10-Q

UNITED STATES SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

FORM 10-Q

(Mark One)
ý	QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(D) OF THE SECURITIES EXCHANGE ACT OF 1934
For the Quarterly Period Ended March 31, 2004
OR
o	TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(D) OF THE SECURITIES EXCHANGE ACT OF 1934
For the transition period from                 to

Commission file number 1-13317

DOT HILL SYSTEMS CORP.

(Exact name of registrant as specified in its charter)

Delaware	13-3460176
(State or other jurisdiction of incorporation or organization)	(I.R.S. Employer Identification No.)
6305 El Camino Real, Carlsbad, CA	92009
(Address of principal executive offices)	(Zip Code)
(760) 931-5500
(Registrant’s telephone number, including area code)
(Former name, former address and former fiscal year, if changed since last report)

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 ý  No o

Indicate by check mark whether the registrant is an accelerated filer (as defined in Rule 12b-2 of the Securities Exchange Act of 1934). Yes ý  No o

The registrant had 43,374,347 shares of common stock, $0.001 par value, outstanding as of May 4, 2004.

DOT HILL SYSTEMS CORP.

FORM 10-Q

For the Quarter Ended March 31, 2004

INDEX

Part I. Financial Information
Item 1.	Financial Statements
	Condensed Consolidated Balance Sheets-December 31, 2003 and March 31, 2004
	Condensed Consolidated Statements of Operations and Comprehensive Operations-Three months ended March 31, 2003 and 2004
	Condensed Consolidated Statements of Cash Flows-Three months ended March 31, 2003 and 2004
	Notes to Condensed Consolidated Financial Statements
Item 2.	Management’s Discussion and Analysis of Financial Condition and Results of Operations
Item 3.	Quantitative and Qualitative Disclosures About Market Risk
Item 4.	Controls and Procedures
Part II. Other Information
Item 1.	Legal Proceedings
Item 2.	Changes in Securities and Use of Proceeds
Item 3.	Defaults Upon Senior Securities
Item 4.	Submission of Matters to a Vote of Security Holders
Item 5.	Other Information
Item 6.	Exhibits and Reports on Form 8-K
Signatures

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Part I.  Financial Information

Item 1.  Financial Statements

DOT HILL SYSTEMS CORP. AND SUBSIDIARIES

CONDENSED CONSOLIDATED BALANCE SHEETS

(In Thousands Except Per Share Amounts)

(Unaudited)

	December 31, 2003			March 31, 2004
ASSETS
Current Assets:
Cash and cash equivalents	$	138,563		$	82,614
Short-term investments	52,982			44,388
Accounts receivable, net of allowance of $467 and $727	14,558			20,643
Inventories	3,158			3,596
Prepaid expenses and other	1,836			2,213
Total current assets	211,097			153,454
Property and equipment, net	4,791			7,392
Goodwill	343			57,111
Other intangible assets, net	—			9,949
Other assets	2,212			1,329
Total assets	$	218,443		$	229,235
LIABILITIES AND STOCKHOLDERS’ EQUITY
Current Liabilities:
Accounts payable	$	24,533		$	29,466
Accrued compensation	4,459			1,920
Accrued expenses	2,052			4,327
Deferred revenue	1,028			1,337
Income taxes payable	1,005			952
Current portion of restructuring accrual	370			375
Total current liabilities	33,447			38,377
Restructuring accrual, net of current portion	554			386
Note payable	—			6,000
Accrued interest	—			994
Borrowings under lines of credit	247			234
Other long-term liabilities	62			975
Total liabilities	34,310			46,966
Commitments and Contingencies (Note 12)
Stockholders’ Equity:
Preferred stock, $0.001 par value, 10,000 shares authorized, no shares issued or outstanding	—			—
Common stock, $0.001 par value, 100,000 shares authorized, 43,307 and 43,316 shares issued and outstanding at December 31, 2003 and March 31, 2004, respectively	43			43
Additional paid-in capital	275,827			275,851
Deferred compensation	(28		)	(23		)
Accumulated other comprehensive loss	(263		)	(273		)
Accumulated deficit	(91,446		)	(93,329		)
Total stockholders’ equity	184,133			182,269
Total liabilities and stockholders’ equity	$	218,443		$	229,235

See accompanying notes to condensed consolidated financial statements.

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DOT HILL SYSTEMS CORP. AND SUBSIDIARIES

CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS

AND COMPREHENSIVE OPERATIONS

(In Thousands, Except Per Share Amounts)
(Unaudited)

	Three Months Ended March 31,
	2003			2004
Net Revenue	$	30,522		$	48,781
Cost of Goods Sold	24,985			35,278
Gross Profit	5,537			13,503
Operating Expenses:
Sales and marketing	3,422			4,615
Research and development	2,057			4,371
General and administrative	1,459			2,314
In-process research and development	—			4,700
Total operating expenses	6,938			16,000
Operating Loss	(1,401		)	(2,497		)
Other Income (Expense):
Interest income	26			574
Interest expense	(47		)	(141		)
Gain (loss) on foreign currency transactions, net	(18		)	167
Other expense, net	(24		)	(21		)
Total other income (expense), net	(63		)	579
Loss Before Income Taxes	(1,464		)	(1,918		)
Income Tax Benefit	—			35
Net Loss	$	(1,464	)	$	(1,883	)
Net Loss Attributable to Common Stockholders:
Net loss	$	(1,464	)	$	(1,883	)
Dividends on preferred stock	(105		)	—
Net loss attributable to common stockholders	$	(1,569	)	$	(1,883	)
Net Loss Per Share:
Basic	$	(0.06	)	$	(0.04	)
Diluted	$	(0.06	)	$	(0.04	)
Weighted Average Shares Used to Calculate Net Loss Per Share:
Basic	26,147			43,315
Diluted	26,147			43,315
Comprehensive Operations:
Net loss	$	(1,464	)	$	(1,883	)
Foreign currency translation adjustments	(86		)	(7		)
Net unrealized loss on short-term investments	—			(3		)
Comprehensive loss	$	(1,550	)	$	(1,893	)

See accompanying notes to condensed consolidated financial statements.

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DOT HILL SYSTEMS CORP. AND SUBSIDIARIES

CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS

(In Thousands)
(Unaudited)

	Three Months Ended March 31,
	2003			2004
Cash Flows From Operating Activities:
Net loss	$	(1,464	)	$	(1,883	)
Adjustments to reconcile net loss to net cash provided by (used in) operating activities:
Depreciation and amortization	499			872
Write-off of in-process research and development	—			4,700
Loss on disposal of property and equipment	27			—
Provision for doubtful accounts and note receivable	191			(99		)
Stock-based compensation expense	5			5
Gain on sale of short-term investments	—			(15		)
Changes in operating assets and liabilities (net of effects of Chaparral acquisition):
Accounts receivable	(5,929		)	(4,217		)
Inventories	199			517
Prepaid expenses and other assets	(82		)	653
Accounts payable	4,482			3,607
Accrued compensation and expenses	569			(1,470		)
Deferred revenue	(125		)	31
Income taxes payable	(85		)	(53		)
Restructuring accrual	(107		)	(163		)
Other liabilities	(2		)	913
Net cash provided by (used in) operating activities	(1,822		)	3,398
Cash Flows From Investing Activities:
Purchases of property and equipment	(846		)	(2,574		)
Sales of short-term investments	—			19,090
Purchases of short-term investments	—			(10,484		)
Cash paid in Chaparral acquisition, net of cash acquired	—			(65,383		)
Net cash used in investing activities	(846		)	(59,351		)
Cash Flows From Financing Activities:
Decrease in restricted cash and investments	2,000			—
Proceeds from bank and other borrowings	14,253			11,407
Payments on bank and other borrowings	(18,785		)	(11,420		)
Proceeds from issuance of common stock and stock warrants, net of issuance costs	16,543			—
Proceeds from exercise of stock options	215			24
Net cash provided by financing activities	14,226			11
Effect of Exchange Rate Changes on Cash	(86		)	(7		)
Net Increase (Decrease) in Cash and Cash Equivalents	11,472			(55,949		)
Cash and Cash Equivalents, beginning of period	10,082			138,563
Cash and Cash Equivalents, end of period	$	21,554		$	82,614
Supplemental Disclosures of Cash Flow Information:
Cash paid for interest	$	41		$	33
Cash paid for income taxes	$	85		$	17
Supplemental Disclosures of Non Cash Investing and Financing Activities:
Dividends payable on preferred stock	$	105		$	—

See accompanying notes to condensed consolidated financial statements.

5

DOT HILL SYSTEMS CORP. AND SUBSIDIARIES

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

(Unaudited)

1.Basis of Presentation

The accompanying unaudited condensed consolidated financial statements have been prepared by Dot Hill Systems Corp. (“Dot Hill”, “we”, “our” or “us”) pursuant to the rules and regulations of the Securities and Exchange Commission (the “SEC”). Accordingly, they do not include all of the information and disclosures required by accounting principles generally accepted in the United States of America for complete financial statements. In the opinion of management, all adjustments and reclassifications considered necessary for a fair and comparable presentation have been included and are of a normal recurring nature. Certain reclassifications have been made to the prior year financial statements to conform with the current year financial statement presentation. The unaudited condensed consolidated financial statements should be read in conjunction with the audited consolidated financial statements and notes thereto included in our Annual Report on Form 10-K for the year ended December 31, 2003. Operating results for the three months ended March 31, 2004 are not necessarily indicative of the results that may be expected for the year ending December 31, 2004.

The preparation of our 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 reported amounts of assets and liabilities, disclosure of contingent assets and liabilities at the date of the financial statements, and the reported amounts of revenues and expenses during the reporting period. Actual results could differ from those estimates under different assumptions and conditions.

2.Acquisition

In accordance with Statement of Financial Accounting Standards, or SFAS, No. 141, Business Combinations, we allocate the purchase price of our acquisitions to the tangible assets, liabilities and intangible assets acquired, including in-process research and development, or IPR&D, based on their estimated fair values. The excess purchase price over those fair values is recorded as goodwill. The fair value assigned to intangible assets acquired is based on valuations prepared by independent third party appraisal firms using estimates and assumptions provided by management.  Goodwill and purchased intangible assets with indefinite useful lives are not amortized but are reviewed at least annually for impairment. Purchased intangible assets with finite lives are amortized on a straight-line basis over their respective useful lives.

On February 23, 2004, we completed the acquisition of Chaparral Network Storage, Inc., or Chaparral, a privately held developer of specialized storage appliances as well as high-performance, mid-range RAID controllers and data routers.  The total transaction cost of approximately $67.6 million consisted of approximately $62 million in cash, the assumption of approximately $4.1 million related to obligations due to certain employees covered by change in control agreements, direct transaction costs of approximately $0.8 million and approximately $0.7 million in accrued integration costs consisting primarily of severance payments and amounts accrued related to Chaparral’s leased facility.  The acquisition of Chaparral is expected to enable us to increase the amount of proprietary technology within our storage systems, broaden our product line and diversify our customer base.

The results of operations of Chaparral have been included in our results prospectively from February 23, 2004.

6

Based on the independent valuation prepared using estimates and assumptions provided by management, the total transaction cost of approximately $67.6 million has been allocated as follows (in thousands):

Assets:
Cash and cash equivalents	$	2,202
Accounts receivable	1,769
Inventories	955
Prepaid expenses and other	147
Property and equipment	648
Goodwill	56,768
Other intangible assets:
Developed technology	2,600
Core technology	5,000
Customer relationships	2,500
Backlog	100
In-process research and development	4,700
Total assets	77,389
Liabilities:
Current liabilities	2,859
Note payable and accrued interest	6,945
Total liabilities	9,804
Net assets acquired	$	67,585

Goodwill recorded in connection with the acquisition totaled approximately $56.8 million.  None of this goodwill will be deductible for tax purposes.  Of the acquired other intangible assets, $4.7 million pertained to IPR&D and was written off by our recognition of a charge to operations on the acquisition date. The remaining acquired intangible assets are being amortized using the straight-line method over their estimated useful lives as follows:  developed and core technology, 2.5 to 4.5 years; customer relationships, 3.5 years; and backlog, 8 months.  None of the other intangible assets will be deductible for tax purposes.

IPR&D recorded in connection with the acquisition of Chaparral represents the present value of the estimated after-tax cash flows expected to be generated by purchased technologies that, as of the acquisition dates, had not yet reached technological feasibility. The classification of the technology as complete or under development was made in accordance with the guidelines of SFAS No. 86, Accounting for the Costs of Computer Software to Be Sold, Leased, or Otherwise Marketed, and Financial Accounting Standards Board, or FASB, Interpretation No. 4, Applicability of SFAS No. 2 to Business Combinations Accounted for by the Purchase Method. In addition, the fair value of the IPR&D projects was determined in accordance with SFAS No. 141 and SFAS No. 142, Goodwill and Other Intangible Assets.

Chaparral’s IPR&D projects were valued through the application of discounted cash flow analyses, taking into account many key characteristics of Chaparral as well as its future prospects, the rate technology changes in the industry, product life cycles, risks specific to each project, and various projects’ stage of completion. Stage of completion was estimated by considering the time, cost, and complexity of tasks completed prior to the acquisition versus the project’s overall expected cost, effort and risks required for achieving technological feasibility. In the application of the discounted cash flow analyses, Chaparral’s management provided distinct revenue forecasts for each IPR&D project. The projections were based on the expected date of market introduction, an assessment of customer needs, the expected pricing and cost structure of the related product(s), product life cycles, and the importance of the existing technology relative to the in-process technology. In addition, the costs expected to complete each project were added to the operating expenses to calculate the operating income for each IPR&D project. As certain other assets contribute to the cash flow attributable to the assets being valued, returns to these other assets were calculated and deducted from the pre-tax operating income to isolate the economic benefit solely attributable to each of the in-process technologies. The present value of IPR&D was calculated based on consideration of discount rates recommended by the American Institute of Certified Public Accountants IPR&D Practice Aid, which depend on the stage of completion and the additional risk associated with the completion of each of the IPR&D projects. We also considered venture capital rates of return and the weighted average cost of capital for Chaparral as an appropriate measure of the discount rates associated with each IPR&D project.  After such consideration, we determined that the weighted average cost of capital for Chaparral, based on a capital asset pricing model was the appropriate discount rate for each IPR&D project.  Accordingly, each IPR&D project was discounted using a rate of 22%.

7

Certain of our employees are former Chaparral employees who were party to agreements with Chaparral providing for payment in the event of a change in control of Chaparral, part of which was payable immediately and part of which is payable 18 months following the acquisition date. As a result of our acquisition of Chaparral, these employees were paid approximately $3.1 million in March 2004, and we assumed the obligation to make remaining estimated cash payments of $1.2 million to these employees in 2005.  Approximately $1.0 million is included in other long-term liabilities at March 31, 2004 related to these payments.  During the three months ended March 31, 2004, we recorded compensation expense of approximately $14,000 relating to these agreements for payments determined to be for services provided to us subsequent to the date of acquisition.

The following unaudited pro forma results of operations present the impact on our results of operations for the three months ended March 31, 2004 and 2003 as if the acquisition of Chaparral had been completed as of the beginning of the period reported on.  The charge of $4.7 million related to the write-off of in-process research and development has been excluded from the pro forma results of operations as it is nonrecurring in nature.

	Three Months Ended March 31, 2003						Three Months Ended March 31, 2004
	Historical			Pro Forma			Historical			Pro Forma
Net revenue	$	30,522		$	32,472		$	48,781		$	51,272
Net loss attributable to common stockholders	$	(1,569	)	$	(5,428	)	$	(1,883	)	$	(413	)
Basic and diluted net loss per share	$	(0.06	)	$	(0.21	)	$	(0.04	)	$	(0.01	)

3.Stock-Based Compensation

SFAS No. 123, Accounting for Stock-Based Compensation, encourages, but does not require, us to record compensation cost for stock-based employee compensation plans at fair value. We have chosen to continue to account for stock-based compensation using the intrinsic value method prescribed in APB Opinion No. 25, Accounting for Stock Issued to Employees, and related interpretations for all periods presented. Accordingly, compensation cost for stock options is measured as the excess, if any, of the fair value of our stock at the date of grant over the amount an employee must pay to acquire the stock.

Had compensation cost for our stock option awards been determined based upon the fair value at the date of grant in accordance with SFAS No. 123, our net loss and basic and diluted net loss per share would have been adjusted to the following amounts for the three months ended March 31, 2004 and 2003 (in thousands, except per share information):

	Three Months Ended March 31,
	2003			2004
Net loss attributable to common stockholders as reported	$	(1,569	)	$	(1,883	)
Stock-based employee compensation expense included in reported net loss attributable to common stockholders	5			5
Stock-based employee compensation expense determined under fair value based method	(774		)	(950		)
Pro forma net loss attributable to common stockholders	$	(2,338	)	$	(2,828	)
Basic and diluted net loss per share:
As reported	$	(0.06	)	$	(0.04	)
Pro forma	$	(0.09	)	$	(0.07	)

8

The fair value of each option grant was estimated on the date of grant using the Black-Scholes option-pricing model with the following weighted average assumptions:

	Three Months Ended March 31,
	2003		2004
Risk free interest rate	2.78	%	3.07	%
Expected dividend yield	—		—
Expected life	7.5 years		7.5 years
Expected volatility	86	%	69	%

4.Net Loss Per Share

Basic net loss per share is calculated by dividing net loss attributable to common stockholders by the weighted average number of common shares outstanding during the period. For the periods presented, diluted net loss per share excludes common stock equivalents, such as stock options, stock warrants and convertible preferred stock, in the weighted average number of common shares outstanding because they are antidilutive for the periods presented.

The following table sets forth a reconciliation of the basic and diluted number of weighted average shares outstanding used in the calculation of net loss per share (in thousands):

	Three Months Ended March 31,
	2003	2004
Shares used in computing basic net loss per share	26,147	43,315
Dilutive effect of stock options, stock warrants and convertible preferred stock	—	—
Shares used in computing diluted net loss per share	26,147	43,315

For the three months ended March 31, 2003 and 2004, outstanding options to purchase 3,847,852 and 3,045,079 shares of our common stock, respectively, and outstanding warrants to purchase 2,021,337 and 2,034,551 shares of our common stock, respectively, were not included in the calculation of diluted net loss per share because their effect was antidilutive.  Additionally, preferred stock convertible into 1,846,152 shares of our common stock has also been excluded from the calculation of diluted loss per share for the three months ended March 31, 2003 because its effect was antidilutive.

5.Short-Term Investments

The following table summarizes our short-term investments as of March 31, 2004 (in thousands):

	Cost		Net Unrealized Losses		Net Unrealized Gains		Fair Value
U.S. Government securities	$	25,839	$	75	$	60	$	25,824
Municipal securities and private debt	8,850		—		6		8,856
Commercial paper	9,671		8		45		9,708
	$	44,360	$	83	$	111	$	44,388

The cost and fair value of short-term investments at March 31, 2004 by contractual maturity are shown below (in thousands). Expected maturities will differ from contractual maturities because the issuers of the securities may have the right to prepay obligations without prepayment penalties.

	Cost		Fair Value
Due in one year or less	$	14,192	$	14,154
Due after one year through five years	21,318		21,378
Due after five years through ten years	—		—
Due after ten years	8,850		8,856
	$	44,360	$	44,388

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6.Inventories

Inventories are stated at the lower of cost (first-in, first-out) or market value. The following is a summary of inventories (in thousands):

	December 31, 2003		March 31, 2004
Purchased parts and materials	$	1,706	$	1,309
Work-in-process	24		27
Finished goods	1,428		2,260
	$	3,158	$	3,596

7.Note Payable

In connection with the acquisition of Chaparral, we assumed a $6 million promissory note, or the Note, payable to a third party manufacturer utilized by Chaparral.  The Note incurs interest at an annual rate of 8% with principal and accrued interest payable on May 15, 2005 and 2008, and is secured by rights to certain technology developed by Chaparral.  Total purchases by us from the third party manufacturer were $0.2 million for the quarter ended March 31, 2004.

The Note has the following scheduled principal payments due for the years ending December 31 (in thousands):

2004	$	—
2005	3,000
2006	—
2007	—
2008	3,000
	$	6,000

8.Goodwill and Other Intangible Assets

Under the provisions of SFAS No. 142, goodwill and intangible assets with indefinite lives are not amortized, but instead are tested for impairment at least annually or more frequently if impairment indicators arise. All of our remaining intangible assets are considered to have finite lives and are being amortized in accordance with this statement.

Intangible assets that are subject to amortization under SFAS No. 142 consist of the following as of March 31, 2004 (in thousands):

	Gross		Accumulated Amortization			Net
Core technology	$	5,000	$	(93	)	$	4,907
Developed technology	2,600		(86		)	2,514
Customer relationships	2,500		(60		)	2,440
Backlog	100		(12		)	88
Total other intangible assets	$	10,200	$	(251	)	$	9,949

Estimated future amortization expense related to other intangible assets as of March 31, 2004 is as follows (in thousands):

Years ending December 31,
2004 (remaining 9 months)	$	2,237
2005	2,865
2006	2,519
2007	1,587
2008	741
Total	$	9,949

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9.Product Warranties

We generally extend to our customers the warranties provided to us by our suppliers and, accordingly, the majority of our warranty obligations to customers are covered by supplier warranties. For warranty costs not covered by our suppliers, we provide for estimated warranty costs in the period the revenue is recognized. There can be no assurance that our suppliers will continue to provide such warranties to us in the future, which could have a material adverse effect on our operating results and financial condition. The changes in our aggregate product warranty liability are as follows for the three months ended March 31, 2004 (in thousands):

Balance, beginning of period	$	262
Current period accrual	780
Amounts charged to accrual	(195		)
Change in estimate	—
Balance, end of period	$	847

10.Restructurings

In March 2001, we announced plans to reduce our full-time workforce by up to 30% and reduce other expenses in response to delays in customer orders, lower than expected revenues and slowing global market conditions. The cost reduction actions were designed to reduce our breakeven point in light of an economic downturn. The cost reductions resulted in a charge for employee severance, lease termination costs and other office closure expenses related to the consolidation of excess facilities. We recorded restructuring expenses in the first quarter of 2001 of approximately $2.9 million, as follows (in thousands):

Employee termination costs	$	1,271
Impairment of property and equipment	1,007
Facility closures and related costs	637
Professional fees and other	20
Total	$	2,935

In June 2001, we announced plans to further reduce our full-time workforce by up to 17% and reduce other expenses in response to a continuing economic downturn and overall decrease in revenue. As a result of these additional restructuring actions, we recorded additional restructuring expenses during the second quarter of 2001 of approximately $1.5 million, as follows (in thousands):

Employee termination costs	$	259
Impairment of property and equipment	350
Facility closures and related costs	861
Total	$	1,470

Employee termination costs consist primarily of severance payments for 180 employees. Impairment of property and equipment consists of the write-down of certain fixed assets associated with facility closures. The facility closures and related costs consist of lease termination costs for five sales offices and closure of the New York City office.

During the fourth quarter of 2001, we increased our March 2001 related restructuring accrual by approximately $0.2 million and our June 2001 Restructuring accrual by approximately $0.3 million due to the continuing deterioration of various real estate markets and the inability to sublet excess space in our Carlsbad and New York City facilities.

During the fourth quarter of 2002, we again increased our March 2001 related restructuring accrual by approximately $0.7 million and our June 2001 related restructuring accrual by approximately $0.9 million to reflect additional deterioration of real estate markets in Carlsbad and New York City, as well as the effects of lease buyouts negotiated on several facilities and a sublease arrangement reached on another facility.

The following is a summary of restructuring activity recorded during the three months ended March 31, 2004 (in thousands):

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March 2001 Restructuring

	Accrued Restructuring Expenses at December 31, 2003		Additional Restructuring Expenses		Current Amounts Utilized			Accrued Restructuring Expenses at March 31, 2004
Employee termination costs	$	—	$	—	$	—		$	—
Impairment of property and equipment	—		—		—			—
Facility closures and related costs	401		—		(69		)	332
Professional fees and other	—		—		—			—
Total	$	401	$	—	$	(69	)	$	332

June 2001 Restructuring

	Accrued Restructuring Expenses at December 31, 2003		Additional Restructuring Expenses		Current Amounts Utilized			Accrued Restructuring Expenses at March 31, 2004
Employee termination costs	$	—	$	—	$	—		$	—
Impairment of property and equipment	—		—		—			—
Facility closures and related costs	523		—		(94		)	429
	$	523	$	—	$	(94	)	$	429

We believe that there are no unresolved issues or additional liabilities that may result in a significant adjustment to restructuring expenses accrued as of March 31, 2004.

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11.Income Taxes

For the three months ended March 31, 2004, the effective income tax rate was 2%. The effective income tax rate is based upon the expected income for the year and the expected composition of that income in different tax jurisdictions. For the three months ended March 31, 2004, the effective tax rate varied from the statutory tax rate primarily because of the expected use of our net operating loss carryforwards, for which a valuation allowance has previously been recorded.

We have federal and state net operating loss carryforwards as of December 31, 2003 of approximately $80.7 million and $53.8 million, respectively. These net operating loss carryforwards are available to offset taxable income generated in 2004 and future years, and such federal and state amounts will begin to expire in the tax years ending 2009 and 2004, respectively. In addition, we have federal tax credit carryforwards as of December 31, 2003 of approximately $2.4 million of which $0.2 million can be carried forward indefinitely to offset future taxable income, and the remaining $2.2 million will begin to expire in the tax year ending 2008. We also have state tax credit carryforwards as of December 31, 2003 of approximately $2.3 million, of which $2.1 million can be carried forward indefinitely to offset future taxable income, and the remaining $0.2 million will begin to expire in the tax year ending 2006. Pursuant to current tax regulations, the annual use of certain of our federal and state net operating loss and tax credit carryforwards is limited as a result of a cumulative change in ownership of more than 50%. Future additional changes in ownership may further limit the use of such amounts.

As a result of our equity transactions, an ownership change, within the meaning of Internal Revenue Code, or IRC, Section 382, occurred on September 18, 2003. As a result, annual use of our federal net operating loss and credit carry forwards is limited to (i) the aggregate fair market value of Dot Hill immediately before the ownership change multiplied by (ii) the long-term tax-exempt rate (within the meaning of IRC Section 382 (f)) in effect at that time. The annual limitation is cumulative and, therefore, if not fully utilized in a year, can be utilized in future years in addition to the Section 382 limitation for those years.

12.Commitments and Contingencies

Operating Leases

In connection with the acquisition of Chaparral, we assumed the operating lease for Chaparral’s Longmont, Colorado facility which expires in July 2007.  Lease payments are approximately $29,000 per month through June 2004.  Effective July 1, 2004, pursuant to a contractual agreement between Chaparral and the landlord, both parties agree to negotiate in good faith a new lease rate reflecting the current market and economic conditions in the surrounding Boulder, Colorado area.

Purchase Commitments

We enter into firm purchase commitments with suppliers and third party manufacturers for our estimated inventory requirements for succeeding months.  The Company had purchase commitments for approximately $0.3 million of inventory as of March 31, 2004.

Legal Matters

On October 17, 2003, Crossroads Systems, or Crossroads, filed a lawsuit against us in the United States District Court in Austin, Texas alleging that our products infringe two United States patents assigned to Crossroads, Patent Numbers 5,941,972 and 6,425,035. We were served with the lawsuit on October 27, 2003. Chaparral was added as a party to the lawsuit in March 2004. The patents involve storage routers and methods for providing virtual local storage. Patent Number 5,941,972 involves the interface of SCSI storage devices and the Fibre Channel protocol and Patent Number 6,425,035 involves the interface of any one transport medium and a second transport medium. We believe that we have meritorious defenses to Crossroads’ claims and are in the process of vigorously defending against them. We believe that the outcome will not have a material adverse effect on our financial condition or operating results. However, we expect to incur significant legal expenses in connection with this litigation. These defense costs, and other expenses related to this litigation, will be expensed as incurred and will negatively affect our operating results.

In addition to the action discussed above, we are subject to various legal proceedings and claims, asserted or unasserted, which arise from time to time in the ordinary course of business. The outcome of such claims against us cannot be predicted with certainty. We believe that such litigation and claims will not have a material adverse effect on our financial condition or operating results.

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13.Segments and Geographic Information

Operating segments are defined as components of an enterprise about which separate financial information is available that is evaluated regularly by our chief operating decision-maker, or decision making group, in deciding how to allocate resources and in assessing performance. Our chief operating decision-maker is the Chief Executive Officer. Our operating segments are managed separately because each segment represents a strategic business unit that offers different products or services.

Our operating segments are organized on the basis of products and services. We have identified operating segments that consist of our SANnet family of systems, legacy and other systems, and services. We currently evaluate performance based on stand-alone segment revenue and gross margin. Because we do not currently maintain information regarding operating income at the operating segment level, such information is not presented.

Sales to our largest channel partner accounted for approximately 75% of our net revenue during the first quarter of 2003 and 85% of net revenue for the quarter ended March 31, 2004.

Information concerning revenue by product and service is as follows (in thousands):

	SANnet Family		Legacy and Other			Services		Total
Three months ended:
March 31, 2004:
Net revenue	$	45,864	$	2,379		$	538	$	48,781
Gross profit (loss)	$	14,584	$	(1,081	)	$	—	$	13,503
March 31, 2003:
Net revenue	$	27,930	$	1,858		$	734	$	30,522
Gross profit (loss)	$	6,762	$	(1,489	)	$	264	$	5,537

Information concerning operating assets by product and service, derived by specific identification for assets related to specific segments and an allocation based on segment volume for assets related to multiple segments, is as follows (in thousands):

	SANnet Family		Legacy and Other		Services		Total
As of:
March 31, 2004	$	219,519	$	6,929	$	2,787	$	229,235
December 31, 2003	$	207,686	$	6,553	$	4,204	$	218,443

Information concerning principal geographic areas in which we operate is as follows (in thousands):

	Three Months Ended March 31,
	2003			2004
Net revenue:
United States	$	28,143		$	46,032
Europe	1,630			1,337
Asia	749			1,412
	$	30,522		$	48,781
Operating loss:
United States	$	(1,125	)	$	(2,306	)
Europe	(224		)	(332		)
Asia	(52		)	141
	$	(1,401	)	$	(2,497	)

Net revenue is recorded in the geographic area in which the sale is originated.

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14.Sun Microsystems Agreement

In January 2004, the existing three-year OEM partner agreement with our largest channel partner, first announced in May 2002, was extended. The agreement will now continue through May 22, 2007, a two-year extension to the original agreement subject to the terms of the agreement including early termination provisions.  In March 2004, this agreement was expanded to include new advanced technology storage products, to be designed and engineered by us to our channel partner’s specifications.

Item 2.Management’s Discussion and Analysis of Financial Condition and Results of Operations

Cautionary Statement for Forward-Looking Information

Certain statements contained in this report, including, statements regarding the development, growth and expansion of our business, our intent, belief or current expectations, primarily with respect to our future operating performance and the products we expect to offer, and other statements regarding matters that are not historical facts, are “forward-looking statements” within the meaning of Section 27A of the Securities Act of 1933, as amended, and Section 21E of the Securities Exchange Act of 1934, as amended, and are subject to the “safe harbor” created by these sections. Future filings with the SEC, future press releases and future oral or written statements made by us or with our approval, which are not statements of historical fact, may also contain forward-looking statements. Because such statements include risks and uncertainties, many of which are beyond our control, actual results may differ materially from those expressed or implied by such forward-looking statements. Some of the factors that could cause actual results to differ materially from those expressed or implied by such forward-looking statements can be found under the caption “Certain Risk Factors Related to the Company’s Business,” and elsewhere in this quarterly report on Form 10-Q. Readers are cautioned not to place undue reliance on forward-looking statements. The forward-looking statements speak only as of the date on which they are made, and we undertake no obligation to update such statements to reflect events that occur or circumstances that exist after the date on which they are made.

The following discussion of our financial condition and results of operations should be read in conjunction with our condensed consolidated financial statements and notes thereto included elsewhere in this quarterly report on Form 10-Q and our consolidated financial statements and notes thereto included in our annual report on Form 10-K for the year ended December 31, 2003.

Overview

We are a provider of storage systems for organizations requiring high reliability, high performance networked storage and data management solutions in an open systems architecture. Our storage solutions consist of integrated hardware and software products employing a modular system that allows end-users to add capacity as needed. Our broad range of products, from medium capacity stand-alone storage units to complete turn-key, multi-terabyte storage area networks, provides end-users with a cost-effective means of addressing increasing storage demands without sacrificing performance.

Our products and services are sold worldwide to end-users primarily through our channel partners, including original equipment manufacturers, or OEMs, systems integrators, or SIs, and value added resellers, or VARs. In May 2002, we entered into a three-year OEM agreement with Sun Microsystems, or Sun, to provide our storage hardware and software products for private label sales by Sun. We have been shipping our products to Sun for resale to Sun’s customers since October 2002. We have continued to develop new products primarily for resale by Sun, such as our SANnet II FC which began shipping to Sun in March 2003. We are discussing with Sun the extent and timing of additional new product shipments. In January 2004, our existing three-year OEM partner agreement with Sun, first announced in May 2002, was extended. The agreement will now continue through May 22, 2007, a two-year extension to the original agreement subject to the terms of the agreement including early termination provisions.  In March 2004, this agreement was expanded to include new advanced technology storage products, to be designed and engineered by us to Sun’s specifications. We intend to continue expanding our non-OEM sales channels through SIs and VARs in order to decrease our revenue concentration with OEMs.

As part of our focus on indirect sales channels, we have outsourced substantially all of our manufacturing operations to Solectron Corporation, or Solectron, a leading electronics manufacturing services company. Our agreement with Solectron allows us to reduce sales cycle times and manufacturing infrastructure, enhance working capital and improve margins by taking advantage of Solectron’s manufacturing and procurement economies of scale.

We derive revenue primarily from sales of our SANnet II family of products. In prior periods, we derived a significant portion of our revenue from sales of our legacy products and SANnet I family of products. Except for one OEM customer to whom we continue to sell our SANnet I products, we have transitioned all customers to our SANnet II products.

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We derive a portion of our revenue from services associated with the maintenance service we provide for our installed products. In May 2003, we entered into a services agreement with Anacomp, Inc. to provide all maintenance, warranty and non-warranty services for our SANnet I and certain legacy products.

Cost of goods sold includes costs of materials, subcontractor costs, salary and related benefits for the production and service departments, depreciation and amortization of equipment used in the production and service departments, production facility rent and allocation of overhead.

Sales and marketing expenses consist primarily of salaries and commissions, advertising and promotional costs and travel expenses. Research and development expenses consist primarily of project-related expenses and salaries for employees directly engaged in research and development. General and administrative expenses consist primarily of compensation to officers and employees performing administrative functions and expenditures for administrative facilities. Restructuring expenses consist primarily of employee severance, lease termination costs and other office closure expenses related to the consolidation of excess facilities.

Other income is comprised primarily of interest income earned on our cash, cash equivalents, and short-term investments and other miscellaneous income and expense items.

In August 1999, Box Hill Systems Corp. merged with Artecon, Inc. and we changed our name to Dot Hill Systems Corp. We reincorporated in Delaware in 2001. Our headquarters is located in Carlsbad, California, and we maintain international offices in Germany, Japan, the Netherlands, Singapore and the United Kingdom.

On February 23, 2004, we completed the acquisition of Chaparral Network Storage, Inc., a privately held developer of specialized storage appliances as well as high-performance, mid-range RAID controllers and data routers. The total transaction cost of approximately $67.6 million consisted of a payment of approximately $62 million in cash, the assumption of approximately $4.1 million related to obligations due certain employee covered by change in control agreements, approximately $0.8 million of direct transaction costs and approximately $0.7 million of accrued integration costs.  The acquisition of Chaparral is expected to enable Dot Hill to increase the amount of proprietary technology within its storage systems, broaden its product line and diversify its customer base.

Critical Accounting Policies and Estimates

Our discussion and analysis of our financial condition and results of operations are based upon our consolidated financial statements, which have been prepared in accordance with accounting principles generally accepted in the United States. The preparation of these financial statements requires us to make estimates and use judgment that may impact the reported amounts of assets, liabilities, revenues, expenses and related disclosure of contingent assets and liabilities. As a part of our on-going internal processes, we evaluate our estimates, including those related to inventory write-downs, warranty cost accruals, revenue recognition, bad debt allowances, long-lived assets valuation, intangible assets valuation, income taxes, including deferred income tax asset valuation, litigation and contingencies. We base these estimates upon both historical information and other assumptions that we believe are valid and reasonable under the circumstances. These assumptions form the basis for making judgments and determining the carrying values of assets and liabilities that are not apparent from other sources. Actual results could vary from those estimates under different assumptions and conditions.

We believe the following critical accounting policies affect our more significant estimates and assumptions used in the preparation of our consolidated financial statements.

Revenue Recognition

We recognize revenue for non-software product sales upon transfer of title to the customer. Reductions to revenue for estimated sales returns are also recorded at that time. These estimates are based on historical sales returns, changes in customer demand and other factors. If actual future returns and allowances differ from past experience, additional allowances may be required. Certain of our sales arrangements include multiple elements. Generally, these arrangements include delivery of the product, installation, training and product maintenance. Maintenance related to product sales entitles the customer to basic product support and significantly greater response time in resolving warranty related issues. We allocate revenue to each element of the arrangement based on its relative fair value. For maintenance contracts this is typically the price charged when such contracts are sold separately or renewed. Because professional services related to installation and training can be provided by other third party organizations, we allocate revenue related to professional services based on rates that are consistent with other like companies providing similar services, i.e., the market rate for such services. Revenue from product maintenance contracts is

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deferred and recognized ratably over the contract term, generally twelve months. Revenue from installation, training and consulting is recognized as the services are performed.

For software sales, we apply Statement of Position No. 97-2, Software Revenue Recognition, whereby revenue is recognized from software licenses at the time the product is delivered, provided there are no significant obligations related to the sale, the resulting receivable is deemed collectible and there is vendor-specific objective evidence supporting the value of the separate contract elements. For arrangements with multiple elements, we allocate revenue to each element using the residual method based on vendor specific objective evidence of the undelivered items. A portion of the arrangement fee equal to the fair value of the undelivered elements, typically software maintenance contracts, is deferred and recognized ratably over the contract term, generally twelve months. Vendor specific objective evidence is based on the price charged when the element is sold separately. A typical arrangement includes a software licensing fee and maintenance agreement.

Valuation of Inventories

Inventories are comprised of purchased parts and assemblies, which include direct labor and overhead. We record inventories at the lower of cost or market value, with cost generally determined on a first-in, first-out basis. We perform periodic valuation assessments based on projected sales forecasts and analyzing upcoming changes in future configurations of our products and record inventory write-downs for excess and obsolete inventory. Although we strive to ensure the accuracy of our forecasts, we periodically are faced with uncertainties. The outcomes of these uncertainties are not within our control, and may not be known for prolonged periods of time. Any significant unanticipated changes in demand or technological developments could have a significant impact on the value of our inventories and commitments, and consequently, on our operating results. If actual market conditions become less favorable than those forecasted, additional inventory write-downs might be required, adversely affecting operating results.

Valuation of Goodwill

We review goodwill for impairment annually and whenever events or changes in circumstances indicate the carrying value of an asset may not be recoverable in accordance with SFAS No. 142.  The provisions of SFAS No. 142 require that a two-step impairment test be performed on goodwill. In the first step, we compare the fair value of each reporting unit to its carrying value. Our reporting units are consistent with the reportable segments identified in the notes to our consolidated financial statements. We determine the fair value of our reporting units using the income approach. Under the income approach, we calculate the fair value of a reporting unit based on the present value of estimated future cash flows.  If the fair value of the reporting unit exceeds the carrying value of the net assets assigned to that unit, goodwill is not impaired and we are not required to perform further testing. If the carrying value of the net assets assigned to the reporting unit exceeds the fair value of the reporting unit, then we must perform the second step in order to determine the implied fair value of the reporting unit’s goodwill and compare it to the carrying value of the reporting unit’s goodwill. If the carrying value of a reporting unit’s goodwill exceeds its implied fair value, then we must record an impairment loss equal to the difference.

The income approach, which we use to estimate the fair value of our reporting units and other intangible assets, is dependent on a number of factors including estimates of future market growth and trends, forecasted revenue and costs, expected periods the assets will be utilized, appropriate discount rates and other variables. We base our fair value estimates on assumptions we believe to be reasonable, but which are unpredictable and inherently uncertain. Actual future results may differ from those estimates.

Results of Operations

The following table sets forth certain items from our statements of operations as a percentage of net revenue for the periods indicated:

	Three Months Ended March 31,
	2003		2004
Net revenue	100.0	%	100.0	%
Cost of goods sold	81.9		72.3
Gross profit	18.1		27.7
Operating expenses:
Sales and marketing	11.2		9.5
Research and development	6.7		9.0
General and administrative	4.8		4.7
In-process research and development	—		9.6
Total operating expenses	22.7		32.8
Operating loss	(4.6	)	(5.1	)
Net loss	(5.1	)%	(3.9	)%

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Three Months Ended March 31, 2004 Compared to Three Months Ended March 31, 2003

Net Revenue

Net revenue increased $18.3 million, or 59.8%, to $48.8 million for the three months ended March 31, 2004 from $30.5 million for the three months ended March 31, 2003. The increase in net revenue was attributable to increased orders for our product from our channel partner, Sun, which accounted for 84.8% of our net revenue for the three months ended March 31, 2004.  Total fiber channel units shipped were 2,271 for the three months ended March 31, 2004 compared to 695 fiber channel units shipped for the three months ended March 31, 2003.  Small computer systems interface, or SCSI, units shipped were 2,777 for the three months ended March 31, 2004 compared to 2,399 SCSI units for the three months ended March 31, 2003.  Non-Sun revenue was $7.4 million for the three months ended March 31, 2004 with $0.7 million being generated by Chaparral. In March 2004, we announced that our existing OEM partner agreement with Sun was expanded to include new advanced technology storage products, to be designed and engineered by us to Sun’s specifications.  We anticipate shipping these new products in the second quarter of 2004, and anticipate a favorable market reception for that product.  Although we are unable to determine the impact that such sales will have on revenue for future quarters, we believe that such sales will be incremental to our 2004 revenue and will not result in decreased sales of our other products.

Cost of Goods Sold

Cost of goods sold increased $10.3 million, or 41.2%, to $35.3 million for the three months ended March 31, 2004 from $25.0 million for the three months ended March 31, 2003. As a percentage of net revenue, cost of goods sold decreased to 72.3% for the three months ended March 31, 2004 from 81.9% for the three months ended March 31, 2003. As described above, the increase in the dollar amount of cost of goods sold was attributable to greater volume of product sales during the three months ended March 31, 2004 compared to the first quarter of the prior year. The decrease in cost of goods sold, as a percentage of our net revenue was primarily attributable to cost reductions related to production materials achieved during the three months ended March 31, 2004.  The decrease in cost of sales as a percentage of revenue also reflects start up costs of $0.6 million incurred during the three months ended March 31, 2003 to outsource the manufacturing of certain fiber channel products.  We did not incur similar start up costs for the three months ended March 31, 2004.

Gross Profit

Gross profit increased $8.0 million, or 143.9%, to $13.5 million for the three months ended March 31, 2004 from $5.5 million for the three months ended March 31, 2003. As a percentage of net revenue, gross profit increased to 27.7% for the three months ended March 31, 2004 from 18.1% for the three months ended March 31, 2003. The increase in the dollar amount of gross profit was attributable to greater volume of product sales during the three months ended March 31, 2004 compared to the three months ended March 31, 2003. The increase in gross profit as a percentage of our net revenue for the three months ended March 31, 2004 when compared to the three months ended March 31, 2003 reflects cost reductions related to production materials achieved during the three months ended March 31, 2004.  Also, during the three months ended March 31, 2004, the gross profit margin for Sun products benefited from ongoing cost reductions.  In March 2004, we announced that our existing OEM partner agreement with Sun was expanded to include new advanced technology storage products, to be designed and engineered by us to Sun’s specifications.  Although we cannot yet predict the impact that these new products will have on future revenue or gross margin, we anticipate that the introduction of such products will result in incremental margin dollars at lower gross margin percentages when compared to our gross profit margin for current Sun products.  Gross profit margin will be negatively impacted by amortization of finite lived intangible assets acquired in the Chaparral transaction.  The charge to cost of sales related to the amortization of intangible assets is anticipated to be approximately $0.6 million per quarter for the year ending December 31, 2004.

Sales and Marketing Expenses

Sales and marketing expenses increased $1.2 million, or 34.9%, to $4.6 million for the three months ended March 31, 2004 from $3.4 million for the three months ended March 31, 2003. As a percentage of net revenue, sales and marketing expenses decreased to 9.5% for the three months ended March 31, 2004 from 11.2% for the three months ended March 31, 2003.  The increase in the dollar amount of sales and marketing expenses was attributable to $0.4 million in increased selling and marketing expense related to Chaparral.  For the three months ended March 31, 2004, sales and marketing expenses reflect 38 days of activity related to Chaparral. We anticipate such costs will increase in the second quarter of 2004 commensurate with the inclusion of Chaparral operations for the entire quarter.

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The remaining increase in sales and marketing expenses for the three months ended March 31, 2004 relates to an increase in a variety of sales and marketing activities none of which are significant on an individual basis.

Research and Development Expenses

Research and development expenses increased $2.3 million, or 112.5%, to $4.4 million for the three months ended March 31, 2004 from $2.1 million for the three months ended March 31, 2003. As a percentage of net revenue, research and development expenses increased to 9.0% for the three months ended March 31, 2004 from 6.7% for the three months ended March 31, 2003. The increase in the dollar amount of research and development expenses was due to continued development effort on our new Serial ATA product of $0.9 million, an increase in salary and related expenses of $0.7 million attributable to an increase in the number of our full-time direct engineering team members located in Carlsbad, California and $0.5 million related to the acquisition of Chaparral that includes expense from both increased head count and expenditures to support on-going development effort.  For the three months ended March 31, 2004, research and development expenses reflect 38 days of activity related to Chaparral.  We anticipate such costs will increase in the second quarter of 2004 commensurate with the inclusion of Chaparral operations for the entire quarter.

General and Administrative Expenses

General and administrative expenses increased $0.8 million, or 58.6%, to $2.3 million for the three months ended March 31, 2004 from $1.5 million for the three months ended March 31,2003. As a percentage of net revenue, general and administrative expenses decreased to 4.7% for the three months ended March 31, 2004 from 4.8% for the three months ended March 31, 2003. The increase in the dollar amount of general and administrative expense during the three months ended March 31, 2004 reflects an increase of payroll-related expenses of $0.2 million related to acquisition of Chaparral personnel and an increase of $0.4 million of legal expenses.

In-Process Research and Development Charges

Projects that qualify as in-process research and development represent those that have not yet reached technological feasibility and for which no future alternative uses exist. Technological feasibility is defined as being equivalent to a beta-phase working prototype in which there is no remaining risk relating to the development. For the three months ended March 31, 2004 we recorded an IPR&D charge of $4.7 million, in connection with the acquisition of Chaparral.

Other Income (Expense)

Other income (expense)increased by $0.6 million to $0.5 million for the three months ended March 31, 2004 from $(0.1) million for the three months ended March 31, 2003. The increase was primarily attributable to an increase in interest income of $0.6 million as a result of our increased cash, cash equivalents and short-term investments balances.

Income Taxes

For the three months ended March 31, 2004, the effective income tax rate was 2%. The effective income tax rate is based upon the expected income for the year and the expected composition of that income in different countries.  For the three months ended March 31, 2004, the effective tax rate varied from the statutory tax rate primarily because of the expected use of our net operating loss carryforwards for which a valuation allowance has previously been recorded.

We have federal and state net operating loss carryforwards as of December 31, 2003 of approximately $80.7 million and $53.8 million, respectively. These net operating loss carryforwards are available to offset taxable income generated in 2004 and future years, and such federal and state amounts will begin to expire in the tax years ending 2009 and 2004, respectively. In addition, we have federal tax credit carryforwards as of December 31, 2003 of approximately $2.4 million of which $0.2 million can be carried forward indefinitely to offset future taxable income, and the remaining $2.2 million will begin to expire in the tax year ending 2008. We also have state tax credit carryforwards as of December 31, 2003 of approximately $2.3 million, of which $2.1 million can be carried forward indefinitely to offset future taxable income, and the remaining $0.2 million will begin to expire in the tax year ending 2006. Pursuant to current tax regulations, the annual use of certain of our federal and state net operating loss and tax credit carryforwards is limited as a result of a cumulative change in ownership of more than 50%. Future additional changes in ownership may further limit the use of such amounts.

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As a result of our equity transactions, an ownership change, within the meaning of Internal Revenue Code, or IRC, Section 382, occurred on September 18, 2003. As a result, annual use of our federal net operating loss and credit carry forwards is limited to (i) the aggregate fair market value of Dot Hill immediately before the ownership change multiplied by (ii) the long-term tax-exempt rate (within the meaning of IRC Section 382 (f)) in effect at that time. The annual limitation is cumulative and, therefore, if not fully utilized in a year, can be utilized in future years in addition to the Section 382 limitation for those years.

Liquidity and Capital Resources

As of March 31, 2004, we had $127.0 million of cash, cash equivalents and short-term investments and working capital of $115.1 million.

During the quarter ended March 31, 2004, we consummated the acquisition of Chaparral for a cash purchase price of approximately $62 million plus the assumption of approximately $4.1 million in liabilities.

For the three months ended March 31, 2004, cash provided by operating activities was $3.4 million compared to cash used in operating activities of $1.8 million for the same period in 2003. The net cash provided by operating activities for the three months ended March 31, 2004 is primarily attributable to a net loss of $1.9 million offset by a non-cash charge of $4.7 million related to the write-off of IPR&D and depreciation and amortization of $0.9 million.  Additionally, cash provided by operating activities reflect a $3.6 increase in accounts payable, a $0.9 million increase in other liabilities and an increase in inventory and prepaid and other assets of $1.2 million.  Cash provided by operating activities decreased by a $4.2 million increase in accounts receivable and a decrease in accrued compensation and expenses of $1.5 million. The increase in accounts receivable reflects the payment terms for our largest OEM channel partner increasing from net 10 days to net 20 days.

Cash used in investing activities for the three months ended March 31, 2004 was $59.4 million compared to $1.0 million for the same period in 2003.  The increase in the use of cash for the three months ended March 31, 2004 compared to the three months ended March 31, 2003 is primarily attributable to the acquisition of Chaparral that reduced cash by $65.4 million net of cash acquired from Chaparral.  We also made capital expenditures of $2.6 million during the three months ended March 31, 2004 primarily to support new product development and made purchases of $10.5 million in short-term investments.  These decreases in our cash were offset by proceeds received from $19.1 million in sales of short-term investments during the three months ended March 31, 2004.

Cash provided by financing activities for the three months ended March 31, 2004 was $11,000 compared to $14.2 million for the three months ended March 31, 2003. The cash provided by financing activities is attributable to exercises of stock options under the Company’s 2000 Stock Incentive Plan of $24,000, offset by net payments made on bank and other borrowings of $13,000.

In connection with the acquisition of Chaparral, we assumed a $6 million promissory note, or the Note, payable to a third party manufacturer utilized by Chaparral. The Note incurs interest at an annual rate of 8% with principal and accrued interest payable on May 15, 2005 and 2008 and is secured by rights to certain technology developed by Chaparral.

We had an agreement with Wells Fargo Bank, National Association, which allowed us to borrow up to $15.0 million under a revolving line of credit that expired May 1, 2004. The maximum amount we could borrow under this line was limited by the amount of our cash and investment balances held at the bank at any given time and could be reduced by the amount of any outstanding letters of credit with the bank. Borrowings under this line of credit were collateralized by a pledge of our deposits held at the bank. As of March 31, 2004, there was no balance outstanding under this line of credit and the amount available on this line was $15.0 million.  We are presently in negotiations to replace this line of credit.

Our Japanese subsidiary has two lines of credit with Tokyo Mitsubishi Bank and one line of credit with National Life Finance Corporation in Japan, for borrowings of up to an aggregate of 45 million yen, or approximately $0.4 million as of March 31, 2004, at interest rates ranging from 1.7% to 1.8%. Interest is due monthly, with principal due and payable on various dates through August 2008. Borrowings are secured by the inventories of our Japanese subsidiary. As of March 31, 2004, the total amount outstanding under the three credit lines was approximately 24.7 million yen, or approximately $0.2 million.

For the three months ended March 31, 2004, capital expenditures amounted to $2.6 million primarily for test equipment and assembly line tooling related to the development of our Serial ATA product.  We expect capital expenditures will decrease to approximately $1 million per quarter through 2004.

We presently expect cash, cash equivalents, short-term investments and cash generated from operations to be sufficient to meet our operating and capital requirements for at least the next twelve months and to enable us to pursue acquisitions or

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significant capital improvements. The actual amount and timing of working capital and capital expenditures that we may incur in future periods may vary significantly and will depend upon numerous factors, including the amount and timing of the receipt of revenues from continued operations, our ability to manage our relationships with third party manufacturers, the status of our relationships with key customers, partners and suppliers, the timing and extent of the introduction of new products and services and growth in personnel and operations.

Certain Risk Factors Related to the Company’s Business

Our business, results of operations and financial condition may be materially and adversely affected due to any of the following risks. The risks described below are not the only ones we face. Additional risks we are not presently aware of or that we currently believe are immaterial may also impair our business operations. The trading price of our common stock could decline due to any of these risks. In assessing these risks, you should also refer to the other information contained or incorporated by reference in this Form 10-Q, including our financial statements and related notes.

Under our OEM agreement with Sun, Sun is not required to make minimum purchases or purchase exclusively from us, and we cannot assure you that our relationship with Sun will not be terminated or will generate significant sales.

Our business is highly dependent on our relationship with Sun. Sales to Sun accounted for 83.4% and 84.8% of our net revenue for the year ended December 31, 2003 and the three months ended March 31, 2004, respectively. Our OEM agreement with Sun had an initial term of three years and was extended in January 2004 for an additional two years through May 2007. However, there are no minimum purchase requirements or guarantees in our agreement with Sun, the agreement does not obligate Sun to purchase its storage solutions exclusively from us and Sun may cancel purchase orders submitted under the agreement at any time. Sun may terminate the entire contract prior to the contract expiration date upon the occurrence of certain events that are not remedied within a specified cure period. The decision by Sun not to renew its contract with us, to terminate the contract, to cease making purchases or to cancel purchase orders would cause our revenues to decline substantially. We cannot be certain if, when or to what extent Sun might terminate its contract with us, cancel purchase orders, cease making purchases or elect not to renew the contract upon the expiration of the initial term. We expect to receive a substantial majority of our projected net revenue for the year ended December 31, 2004 from sales of our products to Sun. We cannot assure you that we will achieve these expected sales levels. If we do not achieve the sales levels we expect to receive from Sun, our business and result of operations will be significantly harmed.

Any decline in Sun’s sales could harm our business.

A substantial majority of our revenues are generated by sales to Sun, which sells our products as separate units or bundled with its servers. If Sun’s storage related sales decline, our revenues will also decline and our business could be materially harmed. In addition, Sun’s quarterly operating results typically fluctuate downward in the first quarter of their fiscal year when compared with the immediately preceding fourth quarter. If these fluctuations cause Sun to decrease purchases of our storage products, our results in the first quarter of Sun’s fiscal years, which is our third quarter, could be harmed.

We are dependent on sales to a relatively small number of customers.

Because we intend to expand sales to channel partners, we expect to experience continued concentration in our customer base. As a result, if our relationship with any of our customers is disrupted, we would lose a significant portion of our anticipated net revenue. We cannot guarantee that our relationship with Sun or other channel partners will expand or not otherwise be disrupted. Factors that could influence our relationship with significant channel partners, including Sun, include:

•our ability to maintain our products at prices that are competitive with those of other storage system suppliers;

•our ability to maintain quality standards for our products sufficient to meet the expectations of our channel partners; and

•our ability to produce, ship and deliver a sufficient quantity of our products in a timely manner to meet the needs of our channel partners.

None of our contracts with our existing channel partners, including Sun, contain any minimum purchasing commitments. Further, we do not expect that future contracts with channel partners, if any, will include any minimum

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purchasing commitments. Changes in the timing or volume of purchases by our major customers could result in lower revenue. In addition, our existing contracts do not require our channel partners to purchase our products exclusively or on a preferential basis over the products of any of our competitors. Consequently, our channel partners may sell the products of our competitors.

The loss of one or more suppliers could slow or interrupt the production and sales of our products.

Solectron, our third party manufacturer, relies on third parties to supply key components of our storage products. Many of these components are available only from limited sources in the quantities and quality we require. Solectron purchases the majority of our redundant arrays of independent disks, or RAID, controllers from Infortrend Technology, Inc., or Infortrend. Solectron may not be able to purchase the type or quantity of components from third party suppliers as needed in the future.

From time to time there is significant market demand for disk drives, RAID controllers and other components, and we may experience component shortages, selective supply allocations and increased prices of such components. In such event, we may be required to purchase our components from alternative suppliers. Even if alternative sources of supply for critical components such as disk drives and controllers become available, incorporating substitute components into our products could delay our ability to deliver our products in a timely manner. For example, we estimate that replacing Infortrend’s RAID controllers with those of another supplier would involve several months of hardware and software modification, which could significantly harm our ability to meet our customers’ orders for our products, damage our customer relationships and result in a loss of sales.

Manufacturing disruptions could harm our business.

We rely on Solectron to manufacture substantially all of our products. If our agreement with Solectron is terminated or if Solectron does not perform its obligations under our agreement, it could take several months to establish alternative manufacturing for our products and we may not be able to fulfill our customers’ orders in a timely manner. Under our OEM agreement with Sun, Sun has the right to require that we use a third party to manufacture our products. Such an external manufacturer must meet Sun’s engineering, qualification and logistics requirements. If our agreement with Solectron terminates, we may be unable to find another external manufacturer that meets Sun’s requirements.

With our increased use of third-party manufacturers, our ability to control the timing of shipments has continued and will continue to decrease. Delayed shipment could result in the deferral or cancellation of purchases of our products. Any significant deferral or cancellation of these sales would harm our results of operations in any particular quarter. Net revenue for a period may be lower than predicted if large orders forecasted for that period are delayed or are not realized, which could result in cash flow problems or a decline in our stock price.

We experienced losses in 2000, 2001 and 2002 and may continue to experience losses in the future.

In 2003, we recorded net income attributable to common shareholders of $12.0 million, however, for the years ended December 31, 2000, 2001 and 2002, we incurred net losses of $0.9 million, $43.4 million and $34.3 million, respectively. We cannot assure you that we will be profitable in any future period. We have expended, and will continue to be required to expend, substantial funds to pursue engineering, research and development projects, enhance marketing efforts and otherwise operate our business. Our future capital requirements will depend on, and could increase substantially as a result of, many factors, including:

•our plans to maintain and enhance our engineering, research, development and product testing programs;

•the success of our manufacturing strategy;

•the success of our sales and marketing efforts;

•the extent and terms of any development, marketing or other arrangements;

•changes in economic, regulatory or competitive conditions; and

•costs of filing, prosecuting, defending and enforcing intellectual property rights.

Our available cash, cash equivalents and short-term investments as of March 31, 2004 totaled $127.0 million.  We presently expect cash, cash equivalents, short-term investments and cash generated from operations to be sufficient to meet our operating and capital requirements through at least the next twelve months. However, unanticipated events, such as Sun’s failure to meet its product purchase forecast or extraordinary expenses or operating expenses in excess of our projections, may require us to raise additional funds. We may not be able to raise additional funds on commercially reasonable terms or at

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all. Any sales of our debt or equity securities in the future may have a substantial dilutive effect on our existing stockholders. If we are able to borrow funds, we may be required to grant liens on our assets to the provider of any source of financing or enter into operating, debt service or working capital covenants with any provider of financing that could hinder our ability to operate our business in accordance with our plans. As a result, our ability to borrow money on a secured basis may be impaired, and we may not be able to issue secured debt on commercially reasonable terms or at all.

Our quarterly operating results have fluctuated significantly in the past and are not a good indicator of future performance.

Our quarterly operating results have fluctuated significantly in the past as shown in the following table and are not a good indicator of future performance.

Quarter	Net Revenue		Net Income (Loss)
	(in millions)
First Quarter 2001	$	18.6	$	(28.7	)
Second Quarter 2001	14.9		(5.7		)
Third Quarter 2001	12.3		(3.3		)
Fourth Quarter 2001	10.5		(5.7		)
First Quarter 2002	10.9		(6.2		)
Second Quarter 2002	11.2		(8.9		)
Third Quarter 2002	8.6		(7.3		)
Fourth Quarter 2002	16.3		(11.9		)
First Quarter 2003	30.5		(1.5		)
Second Quarter 2003	48.4		2.6
Third Quarter 2003	51.0		4.3
Fourth Quarter 2003	57.5		6.7
First Quarter 2004	48.8		(1.9		)

In addition, the announcement of financial results that fall short of the results anticipated by the public markets could have an immediate and significant negative effect on the trading price of our common stock in any given period.

We may have difficulty predicting future operating results due to both internal and external factors affecting our business and operations, which could cause our stock price to decline.

Our operating results may vary significantly in the future depending on a number of factors, many of which are out of our control, including:

•the size, timing, cancellation or rescheduling of significant orders;
•the cost of litigation involving intellectual property and other issues;

•product configuration, mix and quality issues;

•market acceptance of our new products and product enhancements and new product announcements or introductions by our competitors;

•manufacturing costs;

•deferrals of customer orders in anticipation of new products or product enhancements;

•changes in pricing by us or our competitors;

•our ability to develop, introduce and market new products and product enhancements on a timely basis;

•hardware component costs and availability, particularly with respect to hardware components obtained from Infortrend, a sole-source provider;

•our success in creating brand awareness and in expanding our sales and marketing programs;

•the level of competition;

•potential reductions in inventories held by channel partners;

•slowing sales of the products of our channel partners;

•technological changes in the open systems storage market;

•levels of expenditures on research, engineering and product development;

•changes in our business strategies;

•costs of litigation and settlements;

•personnel changes; and

•general economic trends and other factors.

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If our customers delay or cancel orders or return products, our results of operations could be harmed.

We generally do not enter into long-term purchase contracts with customers, and customers usually have the right to extend or delay shipment of their orders, return products and cancel orders. As a result, sales in any period are generally dependent on orders booked and shipped in that period. Delays in shipment orders, product returns and order cancellations in excess of the levels we expect would harm our results of operations.

Our sales cycle varies substantially and future net revenue in any period may be lower than our historical revenues or forecasts.

Our sales are difficult to forecast because the open systems storage market is rapidly evolving and our sales cycle varies substantially from customer to customer. Customer orders for our products can range in value from a few thousand dollars to over a million dollars. The length of time between initial contact with a potential customer and the sale of our product may last from three to 24 months. This is particularly true during times of economic slowdown, for sales to channel partners and for the sale and installation of complex solutions. We have shifted our business strategy to focus primarily on channel partners, with whom sales cycles are generally lengthier, more costly and less certain than direct sales to end-users.

Additional factors that may extend our sales cycle, particularly orders for new products, include:

•the amount of time needed for technical evaluations by customers;

•customers’ budget constraints and changes to customers’ budgets during the course of the sales cycle;

•customers’ internal review and testing procedures; and

•our engineering work to integrate a storage solution with a customer’s system.

Our net revenue is difficult for us to predict since it is directly affected by the timing of large orders. Due to the unpredictable timing of customer orders, we may ship products representing a significant portion of our net sales for a quarter during the last month of that quarter. In addition, our expense levels are based, in part, on our expectations as to future sales. As a result, if sales levels are below expectations, our operating results may be disproportionately affected. We cannot assure you that we will experience sales growth in future periods.

The market for our products is subject to substantial pricing pressure that decreases our margins.

Pricing pressures exist in the data storage market and have harmed and may in the future continue to harm our net revenue and earnings. These pricing pressures are due, in part, to continuing decreases in component prices, such as those of disks and RAID controllers. Decreases in component prices are customarily passed-on to customers by storage companies through a continuing decrease in price of storage hardware systems. In addition, because we expect to continue to make most of our sales to a small number of customers, we are subject to continued pricing pressures from our customers, particularly our OEM customers. Pricing pressures are also due, in part, to the current difficult economic conditions, which have led many companies in our industry to pursue a strategy of decreasing prices in order to win sales, the narrowing of functional differences among competitors, which forces companies to compete on price as opposed to features of products, and the introduction of new technologies, which leaves older technology more vulnerable to pricing pressures. To the extent we are unable to offset those pressures with commensurate cost reductions from our suppliers or by providing new products and features, our margins will be harmed.

Our success depends significantly upon our ability to protect our intellectual property and to avoid infringing the intellectual property of third parties, which could result in costly, time-consuming litigation or even the inability to offer certain products.

We rely primarily on patents, copyrights, trademarks, trade secrets, nondisclosure agreements and common law to protect our intellectual property. For example, we have registered trademarks for SANnet, SANpath, SANscape, Stratis, Dot Hill and the Dot Hill logo and, with the acquisition of Chaparral, we acquired registered trademarks for Raidar, Rio, Riva and Stratis. As of March 31, 2004, we had been awarded a total of eight U.S. patents and, with the acquisition of Chaparral, we acquired one issued U.S. patent, two allowed U.S. patents and 13 U.S. patent applications that are in various stages of the patenting process. Despite our efforts to protect our intellectual property, unauthorized parties may attempt to copy aspects of our products or

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obtain and use information that we regard as proprietary. In addition, the laws of foreign countries may not adequately protect our intellectual property rights. Our efforts to protect our intellectual property from third party discovery and infringement may be insufficient and third parties may independently develop technologies similar to ours, duplicate our products or design around our patents.

On October 17, 2003, Crossroads Systems, or Crossroads, filed a lawsuit against us in the United States District Court in Austin, Texas alleging that our products infringe two United States patents assigned to Crossroads, Patent Numbers 5,941,972 and 6,425,035. We were served with the lawsuit on October 27, 2003. In March 2004, Chaparral was added as a party to the lawsuit. The patents involve storage routers and methods for providing virtual local storage. Patent Number 5,941,972 involves the interface of SCSI storage devices and the Fibre Channel protocol and Patent Number 6,425,035 involves the interface of any one transport medium and a second transport medium. We believe that we have meritorious defenses to Crossroads’ claims and intend to vigorously defend against them. We expect to incur significant legal expenses in connection with this litigation. These defense costs, and other expenses related to this litigation, will be expensed as incurred and will negatively affect our future operating results. Further, parties may assert additional infringement claims against us in the future, which would similarly require us to incur substantial legal fees and expenses, and distract management from the operations of our business.

We expect that providers of storage products will increasingly be subject to infringement claims as the number of products and competitors increases. In addition to the formal claims brought against us by Crossroads, we receive, from time to time, letters from third parties suggesting that we may require a license from such third parties to manufacture or sell our products. We evaluate all such communications to assess whether to seek a license from the patent owner. We may require licenses that could have a material impact on our business. We may not be able to obtain the necessary license from a third party on commercially reasonable terms, or at all. Consequently, we could be prohibited from marketing products that incorporate the protected technology or incur substantial costs to redesign our products in a manner to avoid infringement of third party intellectual property rights.

The market for storage systems is intensely competitive and our results of operations, pricing and business could be harmed if we fail to maintain or expand our market position.

The storage market is intensely competitive and is characterized by rapidly changing technology. We compete primarily against independent storage system suppliers, including EMC Corporation, Hitachi Data Systems, LSI Logic Storage Systems and Network Appliance. We also compete with traditional suppliers of computer systems, including Dell Computer Corporation, Hewlett-Packard Company, and IBM Corporation, which market storage systems as well as other computer products.

Many of our existing and potential competitors have longer operating histories, greater name recognition and substantially greater financial, technical, sales, marketing and other resources than us. As a result, they may have more advanced technology, larger distribution channels, stronger brand names, better customer service and access to more customers than we do. Other large companies with significant resources could become direct competitors, either through acquiring a competitor or through internal efforts. Additionally, a number of new, privately held companies are currently attempting to enter the storage market, some of which may become significant competitors in the future. Any of these existing or potential competitors may be able to respond more quickly to new or emerging technologies and changes in customer requirements, devote greater resources to the development, promotion and sale of products or deliver competitive products at lower prices than us.

We could also lose current or future business to any of our suppliers or manufacturers, some of which directly and indirectly compete with us. Currently, we leverage our supply and manufacturing relationships to provide a significant share of our products. Our suppliers and manufacturers are very familiar with the specific attributes of our products and may be able to provide our customers with similar products.

We also expect that competition will increase as a result of industry consolidation and the creation of companies with new, innovative product offerings. Current and potential competitors have established or may establish cooperative relationships among themselves or with third parties to increase the ability of their products to address the needs of our prospective customers. Accordingly, it is possible that new competitors or alliances among competitors may emerge and rapidly acquire significant market share. Increased competition is likely to result in price reductions, reduced operating margins and potential loss of market share, any of which could harm our business.

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We believe that the principal competitive factors affecting the storage systems market include:

•Product performance, features, scalability and reliability;

•Price;

•Product breadth;

•Timeliness of new product introductions; and

•Interoperability and ease of management.

We cannot assure you that we will be able to successfully incorporate these factors into our products and compete against current or future competitors or that competitive pressures we face will not harm our business. If we are unable to develop and market products to compete with the products of competitors, our business will be materially and adversely affected. In addition, if major channel partners who are also competitors cease purchasing our products in order to concentrate on sales of their own products, our business will be harmed.

The open systems storage market is rapidly changing and we may be unable to keep pace with or properly prepare for the effects of those changes.

The open systems data storage market in which we operate is characterized by rapid technological change, frequent new product introductions, evolving industry standards and consolidation among our competitors, suppliers and customers. Customer preferences in this market are difficult to predict and changes in those preferences and the introduction of new products by us or our competitors could render our existing products obsolete. Our success will depend upon our ability to address the increasingly sophisticated needs of customers, to enhance existing products, and to develop and introduce on a timely basis, new competitive products, including new software and hardware, and enhancements to existing software and hardware, that keep pace with technological developments and emerging industry standards. If we cannot successfully identify, manage, develop, manufacture or market product enhancements or new products, our business will be harmed. In addition, consolidation among our competitors, suppliers and customers may harm our business by increasing the resources of our competitors, reducing the number of suppliers available to us for our product components and increasing competition for customers by reducing customer-purchasing decisions.

A significant percentage of our expenses are fixed, and if we fail to generate revenues in associated periods, our operating results will be harmed.

Although we have taken a number of steps to reduce operating costs, we may have to take further measures to reduce expenses if we continue to experience operating losses or do not achieve a stable net income. A number of factors could preclude us from successfully bringing costs and expenses in line with our net revenue, such as the fact that our expense levels are based in part on our expectations as to future sales, and that a significant percentage of our expenses are fixed, which limits our ability to reduce expenses quickly in response to any shortfalls in net revenue. As a result, if net revenue does not meet our projections, operating results may be negatively affected. We may experience shortfalls in net revenue for various reasons, including:

•significant pricing pressures that occur because of declines in selling prices over the life of a product or because of increased competition;

•sudden shortages of raw materials or fabrication, test or assembly capacity constraints that lead our suppliers and manufacturers to allocate available supplies or capacity to other customers, which, in turn, may harm our ability to meet our sales obligations; and

•the reduction, rescheduling or cancellation of customer orders.

In addition, we typically plan our production and inventory levels based on internal forecasts of customer demand, which is highly unpredictable and can fluctuate substantially. From time to time, in response to anticipated long lead times to obtain inventory and materials from our outside suppliers, we may order materials in advance of anticipated customer demand. This advance ordering has continued and may result in excess inventory levels or unanticipated inventory write-downs due to expected orders that fail to materialize.

Our business and operating results may suffer if we encounter significant product defects.

Our products may contain undetected errors or failures when first introduced or as we release new versions. During 2004, we plan to introduce a number of new products. We may discover errors in our products after shipment, resulting in a loss of or delay in market acceptance, which could harm our business. Our standard warranty provides that if the system does not function to published specifications, we will repair or replace the defective component or system without charge. Significant warranty costs, particularly those that exceed reserves, could adversely impact our business. In addition, defects in our products could result in our customers claiming damages against us for property damage or consequential damage and

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could also result in our loss of customers and goodwill. Any such claim could distract management’s attention from operating our business and, if successful, result in damage claims against us that might not be covered by our insurance.

Our success depends on our ability to attract and retain key personnel.

Our performance depends in significant part on our ability to attract and retain talented senior management and other key personnel. Our key personnel include James Lambert, our President and Chief Executive Officer, Dana Kammersgard, our Chief Technical Officer, and Preston Romm, our Chief Financial Officer. If any one of these individuals were to terminate his employment with us, we would be required to locate and hire a suitable replacement. Competition for attracting talented employees in the technology industry is intense. We may be unable to identify suitable replacements for any employees that we lose. In addition, even if we are successful in locating suitable replacements, the time and cost involved in recruiting, hiring, training and integrating new employees, particularly key employees responsible for significant portions of our operations, could harm our business by delaying our production schedule, our research and development efforts, our ability to execute on our business strategy and our client development and marketing efforts.

Many of our customer relationships are based on personal relationships between the customer and our sales representatives. If these representatives terminate their employment with us, we may be forced to expend substantial resources to attempt to retain the customers that the sales representatives serviced. Ultimately, if we were unsuccessful in retaining these customers, our net revenue would decline.

We have recently made several reductions in our workforce. Although the reductions were designed to reduce our operating costs, the reductions have increased the responsibilities of our remaining employees. As a result, we face risks associated with transferring the duties of our former employees to our remaining employees. In addition to the expense involved in retraining employees, there is a risk that our current work force will be unable to effectively manage all of the duties of our former employees, which could adversely impact our research and development efforts, our general accounting and operating activities, our sales efforts and our production capabilities.

Our executive officers and directors and their affiliates own a significant percentage of our outstanding shares, which could prevent us from being acquired and adversely affect our stock price.

As of March 31, 2004, our executive officers, directors and their affiliates beneficially owned approximately 8.4% of our outstanding shares of common stock. These individual stockholders may be able to influence matters requiring approval by our stockholders, including the election of a majority of our directors. The voting power of these stockholders under certain circumstances could have the effect of delaying or preventing a change in control of us. This concentration of ownership may also make it more difficult or expensive for us to obtain financing. Further, any substantial sale of shares by these individuals could depress the market price of our common stock and impair our ability to raise capital in the future through the sale of our equity securities.

Protective provisions in our charter and bylaws and the existence of our stockholder rights plan could prevent a takeover which could harm our stockholders.

Our certificate of incorporation and bylaws contain a number of provisions that could impede a takeover or prevent us from being acquired, including, but not limited to, a classified board of directors, the elimination of our stockholders’ ability to take action by written consent and limitations on the ability of our stockholders to remove a director from office without cause. Our board of directors may issue additional shares of common stock or establish one or more classes or series of preferred stock with such designations, relative voting rights, dividend rates, liquidation and other rights, preferences and limitations as determined by our board of directors without stockholder approval. In addition, we adopted a stockholder rights plan in May 2003 that is designed to impede takeover transactions that are not supported by our board of directors. Each of these charter and bylaw provisions and the stockholder rights plan gives our board of directors, acting without stockholder approval, the ability to prevent, or render more difficult or costly, the completion of a takeover transaction that our stockholders might view as being in their best interests.

The exercise of outstanding warrants may result in dilution to our stockholders.

Dilution of the per share value of our common stock could result from the exercise of outstanding warrants. As of March 31, 2004 there were outstanding warrants to purchase 2,034,551 shares of our common stock. The warrants have exercise prices ranging from $2.97 to $4.50 per share and expire at various dates through March 14, 2008. When the exercise price of the warrants is less than the trading price of our common stock, exercise of the warrants would have a dilutive effect

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on our stockholders. The possibility of the issuance of shares of our common stock upon exercise of the warrants could cause the trading price of our common stock to decline.

Any failure by us to manage the integration of Chaparral into our operations could harm our financial results, business and prospects.

In February 2004, we completed the acquisition of Chaparral. The related integration issues are complex, time-consuming and expensive and, without proper planning and implementation, could significantly disrupt our business. The challenges involved in integration include:

• combining product offerings or entering into new markets in which we are not experienced and preventing customers and distributors from deferring purchasing decisions or switching to other suppliers, which could result in our incurring additional obligations in order to address customer uncertainty;

• demonstrating to customers and distributors that the transaction will not result in adverse changes in client service standards or business focus and coordinating sales, marketing and distribution efforts;

• consolidating and rationalizing corporate IT infrastructure, including implementing information management and system processes that enable increased customer satisfaction, improved productivity, lower costs, accurate financial reporting, more direct sales and improved inventory management;

• minimizing the diversion of management attention from ongoing business concerns;

• persuading employees that business cultures are compatible, maintaining employee morale and retaining key employees, integrating employees into Dot Hill, and correctly estimating employee benefit costs; and

•coordinating and combining administrative, manufacturing, research and development and other operations, subsidiaries, facilities and relationships with third parties in accordance with local laws and other obligations while maintaining adequate standards, controls and procedures.

Managing the acquisition of Chaparral may divert our attention from other business operations. This transaction also has resulted and in the future may result in significant costs and expenses and charges to earnings, including those related to severance pay, employee benefit costs, asset impairment charges, charges from the elimination of duplicative facilities and contracts, in-process research and development charges, inventory adjustments, legal, accounting and financial advisory fees, and required payments to executive officers and key employees under retention plans. Moreover, Dot Hill has incurred and will incur additional depreciation and amortization expense over the useful lives of certain assets acquired in connection with transactions, and, to the extent the value of goodwill or intangible assets with indefinite lives acquired in connection with a transaction becomes impaired, we may be required to incur additional material charges relating to the impairment of those assets. As a result, the Chaparral transaction may contribute to financial results that differ from the investment community’s expectations in a given quarter.

Our stock price may be highly volatile and could decline substantially and unexpectedly.

The trading price of our shares of common stock has been affected by the factors disclosed in this section as well as prevailing economic and financial trends and conditions in the public securities markets. Share prices of companies in technology-related industries, such as ours, tend to exhibit a high degree of volatility. The announcement of financial results that fall short of the results anticipated by the public markets could have an immediate and significant negative effect on the trading price of our shares in any given period. Such shortfalls may result from events that are beyond our immediate control, can be unpredictable and, since a significant proportion of our sales during each fiscal quarter tend to occur in the latter stages of the quarter, may not be discernible until the end of a financial reporting period. These factors may contribute to the volatility of the trading value of our shares regardless of our long-term prospects. The trading price of our shares may also be affected by developments, including reported financial results and fluctuations in trading prices of the shares of other publicly-held companies, in our industry generally and our business segment in particular, which may not have any direct relationship with our business or prospects.

In the past, securities class action litigation has often been brought against a company following periods of volatility in the market price of its securities. We could be the target of similar litigation in the future. Securities litigation could result in the

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expenditure of substantial funds, divert management’s attention and resources, harm our reputation in the industry and the securities markets and reduce our profitability.

Future sales of our common stock may hurt our market price.

A substantial number of shares of our common stock may become available for resale. If our stockholders sell substantial amounts of our common stock in the public market, the market price of our common stock could decline. These sales might also make it more difficult for us to sell equity securities in the future at times and prices that we deem appropriate. In addition, we are obligated to file a registration statement with respect to the resale of up to 1,394,279 shares of our common stock issuable upon exercise of warrants held by Sun.

Geopolitical military conditions, including terrorist attacks and other acts of war, may materially and adversely affect the markets on which our common stock trades, the markets in which we operate, our operations and our profitability.

Terrorist attacks and other acts of war, and any response to them, may lead to armed hostilities and such developments would likely cause instability in financial markets. Armed hostilities and terrorism may directly impact our facilities, personnel and operations which are located in the United States and internationally, as well as those of our channel partners, suppliers, third party manufacturer and customers. Furthermore, severe terrorist attacks or acts of war may result in temporary halts of commercial activity in the affected regions, and may result in reduced demand for our products. These developments could have a material adverse effect on our business and the trading price of our common stock.

Item 3.  Quantitative and Qualitative Disclosures About Market Risk

Interest Rate and Credit Risk

Our exposure to market rate risk for changes in interest rates relates to our investment portfolio. Our primary investment strategy is to preserve the principal amounts invested, maximize investment yields, and maintain liquidity to meet projected cash requirements. Accordingly, we invest in instruments such as money market funds, certificates of deposit, U.S. Government/Agencies bonds, notes, bills and municipal bonds that meet high credit quality standards, as specified in our investment policy guidelines. Our investment policy also limits the amount of credit exposure to any one issue, issuer, and type of instrument. We do not currently use derivative financial instruments in our investment portfolio and we do not enter into market risk sensitive instruments for trading purposes. We do not expect to incur any material losses with respect to our investment portfolio.

The following table provides information about our investment portfolio at December 31, 2003 and March 31, 2004. For investment securities, the table presents carrying values at December 31, 2003 and March 31, 2004 and, as applicable, and related weighted average interest rates by expected maturity dates.

	December 31, 2003			March 31, 2004
	(amounts in thousands)
Cash equivalents	$	127,790		$	70,753
Average interest rate	1.0		%	0.9		%
Short-term investments	$	52,982		$	44,388
Average interest rate	1.6		%	1.0		%
Total portfolio	$	180,772		$	115,141
Average interest rate	1.2		%	0.9		%

We had a line of credit agreement, which accrued interest at a variable rate and expired May 1, 2004. As of March 31, 2004, we had no balance under this line.  We are presently in negotiations to replace this line of credit.  Were we to incur a balance under this or a similar replacement line of credit, we would be exposed to interest rate risk on such debt.

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Foreign Currency Exchange Rate Risk

A portion of our international business is presently conducted in currencies other than the U.S. dollar. Foreign currency transaction gains and losses arising from normal business operations are credited to or charged against earnings in the period incurred. As a result, fluctuations in the value of the currencies in which we conduct our business relative to the U.S. dollar will cause currency transaction gains and losses, which we have experienced in the past and continue to experience. Due to the substantial volatility of currency exchange rates, among other factors, we cannot predict the effect of exchange rate fluctuations upon future operating results. There can be no assurances that we will not experience currency losses in the future. We have not previously undertaken hedging transactions to cover currency exposure and we do not intend to engage in hedging activities in the future.

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Item 4.  Controls and Procedures

Evaluation of Disclosure Controls and Procedures

Our chief executive officer and chief financial officer, after evaluating the effectiveness of our disclosure controls and procedures (as defined in the Securities Exchange Act of 1934, as amended, Rule 13a-15(e) as of the end of the period covered by this Periodic Report on Form 10-Q, have concluded that as of the end of such period, our disclosure controls and procedures are effective to ensure that information required to be disclosed by us in the reports that we file under the Securities Exchange Act of 1934, as amended, is recorded, processed, summarized and reported within the time period specified in the Commission’s rules and forms.

Changes in Internal Controls

There has been no change in our internal control over financial reporting that occurred during the quarter covered by this Periodic Report on Form 10-Q that has materially affected, or is reasonably likely to materially affect, our internal control over financial reporting.

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Part II. Other Information

Item 1.  Legal Proceedings

On October 17, 2003, Crossroads Systems, or Crossroads, filed a lawsuit against us in the United States District Court in Austin, Texas alleging that our products infringe two United States patents assigned to Crossroads, Patent Numbers 5,941,972 and 6,425,035. We were served with the lawsuit on October 27, 2003. Chaparral was added as a party to the lawsuit in March 2004. The patents involve storage routers and methods for providing virtual local storage. Patent Number 5,941,972 involves the interface of SCSI storage devices and the Fibre Channel protocol and Patent Number 6,425,035 involves the interface of any one transport medium and a second transport medium. We believe that we have meritorious defenses to Crossroads’ claims and are in the process of vigorously defending against them. We believe that the outcome will not have a material adverse effect on our financial condition or operating results. However, we expect to incur significant legal expenses in connection with this litigation. These defense costs, and other expenses related to this litigation, will be expensed as incurred and will negatively affect our operating results.

In addition to the action discussed above, we are subject to various legal proceedings and claims, asserted or unasserted, which arise in the ordinary course of business. The outcome of the claims against us cannot be predicted with certainty. We believe that such litigation and claims will not have a material adverse effect on our financial condition or operating results.

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.

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Item 6.  Exhibits and Reports on Form 8-K

a.List of Exhibits

Exhibit Number	Description
10.1*	Second Amendment to Product Purchase Product Purchase Agreement, dated as of January 26, 2004, by and among Sun Microsystems, Inc., Sun Microsystems International B.V., the registrant and Dot Hill Systems B.V.
10.2*	Third Amendment to Product Purchase Product Purchase Agreement, dated as of March 22, 2004, by and among Sun Microsystems, Inc., Sun Microsystems International B.V., the registrant and Dot Hill Systems B.V.
10.3*	Product Supplement/Award Letter (SATA) by and between Sun Microsystems, Inc. and the registrant, dated as of March 22, 2004.
10.4	Secured Convertible Promissory Note, dated January 17, 2002.
10.5	Security Agreement, dated January 17, 2002, by and between Chaparral Network Storage, Inc. and Xyratex Technology Limited.
31.1	Certification pursuant to 17 CFR 240.13a-14(a) or 17 CFR 240.15d-14(a), as adopted pursuant to Section 302 of the Sarbanes-Oxley Act of 2002.
31.2	Certification pursuant to 17 CFR 240.13a-14(a) or 17 CFR 240.15d-14(a), as adopted 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.

*              Confidential treatment requested.

b.Reports on Form 8-K.

1.The registrant filed a current report on Form 8-K, dated January 28, 2004, announcing the registrant’s earnings for the year ended December 31, 2003 and the two-year extension of its OEM agreement with Sun Microsystems, Inc.

2.The registrant filed a current report on Form 8-K, dated February 24, 2004, announcing the acquisition of Chaparral Network Storage Systems, Inc.

3.The registrant filed a current report on Form 8-K, dated March 22, 2004, announcing that its existing OEM partner agreement with Sun Microsystems, Inc. has been expanded to include new advanced technology storage products.

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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.

	Dot Hill Systems Corp.
Date: May 10, 2004	By	/s/ JAMES L. LAMBERT
		James L. Lambert
		Chief Executive Officer
		(Principal Executive Officer)
Date: May 10, 2004	By	/s/ PRESTON S. ROMM
		Preston S. Romm
		Chief Financial Officer and Treasurer
		(Principal Financial and Accounting Officer)

34

EX-10.1

Exhibit 10.1

[ * ] = Certain confidential information contained in this document, marked by brackets, has been omitted and filed separately with the Securities and Exchange Commission pursuant to Rule 24b-2 of the Securities Exchange Act of 1934, as amended.

Second Amendment	Agreement No. AR-63645-Amd 2
To Product Purchase Agreement

This Second Amendment (the “Second Amendment”) to the Product Purchase Agreement that was made on the 22nd day of May, 2002, as amended and the Award Letters executed thereunder (the “PPA is made and entered into as of this 26 day of January, 2004 (the “Second Amendment Effective Date”) by and among Sun Microsystems, Inc., a Delaware corporation, with an office at 901 San Antonio Road, Palo Alto, California 94303 and Sun Microsystems International B.V., a Netherlands corporation, with an office at Computertweg 1, 3821 AA Amersfoot, the Netherlands (hereafter collectively referred to as “Sun”) and Dot Hill Systems Corporation, a Delaware corporation, with an office at 6305 El Camino Real, Carlsbad, California 92009 and Dot Hill Systems B.V., a Netherlands corporation, with an office at Marssteden 94, 7547 TD Enschede, the Netherlands (hereafter collectively referred to as “Supplier”).  For purpose of interpretation and construction of this Second Amendment, capitalized terms included herein shall have the same meaning as such terms are defined in the PPA.  Additionally, Sun and Supplier may each be referred to in this Second Amendment as a “Party” and collectively as the “Parties.”

Background

Whereas, Sun and Dot Hill desire to amend the PPA to make certain additions and modifications to the PPA, as described below.

Now Therefore, for good and valuable consideration, the receipt and sufficiency of which is hereby acknowledged by both Parties, the Parties hereby agree to amend and do amend the PPA, as follows:

Second Amendment

1.Replace Section 3, Term, of the PPA with the following:

“3 Term.  The term of this Agreement shall commence on the Effective Date and, unless terminated sooner in accordance with Section 24.1, continue until May 22, 2007 (the “Initial Term”).  This Agreement will renew automatically for additional [ * ] periods (each a “Renewal Term”) unless either party gives written Notice of its intent not to renew the Agreement at least [ * ] before the end of the Initial Term or any then-existing Renewal Term, as the case may be.  The Initial Term and any Renewal Terms will collectively be referred to as the “Term” when used elsewhere in this Agreement.”

2.Add the following sentence at the end of Section 4.2, Product Pricing, of the PPA:

1

“Supplier will use [ * ] to establish or derive [ * ] for the Product(s) that are to be provided to Sun under this Agreement.  In certain situations, [ * ].”

3.Replace the last two sentences of Section 4.3.2, Cost Savings, of the PPA with the following:

“The Award Letter will set forth any specific required reductions in pricing to the Product(s) that Sun may obtain from Supplier under this Agreement [ * ], together with the date on which any such required reductions in pricing to the Product(s) are to take effect and the manner in which they are to be implemented.  Additional reductions in pricing, if any, will be agreed by the parties in writing.”

4.Add the following to the PPA as Section 4.3.3:

 “4.3.3 Executive Reviews.  [ * ], then Sun may request that an executive meeting be held between Sun and Supplier to discuss and implement potential changes to pricing for the Product(s) or the business models used in the pricing of Product(s) to Sun to ensure they are priced properly to provide cost competitiveness.  Supplier will accommodate such requests from Sun for such meetings, which will be held at mutually agreed dates and times.”

5.Replace Section 8.1 of the PPA with the following:

“8.1  Unless otherwise specified in an applicable Award Letter, payment is due from Sun to Supplier within the number of days set forth below (the “Payment Due Date”) after the receipt of invoice or the receipt of Product by Sun or its carrier, whichever is later (the “Payment Trigger Event”) unless Sun reasonably disputes whether an invoice from Supplier is due and owing or the Product was not received by Sun or its carrier from Supplier:

Date of Payment Trigger Event	Payment Due Date
[ * ]	[ * ]
[ * ]	[ * ]
[ * ]	[ * ]

[ * ].  Unless otherwise specified in the applicable Award Letter, all payments shall be made in U.S. Dollars.  Sun shall not be required to pay the disputed portion of any invoice, pending resolution of that dispute; provided, however, that Notice of the dispute has been provided by Sun to Supplier prior to the Payment Due Date and Sun has a reasonable basis in providing to Supplier such Notice of dispute.”

6.Replace the last sentence of Section 27.2, Publicity, of the PPA with the following:

“Notwithstanding the foregoing: (i) Supplier may make such disclosures as are reasonably necessary to comply with any securities laws, regulations or rules, subject to Sun’s review and consent which shall not be unreasonably withheld, delayed or

2

conditioned; and (ii) Supplier may issue other press releases in connection with any Product releases for customer revenue for any future major Products that are to be provided by Supplier to Sun, subject to Sun’s written consent to the publication by Supplier of the content in and timing of such press releases, which consent shall not be unreasonably withheld, delayed or conditioned by Sun.”

7.This Second Amendment shall have prospective force and effect as of the Second Amendment Effective Date.  Except as specifically set forth above, the terms and conditions of the PPA, including any Exhibits thereto, and any Award Letters issued under the PPA shall remain unchanged and in full force and effect.  The PPA, as amended by this Second Amendment, together with any Award Letters, constitutes the entire agreement by and between the Parties relating to its subject matter.  Such documents shall supersede all prior and contemporaneous oral or written communications, proposals, conditions, representations and warranties and prevail over any conflicting or additional terms and conditions between the Parties relating to its subject matter.

In Witness Whereof, the Parties have caused this Second Amendment to the PPA to be signed by their duly authorized representatives effective as of the Second Amendment Effective Date.

Sun Microsystems, Inc.

Dot Hill Systems Corporation

By:

/s/ Marcy Alstott

By:

/s/ J. L. Lambert

Printed Name:

Marcy Alstott

Printed Name:

James L. Lambert

Date:

26-Jan-04

Date:

26 Jan 2004

Title:

VP, WW Operations

Title:

President & CEO

Sun Microsystems, International B.V.

Dot Hill Systems B.V.

By:

/s/ Tymen Kos

By:

/s/ B. H. M. van der Woning

Printed Name:

Tymen Kos

Printed Name:

Bert H. M. van der Woning

Date:

27-Jan-04

Date:

25-Jan-04

Title:

Director

Title:

M. D.

[ * ] = Certain confidential information contained in this document, marked by brackets, has been omitted and filed separately with the Securities and Exchange Commission pursuant to Rule 24b-2 of the Securities Exchange Act of 1934, as amended.

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EX-10.2

Exhibit 10.2

[ * ]  = Certain confidential information contained in this document, marked by brackets, has been omitted and filed separately with the Securities and Exchange Commission pursuant to Rule 24b-2 of the Securities Exchange Act of 1934, as amended.

Agreement No.:  AR-63645

Third Amendment

To Product Purchase Agreement

This Third Amendment (the “Third Amendment”) to the Product Purchase Agreement that was made on the 22nd day of May, 2002, as amended (the “PPA”), and the Award Letters executed thereunder, is made and entered into as of this 22 day of March, 2004 (the “Third Amendment Effective Date”) by and among Sun Microsystems, Inc., a Delaware corporation, with an office at 901 San Antonio Road, Palo Alto, California 94303 and Sun Microsystems International B.V., a Netherlands corporation, with an office at Computertweg 1, 3821 AA Amersfoot, the Netherlands (hereafter collectively referred to as “Sun”) and Dot Hill Systems Corporation, a Delaware corporation, with an office at 6305 El Camino Real, Carlsbad, California 92009 and Dot Hill Systems B.V., a Netherlands corporation, with an office at Marssteden 94, 7547 TD Enschede, the Netherlands (hereafter collectively referred to as “Supplier”).  For purpose of interpretation and construction of this Third Amendment, capitalized terms included herein shall have the same meaning as such terms are defined in the PPA.  Additionally, Sun and Supplier may each be referred to in this Third Amendment as a “Party” and collectively as the “Parties.”

Background

Whereas, Sun and Dot Hill desire to amend the PPA and the Award Letters to make certain additions and modifications to the PPA and the Award Letters, as described below.

Now therefore, for good and valuable consideration, the receipt and sufficiency of which is hereby acknowledged by both Parties, the Parties hereby agree to amend and do amend the PPA and the Award Letters, as follows:

Third Amendment

1)Add the following to the PPA as Section 2.8.2.6:

“2.8.2.6 Supplier will provide to Sun’s product marketing and sales group certain mutually agreed technical marketing support including, but not limited to, documents and/or web file content to support the release and ongoing sales of certain agreed Product(s).  [ * ]  .”

2)Add the following to the PPA as Section 2.8.4:

“2.8.4[ * ]  .”

3)Add the following to the PPA as Section 2.8.5:

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“2.8.5[ * ]

4)Add the following to the PPA as Section 2.8.6:

“2.8.6The Parties intend to work together to promote Supplier’s sponsorship, attendance and participation at internal Sun events, Sun events that include Sun channel partners or Sun end user events.  In order to participate in Sun internal events, Supplier must obtain Sun’s prior approval of Supplier’s proposed space, signage, written and electronic content, product demonstrations and other elements.  For any approved events, Sun and Supplier will mutually agree in advance the funding, the marketing materials to be used and which party will set up and man any booths used.  Any Supplier Product marketing materials will only mention Sun Products, instead of any Supplier or third party products. Should Supplier desire to participate in Sun events that include Sun channel partners or in Sun end user events, the above process and requirements will apply, and in addition, Supplier will only support the Sun Products at those events and not have any signs, collateral or other materials that mention Supplier’s name or other products.”

5)Add the following to the PPA as Section 2.11:

a)“2.11[ * ]

6)Add the following to the PPA as Section 2.12:

“2.12Additional Qualification Procedures

i)Supplier will perform at least [ * ]  of the NSTE level testing and will exercise best efforts (within Supplier’s then-current business and operational constraints and resources) to exceed this minimum level for NSTE level testing.  Sun’s expectations of meeting this goal are as follows: (i) [ * ] , Supplier and Sun will jointly establish an appropriate test percentage goal and a timeframe in which such goal may be met.  Notwithstanding the foregoing, Sun acknowledges that the availability of technology to run tests may impact Supplier’s ability to meet any goal or objective that is established.

ii)For new Product(s), Supplier will create a test requirement matrix document based on a Sun-approved product concept design or other official Sun-delivered marketing document.  This required test requirement matrix document would be edited jointly, and then submitted to SUN for final approval.  Upon approval of this test requirement matrix document by Sun, Supplier will develop a test plan, and submit it in a timely manner to Sun for review and approval.  Any test schedule within such agreed test plan will be tracked by Supplier, submitted to Sun on a weekly basis or such other mutually agreed schedule, and reviewed in various meetings between Supplier and Sun, [ * ] .

iii)If changes are made to the product requirements [ * ]  after the test plan and schedule that has been proposed by the Supplier has been approved by Sun, and Sun clearly documents a request for change to Supplier, then the underlying test requirement matrix document will be updated by Supplier and provided promptly to Sun for further review and approval.  Any changes made to an underlying test requirement matrix document will be clearly documented with the date it was changed, and communicated by a party to the other.  Supplier will also promptly provide to Sun an updated test plan that will result from any changes made to such test matrix requirement

2

document, and advise Sun whether there may or may not be any impact on scheduling for the Product(s).  If changes are made by Sun to the product requirements [ * ] .

iv)Either before or after testing has begun, any additions or modifications to test requirements or cases requested by Sun will be negotiated in good faith between Supplier and Sun and, if appropriate, the schedule may be adjusted based on such agreed additions and modifications.

v)If there is an inconsistency or conflict between the provisions of this Section 5.12, including its subsections, and those provisions included elsewhere in this  [ * ], Supplier’s Quality Program, then the provisions of this Section 5.12, including its subsections, shall govern and prevail over such other inconsistent or conflicting provisions.”

7)Replace the sentence in Section 4.2 of the PPA that begins with “Supplier will provide to Sun the agreed upon percentage….” with the following:

[ * ]

8)Replace in their entirety Sections 4.3.1 and 4.3.2 of the PPA with the following:

“4.3.1 Cost Reductions. Supplier will work actively to achieve cost reductions on all materials/processes associated with Product.  Supplier will provide to Sun an anticipated [ * ]  Product costs and Supplier is encouraged to suggest to Sun changes to materials/processes, however small, that will result in improved performance, reliability or yield of Products.

“4.3.2   Price Reductions.    Supplier and Sun will [ * ].  Except as otherwise provided in Section 4.2 or as otherwise agreed by the Parties in writing, Sun will receive [ * ] .

9)Replace Section 14.7.1 of the PPA with the following:

“14.7.1  Supplier agrees to loan to Sun [ * ]  a total of between [ * ]  and [ * ]  Product units for the following geographies: (i) North America, (ii) Europe the Middle East and Africa, and (iii) Asia Pacific.  The maximum period of any loan for such Product(s) will be for [ * ]  days (the “Loan Term”).  All such loaned Product(s) will be returned by Sun to Supplier prior to the expiration of the Loan Term [ * ] .  If Sun fails to return any such Products prior to the expiration of the Loan Term, Supplier will notify Sun of such failure and if the Products have not been returned within [ * ], then such applicable Product(s) [ * ] by Supplier to Sun and, Supplier may invoice Sun for such Product(s) at Sun’s then current Product cost.  Supplier and Sun will each act in a cooperative manner to help to develop the above loan process, including logistics associated with the return of Product(s).  With respect to such loan activities, Supplier will loan to Sun the following Product(s): [ * ] , until such time as Supplier has met its loan obligations as set forth above; provided however, that the Parties may agree at any time to accelerate this schedule.  [ * ] .”

10)  Replace Section 19 of the PPA with the following:

“19. Sun Unique Features. Supplier shall not use, sell, distribute or otherwise transfer the customized configuration of the Products, [ * ] .”

3

11) Replace Section 2 of the Award Letters executed prior to the Third Amendment Effective Date with the following: “PRODUCT DESCRIPTIONS AND PRICING:  Product descriptions and pricing are set forth in Exhibit A to this Award Letter.”

12) Replace Exhibits B (Sun-Unique Turnkey Components), F (External Manufacturers) and G (Business Continuity Plan) in all Award Letters executed prior to the Second Amendment Effective Date with the Exhibits attached hereto as Appendices 1, 2 and 3.  The Parties may update Exhibit B from time to time by mutual written agreement.

13) Add the following as Section 5.24 to Exhibit B, Customer Support Provisions, of the PPA:

“5.24Upon request by either party, [ * ] .”

14) Replace Section 4.2 of Exhibit D-1, Training, of the PPA with the following:

“4.2 For sales and services training, Supplier and Sun will develop training courses with a Sun look and feel for the following audiences and for delivery in the following formats: [ * ] . Sun and Supplier acknowledge and agree that such training courses, training materials or training manuals will be [ * ]  and otherwise in accordance with the rights and subject to the conditions of use set forth in Amendment No. 1 to this Agreement. Upon Sun’s acceptance of the course, materials or manuals, which acceptance will not be unreasonably withheld, delayed or conditioned, [ * ] for each major release of new Product(s) that are developed by Supplier and Sun pursuant to the foregoing provisions in this Section 4.2: (a) [ * ]  and any major updates that Supplier chooses to undertake thereto, plus reasonable and pre-approved travel related costs that Supplier actually incurs.

However, if a major release of new Product(s) only [ * ] . Any revenue-generating and/or custom courses, lab training materials or training manuals that Sun desires for Supplier to develop which are outside of the list above must be agreed to in writing by Sun and Supplier. [ * ] . Any charges for such developmentand/or delivery shall be reasonable in nature and agreed to in writing prior to the commencement of any such development and/or delivery.

15) Replace Section 4.3 of Exhibit D-1, Training, of the PPA with the following:

“4.3 Supplier will deliver, upon Sun’s request, a minimum of [ * ] . Subject to Section 4.15 of this Exhibit D-1, [ * ]  or course delivery will be quoted at time of request. Additionally, Supplier will deliver [ * ]  for any new Product(s) that is (are) made available by Supplier to Sun after January 31, 2004. The delivery to Sun of [ * ] will be addressed by the Parties. Additional charges may apply to the development and delivery of any such training courses.”

16) Replace Section 4.4 of Exhibit D-1, Training, of the PPA with the following:

“4.4[ * ] .  Such training [ * ] if any, will be determined by the Parties and set forth in a training plan that will be agreed to by Supplier and Sun before any such training occurs.  Supplier will make such agreed training available to Sun within a reasonable agreed time frame after

4

receipt of Notice and [ * ] for a period of one (1) year commencing from the first day on which any such training is made available by Supplier.”

This Third Amendment shall have prospective force and effect as of the Third Amendment Effective Date.  Except as specifically set forth above, the terms and conditions of the PPA, including any Exhibits thereto, and any Award Letters issued under the PPA shall remain unchanged and in full force and effect.  The PPA, as amended by this Third Amendment, together with any Award Letters, constitutes the entire agreement by and between the Parties relating to its subject matter.  Such documents shall supersede all prior and contemporaneous oral or written communications, proposals, conditions, representations and warranties and prevail over any conflicting or additional terms and conditions between the Parties relating to its subject matter.

In Witness Whereof, the Parties have caused this Third Amendment to the PPA to be signed by their duly authorized representatives effective as of the Third Amendment Effective Date.

Sun Microsystems, Inc.

Dot Hill Systems Corporation

By:

/s/ Marcy Alstott

By:

/s/ Jim Lambert

Printed Name:

Marcy Alstott

Printed Name:

Jim Lambert

Date:

19 March 2004

Date:

16 Mar 2004

Title:

VP, Worldwide Operations

Title:

President & CEO

Sun Microsystems, International B.V.

Dot Hill Systems B.V.

By:

/s/ Tymen Kos

By:

/s/ B. H. M. van der Woning

Printed Name:

Tymen Kos

Printed Name:

BHM van der Woning

Date:

Director

Date:

22 March 2004

Title:

22 March 2004

Title:

Managing Director

[ * ]  = Certain confidential information contained in this document, marked by brackets, has been omitted and filed separately with the Securities and Exchange Commission pursuant to Rule 24b-2 of the Securities Exchange Act of 1934, as amended.

5

EX-10.3

Exhibit 10.3

[ * ] = Certain confidential information contained in this document, marked by brackets, has been omitted and filed separately with the Securities and Exchange Commission pursuant to Rule 24b-2 of the Securities Exchange Act of 1934, as amended.

Agreement No. AR-63645-04

PRODUCT SUPPLEMENT/AWARD LETTER (SATA)

This Product Supplement/Award Letter (this “Award Letter”) is made on and as of the         day of March, 2004 (“Effective Date”) by and between Sun Microsystems, Inc. (“Sun”) and Dot Hill Systems Corporation (“Supplier”), pursuant to the Product Purchase Agreement, dated as of May 22, 2002, Agreement No. AR-63645, as amended, made between the parties (the “Agreement”).  Capitalized terms not defined in this Award Letter have the meanings set forth in the Agreement.  The parties agree as follows:

1  SCOPE:  Neither this Award Letter nor the Agreement constitutes a commitment by Sun to purchase Products unless Sun, in its sole discretion, issues one or more P.O.’s in the manner described in the Agreement.  The terms and conditions of the Agreement are incorporated herein by reference as if set forth in full.

2  PRODUCT DESCRIPTIONS AND PRICING/COST REDUCTIONS:  Product descriptions and pricing are set forth in Exhibit A to this Award Letter.

3  MINIMUM PURCHASE RIGHTS PERIOD:  Pursuant to the terms of Section 2.1 of the Agreement, the Minimum Purchase Rights Period (as defined therein) is [ * ].

4  UPSIDE SUPPORT:  Sun may request all or any part of Upside Support quantities atanytime during the applicable quarterup to the maximum amount indicated beginning with Sun’s GA of the Sun product or system that incorporates the Product(s).  Requests for Upside Support, above the percentages listed below or within less Days Advance Notice for the listed percentage below, may be subject to additional charges actually incurred by Supplier and other requirements related to manufacturing and materials cycle lead time, availability of personnel and manufacturing capacity.  Supplier will inform Sun in writing of any additional charges and requirements that apply to delivery of Product for this additional Upside Support and obtain approval from Sun to such additional charges and requirements prior to implementing such Upside Support. Supplier shall use commercially reasonable efforts to sell,manufacture and ship such Upside Support quantitiesto Sun on a “first-in, first-out” basis within five (5) business days after Sun’s written request.

Timeframe	Days Advance Notice	Upside Max. Percentage Increase
[ * ]

Supplier shalluse reasonable efforts to accommodate any request from Sunto accelerate delivery of Upside quantities of Productswithinthe timeframes indicated above.  With respect to any request for quantities in excess of Upside Support described above, the parties shallnegotiate in good faith acceptabledelivery dates.

5    SUN-UNIQUE COMPONENTS:  The initial List of Sun-unique Components, Leadtimes and MOQs is set forth as Exhibit B.

6  SPECIFICATION:The Product Specification is set forth as Exhibit C.

7  EXTERNAL MANUFACTURERS:  The list of External Manufacturers, if any, is set forth in Exhibit D.

8 BUSINESS CONTINUITY PLAN: Supplier’s business continuity plan for the Product is set forth in Exhibit E.

9 LICENSED SOFTWARE: The Licensed Software shall mean the most current version of [ * ].

10 QUALITY:  In addition to the quality requirements in Exhibit C of the Agreement, Exhibit F of this Award Letter, which is attached hereto and incorporated by reference, contains component-specific requirements.

11  AWARD LETTER COMPONENTS:  The parties agree to be bound by these terms and conditions which consists of the Award Letter and the Exhibits indicated below:

ý	Exhibit A (Product Descriptions and Pricing)
ý	Exhibit B (Sun-unique Components, Leadtimes and MOQs)
ý	Exhibit C (Specification)

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ý	Exhibit D (External Manufacturers)
ý	Exhibit E (Business Continuity Plan)
ý	Exhibit F (Component Quality Requirements)

The undersigned duly authorized representatives of the parties have executed and delivered this Award Letter as of the Effective Date.

Sun Microsystems, Inc.					Dot Hill Systems Corporation
By:	/s/ Marcy Alstott				By:	/s/ Jim Lambert
Name:				Marcy Alstott	Name:			Jim Lambert
Title:			VP, Worldwide Operations		Title:		President & CEO
Date:		19 March 2004			Date:		17 Mar 2004

Sun Microsystems International B.V.					Dot Hill Systems BV
By:	/s/ Tymen Kos				By:	/s/ BHM van der Woning
Name:				Tymen Kos	Name:				BHM van der Woning
Title:		Director			Title:			Managing Director
Date:			22 March 2004		Date:		14 March 2004

[ * ] = Certain confidential information contained in this document, marked by brackets, has been omitted and filed separately with the Securities and Exchange Commission pursuant to Rule 24b-2 of the Securities Exchange Act of 1934, as amended.

2

EXHIBIT A

PRODUCT DESCRIPTIONS AND PRICING

[ * ]

[ * ] = Certain confidential information contained in this document, marked by brackets, has been omitted and filed separately with the Securities and Exchange Commission pursuant to Rule 24b-2 of the Securities Exchange Act of 1934, as amended.

3

EXHIBIT B

SUN-UNIQUE COMPONENTS, LEADTIMES AND MOQs

[ * ]

[ * ] = Certain confidential information contained in this document, marked by brackets, has been omitted and filed separately with the Securities and Exchange Commission pursuant to Rule 24b-2 of the Securities Exchange Act of 1934, as amended.

4

EXHIBIT C

SPECIFICATION

(To be attached)

5

EXHIBIT D

EXTERNAL MANUFACTURERS

Solectron Corporation

847 Gibraltar Drive

Building 5

Milpitas, CA 95035

Solectron Technology Sdn. Blvd.

Plot 13 Phase IV

Prai Industrial Estate

13600 Prai

Penang.  Malaysia

Solectron Hungary
 Hangár Utca 5-37
H-1183 Budapest

 Hungary

6

[ * ] = Certain confidential information contained in this document, marked by brackets, has been omitted and filed separately with the Securities and Exchange Commission pursuant to Rule 24b-2 of the Securities Exchange Act of 1934, as amended.

EXHIBIT E

BUSINESS CONTINUITY PLAN

DOT HILL SYSTEMS CORP.

DISASTER RECOVERY AN BUSINESS CONTINUITY PLAN

January 19, 2004

This package is to document Dot Hill’s current disaster recovery and business continuity plan.  This package will be updated periodically on an as needed basis.  This package contemplates that products will be manufactured at Solectron Corporation, and therefore, includes Solectron’s Corporate Disaster Response and Recovery Document as part of the overall plan.

[ * ]

[ * ] = Certain confidential information contained in this document, marked by brackets, has been omitted and filed separately with the Securities and Exchange Commission pursuant to Rule 24b-2 of the Securities Exchange Act of 1934, as amended.

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[ * ] = Certain confidential information contained in this document, marked by brackets, has been omitted and filed separately with the Securities and Exchange Commission pursuant to Rule 24b-2 of the Securities Exchange Act of 1934, as amended.

EXHIBIT F

[ * ]

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EX-10.4

Exhibit 10.4

Execution Copy

THE SECURITIES REPRESENTED HEREBY HAVE NOT BEEN REGISTERED UNDERTHE SECURITIES ACT OF 1933, AS AMENDED (THE “SECURITIES ACT”), AND MAY NOT BE OFFERED, SOLD OR OTHERWISE TRANSFERRED, ASSIGNED, PLEDGED OR HYPOTHECATED UNLESS AND UNTIL REGISTERED UNDER THE SECURITIES ACT OR UNLESS THE COMPANY HAS RECEIVED AN OPINION OF COUNSEL REASONABLY SATISFACTORY TO THE COMPANY AND ITS COUNSEL THAT SUCH REGISTRATION IS NOT REQUIRED. THE TERMS AND CONDITIONS OF THE SECURITIES REPRESENTED BY THIS CERTIFICATE, INCLUDING THE TRANSFER OF THE SECURITIES REPRESENTED BY THIS CERTIFICATE, ARE SUBJECT TO THE PROVISIONS OF THAT CERTAIN SECURITIES PURCHASE AGREEMENT, DATED AS OF JANUARY 17, 2002, BY AND BETWEEN THE COMPANY (AS DEFINED THEREIN) AND THE PURCHASER (AS DEFINED THEREIN), AS AMENDED AND MODIFIED FROM TIME TO TIME. A COPY OF SUCH CONDITIONS SHALL BE FURNISHED BY THE COMPANY UPON WRITTEN REQUEST AND WITHOUT CHARGE.

SECURED CONVERTIBLE PROMISSORY NOTE

US $6,000,000	Longmont, Colorado
	January 17, 2002

FOR VALUE RECEIVED, the undersigned, CHAPARRAL NETWORK STORAGE, INC., a Delaware corporation (the “Company”), hereby promises to pay to the order of XYRATEX TECHNOLOGY LIMITED, a corporation organized under the laws of England and Wales (the “Purchaser”), at the offices of the Purchaser, the principal sum of up to Six Million Dollars (US$6,000,000) (the “Principal Amount”) or such lesser Principal Amount thereof as may remain outstanding (“Principal”) in lawful money of the United States of America in immediately available funds, and to pay interest from the date hereof on the Principal Amount hereof from time to time outstanding (“Interest”), in like funds, at said office, at a rate of 8% simple per annum, calculated on the basis of the number of days elapsed in a 365-day year and payable on such dates as determined pursuant to the terms of the Securities Purchase Agreement dated as of the Effective Date, by and between the Company and Purchaser, as the same may be amended, modified, restated or supplemented from time to time (the “Securities Purchase Agreement”) Purchaser has agreed, subject to the terms of, and satisfaction of the conditions set forth in the Securities Purchase Agreement, to advance the Principal Amount to the Company as follows: Two Million United States Dollars (US $2,000,000) to be advanced at Closing and the remaining Four Million United States Dollars (US $4,000,000) to be advanced in four tranches of One Million United States Dollars (US$1,000,000), on the 15th of each month commencing in February 2002, until the total Principal has been paid to the Company. The Company promises to pay Interest and Principal in accordance with the terms of the Securities Purchase Agreement. This Note is issued to and is subject to and the Purchaser or any subsequent holder or assignee is entitled to the benefits of the Securities

Purchase Agreement and the Security Agreement by and between the Company and the Purchaser dated the Effective Date (the “Security Agreement”). The terms and conditions contained in the Securities Purchase Agreement and the Security Agreement that relate to the Note are incorporated herein by reference.

Capitalized terms used herein and not otherwise defined shall have the meanings assigned to them in the Securities Purchase Agreement or the Security Agreement.

The “Maturity Date”of the Note shall be the date that is exactly six years after the disbursement of the last Advance of the Financing Amount (as such amount is adjusted pursuant to Section 3 of the Securities Purchase Agreement). The Principal shall be due and payable as follows: one half, together with accrued and unpaid Interest on the entire Principal (not just one half thereof) shall be due and payable on the date that is exactly three years after the disbursement of the last Advance of the Financing Amount (as such amount is adjusted pursuant to Section 3 of the Securities Purchase Agreement); and the remaining Principal, together with accrued and unpaid Interest on such amount, shall be due and payable on the Maturity Date.

The Company hereby waives diligence, presentment, demand, protest and notice of any kind whatsoever, other than as expressly required by the Securities Purchase Agreement. The non-exercise by the Purchaser of any of its rights hereunder or under the Securities Purchase Agreement in any particular instance shall not constitute a waiver thereof in that or any subsequent instance.

This Note is referred to in the Securities Purchase Agreement. The Securities Purchase Agreement provides that (1) the occurrence of certain events (as specified therein) shall constitute Events of Default by the Company hereunder and  thereunder and (2) upon the occurrence of any such Event of Default and at any time thereafter during the continuation of such Event of Default, the Purchaser may take the actions set forth in Section 9.2 of the Securities Purchase Agreement.

With reference to the Technology Cross-License Agreement described in the Assignment Agreement (Appendix XI to the Master Alliance Agreement), if (i) the Company tenders repayment of the final amount(s) due under this Note, or (ii) an Event of Default by the Company under the Securities Purchase Agreement occurs, and Purchaser does not make the election referred to in Section 9.2.2 of the Securities Purchase Agreement within the time available for making such election, or (iii) an Event of Default by the Purchaser under Section 9.3.1 of the Securities Purchase Agreement occurs and the Company elects to terminate the related agreements referenced in and pursuant to Section 13.4(a)(iv) of the Master Alliance Agreement (other than the Appendix VII Agreements), then the Purchaser shall thereupon tender to the Company an executed assignment of the Technology Cross-License Agreement in the form of Exhibit D to the Securities Purchase Agreement. Purchaser hereby acknowledges that money damages would not be an adequate remedy at law if it fails to perform its obligation to re-assign the Technology Cross-License Agreement as provided in this paragraph of the Note and accordingly agrees that the Company, in addition to any other remedy to which it may be entitled at law or in equity, shall be entitled to seek to compel specific performance of such obligation, without the posting of any bond, in the court having jurisdiction under the terms hereof, and if any action should be brought in equity to enforce such

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obligation Purchaser shall not raise the defense that there is an adequate remedy at law. The provisions of this paragraph shall not limit any other rights and remedies of Purchaser provided under the Securities Purchase Agreement upon the occurrence of an Event of Default under this Note.

Pursuant to, and in accordance with, the terms of the Securities Purchase Agreement, the Principal and Interest are convertible into shares of Common Stock of the Company. Pursuant to the terms the Securities Purchase Agreement, any payment, redemption, conversion or other adjustment of the Principal and Interest shall be reflected in an amendment to Schedule I hereto and shall become effective upon the earlier of (a) notation in Schedule I attached to the Note or (B) confirmation by the Company to the Purchaser of such payment (through satisfactory evidence of wire transfers), redemption, conversion or other adjustment. Following the payment, redemption, conversion or other adjustment of the entire Principal, together with accrued and unpaid Interest thereon, this Note shall be canceled and shall no longer evidence an indebtedness for borrowed money.

The Company shall have the right to prepay this Note at any time prior to the Maturity Date without penalty, in whole or in part, upon 20 Business Days’ prior written notice to Purchaser.

This Note and Purchaser’s rights hereunder may not be transferred or assigned except in accordance with the requirements of the Securities Purchase Agreement and subject to applicable securities laws or regulations. In any dispute, contest, suit, action, or proceeding by a party to this Note to enforce its rights under this Note (whether arising in contract, tort, or both), or seeking a declaration of any rights or obligations under this Note, against any other party to this Note, including any litigation, arbitration, mediation, contested matter, dispute, suit, action, or adversary proceeding, and any appeal or review thereof, in connection with a case, action, or proceeding commenced in any state or federal court or agency, or before an arbitration panel or mediator, or under the United States Bankruptcy Code, or any other applicable federal, state, or foreign bankruptcy or other similar law, the prevailing party shall be awarded its reasonable attorneys’ fees, together with any costs and expenses (including the cost of employing expert witnesses). The Company and the Purchaser intend that the preceding sentence be severable from the other provisions of this Note, survive any judgment and, to the maximum extent permitted by law, not be deemed merged into such judgment.

This Note shall be governed by and construed under the laws of the State of California, without giving effect to the conflicts of laws provisions thereof.

In any dispute, contest, suit, action, or proceeding by a party to this Note to enforce its rights under this Note (whether arising in contract, tort, or both), or seeking a declaration of any rights or obligations under this Note, against any other party to this Note, including any litigation, arbitration, mediation, contested matter, dispute, suit, action, or adversary proceeding, and any appeal or review thereof, in connection with a case, action, or proceeding commenced in any state or federal court or agency, or before an arbitration panel or mediator, or under the Bankruptcy Code, or any other applicable federal, state, or foreign bankruptcy or other similar law, the prevailing party shall be

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awarded its reasonable attorneys’ fees, together with any costs and expenses (including the cost of employing expert witnesses).

THE PARTIES AGREE THAT ALL ACTIONS OR PROCEEDINGS ARISING IN CONNECTION WITH THIS AGREEMENT SHALL BE TRIED AND LITIGATED ONLY IN THE UNITED STATES DISTRICT COURT FOR THE NORTHERN DISTRICT OF CALIFORNIA.  EACH OF THE COMPANY AND PURCHASER WAIVES, TO THE EXTENT PERMITTED UNDER APPLICABLE LAW, ANY RIGHT EACH MAY HAVE TO ASSERT THE DOCTRINE OF FORUM NON CONVENIENS OR TO OBJECT TO VENUE TO THE EXTENT ANY PROCEEDING IS BROUGHT IN ACCORDANCE WITH THIS SECTION. THE COMPANY AND PURCHASER HEREBY WAIVE THEIR RESPECTIVE RIGHTS TO A JURY TRIAL OF ANY CLAIM OR CAUSE OF ACTION BASED UPON OR ARISING OUT OF THE TRANSACTION DOCUMENT OR ANY OF THE TRANSACTIONS CONTEMPLATED THEREIN, INCLUDING CONTRACT CLAIMS, TORT CLAIMS, BREACH OF DUTY CLAIMS, AND ALL OTHER COMMON LAW OR STATUTORY CLAIMS. THE COMPANY AND PURCHASER REPRESENT THAT EACH HAS REVIEWED THIS WAIVER AND EACH KNOWINGLY AND VOLUNTARILY WAIVES ITS JURY TRIAL RIGHTS FOLLOWING CONSULTATION WITH LEGAL COUNSEL. IN THE EVENT OF LITIGATION, A COPY OF THIS AGREEMENT MAY BE FILED AS A WRITTEN CONSENT TO A TRIAL BY THE COURT.

CHAPARRAL NETWORK STORAGE, INC.
By:	/s/ Victor M. Perez
Name:		Victor M. Perez
Title:		Chief Executive Officer and President

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SCHEDULE I

to Secured Convertible Note dated January 17, 2002

Date	Principal Amount Advanced		Repayment, Redemption, Conversion or Adjustment of Principal Amount	Aggregate Outstanding Principal Amount	Company Initials
	$		$	$
Jan. 17-2002	$	2,000,000.00

EX-10.5

Exhibit 10.5

Execution Copy

SECURITY AGREEMENT

This Security Agreement (“Agreement”) is made this 17th day of January, 2002 (the “Effective Date”), by and between Chaparral Network Storage, Inc., a Delaware corporation (“Borrower”), and Xyratex Technology Limited, a company organized under the laws of England and Wales (“Lender”). Capitalized terms used herein without definition have the meaning given to them in the Securities Purchase Agreement dated as of the Effective Date, by and between Borrower and Lender (the “Securities Purchase Agreement”).

RECITALS

A.This Agreement is entered into in connection with Lender’s loan to Borrower of US$6,000,000 (the “Loan”) pursuant to a Secured Convertible Promissory Note dated the Effective Date (the “Note”) and the execution and delivery of the Securities Purchase Agreement and the Commercial Agreements, dated as of the Effective Date, between Borrower and Lender.

B.Borrower and Lender intend to secure all of the payment obligations of Borrower to Lender under the Transaction Documents as provided in Section A.10.

Lender and Borrower agree as follows:

A.Definitions.

1.“Affiliate.” Affiliate means, as applied to any Person, any other Person directly or indirectly controlling, controlled by, or under common control with, that Person.  For purposes of this definition, “control” as applied to any Person means the possession, directly or indirectly, of the power to direct or cause the direction of the management and policies of that Person, whether through the ownership of voting securities, by contract, or otherwise.

2.“Assignment Agreement.” Assignment Agreement means the Assignment Agreement between Borrower and Lender, a form of which is attached as Exhibit XI to the Master Alliance Agreement.

3.“Bankruptcy Code.” Bankruptcy Code means the United States Bankruptcy Code, as amended and in effect at any relevant time.

4.“Business Day.” Business Day means any day other than Saturday, Sunday or a day on which banks are required to be closed in the State of Colorado and/or London, England.

5.“Collateral.” The Collateral shall consist of:

(i)All Intellectual Property now (or hereafter at any time during the term of this Security Agreement) owned by Borrower and which relates to or is used in (x) any member of the Family of FC-FC Integrated Controllers (as defined in the Joint Development Agreement) developed pursuant to the Joint Development Agreement between Borrower and Lender dated as of the Effective Date, (y) any RIO Product (as defined in the Securities Purchase Agreement) and (z) any Successor Products, excluding in each case any Adaptec IP (as defined in the Master Alliance Agreement). The Collateral includes, but is not limited to, the related Chaparral IP (as defined in the Master Alliance Agreement) as the same may exist from time to time; and

(ii)All such right, title and interest as Borrower may now (or hereafter at any time during the term of this Security Agreement) have in the Intellectual Property of third parties which relates to or is used in (x) any member of the Family of FC-FC Integrated Controllers (as defined in the Joint Development Agreement) developed pursuant to the Joint Development Agreement between Borrower and Lender dated as of the Effective Date, (y) any RIO Product (as defined in the Securities Purchase Agreement) and (z) any Successor Products (excluding in each case any Adaptec IP (as defined in the Master Alliance Agreement)) and which is capable of being secured, encumbered or to which a security interest may attach without breach of any obligation upon Borrower, including but not limited to all of Borrower’s right, title and interest in and under the Technology Cross License Agreement.

6.“Insolvency Event.” “Insolvency Event” means any of the following: (1) Borrower (a) commences a voluntary case under Title 11 of the United States Code (“Bankruptcy Code”) or any other applicable bankruptcy, insolvency or other similar law, (b) consents to the entry of an order for relief in an involuntary case under any such law, (c) consents to the appointment of with respect to, or taking possession of, the Borrower, or any substantial part of its assets, by a receiver, liquidator, assignee, trustee, custodian, or similar party, or (d) makes a general assignment for the benefit of creditors, or (e) takes any action in furtherance of any of the foregoing; (2) a proceeding shall have been instituted against the Borrower (a) seeking an order for relief under the Bankruptcy Code or any other applicable bankruptcy, insolvency or other similar law, (b) seeking the appointment of with respect to, or taking possession of, the Borrower or any

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substantial part of its assets a receiver, liquidator, assignee, custodian, trustee, sequestrator (or similar party), or (c) seeking the winding-up or liquidation of the Borrower’s affairs, and such proceeding remains undismissed or unstayed and in effect for a period of 30 days; or (3) the Borrower is adjudicated pursuant to a judgment by any court of competent jurisdiction to be insolvent or admits in writing its inability to generally pay its debts as they come due.

7.“Intellectual Property.” Intellectual Property means (1) all patents and patent applications, domestic or foreign, all licenses relating to any of the foregoing and all income and royalties with respect to any licenses (including such patents and patent applications as described in Schedule A), all rights to sue for past, present or future infringement thereof, all rights arising therefrom and pertaining thereto and all reissues, divisions, continuations, certificates of invention, renewals, reexaminations, extensions and continuations-in-part thereof; (2) trademarks, service marks, logos, mask works, trade names, and corporate names and applications for registration thereof, whether domestic or foreign; (3) computer software (in both source code and object code form), data, database rights and documentation, other than “off-the-shelf,” click to accept and/or shrink-wrap software generally available to the public; (4) trade secrets and information, whether or not patentable and whether or not reduced to practice, know-how, manufacturing and production processes and techniques; and (5) any other proprietary rights and processes.

8.“License Agreement.” License Agreement means the Manufacturing and Chaparral IP License Agreement dated as of the Effective Date, between Borrower and Lender.

9.“Master Alliance Agreement.” Master Alliance Agreement means the Master Alliance Agreement dated as of the Effective Date, between Borrower and Lender.

10.“Obligations.” This Agreement secures the following:

(i)Borrower’s obligations under the Note;

(ii)Borrower’s obligations to make payments to Lender pursuant to the Transaction Documents;

(iii)any other or future advances or extensions of credit that Lender may make to Borrower after the Effective Date, whether or not the instrument evidencing such advance or extension of credit expressly refers to this Agreement;

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(iv)any other amount that Borrower may become obligated to pay to Lender whether for payment of goods or services or otherwise;

(v)the repayment of (a) any amounts that Lender may advance or spend for the maintenance or preservation of the Collateral, and (b) any other expenditures that Lender may make under the provisions of this Agreement or for the benefit of Borrower; and

(vi)all amounts owed under any modifications, renewals or extensions of any of the foregoing obligations;

in all instances whether before or after any Insolvency Event of Borrower.  For avoidance of doubt, Borrower’s failure to make payments, if any, under those of the Transaction Documents which are Commercial Agreements (except to the extent such failure is an Event of Default as defined in Section 9.1.7 and 9.1.8 of the Securities Purchase Agreement) and under Section 10 (iii) or (iv) above shall not be deemed to be an Event of Default under the Securities Purchase Agreement.

11.“Person.” Person means and includes natural persons, corporations, limited liability companies, limited partnerships, general partnerships, joint ventures, trusts, land trusts, business trusts, or other organizations, irrespective of whether they are legal entities, and governments and agencies and political subdivisions thereof.

12.“PTO.” PTO means the United States Patent and Trademark Office

13.“Successor Product” shall mean and include any product developed by the Borrower (either alone or with others) that uses or incorporates any Intellectual Property used or incorporated in any Family of the FC-FC Integrated Controllers (as defined in the Joint Development Agreement) developed pursuant to the Joint Development Agreement and/or any RIO Product (as defined in the Securities Purchase Agreement) which existed at any time during the term of the Joint Development Agreement.

14.“Technology Cross License Agreement.” Technology Cross License Agreement means the Technology Cross License Agreement between Adaptec, Inc. and Borrower dated November 25, 1998, as amended, and specifically without limitation, Amendment No. 2 to the Technology Cross License Agreement dated December 5, 2001.

15.“UCC.” Any term used in the California Uniform Commercial Code (“UCC”) and not defined in this Agreement has the meaning given to the term in the UCC.

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B.Grant and Continuation of Security Interest.

1.Grant of Security Interest.  As security for the payment and performance of the Obligations, Borrower hereby assigns, transfers and conveys to Lender, and grants to Lender a security interest in and mortgage to, all of Borrower’s right, title and interest in, to and under the Collateral.

2.Continuing Security Interest. Borrower agrees that this Agreement shall create a continuing security interest in the Collateral which shall remain in effect until terminated in accordance with Section D.1.

C.Perfection of Security Interests and Further Acts.

1.Filing of Financing Statement.  On a continuing basis, Borrower shall make, execute, acknowledge and deliver, and file and record in the proper filing and recording places, all such instruments and documents, and take all such action as may be necessary or advisable or may be requested by Lender to carry out the intent and purposes of this Agreement, or for assuring, confirming or protecting the grant or perfection of the security interest granted or purported to be granted hereby, to ensure Borrower’s compliance with this Agreement or to enable Lender to exercise and enforce its rights and remedies hereunder with respect to the Collateral, including any documents for filing with the PTO or any applicable state office.  Lender may record this Agreement, an abstract thereof, or any other document describing Lender’s interest in the Collateral with the PTO, at the expense of Borrower. In addition, Borrower authorizes Lender to file financing statements describing the Collateral in any UCC filing office deemed appropriate by Lender. If Borrower shall at any time hold or acquire a commercial tort claim arising with respect to the Collateral, the Borrower shall immediately notify Lender in a writing signed by the Borrower of the brief details thereof and Borrower acknowledges that the proceeds of such tort claim (net of reasonable attorney’s fees and costs) are proceeds of the Collateral and as such are subject to the security interest granted to Lender herein.

D.Term of Agreement.

1.Term.  This Agreement shall become effective upon the Effective Date, and shall continue in full force and effect until the full payment, conversion or other satisfaction of all Principal and Interest under the Note, each in accordance with the terms of the Securities Purchase Agreement.

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2.Effect of Termination. Upon payment in full of all Principal and Interest under the Note, the security interests created by this Agreement shall terminate and Lender (at Borrower’s expense) shall promptly execute and deliver to Borrower such documents and instruments reasonably requested by Borrower as shall be necessary to evidence termination of all such security interests given by Borrower to Lender hereunder, including cancellation of this Agreement by written notice from Lender to the PTO.

E.Covenants and Rights Concerning the Collateral.

1.Personal Property. The Collateral shall remain personal property at all times.

2.Limitations on Obligations Concerning Maintenance of Collateral.

(i)Risk of Loss. Borrower has the risk of loss of the Collateral.

(ii)No Collection Obligation. Lender has no duty to collect any income accruing on the Collateral or to preserve any rights relating to the Collateral.

3.No Disposition of Collateral. Lender does not authorize, and Borrower may not:

(i)sell any of the Collateral other than a sale to the Lender;

(ii)transfer or grant any rights in the Collateral other than to the Lender except in connection with arms-length commercial transactions (including joint development agreements) occurring in the Borrower’s normal course of business consistent with past practice of which Lender has been notified; or

(iii)grant a security interest in any of the Collateral to any party other than Lender other than a security interest which is subordinated to Lender’s security interest, subject to prior written approval by Lender of any subordination, inter-creditor or similar agreement that the Lender may deem desirable and/or necessary, in its sole and absolute discretion.

F.Borrower’s Representations and Warranties.

Borrower warrants and represents that except as set forth in the Disclosure Schedule:

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1.Title to and transfer of Collateral. It has rights in or the power to transfer the Collateral and its title to the Collateral is free of all adverse claims, liens, security interests and restrictions on transfer or pledge except as created by this Agreement.

2.Patents and Patent Applications. A true and correct list of all of the existing Collateral consisting of patents and patent applications or registrations owned by Borrower, in whole or in part, is set forth in Schedule A.

3.Location and Name of Borrower. Borrower’s:

(i)state of incorporation is the state of Delaware; and

(ii)exact legal name is as set forth in the first paragraph of this Agreement.

4.Authority. Borrower has the authority to enter into and perform the Transaction Documents and to execute all documents and perform all other acts as may be necessary to perform all of Borrower’s obligations under the Transaction Documents.

5.Valid and Binding Obligation. Each of the Transaction Documents is a valid and binding obligation of Borrower enforceable in accordance with its respective terms.

6.No Approvals or Consents. No approval or consent by any Person or entity is necessary in connection with the execution of the Transaction Documents by Borrower or the performance of Borrower’s obligations under the Transaction Documents. The consummation of the transactions contemplated by the Transaction Documents does not and will not violate any statute, law, ordinance or regulation.

7.No Violation of Other Obligations. Neither the Transaction Documents nor anything provided to be done under the Transaction Documents violates or shall violate, or shall cause the acceleration of any debt or obligation of Borrower under, any contract, document, understanding, agreement or instrument to which Borrower is a party or by which it may be bound.

G.Events of Default.

The occurrence of any of the events of default set forth in Section 9.1 of the Securities Purchase Agreement shall constitute an event of default (each, an “Event of Default”) under this Agreement.

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H.Default Costs.

Should an Event of Default occur, Borrower will pay to Lender all costs reasonably incurred by the Lender for the purpose of enforcing its rights hereunder, including:

1.costs of foreclosure;

2.costs of obtaining money damages; and

3.a reasonable fee for the services of an attorney employed by Lender for any purpose related to this Agreement or the Obligations, including consultation, drafting documents, sending notices or instituting, prosecuting or defending litigation or arbitration and including, without limitation, such costs and expenses incurred by Lender in pursuing recovery and protecting any of its rights or interests, in any bankruptcy or other insolvency proceeding in which Borrower is the debtor.

I.Remedies Upon Default.

1.General. Upon any Event of Default, all Obligations shall immediately become due and payable without notice or demand. In addition, Lender may pursue any remedy available at law (including those available under the provisions of the UCC), or in equity to collect, enforce, or satisfy any Obligations then owing, whether by acceleration or otherwise.

2.Exceptions for Loan Collection.  If Borrower fails to repay the Principal and Interest when due pursuant to Section 9.2.1 of the Securities Purchase Agreement, then Lender may, at its sole election, with at least 30 Business Days’ written notice elect as a remedy that (a) the license granted by Borrower to Lender under Section 4 of the License Agreement shall come into full force and effect, (b) the Assignment Agreement shall come into full force and effect so that in particular but without limitation Lender shall enjoy the full benefit of the license of the Chaparral IP (as defined in the Master Alliance Agreement) in accordance with the terms set forth in Section 4 of the License Agreement and the full benefit of the Technology Cross License Agreement and the Adaptec IP (asdefined in the Master Alliance Agreement) in accordance with the terms thereof and (c) Lender shall sub-license, and shall be deemed to have sub-licensed in accordance with the Assignment Agreement, to Borrower the rights provided in the Technology Cross License Agreement solely for the purpose of enabling Borrower to continue with its business operations. So long as the License

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Agreement and the Assignment Agreement come into full force and effect as contemplated by Section 4 of the License Agreement and at that time Borrower is not in “liquidation” (as that expression is defined in the Master Alliance Agreement) and for so long as each of the License Agreement and the Assignment Agreement remain in full force and effect as aforesaid, Lender shall not seek to recover the Principal and accrued Interest thereon due and payable pursuant to Section 9.2.1 of the Securities Purchase Agreement and Interest shall not continue to accrue on the Principal; provided, however that if Lender has not received a claim that the License Agreement and/or the Assignment Agreement is not in full force and effect within 12 months of the Principal and Interest becoming due as aforesaid or if Lender has received such claim then when such claim has been withdrawn or adjudicated by a court of final appeal and the result of that adjudication is that the aforesaid full benefit of the license of the Chaparral IP (as defined in the Master Alliance Agreement) and the Technology Cross License Agreement and Adaptec IP (as defined in the Master Alliance Agreement) remains available to Lender, then Borrower shall no longer be obligated to repay the Principal and Interest nor shall the Lender seek damages solely with respect to the Borrower’s failure to repay Principal and Interest as aforesaid, except for an amount equal to the reasonable costs and expenses of litigating, arbitrating and/or settling such claim, all of which shall be recoverable from Borrower by Lender and, upon such recovery, the Lender shall return the Note to the Borrower in accordance with Section 7.3.3 of the Securities Purchase Agreement.

3.Concurrent Remedies. Upon an Event of Default, subject to the election of remedies by Lender set forth in Section I.2 above, Lender shall have the right to pursue any of the following remedies separately, successively, or simultaneously:

(i)File suit and obtain judgment, and, in conjunction with any action, Lender may seek any ancillary remedies provided by law, including levy of attachment and garnishment.

(ii)Take possession of and use any Collateral if not already in its possession without demand and without legal process.

(iii)Sell or otherwise dispose of the Collateral at public or private sale in accordance with the UCC.

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J.Foreclosure Procedures.

1.No Waiver. No delay or omission by the Lender to exercise any right or remedy accruing upon any Event of Default shall (a) impair any right or remedy, (b) waive any default or operate as an acquiescence to the Event of Default, or (c) affect any subsequent default of the same or of a different nature.

2.Notices. Lender shall give Borrower such notice of any private or public sale as may be required by the UCC.

3.No Obligation to Pursue Others. Lender has no obligation to attempt to satisfy the Obligations by collecting them from any other Person liable for them and Lender may release, modify or waive any collateral provided by any other Person to secure any of the Obligations, all without affecting Lender’s rights against Borrower. Borrower waives any right it may have to require Lender to pursue any third person for any of the Obligations.

4.Compliance With Laws. Lender may comply with any applicable state or federal law requirements in connection with a disposition of the Collateral and compliance will not be considered to adversely affect the commercial reasonableness of any sale of the Collateral.

5.Warranties. Lender may sell the Collateral without giving any warranties as to the Collateral. Lender may specifically disclaim any warranties of title or the like. This procedure will not be considered adversely to affect the commercial reasonableness of any sale of the Collateral.

6.No Marshaling. Lender has no obligation to marshal any assets in favor of Borrower, or against or in payment of:

(i)the Note,

(ii)any of the other Obligations, or

(iii)any other obligation owed to Lender by Borrower or any other Person.

K.Miscellaneous.

1.Assignment.

(i)Binds Assignees. This Agreement shall bind and shall inure to the benefit of the heirs, legatees, executors, administrators, successors, and assigns of Lender and shall bind all Persons who become bound as a Borrower to this Agreement.

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(ii)Assignments. Except as otherwise set forth herein, no party hereto shall transfer or assign any of its rights or obligations hereunder without the prior written consent of each of the other parties hereto, except (A) in the event of an assignment by operation of law, or (B) by the Lender in connection with (X) a reorganization of its business, (Y) transfer of the Lender’s RAID Controller or storage business in a sale or in demerger, a “spin-off” or similar transaction or (Z) in a capital financing transaction or providing security to a financing source for the Lender’s business or the business of another member of the same group as the Lender.

2.Severability. Should any provision of this Agreement be found to be void, invalid or unenforceable by a court or panel of arbitrators of competent jurisdiction, that finding shall only affect the provisions found to be void, invalid or unenforceable and shall not affect the remaining provisions of this Agreement.

3.Notices. Any notices required by this Agreement and/or the Note shall be deemed to be delivered when (a) if to Lender, deposited in any United States postal box and if to Borrower, deposited in any United Kingdom post box, airmail postage prepaid, and the notice properly addressed to the appropriate recipient, three Business Days after such deposit, (b) received by telecopy if received during the recipient’s normal business hours or other wise at the opening of the next Business Day after such receipt, (c) received through the Internet and such receipt is confirmed by the recipient, and (d) when personally delivered.

If to Borrower:

Chaparral Network Storage, Inc.
7420 East Dry Creek Parkway
Longmont, Colorado 80503
Attn: Victor Perez, President
Telephone: (303) 845-3200
Facsimile: (303) 845-3636

with a copy to (which copy shall not constitute notice):

Davis Graham & Stubbs LLP
Suite 500
1550 Seventeenth Street
Denver, Colorado 80202

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Attn: Ron Levine, Esq.
Telephone: (303) 892-9400
Facsimile: (303) 893-1379

If to Lender:

Xyratex Technology Limited
Langstone Road
Havant
PO9 1SA
United Kingdom
Attn: David Bradley
Telephone: 023 92 496000
Facsimile: 023 92 453654

with a copy to (which copy shall not constitute notice):

Heller Ehrman White & McAuliffe LLP
601 S. Figueroa St., 40^th Floor
Los Angeles, California 90017
Attn: Stephen E. Newton, Esq.
Telephone: (213) 689-0200
Facsimile: (213) 614-1868

4.Headings. Section headings used in this Agreement are for convenience only. They are not a part of this Agreement and shall not be used in construing it.

5.Governing Law. This Agreement shall be construed and enforced in accordance with the laws of California except to the extent that the UCC provides for the application of the law of any other state.

6.Venue, Jurisdiction; Waiver of Trial by Jury. EXCEPT TO THE EXTENT THAT THE UCC PROVIDES OTHERWISE, THE PARTIES AGREE THAT ALL ACTIONS OR PROCEEDINGS ARISING IN CONNECTION WITH THIS AGREEMENT SHALL BE TRIED AND LITIGATED ONLY IN THE UNITED STATES DISTRICT COURT FOR THE NORTHERN DISTRICT OF CALIFORNIA. EACH OF BORROWER AND LENDER WAIVES, TO THE EXTENT PERMITTED UNDER APPLICABLE LAW, ANY RIGHT EACH MAY HAVE TO ASSERT THE DOCTRINE OF FORUM NON CONVENIENS OR TO

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OBJECT TO VENUE TO THE EXTENT ANY PROCEEDING IS BROUGHT IN ACCORDANCE WITH THIS SECTION K.6. BORROWER AND LENDER HEREBY WAIVE THEIR RESPECTIVE RIGHTS TO A JURY TRIAL OF ANY CLAIM OR CAUSE OF ACTION BASED UPON OR ARISING OUT OF THE AGREEMENT OR THE NOTE OR ANY OF THE TRANSACTIONS CONTEMPLATED THEREIN, INCLUDING CONTRACT CLAIMS, TORT CLAIMS, BREACH OF DUTY CLAIMS, AND ALL OTHER COMMON LAW OR STATUTORY CLAIMS. BORROWER AND LENDER REPRESENT THAT EACH HAS REVIEWED THIS WAIVER AND EACH KNOWINGLY AND VOLUNTARILY WAIVES ITS JURY TRIAL RIGHTS FOLLOWING CONSULTATION WITH LEGAL COUNSEL. IN THE EVENT OF LITIGATION, A COPY OF THIS AGREEMENT MAY BE FILED AS A WRITTEN CONSENT TO A TRIAL BY THE COURT.

7.Rules of Construction.

a.Except as otherwise expressly provided in this Agreement, no reference to “proceeds” in this Agreement authorizes any sale, transfer, or other disposition of the Collateral by the Borrower.

b.“Includes” and “including” are not limiting.

c.“Or” is not exclusive.

d.“All” includes “any” and “any” includes “all.”

8.Integration and Modifications.

(i)The Transaction Documents, together with the Exhibits and Schedules hereto and thereto, constitutes the entire agreement of the Borrower and Lender concerning the subject matter hereof and supersedes all prior drafts and communications relating to such subject matter.

(ii)Any modification to this Agreement must be made in writing and signed by the party adversely affected.

9.Waiver. Any party to this Agreement may waive in a signed writing the enforcement of any provision to the extent the provision is for its benefit.

10.Further Assurances. Borrower agrees to execute any further documents, and to take any further actions, reasonably requested by Lender to evidence or perfect the security interest granted herein, to maintain the first priority of the security interests, or to effectuate the rights granted to Lender herein

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11.Attorneys’ Fees. In any dispute, contest, suit, action, or proceeding by a party to this Agreement to enforce its rights under this Agreement (whether arising in contract, tort, or both), or seeking a declaration of any rights or obligations under this Agreement, against any other party to this Agreement, including any litigation, arbitration, mediation, contested matter, dispute, suit, action, or adversary proceeding, and any appeal or review thereof, in connection with a case, action, or proceeding commenced in any state or federal court or agency, or before an arbitration panel or mediator, or under the Bankruptcy Code, or any other applicable federal, state, or foreign bankruptcy or other similar law, the prevailing party shall be awarded its reasonable attorneys’ fees, together with any costs and expenses (including the cost of employing expert witnesses). The Borrower and Lender intend that the preceding sentence be severable from the other provisions of this Agreement, survive any judgment and, to the maximum extent permitted by law, not be deemed merged into such judgment.

12.Counterparts. This Agreement may be executed in one or more counterparts all of which together shall constitute one instrument.

[Remainder of page intentionally left blank]

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IN WITNESS WHEREOF, the Borrower and Lender have executed this Agreement as of the date first above written.

Borrower:
	CHAPARRAL NETWORK STORAGE, INC.
	By:	/s/ Victor M. Perez
	Name:		Victor M. Perez
	Title:		Chief Executive Officer and President
Lender:
	XYRATEX TECHNOLOGY LIMITED
	By:	/s/ Paul W Hannah
	Name:		PAUL W HANNAH
	Title:		EXEC VP OPERATIONS

[SIGNATURE PAGE TO SECURITY AGREEMENT]

SCHEDULE A (1 of 3)

to the Security Agreement

Issued U.S. Patents owned by Borrower

Patent No.	Issue Date	Title
None.

SCHEDULE A (2 of 3)

Pending U.S. Patent Applications or Registrations of Borrower

Docket No.	Serial No.	Filing Date	Title
USA 4430-22	09751090	12/31/00	Recovering Data from Arrays of Storage Devices after certain failures
USA 4430-23	09799480	3/5/01	Utilizing Parity Caching and Parity Logging while closing the RAID 5 Write Hole
USA 4430-24	09852858	5/9/01	Mirroring between Controllers in an Active-Active Controller pair
USA 4430-26	09942391	8/29/01	Initialization of a Storage System
USA 4430-27	09861308	5/17/01	Method for Automatically detecting and correcting duplicate controller SCSI Ids
USA 4430-28	09967027	9/28/01	Bus Zoning in a Channel Independent Controller Architecture
USA 4430-29	09967126	9/28/01	Controller Data Sharing using a Modular DMA Architecture
USA 4430-30	—	11/8/01	Obtaining Information to facilitate System Usage
USA 4430-32	09967194	9/28/01	Modular Architecture for a Network Storage Controller
USA 4430-34	—	10/29/01	Data Mirroring between Controllers in an Active-Active Controller pair
USA 4430-35	—	11/8/01	Data Mirroring using Shared Buses
USA 4430-38	—	11/9/01	Method and Apparatus for transferring data using Direct Memory Access

SCHEDULE A (3 of 3)

Patent Cooperation Treaty Application

Title of invention:  Recovering Data From Arrays of Storage Devices After

Certain Failures.

Priority Date Claim-12-29-2000

Number us application-9/751.090

Date of filing international-12-21-01

EX-31.1

Exhibit 31.1

CERTIFICATION

I, James L. Lambert, certify that:

1.I have reviewed this quarterly report on Form 10-Q of Dot Hill Systems Corp.;

2.Based on my knowledge, this report does not contain any untrue statement of a material fact or omit to state a material fact necessary to make the statements made, in light of the circumstances under which such statements were made, not misleading with respect to the period covered by this report;

3.Based on my knowledge, the financial statements, and other financial information included in this report, fairly present in all material respects the financial condition, results of operations and cash flows of the registrant as of, and for, the periods presented in this report;

4.The registrant’s other certifying officer and I are responsible for establishing and maintaining disclosure controls and procedures (as defined in Exchange Act Rules 13a-15(e) and 15d-15(e)) for the registrant and have:

a)Designed such disclosure controls and procedures, or caused such disclosure controls and procedures to be designed under our supervision, to ensure that material information relating to the registrant, including its consolidated subsidiaries, is made known to us by others within those entities, particularly during the period in which this report is being prepared;

b)Reserved.

c)Evaluated the effectiveness of the registrant’s disclosure controls and procedures and presented in this report our conclusions about the effectiveness of the disclosure controls and procedures, as of the end of the period covered by this report based on such evaluation; and

d)Disclosed in this report any change in the registrant’s internal control over financial reporting that occurred during the registrant’s most recent fiscal quarter (the registrant’s fourth fiscal quarter in the case of an annual report) that has materially affected, or is reasonably likely to materially affect, the registrant’s internal control over financial reporting; and

5.The registrant’s other certifying officers and I have disclosed, based on our most recent evaluation of internal control over financial reporting, to the registrant’s auditors and the audit committee of the registrant’s board of directors (or persons performing the equivalent functions):

a) All significant deficiencies and material weaknesses in the design or operation of internal control over financial reporting which are reasonably likely to adversely affect the registrant’s ability to record, process, summarize and report financial information; and

b) Any fraud, whether or not material, that involves management or other employees who have a significant role in the registrant’s internal control over financial reporting.

Date: May 10, 2004

/s/ JAMES L. LAMBERT

James L. Lambert

Chief Executive Officer

EX-31.2

Exhibit 31.2

CERTIFICATION

I, Preston S. Romm, certify that:

1.I have reviewed this quarterly report on Form 10-Q of Dot Hill Systems Corp.;

2.Based on my knowledge, this report does not contain any untrue statement of a material fact or omit to state a material fact necessary to make the statements made, in light of the circumstances under which such statements were made, not misleading with respect to the period covered by this report;

3.Based on my knowledge, the financial statements, and other financial information included in this report, fairly present in all material respects the financial condition, results of operations and cash flows of the registrant as of, and for, the periods presented in this report;

4.The registrant’s other certifying officers and I are responsible for establishing and maintaining disclosure controls and procedures (as defined in Exchange Act Rules 13a-15(e) and 15d-15(e)) for the registrant and have:

a)Designed such disclosure controls and procedures, or caused such disclosure controls and procedures to be designed under our supervision, to ensure that material information relating to the registrant, including its consolidated subsidiaries, is made known to us by others within those entities, particularly during the period in which this report is being prepared;

b)Reserved.

c)Evaluated the effectiveness of the registrant’s disclosure controls and procedures and presented in this report our conclusions about the effectiveness of the disclosure controls and procedures, as of the end of the period covered by this report based on such evaluation; and

d)Disclosed in this report any change in the registrant’s internal control over financial reporting that occurred during the registrant’s most recent fiscal quarter (the registrant’s fourth fiscal quarter in the case of an annual report) that has materially affected, or is reasonably likely to materially affect, the registrant’s internal control over financial reporting; and

5.The registrant’s other certifying officers and I have disclosed, based on our most recent evaluation of internal control over financial reporting, to the registrant’s auditors and the audit committee of the registrant’s board of directors (or persons performing the equivalent functions):

a)All significant deficiencies and material weaknesses in the design or operation of internal control over financial reporting which are reasonably likely to adversely affect the registrant’s ability to record, process, summarize and report financial information; and

b)Any fraud, whether or not material, that involves management or other employees who have a significant role in the registrant’s internal control over financial reporting.

Date: May 10, 2004

/s/ PRESTON S. ROMM

Preston S. Romm

Chief Financial Officer

EX-32.1

Exhibit 32.1

DOT HILL SYSTEMS CORP.

OFFICERS’ CERTIFICATE

Pursuant to Section 906 of the Sarbanes-Oxley Act of 2002 (18 U.S.C. § 1350, as adopted), James L. Lambert, Chief Executive Officer of Dot Hill Systems Corp. (the “Company”), and Preston S. Romm, the Chief Financial Officer of the Company, each hereby certify that, to the best of their knowledge:

1.The Company’s Quarterly Report on Form 10-Q for the period ended March 31, 2004, to which this Certification is attached as Exhibit 32.1 (the “Periodic Report”) fully complies with the requirements of Section 13(a) or Section 15(d) of the Securities Exchange Act of 1934, as amended; and

2.The information contained in the Periodic Report fairly presents, in all material respects, the financial condition of the Company at the end of the period covered by the Periodic Report and results of operations of the Company for the period covered by the Periodic Report.

In Witness Whereof, the undersigned have set their hands hereto as of the 10th day of May, 2004.

/s/ JAMES L. LAMBERT	/s/ PRESTON S. ROMM
James L. Lambert	Preston S. Romm
Chief Executive Officer	Chief Financial Officer

A signed original of this written statement required by Section 906 has been provided to the Company and will be retained by the Company and furnished to the Securities and Exchange Commission (the “SEC”) or its staff upon request.

This certification “accompanies” the Periodic Report, is not deemed filed with the SEC and is not to be incorporated by reference into any filing of the Company under the Securities Act of 1933, as amended, or the Securities Exchange Act of 1934, as amended (whether made before or after the date of the Periodic Report), irrespective of any general incorporation language contained in such filing.