Aware Annual Report 1997

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FY1997 Annual Report · Aware

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Wired Solutions

F O R A P R E - W I R E D W O R L D

A W A R E , I N C .

A N N U A L R E P O R T 1 9 9 7

Contents

Breaking the Speed Barrier in Internet Access

Letter to Shareholders

The Technology Solution: A Copper Renaissance

The Company Solution: Aware, Inc.

The ADSL Roll-out Solution: Partnering with Market Leaders

The Future Solution: Beyond ADSL

Senior Management

Financial Information

Corporate Information

B R E A K I N G T H E S P E E D B A R R I E R I N

Internet Access

PC processing power continues to double every 18

months – representing a rapid rate of technological

change that has created a Golden Age of productivity

improvements since computers first arrived on the

scene. But try to access that data by jumping on

the information highway or surfing the Web using

ordinary voiceband modems, and you’re right back in

the Dark Ages – stuck in a frustrating gridlock where

data transmissions slow to a crawl.

Impatient with the pace of today’s modems (not to

mention the unfulfilled promise of ISDN technology),

the millions of computer users around the world are

clamoring for a quantum-leap improvement in

high-speed data access technology. The need for

an affordable, easy-to-install solution is immediate.

The demand will be explosive. And the market size

will be staggering – estimated at a multi-billion

dollar business opportunity.

Aware was an early pioneer in the development

of ultra high-speed transmission technology that

catapults data communications out of the Dark Ages

and into the future. This breakthrough technology

leapfrogs conventional approaches and sets a new

high-speed standard for improving even the most

bandwidth-hungry applications and accessing

media-rich Internet sites. This year’s annual report

spotlights our success in transforming this technology

into product solutions and in forging the strategic

partnerships needed to capitalize on the enormous

market opportunity that lies ahead.

Dear Shareholder

Two noteworthy events propelled Aware toward industry prominence in 1997, our first full year as a public company —

events so significant that they captured the attention of the national news media by promising to accelerate the

widespread deployment of ADSL technology.

The first event is nothing short of a technological breakthrough. In 1997, we cleared a major hurdle blocking the

economical mass-market deployment of ADSL by developing “splitterless” DMT technology. This new technology will

make ADSL as easy to install at customer premises as today’s ordinary PC modems. In addition to eliminating the need

for on-site installation by trained technicians, splitterless DMT supports speeds of up to 1.5 megabits per second –

30 times faster than the fastest conventional voiceband modems. Even more important, its upward compatibility

positions it as an ideal stepping stone to full-rate ADSL technology. While others believed that splitterless DMT could

not be achieved, we have successfully pioneered its development, proved its viability and filed patent applications for

our intellectual property rights.

The advent of our new splitterless DMT technology led to the second major event of the year: the decision by Compaq,

Microsoft and Intel to embrace splitterless DMT for their future generation computer products. In effect, this is a clear

sign that the PC industry is stepping forward to offload the responsibility of deploying ADSL technology at the customer

premise from the telephone companies — eliminating the time and cost of having to send a technician to each customer

site. With the involvement of the PC industry and the on-site installation requirement replaced with a plug-and-play

modem, we expect that the industry is now on the threshold of meaningful ADSL deployment.

The industry momentum created by our splitterless DMT development efforts contributed to the formation of the

Universal ADSL Working Group (UAWG) in 1997. Representing a virtual powerhouse of major computer chip

manufacturers, PC system vendors, telecommunications equipment suppliers and all the leading service providers,

the UAWG is leading an industry-wide charge to establish splitterless DMT as a universal standard — further enhancing

our competitive position by promoting the widespread acceptance of splitterless DMT.

Collectively, these events have transformed the mass deployment of ADSL technology from an “if” to a very foreseeable

“when.” Together with our strategic partners, we are now closer than ever to providing a practical and affordable ADSL

solution for the 700 million existing phone lines worldwide, representing a multi-billion dollar market for our industry.

To prepare for this market opportunity, we continued to build our ADSL product base — successfully moving from

the prototype stage to the initial production of our first commercial products. These include the x200 access router,

the world’s fastest modem using existing copper lines; the AW-910 module, designed for speedy ADSL deployment by

original equipment manufacturers (OEMs), and the ADS-910, a test and development system to accelerate OEMs’

time-to-market. We also co-developed Analog Devices’ first production chipset, the lowest-cost ADSL solution on the

market. Moreover, by outsourcing the manufacturing of our products, we aim to strengthen our bottom line by

achieving higher gross margin performance and lower cost of goods when volume production begins.

JAMES C. BENDER

President & Chief Executive Officer

CHARLES K. STEWART

Chairman of the Board

Aware also redefined its strategic partnership with Analog Devices in early 1998. Analog had been our exclusive partner

on ADSL chipset development since 1993. Our new relationship allows us to more widely proliferate our technology,

promote open systems and drive interoperability. The new agreement enhances Analog Devices’ competitive position and

enables it to more effectively serve our mutual customers. We look forward to continuing to work closely together with

Analog Devices on chipset enhancements through multiple generations of software and semiconductor improvements.

Throughout 1997, Aware continued to pursue new strategic partnerships with leading telecommunications and data

communication equipment manufacturers that are critical to widespread ADSL deployment. Specifically, we formed new

partnerships with Cisco Systems, the world’s leading router company, and with 3Com/US Robotics, the world’s largest

voiceband modem company. In addition, we signed an agreement with Lucent Technologies, a global telecommunica-

tions equipment manufacturer, to develop a modem chipset that contains our new splitterless DMT technology.

Last year we also moved our headquarters into a newly renovated 72,000 square-foot building which we purchased in

Bedford, Massachusetts. In addition to consolidating all of our operations, this new facility significantly increases our

space capacity — enabling us to add the critical resources we need to capitalize on the market opportunities ahead.

In terms of our financial performance, 1997 revenue increased to $6.2 million, up 17% over 1996 revenue of $5.3 million.

Net loss for 1997 was $4.4 million or minus $0.23 per share on a diluted basis, compared to net income of $259,000

or $0.01 per share on a diluted basis in 1996. This loss was principally due to our decision to aggressively ramp up our

activities in two strategic areas during the year. First, we more than doubled our research and development investment

over 1996 in order to position the company with new products designed to capitalize on pent-up consumer demand.

And second, we nearly tripled our sales and marketing spending over 1996 to gear up for the emerging market.

Looking ahead, we expect our products to contribute an increasingly higher percentage of total company revenue

over the next few years.

In closing, we express our deepest appreciation to our employees for their outstanding contributions of the last year.

Their dedication and expertise, coupled with the loyal support of our partners, customers and shareholders, are the

driving forces behind our ability to help move ADSL from promise to realization in the not-too-distant future.

Sincerely,

James C. Bender

President & Chief Executive Officer

Charles K. Stewart

Chairman of the Board

T H E T E C H N O L O G Y S O L U T I O N

A Copper Renaissance

To create the bandwidth needed to deliver the Internet’s

Lightning-fast speed is only one of ADSL’s competitive

rich, multimedia capabilities to the mass market, tele-

advantages. It also eliminates the need for a second

phone companies have been faced with the prospect of

phone line by supporting simultaneous voice and data

scrapping the existing $100 billion network and rewiring

transmission… maximizes performance by automatically

the entire world with higher bandwidth fiber optic cable.

adapting transmission speed to compensate for local line

With 700 million lines worldwide, the sheer size of this

conditions… and will ensure complete interoperability

existing network makes the rewiring job both time- and

by supporting the widely accepted Discrete Multitone

cost-prohibitive — particularly the last mile between

(DMT) standard.

the phone company and each subscriber, which accounts

for about 80% of the cost of the network.

In 1997, Aware made history as the first company to

develop “splitterless” DMT technology. This breakthrough

Enter ADSL (Asymmetric Digital Subscriber Line), a high-

will make customer premises equipment as easy to

speed “last mile” technology that provides a practical and

install as today’s voiceband PC modems in most cases.

proven alternative to rewiring the world. Simply stated,

Not only will splitterless DMT modems simply plug into

ADSL dramatically expands the bandwidth of existing

a regular phone jack, they will perform at up to

telephone networks. As a result, it enables sophisticated

1.5 Mbps — 30 times faster than today’s fastest analog

Internet broadband services to be delivered over the 700

modems. In addition to maintaining full interoperability

million copper access lines in the world today — in effect,

with standards-based ADSL central office equipment,

creating a “copper renaissance.”

splitterless DMT will also expand the local loop to beyond

Aware is a world leader in ultra high-speed ADSL last-mile

22,000 feet — covering virtually all American homes.

technology. Using existing copper phone lines, our ADSL

Based on the initial development and demonstrated

technology transmits data at speeds of over 9 megabits

viability of Aware’s splitterless DMT technology, some

per second — 300 times faster than 28.8 modems, 70

leading computer manufacturers plan to build it into

times faster than ISDN, and 6 times faster than T1 lines.

their name-brand PCs in the near future. By providing an

What’s more, its dedicated bandwidth ensures consistently

upward migration path to full-rate ADSL, splitterless DMT

high performance, unlike the shared bandwidth of cable

is expected to break open the marketplace and accelerate

modems which can diminish transfer rates and create

the wide-scale deployment of full-rate ADSL — predicted

security breaches.

to be a billion dollar market by the year 2000.

x200 ADSL Access Router: The new “splitterless” x200 Lite version of this high-speed access

solution will install as easily as today’s PC modem.

xx220000ADSL Access Router

AAWW––991100

ADSL Transceiver Module

T H E C O M P A N Y S O L U T I O N

Aware, Inc.

Aware is a technology innovator — pioneering the devel-

telecommuting and electronic commerce a reality, the

opment of breakthrough, market-driven solutions that

ultra-fast x200 transmits data and video over ordinary

meet today’s immediate need for ubiquitous high-speed

copper phone lines more than 200 times faster than

Internet access and broadband communications services.

a standard 28.8 Kbps modem — while simultaneously

Being a technology leader demands a commitment to

being first. That’s why Aware is an organization built for

speed. Our “first-to-market” track record — unprecedented

maintaining traditional telephone voice service. The

x200’s routing capabilities also make it well-suited for

remote and branch office routing.

in the DSL industry — speaks for itself:

First DMT ADSL rate-adaptive technology.

First DMT ADSL chipset. Co-developed with Analog

Devices, the AD20msp910 chipset for Original Equipment

Manufacturers (OEMs) enables the development of ADSL

equipment for high-speed Internet access and multimedia

services. Today, it is the lowest-cost, highest-performance

By automatically adapting to a variety of different

telephone line conditions, our DMT ADSL rate-adaptive

technology contained within our modems makes those

connections more reliable and delivers the maximum

performance a line can handle.

DMT ADSL chipset on the market.

First to demonstrate and deliver “splitterless” DMT

First DMT ADSL transceiver module (AW-910).

This plug-and-play module is a fast way for OEMs to

integrate Aware’s ADSL technology into telecommunica-

tions and networking equipment. It contains all the digital

and analog IC components (including the AD20msp910

chipset) which are required to implement both the central

technology. This historic milestone removes one of the

last remaining obstacles to the mass deployment of

ADSL — the time and cost of installing a voice-data split-

ter at the customer premise. It enables the development

of simple plug-and-play, high-speed modems which

eliminate the need for special installation services.

office and customer premise ends of an ADSL connection.

Guided by the proven expertise of our management team,

The AW-910 quickly led to yet another innovation —

our well-capitalized organization brings 12 years of expe-

Aware’s ADS-910 Development System, which provides

rience to bear on extending our technology leadership.

OEMs with a single, compact platform for evaluating

Today, engineering personnel account for more than

both ends of an ADSL link.

two-thirds of our work force — representing a first-rate

First commercially available DMT-based access

router (x200). Designed to make broadband applications

such as high-speed Internet access, video conferencing,

research and development team that continues to build

our technology base and transform our innovations into

successful product solutions.

AW-910 ADSL Transceiver Module: All-in-one, plug-and-play solution for rapidly deploying

ADSL technology.

T H E A D S L R O L L - O U T S O L U T I O N

Partnering with Market Leaders

In order to gain market share and pave the way

What’s more, Aware’s new splitterless DMT technology

for the full-scale deployment of its ADSL innovations,

is rapidly gaining momentum. Spearheaded by PC industry

Aware is forming strategic alliances with the major

giants Compaq, Microsoft and Intel, the newly formed

computer chip manufacturers and system vendors serving

Universal ADSL Working Group (UAWG) is actively lobbying

today’s leading telecommunications service providers.

for the speedy establishment of splitterless DMT as an

Consider, for example, the size and stature of the

computer chip manufacturers who have already selected

Aware’s ADSL technology. In addition to collaborating

with Analog Devices on multiple generations of ADSL

chipsets, we also have a broad technology partnership

with 3Com for DMT modems. Our relationship with

Lucent Technologies is expected to produce the first PC

industry standard. In addition to PC, networking and

semiconductor industry leaders, the UAWG includes key

telecommunications service providers such as Ameritech,

Bell Atlantic, BellSouth, GTE, MCI, SBC Communications,

Sprint, US WEST, France Telecom, Deutsche Telekom

and British Telecom — galvanizing the support of these

pivotal members of the ADSL provider chain.

modem chipset to support the requirements set forth

By gaining the consensus of the critical links in the ADSL

by the Universal ADSL Working Group (UAWG) and the

provider chain, the UAWG’s endorsement of splitterless

International Telecommunications Union (ITU).

DMT technology as an industry standard is expected to

Growing numbers of today’s leading system vendors are

also basing their ADSL product developments on Aware’s

technology. These include three of the four major digital

loop carriers, three of the biggest networking and remote

access vendors, six of the top telecommunications

companies, and the two leading voiceband modem

manufacturers.

accelerate the final decision-making process of the official

standard bodies and to release a groundswell of market

demand for ADSL and splitterless DMT innovations.

Currently positioned with an array of new DMT ADSL

product solutions, Aware is well-prepared to capitalize

on this demand.

AD20msp910 ADSL Chipset: Co-developed with Analog Devices, it’s the lowest cost, most

complete DMT ADSL solution.

AADD2200mmsspp991100ADSL Chipset

AADDSS––991100

ADSL Development System

T H E F U T U R E S O L U T I O N

Beyond ADSL

Aware is constantly raising the bar for ultra high-speed

code will add superior robustness and performance

data access as it takes its technological innovations to

characteristics to our xDSL products by providing higher

the next level. Our next generation technologies are

immunity to electrical noise and interference in the

already taking shape.

environment. A new chipset is currently in development

which will incorporate this patented technology into our

In the short term, we expect our new “lite” versions

of our products which incorporate the full benefits of

future xDSL products.

splitterless DMT technology to begin shipping soon.

Looking farther ahead, the development of our DWMT

Chief among these is the x200 Lite, an easy-to-install

technology opens up an even larger world of broadband

external PC modem for customer premises that supports

network communications which extends beyond ADSL.

speeds of up to 1.5 Mbps downstream and 512 Kbps

For example, DWMT will be the backbone of new Very

upstream. Our plans call for the x200 Lite to migrate

High Speed Digital Subscriber Line (VDSL) versions of our

into a lower-cost, mass-market device by year-end.

products, scheduled for next year. By further expanding

In addition, our new AW-910 Lite transceiver module

the usable bandwidth of telephone lines for simultaneous

provides OEMs with an all-in-one solution for deploying

data and voice communications, our DWMT technology

splitterless DMT technology in central office equipment.

will forge the future for high-speed copper access. In fact,

Meanwhile, a new software upgrade, which enables

it will be the engine for new products from Aware that

our existing chipsets to interoperate with splitterless DMT

target asymmetric data rates of up to 26 Mbps and

central office and customer premise equipment, is

symmetric data rates of up to 12 Mbps.

expected to be available soon.

In addition, we are planning to further enhance our xDSL

holds exciting possibilities. By continuing to push the

technology with our newly developed and patented line

technological envelope, Aware is developing ever-faster,

code, Discrete Wavelet Multitone (DWMT). Based on

ever-more-powerful solutions — effectively transforming

our pioneering wavelet technology, the new DWMT line

those exciting possibilities into practical realities.

The future of high-speed data communications

ADS-910 ADSL Development System: Complete test system for quickly integrating the

AD20msp910 chipset into central office and customer premise equipment.

Senior Management

MICHAEL A. TZANNES

Chief Technology Officer

and General Manager

of Telecommunications

RICHARD P. MOBERG

Chief Financial Officer

and Treasurer

D A V I D C . H U N T E R

Senior Vice President,

Product Development

EDMUND C. REITER

Vice President,

Advanced Products

S E L E C T E D F I N A N C I A L D A T A A N D O V E R V I E W

A w a re , I n c .

S E L E C T E D F I N A N C I A L D A T A

(in 000’s, except per share data)

1997

1996

1995

1994

1993

Year ended December 31,

Statements of Operations Data

Revenue

Loss from operations

Net income (loss)

Net income (loss) per share – basic

Net income (loss) per share — diluted

Balance Sheet Data

$ 6,198

$ 5,301

$ 3,260

$ 3,827

$ 3,172

(6,157)

(4,448)

($0.23)

(538)

259

$0.02

$0.01

(454)

(343)

($0.29)

(1,095)

(1,012)

($0.88)

(1,028)

(992)

($0.87)

Cash and short-term investments

$26,104

$36,719

$ 2,154

$ 2,566

$ 186

Working capital

Total assets

Total liabilities

Total stockholders’ equity

26,774

39,281

1,661

37,620

38,280

40,123

676

39,446

2,516

3,228

309

2,920

2,877

3,930

684

3,246

281

978

493

485

O V E R V I E W

Aware, Inc. (the “Company”) designs, develops and markets telecommunications software, hardware designs, chipsets and
products that incorporate Asymmetric Digital Subscriber Line (ADSL), splitterless lite Digital Subscriber Line (DSL Lite), Very
High Speed Digital Subscriber Line (VDSL), and Symmetric Digital Subscriber Line (SDSL) technologies. These broadband
technologies are designed to increase the speed of data communications over conventional copper telephone lines. The
Company’s products are designed to allow telephone companies to utilize their installed bases of dedicated copper lines
to provide both residential and business customers with interactive data transmission at speeds much higher than currently
available. The Company also offers image compression software products.

M A N A G E M E N T ’ S D I S C U S S I O N A N D A N A L Y S I S

O F F I N A N C I A L C O N D I T I O N A N D R E S U L T S O F O P E R A T I O N S

A w a re , I n c .

R E S U L T S O F O P E R A T I O N S

The following table sets forth, for the periods indicated, certain line items from the Company’s consolidated statements
of operations as a percentage of total revenue:

Year Ended December 31,

1997

1996

1995

Revenue:

Product

License and royalty

Research and development

Total revenue

Costs and expenses:

Cost of product revenue

Research and development
Sales and marketing

General and administrative

Total costs and expenses

Loss from operations

Interest income

Net income (loss)

15.7%

48.9

35.4

12.3%

56.0

31.7

12.5%

31.8

55.7

100.0

20.2

110.9
36.9

31.4

199.4

(99.4)

27.6

(71.8%)

15.7

61.0
14.5

18.9

110.1

(10.1)

15.0

7.4

71.6
12.6

22.3

113.9

(13.9)

3.4

4.9%

(10.5%)

Product Revenue
Product revenue in 1997 and 1996 consisted primarily of revenue from the sale of Asymmetric Digital Subscriber Line
(“ADSL”) modems, transceiver modules, and development systems. Product revenue increased by 49.9% from $649,000 in
1996 to $974,000 in 1997. Product revenue as a percentage of total revenue was 15.7% and 12.3% in 1997 and 1996,
respectively. The product revenue increase in 1997 was primarily attributable to revenue from the sale of transceiver modules
and development systems, which began shipping in the second quarter of 1997. Higher revenue from the sale of these new
products was partially offset by modestly lower revenue from the sale of modems. The decline in revenue from the sale
of modems in 1997 was primarily due to decreased demand for the Company’s modems for ADSL technology trials while
the market for ADSL products remained in an early stage of development.

Product revenue increased by 60% from $406,000 in 1995 to $649,000 in 1996. A year to year comparison of product
revenue for these years is not meaningful due to differences in the composition of product revenue. Product revenue
in 1996 consisted primarily of revenue from the sale of ADSL modems, which were introduced in early 1996. Product
revenue in 1995 consisted primarily of revenue from the sale of video editing chipset products, which the Company
discontinued in 1995.

License and Royalty Revenue
License and royalty revenue consisted primarily of revenue from the sale of intellectual property, such as hardware and
software technology licenses, compression software licenses, and royalties from the sale of chipsets by customers who have
licensed the Company’s technology. As such revenue has only a nominal cost of sale associated with it, the Company does
not report a separate cost of license and royalty revenue line in its Statements of Operations.

License and royalty revenue increased by 2% from $2,971,000 in 1996 to $3,031,000 in 1997. License and royalty revenue
as a percentage of total revenue was 48.9% and 56.0% in 1997 and 1996, respectively. The dollar increase in license and
royalty revenue in 1997 was primarily attributable to higher revenue from the sale of compression software licenses, which
was partially offset by lower telecommunications license and royalty revenue. The increase in compression software license
revenue was primarily due to a significant customer sale in the second quarter of 1997. The decrease in telecommunications
license and royalty revenue was primarily attributable to a decline in revenue from royalty advances, which fell from $350,000
in 1996 to nothing in 1997. Approximately 63% of license and royalty revenue in 1997 was received from three customers.

License and royalty revenue increased by 187% from $1,037,000 in 1995 to $2,971,000 in 1996. The increase in 1996 was
primarily attributable to an increase in the sale of ADSL and other broadband technology licenses to telephone company
equipment suppliers. Revenue from the sale of compression software licenses also contributed to the increase in license and
royalty revenue in 1996. Approximately 51% of license and royalty revenue in 1996 was received from three customers.

Research and Development Revenue
Research and development revenue consisted primarily of revenue from commercial contract engineering and development,
and government research contracts. Research and development revenue as a percentage of total revenue was 35.4% and
31.7% in 1997 and 1996, respectively. Research and development revenue increased by 30.5% from $1,680,000 in 1996
to $2,193,000 in 1997. Higher research and development revenue in 1997 was primarily due to an increase in commercial
engineering projects as well as a modest increase in U.S. government projects. The increase in commercial engineering
projects is primarily driven by telecommunications customers, who have engaged the Company to assist them with the
integration of the Company’s technology into their products.

Research and development revenue decreased by 8% from $1,817,000 in 1995 to $1,680,000 in 1996. The decrease was
primarily due to lower revenue from commercial research and development contracts as well as slightly lower revenue from
U.S. government research contracts.

Cost of Product Revenue
Cost of product revenue consisted primarily of: (i) direct material, direct labor, and overhead costs to produce the
Company’s products, (ii) cost of goods for purchases of finished inventory from third party suppliers, and (iii) provisions
for excess and obsolete inventory.

Cost of product revenue as a percentage of product revenue was 129% in 1997 as compared to 128% in 1996. The cost
of product revenue as a percentage of product revenue in 1997 and 1996 primarily reflects high material, labor, and fixed
manufacturing costs due to relatively low production volumes, and provisions for excess and obsolete inventory of $275,000
in 1997 and $365,000 in 1996. The provisions for obsolete inventory recorded in 1997 and 1996 were primarily driven
by the environment in which the Company operates. This environment was and continues to be characterized by rapid
technological advances, evolving industry standards, changes in end-user requirements, frequent new product introductions,
and evolving telco offerings. Consequently, the Company’s products have relatively short life cycles. Excluding obsolete
inventory provisions, cost of product revenue as a percentage of product revenue was 100% in 1997 and 72% in 1996.

In the third quarter of 1997, the Company entered into an agreement with a third party contract manufacturer that
will supply substantially all finished goods products to the Company. The Company anticipates that this arrangement
will reduce per unit cost of sales if and when product volumes increase.

Cost of product revenue increased by 242% from $243,000 in 1995 to $831,000 in 1996. As a percentage of product
revenue, cost of product revenue increased from 60% in 1995 to 128% in 1996. Such percentages primarily reflect the
cost of modem revenue and obsolete inventory provisions in 1996 and the cost of video editing chipset revenue in 1995.
Accordingly, a comparison of cost of product revenue on a year to year basis is not meaningful due to differences in
the composition of product revenue.

Research and Development
Research and development expense consisted primarily of salaries for engineers, and expenses for consultants, recruiting,
supplies, equipment, depreciation and facilities. Research and development expense increased by 113% from $3,235,000
in 1996 to $6,874,000 in 1997. The increase in research and development expense is primarily due to increased spending
on projects related to the Company’s x200 Access Router, DSL Lite technology, and SDSL technology. Spending related to
these projects was partially offset by lower spending on the Company’s Hybrid Fiber Coaxial (HFC) project, which was
temporarily suspended in 1997. The Company anticipates that research and development spending will continue to grow
in future periods.

Research and development expense increased by 39% from $2,333,000 in 1995 to $3,235,000 in 1996. The increase
in research and development expense was primarily attributable to higher spending on projects to develop, enhance, and
commercialize the Company’s ADSL, VDSL, SDSL, and HFC broadband technologies. Higher spending on these projects
was partially offset by lower spending as a result of the discontinuance of research involving audio compression
technology and lower facilities costs as a result of the relocation of the Company’s facilities in June 1995.

M A N A G E M E N T ’ S D I S C U S S I O N A N D A N A L Y S I S

O F F I N A N C I A L C O N D I T I O N A N D R E S U L T S O F O P E R A T I O N S

A w a re , I n c .

Selling and Marketing
Selling and marketing expense consisted primarily of salaries for sales and marketing personnel, travel, advertising and
promotion, recruiting, and facilities expense. Selling and marketing expense increased 197% from $769,000 in 1996 to
$2,286,000 in 1997. The increase was primarily due to: (i) the addition of sales staff to establish channels of distribution
for the Company’s products and technology, (ii) the addition of marketing staff, and (iii) increased levels of advertising
and promotion to create awareness for the Company’s products, including participation in major industry tradeshows.
The Company anticipates that selling and marketing spending will continue to grow in future periods.

Selling and marketing expense increased 87% from $412,000 in 1995 to $769,000 in 1996. The increase was primarily
due to the addition of sales personnel and increased product advertising related to the Company’s ADSL modem.

General and Administrative
General and administrative expense consisted primarily of salaries for administrative personnel, facilities costs, expenses
related to being a public company, and professional services, such as legal and audit expenses. General and administrative
expense increased by 94% from $1,004,000 in 1996 to $1,943,000 in 1997. The increase was primarily due to:
(i) additions to the Company’s finance, information systems and administrative organizations to support organizational
growth, and (ii) expenses related to investor relations and being a public company.

General and administrative expense increased by 38% from $726,000 in 1995 to $1,004,000 in 1996. The increase was
primarily attributable to additions to the Company’s management team and administrative infrastructure, and expenses
associated with becoming a public company.

Interest Income
Interest income increased 114% from $798,000 in 1996 to $1,708,000 in 1997 primarily as a result of higher average
cash balances due to the investment of net proceeds from the Company’s initial public offering for the full year, as
opposed to approximately five months in 1996. Interest income increased 621% from $111,000 in 1995 to $798,000
in 1996 primarily as a result of higher average cash balances due to the investment of net proceeds from the Company’s
initial public offering.

Provision for Income Taxes
The Company has made no provision for income taxes as it has a history of net losses, which has resulted in tax loss
carryforwards. At December 31, 1997, the Company had available federal net operating loss carryforwards of approximately
$16,586,000, which expire in 2003 through 2012, and federal research and development credit carryforwards of approxi-
mately $791,000, which expire in 2003 through 2012. At December 31, 1997, the Company also had available state net
operating loss carryforwards of approximately $9,261,000, which expire in 1998 through 2002 and state research and
development and investment tax credit carryforwards of approximately $395,000, which expire in 2006 through 2012.
Of the total net operating loss carryforwards, approximately $1,906,000 was attributable to the exercise of stock options
and the tax benefit from these losses, when utilized, will be credited to additional paid in capital.

Other Information
In 1997, the Financial Accounting Standards Board (“FASB”) issued Statement of Financial Accounting Standards (“SFAS”)
No. 128, “Earnings per Share.” Among other requirements, SFAS No. 128 requires restatement of prior period earnings per
share to comply with the provisions of this pronouncement. Upon adoption of SFAS No. 128 in December 1997, the
Company restated earnings per share by applying the provisions of the standard. As a result of this restatement, earnings
per share for certain prior periods changed from the amounts previously reported.

L I Q U I D I T Y A N D C A P I T A L R E S O U R C E S

At December 31, 1997, the Company had cash, cash equivalents and short-term investments of $26,104,000, a decrease of
$10,615,000 from the prior year. The Company has funded its operations primarily from sales of common stock, including
an initial public offering in August 1996, which generated net proceeds of $35,200,000. In 1997, the Company used
approximately $2,656,000 of cash to fund operating losses, which was essentially offset by $2,622,000 of proceeds from
the issuance of common stock in connection with its stock option plans.

Accordingly, the decrease in cash, cash equivalents and short-term investments in 1997 was primarily due to purchases
of property and equipment. Cash invested in property and equipment of $10,581,000 was primarily related to: (i) the
purchase and renovation of a 72,000 square foot commercial office building for $8,224,000, and (ii) the acquisition of
computers, software, furniture, and other equipment primarily used in research and development activities.

While there can be no assurance that the Company will not require additional financing, or that such financing will be
available to the Company, the Company believes that its financial resources are adequate to meet its liquidity requirements
over the next twelve months.

F A C T O R S T H A T M A Y A F F E C T F U T U R E R E S U L T S

Certain statements contained in this Annual Report, including statements regarding the anticipated development and
expansion of the Company’s business, the intent, belief or current expectations of the Company, its directors or its officers,
primarily with respect to the future operating performance of the Company, and other statements contained herein
regarding matters that are not historical facts, are “forward-looking” statements. These forward-looking statements
represent the Company’s present expectations or beliefs concerning future events, however the Company cautions that
such statements are qualified by important factors. Such factors, which include, but are not limited to, the risk factors
identified below, could cause actual results to differ materially from those indicated in this Annual Report.

The Company believes that the occurrence of any one or some combination of the following risk factors could have a
material adverse effect on the Company’s business, financial condition and results of operations.

History of Operating Losses
The Company has incurred operating losses in every fiscal year since inception. Substantial additional research and
development expenses to enhance the performance and reduce the manufacturing costs of the Company’s products will
be required before market acceptance of these products can be determined. Also, the Company anticipates that substantial
selling and marketing expenses will be required to establish sales channels for the Company’s products and technology.
There can be no assurance that the Company will achieve profitable operations in any future period.

Dependence on Acceptance of ADSL Technology
The Company’s future success is substantially dependent upon whether ADSL technology gains widespread commercial
acceptance by the telephone companies (“telcos”) and end users of telco services. The Company has invested substantial
resources in the development of ADSL technology implemented through the Discrete Multi-Tone (“DMT”) modulation
technique. Telcos continue to evaluate DMT-based ADSL technology, and there can be no assurance that the telcos will
pursue the deployment of such ADSL technology. The Company believes that volume deployment of ADSL technology
and equipment will not commence before the second half of 1998, if at all.

Reliance on Telcos; Dependence on a Limited Number of Customers
Even if telcos adopt policies favoring full-scale implementation of ADSL technology, there can be no assurance that sales
of the Company’s ADSL products will become significant. The Company’s customers, including Regional Bell Operating
Companies (“RBOCs”), OEMs and other telcos, are relatively few in number and have significantly greater resources than
that of the Company. The Company has limited ability to influence or control decisions made by these customers. There
can be no assurance that these customers will not use their size and bargaining power to demand unfavorable terms and
conditions (including price), seek alternative suppliers, or undertake internal development of products comparable to
those of the Company’s.

Substantial Dependence on Analog Devices, Inc.
The Company and Analog Devices, Inc. (“ADI”) have entered into a series of agreements to develop integrated chipsets
based on the Company’s technology. The inability or refusal of ADI to manufacture, market and sell such chipsets in
substantial quantities would prevent telcos from adopting the Company’s technology and would have a material adverse
effect on the Company’s business. There can be no assurance that the Company’s relationship with ADI will be successful
or, in the event that the relationship is not successful, that the Company would be able to find a substitute chipset
manufacturer without significant delays.

M A N A G E M E N T ’ S D I S C U S S I O N A N D A N A L Y S I S

O F F I N A N C I A L C O N D I T I O N A N D R E S U L T S O F O P E R A T I O N S

A w a re , I n c .

Proprietary Technology; Risk of Third Party Claims of Infringement
The Company’s ability to compete effectively will depend to a significant extent on its ability to protect its proprietary
information and to operate without infringing the intellectual property rights of others. Despite the precautions the
Company has taken to protect its intellectual property, there can be no assurance that such steps will be adequate to
prevent the misappropriation of its technology. In addition, third parties may assert exclusive patent, copyright and other
intellectual property rights to technologies that are important to the Company. There can be no assurance that other
third parties will not assert such claims against the Company in the future.

Rapid Technological Change; Dependence on New Products
The markets for the Company’s products are characterized by rapid technological advances, evolving industry standards,
changes in end-user requirements, frequent new product introductions, and evolving telco offerings. The Company’s
business will be materially adversely affected if technologies or standards on which Company’s products are based become
obsolete, or if the Company is unable to develop and introduce new products in a timely manner in response to changing
market conditions. In such an environment, product cycles tend to be short, and therefore, the Company may need to
write-off excess and obsolete inventory from time-to-time. The Company recorded provisions for excess and obsolete
inventory of $275,000 and $365,000 in 1997 and 1996, respectively.

Competition
The markets for the Company’s products are intensely competitive and the Company expects competition to increase in
the immediate future. Many of the Company’s competitors and potential competitors have significantly greater financial,
technological, manufacturing, marketing and personnel resources than the Company. There can be no assurance that the
Company will be able to compete successfully or that competition will not adversely affect the Company’s business.

Manufacturing
The Company has limited experience in manufacturing or in supervising the manufacture of its products, including its
ADSL modems, modules, and development systems. In 1997, the Company entered into an agreement with a third party
contract manufacturer that will supply substantially all finished goods products to the Company. There can be no assur-
ance that the Company’s relationship with its contract manufacturer will be successful or, in the event that the relationship
is not successful, that the Company would be able to find a substitute contract manufacturer without significant delays.
Furthermore, there can be no assurance that the Company or its contract manufacturer will not encounter significant
difficulties in manufacturing or controlling the quality of its products, or that its products will be reliable in the field.

Dependence on Hiring and Retaining Personnel
The Company believes that its future success will depend significantly on its ability to attract, motivate and retain
additional highly skilled technical, managerial and marketing personnel. During 1997, the Company experienced difficulty
in hiring the additional engineers it had contemplated in its business plans. Competition for such personnel is intense, and
there can be no assurance that the Company will be successful in attracting, assimilating and retaining the personnel
required to grow and operate profitably.

Year 2000
The Company is in the process of assessing the impact of the transition to the year 2000 on its computer and software
applications. The Company does not believe that any material year 2000 issues exist with software contained within its
product offerings. The Company is in the process of attempting to obtain confirmation from vendors of certain purchased
software that current releases or upgrades, if installed, will not have any material year 2000 issues. To the extent necessary
to address material year 2000 issues, the Company plans to obtain current releases or upgrades from software vendors
prior to the end of 1998. Failure to obtain and implement such releases or upgrades, or the failure of such software
vendors to have eliminated year 2000 issues, could materially and adversely affect the Company.

C O N S O L I D A T E D B A L A N C E S H E E T S

December 31,

A S S E T S

Current assets:

Cash and cash equivalents

Short-term investments

Accounts receivable (less allowance for doubtful

accounts of $50,000 in 1997 and $35,000 in 1996)

Unbilled accounts receivable

Inventories
Prepaid expenses

Total current assets

Property and equipment, net of accumulated depreciation and

amortization of $1,330,281 in 1997 and $557,901 in 1996

Total assets

L I A B I L I T I E S A N D S T O C K H O L D E R S ’ E Q U I T Y

Current liabilities:

Accounts payable

Accrued expenses

Accrued compensation

Accrued professional

Deferred revenue

Total current liabilities

Commitments and contingent liabilities

Stockholders’ equity:

Preferred stock, $1.00 par value; 1,000,000 shares authorized,

none outstanding

Common stock, $.01 par value; 30,000,000 shares authorized; issued

and outstanding, 19,646,024 in 1997 and 18,959,897 in 1996

Additional paid-in capital

Accumulated deficit

Treasury stock

Total stockholders’ equity

Total liabilities and stockholders’ equity

The accompanying notes are an integral part of the financial statements.

A w a re , I n c

1997

1996

$ 23,496,508

$ 31,092,273

2,607,411

5,626,725

1,824,119

1,654,980

—

215,622
290,847

110,722

447,534
23,426

28,434,507

38,955,660

10,846,025

1,166,928

$ 39,280,532

$ 40,122,588

$ 1,075,126

337,339

185,676

326,558

73,370

—

1,660,730

60,091

173,692

65,000

40,000

676,122

—

196,460

52,640,360

(14,764,056)

(452,962)

189,600

50,025,548

(10,315,720)

(452,962)

37,619,802

39,446,466

$ 39,280,532

$ 40,122,588

C O N S O L I D A T E D S T A T E M E N T S O F O P E R A T I O N S

A w a re , I n c .

Year Ended December 31,

1997

1996

1995

Revenue:

Product

License and royalty

Research and development

Total revenue

Costs and expenses:

Cost of product revenue

Research and development

Selling and marketing

General and administrative

Total costs and expenses

Loss from operations
Interest income

Net income (loss) before provision for income taxes

Provision for income taxes

Net income (loss)

Net income (loss) per share — basic

Net income (loss) per share — diluted

Weighted average shares — basic

Weighted average shares — diluted

The accompanying notes are an integral part of the financial statements.

973,782

$ 649,422

$ 406,459

3,031,483

2,192,786

6,198,051

2,971,238

1,680,449

1,036,615

1,816,820

5,301,109

3,259,894

1,251,677

6,874,137

2,285,726

1,943,187

12,354,727

(6,156,676)
1,708,340

(4,448,336)

—

831,241

3,234,799

769,395

1,003,948

5,839,383

(538,274)
797,656

259,382

—

242,983

2,333,200

411,777

725,511

3,713,471

(453,577)
110,615

(342,962)

—

($ 4,448,336)

$ 259,382

($ 342,962)

($0.23)

$0.02

$0.01

19,328,252

10,841,919

17,991,446

($0.29)

1,162,717

C O N S O L I D A T E D S T A T E M E N T S O F C A S H F L O W S

A w a re , I n c .

Year Ended December 31,

1997

1996

1995

Cash flows from operating activities:

Net income (loss)

Adjustments to reconcile net income (loss) to net cash

provided by (used in) operating activities:

Depreciation and amortization

Increase (decrease) from changes in assets and liabilities:

($ 4,448,336)

$ 259,382

($ 342,962)

901,976

352,715

200,701

Accounts receivable

Unbilled accounts receivable

Inventories

Prepaid expenses

Accounts payable

Accrued expenses

Deferred revenue

(169,139)

110,722

231,912

(267,421)

737,787

286,821

(40,000)

Net cash used in operating activities

(2,655,678)

(1,154,152)

5,539

(407,821)

(8,955)

225,820

151,492

(10,000)

(585,980)

94,168

187,840

(18,044)

59,071

14,757

(350,150)

(39,720)

(194,339)

Cash flows from investing activities:

Purchases of property and equipment

Net sales (purchases) of short-term investments

(10,581,073)

3,019,314

(1,116,238)

(5,626,725)

(234,131)

—

Net cash used in investing activities

(7,561,759)

(6,742,963)

(234,131)

Cash flows from financing activities:

Proceeds from issuance of common stock,

net of issuance costs

2,621,672

36,267,535

Net cash provided by financing activities

2,621,672

36,267,535

16,023

Increase (decrease) in cash and cash equivalents

Cash and cash equivalents, beginning of period

(7,595,765)

31,092,273

28,938,592

2,153,681

(412,447)

2,566,128

Cash and cash equivalents, end of period

$ 23,496,508

$31,092,273

$ 2,153,681

Supplemental Noncash Disclosures:

Conversion of preferred stock to common stock

Repurchase of Series D preferred shares for

cancellation of notes

—

$ 127,998

—

$ 457,062

The accompanying notes are an integral part of the financial statements.

Series D

$ 73,266

—

(4,100)

—

69,166

—

Series E

$ 29,432

—

29,432

—

(15,875)
—

(13,525)
—

(69,166)
—

(29,432)
—

C O N S O L I D A T E D S T A T E M E N T S O F S T O C K H O L D E R S ’ E Q U I T Y

Convertible Preferred Stock

Balance, December 31, 1994

Exercise of common stock options, 16,867 shares

Repurchase of Series D preferred stock, 4,100 shares

Net loss

Series B

$ 15,875

Series C

$ 13,525

—

Balance, December 31, 1995

15,875

13,525

Issuance of common stock in initial public offering,

net of issuance costs, 3,910,000 shares

Exercise of common stock options,

1,083,162 shares

Conversion of preferred stock to common stock,

12,799,800 shares

Net income

Balance, December 31, 1996

Exercise of common stock options,

686,127 shares

Net loss

—

Balance, December 31, 1997

$ —

The accompanying notes are an integral part of the financial statements.

Additional
Paid-In
Capital

Accumulated
Deficit

Notes
Receivable For
Issued Stock

$13,792,091

($ 10,232,140)

($457,062)

Common
Stock

$ 11,501

169

—

15,854

—

(342,962)

11,670

13,807,945

(10,575,102)

39,100

10,832

127,998
—

189,600

6,860

—

35,123,900

1,093,703

—
—

—

—
259,382

50,025,548

(10,315,720)

2,614,812

—

(4,448,336)

$196,460

$52,640,360

($14,764,056)

—

457,062

—

—
—

—

A w a re , I n c .

Total
Stockholders’
Equity

$ 3,246,488

16,023

—

(342,962)

2,919,549

35,163,000

1,104,535

—
259,382

Treasury
Stock

—

(452,962)

—

(452,962)

—

—
—

(452,962)

39,446,466

—

2,621,672

(4,448,336)

($452,962)

$37,619,802

N O T E S T O C O N S O L I D A T E D F I N A N C I A L S T A T E M E N T S

A w a re , I n c .

1 . N A T U R E O F B U S I N E S S

Aware, Inc. (the “Company”) designs, develops and markets telecommunications software, hardware designs, chipsets and
products that incorporate Asymmetric Digital Subscriber Line (ADSL), splitterless lite Digital Subscriber Line (DSL Lite),
Very High Speed Digital Subscriber Line (VDSL), and Symmetric Digital Subscriber Line (SDSL) technologies. These
broadband technologies are designed to increase the speed of data communications over conventional copper telephone
lines. The Company’s products are designed to allow telephone companies to utilize their installed bases of dedicated
copper lines to provide both residential and business customers with interactive data transmission at speeds much higher
than currently available. The Company also offers image compression software products.

2 . S U M M A R Y O F S I G N I F I C A N T A C C O U N T I N G P O L I C I E S

Basis of Presentation. The consolidated financial statements include the accounts of Aware, Inc. and its subsidiary.
All significant intercompany transactions have been eliminated.

Cash and Cash Equivalents. Cash and cash equivalents consist primarily of demand deposits, money market funds,
commercial paper, and discount notes in highly liquid short-term instruments with original maturities of three months
or less from the date of purchase and are stated at cost, which approximates market.

Short-term Investments. The Company follows Statement of Financial Accounting Standards (“SFAS”) No. 115,
“Accounting for Certain Investments in Debt and Equity Securities. At December 31, 1997, the Company had categorized
all securities as “available-for-sale,” since the Company may liquidate these investments currently. At December 31, 1996,
the Company had categorized all investments with maturities of less than one year as “held-to-maturity”, because of
the Company’s intent and ability to hold such securities to maturity. In calculating realized gains and losses, cost is
determined using specific identification. Held-to-maturity securities are carried at amortized cost. SFAS No. 115 requires
that unrealized gains and losses on available-for-sale securities be excluded from earnings and reported in a separate
component of stockholders’ equity. As of December 31, 1997 and 1996, unrealized gains and losses were not material.

The amortized cost of securities, which approximates fair value, consists of the following at December 31, 1997 and 1996:

Type of security

1997:

Corporate debt securities

U.S. agency securities

Total

1996:

Corporate debt securities

U.S. agency securities

Total

Maturity

Less than one year

One to five years

Total

$1,574,474

1,032,937

$2,607,411

$3,040,072

984,630

$4,024,702

—

$1,602,023

—

$1,602,023

$1,574,474

1,032,937

$2,607,411

$4,642,095

984,630

$5,626,725

Allowance for Doubtful Accounts. Accounts are charged to the allowance for doubtful accounts as they are deemed
uncollectible based on a periodic review of the accounts. Bad debt expense was approximately $26,000, $20,000, and
$5,000 for 1997, 1996, and 1995, respectively.

Inventories. Inventories are stated at the lower of cost or market with cost being determined by the first-in, first-out
(“FIFO”) method.

Property and Equipment. Property and equipment are stated at cost. Depreciation and amortization of property and
equipment is provided using the straight-line method over the estimated useful lives of the assets ranging from three to
thirty years.

The Company accounts for the impairment of long-lived assets in accordance with the provisions of SFAS No. 121,
“Accounting for the Impairment of Long-Lived Assets and for Long-Lived Assets to Be Disposed Of.”

Revenue Recognition. Product revenue consists primarily of revenue from the sale of tangible products, such as
modems, transceiver modules, development systems and compression chipsets. Revenue is recognized upon shipment.

License and royalty revenue consists primarily of revenue from the sale of intellectual property, such as hardware and
software technology licenses, compression software licenses, and royalties from the sale of chipsets by customers who
have licensed the Company’s technology. Revenue from the sale of technology licenses for the initial transfer of hardware
and software designs is recognized when a definitive agreement is reached, the transfer has been effected, and no
contingent factors are present. Revenue from the sale of compression software licenses is recognized upon shipment.
Royalty revenue is recognized based upon sales reports from customers.

Research and development revenue is comprised of revenue from government and commercial research and development
contracts. Revenue on government contracts is generally recognized when services are performed. Revenue on commercial
contracts is generally recognized as research is performed and milestones are achieved under the terms of the respective
agreements.

Unbilled accounts receivable are stated at estimated realizable value. These amounts will be billable to customers based on
the terms of contracts which include achievement of milestones or completion of the contract.

Income Taxes. The Company accounts for income taxes under SFAS No. 109, “Accounting for Income Taxes.”
SFAS No. 109 requires the Company to compute deferred income taxes based on the differences between the financial
statement and tax basis of assets and liabilities using enacted rates in effect in the years in which the differences are
expected to reverse. SFAS No. 109 also requires the Company to establish valuation allowances to offset temporary
deductible differences, net operating loss carryforwards and tax credits, which are not likely to be realized.

Capitalization of Software Costs. The Company capitalizes certain internally generated software development costs
after technological feasibility of the product has been established. Capitalized software costs also include amounts paid for
purchased software, which has reached technological feasibility. Such costs are amortized, on a product-by-product basis,
on a straight-line basis over their useful economic lives (generally two to four years), or the ratio of current gross revenues
to total gross current and future revenues, whichever is greater. There were no capitalized software costs at December 31,
1997 and 1996, because such costs incurred subsequent to the establishment of technological feasibility, but prior to
commercial availability, were immaterial.

Concentration of Risk. At December 31, 1997 and 1996, the Company had bank cash balances and money market
investments, in excess of federally insured deposit limits of approximately $26,004,000 and $36,619,000, respectively.

Concentration of credit risk with respect to accounts receivable is limited to $524,000, $400,000, and $154,000 with three
customers at December 31, 1997 and to $549,000, $275,000 and $155,000 with three customers at December 31, 1996.

In 1997, the Company entered into an agreement with a third party contract manufacturer that will supply substantially
all finished goods products to the Company.

Stock-Based Compensation. The Company grants stock options for a fixed number of shares to employees with
an exercise price equal to the fair value of the shares at the date of grant. As permitted by SFAS No. 123, the Company
accounts for stock option grants in accordance with Accounting Principles Board (“APB”) Opinion No. 25, “Accounting
for Stock Issued to Employees.” Accordingly, the Company recognized no compensation expense for stock option grants.

Net Income (Loss) Per Share. In 1997, the Company adopted SFAS No. 128, “Earnings Per Share.” SFAS No. 128
establishes standards for computing and presenting earnings per share and applies to entities with publicly held common
stock or potential common stock. Prior to 1997, the Company computed earnings per share in accordance with APB
Opinion No. 15, “Earnings per Share.” As a result of implementation of SFAS No. 128, net income (loss) per share for
the years ended December 31, 1996 and 1995 has been restated.

Use of Estimates. The preparation of the Company’s financial statements in conformity with generally accepted
accounting principles necessarily requires management to make estimates and assumptions that affect the reported
amounts of assets and liabilities and to disclose contingent assets and liabilities at the balance sheet date. Significant

N O T E S T O C O N S O L I D A T E D F I N A N C I A L S T A T E M E N T S

A w a re , I n c .

estimates include reserves for doubtful accounts, reserves for excess and obsolete inventory, useful lives of fixed assets,
valuation allowance for deferred income tax assets, and accrued liabilities. Actual results may differ from these estimates.

Fair Value of Financial Instruments. The carrying amounts of cash and cash equivalents, short-term investments,
accounts receivable, accounts payable and accrued expenses approximate fair value because of their short-term nature.

Future Adoption of Accounting Pronouncements. In 1997, the Financial Accounting Standards Board issued SFAS
No. 130, “Reporting Comprehensive Income”, and SFAS No. 131, “Disclosure About Segments of an Enterprise and Related
Information.”

SFAS No. 130 requires that all items that are required to be recognized under accounting standards as components of
comprehensive income (revenues, expenses, gains and losses) be reported in a financial statement that is displayed with
the same prominence as other financial statements. The provisions of SFAS No. 130 are effective for fiscal years beginning
after December 15, 1997. The Company believes that changes made to comply with this statement will not have a
material effect on the Company’s consolidated financial position or results of operations.

SFAS No. 131 requires public business enterprises to report financial and descriptive information about its operating
segments. The provisions of SFAS No. 131 are effective for periods beginning after December 15, 1997. The Company
believes that implementation of this statement will not have a material effect on the Company’s consolidated financial
position or results of operations, but may impact the level of disclosure of its segment information.

In October 1997, the American Institute of Certified Public Accountants issued Statement of Position (SOP) No. 97-2,
“Software Revenue Recognition.” SOP No. 97-2 provides guidance on applying generally accepted accounting principles
in recognizing revenue on software transactions. The provisions of SOP No. 97-2 are effective for periods beginning
after December 15, 1997. The Company believes that implementation of this statement will not have a material effect
on the Company’s consolidated financial position or results of operations.

3 . I N V E N T O R I E S

Inventories consisted of the following at December 31:

Raw materials

Work-in-process

Finished goods

Total

4 . P R O P E R T Y A N D E Q U I P M E N T

Property and equipment consisted of the following at December 31:

Land

Building

Computer equipment

Furniture and fixtures

Office equipment
Manufacturing equipment

Purchased software
Leasehold improvements

Total

Less accumulated depreciation and amortization

Net

1997

$163,555

—

52,067

$215,622

1996

$408,643

38,891

—

$447,534

1997

$ 1,080,000

7,144,656

1,996,164

401,979

142,313
262,610

1,148,584
—

12,176,306

(1,330,281)

1996

—

983,819

124,677

83,917
118,998

375,467
37,951

1,724,829

(557,901)

$10,846,025

$1,166,928

5 . I N C O M E T A X E S

Deferred income tax assets at December 31 are attributable to the following:

Federal net operating loss carryforwards

Research and development and other tax credit carryforwards

State net operating loss carryforwards

Depreciation

Accrued expenses

Prepaid expenses

Deferred revenue

Alternative minimum tax credit

Total

Less valuation allowance

Net

1997

$ 5,641,000

1,526,000

880,000

41,000

88,000

(94,000)

—

8,082,000

(8,082,000)

1996

$ 3,367,000

761,000

518,000

69,000

187,000

—

22,000

6,000

4,930,000

(4,930,000)

—

A valuation allowance is provided against temporary deductible differences, net operating loss carryforwards and tax credits,
which are not likely to be realized. During 1997 and 1996, the net valuation allowance was increased to fully reserve gross
deferred tax assets.

A reconciliation of the U.S. federal statutory rate to the effective tax rate is as follows:

Federal statutory rate

State rate, net of federal benefit

Tax credits

Operating losses and tax credits with no current tax benefit

Tax benefit from the utilization of net

operating loss carryforwards

Effective tax rate

1997

(34)%

(6)

(17)

—

—%

1996

34%

(69)

(40)

—%

1995

(34)%

(6)

(10)

—

—%

The Company has made no provision for income taxes as it has a history of net losses, which has resulted in tax loss
carryforwards. At December 31, 1997, the Company had available federal net operating loss carryforwards of approximately
$16,586,000, which expire in 2003 through 2012, and federal research and development credit carryforwards of
approximately $791,000, which expire in 2003 through 2012. At December 31, 1997, the Company also had available
state net operating loss carryforwards of approximately $9,261,000, which expire in 1998 through 2002 and state research
and development and investment tax credit carryforwards of approximately $395,000, which expire in 2006 through 2012.
Of the total net operating loss carryforwards, approximately $1,906,000 are attributable to the exercise of stock options
and the tax benefit from these losses, when utilized, will be credited to additional paid-in capital.

N O T E S T O C O N S O L I D A T E D F I N A N C I A L S T A T E M E N T S

A w a re , I n c .

6 . S T O C K H O L D E R S ’ E Q U I T Y

Common Stock. In 1996, the Company increased the number of shares of authorized common stock from 18,650,000
to 30,000,000.

In August 1996, the Company completed an initial public offering of its common stock consisting of 3,910,000 shares at
$10.00 per share. Proceeds to the Company, net of issuance costs, were approximately $35,163,000 (issuance costs were
approximately $3,937,000).

In accordance with the terms of the underlying agreements, all outstanding shares of Series B, C, D, and E convertible
preferred stock were automatically converted into common stock upon completion of the initial public offering.

Preferred Stock. In 1996, the Company authorized 1,000,000 shares of $1.00 par value preferred stock.

7 . S T O C K C O M P E N S A T I O N P L A N S

At December 31, 1997, the Company has three stock-based compensation plans, which are described below. The Company
adopted SFAS No. 123, but, as permitted, applies APB Opinion No. 25 and related Interpretations in accounting for its
plans. Accordingly, no compensation cost has been recognized for its fixed stock option plans and its employee stock
purchase plan. The Company has no performance-based stock option plans. Had compensation cost for the Company’s
three stock-based compensation plans been determined based on the fair value at the grant dates for awards under those
plans consistent with the method of SFAS No. 123, the Company’s net income (loss) and per share amounts would have
been adjusted to the pro forma amounts indicated below:

Year ended December 31,

Net income (loss)

As reported

Pro forma

Basic earnings (loss) per share

As reported

Pro forma

Diluted earnings (loss) per share

As reported

Pro forma

1997

1996

1995

($4,448,336)

($ 8,531,745)

$ 259,382

($4,403,824)

($342,962)

($ 580,611)

($0.23)

($0.44)

($0.23)

($0.44)

$0.02

($0.41)

$0.01

($0.24)

($0.29)

($0.50)

($0.29)

($0.50)

1995

6.25%
4 years
97%
—

The fair value of options on their grant date was measured using the Black-Scholes option pricing model.
Key assumptions used to apply this pricing model are as follows:

Year ended December 31,

Average risk-free interest rate
Expected life of option grants
Expected volatility of underlying stock
Expected dividend yield

1997

6.48%
5 years
96%
—

1996

6.25%
4 years
97%
—

Fixed Stock Option Plans. The Company has two fixed option plans. Under the 1990 Incentive and Nonstatutory Stock
Option Plan, the Company may grant incentive stock options or nonqualified stock options to its employees and directors
for up to 2,873,002 shares of common stock. Under the 1996 Stock Option Plan, the Company may grant incentive
stock options or nonqualified stock options to its employees and directors for up to 3,000,000 shares of common stock.
Under both plans, options: are granted at an exercise price as determined by the Board of Directors; have a maximum
term of ten years; and generally vest either: (i) on a monthly basis over three years, or (ii) 40% two years from the date
of grant with the remaining 60% vesting on a monthly basis over the next three years.

A summary of the status of the Company’s two fixed stock option plans as of December 31, 1997, 1996, and 1995, and
changes during the years ending on those dates is presented below:

1997

1996

1995

Weighted Avg.
Exercise Price

Outstanding at beginning of year

3,396,408

Granted

Exercised

Forfeited

913,186

686,127

69,296

$ 5.01

12.20

3.82

9.10

2,757,500

1,818,250

1,083,162

96,180

$ 1.21

9.10

1.02

14.54

2,481,948

1,139,750

16,867

847,331

Outstanding at end of year

3,554,171

$ 7.01

3,396,408

$ 5.01

2,757,500

$1.45

1.30

.95

1.90

$1.21

Options exercisable at year end

1,754,552

1,343,617

1,447,474

Weighted-average grant date fair value

of options granted during the year

$9.28

$6.07

$0.92

The following table summarizes information about stock options outstanding at December 31, 1997:

Range of Exercise Prices

$1 to 2
8 to 9
10 to 11
12 to 13

Options Outstanding

Options Exercisable

Number
Outstanding
at 12/31/97

1,222,329
1,178,406
450,000
703,436

3,554,171

Weighted Avg.
Remaining
Contractual Life

Weighted Avg.
Exercise Price

7.1 years
8.4
9.2
9.4

8.3

$ 1.30
8.25
10.29
12.75

$ 7.01

Number
Exercisable
at 12/31/97

1,046,230
613,075
87,387
7,860

1,754,552

Weighted Avg.
Exercise Price

$ 1.31
8.25
10.31
12.75

$ .23

Employee Stock Purchase Plan. In June 1996, the Company adopted an Employee Stock Purchase Plan (the
“ESPP Plan”) under which eligible employees may purchase common stock at a price equal to 85% of the lower of the fair
market value of the common stock at the beginning or end of each six-month offering period. Participation in the ESPP
Plan is limited to 6% of an employee’s compensation, may be terminated at any time by the employee and automatically
ends on termination of employment with the Company. A total of 100,000 shares of common stock have been reserved
for issuance. During 1997 and 1996, no shares of common stock were issued under this plan, as the Company had not
commenced implementation of the plan.

8 . C O M M I T M E N T S A N D C O N T I N G E N T L I A B I L I T I E S

Lease Commitments. In 1995, the Company entered into a three-year noncancelable operating lease for its principal
office and research facilities commencing June 1, 1995. In November 1996, the Company entered into a twelve-month
operating lease for additional space for its research facilities commencing December 1, 1996. In November 1997, both of
these leases were either terminated or allowed to lapse at no cost to the Company, and the Company moved into a new
building that it had purchased.

At December 31, 1997, the Company has no material operating leases.

Rental expense was approximately $308,000, $143,000, and $283,000 in 1997, 1996 and 1995, respectively.

Litigation. There are no material pending legal proceedings to which the Company is a party or to which any of its
properties are subject which, either individually or in the aggregate, are expected by the Company to have a material
adverse effect on its business, financial position or results of operations.

N O T E S T O C O N S O L I D A T E D F I N A N C I A L S T A T E M E N T S

A w a re , I n c .

9 . T R A N S A C T I O N S W I T H R E L A T E D P A R T I E S

Consulting Agreements. In prior years, the Company had paid consulting fees for scientific research and development
services provided by certain stockholders. The total charges from related parties approximated $8,000, and $66,000 in
1996 and 1995. There were no amounts due to related parties at December 31, 1997 and 1996.

1 0 . M A J O R C U S T O M E R S

The portion of total revenue that was derived from major customers was as follows:

Year ended December 31,

Customer A

Customer B

Customer C

Customer D

Customer E
Customer F
Customer G

1997

16%

13%

12%

—
—
—

1996

—

12%

17%

22%

10%
—
—

1995

—

12%

23%

—

—
18%
10%

1 1 . E M P L O Y E E B E N E F I T P L A N

In 1994, the Company established a qualified 401(k) Retirement Plan (the “Plan”) under which employees are allowed
to contribute certain percentages of their pay, up to the maximum allowed under Section 401(k) of the Internal Revenue
Code. Company contributions to the Plan are at the discretion of the Board of Directors. There were no Company
contributions in 1997, 1996 and 1995.

1 2 . N E T I N C O M E ( L O S S ) P E R S H A R E

A reconciliation of weighted average shares used for the basic computation and that used for the diluted computation is
as follows:

Year ended December 31,

Weighted average shares — basic

Dilutive effect of:

Convertible preferred stock

Options

1997

1996

1995

19,328,252

10,841,919

1,162,717

—

5,467,106

1,682,421

—

Weighted average shares — diluted

19,328,252

17,991,446

1,162,717

For the years ended December 31, 1997 and 1995, potential common shares are not included in the per share calculations
for diluted EPS, because the effect of their inclusion would be antidilutive. For the year ended December 31, 1996, options
to purchase 1,737,750 shares of common stock at an average weighted price of $8.57 per share were outstanding, but
were not included in the computation of diluted EPS because the options’ exercise prices were greater than the average
market price of the common shares.

1 3 . Q U A R T E R L Y R E S U L T S O F O P E R A T I O N S — U N A U D I T E D

The following table presents unaudited quarterly operating results for each of the Company’s eight quarters in the
two-year period ended December 31, 1997:

Quarters ended

Revenue

Loss from operations

Net loss

Net loss per share – Basic

Net loss per share – Diluted

Quarters ended

Revenue

Income (loss) from operations

Net income (loss)

Net income (loss) per share – Basic

Net income (loss) per share – Diluted

1997

March 31

June 30

Sept. 30

Dec. 31

$1,801,085

$1,870,417

722,500

$ 1,804,049

(724,586)

(276,302)

($0.01)

(748,143)

(275,398)

($0.01)

(2,569,699)

(2,145,946)

($0.11)

(2,114,248)

(1,750,690)

($0.09)

1996

March 31

June 30

Sept. 30

Dec. 31

$ 962,003

$1,128,475

$ 1,505,820

$ 1,704,811

17,651

41,151

$0.04

$0.00

18,300

48,668

$0.01

$0.00

4,250

261,683

$0.02

$0.01

(578,475)

(92,120)

$0.00

R E P O R T O F I N D E P E N D E N T A U D I T O R S

A w a re , I n c .

T H E B O A R D O F D I R E C T O R S A N D S T O C K H O L D E R S O F A W A R E , I N C .

We have audited the accompanying consolidated balance sheets of Aware, Inc. (the “Company”) as of December 31, 1997
and 1996, and the related consolidated statements of operations, stockholders’ equity, and cash flows for each of the
three years in the period ended December 31, 1997. These financial statements are the responsibility of the Company’s
management. Our responsibility is to express an opinion on these financial statements based on our audits.

We conducted our audits in accordance with generally accepted auditing standards. 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 assessing the accounting principles used and significant estimates made by
management, as well as 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 financial
position of Aware, Inc. at December 31, 1997 and 1996, and the results of its operations and its cash flows for each of
the three years in the period ended December 31, 1997, in conformity with generally accepted accounting principles.

Deloitte & Touche LLP

Boston, Massachusetts
January 27, 1998

C O R P O R A T E I N F O R M A T I O N

Aware, Inc .

B O A R D O F D I R E C T O R S

L E G A L C O U N S E L

Charles K. Stewart
Chairman of the Board
Aware, Inc.

James C. Bender
President and Chief Executive Officer
Aware, Inc.

David Ehreth
Division Vice President
DSC Communications, Inc.

Jerald G. Fishman
President, Chief Executive Officer, Director
Analog Devices, Inc.

John K. Kerr
General Partner
Grove Investment Partners

John S. Stafford
Member
Chicago Board of Options

Michael A. Tzannes
Chief Technology Officer and
General Manager of Telecommunications
Aware, Inc.

O F F I C E R S

James C. Bender
President and Chief Executive Officer

Michael A. Tzannes
Chief Technology Officer and General Manager
of Telecommunications

David C. Hunter
Senior Vice President, Product Development

Richard P. Moberg
Chief Financial Officer and Treasurer

Edmund C. Reiter
Vice President, Advanced Products

Creative: Beagan Design – Ha Nguyen
Illustration: John Hersey
Photography: Geoff Stein, Len Rubenstein
Copy: Trish Baumann

Foley, Hoag & Eliot LLP, Boston, MA

I N D E P E N D E N T A C C O U N T A N T S

Deloitte & Touche LLP, Boston, MA

T R A N S F E R A G E N T

Boston Equiserve
150 Royall Street
Canton, MA 02021

A N N U A L M E E T I N G

The annual meeting will be held at 9:00 a.m. on
Wednesday, May 27, 1998 at the Bedford Renaissance
Hotel in Bedford, MA.

S T O C K L I S T I N G

The Company’s common stock is traded on the
Nasdaq National Market under the symbol AWRE.

S T O C K P R I C E H I S T O R Y B Y Q U A R T E R

1997

High
Low

1996

High
Low

First

Second

Third

Fourth

14 7⁄8
8 5⁄8

16 7⁄8
8 1⁄2

15 1⁄8
9 5⁄8

14 15⁄16
9 1⁄8

First

Second

Third

Fourth

n/a
n/a

19
10 1⁄2

17 1⁄2
8 1⁄2

The preceding table sets forth the high and low sales
prices as reported on the Nasdaq National Market from
August 9, 1996, the date of the Company’s initial public
offering, to December 31, 1997. As of February 17,
1998, the Company had approximately 131 shareholders
of record. This number does not include shareholders
for whom shares were held in a “nominee” or “street
name.” The Company has never paid cash dividends on
its common stock and anticipates it will continue to
reinvest any earnings to finance future operations.

C O R P O R A T E H E A D Q U A R T E R S

40 Middlesex Turnpike
Bedford, MA 01730, USA
781-276-4000
http://www.aware.com

I N V E S T O R R E L A T I O N S

For a copy of the Company’s Form 10-K, copies of
this report or other financial information, contact:

Aware, Inc.
Investor Relations
40 Middlesex Turnpike
Bedford, MA 01730, USA
781-276-4000
email: ir@aware.com

4 0 M I D D L E S E X T U R N P I K E , B E D F O R D , M A 0 1 7 3 0

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