiscal 2005, we had one customer that accounted for more than 10% of our revenue, and our top three customers together accounted for approximately 27% of our revenue. In fiscal 2004, we had two customers that accounted for 10% or more of our revenue, and our top three customers together accounted for approximately 27% of our revenue. In fiscal 2003, we had one customer that accounted for more than 10% of our revenue and our top three customers together accounted for approximately 23% of our revenue.

We expect that we will continue to depend upon a relatively small number of customers for a substantial portion of our revenue for the foreseeable future. If we fail to sell sufficient quantities of our products and services to one or more customers in any particular period, or if a large customer reduces purchases of our products or services, defers orders, or fails to renew licenses, our business and operating results will be harmed.

Most of our customers license our software under time-based licensing agreements, with terms that typically vary from 15 months to 48 months. Most of our license agreements automatically expire at the end of the term unless the customer renews the license with us or purchases a perpetual license. If our customers do not renew their licenses, we may not be able to maintain our current revenue or may not generate additional revenue. Some of our license agreements allow customers to terminate an agreement prior to its expiration under limited circumstances—for example, if our products do not meet specified performance requirements or goals. If these agreements are terminated prior to expiration or we are unable to collect under these agreements, our revenue may decline.

Some contracts with extended payment terms provide for payments which are weighted toward the later part of the contract term. Accordingly, as the payment terms are extended, the revenue from these contracts is not recognized evenly over the contract term, but is recognized as the lesser of the cumulative amounts due and payable or ratably for bundled agreements, and as amounts become due and payable for unbundled agreements, at each period end. Revenue recognized under these arrangements will be higher in the later part of the contract term, which puts our revenue recognition in the future at greater risk of the customer’s continuing credit-worthiness. In addition, some of our customers have extended payment terms, which creates additional credit risk.

We compete against companies that hold a large share of the electronic design automation market and competition is increasing among EDA vendors as customers tightly control their EDA spending and use fewer vendors to meet their needs. If we cannot compete successfully, we will not gain market share and our revenue could decline.

We currently compete with companies that hold dominant shares in the electronic design automation market, such as Cadence and Synopsys. Each of these companies has a longer operating history and significantly greater financial, technical and marketing resources than we do, as well as greater name recognition and larger installed customer bases. Our competitors are better able to offer aggressive discounts on their products, a practice they often employ. Our competitors offer a more comprehensive range of products than we do; for example, we do not offer logic simulation, layout verification, full-feature custom layout editing, analog or mixed signal products, which can sometimes be an impediment to our winning a particular customer order. In addition, our industry has traditionally viewed acquisitions as an effective strategy for growth in products and market share and our competitors’ greater cash resources and higher market capitalization may give them a

relative advantage over us in buying companies with promising new chip design products or companies that may be too large for us to acquire without a strain on our resources.

Competition in the EDA Market has increased as customers rationalized their EDA spending by using products from fewer EDA vendors and continued consolidation in the electronic design automation market could intensify this trend. Competitive pressures may prevent us from gaining market share, require us to reduce the price of products and services or cause us to lose existing customers, which could harm our business. To execute our business strategy successfully, we must continue to increase our sales worldwide. If we fail to do so in a timely manner or at all, we may not be able to gain market share and our business and operating results could suffer.

We may not be successful in integrating the operations of acquired companies and acquired technology.

We expect to continuously evaluate the possibility of accelerating our growth through acquisitions, as is customary in the electronic design automation industry. Achieving the anticipated benefits of past and possible future acquisitions will depend in part upon whether we can integrate the operations, products and technology of acquired companies with our operations, products and technology in a timely and cost-effective manner. The process of integrating with acquired companies and acquired technology is complex, expensive and time consuming, and may cause an interruption of, or loss of momentum in, the product development and sales activities and operations of both companies. In addition, the earnout arrangements we use, and expect to continue to use, to consummate some of our acquisitions, pursuant to which we agreed to pay additional amounts of contingent consideration based on the achievement of certain revenue, bookings or product development milestones, can sometimes complicate integration efforts. We cannot be sure that any part or all of the integration will be accomplished on a timely basis, or at all. Assimilating previously acquired companies such as Silicon Metrics Corporation and Mojave, Inc., or any other companies we may seek to acquire in the future, involves a number of other risks, including, but not limited to:

Our operating results may be harmed if our customers do not adopt, or are slow to adopt, 65-nanometer design geometries.

Many Magma customers are currently working on 90-nanometer designs. Magma continues to work toward developing and enhancing its product line in anticipation of increased customer demand for 65-nanometer (sub-90 nanometer) design geometries. Similarly, Magma has acquired Mojave personnel and technology to better address customers’ needs for designing and verifying semiconductors that are manufacturable with higher yield and performance, which is a key design parameter when moving to 65-nanometer geometries. Notwithstanding our efforts to support 65-nanometer geometries, customers may fail to adopt or may be slower to adopt 65-nanometer geometries and we may be unable to convince our customers to purchase our related software products. Accordingly, any revenues we receive from enhancements to our products or acquired technologies may be less than the development or acquisition costs. If customers fail to adopt 65-nanometer design geometries or are slow to adopt 65-nanometer design geometries, our operating results may be harmed.

Because many of our current competitors have pre-existing relationships with our current and potential customers, we might not be able to gain market share, which could harm our operations.

Many of our competitors, including Cadence and Synopsys, have established relationships with our current and potential customers and can devote substantial resources aimed at preventing us from establishing or enhancing our customer relationships. These existing relationships can make it difficult for us to obtain additional customers due to the substantial investment that these potential customers have already made in their current design flows. If we are unable to gain market share due to these relationships with our potential customers, our operating results could be harmed.

Our operating results will be significantly harmed if chip designers do not adopt Blast Fusion.

Blast Fusion has accounted for a significant majority of our revenue since our inception and we believe that revenue from Blast Fusion and related products will account for most of our revenue for the foreseeable future. If integrated circuit designers do not continue to adopt Blast Fusion, our operating results will be significantly harmed. We must continue market penetration of Blast Fusion to achieve our growth strategy and financial success.

If the industries into which we sell our products experience recession or other cyclical effects affecting our customers’ research and development budgets, our revenue would be likely to decline.

Demand for our products is driven by new integrated circuit design projects. The demand from semiconductor and systems companies is uncertain and difficult to predict. Slower growth in the semiconductor and systems industries, a reduced number of design starts, reduction of electronic design automation budgets or continued consolidation among our customers would harm our business and financial condition. We have experienced slower growth in revenue than we anticipated as a result of the prolonged downturn and decreased spending by our customers in the semiconductor and systems industries.

The primary customers for our products are companies in the communications, computing, consumer electronics, networking and semiconductor industries. Any significant downturn in our customers’ markets or in general economic conditions that results in the cutback of research and development budgets or the delay of software purchases would likely result in lower demand for our products and services and could harm our business. For example, the United States economy, including the semiconductor industry, experienced a slowdown starting in 2000, which negatively impacted and may continue to impact our business and operating results. While the semiconductor industry experienced a moderate recovery in 2003 and 2004, our customers have remained cautious, and it is not yet clear when increased R&D spending will occur. The continuing threat of terrorist attacks in the United States, the ongoing events in Iraq and other worldwide events including those in the Middle East have increased uncertainty in the United States economy. If the economy declines as a result of this economic, political and social turmoil, existing customers may delay their implementation of our software products and prospective customers may decide not to adopt our software products, either of which could negatively impact our business and operating results.

In recent years, some Asian countries have experienced significant economic difficulties, including devaluation and instability, business failures and a depressed business environment. These difficulties triggered a significant downturn in the semiconductor market, resulting in reduced budgets for chip design tools, which, in turn, negatively impacted us. We have experienced delayed orders and slower deployment of our products under new orders as a result of reduced budgets for chip design tools. In addition, the electronics industry has historically been subject to seasonal and cyclical fluctuations in demand for its products, and this trend may continue in the future. These industry downturns have been, and may continue to be, characterized by diminished product demand, excess manufacturing capacity and subsequent erosion of average selling prices.

Difficulties in developing and achieving market acceptance of new products and delays in planned release dates of our software products and upgrades may harm our business.

To succeed, we will need to develop innovative new products. We may not have the financial resources necessary to fund all required future innovations. Expanding into new technologies or extending our product line into areas we have not previously addressed may be more costly or difficult than anticipated. Also, any revenue that we receive from enhancements or new generations of our proprietary software products may be less than the costs of development. If we fail to develop and market new products in a timely manner, our reputation and our business will suffer.

Our costs of customer engagement and support are high, so our gross margin may decrease if we incur higher-than-expected costs associated with providing support services in the future or if we reduce our prices.

Because of the complexity of our products, we typically incur high field application engineering support costs to engage new customers and assist them in their evaluations of our products. If we fail to manage our customer engagement and support costs, our operating results could suffer. In addition, our gross margin may decrease if we are unable to manage support costs associated with the services revenue we generate or if we reduce prices in response to competitive pressure.

Product defects could cause us to lose customers and revenue, or to incur unexpected expenses.

Our products depend on complex software, both internally developed and licensed from third parties. Our customers may use our products with other companies’ products, which also contain complex software. If our software does not meet our customers’ performance requirements, our customer relationships may suffer. Also, a limited number of our contracts include specified ongoing performance criteria. If our products fail to meet these criteria, it may lead to termination of these agreements and loss of future revenue. Complex software often contains errors. Any failure or poor performance of our software or the third-party software with which it is integrated could result in:

Our product functions are often critical to our customers, especially because of the resources our customers expend on the design and fabrication of integrated circuits. Many of our licensing agreements contain provisions to provide a limited warranty, which provides the customer with a right of refund for the license fees if we are unable to correct errors reported during the warranty period. If our contractual limitations are unenforceable in a particular jurisdiction or if we are exposed to claims that are not covered by insurance, a successful claim could harm our business. We currently carry insurance coverages and limits that we believe are consistent with similarly situated companies within the EDA industry.

Much of our business is international, which exposes us to risks inherent to doing business internationally that could harm our business. We also intend to expand our international operations. If our revenue from this expansion does not exceed the expenses associated with this expansion, our business and operating results could suffer.

We generated 43% of our total revenue from sales outside North America for fiscal 2005, compared to 48% for the fiscal 2004 and 39% for fiscal 2003. While most of our international sales to date have been denominated in U.S. dollars, our international operating expenses have been denominated in foreign currencies. As a result, a decrease in the value of the U.S. dollar relative to the foreign currencies could increase the relative costs of our overseas operations, which could reduce our operating margins.

The expansion of our international operations includes the maintenance of sales offices in Europe, the Middle East, and the Asia Pacific region. If our revenue from international operations does not exceed the expense of establishing and maintaining our international operations, our business could suffer. Additional risks we face in conducting business internationally include:

Future changes in accounting standards, specifically changes affecting revenue recognition, could cause adverse unexpected revenue fluctuations.

Future changes in accounting standards for interpretations thereof, specifically those changes affecting software revenue recognition, could require us to change our methods of revenue recognition. These changes could result in deferral of revenue recognized in current periods to subsequent periods or in accelerated recognition of deferred revenue to current periods, each of which could cause shortfalls in meeting the expectations of investors and securities analysts. Our stock price could decline as a result of any shortfall. Implementation of internal controls reporting and attestation requirements, as further described below, will impose additional financial and administrative obligations on us and will cause us to incur substantial implementation costs from third party consultants, which could adversely affect our results.

Changes in laws and regulations that affect the governance of public companies have increased our operating expenses and will continue to do so.

Recently enacted changes in the laws and regulations affecting public companies, including the provisions of the Sarbanes-Oxley Act of 2002 and the listing requirements for The Nasdaq Stock Market have imposed new duties on us and on our executives, directors, attorneys and independent registered public accounting firms. In order to comply with these new rules, we have hired additional personnel and use additional outside legal, accounting and advisory services, which have increased and are likely to continue increasing our operating expenses. In particular, we have incurred and will continue to incur additional administrative expenses as we implement Section 404 of the Sarbanes-Oxley Act, which requires management to report on, and our independent registered public accounting firm to attest to, our internal controls. For example, we have incurred and will continue to incur significant expenses in connection with the implementation, documentation and testing of our control systems. Management time associated with these compliance efforts necessarily reduces time available for other operating activities, which could adversely affect operating results. If we are unable to achieve full and

timely compliance with these regulatory requirements, we could be required to incur additional costs, expend additional management time on remedial efforts and make related public disclosures that could adversely affect our stock price and result in securities litigation.

Forecasting the Company’s tax rates is complex and subject to uncertainty.

Management must make significant assumptions, judgments and estimates to determine our current provision for income taxes, deferred tax assets and liabilities, and any valuation allowance that may be recorded against our deferred tax assets. These assumptions, judgments and estimates are difficult to make due to their complexity and the relevant tax law is often changing. Our future effective tax rates could be adversely affected by the following:

Our success will depend on our ability to keep pace with the rapidly evolving technology standards of the semiconductor industry. If we are unable to keep pace with rapidly changing technology standards, our products could be rendered obsolete, which would cause our operating results to decline.

The semiconductor industry has made significant technological advances. In particular, recent advances in deep sub-micron technology have required electronic design automation companies to continuously develop or acquire new products and enhance existing products. The evolving nature of our industry could render our existing products and services obsolete. Our success will depend, in part, on our ability to:

If we are unable, for technical, legal, financial or other reasons, to respond in a timely manner to changing market conditions or customer requirements, our business and operating results could be seriously harmed.

If we fail to offer and maintain competitive stock option packages for our employees, or if our stock price declines materially for a protracted period of time, we might have difficulty retaining our employees and our business may be harmed.

In today’s competitive technology industry, employment decisions of highly skilled personnel are influenced by stock option packages, which offer incentives above traditional compensation only where there is a consistent, long-term upward trend over time of a company’s stock price. Our stock price has declined significantly over the past several years due to market conditions and has recently been negatively affected by uncertainty surrounding the outcome of our patent litigation with Synopsys, Inc. (discussed above under “Item 3, Legal Proceedings”). As a result, many of the options held by our employees have an exercise price significantly above the current trading price of our stock; on April 25, 2005 approximately 75% of the options held by our non-executive employees were “underwater.”

On April 18, 2005, our Board of Directors authorized us to seek stockholder approval of a stock option exchange program which, if approved by stockholders, will allow employees holding options to purchase our common stock at exercise prices greater than or equal to $10.50 to exchange those options for a smaller number of new options at an exercise price equal to fair market value on the date of grant, which is expected to be in August 2005. We are seeking stockholder approval of the program at a special meeting of stockholders set for June 22, 2005. If our stockholders do not approve the stock option exchange program, our ability to retain employees could be affected.

If our stock price continues to decline in the future due to market conditions, investors’ perceptions of the technology industry or managerial or performance problems we have, we may be forced to grant additional options to retain employees. This in turn could result in:

In addition, the new accounting requirements for employee stock options discussed below may adversely affect our option grant practices and our ability to recruit and retain employees.

When the accounting treatment for employee stock options changes, our reported results of operations will likely be adversely affected and we may be forced to change our employee compensation and benefits practices.

We currently account for the issuance of employee stock options under principles that do not require us to record compensation expense for options granted at fair market value. In December 2004, the FASB issued SFAS 123R, “Share-Based Payment,” which eliminates the ability to account for share-based compensation transactions using APB 25, and generally requires instead that such transactions be accounted for using a fair-value based method. Under SFAS 123R, companies are required to recognize an expense for compensation cost related to share-based payment arrangements including stock options and employee stock purchase plans. We will be required to adopt the new rules no later than the first quarter of our fiscal year 2007. We are currently assessing the impact of the adoption of SFAS 123R on our business practices; however, this change in accounting treatment will likely adversely affect our reported results of operations and hinder our ability to achieve profitability. Accordingly, we may consider changing our employee compensation practices, and those changes could make it harder for us to retain existing employees and attract qualified candidates.

If our sales force compensation arrangements are not designed effectively, we may lose sales personnel and resources.

Designing an effective incentive compensation structure for our sales force is critical to our success. We have experimented, and continue to experiment, with different systems of sales force compensation. If our incentives are not well designed, we may experience reduced revenue generation, and we may also lose the services of our more productive sales personnel, either of which would reduce our revenue or potential revenue.

Fluctuations in our growth place a strain on our management systems and resources, and if we fail to manage the pace of our growth our business could be harmed.

Periods of growth followed by efforts to realign costs when revenue growth is slower than anticipated have placed a strain on our management, administrative and financial resources. For example, in fiscal year 2005 and the third quarter of fiscal year 2003, we decreased our workforce by 23 and 32 employees, respectively. Over time we have significantly expanded our operations in the United States and internationally, and we plan to continue to expand the geographic scope of our operations. To pace the growth of our operations with the growth in our revenue, we must continue to improve administrative, financial and operations systems, procedures and controls. Failure to improve our internal procedures and controls could result in a disruption of our operations and harm to our business. We expect to incur a significant amount of consulting and other fees and expenses to

document and enhance our financial processes and accounting controls and capabilities in order to achieve certification under Section 404 of the Sarbanes-Oxley Act of 2002. If we are unable to manage our growth the execution of our business plan could be delayed.

If chip designers and manufacturers do not integrate our software into existing design flows, or if other software companies do not cooperate in working with us to interface our products with their design flows, demand for our products may decrease.

To implement our business strategy successfully, we must provide products that interface with the software of other electronic design automation software companies. Our competitors may not support our or our customers’ efforts to integrate our products into their existing design flows. We must develop cooperative relationships with competitors so that they will work with us to integrate our software into a customer’s design flow. Currently, our software is designed to interface with the existing software of Cadence, Synopsys and others. If we are unable to convince customers to adopt our software products instead of those of competitors offering a broader set of products, or if we are unable to convince other software companies to work with us to interface our software with theirs to meet the demands of chip designers and manufacturers, our business and operating results will suffer.

We may not obtain sufficient patent protection, which could harm our competitive position and increase our expenses.

Our success and ability to compete depends to a significant degree upon the protection of our software and other proprietary technology. We currently have a number of issued patents in the United States, but this number is relatively few in relation to our competitors.

These legal protections afford only limited protection for our technology. In addition, rights that may be granted under any patent application that may issue in the future may not provide competitive advantages to us. Further, patent protection in foreign jurisdictions where we may need this protection may be limited or unavailable. It is possible that:

We believe the patent portfolios of our competitors are far larger than ours, and this may increase the risk that they may sue us for patent infringement and may limit our ability to counterclaim for patent infringement or settle through patent cross-licenses.

We rely on trademark, copyright and trade secret laws and contractual restrictions to protect our proprietary rights, and if these rights are not sufficiently protected, it could harm our ability to compete and generate income.

To establish and protect our proprietary rights, we rely on a combination of trademark, copyright and trade secret laws, and contractual restrictions, such as confidentiality agreements and licenses. Our ability to compete and grow our business could suffer if these rights are not adequately protected. We seek to protect our source code for our software, documentation and other written materials under trade secret and copyright laws. We license our software pursuant to agreements, which impose certain restrictions on the licensee’s ability to utilize the software. We also seek to avoid disclosure of our intellectual property by requiring employees and consultants with access to our proprietary information to execute confidentiality agreements. Our proprietary rights may not be adequately protected because:

The laws of some countries in which we market our products may offer little or no protection of our proprietary technologies. Reverse engineering, unauthorized copying or other misappropriation of our proprietary technologies could enable third parties to benefit from our technologies without paying us for it, which would harm our competitive position and market share.

Our directors, executive officers and principal stockholders own a substantial portion of our common stock and this concentration of ownership may allow them to elect most of our directors and could delay or prevent a change in control of Magma.

Our directors, executive officers and stockholders who currently own over 5% of our common stock beneficially own a substantial portion of our outstanding common stock. These stockholders, in a combined vote, will be able to significantly influence all matters requiring stockholder approval. For example, they may be able to elect most of our directors, delay or prevent a transaction in which stockholders might receive a premium over the market price for their shares or prevent changes in control or management.

Our stock price may decline significantly because of stock market fluctuations that affect the prices of technology stocks. A decline in our stock price could result in securities class action litigation against us, which could divert management’s attention and harm our business.

The stock market has experienced significant price and volume fluctuations that have adversely affected the market prices of common stock of technology companies. These broad market fluctuations may reduce the market price of our common stock. In the past, securities class action litigation has often been brought against a company after periods of volatility in the market price of securities. We may in the future be a target of similar litigation. Securities litigation could result in substantial costs and divert management’s attention and resources, which could harm our ability to execute our business plan.

We may need additional capital in the future, but there is no assurance that funds would be available on acceptable terms.

In the future we may need to raise additional capital in order to achieve growth or other business objectives. This financing may not be available in sufficient amounts or on terms acceptable to us and may be dilutive to existing stockholders. If adequate funds are not available or are not available on acceptable terms, our ability to expand, develop or enhance services or products, or respond to competitive pressures would be limited.

Our certificate of incorporation, bylaws and Delaware corporate law contain anti-takeover provisions which could delay or prevent a change in control even if the change in control would be beneficial to our stockholders. We could also adopt a stockholder rights plan, which could also delay or prevent a change in control.

Delaware law, as well as our certificate of incorporation and bylaws, contain anti-takeover provisions that could delay or prevent a change in control of our company, even if the change of control would be beneficial to the stockholders. These provisions could lower the price that future investors might be willing to pay for shares of our common stock. These anti-takeover provisions:

In addition, Section 203 of the Delaware General Corporation Law and the terms of our stock option plans may discourage, delay or prevent a change in control of our company. That section generally prohibits a Delaware corporation from engaging in a business combination with an interested stockholder for three years after the date the stockholder became an interested stockholder. Also, our stock option plans include change-in-control provisions that allow us to grant options or stock purchase rights that will become vested immediately upon a change in control of us.

The board of directors also has the power to adopt a stockholder rights plan, which could delay or prevent a change in control even if the change in control appeared to be beneficial to stockholders. These plans, sometimes called “poison pills,” are sometimes criticized by institutional investors or their advisors and could affect our rating by such investors or advisors. If the board were to adopt such a plan it might have the effect of reducing the price that new investors are willing to pay for shares of our common stock.

We are subject to risks associated with changes in foreign currency exchange rates.

We transact some portions of our business in various foreign currencies. Accordingly, we are subject to exposure from adverse movements in foreign currency exchange rates. This exposure is primarily related to operating expenses in the United Kingdom, Europe and Japan, which are denominated in the respective local currencies. As of March 31, 2005, we had no hedging contracts outstanding. We do not currently use financial instruments to hedge operating expenses denominated in Euro, British Pounds and Japanese Yen. We assess the need to utilize financial instruments to hedge currency exposures on an ongoing basis.

The convertible notes we issued in May 2003 are debt obligations that must be repaid in cash in May 2008 if they are not converted into our common stock at an earlier date, which is unlikely to occur if the price of our common stock does not exceed the conversion price.

In May 2003, we issued $150.0 million principal amount of our zero coupon convertible notes due May 2008. In early May 2005, we repurchased, in privately negotiated transactions, $44.5 million face amount (or approximately 30 percent of the total) of these notes at an average discount to face value of approximately 22 percent. Magma spent an aggregate of approximately $34.8 million on the repurchases. The repurchase leaves approximately $105.5 million aggregate principal amount of convertible subordinated notes outstanding. We will be required to repay that principal amount in full in May 2008 unless the holders of those notes elect to convert them into our common stock before the repayment date. The conversion price of the notes is $22.86 per share. If the price of our common stock does not rise above that level, conversion of the notes is unlikely and we would be required to repay the principal amount of the notes in cash. There have been previous quarters in which we have experienced shortfalls in revenue and earnings from levels expected by securities analysts and investors, which have had an immediate and significant adverse effect on the trading price of our common stock. In addition, the stock market in recent years has experienced extreme price and trading volume fluctuations that often have been unrelated or disproportionate to the operating performance of individual companies. These broad market fluctuations may adversely affect the price of our stock, regardless of our operating performance. Because the notes are convertible into shares of our common stock, volatility or depressed prices for our common stock could have a similar effect on the trading price of the notes.

Hedging transactions and other transactions may affect the value of our common stock and our convertible notes.

We entered into hedging arrangements with Credit Suisse First Boston International at the time we issued our convertible notes, with the objective of reducing the potential dilutive effect of issuing common stock upon conversion of the notes. At the time of our May 2005 repurchase of our zero coupon convertible notes, a portion of the hedging arrangements were retired. These hedging arrangements are likely to have caused Credit Suisse First Boston International and others to take positions in our common stock in secondary market transactions or to enter into derivative transactions at or after the sale of the notes. Any market participants entering into hedging arrangements are likely to modify their hedge positions from time to time prior to conversion or maturity of the notes by purchasing and selling shares of our common stock or other securities, which may increase the volatility and reduce the market price of our common stock.

Our convertible notes are subordinated and there are no financial covenants in the indenture.

Our convertible notes are general unsecured obligations of Magma and are subordinated in right of payment to all of our existing and future senior indebtedness, which we may incur in the future. In the event of our bankruptcy, liquidation or reorganization, or upon acceleration of the notes due to an event of default under the indenture and in certain other events, our assets will be available to pay obligations on the notes only after all senior indebtedness has been paid. As a result, there may not be sufficient assets remaining to pay amounts due on any or all of the outstanding notes. In addition, we will not make any payments on the notes in the event of payment defaults or other specified defaults on our designated senior indebtedness.

Neither we nor our subsidiaries are restricted under the indenture for the notes from incurring additional debt, including senior indebtedness. If we or our subsidiaries incur additional debt or other liabilities, our ability to pay our obligations on the notes could be further adversely affected. We expect that we and our subsidiaries from time to time will incur additional indebtedness and other liabilities.

We may be unable to meet the requirements under the indenture to purchase our convertible notes upon a change in control.

Upon a change in control, which is defined in the indenture to include some cash acquisitions and private company mergers, note holders may require us to purchase all or a portion of the notes they hold. If a change in control were to occur, we might not have enough funds to pay the purchase price for all tendered notes. Future credit agreements or other agreements relating to our indebtedness might prohibit the redemption or repurchase of the notes and provide that a change in control constitutes an event of default. If a change in control occurs at a time when we are prohibited from purchasing the notes, we could seek the consent of our lenders to purchase the notes or could attempt to refinance this debt. If we do not obtain a consent, we could not purchase the notes. Our failure to purchase tendered notes would constitute an event of default under the indenture, which might constitute a default under the terms of our other debt. In such circumstances, or if a change in control would constitute an event of default under our senior indebtedness, the subordination provisions of the indenture would possibly limit or prohibit payments to note holders. Our obligation to offer to purchase the notes upon a change in control would not necessarily afford note holders protection in the event of a highly leveraged transaction, reorganization, merger or similar transaction involving us.

Failure to obtain export licenses could harm our business by preventing us from transferring our technology outside of the United States.

We are required to comply with U.S. Department of Commerce regulations when shipping our software products and/or transferring our technology outside of the United States or to certain foreign nationals. We believe we have complied with applicable export regulations, however, these regulations are subject to change, and, future difficulties in obtaining export licenses for current, future developed and acquired products and technology could harm our business, financial conditions and operating results.

Our business operations may be adversely affected in the event of an earthquake or other natural disaster.

Our corporate headquarters and much of our research and development operations are located in Silicon Valley, California, which is an area known for its seismic activity. An earthquake, fire or other significant natural disaster could have a material adverse impact on our business, financial condition and operating results.

Our exposure to market risk for changes in interest rates relates primarily to our investment portfolio. The primary objective of our investment activities is to preserve principal while maximizing yields without significantly increasing risk. This is accomplished by investing in widely diversified short-term and long-term investments, consisting primarily of investment grade securities, substantially all of which mature within the next twenty-four months. As of March 31, 2005, a hypothetical 100 basis point increase in interest rates would result in approximately a $0.6 million decline in the fair value of our available-for-sale securities.

The fair value of our fixed rate long-term debt is sensitive to interest rate changes. Interest rate changes would result in increases or decreases in the fair value of our debt, due to differences between market interest rates and rates in effect at the inception of our debt obligation. Changes in the fair value of our fixed rate debt have no impact on our cash flows or consolidated financial statements.

We completed an offering on May 22, 2003 of $150.0 million principal amount of convertible subordinated notes due May 15, 2008. Concurrent with the issuance of the convertible notes, we entered into convertible bond hedge and warrant transactions with respect to our common stock, the exposure for which is held by Credit Suisse First Boston International. Both the bond hedge and warrant transactions may be settled at our option either in cash or net shares and expire on May 15, 2008. The transactions are expected to reduce the potential dilution from conversion of the notes. Subject to the movement in the share price of our common stock, we could be exposed to credit risk in the settlement of these options in our favor. Based on a review of the possible net settlements and the credit strength of Credit Suisse First Boston International and its affiliates, we believe that we do not have a material exposure to credit risk arising from these option transactions.

In April 2005, the Company repurchased $44.5 million face value of its convertible notes for $34.8 million. In doing so, the Company liquidated investments that generated a realized loss of approximately $0.7 million. The Company believes that it was in the best interests of the stockholders to reduce the balance sheet debt despite the one-time loss resulting from the liquidation of marketable securities. The Company’s investments that will mature in the next three to four months will be reinvested in short-term instruments in order to take advantage of rising short-term rates.

A majority of our revenue, expense, and capital purchasing activities are transacted in U.S. dollars. However, we transact some portions of our business in various foreign currencies, primarily related to a portion of revenue in Japan and operating expenses in Europe, Japan and Asia-Pacific. Accordingly, we are subject to exposure from adverse movements in foreign currency exchange rates. As of March 31, 2005, we had no currency hedging contracts outstanding. We do not currently use financial instruments to hedge revenue and operating expenses denominated in foreign currencies. We assess the need to utilize financial instruments to hedge currency exposures on an ongoing basis.

The management of Magma Design Automation (“the Company”) is responsible for establishing and maintaining adequate internal control over financial reporting (as defined in Rule 13a-15(f) under the Exchange Act). Our internal control over financial reporting is a process designed to provide reasonable assurance regarding the reliability of financial reporting and the preparation of financial statements in accordance with generally accepted accounting principles.

We assessed the effectiveness of the Company’s internal control over financial reporting as of March 31, 2005. In making this assessment, we used the criteria set forth by the Committee of Sponsoring Organizations of the Treadway Commission (“COSO”) in Internal Control—Integrated Framework. Based on our assessment using those criteria, we concluded that our internal control over financial reporting was effective as of March 31, 2005.

Management’s assessment of the effectiveness of the Company’s internal control over financial reporting as of March 31, 2005 has been audited by PricewaterhouseCoopers LLP, the Company’s independent registered public accounting firm, as stated in their report which is included in this report for the year ended March 31, 2005.

We have completed an integrated audit of Magma Design Automation, Inc.’s 2005 consolidated financial statements and of its internal control over financial reporting as of March 31, 2005 and an audit of its 2004 consolidated financial statements in accordance with the standards of the Public Company Accounting Oversight Board (United States). Our opinions, based on our audits, are presented below.

In our opinion, the consolidated financial statements listed in the accompanying index present fairly, in all material respects, the financial position of Magma Design Automation, Inc. and its subsidiaries at March 31, 2005 and 2004, and the results of their operations and their cash flows for the years then ended in conformity with accounting principles generally accepted in the United States of America. In addition, in our opinion, the financial statement schedule listed in the accompanying index for the years ended March 31, 2005 and 2004 presents fairly, in all material respects, the information set forth therein when read in conjunction with the related consolidated financial statements. These financial statements and financial statement schedule are the responsibility of the Company’s management. Our responsibility is to express an opinion on these financial statements and financial statement schedule based on our audits. We conducted our audits of these statements in accordance with the standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit of financial statements includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements, assessing the accounting principles used and significant estimates made by management, and evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion.

Also, in our opinion, management’s assessment, included in the accompanying Management’s Report On Internal Control Over Financial Reporting that the Company maintained effective internal control over financial reporting as of March 31, 2005 based on criteria established in Internal Control—Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission (COSO), is fairly stated, in all material respects, based on those criteria. Furthermore, in our opinion, the Company maintained, in all material respects, effective internal control over financial reporting as of March 31, 2005, based on criteria established in Internal Control—Integrated Framework issued by the COSO. The Company’s management is responsible for maintaining effective internal control over financial reporting and for its assessment of the effectiveness of internal control over financial reporting. Our responsibility is to express opinions on management’s assessment and on the effectiveness of the Company’s internal control over financial reporting based on our audit. We conducted our audit of internal control over financial reporting in accordance with the standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform the audit to obtain reasonable assurance about whether effective internal control over financial reporting was maintained in all material respects. An audit of internal control over financial reporting includes obtaining an understanding of internal control over financial reporting, evaluating management’s assessment, testing and evaluating the design and operating effectiveness of internal control, and performing such other procedures as we consider necessary in the circumstances. We believe that our audit provides a reasonable basis for our opinions.

A company’s internal control over financial reporting is a process designed to provide reasonable assurance regarding the reliability of financial reporting and the preparation of financial statements for external purposes in accordance with generally accepted accounting principles. A company’s internal control over financial reporting

includes those policies and procedures that (i) pertain to the maintenance of records that, in reasonable detail, accurately and fairly reflect the transactions and dispositions of the assets of the company; (ii) provide reasonable assurance that transactions are recorded as necessary to permit preparation of financial statements in accordance with generally accepted accounting principles, and that receipts and expenditures of the company are being made only in accordance with authorizations of management and directors of the company; and (iii) provide reasonable assurance regarding prevention or timely detection of unauthorized acquisition, use, or disposition of the company’s assets that could have a material effect on the financial statements.

Because of its inherent limitations, internal control over financial reporting may not prevent or detect misstatements. Also, projections of any evaluation of effectiveness to future periods are subject to the risk that controls may become inadequate because of changes in conditions, or that the degree of compliance with the policies or procedures may deteriorate.

We have audited the accompanying consolidated statements of operations, stockholders’ equity, and cash flows of Magma Design Automation, Inc. and subsidiaries for the year ended March 31, 2003. In connection with our audit of the consolidated financial statements, we have also audited the financial statement schedule for the year ended March 31, 2003 as listed in Item 15(a)(2). These consolidated financial statements and financial statement schedule are the responsibility of the Company’s management. Our responsibility is to express an opinion on these consolidated financial statements and financial statement schedule based on our audit.

We conducted our audit in accordance with the standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion.

In our opinion, the consolidated financial statements referred to above present fairly, in all material respects, the results of operations and cash flows of Magma Design Automation, Inc. and subsidiaries for the year ended March 31, 2003, in conformity with accounting principles generally accepted in the United States of America. Also in our opinion, the financial statement schedule, when considered in relation to the consolidated financial statements taken as a whole, presents fairly, in all material respects, the information set forth therein.

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

Magma Design Automation, Inc. (the “Company” or “Magma”), a Delaware corporation, was incorporated on April 1, 1997. The Company provides design and implementation software that enables chip designers to reduce the time it takes to design and produce complex integrated circuits used in the communications, computing, consumer electronics, networking and semiconductor industries. The Company’s Blast Create and Blast Fusion products utilize a methodology for complex, deep submicron chip design that combines traditionally separate logical design and physical design processes into an integrated design flow. The Company has licensed its flagship product, Blast Fusion, to major semiconductor companies and electronic products manufacturers in Asia, Europe, and the United States.

The consolidated financial statements of Magma include the accounts of the Company and its wholly owned subsidiaries. All significant intercompany balances and transactions have been eliminated. Accounts denominated in foreign-currency have been translated using the U.S. dollar as the functional currency.

On January 26, 2005, the Company’s Board of Directors approved a change in Magma’s fiscal year end from March 31 to a 52-53 week fiscal year ending on the first Sunday subsequent to March 31. After the completion of Magma’s current fiscal year ending March 31, 2005, Magma’s fiscal years will consist of four quarters of 13 weeks each except for each seventh fiscal year, which will include one quarter with 14 weeks. As a result of this change, the first quarter of Magma’s fiscal year 2006 will include three additional days, the results of which will be included in Magma’s Form 10-Q for that quarter.

Certain amounts in the 2004 and 2003 financial statements have been reclassified to conform with the 2005 presentation. Certain auction rate securities have been reclassified from cash equivalents to short-term investments. Auction rate securities are variable rate bonds tied to short-term interest rates with maturities on the face of the securities in excess of 90 days. Auction rate securities have interest rate resets through a modified Dutch auction, at predetermined short-term intervals, usually every 7, 28 or 35 days. They trade at par and are callable at par on any interest payment date at the option of the issuer. Interest paid during a given period is based upon the interest rate determined during the prior auction.

Although these securities are issued and rated as long-tem bonds, they are priced and traded as short-term instruments because of the liquidity provided through the interest rate reset. Based on the Company’s ability either to liquidate the holdings or to roll the investment over to the next reset period, the Company had historically classified some or all of these instruments as cash equivalents if the period between interest rate resets was 90 days or less.

The Company accounts for our marketable securities in accordance with SFAS No. 115, “Accounting for Certain Investments in Debt and Equity Securities.” Such investments are classified as “available for sale” and are reported at fair value in the Company’s balance sheets. The short-term nature and structure, the frequency with which the interest rate resets and the ability to sell auction rate securities at par and at our discretion indicates that such securities should more appropriately be classified as short-term investments with the intent of meeting the Company’s short-term working capital requirements.

Based upon the Company’s re-evaluation of these securities, Magma reclassified as short-term investments any auction rate securities previously classified as cash equivalents for each of the periods presented in the consolidated balance sheets. This resulted in a reclassification from cash and cash equivalents to short-term investments of $55.1 million on the March 31, 2004 consolidated balance sheet. In addition, purchases of short-term and long-term investments and sales of short-term investments included in the consolidated statements of cash flows have been revised to reflect the purchase and sale of auction rate securities during the periods presented. This resulted in a decrease in cash used in investing activities by $3.4 million for the year ended March 31, 2004 and an increase in cash used in investing activities by $58.5 million for the year ended March 31, 2003. These reclassifications had no impact on the previously reported net income or cash flows from operations.

Preparation of the consolidated financial statements in conformity with accounting principles generally accepted in the United States of America 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 consolidated financial statements and the reported amounts of revenues and expenses during the reporting period. Management periodically evaluates such estimates and assumptions for continued reasonableness. Appropriate adjustments, if any, to the estimates used are made prospectively based upon such periodic evaluation. Actual results could differ from those estimates.

Revenue consists of fees for perpetual and time-based licenses for the Company’s software products, post-contract customer support (“PCS”), customer training and consulting. The Company classifies its revenues as licenses or services.

License revenue is comprised of software licenses and PCS where the Company does not have vendor specific objective evidence of fair value of PCS. Service revenue consists of fees for consulting services, training, and PCS associated unbundled license arrangements. PCS sold with unbundled license arrangements is renewable after the initial PCS period expires, generally in one-year increments for a fixed percentage of the net license fee.

The Company recognizes revenue in accordance with the American Institute of Certified Public Accountants Statement of Position 97-2, “Software Revenue Recognition” (“SOP 97-2”), as amended by SOP 98-9, “Modifications of SOP 97-2, Software Revenue Recognition, with respect to certain transactions.” The Company generally recognizes revenue when all of the following criteria are met as set forth in paragraph 8 of SOP 97-2:

Persuasive evidence of an arrangement exists. It is the Company’s customary practice to have a written contract, which is signed by both the customer and Magma, or a purchase order from those customers that have previously negotiated a end-user license arrangement or volume purchase agreement, prior to recognizing revenue on an arrangement.

Delivery has occurred. The Company’s software may be either physically or electronically delivered to its customers. For those products that are delivered physically, the Company’s standard transfer terms are FOB shipping point. For an electronic delivery of software, delivery is considered to have occurred when the customer has been provided with the access codes that allow the customer to take immediate possession of the software on its hardware.

If an arrangement includes undelivered products or services that are essential to the functionality of the delivered product, delivery is not considered to have occurred.

The fee is fixed or determinable. The fee customers pay for products is negotiated at the outset of an arrangement. If the license fees are a function of variable-pricing mechanisms such as the number of units distributed or copied by the customer, or the expected number of users in an arrangement, such fees are not recognized as revenue until such time as amounts become fixed or determinable. In addition, where the Company grants extended payment terms to a specific customer, the Company’s fees are not considered to be fixed or determinable at the inception of the arrangements.

The Company considers arrangements where less than 100% of the license and initial period PCS fee is due within one year from the order date to have extended payment terms. Revenue from such arrangements is recognized at the lesser of the aggregate of amounts due and payable or the amount of the arrangement fee that would have been recognized if the fees had been fixed or determinable. Payments received from customers in advance of revenue being recognized are presented as deferred revenue on the consolidated balance sheets.

Collectibility is probable. Collectibility is assessed on a customer-by-customer basis. The Company typically sells to customers for which there is a history of successful collection. New customers are subjected to a credit review process that evaluates the customers’ financial positions and ultimately their ability to pay. If it is determined from the outset of an arrangement that collectibility is not probable based upon the Company’s credit review process, revenue is recognized on a cash receipts basis (as each payment is collected).

Multiple element arrangements. The Company allocates revenue on software arrangements involving multiple elements to each element based on the relative fair values of the elements. The Company’s determination of fair value of each element in multiple element arrangements is based on vendor-specific objective evidence (“VSOE”). The Company limits its assessment of VSOE for each element to the price charged when the same element is sold separately or renewal rates of PCS.

The Company has analyzed all of the elements included in its multiple-element arrangements and determined that it has sufficient VSOE to allocate revenue to the PCS components of its perpetual license products and consulting. Accordingly, assuming all other revenue recognition criteria are met, revenue from unbundled licenses is recognized upon delivery using the residual method in accordance with SOP 98-9 and revenue from PCS is recognized ratably over the PCS term. The Company recognizes revenue from bundled licenses ratably over the term of the license period, as the license and PCS portions of a bundled license are not sold separately. Revenue from bundled arrangements with extended payment terms is recognized as the lesser of amounts due and payable or ratable portion of the entire fee.

Certain of the Company’s time-based licenses include the rights to specified and unspecified additional products. Revenue from contracts with the rights to unspecified additional software products is recognized ratably over the contract term. The Company recognizes revenue from time-based licenses that include both unspecified additional software products and extended payment terms that are not considered to be fixed or determinable in an amount that is the lesser of amounts due and payable or the ratable portion of the entire fee. Revenue from licenses that include a right to specified upgrades is deferred until the upgrades are delivered because there is no vendor specific objective evidence for the specific upgrade.

The Company provides design methodology assistance and specialized services relating to generalized turnkey design services. The Company has vendor specific objective evidence of fair value for consulting and training services. Therefore, revenue from such services is recognized when such services are performed. The Company’s consulting services generally are not essential to the functionality of the software. The Company’s software products are fully functional upon delivery and implementation does not require any significant modification or alteration. The Company’s services to its customers often include assistance with product adoption and integration and specialized design methodology assistance. Customers typically purchase these professional services to facilitate the adoption of the Company’s technology and dedicate personnel to participate in the services being performed, but they may also decide to use their own resources or appoint other professional service organizations to provide these services. Software products are billed separately and independently from consulting services, which are generally billed on a time-and-materials or milestone-achieved basis. The Company generally recognizes revenue from consulting services as the services are performed.

The Company recognizes sales commission expense as it is earned by its employees based on the terms of the respective commission plan. For orders recorded in fiscal year 2003, commissions were earned and expensed at the same time as revenue was recognized from the respective order. According to the terms of the fiscal 2005 and 2004 commission plan, for orders recorded in fiscal year 2005 and 2004, commissions are paid by the Company to employees over a period of time, typically over two to six quarters, depending on the size of the respective orders. These payments are spread evenly over two to six quarters, depending on the size of the respective orders. Commissions advanced to employees under the fiscal year 2003 compensation plans, in excess of amounts earned and which are considered recoverable, are reflected as prepaid expenses on the consolidated balance sheets. Net prepaid commission totaled $1.4 million and $2.7 million at March 31, 2005 and 2004, respectively.

Unbilled receivables represent revenue that has been recognized in the financial statements in advance of contractual invoicing to the customer. The Company will invoice all of the unbilled receivables within one year. As of March 31, 2005 and March 31, 2004, unbilled receivables were approximately $14.1 million and $14.9 million, respectively, and are included in accounts receivable on the consolidated balance sheets for each of these periods.

Costs incurred in connection with the development of software products are accounted for in accordance with SFAS No. 86, “Accounting for the Costs of Computer Software to Be Sold, Leased or Otherwise Marketed”. Development costs incurred in the research and development of new software products and enhancements to existing software products are expensed as incurred until technological feasibility in the form of a working model has been established. To date, the Company’s software has been available for general release concurrent with the establishment of technological feasibility, and accordingly no costs have been capitalized to date.

Software included in property and equipment includes amounts paid for purchased software and customization services for software used internally which has been capitalized in accordance with SOP 98-1, “Accounting for Costs of Computer Software for Internal Use”.

The financial statements of foreign subsidiaries are measured using the local currency of the subsidiary as the functional currency. Accordingly, assets and liabilities of the subsidiaries are translated at current rates of exchange at the balance sheet date, and all revenue and expense items are translated using weighted-average exchange rates. At March 31, 2005 and 2004, cumulative foreign currency translation loss is included in accumulated other comprehensive loss on the consolidated balance sheet.

The Company invests its excess cash in money market accounts and debt securities and considers all highly liquid debt instruments purchased with an original or remaining maturity of three months or less to be cash equivalents. Investments with an original maturity at the time of purchase between three and twelve months are classified as short-term investments and investments that have a maturity date more than twelve months from the balance sheet date, are classified as long-term investments.

The Company accounts for investments in accordance with SFAS No. 115, “Accounting for Certain Investments in Debt and Equity Securities”. These investments are classified as available for sale, and are recorded on the balance sheet at fair market value as of the balance sheet date with unrealized gains or losses reported as a separate component of stockholders’ equity until realized. The Company classified auction rate securities as available-for-sale short-term investments. Auction rate securities are reported at cost, which approximates fair market value due to the interest rate reset feature of these securities. As such, no gains or losses related to these securities were realized during the years ended March 31, 2005, 2004 and 2003. See “Reclassifications” in Note 1 for information regarding prior period reclassification of auction rate securities.

Cash equivalents, short-term investments, and long-term investments are detailed as follows:

As of March 31, 2005, the stated maturities of the Company’s current investments (including $3.2 million classified as cash equivalent investments in the table above) are $12.2 million within one year, $86.3 million within one to five years, $0 within five to ten years and $19.7 million after ten years.

As of March 31, 2005, $814,000 of the unrealized losses has duration of less than twelve months and $36,000 of the unrealized losses has duration of twelve months or greater. The gross unrealized losses on these investments were primarily due to interest rate fluctuations and market-price movements. The Company reviewed the investment portfolio and determined that the gross unrealized losses on these investments at March 31, 2005 were temporary in nature. The Company has the ability and intent to hold these investments until recovery of their carrying values. The Company also believes that it will be able to collect both principal and interest amounts due to the Company at maturity, given the high credit quality of these investments.

In May 2005, the Company liquidated certain investments to repurchase a portion of the convertible subordinated notes, resulting in a realized loss of approximately $0.7 million. See “Subsequent Events” in Note 15 for information regarding the repurchase of convertible subordinated notes.

As of March 31, 2005 and 2004, the Company had $3.0 million and $2.7 million, respectively, of restricted cash related to acquisitions and asset purchases completed during fiscal 2005 and 2004, to secure certain indemnification obligations related to these transactions. Such amount is disclosed separately on the consolidated balance sheet as of March 31, 2005 and 2004.

Financial instruments that potentially subject the Company to concentrations of credit risk consist principally of cash equivalents, short and long-term investments and accounts receivable. The Company’s cash equivalents, short and long-term investments generally consist of commercial paper, government agencies, municipal obligations and money market funds with high quality financial institutions. Accounts receivable are typically unsecured and are derived from license and service sales. The Company performs ongoing credit evaluations of its customers and maintains allowances for doubtful accounts.

At March 31, 2005, one customer accounted for 10% of accounts receivable. At March 31, 2004, two customers accounted for 19% and 12% of accounts receivable. See Note 11 for a disclosure of customers accounting for greater than 10% of revenue for the years ended March 31, 2005, 2004 and 2003.

Trade accounts receivable are recorded at the invoiced amount and do not bear interest. The allowance for doubtful accounts is Magma’s best estimate of the amount of probable credit losses in the Company’s existing accounts receivable. The Company determines the allowance based on historical write-off experience, current market trends and for larger accounts, the ability to pay outstanding balances. Magma continually reviews its allowances for collectibility. Past due balances over 90 days and other higher risk amounts are reviewed individually for collectibility. Account balances are charged off against the allowance after collection efforts have been exhausted and the potential for recovery is considered remote.

Property and equipment are recorded at cost. Depreciation of property and equipment is based on the straight-line method over the estimated useful lives of the related assets, generally three to five years. Leasehold improvements are amortized on the straight-line method over the shorter of the lease term or the estimated useful life of the asset. Maintenance and repair costs are charged to operations as incurred.

Depreciation expense was $7.8 million, $4.5 million and $4.7 million for the years ended March 31, 2005, 2004 and 2003, respectively.

The cost of equipment previously acquired under capital leases included in above property and equipment was $0.6 million as of March 31, 2005. Accumulated amortization of the leased equipment was $0.1 million as of March 31, 2005. Amortization of assets reported under capital leases was included with depreciation expense for the year ended March 31, 2005. There was no equipment under capital leases prior to the year ended March 31, 2004.

In accordance with the provisions of SFAS 144, “Accounting for the Impairment or Disposal of Long-Lived Assets”, the Company reviews long-lived assets, such as property and equipment, for impairment whenever events or changes in circumstances indicate that the carrying amount of the assets may not be fully recoverable. Under SFAS 144, an impairment loss would be recognized for assets to be held and used when estimated undiscounted future cash flows expected to result from the use of the asset and its eventual disposition is less than its carrying amount. Impairment, if any, is measured by the amount by which the carrying amount of the assets exceeds the fair value of the assets. Assets to be disposed of are reported at the lower of the carrying amount or fair value less costs to sell.

The Company invests in debt and equity of private companies as part of its business strategy. The investments are carried at cost and are included in other long-term assets in the consolidated balance sheets.

The Company regularly reviews the assumptions underlying the operating performance and cash flow forecasts based on information provided by these investee companies. Assessing each investment’s carrying value requires significant judgment by management as this financial information may be more limited, may not be as timely and may be less accurate than information available from publicly traded companies. If the Company determines, based on the best available evidence, that the carrying of an investment is impaired, the Company writes down the carrying value of an investment to its estimated fair value and records the related write-down as a loss in equity investment, which is included in other income (expense), net in its consolidated statements of operations. For the years ended March 31, 2005, 2004 and 2003, the Company recorded net loss in equity investments of $0.8 million, $1.2 million and $0.6 million, respectively. At March 31, 2005 and 2004, the carrying value on the strategic investments was $2.3 million and $1.8 million, respectively.

In July 2003, the Company purchased an equity interest in SiliconCraft, a privately held company, for $0.4 million. The operating results of SiliconCraft were consolidated into the Company’s consolidated statement of operations since the date of investment based on the effective control that the Company exerted over SiliconCraft and the risk of loss associated with this investment. On February 23, 2004, the Company purchased the remaining equity interest in SiliconCraft (see Note 4). The operating results of SiliconCraft up to February 23, 2004 totaling $0.4 million was recorded as research and development expense in our consolidated statement of operations for the year ended March 31, 2004.

Income taxes are accounted for under the asset and liability method. Deferred tax assets and liabilities are recognized for the future tax consequences attributable to differences between the financial statement carrying amounts of existing assets and liabilities and their respective tax bases and operating loss and tax credit carryforwards. Deferred tax assets and liabilities are measured using enacted tax rates expected to apply to taxable income in the years in which those temporary differences are expected to be recovered or settled. The effect on deferred tax assets and liabilities of a change in tax rates is recognized in income in the period that includes the enactment date. A valuation allowance is recorded against deferred tax assets if it is more likely than not that all or a portion of the deferred tax assets will not be realized.

The Company accounts for stock-based employee compensation arrangements in accordance with provisions of Accounting Principles Board (“APB”) Opinion No. 25, “Accounting for Stock Issued to Employees,” as interpreted by Financial Accounting Standards Board (“FASB”) Interpretation No. 44 (“FIN 44”), “Accounting for Certain Transactions Involving Stock Compensation—an Interpretation of APB 25” and Emerging Issues Task Force No. 00-23 (“EITF 00-23”), “Issues related to the Accounting for Stock Compensation under APB 25 and FIN 44,” and FASB Interpretation No. 28, “Accounting for Stock Appreciation Rights and Other Variable Stock Option or Award Plans,” and complies with the disclosure provisions of Statement of Financial Accounting Standards (“SFAS”) No. 148, “Accounting for Stock-Based Compensation—Transition and Disclosure—an amendment of SFAS 123.” Under APB Opinion No. 25, compensation expense is based on the difference, if any, on the date of the grant, between the fair value of the Company’s stock and the exercise price. SFAS No. 123 as amended by SFAS No. 148 requires a fair-value based method of accounting for an employee stock option or similar equity instrument. Had compensation cost for the Company’s stock-based

compensation plan been determined using the Black-Scholes option pricing model at the grant date for awards granted in accordance with the provisions of SFAS No. 123, the Company’s net income (loss) would have been the amounts indicated below (in thousands):

Such pro forma disclosures may not be representative of future compensation cost because options vest over several years and additional grants are made each year.

The weighted-average estimated fair value per share at the date of grant for options granted to employees and for share purchase rights granted under the employee stock purchase plans was as follows:

The fair value of options at the date of grant was estimated using the Black-Scholes option pricing model using the following assumptions:

The fair value option valuation model was developed for use in estimating the fair value of traded options, which have no vesting restrictions and are fully transferable. In addition, option valuation models require the input of highly subjective assumptions, including the expected stock price volatility. Because the Company’s employee stock options have characteristics significantly different from those of traded options, and because changes in the subjective input assumptions can materially affect the fair value estimate, in management’s opinion, the existing models do not necessarily provide a reliable single measure of the fair value of the Company’s employee stock options.

In December 2004, the FASB issued SFAS No. 123 (revised 2004), “Share-Based Payment” (SFAS 123R). SFAS 123R eliminates the ability to account for share-based compensation transactions using APB 25, and instead generally requires that such transactions be accounted for using a fair-value based method. Companies are required to recognize an expense for compensation cost related to share-based payment arrangements including stock options and employee stock purchase plans. The new rules will be effective for fiscal years beginning after June 15, 2005 and, thus, will be effective for the Company beginning with the first quarter of fiscal 2007. The Company is currently evaluating which transition method to use and option valuation methodologies and assumptions in light of SFAS 123R related to employee stock options and employee stock purchase plans.

Financial instruments consist of cash and cash equivalents, short and long-term investments, accounts receivable and payable, accrued liabilities, convertible subordinated notes, convertible bond hedge and written call options. The carrying amounts of cash and cash equivalents, short-term investments, accounts receivable and payable and accrued liabilities approximate their fair values because of the short-term nature of those instruments. The following table summarizes the Company’s carrying values and fair values of its other financial instruments as of March 31, 2005 and 2004 (in thousands):

In May 2005, the Company repurchased a portion of the convertible subordinated debt and terminated the corresponding portion of the hedge and warrant. Additional information is provided in “Note 15—Subsequent Events”.

Statement of Financial Accounting Standards No. 130, “Reporting Comprehensive Income” requires companies to classify items of other comprehensive income by their nature in the financial statements and display the accumulated balance of other comprehensive income separately from retained earnings and additional paid-in-capital in the equity section of the balance sheet. Comprehensive income includes all changes in equity (net assets) during a period from non-owner sources. Accumulated other comprehensive income or loss is shown in the consolidated statement of stockholders’ equity.

Components of accumulated other comprehensive loss were as follows (in thousands):

In December 2004, the FASB issued SFAS No. 123 (revised 2004), “Share-Based Payment.” (“SFAS 123R”) SFAS 123R eliminates the ability to account for share-based compensation transactions using APB 25, and generally requires instead that such transactions be accounted for using a fair-value based method. Companies are required to recognize an expense for compensation cost related to share-based payment arrangements including stock options and employee stock purchase plans. The new rules will be applied on a modified prospective basis as defined in SFAS 123R, and will be effective for annual periods beginning after June 15, 2005 and, thus, will be effective for us beginning with the first quarter of fiscal 2007. The Company is currently evaluating option valuation methodologies and assumptions in light of SFAS 123R related to employee stock options and employee stock purchase plans. The adoption of SFAS 123R will have a significant impact on the Company’s consolidated statement of operations as the Company will be required to expense the fair value of its stock option grants and stock purchases under its employee stock purchase plan rather than disclose the impact on its consolidated net income within the footnotes (see Note 1 to the Consolidated Financial Statements), as is the Company’s current practice.

In March 2005, the SEC issued Staff Accounting Bulletin (“SAB”) No. 107 “Share-Based Payment”. SAB 107 provides guidance related to share-based payment transactions with non-employees, the transition from nonpublic to public entity status, valuation methods (including assumptions such as expected volatility and expected term), the accounting for certain redeemable financial instruments issued under share-based payment arrangements, the classification of compensation expense, non-GAAP financial measures, first-time adoption of Statement 123R in an interim period, capitalization of compensation cost related to share-based payment arrangements, the accounting for income tax effects of share-based payment arrangements upon adoption of Statement 123R, the modification of employee share options prior to adoption of Statement 123R and disclosures in Management’s Discussion and Analysis subsequent to adoption of Statement 123R. The provisions of SAB 107, as appropriate, will be adopted upon implementation of FAS123R in fiscal 2007.

FASB Staff Position (“FSP” ) No. 109-2, “Accounting and Disclosure Guidance for the Foreign Earnings Repatriation Provision within the American Jobs Creation Act of 2004” (“FSP 109-2”), provides guidance under SFAS No. 109, “Accounting for Income Taxes,” (“SFAS 109”) with respect to recording the potential impact of the repatriation provisions of the American Jobs Creation Act of 2004 (the “Jobs Act”) on enterprises’ income tax expense and deferred tax liability. The Jobs Act was enacted on October 22, 2004. FSP 109-2 states that an enterprise is allowed time beyond the financial reporting period of enactment to evaluate the effect of the Jobs Act on its plan for reinvestment or repatriation of foreign earnings for purposes of applying SFAS 109. The Company has completed evaluating the impact of the repatriation provisions. The adoption of FSP 109-2 did not have any impact on the Company’s results of operations or financial condition. Among other things, the Jobs Act repeals an export incentive and creates a new tax deduction for qualified domestic manufacturing activities. At this time, the Company does not expect that the deduction will have a material impact on its reported income tax rate.

The Company computes net income (loss) per share in accordance with SFAS 128, “Earnings per Share”. Basic net income (loss) per share is computed by dividing net income (loss) attributed to common stockholders (numerator) by the weighted average number of common shares outstanding (denominator) during the period. Diluted net income (loss) per share gives effect to all dilutive potential common shares outstanding during the period including stock subject to repurchase, stock options and warrants using the treasury stock method and convertible subordinated notes using the if-converted method. The diluted net loss per share is the same as the basic net loss per share for the year ended March 31, 2005 because potential common shares are not considered in calculation when their effect is antidilutive.

The following is a reconciliation of the weighted average common shares used to calculate basic net income (loss) per share to the weighted average common shares used to calculate diluted net income per share for the years ended March 31, 2005, 2004 and 2003 (in thousands):

For the year ended March 31, 2005, all potential common shares outstanding during the period were excluded from the computation of diluted net loss per share as their effect would be anti-dilutive. This includes 6,562,000 shares for the convertible subordinated notes and 9,990,580 shares of common stock issuable under stock option plans outstanding as of March 31, 2005. The weighted-average exercise price of stock options outstanding was $15.30 per share for the year ended March 31, 2005.

For the years ended March 31, 2004 and 2003, 647,230 and 469,226 shares of common stock issuable under stock options were excluded from the computation of diluted net income per share because their option exercise prices were greater than the average market price, which would result in antidilution under the treasury stock method. The weighted-average exercise price of such shares was $23.30 and $17.77 per share for the year ended March 31, 2004 and 2003, respectively.

Significant components of certain balance sheet items are as follows (in thousands):

On July 1, 2003, the Company completed the acquisition of Aplus Design Technologies, Inc., a privately-held company that designed and developed physical synthesis and physical prototyping solutions for programmable structured logic devices. The Company increased the number of embedded programmable devices on large ASIC devices and integrated the Aplus technology with Magma tools to allow customers to address these embedded programmable structured logic devices in a single tool flow. The results of operations from Aplus have been included in Magma’s results of operations from the acquisition date.

The Company acquired all the outstanding shares of Aplus in exchange for initial consideration of $0.9 million cash and 0.3 million shares of the Company’s common stock at $16.69 per share, the average closing stock price for the period shortly prior to and after the announcement of this transaction. The Company also agreed to pay a total of $3.2 million of cash and 0.8 million shares of the Company’s common stock (collectively, the “Contingent Consideration”) to the Aplus shareholders pursuant to an earnout provision. The shares of common stock included in the Contingent Consideration were issued and placed in escrow and considered to be issued and outstanding as of the consummation date. Under the terms of the earnout provision, the Contingent Consideration was to be distributed to Aplus shareholders upon achieving or exceeding revenue, technology or financial targets. The earnout provisions were amended in April 2004 to revise the technical milestones and eliminate the financial targets, but the total Contingent Consideration remains the same. As of March 31, 2005, the Company had paid the Contingent Consideration of approximately $2.9 million in cash and released 0.7 million shares of the Company’s common stock from the escrow, based on the achievement of the targets as of March 31, 2005. The Contingent Consideration, when earned, is considered an additional acquisition

cost and recorded as an increase to the developed technology intangible asset. That amount is being amortized to cost of revenue over the remaining economic life of the developed technology intangible asset.

The acquisition was accounted as a purchase business combination. The purchase price was allocated to the assets acquired and liabilities assumed based on their respective fair values. A summary of purchase price allocation for the Aplus acquisition and discussion of the valuation methodology used are provided at the end of this footnote.

On October 17, 2003, the Company acquired Silicon Metrics, a privately-held company that developed chip design characterization and modeling software. Silicon Metrics’ library characterization tool suite has provided additional characterization and models of standard cell libraries to enable better quality and results and run time for customers.

In accordance with a merger agreement (the “Merger Agreement”), the Company acquired all the outstanding shares of Silicon Metrics in exchange for initial consideration of $18.0 million in cash to Silicon Metrics shareholders. The Company also agreed to pay up to $14.0 million of cash in contingent consideration to the Silicon Metrics shareholders upon achieving or exceeding certain financial milestones. As of March 31, 2005, the $14.0 million of contingent consideration has been earned, of which $11.2 million has been paid as of March 31, 2005. The contingent consideration, when earned, was considered an additional acquisition cost and was recorded as an increase to goodwill.

Pursuant to the terms of the Merger Agreement, $1.8 million of the initial consideration was retained by the Company in a segregated bank account to secure certain indemnification obligations of the Silicon Metrics shareholders and bonus plan participants. As of March 2005, $1.7 million of this amount has been released to the Silicon Metrics stockholders and the remaining $0.1 million was included in restricted cash, which is separately disclosed on the Company’s consolidated balance sheet as of March 31, 2005. An additional amount of $0.8 million was retained by the Company to secure indemnification obligations with respect to certain litigation, and this amount was released to the Silicon Metrics stockholders in February of 2004 in connection with the settlement of the litigation.

The acquisition was accounted for as a purchase business combination. The purchase price was allocated to the assets acquired and liabilities assumed based on their respective fair values. A summary of purchase price allocation for the Silicon Metrics acquisition and discussion of the valuation methodology used are provided at the end of this footnote.

On October 20, 2003, the Company acquired Random Logic, a privately-held company that developed the parasitic extraction software product QuickCap^{^™}. Random Logic brings the industry’s leading resistance and capacitance extraction technology to the Company, which has allowed the Company to significantly reduce correlation efforts of its customers.

Pursuant to an Agreement and Plan of Merger (the “RLC Merger Agreement”), the Company acquired all the outstanding shares of Random Logic in exchange for cash consideration of $20.0 million. Pursuant to the terms of the RLC Merger Agreement, $5.0 million of that consideration was withheld and placed in an escrow account to secure the indemnification obligations of the Random Logic shareholders. As of March 31, 2005, the entire amount in the escrow account has been released to the Random Logic shareholders. The results of operations from Random Logic have been included in Magma’s results of operations from the acquisition date.

The acquisition was accounted for as a purchase business combination. The purchase price was allocated to the assets acquired and liabilities assumed based on their respective fair values. A summary of purchase price allocation for the Random Logic acquisition and discussion of the valuation methodology used are provided at the end of this footnote.

On February 23, 2004, the Company acquired SiliconCraft, a privately-held company that developed, marketed, and supported advanced timing & power solutions for high-end IC design industry.

Prior to the acquisition, the Company had 20% equity interest in SiliconCraft as a result of earlier equity investment which occurred in October 2003. (See Note 1) In this transaction, the Company acquired all remaining outstanding shares of SiliconCraft in exchange for the initial cash consideration of $1.2 million. In addition to the initial consideration, the Company may pay up to $1.5 million of cash in contingent consideration to the SiliconCraft shareholders upon achieving certain technology milestones. As of March 31, 2005, the $1.5 million of contingent consideration had been earned and paid. The contingent consideration, when earned, was considered an additional acquisition cost and was recorded as an increase to goodwill.

The acquisition was accounted for as a purchase business combination. The purchase price was allocated to the assets acquired and liabilities assumed based on their respective fair values. A summary of purchase price allocation for the SiliconCraft acquisition and discussion of the valuation methodology used are provided below.

A summary of the purchase price allocations pertaining to the acquisitions described above and the amortization periods of the intangible assets acquired is as follows (in thousands):

For each acquisition, the excess of the purchase price over the estimated value of the net tangible assets acquired was allocated to various intangible assets, consisting primarily of developed technology, patents, customer and contract-related assets and goodwill.

The values assigned to developed technologies related to each acquisition were based upon future discounted cash flows related to the existing products’ projected income streams using discount rates ranging from 15% to 22%. The Company believes these rates were appropriate given the business risks inherent in marketing and selling these products. Factors considered in estimating the discounted cash flows to be derived from the existing technology include risks related to the characteristics and applications of the technology, existing and future markets and an assessment of the age of the technology within its life span.

Other intangibles include the value of an existing customer relationship or base, patents, existing customer contracts, no ship right and trademarks. These intangible assets were valued using discount rates ranging from 15% to 17%.

The valuation method used to value in-process research and development is a form of discounted cash flow method commonly known as the “percentage of completion” approach. This approach is a widely recognized appraisal method and is commonly used to value technology assets. The value of the in-process technology is the sum of the discounted expected future cash flows attributable to the in-process technology, taking into consideration the percentage of completion of products utilizing this technology, utilization of pre-existing technology, the risks related to the characteristics and applications of the technology, existing and future markets and the technological risk associated with completing the development of the technology. The cash flows derived from the in-process technology projects were discounted at a rate of 22% for the Silicon Metrics acquisition. The Company believes the rate used was appropriate given the risks associated with the technologies for which commercial feasibility had not been established and there was no alternative use. The percentage of completion for each in-process project was determined by identifying the elapsed time invested in the project as a ratio of the total time required to bring the project to technical and commercial feasibility. The percentage of completion for in-process projects acquired ranged from 51% to 52% for the Silicon Metrics acquisition. Schedules were based on management’s estimate of tasks completed and the tasks to be completed to bring the project to technical and commercial feasibility.

Development of in-process technology remains a substantial risk to the Company due to a variety of factors including the remaining effort to achieve technical feasibility, rapidly changing customer requirements and competitive threats from other companies and technologies. Additionally, the value of other intangible assets acquired may become impaired. The in-process research and development valuation, as well as the valuation of other intangible assets was prepared by management or an independent appraisal firm, based on input from the Company and the acquired companies’ management, using valuation methods that are recognized by the United States Securities and Exchange Commission staff.

Summarized below are the unaudited pro forma results of the Company as though the acquisitions described above occurred at the beginning of the periods indicated. Adjustments have been made for the estimated increases in amortization of intangibles and other appropriate pro forma adjustments. The charges for purchased in-process research and development are not included in the pro forma results, because they are non-recurring. The information presented does not purport to be indicative of the results that would have been achieved had the acquisition been made as of those dates nor of the results which may occur in the future.

On April 29, 2004, the Company completed its acquisition of Mojave, Inc., a privately held developer of advanced technology for integrated circuit manufacturability and verification. The acquisition of Mojave allows Magma to more comprehensively address its customers’ needs of designing and verifying semiconductors that are manufacturable with desirable yield and performance. Manufacturability is a key design parameter as semiconductor process technology moves to sub-90nm geometries. The total initial purchase price of the Mojave acquisition was approximately $25.1 million and the transaction was accounted for as an asset purchase transaction. The Company acquired all of the outstanding common stock of Mojave in exchange for initial consideration of $24.2 million, which consisted of 607,554 shares of Magma common stock valued at $11.8 million and $12.4 million in cash. In addition to the initial merger consideration, the Company agreed to pay contingent consideration of up to $115.0 million, half in stock and half in cash, based on product orders over a period ending March 31, 2009, but such payments are contingent on the achievement of certain technology milestones. The Company did not assume any stock options or warrants. No contingent consideration yet has been paid under the agreement as of March 31, 2005 because none of the milestones have been achieved. The contingent consideration, when earned, will be considered as an additional acquisition cost and recorded as an increase to the developed technology intangible asset. The amount will be amortized over the remaining economic life of the developed technology intangible asset.

Magma allocated the initial purchase price of $25.1 million to the fair values of the assets acquired and liabilities assumed. A summary of the purchase price allocation and the amortization periods of the intangible assets acquired is as follows (in thousands):

The value assigned to developed technology was based upon future discounted cash flows related to the developed technology’s projected income streams using discount rate of 16%. The Company believes this rate was appropriate given the business risks inherent in marketing and selling this technology. Factors considered in estimating the discounted cash flows to be derived from the developed technology included risks related to the characteristics and applications of the technology, existing and future markets and an assessment of the age of the technology within its life span.

The valuation method used to value in-process research and development (“IPR&D”) is a form of discounted cash flow method. This approach is a widely recognized appraisal method and is commonly used to value technology assets. The value of the in-process technology is the sum of the discounted expected future cash

flows attributable to the in-process technology, taking into consideration the percentage of completion of products utilizing this technology, utilization of pre-existing technology, the risks related to the characteristics and applications of the technology, existing and future markets and the technological risk associated with completing the development of the technology. The cash flows derived from the in-process technology project were discounted at a rate of 30%. The Company believes the rate used was appropriate given the risks associated with the technologies for which commercial feasibility had not been established and had no alternative future uses. The percentage of completion for the in-process project was determined by identifying the elapsed time and costs invested in the project as a ratio of the total time and costs required to bring the project to technical and commercial feasibility, as well as consideration of engineering milestones required to complete the project. The percentage of completion for the in-process project acquired was 12.4%. Schedules were based on management’s estimate of tasks completed and the tasks to be completed to bring the project to technical and commercial feasibility. There has been no material change to the IPR&D project schedule as of March 31, 2005. Revenue resulting from the IPR&D project is expected to commence in fiscal year 2006.

Development of in-process technology remains a substantial risk to the Company due to a variety of factors including the remaining effort needed to achieve technical feasibility, rapidly changing customer requirements and competitive threats from other companies and technologies. Additionally, the value of other intangible assets acquired may become impaired. The in-process research and development valuation, as well as the valuation of other intangible assets was prepared and determined by management with the assistance of an independent appraisal firm, based on input from the Company and the acquired company’s management, using valuation methods that are recognized by the United States Securities and Exchange Commission staff.

As part of the initial consideration for the Mojave acquisition, the Company paid cash of $1.3 million which was recorded as deferred cash compensation and issued Magma common stock with a value of $1.3 million which was recorded as deferred stock-based compensation. Both the cash and the shares were unearned on the acquisition date and will be earned based on continued provision of employment services by the former Mojave employees in accordance with pre-defined vesting schedules which range from 20 to 41 months. Accordingly, both the deferred cash compensation and the deferred stock-based compensation are treated as compensation, and are charged to operating expense as services are performed. During year ended March 31, 2005, the Company amortized $0.7 million of deferred cash compensation, and $0.7 million of deferred stock-based compensation related to the Mojave acquisition.

On April 16, 2004, the Company acquired Lemmatis, Inc. (“Lemmatis”), a privately-held developer of formal verification technology. Pursuant to the merger agreement, the Company paid the stockholders of Lemmatis initial consideration of approximately $0.6 million in cash, less $60,000 which the Company withheld to secure the indemnification obligations of the Lemmatis stockholders. In addition to the initial merger consideration, the Company may pay up to an additional $1.4 million contingent upon the achievement of certain technology milestones set forth in the merger agreement. As of March 31, 2005, the Company has paid $0.6 million of contingent consideration in connection with achievement of technology milestones.

Based on management’s estimates and appraisal, the $0.6 million of initial consideration, $76,000 of legal and other professional expenses directly associated with the acquisition and the $0.6 million of contingent consideration paid as of March 31, 2005 were entirely allocated to developed technology and included in the intangible asset balance on the Company’s unaudited condensed consolidated balance sheet as of March 31, 2005. This developed technology intangible asset is being amortized to cost of revenue over the estimated economic life of three years.

On December 22, 2004, the Company acquired Fortis Systems, Inc. (“Fortis”), a privately-held developer of optical proximity correction and lithography simulation technology. Pursuant to the merger agreement, the

Company paid the stockholders of Fortis initial consideration of approximately $0.5 million in cash, less $50,000 which the Company withheld to secure the indemnification obligations of the Fortis stockholders. In addition to the initial merger consideration, the Company may pay up to an additional $1.0 million contingent upon the achievement of certain technology milestones set forth in the merger agreement. As of March 31, 2005, no contingent consideration was paid for milestone achievement. The acquisition of Fortis has been accounted for as an asset purchase transaction.

The Company allocated the initial purchase price of $0.6 million, including the $0.5 million of initial consideration and the $95,000 of legal and other professional expenses directly associated with the acquisition, to the fair values of the assets acquired and liabilities assumed. The fair value of the existing technology and assembled workforce intangible assets and in-process research and development were determined by management with the use of a third party valuation report. A summary of the purchase price allocation and the amortization periods of the intangible assets acquired is as follows (in thousands):

We identified value of in-process research and development through discounted cash flow method and charged it to operating expenses. Such charges related to technologies for which commercial feasibility had not been established and had no alternative future uses. Revenue resulting from the IPR&D project is expected to commence in fiscal year 2007.

On March 26, 2004, the Company acquired a technology license and certain other information from another company for a total fee of $22.8 million. The licensed technology will be integrated into the Company’s current product offerings as a formal verification equivalency checking tool that will be used to verify whether two different representations of a circuit are logically equivalent. Under the license agreement, the Company obtained a perpetual, fully-paid, royalty-free, non-exclusive, assignable, worldwide license. Further, the Company has a three-year period of exclusivity before the licensor can offer the licensed technology to the Company’s competitors. Based on management’s estimates and appraisal, the license fee of $22.8 million and $0.2 million of legal and other professional expenses directly associated with the acquisition of the license were entirely allocated to a licensed technology intangible asset and included in the intangible asset balance on the Company’s consolidated balance sheet as of March 31, 2005 and 2004 (see Note 6). This licensed technology intangible asset is being amortized to cost of revenue over the estimated economic life of three years.

During the year ended March 31, 2004, the Company completed three other asset purchases for an aggregate consideration of $17.7 million in upfront payments and related acquisition expenses of $0.5 million. Two of these purchase transactions included an earnout provision under which the Company may pay contingent

consideration of up to $2.8 million in cash based on the achievement of certain technology milestones as outlined in the respective asset purchase agreement. As of March 31, 2005, the Company has paid $2.5 million and accrued $0.2 million contingent consideration under these arrangements as certain milestones have been met.

The $0.9 million of the initial consideration for one of these asset purchase transactions was retained by the Company in a segregated bank account as of March 31, 2004 to secure certain indemnification obligations. This amount is included in restricted cash, which is separately disclosed on the Company’s consolidated balance sheet as of March 31, 2004. The entire amount has been released to the shareholders as of March 31, 2005.

For each of these asset purchases, the excess of the purchase price over the estimated value of the net tangible assets acquired was allocated to various intangible assets, consisting primarily of developed technology and patents. The values assigned to developed technologies related to each acquisition were based upon future discounted cash flows related to the existing products’ projected income streams.

The following table summarizes the components of goodwill, other intangible assets and related accumulated amortization balances, which were recorded as a result of business combinations and asset purchases described in Notes 4 and 5 (in thousands):

During fiscal 2005, in accordance with certain milestone achievement earnout provisions contained in prior acquisition agreements, the Company accrued or paid approximately $26.9 million in earnout payments, of which $15.5 million was recorded as goodwill and $11.4 million was recorded as developed technology. In the second quarter of fiscal 2005, the Company reduced its goodwill and deferred tax liabilities each by $5.0 million to reflect purchase price adjustments on the Company’s acquisitions. The Company also recorded tax benefits from acquired tax attributes, primarily net operating losses, by reducing its goodwill and income tax payables each by $1.6 million during fiscal 2005.

For the years ended March 31, 2005 and 2004, amortization expense related to other intangible assets was $24.4 million and $4.5 million, respectively, of which $6.4 million and $2.8 million, respectively, is included in cost of sales as they related to the products sold, while the remaining $18.0 million and $1.7 million, respectively, is shown as a separate line item in the Company’s consolidated statement of operations.

As of March 31, 2005, the estimated future amortization expense of other intangible assets in the table above is as follows :

In accordance with SFAS 142, the Company performed an annual goodwill impairment test as of December 31, 2004 and determined that goodwill was not impaired. In performing the impairment test, the Company determined that it had one reporting unit. The Company evaluates goodwill at least on an annual basis and whenever events and changes in circumstances suggest that the carrying amount may not be recoverable from its estimated future cash flow. No assurances can be given that future evaluations of goodwill will not result in charges as a result of future impairment.

During each of the years ended March 31, 2005 and 2003, the Company recorded a restructuring charge of $0.7 million related to employee termination costs of 22 and 32, respectively, employees resulting from the Company’s realignment to current business conditions. All termination costs have been paid as of March 31, 2005.

On May 22, 2003, the Company completed an offering of $150.0 million principal amount of Zero Coupon Convertible Subordinated Notes due May 15, 2008 (the “Notes”) to qualified buyers pursuant to Rule 144A under the Securities Act of 1933, resulting in net proceeds to the Company of approximately $145.1 million. The Notes do not bear coupon interest and are convertible into shares of the Company’s common stock at a conversion price of $22.86 per share, for an aggregate of 6,561,680 shares. The Notes are subordinated to the Company’s existing and future senior indebtedness and effectively subordinated to all indebtedness and other liabilities of the Company’s subsidiaries. The Company paid approximately $4.5 million in transaction fees to the underwriters of the offering and approximately $0.4 million in other debt issuance costs. The Company is amortizing the transaction fees and issuance costs over the life of the Notes using the effective interest method. As of March 31, 2005, approximately $1.8 million of transaction fees and debt issuance costs had been amortized. The shares issuable on the conversion of the Notes are included in “fully diluted shares outstanding” under the if-converted method of accounting for purposes of calculating diluted earnings per share.

In order to minimize the dilutive effect from the issuance of the Notes, the Company undertook the following additional transactions concurrent with the issuance of the Notes:

The 2004 Employment Inducement Award Plan (“Inducement Plan”) was adopted by the Board of Directors on August 30, 2004. Under the Inducement Plan, the Company (with the approval of the Compensation Committee of the Board of Directors (the “Committee”) may grant non-qualified stock options to “New Hire” employees who are not executive officers of the Company. These employees may also be awarded restricted common shares, stock appreciation rights (“SARs”) or stock unit awards (“Stock Units”). The maximum aggregate number of options, SARs, Stock Units and restricted shares that may be awarded under the Inducement Plan is 1,000,000 shares. The Committee determines whether an award may be granted, the number of shares/options awarded, the date an award may be exercised, vesting and the exercise price. Each award must be subject to an agreement between each applicable employee and the company. The term of the plan continues until May 4, 2011. As of March 31, 2005, there were options to purchase 387,625 shares outstanding under the Inducement Plan, and 612,375 shares were available for the grant of future options or other awards under the plan.

The 2001 Stock Incentive Plan (“2001 Plan”) was approved by the stockholders in August 2001. Under the 2001 Plan, the Company may grant incentive stock options or non-qualified stock options to purchase common stock to employees, directors, advisors, and consultants. They may also be awarded restricted common shares, stock appreciation rights (“SARs”) or unit awards (“Stock Units”) based on the value of the common stock. The initial number of shares of common stock issuable under the 2001 Plan was 2.0 million shares, subject to adjustment for certain changes in the Company’s capital structure. As of January 1 of each year, commencing with January 1, 2002, the aggregate number of options, restricted awards, SARs, and Stock Units that may be awarded under the 2001 Plan will automatically increase by a number equal to the lesser of 6% of the total number of shares of common stock then outstanding, 6.0 million shares of common stock, or any lesser number as is determined by the Board of Directors. A committee of the Board of Directors determines the exercise price per share; however, the exercise price of an incentive stock option cannot be less than 100% of the fair market value of the common stock on the option grant date, and the exercise price of a non-qualified stock option cannot be less than the par value of the common stock subject to such non-qualified stock options. As of March 31, 2005, there were options to purchase 8,281,120 shares outstanding under the 2001 Plan, and 680,410 shares were available for the grant of future options or other awards under the plan.

In the year ended March 31, 1998, the Company adopted the 1997 Stock Incentive Plan (“1997 Plan”), and in the year ended March 31, 1999 the Company adopted the 1998 Stock Incentive Plan (“1998 Plan”) (collectively, “the Plans”). Under the Plans, the Company may grant options to purchase common stock to employees, directors, and consultants. Shares that are subject to options that in the future expire, terminate or are cancelled or as to which options have not been granted under these plans will not be available for future option grants or issuance. Options granted under the Plans were either incentive stock options or non-qualified stock options. The exercise price of incentive stock options and non-qualified stock options were no less than 100% and 85%, respectively, of the fair market value per share of the Company’s common stock on the grant date (110% of fair market value in certain instances), as determined by the Board of Directors. Pursuant to the Plans, the Board of Directors also had the authority to set the term of the options (no longer than ten years from the date of grant, five years in certain instances). Under the terms of the Plans, the options become exercisable prior to vesting, and the Company has the right to repurchase such shares at their original purchase price if the optionee is terminated from service prior to vesting. Such rights expire as the options vest over the vesting period, which is generally four years. At March 31, 2005, there were no unvested shares subject to the Company’s repurchase rights.

As a result of the 2001 Option Plan becoming effective, no shares of the Company’s common stock are available for future issuance under the Plans. At March 31, 2005, there were options to purchase 4,000 and 1,294,177 shares outstanding under the 1997 and 1998 plans, respectively.

The Moscape 1997 Incentive Stock Plan (the “Moscape Plan”) provides for the granting of stock options and stock purchase rights to employees, officers, directors and consultants. Both the options and stock purchase rights under the Moscape Plan are exercisable immediately, subject to the Company’s repurchase right in the event of termination, and generally vest over four years. At March 31, 2005, there were options to purchase 23,658 shares outstanding under the Moscape Plan.

Activity under the 1997, 1998, 2001 and 2004 Plans, and the Moscape Plan is summarized as follows:

At March 31, 2005, 2004 and 2003, 4,944,755, 3,230,246 and 3,663,477 outstanding options were exercisable with a weighted average exercise price per share of $14.20, $9.88 and $7.67, respectively.

The following table summarizes information about stock options outstanding at March 31, 2005:

The 2005 Key Contributor Long-Term Incentive Plan (“KC Incentive Plan”) was adopted by the Board of Directors on December 23, 2004. Awards under the KC Incentive Plan are granted in exchange for a participant’s contributions to Magma. Awards may include (i) cash payments, and/or (ii) shares of Magma’s restricted stock granted under Magma’s 2001 Stock Incentive Plan, that vest while the participant remains employed by and in good standing with Magma. Non-executive participants may receive cash awards prior to such awards becoming fully vested and earned. These awards are considered recoverable advances and are to be repaid to Magma in the event that the participant’s employment with Magma is terminated prior to an award being earned. All executive officers as well as certain other participants that receive a restricted stock award under the KC Incentive Plan will have accelerated vesting of such award upon a change in control of Magma. In the event of Magma’s change in control, the participant’s unvested shares of restricted stock granted under the KC Incentive Plan will accelerate by 25%. In addition, if the participant is, or is deemed to have been, involuntarily terminated employment within one year after Magma’s change in control, 50% of the remaining unvested shares of restricted stock will vest. If the award so states, participants that receive a cash or stock award under the KC Incentive Plan will not be eligible to receive equity grants under Magma’s 2001 Stock Incentive Plan, or cash awards under any other Magma cash variable award plans, until such award is fully vested. As of March 31, 2005, 487,803 shares of restricted stock were issued under the KC Incentive Plan. In connection with the restricted stock grants, the Company recognized approximately $6.0 million of stock-based compensation to be amortized over vesting period of approximately four years. During fiscal 2005, the Company amortized $0.8 million of such deferred stock-based compensation.

Deferred stock-based compensation related to an option granted to a senior executive

On May 14, 2003, the Company granted a senior executive an option to purchase 297,393 shares of its common stock at an exercise price of $7.00 per share, of which the first 209,753 shares vested immediately upon grant and the remaining 87,640 shares vest in equal monthly installments through March 5, 2005. In connection with this option grant, the Company recognized approximately $2.1 million of stock-based compensation immediately upon grant with respect to the vested shares and recorded $0.9 million of deferred stock-based compensation to be amortized over vesting period of 22 months for the remaining shares. During fiscal 2005 and 2004, the Company amortized $0.1 million and $0.7 million, respectively, of such deferred stock-based compensation. In aggregate, the Company recognized $0.1 million and $2.8 million, respectively, of stock-based compensation expense related to this option grant in fiscal 2005 and 2004.

During fiscal 2003, the Company granted options to purchase 43,120 shares of common stock to consultants and other non-employees with weighted average exercise prices of approximately $11.250. The fair value of such options was calculated at the end of each reporting period through the applicable vesting date based upon the Black-Scholes option pricing model, and the resulting expense was being amortized based on the term of the consulting agreement or service period. Included in amortization of stock-based compensation in the consolidated statements of operations was amortization related to consultants and other non-employees of $0.5 million for the years ended March 31, 2003. No stock-based compensation expense related to non-employee option grants in fiscal 2003 was recorded during the years ended March 31, 2005 and 2004 as the service agreements with those non-employees were terminated prior to the beginning of fiscal 2004.

The 2001 Employee Stock Purchase Plan (“2001 Purchase Plan”) was established in November 2001. Employees, including officers and employee directors but excluding 5% or greater stockholders, are eligible to participate if they are employed for more than 20 hours per week and five months in any calendar year. The 2001 Purchase Plan provided for a series of overlapping offering periods with a duration of 24 months, with new offering periods, except the first offering period, which commenced on November 19, 2001, beginning in February, May, August, and November of each year. The maximum number of shares a participant may purchase during a single offering period is 4,000 shares. The 2001 Purchase Plan allows employees to purchase common stock through payroll deductions of up to 15% of their defined compensation. Such deductions will accumulate over a three-month accumulation period without interest. After such accumulation period, shares of common stock will be purchased at a price equal to 85% of the fair market value per share of common stock on either the first day preceding the offering period or the last date of the accumulation period, whichever is less. During the year ended March 31, 2005, a total of 593,256 shares were issued under the 2001 Purchase Plan with average price of $9.10 per share.

As of March 31, 2005, a total of 3,337,419 shares of common stock remained available for issuance under the 2001 Purchase Plan. Starting with fiscal 2003, the number of shares reserved for issuance is increased on January 1 of each calendar year through fiscal 2011 by the lesser of 3,000,000 shares, 3% of the outstanding common stock on the last day of the immediately preceding fiscal year, or such lesser number of shares as is determined by the Board of Directors.

In October 2001, the Company’s President, Mr. Roy Jewell, exercised an option to purchase 428,570 shares of common stock at the exercise price of $10.50 per share by executing a full recourse promissory note of

approximately $4.5 million bearing interest of 5.5% per annum and due in March 2006. Terms of the note provided that if the President were still employed by the Company on any anniversary of his date of hire, up to $2.7 million note principal and $0.4 million related total interest to maturity would be forgiven. The forgivable portion of the note and related interest was recorded as a reduction of notes receivable from stockholders and a charge to deferred compensation, which would be amortized to compensation expense over the five-year term of the note. As of March 31, 2003, approximately $1.1 million of principal and related accrued interest had been forgiven. The outstanding principal and accrued interest at March 31, 2003 totaled $3.7 million, of which $1.8 million was subject to forgiveness. On May 14, 2003, the Company repurchased 209,753 shares of common stock from Mr. Jewell for an aggregate purchase price of $3.6 million, or $17.00 per share, which was the closing sale price of the common stock on that date, and he repaid the principal and related accrued interest outstanding under the promissory note in full.

In November 2001, the Company’s Vice President-North America Sales exercised an option to purchase 85,713 shares of common stock at the exercise price of $10.50 per share by executing a full recourse promissory note of approximately $900,000 bearing interest of 5.5% per annum and due in March 2006. The provisions of the note agreement allowed for forgiveness of $540,000 related to principal due under the note and $72,000 related total interest to maturity over the five-year term of the note. In March 2002, the Company forgave approximately $110,000 in principal and interest. The Vice President-North America Sales resigned in September 2002, at which time the outstanding balance of the note including accrued interest was approximately $829,000. In September 2002, the Company repurchased 75,714 shares of common stock from the Vice President-North America Sales for a total of approximately $813,000 by reducing the note balance by that amount. The remaining note balance of approximately $16,000 was offset by amounts owed to the Vice President-North America Sales.

The Company leases its facilities under several non-cancelable operating leases expiring at various dates through July 2010. Approximate future minimum lease payments under these operating leases at March 31, 2005 are as follows (in thousands):

Rent expense for the years ended March 31, 2005, 2004, and 2003 was approximately $4.4 million, $3.1 million and $2.3 million, respectively.

On June 13, 2005, a putative shareholder class action lawsuit captioned The Cornelia I. Crowell GST Trust vs. Magma Design Automation, Inc., Rajeev Madhavan, Gregory C. Walker and Roy E. Jewell., No. C 05 02394, was filed in U.S. District Court, Northern District of California. The complaint alleges that defendants failed to disclose information regarding the risk of Magma infringing intellectual property rights of Synopsys, Inc., in violation of Section 10(b) of the Securities Exchange Act of 1934 and Rule 10b-5 thereunder, and prays for unspecified damages. The Company is currently unable to assess the possible range or extent of damages and/or other relief, if any, that could be awarded to the shareholder class, therefore, no contingent liability has been recorded at March 31, 2005. The ultimate resolution of this matter or other third party assertions could have a material adverse effect on the Company’s financial position, results of operations and cash flows.

In addition to the above, from time to time, the Company is involved in other disputes that arise in the ordinary course of business. The number and significance of these disputes is increasing as the Company’s business expands and the Company grows larger. Any claims against the Company, whether meritorious or not, could be time consuming, result in costly litigation, require significant amounts of management time and result in the diversion of significant operational resources. As a result, these disputes could harm the Company’s business, financial condition, results of operations or cash flows.

The Company enters into standard license agreements in the ordinary course of business. Pursuant to these agreements, the Company agrees to indemnify its customers for losses suffered or incurred by them as a result of any patent, copyright, or other intellectual property infringement claim by any third party with respect to the Company’s products. These indemnification obligations have perpetual terms. The Company’s normal business practice is to limit the maximum amount of indemnification to the amount received from the customer. On occasion, the maximum amount of indemnification the Company may be required to make may exceed its normal business practices. The Company estimates the fair value of its indemnification obligations as insignificant, based upon its historical experience concerning product and patent infringement claims. Accordingly, the Company has no liabilities recorded for indemnification under these agreements as of March 31, 2005.

The Company has agreements whereby its officers and directors are indemnified for certain events or occurrences while the officer or director is, or was, serving at the Company’s request in such capacity. The maximum potential amount of future payments the Company could be required to make under these indemnification agreements is unlimited; however, the Company has a directors’ and officers’ liability insurance policy that reduces its exposure and enables the Company to recover a portion of future amounts paid. As a result of the Company’s insurance policy coverage, the Company believes the estimated fair value of these indemnification agreements is minimal. Accordingly, no liabilities have been recorded for these agreements as of March 31, 2005.

In connection with certain of the Company’s recent business acquisitions, it has also agreed to assume, or cause Company subsidiaries to assume, the indemnification obligations of those companies to their respective officers and directors.

The Company offers its customers a warranty that its products will conform to the documentation provided with the products. To date, there have been no payments or material costs incurred related to fulfilling these warranty obligations. Accordingly, the Company has no liabilities recorded for these warranties as of March 31, 2005 or 2004. The Company assesses the need for a warranty accrual on a quarterly basis, and there can be no guarantee that a warranty accrual will not become necessary in the future.

The Company has adopted the provisions of SFAS 131, “Disclosures about Segments of an Enterprise and Related Information”, which requires the reporting of segment information using the “management approach”. Under this approach, operating segments are identified in substantially the same manner as they are reported internally and used by the Company’s chief operating decision maker (“CODM”) for purposes of evaluating performance and allocating resources. Based on this approach, the Company has one reportable segment as the CODM reviews financial information on a basis consistent with that presented in the consolidated financial statements.

Revenue from North America, Europe, Japan and the Asia Pacific region, which includes India, South Korea, Taiwan, Hong Kong and the People’s Republic of China, was as follows (in thousands, except for percentages shown):

Revenue attributable to significant customers, representing 10% or more of total revenue for at least one of the respective periods, are summarized as follows:

The Company has substantially all of its long-lived assets located in the United States.

Income tax expense differed from the amounts computed by applying the U.S. federal income tax rate of 35% to pretax income (loss) as a result of the following (in thousands):

Reclassifications have been made to our fiscal 2004 presentation in order to conform to the current year’s presentation.

U.S. income taxes and foreign withholding taxes have not been provided for on a cumulative total of $2.7 million of undistributed earnings for certain non-U.S. subsidiaries. We intend to reinvest these earnings indefinitely in operations outside of the U.S.

The types of temporary differences that give rise to significant portions of the Company’s deferred tax assets and liabilities are as follows (in thousands):

At March 31, 2005, the Company had net operating loss carryforwards for federal and state income tax purposes of approximately $106.4 million and $24.6 million, respectively, available to reduce future income subject to income taxes. The net operating loss carryforwards will begin to expire in 2018 and 2006, respectively. The Company also has research credit carryforwards for federal and California tax purposes of approximately $6.1 million and $5.7 million, respectively, available to reduce future income subject to income taxes. The federal research credit carryforwards will begin to expire in 2012 through 2025, and the California research credits carry forward indefinitely.

Management believes that, based on a number of factors, it is more likely than not, that all or some portion of the deferred tax assets will not be realized; and accordingly, for the year ended March 31, 2005 the company has provided a valuation allowance against our net deferred tax assets. The net change in the valuation allowance for the years ended March 31, 2005 and 2004 was a decrease of $5.4 million and an increase of $5.4 million, respectively.

Approximately $14.4 million of the valuation allowance at March 31, 2005 is attributable to employee stock option deductions and original issue discount deductions, the benefit from which will be allocated to additional paid-in capital when and if subsequently realized. Approximately $8.7 million of the valuation allowance at March 31, 2005 is attributable to deferred assets which were recorded in connection with various acquisitions. When recognized, the benefit of these assets will be applied, first, to reduce to zero any goodwill related to these acquisitions; second, to reduce to zero other non-current intangible assets related the acquisitions; and third, to reduce income tax.

The Company’s income taxes payable for federal and state purposes have been reduced by the tax benefits associated with the exercise of employee stock options during the year, original issue discount deductions, and utilization of net operating loss carryovers applicable to acquired entities. The benefits applicable to stock options and original issue discount were credited directly to stockholders’ equity and amounted to $0.5 million and zero for fiscal years 2005 and 2004, respectively. The benefits applicable to acquired entities were credited directly to goodwill and other intangible assets and amounted to $1.6 million and zero for fiscal years 2005 and 2004, respectively.

The Tax Reform Act of 1986 and similar state provisions impose restrictions on the utilization of net operating loss and tax credit carryforwards in the event of an “ownership change” as defined in the Internal

Revenue Code. If an ownership change occurs, the Company’s ability to utilize its net operating loss and tax credit carryforwards may be subject to an annual limitation on the amount that can be utilized in future years to offset future taxable income The annual limitations may result in the expiration of the net operating loss and tax credit carryforwards prior to utilization. The Company has determined that the utilization of the net operating losses that were recorded as part of the acquisition of Silicon Metrcis Corporation will be subject to an annual limitation. As of March 31, 2005 the company had approximately $25.5 million of federal net operating losses recorded from the acquisition and may utilize approximately $1.5 million of these net operating losses each year.

Congress passed the American Jobs Creation Act of 2004 on October 22, 2004 (“the Act”). The Act contains numerous changes to existing tax laws, including both domestic and foreign tax incentives. We have completed evaluating the impact of the repatriation provisions. The adoption of FSP 109-2 did not have any impact on our results of operations or financial condition. Among other things, the Jobs Act repeals an export incentive and creates a new tax deduction for qualified domestic manufacturing activities. At this time, we do not expect that the deduction will have a material impact on our reported income tax rate.

In fiscal 2004, the Company began leasing a building for its corporate headquarters from one of its customers under a seven-year lease agreement which expires in 2010. The total rental commitment for the building over the lease term is $11.4 million. In fiscal 2005 and 2004, the Company recorded $1.7 million and $0.8 million, respectively, of rent expense related to this lease and recognized $2.1 million and $0.5 million, respectively, in revenue from the sale of software licenses to this customer. No revenue was recognized from the sale of software licenses to this customer in fiscal 2003. This customer had $79,000 and $0 outstanding accounts receivable balance at March 31, 2005 and 2004, respectively.

As of March 31, 2005, Magma invested approximately $1.9 million in two private companies. Both of these companies purchased software licenses from the Company during fiscal year 2005 and 2003. For the fiscal years ended March 31, 2005, 2004 and 2003, the Company recognized $0.5 million, $0 and $0.4 million in revenue from these software licenses, respectively.

Effective April 1, 1997, the Company adopted a plan (the “401(k) Plan”) that is intended to qualify under Section 401(k) of the Internal Revenue Code of 1986. The 401(k) Plan covers essentially all employees. Eligible employees may make voluntary contributions to the 401(k) Plan up to 20% of their annual eligible compensation. The Company is permitted to make contributions to the 401(k) Plan as determined by the Board of Directors. The Company has not made any contributions to the Plan.

In May 2005, the Company repurchased, in privately negotiated transactions, $44.5 million face amount (or approximately 30 percent of the total) of the company’s zero coupon convertible subordinated notes due May 2008 at an average discount to face value of approximately 22 percent. The Company spent approximately $34.8 million on the repurchases. The repurchase left approximately $105.5 million principal amount of convertible subordinated notes outstanding. In addition, a portion of a hedge and warrant transaction entered into by Magma in 2003 to limit potential dilution from conversion of the notes was terminated in connection with the repurchase. In connection with the transactions, the Company will record a non-recurring pre-tax gain of $9.7 million on the

repurchase, which was partially offset by the write-off of $0.9 million of deferred financing costs associated with the convertible subordinated notes in the first quarter of fiscal 2006. The proceeds from the termination of the hedge and warrant will be recorded against additional paid-in capital.

On April 13, 2005, the Company announced that its Board of Directors authorized Magma to repurchase up to 2.0 million shares of its common stock. The stock repurchase was completed in May 2005. The Company used approximately $16.0 million to repurchase 2.0 million shares of common stock. The repurchased shares are to be used for general corporate purposes.

On April 18, 2005 the Company’s Board of Directors authorized Magma to seek stockholder approval of an option exchange program designed to promote employee retention and reward contributions to stockholder value. Under the program, the company will offer to exchange outstanding options to purchase common stock at exercise prices greater than or equal to $10.50 for a smaller number of new options at an exercise price equal to fair market value on the date of grant, expected to be in August 2005. Directors and executive officers are not eligible to participate in this option exchange program. The exercise prices of outstanding options that are eligible for the program range from $10.50 to $30.28 per share, and these options are held by approximately 554 employees. The Company is seeking stockholder approval of the program at a special meeting of stockholders set for June 22, 2005.

The following table presents selected unaudited consolidated financial data for each of the eight quarters in the two-year period ended March 31, 2005. In the Company’s opinion, this unaudited information has been prepared on the same basis as the audited information and includes all adjustments (consisting of only normal recurring adjustments) necessary for a fair statement of the financial information for the period presented.

Evaluation of Disclosure Controls and Procedures. We conducted an evaluation required by Rule 13a-15 of the Securities Exchange Act of 1934, as amended, (“Exchange Act”), under the supervision and with the participation of our management, including our Chief Executive Officer and Chief Financial Officer, of the effectiveness of our disclosure controls and procedures (as defined in Rules 13a-15(e) and 15d-15(e) under the Exchange Act) as of March 31, 2005.

The evaluation of our disclosure controls and procedures included a review of our processes and implementation and the effect on the information generated for use in this Annual Report on Form 10-K. In the course of this evaluation, we sought to identify any significant deficiencies or material weaknesses in our internal control over financial reporting, which is part of our disclosure controls and procedures, to determine whether we had identified any acts of fraud involving personnel who have a significant role in our disclosure controls and procedures, and to confirm that any necessary corrective action, including process improvements, was taken. The overall goals of these evaluation activities are to monitor our disclosure controls and procedures and to make modifications as necessary. We intend to maintain these disclosure controls and procedures, modifying them as circumstances warrant.

Based on their evaluation as of March 31, 2005, our Chief Executive Officer and Chief Financial Officer have concluded that our disclosure controls and procedures effectively provide reasonable assurance that information required to be disclosed by us in our reports filed or submitted under the Exchange Act, including this Annual Report on Form 10-K, (i) is recorded, processed, summarized and reported within the time periods specified in the SEC’s rules and forms and (ii) is accumulated and communicated to our management, including our Chief Executive Officer and Chief Financial Officer, as appropriate to allow timely decisions regarding required disclosure. Even though our Chief Executive Officer and Chief Financial Officer concluded that our disclosure controls and procedures were effective as of the end of the period covered by this report, we are committed to enhancing our controls on a continuing basis.

Inherent Limitations on Effectiveness of Controls. Our management, including our CEO and CFO, does not expect that our disclosure controls and procedures or our internal control over financial reporting will prevent or detect all errors and all fraud. A control system, no matter how well conceived and operated, can provide only reasonable, not absolute, assurance that the objectives of the control system are met. Further, the design of a control system must reflect the fact that there are resource constraints, and the benefits of controls must be considered relative to their costs. Because of the inherent limitations in all control systems, no evaluation of controls can provide absolute assurance that all control issues and instances of fraud, if any, within Magma have been detected. Our management, including our CEO and CFO, has concluded that the disclosure controls and procedures are effective at the reasonable assurance level.

Management’s Report on Internal Control over Financial Reporting. Our management’s assessment of the effectiveness of our internal control over financial reporting is discussed in “Management’s Report On Internal Control Over Financial Reporting” appearing under Item 8 of this Annual Report.

Audit Report of PricewaterhouseCoopers LLP. Our independent registered public accounting firm has issued an audit report on our assessment of the effectiveness of the Company’s internal control over financial reporting and on the effectiveness of internal control over financial reporting as of March 31, 2005. This report appears under Item 8 of this Annual Report.

Changes in Internal Control Over Financial Reporting. We have recently completed our first annual company-wide review of our internal control over financial reporting, as part of the process of preparing for compliance with Section 404 of the Sarbanes-Oxley Act of 2002, and as a complement to our existing overall program of internal control over financial reporting. In this connection, we improved the design and effectiveness of our internal control over financial reporting throughout the year ended March 31, 2005. However, there were no changes in our internal control over financial reporting identified in connection with the evaluation described above that occurred during our last fiscal quarter ended March 31, 2005 that have materially affected, or are reasonably likely to materially affect, our internal control over financial reporting.

Information relating to our directors and compliance with Section 16(a) of the Exchange Act, will be presented under the captions “Election of Directors” and “Section 16(a) Beneficial Ownership Reporting Compliance”, respectively, in our definitive proxy statement in connection with our 2005 Annual Meeting of Stockholders to be held on August 30, 2005. That information is incorporated into this report by reference. Certain information required by this item concerning executive officers is set forth in Part I of this Report under the caption “Executive Officers of the Registrant.”

We have adopted a Code of Conduct and Ethics that applies to our principal executive officer, principal financial officer and all other employees of Magma. This Code of Conduct and Ethics is posted on our website at http://investor.magma-da.com/governance/home.cfm. We intend to satisfy the disclosure requirement under Item 10 of Form 8-K regarding our amendment to, or waiver from, a provision of this Code of Conduct and Ethics by posting such information on our website at http://investor.magma-da.com/governance/home.cfm.

Information relating to executive compensation will be presented under the caption “Executive Compensation” in our definitive proxy statement. That information is incorporated into this report by reference.

Information relating to the security ownership of our common stock by our management and other beneficial owners will be presented under the caption “Security Ownership of Certain Beneficial Owners and Management” in our definitive proxy statement. That information is incorporated into this report by reference. Information relating to securities authorized for issuance under equity compensation plans will be presented under the caption “Securities Authorized for Issuance under Equity Compensation Plans” in our definitive proxy statement. That information is incorporated into this report by reference.

Information required by this Item is incorporated by reference from the information contained under the caption “Certain Relationships and Related Transactions” in our definitive proxy statement.

The information required by this item is incorporated by reference from the information contained under the caption “Ratification of Independent Accountants—Audit and Non-Audit Fees” and “Ratification of Independent Accountants—Pre-Approval Policies and Procedures” contained in our definitive proxy statement.

Schedule II—Valuation and Qualifying Accounts for the year ended March 31, 2005, 2004 and 2003.

Schedules not listed above are omitted because they are not required, they are not applicable or the information is already included in the consolidated financial statements or notes thereto.

The exhibit list in the Exhibit Index is incorporated herein by reference as the list of exhibits required as part of this item.

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


MAGMA DESIGN AUTOMATION, INC.

By		/s/ GREGORY C. WALKER
		Gregory C. Walker *Senior Vice President-Finance and Chief Financial Officer*

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


DELAWARE		77-0454924
(State or other jurisdiction of incorporation or organization)		(I.R.S. Employer Identification No.)


		Page
PART I

Item 1.	Business	2
Item 2.	Properties	12
Item 3.	Legal Proceedings	12
Item 4.	Submission of Matters to a Vote of Security Holders	13

PART II

Item 5.	Market for Registrant’s Common Equity, Related Stockholder Matters and Issuer Purchases of Equity Securities	15
Item 6.	Selected Financial Data	16
Item 7.	Management’s Discussion and Analysis of Financial Condition and Results of Operations	17
Item 7A.	Quantitative and Qualitative Disclosures About Market Risk	49
Item 8.	Financial Statements and Supplementary Data	50
Item 9.	Changes in and Disagreements with Accountants on Accounting and Financial Disclosure	95
Item 9A.	Controls and Procedures	95

PART III

Item 10.	Directors and Executive Officers of the Registrant	97
Item 11.	Executive Compensation	97
Item 12.	Security Ownership of Certain Beneficial Owners and Management and Related Stockholder Matters	97
Item 13.	Certain Relationships and Related Transactions	97
Item 14.	Principal Accountant Fees and Services	97

PART IV

Item 15.	Exhibits and Financial Statement Schedule	98

Signatures		99


	High		Low
Fiscal 2006:
First quarter (through May 31, 2005)	$	11.78	$	5.58

Fiscal 2005:
Fourth quarter	$	13.74	$	10.50
Third quarter	$	16.54	$	12.15
Second quarter	$	18.68	$	14.85
First quarter	$	22.23	$	17.58

Fiscal 2004:
Fourth quarter	$	28.88	$	20.00
Third quarter	$	25.50	$	17.77
Second quarter	$	24.05	$	16.00
First quarter	$	20.80	$	7.64


	Year Ended March 31,
	2005			2004			2003			2002			2001
	(in thousands, except per share data)
Consolidated Statements of Operations Data:
Revenue:
Licenses	$	123,995		$	100,387		$	63,631		$	38,175		$	11,270
Services		21,946			13,342			11,461			8,182			572

Total revenue		145,941			113,729			75,092			46,357			11,842
Cost of revenue*		22,216			16,647			11,575			8,364			5,848

Gross profit		123,725			97,082			63,517			37,993			5,994

Operating expenses:
Research and development		41,716			26,097			18,687			18,238			20,600
In-process research and development		4,364			200			—			—			—
Sales and marketing		44,654			36,973			25,656			22,928			21,566
General and administrative		18,057			11,348			10,680			6,033			7,221
Restructuring costs		698			—			727			—			—
Amortization of intangible assets		18,011			1,745			—			—			—
Stock-based compensation**		1,879			7,086			4,773			6,738			3,658

Total operating expenses		129,379			83,449			60,523			53,937			53,045

Operating income (loss)		(5,654	)		13,633			2,994			(15,944	)		(47,051	)

Other income (expense):
Interest income		2,287			2,584			1,841			1,036			1,392
Interest expense		(996	)		(1,066	)		—			(14,604	)		—
Other expense, net		(1,082	)		(100	)		(578	)		(186	)		(232	)

Other income (expense), net		209			1,418			1,263			(13,754	)		1,160

Net income (loss) before income taxes		(5,445	)		15,051			4,257			(29,698	)		(45,891	)
Provision for income taxes		(3,136	)		(3,576	)		(1,183	)		(288	)		(138	)

Net income (loss)		(8,581	)		11,475			3,074			(29,986	)		(46,029	)
Less: preferred stock dividend		—			—			—			(5,814	)		—

Net income (loss) attributed to common stockholders	$	(8,581	)	$	11,475		$	3,074		$	(35,800	)	$	(46,029	)

Net income (loss) per share—basic	$	(0.25	)	$	0.36		$	0.10		$	(2.07	)	$	(5.95	)

Net income (loss) per share—diluted	$	(0.25	)	$	0.29		$	0.10		$	(2.07	)	$	(5.95	)

Weighted average shares—basic		33,861			31,648			30,521			17,258			7,733

Weighted average shares—diluted		33,861			40,245			31,976			17,258			7,733

* Stock-based compensation included in cost of revenue	$	1		$	9		$	57		$	56		$	86

**Components of stock-based compensation included in operating expenses:
Research and development	$	1,336		$	3,638		$	2,096		$	1,326		$	1,098
Sales and marketing		125			317			1,458			2,319			1,203
General and administrative		418			3,131			1,219			3,093			1,357

Total	$	1,879		$	7,086		$	4,773		$	6,738		$	3,658


	March 31,
	2005		2004		2003		2002		2001
	(in thousands)
Consolidated Balance Sheet Data:
Cash and cash equivalents, short-term and long-term investments	$	135,518	$	150,842	$	95,697	$	91,946	$	14,713
Total assets	$	319,224	$	314,475	$	127,478	$	119,709	$	29,289
Notes payable to bank	$	—	$	—	$	—	$	—	$	1,686
Convertible subordinated notes	$	150,000	$	150,000	$	—	$	—	$	—
Other non-current liabilities	$	1,749	$	5,999	$	72	$	130	$	533
Redeemable convertible preferred stock	$	—	$	—	$	—	$	—	$	88,570
Total stockholders’ equity (deficit)	$	121,399	$	117,739	$	105,772	$	92,744	$	(78,894	)


Name	Age	Position
Rajeev Madhavan	39	Chief Executive Officer and Chairman of the Board
Roy E. Jewell	50	President and Chief Operating Officer and Director
Gregory C. Walker	51	Senior Vice President, Finance and Chief Financial Officer
Saeid Ghafouri	47	Senior Vice President, Worldwide Field Operations
Hamid Savoj	44	Senior Vice President, Product Development


	Year Ended March 31,									% Change
	2005			2004			2003			2004 / 2005		2003 / 2004
Revenue:
Licenses	$	123,995		$	100,387		$	63,631		23.5	%	57.8	%
Services		21,946			13,342			11,461		64.5	%	16.4	%

Total revenue		145,941			113,729			75,092		28.3	%	51.5	%
Cost of revenue		22,216			16,647			11,575		33.5	%	43.8	%

Gross profit	$	123,725		$	97,082		$	63,517		27.4	%	52.8	%

Percentage of total revenue:
Licenses revenue		85.0	%		88.3	%		84.7	%
Services revenue		15.0	%		11.7	%		15.3	%
Cost of revenue		15.2	%		14.6	%		15.4	%
Gross profit		84.8	%		85.4	%		84.6	%


	Payments due by period
Contractual Obligations	Total		Less than 1 year		1-3 Years		4-5 Years		After 5 Years
Operating lease obligations	$	13.6	$	3.3	$	5.0	$	4.6	$	0.7
Convertible subordinated notes		150.0		—		—		150.0		—
Purchase obligations		2.4		2.4		—		—		—

Total	$	166.0	$	5.7	$	5.0	$	154.6	$	0.7


		Page
Management’s Annual Report on Internal Control over Financial Reporting		51
Report of Independent Registered Public Accounting Firm (PricewaterhouseCoopers LLP)		52
Report of Independent Registered Public Accounting Firm (KPMG LLP)		54
Consolidated Balance Sheets as of March 31, 2005 and 2004		55
Consolidated Statements of Operations for the years ended March 31, 2005, 2004 and 2003		56
Consolidated Statements of Stockholders’ Equity		57
Consolidated Statements of Cash Flows for the years ended March 31, 2005, 2004 and 2003		59
Notes to Consolidated Financial Statements		61
Selected Consolidated Quarterly Financial Data (Unaudited)		93
Financial Statement Schedule: Schedule II—Valuation and Qualifying Accounts		98


	March 31, 2005			March 31, 2004
ASSETS
Current assets:
Cash and cash equivalents	$	20,622		$	17,634
Restricted cash		2,950			2,662
Short-term investments		114,896			55,050
Accounts receivable, net		33,851			34,237
Prepaid expenses and other current assets		7,088			9,588

Total current assets		179,407			119,171
Property and equipment, net		21,309			15,196
Intangible assets, net		69,573			62,793
Goodwill		43,194			33,529
Long-term investments		—			78,158
Other assets		5,741			5,628

Total assets	$	319,224		$	314,475

LIABILITIES AND STOCKHOLDERS’ EQUITY
Current liabilities:
Accounts payable	$	3,010		$	1,658
Accrued expenses		22,321			19,132
Deferred revenue		20,745			19,947

Total current liabilities		46,076			40,737
Convertible subordinated notes		150,000			150,000
Deferred income taxes		—			5,102
Other long-term liabilities		1,749			897

Total liabilities		197,825			196,736

Commitments and contingencies (Note 10)

Stockholders’ equity:
Preferred Stock, $.0001 par value; 5,000,000 shares authorized and no shares issued and outstanding		—			—
Common stock, $.0001 par value; 150,000,000 shares authorized and 35,249,858 and 33,941,692 shares issued and outstanding at March 31, 2005 and March 31, 2004, respectively		4			3
Additional paid-in capital		261,627			226,586
Deferred stock-based compensation		(5,749	)		(718	)
Accumulated deficit		(115,644	)		(107,063	)
Treasury stock at cost, 1,000,000 and 0 shares at March 31, 2005 and 2004, respectively		(16,606	)		—
Accumulated other comprehensive loss		(2,233	)		(1,069	)

Total stockholders’ equity		121,399			117,739

Total liabilities and stockholders’ equity	$	319,224		$	314,475


	STOCKHOLDERS’ EQUITY																								Accumulated Other Comprehensive loss			Total Stockholders’ Equity
	Common Stock				Additional Paid-in Capital			Deferred stock-based compensation			Notes receivable from stockholders			Accumulated deficit			Treasury Stock					Comprehensive Income
	Shares		Amount		Additional Paid-in Capital			Deferred stock-based compensation			Notes receivable from stockholders			Accumulated deficit			Shares		Amount			Comprehensive Income
BALANCES AT MARCH 31, 2002	30,239,786		$	3	$	223,450		$	(7,161	)	$	(1,936	)	$	(121,612	)	—		$	—					$	—		$	92,744
Exercise of warrants to purchase common stock	1,780			—		—			—			—			—		—			—						—			—
Issuance of common stock under stock incentive plans	810,574			—		4,949			—			—			—		—			—						—			4,949
Issuance of common stock to consultants	27,500			—		336			—			—			—		—			—						—			336
Issuance of common stock in connection with asset purchase	171,646			—		1,225			—			—			—					—						—			1,225
Repurchase of common stock	(78,398	)		—		(405	)		—			813			—		(37,142	)		(408	)					—			—
Repayment of note receivable from stockholder	—			—		—			—			20			—		—			—						—			20
Offset of amounts owed to stockholder against note receivable from stockholder	—			—		—			—			16			—		—			—						—			16
Accrued interest on notes receivable from stockholders	—			—		—			(121	)		(136	)		—		—			—						—			(257	)
Reversal of accrued interest on note receivable	—			—		—			374			(374	)		—		—			—						—			—
Reversal of stock-based compensation related to note receivable	—			—		—			440			(440	)		—		—			—						—			—
Reversal of stock-based compensation for terminated employees	—			—		(1,155	)		1,155			—			—		—			—						—			—
Amortization of deferred stock-based compensation	—			—		—			3,675			—			—		—			—						—			3,675
Comprehensive income
Net income	—			—		—			—			—			3,074		—			—		$	3,074			—			3,074
Other comprehensive loss, net of tax
Unrealized gain on investments	—			—		—			—			—			—		—			—			19			—			19
Cumulative translation adjustment	—			—		—			—			—			—		—			—			(29	)		—			(29	)

Other comprehensive loss																							(10	)		(10	)

Comprehensive income																							3,064

BALANCES AT MARCH 31, 2003	31,172,888			3		228,400			(1,638	)		(2,037	)		(118,538	)	(37,142	)		(408	)					(10	)		105,772
Issuance of common stock under stock incentive plans	3,009,139			—		24,059			—			—			—		—			—						—			24,059
Retirement of treasury stock	—			—		(408	)		—			—			—		37,142			408						—			—
Issuance of common stock in connection with business combination	1,079,418			—		10,405			—			—			—		—			—						—			10,405
Issuance of common stock in connection with asset purchase	—			—		3,486			—			—			—		—			—						—			3,486
Repurchase of common stock	(1,110,000	)		—		(19,980	)		—			—			—		—			—						—			(19,980	)
Settlement of note receivable from stockholder by repurchase of common stock	(209,753	)		—		(1,800	)					1,800			—		—			—						—			—
Repayment of note receivable from stockholder	—			—		—			—			214			—		—			—						—			214
Interest on notes receivable from stockholders	—			—		—			(15	)		23			—		—			—						—			8
Stock-based compensation in connection with employee option grant	—			—		2,098			—			—			—		—			—						—			2,098
Deferred stock-based compensation	—			—		876			(876	)		—			—		—			—						—			—
Reversal of stock-based compensation	—			—		(300	)		300			—			—		—			—						—			—
Amortization of deferred stock-based compensation	—			—		—			1,511			—			—		—			—						—			1,511
Issuance of common stock warrant	—			—		35,904			—			—			—		—			—						—			35,904
Purchase of hedging instrument	—			—		(56,154	)		—			—			—		—			—						—			(56,154	)
Comprehensive income:
Net income	—			—		—			—			—			11,475		—			—			11,475			—			11,475
Cumulative translation adjustments	—			—		—			—			—			—		—			—			(1,151	)		—			(1,151	)
Unrealized gain on investments, net of tax	—			—		—			—			—			—		—			—			92			—			92

Other comprehensive loss	—			—		—			—			—			—		—			—			(1,059	)		(1,059	)

Comprehensive income																						$	10,416

BALANCES AT MARCH 31, 2004	33,941,692		$	3	$	226,586		$	(718	)	$	—		$	(107,063	)	—		$	—					$	(1,069	)	$	117,739


	STOCKHOLDERS’ EQUITY																							Accumulated Other Comprehensive loss			Total Stockholders’ Equity
	Common Stock				Additional Paid-in Capital			Deferred Stock-Based Compensation			Notes Receivable from Stockholders		Accumulated Deficit			Treasury Stock					Comprehensive Loss
	Shares		Amount		Additional Paid-in Capital			Deferred Stock-Based Compensation			Notes Receivable from Stockholders		Accumulated Deficit			Shares		Amount			Comprehensive Loss
BALANCES AT MARCH 31, 2004 (CONTINUED)	33,941,692		$	3	$	226,586		$	(718	)	$	—	$	(107,063	)	—		$	—					$	(1,069	)	$	117,739
Issuance of common stock under stock incentive plans	1,708,716			1		16,353			(6,000	)		—		—		—			—						—			10,354
Issuance of common stock in connection with asset purchase	607,554			—		18,341			(1,088	)		—		—		—			—						—			17,253
Repurchase of common stock	(1,008,104	)		—		(4	)		—			—		—		(1,000,000	)		(16,606	)					—			(16,610	)
Amortization of deferred stock-based compensation, net of forfeitures	—			—		(177	)		2,057			—		—		—			—						—			1,880
Tax benefits associated with exercise of stock options and debt issuance costs	—			—		528			—			—		—		—			—						—			528
Comprehensive loss:
Net loss	—			—		—			—			—		(8,581	)	—			—		$	(8,581	)		—			(8,581	)
Cumulative translation adjustments	—			—		—			—			—		—		—			—			(206	)		—			(206	)
Unrealized loss on investments, net of tax	—			—		—			—			—		—		—			—			(958	)		—			(958	)

Other comprehensive loss	—			—		—			—			—		—		—			—			(1,164	)		(1,164	)

Comprehensive income																					$	(9,745	)

BALANCES AT MARCH 31, 2005	35,249,858		$	4	$	261,627		$	(5,749	)	$	—	$	(115,644	)	(1,000,000	)	$	(16,606	)				$	(2,233	)	$	121,399


	Cost		Unrealized Gains		Unrealized Loss			Estimated Fair Value
	(In Thousands)
March 31, 2005
Classified as current assets:
Cash	$	16,979	$	—	$	—		$	16,979
Money market funds		395		—		—			395
Commercial paper		3,249		—		(1	)		3,248
Auction rate preferreds		6,998		2		—			7000
Government agencies		49,499		—		(525	)		48,974
Corporate bonds		37,506		—		(316	)		37,190
Auction rate certificates		19,650		—		—			19,650
Municipal obligations		2,090		—		(8	)		2,082

	$	136,366	$	2	$	(850	)	$	135,518


	Year Ended March 31
	2005		2004		2003
Stock options:
Risk-free interest	3.00	%	2.57	%	2.43	%
Expected life	2.63 years		3.0 years		4-5 years
Expected dividend yield	0	%	0	%	0	%
Volatility	43	%	63	%	78	%


	Carrying Value			Estimated Fair Value
March 31, 2005
Convertible subordinated notes	$	150,000		$	129,300
Convertible bond hedge	$	(56,154	)	$	(6,858	)
Written call option	$	35,904		$	2,887

March 31, 2004
Convertible subordinated notes	$	150,000		$	165,093
Convertible bond hedge	$	(56,154	)	$	(62,745	)
Written call option	$	35,904		$	43,669


	March 31, 2005			March 31, 2004
Unrealized gain (loss) on available-for-sale investments	$	(847	)	$	111
Foreign currency translation adjustments		(1,386	)		(1,180	)

Accumulated other comprehensive loss	$	(2,233	)	$	(1,069	)


	Silicon Craft			Aplus (1)			Silicon Metrics			Random Logic			Total
2004 Business Combinations
Cash consideration paid	$	1,200		$	2,279		$	17,800		$	20,000		$	41,279
Equity consideration paid		—			10,405			—			—			10,405

Total consideration paid		1,200			12,684			17,800			20,000			51,684
Transactions and other direct acquisition costs		22			167			1,014			144			1,347

Total purchase price	$	1,222		$	12,851		$	18,814		$	20,144		$	53,031

Allocation of purchase price:
Current assets	$	—		$	492		$	4,910		$	726		$	6,128
Deferred income taxes		(388	)		—			(2,360	)		(2,280	)		(5,028	)
Current liabilities		—			(75	)		(8,804	)		—			(8,879	)
Other		—			74			2,277			—			2,351

Net tangible assets acquired		(388	)		491			(3,977	)		(1,554	)		(5,428	)
Intangible assets acquired:
Customer relationship or base		—			—			2,100			100			2,200
Developed technology		970			12,360			1,800			4,100			19,230
Patents		—			—			1,200			800			2,000
Acquired customer contracts		—			—			300			600			900
Trademarks		—			—			300			100			400
In-process research and development		—			—			200			—			200
Goodwill		640			—			16,891			15,998			33,529

	$	1,222		$	12,851		$	18,814		$	20,144		$	53,031

Amortization period of intangibles (in years)
Customer relationship or base		—			—			5			6
Developed technology		4			4			5			6
Patents		—			—			5			6
Acquired customer contracts		—			—			3			3
Trademarks		—			—			5			6


	(Unaudited)
	Year Ended March 31,
(in thousands, except per share data)	2004		2003
Net revenue	$	120,720	$	79,769
Net income	$	7,714	$	90
Net income per share—basic	$	0.24	$	0.00
Net income per share—diluted	$	0.19	$	0.00


	Amount Allocated
Allocation of the preliminary purchase price:
Net tangible assets acquired	$	611
Intangible assets acquired:
Developed technology		16,964
Assembled workforce		966
In-process research and development		4,009
Deferred cash compensation		1,320
Deferred stock-based compensation		1,254

Total purchase price	$	25,124

Amortization period of existing technology		5 years
Amortization period of assembled workforce		4 years


	March 31, 2005							March 31, 2004
	Gross Carrying Amount		Accumulated Amortization			Net Carrying Amount		Gross Carrying Amount		Accumulated Amortization			Net Carrying Amount
Goodwill	$	43,194	$	—		$	43,194	$	33,529	$	—		$	33,529

Other intangible assets:
Developed technology	$	59,083	$	(16,488	)	$	42,595	$	29,507	$	(3,316	)	$	26,191
Licensed technology		23,014		(7,668	)		15,346		22,988		—			22,988
Customer relationship or base		2,200		(637	)		1,563		2,200		(200	)		2,000
Patents		11,792		(3,355	)		8,437		11,282		(1,032	)		10,250
Acquired customer contracts		900		(438	)		462		900		(137	)		763
Assembled workforce		1,235		(330	)		905		200		(31	)		169
No shop right		100		(73	)		27		100		(23	)		77
Trademark		400		(162	)		238		400		(45	)		355

Total	$	98,724	$	(29,151	)	$	69,573	$	67,577	$	(4,784	)	$	62,793


Fiscal year	Estimated Amortization Expense
2006	$	27,353
2007		26,058
2008		9,537
2009		5,827
2010 and after		798

	$	69,573


Exercise Price	Options Outstanding	Weighted Average Remaining Contractual Life in Years	Weighted Average Exercise Price
$ 0.06 – 9.20	1,702,020	7.31	$	7.50
$10.50 – 11.55	1,048,929	5.95	$	10.89
$11.67 – 13.47	875,259	9.21	$	12.92
$13.50 – 13.57	1,536,301	9.84	$	13.57
$15.06 – 16.57	1,376,501	8.56	$	16.34
$16.67 – 20.08	1,184,550	8.67	$	18.44
$20.09 – 22.85	1,445,583	8.73	$	21.81
$23.00 – 30.28	821,437	8.69	$	25.18

	9,990,580	8.38	$	15.30


	Quarter
	First			Second		Third			Fourth
FY 2005
Revenue	$	36,029		$	36,928	$	37,306		$	35,678
Gross profit	$	30,987		$	31,418	$	31,727		$	29,593
Net income (loss)	$	(2,535	)	$	287	$	(719	)	$	(5,614	)
Net income per share—Basic(1)	$	(0.08	)	$	0.01	$	(0.02	)	$	(0.16	)
Net income per share—Diluted(1)	$	(0.08	)	$	0.01	$	(0.02	)	$	(0.16	)

	Quarter
	First			Second		Third			Fourth
FY 2004
Revenue	$	22,813		$	25,817	$	31,052		$	34,047
Gross profit	$	19,567		$	21,925	$	26,311		$	29,279
Net income	$	73		$	3,415	$	3,761		$	4,226
Net income per share—Basic(1)	$	0.00		$	0.11	$	0.12		$	0.13
Net income per share—Diluted(1)	$	0.00		$	0.09	$	0.09		$	0.10


Name	Title	Date

/s/ RAJEEV MADHAVAN Rajeev Madhavan	Chief Executive Officer and Director (Principal Executive Officer)	June 14, 2005

/s/ GREGORY C. WALKER Gregory C. Walker	Senior Vice President-Finance and Chief Financial Officer (Principal Financial Officer and Principal Accounting Officer)	June 14, 2005

/s/ ROY E. JEWELL Roy E. Jewell	President, Chief Operating Officer and Director	June 14, 2005

/s/ KEVIN C. EICHLER Kevin C. Eichler	Director	June 14, 2005

Susumu Kohyama	Director	June 14, 2005

/s/ THOMAS ROHRS Thomas Rohrs	Director	June 14, 2005

/s/ TIMOTHY J. NG Timothy J. Ng	Director	June 14, 2005

/s/ CHET SILVESTRI Chet Silvestri	Director	June 14, 2005


	Balance at Beginning of Period		Additions Charged to Costs and Expenses	Write-offs		Balance at End of Period
Year ended March 31, 2005
Allowance for doubtful accounts	$	323,000	187,000	(85,000	)	$	425,000
Year ended March 31, 2004
Allowance for doubtful accounts	$	531,000	618,000	(826,000	)	$	323,000
Year ended March 31, 2003
Allowance for doubtful accounts	$	100,000	552,000	(121,000	)	$	531,000