-----BEGIN PRIVACY-ENHANCED MESSAGE----- Proc-Type: 2001,MIC-CLEAR Originator-Name: webmaster@www.sec.gov Originator-Key-Asymmetric: MFgwCgYEVQgBAQICAf8DSgAwRwJAW2sNKK9AVtBzYZmr6aGjlWyK3XmZv3dTINen TWSM7vrzLADbmYQaionwg5sDW3P6oaM5D3tdezXMm7z1T+B+twIDAQAB MIC-Info: RSA-MD5,RSA, Sg3LtJMWBeu/QMdw8GWu+ABAswNL0YzweWSOFwyJ5uScGaEAsOAy5Xw4FtaXBjwg o1Hx9z+dMO2pR5Ls6xcuLw== 0000950172-02-000735.txt : 20020416 0000950172-02-000735.hdr.sgml : 20020416 ACCESSION NUMBER: 0000950172-02-000735 CONFORMED SUBMISSION TYPE: 10-K PUBLIC DOCUMENT COUNT: 4 CONFORMED PERIOD OF REPORT: 20011231 FILED AS OF DATE: 20020412 FILER: COMPANY DATA: COMPANY CONFORMED NAME: ZILOG INC CENTRAL INDEX KEY: 0000319450 STANDARD INDUSTRIAL CLASSIFICATION: SEMICONDUCTORS & RELATED DEVICES [3674] IRS NUMBER: 133092996 STATE OF INCORPORATION: CA FISCAL YEAR END: 1231 FILING VALUES: FORM TYPE: 10-K SEC ACT: 1934 Act SEC FILE NUMBER: 001-13748 FILM NUMBER: 02609225 BUSINESS ADDRESS: STREET 1: 910 E HAMILTON AVE CITY: CAMPBELL STATE: CA ZIP: 95008 BUSINESS PHONE: 4085588500 MAIL ADDRESS: STREET 1: 910 E HAMILTON AVE CITY: CAMPELL STATE: CA ZIP: 95008 10-K 1 zilog10k2.txt =============================================================================== SECURITIES AND EXCHANGE COMMISSION Washington, D.C. 20549 ----------------- Form 10-K (Mark One) X ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(D) OF --- THE SECURITIES EXCHANGE ACT OF 1934 for the fiscal year ended December 31, 2001 OR --- TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(D) OF THE SECURITIES EXCHANGE ACT OF 1934 For the transition period __________ to __________ Commission File Number: 001-13748 ZiLOG, INC. (exact name of registrant as specified in its charter) Delaware 13-3092996 (State or other jurisdiction of (I.R.S. Employer incorporation or organization) Identification No.) 532 Race Street, San Jose, CA 95126 (Address of principal executive offices) (Zip Code) Registrant's telephone number, including area code: (408) 558-8500 -------------------- Securities registered pursuant to Section 12(b) of the Act: NONE Securities registered pursuant to Section 12(g) of the Act: NONE Indicate by check mark whether the Registrant (1) has filed all reports required to be filed by Section 13 or 15 (d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports) and (2) has been subject to such filing requirements for the past 90 days. Yes X No ---- ---- Indicate by check mark if disclosure of delinquent filers pursuant to Item 405 of regulation S-K is not contained herein, and will not be contained, to the best of the Registrant's knowledge, in definitive proxy or information statements incorporated by reference in Part III of this Form 10-K or any amendment to this Form 10-K. X ---- The aggregate value of voting Common Stock and Class A Non-Voting Common Stock held by non-affiliates of the Registrant cannot be determined as the Company has filed for bankruptcy and its stock does not trade on an established exchange nor is it quoted on an established or an automated inter-dealer quotation system. At March 1, 2002, 32,017,272 shares of the Registrant's voting Common Stock and 10,000,000 shares of the Registrant's Class A Non-Voting Common Stock were issued and outstanding. ===============================================================================
TABLE OF CONTENTS Part I Item 1. Business Item 2. Properties Item 3. Legal Proceedings Item 4. Submission of Matters to a Vote of Security Holders Part II Item 5. Market for Registrant's Common Equity and Related Stockholder Matters Item 6. Selected Consolidated Financial Data Item 7. Management's Discussion and Analysis of Financial Condition and Results of Operations Item 7A. Quantitative and Qualitative Disclosures about Market Risk Item 8. Financial Statements and Supplementary Data Item 9. Changes in and Disagreements with Accountants on Accounting and Financial Disclosures Part III Item 10. Directors and Executive Officers of the Registrant Item 11. Executive Compensation Item 12. Security Ownership of Certain Beneficial Owners and Management Item 13. Certain Relationships and Related Transactions
Part IV Item 14. Exhibits, Financial Statement Schedules, and Reports on Form 8-K This Report on Form 10-K and other oral and written statements made by the Company contain and incorporate forward-looking statements within the meaning of Section 27A of the Securities Act of 1933, as amended (the "Securities Act"), and Section 21E of the Securities Exchange Act of 1934, as amended (the "Exchange Act"), regarding future events and the Company's plans and expectations that involve risks and uncertainties. When used in this Report, the words "estimate," "project," "intend," "expect," "anticipate," "believe," "may," "will," and similar expressions are intended to identify such forward-looking statements. Forward-looking statements in this report include, but are not limited to, those relating to the general direction of our business; the restructuring of our debt and equity; the utilization of our manufacturing facilities; our ability to sell or lease MOD III and our ability to successfully complete our restructuring of operations and realize expected cost savings, capital expenditures and expenses for future periods. Although we believe our plans, intentions, and expectations reflected in these forward-looking statements are reasonable, we can give no assurance that these plans, intentions, or expectations will be achieved. Actual results, performance, or achievements could differ materially from those contemplated, express or implied, by the forward-looking statements contained in this report. Factors that may cause or contribute to differences include, but are not limited to, continued availability of third-party foundry and assembly services at commercially reasonable quality and prices, under-absorption of manufacturing costs in our wafer fabrication facilities from under-utilization of production capacity, and ZiLOG's distributors and customers significantly reducing their existing inventories before ordering new products, and those discussed below under "Management's Discussion and Analysis of Financial Condition and Results of Operation," "Factors That May Affect Future Results," as well as those discussed elsewhere in this Report and in other reports filed with the Securities and Exchange Commission. These factors are not intended to represent a complete list of the general or specific factors that affect us. Other factors, including general economic factors and business strategies, may be significant, presently or in the future, and the factors set forth in this report may affect us to a greater extent than indicated. The reader is therefore cautioned not to place undue reliance on the forward-looking statements contained herein, that reflect our position as of the date of this report. The Company undertakes no obligation to publicly release updates or revisions to these statements. Based in San Jose, California, we were incorporated in California in October 1981 and reincorporated in Delaware in April 1997. In this report, "ZiLOG," "the Company," "our," "us," "we," and similar expressions refer to ZiLOG, Inc. and its subsidiaries. ZiLOG and Z80 are registered trademarks of ZiLOG, Inc. Extreme Connectivity(C)ZiLOG, Inc. 1999. PART I ITEM 1. BUSINESS Executive Summary We are a worldwide designer, manufacturer and marketer of semiconductor micro-logic devices for use in the embedded control and communications markets. Using proprietary technology that we have developed over our 27-year operating history, we provide semiconductor devices that our customers design into their end products. Our devices, which often include related application software, typically combine a microprocessor and/or digital signal processor, memory, and input and output functions on a single semiconductor. Our embedded control devices enable a broad range of consumer and industrial electronics manufacturers to control the functions and performance of their products. These devices control such functions as the speed of a motor, an infrared remote control and the charging cycle of a battery charger. Our communications devices enable data communications and telecommunications companies to process and transmit information. These devices include serial communication controllers, modems and microprocessors used in communication networks for voice and data transmission. Our primary product focus is on 8-bit and 16-bit microcontrollers and microprocessors. Our microcontroller products include a broad range of standard products for use in hundreds of embedded control applications. We are also developing more application specific standard products (ASSPs) that are more specialized for targeted high potential market segments. These ASSP's include our microcontrollers and modules focused on short-range infra-red communication that are built into applications such as infra-red remote control, and IrDA transceivers for use in PDAs, cellphones, and laptop computers. Our microprocessor products are higher performance products addressing the high-end 8-bit and 16-bit microprocessor and microcontroller markets. These products are available with integrated software that enables the devices to communicate across public and private networks. In these applications the device can function as a stand-alone embedded web server, providing monitoring and control functionality to a remote site, using a standard web browser interface. Our microcontrollers and microprocessors are also used in our modem products, providing low cost connectivity solutions in applications such as credit card readers and set top boxes for satellite television. Over time, we have augmented these core products with serial communication controllers (SCC) and digital signal processing (DSP). Our Industry The semiconductor market is comprised of five broad product segments: micro-logic, other logic, memory, analog and discrete devices. We compete in the micro-logic device segment. Micro-logic devices are processor-based semiconductors that include microprocessors, microcontrollers and digital signal processors that typically process information, output data or control signals according to programmed instructions and various external inputs. Micro-logic devices also include microperipherals that operate in conjunction with these processor-based devices to provide systems support or to control communications, graphics and images, mass storage, voice and other user input systems. Semiconductor manufacturers target the micro-logic market through both application specific standard products tailored for a specific application but are not proprietary to a single customer, and general-purpose products, which are neither application nor customer specific. We design, manufacture and market both ASSPs and general-purpose micro-logic products. Financial Restructuring and Reorganization We filed a pre-packaged Chapter 11 plan of reorganization with the bankruptcy court of the Northern District of California on February 28, 2002 and the bankruptcy court has set a hearing for the confirmation of the plan for April 30, 2002. After we receive such confirmation, we expect to exit from bankruptcy by the middle of May, 2002 or as soon as practicable thereafter. We will continue to operate our business in Chapter 11 in the ordinary course and have obtained the necessary relief from the bankruptcy court to pay our employees, trade, and certain other creditors in full and on time regardless of whether their claims arose before or after the Chapter 11 filing. The claims of our employees, general unsecured creditors (including trade creditors, licensors, and lessors) and secured creditors, other than holders of our senior secured notes, are not impaired under the plan. Under the plan of reorganization, our $280M senior notes will be cancelled. Each holder will receive, in exchange for its senior notes, its pro rata share of: o 100% of our newly-issued common stock, except for 14%, which will be issued or reserved for issuance to our employees, consultants, and directors under a management incentive plan. o 100% of the newly issued series A preferred stock issued by our currently wholly owned subsidiary, MOD III. Holders of MOD III series A preferred stock will be entitled to receive an aggregate liquidation preference of $30 million plus any accrued but unpaid dividends on the MOD III series A preferred stock from the net proceeds of the sale of our MOD III fabrication plant including the facility, equipment and all other assets necessary for the operation of the facility, located in Nampa, Idaho, which we will transfer to MOD III when the plan becomes effective and from certain operating lease proceeds. Dividends will accrue on the MOD III series A preferred stock at 9 1/2% per annum. o 50% of MOD III's newly issued series B preferred stock. We will retain the remaining 50% of the new MOD III series B preferred stock. Holders of the new MOD III series B preferred stock will be entitled to receive the net sale proceeds from any sale of Mod III's assets in excess of $30 million plus accrued but unpaid dividends on the New MOD III series A preferred stock. o The plan of reorganization provides for the cancellation of our currently outstanding preferred and common stock and all options and warrants related thereto. All accumulated dividends and any other obligations with respect to our outstanding preferred and common shares will be extinguished. Each holder of common stock will, however, receive a pro rata share of $50,000. Each holder of preferred stock will receive a pro rata share of $150,000. The plan of reorganization also provides for the payment in full, with interest if appropriate, or reinstatement, as appropriate, of all employee and trade claims. Upon the plan of reorganization's effectiveness, we will, among other things, revise our charter and bylaws, enter into a new secured financing agreement, and designate a new board of directors. Historical background to the plan of reorganization We issued the senior secured notes in connection with our going-private transaction in 1998. Since then, our business and financial growth have been negatively affected by the extremely difficult business climate in which we have been operating. In March 2001, we retained Lazard Freres & Co., LLC as financial advisor to assist us in exploring a number of strategic alternatives. Also in March of 2001, Lazard began the process of soliciting bids for the sale of all or parts of our business. While we received a number of proposals, each of these contained significant financing or due diligence contingencies. After consultation with our financial advisor, we determined that these contingencies could seriously jeopardize the likelihood that a strategic transaction could be consummated. In July 2001, holders of senior notes who collectively held or managed approximately $165.0 million in principal amount of our senior notes formed an informal group to discuss and negotiate the terms of a possible restructuring with us. All members of this group executed confidentiality agreements and on July 13, 2001, members of our management met with these holders and their counsel to discuss a possible restructuring. Discussions continued over the course of the summer and fall of 2001. During the course of these discussions, we concluded that the best vehicle to achieve a restructuring of our senior notes was through consummation of a voluntary pre-packaged plan of reorganization under Chapter 11 of the U.S. Bankruptcy Code. On November 27, 2001, we reached a non-binding agreement regarding the terms of the plan with this informal group of our noteholders. On January 28, 2002, we commenced solicitation of acceptances of the plan of reorganization from the holders of our senior notes and preferred stock. We did not solicit votes from holders of our old common stock. In connection with this solicitation, we entered into lock-up agreements with members of the noteholders' group. Under the lock-up agreements, the members of the noteholders' group agreed, among other things and subject to certain conditions, to vote to accept the plan of reorganization. The voting period for the solicitation ended on February 26, 2002. Holders of approximately $221.0 million of our senior notes accepted the plan of reorganization. None of the holders rejected the plan. All of the holders of preferred stock who voted also accepted the plan of reorganization. We believe that the restructuring will substantially reduce uncertainty with respect to our future and better position us to develop new products and maintain and expand our customer base by focusing on our core business. ZiLOG is a pioneer in the semiconductor industry and we have a well-recognized brand. We believe that the elimination of our senior secured notes will allow us to devote more resources towards developing and expanding our core business. There can be no assurance that we will be successful in consummating the plan of reorganization, however we believe that completion of the plan will provide a stronger financial base upon which we can focus and execute to develop a successful business. Our financial statements do not include any adjustments that reflect the restructuring or other events contemplated by the plan. Products and Applications We rely on our knowledge, experience, customer relationships and expertise in micro-logic devices to target products to compete in the embedded control and communications markets. We work closely with industry leaders in our target markets to design application-specific standard products and general-purpose products that are used for a wide variety of applications. Through our customer relationships, we have been able to provide innovative solutions and thereby attract multiple customers that compete in the same markets. We currently offer approximately 800 products that are sold in a wide selection of configurations to over 5000 original equipment manufacturers and end-users worldwide in the embedded control and communications markets. Embedded Control Products and Applications. Our embedded control devices enable a broad range of consumer and industrial electronics manufacturers to control the functions and performance of their products. These devices control such functions as the speed of a motor, an infrared remote control and the charging cycle of a battery charger. We provide embedded controllers that are adaptable for use in a variety of consumer products and industrial equipment. These microcontrollers are designed to provide increased functionality, performance and ease of use in the products in which they are embedded. Most of our embedded control microcontrollers are based on our Z8 and Z8 Plus microcontroller architecture with read-only-memory, commonly known as ROM, or one-time-programmable, commonly known as OTP, program memory, and a broad range of peripherals. The Z8 and Z8 Plus microcontrollers we design, manufacture and sell are used in such applications as controllers for home appliances, personal consumer appliances, security systems, exercise equipment, battery chargers, and garage door openers. Our infrared remote controller products primarily address the universal remote control market for multiple brands of televisions, videocassette recorders and set top box systems. Embedded control products in development include the Z8 Encore! family of microcontrollers with a higher performance core, new analog and digital peripherals, and flash or ROM program memory. The Z8 Encore! family of products is expected to be introduced throughout 2002. See risks listed under "We may not be able to introduce and sell new products and our inability to do so may harm our business materially." Communications Products and Applications. Our communications products are designed to process the flow of information in communications equipment. Among the many communications products that we currently design, manufacture and sell are serial communication controllers, Z180 family of microprocessors, Z380 family data communications controllers and infrared data transceivers. The primary applications for serial communications controllers are switches and line cards. These microperipherals code and decode information that enables voice and data communications to be transmitted and received over telephone lines. The Z180 family of microprocessors is used in Wide Area Network (WAN) controllers, modems (both wired and wireless) and small office routers. Markets that use these products include point of sale terminals, industrial control, gaming and personal digital assistant devices. Internet connectivity software is available for certain members of this family of products. The Z382 data communication processor is used in a broad range of applications, from general purpose to local area networks (LANs) to wide area networks. The Z382's personal computer memory card international association (PCMCIA) interfaces permit it to be readily integrated into stand-alone, desktop and laptop computer applications. Infrared data transceivers are used for point to point wireless data transmission between a variety of electronic appliances, including notebook computers, printers, digital cameras, mobile phones and personal digital assistants. We launched the first product in our eZ80 Internet Engine family of high performance 8-bit microprocessors in the fourth quarter of 2001 and we expect to introduce additional products in this family during 2002. The eZ80 can function as a high-performance 8-bit microprocessor or as a complete web-server when it is equipped with various communication interfaces and protocols. See risks listed under "We may not be able to introduce and sell new products and our inability to do so may harm our business materially" and "Our future success is dependent on the release and acceptance of our new eZ80 Internet Engine family of products." Development Tools Our Developer Studio (ZDS) is a stand-alone software development environment that provides a comprehensive development solution for embedded designers and incorporates our sophisticated line of development tools. ZDS integrates a language-sensitive editor, project manager, highly optimizing ANSI C-compiler, assembler, linker and symbolic source-level debugger that supports our entire line of Z8, Z8Plus, eZ80, Z80S180 and DSP processors. ZDS provides an industry standard user interface running under all Windows(R)-based operating systems, and features an integrated set of windows, document views, menus and toolbars that enable developers to create, test and refine applications in a familiar and productive environment. ZDS II is the next generation descendant of ZDS that has been enhanced to meet the challenges of our more sophisticated developers. ZDS II supports a scripting engine for more flexible user-configuration and automated regression testing. ZDS II also supports a new communication layer allowing it to be interface with third-party emulation products as well as our new ZPAK II high-speed emulation and evaluation hardware interface. Many independent companies develop and market application development tools and systems that support our standard product architectures. Although we do not generate significant revenues from the sale of development tools, we believe that familiarity with, and adoption of, development systems offered by ourselves as well as third-party vendors will be an important factor when considering ZiLOG as the vendor of choice by new product developers. Customers, Sales and Marketing We use a total marketing approach to build relationships with a targeted list of original equipment manufacturers, distributors and end-users in the communications and embedded control markets. Important embedded control customers include Tyco, Black & Decker, Chamberlain Group, Samsung and Thomson/RCA. Lead communications customers in 2001 included Alcatel, Cisco Systems, Handspring, Lucent Technologies, Hewlett-Packard and Nortel. To market our products to our customers, we utilize a well-trained and highly-skilled direct sales and distribution sales force, a customer-centric website, technical documentation that includes product specifications and application notes, development tools and reference designs, sales promotional materials, targeted advertising and public relations activities, and involvement in key trade shows and technical conferences in North America, Europe and Asia. During 2001, we derived approximately 61% of our net sales from direct sales to original equipment manufacturers, compared to 60% in 2000 and 39% from sales through distributors in 2001, compared to 40% in 2000. Our direct sales force of approximately 100 people focuses on four geographic areas: Americas, Europe, Asia and Japan. We have sales offices located in the metropolitan areas of, Chicago, Dallas, El Paso, Los Angeles, Minneapolis, Philadelphia, San Diego, Beijing, Hong Kong, Kuala Lumpur, London, Munich, San Jose, Seoul, Shanghai, Shenzhen (China), Singapore, Soemmerda (Germany), Taichung City (Taiwan), Taipei, and Toronto. We provide direct customer support through our field application engineers, who are located in our sales offices around the world and work directly with local customers in close consultation with our factory-based technical specialists. Field application engineers typically develop technology expertise in a market segment that is most prominent in their geographic areas. These engineers provide significant aid to the customer throughout the design process. Customer support in the Americas is being provided by our American-based personnel. Our local area sales offices handle customer service functions for Asia and Europe. In 2000, we announced an exclusive full-service distribution agreement with Pioneer-Standard in North America and we terminated our existing relationships with our three largest distributors in North America: Arrow Electronics, Future Electronics and Unique Technologies. These terminations were completed at the end of the third quarter of 2000. In 1999, these three distributors collectively purchased $42.3 million of our products. By virtue of this exclusive agreement, we receive more dedicated sales and marketing resources from Pioneer-Standard than from our previous three distributors combined. These resources include sales representatives focused full-time on our business, co-operative trade advertising, seminars and workshops to train design engineers about our products, direct mail advertising and collateral materials and web site pages dedicated to our products. Pioneer-Standard accounted for approximately 12.6% and 11.5% of our net sales during the years ended December 31, 2001 and 2000, respectively. During the year ended December 31, 1999, Arrow Electronics accounted for approximately 12.6% of our net sales. As further explained in Note 2 to the consolidated financial statements, commencing in 2000, revenue on shipments to distributors who have rights of return and price protection on unsold merchandise held by them is deferred until products are resold by the distributor to end users. Prior to fiscal 2000, revenue on shipments to distributors having rights of return and price protection on unsold merchandise held by them were recognized upon shipment to the distributors, with appropriate provisions for reserves for returns and allowances. The figures presented above for 1999 net sales to Arrow Electronics have not been restated to the new method of accounting for revenue recognition. Manufacturing and Sourcing We operate one five-inch semiconductor wafer fabrication facility in Idaho. We closed our eight-inch wafer fabrication facility, which we call Mod III, at the end of January 2002 and it is being held for sale. Currently our five-inch wafer fabrication facility is producing wafers with circuit geometries of 0.65, 0.8 and 1.2 microns. Our products that have circuit sizes below 0.65 microns are being produced at outside foundries in Taiwan. We conduct most of our final test operations at our facility in the Philippines and outsource our assembly operations to subcontractors located primarily in Indonesia and the Philippines. The National Standards Authority of Ireland granted ISO 9001 and 9002 certifications to our facilities in Idaho. The SGS International Certification Services AG of Zurich, Switzerland granted an ISO 9002 certification to our Philippines test facility. ISO certifications reflect the stringent quality standards to which all of our products are manufactured. We believe that these certifications enhance the reputation and quality of our products. If the plan of reorganization is approved and becomes effective, the assets of Mod III will be transferred to our new subsidiary. The holders of our senior notes will enjoy most of the expected economic value of this Mod III subsidiary if the facility is leased or sold. Research and Development As of December 31, 2001, we employed approximately 131 people in research and development as compared to approximately 140 people as of December 31, 2000. Expenditures for research and development during 2001were $28.7 million, representing 17% of net sales. Expenditures for research and development in 2000 were $36.9 million and represented 15% of net sales; in 1999 our R&D expenditures were $32.8 million and represented 13% of net sales. During 2001, our research and development activities were focused largely on communications product development relating to our eZ80 and CarteZian products. In January 2002, we announced the discontinuation of our Cartezian product development efforts and the closure of our Austin, Texas design center. Accordingly, in 2002, we expect to reduce our research and development spending compared to 2001 levels. In 2002, we expect our research and development expenditures will be focussed largely on new products in the eZ80 family, enhancing our embedded control product offerings and IrDA transceivers. Competition The semiconductor industry is characterized by price erosion, rapid technological change and heightened competition in many markets. The industry consists of major domestic and international semiconductor companies, many of which have substantially greater resources than ours with which to pursue engineering, manufacturing, marketing and distribution of their products. Emerging companies are also expected to increase their participation in the semiconductor market. We compete with other micro-logic device manufacturers who target the same specific market segment. Our current and future products compete with, or are expected to compete with, products offered by Atmel, Hitachi, Intel, Microchip, Mitsubishi, Motorola, NEC, Philips, Samsung, Sanyo, Sharp, ST Microelectronics, Toshiba among others. However, we believe that no single competitor addresses exactly the same set of products or markets as we do. Backlog Our total backlog of released orders was $23.4 million as of December 31, 2001 as compared to $33.0 million as of December 31, 2000. Our sales are generally made pursuant to short-term purchase orders rather than long-term contracts. As a result, our backlog may not be an accurate measure of net sales or operating results for any period. Patents and Licenses As of December 31, 2001, we held 123 U.S. and 10 foreign patents and had 41 U.S. and 28 foreign patent applications pending. We have more than 80 U.S. mask work registrations on our products. We hold copyright registrations to protect proprietary software employed in over 100 of our products. We have 16 U.S. registered trademarks, 3 foreign registered trademarks, 13 pending U.S. trademarks, 2 pending foreign trademarks, and have common law rights in more than 40 trademarks or servicemarks. In addition, we have more than 150 active licenses for product or technology exchange. The purpose of these licenses has, in general, been to provide second sources for standard products or to convey or receive rights to valuable proprietary or patented cores, cells or other technology. Employees As of December 31, 2001, we had 946 full-time employees, including 607 in manufacturing, 131 in research and development, 112 in sales and marketing and a total of 98 in information technology, finance and administration. This compares with 1,611 full-time employees that were employed by us on January 1, 1999. In order to reduce our costs and improve our operating efficiency, we have reduced our worldwide headcount in each of the last three years. Significant headcount reductions occurred in connection with our outsourcing of assembly operations in January 1999 and in connection with the closures in the first quarter of 2002 of our Mod III wafer fabrication facility in Nampa, Idaho and our customer support and engineering design center in Austin, Texas. In addition to these actions, we have also had various other voluntary and involuntary reductions in force during the last three years. We consider our relations with our employees to be good and believe that our future success will depend, in large part, upon our ability to attract, retain, train and motivate our employees. None of our employees are represented by labor unions. Environmental Our manufacturing processes require substantial use of various hazardous substances, and, as a result, we are subject to a variety of governmental laws and regulations related to the storage, use, emission, discharge and disposal of such substances, including the Resource Conservation and Recovery Act, the Comprehensive Environmental Response, Compensation and Liability Act, the Superfund Amendment and Reauthorization Act, the Clean Air Act and the Water Pollution Control Act. We believe we have all the material environmental permits necessary to conduct our business. In February 1999, our facilities in Idaho received ISO 14001 certification by the National Standards Authority of Ireland, an independent auditor of environmental management systems. We believe that ISO 14001 certification is widely recognized as the global standard for measuring the effectiveness of a company's environmental management. To qualify, companies must implement an environmental management system, comply with all relevant regulations, commit to prevent pollution, adopt a program of continual improvement, and submit to periodic outside audits of their environmental management system. Our environmental management system controls and monitors all of the ways in which we impact the environment, including air quality, water use, conservation, waste disposal and chemical handling. ITEM 2. PROPERTIES On January 25, 2002, we moved our headquarters from Campbell, California to a 41,000 square foot facility in San Jose, California, leased through January 31, 2007. Excluding the cost of terminating our old lease and relocation expenditures, this move is expected to save us approximately $5.0 million per year in annual operating costs. We currently own and perform wafer fabrication at our 118,000 square foot building located on a 53-acre site in Nampa, Idaho. We recently closed our Mod III facility, which is approximately 158,000 square feet. In connection with our plan of reorganization, we will transfer the assets of the Mod III facility to an entity primarily owned by our bondholders which will hold this facility pending resale to a third party, subject to certain requirements. A majority of our final test operations are performed at a 54,000 square foot facility in the Philippines, which is leased from a third party through 2004. We recently completed the closure of our 17,000 square foot customer support and engineering design center in Austin, Texas. In 1999, we opened a design center in Bangalore, India and have entered into a lease agreement for approximately 10,000 square feet. In addition, we have short-term leases for its sales offices located in the U.S., Canada, England, Germany, Japan, Korea, Malaysia, the People's Republic of China (including Hong Kong), Singapore and Taiwan. We are in the process of closing several sales offices located in the U.S. and Japan. ITEM 3. LEGAL PROCEEDINGS On July 29, 1996, we filed an action in the Superior Court of the State of California in and for Santa Clara against Pacific Indemnity Company, Federal Insurance Company and Chubb & Son Inc. In that action, we sought a declaration that our former insurers, Pacific and Federal, had an unconditional duty to defend and indemnify us in connection with two lawsuits brought in 1994: (1) in Santana v. ZiLOG and, (2) in Ko v. ZiLOG. Our complaint in the Santa Clara County action also alleged that Chubb, which handled the defense of Santana and Ko on behalf of Pacific and Federal, was negligent. Pacific cross-complained against the Company, seeking reimbursement of defense costs for both underlying lawsuits and a payment it contributed to the settlement of Ko. According to its cross-complaint, Pacific sought a total of approximately six million, three hundred thousand dollars ($6,300,000), plus interest and costs of suit. On February 26, 2002, we agreed to make a payment of $300,000 to fully settle these lawsuits. We have already paid $75,000 of this amount. The balance is to be paid in 3 equal installments over the next twelve months. The outstanding balance accrues interest at 6% per annum. We filed for protection under Chapter 11 of the United States Bankruptcy Code in the Northern District of California on February 28, 2002. Prior to this filing, we solicited the acceptance of our plan of reorganization from holders of our senior notes and our preferred stock. We received unanimous acceptance of our plan of reorganization from the noteholders and preferred shareholders voting. In connection with the filing, we made several motions to the judge requesting, among other things, that we be able to pay our employees and trade creditors in the ordinary course. These motions were granted. We expect to have our plan of reorganization confirmed before the middle of May 2002, or as soon as possible thereafter. The terms of the plan of restructuring are described in greater detail under the heading "ITEM 1. BUSINESS, Financial Restructuring and Reorganization." One party has notified us that we may be infringing certain patents. Four of our customers have notified us that they have been approached by patent holders who claim that they are infringing certain patents. The customers have asked us for indemnification. We are investigating the claims of all of these parties. We have had no further communications about any of this for at least 8 months. In the event that we determine, however, that any such notice may involve meritorious claims, we may seek a license. Based on industry practice, we believe that in most cases any necessary licenses or other rights could be obtained on commercially reasonable terms. However, no assurance can be given that licenses could be obtained on acceptable terms or that litigation will not occur. The failure to obtain necessary licenses or other rights or the advent of litigation arising out of such claims could have a material adverse effect on our financial condition. See Factors That May Affect Future Results - "We could be subject to claims of infringement of third-party intellectual property rights, which could result in significant expense to us and/or loss of such rights." We are participating in other litigation and responding to claims arising in the ordinary course of business. We intend to defend ourselves vigorously in these matters. Our management believes that it is unlikely that the outcome of these matters will have a material adverse effect on our financial statements, although there can be no assurance in this regard. ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS On January 28, 2002, we commenced solicitation of acceptances of the plan of reorganization from the holders of our senior notes and preferred stock by sending a copy of a disclosure statement with respect to the plan of reorganization together with a ballot to each such holder. We established January 16, 2002 as the record date for determining holders of senior notes and preferred stock entitled to vote on the plan of reorganization. The voting period for the solicitation ended on February 26, 2002. The result of the solicitation was the acceptance of the plan of reorganization by holders of senior notes with respect to both number and amount and preferred stock with respect to amount, in each case as required for class acceptance of the plan of reorganization under the Bankruptcy Code, as follows:
For Against -------------------------------- ------------------------------- Amount/ Percent Amount/ Percent Number of Voted Number of Voted -------------------------------- ------------------------------- Principal amount of Senior Notes......... $ 221,210,000 100.0% $ -- 0.0% Number of Senior Notes................... 42 100.0% $ -- 0.0% Principal amount Preferred Stock......... $ 249,014 100 % $ -- 0.0%
We did not solicit votes from holders of our common stock. They are deemed to have rejected the plan of reorganization, and thus, their vote is not required. PART II ITEM 5. MARKET FOR REGISTRANT'S COMMON EQUITY AND RELATED STOCKHOLDER MATTERS Pre-Reorganization Equity As of December 31, 2001, there were approximately 245 stockholders of record of our Common Stock, eight holders of the Company's Class A Non-Voting Common Stock and eight holders of our Series A Cumulative Preferred Stock. We have not paid cash dividends on our Common Stock, Class A Non-Voting Common Stock or Series A Cumulative Preferred Stock and do not anticipate paying any dividends on its Common Stock in the foreseeable future. In addition, the agreements governing our senior notes and our credit facility limit our ability to pay dividends on our capital stock. We intend to retain our earnings for the development of our business. Our Series A Cumulative Preferred Stock accumulates dividends at the rate of 13.5% per annum (payable quarterly) for periods ending on or prior to February 27, 2008, and 15.5% per annum thereafter. Dividends will be payable, at the election of the Board but subject to availability of funds and the terms of the Indenture governing our senior notes and our credit facility, in cash or in kind through a corresponding increase in the liquidation preference of the Series A Cumulative Preferred Stock. The Series A Cumulative Preferred Stock has an initial liquidation preference of $100.00 per share. To the extent that a quarterly dividend payment in respect of a share of Series A Cumulative Preferred Stock is not made in cash when due, the amount of such unpaid dividend will accumulate (whether or not declared by the Board) through an increase in the liquidation preference of such share of Series A Cumulative Preferred Stock equal to the amount of such unpaid dividend, and compounding dividends will accumulate on all such accumulated and unpaid dividends. The liquidation preference will be reduced to the extent that previously accumulated dividends are thereafter paid in cash. We are required on February 27, 2008 to pay in cash all accumulated dividends that have been applied to increase the liquidation preference, but only to the extent that such dividends have not been paid in cash. Shares of Series A Cumulative Preferred Stock may be redeemed at our option, in whole or in part, at 100%, if redeemed on or after February 25, 2003, in each case of the sum of (a) the liquidation preference thereof, increased to the extent that accumulated dividends thereon shall not have been paid in cash, plus (b) accrued and unpaid dividends thereon to the date of redemption. Redemption of shares of the Series A Stock prior to February 26, 2003 would be at a premium to par value based on a declining scale as follows: 101.5% after August 25, 2001; 101% after February 25, 2002 and 100.5% after August 25, 2002. Optional redemption of the Series A Cumulative Preferred Stock will be subject to, and expressly conditioned upon, certain limitations under the Indenture governing our senior notes and our credit facility. In certain circumstances, including the occurrence of a change of control of our ownership, but subject to certain limitations under the indenture governing our senior notes, and under the credit facility, we may be required to repurchase shares of Series A Cumulative Preferred Stock at 101% of (a) the sum of the liquidation preference thereof, increased to the extent that accumulated dividends thereon shall not have been paid in cash, plus (b) accrued and unpaid dividends thereon to the repurchase date. Post-Reorganization Equity Upon effectiveness of our plan of reorganization, our currently outstanding preferred and common stock and all options and warrants related thereto will be cancelled. All accumulated dividends and any other obligations with respect to our outstanding preferred and common stock will be extinguished. Each holder of common stock, however, will receive a pro rata share of $50,000. Each holder of preferred stock will receive a pro rata share of $150,000. The plan of reorganization provides for the cancellation of the senior notes. Each holder will receive, in exchange for its senior notes, its pro rata share of: o 100% of our newly issued common stock, except for 14%, issued or reserved for issuance to our employees, directors and consultants under a management incentive plan. o 100% of the newly issued series A preferred stock issued by our currently wholly owned subsidiary, MOD III, Inc. Holders of the new MOD III Series A preferred stock will be entitled to receive an aggregate liquidation preference of $30 million plus any accrued but unpaid dividends on the new MOD III series A preferred stock from the net proceeds of the sale of our MOD III fabrication plant including the facility, equipment and all other assets necessary for the operation of the facility, located in Nampa, Idaho, which we will transfer to MOD III when the plan of reorganization becomes effective and from certain operating lease proceeds. Dividends will accrue on the new MOD III Series A preferred stock at 9 1/2% per annum. o 50% of MOD III Subsidiary's newly issued series B preferred stock. We will retain the remaining 50% of the MOD III series B preferred stock. Holders of the MOD III series B preferred stock will be entitled to receive the net sale proceeds from the sale of MOD III in excess of $30 million plus accrued but unpaid dividends on the MOD III Series A preferred stock. There were no sales of unregistered securities by us in 2001. ITEM 6. SELECTED CONSOLIDATED FINANCIAL DATA The following table summarizes certain selected consolidated financial data of the Company and its subsidiaries.
Years Ended December 31, (in thousands) ------------------------------------------------- 2001 2000 1999 1998 1997 ------- ------- ------- ------- ------- Consolidated Statements of Operations Data: Net sales................................ $ 172,310 $ 239,213 $ 245,138 $ 204,738 $ 261,097 Cost of sales............................ 130,064 151,721 158,768 163,315 171,722 ------- ------- ------- ------- ------- Gross margin............................. 42,246 87,492 86,370 41,423 89,375 Research and development................. 28,668 36,856 32,777 28,846 30,467 Selling, general and administrative...... 46,143 54,478 59,082 54,317 47,806 Special charges(1)....................... 54,329 17,489 4,686 38,620 -- ------- ------- ------- ------- ------- 129,140 108,823 96,545 121,783 78,273 ------- ------- ------- ------- ------- Operating income (loss).................. (86,894) (21,331) (10,175) (80,360) 11,102 Interest income.......................... 1,144 2,756 2,567 3,755 3,167 Interest expense......................... 33,710 29,062 28,954 24,375 275 Other, net............................... (827) (805) (324) (796) 832 -------- ------- -------- ------- ------ Income (loss) before income taxes, equity investment and cumulative effect of change in accounting principle......... (120,287) (48,442) (36,886) (101,776) 14,826 Provision (benefit) for income taxes..... 499 332 1,004 (14,248) 2,965 ------- ------- ------- ------- ------- Income (loss) before equity investment and cummulative effect of change in accounting principle................... (120,786) (48,774) (37,890) (87,528) 11,861 Equity in loss of Qualcore Group, Inc.... (7,178) (885) -- -- -- ------- ------- ------- ------- ------- Income (loss) before cumulative effect of change in accounting principle...... (127,964) (49,659) (37,890) (87,528) 11,861 Cumulative effect of change in accounting principle.............................. -- (8,518) -- -- -- ------- ------- ------- ------- ------- Net income (loss)........................ $(127,964) $(58,177) $ (37,890) $ (87,528) $ 11,861 ======= ======= ======= ====== ======= Pro forma net loss (2)................... $ -- $(49,659) $ (41,597) $ (84,946) $ -- EBITDA (3)............................... $ 4,662 $ 37,829 $ 46,555 $ 19,259 $ 75,456 Consolidated Balance Sheet Data (at end of period): Working capital.......................... $(306,817) $ 23,692 $ 55,562 $ 46,807 $ 131,594 Total assets............................. $ 115,724 $ 239,747 $ 284,286 $ 297,071 $ 415,639 Notes Payable............................ $ 280,000 $ 280,000 $ 280,000 $ 280,000 $ -- Total preferred stock.................... $ 25,000 $ 25,000 $ 25,000 $ 25,000 $ -- Stockholders' equity (deficiency)........ $(274,057) $(142,883) $ (89,768) $ (48,231) $ 340,482
(1) Special charges consist of asset write-downs, restructuring charges and bond restructuring fees in 2001; asset write-downs; restructuring charges and purchased in-process R&D charge in 2000; asset write-downs and purchased in-process R&D charge in 1999; and recapitalization and restructuring charges in 1998. See Note 5 of Notes to Consolidated Financial Statements. (2) Pro forma net loss reflects pro forma amounts with the change in accounting principle related to revenue recognition applied retroactively for the years 1999 and 1998. Data was not available in sufficient detail to provide pro forma information for 1997. See Note 2 of the Notes to Consolidated Financial Statements. (3) EBITDA represents earnings (losses) before interest, income taxes, depreciation, amortization of intangible assets, non-cash stock compensation expenses, equity in loss of Qualcore, cumulative effect of change in accounting principle and special charges. EBITDA is presented because it is a widely accepted financial indicator of a company's ability to service and/or incur indebtedness. However, EBITDA should not be construed as a substitute for income from operations, net income or cash flows from operating activities in analyzing our operating performance, financial position and cash flows. The EBITDA measure presented herein may not be compared to EBITDA as presented by other companies. Summarized below is a reconciliation of our net income (loss) to EBITDA:
Years Ended December 31, (in thousands) ---------------------------------------------------------------- 2001 2000 1999 1998 1997 ---------------------------------------------------------------- Net income (loss) $ (127,964) $ (58,177) $ (37,890) $ (87,528) $ 11,861 Special charges 54,329 17,489 4,686 38,620 - Depreciation and amortization 37,888 41,954 52,368 61,795 63,522 Non-cash stock charges 166 522 - - - Equity investment loss 7,178 885 - - - Interest expense (income), net 32,566 26,306 26,387 20,620 (2,892) Cumulative effect of accounting change - 8,518 - - - Income tax expense (benefit) 499 332 1,004 (14,248) 2,965 ------------ ----------- ----------- ----------- --------- EBITDA $ 4,662 $ 37,829 $ 46,555 $ 19,259 $ 75,456 ============ =========== =========== =========-- =========
ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS The following is management's discussion and analysis of financial condition and results of operations of the Company and its subsidiaries for the years ended December 31, 2001, 2000 and 1999. This discussion and analysis should be read in conjunction with the section entitled "Selected Consolidated Financial Data" and the consolidated financial statements and notes thereto included elsewhere herein. Management's discussion and analysis provides information concerning our business environment, consolidated results of operations and liquidity and capital resources. We prepare and release quarterly unaudited financial statements prepared in accordance with generally accepted accounting principles or GAAP. We also disclose and discuss EBITDA in our filings with the Securities and Exchange Commission, earnings releases and investor conference calls. This pro forma financial information excludes certain non-cash and special charges, consisting primarily of depreciation and amortization, asset impairments, equity investments, stock-based compensation, debt restructuring, restructuring of operations and lease termination costs. We believe the disclosure of such information helps investors more meaningfully evaluate the results of our ongoing operations. However, we urge investors to carefully review the GAAP financial information included as part of our Quarterly Reports on Form 10-Q, our Annual Reports on Form 10-K, and our quarterly earnings releases, compare GAAP financial information with the pro forma financial results disclosed in our quarterly earnings releases and investor calls, and read the associated reconciliation. Results of Operations Our operating results have and will vary because of a number of factors, including the timing and success of new product introductions, customer design wins and losses, the success of cost reduction programs, changes in product mix, volume, timing and shipment of orders, fluctuations in manufacturing productivity, availability of third-party manufacturing services at commercially reasonable prices and quality, and overall economic conditions. Sales comparisons are also subject to customer order patterns and business seasonality. Critical Accounting Policies We believe our critical accounting policies are as follows: o revenue recognition; o estimating sales, returns and allowances; o estimating allowance for doubtful accounts; o estimating write-downs of excess and obsolete inventories; and o asset impairments A brief description of these policies is set forth below. For more information regarding our accounting policies, see Note 1 in the notes to the consolidated financial statements. The preparation of 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 and disclosures of contingent assets and liabilities at the date of the financial statements and the reported amounts of revenues and expenses during the reporting period. On an on-going basis, we evaluate our estimates, including those related to revenue recognition, sales returns, allowance for bad debts, and inventory write-downs and asset impairments. We base our estimates on historical facts and various other assumptions that we believe to be reasonable at the time the estimates are made. Actual results could differ from those estimates. Revenue recognition. We sell our products through two channels, direct sales to original equipment manufacturers and sales through third-party distributors. During 2001, sales to original equipment manufacturers accounted for approximately 61.2% of our total net sales, and sales to distributors accounted for 38.8% of total net sales. We apply the provisions of Staff Accounting Bulletin 101 "Revenue Recognition." and Statement of Financial Accounting Standards No. 48 "Revenue Recognition When Right of Return Exists." Revenues from product sales to OEMs are recognized upon transfer of title, which usually occurs upon delivery of our products to a customer or their designated shipping agent. At that time, we provide for estimated sales returns and other allowances related to those sales. Approximately 38.8% of our net sales are made to distributors under terms allowing certain rights of return and price protection for our products held in the distributors' inventories. Therefore, we defer recognition of revenue and the proportionate cost of revenues derived from sales to distributors until the distributors sell our products to their customers. We evaluate the amounts to defer based on the level of actual distributors' inventory on hand as well as inventory that is in transit. The gross profit deferred as a result of this policy is reflected as "deferred income on sales to distributors" in the accompanying consolidated balance sheets. See note 2 in the notes to consolidated financial statements. Estimating sales returns and allowances. Net revenue consists of product revenue reduced by estimated sales returns and allowances. To estimate sales returns and allowances, we analyze historical returns, current economic trends, levels of inventories of our products held by our customers, and changes in customer demand and acceptance of our products when initially establishing and then evaluating quarterly the adequacy of the reserve for sales returns and allowances. This reserve is reflected as a reduction to accounts receivable in the accompanying consolidated balance sheets. Increases to the reserve are recorded as a reduction to net revenue. Because the reserve for sales returns and allowances is based on our judgments and estimates, particularly as to future customer demand and acceptance of our products, our reserves may not be adequate to cover actual sales returns and other allowances. If our reserves are not adequate, our net revenues could be adversely affected. Allowance for doubtful accounts. We maintain an allowance for losses we may incur as a result of our customers' inability to make required payments. Any increase in the allowance results in a corresponding increase in our general and administrative expenses. In establishing this allowance, and then evaluating the adequacy of the allowance for doubtful accounts, we analyze historical bad debt, customer concentrations, customer credit-worthiness, current economic trends and changes in our customer payment terms. If the financial condition of one or more of our customers unexpectedly deteriorated, resulting in their inability to make payments, or if we otherwise underestimate the losses we incur as a result of our customers' inability to pay us, we could be required to increase our allowance for doubtful accounts which could adversely affect our operating results. Estimating write-downs of excess and obsolete inventories. We identify excess and obsolete products and analyze historical net sales demand forecasts, current economic trends, inventory age and historical write-offs when evaluating the net realizable value of our inventories. Write-offs of excess and obsolete inventories are reflected as a reduction to inventory values in the accompanying consolidated balance sheets, and an increase in cost of revenues. If actual market conditions are less favorable than our assumptions, we may be required to take further write-downs of our inventory value, which could adversely impact our cost of revenues and operating results. Asset Impairments. We apply the provisions of Statement of Financial Accounting Standards No. 144, "Accounting for the Impairment or Disposal of long-lived Assets." We assess the impairment of long-lived assets whenever events or changes in circumstances indicate that the carrying value may not be recoverable. Factors we consider important which could trigger an impairment review include the following: o significant changes in the manner of our use of the acquired assets; o significant changes in the strategy for our overall business; and o significant negative industry or economic trends. When we determine that the carrying value of long-lived assets may not be recoverable based upon the existence of one or more of the above indicators of impairment, and the undiscounted cash flows estimated to be generated by those assets are less than the asset's carrying value, the carrying value of the assets is reduced to their estimated fair value. The estimated fair value is usually determined based on an estimate of future undiscounted cash flows. Asset impairments are recorded as a reduction in the asset value in our consolidated balance sheets and as special charges in our consolidated statements of operations. During 2001, we reported special charges of $42.7 million relating to write-offs of long-lived assets. If actual market conditions or net proceeds of assets to be sold are less favorable than our assumptions, we may be required to take further special charges for asset impairment, which could adversely impact our operating results. Overview We were founded in 1974 as a designer, developer and manufacturer of 8-bit microprocessors and we have evolved into a designer, manufacturer and marketer of semiconductor micro-logic devices for use in the communications and embedded control markets. Using proprietary technology, we provide devices that our customers design into their end products. Our devices enable data communications and telecommunications companies to process and transmit information and also enable a broad range of consumer and industrial electronics manufacturers to control the functions and performance of their products. Prior to February 1998, our common stock had been publicly traded on the New York Stock Exchange under the symbol "ZLG." On February 27, 1998, we consummated a merger with an affiliate of Texas Pacific Group, and in connection with that transaction we ceased having publicly traded equity. Since the merger was structured as a recapitalization with a continuing minority stockholder group, our financial statements still reflect our historical basis of accounting. After the merger, our strategy changed significantly. Our restructuring activities have included streamlining various production facilities and outsourcing our assembly and some of our wafer fabrication operations. In addition, we have recently discontinued development of our Cartezian family of 32-bit microprocessors and refocused on our core 8-bit and 16-bit product lines. We sell our products through two channels, direct sales to original equipment manufacturers and sales through third-party distributors. During 2001, sales to original equipment manufacturers accounted for approximately 61.2% of our total net sales, and sales to distributors accounted for 38.8% of total net sales. During the same period, our total net sales were comprised of approximately 34.6% domestic sales and 65.4% international sales. In 2000, in order to streamline our distribution channels, we terminated our existing relationships with our three largest distributors in North America: Arrow Electronics, Future Electronics and Unique Technologies. During 2000, we engaged Pioneer-Standard Electronics as our sole exclusive full service distributor in North America. Beginning in the second half of 2000, our customer order levels began to decline as a result of slowing general economic conditions and high customer inventory levels. Our 2001 net sales declined by 28% when compared to net sales in 2000. Under the leadership of our new Chief Executive Officer, Jim Thorburn, we have responded to this protracted market downturn with several restructuring actions. These actions are aimed at refocusing our organization on our core 8-bit micro-logic products and cost reduction actions designed to save approximately $50.0 million of cash expenditures annually, (compared to the first quarter of 2001 cash expenditure levels). Part of our cost reduction actions involves plans to restructure our long-term debt, which will by itself save about $26.6 million in interest payments annually. Some of the significant actions to date include: o Streamlining of executive management, including the termination of 9 senior executives and the appointment of Jim Thorburn as Chairman and Chief Executive Officer; o Reduction of our global headcount by approximately 35% since December 31, 2000; o Closure of our eight-inch wafer manufacturing facility and wafer probe operations in Nampa, Idaho; o Successful migration of production processes to our five-inch wafer fabrication facility, outside foundries and our Philippine wafer probe and test facility; o Termination of our third-party sales representative commission program; o Relocation of our headquarters from a 108,000 square foot facility in Campbell, CA, to a 41,000 square foot facility in San Jose, CA ; o Termination of investment relationship with Qualcore Group, Inc.; o Termination of our development of the Cartezian family of 32-bit microprocessors and closure of our Austin, TX design center; and o Receipt of unanimous support from voting senior note holders for our plan to recapitalize ZiLOG by exchanging $280 million in secured debt, plus accrued interest, for equity. Financial Restructuring and Reorganization We filed a pre-packaged Chapter 11 plan of reorganization with the bankruptcy court of the Northern District of California on February 28, 2002 and the bankruptcy court has set a hearing for the confirmation of the plan for April 30, 2002. After we receive such confirmation, we expect to exit from bankruptcy by the middle of May, 2002 or as soon as practicable thereafter. We will continue to operate our business in Chapter 11 in the ordinary course and have obtained the necessary relief from the bankruptcy court to pay our employees, trade, and certain other creditors in full and on time regardless of whether their claims arose before or after the Chapter 11 filing. The claims of our employees, general unsecured creditors (including trade creditors, licensors, and lessors) and secured creditors, other than holders of our senior secured notes, are not impaired under the plan. Under the plan of reorganization, our $280M senior notes will be cancelled. Each holder will receive, in exchange for its senior notes, its pro rata share of: o 100% of our newly issued common stock, except for 14%, which will be issued or reserved for issuance to our employees, consultants, and directors under a management incentive plan. o 100% of the newly issued series A preferred stock issued by our currently wholly owned subsidiary, MOD III. Holders of MOD III series A preferred stock will be entitled to receive an aggregate liquidation preference of $30 million plus any accrued but unpaid dividends on the MOD III series A preferred stock from the net proceeds of the sale of our MOD III fabrication plant including the facility, equipment and all other assets necessary for the operation of the facility, located in Nampa, Idaho, which we will transfer to MOD III when the plan becomes effective and from certain operating lease proceeds. Dividends will accrue on the MOD III series A preferred stock at 9 1/2% per annum. o 50% of MOD III's newly issued series B preferred stock. We will retain the remaining 50% of the new MOD III series B preferred stock. Holders of the new MOD III series B preferred stock will be entitled to receive the net sale proceeds from any sale of Mod III's assets in excess of $30 million plus accrued but unpaid dividends on the new MOD III series A preferred stock. o The plan of reorganization provides for the cancellation of our currently outstanding preferred and common stock and all options and warrants related thereto. All accumulated dividends and any other obligations with respect to our outstanding preferred and common shares will be extinguished. Each holder of common stock will, however, receive a pro rata share of $50,000. Each holder of preferred stock will receive a pro rata share of $150,000. The plan of reorganization also provides for the payment in full, with interest if appropriate, or reinstatement, as appropriate, of all employee and trade claims. Upon the plan of reorganization's effectiveness, we will, among other things, revise our charter and bylaws, enter into a new secured financing agreement, and designate a new board of directors. Historical background to the plan of reorganization We issued the senior secured notes in connection with our going-private transaction in 1998. Since then, our business and financial growth have been negatively affected by the extremely difficult business climate in which we have been operating. In March 2001, we retained Lazard Freres & Co., LLC as financial advisor to assist us in exploring a number of strategic alternatives. Also in March of 2001, Lazard began the process of soliciting bids for the sale of all or parts of our business. While we received a number of proposals, each of these contained significant financing or due diligence contingencies. After consultation with our financial advisor, we determined that these contingencies could seriously jeopardize the likelihood that a strategic transaction could be consummated. In July 2001, holders of senior notes who collectively held or managed approximately $165.0 million in principal amount of our senior notes formed an informal group to discuss and negotiate the terms of a possible restructuring with us. All members of this group executed confidentiality agreements and on July 13, 2001, members of our management met with these holders and their counsel to discuss a possible restructuring. Discussions continued over the course of the summer and fall of 2001. During the course of these discussions, we concluded that the best vehicle to achieve a restructuring of our senior notes was through consummation of a voluntary pre-packaged plan of reorganization under Chapter 11 of the U.S. Bankruptcy Code. On November 27, 2001, we reached a non-binding agreement regarding the terms of the plan with this informal group of our noteholders. On January 28, 2002, we commenced solicitation of acceptances of the plan of reorganization from the holders of our senior notes and preferred stock. We did not solicit votes from holders of our old common stock. In connection with this solicitation, we entered into lock-up agreements with members of the noteholders' group. Under the lock-up agreements, the members of the noteholders' group agreed, among other things and subject to certain conditions, to vote to accept the plan of reorganization. The voting period for the solicitation ended on February 26, 2002. Holders of approximately $221.0 million of our senior notes accepted the plan of reorganization. None of the holders rejected the plan. All of the holders of preferred stock who voted also accepted the plan of reorganization. We believe that the restructuring will substantially reduce uncertainty with respect to our future and better position us to develop new products and maintain and expand our customer base by focusing on our core business. ZiLOG is a pioneer in the semiconductor industry and we have a well-recognized brand. We believe that the elimination of our senior secured notes will allow us to devote more resources towards developing and expanding our core business. There can be no assurance that we will be successful in consummating the plan of reorganization, however we believe that completion of the plan will provide a stronger financial base upon which we can focus and execute to develop a successful business. Our financial statements do not include any adjustments that reflect the restructuring or other events contemplated by the plan. Upon emergence from Chapter 11 proceedings, we will adopt fresh start reporting pursuant to the provisions of the American Institute of Certified Public Accountant's Statement of Position 90-7. Under statement 90-7, on the consummation date our assets and liabilities will be restated to reflect their fair values, the accumulated deficit will be eliminated, and our debt and capital structure will be recast pursuant to the provisions of the prepackaged plan. Years Ended December 31, 2001 and 2000 Net Sales. Our net sales of $172.3 million in 2001 declined 28% from net sales of $239.2 million in 2000. The decrease was attributable primarily to lower unit shipments of embedded control products. Overall, we experienced a significant decline in bookings and net sales during the fourth quarter of 2000, which continued throughout 2001 and has adversely affected net sales for most of our product lines. We believe that this overall decline in demand for our products is reflective of general economic trends, particularly in the high technology sector, and may continue for several quarters. Net sales from our communications segment declined 15.1% to $77.2 million in 2001 compared to 2000, which was primarily the result of lower unit shipments of serial communications, wireless connectivity and DSL products, offset partially by higher unit sales of Modem products. In 2001, net sales from our embedded control segment decreased 34.4% to $93.1 million as a result of decreased unit shipments of every product line in the segment. During 1999 we began to de-emphasize our peripherals product line and in 2000, we announced the discontinuation of our military business line. Accordingly, during 2001, net sales of our peripheral products were $4.9 million compared to $15.4 million in 2000 and we had no military product sales in 2001, compared to $10.7 million in 2000. We expect continuation of the trend of declining net sales of PC peripheral products. Net sales of our products in the Americas in 2001 decreased 29.8% to $87.0 million. Net sales of our products in Asia, including Japan, in 2001 decreased 28.6% to $64.6 million, and net sales of our products in Europe declined by 16.2% to $20.7 million in 2001. Gross Margin. Our cost of sales represents the cost of our wafer fabrication, assembly and test operations. Cost of sales fluctuates, depending on manufacturing productivity, product mix, equipment utilization and depreciation. Gross margin as a percent of net sales declined to 24.5% in 2001 from 36.6% in 2000. This decline in gross margin was primarily brought on by a substantial reduction in sales volume that translated into significant factory under-utilization and resulted in under-absorbed factory overhead and unfavorable manufacturing variances during 2001. As a consequence of our surplus wafer fabrication capacity, we announced during July of 2001 that our wafer manufacturing plants would be consolidated. In January 2002 we closed our eight-inch Mod III wafer fabrication facility and we expect to realize significant operating cost savings beginning in 2002 as a result of the Mod III closure. These savings will be partially offset by higher spending in our five-inch manufacturing facility and from purchases of manufactured wafers from outside foundries. During December 2000, we wrote-down the book value of our five-inch wafer fabrication facility, which was being held for sale until June of 2001 (see Special Charges below). After actively pursuing the sale of our five-inch wafer fabrication facility to several potential buyers, we were unable to consummate a sale and the fabrication facility was placed back into productive asset status in July 2001. During 2001, depreciation expense was reduced by approximately $2.8 million as a result of the fiscal 2000 write-down in book value of the five-inch wafer fabrication facility assets and due to holding of these assets for sale during the first half of 2001. Research and Development Expenses. Research and development expenses decreased to $28.7 million in 2001 from $36.9 million in 2000. The 2001 decrease in research and development spending was due principally to lower headcount and reduced spending in our central process technology organization, elimination of goodwill amortization in connection with the write-off of our investment in the assets of Seattle Silicon Corporation, and an overall reduction in the number of product development projects. During 2002, we expect further reductions in research and development spending as a consequence of the write-off of goodwill acquired from Calibre, Inc. in the fourth quarter of 2001 and due to the closure of our Austin, Texas design center in the first quarter of 2002. Selling, General and Administrative Expenses. Selling, general and administrative expenses decreased to $46.1 million in 2001 from $54.5 million in 2000, but increased as a percentage of net sales to 26.8% in 2001 from 22.8% in 2000. The decrease in our selling, general and administrative spending in 2001 was due primarily to lower payroll-related costs as a result of lower headcount, elimination of outside sales representative commissions and reduced incentive compensation and commissions. Also during 2000 we incurred a $1.1 million charge for expenses relating to our planned initial public offering of common stock, which costs did not recur in 2001. Special Charges. Special charges, charged to expense, for the years ended December 31, 2001, 2000, and 1999 are as follows (in thousands):
2001 2000 1999 ------------ ------------ ------------ Asset Impairments: Impairment of MOD III assets..................... $ 30,417 $ -- $ -- Other impaired and dispositioned assets.......... 6,501 9,274 3,677 Restructuring of operations: Employee retention bonuses, severance pay and termination benefits........................... 8,537 6,470 -- Termination and exit charges..................... 3,225 200 -- Other............................................ 1,399 -- -- Debt restructuring: Professional Fees................................ 4,250 -- -- Purchased in-process research and development.... -- 1,545 1,009 ------------ ------------ ------------ $ 54,329 $ 17,489 $ 4,686 ============ ============ ============
The following table details special charges accrual activity and ending accrual balances for the years ended December 31, 2001 and December 31, 2000 (in thousands):
Severance Termination, and Cancellation Termination and Exit Debt Benefits Charges Restructuting Other Total ------------- ------------- ------------- ------------- ------------- Balance at December 31, 1999......$ -- $ -- $ -- $ -- $ -- Total charge to special charges... 6,470 200 -- -- 6,670 Cash paid......................... (1,218) (100) -- -- (1,318) Deferred stock compensation....... (1,989) -- -- -- (1,989) ------------- ------------- ------------- ------------- ------------- Balance at December 31, 2000...... 3,263 100 -- -- 3,363 Total charge to special charges... 8,537 3,225 4,250 1,399 17,411 Cash paid......................... (6,187) (550) (3,192) (1,181) (11,110) ------------- ------------- ------------- ------------- ------------- Balance at December 31, 2001......$ 5,613 $ 2,775 $ 1,058 $ 218 $ 9,664 ============= ============= ============= ============= =============
During the fourth quarter of 2001, we recorded a fixed asset impairment charge of $30.4 million to adjust to the carrying value of the Mod III eight-inch wafer fabrication facility in Nampa, Idaho to its estimated fair value of $30.0 million. Mod III completed its final manufacturing in January 2002. The property, plant and equipment of Mod III were idled in January 2002, and are now being held for sale. During the fourth quarter of 2001, we reached a settlement agreement with our equity investment partner, Qualcore Group, Inc. in which we paid Qualcore a termination charge of $450,000, and returned all the shares representing our 20% equity ownership in Qualcore. In return, Qualcore cancelled its right to "put" approximately 11% of Qualcore's common stock to us for an aggregate cost of $5.2 million. All future design services from Qualcore, if any, will be purchased under standard pay-for-performance-and-delivery contracts. During the fourth quarter of 2001, we also recorded an impairment charge of $2.1 million for the entire remaining book value of goodwill associated with our acquisition of Calibre, Inc. The Calibre goodwill was deemed to be impaired because our expected revenues from the acquired business have not been realized. In November 2001, we negotiated an agreement with the owner of our Campbell, California headquarters facility to terminate its lease. We agreed to pay termination charges of $2.7 million in cash and transfer title to certain assets and leasehold improvements in return for cancellation of approximately $10.0 million in future lease commitments on our 108,000 square foot headquarters facility. We recorded $1.5 million of special charges to write-off the net book value of disposed assets in connection with the lease cancellation. During the year ended December 31, 2001, we accrued $2.8 million of termination charges. During the third and fourth quarters of 2001, we charged to expense approximately $4.5 million for employee retention bonuses, severance, and termination benefits for the announced reduction in force due to our plans to close its eight-inch wafer fabrication facility in Nampa, Idaho. This action is expected to affect approximately 200 employees. At December 31, 2001, approximately $4.2 million was reserved for these payments, which are expected to be paid primarily in the first quarter of 2002. Also during the third and fourth quarters of 2001, a charge of $1.0 million was incurred for manufacturing consolidation costs, including new mask sets to support our wafer fabrication consolidation efforts, and relocation costs relating to moving our wafer probe operation to its facilities in the Philippines. Approximately $0.2 million was reserved for payment in connection with the manufacturing consolidation charges. We charged $3.5 million to expense for professional fees related to our debt restructuring efforts that accrued during the third and fourth quarter of 2001. At December 31, 2001, approximately $1.1 million was accrued for payment in connection with these professional fees. During the second quarter of 2001, we incurred special charges of $8.1 million for restructuring of operations comprised of severance-related expenses of $4.0 million, including $1.7 million of non-cash stock-option related expenses, fixed-asset related write-offs of $2.9 million, including planning software and surplus test equipment; manufacturing consolidation charges of $0.4, and $0.8 million relating to consultants who are assisting with the Company's restructuring plans. In connection with this restructuring, we eliminated approximately 200 positions worldwide, including 4 senior vice presidents, with continuation payments through the length of such senior vice presidents' employment agreements. As of December 31, 2001, approximately $0.4 million was reserved for future payments in connection with these restructurings. Details of special charges for the years ended December 31, 2000 and 1999 are described below. Interest Expense. Interest expense increased to $33.7 million in 2001 from $29.1 million in 2000. Interest expense in both years relates primarily to our senior notes issued in conjunction with our recapitalization merger in February 1998. The increase in our interest expense in 2001 compared to 2000 relates primarily to interest on borrowings under our revolving credit facility and a $4.2 million dollar write off of all remaining unamortized net debt issuance cost in the fourth quarter of 2001, as a result of the default on our senior notes. Income Taxes. Our provision for income taxes in both 2001 and 2000 reflects foreign income taxes for the jurisdictions in which we were profitable as well as foreign withholding taxes. Based on available evidence, including our cumulative losses to date, we have provided a full valuation allowance of $79.1 million against our net deferred tax assets. Equity in Loss of Qualcore Group, Inc. In March 2000, we acquired a 20% equity stake in Qualcore Group, Inc. for approximately $8.1 million. We accounted for this investment under the equity method. During the fourth quarter of 2001, we terminated our agreement with Qualcore. As a result of this transaction, we recorded a $5.8 million special charge to write off the book value of our equity investment in Qualcore. The loss in equity of Qualcore Group, Inc. also includes the amortization of goodwill associated with our equity investment. Years Ended December 31, 2000 and 1999 Net Sales. Our net sales of $239.2 million in 2000 declined 2.4% from net sales of $245.1 million in 1999. The decrease was attributable primarily to lower unit shipments of embedded control products Overall, we experienced a significant decline in bookings and net sales during the fourth quarter of 2000 which affected net sales for most of our product lines. Net sales from our communications segment grew 7.4% to $90.9 million in 2000 compared to 1999, which was primarily the result of higher unit shipments of serial communications, wireless connectivity and modem products. In 2000, net sales from our embedded control segment decreased 11.5% to $142.0 million as a result of decreased unit shipments of PC peripheral, TV and ROM-based microcontroller products. These sales declines were partially offset by higher unit shipments of military and infrared remote devices. During 2000, net sales of our peripheral products were $15.4 million compared to $28.2 million in 1999. During 2000, net sales of military products totaled $10.7 million and we expect no further sales of these products. Net sales of our products in the Americas in 2000 increased 21.1% to $137.2 million from $113.3 million in 1999. Net sales of our products in Asia, including Japan, in 2000 decreased 24.0% to $80.4 million, and net sales of our products in Europe remained flat at $26.1 million in 2000. Gross Margin. Our cost of sales represents the cost of our wafer fabrication, assembly and test operations. Cost of sales fluctuates, depending on manufacturing productivity, product mix, equipment utilization and depreciation. Gross margin as a percent of net sales improved to 36.6% in 2000 from 35.2% in 1999. This improvement was primarily a result of reduced depreciation expense in our eight-inch wafer fabrication facility and increased sales of higher-margin communications and military products, offset partially by higher unfavorable manufacturing variances in the second half of 2000 due to a reduction in wafer fabrication facility utilization. Effective July 5, 1999, we changed the estimated useful lives of some of our machinery and equipment located in our eight-inch wafer fabrication facility in Idaho from five to seven years. This change in accounting estimate reduced depreciation expense by $9.1 million during 1999, and by $14.3 million in 2000 compared to the amount we would have recorded under our previous useful life estimates. Had the change in accounting estimate been in effect for the full year in 1999, it would have resulted in an approximately $18.2 million reduction in depreciation expense compared to the amount that would have been recorded under the previous useful life estimates. During December 2000, we recorded an impairment of our five-inch wafer fabrication facility. Research and Development Expenses. Research and development expenses increased to $36.9 million in 2000 from $32.8 million in 1999. The 2000 increase in research and development spending was due principally to higher product and design tool development costs, primarily relating new communications products. Additionally, 2000 was the first full year of operations for our Seattle and India design centers. Selling, General and Administrative Expenses. Selling, general and administrative expenses decreased to $54.5 million in 2000 from $59.1 million in 1999 and decreased as a percentage of net sales to 22.8% in 2000 from 24.1% in 1999. The decrease in our selling, general and administrative spending in 2000 was due primarily to lower payroll-related costs as a result of reduced incentive compensation expense, partially offset by a $1.1 million charge for expenses relating to our planned initial public offering of common stock in 2000. Special Charges. During 2000, we recorded special charges of $17.5 million. In June 2000, we recorded $1.2 million of restructuring charges consisting of $1.0 million of severance and related benefits and $0.1 million of asset write-offs and $0.1 million contractual liabilities. These actions were intended to focus our human and financial resources on our communications segment. We terminated 24 people in connection with this action and an additional 12 were re-deployed from other areas of our business into our communications segment. Approximately $1.5 million was purchased in-process research and development expense related to several partially developed semiconductor product designs that were acquired through the acquisition of Calibre, Inc. in July 2000. In December 2000 we implemented a restructuring action that resulted in termination of 86 employees worldwide, including five members of our senior management. This action resulted in severance and benefits expenses of $5.5 million, including $2.0 million of non-cash stock charges. The $3.5 million cash portion of these severance benefits was scheduled to be paid as follows: $0.5 million in 2000; $2.3 million in 2001; and $0.7 million in 2002. During the fourth quarter of 2000 we also recorded a charge of $0.1 million for contractual liabilities and $9.2 million for write-down of long-lived assets, including $2.3 million for intangible assets acquired from Seattle Silicon and $6.9 million for assets held for sale in our five-inch wafer manufacturing facility in Idaho. In December 2000, management approved a plan for the sale of our five-inch wafer fabrication facility in Nampa, Idaho. The decision to sell this facility was based on our desire to reduce fixed manufacturing overhead costs by transferring most production into its newer eight-inch wafer fabrication facility that was significantly under-utilized. Property, plant, and equipment, with a book value of $9.9 million, were written down by $6.9 million to an estimated realizable value of $3.0 million at December 31, 2000. The Company reclassified these assets and the remaining carrying value of $3.0 million to other current assets during the first half of 2001. The Company engaged in discussions with several prospective buyers of the five-inch wafer fabrication facility, but we were unable to consummate a sale of these assets at an acceptable price. In July 2001, we abandoned our plan to sell the five-inch wafer fabrication facility. In accordance with SFAS No. 144, the $3.0 million of remaining carrying value of the five-inch facility was reclassified back into property, plant and equipment. During 1999, we recorded special charges of $4.7 million. Approximately $1.0 million was purchased in-process research and development expense related to several partially developed semiconductor product designs that were acquired through the acquisition of Seattle Silicon in April 1999. We also recognized a $3.7 million charge in 1999 for the write-down to estimated net realizable value of surplus test equipment. Interest Expense. Interest expense increased to $29.1 million in 1999 from $29.0 million in 1999. Interest expense in both years relates primarily to our senior notes issued in conjunction with our recapitalization merger in February 1998. Income Taxes. Our provision for income taxes in both 2000 and 1999 reflects foreign income taxes for the jurisdictions in which we were profitable as well as foreign withholding taxes. Based on available evidence, including our cumulative losses, we provided a full valuation allowance against our net deferred tax assets at December 31, 2000 and 1999. Equity in Loss of Qualcore Group, Inc. In March 2000, we acquired a 20% equity stake in Qualcore Group, Inc. for approximately $8.1 million. We accounted for this investment under the equity method. The loss in equity of Qualcore Group, Inc. primarily represents amortization of goodwill associated with our equity investment. Liquidity and Capital Resources We incurred substantial indebtedness in connection with our recapitalization merger. We currently have $280.0 million in aggregate principal amount of senior notes outstanding, plus approximately $27.0 million of accrued interest, which are publicly registered and subject us to the reporting requirements of the Securities Exchange Act of 1934. Interest on the senior notes accrues at the rate of 9.5% per annum and is payable semi-annually in arrears on March 1 and September 1, to holders of record on the immediately preceding February 15 and August 15, respectively. We did not make the scheduled semi-annual interest payments of $13.3 million on the notes for either the September 2001 or the March 2002 payment dates. Consequently, we are currently in default on these notes and the noteholders can request payment for the entire amount at any time. We currently do not have sufficient cash to pay the entire amount that would be due if the noteholders demanded payment of the principal and/or interest due on the notes. Accordingly, if the noteholders exercise this right or if they were to foreclose on our collateral assets, we may not be able to continue as a going concern. As noted previously, we have concluded that the best vehicle to achieve a restructuring of its senior secured indebtedness was through consummation of a voluntary prepackaged plan of reorganization pursuant to Chapter 11 of the U.S. Bankruptcy Code. Our primary cash needs over the past three years have been for debt restructuring expenditures, restructuring of operations, working capital, interest on our senior notes, payments to our former chief executive and capital expenditures. We have met these needs with our operating cash flow, cash on hand and available credit lines. As of December 31, 2001, we had cash and cash equivalents of approximately $30.7 million. Additionally, we have a senior secured credit facility from a commercial lender that provides for total borrowings of up to $40.0 million, consisting of a four-year revolving credit facility of up to $25.0 million and a five-year capital expenditure line of up to $15.0 million which expire on December 30, 2002 and 2003, respectively. Borrowings under the credit facility bear interest at a rate per annum equal, at our option, to the commercial lender's stated prime rate or the London Interbank Overnight Rate, commonly known as LIBOR, plus 2.0% (5.7% at December 31, 2001) for the revolving credit facility and the commercial lender's prime rate plus 1.0% (5.8% at December 31, 2001) or LIBOR plus 3.0% (6.7% at December 31, 2001) for the capital expenditure line. As of December 31, 2001 borrowings under the revolving credit facility totaled $12.8 million and there were no borrowings under the capital expenditure line. As of February 24, 2002 borrowings under the revolving credit facility totaled $11.5 million, including $1.2 million representing standby letters of credit. There was no additional borrowing capacity under either facility and this loan is currently in default and could be called by the lender. We have a commitment letter in place from our current lender to replace of current credit facility with a three-year $15.0 million senior secured revolving credit facility upon emergence from our Chapter 11 bankruptcy. The new facility will be on substantially similar terms as the existing facility, except that borrowings will bear interest at a rate per annum equal, at our option, to the commercial lender's stated prime rate or LIBOR, plus 2.5%. The capital expenditure line will be cancelled. During the year ended December 31, 2001, our operating activities used net cash of $18.8 million, which was primarily attributable to our overall net loss of $128 million adjusted for the following non-cash items: $37.9 million of depreciation and amortization; $36.9 million of write-offs of long-lived assets; $1.9 million stock option compensation,, and $7.2 million equity in loss of Qualcore Group, Inc., which includes a write-off of equity assets of $5.8 million. Reductions in inventories, accounts receivable and prepaid and other assets totaled $35.4 million and contributed to 2001 operating cash flow, as did a $13.6 million increase in accrued interest expense. Decreases in accounts payable, accrued compensation and employee benefits and other accrued and non-current liabilities used a total of $24.5 million of operating cash during 2001. During the year ended December 31, 2000, our operating activities provided net cash of $8.5 million, which was primarily attributable to our overall net loss of $58.2 million adjusted for the following non-cash items: $42.0 million of depreciation and amortization; $9.3 million write-down of long-lived assets; $8.5 million cumulative change in accounting principle; $2.6 million stock option compensation; $1.5 million of purchased in-process research and development expense, and $0.9 million equity in loss of Qualcore Group, Inc. During 1999, our operating activities generated net cash of $24.4 million which was primarily attributable to an increase in accounts payable, accrued compensation and employee benefits and other accrued and non-current liabilities of $23.3 million and adjusted by non-cash items including depreciation and amortization of $52.4 million, a write-down of assets held for disposal of $3.7 million and a charge for purchased in-process research and development of $1.0 million. These items were offset by a net loss of $37.9 million and an increase in inventories, accounts receivable and other assets totaling $18.3 million. During the year ended December 31, 2001, our investing activities used cash of $4.1 million consisting entirely of capital expenditures. During the year ended December 31, 2000, our investing activities used cash of $30.3 million consisting of $21.9 million of capital expenditures and $8.1 million, including expenses, for the acquisition of a 20% equity investment in Qualcore with an option to purchase the remaining 80% interest. During 2000, our capital expenditures primarily related to enhancements to our 0. 35-micron wafer manufacturing capability. We used $14.2 million in cash for investing activities in 1999. We invested $8.3 million in capital expenditures primarily for new test equipment, product development tools and computer system upgrades and $5.9 million for the acquisition of the net assets of Seattle Silicon. During the year ended December 31, 2001, cash provided from financing activities totaled $12.9 million and represented $12.8 million of borrowings on our revolving credit facility and $0.1 million of proceeds received from issuance of common stock pursuant to stock option exercises. During the year ended December 31, 2000, cash provided from financing activities totaled $1.8 million and related primarily to $2.7 million of proceeds received from issuance of common stock pursuant to stock sales and stock option exercises, which were offset by principal payments under capital leases of $0.9 million. Cash used by financing activities of $0.2 million in 1999 was from principal payments under capital leases offset by exercises of stock options. Our cash needs include debt-restructuring expenditures, restructuring of operations, working capital, and capital expenditures. As of March 29, 2002, we had commitments of approximately $0.4 million for capital expenditures. The 2002 business climate is expected to continue to be extremely difficult. Upon emergence from Chapter 11, we presently expect that anticipated cash flows from operations and available cash, coupled with some operational restructuring activities and other cash-savings initiatives will allow us to satisfy all of our cash needs for the next 12 months. Whether we are able to do so will depend primarily on our results from operations during 2002 and on the success of our debt restructuring plan and our other initiatives. If we are not able to do so, we may be unable to continue as a going concern unless we can obtain additional cash resources, such as from new sources of debt or equity financing or one or more sales of assets. Effects of Inflation and Changing Prices The Company believes that inflation and/or deflation had a minimal impact on its overall operations during 2001, 2000, and 1999. Recent Accounting Pronouncements In July 2001, the Financial Accounting Standards Board (FASB) issued Statement of Financial Accounting Standards No. 141 (SFAS 141), "Business Combinations." SFAS 141 requires the purchase method of accounting for all business combinations initiated after June 30, 2001 and eliminates the pooling-of-interests method. The adoption of SFAS 141 did not have a material effect on its financial condition or results of operations. In July 2001, the FASB issued SFAS 142, "Goodwill and Other Intangible Assets," which requires the discontinuance of goodwill amortization. SFAS 142 is required to be applied for fiscal years beginning after December 15, 2001, with certain early adoption permitted. We will adopt SFAS 142 for the first fiscal quarter of 2002, and the adoption will not have any effect on our financial condition or results of operations. In August 2001, the FASB issued SFAS 143, "Accounting for Asset Retirement Obligations." SFAS 143 addresses financial accounting and reporting for obligations associated with the retirement of tangible long-lived assets and the associated retirement costs. We are in the process of assessing the effect of adopting SFAS 143. In October 2001, the FASB issued SFAS 144, "Accounting for the Impairment or Disposal of long-lived Assets." SFAS 144 supersedes SFAS 121, "Accounting for the Impairment of long-lived Assets and for long-lived Assets to be Disposed Of," and addresses financial accounting and reporting for the impairment of long-lived assets and for long-lived assets to be disposed of. ZiLOG adopted the provisions of SFAS 144 in 2001 and it had no effect on our financial condition or results of operations. . Factors That May Affect Future Results Risks Related to Our Business and Industry If our plan of reorganization does not become effective, our cash flow will not be sufficient to satisfy all of our cash needs for the remainder of 2002. Our cash needs include future requirements for working capital, capital expenditures, and other projected expenditures, related to our announced restructuring and wafer fabrication facility consolidation plans and payment of our indebtedness. In the event that we do not successfully emerge from Chapter 11 as contemplated under our plan of reorganization we could be required to repay the total outstanding balances due under our senior notes and our credit facility. We do not have sufficient cash to make these payments. If we are unable to restructure these obligations, our creditors could liquidate our assets to satisfy their debt. Recent terrorist activities and resulting military and other actions could harm our business. Terrorist attacks in New York, Washington, D.C. and Pennsylvania in September 2001 have disrupted domestic and international commerce. The continued threat of terrorism, any ongoing military action and heightened security measures in response to this threat may cause significant disruption to commerce throughout the world. To the extent that this disruption results in delays or cancellations of orders, a general decrease in spending on technology products or our inability to effectively market and ship our products, our business and results of operations could be harmed. We are unable to predict whether the threat of terrorism or the responses thereto will result in any long-term commercial disruptions or if such activities or responses will have a long-term adverse effect on our business, results of operations or financial condition. Our quarterly operating results are likely to fluctuate and may fail to meet expectations, which may cause the price of our securities to decline. Our quarterly operating results have fluctuated in the past and will likely continue to fluctuate in the future. Our future operating results will depend on a variety of factors and they may fail to meet expectations. Any failure to meet expectations could cause the price of our securities to fluctuate or decline significantly. In addition, high proportions of our costs are fixed, due in part to our significant sales, research and development and manufacturing costs. Therefore, small declines in revenue could disproportionately affect our operating results in a quarter. A variety of factors could cause our quarterly operating results to fluctuate, including: o our ability to introduce and sell new products and technologies on a timely basis; o changes in the prices of our products; o technological change and product obsolescence; o changes in product mix or fluctuations in manufacturing yields; o variability of our customers' product life cycles; o the level of orders that we receive and can ship in a quarter, customer order patterns and seasonality; o increases in the cost of raw materials; and o gain or loss of significant customers. In addition to causing fluctuations in the price of our securities, any significant declines in our operating performance could harm our ability to meet our debt service and other obligations. We are currently experiencing a downturn in the business cycle and our revenues, cash generation and profitability are being adversely affected. The semiconductor industry is highly cyclical and has experienced significant economic downturns at various times in the last three decades, characterized by diminished product demand, erosion of average selling prices and production over-capacity. In the fourth quarter of 2000, another downturn in our business cycle began and continues today. The terrorist acts of September 2001 in New York City, Washington, D.C. and Pennsylvania, and the United States' military response, have exacerbated the downturn and created an uncertain economic environment. We cannot predict the impact of these events, any subsequent terrorist acts or of any related military action, on our customers or business. We believe that, in light of these events, some businesses may curtail spending on technology, which could also negatively affect our quarterly results or financial condition in the future. We are experiencing a decline in revenues, as our customers are not ordering product from us in the quantities that they previously ordered. We are uncertain how long this decline will last. In 1997 and 1998, we experienced similar significant declines in customer demand for our products. In response to these reductions in demand, other semiconductor manufacturers and we reduced prices to avoid a significant decline in capacity utilization. We are currently experiencing significant declines in our capacity utilization in our manufacturing facilities and we have reduced selling prices on certain products. We may be required to further reduce selling prices given the fixed costs associated with such manufacturing capacity, this decline has had and will continue to have a negative impact on our financial condition. In addition, we are currently, and will likely in the future experience substantial period-to-period fluctuations in future operating results that are attributable to general industry conditions or events occurring in the general economy. Any economic downturn could pressure us to reduce our prices and decrease our revenues, cash generation and profitability. We have a history of losses, we expect future losses and we may not achieve or maintain profitability in the future. We have a history of net losses, we expect future net losses and we do not expect to achieve profitability in the near future. We incurred net losses of $128.0 million in 2001, $58.2 million in 2000, and $37.9 million in 1999. As of December 31, 2001, we had an accumulated deficit of approximately $312.1 million. We have implemented and are considering additional implementing significant cost cutting measures, but these cost-cutting measures may not result in increased efficiency or future profitability. Similar to other semiconductor companies, we have implemented and may consider implementing additional significant cost cutting measures that may include: o consolidation of our wafer fabrication facilities, outsourcing significant manufacturing transfer of our probe operations to the Philippines; o refocusing of business priorities; o reallocation of personnel and responsibilities to better utilize human resources; o reductions in workforce; and o temporary office and facility shutdowns. As part of our cost cutting measures, we are considering the disposition of one or more product lines, business units or other assets. We may not be able to consummate any divestiture at a fair market price. We may also be unable to reinvest the proceeds from any disposition to produce the same level of operating profit as the divested product lines or to generate a commensurate rate of return on the amount of our investment. We may also be required to pay some or all of the proceeds from assets sales to our senior lenders rather than retaining such proceeds for working capital. Our cost cutting measures may not increase our efficiency or future profitability. If we are unable to implement our business strategy, our revenues and future profitability may be harmed materially. Our future financial performance and success are largely dependent on our ability to implement our business strategy. We may be unable to implement our business strategy and, even if we do implement our strategy successfully, our results of operations may fail to improve. In addition, although the semiconductor micro-logic market has grown in prior years, it is currently in a significant downturn. Our revenues and future profitability could be harmed seriously. It is uncertain for how long this slowdown will last. We may not be able to introduce and sell new products and our inability to do so may harm our business materially. Our operating results depend on our ability to introduce and sell new products. Rapidly changing technologies and industry standards, along with frequent new product introductions, characterize the industries that are currently the primary end-users of semiconductors. As these industries evolve and introduce new products, our success will depend on our ability to adapt to such changes in a timely and cost-effective manner by designing, developing, manufacturing, marketing and providing customer support for new products and technologies. Our ability to introduce new products successfully depends on several factors, including: o proper new product selection; o timely completion and introduction of new product designs; o complexity of the new products to be designed and manufactured; o development of support tools and collateral literature that make complex products easy for engineers to understand and use; and o market acceptance of our products and our customers' products. We cannot assure you that the design and introduction schedules for any new products or any additions or modifications to our existing products will be met, that these products will achieve market acceptance or that we will be able to sell these products at prices that are favorable to us. Our future success may be dependent on the release and acceptance of our new eZ80 Internet Engine family of products. We announced our newest product, the eZ80 Webserver family of products, in September 1999. We have delivered samples of our first eZ80 product to some of our customers and have released the first eZ80 product to production. These new products may not perform as anticipated and there may be unforeseen redesigns or delays in their final release. Our failure to release these products as scheduled or the failure of these products to meet our customers' expectations would affect us adversely. While we do expect to receive revenues from these products in 2002, it is not clear how significant those revenues will be. Future revenues may also be insufficient to recover the costs associated with their development. Products as complicated as the eZ80 Webserver frequently contain errors and defects when first introduced or as new versions are released. Delivery of products with such errors or defects, or reliability, quality or compatibility problems, could require significant expenditures of capital and other resources and significantly delay or hinder market acceptance of these products. Any such capital expenditures or delays could harm our operating results materially, damage our reputation and affect our ability to retain our existing customers and to attract new customers. Our industry is highly competitive and we cannot assure you that we will be able to compete effectively. The semiconductor industry is intensely competitive and is characterized by price erosion, rapid technological change and heightened competition in many markets. The industry consists of major domestic and international semiconductor companies, many of which have substantially greater financial and other resources than we do with which to pursue engineering, manufacturing, marketing and distribution of their products. Emerging companies are also increasing their participation in the semiconductor industry. Our current and future communications products compete with, or are expected to compete with, products offered by Advanced Micro Devices, ARM, Atmel, Conexant, Intel, Lucent Technologies, Maxim, MIPS Technologies, Mitel, Motorola, NEC, NetSilicon, Philips, PMC-Sierra, Sharp, Texas Instruments and Toshiba. Our current and future embedded control products compete with, or are expected to compete with, products offered by Atmel, Hitachi, Intel, Microchip, Mitsubishi, Motorola, NEC, Philips, Samsung, Sanyo, Sharp, ST Microelectronics and Toshiba. Our ability to compete successfully in our markets depends on factors both within and outside of our control, including: o our ability to design and manufacture new products that implement new technologies; o our ability to protect our products by effectively utilizing intellectual property laws; o our product quality, reliability, ease of use and price; o the diversity of product line and our efficiency of production; o the pace at which customers incorporate our devices into their products; and o the success of our competitors' products and general economic conditions. To the extent that our products achieve market acceptance, competitors typically seek to offer competitive products or embark on pricing strategies, which, if successful, could harm our results of operations and financial condition materially. Unless we maintain manufacturing efficiency and avoid manufacturing difficulties, our future profitability could be harmed. Our semiconductors are highly complex to manufacture and our production yields are sensitive. Our production yields may be inadequate in the future to meet our customers' demands. Production yields are sensitive to a wide variety of factors, including the level of contaminants in the manufacturing environment, impurities in the materials used and the performance of personnel and equipment. From time to time, we have experienced difficulties in effecting transitions to new manufacturing processes and have suffered delays in product deliveries or reduced yields. We may experience similar difficulties or suffer similar delays in the future, and our operating results could be harmed as a result. For example, we may experience problems that make it difficult to manufacture the quantities of our products that we anticipate producing in our .65 micron wafer fabrication processes. These difficulties may include: o equipment being delivered later than or not performing as expected; o process technology changes not operating as expected; o complications in moving production from our eight-inch wafer fabrication facility to our five-inch wafer fabrication facility or to outside foundries in connection with our announced wafer fabrication facility consolidation plans; and o engineers not operating equipment as expected. If we are unable to obtain adequate production capacity, our business could be harmed. We intend to rely on independent third-party foundry manufacturers to fabricate an increasing percentage of our products. Industry-wide shortages in foundry capacity could harm our financial results. Should we be unable to obtain the requisite foundry capacity to manufacture our complex new products, or should we have to pay high prices to foundries in periods of tight capacity, our ability to increase our revenues might be impaired. Any delay in initiating production at third-party facilities, any inability to have new products manufactured at foundries or any failure to meet our customers' demands could damage our relationships with our customers and may decrease our sales. Other significant risks associated with relying on these third-party manufacturers include: o reduced control over the cost of our products, delivery schedules and product quality; o the warranties on wafers or products supplied to us are limited; o increased exposure to potential misappropriation of our intellectual property; and o the cost and consumption of time associated with switching foundries. We depend on third-party assemblers and the failure of these third parties to continue to provide services to us on sufficiently favorable terms could harm our business. We use outside contract assemblers for packaging our products. If we are unable to obtain additional assembly capacity on sufficiently favorable terms, our ability to achieve continued revenue growth might be impaired. Shortages in contract assembly capacity could cause shortages in our products and could also result in the loss of customers. Because we rely on these third parties, we also have less control over our costs, delivery schedules and quality of our products and our intellectual property is at greater risk of misappropriation. Our international operations subject us to risks inherent in doing business in foreign countries that could impair our results of operations. Approximately 65% of our net sales in 2001 were to foreign customers and we expect that international sales will continue to represent a significant portion of our net sales in the future. We maintain significant operations and rely on a number of contract manufacturers in the Philippines, Indonesia, Taiwan, Malaysia and India. We cannot assure you that we will be successful in overcoming the risks that relate to or arise from operating in international markets. Risks inherent in doing business on an international level include: o economic and political instability; o changes in regulatory requirements, tariffs, customs, duties and other trade barriers; o transportation delays; o power supply shortages and shutdowns; o difficulties in staffing and managing foreign operations and other labor problems; o existence of language barriers and cultural distinctions; o taxation of our earnings and the earnings of our personnel; and o other uncertainties relating to the administration of or changes in, or new interpretation of, the laws, regulations and policies of the jurisdictions in which we conduct our business. In addition, our activities outside the United States are subject to risks associated with fluctuating currency values and exchange rates, hard currency shortages and controls on currency exchange. While our sales are primarily denominated in U.S. dollars, worldwide semiconductor pricing is influenced by currency rate fluctuations, and such fluctuations could harm our operating results materially. The risks inherent in our international operations have been increased by the terrorist attacks of September 2001. These attacks, coupled with the international military response, have created an uncertain economic environment and we cannot predict the impact of these events, any subsequent terrorist acts or of any related military action, on our customers or our business. A significant amount of our revenues comes from relatively few of our customers, and any decrease of revenues from these customers, or the loss of their business, could significantly harm our financial results. Historically we have been, and we expect to continue to be, dependent on a relatively small number of customers for a significant portion of our revenues primarily because we depend on third-party distributors to market and sell our products. These third-party distributors accounted for approximately 40% of our sales in 1999, 40% of our sales in 2000 and 39% of our sales in 2001. Our distributors may not continue to effectively market, sell or support our products. Our ten largest customers accounted for approximately 48% of our net sales in 1999, approximately 49% of our net sales in 2000 and 55% of our net sales in 2001. Arrow Electronics alone accounted for approximately 13% of our net sales in 1999 and Pioneer-Standard accounted for approximately 12% of our net sales in 2000 and approximately 13% of our net sales in 2001. Particular customers may change from period to period, but we expect that sales to a limited number of customers will continue to account for a significant percentage of our revenues in any particular period for the foreseeable future. The loss of one or more major customers or any reduction, delay or cancellation of orders by any of these customers or our failure to market successfully to new customers could harm our business materially. We have very few long-term contracts with our customers and, like us, our customers typically compete in cyclical industries. In the future, these customers may decide not to purchase our products at all, to purchase fewer products than they did in the past, or to alter their purchasing patterns, particularly because substantially all of our sales are made on a purchase order or sales order acknowledgment basis, which permits our customers to cancel, change or delay product purchase commitments upon 30 days notice for standard products and 60 days notice for custom products. Customers may still cancel or reschedule within these time periods, however they routinely incur a cancellation or rescheduling charge. This risk is increased because our customers can purchase some similar products from our competitors. Changes in technologies or consumption patterns could reduce the demand for our products. As a result of technological changes, from time to time our customers design our product out of some devices. Any resulting decreased sales could reduce our profitability. For example, we have learned that a number of our customers have changed the designs of computer mouse pointing devices that they manufacture, and that as a result, these devices will no longer contain our products. Because we do not have long-term supply contracts with most of our customers, changes in the designs of their products can have sudden and significant impacts on our sales. As a result of these design changes, net sales of our computer mouse pointing devices and other computer peripheral products decreased substantially from approximately $28.2 million in 1999 to approximately $15.4 million in 2000 and to approximately $4.9 million in 2001. These reduced sales have and may continue to harm our operating results materially. We depend on key personnel, and the loss of our current personnel or our failure to hire and retain additional personnel could affect our business negatively. We depend on our ability to attract and retain highly skilled technical and managerial personnel. We believe that our future success in developing marketable products and achieving a competitive position will depend in large part on our ability to identify, recruit, hire, train, retain and motivate highly skilled technical, executive, managerial, marketing and customer service personnel. Competition for these personnel is intense, especially in Northern California, where our headquarters are located, and we may not be able to successfully recruit, assimilate or retain sufficiently qualified personnel. Our failure to recruit and retain necessary technical, executive, managerial, merchandising, marketing and customer service personnel could harm our business and our ability to obtain new customers and develop new products. In addition, the current financial condition of the Company could have a negative impact on our ability to recruit and retain employees. We may fail to protect our proprietary rights and the cost of protecting those rights, whether we are successful or not, may harm our ability to compete. The measures we take to protect our intellectual property rights may be inadequate to protect our proprietary technologies and processes from misappropriation, and these measures may not prevent independent third party development of competitive products. We may not be able to detect the unauthorized use of, or take appropriate steps to enforce our intellectual property rights. Despite our efforts to protect our proprietary rights in both the United States and in foreign countries, existing intellectual property laws in the United States provide only limited protection and, in some cases, the laws of foreign countries provide even less protection. Litigation may be necessary in the future to enforce our intellectual property rights, to protect our trade secrets or to determine the validity and scope of our proprietary rights or the proprietary rights of others. Any such litigation could require us to incur substantial costs and divert significant valuable resources, including the efforts of our technical and management personnel, which may harm our business materially. We could be subject to claims of infringement of third-party intellectual property rights, which could result in significant expense to us and/or our loss of such rights. The semiconductor industry is characterized by frequent claims and related litigation regarding patent and other intellectual property rights. Third parties may assert claims or initiate litigation against us, our licensors, our foundries, our service providers, or our customers with respect to existing or future products. Any intellectual property litigation initiated against us could subject us to significant liability for damages and attorneys' fees, invalidation of our proprietary rights, injunctions or other court orders that could prevent us from using specific technologies or engaging in specific business activities. These lawsuits, regardless of their success, would likely be time-consuming and expensive to resolve and would divert management's time and attention from our business. Any potential intellectual property litigation could also force us to do one or more of the following: o pay substantial damages; o cease using key aspects of our technologies or processes that incorporate the challenged intellectual property; o cease the manufacture, use, sale, offer for sale and importation of infringing products; o alter our designs around a third party's patent; o obtain licenses to use the technology that is the subject of the litigation from a third party; o expend significant resources to develop or obtain non-infringing technology; o create new brands for our services and establish recognition of these new brands; or o make significant changes to the structure and the operation of our business. Implementation of any of these alternatives could be costly and time-consuming and might not be possible at all. An adverse determination in any litigation to which we were a party could harm our business, our results of operations and financial condition. In addition, we may not be able to develop or acquire the technologies we need, and licenses to such technologies, if available, may not be obtainable on commercially reasonable terms. Any necessary development or acquisition could require us to expend substantial time and other resources. One party has notified ZiLOG that it may be infringing certain patents. Four of our customers have notified us that they have been approached by patent holders who claim that they are infringing certain patents. The customers have asked us for indemnification. ZiLOG is investigating the claims of all of these parties. Even though we have not heard anything about any of these for at least eight months, and while we believe that we are unlikely to have liability in any of these situations, no assurance can be given in this regard. In the event ZiLOG determines that such notice may involve meritorious claims, ZiLOG may seek a license. Based on industry practice, ZiLOG believes that in most cases any necessary licenses or other rights could be obtained on commercially reasonable terms. However, no assurance can be given that licenses could be obtained on acceptable terms or that litigation will not occur. The failure to obtain necessary licenses or other rights or the advent of litigation arising out of such claims could have a material adverse effect on ZiLOG. We are defending one lawsuit, in the ordinary course of business. We may lose this suit and we may be subject to a material judgment against us. We may engage in acquisitions that harm our operating results, dilute our stockholders' equity, or cause us to incur additional debt or assume contingent liabilities. To grow our business and maintain our competitive position, we have made acquisitions in the past and may acquire other businesses in the future. In the past, for example, we acquired substantially all of the assets and assumed the operating liabilities of Seattle Silicon Corporation in April 1999 for approximately $6.1 million. In July 2000, we acquired Calibre in exchange for 741,880 shares of our common stock, including shares of our common stock issuable upon the exercise of vested options, plus additional shares issuable pursuant to an earn-out provision. Acquisitions involve a number of risks that could harm our business and result in the acquired business not performing as expected, including: o insufficient experience with technologies and markets in which the acquired business is involved that may be necessary to successfully operate and integrate the business; o ineffective communication and cooperation in product development and marketing among senior executives and key technical personnel; o problems integrating the acquired operations, personnel, technologies or products with the existing business and products; o diversion of management time and attention from our core business and to the acquired business; o potential failure to retain key technical, management, sales and other personnel of the acquired business; and o difficulties in retaining relationships with suppliers and customers of the acquired business. In addition, acquisitions could require investment of significant financial resources and may require us to obtain additional equity financing, which may dilute our stockholders' equity, or to incur additional indebtedness. We are subject to a variety of environmental laws and regulations and our failure to comply with present or future laws and regulations could harm our business materially. Our manufacturing processes require us to use various hazardous substances and, as a result, we are subject to a variety of governmental laws and regulations related to the storage, use, emission, discharge and disposal of such substances. Although we believe that we are in material compliance with all relevant laws and regulations and have all material permits necessary to conduct our business, our failure to comply with present or future laws and regulations or the loss of any permit required to conduct our business could result in fines being imposed on us, the limitation or suspension of production or cessation of our operations. Compliance with any future environmental laws and regulations could require us to acquire additional equipment or to incur substantial other expenses. Any failure by us to control the use of, or adequately restrict the discharge of, hazardous materials could subject us to future liabilities that could materially harm our business. In addition, we may be required to incur significant expense in connection with governmental investigations and/or environmental employee health and safety matters. Risks Related to Our Capital Structure Our substantial indebtedness may limit the cash flow we have available for our operations and place us at a competitive disadvantage. At December 31, 2001, we had $280.0 million of consolidated long-term indebtedness and a stockholders' deficiency of $274.1 million. If we are unable to successfully restructure our senior notes, the high degree to which we are leveraged may have important consequences to our business, including: o we may not be able to continue as a going concern; o our ability to obtain additional financing for working capital, capital expenditures, product development, possible future acquisitions or other purposes may be impaired or any such financing may not be available; o a substantial portion or all of any cash flow available from operations after satisfying liabilities that arise in the ordinary course of business will be dedicated to the payment of debt service obligations; o high leverage may place us at a competitive disadvantage, limit our flexibility in reacting to changes in our operating environment and make us more vulnerable to a downturn in our business or the economy generally. o we will be required to generate substantial operating cash flow to pay interest and other obligations. The 2002 business climate is expected to be extremely difficult. We presently expect that anticipated cash flows from operations and available cash, coupled with some operational restructuring activities and other cash-savings initiatives will allow us to satisfy all of our cash needs. Whether we are able to do so will depend primarily on our results from operations during 2002 and on the success of our other initiatives. If we are not able to do so, we may require additional cash resources, such as from new sources of debt or equity financing or one or more sales of assets. The agreements governing our indebtedness may limit our ability to finance future operations or capital needs or engage in business activities that may be in our interest. The terms of our indebtedness contain, and the terms of our post-confirmation credit facility are expected to contain restrictive covenants that may impair our ability to take corporate actions that we believe to be in the best interests of our stockholders, including restricting our ability to: o dispose of assets; o incur additional indebtedness; o prepay other indebtedness or amend some debt instruments; o pay dividends or repurchase our stock; o create liens on assets; o enter into sale and leaseback transactions; o make investments, loans or advances; o make acquisitions or engage in mergers or consolidations; o change the business conducted by us or our subsidiaries; o make capital expenditures or engage in specific transactions with affiliates; and o otherwise restrict other corporate activities. Our ability to comply with these agreements may be affected by events beyond our control, including prevailing economic, financial and industry conditions. The breach of any of such covenants or restrictions could result in a default, which would permit some of our creditors to cause all amounts we owe them to accelerate and become due and payable, together with accrued and unpaid interest. We may not be able to repay all of our borrowings if they are accelerated and, in such event, our business may be harmed materially and the value of our common stock and debt securities could decrease significantly. ITEM 7A. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK Interest Rate Risk Our exposure to market risk for changes in interest rates relate primarily to our short-term investment portfolio and short-term debt obligations. We do not use derivative financial investments in its investment portfolio. Our primary investment objectives are to preserve capital and maintain liquidity. These objectives are met by investing in high quality credit issuances and limiting the amount of credit exposure to any one company. We mitigate default risk by investing in only the highest quality securities and monitoring the credit ratings of such investments. We have no cash flow exposure due to rate changes for its cash equivalents or the fixed-rate debt as these instruments have fixed interest rates. The variable rate debt is an obligation established with a commercial lender, and we have cash flow exposure due to rate changes. See Note 6 of Notes to Consolidated Financial Statements for a discussion on the interest rates. The table below presents principal amounts and related average interest rates by year of maturity for our cash equivalents and debt obligation (in thousands): Fair 2002 Total Value --------- -------- --------- Cash Equivalents: Fixed rate......................... $ 29,239 $ 29,239 $ 29,239 Average interest rate.............. 1.76% 1.76% -- Short-term Debt: Variable-rate debt................. $ 12,800 $ 12,800 $ 12,800 Interest rate...................... 4.75% 4.75% -- Fixed-rate debt.................... $ 280,000 $ 280,000 $ 78,400 Stated interest rate............... 9.50% 9.50% -- ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA
The following financial statements and supplementary data are provided herein: Report of KPMG LLP, Independent Auditors...................................................pg. 38 Report of Ernst & Young LLP, Independent Auditors..........................................pg. 40 Consolidated Balance Sheets as of December 31, 2001 and 2000 ..............................pg. 41 Consolidated Statements of Operations for the Years Ended December 31, 2001, 2000 and 1999.....................................................................pg. 42 Consolidated Statements of Cash Flows for the Years Ended December 31, 2001, 2000 and 1999.....................................................................pg. 43 Consolidated Statements of Stockholders' Deficiency for the Years Ended December 31, 2001, 2000, and 1999.................................................pg. 44 Notes to Consolidated Financial Statements.................................................pg. 45
REPORT OF KPMG LLP, INDEPENDENT AUDITORS The Board of Directors ZiLOG, Inc.: We have audited the accompanying consolidated balance sheet of ZiLOG, Inc. and subsidiaries, (the Company), as of December 31, 2001, and the related consolidated statements of operations, stockholders' deficit, and cash flows for the year then ended. These consolidated financial statements are the responsibility of the Company's management. Our responsibility is to express an opinion on these consolidated financial statements based on our audit. We conducted our audit in accordance with auditing standards generally accepted in the United States of America. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audit provides a reasonable basis for our opinion. In our opinion, the consolidated financial statements referred to above present fairly, in all material respects, the financial position of ZiLOG, Inc. and subsidiaries, as of December 31, 2001, and the results of their operations and their cash flows for the year then ended, in conformity with accounting principles generally accepted in the United States of America. The accompanying consolidated financial statements have been prepared assuming that the Company will continue as a going concern. As discussed in Note 1 to the consolidated financial statements, the Company has suffered recurring losses from operations and has a net capital deficiency that raise substantial doubt about the Company's ability to continue as a going concern. In addition, the Company filed a voluntary petition for relief under Chapter 11 of the United States Bankruptcy Code in the United States Bankruptcy Court on February 28, 2002. Although the Company is currently operating their business as debtor-in-possession under the jurisdiction of the Bankruptcy Court, the continuation of their business as a going concern is contingent upon, among other things, the Company's ability to gain confirmation of their plan of reorganization by the Bankruptcy Court and ultimately to achieve profitable operations and positive cash flow. The accompanying consolidated financial statements to not include any adjustments that might result from the outcome of these uncertainties. /s/ KPMG LLP Mountain View, California March 29, 2002 REPORT OF ERNST & YOUNG LLP, INDEPENDENT AUDITORS The Board of Directors and Stockholders ZiLOG, Inc. We have audited the accompanying consolidated balance sheet of ZiLOG, Inc. as of December 31, 2000 and the related consolidated statements of operations, stockholders' deficiency and cash flows for the years ended December 31, 2000 and 1999. Our audits also included the financial statement schedule for the years ended December 31, 2000 and 1999 listed in the index at Item 14(a). These financial statements and schedule are the responsibility of the Company's management. Our responsibility is to express an opinion on these financial statements and schedule based on our audits. We conducted our audits in accordance with auditing standards generally accepted in the United States. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion. In our opinion, the financial statements referred to above present fairly, in all material respects, the consolidated financial position of ZiLOG, Inc. at December 31, 2000, and the consolidated results of its operations and its cash flows for the years ended December 31, 2000 and 1999, in conformity with accounting principles generally accepted in the United States. Also, in our opinion, the related financial statement schedule, when considered in relation to the basic financial statements taken as a whole, presents fairly in all material respects the information set forth therein. As discussed in Notes 1 and 2 to the consolidated financial statements, during the year ended December 31, 2000, the Company changed its accounting method for recognizing revenue on shipments to its distributors. /s/ Ernst & Young LLP San Jose, California January 26, 2001 CONSOLIDATED BALANCE SHEETS (in thousands, except shares and per share amounts) December 31, --------------------- 2001 2000 --------- --------- ASSETS Current assets: Cash and cash equivalents......................... $ 30,707 $ 40,726 Accounts receivable, less allowance for doubtful accounts of $678 in 2001 and $879 in 2000........ 16,664 29,378 Inventories....................................... 17,362 27,547 Prepaid expenses and other current assets......... 3,905 14,005 --------- --------- Total current assets........................... 68,638 111,656 --------- --------- Property, plant and equipment, at cost: Land, buildings and leasehold improvements........ 6,219 28,860 Machinery and equipment........................... 88,273 286,470 --------- --------- 94,492 315,330 Less:accumulated depreciation and amortization.... (48,708) (205,879) --------- --------- Net property, plant and equipment.............. 45,784 109,451 Other assets......................................... 1,302 18,640 ---------- ---------- $ 115,724 $ 239,747 ========= ========= LIABILITIES AND STOCKHOLDERS' DEFICIENCY Current liabilities: Short-term debt................................... $ 12,800 $ -- Notes payable..................................... 280,000 -- Interest payable on notes......................... 22,516 8,867 Accounts payable.................................. 13,355 17,098 Accrued compensation and employee benefits........ 8,992 27,720 Other accrued liabilities......................... 4,923 5,496 Accrued special charges........................... 9,664 3,363 Dividends payable on preferred stock.............. 16,594 11,422 Deferred income on shipments to distributors...... 6,611 13,998 --------- --------- Total current liabilities...................... 375,455 87,964 Notes payable........................................ -- 280,000 Other non-current liabilities........................ 14,326 14,666 Commitments and contingencies Stockholders' deficiency: Preferred Stock, $100.00 par value; 5,000,000 shares authorized; 1,500,000 shares designated as Series A Cumulative Preferred Stock; 250,000 shares of Series A Cumulative Preferred Stock issued and outstanding at December 31, 2001 and 2000; aggregate liquidation preference $40,750 at December 31, 2001.................................. 25,000 25,000 Common Stock, $0.01 par value; 70,000,000 shares authorized; 32,017,272 and 31,962,845 shares issued and outstanding at December 31, 2001 and 2000, respectively. Class A Stock, $0.01 par value; 30,000,000 shares authorized; 10,000,000 shares issued and outstanding at December 31, 2001 and 2000............................................... 420 419 Deferred stock compensation.......................... (596) (1,462) Additional paid-in capital........................... 13,247 12,151 Accumulated deficit.................................. (312,128) (178,991) --------- --------- Total stockholders' deficiency................. (274,057) (142,883) ---------- ---------- $ 115,724 $ 239,747 ========= ========= See accompanying notes to the consolidated financial statements CONSOLIDATED STATEMENTS OF OPERATIONS (in thousands) Year Ended December 31, ---------------------------- 2001 2000 1999 ------- ------- ------- Net sales................................ $ 172,310 $ 239,213 $ 245,138 Cost of sales............................ 130,064 151,721 158,768 ------- ------- ------- Gross margin............................. 42,246 87,492 86,370 Operating expenses: Research and development................. 28,668 36,856 32,777 Selling, general and administrative...... 46,143 54,478 59,082 Special charges.......................... 54,329 17,489 4,686 ------- ------- ------- 129,140 108,823 96,545 ------- ------- ------- Operating loss........................... (86,894) (21,331) (10,175) Other income (expense): Interest income.......................... 1,144 2,756 2,567 Interest expense......................... (33,710) 29,062 28,954 Other, net............................... (827) (805) (324) ------- ------- ------- Loss before income taxes, equity investment and cumulative effect of change in accounting principle......... (120,287) (48,442) (36,886) Provision for income taxes............... 499 332 1,004 ------- ------- ------- Loss before equity investment and cumulative effect of change in accounting principle................... (120,786) (48,774) (37,890) Equity in loss of Qualcore Group, Inc.... (7,178) (885) -- ------- ------- ------- Loss before cumulative effect of change in accounting principle...... (127,964) (49,659) (37,890) Cumulative effect of change in accounting principle.............................. -- (8,518) -- --------- --------- -------- Net loss................................. (127,964) (58,177) (37,890) Preferred stock dividends accrued........ 5,173 4,528 3,965 --------- --------- -------- Net loss attributable to common stockholders........................... $(133.137) $(62,705) $(41,855) ========= ======== ========= Pro forma amounts with the change in accounting principle related to revenue recognition applied retroactively (unaudited): Net loss................................ $ -- $ -- $(41,597) ========= ========= ========= See accompanying notes to the consolidated financial statements. CONSOLIDATED STATEMENTS OF CASH FLOWS (in thousands) Year Ended December 31, ---------------------------- 2001 2000 1999 ------- ------- ------- CASH FLOWS FROM OPERATING ACTIVITIES: Net loss................................... $ (127,964) $ (58,177) $ (37,890) Adjustments to reconcile net loss to net cash (used) provided by operating activities: Cumulative change in accounting principle............................... -- 8,518 -- Equity in loss of Qualcore Group, Inc... 7,178 885 -- Depreciation and amortization........... 37,888 41,954 52,368 Impairment of long lived assets......... 34,831 6,852 3,677 Impairment of goodwill.................. 2,086 2,422 -- Stock compensation...................... 1,896 2,641 -- Charge for purchased in-process research and development.............. -- 1,545 1,009 Interest on notes payable............... 13,649 -- -- Loss from disposition of equipment...... 700 119 261 Change in assets and liabilities: Accounts receivable..................... 12,714 3,069 (6,683) Inventories............................. 10,185 1,470 (6,224) Prepaid expenses and other current and noncurrent assets......... 12,497 2,121 (5,396) Accounts payable........................ (3,024) (6,037) 5,617 Accrued compensation and employee benefits.............................. (18,728) (4,939) 8,061 Other accrued expenses.................. (2,719) 6,050 9,579 ------- ------- ------- Cash provided (used) by operating activities........................ (18,811) 8,493 24,379 CASH FLOWS FROM INVESTING ACTIVITIES: Capital Expenditures.................... (4,075) (21,926) (8,269) Acquisition of Seattle Silicon, net of cash acquired......................... -- -- (5,931) Acquisition of Calibre, Inc., net of cash acquired......................... -- (355) -- Purchase of equity interest in Qualcore Group, Inc. .......................... -- (8,056) -- ------- ------- ------- Cash used by investing activities... (4,075) (30,337) (14,200) CASH FLOWS FROM FINANCING ACTIVITIES: Proceeds from short-term debt........... 12,800 -- -- Proceeds from issuance of common stock.. 67 2,658 318 Principal payments under capital leases. -- (894) (547) ------- ------- ------- Cash provided (used) by financing activities........................ 12,867 1,764 (229) ------- ------- ------- Increase (decrease) in cash and cash equivalents............................... (10,019) (20,080) 9,950 Cash and cash equivalents at beginning of period................................. 40,726 60,806 50,856 ------- ------- ------- Cash and cash equivalents at end of period.................................... $ 30,707 $ 40,726 $ 60,806 ========= ========= ======== SUPPLEMENTAL DISCLOSURE OF CASH FLOW INFORMATION: Interest paid during the year......... $ 14,365 $ 26,896 $ 26,869 Income taxes paid (net refund) during the year............................ $ 479 $ 175 $ (7,137) SUPPLEMENTAL DISCLOSURE OF NON-CASH INVESTING AND FINANCING ACTIVITIES: Equipment purchased under capital leases.............................. $ -- $ -- $ 2,077 Issuance of common stock in connection with Calibre, Inc. acquisition........... $ -- $ 4,291 $ -- Preferred dividend accrued............ $ 5,173 $ 4,528 $ 3,965 See accompanying notes to the consolidated financial statements. CONSOLIDATED STATEMENTS OF STOCKHOLDERS' DEFICIENCY (dollars in thousands)
CONSOLIDATED STATEMENTS OF STOCKHOLDERS' DEFICIENCY (dollars in thousands) Common Stock Common Stock Deferred Addt'l Total Preferred Stock Voting Class A Stock Paid Accumu- Stock- -------------------- ------------------- ------------------ Compensa- in lated holders' Shares Amount Shares Amount Shares Amount tion Capital Deficit Deficiency --------- --------- ----------- ----- ----------- ----- ----- ------ -------- --------- Balance at January 1, 1999....... 250,000 $ 25,000 30,098,736 $ 301 10,000,000 $ 100 $ -- $ 799 $ (74,431) $ (48,231) Issuance of Common Stock under stock option plans............. -- -- 127,050 1 -- -- -- 317 -- 318 Issuance of Common Stock for employee compensation.......... -- -- 300,000 3 -- -- -- (3) -- -- Preferred dividends accrued...... -- -- -- -- -- -- -- -- (3,965) (3,965) Net loss and comprehensive loss.. -- -- -- -- -- -- -- -- (37,890) (37,890) --------- --------- ----------- ----- ----------- ----- ----- ------ -------- --------- Balance at December 31, 1999..... 250,000 25,000 30,525,786 305 10,000,000 100 -- 1,113 (116,286) (89,768) Issuance of Common Stock under stock option plans............. -- -- 382,393 4 -- -- -- 954 -- 958 Sales of restricted stock........ -- -- 425,000 4 -- -- -- 1,696 -- 1,700 Issuance of common stock for acquisition.................... -- -- 629,666 6 -- -- -- 4,285 -- 4,291 Preferred dividends accrued...... -- -- -- -- -- -- -- -- (4,528) (4,528) Deferred stock compensation...... -- -- -- -- -- -- (2,160) 2,160 -- -- Deferred stock compensation cancellations.................. -- -- -- -- -- -- 333 (333) -- -- Amortization of deferred stock compensation................... -- -- -- -- -- -- 365 -- -- 365 Stock option compensation........ -- -- -- -- -- -- -- 2,276 -- 2,276 Net loss and comprehensive loss.. -- -- -- -- -- -- -- -- (58,177) (58,177) --------- --------- ----------- ----- ----------- ----- ----- ------ -------- --------- Balance at December 31, 2000..... 250,000 25,000 31,962,845 319 10,000,000 100 (1,462) 12,151 (178,991) (142,883) Issuance of Common Stock under stock option plans, net........ -- -- 54,427 1 -- -- -- 66 -- 67 Preferred dividends accrued...... -- -- -- -- -- -- -- -- (5,173) (5,173) Deferred stock compensation cancellations.................. -- -- -- -- -- -- 700 (700) -- -- Amortization of deferred stock compensation................... -- -- -- -- -- -- 166 -- -- 166 Stock option compensation........ -- -- -- -- -- -- -- 1,730 -- 1,730 Net loss and comprehensive loss.. -- -- -- -- -- -- -- -- (127,964) (127,964) --------- --------- ----------- ----- ----------- ----- ----- ------ -------- --------- Balance at December 31, 2001..... 250,000 $ 25,000 32,017,272 $ 320 10,000,000 $ 100 $ (596)$13,247 $(312,128) $(274,057) ========= ========= =========== ===== =========== ===== ===== ======= ======== ========= See accompanying notes to the consolidated financial statements.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS December 31, 2001 NOTE 1. DESCRIPTION OF BUSINESS AND SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES ---------------------------------------------------------------------- Nature of business: ZiLOG designs, develops, manufactures and markets integrated circuits for application specific standard products (ASSPs) for the communications, integrated controls, and home entertainment markets. Basis of Presentation: The consolidated financial statements include the accounts of ZiLOG, Inc. and its subsidiaries. All significant transactions and accounts between the Company and these subsidiaries have been eliminated in consolidation. The Company has incurred recurring operating losses and has a net capital deficiency as of December 31, 2001. As described in Note 16, on February 28, 2002, ZiLOG filed a plan of reorganization under Chapter 11 of the U.S. Bankruptcy Code with the Northern District of California (the Reorganization Plan") and currently expects to emerge sometime in May 2002. We believe there is a strong likelihood that the Reorganization Plan will be approved by the Bankruptcy Court because the holders of our senior notes and preferred stock have already approved the terms of the plan. None of ZiLOG's other debts are being restructured as part of this plan. Consequently it is not expected that employees and general unsecured creditors will be compromised under this Reorganization Plan. Although ZiLOG believes that it is likely that the Reorganization Plan will be approved with terms and conditions substantially the same as those submitted and discussed above, there is a possibility that the Reorganization Plan may not be approved. In the event that the Reorganization Plan is not approved or if the Bankruptcy Court changes the Reorganization Plan significantly, ZiLOG's ability to continue as a going concern could be severely adversely affected. The consolidated financial statements do not include any adjustments to reflect the possible future effects on the recoverability and classification of assets or the amounts and classification of liabilities that may result from the outcome of this uncertainty. Revenue recognition: Revenue from product sales to OEM customers is recognized upon shipment net of appropriate allowances for returns and warranty costs, recorded at the time of shipment. As further explained in Note 2, commencing in 2000, revenue on shipments to distributors who have rights of return and price protection on unsold merchandise held by them, is deferred until products are resold by the distributors to end users. Prior to fiscal 2000, revenue on shipments to distributors having rights of return and price protection on unsold merchandise held by them were recognized upon shipment to the distributors, with appropriate provisions for reserves for returns and allowances. In December 1999, the Securities and Exchange Commission ("SEC") issued SEC Staff Accounting Bulletin No. 101 (SAB 101), "Revenue Recognition in Financial Statements." In October 2000, the SEC issued a summary of Frequently Asked Questions ("FAQ") relating to SAB 101. SAB 101 and the related FAQ provide guidance on the recognition, presentation and disclosure of revenue in financial statements. Adoption of SAB 101 had no impact on the Company's consolidated financial statements. Foreign currency translation: All of the Company's subsidiaries use the U.S. dollar as the functional currency. Accordingly, monetary accounts and transactions are remeasured at current exchange rates, and non-monetary accounts are remeasured at historical rates. Revenues and expenses are remeasured at the average exchange rates for each period, except for depreciation expense, which is remeasured at historical rates. Foreign currency exchange losses were included in determining results of operations and aggregated $0.2 million, $0.3 million and $0.2 million for the years ended December 31, 2001, 2000 and 1999, respectively. Cash and cash equivalents: Cash and cash equivalents consist of financial instruments, including auction rate securities, which are readily convertible to cash and have original maturities of three months or less at the time of acquisition. Auction-rate securities included in cash and cash equivalents totaled $11.0 million at December 31, 2000. ZiLOG had no outstanding auction-rate securities in cash and cash equivalents at December 31, 2001. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS December 31, 2001 - (Continued) Inventories: Inventories are stated at the lower of standard cost (which approximates actual cost on a first-in, first-out basis) or market and consist of the following (in thousands): December 31, ------------------------- 2001 2000 ------- ------- Raw materials............... $ 1,011 $ 1,313 Work-in-process............. 10,295 19,827 Finished goods.............. 6,056 6,407 -------- -------- $ 17,362 $ 27,547 ======== ======== Property, plant and equipment: Property, plant and equipment are stated at cost. Depreciation is computed using the straight-line method over the estimated economic lives of the assets, which are generally between three and seven years for machinery and equipment and 30 years for buildings. Significant impairments of property, plant and equipment were recorded in 2001 due to the operational restructuring of the Company, and write-down of ZiLOG's eight-inch wafer fabrication facility to its expected realizable value. See Note 5 below for a further discussion. Amortization of leasehold improvements is computed using the shorter of the remaining terms of the leases or the estimated economic lives of the improvements. Depreciation expense of property, plant and equipment was $35.2 million, $39.4 million and $51.1 million for 2001, 2000 and1999, respectively. Assets leased under a capital lease are recorded at the present value of the lease obligation and are primarily amortized over the shorter of the remaining term of the lease or the estimated economic life of the asset. Amortization of leased assets was approximately $0.2 million in 2001, $0.7 million in 2000 and $0.7 million in 1999. Advertising expenses: The Company accounts for advertising costs as expense for the period in which they are incurred. Advertising expenses for 2001, 2000, and 1999 were approximately $0.7 million, $1.0 million and $1.7 million, respectively. Shipping costs: Shipping costs are included in cost of sales. Use of estimates: The preparation of consolidated financial statements in conformity with generally accepted accounting principles requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities at the date of financial statements and the reported amounts of revenues and expenses during the reporting period. Actual results could differ from those estimates. Stock awards: The Company accounts for employee stock awards in accordance with Accounting Principles Board Opinion No. 25, Accounting for Stock Issued to Employees. For stock option grants issued with an exercise price equal to the fair market value of the stock as determined by the board of directors, the Company recognizes no compensation expense for stock option grants. Pro forma information required by FASB Statement No. 123, Accounting for Stock Based Compensation is presented in Note 9 below. In March 2000, the FASB issued FASB Interpretation No. 44, Accounting for Certain Transactions Involving Stock Compensation--an Interpretation of APB No. 25, or FIN 44. FIN 44 clarifies the application of APB No. 25 and, among other issues, clarifies the following: the definition of an employee for purposes of applying APB No. 25; the criteria for determining whether a plan qualifies as a non-compensatory plan; the accounting consequence of various modifications to the terms of previously fixed stock options or awards; and the accounting for an exchange of stock compensation awards in a business combination. FIN 44 is effective July 1, 2000, but some provisions of FIN 44 cover specific events that occurred after either December 15, 1998 or January 12, 2000. The adoption of FIN 44 did not have any impact on our financial position or results of operations. Recent Accounting Pronouncements: In July 2001, the FASB issued Statements of Financial Accounting Standards No. 141, "Business Combinations" ("FAS 141") and No. 142, "Goodwill and Other Intangible Assets" ("FAS 142"). FAS 141 requires all business combinations initiated after June 30, 2001 to be accounted for using the purchase methods. Under FAS 142, goodwill and intangible assets with indefinite lives are no longer amortized, but are reviewed annually (or more frequently if impairment indicators arise) for impairment. Separable intangible assets that are not deemed to have indefinite lives will continue to be amortized over their useful lives (but with no maximum life). The amortization provisions of FAS 142 apply to goodwill and intangible assets acquired after July 1, 2001. With respect to goodwill and intangible assets acquired prior to July 2, 2001, ZiLOG is required to adopt FAS 142 effective January 1, 2001. The Company expects no impact from the adoption of the provisions to FAS 142 that are effective January 1, 2002. In August 2001, the FASB issued Statement of Financial Accounting Standards No. 144, "Impairment of Disposal of Long-Lived Assets" ("FAS 144"), which is applicable to financial statements for fiscal years beginning after December 15, 2001. The provisions of this statement provide a single accounting model for impairment if long-lived assets. The Company adopted FAS 144 in 2001 there was no impact to the consolidated financial statements. NOTE 2. ACCOUNTING CHANGE - RECOGNITION OF REVENUE ON SALES TO DISTRIBUTORS ------------------------------------------------------------------- In the fourth quarter of 2000, the Company changed its accounting method for recognizing revenue on shipments to distributors who have rights of return and price protection on unsold merchandise held by them. The Company previously recognized revenue upon shipment to these distributors, net of appropriate allowances for sales returns, price protection and warranty costs. Following the accounting change, revenue recognition on shipments to these distributors is deferred until the products are resold by the distributors to their customers. The Company believes that deferral of revenue recognition on these distributor shipments and related gross margin until the product is shipped by the distributor results in a more meaningful measurement of results of operations as it better conforms to the changing business environment and is more consistent with industry practice; therefore it is a preferable method of accounting. The cumulative effect of the change in accounting method was a charge of $8.5 million, net of a zero income tax effect. The pro forma effects of the accounting change on prior years' results are shown in the statement of operations. The effect of adopting the new accounting method in 2000 resulted in an increase in the net loss of $1.6 million, exclusive of the cumulative effect of the accounting change. In the below table, net loss for 2000 represents net loss after the cumulative effect adjustment as a result of the accounting change and pro forma net loss represents net loss before the cumulative effect adjustment. The pro forma effects of the accounting change on prior years' results are as follows (in thousands): Year Ended December 31, ------------------------- 2000 1999 ------- ------- As reported Net sales................... $ 239,213 $ 245,138 Net loss.................... (58,177) (37,890) Pro forma amounts with the change in accounting principle related to revenue recognition applied retroactively (unaudited): Net sales................... $ 239,213 $ 240,694 Net loss.................... (49,659) (41,597) NOTE 3: ACQUISITIONS AND EQUITY INVESTMENT - ------------------------------------------ On July 27, 2000, ZiLOG acquired Calibre, Inc. ("Calibre") pursuant to a merger agreement for 629,666 shares of ZiLOG common stock, par value $.01 per share ("Common Shares") and 112,214 Common Shares issuable upon exercise of vested options. The purchase price of approximately $4.9 million, including acquisition costs of approximately $0.1 million, was allocated based on fair values as follows: tangible net assets of $0.1 million; goodwill of $3.3 million and in-process research and development of approximately $1.5 million. Goodwill was being amortized on a straight-line basis over four years and the net book value at December 31, 2000 is $2.9 million. During the fourth quarter of 2001, the remaining $2.1 million net book value of this goodwill was deemed impaired and recorded as special charges. For financial statement purposes, the acquisition was accounted for as a purchase and, accordingly, the results of operations of Calibre subsequent to July 27, 2000 are included in the Company's consolidated statements of operations. Calibre's in-process research and development, primarily focused on a partially developed technology that replaces third-party transceivers to enable wireless communications, was expensed in the third quarter because the projects related to the acquired research and development had not reached technological feasibility and have no alternative future use. The nature of efforts required to develop the purchased in-process technology into commercially viable products primarily relates to completion of design, prototyping and testing to ensure the products can be produced to meet customer design specifications. Such customer design specifications include product functions, features and performance requirements. To date, we have been unsuccessful in marketing these products and there can be no assurance that these products will ever achieve commercial viability. Factors considered in valuing Calibre's in-process research and development included the state of development of each project, target markets and associated risks of achieving technological feasibility and market acceptance of the products. The value of the purchased in-process technology was determined by estimating the projected net cash flows relating to such products, including costs to complete the technology and product development and the future expected income upon commercialization of the products over periods ranging from three to five years. These cash flows were then discounted to their net present value using an after-tax discount rate of 40 percent. The estimated steps of completion were applied to the net present value of the future discounted cash flows to arrive at the $1.5 million charge for in-process research and development that was immediately written off to the statement of operations. Calibre's pro forma results are not presented, as the pro forma results of operations would not be materially different from ZiLOG's financial statements. On March 22, 2000, ZiLOG acquired 3.0 million shares or 20 percent of the then-outstanding common stock of Qualcore Group, Inc. ("Qualcore") for cash of $8.0 million plus expenses of $0.1 million, pursuant to a purchase and sale agreement (the "Qualcore Agreement"). Subject to the Qualcore Agreement, $5.5 million was paid on March 22, 2000 and $2.5 million was paid on April 14, 2000. ZiLOG accounted for its investment in Qualcore common stock using the equity method. The difference between the total cost of ZiLOG's investment in Qualcore of $8.1 million and ZiLOG's underlying equity in Qualcore's net assets was being amortized on a straight-line basis over five years. Under the terms of the Agreement, ZiLOG had the option until June 30, 2001 to acquire all of the remaining outstanding shares of common stock of Qualcore for cash and/or a number of ZiLOG's Common Shares. If ZiLOG did not exercise this option, Qualcore had the right to put approximately 11% of Qualcore's common stock to the Company for $5.2 million. The Company did not exercise this option. During the fourth quarter of 2001, the Company reached a settlement agreement with Qualcore in which the Company paid Qualcore a termination charge of $450,000, and returned all the shares representing ZiLOG's 20% equity ownership in Qualcore. The termination charge has been recorded as a special charge. In return, Qualcore cancelled its put right. In connection with this settlement the Company wrote-off the remaining balance of its investment in Qualcore. On April 20, 1999, ZiLOG acquired substantially all of the assets and assumed the operating liabilities of Seattle Silicon Corporation ("Seattle Silicon") a fabless semiconductor company based in Bellevue, Washington that offers a customized design capability for analog devices and mixed signal system-on-a-chip (SOC) technology. The purchase price of approximately $6.1 million, including acquisition costs of approximately $0.4 million, was allocated based on fair values as follows: tangible net assets of $0.1 million; in-process research and development of $1.0 million; and goodwill of $5.0 million. Goodwill was being amortized on a straight-line basis over three years and the net book value at December 31, 1999, was $3.9 million. During the fourth quarter of 2000, the remaining $2.3 million net book value of this goodwill was expensed to special charges, see Note 5 below. For financial statement purposes, this acquisition was accounted for as a purchase, and accordingly, the results of operations of Seattle Silicon subsequent to April 20, 1999, are included in the Company's consolidated statements of operations. In-process research and development was expensed in April 1999 because the projects related to the acquired research and development (partially developed semiconductor product designs), had not reached technological feasibility and have no alternative future use. The nature of efforts required to develop the purchased in-process technology into commercially viable products primarily relates to completion of design, prototyping and testing to ensure the products can be produced to meet customer design specifications, including functions, features and performance requirements. The cost of completing these projects was not material and the Company was not successful in bringing these products to commercial viability. Factors considered in valuing in-process research and development included the stage of development of each project, target markets and associated risks of achieving technological feasibility and market acceptance of the products. The value of the purchased in-process technology was determined by estimating the projected net cash flows arising from commercialization of the products over periods ranging from one to four years. These cash flows were then discounted to their net present value using a discount rate of 25 percent. The estimated stage of completion was applied to the net present value of future discounted cash flows to arrive at the $1.0 million charge for in-process research and development that was immediately written off to the statement of operations. Seattle Silicon's pro forma results are not presented, as the pro forma results of operations would not be materially different from ZiLOG's financial statements. NOTE 4. FAIR VALUES OF FINANCIAL INSTRUMENTS ------------------------------------ Cash and cash equivalents consist primarily of cash in bank accounts, commercial paper, money market accounts and short-term time deposits. The short-term debt represents borrowings under a revolving line of credit with a commercial lender. The Notes Payable are 9.5% Senior Secured Notes which mature on March 1, 2005. The carrying amount on the balance sheet for Cash and cash equivalents at December 31, 2001 and 2000 were $30.7 million and $40.7 million, respectively, which approximates fair value, due to their short maturities. Based on market quoted values, the Notes had an estimated fair value of $78.4 million and $159.6 million at December 31, 2001 and 2000, respectively. The carrying amount, which approximates fair value, on the balance sheet at December 31, 2001 for the short-term debt was $12.8 million, which represents the principle amount borrowed. NOTE 5. SPECIAL CHARGES --------------- During the fourth quarter of 2001, ZiLOG recorded an impairment of $30.4 million to the carrying amount of the Mod III eight-inch wafer fabrication facility in Nampa, Idaho ("Mod III"), to its estimated fair value of $30.0 million. The fabrication facility completed its final manufacturing in January 2002. The property, plant and equipment of Mod III were idled in January 2002, and at that time were classified as assets held for sale. During the fourth quarter of 2001, the Company reached a settlement agreement with our equity investment partner, Qualcore Group ("Qualcore") in which the Company paid Qualcore a termination charge of $450,000, and returned all the shares representing ZiLOG's 20% equity ownership in Qualcore. In return, Qualcore cancelled its right to "put" approximately 11% of Qualcore's common stock to the Company for an aggregate cost of $5.2 million. All future design services from Qualcore, if any, will be purchased under standard pay-for-performance-and-delivery contracts. In addition, net goodwill of $2.1 million for Calibre was deemed to be impaired and was written off because expected revenues from this acquired business have not been realized. In November 2001, the Company negotiated with the owner of its Campbell, California headquarters facility to terminate its lease. The Company has agreed to pay termination charges of $2.8 million in cash and transfer title to certain assets and leasehold improvements in return for cancellation of approximately $10.0 million in future lease commitments on its 108,000 square foot headquarters facility. The Company incurred $1.5 million of special charges to write-off the net book value of assets in connection with the lease termination. At December 31, 2001, approximately $2.8 million of lease termination charges were accrued and were paid in February 2002. During the third and fourth quarters of 2001, ZiLOG incurred special charges of approximately $4.5 million for employee retention bonuses, severance, and termination benefits for the announced reduction in force due to ZiLOG's management plans to close its eight-inch fabrication facility in Nampa, Idaho. This action affected approximately 200 employees. At December 31, 2001, approximately $4.2 million was accrued for these payments, which were made in the first quarter of 2002. During the third and fourth quarters of 2001, special charges aggregating $1.0 million were recognized for manufacturing consolidation costs, including new mask sets to support ZiLOG's wafer fabrication facility consolidation efforts and relocation costs relating to moving the Company's wafer probe operation to its facilities in the Philippines. At December 31, 2001, approximately $0.2 remained accrued in connection with the manufacturing consolidation charges. ZiLOG charged $3.5 million to expense for professional fees related to its debt restructuring efforts during the third and fourth quarter of 2001. At December 31, 2001, approximately $1.1 million remained accrued for payment in connection with these professional fees. During the second quarter of 2001, ZiLOG incurred special charges of $8.1 million for restructuring of operations comprised of severance-related expenses of $4.0 million, including $1.7 million of non-cash stock-option related expenses, fixed-asset related write-offs of $2.9 million, including planning software and surplus test equipment; manufacturing consolidation charges of $0.4 million, and $0.8 million relating to consultants who are assisting with the Company's restructuring plans. In connection with this restructuring, ZiLOG eliminated approximately 200 positions worldwide, including 4 senior vice presidents, with continuation payments through the length of such senior vice presidents' employment agreements. As of December 31, 2001, approximately $0.4 million was accrued for future payments in connection with these agreements. During the fourth quarter of 2000, ZiLOG incurred special charges totaling $14.8 million. In December 2000, management approved a plan for the sale of the Company's five-inch wafer fabrication facility in Nampa, Idaho. The decision to sell this facility was based on the Company's desire to reduce fixed manufacturing overhead costs by transferring most production into its newer eight-inch wafer fabrication that was under-utilized. Property, plant, and equipment, with a book value of $9.9 million, were written down by $6.9 million to an estimated realizable value of $3.0 million at December 31, 2000. In 2000, the Company reclassified these assets and the remaining carrying value of $3.0 million to other current assets. As of July 1, 2001, the Company changed its decision and now intends to keep its five-inch wafer fabrication facility and close its eight-inch fabrication facility. The Company then reclassified the $3.0 million carrying value of the five-inch wafer fabrication facility from other current assets to property, plant and equipment. For the year ended December 31, 2001, depreciation expense was lowered by approximately $2.8 million, compared to what would have been recorded without the December 2000 write-down and reclassification of these assets. Also, during the fourth quarter of 2000, the net unamortized Seattle Silicon goodwill of $2.3 million was written off as the Company decided not to pursue further development on commercial production of the products and technology that the goodwill was originally established for. ZiLOG also incurred special charges of $0.1 million for the cancellation of contractual liabilities and $5.5 million for severance benefits, which includes $2.0 million of non-cash stock option compensation. Of the approximately $3.5 million cash payments for severance benefits, $2.1 million and $0.5 million was paid in 2001 and 2000, respectively. The Company expects to make cash payments of approximately $0.9 million in 2002. In connection with this action, approximately 86 employees were terminated, including 5 senior vice presidents, with continuation payments through the length of such senior vice presidents' employee agreements. During the third quarter of 2000, ZiLOG incurred a special charge of $1.5 million of in-process research and development resulting from the acquisition of Calibre, Inc. During the second quarter of 2000, ZiLOG incurred special charges of $1.2 million relating to a restructuring of its Communications segment. In connection with this action, approximately 24 employees were terminated and 12 other employees were transferred into the Communications segment from other areas of the Company. The $1.2 million charge included $0.9 million for severance and benefits, $0.1 million of non-cash stock option compensation, $0.1 million for write-off of impaired assets, and $0.1 million for contractual liabilities. As of December 31, 2001, approximately $0.1 million was accrued for payment of severance and termination benefits. During the second quarter of 1999, ZiLOG incurred special charges of $4.7 million. Approximately $1.0 million was purchased in-process research and development related to several partially developed semiconductor product designs that were acquired through the acquisition of Seattle Silicon in April 1999. ZiLOG also recognized a $3.7 million charge for the write-down to estimated fair value for test equipment held for sale, which was based on an independent appraisal. These assets were disposed of during the year ended December 31, 2000. The following table details special charges activity for the years ended December 31, 2001 and December 31, 2000 (in thousands):
Severance Termination and Cancellation Termination and Exit Debt Benefits Charges Restructuting Other Total ------------- ------------- ------------- ------------- ------------- Balance at December 31, 1999......$ -- $ -- $ -- $ -- $ -- Total charge to special charges... 6,470 200 -- -- 6,670 Cash paid......................... (1,218) (100) -- -- (1,318) Deferred stock compensation....... (1,989) -- -- -- (1,989) ------------- ------------- ------------- ------------- ------------- Balance at December 31, 2000...... 3,263 100 -- -- 3,363 Total charge to special charges... 8,537 3,225 4,250 1,399 17,411 Cash paid......................... (6,187) (550) (3,192) (1,181) (11,110) ------------- ------------- ------------- ------------- ------------- Balance at December 31, 2001......$ 5,613 $ 2,775 $ 1,058 $ 218 $ 9,664 =========== =========== ========== ============= ===========
Special charges, charged to expense, for the years ended December 31, 2001, 2000, and 1999 are as follows (in thousands):
2001 2000 1999 ------------ ------------ ------------ Asset Impairments: Impairment of MOD III assets..................... $ 30,417 $ -- $ -- Other impaired and dispositioned assets.......... 6,501 9,274 3,677 Restructuring of operations: Employee retention bonuses, severance pay and termination benefits........................... 8,537 6,470 -- Termination and exit charges..................... 3,225 200 -- Other............................................ 1,399 -- -- Debt restructuring: Professional Fees................................ 4,250 -- -- Purchased in-process research and development.... -- 1,545 1,009 ------------ ------------ ------------ $ 54,329 $ 17,489 $ 4,686 ============ ============ ============
NOTE 6. CREDIT FACILITY --------------- On December 30, 1998, ZiLOG executed an agreement with a financial institution (the "Lender") for up to $40 million in the form of a senior secured revolving line of credit and capital equipment credit facility (the "Facility"). The Facility provides for borrowings of up to $25 million, subject to a borrowing base consisting of 80% of eligible accounts receivable and 40% of eligible inventories. The Facility also provided $15 million for a capital expenditure line, which is secured by eligible equipment financed. Borrowings, on the $25 million portion bear interest at a rate per annum (at ZiLOG's option) equal to the London Inter-Bank Overnight Rate (LIBOR) plus 2%, or the Lender's published prime rate. Borrowings for the capital expenditure line under the Facility bear interest at a rate per annum (at ZiLOG's option) equal to LIBOR plus 3% or the Lender's prime rate plus 1%. As of December 31, 2001, The Company had borrowings of $12.8 million on the revolving line of credit, which bore interest at 4.75%, per annum. There were no borrowings under the capital equipment credit facility. The Company's default on the payment due on notes payable, and the expiration of the applicable grace period on this payment on October 4, 2001, constitutes a default under the Facility. As a result, this lender is under no obligation to make additional loans to the Company, and the Company therefore may not be able to borrow any additional amounts under this Facility. In addition, this lender has the option to call the loan and render the amounts outstanding under the Facility immediately due and payable. The term of the revolving credit facility is four years and the capital expenditure line is five years, and they expire on December 30, 2002 and 2003, respectively. We received a commitment letter from its current lender to replace the Facility with a three-year $15.0 million senior secured revolving credit facility upon emergence from Chapter 11 bankruptcy. The terms of the commitment letter indicate that the new facility will be on substantially similar terms as the Facility, except that borrowings will bear interest at a rate per annum equal to the commercial lender's stated prime rate or LIBOR, plus 2.5%, and the capital expenditure line will be cancelled. NOTE 7. NOTES PAYABLE ------------- The Company has issued $280 million 9.5% senior secured notes ("the Notes"), which mature on March 1, 2005. Interest is payable semi-annually on the first of March and September. ZiLOG did not make its scheduled semi-annual interest payment of $13.3 million on the outstanding senior notes that was due on September 4, 2001. As a result, the senior notes are now callable by the bondholders at any time. Accordingly, during the third quarter of 2001, the Company reclassified its indebtedness under the senior notes from a long-term liability to a current liability on the consolidated balance sheet. ZiLOG has continued to accrue interest, including associated penalties, amounting to approximately $22.5 million at December 31, 2001. Subsequent to December 31, 2001, the Company reached agreement with the holders of the senior notes to convert the senior notes and accrued interest and penalties into equity. See Note 16 for a further discussion of our planned financial restructuring and reorganization. Expenses associated with the senior notes of approximately $9.9 million were deferred and are being amortized to interest over the term of the senior notes. According to the terms of the senior note agreement, the Company had until October 4, 2001, to pay the interest due on September 4, 2001. Since this did not happen, the debt became immediately due and payable at the option of the holders, and accordingly, the Company charged to interest expense the $4.2 million of remaining unamortized net debt issuance costs during the fourth quarter of 2001. The senior notes contain a number of significant covenants that, among other things, restrict the ability of the Company to dispose of assets, incur additional indebtedness or amend certain debt instruments, pay dividends, create liens on assets, enter into sale and leaseback transactions, make investments, loans or advances, make acquisitions, engage in mergers or consolidations, change the business conducted by the Company or its subsidiaries, make capital expenditures or engage in certain transactions with affiliates and otherwise restrict certain corporate activities. NOTE 8. RETIREMENT AND PENSION PLANS ---------------------------- The Company has an employee savings plan that qualifies as a deferred salary arrangement under Section 401(k) of the Internal Revenue Code (the "401(k) Plan"). Under the 401(k) Plan, participating U.S. employees may defer a portion of their pretax earnings, up to the Internal Revenue Service annual contribution limit ($10,500 for calendar year 2001). The Company may make matching contributions on behalf of each participating employee in an amount equal to 100% of the participant's deferral contribution, up to 1.5% of the participant's compensation on a quarterly basis. The Company may also make additional discretionary contributions to the 401(k) Plan. Matching contributions to the 401(k) Plan were approximately $0.6 million, $0.8 million, and $0.7 million in 2001, 2000, and 1999, respectively. There were no discretionary contributions made for 2001, 2000 or 1999. During the second quarter of 2001, ZiLOG's Board of Directors cancelled the Company's Deferred Compensation Plan (the "Plan"), which allowed certain management employees to defer their receipt of selected amounts of compensation. These deferrals were transferred to a third party Trustee for investment purposes. The third party Trustee paid out the deferred compensation to the affected employees upon termination of the Plan. The Company's Philippines subsidiaries maintain a defined benefit pension plan for local employees, which is consistent with local statutes and practices. This benefit plan had no material impact on the Company's financial statements for the periods presented. NOTE 9. STOCKHOLDERS' DEFICIENCY ------------------------ Common stock: Holders of Common Stock are entitled to one vote per share on all matters submitted to a vote of stockholders. Approval of matters brought before the stockholders requires the affirmative vote of a majority of the holders of the outstanding shares of Common Stock, except as otherwise required by the General Corporation Law of the State of Delaware (the "DGCL"). Holders of Class A Non-Voting Common Stock do not have any voting rights, except the right to vote as a class to the extent required by DGCL. Except for differences in voting rights described above, the rights, powers, preferences, and limitations of the Common Stock and Class A Non-Voting Common Stock are identical. Subject to the rights of holders of Series A Stock and other classes and/or series of preferred stock, if any, all shares of Common Stock and Class A Non-Voting Common Stock are entitled to share in such dividends as the Board may from time to time declare from sources legally available therefore. Subject to the rights of creditors and holders of Series A Stock and other classes and/or series of preferred stock, if any, holders of Common Stock and Class A Non-Voting Common Stock are entitled to share ratably in a distribution of assets of the surviving corporation upon any liquidation, dissolution or winding up of a surviving corporation. Preferred stock: The Board has the authority to issue, from time to time, by resolution and without any action by stockholders, up to 5,000,000 shares of preferred stock, par value $100.00 per share, in one or more classes and/or series and may establish the powers, designations, preferences, rights and qualifications, limitations or restrictions (which may differ with respect to each such class and/or series) of such class and/or series. The Board adopted a resolution on February 26, 1998, providing for the creation of series A cumulative preferred stock ("Series A Stock"). On February 28, 1998, the Board issued 250,000 shares of series A stock, which is a non-voting 13.5% preferred stock with a par value of $100.00 per share. The series A stock will accumulate dividends at the rate of 13.5% per annum (payable quarterly) for periods ending on or prior to February 27, 2008, and 15.5% per annum thereafter. Dividends will be payable, at the election of the Board but subject to availability of funds and the terms of the Notes in cash or in kind through corresponding increase in the liquidation preference (as described below) of the Series A Stock. The Series A Stock had an initial liquidation preference of $100.00 per share. To the extent that a quarterly dividend payment in respect to a share of series A stock is not made in cash when due, the amount of such unpaid dividend will accumulate (whether or not declared by the Board) through an increase in the liquidation preference of such share of series A stock equal to the amount of such unpaid dividend, and compounded dividends will accumulate on all such accumulated and unpaid dividends. The liquidation preference will be reduced to the extent that previously accumulated dividends are thereafter paid in cash. The Company is required to pay in cash all accumulated dividends that have been applied to increase the liquidation preference on February 27, 2008 (the "Clean-Down"). Shares of Series A Stock may be redeemed at the option of the Company, in whole or in part, at 100% of par value, if redeemed after February 25, 2003, in each case of the sum of (i), the liquidation preference thereof, increases to the extent that accumulated dividends thereon shall not have been paid in cash, plus (ii) accrued and unpaid dividends thereon to the date of redemption. Redemption of shares of the series A stock prior to February 26, 2003 would be at a premium to par value based on a declining scale as follows: 103.5% after August 25, 1999; 103.0% after February 25, 2000; 102.5% after August 25, 2000; 102.0% after February 25, 2001; 101.5% after August 25, 2001; 101% after February 25, 2002 and 100.5% after August 25, 2002. Optional redemption of the series A stock will be subject to, and expressly conditioned upon, certain limitations under the notes. In certain circumstances, including the occurrence of a change of control at the Company, but again subject to certain limitations under the notes, the Company may be required to repurchase shares of series A stock at 101% of the sum of the liquidation preference thereof, increased to the extent that accumulated dividends thereon shall not have been paid in cash, plus accumulated and unpaid dividends to the repurchase date. Holders of series A stock will not have any voting rights with respect thereto, except for (i) such rights as are provided under the DGCL, (ii) the right to elect, as a class, one director of the Company in the event that the Company fails to comply with its Clean-Down or repurchase obligations and (iii) class voting rights with respect to transactions adversely affecting the rights, preferences or powers of the series A stock and certain transactions involving stock that ranks junior in payment of dividends, or upon liquidation, to the series A stock. Deferred stock compensation: During the second quarter of 2000, in connection with a planned public offering of the Company's common stock, management determined that the Company had issued stock options to employees having exercise prices below the deemed fair value for financial reporting purposes of the common shares on the date of grant. Accordingly, ZiLOG recorded deferred stock compensation of $2.1 million, representing the excess of the deemed fair value of the common shares on the date of grant over the options' exercise price. Deferred compensation expense is generally being amortized ratably over the four-year option-vesting period. Stock option compensation expense related to these options totaled approximately $0.2 million and $0.5 million for the years ended December 31, 2001 and 2000, respectively. In addition, the vesting periods on certain stock options were accelerated for employees subject to the reduction in force during the second quarter of 2001 and the second and fourth quarters of 2000 (See Note 5). Accordingly, the excess of the fair market value over the exercise price of $2.1 million and $1.7 million for these options were recorded as a special charge during the years ended December 31, 2000 and December 31, 2001, respectively. 1998 stock plans: In August 1998, the ZiLOG, Inc. Long-Term Stock Incentive Plan (the "Plan") and the ZiLOG, Inc. 1998 Executive Officer Stock Incentive Plan (the "Executive Plan"), jointly referred to as the "1998 Plans," were adopted by the Board. Under the 1998 Plans, the Company may grant eligible employees, directors and consultants restricted shares, stock units and nonstatuatory and incentive stock options. Options under the 1998 Plans generally have a life of 10 years and vest at a rate of 25% on each of the first four anniversaries following the option grant date. The terms and conditions of each option or stock award under the 1998 Plans are determined by a committee of the Board and are set forth in agreements between the recipient and the Company. As of December 31, 2001, 4.65 million and 6.75 million shares have been reserved for issuance and approximately 2,669,000 and 4,400,000 options have been granted, net of cancellations, under the Plan and the Executive Plan, respectively. 2000 stock plan: In February 2001, the ZiLOG, Inc. 2000 Stock Incentive Plan ("2000 Plan") was adopted by the Board. Under the 2000 Plan, the Company may grant eligible employees, directors and consultants restricted shares, stock units and nonstatutory and incentive stock options. Options under the 2000 Plan have a maximum life of 10 years and vest at a rate of 25% on the first anniversary of the date of the grant and ratably each month for the following three (3) years. The terms and conditions of each option stock award under the 2000 Plan are determined by a committee of the Board and are set forth in agreements between the recipient and the Company. A total of 3.0 million shares have been reserved for issuance under the 2000 Plan. No grants were awarded under the 2000 Plan as of December 31, 2001. A summary of the Company's activity for all stock plans for the years ended December 31, 2001, 2000 and 1999, is as follows:
Shares Weighted- Available Average for Options Exercise Grant Outstanding Price ------------ ------------ ------------ The 1998 and 2000 Plans (1) Balance as of January 1, 1999.................... 1,701,550 6,198,450 $2.90 Additional shares reserved...................... 3,100,000 -- -- Options granted................................. (1,571,575) 1,571,575 $3.05 Shares granted.................................. (300,000) -- $0.00 Options exercised............................... -- (127,050) $2.50 Options cancelled............................... 371,974 (371,974) $2.50 ------------ ------------ Balance as of December 31, 1999.................. 3,301,949 7,271,001 $2.96 Additional shares reserved...................... 3,300,000 -- -- Options granted................................. (3,282,899) 3,282,899 $5.58 Restricted shares sold.......................... (425,000) -- $0.00 Options exercised............................... -- (382,393) $2.50 Options cancelled............................... 1,165,960 (1,165,960) $3.77 ------------ ------------ Balance as of December 31, 2000.................. 4,060,010 9,005,547 $3.83 Options granted................................. (247,815) 247,815 $6.00 Options exercised............................... -- (60,613) $1.72 Options cancelled............................... 2,694,019 (2,694,019) $4.08 ------------ ------------ Balance as of December 31, 2001.................. 6,506,214 6,498,730 $3.83 ============ ============
(1) No grants were awarded under the 2000 Plan as of December 31, 2001. The following table summarizes information about stock options outstanding at December 31, 2001:
Options Outstanding Options Exercisable --------------------------------------------------------- ------------------------------------- Weighted- Average Weighted- Weighted- Number Remaining Average Number Average Range of Out- Contractual Exercise Exer- Exercise Exercise Prices standing Life Price cisable Price ----------------- ----------------- ----------------- ----------------- ----------------- ----------------- $1.09 - $1.09 21,338 8.01 $1.09 21,338 $1.09 $2.39 - $2.50 3,465,973 6.60 $2.50 2,746,003 $2.50 $4.00 - $6.00 3,001,419 7.82 $5.39 1,501,243 $5.01 ----------------- ----------------- ----------------- ----------------- ----------------- $1.09 - $6.00 6,498,730 7.17 $3.83 4,268,584 $3.37 ----------------- ----------------- ----------------- ----------------- -----------------
The weighted average grant date fair value of options granted in 2001, 2000, and 1999 were $0.95, $1.24, and $1.13, per share, respectively. Options that were exercisable as of December 31, 2001, 2000, and 1999 were 4,268,584, 3,726,909, and 2,014,281, respectively. Pro forma stock based compensation: FAS No. 123 requires that the information be determined as if the Company has accounted for its employee options granted subsequent to December 31, 1994 under the fair value method of that statement. The fair value of the options granted under the 1998 Plans was estimated at the date of grant using the Minimum Value Method option-pricing model using the following weighted average assumptions for 2001, 2000, and 1999:
Year Ended December 31, -------------------------------- 2001 2000 1999 -------------------------------- Annual average risk free interest rate................... 3.5% 5.0% 6.7% Estimated life in years.................................. 5 5 5 Dividend yield........................................... 0.0% 0.0% 0.0%
For purposes of pro forma disclosure, the expense amortization of the options' fair value is allocated over the options' four-year vesting period. Future pro forma net income (loss) results may be materially different from actual amounts reported. The pro forma net loss amounts for the year ended December 31, 2001,2000, and 1999 were approximately $124.8 million, $60.6 million, and $39.0 million, respectively. NOTE 10. INCOME TAXES ------------ The provision for income taxes is as follows (in thousands): Year Ended December 31, --------------------------- 2001 2000 1999 ------- ------- ------- State, All Current............................... $ 179 $ -- $ 197 ------- ------- ------- 179 -- 197 Foreign, All Current............................. 320 332 807 ------- ------- ------- 320 332 807 ------- ------- ------- Provision for income taxes........... $ 499 $ 332 $ 1,004 ======= ======= ======= Pretax income (loss) from foreign operations was $(1.8) million, $(2.5) million and $1.4 million for the years ended December 31, 2001, 2000, and 1999, respectively. The provision for income taxes differs from the amount computed by applying the statutory income tax rate to income before taxes. The source and tax effects of the differences are as follows (in thousands): Year Ended December 31, --------------------------- 2001 2000 1999 ------- ------- ------- Computed expected benefit..................... $(42,100) $(16,955) $ (12,910) State taxes, net of federal benefit........... 116 -- 197 Foreign taxes................................. 320 332 807 MOD III write-off............................. 10,646 -- -- Calibre Goodwill write-off.................... 730 -- -- Foreign losses not benefited.................. 731 1,047 -- Losses for which no current year benefit is recognized.................................. 30,012 15,799 12,630 Other......................................... 44 109 280 ------- ------- ------- $ 499 $ 332 $ 1,004 ======= ======= ======== Deferred income taxes reflect the net tax effects of temporary differences between the carrying amounts of assets and liabilities for financial reporting purposes and the amounts used for income tax purposes. Significant components of the Company's deferred tax liabilities and assets are as follows (in thousands): December 31, --------------------------- 2001 2000 ------- ------- Deferred tax liabilities - tax over book depreciation................................. $(10,019) $(11,828) Deferred tax assets: Net operating losses carryforward............ 77,315 42,368 Accruals not currently deductible............ 4,213 4,958 Inventory valuation adjustments.............. 7,161 4,815 Tax credits carryforward..................... 9,120 2,540 Prepaid expenses and other................... 308 (257) ------- ------- 98,117 54,424 Deferred tax asset valuation allowan.......... (88,098) (42,596) ------- ------- Net deferred taxes............................ $ -- $ -- ======= ======= Realization of deferred tax assets is dependent on future earnings, which are uncertain. Accordingly, a valuation allowance, in an amount equal to the net deferred tax assets as of December 31, 2001 has been established to reflect this uncertainty. The valuation allowance increased by approximately $45.5 million, $14.0 million, and $11.1 million during the fiscal years ended December 31, 2001, 2000, and 1999, respectively. As of December 31, 2001, the Company had federal and California net operating loss carryforwards of approximately $213.0 million and $63.0 million, respectively, which will expire beginning in years 2004 through 2021, if not utilized. As of December 31, 2001, the Company also had federal and California tax credit carryforwards of approximately $7.0 million and 3.2 million, respectively, which will expire at various dates beginning in 2004 through 2021, if not utilized. Utilization of the net operating loss carryforwards and tax credit carryforwards may be subject to a substantial annual limitation due to the "change of ownership" limitations provided by the Internal Revenue Code of 1986, as amended, and similar state provisions. The annual limitations may result in the expiration of net operating loss carryforwards and tax credit carryforwards before full utilization. The Company expects that consummation of the financial restructuring plan described in Note 16 will result in a change in ownership and that substantially all of its tax attributes will be either eliminated or significantly limited. NOTE 11. COMMITMENTS AND CONTINGENCIES ----------------------------- The Company leases certain of its facilities and equipment under non-cancelable operating leases, which expire in 2002 through 2007. The facility lease agreements generally provide for base rental rates which increase at various times during the terms of the leases and also provide for renewal options at fair market rental value. Minimum future lease payments under these non-cancelable leases at December 31, 2001 are as follows (in thousands): Operating Leases --------- 2002................................ $ 2,554 2003................................ 1,529 2004................................ 1,341 2005................................ 1,130 2006................................ 1,041 Thereafter.......................... 83 --------- Total minimum lease payments........ 7,678 ========= The Company is also responsible for common area maintenance charges on certain office leases, which are not included in the above table. These charges are generally less than 10% of base rents. Total operating lease expense, including month-to-month rentals, was approximately $6.9 million, $7.3 million, and $6.6 million, for the years ended December 31, 2001, 2000, and 1999, respectively. On July 29, 1996, the Company filed an action in the Superior Court of the State of California in and for Santa Clara against Pacific Indemnity Company, Federal Insurance Company and Chubb & Son Inc. In that action, we sought a declaration that our former insurers, Pacific and Federal, had an unconditional duty to defend and indemnify us in connection with two lawsuits brought in 1994: (1) in Santana v. ZiLOG and, (2) in Ko v. ZiLOG. Our complaint in the Santa Clara County action also alleged that Chubb, which handled the defense of Santana and Ko on behalf of Pacific and Federal, was negligent. Pacific cross-complained against the Company, seeking reimbursement of defense costs for both underlying lawsuits and a payment it contributed to the settlement of Ko. According to its cross-complaint, Pacific sought a total of approximately six million, three hundred thousand dollars ($6,300,000), plus interest and costs of suit. On February 26, 2002, the Company agreed to make a payment of $300,000 to fully settle these lawsuits. We have already paid $75,000 of this amount. The balance is to be paid in 3 equal installments over the next twelve months. The outstanding balance accrues interest at 6% per annum. One party has notified ZiLOG that it may be infringing certain patents. Four of our customers have notified us that they have been approached by patent holders who claim that they are infringing certain patents. The customers have asked us for indemnification. ZiLOG is investigating the claims of all of these parties. In the event ZiLOG NOTES determines that such notice may involve meritorious claims, ZiLOG may seek a license. Based on industry practice, ZiLOG believes that in most cases any necessary licenses or other rights could be obtained on commercially reasonable terms. However, no assurance can be given that licenses could be obtained on acceptable terms or that litigation will not occur. The failure to obtain necessary licenses or other rights or the advent of litigation arising out of such claims could have a material adverse effect on ZiLOG. ZiLOG is participating in other litigation and responding to claims arising in the ordinary course of business. The Company intends to defend itself vigorously. The Company believes that it is unlikely that the outcome of these matters will have a material adverse effect on the Company, although there can be no assurance in this regard. NOTE 12. RELATED PARTY TRANSACTIONS -------------------------- In January 1999, ZiLOG entered into an agreement with P.T. Astra Microtronics Technology, now known as Advanced Interconnect Technologies, ("AIT"), pursuant to which, AIT provides the Company with semiconductor assembly and test services through January 2003. AIT is owned by Newbridge Asia, an affiliate of Texas Pacific Group, which in turn is an affiliate of our principal stockholder. ZiLOG purchased services from AIT totaling approximately $6.3 million, $17.4 million, and $23.1 million for the years ended December 31, 2001, 2000, and 1999, respectively. The Company had payments due to AIT of approximately $0.5 million, $1.5 million and $3.8 million at December 31, 2001, 2000 and 1999, respectively. The Company's payment terms with AIT are net 30 days. The Company sells products and engineering services to Globespan, of which Texas Pacific Group is a significant stockholder. The Company's net sales to Globespan totaled approximately $6.0 million, $9.2 million and $0.9 million for the years ended December 31, 2001, 2000, and 1999, respectively. ZiLOG's receivables from Globespan were approximately $0.3 million, $2.6 million and $0.5 million for the years ended December 31, 2001, 2000, and 1999, respectively. Payment terms between Globespan and ZiLOG are net 30 days. During 2001, our present Chief Executive Officer, Jim Thorburn, was functioning as ZiLOG's Acting CEO pursuant to a consulting agreement with Texas Pacific Group. Under the agreement, Mr. Thorburn was paid $3000 per day, plus out-of-pocket expenses. In 2001, ZiLOG paid Mr. Thorburn consulting fees of $574,000, pursuant to this agreement. NOTE 13. SEGMENT REPORTING ----------------- Effective January 1, 1998, the Company adopted FAS No. 131, "Disclosures about Segment of an Enterprise and Related Information". FAS No. 131 establishes standards for reporting information about operating segments and related disclosures about products, geographic information and major customers. During the second quarter of fiscal 2000, ZiLOG reorganized its operating segments. This reorganization resulted in military products being reclassified from the communications segment to the embedded control segment. ZiLOG continues to have two reportable segments, communications and embedded control. The 1999-year information presented below has been reclassified to reflect the change. The Company's embedded control segment is divided into two business units: Field Programmable Microcontrollers and Home Entertainment. Consistent with the rules of FAS No. 131, the Company has aggregated these two business units into one reportable segment because both units have similar gross margins and target consumer and industrial customer applications based largely on ZiLOG's Z-8 line of 8-bit microcontrollers and digital signal processors. ZiLOG's communications segment consisted of its Communications business unit, which is generally more profitable than the Company's other business units and is predominantly based on the Company's Z80 line of 8-bit microprocessors and serial communication devices. In 2000, net sales, EBITDA, and depreciation and amortization, included in Corporate and other, were generated from foundry work performed for manufacturing partners. ZiLOG's Chief Executive Officer has been identified as the chief operating decision maker ("CODM") for FAS No. 131 purposes as he assesses the performance of the business units and decides how to allocate resources to the business units. EBITDA, which is defined as earnings from operations before interest income and expense (including amortization of deferred financing costs), income taxes, depreciation, amortization of goodwill, non-cash stock option compensation and special charges, is the measure of profit and loss that the CODM uses to assess performance and make decisions. ZiLOG's sales and corporate marketing, manufacturing, central technology, finance and administration groups are shared resources and therefore allocated to operating segments included in the results below. Interest income, interest expense and net other are considered to be corporate items. ZiLOG's business units do not sell to each other and, accordingly, there are no inter-segment sales. ZiLOG's CODM does not review total assets by operating segment and such data is not presented below since these items are shared resources of the Company and not separated, therefore no breakout by segment exists. The accounting policies for reporting segments are the same as for the Company as a whole. Subsequent to the Merger in 1998, the Company hired new management who defined the Company's current internal reporting structure that included budgeting and evaluating business units' financial performance by the CODM commencing in 1999. During 1998, the Company was managed and reported operating results at the enterprise level and comparable segment financial data is not available. Information regarding reportable segments for the years ended December 31, 2001, 2000, and 1999 is as follows (in thousands):
Embedded Corporate Total Communications Control and Other Consolidated --------------- -------------- -------------- -------------- 2001 Net sales.............................. $ 77,245 $ 93,108 $ 1,957 $ 172,310 ============== EBITDA................................. (6,585) 10,186 1,061 4,662 Depreciation and amortization.......... (12,052) (24,701) (1,135) (37,888) Special charges........................ -- -- (54,329) (54,329) Amortization of deferred stock option compensation........................ -- -- (166) (166) Interest income........................ -- -- 1,144 1,144 Interest expense....................... -- -- (33,710) (33,710) -------------- Loss before income taxes and equity investment.......................... $ (120,287) ============= 2000 Net sales.............................. $ 90,931 $ 141,990 $ 6,292 $ 239,213 ============= EBITDA................................. 29,136 9,488 (795) 37,829 Depreciation and amortization.......... (10,608) (30,900) (446) (41,954) Special charges........................ -- -- (17,489) (17,489) Amortization and direct stock option compensation charges................ -- -- (522) (522) Interest income........................ -- -- 2,756 2,756 Interest expense....................... -- -- (29,062) (29,062) -------------- Loss before income taxes, equity investment and cumulative effect of change in accounting principle............................ $ (48,442) ============= 1999 Net sales.............................. $ 84,697 $ 160,441 $ -- $ 245,138 ============= EBITDA................................. 32,368 13,523 664 46,555 Depreciation and amortization......... (10,420) (41,948) -- (52,368) Special charges........................ -- -- (4,686) (4,686) Interest income........................ -- -- 2,567 2,567 Interest expense....................... -- -- (28,954) (28,954) -------------- Loss before income taxes............... $ (36,886) =============
Net sales are attributable to the ship-to location of ZiLOG's customers as presented in the following table (in thousands): Year Ended December 31, -------------------------------- 2001 2000 1999 --------- --------- --------- United States..................... $ 59,648 $ 110,884 $ 93,361 Mexico............................ 18,294 1,267 41 China (including Hong Kong)....... 17,086 26,880 40,669 Korea............................. 11,545 14,600 22,417 Singapore......................... 11,287 12,962 7,595 Canada............................ 8,818 8,788 8,802 Other Foreign Countries........... 45,632 63,832 72,253 --------- ------- ------- Total....................... $ 172,310 239,213 245,138 ========= ======= ======= The following table shows the location of long-lived assets (in thousands): December 31, ------------------------ 2001 2000 -------- -------- United States (including corporate assets)......................... $ 43,982 $ 104,010 Philippines....................... 1,477 5,031 Other............................. 325 410 -------- -------- Total assets................. $ 45,784 109,451 ======== ======== Major customers: During the years ended December 31, 2001 and 2000, one distributor, Pioneer-Standard Electronics, who buys from both segments, accounted for approximately 12.6% and 11.5% of net sales, respectively. During the year ended December 31, 1999, one distributor, Arrow Electronics, Inc., who buys from both segments, accounted for approximately 12.6% of net sales. NOTE 14. CONCENTRATION OF CREDIT RISK ---------------------------- Financial instruments which potentially subject the Company to concentrations of credit risk consist primarily of cash equivalents, short-term investments and trade accounts receivable. By policy, the Company places its investments only with high credit quality financial institutions. Almost all of the Company's trade accounts receivable are derived from sales to electronics distributors and original equipment manufacturers in the areas of computers and peripherals, consumer electronics, appliances and building controls. The Company performs ongoing credit evaluations of its customers' financial condition and limits its exposure to accounting losses by limiting the amount of credit extended whenever deemed necessary and generally does not require collateral. NOTE 15. QUARTERLY RESULTS (UNAUDITED) ----------------------------- The following tables present unaudited quarterly financial information (in thousands) for the eight quarters of 2001 and 2000. The financial information presented for the first three quarters of 2000 has been restated and gives effect to the accounting change discussed in Note 2. The Company's year-end is December 31, with interim results based on fiscal quarters of thirteen weeks of duration ending on the last Sunday of each quarter. Quarter Ended (Unaudited) --------------------------------------------- Dec. 31, Sep. 30, July 1, April 1, 2001 2001 2001 2001 -------- -------- -------- -------- Net sales.................. $ 41,418 $ 42,659 $ 43,983 $ 44,250 Gross margin............... 14,427 13,212 8,528 6,079 Special charges............ 41,700 4,513 8,116 -- Net loss................... (62,046) (14,738) (27,124) (24,056) Quarter Ended (Unaudited) --------------------------------------------- Dec. 31, Oct. 1, July 2, April 2, 2000 2000 2000 2000 -------- -------- -------- -------- Net sales.................. $ 56,010 $ 66,216 $ 61,143 $ 55,844 Gross margin............... 15,538 24,669 25,296 21,989 Special charges............ 14,753 1,545 1,191 -- Net loss................... (25,211) (7,876) (6,353) (18,737) NOTE 16. FINANCIAL RESTRUCTURING AND REORGANIZATION ------------------------------------------ As discussed in Note 1 to the financial statements, the Company has suffered recurring losses from operations, has a net stockholders' deficiency and its business and financial growth were negatively affected by the extremely difficult business climate. These conditions raise substantial doubt about the Company's ability to continue as a going concern and have lead to the need to restructure the Notes. ZiLOG filed a pre-packaged Reorganization Plan was filed with the bankruptcy court of the Northern District of California on February 28, 2002 and the bankruptcy court has set a hearing for the confirmation of the Reorganization Plan for April 30, 2002. After such confirmation, the Company expects to exit from bankruptcy by the middle of May, 2002 or as soon as practicable thereafter. The Company will continue to operate its business in Chapter 11 in the ordinary course and has obtained the necessary relief from the bankruptcy court to pay employees, trade, and certain other creditors in full and on time regardless of whether their claims arose before or after the Chapter 11 filing. The claims of employees, general unsecured creditors (including trade creditors, licensors, and lessors) and secured creditors, other than holders of the Notes, are not impaired under the Reorganization Plan. Under the Reorganization Plan, the Notes will be cancelled. Each noteholder will receive, in exchange for its senior notes, its pro rata share of: o 100% of ZiLOG's newly-issued common stock, except for 14%, which will be issued or reserved for issuance to employees, consultants, and directors under a management incentive plan. o 100% of the newly issued series A preferred stock issued by a currently wholly-owned subsidiary, MOD III, Inc. Holders of MOD III series A preferred stock will be entitled to receive an aggregate liquidation preference of $30 million plus any accrued but unpaid dividends on the MOD III series A preferred stock from the net proceeds of the sale of the MOD III fabrication plant including the facility, equipment and all other assets necessary for the operation of the facility, located in Nampa, Idaho, which the Company will transfer to MOD III when the Reorganization Plan becomes effective and from certain operating lease proceeds. Dividends will accrue on the MOD III series A preferred stock at 9 1/2% per annum. o 50% of MOD III's newly issued series B preferred stock. ZiLOG will retain the remaining 50% of the new MOD III series B preferred stock. Holders of the new MOD III series B preferred stock will be entitled to receive the net sale proceeds from any sale of MOD III's assets in excess of $30 million plus accrued but unpaid dividends on the new MOD III series A preferred stock. o The Reorganization Plan provides for the cancellation of all currently outstanding preferred and common stock and all options and warrants related thereto. All accumulated dividends and any other obligations with respect to the Company's outstanding preferred and common shares will be extinguished. Each holder of common stock will, however, receive a pro rata share of $50,000. Each holder of preferred stock will receive a pro rata share of $150,000. The Reorganization Plan also provides for the payment in full, with interest if appropriate, or reinstatement, as appropriate, of all employee and trade claims. Upon the Reorganization Plan's effectiveness, the Company will, among other things, revise its charter and bylaws, enter into a new secured financing agreement, and designate a new board of directors. Historical background to the Reorganization Plan The Notes were issued in connection with ZiLOG's going-private transaction in 1998. Since then, the Company's business and financial growth have been negatively affected by the extremely difficult business climate in which it has been operating. In March 2001, ZiLOG retained Lazard Freres & Co., LLC as financial advisor to assist in exploring a number of strategic alternatives. Also in March of 2001, Lazard began the process of soliciting bids for the sale of all or parts of the Company. Although the Company received a number of proposals, each of these contained significant financing or due diligence contingencies. After consultation with its financial advisor, ZiLOG determined that these contingencies could seriously jeopardize the likelihood that a strategic transaction could be consummated. In July 2001, holders of senior notes who collectively held or managed approximately $165.0 million in principal amount of the Notes formed an informal group to discuss and negotiate the terms of a possible restructuring plan. All members of this group executed confidentiality agreements and on July 13, 2001, members of ZiLOG's management met with these holders and their counsel to discuss a possible restructuring. Discussions continued over the course of the summer and fall of 2001. During the course of these discussions, the Company concluded that the best vehicle to achieve a restructuring of the Notes was through consummation of a voluntary pre-packaged reorganization plan under Chapter 11 of the U.S. Bankruptcy Code. On November 27, 2001, the Company reached a non-binding agreement regarding the terms of a reorganization plan with this informal group of noteholders. On January 28, 2002, the Company commenced solicitation of acceptances of the Reorganization Plan from the holders of the Notes and Series A stock. No voting was solicited from holders of the Company's common stock. In connection with this solicitation, ZiLOG entered into lock-up agreements with members of the noteholders' group. Under the lock-up agreements, the members of the noteholders' group agreed, among other things and subject to certain conditions, to vote to accept the Reorganization Plan. The voting period for the solicitation ended on February 26, 2002. Holders of approximately $221.0 million of the Notes accepted the Reorganization Plan and there were no votes to reject the Reorganization Plan. All of the holders of preferred stock who voted also accepted the Reorganization Plan. The Company believes that consummation of the Reorganization Plan will substantially reduce uncertainty with respect to ZiLOG's future and better position it to develop new products and maintain and expand its customer base by focusing on its core business. ZiLOG is a pioneer in the semiconductor industry and has a well-recognized brand. It is expected that the retirement of the Notes will allow the Company to devote more resources towards developing and expanding its core business. There can be no assurance that the Company will be successful in consummating the Reorganization Plan, however management believes that completion of the Reorganization Plan will provide a stronger financial base upon which to focus and execute its business plans. The consolidated financial statements do not include any adjustments that reflect the restructuring or other events contemplated by the Reorganization Plan. NOTE 17. SUBSEQUENT EVENT (UNAUDITED) ---------------------------- In January 2002, ZiLOG terminated development of its Cartezian family of 32-bit RISC microprocessors. As a result, the Company will close its Austin, Texas Design Center and will reduce its workforce by approximately 50 people in both research and development, as well as its sales general and administrative organizations. The Company expects to incur special charges of approximately $3.5 million in the first quarter of 2002 to cover costs of severance, relocation, and asset impairment write-offs. ITEM 9. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL DISCLOSURES On December 21, 2001, ZiLOG dismissed Ernst & Young LLP as its independent auditors. This dismissal was recommended by ZiLOG's Audit Committee and approved by the Company's Board of Directors. Also, on December 21, 2001, the Company engaged KPMG LLP as its principal accountant to audit its financial statements. PART III ITEM 10. DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANT Directors and Executive Officers The following table sets forth information regarding individuals who currently serve as our directors or executive officers. Each director will hold office until the next annual meeting of stockholders or until his or her successor is elected and qualified. If the Reorganization Plan is approved and becomes effective, we do not expect that John W. Marren and William S. Price, III, will continue as directors. We expect that certain new directors will be elected. Officers are appointed by the Board of Directors and serve at the Board's discretion. The executive officers listed below serve on our Executive Council, which meets periodically to advise the CEO concerning certain matters.
Name Age Position ---- --- -------- John W. Marren ......................... 39 Director William S. Price, III................... 46 Director James M. Thorburn........................ 46 Chairman, Chief Executive Officer and Director Michael D. Burger....................... 43 President and Director Gerald J. Corvino....................... 54 Executive Vice President and Chief Information Officer Perry Grace............................. 44 Vice President and Chief Financial Officer Daniel M. Jochnowitz..................... 40 Vice President, General Counsel and Secretary
John W. Marren joined Texas Pacific Group in 2000 as a partner and currently leads TPG's technology team. He also serves on the Board of Directors of GlobeSpan and Zhone, and on the Advisory Board of Intel 64 Venture Fund. From 1996 through 2000, Mr. Marren was a Managing Director at Morgan Stanley Dean Witter, most recently as co-head of the Technology Investment Banking Group. Prior to Morgan Stanley, he was a Managing Director and Senior Semiconductor Research Analyst at Alex. Brown and Sons. He spent eight years in the semiconductor industry working for VLSI Technology and Vitesse Semiconductor. Mr. Marren received his B.S. in Electrical Engineering from the University of California in Santa Barbara. William S. Price III became a director of the Company upon consummation in 1998. Mr. Price was a founding partner of Texas Pacific Group in 1993. Prior to forming Texas Pacific Group, Mr. Price was Vice President of Strategic Planning and Business Development for GE Capital, and from 1985 to 1991 he was employed by the management consulting firm of Bain & Company, attaining partnership status and acting as co-head of the Financial Services Practice. Mr. Price is a graduate of Stanford University and received a Juris Doctorate degree from the Boalt Hall School of Law at the University of California, Berkeley. Mr. Price is Chairman of the Board of Favorite Brands International, Inc. and Co-Chairman of the Board of Beringer Wine Estates. He also serves on the Boards of Directors of Continental Airlines, Inc., Del Monte Foods, Denbury Resources, Inc., Vivra Specialty Partners, Inc., Landis & Gyr, Belden & Blake Corporation, Punch Taverns, Aerfi, and American Center for Wine, Food and Arts. James M. Thorburn was appointed Chief Executive Officer, Chairman of the Board, and a director in January 2002. In March 2001, Mr. Thorburn was appointed the acting Chief Executive Officer and President. He is also employed by Texas Pacific Group as a consultant. Prior to his joining us, Mr. Thorburn was Senior Vice President and Chief Operating Officer of ON Semiconductor. From May 1998 until August 1999, Mr. Thorburn served as our Senior Vice President and Chief Financial Officer. Prior to May 1998, Mr. Thorburn was the Vice President of Operations Finance at National Semiconductor. During his 17-year career at National Semiconductor, Mr. Thorburn managed the financial needs for National Semiconductor's Communications and Computing Group, Analog Division and European Operations. Mr. Thorburn holds a Bachelor of Science degree in Economics from the University of Glasgow, Scotland and is a qualified accountant with the Institute of Chartered Management Accountants. Michael D. Burger was appointed President and a director in January 2002. In April 2001, Mr. Burger was appointed Executive Vice President and General Manager of the Connecting Technology Business Unit. He joined us in December 1998 as Senior Vice President of Worldwide Sales. Before joining us, Mr. Burger was Vice President of Worldwide Marketing and Sales at QuickLogic Corporation. Prior to QuickLogic, Mr. Burger was the Vice President and Managing Director for National Semiconductors ASICs Division based in Hong Kong. Mr. Burger holds a Bachelor of Science degree in Electrical Engineering from New Mexico State University. He is a graduate of Stanford's Executive Management Program. Gerald J. Corvino was appointed Executive Vice President in January 2002. In June 1998, Mr. Corvino was appointed Senior Vice President and Chief Information Officer. Beginning in 1996, 1994 and 1979 respectively, Mr. Corvino held the position of CIO for Oracle Corporation, CIO for AT&T Microelectronics, and Vice President Corporate Information Services at Amdahl. Mr. Corvino studied three years toward a Bachelor of Science in Mathematics at Boston College and is certified for Managing Information Systems Resources from Harvard Business School. Perry Grace was appointed Vice President and Chief Financial Officer for ZiLOG in July 2001. Prior to ZiLOG, Mr. Grace served as Vice President of Finance and Chief Financial Officer for Ramp Networks, an Internet security appliance provider acquired by Nokia in 2001. Prior to Ramp Networks, Mr. Grace was employed by National Semiconductor Corporation from 1987 to 1999, where he held several finance and controller positions. Mr. Grace holds a Bachelor of Science degree in Accounting and Finance, Commercial Law, and Computer Science from Deakin University in Geelong, Australia, and is a chartered accountant. Daniel J. Jochnowitz was appointed Vice President, General Counsel and Secretary for ZiLOG in June 2001. Prior to ZiLOG, Mr. Jochnowitz served as Senior Corporate Counsel for Inktomi Corporation. Prior to Inktomi, Mr. Jochnowitz was the Senior Vice President and General Counsel for BHP Power, Inc. Earlier in his career, Mr. Jochnowitz worked for O'Melveny & Meyers; Milbank, Tweed, Hadley & McCloy; and Milgrim Thomajan & Lee PC. He also clerked for the Honorable William E. Doyle of the Tenth Circuit Court of Appeals in Denver, Colo. Mr. Jochnowitz received a Bachelor of Arts degree and a Juris Doctorate from Columbia University. ITEM 11. EXECUTIVE COMPENSATION Employment Contracts and Termination of Employment and Change in Control Arrangements In connection with our plan of reorganization, we entered into a two-year employment agreement, dated January 7, 2002, with our Chief Executive Officer and Chairman, James M. Thorburn. This agreement provides that: (1) Mr. Thorburn will be employed as our Chairman and Chief Executive Officer and will be paid an annual salary of $800,000; (2) Mr. Thorburn will be eligible to earn an annual incentive payment in an amount between 25% and 200% of his annual base salary based on our annual EBITDA; (3) on the effective date of the plan of reorganization, Mr. Thorburn will be eligible to receive up to 4% of the shares of our common stock in options and restricted stock; and (4) Mr. Thorburn will receive a signing bonus of $650,000 upon the fulfillment of certain conditions. These conditions were met as of February 28, 2002 and the signing bonus was paid to Mr. Thorburn on March 8, 2002. Mr. Thorburn's employment agreement automatically terminates on the second anniversary of the Effective Date. In the event that, before such second anniversary, we terminate Mr. Thorburn's employment without cause, or Mr. Thorburn resigns at any time for good reason, we shall pay to Mr. Thorburn the greater of (a) 180% Mr. Thorburn's base salary, or (b) Mr. Thorburn's base salary for the balance of the term of the agreement plus an additional amount equal to 80% of Mr. Thorburn's base salary for the balance of the term of the agreement. For the purposes of this employment agreement, "cause" means one or more of the following: (i) Mr. Thorburn's material breach of the agreement; (ii) Mr. Thorburn's failure to reasonably and substantially perform his duties under the agreement; (iii) Mr. Thorburn's willful misconduct or gross negligence which materially injures us; or (iv) Mr. Thorburn's conviction or plea of nolo contendere to (A) a felony, or (B) other serious crime involving moral turpitude. Also for the purposes of this agreement, "good reason" means a material diminution in Mr. Thorburn's duties and responsibilities set forth in his employment agreement. Upon any change in control prior to the effective date of the plan of reorganization, Mr. Thorburn will be entitled to a percentage of the purchase price of the company equal to (i) 2.14% of the purchase price, plus (ii) the difference between (a) 1.86% of the purchase price and (b) the price per share that Mr. Thorburn would be obligated to pay to acquire 1.86% of the stock under the applicable stock option agreement, plus (iii) one year's base salary and annual bonus. If Mr. Thorburn decides to terminate his employment with us, with or without good reason, within thirty days following a change of control, we shall pay Mr. Thorburn the balance of his then current base salary for the remainder of the term of his employment agreement plus an amount equal to 80% of Mr. Thorburn's then current base salary. In addition, we will accelerate the vesting on all stock, stock options and other stock awards held by Mr. Thorburn. Compensation of Directors As of December 31, 2001, each outside director receives an option grant of 15,000 shares of common stock effective as of the date of their commencement as a member of the Board of Directors. On each outside director's anniversary date of the commencement of their term as a member of the Board, they shall receive an annual stock option grant of 7,500 shares. Beginning January 2001, a cash retainer of $20,000 per annum was paid to each outside director. Each outside director also receives $1,000 per meeting of the Board or any committee of the Board whether the outside director appears in person or by telephone and reimbursement of reasonable expenses incurred to attend such meeting of the Board or committee meeting. This compensation is not paid pursuant to consulting contracts. The Company's other directors currently do not receive any compensation for service on the Board of Directors. There are no family relationships between any directors or executive officers of the Company. Compensation for outside directors is currently being reviewed and may change. Compensation Committee Report Our compensation program for officers is administered by the Compensation Committee of the Board of Directors, which is currently composed of Mr. Price. Our compensation policy for executive officers is designed to support the overall objective of enhancing value for shareholders by attracting, developing, rewarding and retaining highly qualified and productive individuals, relating compensation to both our performance and individual performance, and ensuring compensation levels that are externally competitive and internally equitable. The key elements of our current executive officer compensation consist of base salary, a cash bonus, stock options and restricted stock for executive officers. The Compensation Committee's policies with respect to each of these elements, including the bases for the compensation awarded to Mr. Thorburn, are discussed below. In addition, while the elements of compensation described below are considered separately, the Compensation Committee takes into account the full compensation package afforded by us to the individual, including insurance and other benefits. Prior to January 2002, Mr. Thorburn was paid pursuant to a contract between TPG Partners II, L.P., and Mr. Thorburn. Under this contract, Mr. Thorburn was paid by us $3,000/per day, plus reimbursement for reasonable expenses. The Committee reviews each officer's salary annually. In determining appropriate salary levels, consideration is given to scope of responsibility, experience, Company and individual performance, as well as pay practices of other companies relating to executives with similar responsibility. In determining compensation for Mr. Thorburn, the Compensation Committee considered the role he played in cutting costs and refocusing our business as well as pay practices at other technology companies of comparable size and Mr. Thorburn's past business experience. Our officers may be considered for annual cash bonuses, which are awarded based on our meeting certain financial goals. In awarding a bonus to executive officers, the Compensation Committee reviews compensation levels and financial results available to it for executive officers for similarly sized technology companies, as well as those companies located near the Company's headquarters. In 2001, our financial performance goals were met for the executive officers. Consequently, the executive officers received a bonus based upon the Company's financial performance in the year 2001. Mr. Thorburn and other executive officers that remained employed by us in the first quarter of 2001 received the long-term components of bonuses paid to them in 1998 and 1999. Under the ZiLOG 1998 Long Term Stock Incentive Plan and the ZiLOG 1998 Executive Officer Stock Incentive Plan, restricted shares, stock units and stock options may be granted to the Company's employees, including executive officers, directors and consultants. Grants are determined by the Compensation Committee after recommendation by the Company's management, and the number of options or shares granted under either plan is determined by the subjective evaluation of the person's ability to influence the Company's long-term growth and profitability. Because the value of an option bears a direct relationship to the Company's stock price, it is an effective incentive for employees to create value for shareholders. The Committee therefore views stock units, stock options and restricted stock as an important component of its compensation policy. Section 162(m) of the Internal Revenue Code limits the Company's tax deductions to $1 million for compensation paid to certain executive officers named in Item 11 hereof unless the compensation is "performance based" within the meaning of Section 162(m). The Compensation Committee's intention is and has been to comply with the requirements of Section 162(m) unless the Compensation Committee concludes that such compliance would not be in the best interest of the Company or its stockholders. Compensation Committee Members: /s/ William S. Price, Chairman Compensation Committee Interlocks and Insider Participation in Compensation Decisions In 2001, the compensation committee was comprised of William S. Price III, Chairman, Richard S. Friedland and Murray A. Goldman. Mr. Friedland and Mr. Goldman resigned as members of the Board of Directors and the Compensation Committee on December 31, 2001. There were no Compensation Committee Interlocks as that term is defined under Item 402 (j) of Regulation S-K as promulgated under the Securities Exchange Act of 1934, as amended, among the committee members. The Acting Chief Executive Officer and President of the Company, the Senior Vice President of Human Resources and the General Counsel provided staff to support this committee. None of the Chairman of the Company, the Senior Vice President of Human Resources nor the General Counsel participated in the deliberations concerning their own respective compensation. SUMMARY COMPENSATION TABLE The following table sets forth the compensation earned by our Chief Executive Officers and the four other most highly compensated executive officers who were serving as executive officers as of December 31, 2001, 2000, and 1999, (collectively, the "Named Executive Officers"):
Annual Compensation ---------------------------------------------- Long-Term Compensation Awards Other ----------------------------- All Annual Restricted Securities Other Name and Compensa- Stock Underlying Compensa- Principal Position Year Salary ($) Bonus ($) (1) tion ($) Awards ($) Options (#) tion ($)(2) - -------------------------------- ----- ------------ -------------- -------------- ------------ -------------- ----------- James M. Thorburn............... 2001 $ 574,000 $ -- $ -- $ -- -- $ 8,743(3) Chairman, Chief Executive 2000 -- -- -- -- -- -- Officer and Director 1999 158,796 195,000(4) 108,061(5) -- -- 2,400 Curtis J. Crawford (15)......... 2001 204,463 10,236,730(16) 121,087(17) -- -- 1,013,958(18) Chairman, President and Chief 2000 885,216 -- 58,155(19) -- 400,000 1,450 Executive Officer, Director 1999 839,231 1,380,000 47,026(20) 750,000(21) -- 2,400 Michael D. Burger............... 2001 281,087 204,416(6) -- -- -- 828(7) President and Director 2000 217,493 -- -- -- 54,500 -- 1999 226,569 220,000 -- -- -- 3,491(8) Gerald J. Corvino............... 2001 280,074 204,316(9) -- -- -- 293,613(10) Executive Vice President and 2000 222,778 -- 131,250(11) -- 49,500 2,400 Chief Information Officer 1999 232,944 220,000 734(12) -- -- 2,400 Perry Grace (22)................ 2001 88,702 95,950(13) -- -- -- -- Vice President and Chief 2000 -- -- -- -- -- -- Financial Officer 1999 -- -- -- -- -- -- Daniel M. Jochnowitz (23)....... 2001 92,977 47,760(14) -- -- 30,000 1,523 Vice President, General Counsel 2000 -- -- -- -- -- -- and Secretary 1999 -- -- -- -- -- --
(1) For each named executive in the table above, one-half of the amount indicated is a long-term bonus earned in 1999 of which 50% of that amount was paid in February 2000 and 25% was paid in February 2001 and 2002. Such long-term bonuses require that the executive be employed by ZiLOG, Inc. at the time of payment. (2) Unless otherwise indicated, amounts represent the Company's matching contributions to the ZiLOG, Inc. Tax-Deferred 401(k) Investment Plan. (3) Represents deferred compensation plan distribution. (4) Represents a prorated long-term bonus paid in advance. (5) Represents a realized gain of $105,000 on the exercise of 70,000 stock options in 1999, and accrued vacation paid of $3,061 upon termination of employment. (6) Represents quarterly incentive bonuses. (7) Represents deferred compensation plan distribution. (8) Represents imputed interest on a personal loan made to Mr. Burger. (9) Represents quarterly incentive bonuses. (10) Deferred compensation plan distribution of $291,063. (11) Represents realized gain on the exercise of 37,500 stock options in 2000. (12) Represents airfare for family members. (13) Represents a sign-on bonus of $55,000 and a quarterly incentive bonus of $40,950. (14) Represents quarterly incentive bonuses. (15) Curtis J. Crawford resigned as Chairman of the Board, President and Chief Executive Officer effective March 16, 2001. (16) Represents payment of a contractual obligation paid at termination. (17) Represents payment of accrued vacation at termination. (18) Deferred compensation plan distribution of$1,011,558. (19) Represents payroll gross-up for taxable moving expenses. (20) Represents the amount paid for relocation expenses. (21) Reflects earnings relating to a grant of 300,000 shares of our common stock to Mr. Crawford. These shares were initially issued as restricted stock, though in 1999 these restrictions lapsed. No dividends will be paid on these shares. (22) Mr. Grace commenced employment with the Company in July 2001. (23) Mr. Jochnowitz commenced employment with the Company in June 2001. OPTION GRANTS IN LAST FISCAL YEAR The following table sets forth further information regarding option grants to each of our Named Executive Officers during 2001. In accordance with the rules of the Securities and Exchange Commission, the table sets forth the hypothetical gains or "option spreads" that would exist for the options at the end of their respective ten-year terms. These gains are based on assumed rates of annual compound stock price, and appreciation of 5% and 10% from the date the option was granted to the end of the option terms.
Individual Grants Potential Realized ------------------------------------------ Value at Assumed % of Total Annual Rates of Number of Options Stock Price Securities Granted to Appreciation for Underlying Employees Exercise Option Term Options in Fiscal Price Expiration ------------------------- Name Granted Year ($/SH) Date 5%($) 10%($) - ----------------------------- ---------- ---------- ---------- ---------- ------------------------- Daniel M. Jochnowitz......... 30,000(1) 12.1% $6.00 (2) 06/25/11 $ 113,201 $ 286,874
(1) Mr. Jochnowitz's options vest and become exercisable at the rate of 25% on each of the first four anniversaries following the option grant date. (2) This option was granted at the fair value for our common stock at the grant date, as determined by our board of directors. AGGREGATED OPTION EXERCISES IN LAST FISCAL YEAR AND OPTION VALUES AT DECEMBER 31, 2001 The following table provides information regarding the aggregate option exercises and fiscal year-end option values for each of the Company's Named Executive Officers for the year ended December 31, 2001. Also reported are values of unexercised "in-the-money" options, which represent the positive spread between the respective exercise prices of outstanding stock options and the fair value of our common stock on December 31, 2001, as determined by our board of directors to be $6.00 per share.
Number of Securities Underlying Value of Unexercised Unexercised Options In-The-Money Options Acquired at Fiscal Year End (#) at Fiscal Year End ($) Shares on Value --------------------------- ---------------------------- Name Exercise(#) Realized($) Exercisable Unexercisable Exercisable Unexercisable - ------------------------ -------- ---------- --------------------------- ---------------------------- James M. Thorburn....... -- $ -- -- -- $ -- $ -- Curtis J. Crawford...... -- -- 1,500,000 -- 3,375,000 -- Michael D. Burger....... -- -- 159,500 75,000 501,500 157,500 Gerald J. Corvino....... -- -- 98,250 63,750 291,500 131,250 Perry Grace............. -- -- -- -- -- -- Daniel M. Jochnowitz.... -- -- -- 30,000 -- --
ITEM 12. Security Ownership of Certain Beneficial Owners and Management The following table sets forth certain information regarding the beneficial ownership of ZiLOG, Inc. common and preferred stock as of March 1, 2002, by (i) each stockholder known by the Company to be the beneficial owner of more than five percent of ZiLOG, Inc. common or preferred stock, (ii) each of the directors of ZiLOG, Inc., (iii) each of the Named Executive Officers, and (iv) all current executive officers and directors of ZiLOG, Inc. as a group.
Series A Class A Non-voting Preferred Stock Common Stock Common Stock ------------------- -------------------- ---------------------- Amount Amount Amount and and and Nature of Nature of Nature of Benefi- Benefi- Benefi- cial Percent cial Percent cial Percent Name and Address Owner- of Owner- of Owner- of of Beneficial Owner ship(1) Class ship(1) Class(2) ship(1) Class - --------------------------------------- ------- ------ ---------- ------- ---------- ------ TPG Partners II, L.P. (3).............. 242,343 96.9% 26,172,770 81.7% 9,693,620 96.9% 201 Main Street Suite 2420 Fort Worth, TX 76102 Cede & Co. Depository Trust Company.... -- -- 2,831,016 8.8 -- -- Curtis J. Crawford (4),(9)............. 2,127 * 2,129,786 6.7 85,106 * Michael D. Burger (5).................. -- -- 159,500 * -- -- Gerald J. Corvino (6).................. -- -- 135,750 * -- -- James M. Thorburn...................... -- -- 70,000 * -- -- Perry Grace............................ -- -- -- -- -- -- Daniel M. Jochnowitz................... -- -- -- -- -- -- John W. Marren (7)..................... -- -- -- -- -- -- William S. Price, III (8).............. -- -- -- -- -- -- All current executive.................. -- -- 365,250 1.1 -- -- officers and directors, as a group (7 persons)
- ------------------- * Less than 1 percent. (1) Unless otherwise indicated, the persons and entity named in the table have sole voting and sole investment power with respect to all shares beneficially owned, subject to community property laws where applicable. (2) Applicable percentage ownership is based upon 32,017,272 shares of common stock outstanding at March 1, 2002. (3) Includes 2,328,330 and 1,523,256 shares of common stock; 862,344 and 564,168 shares of Class A non-voting common stock; and 21,559 and 14,104 shares of preferred stock held by TPG Investors II, L.P. and TPG Parallel II, L.P., respectively. (4) Includes 1,500,000 shares, which Mr. Crawford has the right to acquire within 60 days of March 1, 2002 through the exercise of options. (5) Includes 159,500 shares, which Mr. Burger has the right to acquire within 60 days of March 1, 2002 through the exercise of options. (6) Includes 98,250 shares, which Mr. Corvino has the right to acquire within 60 days of March 1, 2002 through the exercise of options. (7) Mr. Marren serves as a director for the Company and also is a partner of TPG Partners II, L.P., and disclaims beneficial ownership of such securities, except to the extent of his respective pecuniary interests therein. (8) Mr. Price serves as a director for the Company and also is a partner of TPG Partners II, L.P., and disclaims beneficial ownership of such securities except to the extent of his respective pecuniary interests therein. (9) Curtis J. Crawford resigned as Chairman of the Board, President and Chief Executive Officer effective March 16, 2001. ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS See Note 12 to the consolidated financial statements for a discussion of related party transactions. PART IV ITEM 14. EXHIBITS, FINANCIAL STATEMENT SCHEDULES AND REPORTS ON FORM 8-K (a) The following documents are filed as part of this report:
1. Consolidated Financial Statements and Supplementary Data: Report of KPMG LLP, Independent Auditors..........................................pg. 38 Report of Ernst & Young LLP, Independent Auditors.................................pg. 40 Consolidated Balance Sheets as of December 31, 2001 and 2000......................pg. 41 Consolidated Statements of Operations for the Years Ended December 31, 2001, 2000, and 1999.................................................pg. 42 Consolidated Statements of Cash Flows for the Years Ended December 31, 2001, 2000, and 1999.................................................pg. 43 Consolidated Statements of Stockholders' Deficiency for the Years Ended December 31, 2001, 2000, and 1999...........................................pg. 44 Notes to Consolidated Financial Statements........................................pg. 45
2. Financial Statement Schedules The Financial Statement Schedule listed below is filed as part of this Report: Form 10-K Page ---------- Schedule II Valuation and Qualifying Accounts II-1 All other schedules are omitted because they are not applicable or the required information is shown in the Financial Statements or the Notes thereto. (b) Reports on Form 8-K The Company filed a Current Report on Form 8-K on December 28, 2001, in which it reported a change in its certifying accountant under Item 4. (c) Exhibits The exhibits listed in the accompanying index to exhibits are filed or incorporated by reference (as stated therein) as part of this annual report. (d) Financial Statements Schedules See Item 14 (a)(2) above. SIGNATURES Pursuant to the requirements of Section 13 or 15 (d) 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. ZiLOG, INC. By: /s/ JAMES M. THORBURN Date: April 12, 2002 -------------------------------- (James M. Thorburn) (Chairman, Chief Executive Officer and Director) Pursuant to the requirements of the Securities and Exchange Act of 1934, this report has been signed by the following persons on behalf of the Registrant and in the capacities and on the dates indicated.
Signatures Title Date ---------- ----- ---- /s/ JAMES M. THORBURN Chairman, Chief Executive Officer, - ------------------------- and Director April 12, 2002 (James M. Thorburn) /s/ MICHAEL D. BURGER President and Director April 12, 2002 - ------------------------- (Michael D. Burger) /s/ PERRY GRACE Vice President and Chief Financial April 12, 2002 - --------------------- Officer (Perry Grace) /s/ JOHN W. MARREN Director April 12, 2002 - ----------------------- (John W. Marren) /s/ WILLIAM S. PRICE, III Director April 12, 2002 - ----------------------------- (William S. Price)
EXHIBIT INDEX Exhibit No. Description ------- ----------- 2.1 (a) Agreement and Plan of Merger, dated as of July 20, 1997, between TPG Partners II, L.P. and ZiLOG Inc. (the Recapitalization Agreement). NOTE: Pursuant to the provisions of paragraph (b) (2) of Item 601 of Regulation S-K, the Registrant hereby undertakes to furnish to the Commission upon request copies of any Schedule to the Recapitalization Agreement. 2.2 (a) Amendment Number One to the Recapitalization Agreement, dated as of November 18, 1997, by and between TPG Partners II, L.P., TPG Zeus Acquisition Corporation and ZiLOG, Inc. 2.3 (a) Amendment Number Two to the Recapitalization Agreement, dated as of December 10, 1997, by and between TPG Partners II, L.P., TPG Zeus Acquisition Corporation and ZiLOG, Inc. 2.4 (a) Amendment Number Three to the Recapitalization Agreement, dated as of January 26, 1998, by and between TPG Partners II, L.P., TPG Zeus Acquisition Corporation and ZiLOG, Inc. 3.1 (a) Certificate of Incorporation of ZiLOG, Inc. 3.2 (a) Certificate of Merger of TPG Zeus Acquisition Corporation into ZiLOG, Inc filed with the Delaware Secretary of State on February 27, 1998. 3.3 (a) Bylaws of ZiLOG, Inc. 3.4 (a) Certificate of Designation of Series A Cumulative Preferred Stock of ZiLOG, Inc. 3.5 (b) Certificate of Amendment of Certificate of Incorporation of ZiLOG, Inc. 4.1 (a) Stockholders Voting Agreement dated as of July 20 1997, by and among TPG Partners II, L.P., on the one hand, and Warburg, Pincus Capital Company, L.P. and Warburg, Pincus & Co., on the other hand. 4.2 (a) Stockholders' Agreement dated as of February 27, 1998, by and among ZiLOG, Inc., TPG Partners II, L.P., TPG Investors II, L.P., TPG Parallel II, L.P. and certain other stockholders of ZiLOG, Inc. 4.3 (a) Letter Agreement, dated as of November 18, 1997, by and among TPG Partners II, L.P., Warburg, Pincus Capital Company, L.P. and Warburg, Pincus & Co., and ZiLOG, Inc. 4.4 (a) Form of 9.5% Senior Secured Notes due 2005 of ZiLOG, Inc. 4.5 (a) Indenture, dated as of February 27, 1998, by and among ZiLOG, Inc., ZiLOG Europe, ZiLOG TOA Company and State Street Bank and Trust Company. NOTE: Pursuant to the provisions of paragraph (b) (2) of Item 601 of Regulation S-K, the Registrant hereby undertakes to furnish to the Commission upon request copies of any schedule to the Indenture. 4.6 (a) Purchase Agreement dated as of February 23, 1998, by and among ZiLOG, Inc., ZiLOG Europe, ZiLOG TOA Company, Goldman, Sachs & Co., BancBoston Securities Inc. and Citicorp Securities, Inc. 4.7 (a) Registration Rights Agreement dated as of February 27, 1998, by and among ZiLOG, Inc., ZiLOG Europe, ZiLOG TOA Company, Goldman, Sachs, & Co., BancBoston Securities Inc. and Citicorp Securities, Inc. 4.8 (a) Company Security Agreement dated as of February 27, 1998 by and between ZiLOG, Inc. and State Street Bank and Trust Company. NOTE: Pursuant to the provisions of paragraph (b)(2) of Item 601 of Regulation S-K, the Registrant hereby undertakes to furnish to the Commission upon request copies of any schedule to the Company Security Agreement. 4.9 (a) Subsidiary Security Agreement dated as of February 27, 1998 by and among each of the direct and indirect ZiLOG, Inc. Subsidiary signatories thereto and State Street Bank and Trust Company. NOTE: Pursuant to the provisions of paragraph (b) (2) of item 601 of Regulation S-K, the Registrant hereby undertakes to furnish to the Commission upon request copies of any schedule to the Subsidiary Security Agreement. 4.10 (a) Company Pledge Agreement dated as of February 27, 1998 by and between ZiLOG, Inc. and State Street Bank and Trust Company. NOTE: Pursuant to the provisions of paragraph (b)(2) of Item 601 of Regulation S-K, the Registrant hereby undertakes to furnish to the Commission upon request copies of any schedule to the Company Pledge Agreement. 4.11 (a) Subsidiary Pledge Agreement dated as of February 27, 1998 by each of the direct and indirect ZiLOG, Inc. Subsidiary signatories thereto and State Street Bank and Trust Company. NOTE: Pursuant to the provisions of paragraph (b)(2) of Item 601 of Regulation S-K, the Registrant hereby undertakes to furnish to the Commission upon request copies of any schedule to the Subsidiary Pledge Agreement. 4.12 (a) Company and Subsidiary Patent and Trademark Security Agreement, dated as of February 27, 1998 by and among ZiLOG, Inc., each of the direct and indirect domestic ZiLOG, Inc. Subsidiary signatories thereto and State Street Bank and Trust Company. NOTE: Pursuant to the provisions of paragraph (b) (2) of Item 601 of Regulation S-K, the Registrant hereby undertakes to furnish to the Commission upon request copies of any schedule to the Company and Subsidiary Patent and Trademark Security Agreement. 4.13 (a) Copyright Security Agreement dated as of February 27, 1998 by ZiLOG, Inc., each of the direct and indirect ZiLOG, Inc. Subsidiary signatories thereto and State Street Bank and Trust Company. NOTE: Pursuant to the provisions of paragraph (b) (2) of Item 601 of Regulation S-K, the Registrant hereby undertakes to furnish to the Commission upon request copies of any schedule to the Copyright Security Agreement. 4.14 (a) Stockholders' Agreement, dated as of March 26, 1998, by and among ZiLOG, Inc., TPG Partners II, L.P., TPG Investors II, L.P. TPG Parallel II, L.P. and certain other stockholders of ZiLOG. 10.1(a) Contract of Lease, dated March 22, 1979, by and between ZiLOG Philippines, Inc. and Fruehauf Electronics Phils. Corporation. NOTE: Pursuant to the provisions of paragraph (b)(2) of Item 601 of Regulation S-K, the Registrant hereby undertakes to furnish to the Commission upon request copies of any schedule to the Contract of Lease. 10.2 (c) Credit Agreement dated December 30, 1998, by and between ZiLOG, Inc. and The CIT Group/ BusinessCredit, Inc. 10.2.1(f) Amendment Number One to the Credit Agreement, by and between ZiLOG, Inc. and The CIT Group/Business Credit, Inc. 10.2.2(f) Amendment Number Two to the Credit Agreement, dated August 18, 2000, by and between ZiLOG, Inc. and The CIT Group/Business Credit, Inc. 10.2.3(f) Amendment Number Three to the Credit Agreement, dated December 27, 2000, by and between ZiLOG, Inc. and The CIT Group/Business Credit, Inc. 10.3 (a) Form of 1997 Employee Performance Incentive Plan (1). 10.4 (a) 1997 ZiLOG Employee Performance Incentive Plan Administrative Guide (1). 10.5 (a) 1997 ZiLOG Employee Performance Incentive Plan Executive Bonus Administrative Guide (1). 10.8 (f) Employment Agreement effective September 1, 2000, by and between Tom Vanderheyden and ZiLOG, Inc. (1) 10.9 (f) Employment Agreement effective November 20, 2000, by and between Michael Burger and ZiLOG, Inc. (1) 10.12 (f) Employment Agreement effective May 30, 2000, by and between Gerald J. Corvino and ZiLOG, Inc. (1). 10.13 (f) ZiLOG, Inc. 2000 Stock Incentive Plan. 10.16 Lease, dated as of December 21, 2001, between ZiLOG, Inc. and The Sobrato Group. NOTE: Pursuant to the provisions of paragraph (b)(2) of item 601 of Regulation S-K, the registrant hereby undertakes to furnish to the Commission upon request copies of any schedule to the Lease. 10.17 (d) ZiLOG, Inc. 1998 Long-Term Stock Incentive Plan, as amended. 10.18 (d) ZiLOG, Inc. Executive Officer Stock Incentive Plan, as amended. 10.21 (e) Restricted Share Agreement dated January 13, 2000, by and between Robert D. Norman and ZiLOG, Inc. 10.22 (d) Restricted Share Agreement dated February 7, 2000, by and between Richard S. Friedland and ZiLOG, Inc. 10.23 (d) Restricted Share Agreement dated February 7, 2000 by and between Murray A. Goldman and ZiLOG, Inc. 10.24 (d) Restricted Share Agreement dated February 1, 2000 by and between Lionel Sterling and ZiLOG, Inc. 10.25 (d) Distributor Agreement dated February 2, 2000 by and between Pioneer-Standard Electronics, Inc. and ZiLOG, Inc. 10.26 (e) Purchase and Sale Agreement dated March 22, 2000, by and between ZiLOG, Inc., Dasaradha R. Gude, certain stockholders, Virtual IP Group, Inc., Qualcore Group, Inc. and Qualcore Logic Private Limited. NOTE: Pursuant to the provisions of paragraph (b) (2) of Item 601 of Regulation S-K, the Registrant hereby undertakes to furnish to the Commission, upon request, copies of any Schedule to the Purchase and Sale Agreement. 10.27 (e) Merger Agreement dated July 16, 2000, by and between ZiLOG, Inc. and Calibre, Inc. NOTE: Pursuant to the provisions of paragraph (b) (2) of Item 601 of Regulation S-K, the Registrant hereby undertakes to furnish to the Commission, upon request, copies of any Schedule to the Merger Agreement. 18.1 (f) Letter from Ernst & Young LLP, independent auditors, regarding change in accounting principle. 21.1 (a) Subsidiaries of ZiLOG, Inc. 23.1 Consent of KPMG LLP, independent auditors. 23.2 Consent of Ernst & Young LLP, independent auditors. 25.1 (a) Form T-1 with respect to the eligibility of State Street Bank and Trust Company with respect to the Indenture. ------------------------ (a) Incorporated herein by reference to the item of the same name filed as an Exhibit to the Company's Registration Statement on Form S-4 (File No. 333-51203) declared effective by the Securities and Exchange Commission on July 9, 1998. (b) Incorporated herein by reference to the item of the same name filed as an Exhibit to the Company's Quarterly Report on Form 10-Q for the Quarter ended September 30, 1998. (c) Incorporated herein by reference to the item of the same name filed as an Exhibit to the Company's Annual Report on Form 10-K for the year ended December 31, 1998. (d) Incorporated herein by reference to the item of the same name filed as an Exhibit to the Company's Annual Report on Form 10-K for the year ended December 31, 1999. (e) Incorporated herein by reference to the item of the same name filed as an Exhibit to the Company's Registration Statement on Form S-1 filed with the Securities and Exchange Commission on August 3, 2000. (f) Incorporated herein by reference to the item of the same name filed as an Exhibit to the Company's Annual Report on Form 10-K for the year ended December 31, 2000. (1) Represents a management contract or compensatory plan or agreement. SCHEDULE II ZiLOG, INC. VALUATION AND QUALIFYING ACCOUNTS (in thousands)
Additions Charged Balance at to Costs Balance at Beginning and Deductions Ending of Period Expenses (1) of Period --------- --------- --------- --------- December 31, 2001 Allowance for doubtful accounts........ $879 $100 $(301) $678 ========= ========= ========= ========= December 31, 2000 Allowance for doubtful accounts........ $423 $456 $ -- $879 ========= ========= ========= ========= December 31, 1999 Allowance for doubtful accounts........ $366 $127 $ (70) $423 ========= ========= ========= =========
- ----------------- (1) Uncollectable accounts written off, net of recoveries. EX-10.16 3 ziloglease.txt LEASE AGREEMENT EXHIBIT 10.16 Lease between The Sobrato Group and ZiLOG, Inc. Section...................................................................Page # Parties........................................................................1 Premises.......................................................................1 Use............................................................................1 Permitted Uses..............................................................1 Uses Prohibited.............................................................1 Advertisements and Signs....................................................1 Covenants, Conditions and Restrictions......................................2 Term and Rental................................................................2 Base Monthly Rent...........................................................2 Late Charges................................................................2 Security Deposit............................................................3 This paragraph intentionally left blank........................................3 Acceptance of Possession and Covenants to Surrender............................3 Delivery and Acceptance.....................................................3 Early Access................................................................4 Condition Upon Surrender....................................................4 Failure to Surrender........................................................5 Alterations and Additions......................................................5 Tenant's Alterations........................................................5 Free From Liens.............................................................6 Compliance With Governmental Regulations....................................6 Maintenance of Premises........................................................6 Landlord's Obligations......................................................6 Tenant's Obligations........................................................6 Landlord and Tenant's Obligations Regarding Reimbursable Operating Costs.............................................................6 Reimbursable Operating Costs................................................7 Tenant's Allocable Share....................................................9 Waiver of Liability.........................................................9 Waiver of Liability.........................................................9 Hazard Insurance..............................................................10 Tenant's Use...............................................................10 Landlord's Insurance.......................................................10 Tenant's Insurance.........................................................10 Waiver.....................................................................10 Taxes.........................................................................11 Utilities.....................................................................11 Toxic Waste and Environmental Damage..........................................11 Use of Hazardous Material..................................................11 Tenant's Indemnity Regarding Hazardous Material............................12 Notice of Release or Violation.............................................12 Remediation Obligations....................................................13 Environmental Monitoring...................................................13 Tenant's Default..............................................................13 Remedies...................................................................14 Right to Re-enter..........................................................14 Abandonment................................................................14 No Termination.............................................................15 Non-Waiver.................................................................15 Performance by Landlord....................................................15 Landlord's Liability.........................................................15 Limitation on Landlord's Liability.........................................15 Limitation on Tenant's Recourse............................................16 Indemnification of Landlord................................................16 Destruction of Premises.......................................................16 Landlord's Obligation to Restore...........................................16 Limitations on Landlord's Restoration Obligation...........................16 Condemnation..................................................................17 Assignment or Sublease........................................................17 Consent by Landlord........................................................17 Assignment or Subletting Consideration.....................................18 No Release.................................................................19 Reorganization of Tenant...................................................19 Permitted Transfers........................................................20 Effect of Default..........................................................20 Effects of Conveyance......................................................20 Successors and Assigns.....................................................20 Option to Extend the Lease Term...............................................20 Grant and Exercise of Option...............................................20 Determination of Fair Market Rental........................................21 Resolution of a Disagreement over the Fair Market Rental...................21 Personal to Tenant.........................................................21 General Provisions............................................................22 Attorney's Fees............................................................22 Authority of Parties.......................................................22 Brokers....................................................................22 Choice of Law..............................................................22 Dispute Resolution.........................................................22 Entire Agreement...........................................................23 Entry by Landlord..........................................................23 Estoppel Certificates......................................................24 Exhibits...................................................................24 Interest...................................................................24 No Presumption Against Drafter.............................................24 Notices....................................................................24 Property Management........................................................24 Rent.......................................................................25 Representations............................................................25 Rights and Remedies........................................................25 Severability...............................................................25 Submission of Lease........................................................25 Subordination..............................................................25 Survival of Indemnities....................................................26 Time.......................................................................26 Transportation Demand Management Programs..................................26 Waiver of Right to Jury Trial..............................................26 Consents...................................................................26 EXHIBIT A - Premises & Building...............................................28 EXHIBIT B - Tenant's Signage..................................................29 EXHIBIT C - Draft Letter of Credit............................................30 EXHIBIT D - Initial Alterations...............................................31 EXHIBIT E - Hypothecation Form................................................32 1. Parties: THIS LEASE, is entered into on this 21st day of December 2001, ("Effective Date") between The Sobrato Group, a California Limited Partnership, whose address is 10600 North De Anza Boulevard, Suite 200, Cupertino, California, 95014 ("Landlord") and ZiLOG, Inc., a Delaware Corporation, whose address is 910 East Hamilton Avenue, Campbell, California, 95008 ("Tenant"). Landlord and Tenant are collectively referred to in this Lease as the "Parties". 2. Premises: Landlord hereby leases to Tenant, and Tenant hires from Landlord those certain Premises (the "Premises") consisting of a building of 40,792 square feet located at 532 Race Street in the city of San Jose, California ("Building") and depicted on Exhibit "A" attached hereto, together with all appurtenances located thereon and related thereto including, without limitation, parking areas and structures, landscaping, loading docks, sidewalks, service areas and other facilities located therein and thereon, together with the right to use 140 parking spaces located adjacent thereto. The parking spaces shall be available for Tenant's exclusive use but shall not be designated or segregated from the balance of the parking area. The Building is situated within a project site shared with five (5) additional buildings owned by Landlord as outlined in Exhibit "A" attached hereto ("Project"). 3. Use: A. Permitted Uses: Tenant and Tenant's agents, advisors, employees, partners, shareholders, directors, customers, invitees and independent contractors (collectively, "Tenant's Agents") shall use the Premises as permitted under applicable zoning laws only for the following purposes and shall not change the use of the Premises without the prior written consent of Landlord: Office, research and development, marketing, light manufacturing, ancillary storage and other incidental uses, and for any other uses permitted by law. Tenant and Tenant's Agents shall use only the number of parking spaces allocated to Tenant under this Lease. Tenant shall use its best efforts to ensure that all commercial trucks and delivery vehicles shall be: (i) parked at the rear of the Building, (ii) loaded and unloaded in a manner which does not interfere with the businesses of other occupants of the Project, and (iii) permitted to remain within the Project only so long as is reasonably necessary to complete the loading and unloading. Landlord makes no representation or warranty that any specific use of the Premises desired by Tenant is permitted pursuant to any Laws (as hereinafter defined). B. Uses Prohibited: Tenant shall not commit or suffer to be committed on the Premises any waste, nuisance, or other act or thing which may disturb the quiet enjoyment of any other tenant in or around the Premises and Project, nor allow any sale by auction or any other use of the Premises for an unlawful purpose. Tenant shall not (i) damage or overload the electrical, mechanical or plumbing systems of the Premises, (ii) attach, hang or suspend anything from the ceiling, walls or columns of the building that would jeopardize the structural integrity of the Premises, or set any load on the floor in excess of the load limits for which such floors are designed, or (iii) generate dust, fumes or waste products which create a fire or health hazard or damage the Premises or any portion of the Project, including without limitation the soils or ground water in or around the Project. No materials, supplies, equipment, finished products or semi-finished products, raw materials or articles of any nature, or any waste materials, refuse, scrap or debris, shall be stored upon or permitted to remain on any portion of the Premises outside of the Building without Landlord's prior approval, which approval may be withheld in its sole discretion. C. Advertisements and Signs: Tenant will not place or permit to be placed, in, upon or about the exterior of the Building any signs not approved by the City of San Jose and any other governing authority having jurisdiction. Tenant will not place or permit to be placed upon the exterior of the Building (or visible from the exterior of the Building) any signs, advertisements or notices without the written consent of Landlord as to type, size, design, lettering, coloring and location, which consent will not be unreasonably withheld. Landlord hereby consents to the Building and monument signage described on Exhibit "B" attached hereto. Any sign placed on the Premises shall be removed by Tenant, at its sole cost, prior to the Expiration Date (as hereinafter defined) or promptly following the earlier termination of the Lease, and Tenant shall repair, at its sole cost, any damage or injury to the Premises caused thereby, and if not so removed, then Landlord may have such signage removed at Tenant's expense. D. Covenants, Conditions and Restrictions: This Lease is subject to the effect of (i) any covenants, conditions, restrictions, easements, mortgages or deeds of trust, ground leases, rights of way of record and any other matters or documents of record as of the Effective Date; and (ii) any zoning laws of the city, county and state where the Building is situated (collectively referred to herein as "Restrictions") and Tenant will conform to and will not violate the terms of any such Restrictions. With respect to item (i) above, Tenant acknowledges receipt of a title report dated November 29, 2001 from Alliance Title, together with all underlying documents referenced therein. To the best of Landlord's knowledge, there are no other liens or encumbrances affecting the Premises or the Building except as disclosed in said title report. 4. Term and Rental: A. Base Monthly Rent: The term ("Lease Term") shall be for sixty (60) months, commencing on February 1, 2002 ("Commencement Date") and ending January 31, 2007 ("Expiration Date"). Notwithstanding the foregoing, this Lease and all of the obligations of Landlord and Tenant hereunder shall be binding and in full force and effect from and after the Effective Date through the remainder of the Lease Term. In addition to all other sums payable by Tenant under this Lease, Tenant shall pay base monthly rent ("Base Monthly Rent") for the Premises commencing on the Commencement Date in accordance with the following schedule: Month 01: none Month 02: $59,088.00 Months 03 -12: $79,544.00 per month Months 13 -24: $81,992.00 per month Months 25 -36: $84,439.00 per month Months 37 -48: $86,887.00 per month Months 49 -60: $89,334.00 per month Base Monthly Rent shall be due in advance on or before the first day of each calendar month during the Lease Term. All sums payable by Tenant under this Lease shall be paid to Landlord in lawful money of the United States of America, without offset or deduction and without prior notice or demand, at the address specified in Section 1 of this Lease or at such place or places as may be designated in writing by Landlord during the Lease Term. Base Monthly Rent for any period less than a calendar month shall be a pro rata portion of the monthly installment. B. Late Charges: Tenant hereby acknowledges that late payment by Tenant to Landlord of Base Monthly Rent and other sums due hereunder will cause Landlord to incur costs not contemplated by this Lease, the exact amount of which is extremely difficult to ascertain. Such costs include but are not limited to: administrative, processing, accounting, and late charges which may be imposed on Landlord by the terms of any contract, revolving credit agreement, mortgage, or trust deed covering the Premises. Accordingly, if any installment of Base Monthly Rent or other sum due from Tenant shall not be received by Landlord or its designee within five (5) days after receipt of written notice to Tenant from Landlord that such sum is overdue, then Tenant shall pay to Landlord a late charge equal to five (5%) percent of such overdue amount, which late charge shall be due and payable on the same date that the overdue amount was due. The parties agree that such late charge represents a fair and reasonable estimate of the costs Landlord will incur by reason of late payment by Tenant, excluding interest and attorneys fees and costs. If any Base Monthly Rent or other sum due from Tenant remains delinquent for a period in excess of thirty (30) days then, in addition to such late charge, Tenant shall pay to Landlord interest on any rent that is not paid when due at the Agreed Interest Rate specified in Section 19.J following the date such amount became due until paid. Acceptance by Landlord of such late charge shall not constitute a waiver of Tenant's default with respect to such overdue amount nor prevent Landlord from exercising any of the other rights and remedies granted hereunder. In the event that a late charge is payable hereunder, whether or not collected, for four (4) consecutive installments of Base Monthly Rent, then the Base Monthly Rent shall automatically become due and payable quarterly in advance, rather than monthly, notwithstanding any provision of this Lease to the contrary. C. Security Deposit: Concurrently with Tenant's execution of this Lease, Tenant has deposited with Landlord the sum of Eighty Four Thousand Five Hundred and No/100 Dollars ($84,500.00) ("Cash Security "Deposit"). In addition, on or before January 4, 2002, Tenant shall deposit with Landlord a letter of credit substantially in the form attached hereto as Exhibit "C" ("Letter of Credit") in an initial amount of Three Hundred Twenty Four Thousand Dollars ($324,000.00). The Cash Security Deposit and Letter of Credit are collectively referred to as the Security Deposit. Landlord shall not be deemed a trustee of the Security Deposit, may use the Cash Security Deposit in business, and shall not be required to segregate the Cash Security Deposit from its general accounts. Tenant shall not be entitled to interest on the Security Deposit. If Tenant defaults with respect to any provisions of the Lease, including but not limited to the provisions relating to payment of Base Monthly Rent or other charges, Landlord may, to the extent reasonably necessary to remedy Tenant's default, use any or all of the Security Deposit (provided, however, Landlord shall use all of the Cash Deposit prior to drawing on all or any portion of the Letter of Credit) towards payment of the following: (i) Base Monthly Rent or other charges in default; (ii) any other amount which Landlord actually and reasonably incurs by reason of Tenant's default hereunder including, but not limited to Tenant's failure to restore or clean the Premises following vacation thereof in accordance with the terms of this Lease. If any portion of the Cash Security Deposit is so used or applied, Tenant shall, within ten (10) days after written demand from Landlord, deposit cash with Landlord in an amount sufficient to restore the Cash Security Deposit to its full original amount, and shall pay to Landlord such other sums as may be due pursuant to subsection (ii) of the immediately preceding sentence. Tenant may not assign or encumber the Security Deposit without the consent of Landlord. Any attempt to do so shall be void and shall not be binding on Landlord. The Security Deposit shall be returned to Tenant within thirty (30) days after the Expiration Date and surrender of the Premises to Landlord, less any amount deducted in accordance with this Section, together with Landlord's written notice itemizing the amounts and purposes for such deduction. Landlord shall be entitled to draw against the Letter of Credit at any time provided only that Landlord certifies to the issuer of the Letter of Credit that Tenant is in default under the Lease. Landlord shall only draw the amount necessary to cure the default unless such default is the third default that has occurred in any consecutive 18-month period during the Lease Term, in which case Landlord shall be permitted to draw the entire amount of the Letter of Credit and convert it to cash, subject to the provisions of this Lease regulating the handling of the Cash Security Deposit. Tenant shall keep the Letter of Credit in effect during the Lease Term as required herein. At least thirty (30) days prior to expiration of the Letter of Credit, the term thereof shall be renewed or extended for a period of at least one (1) year in the amount required by this Section 4. Tenant's failure to so renew or extend the Letter of Credit shall be a material default of this Lease by Tenant. In the event Landlord draws against the Letter of Credit, Tenant shall replenish the existing Letter of Credit or cause a new Letter of Credit to be issued such that the aggregate amount available to Landlord at all times during the Lease Term is the amount of the Letter of Credit then required. Notwithstanding the foregoing, and provided Tenant is not then in default of the Lease (beyond any applicable notice and cure period) and the Cash Security Deposit is at its required amount, the amount of the Letter of Credit shall be reduced annually by $108,000.00, commencing on February 1, 2003, such reduction to continue annually until the Letter of Credit is entirely eliminated. 5. This paragraph intentionally left blank.: 6. Acceptance of Possession and Covenants to Surrender: A. Delivery and Acceptance: On the Commencement Date, Landlord shall deliver the Premises to Tenant in broom clean condition, with all interior walls cleaned and repaired, any carpets cleaned, all floors cleaned and waxed, with all existing Building systems and fixtures fully operational, with all property of the prior tenant removed. Additionally, Landlord shall perform the following work prior to the Commencement Date (all such work to be completed to the reasonable satisfaction of Tenant): (i) fix the roof leak over the computer room and any other roof leaks that currently exist; (ii) repair the transformer in fire alarm room so as to reduce the noise; and (iii) replace damaged tiles in the computer room. On the Commencement Date, Tenant shall accept possession of the Premises and enter into occupancy of the Premises on the Commencement Date. If for any reason whatsoever, Landlord cannot deliver possession of the Premises to Tenant on or before the Commencement Date, Tenant shall not be liable for Basic Monthly Rent or any other amounts otherwise due hereunder until Landlord delivers possession of the Premises to Tenant in accordance with the terms hereof. Tenant acknowledges that it has had an opportunity to conduct, and has conducted, such inspections of the Premises as it deems necessary to evaluate its condition. Except for Landlord's obligation to complete the work and deliver the Premises in accordance with this Section 6, Tenant agrees to accept possession of the Premises in its then existing condition, subject to all Restrictions and without representation or warranty by Landlord except for latent defects and any express representations made by Landlord hereunder. Within twelve (12) months after the Commencement Date, Tenant agrees to be utilizing at least fifty percent (50%) of the Building. Landlord hereby represents and warrants to Tenant that, as of the date of this Lease, Landlord has terminated the prior lease of any and all tenants of the Premises. Landlord further represents and warrants that (i) it has good, valid and marketable fee simple title to the Building and the Project, and (ii) upon the Effective Date and during the Lease Term, Tenant shall have quiet enjoyment and peaceful possession of the Premises subject to rights specifically granted Landlord under this Lease (including Landlord's right and obligation to perform its obligations described in this Section 6.A) or remedies specifically available to Landlord under this Lease for a default by Tenant. In addition to Landlord's work as set forth under this Section 6.A., Landlord shall pay Sixty Seven Thousand Five Hundred Dollars ($67,500.00) towards the cost to construct a new restroom core near the Building lobby (in the same location as when the Building was initially improved and subject to Landlord's prior approval of the plans as set forth in Section 7.A. below), such construction to occur as part of Tenant's Alterations (as hereinafter defined) during the first year of the Lease Term. Landlord's Initial payment shall be made to Tenant within fifteen (15) days from completion of the work and payment of the cost by Tenant. B. Early Access: Tenant shall be allowed early access and occupancy of the Premises from the date on which Tenant has deposited its Letter of Credit pursuant to Section 4.C. above until the Commencement Date ("Early Occupancy Period"). Tenant shall be subject to all the terms and conditions of the Lease during the Early Occupancy Period except that no Base Monthly Rent or other expenses or amounts shall be due or payable (excluding utility charges incurred by Tenant). C. Condition Upon Surrender: Tenant further agrees on the Expiration Date or on the sooner termination of this Lease, to surrender the Premises to Landlord in good condition and repair (damage by acts of God, fire, and normal wear and tear excepted. In this regard, "normal wear and tear" shall be construed to mean wear and tear caused to the Premises by the natural aging process which occurs in spite of prudent application of commercially reasonable standards for maintenance, repair replacement, and janitorial practices, and does not include items of neglected or deferred maintenance. In any event, Tenant shall cause the following to be done prior to the Expiration Date or sooner termination of this Lease: (i) all interior walls shall be patched, cleaned, and otherwise made paint-ready, (ii) all tiled floors shall be cleaned and waxed, (iii) all carpets shall be cleaned and shampooed, (iv) all broken, marred, stained or nonconforming acoustical ceiling tiles shall be replaced, (v) all cabling placed above the ceiling by Tenant or Tenant's contractors shall be removed, (vi) all windows shall be washed; (vii) the HVAC system shall be serviced by a reputable and licensed service firm and left in "good operating condition and repair" as so certified by such firm, (viii) the plumbing and electrical systems and lighting shall be placed in good order and repair (including replacement of any burned out, discolored or broken light bulbs, ballasts, or lenses. On or before the Expiration Date or sooner termination of this Lease, Tenant shall remove all its personal property and trade fixtures from the Premises. All property and fixtures not so removed shall be deemed as abandoned by Tenant. On or before the Expiration Date or sooner termination of this Lease, Tenant shall remove any or all Alterations (as hereinafter defined) and restore the Premises to the condition prior to the Alteration (including repair of any damage caused by such removal) provided that Landlord notified Tenant in writing of such removal obligation at the time Tenant requested Landlord's consent to such Alterations. All Alterations except those which Landlord (in accordance with the terms hereof) previously required Tenant to remove shall remain in the Premises as the property of Landlord. Such repair and restoration shall include causing the Premises to be brought into compliance with all applicable building codes and laws in effect at the time of the removal to the extent such compliance is necessitated by the removal of the Alterations. D. Failure to Surrender: If the Premises are not surrendered at the Expiration Date or sooner termination of this Lease in the condition required by this Section 6, Tenant shall be deemed in a holdover tenancy pursuant to this Section 6.C and Tenant shall indemnify, defend, and hold Landlord harmless against loss or liability resulting from delay by Tenant in so surrendering the Premises including, without limitation, any claims made by any succeeding tenant founded on such delay and costs incurred by Landlord in returning the Premises to the required condition, plus interest at the Agreed Interest Rate. If Tenant remains in possession of the Premises after the Expiration Date or sooner termination of this Lease without Landlord's consent, Tenant's continued possession shall be on the basis of a tenancy at sufferance and Tenant shall pay as rent during the holdover period an amount equal to one hundred fifty percent (150%) of the Base Monthly Rent due in the month preceding the termination or Expiration Date, plus all other amounts payable by Tenant under this Lease. Any holding over shall otherwise be on the terms and conditions herein specified, except those provisions relating to the Lease Term and any options to extend or renew, which provisions shall be of no further force and effect following the expiration of the applicable exercise period. Notwithstanding anything to the contrary contained herein, Tenant's obligation to pay holdover rent, as well as its indemnification obligations under this Section 6.D. shall expire at such time as Landlord has completed the work necessary to restore the Premises to the condition required under Section 6.C. of this Lease and has charged Tenant for such work in accordance with this Lease. This provision shall survive the termination or expiration of the Lease. 7. Alterations and Additions: A. Tenant's Alterations: Tenant shall not make, or suffer to be made, any alteration or addition to the Premises ("Alterations"), or any part thereof, without obtaining Landlord's prior written consent and delivering to Landlord the proposed architectural and structural plans for all such Alterations at least ten (10) days prior to the start of construction. If such Alterations affect the structure of the Building, Tenant additionally agrees to reimburse Landlord its reasonable out-of-pocket costs incurred in reviewing Tenant's plans. After obtaining Landlord's consent, Tenant shall not proceed to make such Alterations until Tenant has obtained all required governmental approvals and permits. Tenant agrees to provide Landlord (i) written notice of the anticipated and actual start-date of the work, (ii) a complete set of half-size (15" X 21") vellum as-built drawings, and (iii) a certificate of occupancy for the work upon completion of the Alterations. All Alterations shall be constructed in compliance with all applicable building codes and laws including, without limitation, the Americans with Disabilities Act of 1990 as amended from time to time. Upon the Expiration Date, all Alterations, except movable furniture and trade fixtures, shall become a part of the realty and belong to Landlord but shall nevertheless be subject to removal by Tenant as provided in Section 6 above. Alterations which are not deemed as trade fixtures include heating, lighting, electrical systems, air conditioning, walls, carpeting, or any other installation which has become an integral part of the Premises. All Alterations shall be maintained, replaced or repaired by Tenant at its sole cost and expense. Landlord hereby acknowledges and agrees that during the Early Occupancy Period, Tenant intends to make the Alterations described on Exhibit "D" ("Initial Alterations") attached hereto, and Landlord hereby approves such Alterations in satisfaction of its approval right set forth in this Section 7.A. Notwithstanding the foregoing, Tenant shall be entitled, without obtaining Landlord's consent, to make Alterations which do not affect the structure of the Buildings and which do not cost more than Fifty Thousand Dollars ($50,000.00) per Alteration ("Permitted Alterations"); provided, however, that: (i) Tenant shall still be required to comply with all other provisions of this paragraph; and (ii) Landlord may elect to have Tenant remove such Permitted Alterations at the expiration or earlier termination of the Lease, unless Tenant has notified Landlord of such Permitted Alterations at least ten (10) days prior to commencing construction and received approval from Landlord that such Permitted Alterations will not be required to be removed at the expiration of the Lease. B. Free From Liens: Tenant shall keep the Premises free from all liens arising out of work performed, materials furnished, or obligations incurred by Tenant or claimed to have been performed for Tenant. In the event Tenant fails to discharge (or post a proper bond over) any such lien within ten (10) days after receiving written notice of the filing, Landlord shall immediately be entitled to discharge the lien at Tenant's expense and all resulting costs incurred by Landlord, including reasonable attorney's fees shall be due from Tenant as additional rent. C. Compliance With Governmental Regulations: The term Laws or Governmental Regulations shall include all federal, state, county, city or governmental agency laws, statutes, ordinances, standards, rules, requirements, or orders now in force or hereafter enacted, promulgated, or issued. The term also includes government measures regulating or enforcing public access, traffic mitigation, occupational, health, or safety standards for employers, employees, landlords, or tenants. Tenant, at Tenant's sole expense, shall comply with all Governmental Regulations pertaining to Tenant's particular use of the Premises and shall make all repairs, replacements, alterations, or improvements necessary to comply with all Governmental Regulations pertaining to Tenant's particular use of the Premises. Landlord shall comply with all Governmental Requirements pertaining to the Building or the Project or which are applicable to it, and secure any necessary permits therefore. Landlord shall have sole responsibility for costs related to required compliance with the Americans with Disabilities Act ("ADA") unless said compliance was triggered by any Alterations. Once restrooms have been added pursuant to Section 6.A. Landlord hereby represents and warrants that to the best of its knowledge, as of the date hereof, the Building and Premises are in full compliance with all Laws and Governmental Regulations. The judgment of any court of competent jurisdiction or the admission of Tenant in any action or proceeding against Tenant (whether Landlord be a party thereto or not) that Tenant has violated any such law, regulation or other requirement in its use of the Premises shall be conclusive of that fact as between Landlord and Tenant. 8. Maintenance of Premises: A. Landlord's Obligations: Landlord at its sole cost and expense, shall maintain in good condition, order, and repair, and replace as and when necessary, the foundation, exterior load bearing walls and roof structure of the Building Shell. Landlord shall also, at Tenant's expense through reimbursement to Landlord as provided in Section 8.C. below, maintain in good order, condition and repair, and replace when necessary: (i) all plumbing and sewage facilities outside the Building and/or beneath the Building slab; (ii) the parking lot and all underground utility facilities servicing the Premises, (iii) the roof membrane system, and (iv) all waterscape, landscaping and shrubbery. B. Tenant's Obligations: Tenant shall clean, maintain, repair and replace when necessary the Premises and every part thereof through regular inspections and servicing, including but not limited to: (i) all plumbing and sewage facilities inside the Building and above the slab, (ii) all heating ventilating and air conditioning facilities and equipment, (iii) all fixtures, interior walls floors, carpets and ceilings, (iv) all windows, door entrances, plate glass and glazing systems including caulking, and skylights, (v) all electrical facilities and equipment that serve the Building exclusively, and (vi) all automatic fire extinguisher equipment. All wall surfaces and floor tile are to be maintained in an as good a condition as when Tenant took possession free of holes, gouges, or defacements. With respect to item (ii) above, Tenant shall provide Landlord a copy of paid invoices detailing work performed if requested by Landlord. C. Landlord and Tenant's Obligations Regarding Reimbursable Operating Costs: In addition to the direct payment by Tenant of expenses as provided in Sections 8.B, 9, 10 and 11 of this Lease, Tenant agrees to reimburse Landlord for Tenant's Allocable Share (as defined in Section 8.E below) of Reimbursable Operating Costs (as defined in Section 8.D below) resulting from Landlord payment of expenses related to the Building or Project which are not otherwise paid by Tenant directly. Tenant agrees to pay its Allocable Share of the Reimbursable Operating Costs as additional rental within twenty (20) days after its receipt of a written statement from Landlord detailing Tenant's Allocable Share of Reimbursable Operating Costs (together with invoices and other reasonably satisfactory evidence of all applicable costs) incurred since Tenant's most recent payment of Reimbursable Operating Costs, which statement shall be provided no more frequently than monthly and no less frequently than annually. Tenant or its CPA (as defined below) shall have the right, at Tenant's sole cost and expense, upon at least thirty (30) days prior written notice to Landlord, at any time during regular business hours (but no more than twice a year) to audit, review and photocopy Landlord's records pertaining to Reimbursable Operating Costs for the immediately previous calendar year only. Any Certified Public Accountant ("CPA") engaged by Tenant to inspect Landlord's records shall be compensated by Tenant and shall be subject to Landlord's prior written approval. The inspection of Landlord's records must be completed within five (5) days after such records are made available to Tenant or its CPA. Tenant agrees to keep, and to cause its CPA to keep, all information thereby obtained by Tenant or its CPA confidential, except that Tenant shall be permitted to disclose such information to the extent reasonably necessary in connection with any dispute with Landlord regarding Reimbursable Operating Costs. D. Reimbursable Operating Costs: For purposes of calculating Tenant's Allocable Share of Building and Project Costs, the term "Reimbursable Operating Costs" is defined as all costs and expenses of the nature hereinafter described which are incurred by Landlord in connection with ownership and operation of the Building or the Project in which the Premises are located. All costs and expenses shall be determined in accordance with generally accepted accounting principles which shall be consistently applied (with accruals appropriate to Landlord's business), including but not limited to the following: (i) common area utilities, including water, power, telephone, heating, lighting, air conditioning, ventilating, and Building utilities to the extent not separately metered and paid by Tenant in accordance with Section 11 below; (ii) common area maintenance and service agreements for the Building and/or Project and the equipment therein, including without limitation, common area janitorial services, alarm and security services, exterior window cleaning, and maintenance of the sidewalks, landscaping, waterscape, roof membrane, parking areas, driveways, service areas, mechanical rooms, and the building exterior; (iii) insurance premiums and costs, including without limitation, the premiums and cost of fire, casualty and liability coverage and rental abatement and, if elected by Landlord, earthquake insurance applicable to the Building or Project provided that the cost thereof does not exceed three cents ($.03) per square foot of the Premises per month (if the premium due for such insurance exceeds the foregoing amount, Landlord can elect to continue such insurance and pay the excess portion of the premium without reimbursement, or may terminate earthquake coverage upon ten (10) days' prior written notice to Tenant, unless Tenant notifies Landlord in writing within such ten (10) day period that Tenant will pay Tenant's Allocable Share of the full cost of the insurance premium due for that year); (iv) repairs, replacements and general maintenance (excluding repairs and general maintenance paid by proceeds of insurance or by Tenant or other third parties, and repairs or alterations attributable solely to tenants of the Building or Project other than Tenant); and (v) all real estate taxes and assessment installments or other impositions or charges which may be levied on the Building or Project (but with regard to the Project, only to the extent that the Building is part of a larger tax lot that includes all or a portion of the Project), upon the occupancy of the Building or Project (but with regard to the Project, only to the extent that the Building is part of a larger tax lot that includes all or a portion of the Project) and including any substitute or additional charges which may be imposed during, or applicable to the Lease Term including such portion (as described below) of real estate tax increases due to a sale, transfer or other change of ownership of the Building or Project, as such taxes are levied or appear on the City and County tax bills and assessment rolls. Notwithstanding anything to the contrary contained in this Lease, the following shall not be included within Reimbursable Operating Costs: (i) leasing commissions, attorneys' fees, costs, disbursements, and other expenses incurred in connection with negotiations or disputes with tenants or in connection with leasing, renovating, or improving space for tenants or other occupants or prospective tenants or other occupants of the Building or the Project; (ii) the cost of any service sold to any tenant (including Tenant) or other occupant for which Landlord is entitled to be reimbursed as an additional charge or rental over and above the basic rent and escalations payable under the lease with that tenant; (iii) any depreciation on the Building or the Project; (iv) expenses in connection with services or other benefits of a type that are not provided to Tenant but which are provided another tenant or occupant of the Building or Project; (v) costs incurred due to Landlord's violation of any terms or conditions of this Lease or any other lease relating to the Building or Project; (vi) overhead profit increments paid to Landlord's subsidiaries or affiliates for services on or to the Building or Project or for supplies or other materials to the extent that the cost of the services, supplies, or materials exceeds the cost that would have been paid had the services, supplies, or materials been provided by unaffiliated parties on a competitive basis; (vii) all interest, loan fees, and other carrying costs related to any mortgage or deed of trust or related to any capital item, and all rental and other payable due under any ground or underlying lease, or any lease for any equipment ordinarily considered to be of a capital nature (except janitorial equipment which is not affixed to the Building); (viii) any compensation paid to clerks, attendants, or other persons in commercial concessions operated by Landlord; (ix) advertising and promotional expenditures; (x) costs of repairs and other work occasioned by fire, windstorm, or other casualty of an insurable nature and intended to be covered by insurance required to be carried by Landlord; (xi) any costs, fines, or penalties incurred due to violations by Landlord of any governmental rule or authority, this Lease or any other lease in the Project, or due to Landlord's gross negligence or willful misconduct; (xii) costs for sculpture, paintings, or other objects of art (nor insurance thereon or extraordinary security in connection therewith); (xiii) wages, salaries, or other compensation paid to any executive employees above the grade of building manager; (xiv) the cost of correcting any building code or other violations which were violations prior to the Commencement Date; (xv) the cost of containing, removing, or otherwise remediating any contamination of the Project (including the underlying land and ground water) by any toxic or hazardous materials where such contamination was not caused by Tenant or its agents, invitees, employees, or suppliers; (xvi) reserves for any Reimbursable Operating Costs; (xvii) repairs and maintenance to buildings of the Project in which Tenant is not an occupant, (xviii) costs of after-hours heating, ventilation and air conditioning provided to other tenants of the Project and to the extent Landlord has billed Tenant therefore, any after-hours heating, ventilation and air conditioning provided to Tenant; (xix) any property management or similar fee in excess of 1.5% of the Base Monthly Rent as provided for in Section 19.N below; and (xx) transfer taxes imposed as a result of a sale of the Premises or the Project. Landlord shall have no obligation to provide guard services or other security measures for the benefit of the Project. Tenant assumes all responsibility for the protection of Tenant and Tenant's Agents from acts of third parties; provided, however, that nothing contained herein shall prevent Landlord, at its sole option, from providing security measures for the Project. This is a "Net" Lease, meaning that Base Monthly Rent is paid to Landlord absolutely net of all costs and expenses, except as expressly excluded hereunder. The provision for payment of Reimbursable Operating Costs by means of periodic payment of Tenant's Allocable Share of Building and/or Project Costs is intended to pass on to Tenant and reimburse Landlord for all costs of operating and managing the Building and/or Project except as specifically excluded in this Lease. Notwithstanding the foregoing, if property taxes increase during the Lease Term as a result of a reassessment due to a change of ownership, Tenant's shall be responsible for payment of the resulting property tax increase as follows: (i) Tenant shall not be responsible for payment of any increase in property taxes if the Premises are reassessed due to a change of ownership during the first year of the Lease Term; and (ii) if the Premises are reassessed after the first year of the Lease Term, then during the first twelve months thereafter, Tenant shall be responsible for payment of Tenant's Allocable Share of thirty three percent (33%) of the tax increase; during the second twelve months thereafter, Tenant shall be responsible for payment Tenant's Allocable Share of of sixty seven percent (67%) of the tax increase, and thereafter Tenant shall be responsible for payment of Tenant's Allocable Share of the entire tax increase. E. Tenant's Allocable Share: For purposes of prorating Reimbursable Operating Costs which Tenant shall pay, Tenant's Allocable Share of Reimbursable Operating Costs shall be computed by multiplying the Reimbursable Operating Costs by a fraction, the numerator of which is the rentable square footage of the Premises and the denominator of which is either the total rentable square footage of the Building if the service or cost is allocable only to the Building, or the total square footage of the Project if the service or cost is allocable to the entire Project. Tenant's obligation to share in Reimbursable Operating Costs shall be prorated for any partial months during the Lease Term, and is subject to recalculation in the event of expansion of the Project. Using the above formula, Tenant's Allocable Share for the Building is 100% and for the Project is 14.5%. Landlord hereby represents that the following expenses would have totaled approximately 19(cent) p.s.f. per month payable by Tenant for calendar year 2001 had Tenant been in occupancy during 2001: (i) property taxes; (ii) property insurance; (iii) roof maintenance; (iv) scheduled weekly landscape maintenance, (iv) parking lot sweeping; and (v) Common Area utilities. To the best of Landlord's knowledge, there are no significant increases foreseen in the above expenses for calendar year 2002. F. Waiver of Liability: Failure by Landlord to perform any defined services, or any cessation thereof, when such failure is caused by accident, breakage, repairs, strikes, lockout or other labor disturbances or labor disputes of any character or by any other cause beyond Landlord's reasonable control and excepting any failure due to Landlord's or Landlord's agents' gross negligence or willful misconduct, shall not render Landlord liable to Tenant in any respect, including damages to either person or property, nor be construed as an eviction of Tenant, nor cause an abatement of rent, nor relieve Tenant from fulfillment of any covenant or agreement hereof. Should any equipment or machinery utilized in supplying the services listed herein break down or for any cause cease to function properly, upon receipt of written notice from Tenant of any deficiency or failure of any services, Landlord shall use reasonable diligence to repair the same promptly, but Tenant shall have no right to terminate this Lease and shall have no claim for rebate of rent or damages on account of any interruptions in service occasioned thereby or resulting therefrom. Tenant waives the provisions of California Civil Code Sections 1941 and 1942 concerning the Landlord's obligation of tenantability and Tenant's right to make repairs and deduct the cost of such repairs from the rent. Landlord shall not be liable for a loss of or injury to person or property, however occurring, through or in connection with or incidental to furnishing, or its failure to furnish, any of the foregoing excepting any loss or injury due to Landlord's or Landlord's agents' gross negligence or willful misconduct. Notwithstanding any of the foregoing provisions of this Paragraph 8.F. to the contrary, if solely as a result of Landlord's gross negligence or willful misconduct, Landlord fails to provide utilities which Landlord is required to provide to the Premises pursuant to this Lease (an "Abatement Condition"), which prevents Tenant from occupying all or a material portion of the Premises (the "Abatement Space"), then, as Tenant's sole and exclusive remedy for such failure, Base Rent and Tenant's Allocable Share payable hereunder shall abate in the proportion that the rentable square foot area of the Abatement Space actually vacated bears to the rentable square foot area of the Premises, for a period equal to the lesser of (i) the period during which Tenant has actually vacated the Abatement Space, or (ii) the period of time between Tenant's having vacated the Abatement Space and the date Tenant receives notice from Landlord that the Abatement Condition has been cured. For purposes of this Paragraph 8.F., vacation of the Abatement Space shall not require Tenant to remove furniture, fixtures or equipment. Tenant shall be deemed to have vacated the Abatement Space if, due to the Abatement Condition, the Abatement Space is not occupiable by Tenant, and Tenant does not in fact conduct any business in or use the Abatement Space. G. Capital Improvements: If as a part of the maintenance of the Premises, Tenant is liable under Section 8.D for payment of a replacement to the Premises that would typically be capitalized under normal accounting procedures, Landlord shall credit Tenant for the cost of the replacement less that portion of the cost equal to the product of such total cost multiplied by a fraction, the numerator of which is the number of years remaining in the Lease Term, the denominator of which is the useful life (in years) of the replacement, as reasonably determined by Landlord in accordance with generally accepted accounting principles. If the capital improvement is made during the initial Lease Term, Tenant's share shall initially be based on the initial Lease Term and if Tenant thereafter exercises its renewal option, then upon the commencement of the Option term, an adjustment shall be made so that during the Option Term Tenant shall reimburse Landlord an amount determined by multiplying the cost of the capital improvement by a fraction, the numerator of which is the sum of the Lease Term remaining at the time the capital expenditure was made and the Option Term and the denominator of which is the useful life of the capital improvement. 9. Hazard Insurance: A. Tenant's Use: Tenant shall not use or permit the Premises, or any part thereof, to be used for any purpose other than that for which the Premises are hereby leased; and no use of the Premises shall be made or permitted, nor acts done, which will cause an increase in premiums or a cancellation of any insurance policy covering the Premises or any part thereof, nor shall Tenant sell or permit to be sold, kept, or used in or about the Premises, any article prohibited by the standard form of fire insurance policies. Tenant shall, at its sole cost, comply with all material terms and requirements of any insurance company or organization necessary for the maintenance of reasonable fire and public liability insurance covering the Premises and appurtenances. B. Landlord's Insurance: Landlord agrees to purchase and keep in force All Risk and fire insurance in an amount equal to the replacement cost of the Building (not including any Alterations paid for by Tenant) as determined by Landlord's insurance company's appraisers. At Landlord's election, such fire and property damage insurance may be endorsed to cover loss caused by such additional perils against which Landlord may elect to insure, including earthquake and/or flood (subject to the limits set forth in Section 8.D above), and shall contain reasonable deductibles. Additionally Landlord may maintain a policy of (i) commercial general liability insurance insuring Landlord (and such others designated by Landlord) against liability for personal injury, bodily injury, death and damage to property occurring or resulting from an occurrence in, on or about the Premises or Project in an amount as Landlord determines is reasonably necessary for its protection, and (ii) rental loss insurance covering a twelve (12) month period. Tenant agrees to pay Landlord as additional rent pursuant to Section 8.D, the full cost of said insurance as evidenced by insurance billings to Landlord, and in the event of damage to the Premises covered by said insurance, the amount of any deductible under such policy. Payment shall be due to Landlord within thirty (30) days after written invoice to Tenant. It is understood and agreed that Tenant's obligation under this Section shall be prorated for any partial months during the Lease Term. C. Tenant's Insurance: Tenant agrees, at its sole cost, to insure its personal property and Alterations against damage. Landlord has no obligation to insure Tenant's personal property and Alterations. Said insurance shall provide All Risk and fire coverage. The property casualty insurance provided by Tenant as required by this paragraph shall be carried in favor of Landlord and Tenant as their respective interests may appear. Upon request by Landlord, Tenant shall deliver a copy of the policy and renewal certificate to Landlord. Tenant agrees, at its sole cost, and to obtain worker's compensation and Commercial General Liability insurance for occurrences within the Premises with a combined single limit of not less than Five Million Dollars ($5,000,000.00). Tenant's liability insurance shall be primary insurance containing a cross-liability endorsement, and shall provide coverage on an "occurrence" rather than on a "claims made" basis. All such insurance shall provide for severability of interests; shall provide that an act or omission of one of the named (additional) insureds shall not reduce or avoid coverage to the other named (additional insureds). Tenant shall name Landlord and Landlord's lender as an additional insured and shall, upon Landlord's written request, deliver a copy of the policies and renewal certificates to Landlord. All insurance policies required under this section shall provide for thirty (30) days' prior written notice to Landlord of any cancellation, termination, or reduction in coverage. D. Waiver: Landlord and Tenant hereby waive all tort, contract or other rights each may have against the other on account of any loss or damage sustained by Landlord or Tenant, as the case may be, or to the Premises or its contents, which may arise from any risk covered by their respective insurance policies (or which would have been covered had such insurance policies been maintained in accordance with this Lease) as set forth above. The Parties shall each obtain from their respective insurance companies a waiver of any right of subrogation which said insurance company may have against Landlord or Tenant, as the case may be. Nothing in this Section 9.D shall relieve a party of liability to the other for failure to carry insurance required by this Lease. 10. Taxes: Tenant shall be liable for and shall pay as additional rental, prior to delinquency, the following: (i) all taxes and assessments levied against Tenant's personal property and trade or business fixtures; (ii) all real estate taxes and assessment installments or other impositions or charges which may be levied on the Premises or upon the occupancy of the Premises, including any substitute or additional charges which may be imposed applicable to the Lease Term; and (iii) real estate tax increases due to an increase in assessed value resulting from a sale, transfer or other change of ownership of the Premises as it appears on the City and County tax bills during the Lease Term (subject to the phased payment of such increased taxes as set forth in Section 8.D above). All real estate taxes shall be prorated to reflect the Lease Commencement and Expiration Dates. In the case of item (i), Tenant shall pay such taxes and assessments directly; in the case of item (ii), Landlord shall make such payment and Tenant shall reimburse Landlord as part of its payment of its Allocable Share of Reimbursable Operating Costs. If, at any time during the Lease Term a tax, excise on rents, business license tax or any other tax, however described, is levied or assessed against Landlord as a substitute or addition, in whole or in part, for taxes assessed or imposed on land or Buildings, Tenant shall pay and discharge Tenant's Allocable Share of such tax or excise on rents or other tax before it becomes delinquent; except that this provision is not intended to cover net income taxes, inheritance, gift or estate tax imposed upon Landlord. In the event that a tax is placed, levied, or assessed against Landlord and the taxing authority takes the position that Tenant cannot pay and discharge its pro rata share of such tax on behalf of Landlord, then at Landlord's sole election, Landlord may increase the Base Monthly Rent by the exact amount of such tax and Tenant shall pay such increase. If by virtue of any application or proceeding brought by Landlord, there results a reduction in the assessed value of the Premises during the Lease Term, Tenant agrees to pay Landlord a fee consistent with the fees charged by a third party appeal firm for such services. Notwithstanding the foregoing, Tenant shall not be responsible for any fines or penalties imposed as a result of Landlord's failure to pay any taxes when due. 11. Utilities: Tenant shall pay directly to the providing utility all water, gas, electric, telephone, and other utilities supplied to the Premises. Landlord shall not be liable for loss of or injury to person or property, however occurring, through or in connection with or incidental to furnishing or the utility company's failure to furnish utilities to the Premises, and in such event Tenant shall not be entitled to abatement or reduction of any portion of Base Monthly Rent or any other amount payable under this Lease; provided, however, the foregoing shall not limit Landlord's liability pursuant to applicable law for the gross negligence or willful misconduct of Landlord, its agents, employees or contractors in connection with the provision of utility services to the Building. 12. Toxic Waste and Environmental Damage: A. Use of Hazardous Material: Tenant or Tenant's Tenant's Agents shall not cause or permit any Hazardous Material, as defined below, to be generated, brought onto, used, stored, created, released or disposed of in or about the Premises, except that Tenant and Tenant's Agents may use and store small quantities of common household cleaners and office supplies on the Premises provided such use and storage is in strict compliance with all Environmental Laws, as defined below, and except for Hazardous Materials present in or about the Premises on the Effective Date. As used herein, the term "Hazardous Material" shall mean any substance, material or waste (whether liquid, solid or gaseous), which is a pollutant or contaminant, or which is hazardous, toxic, ignitable, reactive, corrosive, dangerous, harmful or injurious, or which presents a risk to public health or the environment, or which is or may become regulated by or under the authority of any Environmental Laws, as defined below, including, without limitation, asbestos or asbestos containing materials, petroleum products, pesticides, polychlorinated biphenyls, flammable explosives, radioactive materials and urea formaldehyde. As used herein, the term "Environmental Laws" shall mean any present or future federal, state or local law, whether common law, statute, rule, regulation or ordinance, judgment, order, or other governmental restriction, guideline, listing or requirement, relating to the environment or any Hazardous Material, including without limitation, the Comprehensive Environmental Response, Compensation, and Liability Act of 1980, 42 U.S.C. ss.9601 et seq., the Resource Conservation and Recovery Act of 1976, 42 U.S.C. ss.6901 et seq., and applicable provisions of the California Health and Safety Code and the California Water Code, all as heretofore or hereafter may be amended from time to time. Tenant represents and warrants that it shall comply in every material respect with all Governmental Regulations applicable to Hazardous Material including doing the following: (i) adhering to all applicable reporting and inspection requirements imposed by Federal, State, County or Municipal laws, ordinances or regulations and provide Landlord a copy of any such reports or agency inspections; (ii) obtaining and providing Landlord copies of all necessary permits required for the use and handling of Hazardous Material on the Premises; (iii) enforcing Hazardous Material handling and disposal practices consistent with industry standards; (iv) surrendering the Premises free from any Hazardous Materials arising from Tenant's generating, bringing, using, storing, creating, releasing, or disposing of Hazardous Material; and (v) properly closing the facility with regard to Hazardous Material including the removal or decontamination of any process piping, mechanical ducting, storage tanks, containers, or trenches which have come into contact with Hazardous Material and obtaining a closure certificate from the local administering agency prior to the Expiration Date. B. Tenant's Indemnity Regarding Hazardous Material: Tenant shall, at its sole cost and expense and with counsel reasonably acceptable to Landlord, indemnify, defend and hold harmless Landlord and Landlord's trustees, shareholders, directors, officers, employees, partners, affiliates, agents, successors and assigns from, and against any and all claims, liabilities, obligations, penalties, fines, actions, costs or expenses incurred or suffered arising from generating, bringing, using, storing, creating, releasing or disposing of Hazardous Material by Tenant or Tenant's Agents in or about the Premises, or the violation of any Governmental Regulation or Environmental Laws by Tenant or Tenant's Agents. This indemnification applies whether or not the concentrations of any such Hazardous Material exceed applicable maximum contaminant or action levels or any governmental agency has issued a cleanup order. Tenant's indemnification, defense, and hold harmless obligations include, without limitation, the following: (i) claims, liabilities, costs or expenses resulting from or based upon administrative, judicial (civil or criminal) or other action, legal or equitable, brought by any private or public person under present or future laws, including Environmental Laws; (ii) claims, liabilities, costs or expenses pertaining to the identification, monitoring, cleanup, containment, or removal of Hazardous Material from soils, riverbeds or aquifers including the provision of an alternative public drinking water source; (iii) losses attributable to diminution in the value of the Premises or the Building (iv) loss or restriction of use of rentable space in the Building; (v) adverse effect on the marketing of any space in the Building; and (vi) all other liabilities, obligations, penalties, fines, claims, actions (including remedial or enforcement actions of any kind and administrative or judicial proceedings, orders or judgments), damages (including consequential and punitive damages), and costs (including attorney, consultant, and expert fees and expenses) resulting from the release or violation. This Section 12.B shall survive the expiration or termination o this Lease. C. Notice of Release or Violation: If, during the Lease Term (including any extensions), Tenant becomes aware of (i) any actual or threatened release of a Hazardous Material on, under or about the Premises or (ii) any inquiry, investigation, proceeding, claim, notice or order by any private or public person or entity regarding the presence of Hazardous Material on, under or about the Premises, including alleged violations of Environmental Laws by Tenant or Tenant's Agents., Tenant shall give Landlord written notice of the release or investigation within five (5) days after learning of it and shall simultaneously and thereafter furnish Landlord with copies of any claims, notices of violation, reports, or other writings received by Tenant concerning the release or investigation. In the event of an actual release of Hazardous Materials, Tenant shall also give Landlord prompt verbal notice of such release. In the event that Landlord first receives any of the information described in the immediately preceding two (2) sentences, Landlord shall provide equivalent notices to Tenant as are required of Tenant under this Section 12.C. In the event of any release on or into the Premises or into the soil or ground water under the Premises, the Building or the Project of any Hazardous Materials used, treated, stored or disposed of by Tenant or Tenant's Agents, Tenant agrees to comply, at its sole cost, with all laws, regulations, ordinances and orders of any federal, state or local agency relating to the monitoring or remediation of such Hazardous Materials. In the event of any such release of Hazardous Materials Tenant shall immediately give verbal and follow-up written notice of the release to Landlord, and Tenant agrees to meet and confer with Landlord and its Lender to attempt to eliminate and mitigate any financial exposure to such Lender and resultant exposure to Landlord under California Code of Civil Procedure Section 736(b) as a result of such release, and promptly to take reasonable monitoring, cleanup and remedial steps given, inter alia, the historical uses to which the Property has and continues to be used, the risks to public health posed by the release, the then available technology and the costs of remediation, cleanup and monitoring, consistent with acceptable customary practices for the type and severity of such contamination and all applicable laws. Nothing in the preceding sentence shall eliminate, modify or reduce the obligation of Tenant under 12.B of this Lease to indemnify, defend and hold Landlord harmless from any claims liabilities, costs or expenses incurred or suffered by Landlord. Tenant shall provide Landlord prompt written notice of Tenant's monitoring, cleanup and remedial steps. In the absence of an order of any federal, state or local governmental or quasi-governmental agency relating to the cleanup, remediation or other response action required by applicable law, any dispute arising between Landlord and Tenant concerning Tenant's obligation to Landlord under this Section 12.C concerning the level, method, and manner of cleanup, remediation or response action required in connection with such a release of Hazardous Materials shall be resolved by mediation and/or arbitration pursuant to this Lease. D. Remediation Obligations: In the event of any release on, under or about the Premises of any Hazardous Material generated, brought onto, used, stored, created or disposed of by Tenant or Tenant's Agents, Tenant shall, at its sole cost, promptly take all necessary and appropriate actions, in compliance with applicable Environmental Laws, to remove or remediate such Hazardous Material, whether or not any governmental agency has issued a cleanup order, so as to return the Premises to the condition that existed before the introduction of such Hazardous Material. Tenant shall obtain Landlord's written consent prior to implementing any proposed removal or remedial action, provided, however, that Tenant shall be entitled to respond immediately to an emergency without first obtaining Landlord's written consent. Nothing in the preceding sentence shall in any way eliminate, modify or reduce the obligation of Tenant under 12.B of this Lease to indemnify, defend and hold Landlord harmless from any claims, liabilities, costs or expenses incurred or suffered by Landlord. E. Environmental Monitoring: Landlord and its agents shall have the right (subject to Tenant's notice rights under Section 19.G below) to inspect, investigate, sample and monitor the Premises, including any air, soil, water, ground water, or to conduct any other sampling or testing, digging, drilling or analysis, to determine whether Tenant is complying with the terms of this Section 12. If Landlord discovers that Tenant is not in compliance with the terms of this Section 12, any costs incurred by Landlord in determining Tenant's non- compliance, including reasonable attorneys', consultants' and experts' fees, shall be due and payable by Tenant to Landlord within five (5) days following Landlord's written demand therefor. 13. Tenant's Default: The occurrence of any of the following shall constitute a material default and breach of this Lease by Tenant: (i) Tenant's failure to pay the Base Monthly Rent including additional rent or any other payment due under this Lease within five (5) business days after Tenant's receipt of written notice of the late payment, (ii) the abandonment of the Premises by Tenant; (iii) Tenant's failure to observe and perform any other required provision of this Lease, where such failure continues for thirty (30) days after written notice from Landlord; provided, however, that if the nature of the default is such that it cannot reasonably be cured within said 30-day period, Tenant shall not be deemed to be in default if it commences within such period to cure, and thereafter diligently prosecutes the same to completion; (iv) Tenant's making of any general assignment for the benefit of creditors; (v) the filing by or against Tenant of a petition to have Tenant adjudged a bankrupt or of a petition for reorganization or arrangement under any law relating to bankruptcy (unless, in the case of a petition filed against Tenant, the same is dismissed after the filing); (vi) the appointment of a trustee or receiver to take possession of substantially all of Tenant's assets located at the Premises or of Tenant's interest in this Lease, where possession is not restored to Tenant within thirty (30) days; or (vii) the attachment, execution or other judicial seizure of substantially all of Tenant's assets located at the Premises or of Tenant's interest in this Lease, where such seizure is not discharged within thirty (30) days. A. Remedies: In the event of any default by Tenant as defined in this Section 13, then in addition to other remedies available to Landlord at law or in equity, Landlord shall have the immediate option to terminate this Lease and all rights of Tenant hereunder by giving written notice of such intention to terminate. In the event Landlord elects to so terminate this Lease, Landlord may recover from Tenant all the following: (i) the worth at time of award of any unpaid rent which had been earned at the time of such termination; (ii) the worth at time of award of the amount by which the unpaid rent which would have been earned after termination until the time of award exceeds the amount of such rental loss for the same period that Tenant proves could have been reasonably avoided; (iii) the worth at time of award of the amount by which the unpaid rent for the balance of the Lease Term after the time of award exceeds the amount of such rental loss that Tenant proves could be reasonably avoided; (iv) any other amount necessary to compensate Landlord for all detriment proximately caused by Tenant's failure to perform its obligations under this Lease, or which in the ordinary course of things would be likely to result therefrom; including the following: (x) reasonable expenses for repairing, altering or remodeling the Premises for purposes of reletting, (y) reasonable broker's fees, advertising costs or other expenses of reletting the Premises, and (z) reasonable costs of carrying the Premises such as taxes, insurance premiums, utilities and security precautions; and (v) at Landlord's election, such other amounts in addition to or in lieu of the foregoing as may be permitted by applicable California law. The term "rent", as used herein, is defined as the minimum monthly installments of Base Monthly Rent and all other sums required to be paid by Tenant pursuant to this Lease, all such other sums being deemed as additional rent due hereunder. As used in (i) and (ii) above, "worth at the time of award" shall be computed by allowing interest at a rate equal to the discount rate of the Federal Reserve Bank of San Francisco plus five (5%) percent per annum. As used in (iii) above, "worth at the time of award" shall be computed by discounting such amount at the discount rate of the Federal Reserve Bank of San Francisco at the time of award plus one (1%) percent. B. Right to Re-enter: In the event of any such default by Tenant, Landlord shall have the right, after terminating this Lease, to re-enter the Premises and remove all persons and property. Such property may be removed and stored in a public warehouse or elsewhere at the cost of and for the account of Tenant, and disposed of by Landlord in any manner permitted by law. C. Abandonment: If Landlord does not elect to terminate this Lease as provided in Section 13.A or 13.B above, then the provisions of California Civil Code Section 1951.4, (Landlord may continue the lease in effect after Tenant's breach and abandonment and recover rent as it becomes due if Tenant has a right to sublet and assign, subject only to reasonable limitations) as amended from time to time, shall apply and Landlord may from time to time, without terminating this Lease, either recover all rental as it becomes due or relet the Premises or any part thereof for such term or terms and at such rental or rentals and upon such other terms and conditions as Landlord in its sole discretion may deem advisable, with the right to make alterations and repairs to the Premises. In the event that Landlord elects to so relet, rentals received by Landlord from such reletting shall be applied in the following order to: (i) the payment of any indebtedness other than Base Monthly Rent due hereunder from Tenant to Landlord; (ii) the payment of any cost of such reletting; (iii) the payment of the cost of any alterations and repairs to the Premises; and (iv) the payment of Base Monthly Rent and other sums due and unpaid hereunder. The residual rentals, if any, shall be held by Landlord and applied in payment of future Base Monthly Rent as the same may become due and payable hereunder. Landlord shall the obligation to market the space but shall have no obligation to relet the Premises following a default if Landlord has other comparable available space within the Building or Project. In the event the portion of rentals received from such reletting which is applied to the payment of rent hereunder during any month be less than the rent payable during that month by Tenant hereunder, then Tenant shall pay such deficiency to Landlord immediately upon demand. Such deficiency shall be calculated and paid monthly. Tenant shall also pay to Landlord, as soon as ascertained, any costs and expenses incurred by Landlord in such reletting or in making such alterations and repairs not covered by the rentals received from such reletting. D. No Termination: Landlord's re-entry or taking possession of the Premises pursuant to 13.B or 13.C shall not be construed as an election to terminate this Lease unless written notice of such intention is given to Tenant or unless the termination is decreed by a court of competent jurisdiction. Notwithstanding any reletting without termination by Landlord because of any default by Tenant, Landlord may at any time after such reletting elect to terminate this Lease for any such default. E. Non-Waiver: Landlord may accept Tenant's payments without waiving any rights under this Lease, including rights under a previously served notice of default. No payment by Tenant or receipt by Landlord of a lesser amount than any installment of rent due shall be deemed as other than payment on account of the amount due. If Landlord accepts payments after serving a notice of default, Landlord may nevertheless commence and pursue an action to enforce rights and remedies under the previously served notice of default without giving Tenant any further notice or demand. Furthermore, the Landlord's acceptance of rent from the Tenant when the Tenant is holding over without express written consent does not convert Tenant's Tenancy from a tenancy at sufferance to a month to month tenancy. No waiver of any provision of this Lease shall be implied by any failure of Landlord to enforce any remedy for the violation of that provision, even if that violation continues or is repeated. Any waiver by Landlord of any provision of this Lease must be in writing. Such waiver shall affect only the provision specified and only for the time and in the manner stated in the writing. No delay or omission in the exercise of any right or remedy by Landlord shall impair such right or remedy or be construed as a waiver thereof by Landlord. No act or conduct of Landlord, including, without limitation, the acceptance of keys to the Premises, shall constitute acceptance of the surrender of the Premises by Tenant before the Expiration Date. Only written notice from Landlord to Tenant of acceptance shall constitute such acceptance of surrender of the Premises. Landlord's consent to or approval of any act by Tenant which requires Landlord's consent or approvals shall not be deemed to waive or render unnecessary Landlord's consent to or approval of any subsequent act by Tenant. F. Performance by Landlord: If Tenant fails to perform any obligation required under this Lease or by Law or Governmental Regulation (beyond any applicable notice and cure period) Landlord in its sole discretion may, without further notice, without waiving any rights or remedies and without releasing Tenant from its obligations hereunder, perform such obligation, in which event Tenant shall pay Landlord as additional rent all sums paid by Landlord in connection with such substitute performance, including interest at the Agreed Interest Rate (as defined in Section 19.J) within ten (10) days of Landlord's written notice for such payment. 14. Landlord's Liability: A. Limitation on Landlord's Liability: In the event of Landlord's failure to perform any of its covenants or agreements under this Lease, Tenant shall give Landlord written notice of such failure and shall give Landlord thirty (30) days to cure or commence to cure such failure prior to any claim for breach or resultant damages, provided, however, that if the nature of the default is such that it cannot reasonably be cured within the 30-day period, Landlord shall not be deemed in default if it commences within such period to cure, and thereafter diligently prosecutes the same to completion. In addition, upon any such failure by Landlord, Tenant shall give notice by registered or certified mail to any person or entity with a security interest in the Premises ("Mortgagee") that has provided Tenant with notice of its interest in the Premises (with a copy of such notice concurrently sent to Landlord), and in the event Landlord does not cure or commence to cure such failure within the requisite time period set forth hereinabove, shall provide Mortgagee thirty (30) days to cure or commence to cure such failure prior to any claim for breach or resultant damages, provided, however, that if the nature of the default is such that it cannot reasonably be cured within the 30-day period, Mortgagee shall not be deemed in default if it commences within such period to cure, and thereafter diligently prosecutes the same to completion. Tenant agrees that each of the Mortgagees to whom this Lease has been assigned is an expressed third-party beneficiary hereof. Tenant waives any right under California Civil Code Section 1950.7 or any other present or future law to the collection of any payment or deposit from Mortgagee or any purchaser at a foreclosure sale of Mortgagee's interest unless Mortgagee or such purchaser shall have actually received and not refunded the applicable payment or deposit. Except for Tenant's right to terminate the Lease as specifically set forth in Section 15.B and 19.T, Tenant further waives any right to terminate this Lease and to vacate the Premises on Landlord's default under this Lease. Tenant's sole remedy on Landlord's default is an action for damages or injunctive or declaratory relief. B. Limitation on Tenant's Recourse: If Landlord is a corporation, trust, partnership, joint venture, unincorporated association or other form of business entity, then (i) the obligations of Landlord shall not constitute personal obligations of the officers, directors, trustees, partners, joint venturers, members, owners, stockholders, or other principals or representatives except to the extent of their interest in the Project. Tenant shall have recourse only to the interest of Landlord in the Project or for the satisfaction of the obligations of Landlord and shall not have recourse to any other assets of Landlord for the satisfaction of such obligations. C. Indemnification of Landlord: Except to the extent due to the negligence or willful misconduct of Landlord, as a material part of the consideration rendered to Landlord, Tenant hereby waives all claims against Landlord for damages to goods, wares and merchandise, and all other personal property in, upon or about said Premises and for injuries to persons in or about said Premises, from any cause arising at any time to the fullest extent permitted by law, and Tenant shall indemnify, defend with counsel reasonably acceptable to Landlord and hold Landlord, and their shareholders, directors, officers, trustees, employees, partners, affiliates and agents from any claims, liabilities, costs or expenses incurred or suffered arising from the use of occupancy of the Premises or any part of the Project by Tenant or Tenant's Agents, the acts or omissions of Tenant or Tenant's Agents, Tenant's breach of this Lease, or any damage or injury to person or property occurring on the Premises from any cause or any damage or injury to person or property occurring on any other part of the Project and caused by the acts or omissions of Tenant or Tenant's Agents, or from the failure of Tenant to keep the Premises in good condition and repair as herein provided,. Further, in the event Landlord is made party to any litigation due to the acts or omission of Tenant or Tenant's Agents, Tenant will indemnify, defend (with counsel reasonably acceptable to Landlord) and hold Landlord harmless from any such claim or liability including Landlord's costs and expenses and reasonable attorney's fees incurred in defending such claims. 15. Destruction of Premises: A. Landlord's Obligation to Restore: In the event of a destruction of the Premises during the Lease Term Landlord shall repair the same to a similar condition to that which existed prior to such destruction. Such destruction shall not annul or void this Lease; however, Tenant shall be entitled to a proportionate reduction of Base Monthly Rent while repairs are being made, such proportionate reduction to be based upon the extent to which the repairs interfere with Tenant's business in the Premises, as reasonably determined by Landlord. In no event shall Landlord be required to replace or restore Alterations, Tenant Improvements paid for by Tenant from sources other than the Work Allowance or Tenant's fixtures or personal property. B. Limitations on Landlord's Restoration Obligation: Notwithstanding the provisions of Section 15.A, Landlord shall have no obligation to repair, or restore the Premises if any of the following occur: (i) if the repairs cannot be made in one hundred eighty (180) days from the date of receipt (provided that Landlord has diligently pursued the issuance of same) of all governmental approvals necessary under the laws and regulations of State, Federal, County or Municipal authorities, as reasonably determined by Landlord, (ii) if the holder of the first deed of trust or mortgage encumbering the Building elects not to permit the insurance proceeds payable upon damage or destruction to be used for such repair or restoration, (iii) the damage or destruction is not fully covered by the insurance maintained or required to be maintained by Landlord, (iv) the damage or destruction occurs in the last twenty four (24) months of the Lease Term, (v) Tenant is in default pursuant to the provisions of Section 13 hereof (beyond any applicable notice or cure periods), or (vi) Tenant has vacated the Premises for more than ninety (90) days. In any such event Landlord may elect either to (i) complete the repair or restoration, or (ii) terminate this Lease by providing Tenant written notice of its election within forty five (45) days following the damage or destruction. If Landlord elects to repair or restore, this Lease shall continue in full force and effect. Tenant shall also have the right to terminate this Lease in the event of either (i) or (iv) above, by providing Landlord with written notice of its election to do so within forty five (45) days following the damage or destruction. If Tenant elects not to terminate the Lease and Landlord thereafter fails to diligently pursue to completion the repairs so that it becomes clearly apparent that Landlord will not complete the repairs on or before the date that is 180 days from the date of receipt of all governmental approvals necessary under the laws and regulations of State, Federal, County or Municipal authorities as set forth above, then Tenant may terminate this Lease on written notice to Landlord within fifteen (15) business days of such determination by Tenant; provided, however, if Tenant elects not to terminate this Lease, Landlord and Tenant shall reasonably agree on a revised completion schedule, and if Landlord shall fail to complete the restoration within said revised time period, Tenant shall again have the termination right described in this sentence. 16. Condemnation: If any part of the Premises shall be taken for any public or quasi-public use, under any statute or by right of eminent domain or private purchase in lieu thereof, and only a part thereof remains which is susceptible of occupation hereunder, this Lease shall, as to the part so taken, terminate as of the day before title vests in the condemnor or purchaser ("Vesting Date") and Base Monthly Rent payable hereunder shall be adjusted so that Tenant is required to pay for the remainder of the Lease Term only such portion of Base Monthly Rent as the value of the part remaining after such taking bears to the value of the entire Premises prior to such taking. Further, in the event of any such partial taking of any rentable square footage of the Premises that could reasonably be expected to have a material adverse effect on the intended use of the Premises by Tenant, either Party shall have the option to terminate this Lease as of the Vesting Date. If all of the Premises or such part thereof be taken so that there does not remain a portion susceptible for occupation hereunder, this Lease shall terminate on the Vesting Date. If part or all of the Premises be taken, all compensation awarded upon such taking shall go to Landlord, and Tenant shall have no claim thereto; except Landlord shall cooperate with Tenant, without cost to Landlord, to recover compensation for damage to or taking of any Alterations, Tenant Improvements paid for by Tenant from sources other than the Work Allowance, or for Tenant's moving costs. Tenant hereby waives the provisions of California Code of Civil Procedures Section 1265.130 and any other similarly enacted statue, and the provisions of this Section 16 shall govern in the case of a taking. 17. Assignment or Sublease: A. Consent by Landlord: Except as specifically provided in Section 17.E, Tenant may not voluntarily, involuntarily or by operation of law, assign, sell or otherwise transfer all or any part of Tenant's interest in this Lease or in the Premises, cause or permit any part of the Premises to be sublet, occupied or used by anyone other than Tenant, or permit any person to succeed to any interest in this Lease or the Premises (all of the foregoing being a "Transfer") without the express written consent of Landlord. In the event Tenant desires to effectuate a Transfer, Tenant shall deliver to Landlord (1) a copy of the proposed sublease or assignment agreement and of all ancillary agreements with the proposed transferee, (2) current financial statements of the transferee covering the preceding three years, (3) the nature of the proposed transferee's business to be carried on in the Premises, and (4) a statement outlining all consideration to be given on account of the Transfer. Landlord may condition its approval of any Transfer on receipt of a certification from both Tenant and the proposed transferee of all consideration to be paid to Tenant in connection with such Transfer. At Landlord's request, Tenant shall also provide additional information reasonably required by Landlord to determine whether it will consent to the proposed Transfer. Landlord shall have a ten (10) business-day period following receipt of all the foregoing within which to notify Tenant in writing that Landlord elects to: (i) permit Tenant to Transfer such space to the named transferee on the terms and conditions stated in the proposed sublease or assignment agreement; or (ii) refuse consent. If Landlord should fail to notify Tenant in writing of such election within the 10 business-day period, Tenant shall again notify Landlord in writing and shall give Landlord an additional five (5) business days to respond. If Landlord fails to notify Tenant in writing of such election within this second 5 business-day period, then Landlord shall be deemed to have elected option (i) above. In the event Landlord does not elect option (i) above, Landlord's consent to the proposed Transfer shall not be unreasonably withheld, provided and upon the condition that: (i) the proposed transferee is engaged in a business that is limited to the use expressly permitted under this Lease; (ii) the proposed transfer agreement is in form reasonably satisfactory to Landlord; (iii) the proposed Transfer will not result in there being greater than three (3) subtenants or other occupants (not including employees) within the Premises at any time during the Lease Term; and (iv) Tenant reimburses Landlord promptly after demand for any reasonable costs that may be incurred by Landlord in connection with said Transfer, including the costs of making investigations as to the acceptability of the proposed transferee and legal costs incurred in connection with the granting or denial of any requested consent. In the event all or any one of the foregoing conditions are not satisfied (without limiting other factors that may be considered or conditions that may be imposed by Landlord in connection with a requested Transfer), Landlord shall be considered to have acted reasonably if it withholds its consent. Tenant shall not hypothecate, mortgage, pledge or otherwise encumber Tenant's interest in this Lease or the Premises or otherwise use the Lease as a security device in any manner without the consent of Landlord, (all of the foregoing being an "Hypothecation") which consent Landlord may withhold in its sole discretion; provided, however, Landlord hereby acknowledges and agrees that, so long as Tenant is not in default hereunder, Tenant shall be permitted, with Landlord's reasonable consent, to pledge its interest in this Lease in connection with the pledge of all or substantially all of its assets as part of any master credit facility. In the event Landlord consents to such a Hypothecation, Landlord's consent shall be evidenced by a written consent in substantially the form attached as Exhibit "E" hereto. Tenant shall reimburse Landlord on demand for any reasonable costs that may be incurred by Landlord in connection with an Hypothecation, including legal costs incurred in connection with the granting or denial of any requested consent. Landlord's consent to one or more Transfers or Hypothecations shall not operate to exhaust Tenant's obligation to obtain Landlord's consent to other Transfers or Hypothecations nor constitute consent to an assignment or other Transfer following foreclosure of any permitted lien, mortgage or other encumbrance. If Tenant is a corporation, limited liability company, unincorporated association, partnership or other legal entity, the sale, assignment, transfer or hypothecation of any stock, membership or other ownership interest in such entity (whether occurring at one time or over a period of time) in the aggregate of more than fifty percent (50%) (determined cumulatively) shall be deemed an assignment of this Lease; in the case of a partnership, any withdrawal or substitution (whether occurring at one time or over a period of time) of any partners owning fifty percent (50%) or more (cumulatively) of the partnership, or the dissolution of the partnership shall be deemed an assignment of this Lease; provided that, subject to Section 17.D below, the foregoing provisions of this sentence shall not apply to a transfer of stock in a corporation whose stock is publicly traded on a public stock exchange, a transfer of stock or ownership interest resulting from a financing of Tenant or a private or public offering, and the issuance of warrants or stock options to purchase Tenant's stock (and the exercise of purchase rights under any such warrants or stock options). If Tenant is a corporation whose stock is not publicly traded on a public stock exchange, any dissolution, merger, consolidation or reorganization of Tenant shall be deemed a Transfer. B. Assignment or Subletting Consideration: Landlord and Tenant hereby agree that fifty percent (50%) of any rent or other economic consideration (including without limitation, payments for trade fixtures and personal property in excess of the fair market value thereof, stock, warrants, and options) in excess of the Base Monthly Rent payable hereunder (after deducting therefrom Reasonable Transfer Costs (defined below) (i) realized by Tenant in connection with any Transfer by Tenant, and/or (ii) realized by Tenant in connection with any sublease, assignment, or other Transfer by a subtenant or any other person or entity (other than Tenant), shall be paid by Tenant to Landlord promptly after such amounts are paid to Tenant. As used in this Section 17.B, "Reasonable Transfer Costs" shall mean the following costs, to the extent reasonably incurred in connection with the Transfer in question: (i) advertising costs and brokerage commissions payable to unaffiliated third parties, and (ii) tenant improvement costs incurred solely in connection with such Transfer. Tenant's obligation to pay over Landlord's portion of the consideration constitutes an obligation for additional rent hereunder. The above provisions relating to the allocation of excess rent is an independently negotiated term of the Lease which constitutes a material inducement for the Landlord to enter into the Lease, and is agreed by the Parties to be commercially reasonable. No Transfer by Tenant shall relieve it of any obligation under this Lease. Any Transfer which conflicts with the provisions of this Lease shall be void. C. No Release: Any Transfer shall be made only if and shall not be effective until the transferee shall execute, acknowledge, and deliver to Landlord an agreement, in form and substance reasonably satisfactory to Landlord, whereby the transferee shall assume all the obligations of this Lease on the part of Tenant to be performed or observed to the extent of the interest being transferred and shall be subject to all the covenants, agreements, terms, provisions and conditions in this Lease to the extent applicable to the interest being transferred. Notwithstanding any Transfer and the acceptance of rent or other sums by Landlord from any transferee, Tenant and any guarantor shall remain fully liable for the payment of Base Monthly Rent and additional rent due, and to become due hereunder, for the performance of all the covenants, agreements, terms, provisions and conditions contained in this Lease on the part of Tenant to be performed and for all acts and omissions of any transferee or any other person claiming under or through any transferee that shall be in violation of any of the terms and conditions of this Lease, and any such violation shall be deemed a violation by Tenant. Tenant shall indemnify, defend and hold Landlord harmless from and against all losses, liabilities, damages, costs and expenses (including reasonable attorney fees) resulting from any claims that may be made against Landlord by the proposed transferee or by any real estate brokers or other persons claiming compensation in connection with the proposed Transfer. D. Reorganization of Tenant: The provisions of this Section 17.D shall apply if Tenant is a publicly-held corporation and: (i) there is a dissolution, merger, consolidation, or other reorganization of or affecting Tenant, where Tenant is not the surviving corporation, or (ii) there is a sale or transfer of stock possessing more than 50% of the total combined voting power of all classes of Tenant's capital stock issued, outstanding and entitled to vote for the election of directors to one person or entity (or to any group of related persons or entities) (the "Acquiring Entity"), and after such sale or transfer of stock Tenant's stock is no longer publicly traded. In a transaction under clause (i), the surviving corporation shall promptly execute and deliver to Landlord an agreement in form reasonably satisfactory to Landlord under which such surviving corporation assumes the obligations of Tenant hereunder. In a transaction under clause (ii), the Acquiring Entity shall promptly execute and deliver to Landlord a guaranty of lease in form reasonably satisfactory to Landlord under which the Acquiring Entity guarantees the full payment and performance of the obligations of Tenant under the Lease (`Lease Guaranty"). The foregoing notwithstanding, in the event the Acquiring Entity is itself not a publicly-traded corporation, but is instead the subsidiary of a publicly-traded corporation (or a subsidiary of a subsidiary of a publicly-traded corporation, or a subsidiary in a chain of entities in which a parent corporation is publicly traded), then the publicly-traded parent corporation shall be required to execute and deliver to Landlord the Lease Guaranty. In addition, in the event that after such acquisition Tenant no longer prepares audited financial statements, then in addition to the financial statements required to be delivered by Tenant hereunder, the entity required to execute the Lease Guaranty shall provide Landlord its audited financial statements at the times and in the manner required of Tenant hereunder. It is the intent of the parties that after such an acquisition of the stock of Tenant, Landlord shall be entitled to rely on the creditworthiness of a publicly-traded corporation and to receive audited financial information from a publicly-traded corporation. E. Permitted Transfers: Notwithstanding anything contained in this Section 17, so long as Tenant otherwise complies with the provisions of this Section 17, Tenant may enter into any of the following Transfers (a "Permitted Transfer") without Landlord's prior consent, and Landlord shall not be entitled to terminate the Lease or to receive any part of any subrent or other consideration resulting therefrom that would otherwise be due pursuant to Sections 17.A and 17.B. Tenant may sublease all or part of the Premises or assign its interest in this Lease to (i) any corporation which controls, is controlled by, or is under common control with the original Tenant to this Lease by means of an ownership interest of more than 50%; (ii) a corporation which results from a merger, consolidation or other reorganization in which Tenant is not the surviving corporation, so long as the surviving corporation has a net worth at the time of such assignment that is equal to or greater than the net worth of Tenant immediately prior to such transaction; and (iii) a corporation which purchases or otherwise acquires all or substantially all of the assets of Tenant so long as such acquiring corporation has a net worth at the time of such assignment that is equal to or greater than the net worth of Tenant immediately prior to such transaction. F. Effect of Default: In the event of Tenant's default beyond any applicable notice and cure period), Tenant hereby assigns all amounts due to Landlord from any Transfer as security for performance of Tenant's obligations under this Lease, and Landlord may collect such amounts as Tenant's Attorney-in-Fact, except that Tenant may collect such amounts unless a default occurs as described in Section 13 above. A termination of the Lease due to Tenant's default shall not automatically terminate a Transfer then in existence; rather at Landlord's election, such Transfer shall survive the Lease termination, the transferee shall attorn to Landlord, and Landlord shall undertake the obligations of Tenant under the transfer agreement; except that Landlord shall not be liable for prepaid rent, security deposits or other defaults of Tenant to the transferee, or for any acts or omissions of Tenant and Tenant's Agents. G. Conveyance by Landlord: As used in this Lease, the term "Landlord" is defined only as the owner for the time being of the Premises, so that in the event of any sale or other conveyance of the Premises or in the event of a master lease of the Premises, Landlord shall be entirely freed and relieved of all its covenants and obligations hereunder from and after the date of such transfer, and it shall be deemed and construed, without further agreement between the Parties and the purchaser at any such sale or the master tenant of the Premises, that the purchaser or master tenant of the Premises has assumed and agreed to carry out any and all covenants and obligations of Landlord hereunder from and after the date of such transfer. Such transferor shall transfer and deliver Tenant's security deposit to the purchaser at any such sale or the master tenant of the Premises, and thereupon the transferor shall be discharged from any further liability in reference thereto. H. Successors and Assigns: Subject to the provisions of this Section 17, the covenants and conditions of this Lease shall apply to and bind the heirs, successors, executors, administrators and assigns of all Parties hereto; and all parties hereto comprising Tenant shall be jointly and severally liable hereunder. 18. Option to Extend the Lease Term: A. Grant and Exercise of Option: Landlord grants to Tenant, subject to the terms and conditions set forth in this Section 18.A, an option ("Option") to extend the Lease Term for an additional term (the "Option Term"). The Option Term shall be for a period of three (3) years and shall be exercised, if at all, by written notice to Landlord no earlier than eighteen (18) months prior to the date the Lease Term would expire but for such exercise but no later than twelve (12) months prior to the date the Lease Term would expire but for such exercise, time being of the essence for the giving of such notice. If Tenant exercises the Option, all of the terms, covenants and conditions of this Lease shall apply except for the grant of additional Options pursuant to this Section, provided that Base Monthly Rent for the Premises payable by Tenant during the Option Term shall be at the Fair Market Rental as hereinafter defined. Notwithstanding anything herein to the contrary, if Tenant is in monetary or material non-monetary default (beyond applicable notice and cure periods) under any of the terms, covenants or conditions of this Lease either at the time Tenant exercises the Option or at any time thereafter prior to the commencement date of the Option Term, then Landlord shall have, in addition to all of Landlord's other rights and remedies provided in this Lease, the right to terminate the Option upon notice to Tenant, in which event the Lease Term shall not be extended pursuant to this Section 18.A. As used herein, the term "Fair Market Rental" is defined as the rental and all other monetary payments, including any escalations and adjustments thereto (including without limitation Consumer Price Indexing) that Landlord could obtain during the Option Term from a third party desiring to lease the Premises, based upon the current use and other potential uses of the Premises, as determined by the rents then obtainable for new leases of space comparable in age, size and quality to the Premises in the same real estate submarket as the Building. B. Determination of Fair Market Rental: If Tenant exercises the Option, Landlord shall send Tenant a notice setting forth the Fair Market Rental for the Option Term within thirty (30) days following the Exercise Date. If Tenant disputes Landlord's determination of Fair Market Rental for the Option Term, Tenant shall, within thirty (30) days after the date of Landlord's notice setting forth Fair Market Rental for the Option Term, send to Landlord a notice stating that Tenant either elects to terminate its exercise of the Option, in which event the Option shall lapse and this Lease shall terminate on the Expiration Date, or that Tenant disagrees with Landlord's determination of Fair Market Rental for the Option Term and elects to resolve the disagreement as provided in Section 18.C below. If Tenant does not send Landlord a notice as provided in the previous sentence, Landlord's determination of Fair Market Rental shall be the Base Monthly Rent payable by Tenant during the Option Term. If Tenant elects to resolve the disagreement as provided in Section 18.C and such procedures are not concluded prior to the commencement date of the Option Term, Tenant shall pay to Landlord as Base Monthly Rent the Fair Market Rental as determined by Landlord in the manner provided above. If the Fair Market Rental as finally determined pursuant to Section 18.C is greater than Landlord's determination, Tenant shall pay Landlord the difference between the amount paid by Tenant and the Fair Market Rental as so determined in Section 18.C within thirty (30) days after such determination. If the Fair Market Rental as finally determined in Section 18.C is less than Landlord's determination, the difference between the amount paid by Tenant and the Fair Market Rental as so determined in Section 18.C shall be credited against the next installments of Base Monthly Rent due from Tenant to Landlord hereunder. C. Resolution of a Disagreement over the Fair Market Rental: Any disagreement regarding Fair Market Rental shall be resolved as follows: 1. Within thirty (30) days after Tenant's response to Landlord's notice setting forth the Fair Market Rental, Landlord and Tenant shall meet at a mutually agreeable time and place, in an attempt to resolve the disagreement. 2. If within the 30-day period referred to above, Landlord and Tenant cannot reach agreement as to Fair Market Rental, each party shall select one appraiser to determine Fair Market Rental. Each such appraiser shall arrive at a determination of Fair Market Rental and submit their conclusions to Landlord and Tenant within thirty (30) days after the expiration of the 30-day consultation period described above. 3. If only one appraisal is submitted within the requisite time period, it shall be deemed as Fair Market Rental. If both appraisals are submitted within such time period and the two appraisals so submitted differ by less than ten percent (10%), the average of the two shall be deemed as Fair Market Rental. If the two appraisals differ by more than 10%, the appraisers shall immediately select a third appraiser who shall, within thirty (30) days after his selection, make and submit to Landlord and Tenant a determination of Fair Market Rental. This third appraisal will then be averaged with the closer of the two previous appraisals and the result shall be Fair Market Rental. 4. All appraisers specified pursuant to this Section shall be members of the American Institute of Real Estate Appraisers with not less than ten (10) years experience appraising office and industrial properties in the Santa Clara Valley. Each party shall pay the cost of the appraiser selected by such party and one-half of the cost of the third appraiser. D. Personal to Tenant: All Options provided to Tenant in this Lease are personal and granted to ZiLOG, Inc. or a permitted transferee pursuant to Section 17.E above, and are not exercisable by any third party should Tenant assign or sublet all or a portion of its rights under this Lease, unless Landlord consents to permit exercise of any option by any assignee or subtenant, in Landlord's sole and absolute discretion. In the event Tenant has multiple options to extend this Lease, a later option to extend the Lease cannot be exercised unless the prior option has been properly exercised. 19. General Provisions: A. Attorney's Fees: In the event a suit or alternative form of dispute resolution is brought for the possession of the Premises, for the recovery of any sum due hereunder, to interpret the Lease, or because of the breach of any other covenant herein; then the losing party shall pay to the prevailing party reasonable attorney's fees including the expense of expert witnesses, depositions and court testimony as part of its costs which shall be deemed to have accrued on the commencement of such action. The prevailing party shall also be entitled to recover all costs and expenses including reasonable attorney's fees incurred in enforcing any judgment or award against the other party. The foregoing provision relating to post-judgment costs is severable from all other provisions of this Lease. B. Authority of Parties: Each party represents and warrants that it is duly formed and in good standing, and is duly authorized to execute and deliver this Lease on behalf of said partnership or corporation and that this Lease is legally valid and binding upon said corporation or partnership in accordance with its terms. At the request of either party, the other party shall provide the requesting party with corporate or partnership resolutions or other proof in a form acceptable to the requesting party, authorizing the execution of the Lease. C. Brokers: Tenant represents it has not utilized or contacted a real estate broker or finder with respect to this Lease other than Grubb & Ellis Company ("Broker"). Landlord and Tenant each represent and warrant to the other that neither it nor its officers or agents nor anyone acting on its behalf has dealt with any real estate representative other than Broker in the negotiating or making of this Lease, and each Party agrees to indemnify and hold harmless the other from any claim or claims, and costs and expenses, including attorneys' fees, incurred by the indemnified Party in conjunction with any such claim or claims of any other broker or brokers to a commission in connection with this Lease as a result of the actions of the indemnifying party(s). Landlord agrees to pay the commissions owing to the Broker pursuant to separate written agreement. D. Choice of Law: This Lease shall be governed by and construed in accordance with California law. Except as provided in Section 19.E, venue shall be Santa Clara County. E. Dispute Resolution: Landlord and Tenant and any other party that may become a party to this Lease or be deemed a party to this Lease including any subtenants agree that, except for any claim by Landlord for unlawful detainer or any claim within the jurisdiction of the small claims court (which small claims court shall be the sole court of competent jurisdiction), any controversy, dispute, or claim of whatever nature arising out of, in connection with or in relation to the interpretation, performance or breach of this Lease, including any claim based on contract, tort, or statute, shall be resolved at the request of any party to this agreement through a two-step dispute resolution process administered by J.A.M.S. or another judicial mediation service mutually acceptable to the parties located in Santa Clara County, California. The dispute resolution process shall involve first, mediation, followed, if necessary, by final and binding arbitration administered by and in accordance with the then existing rules and practices of J.A.M.S. or other judicial mediation service selected. In the event of any dispute subject to this provision, either party may initiate a request for mediation and the parties shall use reasonable efforts to promptly select a J.A.M.S. mediator and commence the mediation. In the event the parties are not able to agree on a mediator within thirty (30) days, J. A. M. S. or another judicial mediation service mutually acceptable to the parties shall appoint a mediator. The mediation shall be confidential and in accordance with California Evidence Code ss. 1119 et. seq. The mediation shall be held in Santa Clara County, California and in accordance with the existing rules and practice of J. A. M. S. (or other judicial and mediation service selected). The parties shall use reasonable efforts to conclude the mediation within sixty (60) days of the date of either party's request for mediation. The mediation shall be held prior to any arbitration or court action (other than a claim by Landlord for unlawful detainer or any claim within the jurisdiction of the small claims court which are not subject to this mediation/arbitration provision and may be filed directly with a court of competent jurisdiction). Should the prevailing party in any dispute subject to this Section 19.E attempt an arbitration or a court action before attempting to mediate, the prevailing party shall not be entitled to attorney's fees that might otherwise be available to them in a court action or arbitration and in addition thereto, the party who is determined by the arbitrator to have resisted mediation, shall be sanctioned by the arbitrator or judge. If a mediation is conducted but is unsuccessful, it shall be followed by final and binding arbitration administered by and in accordance with the then existing rules and practices of J.A.M.S. or the other judicial and mediation service selected, and judgment upon any award rendered by the arbitrator(s) may be entered by any state or federal court having jurisdiction thereof AS PROVIDED BY CALIFORNIA CODE OF CIVIL PROCEDURE SECTION 1280 ET. SEQ, AS SAID STATUTES THEN APPEAR, INCLUDING ANY AMENDMENTS TO SAID STATUTES OR SUCCESSORS TO SAID STATUTES OR AMENDED STATUTES, EXCEPT THAT in no event shall the parties be entitled to propound interrogatories or request for admissions during the arbitration process. The arbitrator shall be a retired judge or a licensed California attorney. The venue for any such arbitration or mediation shall be in Santa Clara County, California. NOTICE: BY INITIALING IN THE SPACE BELOW YOU ARE AGREEING TO HAVE ANY DISPUTE ARISING OUT OF THE MATTERS INCLUDED IN THE "MEDIATION AND ARBITRATION OF DISPUTES" PROVISION DECIDED BY NEUTRAL ARBITRATION AS PROVIDED BY CALIFORNIA LAW AND YOU ARE GIVING UP ANY RIGHTS YOU MIGHT POSSESS TO HAVE THE DISPUTE LITIGATED IN A COURT OR JURY TRIAL. BY INITIALING IN THE SPACE BELOW YOU ARE GIVING UP YOUR JUDICIAL RIGHTS TO DISCOVERY AND APPEAL, UNLESS THOSE RIGHTS ARE SPECIFICALLY INCLUDED IN THE "MEDIATION AND ARBITRATION OF DISPUTES" PROVISION. IF YOU REFUSE TO SUBMIT TO ARBITRATION AFTER AGREEING TO THIS PROVISION, YOU MAY BE COMPELLED TO ARBITRATE UNDER THE AUTHORITY OF THE CALIFORNIA CODE OF CIVIL PROCEDURE. YOUR AGREEMENT TO THIS ARBITRATION PROVISION IS VOLUNTARY. WE HAVE READ AND UNDERSTAND THE FOREGOING AND AGREE TO SUBMIT DISPUTES ARISING OUT OF THE MATTERS INCLUDED IN THE "MEDIATION AND ARBITRATION OF DISPUTES" PROVISION TO NEUTRAL ARBITRATION. LANDLORD: ______ TENANT: _______ F. Entire Agreement: This Lease and the exhibits attached hereto contain all of the agreements and conditions made between the Parties hereto and may not be modified orally or in any other manner other than by written agreement signed by all parties hereto or their respective successors in interest. This Lease supersedes and revokes all previous negotiations, letters of intent, lease proposals, brochures, agreements, representations, promises, warranties, and understandings, whether oral or in writing, between the parties or their respective representatives or any other person purporting to represent Landlord or Tenant. G. Entry by Landlord: Upon not less than twenty-four (24 hours prior notice to Tenant (except in the case of an emergency) and subject to Tenant's reasonable security regulations, Tenant shall permit Landlord and his agents to enter into and upon the Premises at all reasonable times, and without any rent abatement or reduction or any liability to Tenant for any loss of occupation or quiet enjoyment of the Premises thereby occasioned (except for actual damages resulting from the gross negligence or willful misconduct of Landlord or its agents), for the following purposes only: (i) inspecting and maintaining the Premises; (ii) making repairs, alterations or additions to the Premises; (iii) performing any obligations of Landlord under the Lease including remediation of Hazardous Materials if determined to be the responsibility of Landlord, (iv) posting and keeping posted thereon notices of non-responsibility for any construction, alteration or repair thereof, as required or permitted by any law, and (v) showing the Premises to Landlord's existing or potential successors, purchaser, and lenders (and their brokers). Provided that Tenant has not then exercised its Option, Tenant shall permit Landlord and his agents, at any time within twelve (12) months prior to the Expiration Date (or at any time during the Lease if Tenant is in default hereunder), to place upon the Premises "For Lease" signs and exhibit the Premises to real estate brokers and prospective tenants at reasonable hours, subject to the notification obligation of Landlord set forth above. H. Estoppel Certificates: At any time during the Lease Term, each party (the "Responding Party") shall, within twenty (20) days following written notice from the other party (the "Requesting Party"), execute and deliver to the Requesting Party a written statement certifying, if true, the following: (i) that this Lease is unmodified and in full force and effect (or, if modified, stating the nature of such modification); (ii) the date to which rent and other charges are paid in advance, if any; (iii) acknowledging that there are not, to Responding Party's knowledge, any uncured defaults on Requesting Party's part hereunder (or specifying such defaults if they are claimed); and (iv) such other information as Requesting Party may reasonably request. Any such statement may be conclusively relied upon by any prospective purchaser or encumbrancer of Requesting Party's interest in the Premises. The Responding Party's failure to deliver such statement within such time shall be conclusive upon the Responding Party that this Lease is in full force and effect without modification, except as may be represented by the Requesting Party, and that there are no uncured defaults in Requesting Party's performance. Tenant agrees to provide, within ten (10) days of Landlord's request, Tenant's most recent three (3) years of audited financial statements for Landlord's use in financing or sale of the Premises or Landlord's interest therein. Landlord agrees to keep such financial statements confidential. I. Exhibits: All exhibits referred to are attached to this Lease and incorporated by reference. J. Interest: All rent due hereunder, if not paid when due (beyond any applicable grace period), shall bear interest at the rate of the Reference Rate published by Bank of America, San Francisco Branch, plus two percent (2%) per annum from that date until paid in full ("Agreed Interest Rate"). This provision shall survive the expiration or sooner termination of the Lease. Despite any other provision of this Lease, the total liability for interest payments shall not exceed the limits, if any, imposed by the usury laws of the State of California. Any interest paid in excess of those limits shall be refunded to Tenant by application of the amount of excess interest paid against any sums outstanding in any order that Landlord requires. If the amount of excess interest paid exceeds the sums outstanding, the portion exceeding those sums shall be refunded in cash to Tenant by Landlord. To ascertain whether any interest payable exceeds the limits imposed, any non-principal payment (including late charges) shall be considered to the extent permitted by law to be an expense or a fee, premium, or penalty rather than interest. K. This section intentionally left blank. L. No Presumption Against Drafter: Landlord and Tenant understand, agree and acknowledge that this Lease has been freely negotiated by both Parties; and that in any controversy, dispute, or contest over the meaning, interpretation, validity, or enforceability of this Lease or any of its terms or conditions, there shall be no inference, presumption, or conclusion drawn whatsoever against either party by virtue of that party having drafted this Lease or any portion thereof. M. Notices: All notices, demands, requests, or consents required to be given under this Lease shall be sent in writing by U.S. certified mail, return receipt requested, or by personal delivery addressed to the party to be notified at the address specified in Section 1 of this Lease (with respect to Landlord), at the Premises (with respect to Tenant) or to such other place as the party to be notified may from time to time designate by at least fifteen (15) days prior notice to the notifying party. When this Lease requires service of a notice, that notice shall replace rather than supplement any equivalent or similar statutory notice, including any notices required by Code of Civil Procedure Section 1161 or any similar or successor statute. N. Property Management: In addition, Tenant agrees to pay Landlord along with the expenses to be reimbursed by Tenant a monthly fee for management services rendered by either Landlord or a third party manager engaged by Landlord (which may be a party affiliated with Landlord), in the amount of one and a half percent (1.5 %) of the Base Monthly Rent. O. Rent: All monetary sums due from Tenant to Landlord under this Lease, including, without limitation those referred to as "additional rent", shall be deemed as rent. P. Representations: Tenant acknowledges that neither Landlord nor any of its employees or agents have made any agreements, representations, warranties or promises with respect to the Premises or with respect to present or future rents, expenses, operations, tenancies or any other matter except as expressly set forth herein. Except as herein expressly set forth herein, Tenant relied on no statement of Landlord or its employees or agents for that purpose. Q. Rights and Remedies: Subject to Section 14 above, All rights and remedies hereunder are cumulative and not alternative to the extent permitted by law, and are in addition to all other rights and remedies in law and in equity. R. Severability: If any term or provision of this Lease is held unenforceable or invalid by a court of competent jurisdiction, the remainder of the Lease shall not be invalidated thereby but shall be enforceable in accordance with its terms, omitting the invalid or unenforceable term. S. Submission of Lease: Submission of this document for examination or signature by the parties does not constitute an option or offer to lease the Premises on the terms in this document or a reservation of the Premises in favor of Tenant. This document is not effective as a lease or otherwise until executed and delivered by both Landlord and Tenant. T. Subordination: This Lease is subject and subordinate to ground and underlying leases, mortgages and deeds of trust (collectively "Encumbrances") which may now affect the Premises, to any covenants, conditions or restrictions of record as of the Effective Date, and to all renewals, modifications, consolidations, replacements and extensions thereof (that do not have a material adverse effect upon Tenant); provided, however, if the holder or holders of any such Encumbrance ("Holder") require that this Lease be prior and superior thereto, within seven (7) days after written request of Landlord to Tenant, Tenant shall execute, have acknowledged and deliver all documents or instruments, in the form presented to Tenant, which Landlord or Holder deems necessary or desirable for such purposes. Landlord shall have the right to cause this Lease to be and become and remain subject and subordinate to any and all Encumbrances which are now or may hereafter be executed covering the Premises or any renewals, modifications, consolidations, replacements or extensions thereof, for the full amount of all advances made or to be made thereunder and without regard to the time or character of such advances, together with interest thereon and subject to all the terms and provisions thereof; provided only, that in the event of termination of any such lease or upon the foreclosure of any such mortgage or deed of trust, Holder agrees to recognize Tenant's rights under this Lease as long as Tenant is not then in default and continues to pay Base Monthly Rent and additional rent and observes and performs all required provisions of this Lease. Within ten (10) days after Landlord's written request, Tenant shall execute any documents reasonably required by Landlord or the Holder to make this Lease subordinate to any lien of the Encumbrance. If Tenant fails to do so, then it shall be deemed that this Lease is so subordinated to such Encumbrance. Notwithstanding anything to the contrary in this Section, Tenant hereby attorns and agrees to attorn to any entity purchasing or otherwise acquiring the Premises at any sale or other proceeding or pursuant to the exercise of any other rights, powers or remedies under such encumbrance. Landlord shall cause the existing lender for the Building to furnish to Tenant, within thirty (30) days of the date of both parties' execution of this Lease, with a written agreement, in form and substance reasonably acceptable to Tenant, providing for (i) recognition by the lender of all of the terms and conditions of this Lease; and (ii) continuation of this Lease upon foreclosure of existing lender's security interest in the Premises. In the event that Landlord is unable to provide such agreement, Tenant's sole remedy shall be termination of the Lease, which election shall be made within thirty (30) days following the expiration of such 30-day period. U. Survival of Indemnities: All indemnification, defense, and hold harmless obligations of Landlord and Tenant under this Lease shall survive the expiration or sooner termination of the Lease. V. Time: Time is of the essence hereunder. W. Transportation Demand Management Programs: Should a government agency or municipality require Landlord to institute TDM (Transportation Demand Management) facilities and/or programs, Tenant agrees that the cost of TDM imposed facilities and programs required on the Premises, including but not limited to employee showers, lockers, cafeteria, or lunchroom facilities, shall be paid by Tenant. Further, any ongoing costs or expenses associated with a TDM program which are required for the Premises and not provided by Tenant, such as an on-site TDM coordinator, shall be provided by Landlord with such costs being included as additional rent and reimbursed to Landlord by Tenant within thirty (30) days after demand. If TDM facilities and programs are instituted on a Project wide basis, Tenant shall pay its proportionate share of such costs in accordance with Section 8 above. X. Waiver of Right to Jury Trial: Landlord and Tenant waive their respective rights to trial by jury of any contract or tort claim, counterclaim, cross-complaint, or cause of action in any action, proceeding, or hearing brought by either party against the other on any matter arising out of or in any way connected with this Lease, the relationship of Landlord and Tenant, or Tenant's use or occupancy of the Premises, including any claim of injury or damage or the enforcement of any remedy under any current or future law, statute, regulation, code, or ordinance. Y. Consents: Except as expressly stated to the contrary in this Lease, wherever in this Lease the consent of either Party is required, such consent shall not be unreasonably withheld, conditioned or delayed. IN WITNESS WHEREOF, Landlord and Tenant have executed this Lease on the day and year first above written. Landlord: The Sobrato Group, Tenant: ZiLOG, Inc., a California Limited Partnership a Delaware Corporation By: _____________________________ By: ______________________________ Its: _____________________________ Its: ______________________________ Exhibit "A" - Premises & Building EXHIBIT "B" - Tenant's Signage (Attached) EXHIBIT "C" - Draft Letter of Credit (attached) EXHIBIT "D" - Initial Alterations (Attached) EXHIBIT "E" - Hypothecation Form LANDLORD'S CONSENT TO MORTGAGE To: [tenant name and address] ____________________________________ ________, CA 9____ Attention: _________________ Re: Lease by and between ________________, a California ___________________, and _____________________________, a ____________________, dated ________ __, ____, for the Premises located at _________________, ________, California (the "Lease") Landlord's Consent to Leasehold Mortgage ("Landlord's Consent") Ladies and Gentlemen: ________________, a California ___________________ ("Landlord"), is in receipt of the request by _____________________________, a ____________________ ("Tenant"), for Landlord's consent to the creation of a leasehold mortgage ("Mortgage") in favor of ___________________, a _____________________ ("Mortgagee"), on Tenant's interest under the above-referenced Lease. Landlord hereby consents to the granting by Tenant of a Mortgage on Tenant's interest in the Lease and the leasehold estate created by the Lease to Mortgagee. This Landlord's Consent is not, and should not be deemed or construed as, a consent to any other or further mortgaging, assignment or subletting. This Landlord's Consent shall not, and shall not be deemed or construed to, modify, waive, or alter any of the terms, provisions, covenants, or conditions of the Lease, waive any breach thereof or any of the rights of Landlord thereunder, or enlarge or increase Landlord's obligations under the Lease. In granting this Landlord's Consent, Landlord does not consent to or approve any term, provision, covenant or condition contained in the Mortgage and Landlord shall not be bound thereby. [signature block for landlord] EX-23.1 4 zilogexh231.txt Exhibit 23.1 Report on Schedule and Consent of KPMG LLP, Independent Auditors The Board of Directors ZiLOG, Inc. The audit referred to in our report dated March 29, 2002, included the related consolidated financial statement schedule as of December 31, 2000, and for the year ended December 31, 2001, as listed in the Index in Item 14(a)2. This financial statement schedule is the responsibility of the Company's management. Our responsibility is to express an opinion on this financial statement schedule based on our audit. In our opinion, such financial statement schedule, when considered in relation to the basic consolidation financial statements taken as a whole, presents fairly in all material respects, the information set forth therein. We consent to incorporation by reference in the registration statements (Nos. 333-81697, 333-33564 and 333-55522) on form S-8 of ZiLOG, Inc. of our report dated March 29, 2002, relating to the consolidated balance sheet of ZiLOG, Inc. as of December 31, 2001, and the related consolidated statement of operations, stockholders' deficit, and cash flows for the year then ended, and the related financial statement schedule which report appears in the December 31, 2001 Form 10k of ZiLOG, Inc. Our reports, dated March 29, 2002, contain an explanatory paragraph that states that the Company has suffered recurring losses from operations and has a net capital deficiency that raise substantial doubt about the Company's ability to continue as a going concern. In addition, the Company filed a voluntary petition for relief under Chapter 11 of the United States Bankruptcy Code in the United States Bankruptcy Court on February 28, 2002. Although the Company is currently operating their business as debtor-in-possession under the jurisdiction of the Bankruptcy Court, the continuation of their business as a going concern is contingent upon, among other things, the Company's ability to gain confirmation of their plan of reorganization by the Bankruptcy Court and ultimately to achieve profitable operations and positive cash flow. The accompanying consolidated financial statements do not include any adjustments that might result from the outcome of these uncertainties. Mountain View, California April 9, 2002 EX-23.2 5 zilogexh232.txt Exhibit 23.2 Consent of Ernst & Young LLP, Independent Auditors We consent to the incorporation by reference in the Registration Statement (Form S-8 No. 333-81697) pertaining to the 1998 Long Term Stock Incentive Plan and 1998 Executive Officer Incentive Plan, in the Registration Statement (Form S-8 No. 333-33564) pertaining to the 1998 Long Term Stock Incentive Plan, as amended, and 1998 Executive Officer Incentive Plan, as amended, and in the Registration Statement (Form S-8 No. 333-55522) pertaining to the 2000 Stock Incentive Plan of Zilog Inc., of our report dated January 26, 2001, with respect to the 2000 and 1999 consolidated financial statements and schedule of Zilog Inc. included in this Annual Report (Form 10-K) for the year ended December 31, 2001. /s/ Ernst & Young LLP San Jose, California April 9, 2002 -----END PRIVACY-ENHANCED MESSAGE-----