UNITED STATES
SECURITIES AND EXCHANGE COMMISSION

FORM 10-Q

(Mark One)

OR

Commission file number 000-31089

VIRAGE LOGIC CORPORATION

47100 Bayside Parkway
Fremont, California 94538
(Address of principal executive offices)

(510) 360-8000
(Registrant’s telephone number, including area code)

Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days.

Yes [X] No [  ]

Indicate by a check whether the registrant is an accelerated filer (as defined in Rule 12b-2 of the Act). Yes [X] No [  ]

As of July 31, 2004 there were 21,482,331 shares of the Registrant’s Common Stock outstanding.

VIRAGE LOGIC CORPORATION

FORM 10-Q

INDEX

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VIRAGE LOGIC CORPORATION

See accompanying notes to unaudited condensed consolidated financial statements.

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VIRAGE LOGIC CORPORATION

See accompanying notes to unaudited condensed consolidated financial statements.

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VIRAGE LOGIC CORPORATION

See accompanying notes to unaudited condensed consolidated financial statements.

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VIRAGE LOGIC CORPORATION

Note 1. Organization and Summary of Significant Policies

   Description of Business

     Virage Logic Corporation (the Company) was incorporated in California in November 1995 and subsequently reincorporated in Delaware in July 2000. The Company provides semiconductor intellectual property (IP) platforms based on memory, logic, and I/Os (input/output interface components) that are silicon-proven and production ready. These various forms of IP are utilized by the Company’s customers to design and manufacture System-on-Chip (SoC) integrated circuits that are used in a variety of electronic products including high-speed communications, computer and consumer products, such as cellular and digital phones, pagers, PDAs, digital cameras, DVD players, switches and modems.

   Principles of Consolidation

The accompanying condensed consolidated financial statements include the accounts of Virage Logic Corporation and its wholly-owned subsidiaries. All significant intercompany balances and transactions have been eliminated in consolidation.

   Use of Estimates

     The preparation of consolidated financial statements in conformity with accounting principles generally accepted in the United States of America requires management to make estimates and assumptions that affect the amounts reported in the financial statements and accompanying notes. Actual results could differ from those estimates.

   Unaudited Interim Financial Statements

     The accompanying condensed consolidated financial statements as of June 30, 2004, and for the three and nine months ended June 30, 2004 and 2003, are unaudited. The unaudited condensed consolidated financial statements have been prepared on the same basis as the annual consolidated financial statements and, in the opinion of management, reflect all adjustments, which include only normal recurring adjustments, necessary to present fairly our financial position, as of June 30, 2004 our results of operations for the three and nine months ended June 30, 2004 and 2003, and cash flows for the nine months ended June 30, 2004 and 2003, respectively. These condensed consolidated financial statements and related notes should be read in conjunction with our audited consolidated financial statements and related notes included in our 2003 Annual Report on Form 10-K as filed with the Securities and Exchange Commission. Our balance sheet as of September 30, 2003, was derived from audited financial statements but does not include all disclosures required for annual reporting. Our results for the three and nine months ended June 30, 2004 are not necessarily indicative of the expected results for any other interim period or for the year ending September 30, 2004.

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     Revenue Recognition

     Our revenue recognition policy follows specific and detailed guidelines and is based on the American Institute of Certified Public Accountants Statement of Position 97-2, “Software Revenue Recognition” as amended by Statement of Position 98-4, Statement of Position 98-9 and Statement of Position 81-1.

     Revenues from perpetual licenses for our semiconductor IP products are generally recognized when persuasive evidence of an arrangement exists, delivery of the product has occurred, there are no significant remaining obligations on our part, the fee is fixed or determinable, and collectability is reasonably assured. If any of these criteria are not met, we defer recognizing the revenue until such time as all criteria are met. Revenues from term-based licenses, which are generally twelve months in duration, are recognized ratably over the term of the license, provided the criteria mentioned above are met.

     License of custom memory compilers, logic libraries and I/Os may involve customization to the functionality of the software, therefore revenues from such licenses are recognized over the period that we perform the services. Generally our contracts are established as fixed fee arrangements. Revenue derived from custom products are recognized using a percentage-of-completion method. For all license and service agreements accounted for using the percentage-of-completion method, we determine progress-to-completion based on labor hours incurred and estimates of efforts required to complete each project. These estimates are based on the amount of work we require, and we believe we are able to reasonably and reliably estimate the costs to complete projects accounted for using the percentage-of-completion method. However, use of different assumptions under the percentage-of-completion method could affect our revenues and the timing of recognizing certain revenues. Alternatively, for customers’ transactions for which we can not reasonably and reliably estimate the costs to complete a project, the completed contract method of accounting is used, such that costs are deferred until the project is completed at which time revenues are recognized. A provision for estimated losses on engagements is made in the period in which the loss becomes probable and can be reasonably estimated. Costs incurred in advance of billings are recorded as costs in excess of related billings on in-process contracts. If customer acceptance is required for completion of specified milestones, the related revenue is deferred until the acceptance criteria is met.

     For agreements that include multiple elements, we recognize revenues attributable to delivered or completed elements covered by such agreements when such elements are completed or delivered. The amount of such revenues is determined by deducting the aggregate fair value of the undelivered or uncompleted elements, which we determine by each such element’s vendor-specific objective evidence of fair value, from the total revenues recognizable under such agreement. Vendor-specific objective evidence of fair value of each element of an arrangement is based upon the normal pricing for such licensed product and service when sold separately, and for maintenance, it is determined based on the stated renewal rate in each contract. Maintenance revenues are recognized ratably over the contractual term of the maintenance period, which is generally one year.

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     Amounts invoiced to our customers in excess of recognized revenues are recorded as deferred revenues. The timing and amounts invoiced to customers can vary significantly depending on specific contract terms and can therefore have a significant impact on deferred revenues in any given period.

     Royalty revenues are generally determined and recognized one quarter in arrears, when a production volume report is received from the customer or foundry, and are calculated based on actual production volumes of wafers containing chips utilizing our semiconductor IP technologies based on a rate per-chip or rate per-wafer depending on the terms of the respective license agreement. From time to time, we may exercise our audit rights under our contracts with customers to audit our licensees’ royalty records. The results of such royalty audits could result in an increase, as a result of a licensee’s underpayment, or decrease, as a result of a licensee’s overpayment, to royalty revenues. Such adjustments are recorded in the period they are determined.

     Stock-based compensation

     The Company accounts for stock-based compensation arrangements in accordance with the provision of Accounting Principles Board Opinion No. 25, “Accounting for Stock Issued to Employees” (APB Opinion No. 25), and related interpretations in accounting for its employee stock options and complies with the disclosure provisions of Statement of Financial Accounting Standards No. 123, “Accounting for Stock-Based Compensation” (SFAS 123), as amended by Statement of Financial Accounting Standards No. 148, “Accounting for Stock-based Compensation Transition and Disclosure, an Amendment of FASB 123” (SFAS 148). Under APB Opinion No. 25, when the exercise price of the Company’s employee stock options equals the market price of the underlying stock on the date of grant, no compensation expense is recognized.

     The following table illustrates the effect on net income (loss) and net income (loss) per share if the Company had accounted for its stock options and stock purchase plans under the fair value method of accounting under SFAS 123 (in thousands, except per share data):

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     The SFAS 123 adjusted impact of options on the net income (loss) for the three and nine months ended June 30, 2004 and 2003 is not representative of the effects on net income (loss) for future periods.

Note 2. Net Income (Loss) Per Share

     Basic and diluted net income (loss) per share is presented in conformity with Statement of Financial Accounting Standards No. 128, “Earnings Per Share” (SFAS 128). Accordingly, basic and diluted net income (loss) per share have been computed using the weighted average number of shares of common stock outstanding during the period, less weighted average shares outstanding that are subject to repurchase by the Company.

     The following table presents the computation of basic and diluted net loss per share applicable to common stockholders (in thousands, except per share data):

     Potentially dilutive shares are excluded from the calculation of diluted net loss per share because they are antidilutive. For the three months ended June 30, 2004 and 2003, potential common shares that were excluded from the net income (loss) per share computations as their effect would be antidilutive were 3.7 million and 5.1 million, and for the nine months ended June 30, 2004 and 2003 were 5.6 million and 5.1 million. Shares subject to repurchase total approximately 0 and 135,000 for the three and nine months ended June 30, 2004 and 2003, respectively.

Note 3. Comprehensive Income (Loss)

     Statement of Financial Accounting Standards No. 130, “Reporting Comprehensive Income” (SFAS 130) established standards for the reporting and display of comprehensive income (loss). Comprehensive income includes unrealized gains and losses on investments and accumulated other comprehensive income is included as a component of stockholders’ equity.

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     Total comprehensive income (loss) is as follows (in thousands):

Note 4. Segment Information

     The Company operates only in one segment, the sale of semiconductor IP platforms based on memory, logic, and I/Os and the sale of the individual platform components.

     The Chief Executive Officer has been identified as the Chief Operating Decision Maker (CODM) because he has final authority over resource allocation decisions and performance assessment. The CODM does not receive discrete financial information about the individual components.

Revenues by geographic region are based on the region in which the customers are located.

Total revenues by geography and license revenues by geometry are as follows (in thousands):

Included in the Other category total revenues by geography above are revenues from the customers in China, Korea, Malaysia and Singapore.

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Long-lived assets are located primarily in the United States, with the exception of a building in Armenia, which is owned by the Company. The Armenian building and leasehold improvements are valued at a cost of approximately $1.8 million.

Note 5. Recently Issued Accounting Pronouncements

     In December 2003, the Securities and Exchange Commission released Staff Accounting Bulletin No. 104, “Revenue Recognition” (SAB 104). SAB 104 revises or rescinds portions of the interpretative guidance related to revenue recognition included in Topic 13 of the codificaton of the staff accounting bulletins. The Company has assessed the impact of SAB 104 and concluded that the adoption of SAB 104 by the Company did not have a material impact on its financial statements.

     In December 2003, the FASB issued additional guidance clarifying the provisions of FASB Interpretation No. 46, “Consolidation of Variable Interest Entities, an Interpretation of ARB No. 51” (FIN 46-R). FIN 46-R provides a deferral of FIN 46 for certain entities. FIN 46 requires certain variable interest entities to be consolidated by the primary beneficiary of the entity if the equity investors in the entity do not have the characteristics of a controlling financial interest or do not have sufficient equity at risk for the entity to finance its activities without additional subordinated financial support from other parties. The Company believes that the adoption of this standard will have no material impact on its financial statements.

     In November 2003, the Emerging Issues Task Force reached consensus on Issue No. 03-01 (“EITF 03-01”), “The Meaning of Other-Than-Temporary Impairment and Its Application to Certain Investments.” EITF 03-01 requires that certain quantitative and qualitative disclosures should be required for debt and marketable equity securities classified as available-for-sale or held-to-maturity under SFAS No. 115, “Accounting for Certain Investments in Debt and Equity Securities” and SFAS No. 124, “Accounting for Certain Investments Held by Not-for-Profit Organizations” that are impaired at the balance sheet date but for which an other-than-temporary impairment has not been recognized. The Company has assessed the impact of EITF 03-01 and concluded that the adoption of this issue will have no material impact on its financial statements.

Note 6. Commitments and Contingencies

Indemnifications. The Company enters into standard license agreements in its ordinary course of business. Pursuant to these agreements, the Company agrees to indemnify its customers for losses suffered or incurred by them as a result of any patent, copyright, or other intellectual property infringement claim by any third party with respect to the Company’s products. These agreements generally have perpetual terms. The maximum amount of indemnification the Company could be required to make under these agreements is generally limited to the license fees received by the Company. The Company estimates the fair value of its indemnification obligation as insignificant, based upon its history of litigation concerning product and patent infringement claims. Accordingly, the Company has no liabilities recorded for indemnification under these agreements as of June 30, 2004.

Warranties. The Company offers its customers a warranty that its software products will substantially conform to their functional specifications. To date, there have been no payments or material costs incurred related to fulfilling these warranty obligations.

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Accordingly, the Company has no liabilities recorded for these warranties as of June 30, 2004. The Company assesses the need for a warranty reserve on a quarterly basis and there can be no guarantee that a warranty reserve will not become necessary in the future.

ITEM 2.

MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS

Statements made in this section, “Management’s Discussion and Analysis of Financial Condition and Results of Operations”, other than statements of historical fact, are forward-looking statements that involve risks and uncertainties. These statements relate to products, customers, business prospects, technologies, trends and effects of acquisitions. In some cases, forward-looking statements can be identified by terminology such as “may,” “will,” “should,” “expect,” “anticipate,” “intend,” “plan,” “believe,” “estimate,” “potential,” or “continue,” the negative of these terms or other comparable terminology. Forward-looking statements are subject to a number of known and unknown risks and uncertainties which might cause actual results to differ materially from those expressed or implied by such statements. These risks include our ability to forecast our business, including our revenue, income and order flow outlook, our ability to execute on our strategy of being a provider of semiconductor IP platforms, our ability to continue to develop new products and maintain and develop new relationships with third-party foundries, integrated device manufacturers, and fabless semiconductor companies, our ability to overcome the challenges associated with establishing licensing relationships with semiconductor companies, our ability to obtain royalty revenues from customers in addition to license fees, our ability to receive accurate information necessary for calculation of royalty revenues and to collect royalty revenues from customers, business and economic conditions generally and in the semiconductor industry in particular, pace of adoption of new technologies by our customers, competition in the market for semiconductor IP platforms, and other risks and uncertainties including those set forth below under “Risk Factors”. These forward-looking statements speak only as of the date hereof, we expressly disclaim any obligation or undertaking to release publicly any updates or revisions to any forward-looking statements contained herein. The following information should be read in conjunction with the “Management’s Discussion and Analysis of Financial Condition and Results of Operations” section of the Company’s Form 10-K for the fiscal year ended September 30, 2003 filed with the Securities and Exchange Commission.

Overview

     Virage Logic provides semiconductor intellectual property (IP) platforms that are based on memory, logic, and I/Os (input/output interface components) that are silicon-proven and production ready. Virage Logic’s product portfolio provides foundries, integrated device manufacturers (IDMs) and fabless customers with key competitive advantages including higher performance, lower power, higher density and optimal yield. Virage Logic’s customers are primarily focused on the consumer, communications and networking, handheld and portable, and computer and graphics markets.

     We continue to see signs of improved business activity in the semiconductor industry which has translated into increased customer momentum for our semiconductor IP

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platforms for the 0.13 micron and 90-nanometer processes and for our Self-Test and Repair (STAR) Memory System™. As more designs move to the 0.13 micron and 90-nanometer process nodes, the capabilities offered by our STAR Memory System become more important to improve yield and time-to-market and help to reduce our customers’ overall costs.

     Our revenues continue to grow from licenses of our semiconductor IP platforms, which are based on the following products:

	•		embedded memories, including memory compilers for static RAM, register files, CAMs and non-volatile memory, as well as memory test processor and fuse box components for embedded test and repair of defective memory cells;
	•		logic elements, including Metal Programmable Cell Libraries that save configuration costs by reprogramming only a few masks and Standard Cell Libraries that deliver up to a 30% smaller area over conventional standard cell implementations; and
	•		I/O libraries, providing a rich set of I/O cells.

     In addition to licensing, royalty and maintenance revenues for our standard logic products, we also derive licensing and royalty revenues for custom design and consulting services of our logic offering.

     Our revenues are reported in two separate categories: license revenues and royalty revenues. License revenues are derived from license fees, maintenance fees, fees for custom design services, library design services and consulting services. Royalty revenues are derived from fees paid by a customer on a per-chip design basis or a third-party foundry based on production volumes of wafers containing chips utilizing our semiconductor IP technologies.

     The license of our semiconductor IP typically covers a range of embedded memory, logic and I/O products. Licenses of our semiconductor IP products can be either perpetual or term-based. In addition, maintenance can be purchased for both types of licenses. All revenues to date have been denominated in U.S. dollars.

     We derive our royalty revenues from third-party foundries, fabless customers and integrated device manufacturers that manufacture chips incorporating our Area, Speed and Power (ASAP) Memory™ products, ASAP Logic™ products, Self-Test and Repair (STAR) Memory System™, NetCAM™, NOVeA®, and Base I/O Library technologies. Royalty payments are in addition to the license fees we collect from our customers, and are calculated based on production volumes of wafers containing chips utilizing our semiconductor IP technologies based on a rate per-chip or rate per-wafer depending on the terms of the respective license agreement. Royalty revenues are generally determined and recognized one quarter in arrears, when a production volume report is received from the customer or foundry. Time delays for receiving royalty revenues are due to the typical length of time required for the customer to implement our semiconductor IP into their design, and then to manufacture and bring to market a product incorporating our products.

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     Currently, license fees represent the majority of our revenues. Royalty revenues for the three months ended June 30, 2004 and 2003 were $1.9 million and $1.1 million, respectively, and for the nine months ended June 30, 2004 and 2003 were $5.1 million and $2.2 million, respectively.

     We have been dependent on a limited number of customers for a substantial portion of our annual revenues, although that dependence continues to decrease. Our customers comprising the top 10 customer group have changed from time to time. For the three months ended June 30, 2004, Agere Systems accounted for 12% of our revenues. For the three months ended June 30, 2003, Silterra Malaysia accounted for 12% of our revenues. No single customer generated more than 10% of our revenues for the nine months ended June 30, 2004 and 2003.

Critical Accounting Policies

     The preparation of financial statements in accordance with generally accepted accounting principles in the United States requires that we make estimates and judgments, which affect the reported amounts of assets, liabilities, revenues and expenses, and related disclosures of contingent assets and liabilities. We continually evaluate our estimates, including those related to percentage-of-completion, allowance for doubtful accounts, investments, intangible assets, income taxes, and contingencies such as litigation. We base our estimates on historical experience and other assumptions that we believe are reasonable under the circumstances. Actual results may differ from these estimates under different assumptions or conditions.

     We have identified the following as critical accounting policies to our company:

•		revenue recognition
•		valuation of accounts receivable
•		valuation of long-lived assets and investments
•		valuation of purchased intangibles, including goodwill
•		accounting for stock options
•		income taxes.

Revenue Recognition

     Our revenue recognition policy follows specific and detailed guidelines and is based on the American Institute of Certified Public Accountants Statement of Position 97-2, “Software Revenue Recognition” as amended by Statement of Position 98-4, Statement of Position 98-9 and Statement of Position 81-1.

     Revenues from perpetual licenses for our semiconductor IP products are generally recognized when persuasive evidence of an arrangement exists, delivery of the product has occurred, there are no significant remaining obligations on our part, the fee is fixed or determinable, and collectability is reasonably assured. If any of these criteria are not met,

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we defer recognizing the revenue until such time as all criteria are met. Revenues from term-based licenses, which are generally twelve months in duration, are recognized ratably over the term of the license, provided the criteria mentioned above are met.

     License of custom memory compilers, logic libraries and I/Os may involve customization to the functionality of the software, therefore revenues from such licenses are recognized over the period that we perform the services. Our contracts are established as fixed fee arrangements. Revenue derived from custom products are recognized using a percentage-of-completion method or as services are performed. For all license and service agreements accounted for using the percentage-of-completion method, we determine progress-to-completion based on labor hours incurred and estimates of efforts required to complete each project. These estimates are based on the amount of work we require for comparable projects, and we believe we are able to reasonably and reliably estimate the costs to complete projects accounted for using the percentage-of-completion method. However, use of different assumptions under the percentage-of-completion method could affect our revenues and the timing of recognizing certain revenues. Alternatively, for customers’ transactions for which we cannot reasonably and reliably estimate the costs to complete a project, the completed contract method of accounting is used, such that costs are deferred until the project is completed at which time revenues are recognized. A provision for estimated losses on engagements is made in the period in which the loss becomes probable and can be reasonably estimated. Costs incurred in advance of billings are recorded as costs in excess of related billings on in-process contracts. If customer acceptance is required for completion of specified milestones, the related revenue is deferred until the acceptance criteria is met.

     For agreements which include multiple elements, we recognize revenues attributable to delivered or completed elements covered by such agreements when such elements are completed or delivered. The amount of such revenues is determined by deducting the aggregate fair value of the undelivered or uncompleted elements, which we determine by each such element’s vendor-specific objective evidence of fair value, from the total revenues recognizable under such agreement. Vendor-specific objective evidence of fair value of each element of an arrangement is based upon the normal pricing for such licensed product and service when sold separately, and for maintenance, it is determined based on the stated renewal rate in each contract. Maintenance revenues are recognized ratably over the contractual term of the maintenance period, which is generally one year.

     Amounts invoiced to our customers in excess of recognized revenues are recorded as deferred revenues. The timing and amounts invoiced to customers can vary significantly depending on specific contract terms and can therefore have a significant impact on deferred revenues in any given period.

     Royalty revenues are generally determined and recognized one quarter in arrears, when a production volume report is received from the customer or foundry, and are calculated based on actual production volumes of wafers containing chips utilizing our semiconductor IP technologies based on a rate per-chip or rate per-wafer depending on the terms of the respective license agreement. From time to time, we may exercise our audit rights under our contracts with customers to audit our licensees’ royalty records. The results of such royalty audits could result in an increase, as a result of a licensee’s underpayment, or decrease, as a result of a licensee’s overpayment, to royalty revenues. Such adjustments are recorded in the period they are determined.

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Valuation of Accounts Receivable

     We perform ongoing credit evaluations of our customers and adjust customers’ credit limits based upon payment history and the customers’ current credit worthiness, as determined by our review of their then-current credit information. We continuously monitor collections and payments from our customers and maintain an allowance for estimated credit losses based upon our historical experience and any specific customer collection risks that we have identified. While such credit losses have historically been within our expectations and the allowance we have established, we cannot guarantee that we will continue to experience the same credit loss rates that we have in the past. Since our accounts receivable are concentrated in a relatively small number of customers, a significant change in the liquidity or financial position of any one of these customers could have a material adverse impact on the quality of our accounts receivables and our future operating results.

Valuation of Long-Lived Assets and Investments

     We periodically review the carrying value of our long-lived assets and investments for continued realizability. This review is based upon our projections of anticipated future cash flows from such assets and investments. While we believe that our estimates of future cash flows are reasonable, different assumptions regarding the amount and timing of such cash flows resulting from different outlooks on the general economic condition and the state of the semiconductor industry could materially affect our evaluations. This could result in an impairment charge and have a materially adverse impact on our future operating results.

Valuation of Purchased Intangibles, Including Goodwill

     We periodically evaluate purchased intangibles, including goodwill, for impairment. An assessment of goodwill is subjective by nature, and significant management judgment is required to forecast future operating results, projected cash flows and current period market capitalization levels. If our estimates or related assumptions change in the future, these changes in conditions could require material write-downs of net intangible assets, including impairment charges for goodwill. In connection with the acquisition of In-Chip Systems Inc., the valuation of intangible assets was based on management’s estimates. Such estimates included cash flow projections, discount rates and estimated life of technology, which management believes are reasonable under the circumstances. Use of other estimates or assumptions may have resulted in a different valuation for such intangible assets acquired leading to changes in recorded asset values. Intangible assets with finite useful lives are amortized over the estimated life of each asset. As of June 30, 2004, management believes no impairment of intangible assets has occurred. The carrying value of purchased intangibles, including goodwill, is $12.6 million at June 30, 2004. If the asset is deemed impaired, the maximum amount of impairment would be the full carrying value of the asset.

Accounting for Stock Options

     We account for outstanding stock options under Accounting Principles Board (APB) Opinion No. 25, “Accounting for Stock Issued to Employees” (APB 25) and Financial Accounting Standards Board Interpretation No. 44 (FIN 44), and comply with the disclosure provisions of SFAS No. 123, “Accounting for Stock-Based Compensation”

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(SFAS 123), as amended by Statement of Financial Accounting Standards No. 148, “Accounting for Stock-based Compensation Transition and Disclosure, an Amendment of FASB 123” (SFAS 148). In accordance with APB 25, we do not recognize compensation expense for options granted to employees as all employee options are granted with an exercise price equal to the fair market value of the underlying stock at the grant date.

     The Company accounts for stock options or warrants granted to non-employees, excluding non-employee directors, under SFAS 123 and EITF Issue No. 96-18, “Accounting for Equity Instruments with Variable Terms that are Issued for Consideration Other Than Employee Services under SFAS 123.” We record the expense of such services based upon the estimated fair value of the equity instrument using the Black-Scholes pricing model. Assumptions used to value the equity instruments are consistent with equity instruments issued to employees. We charge the value of the equity instrument to earnings over the term of the service agreement. At the time all non-employee options and warrants were valued, the instruments were immediately exercisable and there were no ongoing obligations from the holders. Expenses recorded for stock options granted to non-employees for the three months ended June 30, 2004 and 2003 were $0 and $35,000, respectively, and for the nine months ended June 30, 2004 and 2003 were $0 and $790,000, respectively.

     We make estimates and assumptions for the inputs, such as interest rate, weighted average expected option life and volatility, used in the fair value calculation. Current regulatory activity indicates that stock options granted to both employees and non-employees will need to be valued at their fair value and included in operating expenses in the near future. At such time as the regulation takes effect, material differences in amounts of expense may result if different estimates and assumptions are required or if a different valuation model were to be implemented.

Income taxes

     We record the estimated future tax effects of temporary differences between the tax bases of assets and liabilities and amounts reported in the accompanying consolidated balance sheets. These differences resulted in deferred tax assets of $2.9 million and deferred tax liabilities of $1.2 million at June 30, 2004. The carrying value of the Company’s net deferred tax assets assumes that we will be able to generate sufficient future taxable income in certain tax jurisdictions, based on estimates and assumptions. Management periodically evaluates the recoverability of the deferred tax assets and recognizes the tax benefit only as reassessment demonstrates they are realizable. At such time it is determined that it is more likely than not that the deferred tax assets are not realizable, the valuation allowance is adjusted. This assessment is based on projections of future taxable income, which is impacted in future periods by income before taxes and stock option exercises. The actual taxable income realized in the future and other factors determine how much benefit the Company ultimately realizes from the deferred tax assets.

     In the event that actual results differ from the estimates or adjustments are made to the estimates used in determining the valuation allowance, an additional valuation allowance may be required, which could materially impact the Company’s financial position and results of operations.

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Results of Operations – Three and Nine Months Ended June 30, 2004 and 2003

     The following table lists the percentage of revenues for certain items in our consolidated statements of operations for the periods indicated:

     Revenues. Revenues increased by 45% to $13.9 million from $9.6 million for the three months ended June 30, 2004 and 2003, respectively, and increased by 22% to $37.7 million from $30.8 million for the nine months ended June 30, 2004 and 2003, respectively. The increase in revenues for the three and nine months ended June 30, 2004 and 2003 was due to increased license revenues from customers across all global regions and increased royalty revenue.

     License revenues increased by 40% to $11.9 million from $8.5 million for the three months ended June 30, 2004 and 2003, respectively, and increased 14% to $32.6 million from $28.6 million for the nine months ended June 30, 2004 and 2003, respectively. The increase in license revenue was primarily due to a few large agreements in each of the North America, Europe and Asia global regions. Additionally, we experienced increased sales of our 90-nanometer technology products.

     Royalties increased 73% to $1.9 million from $1.1 million for the three months ended June 30, 2004 and 2003, respectively, and 132% to $5.1 million from $2.2 million for the nine months ended June 30, 2004 and 2003, respectively. The increase was due to macroeconomic factors associated with the overall industry-wide increase in production volumes, higher number of specific products incorporating our semiconductor IP on the 0.13 micron process moving into production and increased royalties from our customers using our STAR Memory System product family as they increase production.

     For the three and nine months ended June 30, 2004 and 2003, total revenues by geography and license revenues by geometry are as follows (in thousands):

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     Sales to customers in EMEA region increased in the third quarter and first nine months of 2004 as compared to 2003 primarily due to additional license revenue from Philips Semiconductor of $1.1 million in the third quarter, $3.1 million for first nine months of 2004 and $600,000 of license revenue from a third quarter Tower arrangement. Sales to customers in the United States were higher in the third quarter of 2004, but slightly lower for the first nine months of 2004 as compared to 2003 reflecting a continuing focus on global markets, specifically continued penetration of the emerging foundries in Asia and large integrated device manufacturer customers in Europe.

     License revenues on the 90-nanometer technology products increased to 31% from 18% for the third quarter of 2004 and to 31% from 8% for the nine months ended June 30, 2004 and 2003, respectively. This increase in the 90-nanometer process node is due to higher number of design starts at this process node. Revenues for the 0.13 micron technology decreased to 45% from 48% for the third quarter of 2004 and to 48% from 55% for the nine months ended June 30, 2004 and 2003, respectively. While license revenues from 0.13 micron technology products increased in absolute dollars in the third quarter and in the first nine month of fiscal 2004, they were lower on a percentage basis as a result of the industry transition towards the 90-nanometer process node.

     Cost of Revenues. Cost of revenues consists primarily of personnel expenses and the allocation of facilities, software and equipment expenses. Cost of revenues increased 29% to $2.9 million for the third quarter of fiscal 2004 from $2.2 million in 2003 and increased 15% to $8.2 million for the first nine months of 2004 from $7.1 million for the comparable prior period as a result of higher license revenues and amortization of the purchase cost of software tools for the engineering design teams. The cost of revenues for the third quarter of fiscal 2004 also included costs associated with outsourced engineering design work specific to projects delivered during the quarter. The Company believes cost of revenues will continue to fluctuate in the future, both in absolute dollars and as a percentage of revenues, based on the percentage of customized products sold by us and the level of license revenues. Cost of revenues excludes $7,000 and $27,000 of amortization of stock-

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based compensation for the three months ended June 30, 2004 and 2003, respectively, and $29,000 and $245,000 of amortization of stock-based compensation for the nine months ended June 30, 2004 and 2003, respectively.

     Research and Development Expense. Research and development expense primarily includes personnel expense, software license and maintenance fees, and depreciation related to capital spending. Research and development expense decreased 1% to $4.6 million for the three months ended June 30, 2004 from $4.7 million for the same period last fiscal year and decreased 4% to $13.7 million for the nine months ended June 30, 2004 from $14.3 million for the comparable prior period. Research and development expense as a percentage of revenues decreased during the third quarter and the first nine months of 2004 compared to the same periods in the prior year. The decrease in research and development expense during the third quarter of 2004 and first nine months of 2004, respectively, compared to the same periods in the prior year was primarily due to lower depreciation expense of $97,000 and $257,000 resulting from fixed assets purchased in prior periods which are fully depreciated. Research and development expense was also lower for the first nine months ended June 30, 2004 as compared with the nine months ended June 30, 2003 in the amount of $453,000 in cost savings from a reduction in the number of employees involved in research and development activities as several employees’ responsibilities were re-focused to cost of revenue activities associated with the higher 2004 license revenue. Headcount directly reporting to the research and development group decreased in fiscal year 2004 to 135 at period end from 140 the prior year period. Despite the recent decrease, we anticipate that research and development expense will increase as we expand our product offerings and invest in technologies for future delivery. Research and development expense excludes $12,000 and $56,000 of amortization of stock-based compensation for the three months ended June 30, 2004 and 2003, respectively, and $49,000 and $479,000 of amortization of stock-based compensation for the nine months ended June 30, 2004 and 2003, respectively.

     Sales and Marketing Expense. Sales and marketing expense consists primarily of personnel expenses, commissions, advertising and promotion-related costs. Sales and marketing expense increased 16% to $3.9 million for the three months ended June 30, 2004 from $3.3 million for the same period last fiscal year, and increased 16% to $10.8 million for the nine months ended June 30, 2004 from $9.4 million for the comparable prior year period. Sales and marketing expense as a percentage of revenues decreased 7.1% for the three months ended June 30, 2004, and decreased 1.7% as a percentage of revenues for the nine months ended June 30, 2004 when compared with the respective periods of the prior year. Sales commissions increased $35,000 and $364,000 during the third quarter of 2004 and first nine months of 2004, respectively, compared to the same periods in the prior year due to higher revenues in fiscal 2004. While headcount increased by 1 to 53 over the respective periods, salary and related expenses increased $228,000 and $549,000 during the third quarter of 2004 and first nine months of 2004, respectively, compared to the same periods in the prior year as a result of positions, such as the Vice President of Marketing, being filled and the reinstatement of salary levels in effect prior to a 5% salary reduction effected last year. Travel expense increased $79,000 and $225,000 during the third quarter of 2004 and first nine months of 2004, respectively, compared to the same periods in the prior year as a result of increased travel to develop customer relationships internationally. Consulting expense decreased $129,000 and $142,000 during the third quarter of 2004 and first nine

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months of 2004, respectively. Combined rent and insurance costs for our global sales offices increased $94,000 and $340,000 during the third quarter of 2004 and first nine months of 2004, respectively, compared to the same periods prior year. We anticipate that sales and marketing expense will continue to increase as we expand our product lines and target new customers and markets for our technologies. Sales and marketing expense excludes $9,000 and $40,000 of amortization of stock-based compensation for the three months ended June 30, 2004 and 2003, respectively, and $37,000 and $306,000 of amortization of stock-based compensation for the nine months ended June 30, 2004 and 2003, respectively.

     General and Administrative Expense. General and administrative expense consists primarily of personnel, corporate governance and other costs associated with the management of our business. General and administrative expense increased by 55% to $1.8 million for the three months ended June 30, 2004 from $1.1 million for the same period last fiscal year and increased 33% to $4.8 million from $3.6 million for the nine months ended June 30, 2004 from the comparable prior period. General and administrative expense as a percentage of revenues increased approximately 1% for the third quarter and increased 1% for the first nine months of 2004 as compared to 2003. The increase in general and administrative expense for the third quarter of 2004 and nine months ended June 30, 2004 was due to higher payroll and related, recruiting and consulting expenses. Payroll and related costs increased $415,000 and $493,000 for the third quarter of 2004 and first nine months of 2004, respectively, compared to the same period in the prior year primarily due to headcount increase, and the reinstatement of salary levels in effect prior to a 5% salary reduction effected last year. Combined rent and insurance costs increased $84,000 and $376,000 during the third quarter of 2004 and first nine months of 2004, respectively, compared to the same periods in the prior year associated with contractual rent increases and broader insurance coverage worldwide. Consulting expense increased $70,000 and $181,000 for the third quarter of 2004 and first nine months of 2004, respectively over the comparable prior year periods, due to corporate governance matters. Recruiting expense increased $10,000 and $131,000 during the third quarter of 2004 and first nine months of 2004, respectively, compared to the same periods in the prior year related to the recruitment or replacement of several employees. We anticipate that general and administrative expense will increase as we add additional headcount in key positions and continue to incur professional service costs in preparation for compliance under Sarbanes-Oxley Section 404 regulations. General and administrative expense excludes $4,000 and $14,000 of amortization of stock-based compensation for the three months ended June 30, 2004 and 2003, respectively, and $16,000 and $123,000 of amortization of stock-based compensation for the nine months ended June 30, 2004 and 2003, respectively.

     Stock-Based Compensation. With respect to the grant of stock options and restricted stock to employees, the remaining deferred stock-based compensation was fully amortized in the third quarter of 2004 in the amount of $32,000.

     Interest Income and Other Expenses. Interest income increased to $164,000 for the three months ended June 30, 2004 from $145,000 for the same period last fiscal year. Interest income decreased $65,000 to $468,000 for the nine months ended June 30, 2004 from $533,000 the comparable prior year period. This decrease was due to the overall declining interest rate environment from fiscal year 2003 to fiscal year 2004.

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     Income Tax Provision. For the three months ended June 30, 2004, we recorded an income tax provision of $268,000 on pre-tax income of $839,000, yielding an effective tax rate of 32%. For the three months ended June 30, 2003, we recorded an income tax benefit for income taxes of $596,000 on a pre-tax loss of $1.8 million, yielding an effective tax rate of (33%). For the nine months ended June 30, 2004, we recorded an income tax provision of $82,000 on a pre-tax income of $483,000, yielding an effective tax rate of 17%. For the nine months ended June 30, 2003, we recorded an income tax benefit of $1.1 million on a pre-tax loss of $4.3 million, yielding an effective tax rate of (26%). The fiscal 2003 rates differ from the U.S. statutory rates primarily due to the impact of stock-based compensation related charges that are non-deductible for tax purposes. In fiscal 2004, the rates differ from the U.S. statutory rates primarily due to the Research and Development tax credits. The change in the effective tax rate from the three months ended June 30, 2004 to 2003 is primarily due to the smaller amount of stock-based compensation recorded in the three months ended June 30, 2004 and the change from a taxable loss position to a taxable net income position.

Liquidity and Capital Resources

     At June 30, 2004, the Company had $43.0 million in cash and cash equivalents, as compared with $38.9 million at September 30, 2003. The increase in the cash balance at June 30, 2004 was due primarily to cash provided by operating activities. Additionally, we held $20.2 million in investments at June 30, 2004 and September 30, 2003. For the three and nine months ended June 30, 2004 and 2003, operations were funded primarily from net operating cash flows.

     Net cash provided by operating activities was $3.9 million for the first nine months of fiscal 2004 and net cash provided by operating activities was $102,000 for the first nine months of fiscal 2003. Net cash provided by operating activities resulted from net income of $401,000, net income adjusted for the following items: depreciation and amortization of $2.7 million, increase in accrued expenses of $1.4 million and an increase in deferred revenues of $3.3 million resulting from a greater number of orders with deferred maintenance, offset by the net effect of the increase in income taxes receivable and income tax payable of $830,000 and an increase in accounts receivable of $3.2 million.

     Net cash used in investing activities was $1.3 million for the first nine months of 2004 and $5.1 million was provided by investing activities for the first nine months of 2003. Net cash used in investing activities was due to the maturing of $17.2 million of investments in government agency securities, offset by the purchase of $17.3 million in similar treasury investments, payment of merger-related liabilities of $500,000 and acquisitions of property and equipment of $742,000.

     Net cash provided by financing activities was $1.4 million and $765,000 for the first nine months of fiscal 2004 and 2003, respectively. Net cash provided by financing activities was primarily due to proceeds from the purchase of stock under the Company’s Employee Stock Purchase Plan in February 2004 and from the issuance of common stock upon the exercise of options by employees.

     Our future capital requirements will depend on many factors, including the rate of sales growth, market acceptance of our existing and new technologies, the amount and timing of research and development expenditures, the timing of the introduction of new technologies, expansion of sales and marketing efforts, potential acquisitions, and levels of working capital, primarily accounts receivable. There can be no assurance that additional

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equity or debt financing, if required, will be available on satisfactory terms. We believe that our current capital resources and cash generated from operations will be sufficient to meet our needs for at least the next twelve months, although we may seek to raise additional capital during that period and there can be no assurance that we will not require additional financing beyond this time frame.

     The following table summarizes our contractual obligations:

(1)		Includes $873,000, $1.1 million and $553,000, respectively, payable under the lease agreement for our corporate office lease in Fremont, California, which was extended through fiscal year 2006.
(2)		Reflects amounts payable under an agreement with a third party for the right to market certain semiconductor I/O technology developed by such third party and create, modify and market derivatives of this technology.

Risk Factors

Inability or delayed execution on our strategy to be a leading provider of semiconductor IP platforms could adversely affect our revenues and profitability.

     From inception to May 2002, primarily all of our revenues resulted from licenses to our embedded memory products. After our acquisition of In-Chip Systems, Inc. in May 2002, we were able to expand our product offering to also include logic products. In 2003, we added I/Os to our product offering to enable us to offer what we define as a semiconductor IP platform. If our strategy to be a provider of semiconductor IP platforms is not broadly accepted by potential customers or acceptance is delayed for whatever reason, our revenues and profitability could be adversely affected. In addition, our profitability could also be adversely affected due to investment of resources towards the development and/or acquisition purchase of logic and I/O products and lower than anticipated revenues from the sale of such products. Factors that could prevent us gaining market acceptance of our semiconductor IP platform include:

•		Difficulty convincing customers of our memory products to purchase other products from us;
•		Competition resulting in minority market share;
•		Inability to migrate technologies to new foundries due to less design experience;
•		Limited experience in sales and marketing of the platform strategy and knowledge of the market; and

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•

Difficulties and delays in expanding our logic and I/O product offerings.

The technology used in the semiconductor industry is rapidly changing and if we are unable to develop new technologies and adapt our existing IP to new processes, we will be unable to attract or retain customers.

     The semiconductor industry has been characterized by an increasingly rapid rate of development of new technologies and manufacturing processes, rapid changes in customer requirements, frequent product introductions and ongoing demands for greater speed and functionality. Our future success depends on our ability to develop new technologies and introduce new products to the marketplace in a timely manner, and to adapt our existing IP to satisfy the requirements of new processes and our customers. If our development efforts are not successful or are significantly delayed, or if the enhancements or new generations of our products do not achieve market acceptance, we may be unable to attract or retain customers and our operating results could be harmed.

     Our ability to continue developing technical innovations involves several risks, including:

•		our ability to anticipate and respond in a timely manner to changes in the requirements of semiconductor companies;
•		the emergence of new semiconductor manufacturing processes and our ability to enter into strategic relationships with third-party semiconductor foundries to develop and test technologies for these new processes and provide customer referrals;
•		the significant research and development investment that we may be required to make before market acceptance, if any, of a particular technology;
•		the possibility that the industry may not accept a new technology or may delay use of a new technology after we have invested a significant amount of resources to develop it; and
•		new technologies introduced by our competitors.

     If we are unable to adequately address these risks, our IP will become obsolete and we will be unable to sell our products. Further, as new technologies or manufacturing processes are announced, customers may defer licensing our IP until those new technologies become available or our IP has been adopted for that manufacturing process.

     In addition, research and development requires a significant expense and resource commitment. Since we have a limited operating history, we are unable to predict our future resources. As a result, we may not have the financial and other resources necessary to develop the technologies demanded in the future and may be unable to attract or retain customers.

Our quarterly operating results may fluctuate significantly and any failure to meet financial expectations for any fiscal quarter may cause our stock price to decline.

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     Our quarterly operating results were lower than expected in the first and second quarters of fiscal 2003 and are likely to fluctuate in the future due to a variety of factors, many of which are outside of Virage Logic’s control. Factors that could cause our revenues and operating results to vary from quarter to quarter include:

•		large orders unevenly spaced over time;
•		establishment or loss of strategic relationships with third-party semiconductor foundries;
•		pace of adoption of new technologies by customers;
•		timing of new technologies and technology enhancements by us and our competitors;
•		shifts in demand for products that incorporate our IP;
•		constrained or deferred spending decisions by customers;
•		the timing and completion of milestones under customer agreements;
•		the impact of competition on license revenues or royalty rates;
•		the cyclical nature of the semiconductor industry and the general economic environment;
•		difficulties in forecasting royalty revenues because of factors out of our control, such as the timing of manufacturing of semiconductors subject to royalty obligations and the number of such semiconductors actually produced (manufactured);
•		changes in development schedules, research and development expenditure levels and product support by us and our customers;
•		recording a significant portion of our quarterly revenues in the last month of a quarter. This is the result of closing more product orders, and therefore, a higher percentage of product shipments, in the last month of a quarter than in the first months of a quarter. Some customers believe they can enhance their bargaining power by waiting until the end of the quarter to finalize negotiations; and
•		costs associated with merger and acquisition plans that are not pursued.

     As a result, we believe that period-to-period comparisons of our results of operations are not necessarily meaningful and you should not rely on these comparisons as indications of future performance. These factors, together with the fact that our expenses are primarily fixed and independent of revenues in any particular period, make it difficult for us to accurately predict our revenues and operating results and may cause them to be below market analysts’ expectations in some future quarters, which could cause the market price of our stock to decline significantly, as happened in connection with our operating results for the first and second quarters of fiscal 2003.

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Our international operations may be adversely affected by instability in the countries in which we operate.

     We currently have subsidiaries or branches in Armenia, India, the United Kingdom, Israel, Germany and Japan. In addition, a significant portion of our IP is being developed in development centers located in the Republic of Armenia and India. Israel continues to face an increased level of violence and terror, India is experienced rising costs and Armenia, only independent since 1991, has suffered significant political and economic instability. Accordingly, continued and heightened unrest in areas of the world in which we operate may adversely affect our business in a number of ways, including the following:

•		changes in the political or economic conditions in Armenia and India and the surrounding region, such as fluctuations in exchange rates, changes in laws protecting IP, the imposition of currency transfer restrictions or limitations, or the adoption of burdensome trade or tax policies, procedures, rules, regulations or tariffs, could adversely affect our ability to develop new products, to take advantage of the cost savings associated with operations in Armenia and India, and to otherwise conduct business effectively in Armenia and India;
•		our ability to continue conducting business in Israel and other countries in the normal course may be adversely affected by increased risk of social and political instability and our employees working and visiting in Israel may be affected by terrorist attacks;
•		our Israeli customers’ demand for our products may be adversely affected because of negative economic consequences associated with reduced levels of safety and security in Israel.

General economic conditions and future terrorist attacks may reduce our revenues and harm our business.

     As our business has grown, we have become increasingly subject to the risks arising from adverse changes in domestic and global economic conditions. As a result of the recent economic slowdown in the United States and in other parts of the world, many industries are still delaying or reducing technology purchases and investments and similarly, our customers may delay payment for Virage Logic products causing our accounts receivable to increase. In addition, continued unrest in Israel and the Middle East may negatively impact the investments our worldwide customers make in these geographic regions. The impact of this slowdown on us is difficult to predict, but if businesses or consumers defer or cancel purchases of new products that contain complex semiconductors, purchases by fabless semiconductor companies and integrated device manufacturers and production levels by semiconductor manufacturers could decline causing our revenues to be adversely affected, which would have an adverse effect on our results of operations and could have an adverse effect on our financial condition.

If we are unable to maintain existing relationships and develop new relationships with third-party semiconductor manufacturers, or foundries, we will be unable to verify our technologies on their processes and license our IP to them or their customers.

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     Our ability to verify our technologies for new manufacturing processes depends on entering into development agreements with third-party foundries to provide us with access to these processes. In addition, we rely on third-party foundries to manufacture our silicon test chips, to provide referrals to their customer base and to define the focus of our research and development activities. We currently have agreements with Taiwan Semiconductor Manufacturing Company (TSMC), United Microelectronics Corporation (UMC), Chartered Semiconductor Manufacturing (Chartered), Tower Semiconductor (Tower), Silterra Malaysia (Silterra), Semiconductor Manufacturing International Corporation (SMIC) and DongbuAnam Semiconductor. If we are unable to maintain our existing relationships with these foundries or enter into new agreements with other foundries, we will be unable to verify our technologies for their manufacturing processes and our ability to develop products for emerging technologies will be hampered. We would then be unable to license our IP to fabless semiconductor companies that use these foundries to manufacture their silicon chips, which is a significant source of our revenues.

If demand for products incorporating complex semiconductors and semiconductor IP platforms does not increase, our business may be harmed.

     Our business and the adoption and continued use of our IP by semiconductor companies depends on the demand for products requiring complex semiconductors, embedded memories and logic elements, such as cellular and digital phones, pagers, PDAs, digital cameras, DVD players, switches and modems. The demand for such products is uncertain and difficult to predict. A reduction in the demand for products incorporating complex semiconductors and semiconductor IP or in the general economic environment which results in the cutback of research and development budgets or capital expenditures would likely result in a reduction in demand for our products and could harm our business.

     In addition, the semiconductor industry is highly cyclical and has fluctuated between significant economic downturns characterized by diminished demand, accelerated erosion of average selling prices and production overcapacity, as well as periods of increased demand and production capacity constraints. Until recently, the semiconductor industry has been experiencing a downturn during a significant economic slowdown resulting in lower levels of technology expenditures by businesses and individuals. As a result of such fluctuations in the semiconductor industry and the general economic slowdown, we may face a reduced number of design starts, tightening of customers’ operating budgets, extensions of the approval process for new orders and projects and consolidation among our customers, all of which may harm the demand for our products and may cause us to experience substantial period-to-period fluctuations in our operating results. Further, the markets for third-party semiconductor IP have emerged only in recent years. Because of the recent emergence of these markets, it is difficult to forecast whether these markets will continue to develop or grow at a rate sufficient to support our business.

Problems associated with international business operations could affect our ability to license our IP.

     Sales to customers located outside North America accounted for 52%, 44% and 42% of our revenues for fiscal years 2003, 2002, and 2001, respectively. For the three months ended June 30, 2004 and 2003, sales to customers located outside North America accounted for 51% and 52% of our revenues, respectively, and for the nine months ended June 30, 2004 and 2003, accounted for 61% and 53% of our revenues, respectively. We

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anticipate that sales to customers located outside North America will increase and will continue to represent a significant portion of our total revenues in future periods. In addition, most of our customers that do not own their own fabrication plants rely on third-party foundries located outside of North America. Accordingly, our operations and revenues are subject to a number of risks associated with doing business in international markets, including the following:

•		managing foreign distributors and sales partners and sharing revenues with such third parties;
•		staffing and managing foreign branch offices and subsidiaries;
•		political and economic instability;
•		international conflicts or other crises, such as the outbreak of Severe Acute Respiratory Syndrome, or SARS;
•		greater difficulty in collecting account receivables resulting in longer collection periods;
•		foreign currency exchange fluctuations;
•		changes in tax laws and tariffs;
•		compliance with, and unexpected changes in, a wide variety of foreign laws and regulatory environments with which we are not familiar;
•		timing and availability of export licenses;
•		inadequate protection of IP rights in some countries; and
•		obtaining governmental approvals for certain technologies.

     If these risks actually materialize, our international operations may be adversely affected and sales to international customers, as well as those domestic customers that use foreign fabrication plants, may decrease.

If we are unable to continue establishing relationships with semiconductor companies to license our IP, our business will be harmed.

     We currently rely on license fees from the sale of perpetual and term licenses to generate a large portion of our revenues. These licenses produce large amounts of revenue in the periods in which the license fees are recognized, but are not necessarily indicative of a commensurate level of revenue from the same customers in future periods. In addition, our agreements with our customers do not obligate them to license new or future generations of our IP. As a result, the growth of our business depends significantly on our ability to expand our business with existing customers and attract new customers.

     We face numerous challenges in entering into license agreements with semiconductor companies on terms beneficial to our business, including:

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•		the lengthy and expensive process of building a relationship with a potential licensee;
•		competition with the internal design teams of semiconductor companies; and
•		the need to persuade semiconductor companies to rely on us for critical technology.

     These factors may make it difficult for us to maintain our current relationships or establish new relationships with additional licensees. Further, there are a finite number of fabless semiconductor companies and integrated device manufacturers to which we can license our IP. If we are unable to establish and maintain these relationships, we will be unable to generate license fees, and our revenues will decrease.

If we are unsuccessful in increasing our royalty revenues, our revenues and profitability may not be as large as we anticipate.

     We have historically generated revenues almost entirely from license fees. We have agreements with certain third-party semiconductor foundries to pay us royalties on their sales of silicon chips they manufacture for our fabless customers. Beginning with our STAR Memory System, CAM technologies and more recently with the introduction of our NOVeA technology, in addition to collecting royalties from third-party semiconductor foundries, we intend to increase our royalty base by collecting royalties directly from our integrated device manufacturer and fabless customers. For the three months ended June 30, 2004 and 2003, we recorded royalty revenues of approximately $1.9 million and $1.1 million, respectively and for the nine months ended June 30, 2004 and 2003, royalties were $5.1 million and $2.2 million, respectively. The continued growth of our revenues depends in part on increasing our royalty revenues, but we may not be successful in convincing all customers to agree to pay us royalties. Recently we have completed agreements whereby significant upfront license fees are reduced or limited in exchange for higher royalty rates, which should result in future royalty revenues. Additionally, these royalty arrangements may not provide us with the anticipated benefits as sales of products incorporating our IP may not offset lower license fees. Many factors beyond our control, such as fluctuating sales volumes of products that incorporate our IP, potential slow down for manufacturing of certain newer process technology, foundry rate adjustments, the cyclical nature of the semiconductor industry that affects the number of designs, commercial acceptance of these products, accuracy of revenue reports and difficulties in the royalty collection process, all impact our ability to forecast our royalty revenues.

It is difficult for us to verify royalty amounts owed to us under our licensing arrangements, and this may cause us to lose revenues.

     The standard terms of our license agreements require our licensees to document the manufacture and sale of products that incorporate our technology and report this data to us on a quarterly basis. While standard license terms give us the right to audit the books and records of our licensees to verify this information, audits can be expensive, time consuming and potentially detrimental to our ongoing business relationship with our licensees. Our failure to audit our licensees’ books and records may result in us receiving more or less royalty revenue than we are entitled to under the terms of our license agreements. The results of such audits could also result in an increase, as a result of a licensees’ underpayment, or decrease, as a result of a licensees’ overpayment, to royalty revenues. Such adjustments are recorded in the period they are determined. Any adverse

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material adjustments resulting from royalty audits may cause our revenues and operating results to be below market expectations, which could cause our stock price to decline. The royalty audit may also trigger disagreements over contract terms with our licensees and such disagreements could hamper customer relations, divert the efforts and attention of our management from normal operations and impact our business operations.

We have a long and variable sales cycle, which can result in uncertainty and delays in generating additional revenues.

     Historically, because of the complexity of our products, it can take a significant amount of time and effort to explain the benefits of our products and to negotiate a sale. For example, it generally takes at least three to nine months after our first contact with a prospective customer before we start licensing our IP to that customer. In addition, purchase of our products is usually made in connection with new design starts, which are out of our control. Accordingly, we may be unable to predict accurately the timing of any significant future sales of our products. We may also spend substantial time and management attention on potential license agreements that are not consummated, thereby foregoing other opportunities.

We rely on a small number of customers for a substantial portion of our revenues and our accounts receivables are concentrated among a small number of customers.

     We have been dependent on a limited number of customers for a substantial portion of our annual revenues in each fiscal year, although the customers comprising this group have changed from time to time. For the three months ended June 30, 2004, Agere Systems accounted for 12% of revenues. For the three months ended June 30, 2003, Silterra Malaysia accounted for 12% of revenues. No single customer generated more than 10% of our revenues for the nine months ended June 30, 2004 and 2003. Since fiscal year 2001, our five largest customers have represented between 25-45% of our revenues. The license agreements we enter into with our customers do not obligate them to license future generations of our IP and, as a result, we cannot predict if and when they will purchase additional products from us. As a result of this customer concentration, we could experience a dramatic reduction in our revenues if we lose one or more of our significant customers and are unable to replace them. In addition, since our accounts receivable are concentrated in a relatively small number of customers, a significant change in the liquidity, financial position, or issues regarding timing of payments of any one of these customers could have a material adverse impact on the collectability of our accounts receivables, historical revenues recorded and our future operating results.

The market for semiconductor IP platforms is highly competitive, and we may lose market share to larger competitors with greater resources and to companies that develop their semiconductor IP platforms using internal design teams.

     We face competition from both existing suppliers of third-party semiconductor IP as well as new suppliers that may enter the market. We also compete with the internal design teams of large, integrated device manufacturers. Many of these internal design teams have substantial programming and design resources and are part of larger organizations with substantial financial and marketing resources. These internal teams may develop technologies that compete directly with our technologies or may actively seek to license

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their own technologies to third parties, which could negatively affect our revenue and operating results.

     Many of our existing competitors have longer operating histories, greater brand recognition and larger customer bases, as well as greater financial and marketing resources, than we do. This may allow them to respond more quickly than we can to new or emerging technologies and changes in customer requirements. It may also allow them to devote greater resources than we can to the development and promotion of their products. In addition, the intense competition in the market for semiconductor IP could result in pricing pressures, reduced license revenues, reduced margins or lost market share, any of which could harm our operating results and cause our stock price to decline.

Our stock price may be volatile and could decline substantially.

     The market price of our common stock has fluctuated significantly in the past, will likely continue to fluctuate in the future and may decline. Fluctuations or a decline in our stock price may occur regardless of our performance. Among the factors that could affect our stock price, in addition to our performance, are:

•		variations between our operating results and the published expectations of securities analysts;
•		changes in financial estimates or investment recommendations by securities analysts following our business;
•		announcements by us or our competitors of significant contracts, new products or services, acquisitions, or other significant transactions;
•		sale of our common stock or other securities in the future;
•		the inclusion or exclusion of our stock in various indices or investment categories, especially as compared to the investment profiles of our stockholders at a given time;
•		changes in economic and capital market conditions;
•		changes in business regulatory conditions; and
•		the trading volume of our common stock.

We may be unable to attract and retain key personnel who are critical to the success of our business.

     We believe that one of our significant competitive advantages is the size and quality of our engineering team. Our future success also depends on our ability to attract and retain engineers and other highly skilled personnel and senior managers. In addition, in order to meet our planned growth we must increase our sales force, both domestic and international, with qualified employees. Hiring qualified technical, sales and management personnel is difficult due to a limited number of qualified professionals and competition in our industry for these types of employees. We have in the past experienced delays and difficulties in recruiting and retaining qualified technical and sales personnel and believe

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that at times our employees are recruited aggressively by our competitors and start-up companies. Our employees are “at will” and may leave our employment at any time, and under certain circumstances, start-up companies can offer more attractive stock option packages than we offer. As a result, we may experience significant employee turnover. Failure to attract and retain personnel, particularly sales and technical personnel would make it difficult for us to develop and market our technologies.

     In addition, our business and operations are substantially dependent on the performance of our key personnel, including Adam A. Kablanian, our President and Chief Executive Officer, and Alexander Shubat, our Vice President of Research and Development and Chief Technical Officer. We do not have formal employment agreements with Mr. Kablanian or Dr. Shubat and do not maintain “key man” life insurance policies on their lives. If Mr. Kablanian or Dr. Shubat were to leave or become unable to perform services for our company, our business would be severely harmed.

We may be unable to deliver our customized memory, logic and I/O products in the time-frame demanded by our customers, which could damage our reputation and future sales.

     A portion of our contracts require us to provide customized products to our customers within a specified delivery timetable. While we have experienced delays in delivering product to our customers, the duration of these delays was sufficiently short in length so as to not materially damage our relationship with our customers. Furthermore, these delays did not result in a material impact on our operations. However, any failure to meet significant customer milestones could damage our reputation in our industry and harm our ability to attract new customers.

We may need additional capital that may not be available to us and, if raised, may dilute our stockholders’ ownership interest in us.

     We may need to raise additional funds to develop or enhance our technologies, to fund expansion, to respond to competitive pressures or to acquire complementary products, businesses or technologies. Additional financing may not be available on terms that are acceptable to us. If we raise additional funds through the issuance of equity or convertible debt securities, the percentage ownership of our stockholders would be reduced and these securities might have rights, preferences and privileges senior to those of our current stockholders. If adequate funds are not available on acceptable terms, our ability to fund our expansion, take advantage of unanticipated opportunities, develop or enhance our products or services, or otherwise respond to competitive pressures would be significantly limited.

We may have difficulty sustaining profitability and may experience additional losses in the future.

     For the recent three month periods ended June 30, 2004, and March 31, 2004 we recorded net income of $571,000 and $189,000 respectively, following five quarters of consecutive net losses. In fiscal year 2002, we recorded our first profitable year of operations. The losses recorded in fiscal 2003 and the first quarter of 2004 were due principally to fewer project design starts by fabless semiconductor customers on the 0.13 micron technology and the slow-down in industry adoption of the 90-nanometer process

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technology. Continued losses would prevent us from being able to fully utilize our deferred tax asset therefore resulting in the need for a valuation allowance to be recorded. In order to maintain and improve our profitability, we will need to continue to generate new sales while controlling our costs. As we plan on continuing the growth of our business while implementing cost control measures, we may not be able to successfully generate enough revenues to remain profitable with this growth. Any failure to increase our revenues and control costs as we pursue our planned growth would harm our profitability and would likely negatively affect the market price of our stock.

If we are required to record compensation expense in connection with stock option grants, our profitability may be reduced significantly.

The Financial Accounting Standards Board (“FASB”) has recently proposed an accounting standard that will require the fair value of all equity-based awards granted to employees be recognized in the income statement as compensation expense. The various methods for determining the fair value of stock options are based on, among other things, the volatility of the underlying stock. Our stock price has historically been volatile. Therefore, the adoption of an accounting standard requiring companies to expense stock options could negatively affect our profitability and may adversely affect our stock price. Such adoption could also limit our ability to continue to use stock options as an incentive and retention tool, which could, in turn, hurt our ability to recruit employees and retain existing employees. FASB is expected to issue final rules on stock option expensing in late 2004. We will continue to monitor FASB’s progress on the issuance of this standard.

If we are unable to effectively manage our growth, our business may be harmed.

     Our future success depends on our ability to successfully manage our growth. Our ability to manage our business successfully in a rapidly evolving market requires an effective planning and management process. Our customers rely heavily on our technological expertise in designing and testing our products. Relationships with new customers may require significant engineering resources. As a result, any increase in the demand for our products will increase the strain on our personnel, particularly our engineers.

     Our historical growth, international expansion, and the acquisition of In-Chip Systems, Inc. in May 2002, have placed, and are expected to continue to place, a significant strain on our managerial and financial resources as well as our limited financial and management controls, reporting systems and procedures. Although some new controls, systems and procedures have been implemented, our future growth, if any, will depend on our ability to continue to implement and improve operational, financial and management information and control systems on a timely basis, together with maintaining effective cost controls. Our inability to manage any future growth effectively would be harmful to our revenues and profitability.

Any acquisitions we make may not provide us the expected benefits and could disrupt our business and harm our financial condition.

     We acquired In-Chip Systems, Inc. in May 2002, and we may continue to acquire businesses or technologies that we believe are a strategic fit with our business. The In-Chip acquisition as well as other future acquisitions may result in unforeseen operating

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difficulties and expenditures and may absorb significant management attention that would otherwise be available for ongoing development of our business. In addition, the integration of the business of In-Chip and of other acquisition targets may prove to be more difficult than expected, and we may be unsuccessful in maintaining and developing relations with the employees, customers and business partners of In-Chip and other acquisition targets. Since we will not be able to accurately predict these difficulties and expenditures, it is possible that these costs may outweigh the value we realize from a future acquisition. Future acquisitions could result in issuances of equity securities that would reduce our stockholders’ ownership interest, the incurrence of debt, contingent liabilities, deferred stock based compensation or expenses related to the valuation of goodwill or other intangible assets and the incurrence of large, immediate write-offs.

If we are not able to protect our IP adequately, we will have less proprietary technology to license, which will reduce our revenues and profits.

     Our patents, copyrights, trademarks, trade secrets and other IP are critical to our success. We rely on a combination of patent, trademark, copyright, mask work and trade secret laws to protect our proprietary rights. We cannot be sure that the U.S. Patent and Trademark Office will issue patents or trademark registrations for any of our pending applications. Further, any patents or trademark rights that we hold or may hold in the future may be challenged, invalidated or circumvented or may not be of sufficient scope or strength to provide meaningful protection or any commercial advantage to us. We have not attempted to secure patent protection in foreign countries, and the laws of some foreign countries may not adequately protect our IP as well as the laws of the United States. Also, the portion of our IP developed outside of the United States may not receive the same copyright protection that it would receive if it was developed in the United States. As we increase our international presence, we expect that it will become more difficult to monitor the development of competing technologies that may infringe on our rights as well as unauthorized use of our technologies.

     We use licensing agreements, confidentiality agreements and employee nondisclosure and assignment agreements to limit access to and distribution of our proprietary information and to obtain ownership of technology prepared on a work-for-hire basis. Even though we have taken all customary industry precautions, we cannot be sure that we have taken adequate steps to protect our IP rights and deter misappropriation of these rights or that we will be able to detect unauthorized uses and take immediate or effective steps to enforce our rights. Since we also rely on unpatented trade secrets to protect some of our proprietary technology, we cannot be certain that others will not independently develop or otherwise acquire the same or substantially equivalent technologies or otherwise gain access to our proprietary technology or disclose that technology. We also cannot be sure that we can ultimately protect our rights to our unpatented proprietary technology. In addition, third parties might obtain patent rights to such unpatented trade secrets, which they could use to assert infringement claims against us.

Third parties may claim we are infringing or assisting others to infringe their IP rights, and we could suffer significant litigation or licensing expenses or be prevented from licensing our technology.

     While we do not believe that any of our technology infringes the valid IP rights of third parties, we may be unaware of IP rights of others that may cover some of our technology.

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As a result, third parties may claim we or our customers are infringing their IP rights. Our license agreements typically require us to indemnify our customers for infringement actions related to our technology.

     Any litigation regarding patents or other IP could be costly and time-consuming, and divert our management and key personnel from our business operations. The complexity of the technology involved makes any outcome uncertain. If we do not prevail in any infringement action, we may be required to pay significant damages and may be prevented from developing some of our technology or from licensing some of our IP for certain manufacturing processes unless we enter into a royalty or license agreement. In addition, if challenging a claim is not feasible, we might be required to enter into royalty or license agreements in order to settle a claim and continue to license or develop our IP, which may result in significant expenditures. We may not be able to obtain such agreements on terms acceptable to us or at all, and thus, may be prevented from licensing or developing our technology.

Changes to accounting standards and rules could either delay our recognition of revenues or reduce the amount of revenues that we may recognize at a specific time, and thus defer or reduce our profitability. These effects on our reported results could cause our stock price to be lower than it otherwise might have been.

     We adopted the American Institute of Certified Public Accountants’ Statement of Position, or SOP, 97-2, “Software Revenue Recognition,” as of October 1, 1998. In December 1998, the American Institute of Certified Public Accountants issued SOP 98-9, “Modification of SOP 97-2, Software Revenue Recognition, with Respect to Certain Transactions.” We implemented these provisions as of October 1, 1999. In December 1999, the Securities and Exchange Commission issued SEC Staff Accounting Bulletin No. 101, “Revenue Recognition in Financial Statements” which summarizes certain of the SEC’s views in applying generally accepted accounting principles to revenue recognition in financial statements. Additional accounting guidance or pronouncements in the future could affect the timing of our revenue recognition in the future, which could cause our operating results to fail to meet the expectations of investors and securities analysts. In addition, changes to accounting policies that affect other aspects of our business, such as employee stock option grants may adversely affect our reported financial results.

Item 3. Quantitative and Qualitative Disclosures about Market Risk

     Our core business, the sale of semiconductor IP for the design and manufacture of system-on-a-chip integrated circuits, has limited exposure to financial market risks, including changes in foreign currency exchange rates and interest rates. A significant portion of our customers are located in Asia, Canada and Europe. However, to date, our exposure to foreign currency exchange fluctuations has been minimal because all of our license agreements provide for payment in U.S. dollars.

     Our foreign subsidiaries incur most of their expenses in the local currency. Our international business is subject to risks typical of an international business, including, but not limited to differing economic conditions, changes in political climate, differing tax structures, other regulations and restrictions and foreign exchange rate volatility. International operations have not been material, therefore, we do not anticipate our future results to be materially adversely impacted by changes in these factors.

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     We maintain an investment portfolio of various issuers, types and maturities. These securities are generally classified as available-for-sale and, consequently, are recorded on the balance sheet at fair value with unrealized gains or losses reported as a separate component of stockholders’ equity. Our investments primarily consist of short-term money market mutual funds, United States government obligations and mortgage-backed securities and commercial paper. Our investments balance of $9.6 million at June 30, 2004 consists of instruments with original maturities of less than one year. Due to the short-term nature of these investments, we do not believe our investment balance is materially exposed to interest rate risk. We also hold $10.6 million in U.S. government obligations with maturities up to two years.

Item 4. Controls and Procedures

     An evaluation was performed under the supervision and with the participation of our management, including the President and Chief Executive Officer along with the Chief Financial Officer, of the effectiveness of the design and operation of our disclosure controls and procedures as of the end of the period covered by this quarterly report. Based on that evaluation, the Company’s management, including the President and Chief Executive Officer along with the Chief Financial Officer, concluded that the Company’s disclosure controls and procedures were effective. There have been no significant changes in the Company’s internal controls or in other factors that could significantly affect internal controls subsequent to their evaluation. We intend to review and evaluate the design and effectiveness of our disclosure controls and procedures on an ongoing basis and to improve our controls and procedures over time and to correct any deficiencies that we may discover in the future. Our goal is to ensure that our senior management has timely access to all material financial and non-financial information concerning our business. While we believe the present design of our disclosure controls and procedures is effective to achieve our goal, future events affecting our business may cause us to significantly modify our disclosure controls and procedures.

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PART II - OTHER INFORMATION

ITEM 1. Legal Proceedings

     None

ITEM 2. Changes in Securities and Use of Proceeds

     None

ITEM 3. Defaults upon Senior Securities

     None

ITEM 4. Submission of Matters to a Vote of Security Holders

     None

ITEM 5. Other Information

     None

ITEM 6. Exhibits and Reports on Form 8-K

(a)

Exhibits:

	31.1		Certification Pursuant to Rule 15d-14 of the Securities and Exchange Act as amended, as Pursuant to Section 302 of the Sarbanes-Oxley Act of 2002
	31.2		Certification Pursuant to Rule 15d-14 of the Securities and Exchange Act as amended, as Pursuant to Section 302 of the Sarbanes-Oxley Act of 2002
	32.1		Certification Pursuant to 18 U.S.C. Section 1350, as Adopted Pursuant to Section 906 of the Sarbanes-Oxley Act of 2002
	32.2		Certification Pursuant to 18 U.S.C. Section 1350, as Adopted Pursuant to Section 906 of the Sarbanes-Oxley Act of 2002

(b)		Reports on Form 8-K
		The registrant furnished a Current Report on Form 8-K on April 20, 2004 to provide its earnings release for the second fiscal quarter of fiscal 2004.

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SIGNATURES

Pursuant to the requirements of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned thereunto duly authorized.

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EXHIBIT INDEX

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