TERAYON COMMUNICATION SYSTEMS - TERN Securities Registration Statement (S-1/A) BUSINESS

The following is an excerpt from a S-1/A SEC Filing, filed by TERAYON COMMUNICATION SYS ... on 7/20/1998.

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BUSINESS

OVERVIEW

Terayon develops, markets and sells cable modem systems that enable cable operators to cost-effectively deploy reliable two-way broadband access services. The Company's TeraComm system is designed to allow cable operators to minimize time-consuming and costly network infrastructure upgrades, achieve reduced time to market and provide a wide range of service levels to residential and commercial end users. Cable operators using the TeraComm system are able to provide additional revenue-generating services to end users, enabling cable operators to compete effectively in the emerging market for broadband access services.

The Company's TeraComm system, comprised of the TeraPro cable modem, the TeraLink 1000 Master Controller, the TeraLink Gateway and the TeraView Element Management and Provisioning Software, is based on Terayon's S-CDMA technology. S-CDMA enables reliable two-way broadband communications over both pure coaxial and HFC cable infrastructure by maximizing resistance to noise that interferes with data transmissions over previously unusable frequency spectrum.

INDUSTRY BACKGROUND

DEMAND FOR BROADBAND ACCESS

In recent years, the volume of bandwidth intensive data, voice and video traffic across the Internet, corporate intranets and other public networks has increased dramatically. This demand has been driven by the proliferation of residential and commercial computer users that are accessing networks in a variety of applications, including communications via the Internet, electronic commerce and telecommuting. These applications often require the transmission of large, multimedia-intensive files. IDC estimates that the number of Internet users will increase from approximately 69 million at the end of 1997 to approximately 320 million by the end of 2002. IDC also estimates that the number of home office households will increase from approximately 35 million at the end of 1997 to approximately 50 million by the end of 2002.

Despite significant advances in the performance of computer processors and data backbone networks, high speed data transmission has been limited by the existing local access network infrastructure (the local loop), which is not optimized for distribution of data-intensive multimedia content. Users of dial- up analog modems with maximum data rates of only 28.8 Kbps to 56 Kbps often experience frustration, as they encounter frequent and lengthy delays or complete failures in transmission. In response to the growing demand for increased bandwidth, the communications industry has begun to deploy new broadband access technologies that can deliver megabit per second ("Mbps") or better performance to end users.

ADVANTAGES OF CABLE MODEMS OVER ALTERNATIVE BROADBAND ACCESS TECHNOLOGIES

As residential and commercial demand for faster Internet access continues to grow, particularly for applications such as streaming audio and video, IP telephony and interactive two-way video, service providers are investing in enabling infrastructure and technologies. Various technologies have emerged to address the need for broadband access. The leading technologies include ISDN, ADSL and xDSL technologies being marketed by telecommunications companies, and cable infrastructure technologies such as cable modems being marketed by cable operators. These digital technologies offer substantial performance increases over traditional analog 56 Kbps dial-up modem technologies.

The following chart depicts the maximum available throughput of various broadband access technologies:

COMPARISON OF ALTERNATIVE BROADBAND TECHNOLOGIES

MAXIMUM AVAILABLE THROUGHPUT ------------------------ TECHNOLOGY DESCRIPTION DOWNSTREAM UPSTREAM ---------------------------------------------------------------------------- Cable Modems High speed digital technology over 27.0 to 36.0 2.0 to 14.0 HFC and pure coaxial systems Mbps Mbps ---------------------------------------------------------------------------- ADSL High speed digital technology over 1.5 to 6.1 640 Kbps existing copper wire Mbps ---------------------------------------------------------------------------- ISDN High speed digital technology over 128 Kbps 128 Kbps existing copper wire ---------------------------------------------------------------------------- Dial-up Digital-to-analog conversion 56 Kbps 33 Kbps Analog Access utilizing existing copper wire ----------------------------------------------------------------------------

Of the digital technologies, cable modems currently provide the highest available two-way transmission speeds and their "always on" availability eliminates the tedious and unreliable dial-up process of other technologies. The existing cable infrastructure offers other important advantages over alternative broadband architectures. Currently, the cable infrastructure passes over 95% of homes in the United States and a large number of small businesses. In addition, the cable infrastructure has the capacity to offer a wide range of broadband services, such as digital TV, Internet access and IP telephony. Many cable operators have recognized the need to expand beyond broadcast and video TV services to diversify their business and remain competitive. A growing number of cable operators have already expanded their business to include data- over-cable services through affiliations with service providers such as @Home and Road Runner, and several cable operators are exploring voice-over-cable services as well. Kinetic Strategies Inc. estimates that over 200,000 North American homes currently have data-over-cable services.

LIMITATIONS OF EXISTING CABLE INFRASTRUCTURE

Most cable networks were designed to provide one-way video broadcast from the cable headend to subscribers. Data-over-cable and other two-way services require cable operators to provide an upstream return path from subscribers to the headend. Noise interferes with upstream signal transmissions, potentially resulting in corrupted information or service outages. Common noise problems are (i) "ingress noise," a relatively constant level of interference resulting from home appliances and consumer electronics leaking noise into the cable system through imperfections in the cable plant, such as faulty connections or cracked cable shielding and (ii) "impulse noise," which is transient, unpredictable interference that results from home appliances switching on and off. Noise is a particular problem in the upstream return path because each home's noise is aggregated into the headend. In addition, the 5 to 42 MHz frequency spectrum reserved for subscriber-to-headend transmissions is highly susceptible to ingress and impulse noise.

CABLE OPERATOR OBJECTIVES IN DEPLOYING BROADBAND ACCESS SERVICES

In order to successfully exploit the opportunities offered by the increasing demand for broadband access, cable operators face a number of challenges.

Cost-effectively manage system noise. Cable modems based on current- generation TDMA technologies typically require a Signal-to-Noise Ratio ("SNR") of 20dB or better for reliable operation. To respond to ingress noise, cable operators using cable modems based on TDMA often must upgrade their networks to an HFC architecture. An upgrade to an HFC system includes replacing a substantial portion

of the existing coaxial network with optical fiber, replacing the headend transmission equipment with optical transmission systems and providing additional interface layers between the optical fiber and the coaxial connection into the home.

To further address ingress noise and attempt to prevent impulse noise interference, cable operators must often completely rebuild their HFC network. This entails dividing the network into smaller segments, to isolate noise and therefore limit the aggregate noise arriving at the headend, as well as replacing coaxial drops in the homes of subscribers for data services and placing filters on non-subscriber homes. In addition, many TDMA-based systems employ a frequency-agile scheme where the transmission system will shift transmission to a pre-reserved backup channel if the primary channel is affected by a noise event. Despite these expenditures, cable operators using TDMA may still be required to increase routine maintenance procedures in order to provide reliable service and to restrict two-way services to a limited portion of the 5 to 42 MHz frequency spectrum where noise events are less likely to occur. To reduce these costs and improve the quality of their service, cable operators require new upstream transmission technologies that address both ingress and impulse noise.

Minimize network capital equipment costs. Noise levels are directly related to the number of homes passed by a network, regardless of the number of subscribers on such network. As a result, the number of homes that can be supported by a single TDMA-based cable modem headend is limited, even in the early phase of deployment, when the number of subscribers may be very small. Cable operators using TDMA technology are often required to deploy a large number of headends to create a large service area "footprint." Minimizing initial investments and attaining "pay-as-you-go" capability that allows revenues to support incremental investment are vital to the ability of cable operators to enter the broadband access market.

Time to market. As telecommunications operators move quickly to offer broadband services, the Company believes that a cable operator's success in a particular geographic market will be determined by being first to market with broadband access services. Therefore, the Company believes that cable operators will need the ability to accelerate cable modem deployments in order to enhance their competitive position.

Ability to offer tiered services. The Company believes that cable operators can benefit from having a network capable of offering tiered services that allow them to maximize revenue from bandwidth allocated to those services. For example, a residential end user who only utilizes e-mail or Internet access may only be willing to pay a small premium over the cost of a dial-up connection, while commercial end users may be willing to pay a substantial premium for guaranteed bandwidth. In order to offer multiple tiers of service with varied access speeds and priority connections, cable operators need the ability to assign a portion of shared bandwidth to individual end users.

To meet these challenges, cable operators require a highly reliable broadband access solution that can be deployed rapidly at low initial costs, that enables cable operators to maximize revenues from available bandwidth capacity, and that scales as the number of broadband access subscribers increases.

THE TERAYON SOLUTION

The Company's TeraComm system is designed to enable cable operators to minimize time-consuming and costly network infrastructure upgrades, achieve reduced time to market and provide a wide range of service levels to residential and commercial end users. Cable operators using the TeraComm system are able to provide additional revenue-generating services to end users, enabling cable operators to compete effectively in the emerging market for broadband access services. The Company's system is based on its spread- spectrum technology, S-CDMA, which offers cable operators the following advantages:

Minimize cable infrastructure upgrades. Terayon's S-CDMA technology operates at extremely low SNRs, which enables Terayon's cable modems to be deployed on pure coaxial or HFC-upgraded systems, with minimal system upgrades. TDMA-based systems, which demand higher SNRs for operation, often require costly system upgrades or complete rebuilds to high quality HFC in order to support comparable broadband access services.

Reduce time to market. Activating two-way transmission by installing the TeraComm system does not require the time-consuming network upgrades or rebuilds usually required to support TDMA-based transmission equipment. As a result, cable operators can accelerate cable modem deployment and reduce their time to market with broadband access services, thereby enhancing their competitive position.

Minimize initial headend capital equipment costs. By deploying the TeraComm system, cable operators can minimize the initial capital expense for headend equipment. The noise-resistant properties of S-CDMA allow more cable segments to be aggregated to form a single shared upstream channel. These properties provide cable operators with a cost-effective solution during initial stages of deployment even with a limited number of users. As the number of users increases, additional Terayon equipment can be installed for a smooth transition to a larger-scale network. For large deployments, the routed architecture of Terayon's system will support a large number of headends, enabling cable operators to effectively manage thousands of subscribers as a single IP network with multiple logical sub-networks. In contrast, TDMA-based systems only support a smaller number of homes passed per headend due to susceptibility to noise-related service problems.

Increase signal transmission reliability. Cable operators who plan to offer broadband access services must demonstrate the ability to provide reliable and continuous service. S-CDMA enables cable operators to maintain signal transmission even in high noise environments. Further, S-CDMA's rate-adaptive response to sudden changes in plant conditions prevents even short service outages, unlike alternative systems that utilize a frequency-agile scheme, which can result in a loss of service.

Maximize spectrum usage. The TeraComm system is designed to operate effectively in the lowest frequency ranges of the upstream spectrum, where noise is too severe to allow the operation of TDMA-based systems. As a result, cable operators who employ the TeraComm system can utilize more of the existing upstream bandwidth than alternative broadband access technologies.

Generate additional revenue through tiered services. The high capacity and dynamic bandwidth management capabilities of the TeraComm system are designed to enable cable operators to offer a wide range of services at tiered prices. Cable operators can emulate high margin commercial-service offerings such as T-1, frame-relay and leased lines in the same network as lower margin, residential, Internet access.

Reduce ongoing cable infrastructure maintenance costs. Cable operators utilizing the TeraComm system can capitalize on S-CDMA's noise-resistant properties, which enable cable operators to operate plants in a wide range of conditions, thus reducing on-going maintenance costs and minimizing service problems. For example, while all cable operators monitor their networks on a regular basis, cable operators using TDMA-based systems are generally required to take more frequent corrective action than cable operators using S-CDMA- based systems to prevent normal "wear and tear" on the cable system from impacting service.

STRATEGY

The Company's objective is to be the leading provider of cable modem systems to cable operators seeking to provide broadband access services to residential and commercial end users. Key elements of the Company's strategy are as follows:

Supply leading cable operators worldwide. The Company's initial target market is the ten largest cable companies in each major geographic area. In most markets, a small number of large cable operators often provide services to a majority of subscribers in a specific region and thus influence the purchase decisions of smaller cable operators. In the United States, ten cable operators together own and operate facilities passing approximately 74% of total homes passed. To date, three of the largest North American cable operators are deploying the TeraComm system commercially.

Establish relationships with industry leaders. The Company seeks to provide cable operators with a complete broadband access solution by establishing relationships with networking companies, systems integrators and other industry leaders. For example, the Company has a co-development agreement with Cisco to create an integrated headend solution. Additionally, the Company and @Home have integrated the Company's products with @Home's service. The Company will continue to pursue strategic relationships to expand the capabilities of its system.

Expand worldwide distribution channels. The Company intends to continue to increase its direct sales efforts and to establish strategic relationships with leading distributors worldwide. The Company's distribution strategy is to customize its sales and distribution efforts to address the specific needs of each market. For example, the Company has an agreement with Sumitomo, through its subsidiary Crossbeam Networks Corporation ("Crossbeam"), to distribute the Company's products in Japan. In Latin America, Europe and other parts of Asia the Company has appointed local distributors with expertise in their specific geographic regions. In the United States, the Company has begun to establish distribution relationships to provide broadband access solutions to smaller cable operators.

Provide superior customer service and support. The Company believes that its ability to provide consistent high quality service and support will be a key factor in attracting and retaining customers. In addition to assigning a field applications engineer to each customer account, the Company provides its customers with technical support and training through customer support representatives and representatives of distributors. The Company provides service and support to its customers 24 hours a day, 7 days a week.

Adopt and advocate industry standards. The rapidly evolving market in which the Company participates has recently adopted DOCSIS for cable modem standards, and the industry has commenced discussion of a next-generation cable modem standard, DOCSIS 2.0. The Company is developing a next-generation product, known as the UCM, which is intended to offer a mode of operation compliant with DOCSIS. The Company is actively participating in industry standard-setting efforts and intends to work with the MCNS consortium to incorporate S-CDMA into the DOCSIS 2.0 standard.

Leverage S-CDMA technology. The Company believes that its S-CDMA technology provides significant advantages over alternative broadband access technologies. The Company's team of engineers has extensive experience in many areas of broadband access system design, including communication systems, ASICs, data networking, RF, software and hardware. The Company intends to leverage these engineering capabilities to expand the features and functionality of its S-CDMA technology, and to apply S-CDMA to additional applications such as IP telephony, wireless communications and LMDS.

TECHNOLOGY

Terayon's products are based on the Company's S-CDMA technology. S-CDMA is integrated into a single ASIC chip, which implements the physical ("PHY") layer and media access control ("MAC") layer

communication protocols in the TeraComm system. S-CDMA is the primary differentiator between Terayon's cable modems and those of competitors who use TDMA-based technology for the PHY and MAC layer protocols. S-CDMA is designed to maximize resistance to noise, optimize use of network capacity and provide cable operators with multiple revenue streams through the ability to offer multiple Quality of Service levels.

Maximum noise resistance through spread spectrum and rate adaptive technologies. S-CDMA, like asynchronous Code Division Multiple Access ("CDMA") commonly used in mobile communications, is a form of spread spectrum technology. Spread spectrum technology was originally designed for use by the military to provide reliable and secure communications in harsh RF environments. The RF environment is subject to a variety of noise sources that can interfere with the transmission of data. In spread spectrum systems, data is transmitted by spreading the information across a range of frequencies and across a period of time, allowing sufficient information reception for the data to be reconstructed by the receiver. Data is encoded by transmitters in unique spreading codes that allow multiple data streams to be received and decoded by the receiver simultaneously. Therefore, noise events that are typically specific to a particular frequency or a period of time do not significantly interfere with transmission

In addition to spread spectrum, S-CDMA incorporates other techniques, including forward error correction and interleaving, that further enhance the ability of S-CDMA to resist impulse and ingress noise. In extremely harsh noise environments, S-CDMA incorporates a rate adaptive mode of operation that changes modulation schemes, reducing capacity, but allowing continued reliable transmission. This combination of techniques enables S-CDMA-based systems to operate in SNR environments as low as 13dB at full capacity, and as low as - 13dB in rate adaptive mode.

Optimal capacity utilization through synchronization. In asynchronous CDMA systems, codes arriving at the receiver are unaligned. This causes mutual interference between the codes, which forces the use of lower order modulation schemes resulting in significantly reduced data capacity. S-CDMA minimizes mutual interference by ensuring that codes are synchronized with each other through ranging, power management and adaptive equalization. The process of ranging guarantees time alignment by ensuring all codes arrive at the receiver at the same time. Power management and adaptive equalization compensate for variables such as temperature and changes in network topology. These techniques allow S-CDMA to utilize higher order modulation schemes providing a capacity of 14 Mbps in a 5 MHz channel in both the upstream and downstream paths. This 14 Mbps capacity is divided into 144 data streams, each of which is represented by a unique S-CDMA spreading code.

Efficient bandwidth management for multiple levels of Quality of Service. The TeraComm system segments each 14 Mbps upstream and downstream channel into 128 user data streams and 16 management and control data streams. Separating user data from management and control ensures high channel efficiency under heavy channel loading. Each of the 128 user data streams has a continuous data payload capacity of 64 Kbps. The bandwidth manager software residing in the system headend allocates data streams to cable modems individually or in groups. Data streams can also be assigned on a permanent basis, or can be multiplexed among multiple modems based on a fairness algorithm in the bandwidth manager. This capability allows the TeraComm system to provide a variety of Quality of Service levels. Constant Bit Rate ("CBR") services can be provisioned in increments of 64 Kbps by continuous assignment of data streams to a TeraPro cable modem. As a result, services such as leased lines and T-1 circuits can be emulated. Unspecified Bit Rate ("UBR") services can be supported by allowing modems to contend for data streams on an "as requested" basis. Because all access requests and grants are communicated through management streams, the impact on channel efficiency is minimized as more modems contend for bandwidth. Both CBR and UBR services can co-exist on a single channel enabling a cable operator to create multiple service levels and maximize revenue from the available bandwidth capacity.

PRODUCTS

CURRENT PRODUCTS

The Company's TeraComm system enables cable operators to cost-effectively deploy reliable two-way broadband access services. The TeraComm system is comprised of the TeraPro cable modem, the TeraLink 1000 Master Controller, the TeraLink Gateway and the TeraView Element Management and Provisioning Software.

The following diagram illustrates the TeraComm system:

[Diagram of the components of the TeraComm system]

THE TERACOMM SYSTEM

TeraPro Cable Modem. The TeraPro cable modem is a data communications device installed in a subscriber's home or business. The TeraPro cable modem connects to the subscriber's PC via a standard 10BaseT Ethernet connector and to the cable network via a standard coaxial cable connector. The TeraPro cable modem automatically configures itself without user intervention, thus minimizing modem installation time. In addition, the configuration software for the TeraPro cable modem is downloaded remotely, allowing centralized software upgrades directly from the headend management system.

The TeraPro cable modem delivers full two-way communication over the cable network, with data rates of up to 14 Mbps per 5 MHz channel in both the upstream and the downstream direction. The TeraPro cable modem operates at full capacity at an SNR as low as 13 dB, and gradually adjusts throughput to provide transmission at an SNR as low as -13 dB. This feature will permit the TeraPro cable modem to operate across any portion of the 5 to 42 MHz upstream RF spectrum.

TeraLink 1000 Master Controller. The TeraLink 1000 Master Controller is a data channel controller and multiplexer located at the cable headend system or distribution hub. The TeraLink 1000 Master Controller provides control, management and data transport functions for TeraPro cable modems connected to the cable network. It offers dynamic bandwidth management, high-speed traffic concentration, access control to data networking resources, and data service quality and integrity.

The TeraLink 1000 Master Controller is a single channel, rack-mountable controller that supports up to 2,000 cable modems per channel. Additional TeraLink 1000 Master Controllers can be added to scale service as performance and subscriber needs grow. The TeraLink 1000 Master Controller, with the TeraLink Gateway, provides a 100 BaseT interface for direct connectivity to a private backbone or any vendor's router or switch. Alternatively, the TeraLink 1000 Master Controller, with its built-in ATM OC-3 interface, can be connected via an ATM switch, or directly to Cisco's 7500 series routers.

TeraLink Gateway. The TeraLink Gateway is a rack-mountable edge concentrator providing end-user clients with broadband access to a remote IP backbone (e.g., Internet) as well as efficient communication between modems. The TeraLink Gateway includes an ATM OC-3 interface for connectivity to up to two TeraLink 1000 Master Controllers or an ATM switch. It also provides a 10/100 BaseT Ethernet/Fast Ethernet auto-sense interface to a headend backbone or any IP router including the Cisco Universal Broadband Router. The TeraLink Gateway also includes a separate 10 BaseT interface, which may be connected to a separate management network or the headend network. The TeraLink Gateway supports up to 2,000 cable modems per RF channel when connected to a TeraLink 1000 Master Controller. When used with the TeraLink Gateway, the TeraPro cable modems behave as an extension of the TeraLink Gateway, providing maximum bandwidth and privacy.

TeraView Element Management and Provisioning Software. The TeraView Element Management and Provisioning Software is a Windows 95 and Windows NT standards- based software application installed at the headend system or the network operations center. The TeraView software allows cable operators to configure, control, monitor and maintain multiple channels of the TeraComm system.

PRODUCTS UNDER DEVELOPMENT

Universal Cable Modem and TeraLink 2000 Master Controller. The Company currently is designing and developing a next-generation system, which includes the UCM and an accompanying headend controller, the TeraLink 2000 Master Controller. The UCM and the TeraLink 2000 Master Controller will be designed to be fully compliant with DOCSIS standards, while also offering additional features and performance enabled by the use of the S-CDMA technology. The UCM and the TeraLink 2000 Master Controller are in the early stages of development and the Company does not anticipate commercial deployment of these products until 1999.

The UCM will be designed to operate in any of three modes: (i) as an existing TeraPro cable modem to ensure backward compatibility for existing TeraComm system users; (ii) as a DOCSIS-compliant modem that will be compatible with multiple vendors' DOCSIS-compliant systems; and (iii) as an advanced system. In the advanced mode the UCM will be designed to offer DOCSIS-compliant 64/256 QAM modulation downstream channels, coupled with an advanced S-CDMA upstream channel, offering up to 40 Mbps downstream channel capacity and 30 Mbps upstream channel capacity.

CUSTOMERS

The Company markets its products to cable operators that seek to provide broadband access services to both residential and commercial end users. The Company's initial target market consists of the ten largest cable companies in each major geographic area. In most markets, a small number of large cable operators often provide services to a majority of subscribers in a specific region and thus influence the purchasing decisions of smaller cable operators. In the United States, ten cable operators together own and operate facilities passing approximately 74% of total homes passed. The Company commenced volume shipments of its products in the first quarter of 1998. To date, three of the largest North American cable operators are deploying the TeraComm system commercially.

Selected examples of the range of customers and applications for which the TeraComm system is being commercially deployed are as follows:

Cablevision. Cablevision is the fifth largest cable operator in the United States, with cable infrastructure passing approximately 5.1 million homes, primarily located in New York, New Jersey, Connecticut, Ohio and Massachusetts. Cablevision is currently deploying Terayon's products in systems located in Long Island, New York and areas of Connecticut for its optimum high speed data service.

Shaw Cable. Shaw is the third largest cable operator in Canada, with cable infrastructure passing approximately 2.0 million homes. Shaw currently has the largest cable modem deployment in Canada, with over 35,000 cable modem users. Shaw has selected Terayon to supply cable modem systems for Shaw's @Home service deployments in Victoria, British Columbia, Edmonton, Alberta and parts of metropolitan Toronto, Ontario.

Sumitomo. The Company has a distribution agreement with Sumitomo under which Crossbeam is distributing the TeraComm system to three of Japan's leading cable operators. The TeraComm system's noise resistant properties are designed to enable two-way broadband access over pure coaxial networks, which comprise the majority of Japan's cable infrastructure.

TCA Cable TV, Inc. TCA is the 16th largest cable operator in the United States, with cable infrastructure passing approximately 1.2 million homes, primarily in Texas, Arkansas and Louisiana. TCA has deployed the TeraComm system in Bryan/College Station, Texas and Amarillo, Texas. TCA provides a tiered service offering, with prices ranging from $49.95 per month for residential Internet access to $175 per month for commercial Internet access. TCA has announced that it intends to leverage the noise resistant properties of Terayon's products to deploy broadband access services on a pure coaxial network in Tyler, Texas.

Three customers accounted for approximately 73% of the Company's revenues in 1997 and for approximately 64% of the Company's revenues in the first six months of 1998. In 1997, sales to Telegate, Sumitomo and NET Brasil represented approximately 30%, 29% and 14%, respectively, of the Company's revenues. In the first six months of 1998, sales to Shaw, Sumitomo and Cablevision represented approximately 40%, 14% and 10%, respectively, of the Company's revenues. The Company believes that a substantial majority of its revenues will continue to be derived from sales to a relatively small number of customers for the foreseeable future. In addition, the Company believes that sales to these customers will be focused on a small number of projects. See "Risk Factors--Dependence on Small Number of Customers."

RESEARCH AND DEVELOPMENT

The Company believes that its future success will depend upon its ability to enhance its existing products and to develop and introduce new products that meet a wide range of evolving cable operator and end user needs. In addition, to address competitive and pricing pressures, the Company expects that it will have to reduce the unit cost of manufacturing its cable modems through design and engineering changes. For example, the Company has developed and intends to introduce a single-board modem by the end of 1998, which the Company anticipates will provide cost savings over its current dual-board modem. There can be no assurance that the Company will be successful in redesigning its products, that any such redesign will be made on a timely basis and without introducing significant errors and product defects, or that any such redesign, including the single-board modem, would result in sufficient cost reductions to allow the Company to significantly reduce the list price of its products or improve its gross margin.

The Company also currently is designing and developing a next-generation system, which includes the UCM and an accompanying headend controller, the TeraLink 2000 Master Controller. The UCM and the TeraLink 2000 Master Controller will be designed to be fully compliant with emerging DOCSIS standards, while also offering additional features and performance enabled by the use of the S-CDMA technology. The UCM and the TeraLink 2000 Master Controller are in the early stages of development and the

Company does not anticipate commercial deployment of these products until 1999. See "Risk Factors--Evolving Market; Rapid Technological Change; Market Acceptance of S-CDMA," "--Ability to Achieve Cost Reductions," "--Evolving Industry Standards" and "--Dependence on Products Under Development."

As of June 30, 1998, the Company had 51 employees engaged in research and development. The Company's total research and development expenses for 1995, 1996 and 1997 and the first six months of 1998 were $2.0 million, $8.0 million, $11.3 million and $4.9 million, respectively.

SALES AND MARKETING

Terayon has direct sales forces in North America, Latin America and Europe. The Company also distributes its products via distributors and systems integrators. Terayon has signed a distribution agreement with Sumitomo under which Crossbeam is distributing the TeraComm system to three of Japan's leading cable operators.

The Company markets its products directly to cable operators through its sales force, key distribution and technology partners, as well as other marketing vehicles such as industry press, trade shows and the World Wide Web. Through its marketing efforts, the Company strives to educate cable operators on the technological and business benefits of its system solution, as well as the Company's ability to provide quality support and service to the customer. Terayon participates in the major trade shows and industry events for the cable industry in the United States and is expanding its presence in other markets through joint participation at local events with its international sales and marketing partners. Industry referrals and reference accounts are significant marketing tools developed and utilized by the Company.

CUSTOMER SERVICE AND TECHNICAL SUPPORT

The Company believes that its ability to consistently provide high quality service and support will be a key factor in attracting and retaining customers. The Technical Services and Support ("TSS") organization provides support 24 hours a day, seven days per week. Prior to deployment of the Company's systems, each cable operator's needs are assessed and proactive solutions are implemented, including various levels of training, periodic management and coordination meetings, and problem escalation procedures. Terayon places a strong emphasis on technical training, both for cable operators and systems integrators. Initial training is offered to cable operators and systems integrators at no cost, both in Terayon's headquarters in Santa Clara and on a cable operator's or system integrator's premises. At June 30, 1998, the TSS organization consisted of 13 employees located in North America, Europe, Latin America and Asia.

In addition, Terayon has developed sophisticated tools for remote diagnosis and monitoring of the TeraComm systems deployed by cable operators. Such tools enable the Company to monitor cable operators' installations of the TeraLink 1000 Master Controller and to proactively suggest solutions before problems become noticeable to end users. The Company is developing a Web-based knowledge system to provide cable operators with access to the latest technical support information.

MANUFACTURING

The Company outsources the materials procurement, printed circuit board assembly, and product assembly and testing to turnkey contract manufacturers. Currently, the Company contracts with Solectron, located in Milpitas, California, for the manufacture of the majority of its products. CMC, located in Santa Clara, California, also manufactures certain of the Company's products. The Company has a limited in-house manufacturing capability at its headquarters in Santa Clara. This facility is currently used for the assembly and final testing of TeraLink 1000 Master Controller and TeraLink Gateways, pilot production of new modem designs, sample testing of products received from volume modem manufacturers, developing the manufacturing process and documentation for new products in preparation for outsourcing. The Company also repairs products returned from customers with its in-house manufacturing resources.

The Company's future success will depend in significant part on its ability to obtain high volume manufacturing at low costs. As volume increases, the Company plans to engage additional contract

manufacturers, to procure additional manufacturing facilities and equipment, to modify existing inventory procedures, to substantially increase its personnel and to revise its quality assurance and testing practices. There can be no assurance that any of these efforts will be successful. The Company anticipates that the need to reduce the manufacturing costs of its cable modem and will continue to evaluate the use of low cost third-party suppliers and manufacturers. See "Risk Factors--Ability to Achieve Cost Reductions" and "-- Limited Manufacturing Experience and Dependence on Contract Manufacturer."

Subcontractors supply the Company's contract manufacturers with both standard components and subassemblies manufactured to the Company's specifications. The Company is dependent upon certain key suppliers for a number of the components for its products. For example, the Company currently relies on VLSI for the Company's S-CDMA ASIC, which is used in the Company's headend and cable modem products. In addition, all of the Company's products contain one or more components that are currently only available from a single source.