Wired Solutions
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`F O R A P R E - W I R E D W O R L D
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`A W A R E , I N C .
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`A N N U A L R E P O R T 1 9 9 7
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`

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`Contents
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`1
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`2
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`4
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`7
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`8
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`11
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`12
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`13
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`33
`
`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
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`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
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`ordinary voiceband modems, and you’re right back in
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`the Dark Ages – stuck in a frustrating gridlock where
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`data transmissions slow to a crawl.
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`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
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`clamoring for a quantum-leap improvement in
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`high-speed data access technology. The need for
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`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
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`leapfrogs conventional approaches and sets a new
`
`high-speed standard for improving even the most
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`bandwidth-hungry applications and accessing
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`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.
`
`1
`
`

`
`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
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`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
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`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.
`
`2
`
`

`
`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
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`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-
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`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.
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`Their dedication and expertise, coupled with the loyal support of our partners, customers and shareholders, are the
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`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
`
`3
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`

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`T H E T E C H N O L O G Y S O L U T I O N
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`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
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`the entire world with higher bandwidth fiber optic cable.
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`adapting transmission speed to compensate for local line
`
`With 700 million lines worldwide, the sheer size of this
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`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.
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`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
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`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
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`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
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`modems which can diminish transfer rates and create
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`the wide-scale deployment of full-rate ADSL — predicted
`
`security breaches.
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`to be a billion dollar market by the year 2000.
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`x200 ADSL Access Router: The new “splitterless” x200 Lite version of this high-speed access
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`solution will install as easily as today’s PC modem.
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`4
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`

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`xx220000ADSL Access Router
`
`

`
`AAWW––991100ADSL Transceiver Module
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`

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`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
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`opment of breakthrough, market-driven solutions that
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`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
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`Internet access and broadband communications services.
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`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
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`in the DSL industry — speaks for itself:
`
`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
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`DMT ADSL chipset on the market.
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`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
`
`maintaining traditional telephone voice service. The
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`x200’s routing capabilities also make it well-suited for
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`remote and branch office routing.
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`First DMT ADSL rate-adaptive technology.
`By automatically adapting to a variety of different
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`telephone line conditions, our DMT ADSL rate-adaptive
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`technology contained within our modems makes those
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`connections more reliable and delivers the maximum
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`performance a line can handle.
`
`First to demonstrate and deliver “splitterless” DMT
`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
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`eliminate the need for special installation services.
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`office and customer premise ends of an ADSL connection.
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`Guided by the proven expertise of our management team,
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`The AW-910 quickly led to yet another innovation —
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`our well-capitalized organization brings 12 years of expe-
`
`Aware’s ADS-910 Development System, which provides
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`rience to bear on extending our technology leadership.
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`OEMs with a single, compact platform for evaluating
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`Today, engineering personnel account for more than
`
`both ends of an ADSL link.
`
`First commercially available DMT-based access
`router (x200). Designed to make broadband applications
`such as high-speed Internet access, video conferencing,
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`two-thirds of our work force — representing a first-rate
`
`research and development team that continues to build
`
`our technology base and transform our innovations into
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`successful product solutions.
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`AW-910 ADSL Transceiver Module: All-in-one, plug-and-play solution for rapidly deploying
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`ADSL technology.
`
`7
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`

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`T H E A D S L R O L L - O U T S O L U T I O N
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`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
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`today’s leading telecommunications service providers.
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`for the speedy establishment of splitterless DMT as an
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`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
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`with 3Com for DMT modems. Our relationship with
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`Lucent Technologies is expected to produce the first PC
`
`industry standard. In addition to PC, networking and
`
`semiconductor industry leaders, the UAWG includes key
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`telecommunications service providers such as Ameritech,
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`Bell Atlantic, BellSouth, GTE, MCI, SBC Communications,
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`Sprint, US WEST, France Telecom, Deutsche Telekom
`
`and British Telecom — galvanizing the support of these
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`pivotal members of the ADSL provider chain.
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`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
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`International Telecommunications Union (ITU).
`
`DMT technology as an industry standard is expected to
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`Growing numbers of today’s leading system vendors are
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`also basing their ADSL product developments on Aware’s
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`technology. These include three of the four major digital
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`loop carriers, three of the biggest networking and remote
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`access vendors, six of the top telecommunications
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`companies, and the two leading voiceband modem
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`manufacturers.
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`accelerate the final decision-making process of the official
`
`standard bodies and to release a groundswell of market
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`demand for ADSL and splitterless DMT innovations.
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`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.
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`8
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`

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`AADD2200mmsspp991100ADSL Chipset
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`

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`AADDSS––991100
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`ADSL Development System
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`

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`T H E F U T U R E S O L U T I O N
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`Beyond ADSL
`
`Aware is constantly raising the bar for ultra high-speed
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`code will add superior robustness and performance
`
`data access as it takes its technological innovations to
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`characteristics to our xDSL products by providing higher
`
`the next level. Our next generation technologies are
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`immunity to electrical noise and interference in the
`
`already taking shape.
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`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.
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`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.
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`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
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`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
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`central office and customer premise equipment, is
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`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,
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`code, Discrete Wavelet Multitone (DWMT). Based on
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`ever-more-powerful solutions — effectively transforming
`
`our pioneering wavelet technology, the new DWMT line
`
`those exciting possibilities into practical realities.
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`The future of high-speed data communications
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`ADS-910 ADSL Development System: Complete test system for quickly integrating the
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`AD20msp910 chipset into central office and customer premise equipment.
`
`11
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`

`
`Senior Management
`
`MICHAEL A. TZANNES
`
`Chief Technology Officer
`
`and General Manager
`
`of Telecommunications
`
`RICHARD P. MOBERG
`
`Chief Financial Officer
`
`and Treasurer
`
`DAVID C. HUNTER
`
`Senior Vice President,
`
`Product Development
`
`EDMUND C. REITER
`
`Vice President,
`
`Advanced Products
`
`12
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`

`
`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
`
`Aware, Inc .
`
`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
`
`Year ended December 31,
`1996
`1995
`
`1994
`
`1993
`
`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
`Cash and short-term investments
`Working capital
`Total assets
`Total liabilities
`Total stockholders’ equity
`
`$ 6,198
`(6,157)
`(4,448)
`($0.23)
`($0.23)
`
`$26,104
`26,774
`39,281
`1,661
`37,620
`
`$ 5,301
`(538)
`259
`$0.02
`$0.01
`
`$36,719
`38,280
`40,123
`676
`39,446
`
`$ 3,260
`(454)
`(343)
`($0.29)
`($0.29)
`
`$ 2,154
`2,516
`3,228
`309
`2,920
`
`$ 3,827
`(1,095)
`(1,012)
`($0.88)
`($0.88)
`
`$ 2,566
`2,877
`3,930
`684
`3,246
`
`$ 3,172
`(1,028)
`(992)
`($0.87)
`($0.87)
`
`$ 186
`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.
`
`13
`
`

`
`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
`
`Aware, Inc .
`
`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,
`
`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)
`
`1997
`
`1996
`
`1995
`
`15.7%
`48.9
`35.4
`
`100.0
`
`20.2
`110.9
`36.9
`31.4
`
`199.4
`
`(99.4)
`27.6
`
`(71.8%)
`
`12.3%
`56.0
`31.7
`
`100.0
`
`15.7
`61.0
`14.5
`18.9
`
`110.1
`
`(10.1)
`15.0
`
`12.5%
`31.8
`55.7
`
`100.0
`
`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.
`
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`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.
`
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`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
`
`Aware, Inc .
`
`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