Voluntary delisting from Nasdaq

Effective March 26, 2004, we voluntarily delisted from Nasdaq and applied to begin trading on the pink sheets. Due to the structure of the transaction contemplated by the investment agreement, we were no longer in compliance with certain Nasdaq listing requirements. We felt that a voluntary delisting from Nasdaq and a move to the pink sheets would provide the best option to our shareholders by retaining liquidity in our common stock.

In January 2003, the Financial Accounting Standards Board ("FASB") issued FASB Interpretation No. 46, "Consolidation of Variable Interest Entities, an Interpretation of ARB No. 51." FIN 46 requires certain variable interest entities to be consolidated by the primary beneficiary of the entity if the equity investors in the entity do not have the characteristics of a controlling financial interest or do not have sufficient equity at risk for the entity to finance its activities without additional subordinated financial support from other parties. FIN 46 is effective immediately for all new variable interest entities created or acquired after January 31, 2003. For variable interest entities created or acquired prior to February 1, 2003, the FASB recently delayed the required implementation date such that the provisions of FIN 46 are required to be adopted no later than the end of the first reporting period that ends after March 15, 2004. The company believes that the adoption of this standard will have no material impact on its financial statements.

In April 2003, the FASB issued SFAS No. 149, "Amendment of Statement 133 on Derivative Instruments and Hedging Activities". SFAS 149 amends and clarifies accounting for derivative instruments and hedging activities under SFAS 133, "Accounting for Derivative Instruments and Hedging Activities". SFAS 149 provides guidance relating to decisions made (a) as part of the Derivatives Implementation Group process, (b) in connection with other FASB projects dealing with financial instruments and (c) regarding implementation issues raised in the application of the definition of a derivative and the characteristics of a derivative that contains financing components. SFAS 149 is effective for contracts entered into or modified and for hedging relationships designated after June 30, 2003. The adoption of SFAS 149 did not have a material impact on our financial condition or results of operations.

In May 2003, the FASB issued SFAS No. 150 "Accounting for Certain Financial Instruments with Characteristics of both Liabilities and Equity". SFAS 150 requires freestanding financial instruments such as mandatory redeemable shares, forward purchase contracts and written put options to be reported as liabilities by their issuers as well as related new disclosure requirements. The provisions of SFAS 150 are effective for instruments entered into or modified after May 31, 2003 and pre-existing instruments as of the beginning of the first interim period that commences after June 15, 2003. The adoption of SFAS 150 did not have a material impact on our financial condition or results of operations.

We have prepared our consolidated financial statements assuming we will continue as a going concern and meet our obligations as they become due. We incurred a net loss and negative cash flows from operations in 2002 and 2003 and expect to incur net losses through the third quarter of 2004. These factors together with our working capital position and our significant debt service and other contractual obligations at December 31, 2003, raise substantial doubt about our ability to continue as a going concern without restoring profitable operations, generating cash flow from operating activities and obtaining additional financing. These and other factors related to our business during recent years, including the restatement in 2000 of our financial statements for prior periods, operating losses in 1998, 1999, 2000, 2002 and 2003, our past failure to comply with covenants in our financing agreements and our voluntary delisting from Nasdaq in March 2004 may make it difficult for us to secure the required additional borrowings on favorable terms or at all. We intend to seek additional borrowings or alternative sources of financing, however, difficulties in borrowing money or raising financing could have a material adverse effect on our operations, planned capital expenditures, ability to comply with the terms of government grants and our ability to continue as a going concern.

If we do not obtain stockholder approval of a proposed amendment to increase the number of shares that we are authorized to issue under our charter, we may be unable to meet our obligations to issue shares of capital stock under the investment agreement and amounts due under the convertible notes will accelerate. The approval of our stockholders is required to amend our charter, and we intend to seek such approval at a special meeting of our stockholders. There can be no assurance, however, that our stockholders will approve such amendment. Without the proceeds from the convertible notes, the amount of capital available to us for general working capital purposes will be severely limited and we will not be able to fund our operations, service our existing debt obligations or continue as a going concern. In the likely event we are unable to secure an alternative financing plan, we will become insolvent and be required to file for bankruptcy protection. Furthermore, there can be no assurances that we will not be sued by the holders of our options, warrants or convertible notes if we do not have enough authorized shares of common stock to make the required issuances if they seek to exercise or convert those securities, as applicable.

As a result of the consummation of the financing transactions in December 2003 and February 2004 with Needham, its affiliates and Dolphin, our shareholders suffered material dilution. As our largest stockholder and the guarantor of our line of credit, and holder of our convertible notes, Needham could prevent us from seeking additional borrowings or alternative sources of financing that we require for future operations or otherwise control the company in ways that might have a material adverse effect on the company or our stock price.

As of December 31, 2003, we had total outstanding obligations under our credit agreements of $15.9 million. Our inability to make timely payments of interest or principal under these facilities could materially adversely affect our ability to borrow money under existing credit facilities, to secure additional borrowings or to function as a going concern. Our current credit facilities contain financial covenants that will require us to meet certain financial performance targets and operating covenants that limit our discretion with respect to business matters. Among other things, these covenants restrict our ability to borrow additional money, create liens or other encumbrances, and make certain payments including dividends and capital expenditures. Many of these loans contain provisions that permit the lender to declare the loans immediately due if there is a material adverse change in our business. These credit facilities also contain events of default that could require us to pay off indebtedness before its maturity. In addition, our convertible notes issued to Needham and affiliates and Dolphin provide that they will accelerate to become due in 45 days if we fail to obtain approval of our stockholders to amend our charter to increase the number of shares that we are authorized to issue. At December 31, 2003 we were not in compliance with the minimum tangible net worth covenant and current ratio covenant set forth in the credit agreements in our factoring line of credit facility and subsequently were in default. The restrictions imposed by these credit facilities or the failure of lenders to advance funds under these facilities could force us to curtail our operations or have a material adverse effect on our liquidity.

Our equipment is custom designed for a special purpose. In addition, a large portion of our accounts receivable are from foreign sales, which are often more difficult to collect than domestic accounts receivable. As a result of the nature of our equipment and accounts receivable, lenders will generally allow us to borrow less against these items as collateral than they would for other types of equipment or domestic accounts receivable, or require us to provide additional credit enhancements.

In connection with our current borrowing facilities and financing arrangements, we have granted security interests in and liens on substantially all of our assets, including our production machines and our Dresden facility, to secure the loans. If our senior lenders were to repossess one or more of those machines, our ability to produce product would be materially impaired. Our revenues, gross margins and operating efficiency would also be materially adversely affected. At December 3, 2003, we were not in compliance with the minimum tangible net worth covenant and current ratio covenant set forth in the credit agreements in our factoring line of credit facility governing our factoring line of credit facility. Our obligations under our secured credit facilities contain cross-default and cross-acceleration provisions and provisions that allow the lenders to declare the loans immediately due if there is a material adverse change in our business. If we default under the credit facilities or financing arrangements the lenders could declare all of the funds borrowed there under, together with all accrued interest, immediately due and payable. If we are unable to repay such indebtedness, the lenders could foreclose on the pledged assets. If the lenders foreclose on our assets, we would be forced to significantly curtail or even cease our operations.

Our quarterly revenue and operating results have varied significantly in the past and will likely vary significantly in the future. Our revenue and operating results may fall below the expectations of securities analysts or investors in future periods. Our failure to meet these expectations would likely adversely affect the market price of our common stock.

Our quarterly revenue and operating results may vary depending on a number of factors, including:

• fluctuating customer demand, which is influenced by a number of factors, including market acceptance of our products and the products of our customers and end-users, changes in product mix, and the timing, cancellation or delay of customer orders and shipments;

• the timing of shipments of our products by us and by independent subcontractors to our customers;

• manufacturing and operational difficulties that may arise due to, among other things, quality control, capacity utilization of our production machines, unscheduled equipment maintenance, and the hiring and training of additional staff;

• our ability to introduce new products on a timely basis; and

• competition, including the introduction or announcement of new products by competitors, the adoption of competitive technologies by our customers, the addition of new production capacity by competitors and competitive pressures on prices of our products and those of our customers.

In 2003, approximately 34% of our revenues were denominated in euros, primarily related to sales from our Dresden operation, including sales to one of our largest customers, a European automotive glass manufacturer. In addition, other customers may request to make payments in foreign currencies. Also, certain transactions with foreign suppliers are denominated in foreign currencies, primarily Japanese Yen.

A strengthening in the dollar relative to the currencies of those countries in which we do business would increase the prices of our products as stated in those currencies and could hurt our sales in those countries. Significant fluctuations in the exchange rates between the U.S. dollar and foreign currencies could cause us to lower our prices and thus reduce our profitability and cash flows. These fluctuations could also cause prospective customers to cancel or delay orders because of the increased relative cost of our products.

As a result of our financial performance and voluntary delisting from Nasdaq, our suppliers and creditors may impose more onerous payment terms on us, which may have a material adverse effect on our financial performance and our liquidity. For example, one of our subcontractors has required us to provide it with a security interest in all of our inventory held by it and has limited the amount of unpaid orders we may have outstanding with it at any time.

Our ten largest customers accounted for approximately 85%, 84% and 84% of net sales in 2001, 2002 and 2003, respectively. We have contracts extending past 2004 with only two of these customers. We expect to continue to derive a significant portion of our net sales from this relatively small number of customers. Accordingly, the loss of a large customer could materially hurt our business, and the deferral or loss of anticipated orders from a large customer or a small number of customers could materially reduce our revenue and operating results in any period. Some of our largest automotive glass customers have used a technology-direct-to-glass sputtering-as an alternative to our window films, which in 2002 and 2003 resulted in a decrease in orders from these customers. The continued or expanded use of this technology by our automotive glass customers would have a material adverse effect on our results of operations and financial position.

Our future success depends upon our ability to introduce new products, improve existing products and processes to keep pace with technological and market developments, and to address the increasingly sophisticated and demanding needs of our customers, especially in the electronic display and automotive markets. Technological changes, process improvements, or operating improvements that could adversely affect us include:

• the development of competing technologies to our anti-reflective and silver reflector films for liquid crystal displays in the flat panel display industry;

• changes in the way coatings are applied to alternative substrates such as tri-acetate cellulose, or TAC;

• the development of new technologies that improve the manufacturing efficiency of our competitors;

• the development of new materials that improve the performance of products that could compete with our products; and

• improvements in the alternatives to the sputtering technology we use to produce our products, such as plasma enhanced chemical vapor deposition, or PECVD.

Our research and development efforts may not be successful in developing products in the time, or with the characteristics, necessary to meet customer needs. If we do not adapt to technological changes, or process or operating improvements, our competitive position, operations and prospects would be materially adversely affected.

A potential part of our continuing business strategy is to consider acquiring companies, products, and technologies that complement our current products, enhance our market coverage, technical capabilities or production capacity, or offer other growth opportunities. Our ability to successfully complete acquisitions requires that we identify suitable target companies, agree on acceptable terms, and obtain acquisition financing on acceptable terms. In connection with these acquisitions, we could incur debt, amortization expenses relating to identified intangibles, impairment charges relating to goodwill, or merger related charges, or could issue stock that would dilute our current shareholders' percentage of ownership. The success of any acquisitions will depend upon our ability to integrate acquired operations, retain and motivate acquired personnel, and increase the customer base of the combined businesses. We cannot assure you that we will be able to accomplish all of these goals. Any future acquisitions would involve certain additional risks, including:

• difficulty integrating the purchased operations, technologies, or products;

• unanticipated costs, which would reduce our profitability;

• diversion of management's attention from our core business;

• potential entrance into markets in which we have limited or no prior experience; and

• potential loss of key employees, particularly those of the acquired business.

Our long-term competitive position will depend to a significant extent on our manufacturing capacity. The failure to have sufficient capacity, to fully utilize capacity when needed or to successfully integrate and manage additional capacity in the future could adversely affect our relationships with customers and cause customers to buy similar products from our competitors if we are unable to meet their needs. For example, we believe that we lost substantial potential architectural products sales in 2001 because we did not have the capacity to manufacture the required amounts of products. Also, our failure to produce required amounts of products under some of our contracts will result in price reductions on future sales under such contracts or penalties under which we would be required to reimburse the customer for the full cost of any product not delivered in a timely manner, either of which would reduce our gross margins.

We sell a substantial portion of our products to a relatively small number of original equipment manufacturers, or OEMs. The timing and amount of sales to these customers ultimately depend on sales levels and shipping schedules for the OEM products into which our products are incorporated. We have no control over the volume of products shipped by our OEM customers or shipping dates, and we cannot be certain that our OEM customers will continue to ship products that incorporate our products at current levels or at all. We currently have long-term contracts with only three of our OEM customers. Failure of our OEM customers to achieve significant sales of products incorporating our products and fluctuations in the timing and volume of such sales could be harmful to our business. Failure of these customers to inform us of changes in their production needs in a timely manner could also hinder our ability to effectively manage our business.

We rely on our OEM customers to inform us of opportunities to develop new products that serve end-user demands. If our OEM customers do not present us with market opportunities early enough for us to develop products to meet end-user needs in a timely fashion, or if the OEMs fail to anticipate end-user needs at all, we may fail to develop new products or modify our existing products for the end-user markets for our products. In addition, if our OEM customers fail to accurately anticipate end- user demands, we may spend resources on products that are not commercially successful.

We primarily use one independent distributor to sell our after-market products. We have a distribution agreement with Globamatrix Holdings Pte. Ltd., or Globamatrix, under which we granted an exclusive worldwide license to distribute our after-market applied film in the automotive and architectural glass markets. Failure of Globamatrix to achieve significant sales of products incorporating our products and fluctuations in the timing and volume of such sales could be harmful to our business. We believe that the success of our after-market products will continue to depend upon this distributor.

The market for each of our products is intensely competitive and we expect competition to increase in the future. Competitors vary in size and in the scope and breadth of the products they offer. We compete both with companies using technology similar to ours and companies using other technologies or developing improved technologies. Direct-to-glass sputtering represents the principal alternative technology to our sputter-coated film products. Direct-to-glass is a mature, well-known process for applying thin film coatings directly to glass, which is used by some of our current and potential customers to produce products that compete with our products. This technology is commonly used to manufacture products that conserve energy in buildings and automobiles. Many of our current and potential competitors have significantly greater financial, technical, marketing and other resources than we have. In addition, many of our competitors have well-established relationships with our current and potential customers and have extensive knowledge of our industry.

Our newest production machine (PM 10) is at our Dresden manufacturing facility and began commercial production in the first quarter of 2003. During the processes of bringing PM 10 up to commercial production levels, we experienced decreased manufacturing yields and higher costs, which lowered our gross margins.

We manufacture all of our products using materials procured from third-party suppliers. We do not have long-term contracts with our third-party suppliers. Certain of the materials we require are obtained from a limited number of sources. Delays or reductions in product shipments could damage our relationships with customers. Further, a significant increase in the price of one or more of the materials used in our products could have a material adverse effect on our cost of goods sold and operating results.

We rely on third-party subcontractors to add properties, such as adhesives, to some of our products. There are only a limited number of qualified subcontractors that can provide some of the services we require, and we do not have long-term contracts with any of those subcontractors. Qualifying alternative subcontractors could take a great deal of time or cause us to change product designs. The loss of a subcontractor could adversely affect our ability to meet our scheduled product deliveries to customers, which could damage our relationships with customers. If our subcontractors do not produce a quality product, our yield will decrease and our margins will be lower. Further, a significant increase in the price charged by one or more of our subcontractors could force us to raise prices on our products or lower our margins, which could have a material adverse effect on our operating results.

Our production machines are large, complex and difficult to manufacture. It can take up to a year from the time we order a machine until it is delivered. Following delivery, it can take us, with the assistance of the manufacturer, up to six additional months to test and prepare the machine for commercial production. There are a very limited number of companies that are capable of manufacturing these machines. Our inability in the future to have new production machines manufactured and prepared for commercial production in a timely manner would prevent us from delivering product on a timely basis and limit our capacity for revenue growth.

Our business depends in part on sales by manufacturers of products that include electronic displays. The markets for electronic display products are highly cyclical and have experienced periods of oversupply resulting in significantly reduced demand for our products. For example, due to the deteriorating economic environment, sales by flat cathode ray tube manufacturers decreased in 2002 and further in 2003, contributing to our electronic display product revenues declining by 11% 2002, and another 3% for 2003. Mitsubishi Electric is the only CRT manufacturer that buys our anti- reflective, or "AR", film and it has decided to consolidate all of the manufacturing of this product to Japan. In connection with that consolidation, Mitsubishi ceased production of the 17" AR product in its Mexico plant during the third quarter of 2003. We expect to continue to produce AR product in the 22" and 19" sizes for Mitsubishi Electric. We expect a further reduction in revenues of the AR product in succeeding years. If the flat display and other electronic display markets in which we sell our products do not recover or experience further slowdowns in the future, it could cause revenues from our electronic display products to decrease further.

We manufacture our products based on specific, technical requirements of each of our customers. We believe that future orders of our products will depend in part on our ability to maintain the performance, reliability and quality standards required by our customers. If our products have performance, reliability or quality problems, then we may experience:

• delays in collecting accounts receivable;

• higher manufacturing costs;

• additional warranty and service expenses; and

• reduced or cancelled orders.

For example, in 1998, our operating results were materially adversely affected by quality problems associated with the electronic display film produced by us for one of our largest customers.

We require the services of a substantial number of qualified technical personnel. Intense competition and aggressive recruiting, as well as a high-level of employee mobility characterize the market for skilled technical personnel. These characteristics make it particularly difficult for us to attract and retain the qualified technical personnel we require. We have experienced, and we expect to continue to experience, difficulty in hiring and retaining highly skilled employees with appropriate technical qualifications. It is especially difficult for us to recruit qualified personnel to move to the location of our Palo Alto, California offices because of the high-cost of living. If we are unable to recruit and retain a sufficient number of qualified technical employees, we may not be able to complete the development of, or enhance, our products in a timely manner. As a result, our business may be harmed and our operating results may suffer.

In addition to our dependence on our technical personnel, our success also depends on our continuing ability to attract and retain other highly skilled employees. We depend on the continued services of our senior management, particularly Thomas G. Hood, our President and Chief Executive Officer. We do not have employment contracts with any of our officers or key person life insurance covering any officer or employee. Our officers have technical and industry knowledge that cannot easily be replaced. Competition for similar personnel in our industry where we operate is intense. We have experienced, and we expect to continue to experience, difficulty in hiring and retaining highly skilled employees with appropriate qualifications. If we do not succeed in attracting or retaining the necessary personnel, our business could be adversely affected.

Our success depends in large part upon our proprietary technology. We rely on our know-how, as well as a combination of patent, trademark and trade secret protection, to establish and protect our intellectual property rights. Despite our efforts to protect our proprietary rights, unauthorized parties may attempt to copy aspects of our products or to obtain and use information that we regard as proprietary. Policing unauthorized use of our products is difficult. Our means of protecting our proprietary rights may not be adequate. In addition, the laws of some foreign countries do not protect our proprietary rights to as great an extent as do the laws of the United States. In the next three years, one of our U.S. patents relating to our architectural products will expire. Expiration of these patents or our failure to adequately protect our proprietary rights may allow third parties to duplicate our products or develop functionally equivalent or superior technology. In addition, our competitors may independently develop similar technology or design around our proprietary intellectual property.

International revenues amounted to approximately 87%, 85%, and 89% of our net revenues during 2001, 2002 and 2003, respectively. The distance between the two locations of our manufacturing creates logistical and communications challenges. In addition, to achieve acceptance in international markets, our products must be modified to handle a variety of factors specific to each international market as well as local regulations. We may also be subject to a number of other risks associated with international business activities. These risks include:

• unexpected changes in and the burdens and costs of compliance with a variety of foreign laws and regulatory requirements;

• potentially adverse tax consequences; and

• global economic turbulence and political instability.

We use hazardous chemicals in producing our products and have air and water emissions that require controls. As a result, we are subject to a variety of local, state and federal governmental regulations relating to the storage, discharge, handling, emission, generation, manufacture and disposal of toxic or other hazardous substances used to manufacture our products, compliance with which is expensive. Our failure to comply with current or future regulations could result in the imposition of substantial fines on us, suspension of production, alteration of our manufacturing processes, increased costs or cessation of operations.

We use independent sales representatives to promote our Heat Mirror products to architects in the United States. If some or all of our sales representatives experience financial difficulties, or otherwise become unable or unwilling to promote our products, our business could be harmed. These sales representatives could reduce or discontinue promotion of our products. They may not devote the resources necessary to provide effective marketing support to us. In addition, we depend upon the continued viability and financial resources of these representatives, many of which are small organizations with limited working capital. These representatives, in turn, depend substantially on general economic conditions and other factors affecting the markets for the products they promote. We believe that our success in this market will continue to depend upon these sales representatives.

In the ordinary course of business, we have periodically become engaged in litigation principally as a result of disputes with customers of our architectural products. We have settled some of these suits and others are pending. We may become engaged in similar or other lawsuits in the future. Some of our products that have been the basis for lawsuits against us could be the basis for future lawsuits. An adverse outcome in the defense of a warranty or other claim could subject us to significant liabilities to third parties. Any litigation, regardless of the outcome, could be costly and require significant time and attention of key members of our management and technical personnel.

Several of our insurance carriers have reserved their rights to seek indemnification from us for substantial amounts paid to plaintiffs by the insurance carriers as part of settlements of litigation relating to our architectural products. Our insurance carriers in a case in which the plaintiff alleged we were responsible for defects in window products manufactured by others have advised us that they intend to seek reimbursement for settlement and defense costs. Any claims, with or without merit, could require significant time and attention of key members of our management and result in costly litigation.

Financing risk: Our exposure to market rate risk for changes in interest rates relates primarily to our term loans, specifically our factoring line of credit which bears an interest rate equal to 7% above the bank Base Rate (which was 4.25% at December 31, 2003) and is calculated based on the average daily balance of the accounts receivable against which we have borrowed, and our line of credit facility with our senior lender which bears an interest rate equal to 2.5% above the bank Prime Rate (which was 4.25% at December 31, 2003) and is calculated based on the average daily balance of the amounts we have borrowed. In addition, the interest rate on one of our German loans will be reset to the prevailing market rate in 2004 and another of our German loans will have its interest rate reset to the prevailing market rate in 2009. Fluctuations or changes in interest rates may adversely affect our expected interest expense. The effect of a 10% fluctuation in the interest rate on our factoring line of credit and our other line of credit would have had an effect of less than $11,000 on our interest expense for 2003.

Investment risk We invest our excess cash in money market accounts and, by practice, limit the amount of exposure to any one institution. Investments in both fixed rate and floating rate interest earning instruments carry a degree of interest rate risk. Fixed rate securities may have their fair market value adversely affected due to a rise in interest rates, while floating rate securities may produce less income than expected if interest rates fall. The effect of a 10% fluctuation in the interest rate of any floating rate securities would have had an adverse effect of less than $54,000 for 2003.

Foreign currency risk International revenues (defined as sales to customers located outside of the United States) accounted for approximately 89% of our total sales in 2003. Of this amount, approximately 39% was denominated in euros relating to sales from our Dresden operation. The other 61% of our international sales were denominated in US dollars. In addition, certain transactions with foreign suppliers are denominated in foreign currencies (principally Japanese Yen). The effect of a 10% fluctuation in the euro exchange rate would have had an effect of $1.8 million on net revenues for the year ended December 31, 2003 and the effect on expenses of a 10% fluctuation in the Yen exchange rate would have been approximately $0.8 million for 2003.

To the Board of Directors and Stockholders of
Southwall Technologies Inc.

In our opinion, the consolidated financial statements listed in the accompanying index under Item 15(a)(1) on page __ present fairly, in all material respects, the financial position of Southwall Technologies Inc. and its subsidiaries at December 31, 2003 and 2002, and the results of their operations and their cash flows for each of the three years in the period ended December 31, 2003, in conformity with accounting principles generally accepted in the United States of America. In addition, in our opinion, the financial statement schedules listed in the index appearing under Item 15(a)(2) on page __ present fairly, in all material respects, the information set forth therein when read in conjunction with the related consolidated financial statements. These financial statements and financial statement schedules are the responsibility of the Company's management; our responsibility is to express an opinion on these financial statements and financial statement schedules based on our audits. We conducted our audits of these statements in accordance with auditing standards generally accepted in the United States of America, which 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, assessing the accounting principles used and significant estimates made by management, and evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion.

The accompanying consolidated financial statements have been prepared assuming that the Company will continue as a going concern. The Company incurred a net loss and negative cash flows from operating activities in 2003 and has significant debt service and other contractual obligations at December 31, 2003. These factors raise substantial doubt about its ability to continue as a going concern. Management's plans are outlined in Note 2. The consolidated financial statements do not include any adjustments that may result from the ultimate resolution of this matter.

PricewaterhouseCoopers LLP

San Jose, California
April 13, 2004

SOUTHWALL TECHNOLOGIES INC.
CONSOLIDATED BALANCE SHEETS
(dollars and shares in thousands, except per share data)

                                                                        December 31,
                                                                    --------------------
                                                                      2002       2003
                                                                    ---------  ---------
                              ASSETS
Current Assets:
  Cash and cash equivalents....................................... $   1,998  $   1,152
  Restricted cash.................................................       631        739
  Accounts receivable, net of allowance for bad debts of
      $552 and $778 in 2002 and 2003, respectively................     8,995      7,096
  Inventories, net................................................     8,537      6,830
  Other current assets............................................     4,310      2,617
                                                                    ---------  ---------
          Total current assets....................................    24,471     18,434
Property, plant and equipment, net................................    50,251     21,787
Restricted loan proceeds..........................................       885      1,066
Other assets......................................................       975        434
                                                                    ---------  ---------
          Total assets............................................ $  76,582  $  41,721
                                                                    =========  =========
               LIABILITIES AND STOCKHOLDERS' EQUITY
Current Liabilities:
  Current portion of term debt and capital leases................. $   7,499  $   2,042
  Line of credit..................................................        --      6,844
  Accounts payable................................................     9,244      6,315
  Accrued compensation............................................     1,254      1,392
  Other accrued liabilities.......................................     5,886      6,051
                                                                    ---------  ---------
          Total current liabilities...............................    23,883     22,644
Term debt and capital leases......................................     9,253     13,658
Government grants advanced........................................       604        614
Other.............................................................     2,368      3,084
                                                                    ---------  ---------
          Total liabilities.......................................    36,108     40,000
                                                                    ---------  ---------
Commitments and contingencies (Note 10)
Stockholders' Equity:
  Common stock, $0.001 par value; 20,000 shares authorized and
     outstanding: 12,527 and 12,548 at 2002 and 2003, respectively        12         13
  Capital in excess of par value..................................    69,657     70,861
  Notes receivable................................................      (126)        --
  Accumulated other comprehensive income
    Translation gain on subsidiary................................     1,032      3,240
  Accumulated deficit.............................................   (30,101)   (72,393)
                                                                    ---------  ---------
          Total stockholders' equity .............................    40,474      1,721
                                                                    ---------  ---------
          Total liabilities and stockholders' equity ............. $  76,582  $  41,721
                                                                    =========  =========

The accompanying notes are an integral part of these consolidated financial statements.

SOUTHWALL TECHNOLOGIES INC.
CONSOLIDATED STATEMENTS OF OPERATIONS
(dollars and shares in thousands, except per share data)

                                                                         Years Ended December 31,
                                                                   ----------------------------------
                                                                      2001        2002        2003
                                                                   ----------  ----------  ----------

Net revenues..................................................... $   82,976  $   68,759  $   53,326

Cost of sales....................................................     60,148      49,614      45,914
                                                                   ----------  ----------  ----------
Gross profit (loss)..............................................     22,828      19,145       7,412
                                                                   ----------  ----------  ----------
Operating expenses:
  Research and development.......................................      5,456       7,685       6,714
  Selling, general and administrative............................     11,036      12,450      12,348
  Restructuring expenses.........................................         --       2,624         (65)
  Impairment charge for long-lived assets........................         --          --      27,990
                                                                   ----------  ----------  ----------
          Total operating expenses...............................     16,492      22,759      46,987
                                                                   ----------  ----------  ----------
Income (loss) from operations....................................      6,336      (3,614)    (39,575)
  Interest expense...............................................     (2,872)     (1,734)     (1,590)
  Costs of warrants issued.......................................         --          --        (865)
  Other income, net..............................................      1,385       1,070         419
                                                                   ----------  ----------  ----------
Income (loss) before provision for (benefit from) income taxes...      4,849      (4,278)    (41,611)
Provision for (benefit from) incomes taxes.......................        214         (87)        681
                                                                   ----------  ----------  ----------
Net income (loss)................................................ $    4,635  $   (4,191) $  (42,292)
                                                                   ==========  ==========  ==========

Net income (loss) per share:
Basic............................................................ $     0.58  $    (0.40) $    (3.37)
Diluted.......................................................... $     0.57  $    (0.40) $    (3.37)

Weighted average shares of common stock and dilutive
  potential common stock:
Shares used in computation, basic and diluted....................      8,032      10,418      12,537
Shares used in computation, basic and diluted....................      8,186      10,418      12,537

The accompanying notes are an integral part of these consolidated financial statements.

SOUTHWALL TECHNOLOGIES INC.
CONSOLIDATED STATEMENTS OF STOCKHOLDERS' EQUITY
(dollars and shares in thousands, except share data)

                                                                                                      Accumulated
                                                                                                        Other                    Total
                                                                                                       Compre-                   Stock-      Compre-
                                                 Common Stock      Capital in                          hensive                  holders'     hensive
                                              -------------------  Excess of   Treasury     Notes       Income    Accumulated    Equity       Income
                                                Shares     Amount  Par Value     Stock    Receivable    (Loss)     Deficit    (Deficiency)    (Loss)
                                              -----------  ------  ----------  ---------  ----------  ----------  ----------  ------------  ----------
Balances, January 1, 2001....................      7,889  $    8  $   51,764  $    (839) $      (99)       (151) $  (30,545) $     20,138  $   (6,291)
Exercise of stock options....................         22      --        (107)       644          --          --          --           537          --
Sale of stock, net...........................        422      --         970         --          --          --          --           970          --
Sales to employees under
  stock purchase plan........................         --      --        (107)       192          --          --          --            85          --
Issuance of stock for bonuses................         --      --          (1)         3          --          --          --             2          --
Accelerated vesting on exercise
  of stock option............................         --      --          94         --          --          --          --            94          --
Repayments of notes receivable...............         --      --          --         --          11          --          --            11          --
Translation loss on foreign subsidiary.......         --      --          --         --          --         (21)         --           (21)        (21)
Net income...................................         --      --          --         --          --          --       4,635         4,635       4,635
                                              -----------  ------  ----------  ---------  ----------  ----------  ----------  ------------  ----------
Balances, December 31, 2001..................      8,333       8      52,613         --         (88)       (172)    (25,910)       26,451       4,614
Exercise of stock options....................        328      --       1,642         --          --          --          --         1,642          --
Net proceeds from follow-on
  public offering............................      3,807       4      15,129         --          --          --          --        15,133          --
Sales to employee under
  stock purchase plan........................         59      --         231         --          --          --          --           231          --
Stock-based compensation.....................         --      --          42         --          --          --          --            42          --
Issuance of notes receivable.................         --      --          --         --         (14)         --          --           (14)         --
Interest accrued on notes receivable.........         --      --          --         --         (24)         --          --           (24)         --
Translation loss on foreign subsidiary.......         --      --          --         --          --       1,204          --         1,204       1,204
Net loss.....................................         --      --          --         --          --          --      (4,191)       (4,191)     (4,191)
                                              -----------  ------  ----------  ---------  ----------  ----------  ----------  ------------  ----------
Balances, December 31, 2002..................     12,527      12      69,657         --        (126)      1,032     (30,101)       40,474      (2,987)
Sales to employee under
  stock purchase plan........................         21       1          21         --          --          --          --            22          --
Issuance of warrants to investors............                            865                                                          865
Issuance of warrants to creditors............                            201                                                          201
Issuance of shares to directors..............                             83                                                           83
Accelerated vesting on exercise                                                                                                        --
  of stock option............................         --      --          34         --          --          --          --            34          --
Forgiveness of notes receivable..............         --      --          --         --         126          --          --           126          --
Translation loss on foreign subsidiary.......         --      --          --         --          --       2,208          --         2,208       2,208
Net loss.....................................         --      --          --         --          --          --     (42,292)      (42,292)    (42,292)
                                              -----------  ------  ----------  ---------  ----------  ----------  ----------  ------------  ----------
Balances, December 31, 2003..................     12,548  $   13  $   70,861  $      --  $       --       3,240  $  (72,393) $      1,721  $  (40,084)
                                              ===========  ======  ==========  =========  ==========  ==========  ==========  ============  ==========

The accompanying notes are an integral part of these consolidated financial statements.

SOUTHWALL TECHNOLOGIES INC.
CONSOLIDATED STATEMENTS OF CASH FLOWS
(in thousands)

                                                                                   Years Ended December 31,
                                                                             -------------------------------
                                                                               2001       2002       2003
                                                                             ---------  ---------  ---------
Cash flows provided by or (used in) operating activities:
  Net income (loss)........................................................ $   4,635  $  (4,191) $ (42,292)
  Adjustments to reconcile net income (loss) to net cash provided by or
    (used in) operating activities:
    Impairment charge for long-lived assets................................        --         --     27,990
    Depreciation and amortization..........................................     5,982      6,053      6,071
    Loss on disposal of capital equipment..................................        --         --        133
    Stock-based compensation charge........................................        --         42        117
    Amortization of debt issuance costs....................................        --         --         28
    Warrants issued to investors and creditors.............................        --         --        865
    Interest on notes receivable...........................................        --        (24)        --
    Officer loan forgiveness...............................................        --         --        126
    Changes in operating assets and liabilities:
      Accounts receivable..................................................     4,297       (547)     1,899
      Inventories..........................................................     4,023     (2,385)     1,707
      Other current and non-current assets.................................      (610)      (560)     2,171
      Accounts payable and accrued liabilities.............................    (4,535)    (1,212)    (1,884)
                                                                             ---------  ---------  ---------
        Net cash provided by (used in) operating activities................    13,792     (2,824)    (3,069)
                                                                             ---------  ---------  ---------
Cash flows used in investing activities:
  Restricted cash..........................................................       247      1,071        (77)
  Expenditures for property, plant  and equipment and other assets.........    (5,945)    (7,085)    (2,500)
                                                                             ---------  ---------  ---------
        Net cash used in investing activities..............................    (5,698)    (6,014)    (2,577)
                                                                             ---------  ---------  ---------
Cash flows provided by (used in)financing activities:
  Proceeds from borrowings.................................................     1,710         --         88
  Principal payments on borrowings.........................................    (4,311)    (7,383)    (3,132)
  Borrowings (repayments) on line of credit................................    (5,745)    (2,974)     6,844
  Proceeds from investment allowances......................................     2,050      1,044      1,495
  Proceeds from sale of stock in follow-on offering,net....................       970     15,128         --
  Proceeds from stock options and employee stock purchase plan exercises...       706      1,879         22
  Repayment of stockholders' note receivable...............................        11         --         --
  Issuance of note receivable..............................................       (19)       (15)        --
                                                                             ---------  ---------  ---------
        Net cash provided by  (used in) financing activities...............    (4,628)     7,679      5,317
                                                                             ---------  ---------  ---------
Effect of foreign exchange rate changes on cash............................      (165)      (205)      (517)
                                                                             ---------  ---------  ---------
Net increase (decrease) in cash and cash equivalents.......................     3,301     (1,364)      (846)
Cash and cash equivalents, beginning of year...............................        61      3,362      1,998
                                                                             ---------  ---------  ---------
Cash and cash equivalents, end of year..................................... $   3,362  $   1,998  $   1,152
                                                                             =========  =========  =========
Supplemental cash flow disclosures:
  Interest paid............................................................ $   2,971  $   1,401  $   1,153
                                                                             =========  =========  =========
  Income taxes paid........................................................ $     111  $      86  $     211
                                                                             =========  =========  =========

Supplemental schedule of non-cash investing and financing activities:
  Exercise stock options with issuance of stockholders note receivable..... $      19  $      14  $      --
                                                                             =========  =========  =========
  Offset deposit to reduce sales and leaseback commitments................. $   1,000  $      --  $      --
                                                                             =========  =========  =========
  Warrants issued to creditors and investors............................... $      --  $      --  $   1,066
                                                                             =========  =========  =========

The accompanying notes are an integral part of these consolidated financial statements.

Southwall Technologies Inc. is a global developer, manufacturer and marketer of thin film coatings for the automotive glass, electronic display and architectural markets. The Company has developed a variety of products that control sunlight in automotive glass, reduce light reflection and improve image quality in electronic display products and conserve energy in architectural products. The Company's products consist of transparent solar-control films for automotive glass, anti-reflective films for computer screens, including flat panel and plasma displays, transparent conductive films for use in touch screen and liquid crystal displays, energy control films for architectural glass, and various other coatings.

The consolidated financial statements include the accounts of Southwall and its wholly-owned subsidiaries. All inter-company balances and transactions have been eliminated in consolidation.

The Company's German subsidiary used the EURO as its functional currency. Accordingly, the financial statements of this subsidiary are translated into U.S. dollars in accordance with Statement of Financial Accounting Standards ("SFAS") No. 52, "Foreign Currency Translation." Assets and liabilities are translated at exchange rates in effect at the balance sheet date and revenue and expense accounts at average exchange rates during the quarter. Exchange gains or losses from the translation of assets and liabilities are included in the cumulative translation adjustment component of accumulated other comprehensive income (loss). Gains and losses arising for transactions denominated in currencies other than the functional currency are included in other income, net.

The preparation of 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 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. Actual results could differ from those estimates.

Restricted cash consists of the unapplied portion of grants received from the Saxony government to co-finance the costs of the construction of the Company's Dresden facility. In the event the Company fails to meet certain conditions related to the grants, the Saxony government has the right to reclaim the total grants. (See Note 5).

We recognize revenue when persuasive evidence of an arrangement exists, delivery has occurred or services have been provided, the sale price is fixed or determinable, and collectibility is reasonably assured. Accordingly, we generally recognize revenue from product sales when the terms of sale transfer title and risk of loss, which occurs either upon shipment or upon receipt by customers. In connection with product sales, we make allowances for estimated returns and warranties. We adjust these allowances periodically to reflect our actual and anticipated experience. If any of these conditions to recognize revenue is not met, we defer revenue recognition.

The Company has agreements under which it receives fees for certain licensing rights to technology and products. The Company does not allocate cost of sales to license revenues because such costs are insignificant. License revenues associated with these agreements are recognized ratably over the period of the contract when collection of the resulting receivable is probable. License revenues were $211,000, $287,000 and $525,000 for the years 2001, 2002 and 2003, respectively.

We establish allowances for doubtful accounts and warranties for specifically identified, as well as anticipated, doubtful accounts and warranty claims based on credit profiles of our customers, current economic trends, contractual terms and conditions, and historical payment and warranty experience. As of December 31, 2002, our balance sheet included allowances for doubtful accounts of $0.6 million and $2.1 million for warranties. As of December 31, 2003, our balance sheet included allowances for doubtful accounts of $0.8 million and $1.9 million for warranties.

Financial instruments that potentially subject the Company to significant concentrations of credit risk consist principally of cash and trade accounts receivable.

The Company invests in a variety of financial instruments such as certificates of deposits and money market funds. By policy, the Company limits the amount of credit exposure to any one financial institution or commercial issuer.

The Company sells its products throughout the world. The Company performs ongoing credit evaluations of its customers' financial condition and, generally, requires no collateral from its customers. The Company maintains an allowance for uncollectible accounts receivable based upon anticipated collectibility of all accounts receivable.

The Company's ten largest customers accounted for approximately 85%, 84% and 84% of net product sales in 2001, 2002 and 2003 respectively. During 2003, Mitsui Chemicals, Saint Gobain Sekurit, Pilkington PLC and V-Kool accounted for 21.4%, 17.2%, 13.7% and 10.0%, respectively, of our net sales. During 2002, Saint Gobain Sekurit, Mitsubishi, Mitsui Chemicals and Pilkington PLC accounted for 18.7%, 18.0%, 15.7% and 10.8%, respectively, of our net sales. During 2001, Pilkington, Mitsubishi and Saint Gobain Sekurit accounted for 15.8%, 21.2% and 23.9%, respectively, of our net sales. The Company expects to continue to derive a significant portion of its net product sales from a relatively small number of customers. Accordingly, the loss of a large customer could materially hurt the Company's business, and the deferral or loss of anticipated orders from a small number of customers could materially reduce its revenue, operating results and cash flows in any period. At December 31, 2003, receivables from five customers represented 24%, 14%, 13%, 12% and 6% of the Company's accounts receivable, respectively. At December 31, 2002, receivables from two customers represented 32%, and 16% of the Company's accounts receivable, respectively.

Inventories are stated at the lower of cost (determined by the first-in, first-out method) or market. Cost includes materials, labor and manufacturing overhead. Southwall establishes provisions for excess and obsolete inventories to reduce such inventories to their estimated net realizable value. Such provisions are charged to cost of sales.

Property and equipment are stated at cost. The Company uses the units-of-production method for calculating depreciation on certain of its production machines and the straight-line method for all other property and equipment. Estimated useful lives of the assets range from five to ten years. On its large-scale production machines for which the units-of-production depreciation method is used, the Company records minimum annual depreciation of at least one-half of the depreciation that would have been recorded utilizing the straight-line depreciation method over a ten-year life. Leasehold improvements are amortized using the term of the related lease or the economic life of the improvements, if shorter.

Additions, major renewals and enhancements are included in the asset accounts at cost. Ordinary maintenance and repairs are charged to expense as incurred. Gains or losses from disposal are included in earnings.

Depreciation and amortization expense related to property and equipment for the years ended December 31, 2001, 2002 and 2003 was $6.0 million, $6.1 million and $6.1 million, respectively.

Long-lived assets held and used by the Company are reviewed for impairment whenever events or circumstances indicate that the carrying amount of an asset may not be recoverable. Factors that could trigger an impairment review include the following: (i) significant negative industry or economic trends; (ii) exiting an activity in conjunction with a restructuring of operations; (iii) current, historical or projected losses that demonstrate continuing losses associated with an asset; or (iv) a significant decline in our market capitalization, for an extended period of time, relative to net book value. When we determine that there is an indicator that the carrying value of long-lived assets may not be recoverable, we measure impairment based on estimates of future cash flows. These estimates include assumptions about future conditions such as future revenues, gross margins, operating expenses within our company, the fair values of certain assets based on appraisals, and industry trends. All long-lived assets to be disposed of are reported at the lower of carrying amount or fair market value, less expected selling costs.

The Company has estimated the fair value amounts of its financial instruments, including cash and cash equivalents, accounts receivable, accounts payable and accrued liabilities using available market information and valuation methodologies considered to be appropriate and have determined that the book value of those instruments at December 31, 2002 and 2003 approximates fair value.

The Company accounts for derivative financial instruments under SFAS No. 133, Accounting for Derivative Instruments and Hedging Activities. SFAS No. 133 establishes methods of accounting for derivative financial instruments and hedging activities related to those instruments as well as other hedging activities.

SFAS No. 148, "Accounting for Stock-Based Compensation - Transition and Disclosure, an Amendment of FASB Statement No. 123" amends the disclosure requirements of SFAS No. 123, "Accounting for Stock-Based Compensation," to require more prominent disclosures in both annual and interim financial standards regarding the method of accounting for stock-based employee compensation and the effect of the method used on reported results.

The Company accounts for stock-based employee compensation arrangements in accordance with provisions of Accounting Principles Board ("APB") Opinion No. 25, "Accounting for Stock Issued to Employees" and related interpretations. Under APB 25, compensation expense is based on the difference, if any, on the date of the grant, between the fair value of the Company's stock and the exercise price.

The following table illustrates the effect on net income and earnings per share if the Company had applied the fair value recognition provisions of SFAS 123 and SFAS 148 to stock-based employee compensation:

                                                                                         Years Ended December 31,
                                                                                  -------------------------------------
                                                                                     2001         2002         2003
                                                                                  -----------  -----------  -----------
                                                                                 (in thousands except per share amounts)

Net income (loss)
   As reported.................................................................. $     4,635  $    (4,191) $   (42,292)
   Add: Stock-based employee compensation expense included
         in reported net income (loss), net of related tax effects..                      --           42           34
   Deduct: Total stock-based employee compensation determined under fair value
            based method for all awards, net of related tax effects.............        (802)      (1,330)        (695)
                                                                                  -----------  -----------  -----------
   Pro forma.................................................................... $     3,833  $    (5,479) $   (42,953)
                                                                                  ===========  ===========  ===========
Net income (loss) per share:
   As reported - basic.......................................................... $      0.58  $     (0.40) $     (3.38)
   Pro forma - basic............................................................ $      0.48  $     (0.53) $     (3.43)

   As reported - diluted........................................................ $      0.57  $     (0.40) $     (3.38)
   Pro forma - diluted.......................................................... $      0.47  $     (0.53) $     (3.43)

All options outstanding during 2002 and 2003 were excluded from the diluted net loss per share calculations because they were anti-dilutive in view of the losses incurred by the Company in those years.

For the stock option plans, the fair value of each option grant is estimated on the date of grant using the Black-Scholes option pricing model, for the multiple option approach, with the following weighted average assumptions used for grants in 2001, 2002 and 2003, respectively: expected volatility of 89%, 96% and 99%; risk-free interest rate of 4.6%, 3.8% and 2.3%; and expected lives from vesting date of 3.26, 3.49, and 2.77 years. Southwall has not paid dividends and assumed no dividend yield. The weighted average fair value of stock options granted in 2001, 2002 and 2003 was $1.89, $4.95 and $1.00 per share, respectively.

For the employee stock purchase plans, the fair value of each purchase right is estimated at the beginning of the offering period using the Black-Scholes option pricing model with the following weighted-average assumptions used in 2001, 2002 and 2003 respectively: expected volatility of 89%, 96% and 99%; risk-free interest rate of 4.19%, 4.13% and 2.70%; and expected lives of 0.5 years in each year. The Company has not paid dividends and assumed no dividend yield. The weighted-average fair value of those purchase rights granted in 2001, 2002 and 2003 was $1.21, $2.65 and $0.56 per right, respectively.

Research and development costs are expensed as incurred.

The Company has adopted the provisions of SFAS No. 130 "Reporting Comprehensive Income". SFAS 130 establishes standards for reporting and display in the financial statements of total net income and the components of all other non-owner changes in equity, referred to as comprehensive income (loss). Accordingly, the Company has reported the translation gain (loss) from consolidation of its foreign subsidiary in comprehensive income (loss).

The Company manufactures all of its products using materials procured from third-party suppliers. Certain of these materials are obtained from a limited number of sources. Delays or reductions in product shipments could damage the Company's relationships with customers. Further, a significant increase in the price of one or more of the materials used in the Company's products could have a material adverse effect on the Company's cost of goods sold and operating results.

The Company relies on third-party subcontractors to add properties, such as adhesives, to some of its products. There are only a limited number of qualified subcontractors that can provide some of the services the Company requires. Qualifying alternative subcontractors could take a great deal of time or cause the Company to change product designs. The loss of a subcontractor could adversely affect the Company's ability to meet its scheduled product deliveries to customers, which could damage its relationships with customers. If the Company's subcontractors do not produce a quality product, the Company's yield will decrease and its margins will be lower. Further, a significant increase in the price charged by one or more of the Company's subcontractors could force it to raise prices on its products or lower its margins, which could have a material adverse effect on its operating results.

The Company's production machines are large, complex and difficult to manufacture. It can take up to a year from the time the Company orders a machine until it is delivered. Following delivery, it can take the Company, with the assistance of the manufacturer, up to six additional months to test and prepare the machine for commercial production. There are a very limited number of companies that are capable of manufacturing these machines. The Company's inability in the future to have new production machines manufactured and prepared for commercial production in a timely manner would prevent the Company from delivering product on a timely basis and limit the Company's capacity for revenue growth.

For restructuring activities initiated prior to December 31, 2002 Southwall recorded restructuring costs when the Company committed to a plan to exit certain facilities, and significant changes to the exit plan were not likely to occur. For restructuring activities initiated after December 31, 2002, the Company records restructuring reserves when management has approved a plan to restructure operations and a liability has been incurred in accordance with SFAS No. 146, "Accounting for Costs Associated with Exit or Disposal Activities" as discussed in Note 12.

The Company accounts for deferred income taxes under the liability approach whereby the expected future tax consequences of temporary differences between the book and tax basis of assets and liabilities are recognized as deferred tax assets and liabilities. A valuation allowance is established for any deferred tax assets for which realization is uncertain.

Basic net income (loss) per share is computed by dividing income available to common shareholders (numerator) by the weighted average number of common shares outstanding (denominator) for the period. Diluted net income (loss) per share gives effect to all dilutive potential common shares outstanding during the period. The computation of diluted earnings per share uses the average market prices during the period. The total amount of the difference in the basic and diluted weighted average shares of common stock and potentially dilutive securities in the periods where there is net income is attributable to the effect of dilutive stock options. In net loss periods, the basic and diluted weighted average shares of common stock and common stock equivalents are the same because inclusion of stock options would be anti-dilutive. At December 31, 2003 and 2002, there was no difference between the denominators used for calculation of basic and diluted net income (loss) per share.

Certain costs in the 2001 consolidated financial statements have been reclassified to conform to the current year's presentation. Certain assets in 2002 consolidated financial statements have been reclassified to conform to the current's year presentation. These reclassifications did not change previously reported net income, stockholders' equity, or cash flows.

In January 2003, the Financial Accounting Standards Board ("FASB") issued FASB Interpretation No. 46, "Consolidation of Variable Interest Entities, an Interpretation of ARB No. 51." FIN 46 requires certain variable interest entities to be consolidated by the primary beneficiary of the entity if the equity investors in the entity do not have the characteristics of a controlling financial interest or do not have sufficient equity at risk for the entity to finance its activities without additional subordinated financial support from other parties. FIN 46 is effective immediately for all new variable interest entities created or acquired after January 31, 2003. For variable interest entities created or acquired prior to February 1, 2003, the FASB recently delayed the required implementation date such that the provisions of FIN 46 are required to be adopted no later than the end of the first reporting period that ends after March 15, 2004. The company believes that the adoption of this standard will have no material impact on its financial statements.

In April 2003, the FASB issued SFAS No. 149, "Amendment of Statement 133 on Derivative Instruments and Hedging Activities". SFAS 149 amends and clarifies accounting for derivative instruments and hedging activities under SFAS 133, "Accounting for Derivative Instruments and Hedging Activities". SFAS 149 provides guidance relating to decisions made (a) as part of the Derivatives Implementation Group process, (b) in connection with other FASB projects dealing with financial instruments and (c) regarding implementation issues raised in the application of the definition of a derivative and the characteristics of a derivative that contains financing components. SFAS 149 is effective for contracts entered into or modified and for hedging relationships designated after June 30, 2003. The adoption of SFAS 149 did not have a material impact on our financial condition or results of operations.

In May 2003, the FASB issued SFAS No. 150 "Accounting for Certain Financial Instruments with Characteristics of both Liabilities and Equity". SFAS 150 requires freestanding financial instruments such as mandatory redeemable shares, forward purchase contracts and written put options to be reported as liabilities by their issuers as well as related new disclosure requirements. The provisions of SFAS 150 are effective for instruments entered into or modified after May 31, 2003 and pre-existing instruments as of the beginning of the first interim period that commences after June 15, 2003. The adoption of SFAS 150 did not have a material impact on our financial condition or results of operations.

The Company has prepared its consolidated financial statements assuming it will continue as a going concern and meet its obligations as they become due. The Company incurred a net loss and negative cash flows from operations in 2002 and 2003, and expects to incur net losses through at least the third quarter of 2004.

In the second quarter of 2003, the Company entered into a credit agreement with a financial institution that provided for a credit facility up to $10.0 million, subject to certain restrictions in the borrowing base based on eligibility of receivables. In the fourth quarter of 2003 it amended the credit agreement to provide for a credit facility of up to $7.0 million, subject to the same restrictions in borrowing capacity. The amendment to its credit facility was made following an agreement reached with Needham and Company, Inc., the financial institution and the Company to enable it to borrow up to $3.0 million for working capital purposes, in addition to the $7.0 million credit facility. At December 31, 2003, the Company was not in compliance with the minimum tangible net worth covenant and the current ratio covenants set forth in the credit agreements. The Company reached an agreement with the financial institution wherein they have agreed to forbear from exercising the rights and remedies available to them as a result of the default condition. The current credit agreement will expire on May 5, 2004.

The Company is in discussions with potential lenders regarding establishing a new credit facility. The Company cannot provide any assurance that alternative sources of financing will be available at all or on terms acceptable to it. The Company's ability to enter into a new facility or to raise additional funds may be adversely affected by a number of factors including delisting from the Nasdaq National Market and the approval by its stock holders for an increase in authorized shares (failure to secure approval will accelerate the due date of its convertible notes as discussed below). If the Company is unable to put in place a new credit facility or obtain additional financing, it may be unable to satisfactorily meet all of its cash commitments required to fully implement its business plans. These factors together with the Company's working capital position and its significant debt service and other contractual obligations at December 31, 2003, raise substantial doubt about the Company's ability to continue as a going concern. Effective March 26, 2004, the Company voluntarily delisted from Nasdaq and applied to begin trading on the pink sheets. Due to the structure of the transaction contemplated by the investment agreement, we were no longer in compliance with certain Nasdaq listing requirements. We felt that a voluntary delisting from Nasdaq and a move to the pink sheets would provide the best option to our shareholders by retaining liquidity in our common stock.

During 2003, the Company experienced a significant deterioration in its working capital position, which raised concerns about its ability to fund its operations and continue as a going concern in the short term and its ability to meet obligations coming due over the next few years.

On October 8, 2003, the Company reviewed the revenue forecast for the fourth quarter of 2003 and determined that the anticipated sales for the quarter would not generate enough cash flow to continue operations through the end of the quarter. Management presented its findings to the Company's Board of Directors on October 10, 2003 and the directors instructed the management team to develop an emergency restructuring plan to improve the Company's cash flow and to obtain new financing.

The primary elements of management's restructuring plan included:

• Shutting down a majority of the domestic manufacturing and transferring that production to the Dresden, Germany facility;
• Beginning a series of staggered layoffs;
• Arranging new payment terms with all major creditors and vendors to extend or reduce payment obligations;
• Accelerating cash collections;
• Reducing operating expenses and inventory levels; and
• Minimizing capital expenditures.

The Company also began to solicit and receive proposals from potential investors and lenders.

After reviewing the proposals submitted, the Board determined to proceed with an offer from Needham & Company, Inc. ("Needham") and entered into a non-binding letter of intent with Needham on November 11, 2003. In connection with the letter of intent the Company agreed to issue warrants to Needham exercisable for 1,254,235 of shares of its common stock equal to 10% of the total shares outstanding (See Note 8 - Warrants).

On December 18, 2003, the Company entered into definitive investment agreements for a new bank loan guarantee and equity-financing package of up to $7.5 million with Needham, affiliates of Needham and Dolphin Direct Equity Partners, L.P. ("Dolphin") (collectively the "Investors") and Pacific Business Funding ("PBF"). The agreements enabled the Company to receive up to $3.0 million in new borrowings under its line of credit facility with PBF, supported by guarantees provided by Needham, in two separate allotments of $2.25 million and $0.75 million; and to receive $4.5 million from the issuance of equity in two separate tranches of $1.5 million and $3.0 million. The new borrowings and the purchase of each equity tranche were subject to certain conditions, including, among other things, the receipt of concessions by the Company from creditors and landlords, the completion of certain restructuring actions and the achievement of cash flow break-even at quarterly revenue levels below those of third quarter 2003.

Needham provided the $2.25 million and $0.75 million guarantees on December 18, 2003 and January 15, 2004, respectively. In exchange for the guarantees the Company issued two allotments of warrants, both for 941,115 shares of common stock, on the date of the guarantees (See Note 8- Warrants and Note 14 - Subsequent Events).

On February 20, 2004, the parties amended and restated the investment agreement to provide that the Company would issue and sell to the Investors an aggregate of $4.5 million of convertible notes in one tranche instead of Series A convertible preferred shares in two separate tranches. The convertible notes are convertible into Series A convertible preferred stock, which is convertible into common stock. In connection with the convertible notes the Company issued warrants for 1,694,007 shares of common stock (See Note 12 - Subsequent Events).

Following completion of the financing, based on securities outstanding as of March 28, 2004, the following summarizes arrangements that were made with the Investors regarding the convertible securities and warrants:

• if Needham and its affiliated entities were to exercise all of their warrants and convert all of their Series A shares (issuable upon conversion of its convertible notes), while maintaining their current ownership of approximately 2,200,067 shares of common stock, then Needham and its affiliated entities would own approximately 15,166,764 shares of the common stock, or about 59.4% of the total shares outstanding, including such issuances to Needham and its affiliates but excluding outstanding warrants and Series A shares held by other Investors.
• if Dolphin Direct Equity Partners, LP were to exercise all warrants and convert all of its Series A shares (issuable upon conversion of its convertible notes), then Dolphin would own approximately 5,498,141shares of the common stock, or about 30.5% of the total shares outstanding, including such issuances to Dolphin but excluding outstanding warrants and Series A shares held by other Investors.
• The Company currently has 20,000,000 shares of common stock authorized under its certificate of incorporation. The Company expects to call a special meeting of its stockholders for the purpose of seeking approval of an amendment to its certificate of incorporation increasing the number of authorized shares available for issuance to a number that would allow it to meet fully its obligations to issue shares of capital stock under the investment agreement. If an amendment to the Company's certificate of incorporation is not approved, the amounts due under the convertible notes will accelerate, and it will not be able meet its obligations under the investment agreement. The resulting lack of capital will prevent the Company from funding its operations and continuing as a going concern.

Agreements with Major Creditors

The investment agreements required the Company to negotiate settlement terms with certain major creditors including Teijin, Matrix Capital, and the Company's landlords as part of a restructuring plan.

Teijin previously guaranteed the Company's outstanding debt owed to UFJ Bank Limited (formerly known as Sanwa Bank Limited). On November 5, 2003, the Company defaulted on this debt and Teijin honored its guarantee by satisfying the obligation. Under the terms of Teijin's guarantee, the Company was obligated to immediately repay the amounts paid by Teijin. As part of the restructuring plan, the Company entered into a guaranteed Loan Agreement with Teijin in January 2004 to satisfy Teijin's claim. The agreement included a payment schedule that spread the payments out over a period of four years until 2008. The obligations owed to Teijin will not accrue interest if paid according to the payment schedule. The Company's obligations to Teijin are guaranteed by its subsidiary, Southwall Europe GmbH. (See Note 4 - Term Debt and Note 14 - Subsequent Events).

As of December 31, 2003, the Company was in default under a master sale-leaseback agreement with respect to two of its production machines. The Company had withheld lease payments in connection with a dispute with the leasing company, Matrix Funding Corporation. An agent purporting to act on behalf of the leasing company filed suit against the Company to recover the unpaid lease payments and the alleged residual value of the machines, totaling $6.5 million in the aggregate. In February 2004, the Company reached a settlement agreement with the agent for $2.0 million to be repaid over six years at a stepped rate of interest (See Note 4 - Term Debt and Note 14 - Subsequent Events).

In December 2003 and January and February 2004, the Company reached agreements with three of its five landlords to reduce, or extend the payment period, of its contractual obligations (See Note 10 - Commitments and Contingencies and Note 14 - Subsequent Events).

On May 16, 2003, the Company entered into credit agreements for a $10.0 million receivables financing line of credit (which were amended on June 16, 2003) with a financial institution that was due to expire on May 16, 2004, subject to automatic one-year renewals unless terminated at any time by either party. The line of credit bears an annual interest rate of 7% above the financial institution's Base Rate (which was 4.0% at December 31, 2003), and is calculated based on the average daily accounts receivable against which the Company has borrowed. Half of the $10.0 million line of credit is represented by a $5.0 million credit line, guaranteed by the United States Export-Import Bank ("EXIM"). Availability under the EXIM line is limited to 80% of eligible foreign receivables acceptable to the lender. The remaining $5.0 million portion of the $10.0 million credit line is supported by domestic receivables. Availability under the domestic line of credit is limited to 70% of eligible domestic receivable acceptable to the lender. The financial institution reserves the right to lower the 70% and 80% of eligible receivable standards for borrowings under the credit agreements. In connection with the line of credit, the Company granted to the bank a lien upon and security interest in, and right of set off with respect to all of the Company's right, title and interest in all personal property and other assets, other than certain of the Company's Germany property or assets. The borrowing arrangements require the Company to comply with financial covenants to maintain minimum net tangible net worth of $33.0 million, a current ratio of at least 0.70, and revenues equal to or greater than 80% of revenues projected. As part of the agreements, the Company incurred and paid a one-time commitment fee of $0.1 million in the second quarter of 2003, which will be amortized over the term of the agreements.

As a result of the impairment charge recorded at the end of the third quarter and a deterioration in our working capital position during the fourth quarter of 2003, the Company was in violation of the minimum net tangible net worth covenant and current ratio covenant set forth in each of the credit agreements, and, therefore, in default there under. On December 18, 2003 we signed a Forbearance Agreement with the financial institution to forbear from exercising its rights and remedies available to it owing to the default condition. The forbearance will remain in effect until the expiration date of the credit agreement subject to the Company's achievement of certain operational and financial milestones. The credit agreements will expire on May 5, 2004. Concurrent with the Forbearance Agreement, the credit agreement was amended to reduce the facility to $7.0 million, subject to the same restrictions in borrowing capacity. The amendment to the credit facility was made following an agreement reached with Needham to guarantee an additional $3.0 million facility with PBF. The guarantee was provided in two separate allotments of $2.25 million on December 18, 2003 and $0.75 million on January 15, 2004. In exchange for the guarantees, the Company issued two separate allotments of warrants for 941,115 shares of common stock. (See Note 8 - Warrants) As of December 31, 2003, the Company had approximately $6.8 million of borrowings outstanding and no availability to borrow under the credit agreement.

The Company's term debt and capital leases as of December 31, 2003 consists of the following:

                                                            Balance at
                                                           December 31,    Due in
Description                                       Rate         2003         2004
---------------------------------------------  ----------  ------------  ----------
Term debt:
 Japanese bank loan guaranteed by Teijin.....    6.45%(1) $      1,250  $      254
 German bank loan dated May 12, 1999.........    6.13%(2)        2,691         539
 German bank loan dated May 28, 1999.........    7.10%(3)        3,157          --
 German bank loan dated May 28, 1999.........       3.75%        1,082         361
 German bank loan dated July 25, 2000........    7.15%(4)        2,084         372
 German bank loan dated
   August 14, 1999 (due June 30, 2009).......       5.75%        2,131          --
 German bank loan dated June 29, 2000........       5.75%          108         108
 German bank loan dated July 10, 2000........       7.10%          108         108
 German bank loan dated December 18, 2000....       7.50%          109         109
 German bank loan dated December 19, 2000....        8.0%           97          97
 Sales-leaseback dated July 19, 1999.........      13.00%        2,321          --
 Sales-leaseback dated October 19, 1999......      13.00%          461          --
                                                           ------------  ----------
   Total term debt...........................                   15,599       1,948
Capital leases:
 Other equipment financings..................                      101          94
                                                           ------------  ----------
   Total capital leases......................                      101          94
                                                           ------------
   Total term debt and capital leases........                   15,700  $    2,042
                                                           ------------  ==========
   Less current portion......................                    2,042
                                                           ------------
Term debt, non currrent......................             $     13,658
                                                           ============

The above table reflects changes to current and noncurrent classifications resulting from agreements reached in the subsequent events period with our term debt holders as part of our restructuring plan.

The Japanese bank loan, dated May 6, 1997, is guaranteed by Teijin Limited (Teijin), a Japanese company. Teijin is a stockholder of and supplier of substrate materials to the Company. The Teijin guarantee was collateralized by certain equipment located in Southwall's Tempe manufacturing facility and inventory, to the extent necessary to provide 120% net book value coverage of the outstanding loan balance. The interest rate on the loan was re-set semi-annually at LIBOR plus 1.0%, (3.14% at December 31, 2002, and December 31, 2003). The Company was also subject to certain financial covenants under the guarantee. The Company paid Teijin semi-annually a loan guarantee service fee equal to 0.5625% of the outstanding balance. The loan required semi-annual payments of interest only during the first four years, followed by semi-annual installments plus interest, beginning in May 2001, for the remaining three and one half year term. At December 31, 2001 and 2002, the Company was not in compliance with certain of the financial covenants with Teijin pertaining to this promissory note. Southwall received a waiver from Teijin and the Japanese bank of any defaults that may exist through and including September 30, 2003 arising out of its failure to comply with the financial covenants of the guarantee agreement relating to minimum quick ratio, tangible net worth and maximum debt/tangible net worth. The waiver was conditioned on the Company's agreement to prepay $2.5 million of the debt from the proceeds of its public offering. The Company paid $2.5 million, in addition to the scheduled principal payment of $1.25 million, on November 6, 2002. On May 6, 2003, the Company made a scheduled payment of $1.25 million. However, the Company did not make the scheduled payment of $1.25 million due on November 5, 2003 thereby defaulting on the debt. Teijin honored its guarantee by satisfying the obligation. Under the terms of Teijin's guarantee, the Company was obligated to immediately repay the amounts paid by Teijin. As part of the restructuring plan, the Company entered into a guaranteed Loan Agreement with Teijin to satisfy Teijin's claim. The agreement included a payment schedule that spread the payments out over a period of four years until 2008. The obligations owed to Teijin will not accrue interest if paid according to the payment schedule. The Company's obligations to Teijin are guaranteed by its subsidiary, Southwall Europe GmbH. The Company has classified the amount to be paid in 2003 and thereafter under the agreed payment schedule as noncurrent debt on the balance sheet at December 31, 2003. (See Note 13 - Subsequent Events)

During 1999, Southwall entered into a master equipment sale-leaseback agreement with a leasing company, Matrix Funding Corporation ("lessor"). Because the Company has an option to purchase the equipment at a price to be determined between Southwall and the lessor at the end of the lease period, the sale-leaseback agreements have been treated as a financing. One lease has a lease term of three years and the other lease has an initial lease term of two years with an option to extend it for an additional year. The leased equipment and certain other production equipment owned by the Company collateralize the sale-leaseback agreements. The effective interest rate of both is approximately 13% per annum and the leases are repayable over the lease term commencing in May 2000. The Company was in dispute with the lessor over interpretation of certain terms of the lease agreement and withheld lease payments due since March 2001. The lessor notified the Company that it considered the Company to be in default and in January 2002 drew down on a letter of credit in the amount of $0.5 million that collateralized the Company's obligations. In May, 2002, a suit was filed against the Company by an agent of the successor to the lease demanding payment of unpaid lease payments and alleged residual values. (See Note 10 - Commitments and Contingencies.) In February 2004, we reached a settlement agreement with the agents for $2.0 million bearing interest at a stepped rate. The settlement requires the Company to make an interest payment in 2004, and beginning in 2005, to make quarterly principal and interest payments until 2010. The obligation is guaranteed by the Company's subsidiary Southwall Europe Gmbh. (See Note 14 - Subsequent Events.) The Company classified the payments due in 2005 and thereafter under the settlement agreement as noncurrent on the balance sheet as of December 31, 2003.

On May 12, 1999, the Company entered into a loan agreement with a German bank that provides for borrowings up to euros 3.1 million ($3.9 million). Under the terms of this agreement, the funds were used solely for the purpose of capital investment by Southwall's German subsidiary. The term of the loan is for a period of 10 years and the principal is repayable in euros after the end of one year in 36 quarterly payments. The loan bears interest at 6.125% per annum for the first five years, and will be revised to the prevailing rate at the end of the fifth year. Of the borrowings outstanding of $2.7 million under this bank loan at December 31, 2003, $2.2 million was classified as noncurrent in the accompanying balance sheet.

On May 28, 1999, the Company entered into a general loan agreement with a German bank. Under the terms of the loan agreement, funds were made available in three tranches, and were used solely for the purpose of capital investment by the Company's German subsidiary. The agreement contains various covenants with which the Company was in compliance at December 31, 2003; the Company is current with respect to all principal and interest payments due under the loan agreement. Under the first tranche, the Company borrowed euro 2.5 million ($3.2 million) for a term of twenty years beginning on May 28, 1999. The principal is repayable in euros beginning after ten years in ten equal, semi-annual payments. The loan bears fixed interest of 7.1% per annum for the first ten years, after which time the rate will be adjusted to a current prevailing rate. Of the borrowings outstanding under this tranche of $3.2 million at December 31, 2003, $3.2 million was classified as noncurrent in the accompanying balance sheet. Under the second tranche, the Company borrowed euro 1.7 million ($2.1 million) for a term of seven years beginning May 28, 1999 and the principal is repayable after one year in twelve equal, semi-annual payments. The loan bears fixed interest at 3.75% per annum for the period of seven years. At December 31, 2003, the amount due under this second tranche was $1.1 million, and $0.7 million was classified as a noncurrent liability. Under the third tranche, of the Company borrowed euro 2.1 million ($2.7 million) for a term of ten years beginning on July 25, 2000, and the principal is repayable after one year, in thirty-six equal quarterly payments. The loan bears fixed interest of 7.15% per annum for the first five years, after which time the rate will be adjusted to a current prevailing market rate. At December 31, 2003, the amount due was $2.1 million; of this amount, $1.7 million was classified as noncurrent.

On August 14, 1999, the Company entered into a loan agreement with a German bank that provides for borrowings up to euros 1.7 million ($2.1 million). As required by this agreement, the funds were used solely for the purpose of capital investment by the Company's German subsidiary. The principal balance is due in a single payment on June 30, 2009 and bears interest at a rate of 5.75% per annum. The interest is payable quarterly in euros. Fifty percent of the loan proceeds are restricted in an escrow account for the duration of the loan period and are classified as non-current "Restricted loan proceeds." The amount due under this bank loan at December 31, 2003 was $2.1 million, which was classified as noncurrent.

On June 29, 2000, the Company entered into a loan agreement with a German bank that provides for borrowings up to euros 0.5 million ($0.6 million). As required by this agreement, the funds were used solely for the purpose of capital investment by the Company's German subsidiary. The principal balance is repayable in 12 quarterly payments beginning June 2001 and bears interest at a rate of 5.8% per annum. The interest is payable quarterly in euros. The agreement contains various covenants with which the Company was in compliance at December 31, 2003. The amount due under this bank loan was $0.1 million at December 31, 2003.

On July 10, 2000, the Company entered into a loan agreement with a German bank that provides for borrowings up to euros 0.5 million ($0.6 million). As required by this agreement, the funds were used solely for the purpose of capital investment by the Company's German subsidiary. The principal balance is repayable in 12 quarterly payments beginning June 2001 and bears interest at a rate of 7.10% per annum. The interest is payable quarterly in euros. The amount due under this bank loan was $0.1 million at December 31, 2003.

On December 18, 2000, the Company entered into a loan agreement with a German bank that provides for borrowings up to euros 0.2 million ($0.3 million). As required by this agreement, the funds were used solely for the purpose of capital investment by the Company's German subsidiary. The principal balance is repayable in nine quarterly payments beginning March 2002 and bears interest at a rate of 7.5% per annum. The interest is payable quarterly in euros. At December 31, 2003, the amount outstanding under this bank loan was $0.1 million.

On December 19, 2000, the Company entered into a loan agreement with a German bank that provides for borrowings up to euros 0.3 million ($0.4 million). As required by this agreement, the funds were used solely for the purpose of capital investment by the Company's German subsidiary. The principal balance is repayable in 12 quarterly payments beginning March 2002 and bears interest at a rate of 7.5% per annum. The interest is payable quarterly in euros. At December 31, 2003, the amount outstanding under this bank loan was $97,000.

The preceding German bank loans are collateralized by the production equipment, building and land owned by the Company's German subsidiary. The dollar equivalent value for the preceding German bank loans has been calculated using the euro exchange rate as of December 31, 2003.

Other term debt consists of capitalized leases related primarily to certain computer equipment used by the Company.

Scheduled principal reductions of term debt for the next five years and thereafter, are as follows:

                                                                           Amount
                                                                         ----------

2004................................................................... $    2,042
2005...................................................................      1,556
2006...................................................................      1,600
2007...................................................................      1,240
2008...................................................................      1,240
Thereafter.............................................................      8,022
                                                                         ----------
          Total........................................................ $   15,700
                                                                         ==========

The above table reflects changes to current and noncurrent classifications resulting from agreements reached in the subsequent events period with our term debt holders as part of our restructuring plan.

The Company incurred total interest on indebtedness of $2.9 million, $1.7 million and $1.6 million in 2001, 2002 and 2003, respectively.

The Company has an agreement to receive cash grant awards (the "Grant"), which was approved by the Saxony government in May 1999. As of December 31, 2003, the Company had received approximately euros 5.6 million ($7.1 million) under this Grant and accounted for the Grant by applying the proceeds received to reduce the cost of fixed assets of the Dresden manufacturing facility. Additionally, as of December 31, 2003, the Company has a balance remaining from the government grants received in May 1999 of euros 0.5 million ($0.6 million) which has been recorded as an advance and held as restricted cash until the Company receives approval from the Saxony government to apply the funds to reduce its capital expenditures.

Giving effect to an amendment of the terms of the Grant in 2002, the Grant is subject to the following requirements:

If the Company fails to meet the above requirements, the Saxony government has the right to demand repayment of the Grant.

In addition to the Grant, the Company is further eligible for cash investment allowances from the Saxony government calculated based on the total projected capital investment by the Company in its Dresden facility of euros 47.0 million ($59.4 million), subject to European Union regulatory approval. During 2000, 2001, 2002 and 2003, the Company received euros 1.2 million ($1.5 million), euros 2.5 million ($3.2 million), euros 1.2 million ($1.5 million), and euros 1.3 million ($1.6 million), respectively, in investment allowances from the Saxony government, and those proceeds were applied to reduce the capitalized construction cost of the Dresden facility. These investment allowances are subject to the following requirements:

If the Company fails to meet the above requirements, the Saxony government has the right to demand repayment of the allowances.

The Grants and investment allowances, if any, that the Company is entitled to seek from the Saxony government varies from year to year based upon the amount of capital expenditures that meet the above requirements. Generally, Southwall is not eligible to seek total investment grants for any year in excess of 33% of its eligible capital expenditures for that year. The Company cannot guarantee that it will be eligible for or receive additional grants or allowances in the future.

The income tax provision relates primarily to foreign withholding taxes on royalty payments and federal statutory and state alternative minimum tax obligations. The effective income tax rate differs from the federal statutory rate as a result of valuation allowances established for deferred tax assets. The Company believes that sufficient uncertainty exists with regard to the realization of these tax assets; accordingly, a full valuation allowance is necessary. These factors include the lack of a significant history of consistent profits and the lack of carryback capacity to realize these assets. In the absence of objective evidence, the Company is unable to assert that it will generate sufficient taxable income to realize the deferred tax assets.

Deferred tax (liabilities) assets are comprised of the following:

                                                               December 31,
                                                          ----------------------
                                                             2002        2003
                                                          ----------  ----------
                                                             (in thousands)

Depreciation............................................ $   (4,606) $   (5,057)
Other...................................................       (262)         --
                                                          ----------  ----------
Gross deferred tax liabilities..........................     (4,868)     (5,057)
Inventory reserves......................................        520         574
Write-off of fixed assets...............................        963      11,987
Bad debt reserves.......................................        208         310
Sales returns and allowances............................        809         737
Accrued compensation reserves...........................      1,052         422
Restructuring reserves..................................        774         625
Other various reserves..................................        702       2,750
Other...................................................         53       1,141
Loss carryforwards......................................     12,761      14,241
Credit carryforwards....................................      1,697       1,971
                                                          ----------  ----------
Gross deferred tax assets...............................     19,539      34,758
Deferred tax assets valuation allowance.................    (14,671)    (29,701)
                                                          ----------  ----------
Net deferred taxes...................................... $       --  $       --
                                                          ==========  ==========

At December 31, 2003, the Company had net federal operating loss carryforwards of approximately $xx.x million that expire at various dates from 2004 through 2023. Certain of the net operating loss carryforwards resulted from employee exercises of non-incentive stock options or disqualifying dispositions, the tax benefit of which, when realized, will be accounted for as an addition to capital in excess of par value, rather than as a reduction of the provision for income taxes. The Company has state net operating loss carryforwards that expire at various future dates. Research and development, investment and foreign tax credit carryovers of approximately $x.x million are also available to reduce future federal and state income taxes and expire at various dates through 2023. If certain substantial changes in ownership of the Company occur, there would be an annual limitation on the amount of the carryforwards that can be utilized.

The Company has granted stock options under various option plans and agreements in the past and currently grants stock options under the 1997 Stock Incentive Plan and the 1998 Stock Option Plan for Employees and Consultants. The board of directors adopted the 1998 Stock Option Plan for Employees and Consultants on August 6, 1998. The Human Resources Committee of the board of directors administers the plans and agreements. The exercise price of options granted under the 1997 and 1998 plans must be at least 85% of the fair market value of the stock at the date of grant.

Generally, options granted under the plans vest at a rate of 25% per year, are non-transferable and expire over terms not exceeding ten years from the date of grant or three months after the optionee terminates his relationship with the Company.

From 1998 to 2002 an certain officer of Southwall exercised stock options under the plans by issuing full recourse notes with an annual rate of interest of generally 7%, as discussed in Note 10.

As of December 31, 2003, there were 450,537 shares of Common Stock available for grant under the two stock option plans.

The activity under the option plans, combined, was as follows:

                                                                         Weighted
                                                            Range of      Average
                                               (000's)      Exercise     Exercise
                                               Options       Price         Price
                                             ----------- --------------  ---------
Options outstanding at January 1, 2001......      1,968  $1.56 - $11.50 $    4.92
Granted.....................................        541  $2.13 - $6.06       3.19
Exercised...................................       (150) $1.56 - $6.88       3.59
Cancelled or expired........................       (448) $2.13 - $11.50      4.80
                                             ----------- --------------  ---------
December 31, 2001...........................      1,911  $1.56 - $11.50      4.81
Granted.....................................        655  $2.25 - $15.00      7.81
Exercised...................................       (322) $2.13 - $11.50      5.10
Cancelled or expired........................       (291) $2.13 - $15.00      5.65
                                             ----------- --------------  ---------
December 31, 2002...........................      1,953  $2.13 - $15.00      5.64
Granted.....................................        719  $0.88 - $2.28       1.65
Exercised...................................         --             --         --
Cancelled or expired........................       (585) $1.92 - $15.00      5.18
                                             ----------- --------------  ---------
December 31, 2003...........................      2,087  $1.56 - $11.50 $    4.39
                                             ===========

The following table summarizes information about stock options outstanding at December 31, 2003:

                          Options Outstanding            Options Exercisable
                     --------------------------------- -----------------------
                                 Weighted
                                 Average
                      (000's)   Remaining    Weighted                Weighted
      Range of         Number   Contractual  Average                  Average
      Exercise          Out-       Life      Exercise     Number     Exercise
       Prices         standing   (years)      Price    Exercisable     Price
-------------------- ---------- ----------  ---------- ------------  ---------
 $ 0.88 -- $1.05           315        6.6  $     1.02           16  $    0.96
 $ 1.56 -- $2.28           378        7.2        2.13           46       2.04
 $ 2.63 -- $3.49           261        4.4        3.03          159       2.91
 $ 3.58 -- $4.50           262        3.8        4.06          251       4.06
 $ 4.87 -- $5.07           219        2.3        5.01          204       5.00
 $ 5.21 -- $7.06           258        2.8        6.24          202       6.17
 $ 7.44 -- $8.00           241        6.2        7.95           96       7.88
 $ 8.72 -- $9.90           126        5.3        9.62           38       9.67
 $11.50 -- $11.50           10        3.2       11.50            8      11.50
 $15.00 -- $15.00           17        5.3       15.00            4      15.00
                     ----------                        ------------
 $ 0.88 -- $15.00        2,087        5.0  $     4.40        1,024  $    5.01
                     ==========                        ============

In March 1997, the Company adopted the 1997 Employee Stock Purchase Plan ("the 1997 Plan") and reserved 100,000 shares of Common Stock for issuance thereunder. Employees, subject to certain limitations, may purchase shares at 85% of the lower of the fair market value of the Common Stock at the beginning of the six-month offering period, or the last day of the purchase period. During 2001, 2002 and 2003, 38,000, 59,000 and 20,771 shares, respectively, were sold under the 1997 Plan. At December 31, 2003, there were 77,666 shares available for issuance under the 1997 Plan.

In 1998, the Company sponsored a 401(k) defined contribution plan covering eligible employees who elect to participate. Southwall is allowed to make discretionary profit sharing and 401(k) matching contributions as defined in the plan and as approved by the board of directors. The Company matches 25% of each eligible participant's 401(k) contribution up to a maximum of 20% of the participant's compensation, not to exceed one thousand dollars per year. Southwall's actual contribution may be reduced by certain available forfeitures, if any, during the plan year. No discretionary or profit sharing contributions were made for the years ending December 31, 2001, 2002 and 2003. Matching contributions for the years ended December 31, 2001, 2002 and 2003 were $0.1 million for each year.

The warrants described below are for common stock at an exercise price of $0.01. With the exception of the warrants issued in connection with the letter of intent, the term of the warrants is five years from the date of issuance. The Company classified the warrants as equity at December 31, 2003 in accordance with EITF 00-19 Accounting for Derivative Financial Instruments Indexed to, and Potentially Settled in, a Company's Own Stock.

As a result of the nominal exercise price of the warrants, the warrant value is based on the value of the common stock on the date of issuance.

The quoted market price of the Company's common stock was not regarded as an appropriate basis for warrant values, on account of the dilution of the stock and the thin trading of the stock. The fair value of the common stock was based on a Company wide valuation performed by management using accepted valuation methodologies.

In connection with the November 11, 2003 Letter of Intent signed between Needham and the Company outlining the proposed debt guarantee and equity financing the Company issued warrants for 1,254,235 shares of common stock, representing 10% of the outstanding common stock of the Company, at $0.01 per share. The warrants expire on November 11, 2008 or execution of definitive investment agreements, whichever is earlier. The warrants expired on December 18, 2003, the date of the signing of the definitive investment agreements.

The warrant includes anti-dilution protection whereby the number of warrants would be increased to 10% of the fully diluted number of shares of the Company in the event that the Company entered into a financing agreement with an alternate investor before the end of the first quarter of 2004.

Needham did not seek exclusive negotiations with the Company and the warrant was considered as compensation for Needham investing time in negotiating and structuring the potential transaction.

The warrants were valued by the Company at $100,000 and reflect the relative probabilities of an agreement being reached and the anti- dilution feature. The fair value of the warrant was recorded as non-operating expense.

In accordance with the investment agreement warrants were to be issued to the Investors on the closing of each guarantee and equity tranche. However, the terms of the investment agreement were such that the Investors were entitled to receive the 752,892 warrants associated with the second tranche of equity regardless of whether the second equity closing occurred or not. This term was inserted to the agreements as further incentive for the Investors to enter into definitive agreements. As the Company has an enforceable obligation to issue the warrants and as the terms of the warrant were known as of the date of the investor agreement, the warrants are considered issued for accounting purposes as of December 18, 2003.

As issued as an incentive to enter into definitive agreements for transactions that the Investors are not committed to, the Company determined that the value of the warrants should be recorded as non-operating expense. The Company considered that the Investors were not committed to the contemplated transactions as a result of the judgmental nature of the closing conditions. Management has determined the value of the warrants to be $309,000.

The investment agreement also included terms that required the Company to issue additional warrants to the Investors if, as part of the restructuring efforts, the Company issued any equity instruments, notes or other debt instruments to any creditor, landlord, employee, director, agent or consultant.

Following the issuance of equity instruments the Company is required to issue to each of the Investors warrants in such amounts as would allow the investors to maintain their aggregate ownership percentage (on a fully-diluted basis) as if such issuance had not occurred. Such warrants represent anti-dilution protection for the investor and are therefore not valued as a stand-alone instrument.

Following note or debt issuances to creditors the Company is required to issue additional warrants to each of the Investors representing the right to purchase that number of shares of common stock equal to the product of (x) 1.25 and (y) the original principal amount of such note or debt instrument. Such warrants represent penalties for the Company failing to eliminate obligations to creditors, and are regarded as issued for accounting purposes as of the date of the agreement triggering legal entitlement.

In December 2003, additional warrants totaling 409,246 were triggered by note or debt issuances. The Company determined the value of the warrants to be $168,000. The fair value of the warrants was recorded as non- operating expense.

In connection with the guarantee from Needham and as additional incentive to complete the financing closings, as contemplated in the investment agreement, the Company issued warrants for 941,115 shares of common stock. Management has determined the value of the guarantee and warrants at $98,000 and $386,000, respectively.

The Company recorded the amount of the warrant value equal to the fair value of the guarantee, $98,000, as debt issuance costs to be amortized over the life of the line of credit. The residual value of the warrants, $288,000, is recorded as non-operating expense, as representing an incentive to enter into definitive agreements for transactions to which Needham are not committed.

In November 2003, and continuing thereafter, the Company defaulted under its Factoring Agreements with PBF. On account of the default, PBF is entitled to demand immediate repayment of all outstanding obligations, or to foreclose its security interest in the Company's collateral. In consideration of PBF's forbearance from exercising its rights and as incentive to provide $3.0 million of borrowings under the line credit, the Company agreed to issue warrants for 250,000 shares of the Company's common stock. In addition, the Company paid a forbearance fee of $70,000 and reimbursed PBF for $31,000 of legal fees. The Company determined that the fair value of the warrants was $102,500. The Company has recorded the fair value of the warrants and the fees to debt issuance costs and is amortizing the amount over the life of the line of credit.

Southwall reports segment information using the management approach to determine segment information. The management approach designates the internal organization that is used by management for making operating decisions and assessing performance as the source of its reportable segments. The Company is organized on the basis of products and services. However, we do not separately track costs associated with our segments. The total net revenues for the automotive glass, electronic display, and architectural product lines were as follows:

                                   2001          2002         2003
                                 ---------     ---------    ---------
                               (in thousands except per share amounts)
Automotive glass..............  $  37,385     $  25,697    $  23,245
Electronic display............     29,691        26,555       19,019
Architectural.................     15,900        16,507       11,062
                                 ---------     ---------    ---------
        Total net revenues....  $  82,976     $  68,759    $  53,326
                                 =========     =========    =========

The following is a summary of net revenue by geographic area for 2001, 2002 and 2003:

                                      2001       2002       2003
                                    ---------  ---------  ---------
                                               (in thousands)
United States..................... $  10,881  $  10,597  $   5,707
Japan.............................    26,755     24,853     17,118
France............................    19,842     12,922      9,327
Pacific Rim.......................     9,113      9,326      7,335
Rest of world.....................     7,830      5,636      6,760
Germany...........................     8,555      5,425      7,079
                                    ---------  ---------  ---------
   Total net revenues............. $  82,976  $  68,759  $  53,326
                                    =========  =========  =========

Southwall operates from facilities located in the United States and Germany. Identifiable assets were as follows:

                                                       December 31,
                                                  ----------------------
                                                     2002        2003
                                                  ----------  ----------
                                                      (in thousands)
United States................................... $   53,838  $   15,392
Germany.........................................     22,744      26,329
                                                  ----------  ----------
   Consolidated................................. $   76,582  $   41,721
                                                  ==========  ==========

The Company leases certain property and equipment as well as its facilities under noncancellable operating and capital leases. These leases expire at various dates through 2009. As of December 31, 2003, the future minimum payments under these leases are as follows:

                                                             Capital     Operating
Year Ending December 31,                                      Leases       Leases
---------------------------------------------              ------------  ----------
                                                              (in thousands)
2004.........................................             $        104  $    2,939
2005.........................................                        6         790
2006.........................................                       --         488
2007.........................................                       --         250
2008.........................................                       --          --
Thereafter...................................                       --          --
                                                           ------------  ----------
Future minimum lease payments................                      110  $    4,467
Less - amounts representing interest.........                      (10)  ==========
                                                           ------------
Present value of future minimum lease payment             $        100
                                                           ============
Current maturities...........................             $         94
                                                           ============
Long-term lease obligations..................             $          6
                                                           ============

Rent expense under operating leases was approximately $3.7 million, $3.7 million and $2.2 million in 2001, 2002 and 2003, respectively. In December 2003 we reached an agreement with the landlord of one of our Palo Alto buildings to change the terms of the lease. As we intend to occupy the premises through December 2004, we accounted for the change as a lease modification in accordance with SFAS No. 13, Accounting for Leases. The modification is reflected in the above table. In January and February 2004, we reached agreements with two further landlords to reduce, or extend the payment periods of our contractual obligations (See Note 13 - Subsequent Events). The 2004 lease modifications are not reflected in the above table.

In July 2002, we were served with a complaint in a lawsuit captioned "Hurricane Glass v. Southwall Technologies Inc. and V-Kool, Inc." filed in the Circuit Court of the Twelfth Judicial Circuit in and for Sarasota County, Florida. The complaint alleges that Hurricane was a distributor of our "Solis" product, that Hurricane's customers experienced various problems and failures with the product and that, as a result, Hurricane was required to perform repairs and replacements under its warranty provisions. The complaint alleges approximately $0.4 million in damages against both defendants. We filed a motion to dismiss based on improper venue, which was denied. On June 4, 2003, the Court of Appeals overturned the lower court's order and granted our motion to dismiss. On October 20, 2003, we were served with a substantially similar lawsuit captioned "Hurricane Glass Shield, Inc. v. Southwall Technologies, Inc." filed in the Superior Court of the State of California in Santa Clara, California. We have filed a demurrer motion seeking to dismiss the case in its entirety. A hearing on that motion is scheduled for May 20, 2004.

We have been named as a defendant, along with Bostik, Inc., in an action entitled "WASCO Products, Inc. v. Southwall Technologies Inc. and Bostik, Inc.," Civ. Action No. C 02-2926 CRB, which was filed in Federal District Court for the Northern District of California on June 18, 2002. We previously filed a Motion to Dismiss and an Opposition to Class Certification. The Motion to Dismiss was granted to us on May 29, 2003. The plaintiff filed its Third Amended Complaint on June 27, 2003. On December 23, 2003, our motion for summary judgment on all of Wasco's remaining claims was granted in our favor. Wasco has filed a notice of appeal to the United States Court of Appeals for the Ninth Circuit.

We were a defendant in an action entitled "Portfolio Financial Servicing Company v. Southwall Technologies Inc.," which was filed in state court in Utah on May 22, 2002. This action arose out of sale-leaseback agreements, which we entered into with an entity formerly known as Matrix Funding Corporation, or Matrix, in 1999 in connection with the acquisition of two of our production machines. Matrix thereafter filed bankruptcy proceedings. Plaintiffs in the action were Bank of America, which alleged that it was the successor in interest to Matrix, and Portfolio Financial Servicing Company which claimed to be an agent of the successor to Matrix. The plaintiffs demanded payment of $6.5 million, which they alleged constituted unpaid lease payments, plus the alleged residual value of the equipment, less monies that Matrix owed to Southwall. We asserted that Matrix violated certain material terms of the lease. We entered into a settlement agreement with the plaintiffs on July 31, 2003, pursuant to which this claim would have been extinguished by payment from us to the plaintiffs of $2.5 million. The settlement agreement was subject to the satisfaction of certain conditions, which were required to be fulfilled on or before October 1, 2003, including the payment of the settlement amount, substantially all of which we needed to borrow. The conditions were not satisfied by October 1, 2003, and the settlement agreement terminated. We reentered discussions with the plaintiffs and achieved a revised settlement agreement on February 20, 2004. Pursuant to the revised settlement agreement, we agreed to pay the plaintiffs a total of $2.0 million plus interest over a period of 6 years from December 31, 2004 until December 31, 2010. We also agreed to return to the plaintiffs the equipment in question. If we fail to make the required payments, the plaintiffs may enter a confession of judgment against us in the amount of $5.9 million. (See Note 13 - Subsequent Events)

We are a defendant in an action filed on April 5, 1996 entitled "Four Seasons Solar Products Corp. vs. Black & Decker Corp., Bostik, Inc. and Southwall Technologies Inc.," No. 5 CV1695, pending in the United States District Court for the Eastern District of New York. Plaintiff is a manufacturer of insulated glass units, which incorporate our Heat Mirror film. Plaintiff alleges that a sealant provided by the co-defendant is defective, asserts causes of action for breach of contract, unfair competition, and fraudulent concealment, and seeks monetary damages of approximately $36 million for past and future replacement costs, loss of customer goodwill, and punitive damages against all defendants. We filed a motion to dismiss. On April 8, 2003, the court issued an order granting final judgment in the Company's favor. Four Seasons has filed a Notice of Appeal. The appeal has been fully briefed and argued, but no decision has been rendered.

The insurance carriers in some of the litigation related to alleged product failures and defects in window products manufactured by others in which we were a defendant in the past paid the defense and settlement costs related to such litigation. Those insurance carriers reserved their rights to recover a portion or all of such payments from us. As a result, those insurance carriers could seek from us up to an aggregate of $12.9 million plus defense costs, although any such recovery would be restricted to claims that were not covered by our insurance policies. We intend to vigorously defend any attempts by these insurance carriers to seek reimbursement. We are not able to estimate the likelihood that these insurance carriers will seek to recover any such payments, the amount, if any, they might seek, or the outcome of such attempts.

In addition, we are involved in certain other legal actions arising in the ordinary course of business. We believe, however, that none of these actions, either individually or in the aggregate, will have a material adverse effect on our business, our consolidated financial position, results of operations or cash flows.

On April 9, 1997, Southwall signed collaborative agreements with a major supplier of the Company's raw materials, Teijin Limited. The agreements provided for, among other things, the purchase by Teijin of 667,000 shares of the Company's common stock at a price of $7.50 per share; a guarantee by Teijin of a $10.0 million loan to the Company; and an agreement to collaborate to achieve closer marketing and product development ties between the two companies. The Company paid an annual loan guarantee fee to Teijin of 0.5625% of the outstanding principal balance of the loan guaranteed by Teijin. The Company paid a loan guarantee fee of approximately $39,179 and $7,070 to Teijin in 2002 and 2003, respectively. Pursuant to a letter agreement dated March 28, 2002, the Company was obligated to prepay $2.5 million of the loan guaranteed by Teijin with the proceeds from common stock sold in a public offering or an amount equal to 10% of the proceeds from a sale of stock other than in a public offering. As a result of the Company's successful follow-on public offering in 2002 (See Note 4), the Company paid $2.5 million, in addition to the scheduled principal payment of $1.25 million, on November 6, 2002. The Company made the scheduled payment of $1.25 million in May 2003. However, we did not make the scheduled payment of $1.25 million due on November 5, 2003 under the loan and Teijin paid the $1.25 million to the Japanese bank in November 2003. On January 19, 2004 we entered into a Guaranteed Loan Agreement with Teijin to satisfy Teijin's claim. (See Note 14 - Subsequent Events)

During 2001, 2002 and 2003 the Company paid Teijin approximately $9.0 million, $6.30 million and $2.2 million for purchases of raw material substrates. At December 31, 2002 and 2003, accounts payable to Teijin were $0.4 million and $0.2 million.

The Company has two distribution agreements with Globamatrix under which the Company granted it exclusive licenses in North America to distribute the Company's after-market applied film in the automotive and architectural glass markets. Under the agreements, which are scheduled to expire in 2007 and 2008, Globamatrix agreed to purchase an annually increasing amount of our products; however, the Company did not enforce the minimum purchase obligation provision in 2002. During 2001, 2002 and 2003 sales to Globamatrix were $5.6 million, $6.4 million and $7.8 million. At December 31, 2002 and 2003, accounts receivable from Globamatrix were $2.9 million and $2.1 million. In December 2002, the Company reached a settlement in the amount of $1.5 million with Globamatrix on a product defect claim that arose in October 2002; of the $1.5 million settlement, $0.5 million was provided as a discount against future purchases beginning January 1, 2003 through October 2003, and had been accrued at December 31, 2002. In August 2003, the Company amended the distribution agreements to reduce Globamatrix' minimum purchase commitment for 2003 from $13.3 million to $7.6 million. In December 2003, the Company further amended the distribution agreements to lower Globamatrix' 2004 minimum purchase commitments from $15.3 million, to $9.0 million.

On April 20, 2001, Globamatrix purchased 422,119 shares of the Company's common stock for $1.0 million (approximately $2.37 per share) pursuant to a stock purchase agreement. The closing price of the Company's common stock on the Nasdaq National Market was $2.10 per share on April 19, 2001, and $2.19 per share on April 20, 2001. The shares were not registered in 2002 and 2003 under the Securities Act. Globamatrix holds registration rights with respect to the shares.

In April 1997, the Company entered into a development and technology agreement with Energy Conversion Devices, Inc., or ECD. This agreement provides that the Company will pursue with ECD the commercialization of the process of sputter coating on flexible substrates using PECVD processes. The agreement further provides that the Company will pay ECD a royalty in an amount based upon the sales volume of product produced through the PECVD process. Southwall agreed to pay to ECD 2.25% of its net sales in connection with PECVD technology for five years and 1.25% of net sales after that. Through December 31, 2003, the process had not been commercialized and the Company had not paid ECD royalties under the agreement. In February 1999, the Company entered into an equipment purchase contract with ECD pursuant to which ECD agreed to modify one of the Company's production machines (PM 7) so that the machine would produce products by means of the PECVD process. The Company paid ECD approximately $0.01 million in 2000, $0.29 million in 2001 and nothing in 2002 and 2003 in connection with its conversion of PM 7 to the use of PECVD technology. A director of Southwall is the Chairman of ECD. As a requirement of the settlement reached with Portfolio Financial Servicing Company (See Note 10), the Company transferred possession of PM 7 to Portfolio Financial Servicing Company, the lien holder of PM 7. At December 31, 2002, the Company owed ECD approximately $0.07 million in connection with the conversion of PM 7, which was represented by a note payable. A final payment of $0.07 million was made in 2003.

During 1998, 1999, 2000, 2001 and 2002, we lent $43,875, $25,313, $0, $18,750 and $14,700, respectively, to Thomas G. Hood, our President and Chief Executive Officer and a director, to permit him to exercise stock options that were about to expire at a time when he was not able to sell the shares issuable upon exercise to pay the exercise price. The indebtedness is represented by full recourse notes payables to us, which are due on June 30, 2003 each bearing interest at the rate of 7.0% per annum. The largest amount of indebtedness outstanding under these notes at any time during 2003 was $130,731, including interest. While the board of director's intention was to enforce collection of the notes, on June 30, 2003, the Company's board of directors forgave all of the outstanding loans, totaling $0.13 million including interest, in lieu of a bonus earned which otherwise would have been paid in cash. The Company recorded this transaction as compensation expense during the second quarter of 2003.

                                                     December 31,
                                               ------------------------
                                                  2002         2003
                                               ----------  ------------
                                                    (in thousands)
Raw materials................................ $    3,703  $      1,690
Work-in-process .............................      3,432         1,502
Finished goods ..............................      1,402         3,638
                                               ----------  ------------
                                              $    8,537  $      6,830
                                               ==========  ============


                                                                 December 31,
                                                           ------------------------
                                                               2002         2003
                                                           ------------  ----------
                                                                (in thousands)
Land, buildings and leasehold improvements...             $     10,297  $    7,737
Machinery and equipment......................                   69,884      29,868
Furniture and fixtures.......................                    7,233       1,036
Construction-in-process......................                   10,870          --
                                                           ------------  ----------
                                                                98,284      38,641
Less - accumulated depreciation..............                  (48,033)    (16,854)
                                                           ------------  ----------
          Total property, plant and equipment             $     50,251  $   21,787
                                                           ============  ==========

Depreciation and amortization expense for the years ended December 31, 2001, 2002 and 2003 was $6.0 million, $6.1 million, and $6.0 million respectively. See Note 5 to the financial statements with respect to a government grant received to offset construction and equipment costs for the German subsidiary.

In December 2002 we implemented a reduction in force at our Palo Alto location in December 2002, and elected to vacate certain buildings in Palo Alto. As a result of these actions, we incurred a restructuring charge of $2.6 million in 2002 relating to employee severance packages and the remaining rents due on excess facilities in Palo Alto no longer occupied. In 2003, we recorded an accounting adjustment of $65,000 as a result of modifications to the severance packages of certain employees. As part of the restructuring plan commenced in the fourth quarter of 2003, we implemented a reduction in force at our Palo Alto and closed our Tempe facilities; however, there were no restructuring charges recorded in the fourth quarter associated with this action.

The remaining outstanding obligations at December 31, 2003 are:

                                           Workforce      Excess
                                           Reduction    Facilities       Total
                                         -------------  -----------  -------------
Balance at January 1, 2002............. $          --  $        --  $          --
Provisions.............................           365        2,281          2,646
Cash payments..........................          (240)          --           (240)
                                         -------------  -----------  -------------
     Balance at December 31, 2002...... $         125  $     2,281  $       2,406
                                         =============  ===========  =============


                                                                                  
                                           Workforce      Excess
                                           Reduction    Facilities       Total
                                         -------------  -----------  -------------
Balance at January 1, 2003............. $         125  $     2,281  $       2,406
Provisions.............................           143           --            143
Adjustment to reserve..................           (65)          --            (65)
Cash payments..........................          (203)        (712)          (915)
                                         -------------  -----------  -------------
     Balance at December 31, 2003...... $          --  $     1,569  $       1,569
                                         =============  ===========  =============

The Company establishes a reserve for warranties and sales returns for specifically identified, as well as, anticipated warranty claims based on warranty experience. As of December 31, 2003 our reserve for warranty and sales returns was as follows (in thousands):

                                                                                 
                                  Balance at                          Balance at
                                 December 31,                        December 31,
                                     2002      Provision  Utilized       2003
                                 ------------  ---------  ---------  ------------
Accrued warranty............... $      2,069  $   2,271  $  (2,489) $      1,851
                                 ============  =========  =========  ============

                                                                                 Long-Term Compensation Awards
                                                                                 -----------------------------
                                                          Annual Compensation    Securities
                                                         ----------------------  Underlying     All Other
         Name and Principal Position            Year     Salary (1)   Bonus (1)  Options       Compensation (2)
---------------------------------------------  -------   ---------    ---------  ----------    -------------
Thomas G. Hood                                  2003    $ 290,354    $ 130,731      60,000    $       1,000
President and Chief Executive Officer           2002      297,513         -         50,000            1,000
                                                2001      270,000      123,571      50,000            1,000

Wolfgang Heinze                                 2003      221,224       28,482      10,000           -
Vice-President, General Manager                 2002      163,660       70,545      20,000           -
Dresden Operations                              2001      175,910         -           -              -

Michael E. Seifert (3)                          2003      214,477         -         25,000           -
Senior Vice President and                       2002         -            -           -              -
Chief Financial Officer                         2001         -            -           -              -

Sicco W. T. Westra                              2003      211,650         -         15,000              529
Senior Vice-President Sales and                 2002      219,469         -         20,000              516
Marketing                                       2001      195,000       50,821      30,000            1,000

Bruce M. Lairson                                2003      185,054         -         25,000            1,000
Vice President, Product and Technology          2002      161,846         -         34,000            1,000
Development                                     2001       47,961       35,018      20,000            1,000

                                                                           Annual Rates of
                    Number of     Percent of                                Stock Price
                    Securities  Total Options                             Appreciation for
                    Underlying    Granted to    Exercise                   Option Term (3)
                     Options     Employees in     Price    Expiration   --------------------
       Name         Granted (1)  Fiscal Year    ($/Sh) (2)    Date         5%         10%
------------------  ----------  --------------  ---------  -----------  ---------  ---------
Thomas G. Hood         60,000             8.3 %    $2.28   02/25/2010    $86,033   $218,024
Wolfgang Heinze        10,000             1.4 %     2.28   02/25/2010     22,800     36,337
Michael E. Seifert     25,000             3.5 %     2.28   02/25/2010     35,847     90,843
Sicco W.T. Westra      15,000             2.1 %     2.28   02/25/2010     21,508     54,506
Bruce M. Lairson       25,000             3.5 %     2.28   02/25/2010     35,847     90,843

                                                   Value of Unexercised
                        Number of Securities          In-the-Money
                       Underlying Unexercised       Options at Fiscal
                      Options at Fiscal Year-End       Year-End
                      ------------------------   -------------------------
        Name          Exercisable  Unexercisable Exercisable   Unexercisable
--------------------  -----------  -----------   -----------   -----------
Thomas G. Hood           244,502      125,714   $     -       $     -
Wolfgang Heinze           29,465       25,535         -             -
Michael E. Seifert        18,750       81,250         -             -
Sicco W.T. Westra         91,015       36,785         -             -
Bruce M. Lairson          18,500       60,500         -             -

                                                                      Common
                                                                      Stock      Percent of
                                                                   Beneficially  Outstanding
    Name and Address                                                Owned (1)    Shares (1)
-----------------------------------------------------------------  ------------  -----------
Needham Investment Management, LLC                                   2,200,067         17.5 %
   445 Park Avenue
   New York, New York  10022
Needham & Company, Inc (7).                                          1,882,230         13.0 %
   445 Park Avenue
   New York, New York  10022
Needham Capital Partners II, L.P. (7)                                3,312,406         20.9 %
   445 Park Avenue
   New York, New York  10022
Needham Capital Partners II (Bermuda), L.P. (7)                        341,375          2.6 %
   445 Park Avenue
   New York, New York  10022
Needham Capital Partners III, L.P. (7)                               5,798,843         31.6 %
   445 Park Avenue
   New York, New York  10022
Needham Capital Partners IIIA, L.P. (7)                                598,878          4.6 %
   445 Park Avenue
   New York, New York  10022
Needham Capital Partners III (Bermuda), L.P. (7)                     1,155,727          8.4 %
   445 Park Avenue
   New York, New York  10022
Needham Capital Partners II (Bermuda), L.P. (7)                        464,317          3.6 %
   445 Park Avenue
   New York, New York  10022
Dolphin Direct Equity Partners, L.P. (8)                             5,498,141         30.5 %
   129 East 17th Street
   New York, New York 10003
Wellington Management Company, LLP                                   1,000,000          8.0 %
   75 State Street
   Boston, Massachusetts  02109
Teijin Limited (2)                                                     667,696          5.3 %
   6-7, Minami-honmachi, 1-Chome
   Chuo-ku, Osaka 541, Japan

William A. Berry                                                            --           *
George Botadjieff                                                           --           *
Jami K. Nachtsheim                                                          --           *
Bruce M. Jaffe                                                              --           *
Joseph B. Reagan (2)                                                    92,867           *
Walter C. Sedgwick (3)                                                 419,829          3.3 %
Robert C. Stempel (5)                                                   20,844           *
Thomas G. Hood (4)                                                     300,627          2.3 %
Wolfgang Heinze (5)                                                     31,965           *
Bruce M. Lairson (5)                                                     5,477           *
Michael Seifert (5)                                                     18,750           *
Sicco W.T. Westra (5)                                                   95,965           *

All current officers and directors as a Group (16 persons) (6)       1,033,685          7.9 %

                                            Balance
                                              at                                   Balance
                                           Beginning                               at End
Description                                 of Year   Additions     Deductions     of Year
-----------------------------------------  ---------  ---------     ---------     ---------
2003
Inventory reserves....................... $     988  $   1,087     $     456 (2) $   1,619
Allowance for Bad Debts.................. $     552  $     275     $      49 (2) $     778
Reserves for warranty and sales returns.. $   2,069  $   2,271 (1) $   2,489 (2) $   1,851
Tax valuation allowance.................. $     751  $  33,827     $      --     $  34,578

2002
Inventory reserves....................... $   1,001  $     255     $     268 (2) $     988
Allowance for Bad Debts.................. $     388  $     353     $     189 (2) $     552
Reserves for warranty and sales returns.. $   2,642  $   2,229 (1) $   2,802 (2) $   2,069
Tax valuation allowance.................. $     996  $      --     $     245     $     751

2001
Inventory reserves....................... $   1,418  $     876     $   1,293 (2) $   1,001
Allowance for Bad Debts.................. $     640  $     460     $     712 (2) $     388
Reserves for warranty and sales returns.. $   1,903  $   3,945 (1) $   3,206 (2) $   2,642
Tax valuation allowance.................. $     557  $     439     $      --     $     996