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UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

FORM 10-K

(Mark One)

For the fiscal year ended September 28, 2003

OR

For the transition period from              to             

Commission file number 1-8402

IRVINE SENSORS CORPORATION

(Exact Name of Registrant as Specified in Its Charter)

3001 Redhill Avenue,

Costa Mesa, California 92626

(Address of Principal Executive Offices) (Zip Code)

Registrant’s Telephone Number, Including Area Code:

(714) 549-8211

Securities registered pursuant to Section 12(b) of the Act:

Securities registered pursuant to Section 12(g) of the Act: None

Indicate by check mark whether the registrant: (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days.    Yes  x    No  ¨

Indicate by check mark if disclosure of delinquent filers pursuant to Item 405 of Regulation S-K is not contained herein, and will not be contained, to the best of registrant’s knowledge, in definitive proxy or information statements incorporated by reference in Part III of this Form 10-K or any amendment to this Form 10-K.    x

Indicate by check mark whether the registrant is an accelerated filer (as defined in Exchange Act Rule 12b-2.)    Yes  ¨    No  x

To the extent known by the registrant, the aggregate market value of the common stock held beneficially by non-affiliates of the registrant on March 28, 2003, the last business day of the registrant’s most recently completed second fiscal quarter, was approximately $8.4 million, based on the closing sales price of the registrant’s common stock as reported by the Nasdaq SmallCap Market on that date. The preferred stock has not been included in the computation because it is not publicly traded.

As of December 23, 2003, there were 14,892,460 shares of common stock outstanding.

DOCUMENTS INCORPORATED BY REFERENCE:

Items 10-13 of Part III, to the extent not set forth herein, incorporate by reference certain information contained in the registrant’s Definitive Proxy Statement to be used in connection with the registrant’s 2004 Annual Meeting of Stockholders.

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IRVINE SENSORS CORPORATION

ANNUAL REPORT ON FORM 10-K

FOR THE FISCAL YEAR ENDED SEPTEMBER 28, 2003

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SPECIAL NOTE REGARDING FORWARD-LOOKING STATEMENTS

In this report, the terms “Irvine Sensors,” “ISC,” “Company,” “we,” “us” and “our” refer to Irvine Sensors Corporation and its subsidiaries.

This report contains forward-looking statements regarding Irvine Sensors which include, but are not limited to, statements concerning projected revenues, expenses, gross profit and income, market acceptance of products, the competitive nature of our business and markets, the success and timing of new product introductions and commercialization of our technologies, the need for additional capital, and the success of pending litigation. These forward-looking statements are based on our current expectations, estimates and projections about our industry, management’s beliefs, and certain assumptions made by us. Words such as “anticipates,” “expects,” “intends,” “plans,” “predicts,” “potential,” “believes,” “seeks,” “estimates,” “should,” “may,” “will” and variations of these words or similar expressions are intended to identify forward-looking statements. These statements are not guarantees of future performance and are subject to risks, uncertainties and assumptions that are difficult to predict. Therefore, our actual results could differ materially and adversely from those expressed in any forward-looking statements as a result of various factors. Such factors include, but are not limited to the following:

We do not undertake any obligation to revise or update publicly any forward-looking statements for any reason.

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PART I

Item 1. Business

General

Irvine Sensors Corporation designs, develops, manufactures and sells electronic products, including subsystems and semiconductors, and other products related to miniaturized electronics for defense, security and commercial applications. We also perform customer-funded contract research and development related to these technologies.

By utilizing our proprietary technologies, we have been able to produce extremely compact packages of solid state microcircuitry, which we believe offer volume, power, weight and operational advantages over competing technologies. These advantages result from our ability to assemble microelectronic chips in a three-dimensional “stack” instead of alongside each other on a flat surface, as is the case with more conventional methods. These stacking technologies have also led to our development of collateral technologies for the design of low power and low noise chips, thinning of chips and various specialized applications of chips and stacked chip assemblies in a variety of fields, including wireless infrared transmission, miniaturized sensors, image processing, infrared cameras, and internet data transmission and switching.

Our core chip-stacking technology was originally conceived and developed as a means of addressing the demands of space-based surveillance. However, the degree of miniaturization potentially realizable from our technologies has attracted research and development sponsorship from various government funding agencies for a wide variety of potential military and space applications, including but not limited to stacked memories, embedded systems, miniaturized cameras and other communications and electro-optical systems. For much of our operating history, we derived most of our revenues from such government-funded research and development. Until the latter part of fiscal 2003, we conducted that funded research and development through a separately organized business unit, which we most recently referred to as our Advanced Technology Division, or ATD. We also had a separate business unit that we referred to as our Microelectronics Product Division, or MPD, which we organized to build and sell specialized stacked chip products for both government and commercial applications. Stacked chip products sold by MPD were a material contributor to our revenues in only one of our last three fiscal years, fiscal 2002, when they accounted for approximately 12% of our total revenues. During fiscal 2003, we reorganized and consolidated ATD and MPD into one business unit to reduce expenses and more effectively deploy our staffing and facilities to support both our contract research and development business and our product business. In addition to customer-funded research and development, we incurred approximately $2.7 million of internally funded research and development expense in fiscal 2003. Since our products generally are derived from technologies that are at least partially developed under government contractual funding, our internal investment is typically focused to complement our customer-funded research and development activities.

ISC was incorporated in California in December 1974 and was reincorporated in Delaware in January 1988. Our principal executive offices are located at 3001 Redhill Avenue, Building 4, Costa Mesa, California 92626, and our telephone number is (714) 549-8211.

ISC Subsidiaries

In recent years, we sought to commercialize some of our technologies by creating independently managed subsidiaries that could pursue their own financing strategies separately from ISC, including Novalog, Inc. (“Novalog”), MicroSensors, Inc. (“MSI”), RedHawk Vision, Inc. (“RedHawk”), iNetWorks Corporation (“iNetWorks”) and our former subsidiary Silicon Film Technologies, Inc. (“Silicon Film”). Other than Novalog, none of our commercial subsidiaries have contributed substantial revenues or earnings to our consolidated results.

Starting in fiscal 2001, we substantially reduced our investments in our subsidiaries, and in fiscal 2003, we reorganized to consolidate our administrative and engineering resources to support all segments of our business, including our subsidiaries, thereby eliminating the need for redundant resources in the individual subsidiaries. At September 28, 2003, none of our subsidiaries had separate employees or facilities. Novalog and MSI continue to sell their respective semiconductor products through ISC. ISC manages and is still seeking licensing relationships and third-party strategic partners to further the potential commercial exploitation of the technologies of our subsidiaries.

The capital structure and ownership of our subsidiaries vary depending on the extent to which the subsidiaries have received equity financing from third-party sources other than ISC. Novalog and RedHawk have received third party financing consisting of private sales of common stock of those subsidiaries initially representing approximately 32% and 30%, respectively, of their issued equity interests. These sales of subsidiary minority interests in Novalog and RedHawk resulted in net proceeds to those subsidiaries in the aggregate of approximately $4.1 million and $581,000, respectively. In fiscal years 1998 and 1999, we repurchased approximately 27.5% of the common stock of Novalog from certain of the minority investors through the issuance of 96,100 shares of ISC common stock, as adjusted to reflect the 1-for-20 reverse stock split in

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September 2001. Those ISC shares were valued at approximately $3.2 million at the time of their issuance. In fiscal 2003, we redeemed approximately 11% of RedHawk’s then outstanding common stock and retired accrued compensation obligations totaling $61,300 for the issuance of 45,000 shares of our common stock valued at $50,000 as part of a settlement agreement with RedHawk’s former Chief Executive Officer. Accordingly, as of September 28, 2003, our ownership of the issued and outstanding capital stock of Novalog, MSI, RedHawk and iNetWorks was approximately 95%, 98%, 81% and 94%, respectively. Assuming the exercise of all of the outstanding options and warrants and additional options that may be granted under existing option plans, our ownership of these subsidiaries would be approximately 67%, 58%, 55% and 69%, for Novalog, MSI, RedHawk and iNetWorks, respectively.

Novalog, MSI, RedHawk and iNetWorks all have substantial intercompany debts payable to ISC. At September 28, 2003, the amount of these intercompany obligations were approximately $3.1 million, $11.2 million, $1.5 million and $2.4 million for Novalog, MSI, RedHawk and iNetWorks, respectively. The obligations are not interest-bearing and contain no conversion rights. However, ISC could elect to cancel some of the indebtedness from Novalog to exercise warrants to purchase up to 3.0 million shares of Novalog’s common stock at the exercise price of $1.00 per share and to cancel some of the indebtedness from MSI to exercise warrants to purchase up to 4.0 million shares of MSI’s common stock at the exercise price of $1.00 per share. In the event that these subsidiaries are successful in attracting additional third-party equity financing, it is possible that we may be required or may elect to convert these obligations into additional equity securities of these subsidiaries.

Novalog, Inc. We formed Novalog in October 1995 to commercially exploit our low power chip technology as applied to wireless infrared data transmission. Novalog is currently a 95% owned subsidiary of ISC that designs, develops and sells proprietary integrated circuits and related products for use in wireless infrared communication. In the past, Novalog has been an active participant in the Infrared Data Association (“IrDA”), which establishes the hardware and software protocols for such products. Novalog’s revenues have declined from approximately $4.5 million in fiscal 2001 to approximately $2.1 million in fiscal 2002 and approximately $1.0 million in fiscal 2003, largely as a result of a decline in sales to suppliers of Palm Computing, historically the primary end-user of Novalog’s products. In fiscal 2003, 2002 and 2001, Novalog accounted for approximately 8%, 14% and 42% of our total revenues, respectively. Novalog incurred approximately $73,600 of internally funded research and development expense in fiscal 2003. At September 28, 2003, the Chief Executive Officer of Novalog was Robert G. Richards, who also serves as the Chief Executive Officer and a Director of ISC.

MicroSensors, Inc. We formed MSI in April 1997 to commercially exploit our technologies for low noise readout electronics and miniaturized inertial sensors. MSI is currently a 98% owned subsidiary of ISC that licenses technology for proprietary micromachined sensors and related electronics. Micromachining involves the use of semiconductor manufacturing processes to build electromechanical devices with feature sizes measured in microns or fractions thereof. As prices have declined for micromachined devices, such solid-state units have migrated from initial aerospace and military applications to automotive, industrial process-control and medical applications. MSI has developed the prototype of a proprietary micromachined inertial sensor, the Silicon MicroRing Gyro^™, which has been designed to measure rotational motion. MSI has also developed a proprietary 3-axis silicon accelerometer, which has been designed to measure motion along a specified axis. MSI has licensed its gyro and accelerometer technology to a third party for further development applicable to automotive applications. The licensee must meet specified financial objectives through December 2004 to retain exclusivity for the licensed use. While this license is royalty bearing to us, we do not anticipate that we will receive significant royalties from this license in the next several years, if at all.

In addition to inertial sensors, MSI has designed application specific integrated circuits (“ASICs”) to readout micromachined sensors and other electronic systems. MSI has shipped engineering samples, qualification lots and small production volumes of such an ASIC product called the Universal Capacitive Readout^™ (“UCR”) to various product developers who wish to evaluate or use it as readout electronics in their products. We believe that there are many uncertainties surrounding the development of MSI’s business, including the risk that large companies may be reluctant to purchase critical parts of the nature that MSI is developing from a small company. This may be true even if MSI, or any licensees, succeed in surmounting all of the developmental challenges of the potential product applications. MSI accounted for approximately 2% of our total revenues in fiscal 2003. MSI incurred no internally funded research and development expense in fiscal 2003. At September 28, 2003, the Chief Executive Officer of MSI was John C. Carson, who also serves as the President and a Director of ISC.

RedHawk Vision, Inc. RedHawk is currently a 81% owned subsidiary of ISC that we formed in March 2000 to design and sell personal computer software tools that digitally enhance video data and extract improved quality images from any video source including personal camcorders, the Internet and television. RedHawk has realized limited revenues from an initial version of this software intended for professional use. In September 2002, RedHawk entered into an agreement with a software developer to further develop its software and manage its sales. While this agreement provides for ISC to receive royalties on future sales of this software, we do not expect to generate material revenues from this agreement in the foreseeable future, if at all. We are seeking strategic partners to further exploit RedHawk’s technology, but we cannot guarantee the

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success of that search. RedHawk did not generate any significant revenues in fiscal 2003. RedHawk incurred no internally funded research and development expense in fiscal 2003. At September 28, 2003, the Chief Executive Officer of RedHawk was Robert G. Richards.

iNetWorks Corporation. iNetWorks is currently a 95% owned subsidiary of ISC that we formed in October 2000 to develop proprietary switches and routers for Internet and telecommunications networks. iNetWorks is a development stage company that has not yet generated any material revenues. iNetWorks has sought strategic partnerships and financing to support its development plans. We have not entered into any such strategic partnerships to date and cannot assure you that such search will be successful in the future. In the interim, we have sought and received government research and development contracts to partially develop technology usable by iNetWorks. iNetWorks incurred no internally funded research and development expenses in fiscal 2003. At September 28, 2003, the Chief Executive Officer of iNetWorks was Mel Brashears, who is also the current Chairman of the Board of ISC.

Silicon Film Technologies, Inc. We formed Silicon Film in June 1998 to commercially exploit some of our digital photography technologies, particularly those related to electronic film systems. Silicon Film suspended operations in September 2001 and was liquidated in fiscal 2002 pursuant to bankruptcy proceedings. At the time of its liquidation, Silicon Film was a 51% owned subsidiary of ISC. Over its operating lifetime, Silicon Film secured third-party investments, developed and demonstrated product prototypes, entered into manufacturing and distribution agreements and completed certification testing on initial elements of its first planned product. Ultimately, however, Silicon Film was not able to achieve launch of its planned products within its available financing. All financial statements and schedules of ISC reflect the discontinuation of Silicon Film’s operations.

Products and Technologies

We have developed a wide variety of technologies that have been derived from our early entry into the field of chip stacking. We have previously sought to commercially exploit many of these technologies through subsidiaries organized to meet the needs of various markets. However, we no longer separate our commercialization activities by subsidiaries or business units, although we do retain the branded nature of products developed by our subsidiaries. We now integrate the development and marketing of our present and future products, regardless of origin, in order to reduce our overall expenses.

We are currently offering products in the following areas:

Stacked Chip Assemblies. We have developed a family of standard products consisting of stacked memory chips that are used for numerous applications, both governmental and commercial. Our technology is applicable to stacking of a variety of microchips, both packaged and unpackaged, that we believe can offer demonstrable benefits to designers of systems that incorporate numerous integrated circuits, both memory and otherwise, by improving speed and reducing size, weight and power usage. In addition, since our technology reduces the number of interconnections between chips, potential system failure points can also decrease. We believe that the features achievable with our chip stacking technology will have applications in space and in aircraft in which weight and volume considerations are dominant, as well as in various other commercial and governmental applications in which portability is required and speed is important.

We are seeking to exploit our chip stacking technology both for the stacking of packaged chips and the stacking of bare or unpackaged chips. We are able to achieve the highest density assemblies through the stacking of bare chips. Accordingly, we market our bare chip stacking technology, largely through the sale of customer-funded development and products, to high end, high margin government and commercial users to whom the technical improvement will be most valuable. While these applications tend to involve lower unit volumes, the potential sales are anticipated to be at significantly higher prices than many applications involving high volume production. While we have existing relationships with both government and commercial customers in this market and have shipped limited quantities of stacked bare memory chip products since fiscal 1995, we are not presently generating significant revenues from sales of such products. We hope to be able to market stacked bare chip products for more widespread applications in the future, but we cannot guarantee our success in that regard.

We have also introduced a number of products in which the chips are enclosed in pre-existing packages, which we modify for stacking. These products are primarily oriented toward meeting the needs of potential commercial customers who are seeking to emulate the performance of advanced monolithic chip packages through the stacking of two or more prior generation packages. Such an approach can offer economic advantages because of the high costs of advanced monolithic chip packages during early phases of the monolithic product lifetime. These types of stacked chip-package products are also available from competitors, but we believe that our chip-package stacking technology has advantages in terms of board space utilized and performance over that of competitors. Since our introduction of such products, we have achieved limited market penetration, largely for non-commercial applications. We believe that the market for such products is currently in a state of transition as industry standard chip-packaging is shifting from Thin Small Outline Packages (“TSOPs”), in which wire bonds

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are used to attach chip packages to boards, to more widespread use of smaller chip packages that use Ball Grid Array (“BGA”) solder ball connections for board mounting to enable smaller and higher density product applications. We believe that this industry transition may broaden our prospects for commercial market penetration. However, we have not yet achieved commercial orders of sufficient size to provide validation of that belief, and we cannot assure you that we will achieve such orders in the future. Our revenues from the sale of stacked chip packages, which to date have all been TSOPs, represented only 5.4% of our total revenues in fiscal 2001, 11.9% of our total revenues in fiscal 2002 and 7.7% of our total revenues in fiscal 2003, so we do not have sufficient history to assure you that such products will ever achieve broad market acceptance.

Customers’ demand for enhanced performance of electronic systems has produced a wide variety of competitors and competitive systems offering higher density microelectronics ranging from various three-dimensional designs to highly dense two-dimensional designs. Although some of our competitors are better financed, more experienced and organizationally stronger than us, we are not aware of any system in existence or under development that can stack chips more densely than our three-dimensional approach. See “Competition.”

Miniaturized Infrared Cameras. Several of our research and development contracts have involved the miniaturization of imaging devices, particularly those using infrared detectors that create images by sensing the heat emitted by objects being viewed. Such technology is directly applicable to applications requiring vision at night or in smoke-filled environments. Our initial product development using this technology has focused on low-power, rugged infrared cameras for security and surveillance applications. A combination of our miniaturization activities with the advanced electronic packaging available using our chip stacking has led to the development of an “instant-on” infrared camera that overcomes power limitations of competitive approaches. We have shipped small quantities of such a product to several customers for testing, and have announced the availability of this product for limited production. We also intend to market products utilizing this core technology in applications such as weapons sights and helmet-mounted imaging devices for firefighters.

Microchips and Sensors. Our Novalog subsidiary has developed a serial infrared communications chip using elements of our sensor chip design technology. This device is being used in products in order to allow computers, computer peripherals and hand-held portable electronics devices such as personal organizers, pagers and cellular phones to communicate using infrared transmissions in a manner similar to that used by remote control units for televisions and video cassette recorders. Novalog has been shipping such devices since 1995. We continue to sell various forms of this chip under the Novalog brand name.

Our MSI subsidiary has introduced the UCR ASIC readout chip intended for use by manufacturers of micromachined products who require low noise electronic readout circuitry. MSI has shipped engineering samples, qualification volumes and small production volumes of both standard and specialized versions of the UCR to various customers. We continue to sell various forms of the UCR chip under the MSI brand name. MSI has also developed a proprietary inertial sensor, the Silicon MicroRing Gyro, which is intended to provide an inexpensive means to measure rotational motion for a wide variety of potential applications. In September 1999, a United States patent, assigned to MSI, was granted covering the design of the Silicon MicroRing Gyro. The commercial exploitation, if any, of the Silicon MicroRing Gyro is expected to be paced by product design-in lead times of customers, principally Original Equipment Manufacturers, or OEMs. Similarly, MSI has also developed a proprietary 3-axis silicon accelerometer that is also dependent on OEM schedule considerations. MSI’s gyro and accelerometer technology has been licensed to a third party for further development targeted for automotive applications. Because of the long lead-time of such product applications and the technical challenges of such development, we do not expect material revenues from the gyro and accelerometer technology for several years, if at all.

Software. We formed our RedHawk subsidiary to exploit our proprietary software technology for extracting quality still photographs from any video source. In September 2000, RedHawk introduced an initial version of its software primarily intended for use by professionals in the video and photographic industries. RedHawk has an agreement with an individual software developer to further develop this product, pursuant to which this developer introduced an enhanced version of RedHawk’s product in October 2003. We are seeking strategic relationships to more broadly exploit this technology. Pending such strategic relationships, an outcome that we cannot guarantee, RedHawk’s revenues are minimal.

Potential Product Applications

Embedded Systems. In fiscal 1998, we commenced exploration of a technology to stack chips of different functionality and dimensions within the same chip stack, in effect creating a complete, miniaturized electronic system that can be embedded in a higher-level product. We refer to this technology as “NeoStack.”^™ In fiscal 1999, a U.S. patent was granted on our NeoStack technology. We initially demonstrated our NeoStack technology to support a government program to develop a wearable computer. We are presently developing potential commercial applications of this technology under other government contracts. We believe, but cannot assure, that our NeoStack approach will offer advantages in terms of compactness and power consumption to developers of a wide variety of embedded computer and control systems. However, we have not yet developed this technology to the point at which we can make forecasts of potential revenue, if any, resulting from our licensing or application by OEMs.

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Active Imaging Systems. Many of the potential government applications for which we have received developmental funding over the years have involved advanced techniques for acquiring and interpreting images. In fiscal 2002, an industry team that we formed and led, and one other industry team, won an open competition to design an advanced imaging system based on integration of laser pulse returns to allow the extraction of images of objects concealed by foliage. The prototype units built under this contract were successfully demonstrated in fiscal 2003 and may have further applications. We have been notified of additional government contract awards related to this technology, which may help us to further explore possible future product applications.

Internet Routers. In October 2000, we formed our iNetWorks subsidiary to exploit our proprietary chip-stacking technology, combined with superconducting chip technology, to develop ultra-high-speed switches and routers for Internet and telecommunications networks. We have sought and received some government-funded research and development contracts to support the development of our router-related technology, while iNetWorks has sought appropriate strategic and financial partners to commercialize this technology. This search has not yet been successful, and we anticipate that development of this technology for its intended application will require substantial additional financial resources, which may not be available on acceptable terms, if at all.

Neural Networks. We have received a number of contracts from government agencies regarding the development of artificial neural networks. Neural networks contain large numbers of processing nodes which continuously interact with each other, similar to the way that the neurons of a human brain interact to process sensory stimuli. Neural networks are the subject of scientific inquiry because pattern recognition and learning tasks, which humans perform well, and computers perform poorly, appear to be dependent on such processing. Neither conventional computers nor advanced parallel processors have the interconnectivity needed to emulate neural network processing techniques. We are presently pursuing additional contracts under which we would deliver demonstration products to various branches of the Department of Defense incorporating such technology. We believe our chip stacking technology offers a way to achieve the very high levels of interconnectivity necessary to construct an efficient artificial neural network. While the full embodiment of our neural network technology is expected to be years away, if at all, we intend to continue to pursue research and development in this area in order to broaden the potential product application of the technology.

Infrared Sensors. The focus of our original government funded research and development and much of our subsequent follow on awards has been in the field of government applications of infrared sensors. We intend to continue to pursue such contracts with the goal of developing and selling infrared sensors for surveillance, acquisition, tracking and interception applications for a variety of Department of Defense and NASA missions.

Manufacturing

We use contract manufacturers to fabricate and assemble our stacked chip, microchip and sensor products. At our current limited levels of product sales, we typically use single contract manufacturing sources for such products and are thus vulnerable to disruptions in these sources. However, for these products, we use semiconductor fabrication and related manufacturing sources that we believe are widely available worldwide should such disruption occur. At their present low volumes, we currently manufacture our camera products ourselves. Our RedHawk licensee manufactures our software products. We are not currently manufacturing any iNetWorks products and are seeking strategic partners to provide manufacturing support in the future.

Our original bare chip stacking technology involves a standard manufacturing process that fabricates cubes comprising multiple die layers along with ceramic cap and base substrates laminated with an extremely thin adhesive layer and interconnected with a thin-film bus metalization to bring the chip input/output signals out to the top surface of the stacks. The cubes can then be segmented or split into subsections as required for the particular product configuration being built. Finally, the cubes, mini-cubes or short stacks are burned in, tested, graded, kitted for packaging, out-sourced for packaging and screening, and returned for final test. Our facility is designed for low volume and prototype production of such parts.

We have also developed an advanced process of ultra-high-density stacking in which we first embed more than one bare chip or supporting electronics component in an adhesive layer, thereby creating what we refer to as a “Neo-Chip.”^™ We then use manufacturing processes similar to our original bare chip stacking technology to stack these Neo-Chips, resulting in a Neo-Stack. (See “Business – Potential Product Applications – Embedded Systems.”)

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In the last several years, we have introduced more cost-competitive stacked packaged chip products that are manufactured with current state-of-the-art manufacturing technologies that we have selected to also be compatible with stacking of Neo-Chip products in the future. We use independent third party qualified source vendors for the manufacturing of these products. We currently have no long-term manufacturing contracts for any of our products.

The primary components of our non-memory products are integrated circuits and infrared detectors. We typically design the integrated circuits for manufacture by third parties from silicon wafers and other materials readily available from multiple sources. While we do not have any long-term arrangements with suppliers for the purchase of these materials, we believe we will have sufficient capacity to address our near term needs.

Because of the nature of the sophisticated work performed under our research and development contracts, we design and assemble equipment for testing and prototype development. We use the unique capability of this equipment to seek, qualify for and perform additional contract research and development for our customers.

Backlog

Funded backlog includes amounts under contracts that have been awarded to us and for which we have authority to bill. At November 21, 2003, our consolidated funded backlog was approximately $2.6 million compared to approximately $1.6 million at November 24, 2002. We anticipate that substantially all of our current funded backlog will be filled in fiscal 2004. In addition, we have unfunded backlog on contracts that we have won, but that have not yet been fully funded, in which funding increments are expected to be received when the previously funded amounts have been expended. We are also continuing to negotiate for additional research contracts and commercial product sales. Many of these proposals for additional research contracts are submitted under the Small Business Innovation Research (“SBIR”) provisions of all government agencies that conduct funded research and development. In the past, we have submitted approximately 50 or more Phase 1 SBIR proposals in any given fiscal year, with between five and ten of those proposals generally leading to initial contract awards valued between $50,000 - $100,000 each. Of those Phase 1 contracts, approximately half of them have historically resulted in follow-on Phase 2 awards, usually valued between $500,000 – $1,000,000 each. In fiscal 2003, fiscal 2002 and fiscal 2001, we generated approximately $1.6 million, $2.0 million and $2.4 million, respectively, of funded contract revenue from these proposals. We cannot guarantee you that future SBIR contract awards, if any, will match or exceed our historical experience, and we may not be successful in securing future contract awards. Failure to continue to obtain these SBIR awards and other funded research and development contracts in a timely manner, or at all, could materially and adversely affect our business, financial condition and results of operations.

Customers and Marketing

Historically, we have primarily focused our marketing of research and development contracts directly on U.S. government agencies or contractors to those agencies. Under our recently consolidated organization, we intend to continue to seek and prepare proposals for additional contracts from such sources. We also develop potential non-military uses of our technology. We believe that there will be more emphasis and funds directed to advanced technology systems and research programs for which we are qualified to compete. We believe that we may be successful in competing for some potential programs of this nature, although we cannot guarantee this outcome.

We market our infrared sensors and related microchips directly to OEMs that supply infrared communications devices complying with the standards of IrDA. Novalog has established relationships with these OEMs and their suppliers. We also believe that Novalog’s history of participation in IrDA facilitates its marketing to those customers.

We market our UCR microchips and related inertial sensors toward three commercial areas: (i) customers with a need for custom ASICs that require low capacitance; (ii) OEMs that have a need for the cost and performance features that could be provided by MSI’s Silicon MicroRing Gyro or 3-axis accelerometer, with particular emphasis toward manufacturers of electronic toys and games, industrial monitoring equipment, medical instrumentation and automotive markets; and (iii) the manufacturers of micromachined sensors who may be able to utilize MSI’s UCR general purpose ASIC designed to support a variety of sensors requiring high accuracy capacitive readout and control electronics. MSI has licensed a third party to pursue development and marketing of these products for automotive applications. We are also focused on securing strategic partnerships with significant, existing market presence in other business areas to market these products.

We have focused our initial marketing efforts for our software product on high-end users of professional photo-editing software. Our initial product was designed as a plug-in to such software. RedHawk has licensed a software developer to further develop our software product and is seeking strategic partners to facilitate the development and marketing of future versions of its software to address broader market opportunities. This licensee introduced a stand-alone version of RedHawk’s software in October 2003.

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The target market for our Super Router is expected to be OEMs and carriers that support Internet and telecommunications infrastructure. We have sought strategic relationships with such entities to facilitate the development and marketing of the contemplated Super Router and related products, but have not yet secured such relationships.

In fiscal 2003, direct contracts with the U.S. government accounted for approximately 76% of our total revenues and second-tier government contracts with prime government contractors accounted for approximately 7% of our total revenues. The remaining 17% of our total revenues was derived from non-government sources. During fiscal 2003, revenues derived from the U.S. Army and the Defense Advanced Research Projects Agency accounted for approximately 49% and 16% of total revenues, respectively. Loss of either of these customers would have a material adverse impact on our business, financial condition and results of operations. No other customer accounted for more than 10% of our total revenues for fiscal 2003.

Contracts with government agencies may be suspended or terminated by the government at any time, subject to certain conditions. Similar termination provisions are typically included in agreements with prime contractors. We cannot assure you that we will not experience suspensions or terminations in the future.

We focus marketing in specific areas of interest in order to best use our relatively limited marketing resources. With our de-emphasis on subsidiaries and reintegration of subsidiary operations, we are coordinating our marketing through a centralized director of marketing and individuals with specific responsibilities for Novalog, MSI and stacked chip products. The marketing of RedHawk products is conducted through a service relationship with the software developer licensee of that technology.

Competition

The demand for high performance semiconductors has produced a wide variety of competitors and competitive systems, ranging from various three-dimensional designs to highly dense two-dimensional designs. For most commercial applications, the principal competitive factor is cost, although operating speed is increasingly becoming a factor. For some applications in which volume and weight are critical, such as space or avionics, we believe density is the principal competitive factor. We believe that many of our competitors are better financed, more experienced and have more extensive support infrastructure than us. Accordingly, we may not be able to successfully compete in such markets in the future.

We are aware of three primary companies that have developed or acquired competing approaches to high-density chip stacking, Micro Technologies, Inc., 3D Plus and Vertical Circuits, Inc. In addition, there are several independent companies such as Staktek Corporation, DST Modules, and Tessera Technologies and divisions of large companies that have various technologies for stacking a limited number of chips in packaged form.

We are also aware of many companies that are currently servicing the military market for electro-optical sensors of the type that our products are also designed to support. We believe the principal competitive factor in this business area is the performance sensitivity and selectivity achievable by alternative sensor approaches and designs. Our primary competitors include Texas Instruments, Inc., Lockheed Martin Corporation, Raytheon, Northrop Grumman, BAE Systems, EG&G Judson, OptoElectronics-Textron, Inc. and Boeing Corporation. We believe that most of our competitors in this area have greater financial, labor and capital resources than us, and accordingly, we may not be able to compete successfully in this market.

We believe that our major competitor for miniaturized infrared camera products is Indigo Systems. Indigo Systems has announced a pending merger with FLIR Systems, Inc., scheduled to be effective in 2004. We believe that our current miniaturized infrared camera product has some performance advantages over products of Indigo Systems, but both Indigo Systems and FLIR Systems have greater financial, labor and capital resources than us, and accordingly, we may not be able to compete successfully in this market.

We currently compete with several companies that service the market for serial infrared detectors. For battery-powered applications, we believe that the principal competitive factors for such products are costs and power consumption. For desktop and related applications, we believe that the principal competitive factor is the speed of data transmission achievable. We believe that our serial infrared detectors have competitive advantages in the battery-powered applications. Our primary competitors in this sector include Agilent and Vishay Intertechnology, Inc., among others, both of whom have greater financial, labor and capital resources than us.

We believe that the primary competitors for our Silicon MicroRing Gyro include several larger companies, such as Delco Electronics, Motorola, Bosch Corporation and Systron-Donner. We believe that the principal competitive factor for these applications is cost. The expected costs for products utilizing Silicon MicroRing Gyro and accelerometer technologies are anticipated to provide a significant competitive advantage through a lower market price if our licensees can successfully develop and qualify products using our technology. We have no present knowledge of competitors planning to introduce

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ASICs competitive to our UCR product, but given the widespread availability of integrated circuit design capabilities in the electronics industry, we believe that the emergence of competitive products is likely. To address these competitive challenges, we are seeking strategic partners with appropriate market presence and financial resources.

We are aware of some competitive software products intended to capture still photographs from video and the existence of a number of hardware applications to achieve this result, but we are not aware of any significant competitor that is able to attain the quality level achievable with the RedHawk software. We are currently seeking strategic partners to enhance our ability to compete in this market.

We believe the primary competitors for our Super Router are presently Cisco Systems, Inc. and Juniper Networks, Inc. We anticipate that we will have to face numerous large competitors of this nature with respect to our Super Router, if we are able to get its development financed, an outcome that we cannot assure. Accordingly, we may not be able to compete successfully in this market.

Research and Development

We believe that government and commercial research contracts will provide a portion of the funding necessary for continuing development of some of our products. However, the manufacture of stacked circuitry modules in volume will require substantial additional funds, which may involve additional equity or debt financing or a joint venture, license or other arrangement. Furthermore, the development of some of the products of our subsidiaries, particularly iNetWorks, is likely to require substantial external funding. We cannot assure you that sufficient funding will be available from government or other sources or that we will successfully develop new products for volume production.

Our consolidated research and development expenses for the fiscal years ended September 28, 2003, September 29, 2002 and September 30, 2001 were approximately $2.7 million, $2.0 million and $6.0 million, respectively. These expenditures were in addition to the cost of revenues associated with our customer-sponsored research and development activities. The increase in spending levels of our own funds on research and development in fiscal 2003 was largely due to our deployment of underutilized direct personnel to such activities during periods when government contracts were delayed.

We have historically funded our research and development activities primarily through contracts with the federal government and with funds from our public and private stock offerings.

Patents, Trademarks and Licenses

We primarily protect our proprietary technology by seeking to obtain, where practical, patents on the inventions made by our employees. As of September 28, 2003, 64 currently effective U.S. and foreign patents have been issued and other U.S. patent applications are pending. Foreign patent applications corresponding to several of the U.S. patents and patent applications are also pending. Seven of these patents, covering early versions of our stacking technology, expire in two years or less. An additional six patents covering early versions of our stacking technology expire in three to five years. The remainder of our stacking patents, including those covering the stacking technologies that are the basis of our current product and product development activities, have durations ranging from six to 18 years. We also have patents on a variety of collateral technologies that we developed to support, facilitate or utilize our stacking technologies. Those patents have durations ranging from one to 18 years. The patent covering certain circuit technology embodied in Novalog’s products has a remaining duration of over ten years. We cannot assure you that additional patents will issue in the U.S. or elsewhere. Moreover, the issuance of a patent does not carry any assurance of successful application, commercial success or adequate protection. We cannot assure you that our existing patents or any other patent that may issue in the future will be upheld if we seek enforcement of our patent rights against an infringer or that we will have sufficient resources to prosecute our rights. We also cannot assure you that our patents will provide meaningful protection from competition. In addition, if others were to assert that we are using technology covered by patents held by them, we would evaluate the necessity and desirability of seeking a license from the patent holder. We cannot assure you that we are not infringing on other patents or that we could obtain a license if we were so infringing.

The products and improvements that we develop under government contracts are generally subject to royalty-free use by the government for government applications. However, we have negotiated certain “non-space” exclusions in government contracts and have the right to file for patent protection on commercial products which may result from government-funded research and development activities.

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In February 1998, we entered into an assignment of patent and intellectual rights agreement with F.K. Eide, our Vice-President. As part of an employment agreement, Mr. Eide assigned to us all rights and interests to five U.S. Provisional Patent Applications owned by him. In consideration for this assignment, Mr. Eide will receive a 1% royalty on the gross sales revenues, if any, of any products incorporating the technology of these patent assignments for the lifetime of these patents.

Employees

As of December 17, 2003, we had 85 full-time employees and two consultants. Of the full-time employees, 68 were engaged in engineering, production and technical support, four in sales and marketing and 13 in finance and administration. None of our employees is represented by a labor union, and we have experienced no work stoppages due to labor problems. We consider our employee relations to be good.

RISK FACTORS

Our future operating results are highly uncertain. Before deciding to invest in our common stock or to maintain or increase your investment, you should carefully consider the risks described below, in addition to the other information contained herein, and in our other filings with the SEC, including any subsequent reports filed on Forms 10-Q and 8-K. The risks and uncertainties described below are not the only ones that we face. Additional risks and uncertainties not presently known to us or that we currently deem immaterial may also affect our business and results of operations. If any of these risks actually occur, our business, financial condition or results of operations could be seriously harmed. In that event, the market price for our common stock could decline and you may lose all or part of your investment.

We have historically generated substantial losses, which, if continued, could make it difficult to fund our operations or successfully execute our business plan, and could adversely affect our stock price. Since our inception, we have generated net losses in most of our fiscal periods. We experienced net losses of approximately $6.3 million for the fiscal year ended September 28, 2003, $6.0 million for the fiscal year ended September 29, 2002 and $14.6 million for the fiscal year ended September 30, 2001. In recent years, much of our losses were incurred as a result of our significant investments in our development stage operating subsidiaries or their related technologies. While we have significantly reduced our investment in our subsidiaries and their technologies and correspondingly have reduced our net losses, we cannot assure you that we will be able to achieve or sustain profitability on a quarterly or annual basis in the future. In addition, because a large portion of our expenses are fixed, we generally are unable to reduce expenses significantly in the short-term to compensate for any unexpected delay or decrease in anticipated revenues. We experienced contract delays in the fiscal year ended September 28, 2003 that resulted in unanticipated additional operating expenses to keep personnel on staff while the contracts were pending with no corresponding revenues. Such factors could cause us to continue to experience net losses in future periods, which will make it difficult to fund our operations and achieve our business plan, and could cause the market price of our common stock to decline.

We will need to raise additional capital in the future, and additional funds may not be available on terms that are acceptable to us, or at all. We have generated significant net losses in recent periods, and experienced negative cash flows from operations in the amount of approximately $3.8 million for the fiscal year ended September 28, 2003, approximately $1.4 million for the fiscal year ended September 29, 2002 and approximately $10.2 million for the fiscal year ended September 30, 2001. As a result of these significant losses, we have historically funded our operations through multiple equity financings, and to a lesser extent through receivable financing. We anticipate that we will continue to rely on such funding for at least the foreseeable future. We engaged in various financing transactions in fiscal years 2003, 2002 and 2001, raising aggregate net proceeds of approximately $12.2 million. When combined with various non-cash transactions to retire payables and expenses and the sale and conversion of convertible preferred stock, the amount of common stock we issued in that three fiscal year period exceeded 10.6 million shares, resulting in significant dilution to our existing stockholders.

At September 28, 2003, we had consolidated negative working capital of approximately $261,400. We cannot guarantee that we will be able to generate sufficient funds from our operations to meet our immediate working capital needs. In addition, our current growth plans require certain equipment, facility and product development expenditures that cannot be funded solely from cash generated from operations unless and until our current liabilities are substantially retired. Accordingly, we anticipate that we may need to raise additional capital in the near future. We cannot assure you that any additional capital will be available on a timely basis, on acceptable terms, or at all. Future financings may require stockholder approval, which may not be obtainable. If we are not able to obtain additional capital in the near future, our business, financial condition and results of operations will be materially and adversely affected.

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We anticipate that our capital requirements will depend on many factors, including:

If our capital requirements are materially different from those currently planned, we may need additional capital sooner than anticipated. Additional funds may be raised through borrowings, other debt or equity financings, or the divestiture of business units or select assets. If additional funds are raised through the issuance of equity or convertible debt securities, the percentage ownership of our stockholders will be reduced and such securities may have rights, preferences and privileges senior to our common stock.

Additional funds may not be available on favorable terms or at all. Even if available, financings can involve significant costs and expenses, such as legal and accounting fees, diversion of management’s time and efforts, or substantial transaction costs or break-up fees in certain instances. If adequate funds are not available on acceptable terms, or at all, we may be unable to finance our operations, develop or enhance our products, expand our sales and marketing programs, take advantage of future opportunities or respond to competitive pressures.

If we are not able to commercialize our technology, we may not be able to increase our revenues or achieve or sustain profitability. Since commencing operations, we have developed technology, principally under government research contracts, for various defense-based applications. Contract research and development revenue accounted for approximately 69% of our total revenues for the fiscal year ended September 29, 2002 and approximately 82% of our total revenues for the fiscal year ended September 28, 2003. However, since our margins on government contracts are generally limited, and our revenues from such contracts are tied to government budget cycles and influenced by numerous political and economic factors beyond our control, and are subject to our ability to win additional contracts, our long-term prospects of realizing significant returns from our technology or achieving and maintaining profitability will likely also require penetration of commercial markets. In prior years, we have made significant investments to commercialize our technologies without significant success. These efforts included the purchase and later shut down of the IBM cubing line, the formation of the Novalog, MSI, Silicon Film, RedHawk and iNetWorks subsidiaries and the development of various stacked-memory products intended for military, aerospace and commercial markets. While these changes have developed new revenue sources, they have not yet resulted in consolidated profitability to date, and a majority of our total revenues for the fiscal years ended September 29, 2002 and September 28, 2003 were still generated from contract research and development. Only our Novalog subsidiary has experienced periods of profitability, and that subsidiary is not currently profitable primarily due to the decline in the sales of its products for use in Palm PDAs, the largest historical end use application of Novalog’s products. We are currently focusing on introducing a line of stacked memory products incorporating Ball Grid Array or BGA attachment technology because we believe emerging commercial demand exists for such products. We are currently dedicating significant development resources and funding to pursue the commercialization of our BGA stacking technology, a process which involves technical risk. If our perceptions about market demand are incorrect or we fail to successfully complete development, introduce and achieve market penetration for these products, our total revenues will not be sufficient to fully absorb our present indirect expenses and achieve profitability. We cannot assure you that our BGA products or our other current or contemplated products will achieve broad market acceptance in commercial marketplaces, and if they do not, our business, results of operations and financial condition will be materially and adversely affected.

If we are not able to obtain market acceptance of our new products, our revenues and results of operations will be adversely affected. We generally focus on markets that are emerging in nature. Market reaction to new products in these circumstances can be difficult to predict. Many of our planned products, including our new stacked BGA products, incorporate our chip stacking technologies that have not yet achieved broad market acceptance. We cannot assure you that our present or future products will achieve market acceptance on a sustained basis. In addition, due to our historical focus on

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research and development, we have a limited history of competing in the intensely competitive commercial electronics industry. As such, we cannot assure you that we will be able to successfully develop, manufacture and market additional commercial product lines or that such product lines will be accepted in the commercial marketplace. If we are not successful in commercializing our new products, our ability to generate revenues and our business, financial condition and results of operations will be adversely affected.

We are defendants in a class-action stockholders lawsuit, an unfavorable outcome of which could harm our ability to continue our operations, and the defense of which has also substantially increased our operating expenses and diverted our resources. We have been sued in a securities class action by certain stockholders who allege that we made false and misleading statements about the prospects of our Silicon Film subsidiary during the period January 6, 2000 to September 15, 2001, inclusive. The complaint asserts claims for violations of Sections 10(b) and 20(a) of the Securities Exchange Act of 1934, as amended (the “Exchange Act”), and SEC Rule 10b-5, and seeks damages of an unspecified amount. A preliminary trial date has been set for July 2004, provided that the lawsuit is not settled or dismissed prior to then. We believe that the class action is without merit and have retained counsel to vigorously defend against the lawsuit. As a result of this lawsuit, our legal expenses increased by $250,000 in fiscal 2002, which satisfied the threshold requirement for retention under our directors and officers insurance policy with the result that our fiscal 2003 legal expenses for the defense of this lawsuit were born by our insurance carrier. It is possible that the costs of, or any judgment against us, in such lawsuit could exceed the policy limits of such insurance policy. In addition, this litigation process is placing an increasing demand on our personnel, diverting such resources from other, more productive activities. Moreover, the outcome of any litigation is inherently uncertain, and we may not be able to satisfy an unfavorable outcome in this litigation, which could cause us to discontinue our operations.

Our common stock may be delisted from the Nasdaq SmallCap Market if our stock price declines further or if we cannot maintain Nasdaq’s minimum net worth listing requirements. In such case, the market for your shares may be limited, and it may be difficult for you to sell your shares at an acceptable price, if at all. Our common stock is currently listed on the Nasdaq SmallCap Market. Among other requirements, to maintain this listing, our common stock must continue to trade above $1.00 per share. In July 2001, our stock had failed to meet this criterion for over 30 consecutive trading days. As a result, in accordance with Marketplace Rule 4310(c)(8)(B), we were notified by Nasdaq that we had 90 calendar days or until October 2001 to regain compliance with this Rule by reestablishing a sales price of $1.00 per share or greater for ten consecutive trading days. To regain compliance, we sought and received approval from our stockholders to effect a 1-for-20 reverse split of our common stock that became effective in September 2001, resulting in recompliance by the Nasdaq deadline. However, subsequent to the reverse split, our common stock has, at various times, traded close to or below the $1.00 per share minimum standard, and we cannot assure you that the sales price of our common stock will continue to meet Nasdaq’s minimum listing standards. At December 12, 2003, the closing sales price of our common stock on the Nasdaq SmallCap Market was $3.25 per share.

In addition to the price requirement, in the absence of sustained profitability, we must also meet at least one of the three following additional standards to maintain our Nasdaq listing: (1) maintenance of stockholders’ equity at $2.5 million or greater, (2) maintenance of our market capitalization in excess of $35 million as measured by market prices for trades executed on Nasdaq, or (3) net income from continuing operations of $500,000 in the latest fiscal year or two of the last three fiscal years. In July 2001, Nasdaq notified us that we were deficient with respect to all of these additional standards based on our financial statements as of April 1, 2001. In August 2001, Nasdaq advised us that, based on updated information, we had reestablished compliance with the $35 million market capitalization standard. However, the subsequent decline in the price of our common stock resulted in another deficiency notice from Nasdaq in August 2001. At that time, we did not comply with either the market capitalization standard or the stockholders’ equity standard. However, based solely on improvements in our stockholders’ equity resulting from the net gain of approximately $0.9 million realized from the discontinuance of operations of our Silicon Film subsidiary in September 2001, we were able to meet the minimum stockholders’ equity standard and reestablish compliance in November 2001. As of September 28, 2003, we had stockholders’ equity of approximately $4.5 million. Although we are currently in compliance with Nasdaq’s listing maintenance requirements, we cannot assure you that we will be able to maintain our compliance with these requirements in the future. If we fail to meet these or other listing requirements, our common stock could be delisted, which would eliminate the primary market for your shares of common stock. As a result, you may not be able to sell your shares at an acceptable price, if at all. In addition, such delisting may make it more difficult for us to raise additional capital in the future since we may no longer qualify to register shares for resale on a Form S-3 registration statement.

If we are delisted from the Nasdaq SmallCap Market, your ability to sell your shares of our common stock would also be limited by the penny stock restrictions, which could further limit the marketability of your shares. If our common stock is delisted, it would come within the definition of “penny stock” as defined in the Exchange Act and would be covered by Rule 15g-9 of the Exchange Act. That Rule imposes additional sales practice requirements on broker-dealers who sell securities to persons other than established customers and accredited investors. For transactions covered by Rule 15g-9, the broker-dealer must make a special suitability determination for the purchaser and receive the purchaser’s written agreement

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to the transaction prior to the sale. Consequently, Rule 15g-9, if it were to become applicable, would affect the ability or willingness of broker-dealers to sell our securities, and accordingly would affect the ability of stockholders to sell their securities in the public market. These additional procedures could also limit our ability to raise additional capital in the future.

Our stock price has been subject to significant volatility. You may not be able to sell your shares of common stock at or above the price you paid for them. The trading price of our common stock has been subject to wide fluctuations in the past. Since January 2000, our common stock has traded at prices as low as $0.75 per share and as high as $375.00 per share (after giving effect to the 1-for-20 reverse stock split effected in September 2001). We may not be able to increase or sustain the current market price of our common stock in the future. As such, you may not be able to resell your shares of common stock at or above the price you paid for them. The market price of the common stock could continue to fluctuate in the future in response to various factors, including, but not limited to: