ITEM 1. BUSINESS.

Introduction

Interphase Corporation and subsidiaries ("Interphase" or the "Company") designs, develops, manufactures, markets and supports high-performance network and mass storage products based on advanced technologies for some of today's most powerful computer systems. Interphase's network and mass storage products include high performance network adapters, concentrators and computer network operating system software drivers. The Company's local area network ("LAN") products implement high speed networking technologies such as Fiber Distributed Data Interface ("FDDI"), Asynchronous Transfer Mode ("ATM"), fast ethernet (both 100 VG-AnyLAN and 100 Base T), as well as ethernet (10Base T) and Token Right technologies that facilitate the high speed movement of information across computer networks. The Company's wide area network ("WAN") products serving both the server class and client class utilize Integrated Services Digital Network ("ISDN") and X.25 technologies. In addition, the Company announced, in early 1997, its first Digital Subscriber Loop "(xDSL") product, an Asynchronous DSL ("ADSL") adapter card. The Company's mass storage controllers are currently based on Small Computer Systems Interface ("SCSI") technology and high speed Fibre Channel technology to facilitate the movement of data to and from mass storage devices. Fibre Channel can also be used for a high speed interconnect in clustered applications. The Company's products are designed to not only comply with the appropriate open system technical standards but also optimize the performance of the customer's network and mass storage environments.

The Company's LAN adapters and mass storage controllers consist of both hardware and software. The hardware is essentially printed circuit boards which plug into the backplane of a computer and incorporate industry standard bus architectures of the most popular client/server platforms such as PCI, Sbus, EISA, VME, GIO and PMC, as well as input-output front-ends for many performance oriented computer systems. The Company's network adapters support a variety of media including fiber optic cabling and unshielded twisted pair ("UTP") and shielded twisted pair ("STP") copper wire. The Company's software consists of drivers for the most popular client/server operating systems such as Windows NT, Netware, HP-UX, IRIX, O/S2, Solaris, SunO/S, AIX and certain real-time operating systems. In addition the software may include diagnostics, station management ("SMT") and in certain cases off loads the processing of the protocol stack from the server to the adapter card. The Company's FDDI concentrator products are stand-alone network devices which serve as a single point of connection for multi-port local area networks as well as perform certain network traffic management tasks. The mass storage controllers provide a high-speed connection to computer peripheral devices, such as disk drives, tape drives and printers. The Company's WAN adapters are complete ISDN packages that allow standalone desktops and notebooks to connect to Shiva Lan Rover, PPP/ISDN routers, and FTP software ONnet as well as X.25 remote access products. The Company's products are used in a wide range of computer applications including graphics workstations, high performance work groups, CPU clusters, medical imaging, telephone switching, on-line transaction processing and financial services networks.

With respect to the client/server computer market, the majority of the Company's products have traditionally been installed in the server (or "host") as opposed to the client (or "desktop") side of the network. This reflects the Company's historical focus on the development of high-performance, fully featured products that are targeted for the most demanding computer networks. Given the recent emergence of more powerful desktop computing environments and a growth in demand for data intensive applications, the Company believes that its strengths in certain network and mass storage technologies will create significantly more opportunities for desktop installations of its products in future years.

The Company believes that its success in gaining significant market share in its selected markets is dependent upon not only the development and manufacturing of high performance, high quality products but also in establishing and maintaining the appropriate distribution channels. The Company has original equipment manufacturer ("OEM") agreements with some of the best known companies in the computer business for its network products and mass storage controllers. The Company's customers include OEM's of computer systems and network switches, systems integrators, value added resellers ("VAR"), distributors and end-users. The Company believes that it must maintain an ongoing synergistic relationship with its customers and demonstrate technology leadership coupled with sophisticated manufacturing and customer support capabilities. The Company's manufacturing and development activities are certified under the ISO 9001 international quality standard. This standard, considered the most comprehensive of the ISO 9000 standards, applies to not only manufacturing quality, but design, development and support quality systems as well. Certain companies in the United States and Europe now require ISO certification of their key suppliers. The Company's headquarters and manufacturing facilities are located in Dallas, Texas.

Effective June 29, 1996, the Company purchased all the issued and outstanding capital stock of Synaptel S.A. ("Synaptel"). Synaptel designs and distributes a broad line of remote access and ISDN products, which include both significant software content and interoperability with a broad range of networking protocols.

The Company, a Texas corporation, was founded in 1977.

Product Overview

The bus structure of a computer system is the pathway over which data flows among the system's components, such as the central processing units ("CPU"), disk or tape drives and network adapters. The bus structure of a computer coordinates the timing and routing of data, as well as defines the system architecture for components which interface with each other. The Company develops and sells products based on high performance bus architectures such as PCI, Sbus, EISA, VME, GIO and PMC. These bus architectures were developed by computer system manufacturers and are considered "open systems" since certain specifications of the architecture are published. The concept of open systems has gained significant momentum in recent years and has allowed end-users to configure a computing and network environment that incorporates desired technology, features, scalibility and support from a variety of product and service providers.

The CPU of a computer performs basic arithmetic, local memory access and input/output functions for communication with peripheral equipment as well as other functions associated with data transfers within a network such as protocol processing. When commanded by the CPU, a network adapter facilitates the high-speed communication of data among computer systems over a network as well as validates data completeness and integrity. Network adapters also perform varying levels of protocol processing and network management tasks. A network protocol is the set of rules or conventions used to govern the exchange of information between networked nodes or LANs. Most computer applications require immediate access to a greater volume of data than can be stored in the computer's local memory. This necessitates external data storage capacity provided by disk or tape drives. A disk controller directs the data storage and retrieval operations of the disk drive and controls the flow of data between the CPU and disk drive. The disk controller locates and formats the data stored on the disk, performs data validity checking, data error detection and correction and informs the CPU of the status of these operations and of the controller itself. A tape controller performs the same functions as a disk controller but interfaces with a tape drive. Multifunction controllers operate like a disk controller but allow the CPU to access disk drives and tape drives simultaneously.

Intelligent controllers designed by the Company incorporate proprietary firmware (i.e., programs developed by the Company and stored in memory on the product) and software to perform these functions simultaneously and independently from the CPU, which allows the CPU to perform other operations at the same time as network communications, data storage or retrieval occurs.

Network Products

Revenues derived from networking products represented approximately 77% and 71% of consolidated revenues for the years ended December 31, 1997 and 1996, respectively and 61% of consolidated revenues during the year ended October 31, 1995.

LAN

Over the past several years the Company has developed a diverse line of LAN products targeted for the VME, Sbus, EISA, PCI, GIO and PMC bus marketplace. The majority of these products are sold directly to OEMs but a substantial portion are also sold to VAR's, system integrators, distributors and large end-users.

The Company's products included within this broad grouping can be further divided into board level controller (adapter) products and stand-alone network devices.

Board Level Products-

FDDI Product Line-

FDDI is a stable, standardized, 100Mbit per second technology. Its combination of speed and stability make FDDI ideal for reliable high- performance workgroup connections. FDDI high performance adapters are often used for movement of large graphical images such as color prepress and medical imaging applications. These adapters are also used in enterprise servers for high-demand transaction processing networks in corporate systems.

PMC/FDDI 4511 provides reliable, high-performance 100 Mbps FDDI connectivity for PMC-based systems. It supports multimode fiber and copper wiring.

EISA/FDDI 4811 is a high performance FDDI network adapter for EISA bus systems. It provides for full implementation of FDDI Station Management (SMT) on-board, freeing the host CPU to execute applications and upper level protocols.

VME/FDDI 5211 represents a third generation FDDI network adapter from Interphase. This host based product is capable of supporting varying types of media (e.g., fiber or copper) and contains an optical bypass control. It can be used in VME64 systems and is capable of link level or on-board protocol processing. Its RISC-based architecture can be configured for either single or dual attachment to an FDDI network and is available in a 9U or 6U form factor (refers to standard form factors of the printed circuit board).

PCI/FDDI 5511 is a high performance FDDI network adapter for PCI based systems. It provides Single Attach (SAS) connectivity for FDDI workstations or server connectivity to a concentrator in a workgroup topology. It also comes with a Dual Attach (DAS) option for direct A-B connectivity to an FDDI ring or concentrator, or for dual homing between two concentrators. The 5511 provides connections for multimode fiber and TP-PMD compliant Category 5 Unshielded Twisted Pair copper wiring.

Sbus/FDDI 5611 is a high performance FDDI network adapter for SBus systems. The 5611 is designed to capitalize on the high performance of Sun SPARC and compatible systems with a direct memory access (DMA) architecture.

Sbus/FDDI CDDI WA-C303 adapter provides high performance, 100-Mbps connectivity to FDDI networks for SPARC-based worstations and servers. It supports single attachment and fault-tolerant, dual attachment connections.

EISA/FDDI CDDI WA-C323 adapter provides high performance 100 Mbps connectivity to workgroup servers and workstations.

Ethernet and Fast Ethernet Product Line-

VME/Ethernet 4207 provides a connection to an ethernet network for VMEbus systems. It is a high performance protocol processor that is capable of data rate transfers of over 30 Mbytes/second.

VME Ethernet 4221 adapter is a 10 Base-T product. This adapter is an intelligent network interface which can provide up to four Ethernet ports from a single VME or VME64 slot.

PMC/100 Base T 4524 adapter provides 802.3u 100Base-T connectivity for most PMC-compliant systems. Driver support includes: AIX, Solaris and Window NT.

SBus /100VG-AnyLan 4622 adapter provides Sun SPARC stations and 100% compatibles with selectable connectivity to networks based either on 10Base-T or 100VG-AnyLAN technology.

EISA/100 Base-T 4824 adapter provides either 100 Mbps or 10 Mbps automatically configured based on the type of network connection.

ATM Product Line-

ATM is a scalable network technology capable of providing enhanced quality of service in managing video, audio and data transmissions compared to other existing network technologies. The scalable capability of ATM allows the deployment of products with data transfer rates of 25 Mb, 51 Mb, 100 Mb, 155 Mb and 622 Mb, based upon the same core technology and operating within the same network.

ATM will also provide enhanced network management capabilities and is expected to be suitable for many desktop and server computing environments. This developing industry standard is expected to gain wide acceptance among both network and computer system manufacturers as well as large cable system operations and telecommunications firms (by whom it was initially developed and promoted). The ATM adapter market is anticipated to grow rapidly over the next several years. These adapters can connect stations over ATM using multimode fiber, single-mode fiber, or Category 5 Unshielded Twisted Pair copper cable.

PMC ATM 4515 adapter provides reliable, high performance ATM connectivity for PMC-based systems. This adapter supports SONET OC-3 155 Mpbs connectivity.

SBus ATM 4615 adapter provides full duplex ATM connectivity for virtually all Sun Sbus platforms from 600 MP Servers to the SPARCcenter 2000. This adapter supports SunOS 4.1.3. and Solaris 2.3 or greater.

EISA ATM 4815 adapter provides full duplex ATM connectivity for many EISA-compliant systems from high performance PCs and workstations to powerful mutiprocessing servers running Windows NT and Novell

GIO ATM 4915 adapter provides full duplex ATM connectivity for virtually all Silicon Graphics GIO-based platforms. This adapter supports SGI's IRIX operating system version 5.3.

VME ATM 5215 adapter provides full duplex ATM connectivity for SGI Onyz and Challenge systems running the IRIX

PCI ATM 5515 / 5575 adapter provides full duplex ATM connectivity for most PCI-compliant systems. This adapter supports Windows NT, Novell NetWare UnixWare, Solaris and AIX. NetWare.

PCI ATM 5525 adapter provides full duplex 25 Mbps ATM connectivity for most PCI-compliant systems.

Stand Alone Network Devices-

M1600 FDDI Concentrator provides multiport connectivity to an FDDI network. It supports up to 16 master ports and facilitates high speed FDDI networking between a variety of computing devices and across different types of FDDI media including fiber and copper. This device is "hot swappable" meaning that individual modules may be replaced, removed or added without interrupting the entire network. Other fault tolerance features include an external optical bypass control and an optional redundant power supply, making the M1600 well-suited for demanding FDDI backbone environments.

M800 FDDI Concentrator contains many of the same high performance features as the M1600 FDDI Concentrator but is designed for smaller workgroups with large data transfer requirements. It is available in a table top or rack mountable design.

M400 FDDI Concentrator is a compact, fixed port concentrator ideal for small workgroup cluster. Available in either 4 or 8 port configurations, the M400 provides options for fiber or copper media connectivity and the ability to select managed or unmanaged operations.

WAN

Interphase has a line of WAN products that provide optimal WAN and ISDN connectivity solutions for servers, remote LANs and PCs in multi-vendor networking environments. Interphase WAN products are compatible with Novell, Microsoft, IBM, Sun, Unix, SNA, X.25 Frame Relay and ISDN.

Server Class products include fully featured, multi-purpose and multi-operating systems products for ISDN or X.25 technologies. These products are used by networking professionals to outfit remote offices or central offices with ISDN/WAN adapter that can manage multiple ISDN channels or multiple communication modes.

Client Class products are passive ISDN or modem, board level products which are used in desktop and laptop computers. Typical products are Syncard Modems, Syncard PCMCIA ISDN, and Syncard ISDN, and are dedicated primarily to Windows operating systems for desktop and laptop applications.

Mass Storage Controller Products

Revenues derived from mass storage controller products represented approximately 12% and 14% of consolidated revenues for the years ended December 31, 1997 and 1996, respectively and 34% of consolidated revenues during the year ended October 31, 1995.

The Company's mass storage product line includes products that function in VMEbus, EISA bus, Multibus and PCIbus systems. Presently, SCSI is the most popular mass storage technology for both desktop and server applications since it is "device independent" whereas many technologies prior to SCSI were not. Device independent refers to the fact that the controller can access and send data to and from a variety of peripheral devices (e.g., disk drives, tape drives or printers). Historically, the primary market for these products has been computer system OEM's. The Company introduced its first Fibre Channel product in 1996. Fibre Channel is an emerging high-speed data transfer technology. Fibre Channel is regarded as a follow-on migration path from SCSI. It is 10 to 250 times faster than existing technologies, including SCSI, capable of transmitting at rates of one gigabit per second simultaneously in both directions. This kind of performance is a practical necessity when sizable files containing x-rays or MRI scans are retrieved from a storage device. Fibre Channel can also operate over distances up to 10 km. For disaster recovery purposes it is an ideal technology for backing up mission critical data to mass storage device at a secure remote location.

SCSI

V/SCSI 4210 is a high performance dual channel SCSI host adapter for VMEbus applications. It supports up to seven SCSI devices per channel and can be configured with one or two independent SCSI channels. By utilizing the BUSpacket Interface it can provide transfer rates of up to 5 MBytes/second in synchronous mode and up to
1.5 MBytes/second in the asynchronous mode. This product is available in either a 6U or 9U form factor.

V/SCSI-2 4220 is designed for VMEbus and VME64 systems. It complies with the industry standard SCSI-2 interface. It also contains two channels that support up to 14 SCSI-1 or SCSI-2 devices. It is capable of data rates of up to 10 MBytes/second in the synchronous mode and 5 MBytes/second in the asynchronous mode. This product is available in either a 6U or 9U form factor. Additionally, an optional daughter card is available which allows for a connection to an Ethernet network. The incorporation of an Ethernet daughter card with a SCSI adapter in this manner utilizes only one slot in a computer backplane.

Fibre Channel

PCI/Fibre Channel 5526 adapter provides single port connection, powered by the Hewlett-Packard Tachyon Fibre Channel protocol engine.

PCI/Fibre Channel 6526 adapter is a 3U CompactPCI adapter which delivers full 100mbps throughput for next generation mass storage applications.

Interphase (i)chipTPI is a single chip solution which allows the Hewlett-Packard Tachyon Fibre Channel controller to be used in conjunction with the industry standard PCI bus.

New Product Development

The markets for the Company's products are characterized by rapid technological development, evolving industry standards, frequent new product introductions and relatively short product life cycles. The Company's success is substantially dependent upon its ability to anticipate and react to these changes, maintain its technological expertise, expand and enhance its product offerings in existing technologies, and to develop in a timely manner new products in emerging technologies, such as ATM-based networking, which achieve market acceptance. The Company believes it must offer products to the market which not only meet ever-increasing performance and quality standards, but also provide compatibility and interoperability with products and architectures offered by various computer and network systems vendors. The continued utility of the Company's products can be adversely affected by products or technologies developed by others.

The Company has been engaged in the development of new products and the refinement of its existing products since its inception. Interphase has been active in the formulation of industry standards sanctioned by groups such as the IEEE and ANSI and is a member of the ATM Forum, VME International Trade Association (VITA), Fibre Channel Association, RAID Advisory Board, PCI Bus Consortium, Fast Ethernet Alliance, SCSI Committee, the LADDIS Group, ONC/NFS Consortium, University of New Hampshire FDDI Interoperability Lab, FC-Open (Fibre Channel) Consortium, and ANTC Consortium for FDDI interoperability testing.

In 1997, the Company applied the majority of its engineering development resources to products for the emerging ATM market. This network technology provides for the integration of voice, video and data transmission in local area networks and wide area networks, significant improvements in network managability, and scalability of speed from 25 megabits per second ("Mbps") to 51, 100, 155 and 622 Mbps.

In addition, the Company has continued its focus on FDDI products, including PCI, GIO, and Sbus FDDI adapter cards and the M400 low cost four or eight port FDDI concentrator with copper or fiber connectivity and optional SNMP management.

Since the acquisition of Synaptel, engineering development activities have also been focused on products for the WAN market. These development efforts include products based upon ISDN, X.25 and xDSL technologies.

Marketing and Customers

The Company's standard products are sold to OEM's for inclusion in scientific, industrial, medical, engineering workstations, printing, mini-supercomputer, graphics and other computer applications. These purchasers incorporate the Company's products in proprietary systems for resale to distributors, system integrators and VAR's (which add specially designed software) prior to resale to end-users. Also, the Company sells products directly to sophisticated end-users such as large corporations, universities and scientific research organizations. During 1997 sales to Hewlett Packard accounted for $26,402,000 or 40% of consolidated revenue, and was the only customer accounting for more than 10% of consolidated revenues. During 1996 no single customer accounted for more that 10% of consolidated revenues. During the year ended October 31, 1995, sales to Pyramid Corporation accounted for $7,039,000 or 15% of consolidated revenues, and was the only customer accounting for more than 10% of consolidated revenues.

In 1989, Motorola purchased 660,000 shares of common stock of the Company at a price of $11.00 per share. In addition, Motorola received warrants to purchase an additional 660,000 shares of common stock at an exercise price of $15.40 per share. The warrants were not exercised by Motorola and expired in March 1996. Sales to Motorola approximated 3%, 6% and 6% of the Company's revenues for the years ended December 31, 1997, 1996, and October 31, 1995, respectively.

The Company markets its products through its own sales organization and, to a lesser extent, through a network of independent sales representatives. In addition to the Company's headquarters in Dallas, Texas, the Company has sales offices located in or near Santa Clara, California; Boston, Massachusetts; Phoenix, Arizona; Minneapolis, Minnesota; Tokyo, Japan; London, England; and Paris, France. The Company's sales personnel market products directly to key customers as well as support the sales representative network. In addition, the Company has entered into distribution agreements with key national and international distribution partners, including Anixter, Fuji-Xerox, Gates/Arrow and Westcon.

Interphase emphasizes its extensive product support, training and field support to its customers. The Company's products are generally sold with a one year warranty covering components and labor. After the expiration of the warranty period, support services are generally provided by the Company for a stated flat fee.

The Company and its customers generally enter into written agreements specifying, among other items standard in commercial agreements, product specifications, failure rates, shipping requirements, shipment rescheduling terms, price/volume schedules and manufacturer warranties. Substantially all of these agreements do not contain determinable purchase commitments of the customers, providing instead that actual purchase and shipments of products be made by specific purchase order. Accordingly, any shipment rates stated in such contracts are subject to rescheduling and/or cancellation, and therefore are not indicative of the future purchase orders to be submitted by such customer. In addition, the actual terms of the contracts tend to be modified in the ordinary course of business by means of subsequent purchase order terms and by course of dealing.

The Company does not believe that the level of backlog of orders is either material or indicative of future results, since its contracts are subject to revision through subsequent purchase orders and since its customers are generally permitted to cancel purchase orders, within certain parameters, prior to shipment without penalty.

The majority of the Company's sales are to OEMs with payment terms typically being net 30-45 days from date of invoice.

Manufacturing and Supplies

Most manufacturing operations are currently conducted at the Company's headquarters in Dallas, Texas. In addition, the Company utilizes contract manufacturing operations for the assembly of certain products, including those produced in France. The Company's products consist primarily of various integrated circuits, other electronic components and firmware assembled onto an internally designed printed circuit board.

The Company uses internally designed, applications specific integrated circuits ("ASIC"), some of which are sole-sourced, on most of its products as well as standard off-the shelf items presently available from two or more suppliers. Historically the Company has not experienced any significant problems in maintaining an adequate supply of these parts sufficient to satisfy customer demand, and the Company believes that it has good relations with its vendors

The Company generally does not manufacture products to stock in finished goods inventory, as substantially all of the Company's production is dedicated to specific customer purchase orders. As a result, the Company does not have any material requirements to maintain significant inventories or other working capital items.

Intellectual Property and Patents

While the Company believes that its success is ultimately dependent upon the innovative skills of its personnel and its ability to anticipate technological changes, its ability to compete successfully will depend, in part, upon its ability to protect proprietary technology contained in its products. The Company does not currently hold any patents relative to its current product lines. Instead, the Company relies upon a combination of trade secret, copyright and trademark laws and contractual restrictions to establish and protect proprietary rights in its products. The development of alternative, proprietary and other technologies by third parties could adversely affect the competitiveness of the Company's products. Further, the laws of some countries do not provide the same degree of protection of the Company's proprietary information as do the laws of the United States. Finally, the Company's adherence to industry-wide technical standards and specifications may limit the Company's opportunities to provide proprietary product features capable of protection.

The Company is also subject to the risk of litigation alleging infringement of third party intellectual property rights. Infringement claims could require the Company to expend significant time and money in litigation, pay damages, develop non-infringing technology or acquire licenses to the technology which is the subject of asserted infringement.

The Company has entered into several nonexclusive software licensing agreements that allow the Company to incorporate software into its product line thereby increasing its functionality, performance and interoperability.

Employees

At December 31, 1997, the Company had 222 full-time employees, of which 74 were engaged in manufacturing and quality assurance, 72 in research and development, 50 in sales, sales support, service and marketing and 26 in general management and administration.

The Company's success to date has been significantly dependent on the contributions of a number of its key technical and management employees. The Company does not maintain life insurance policies on its key employees and, except for a few executive officers, does not have employment agreements with key employees. The loss of the services of one or more of these key employees could have a material adverse effect on the Company. In addition, the Company believes that its future success will depend in large part upon its ability to attract and retain highly skilled and motivated technical, managerial, sales and marketing personnel. Competition for such personnel is intense.

None of the Company's employees are covered by a collective bargaining agreement and there have been no work stoppages. Additionally, the Company considers its relationship with its employees to be good.

Competition

The computer network industry is intensely competitive and is significantly affected by product introductions and market activities of industry participants. The Company expects substantial competition to continue. The Company's competition includes vendors specifically dedicated to the mass storage controller and computer network product markets. Traditionally the Company's major OEM customers have chosen not to manufacture adapters for their products or do not manufacture sufficient quantities or types of controllers to meet their needs. Increased competition could result in price reductions, reduced margins and loss of market share.

Many of the Company's current and potential competitors have significantly greater financial, technical, marketing and other resources and larger installed bases than the Company. Several of the Company's competitors have been acquired by major networking companies. These acquisitions are likely to permit the Company's competitors to devote significantly greater resources to the development and marketing of new competitive products and the marketing of existing competitive products to their larger installed bases. The Company expects that competition will increase substantially as a result of these and other industry consolidations and alliances, as well as the emergence of new competitors. The Company believes that it has been able to compete as a result of its perceived technological leadership within the Company's market segment and its reputation for high product performance.