1 ================================================================================ UNITED STATES SECURITIES AND EXCHANGE COMMISSION WASHINGTON, D.C. 20549 ------------------------ FORM 10-K (MARK ONE) [X] ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934 FOR THE FISCAL YEAR ENDED DECEMBER 31, 1997 OR [ ] TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934 FOR THE TRANSITION PERIOD FROM TO . COMMISSION FILE NUMBER 0-26660 ------------------------ ESS TECHNOLOGY, INC. (EXACT NAME OF REGISTRANT AS SPECIFIED IN ITS CHARTER) <TABLE> <S> <C> CALIFORNIA 94-2928582 (STATE OR OTHER JURISDICTION OF (I.R.S. EMPLOYER INCORPORATION OR ORGANIZATION) IDENTIFICATION NO.) 48401 FREMONT BLVD., FREMONT, CALIFORNIA 94538 (ADDRESS OF PRINCIPAL EXECUTIVE OFFICES) (ZIP CODE) </TABLE> REGISTRANT'S TELEPHONE NUMBER, INCLUDING AREA CODE: (510) 492-1088 SECURITIES REGISTERED PURSUANT TO SECTION 12(B) OF THE ACT: NONE SECURITIES REGISTERED PURSUANT TO SECTION 12(G) OF THE ACT: COMMON STOCK, NO PAR VALUE (TITLE OF CLASS) Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days. Yes [X] No [ ] Indicate by check mark if disclosure of delinquent filers pursuant to Item 405 of Regulation S-K is not contained herein, and will not be contained, to the best of the registrant's knowledge, in definitive proxy or information statements incorporated by reference in Part III of this Form 10-K or any amendment to this Form 10-K. [ ] State the aggregate market value of the voting and non-voting common equity held by non-affiliates of the registrant, based upon the closing sale price of the Common Stock on February 27, 1998 ($7.625) as reported on the Nasdaq National Market, was approximately $195,708,000. Shares of Common Stock held by each officer and director and by each person who owned 5% or more of the registrant's outstanding Common Stock on that date have been excluded in that such persons may be deemed to be affiliates. This determination of affiliate status is not necessarily a conclusive determination for other purposes. As of February 27, 1998, registrant had outstanding 40,833,580 shares of Common Stock. ------------------------ DOCUMENTS INCORPORATED BY REFERENCE Portions of the Proxy Statement for Registrant's 1998 Annual Meeting of Stockholders are incorporated by reference in Part III. ================================================================================

2 ESS TECHNOLOGY, INC. 1997 FORM 10-K TABLE OF CONTENTS <TABLE> <CAPTION> PAGE ---- <S> <C> <C> PART I Item 1. Business.................................................... 2 Item 2. Properties.................................................. 10 Item 3. Legal Proceedings........................................... 10 Item 4. Submission of Matters to a Vote of Security Holders......... 11 Item 4A. Executive Officers of the Registrant........................ 11 PART II Item 5. Market for the Registrant's Common Stock and Related Stockholder Matters......................................... 13 Item 6. Selected Financial Data..................................... 14 Item 7. Management's Discussion and Analysis of Financial Condition and Results of Operations................................... 15 Item 8. Financial Statements and Supplementary Data................. 24 Item 9. Changes in and Disagreements with Accountants on Accounting and Financial Disclosures................................... 43 PART III Item 10. Directors and Executive Officers of the Registrant.......... 44 Item 11. Executive Compensation...................................... 44 Item 12. Security Ownership of Certain Beneficial Owners and Management.................................................. 44 Item 13. Certain Relationships and Related Transactions.............. 44 PART IV Item 14. Exhibits, Financial Statement Schedules, and Reports on Form 8-K......................................................... 44 Signatures............................................................. 48 </TABLE> 1

3 Statements contained in this filing that are not statements of historical fact may be deemed to be forward-looking statements. A number of important factors could cause actual events or the Company's actual results to differ materially from those indicated by such forward-looking statements, including dependence on continued growth in demand for PC audio, video and other multimedia capabilities for notebook and desktop computers, as well as consumer electronic products; the Company's ability to take advantage of new markets; increased competition and pricing pressures, general economic conditions and conditions specific to the semiconductor industry; the timing and market acceptance of new product introductions; the timely development of new products; continued availability of quality foundry capacity; and other risks set forth in this filing and in the Company's filings from time to time with the Securities and Exchange Commission. PART I ITEM 1. BUSINESS ESS Technology, Inc. ("ESS" or the "Company"), a California corporation, designs, markets and supports highly integrated mixed signal semiconductor and software solutions for multimedia applications in the personal computer ("PC") and consumer marketplaces. The Company offers comprehensive solutions for audio, video and modem applications. ESS has established itself as a leading supplier of mixed-signal PC audio solutions that integrate all essential audio components on a single chip. During 1997, ESS expanded its core audio family to include PCI audio solutions which address more advanced audio applications including positional 3D, sample rate conversion, and hardware accelerated wavetable synthesis and speaker virtualization. AudioDrive Products ESS' single chip AudioDrive products enable PC manufacturers to provide audio capabilities on add-on sound cards and directly on the motherboards of desktop and notebook computers. The Company has established itself as a leader in integrated audio solutions and counts many of the leading manufacturers of personal computers and sound cards among its customers. Recently, demand for audio products has increased due to four dynamic factors: (1) increased market demand for PCs incorporating audio functionalities; (2) growth in PC entertainment, educational and business applications; (3) increases in use of on-line services; and (4) the low cost of these solutions. The Company's AudioDrive products are based on ESS' audio technologies, design methodologies, and software and firmware expertise. ESS has developed a proven set of ISA and PCI product solutions for the PC market. The AudioDrive ISA product family integrates ESFM(TM), a proprietary FM sound synthesis technology, that produces superior sound quality by enhancing traditional FM synthesis techniques, with hardware, software and music database technology. ESS also utilizes its proprietary advanced analog and mixed signal design methodologies, together with its library of audio semiconductor designs, to produce highly integrated mixed signal audio chips. ESS software technology is bundled as part of its comprehensive solution and consists of its AudioDrive device drivers for Microsoft(R) Windows(R)3.1, Windows NT(R) Windows 95(R), IBM OS/2(R)Warp(R), DirectX(TM)PC games, and audio applications, including ESS AudioRack(TM) controller, an integrated graphical controller for the entire PC audio system. ISA AudioDrive Products ES692: a wavetable music synthesizer chip. The ES692 includes reverb special effects without need for external RAM. With its embedded microcontroller, the ES692 supports General MIDI, providing for 128 melodic instruments with ability to play back 32 voices of 16-bit data at a sampling rate of 44.1kHz. Music is produced in high fidelity with the realism of a live symphony orchestra. The ES692 includes a 1MB wavetable ROM to provide a complete wavetable solution. This internal ROM provides digitally recorded sound samples of musical instruments. 2

4 ES1868: a single mixed signal 16-bit stereo audio chip with integrated ESFM synthesizer, plug-and-play, full-duplex operation and game support. The ES1868 integrates digital logic and a microcontroller with audio CODEC and other analog functions onto one chip, and includes ESFM synthesis. The ES1868 is PC games compatible in SB and SB Pro modes and is compatible with Microsoft Windows and other operating systems. The ES1868 provides full ISA plug-and-play support and includes hardware volume control, 64 step volume control and dual game/joystick port for game support. The ES1868 also supports full-duplex operation with simultaneous record and playback with two DMA channels. ES1869: a single mixed signal 16-bit stereo audio chip with integrated ESFM synthesizer, plug-and-play, full-duplex operation, Zoom Video support, game support and three-dimensional sound effect. The ES1869 integrates digital logic and a microcontroller with audio CODEC and other analog functions onto one chip, and includes ESFM synthesis. The ES1869 is PC games compatible in SB and SB Pro modes and is compatible with Microsoft Windows and other operating systems. The ES1869 provides full ISA plug-and-play support and includes hardware volume control, 64 step volume control and dual game/joystick port for game support. The ES1869 supports full-duplex operation with simultaneous record and playback with two DMA channels and contains an I2S interface to support Zoom Video port for MPEG audio. It also integrates circuitry to produce a three-dimensional sound effect from two speakers. ES1878: a single mixed signal 16-bit stereo audio chip with integrated ESFM synthesizer, full-duplex operation, Zoom Video support, and game support. The ES1878 integrates digital logic and a microcontrol-ler with audio CODEC and other analog functions onto one chip, and includes ESFM synthesis. The ES1878 is PC games compatible in SB and SB Pro modes and is compatible with Microsoft Windows and other operating systems. The ES1878 includes hardware volume control, 64 step volume control and dual game/joystick port for game support. The ES1878 provides full plug-and-play support. The ES1878 also includes support for full-duplex operation with simultaneous record and playback, and it contains an I2S interface to support the PCMCIA Zoom Video port specification for MPEG input to PCs. The ES1878 provides full plug-and-play support and provides an interface to a docking station unit. ES1879: a single mixed signal 16-bit stereo audio chip with integrated ESFM synthesizer, full-duplex operation, Zoom Video support, telegaming and game support and three-dimensional sound effect. The ES1879 combines the features of the ES1878 with I2S interface for Zoom Video support, as well as circuitry to produce three-dimensional sound effect from two speakers. The ES1879 provides full plug-and-play support and provides interface to a docking station unit. ES1887: a single mixed signal 16-bit stereo audio chip with integrated ESFM synthesizer, full-duplex operation, game support and plug-and-play through the PC's BIOS. The ES1887 integrates digital logic and a microcontroller with audio CODEC and other analog functions onto one chip, and includes ESFM synthesis. The ES1887 is PC games compatible in SB and SB Pro modes and is compatible with Microsoft Windows and other operating systems. The ES1887 includes hardware volume control, 64 step volume control and dual game/joystick port for game support. The ES1887 also includes support for full-duplex operation with simultaneous stereo record and playback with two DMA channels. The ES1887 supports plug-and-play through the PC's BIOS. PCI AudioDrive Products ES1918: Maestro PCI audio CODEC. The ES1918 is a single mixed signal AC '97 CODEC and mixer for a digital audio controller. The ES1918 meets PC97 and Audio CODEC '97 specifications. ES1948: Maestro-1: a PCI digital audio accelerator. The Maestro-1 provides enhanced audio, utilizing the additional bandwidth provided by the PCI bus and taking advantage of the Intel AC-97 architecture. The Maestro-1 implements positional 3D and 64 channel hardware wavetable using system memory to dramatically improve the multimedia gaming experience. The Maestro-1 uses ESS proprietary technology called TDMA to provide legacy compatibility for DOS games which is a requirement for multimedia PCs. ES1968: Maestro-2: a PCI digital audio accelerator. The Maestro-2 provides enhanced audio, utilizing the additional bandwidth provided by the PCI bus and taking advantage of the Intel AC-97 architecture. The 3

5 Maestro-2 implements positional 3D using CRL's Digital Ear(TM) and Sensura(TM) 3D audio technology to dramatically improve the multimedia gaming experience. The Maestro-2 implements 64 channel hardware wavetable using system memory to reduce size, cost and host utilization while increasing sound quality for MIDI. The Maestro-2 utilizes ACPI and small form factor to enable low power designs for notebooks and motherboards. The Maestro-2 also uses ESS proprietary technology, TDMA to provide legacy compatibility for DOS games, a requirement for multimedia PCs. ES1938: Solo-1: A PCI single mixed signal audio chip. The ES1938 provides a single chip PCI audio solution providing high-quality audio processing while maintaining full legacy DOS game compatibility. The ES1938 has 16-bit stereo with 7 channel record and playback mixers and an integrated 3-D sound effects processor. It supports ACPI, PPMI and PCI Mobile Design Guide specifications. TeleDrive Products Internet-related applications, such as voice e-mail, Internet radio, audio home pages, and news on demand, are increasing the demand for integrated audio and computer fax/modem functions on the personal computer. ESS TeleDrive products enable PC manufacturers to provide fax/modem capabilities to add-on cards and directly onto the motherboards of desktop and notebook PCs. ES336V: a V.34bis chipset data/fax/voice controller-less modem solution. The ES336V provides base data, full duplex speaker phone, telephone answer machine and V.80 support for H.324 video conferencing applications. ES56V: a X2 or V.90 chipset data/fax/voice controller-less modem solution. The ES56V is a superset of the ES336V and is compliant with the V.90 worldwide modem standard via proprietary software. ES56CV: a ES336V/ES56V modem solution with 16 or 32 bit full duplex stereo. The ES56CV combines the ES336V/ES56V modem solution with a single mixed signal 16 or 32 bit stereo audio chip with integrated ESFM synthesizer, plug-and-play full-duplex operation and game support. VideoDrive Products ESS VideoDrive products provide consumer original equipment manufacturers ("OEMs") of VCD and DVD players with total programmable system solutions. The VideoDrive products provide OEMs of VCD players with a programmable single-chip processor which includes MPEG-1 video, audio and system decoder. It delivers full-screen, full-motion video at 30 frames per second with selectable CD-quality audio and can be combined with memory and video/audio DACs. The products also provide OEMs of DVD players with a programmable single chip processor which includes MPEG-2 audio/video/system and transport layer decoder, AC3 and video post-processing. These chips are designed for a variety of applications in consumer electronics such as set-top boxes and DVD players. VCD Player Products ES3204: Single chip programmable VCD processor which includes MPEG-1 audio/video/system decoder for use in VCD players. The ES3204 is a single chip that supports MPEG-1 video decoding and provides on-screen display, Karaoke functions, programmable playback control for VCD 2.0 and trick play mode features. ES3207: Analog companion chip. The ES3207 provides echo, surround sound, 3D audio, TV encoder with clock generation and audio DAC functions. ES3209: Analog companion chip to VDC processor chip. The ES3209 incorporates the ES3207 features of echo, surround sound, 3D audio, TV encoder with clock generation, audio DAC functions with HTML, hyperlink and a graphic user interface. ES3210: Single chip programmable VCD processor which includes MPEG-1 audio/video/system decoder for use in standalone and portable VCD players. The ES3210 is a single chip that supports MPEG-1 video decoding and incorporates on-screen display, Karaoke functions, programmable playback control, trick play 4

6 mode features, an integrated SRAM and remote control interface logic in a smaller form factor allowing a more compact design. ES3211: Arcade accelerator. The ES3211 enables direct interface with external games controllers to allow CD-ROM games to be played on a VCD player. DVD Player Products ES3301: Audio/video Transport Demultiplexer and Descrambler. The ES3301 is a transport-layer demultiplexer, parser and descrambler designed for the set-top box, DVD and Broadcast PC applications. ES3308: Single chip programmable DVD processor that includes MPEG-2 audio/video/system decoder for use in DVD players and digital set-top boxes. The ES3308 is a single chip solution that supports MPEG-2 video decoding and provides on-screen display and transport layer compliance with DVD standard as well as Digital Broadcast Signal standards. Software and Support ESS provides comprehensive support for its products including software that can be bundled with its products. This software includes device drivers for Microsoft Windows 3.1, Windows NT, Windows 95 and Windows 98, IBM OS/2 Warp, Intel NSP and PC games, for PC products and systems support for the Company's VCD and DVD products. Other support software that is available to customers includes localization software and installation software that allows customers to tailor their products for specific applications and needs. Customer development support includes an Evaluation Kit that contains a reference add-in card design with all the necessary information to incorporate an ESS chip in the customer's product. To assist customers in further reducing their time to market, ESS also provides a Manufacturing Kit that contains manufacturing information, including a bill-of-materials, printed circuit board layout and production test software. CUSTOMERS ESS sells its product principally to OEMs of PCs, PC-related add-in boards and consumer electronics systems. The Company sells its product through a direct sales force in the United States and through direct sales and distributors in Asia and Europe. The following table shows representative customers worldwide: <TABLE> <CAPTION> HONG KONG UNITED STATES TAIWAN JAPAN(1) REST OF THE WORLD --------- ------------- ------ -------- ----------------- <S> <C> <C> <C> <C> Eastbase Compaq Acer Fujitsu Best Union Dynax(2) Diamond Multimedia BTC Hitachi Hyundai Weikeng(2) Digital Equipment FIC Matsushita Multiwave EDO GVC NEC Philips Hewlett Packard Inventec Sanyo Pineview IBM Labway Sony Samsung Mitac Trigem Quanta Wearnes </TABLE> --------------- (1) Sales in Japan are made through a distributor. (2) Distributors of the Company. A limited number of customers have historically accounted for a substantial portion of the Company's net revenues. In 1995, 1996 and 1997, sales to the Company's top five customers, including sales to its international distributors, accounted for approximately 48%, 40% and 49%, respectively, of the Company's net revenues. In 1995, Compaq and Universe Electron Corporation, a Japanese distributor, each accounted for approximately 17% of the Company's net revenues. In 1996, Compaq and Universe Electron Corporation each accounted for approximately 12% and 13%, respectively, of the Company's net revenues. In 1997, Eastbase and Dynax, a Hong Kong distributor, each accounted for approximately 13% of the Company's net revenues. The Company expects that a limited number of customers may continue to account for a substantial portion of 5

7 its net revenues for the foreseeable future. The Company has experienced changes from year to year in the composition of its major customer base and believes this will continue in the future. SALES AND MARKETING The Company sells and markets to leading PC and consumer OEM's worldwide. The Company markets its products through its direct sales force, distributors and manufacturer representatives. In 1995, 1996 and 1997, international sales comprised approximately 73%, 92% and 89% of the Company's net revenues, respectively. The Company's international revenues in 1995, 1996 and 1997 have been derived primarily from Asian customers who manufacture PCs, PC-related add-in boards and consumer OEM's of VCD players. A large percentage of the worldwide supply of these products is manufactured by suppliers in Asia. ESS has direct sales personnel and technical staff located in Taiwan. A significant portion of the Company's Asian sales have been to customers located in Taiwan. See "Factors That May Affect Future Results -- International Operations." The Company has opened new customer and technical support centers in Shenzhen-China, Hong Kong and Korea in order to support its broadening customer base. The Company's products are also sold internationally through distributors and manufacturer representatives located in Hong Kong, Taiwan, Japan, India, Singapore, Korea and Germany. The Company's manufacturer representatives and distributors are not subject to minimum purchase requirements and can discontinue marketing any of the Company's products at any time. In addition, certain of the Company's manufacturer representatives, distributors and customers typically are authorized certain rights of return for unsold product or pricing allowances to compensate for rapid, unexpected prices changes. See "Factors That May Affect Future Results -- Customer Concentration." The Company believes that customer service and technical support are important competitive factors in selling to major customers. The Company provides technical support to its customers. Manufacturer representatives and distributors supplement the Company's efforts by providing additional customer service at the local level. The Company believes that close contact with its customers not only improves the customers' level of satisfaction, but also provides important insight into future market direction. Sales of the Company's products are generally made pursuant to standard purchase orders, which are frequently revised to reflect changes in the customer's requirements. Product deliveries are scheduled upon the Company's receipt of purchase orders. Generally, these purchase orders allow customers to reschedule delivery dates and cancel purchase orders without significant penalties. For these reasons, the Company believes that its backlog, while useful for scheduling production, is not necessarily a reliable indicator of future revenues. See "Factors That May Affect Future Results -- Potential Fluctuations in Operating Results." RESEARCH AND DEVELOPMENT In order to compete successfully, the Company believes that it must continually design, develop and introduce new products that take advantage of market opportunities and address emerging technical standards. The Company's strategy is to leverage its base of design expertise, analog, digital and mixed signal design capabilities and process technologies, and software and systems expertise to develop audio, modem and video solutions for the PC and consumer marketplace. ESS has in the past acquired and in the future will consider acquiring technology and product lines to enhance its own product offerings and to accelerate its time-to-market. The Company intends to continue to provide comprehensive solutions for its customers by developing state of the art semiconductor chips, device drivers, firmware and application software in its chosen markets. ESS utilizes a design environment based on workstations, dedicated product simulators, system simulation with hardware and software modeling, and a high level design description language. The Company invests regularly in new advanced equipment and software tools and intends to maintain and enhance its library of core cells. The Company opened a new design center in Beijing-China during 1997 in order to gain access to additional engineering talent. At December 31, 1997, ESS had a staff of 209 research and development personnel, 148 of which were involved in semiconductor design and process development and 61 of which were involved in software 6

8 development. In addition, ESS has engaged outside developers to develop certain technologies to the Company's specifications and intends to continue to utilize outside developers in the future. During 1995, 1996 and 1997 the Company spent approximately $8.7 million, $20.3 million and $29.5 million, respectively, on research and development activities, excluding a one-time pre and post-tax charge of $30.4 million related to acquired research and development in-process from the acquisitions of VideoCore Technology, Inc. ("VideoCore") and OSEE Technology, Inc. ("OSEE") in the first quarter of 1996 and a one-time pre and post-tax charge of $22.2 million related to acquired research and development in-process from the acquisition of Platform Technologies, Inc. ("Platform") in the second quarter of 1997. In June 1997, the Company completed its acquisition of Platform pursuant to which the Company obtained all the outstanding capital stock of Platform in exchange for approximately 2.54 million shares of the Company's Common Stock including approximately 954,000 options with a value of $32.7 million. Platform is a wholly owned subsidiary of the Company. The acquisition of Platform provided the Company with certain PCI audio expertise and designs in process, along with significant engineering talent. In January 1996, the Company completed its acquisition of VideoCore pursuant to which the Company acquired all of the outstanding capital stock of VideoCore in exchange for approximately 525,000 shares of the Company's Common Stock and $5.7 million in cash. VideoCore, a wholly owned subsidiary of the Company, is developing integrated circuits which incorporates advanced compression technology for digital video products. In March 1996, the Company completed its acquisition of OSEE pursuant to which the Company acquired all of the outstanding capital stock of OSEE in exchange for approximately 217,000 shares of the Company's Common Stock and $3.6 million in cash. OSEE, a wholly owned subsidiary of the Company, is developing algorithm technology which enables the Company to offer modem applications to its customers. The Company may continue to utilize cash and equity to acquire or invest in complementary businesses or products or to obtain the right to use complementary technologies. From time to time, in the ordinary course of business, the Company may evaluate potential acquisitions of or investments in such businesses, products or technologies owned by third parties. MANUFACTURING The Company contracts with independent foundries and assembly and test service providers to manufacture all of its products. This manufacturing strategy enables the Company to focus on its design strengths, minimize fixed costs and capital expenditures and gain access to advanced manufacturing capabilities. Semiconductor manufacturing consists of foundry activity where wafer fabrication takes place, and assembly and test activities. Wafer fabrication is performed by two independent foundries, which utilize advanced manufacturing technologies. A substantial majority of the Company's products are manufactured by Taiwan Semiconductor Manufacturing Company Ltd. ("TSMC"), which has manufactured certain of the Company's products since 1989. The Company also has a foundry arrangement with United Microelectronics Corporation ("UMC") in Taiwan. Most of the Company's devices are currently fabricated using a mixed signal CMOS 0.5 and 0.35 micron process technology. The Company is currently developing new products and converting some existing products to a 0.25 micron process technology. The Company is dependent on its foundries to allocate to the Company a portion of their foundry capacity sufficient to meet the Company's needs and to produce products of acceptable quality and with acceptable manufacturing yields in a timely manner. These foundries fabricate products for other companies and manufacture products of their own design. In November 1995, the Company entered into long-term agreements with TSMC and UMC. Under the Company's long-term agreement with TSMC, in exchange for TSMC's wafer capacity commitments for the years 1996 through 1999, the Company made payments of approximately $32 million in two installments in 1996 and 1997. Under the Company's agreement with UMC, the Company entered into a joint venture arrangement with UMC and other U.S. semiconductor companies to build a separate semiconductor manufacturing facility to be located in Taiwan at an estimated cost of $1 billion. The Company has invested approximately $24.6 million in this joint venture. Under the terms of the agreement, the Company will receive approximately a 5% equity ownership in the joint venture company and capacity rights. The new fabrication facility is currently projected to commence production of 8-inch wafers in 1999. The facility was scheduled to open 7

9 during 1998, but several fires during construction impeded progress. UMC has stated that it expects insurance will cover its recent fire losses at the joint venture foundry. There can be no assurance that the Company will be able to obtain additional capacity when necessary. All of the Company's semiconductor products are assembled and tested by third-party vendors, primarily OSE and Advanced Semiconductor Engineering in Taiwan, ASAT in Hong Kong, and Astra Microtronics in Indonesia. The Company has internally designed and developed its own test software and certain test equipment, which is provided to the Company's test vendors. Shortages of raw materials or disruptions in the provision of services by the Company's assembly vendors could lead to supply constraints or delays in the delivery of the Company's products. Such constraints or delays might result in the loss of customers, limitations or reductions in the Company's revenues or other material adverse effects on the Company's business, financial condition and results of operations. The Company's reliance on third-party assembly and testing vendors involves a number of other risks, including reduced control over delivery schedules, quality assurance and costs. The inability of such third parties to deliver products of acceptable quality and in a timely manner could have a material adverse effect on the Company's business, financial condition and results of operations. See "Factors That May Affect Future Results -- Dependence on TSMC and Other Third Parties" and " -- International Operations." COMPETITION The markets in which the Company competes are intensely competitive and are characterized by rapid technological change, price declines and rapid product obsolescence. The Company currently competes with add-in card suppliers and other semiconductor manufacturers. The Company expects competition to increase in the future from existing competitors and from other companies that may enter the Company's existing or future markets with products that may be at lower costs or provide higher levels of integration, higher performance or additional features. The Company is unable to predict the timing and nature of any such competitive product offerings. The announcement and commercial shipment of competitive products could adversely affect sales of the Company's products and may result in increased price competition that would adversely affect the average selling prices ("ASPs") and margins of the Company's products. In general, product prices in the semiconductor industry have decreased over the life of a particular product. The markets for most of the applications for the Company's products are characterized by intense price competition. The willingness of prospective customers to design the Company's products into their products depends to a significant extent upon the ability of the Company to sell its products at a price that is cost-effective for such customers. As the markets for the Company's products mature and competition increases, the Company anticipates that prices for its products will continue to decline. If the Company is unable to reduce its costs sufficiently to offset declines in product prices or is unable to introduce more advanced products with higher product prices, the Company's business, financial condition and results of operations would be materially adversely affected. See "Factors That May Affect Future Results -- Potential Fluctuations in Operating Results." The Company's existing and potential competitors consist principally of large domestic and international companies that have substantially greater financial, manufacturing, technical, marketing, distribution and other resources, greater intellectual property rights, broader product lines and longer-standing relationships with customers than the Company. The Company's competitors also include a number of smaller and emerging companies. The Company's principal audio competitors include Cirrus Logic, Creative Technology and Yamaha. The Company's principal video competitors include C-Cube, Windbond, LSI Logic and SGS Thompson. The Company's principal modem competitors include Cirrus Logic, Lucent, Rockwell, 3Com and Texas Instruments. Certain of the Company's current and potential competitors maintain their own semiconductor foundries and may therefore benefit from certain capacity, cost and technical advantages. The Company believes that its ability to compete successfully depends on a number of factors, both within and outside of its control, including the price, quality and performance of the Company's and its competitors' products, the timing and success of new product introductions by the Company, its customers and its competitors, the emergence of new multimedia standards, the development of technical innovations, the ability to obtain adequate foundry capacity and sources of raw materials, the efficiency of production, the rate 8

10 at which the Company's customers design the Company's products into their products, the number and nature of the Company's competitors in a given market, the assertion of intellectual property rights and general market and economic conditions. There can be no assurance that the Company will be able to compete successfully in the future. Each successive generation of microprocessors has provided increased performance, which could in the future result in a microprocessor capable of performing multimedia functions. In this regard, Intel Corporation has developed Native Signal Processing ("NSP") capability and an extended multimedia system architecture ("MMX") for use in conjunction with its Pentium microprocessor, and is promoting the processing power of the Pentium for data and signal intensive functions such as graphics acceleration and other multimedia functions. There can be no assurance that the increased capabilities of microprocessors will not adversely affect demand for the Company's products. See "Factors That May Affect Future Results -- Importance of New Products and Technological Changes." PATENTS AND PROPRIETARY RIGHTS The Company relies on a combination of patents, trademarks, copyrights, trade secret laws and confidentiality procedures to protect its intellectual property rights. As of December 31, 1997, the Company had 9 patents granted in the United States, which expire over time, commencing in 1999 and ending in 2013, and 10 corresponding foreign patents. In addition, the Company intends to seek further United States and international patents on its technology. There can be no assurance that patents will be issued from any of the Company's pending applications or applications in preparation or that any claims allowed from pending applications or applications in preparation will be of sufficient scope or strength, or be issued in all countries where the Company's products can be sold, to provide meaningful protection or any commercial advantage to the Company. Also, competitors of the Company may be able to design around the Company's patents. The laws of certain foreign countries in which the Company's products are or may be designed, manufactured or sold, including various countries in Asia, may not protect the Company's products or intellectual property rights to the same extent as do the laws of the United States and thus make the possibility of piracy of the Company's technology and products more likely. Although the Company is not aware of the development, distribution or sales of any illegal copies of the Company's hardware or software, any infringements of its patents, copyrights or trademarks, or any violation of its trade secrets, confidentiality procedures or licensing agreements to date, there can be no assurance that the steps taken by the Company to protect its proprietary information will be adequate to prevent misappropriation of its technology or that the Company's competitors will not independently develop technologies that are substantially equivalent or superior to the Company's technology. The semiconductor industry is characterized by vigorous protection and pursuit of intellectual property rights or positions, which have resulted in significant and often protracted and expensive litigation. Except for the Creative Technology litigation (See "Item 3. Legal Proceedings"), there is no pending intellectual property litigation against the Company. However, the Company or its foundries may from time to time receive notice of claims that the Company has infringed patents or other intellectual property rights owned by others. The Company may seek licenses under such patents or other intellectual property rights. However, there can be no assurance that licenses will be offered or that the terms of any offered licenses will be acceptable to the Company. The failure to obtain a license from a third party for technology used by the Company could cause the Company to incur substantial liabilities and to suspend the manufacture of products or the use by the Company's foundries of processes requiring the technology. Furthermore, the Company may initiate claims or litigation against third parties for infringement of the Company's proprietary rights or to establish the validity of the Company's proprietary rights. Litigation by or against the Company could result in significant expense to the Company and divert the efforts of the Company's technical and management personnel, whether or not such litigation results in a favorable determination for the Company. In the event of an adverse result in any such litigation, the Company could be required to pay substantial damages, cease the manufacture, use and sale of infringing products, expend significant resources to develop non-infringing technology, discontinue the use of certain processes or obtain licenses for the infringing technology. There can be no assurance that the Company would be successful in such development or that such licenses would be 9

11 available on reasonable terms, or at all, and any such development or license could require expenditures by the Company of substantial time and other resources. Although patent disputes in the semiconductor industry have often been settled through cross-licensing arrangements, there can be no assurance that in the event that any third party makes a successful claim against the Company or its customers, a cross-licensing arrangement could be reached. In such a case, if a license is not made available to the Company on commercially reasonable terms, the Company's business, financial condition and results of operations could be materially adversely affected. The Company currently licenses certain of the technology utilized by the Company in its products, and expects to continue to do so in the future. The Company has no current plans to grant licenses with respect to its products or technology; however, it may become necessary for the Company to enter into product licenses in the future in order, among other things, to secure foundry capacity. Although the Company has in the past granted licenses to certain of its technology, some of which have expired, such licenses have been limited and the Company has not derived material revenues from such licenses in recent periods. See "Factors That May Affect Future Results -- Uncertainty Regarding Patents and Protection of Proprietary Rights." EMPLOYEES As of December 31, 1997, the Company had 447 full-time employees, including 209 in research and development, 110 in marketing, sales and support and 128 in operations, finance and administration. The Company's future success will depend, in part, on its ability to continue to attract, retain and motivate highly qualified technical and management personnel, particularly highly skilled semiconductor design personnel and software engineers involved in new product development, for whom competition is intense. The Company's employees are not represented by any collective bargaining unit, and the Company has never experienced a work stoppage. See "Factors That May Affect Future Results -- Dependence on Key Personnel." ITEM 2. PROPERTIES Prior to October 1996, the Company leased two facilities in Fremont, California. The leases for such facilities expired on June 30 and October 31, 1996. The facilities consisted of two buildings comprising approximately 62,000 square feet, which were used as the Company's headquarters. In October 1995, the Company purchased approximately 16 acres of land near its previous Fremont headquarters and constructed a new headquarters facility of 93,000 square feet. The Company relocated its operations from the leased facility to the new facility in September 1996. The Company anticipates that it will complete construction of an additional building to house research and development efforts on the existing land in the spring of 1998. The Company also plans to construct a dormitory to house visitors and guest workers during 1998. ITEM 3. LEGAL PROCEEDINGS On March 11, 1998, Creative Technology Ltd. and its subsidiary E-mu Systems, Inc. (together, "Creative") filed a lawsuit against the Company and one of its customers, Diamond Multimedia Systems, Inc. ("Diamond"), alleging infringement of U.S. Patent No. 5,698,803 (the "803 patent"), by the Company's Maestro products, one of which is included in products sold by Diamond. The complaint requests preliminary and permanent injunctions, and unspecified damages. Creative also claims willful infringement and requests treble damages and attorney's fees. The lawsuit, entitled Creative Technology Ltd. et al v. ESS Technology, Inc. et al, is pending in the U.S. District Court for the Central District of California. No date has been set for any hearing or for trial of the matter. The Company is still engaged in investigating the claim. Although the Company believes that it does not infringe any valid claim of the 803 patent, the Company cannot predict the ultimate resolution of the lawsuit. The grant of a preliminary or permanent injunction enjoining the sales of the Maestro products could result in a material adverse effect on the Company's business, financial condition and results of operations, including a reduction in the Company's revenues and income, losses for an extended period of time and a 10

12 depletion in the Company's financial resources. In addition, the Company could be required to pay monetary damages to Creative, which are subject to trebling in the event of a finding of willful infringement. Further, the Company may have to indemnify Diamond from liability with respect to claimed infringements of the 803 patent and, in the event of a determination of infringement and the grant of an injunction, the Company may have to compensate Diamond for damages related to such determination and secure a license for Diamond to continue using the enjoined chips, replace the chips with non-infringing chips or remove the chips and refund the purchase price of such chips. Such indemnification could increase the Company's exposure to, and amount of, potential costs and liability in such event, and could have a material adverse effect on the Company's business, financial condition and results of operations. In connection with the Creative litigation, the Company may incur substantial legal and other expenses. In addition, the Creative litigation may divert the efforts and attention of the Company's management and technical personnel. Patent litigation is highly complex and can extend for a protracted period of time, which can substantially increase the cost of such litigation. Accordingly, the expenses and diversion of resources associated with the Creative litigation could have a material adverse effect on the Company's business, financial condition and results of operations. See "Item 1. Business -- Patents and Proprietary Rights." ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS No matters were submitted to a vote of security holders during the quarter ended December 31, 1997. ITEM 4A. EXECUTIVE OFFICERS OF THE REGISTRANT The following table sets forth certain information regarding the Company's current executive officers: <TABLE> <CAPTION> NAME AGE POSITION ---- --- -------- <S> <C> <C> Fred S.L. Chan......................... 51 President, Chief Executive Officer and Chairman of the Board of Directors John H. Barnet......................... 62 Vice President, Chief Financial Officer and Secretary Chi-Shin Wang.......................... 51 Chief Technical Officer Robert L. Blair........................ 50 Executive Vice President, Operations Nicholas Aretakis...................... 36 Vice President Marketing and Sales, - PC Products Johnston Chen.......................... 37 Vice President, Sales - Consumer Products Howard Hideshima....................... 38 Controller and Chief Accounting Officer </TABLE> Mr. Chan joined the Company in November 1985 as President and has been a director since January 1986. He was appointed Chairman of the Board of Directors in October 1992 and Chief Executive Officer in June 1994. Mr. Chan has been serving as President since February 1997. Mr. Chan served as Secretary from October 1992 to August 1995 and Chief Financial Officer from October 1992 to May 1995. From 1984 to 1985, Mr. Chan was founder, President and Chief Executive Officer of AC Design Inc., a VLSI chip design center providing CAD, engineering and design services. From 1982 to 1984, he was co-founder, President and Chief Executive Officer of CADCAM Technology, Inc., a company in the business of CAE systems development. Mr. Chan holds B.S.E.E. and M.S.C. degrees from the University of Hawaii. Mr. Chan is the husband of Annie M. H. Chan, a director of the Company. Mr. Barnet joined the Company in September 1996 as Vice President, Finance, Chief Financial Officer and Secretary. Prior to joining the Company, he was Executive Vice President, Finance and Chief Financial Officer of Trimble Navigation Limited from 1993. From mid 1992 to mid 1993 he served as Senior Vice President, Finance and Chief Financial Officer of Centex Telemanagement, Inc., a telecommunications management company. From 1988 to 1992, he was Vice President, Finance and Chief Financial Officer of Acurex Corporation, a conglomerate engaged in military and commercial aerospace, environmental systems, and industrial process controls. Previously he held executive positions at BankAmerica Corporation, Signetic Corporation and Teledyne, Inc. Mr. Barnet received a BS degree in Industrial Engineering from Stanford University in 1957 and an MBA degree from Columbia University Graduate Business School in 1961. 11

13 Dr. Wang has been Chief Technical Officer of the Company since December 1995. Prior to joining the Company he was a co-founder of Integrated Information Technology, a semiconductor company, and served as President and Chief Executive Officer from 1987 to December 1995. From 1981 to 1986, he was a co-founder of Weitek Corporation and served as Vice President of Engineering. Dr. Wang was a member of the technical staff of Hughes Aircraft Company from 1973 to 1976 and a project manager of Hewlett Packard from 1976 to 1981. He holds a M.S. degree in Physics from the California Institute of Technology and a Ph.D.E.E. from Stanford University. Mr. Blair has been Executive Vice President, Operations of the Company since April 1997. From December 1994 to March 1997, he was Vice President of Operations of the Company. From December 1991 to November 1994, he was Senior Vice President Operations (Software Packaging & Printing Division) of Logistix Corporation, a software turnkey company, and from 1989 to November 1991, he was Vice President and co-owner of Rock Canyon Investments, a real estate development planning firm in California. From 1986 to 1989, he held various positions at Xidex Corporation, a computer diskette manufacturer, including President/General Manager, at XEMAG, a division of Xidex Corporation. From 1973 to 1986 he was Vice President, High Reliability Operations at Precision Monolithics, Inc. Mr. Aretakis has been Vice President, Marketing and Sales -- PC Products of the Company since December 1997. From January 1997 to November 1997, he was Vice President Sales -- PC Products of the Company. From August 1994 to December 1996, he was Vice President of Sales of the Company. Prior to joining the Company, he held sales positions in various semiconductor companies, including Director of OEM Sales at Media Vision, a computer peripherals manufacturer, from March 1993 to July 1994 and Director of Sales at SEEQ from 1988 to January 1993. From 1984 through 1988, Mr. Aretakis held various marketing positions at Microchip Technology Inc. Mr. Aretakis holds a B.S.E.E. degree from Columbia University and a BA degree in Mathematics from Hobart College. Mr. Chen has been Vice President, Sales - Consumer Products of the Company since January 1997. From February 1995 to December 1996, he was Director of APAC Sales of the Company. Prior to joining the Company, he was co-owner of Internet Corporation, a semiconductor sales representation company for the Far East market, and served as Director of Sales and Marketing from February 1992 to February 1995. From 1988 to 1992, he was Product Marketing Manager at FIFO Division of Integrated Device Technology. From 1983 to 1988, Mr. Chen held various engineering, marketing, and management positions at PMI Division of Analog Devices, Inc., Siliconix, and Soletron. Mr. Chen holds a B.S.E.E. degree from San Jose State University and an MBA degree from Santa Clara University. Mr. Hideshima has been Chief Accounting Officer since July 1997 and Controller of the Company since December 1994. Prior to joining the Company, he was Controller of Hoya MicroMask, Inc., a semiconductor mask company from August 1991 to November 1994 and Accounting Manager at Hoya Corporation USA from July 1990 to July 1991. From June 1985 through June 1990, Mr. Hideshima was an auditor with Arthur Andersen & Company. Mr. Hideshima holds a MBA degree from San Francisco State University and BS degree in Business from University of California -- Berkeley. 12

14 PART II ITEM 5. MARKET FOR THE REGISTRANT'S COMMON STOCK AND RELATED STOCKHOLDER MATTERS The Company's Common Stock has been trading on the NASDAQ National Market under the symbol "ESST" since October 6, 1995. The following table sets forth the high and low last reported sales prices for the Common Stock as reported by the NASDAQ National Market during the period indicated. <TABLE> <CAPTION> HIGH LOW ---- ---- <S> <C> <C> FISCAL 1995: Fourth Quarter (since October 6, 1995)...................... $39 $14 1/16 FISCAL 1996: First Quarter............................................... 24 16 Second Quarter.............................................. 25 1/4 16 1/4 Third Quarter............................................... 18 1/2 9 1/4 Fourth Quarter.............................................. 30 15 1/8 FISCAL 1997: First Quarter............................................... 34 1/4 21 1/2 Second Quarter.............................................. 29 1/2 11 7/8 Third Quarter............................................... 18 1/4 13 1/4 Fourth Quarter.............................................. 14 3/8 7 9/16 </TABLE> As of February 27, 1998, there were approximately 272 record holders of the Company's Common Stock. The Company has never declared or paid any cash dividends on its Common Stock. The Company currently anticipates that it will retain all future earnings for use in its business and does not anticipate paying any cash dividends in the foreseeable future. 13

15 ITEM 6. SELECTED FINANCIAL DATA The following selected consolidated financial data should be read in conjunction with the Consolidated Financial Statements and related notes thereto and "Management's Discussion and Analysis of Financial Condition and Results of Operations" appearing elsewhere in this Form 10-K. <TABLE> <CAPTION> YEAR ENDED DECEMBER 31, ------------------------------------------------------- 1993 1994 1995 1996 1997 -------- -------- -------- -------- -------- (IN THOUSANDS, EXCEPT PER SHARE DATA) <S> <C> <C> <C> <C> <C> STATEMENT OF OPERATIONS DATA: Net revenues.......................... $ 15,218 $ 33,435 $105,744 $226,455 $249,517 Cost of revenues...................... 6,733 12,047 39,584 106,818 171,859 -------- -------- -------- -------- -------- Gross profit........................ 8,485 21,388 66,160 119,637 77,658 Operating expenses: Research and development............ 2,915 3,711 8,665 20,270 29,471 Research and development in-process....................... -- -- -- 30,355 22,200 Selling, general and administrative................... 3,005 3,233 9,758 16,814 25,198 -------- -------- -------- -------- -------- Operating income...................... 2,565 14,444 47,737 52,198 789 Nonoperating income, net.............. 598 283 2,694 3,241 2,183 -------- -------- -------- -------- -------- Income before income taxes............ 3,163 14,727 50,431 55,439 2,972 Provision for income taxes............ 2,880 6,346 20,545 33,813 13,838 -------- -------- -------- -------- -------- Net income (loss)..................... $ 283 $ 8,381 $ 29,886 $ 21,626 $(10,866) -------- -------- -------- -------- -------- Net income (loss) per share --basic... $ 0.01 $ 0.25 $ 0.96 $ 0.57 $ (0.27) ======== ======== ======== ======== ======== Net income (loss) per share -- diluted(1)................. $ 0.01 $ 0.22 $ 0.79 $ 0.52 $ (0.27) ======== ======== ======== ======== ======== Shares used in calculating net income (loss) per share -- basic........... 31,641 33,510 31,265 37,702 39,593 ======== ======== ======== ======== ======== Shares used in calculating net income (loss) per share -- diluted(1)...... 35,849 37,413 37,775 41,588 39,593 ======== ======== ======== ======== ======== </TABLE> <TABLE> <CAPTION> DECEMBER 31, ------------------------------------------------------ 1993 1994 1995 1996 1997 ------- ------- -------- -------- -------- (IN THOUSANDS) <S> <C> <C> <C> <C> <C> BALANCE SHEET DATA: Cash, cash equivalents and short-term investments......................... $ 8,114 $10,860 $ 78,124 $ 69,204 $ 42,284 Working capital....................... 2,940 11,135 70,602 65,207 74,238 Total assets.......................... 15,108 24,014 162,703 211,985 231,654 Long-term debt, less current portion............................. -- -- 15,960 -- -- Total shareholders' equity............ 5,889 14,458 105,208 143,176 171,107 </TABLE> --------------- (1) See Note 1 of Notes to Consolidated Financial Statements for an explanation of shares used in calculating net income (loss) per share -- diluted. 14

16 ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS OVERVIEW ESS designs, develops and markets highly integrated mixed signal semiconductor products for sale to the PC and consumer marketplace. In 1997, ESS had revenues totaling $249.5 million, a 10% increase from the 1996 total of $226.5 million and 136% increase from 1995 revenues of $105.7 million. Net income decreased by 78% from $52.0 million in 1996, excluding a one-time pre and post-tax charge of $30.4 million related to acquired research and development in-process for the VideoCore and OSEE acquisitions, to $11.3 million in 1997, excluding a one-time pre and post-tax charge of $22.2 million related to acquired research and development in process for the acquisition of Platform. 1996 net income, excluding the one time pre and post-tax charge for acquired research and development in-process, increased by 74% over 1995 net income of $29.9 million. The gross margin for 1997 was 31%, reflecting price competition and an inventory reserve charge of $18.3 million in the fourth quarter of 1997 offset in part by manufacturing cost reductions, compared to gross margin in 1996 of 53%. 1996 margin declined from 63% in 1995 primarily due to price competition in the audio segment offset in part by manufacturing cost reductions. The Company is a leader in semiconductor audio products for the PC marketplace and semiconductor video products for the VCD player market. In 1996, the Company entered the VCD player market after its January 1996 acquisition of VideoCore pursuant to which the Company acquired all of the outstanding capital stock of VideoCore in exchange for approximately 525,000 shares of the Company's Common Stock and $5.7 million in cash. VideoCore develops integrated circuits which incorporate advanced compression technology in digital video products under the trade-name VideoDrive. In March 1996, the Company completed its acquisition of OSEE pursuant to which the Company acquired all of the outstanding capital stock of OSEE in exchange for approximately 217,000 shares of the Company's Common Stock and $3.6 million in cash. OSEE develops advanced modem algorithm technology that enables the Company to provide modem products under the trade name TeleDrive. Both acquisitions were accounted for as purchases and the portion of the purchase prices attributable to research and development in-process was expensed in the first quarter of 1996. In 1995, 1996 and 1997, the Company's AudioDrive products served the market for the ISA standard. In June 1997, the Company completed its acquisition of Platform pursuant to which the Company acquired all the outstanding capital stock of Platform in exchange for approximately 2.54 million shares of the Company's Common Stock including approximately 954,000 options. The acquisition was accounted for as a purchase and the portion of the purchase price attributable to research and development in-process was expensed in the second quarter of 1997. The acquisition of Platform allowed the Company to develop and subsequently introduce products for the PCI standard. In 1996, the Company introduced its VideoDrive product, a single-chip MPEG-1 decoder that provides full-screen, full-motion video and selectable CD-quality audio for VCD players. Shipments of these chips to the VCD player market began in the second quarter of 1996. The Company introduced its first MPEG-2 video chip solution, a fully programmable, single-chip processor that incorporates the additional features needed for consumer electronics applications such as DVD players, set-top boxes, multimedia personal computers and home entertainment units. The TeleDrive products for the Internet and other modem markets were developed following the Company's first quarter of 1996 acquisition of OSEE. In 1997, the Company began production volume shipments of V.34bis modem solutions and introduced the V.90 56K modem solutions. The Company is currently shipping both V.34bis and V.90 56K modem solutions. At the end of 1995, ESS purchased 16 acres of land in Fremont, California, near its previous facilities. By the end of 1996, the Company completed and occupied a two-story, 93,000-square-foot headquarters. During 1997, the Company began construction of another building to be completed in the spring of 1998 to house additional engineering capacity and other needs. A dormitory is also planned to be built during 1998. In 1997, the Company's growth was focused on sales of VCD player products to the Asia/Pacific region. ESS supplemented its existing sales and technical support centers with new centers in Shenzhen-China, Hong Kong and Korea. These new centers are supporting the Company's new video products. 15

17 During the fourth quarter of 1997, the Company established a wholly owned foreign subsidiary in the Cayman Islands, British West Indies and transferred a substantial portion of its business operations to it. The Company expects to generate significant future tax benefits from the transfer of these operations. RESULTS OF OPERATIONS The following table sets forth certain items from the Company's consolidated statement of operations as a percentage of net revenues for the periods indicated. <TABLE> <CAPTION> YEARS ENDED DECEMBER 31, --------------------------- 1995 1996 1997 ----- ----- ----- <S> <C> <C> <C> Net revenues.................................... 100.0% 100.0% 100.0% Cost of revenues................................ 37.4 47.2 68.9 ----- ----- ----- Gross margin.................................. 62.6 52.8 31.1 Operating expenses: Research and development...................... 8.2 9.0 11.8 Research and development in-process........... -- 13.4 8.9 Selling, general and administrative........... 9.2 7.4 10.1 ----- ----- ----- Operating income................................ 45.2 23.0 0.3 Nonoperating income, net........................ 2.5 1.5 0.9 ----- ----- ----- Income before income taxes...................... 47.7 24.5 1.2 Income taxes.................................... (19.4) (14.9) (5.5) ----- ----- ----- Net income (loss)............................... 28.3% 9.6%* (4.3)%** ===== ===== ===== </TABLE> --------------- * Includes a one-time pre and post-tax charge of 13.4% related to acquired research and development in-process. ** Includes a one-time pre and post-tax charge of 8.9% related to acquired research and development in-process. Net Revenues. Net revenues were $105.7 million, $226.5 million and $249.5 million in 1995, 1996 and 1997, respectively. Net revenues rose by 10% between 1996 and 1997 primarily from increased sales of the Company's video products. During 1997, the Company experienced severe average selling price ("ASP") erosion in a highly competitive sales environment in both the audio and video markets. Net revenues for 1996 increased 114% from 1995 primarily as a result of the increased sales growth of the Company's existing PC audio products as well as from the introduction of new PC audio and video semiconductor products. The Company's PC audio products accounted for substantially all of the Company's net revenues for 1996 and a majority in 1997. International revenues accounted for approximately 73%, 92% and 89% of net revenues for 1995, 1996 and 1997, respectively. The significant increase in international sales as a percentage of net revenues between 1995 and 1996 primarily reflects the transfer of production by U.S. based PC customers from U.S. to Asia and growth in the sales of video products which are sold in Asian markets. The Company expects that its percentage of international sales will remain high in the future. Gross Margin. Gross profit was $66.2 million, $119.6 million and $77.7 million in 1995, 1996 and 1997, respectively, representing corresponding gross margins of 62.6%, 52.8% and 31.1% of net revenues for such years. Gross margin declined from 1995 to 1996 as a result of lower ASPs on existing products arising from highly competitive market conditions and manufacturing startup costs associated with the Company's new PC audio, video and modem products. These lower ASPs on existing products were partially offset by a reduction in product costs and higher ASPs associated with the new PC audio and video products. The decrease in gross margins from 1996 to 1997 were a result of lower ASPs on the Company's products throughout the year and an inventory charge to cost of goods sold during the fourth quarter of $18.3 million for inventory reserves. The charge was for excess inventory positions. During the third quarter, indication of strong demand led to a high order rate. After non-cancelable production orders were placed, yields improved dramatically and the marketplace demand was lower than expected. The Company was under contractual agreement to pay a pre- 16

18 established per-die price, and was unable to realize the benefit of the enhanced yields and was committed to take the increased volume. These factors led to the inventory charge and the decrease in gross profit. The Company's overall gross profit and margin are subject to change due to various factors, including among others, competitive product pricing, unit volumes shipped, new product introductions, yields, wafer costs, assembly costs and product mix. The Company has encountered increased competition from other suppliers who are offering competitive products and new features. In addition, the Company expects the overall ASPs for its existing products to decline significantly over the life of the products. The Company believes that in order to maintain or increase gross profit, it must achieve higher unit volume shipments, cost reductions, new features and product introductions. However, no assurance can be given that the Company will be able to ship higher volumes, reduce costs, add new features or introduce new products that gain market acceptance. Research and Development Expenses. On-going research and development expenses were $8.7 million, $20.3 million and $29.5 million, or 8.2%, 9.0% and 11.8% of net revenues, in 1995, 1996 and 1997, respectively. Research and development in-process represents one-time pre and post-tax charges of $30.4 million from the acquisition of VideoCore and OSEE in the first quarter of 1996 and of $22.2 million from the acquisition of Platform in the second quarter of 1997. The increase in absolute dollars in research and development expenses from 1995 to 1996 is primarily due to the increase in the Company's engineering staff, engineering test runs, masks, internal and external consultants and one-time license fees. The growth in on-going research and development expenses between 1996 and 1997 was primarily due to the increase in the Company's engineering staff, engineering test runs, masks, internal and external consulting expenses and licensing fees associated with the research and development efforts to support the introduction of new products. The Company expects that research and development expenses will remain relatively constant as a percentage of net revenues. There can be no assurance, however, that revenues will grow at the same rate as the anticipated research and development expenses. Selling, General and Administration Expenses. Selling, general and administrative expenses were $9.8 million, $16.8 million and $25.2 million, or 9.2%, 7.4% and 10.1% of net revenues, in 1995, 1996 and 1997, respectively. The increase in selling, general and administration expenses from 1995 to 1996 was primarily due to increase in commissions and bonuses on higher sales volumes, increased personnel and related expenses resulting from Company's status as a public company. The increase in selling, general and administration expenses from 1996 to 1997 was primarily attributable to increased spending for additional sales and administrative employees. The increase in expense was also due to commissions on higher sales levels and, to a lesser extent, promotional expenses and costs associated with the expansion of the Company's sales activities. The Company expects to incur higher selling, general and administrative expenses in the future due to the need to increase selling activities, although these expenses are expected to remain relatively constant as a percentage of net revenues. There can be no assurance, however, that revenues will grow at the same rate as the anticipated selling, general and administrative expenses. Non-Operating Income, Net. Non-operating income, net was $2.7 million, $3.2 million and $2.2 million in 1995, 1996 and 1997 respectively. In 1995, 1996 and 1997 non-operating income, net consisted primarily of interest income and gains on sale of marketable securities, net of interest expense. Provision for Income Taxes. The Company's effective tax rate was 41%, 61% and 466% for 1995, 1996 and 1997, respectively. The Company's tax rate for 1995 was at the combined federal and state statutory rate of 41%. The tax rate for 1996 of 61% reflects a non-deductible expense for the one-time pre and post-tax charge of $30.4 million related to acquired research and development in-process from the acquisition of VideoCore and OSEE in the first quarter 1996. The pro forma tax rate excluding this charge of $30.4 million was 39%. The Company's pro forma tax rate for 1996 was slightly lower than the combined federal and state statutory rate of 41% as a result of tax exempt interest income and research and development credits. The reported tax rate for 1997 of 466% of pre-tax income significantly exceeds the combined federal and statutory tax rate of 41% due to two charges that are not deductible in the federal and state returns. The first charge is the one-time pre- and post-tax charge of $22.2 million for the acquisition of Platform in the second quarter of 1997. The second is the charge to increase inventory reserves in the fourth quarter of 1997. Because the majority of the inventories were held by a foreign subsidiary, a majority of the charges are not deductible on the U.S. and state income tax returns. See Note 4 of Notes to Consolidated Financial Statements. 17

19 LIQUIDITY AND CAPITAL RESOURCES Since its inception, the Company has financed its cash requirements from cash generated by operations, the sale of equity securities, bank lines of credit and short-term and long-term debt. At December 31, 1997, ESS had cash and cash equivalents and short-term investments of $42.3 million and working capital of $74.2 million. As of December 31, 1997, the Company had a $20.0 million line of credit expiring on May 31, 1999, and a $10.0 million line of credit expiring on June 10, 1998. These lines of credit require the Company to achieve certain financial ratios and operating results. At December 31, 1997, a criteria on one of the lines was not met. A waiver was obtained during the first quarter of 1998, and the Company is in conformity with its borrowing criteria under these lines. There were no borrowings under these lines of credit as of December 31, 1997. In 1997, the Company used net cash of $20.3 million in operating activities. This resulted from a net loss of $10.9 million, a one-time non-cash charge for research and development in-process of $22.2 million and depreciation and amortization of $7.9 million, less a gain on sale of short-term investments of $0.1 million and investment in working capital of $39.5 million. The company received net proceeds of $5.6 million from sale of marketable equity securities, $3.1 million from the issuance of common stock from exercise of stock options and employee stock purchase plan, $3.0 million in income tax credits from disqualifying disposition of common stock options and $2.5 million from the acquisition of Platform. The Company invested $15.2 million in property and equipment. For the year, cash and cash equivalents declined $21.3 million. In 1996, the Company generated net cash from operating activities of $36.4 million. This resulted from net income of $21.6 million, a one-time non-cash charge for research and development in-process of $30.4 million and depreciation and amortization of $3.2 million, less a gain on sale of short-term investments of $1.0 million and investment in working capital of $17.8 million. The Company received net proceeds of $7.1 million from sale of marketable equity securities, $3.8 million from the issuance of common stock from exercise of stock options and employee stock purchase plan, and $8.9 million in income tax credits from disqualifying disposition of common stock options. The Company invested $14.0 million in property and equipment, repurchased stock for $19.7 million, paid $16.0 million on capacity commitments and $9.3 million for acquisition of VideoCore and OSEE. For the year, cash and cash equivalents declined $2.8 million. In 1995, the Company generated net cash from operating activities of $13.5 million. This resulted from net income of $29.9 million, depreciation and amortization of $0.9 million less a gain on sale of marketable equity securities of $1.3 million and investment in working capital of $16.0 million. The Company received net proceeds of $60.8 million from the issuance of common stock related to its initial public offering. The Company purchased $24.9 million in short-term investments and invested $8.4 million in property and equipment. For the year, cash and cash equivalents increased $41.0 million. The Company believes that its existing cash and cash equivalents as of December 31, 1997 together with the cash generated from operations, available borrowings under its line of credit and other financing options, will be sufficient to fund acquisitions of property and equipment and provide adequate working capital through at least the next twelve months. Capital expenditures for the next twelve months are anticipated to be approximately $19.0 million of which approximately $5.0 million will be used to fund construction of additional facilities and approximately $14.0 million will be used to acquire capital equipment. The Company may also utilize cash to acquire or invest in complementary businesses or products or to obtain the right to use complementary technologies. From time to time, in the ordinary course of business, the Company may evaluate potential acquisitions of or investment in such businesses, products or technologies owned by third parties. The Company also has bank lines of credit which may be utilized to provide additional cash. FACTORS THAT MAY AFFECT FUTURE RESULTS Except for the historical information contained in this Annual Report on Form 10-K, the matters discussed in this report are forward looking statements which involve risks and uncertainties that could cause actual results to differ from those indicated by such forward looking statements. Such risks and uncertainties 18

20 include but are not limited to those set forth below. In any event, the matters set forth below should be carefully considered when evaluating the Company's business and prospects. Potential Fluctuations in Operating Results. The Company's operating results are subject to quarterly and other fluctuations due to a variety of factors, including the gain or loss of significant customers, increased competitive pressures, changes in pricing policies by the Company, its competitors or its suppliers, including decreases in unit ASPs of the Company's products, the timing of new product announcements and introductions by the Company or its competitors and market acceptance of new or enhanced versions of the Company's and its customers' products. Other factors include the availability of foundry capacity, fluctuations in manufacturing yields, availability and cost of raw materials, changes in the mix of products sold, the cyclical nature of both the semiconductor industry and the market for PCs, seasonal customer demand, the timing of significant orders and significant increases in expenses associated with the expansion of operations. The Company's operating results could also be adversely affected by economic conditions generally in various geographic areas where the Company or its customers do business, or order cancellations or rescheduling. These factors are difficult to forecast, and these or other factors could materially affect the Company's quarterly or annual operating results. There can be no assurance as to the level of sales or earnings that may be attained by the Company in any given period in the future. The Company currently places noncancelable orders to purchase its products from independent foundries on an approximately three month rolling basis, while its customers generally place purchase orders with the Company less than four weeks prior to delivery that may be canceled without significant penalty. Consequently, if anticipated sales and shipments in any quarter are canceled or do not occur as quickly as expected, expense and inventory levels could be disproportionately high and the Company's business, financial condition and results of operations could be materially adversely affected. See "Management's Discussion and Analysis of Financial Condition and Results of Operations." Competition; Pricing Pressures. The markets in which the Company competes are intensely competitive and are characterized by rapid technological change, price declines and rapid product obsolescence. See "Item 1. Business -- Competition." Dependence on the PC and Consumer Markets. In 1995, 1996 and 1997 sales of PC audio semiconductor chips accounted for a majority of the Company's net revenues, and the Company expects that sales of audio semiconductors will continue to account for a significant portion of its net revenues for the foreseeable future. In 1997, sales of video semiconductor chips to the VCD player market accounted for a significant portion of the Company's revenues. Any reduction in ASPs or demand for the Company's semiconductor chips, whether because of a reduction in demand for PCs or VCD players in general, increased competition or otherwise, would have a material adverse effect on the Company's business, financial condition and results of operations. The Company is currently engaged in the development and introduction of new PC audio, video and fax/ modem semiconductor devices for the PC and consumer markets. There can be no assurance that the Company will be able to identify market trends or new product opportunities, develop and market new products, achieve design wins or respond effectively to new technological changes or product announcements by others. A failure in any of these areas would have a material adverse effect on the Company's business, financial condition and results of operations. See "Item 1. Business -- AudioDrive Products," " -- VideoDrive Products" and " -- TeleDrive Products." The Company's products are sold for incorporation into desktop and notebook computers and VCD players. Therefore, the Company is heavily dependent on the continued growth of the markets and the cost requirements for desktop and notebook computers and VCD players. There can be no assurance that these markets will be able to sustain continued growth. A slowing in unit volume and a decrease in ASPs could result in a decline in revenues which would have a material adverse effect on the Company's business, financial condition and results of operations. Importance of New Products and Technological Change. The markets for the Company's products are characterized by evolving industry standards, rapid technological change and product obsolescence. The Company's success is highly dependent upon the successful development and timely introduction of new 19

21 products at competitive price and performance levels. The success of new products depends on a number of factors, including timely completion of product development, market acceptance of the Company's and its customers' new products, securing sufficient foundry capacity for volume manufacturing of wafers, achievement of acceptable wafer fabrication yields by the Company's independent foundries and the Company's ability to offer new products at competitive prices. In order to succeed in having the Company's products incorporated into new products being designed by its customers, the Company must anticipate market trends and meet performance, quality and functionality requirements of such OEMs and must successfully develop and manufacture products that adhere to these requirements. In addition, the Company must meet the timing and price requirements of such manufacturers and must make such products available in sufficient quantities. Accordingly, in selling to OEMs, the Company can often incur significant expenditures prior to volume sales of new products, if any. In order to help accomplish these goals, the Company has in the past and will continue to consider in the future the acquisition of other companies or the products and technologies of other companies. Such acquisitions carry additional risks such as a lack of integration with existing products and corporate culture, the potential for large write-offs and the diversion of management attention. There can be no assurance that the Company will be able to identify market trends or new product opportunities, develop and market new products, achieve design wins or respond effectively to new technological changes or product announcements by others. A failure in any of these areas would have a material adverse effect on the Company's business, financial condition and results of operations. See "Item 1. Business -- Research and Development." Dependence on TSMC and Other Third Parties. The Company relies on independent foundries to manufacture all of its products. A substantial majority of the Company's products are currently manufactured by TSMC, which has manufactured certain of the Company's products since 1989. The Company also has foundry arrangements with UMC, which has manufactured certain of the Company's products since 1995. These relationships provide the Company with access to advanced process technology necessary for the manufacture of the Company's products. These foundries fabricate products for other companies and, in certain cases, manufacture products of their own design. In November 1995, the Company entered into long-term agreements with TSMC and UMC in which the Company has secured access to additional capacity and to leading edge technology. See "Item 1. Business -- Manufacturing." While the Company has entered into long-term agreements with its two foundries, the Company's reliance on these independent foundries involves a number of risks, including the absence of adequate capacity, the unavailability of, or interruption in access to, certain process technologies and reduced control over delivery schedules, manufacturing yields and costs, and the international risks more fully described below. In addition, the Company has pre-negotiated certain of its purchase orders and could be unable to benefit from enhanced yields realized by its vendors. The Company expects to rely upon TSMC and UMC to manufacture substantially all of the Company's products for the foreseeable future. In the event that TSMC and UMC are unable to continue to manufacture the Company's key products in required volumes, the Company will have to identify and secure additional foundry capacity. In such an event, the Company may be unable to identify or secure additional foundry capacity from another manufacturer. Even if such capacity is available from another manufacturer, the qualification process could take six months or longer. The loss of any of its foundries as a supplier, the inability of the Company to acquire additional capacity at its current suppliers or qualify other wafer manufacturers for additional foundry capacity should additional capacity be necessary, or any other circumstances causing a significant interruption in the supply of semiconductors to the Company would have a material adverse effect on the Company's business, financial condition and results of operations. To address potential foundry capacity constraints in the future, ESS will continue to consider and may be required to enter into additional arrangements, including equity investments in or loans to independent wafer manufacturers in exchange for guaranteed production capacity, joint ventures to own and operate foundries, or "take or pay" contracts that commit the Company to purchase specified quantities of wafers over extended periods. Any such arrangements could require the Company to commit substantial capital and grant licenses to its technology. The need to commit substantial capital may require the Company to obtain additional debt or equity financing, which could result in dilution to the Company's shareholders. There can be no assurance 20

22 that such additional financing, if required, will be available when needed or, if available, will be obtained on terms acceptable to the Company. Customer Concentration. A limited number of customers have accounted for a substantial portion of the Company's net revenues. In 1995, 1996 and 1997, sales to the Company's top five customers, including sales to distributors, accounted for approximately 48%, 40% and 49% respectively, of the Company's net revenues. In 1995, Compaq and Universe Electron Corporation, the Company's Japanese distributor, each accounted for approximately 17% of the Company's net revenues. In 1996, Compaq and Universe Electron Corporation each accounted for approximately 12% and 13%, respectively, of the Company's net revenues. In 1997, Eastbase and Dynax, a Hong Kong distributor, each accounted for approximately 13% of the Company's net revenues. These customers purchased VCD devices, reflecting the Company's revenue growth in that market. Sales to distributors are generally subject to agreements allowing limited rights of return and price protection with respect to unsold products. Returns and allowances in excess of reserves could have a material adverse impact on the Company's business, financial condition and results of operation. During 1997, the Company adopted a policy of deferring revenue recognition on sales of devices to distributors in Hong Kong and Taiwan until devices are sold to the end customers. This has led to increased operational visibility on product moving through the channel. The Company expects that a limited number of customers may account for a substantial portion of its net revenues for the foreseeable future. The Company has experienced changes from year to year in the composition of its major customer base and believes this pattern may continue. The Company does not have long-term purchase agreements with any of its customers. The reduction, delay or cancellation of orders from one or more major customers for any reason or the loss of one or more of such major customers could materially and adversely affect the Company's business, financial condition and results of operations. In addition, since the Company's products are often sole sourced to its customers, the Company's operating results could be materially and adversely affected if one or more of its major customers were to develop other sources of supply. There can be no assurance that the Company's current customers will continue to place orders with the Company, that orders by existing customers will not be canceled or will continue at the levels of previous periods or that the Company will be able to obtain orders from new customers. Management of Growth. During 1997, the Company experienced significant growth in unit shipments and the addition of multiple product lines that require additional management systems and processes. To manage its future operations and growth effectively, the Company will need to continue to improve its operational, financial and management information systems, implement additional systems and controls, and hire, train, motivate, manage and retain its employees. There can be no assurance that the Company will be able to manage such growth effectively, and the failure to do so could have a material adverse effect on the Company's business, financial condition and results of operations. International Operations. During 1995, 1996 and 1997, international sales accounted for approximately 73%, 92% and 89% of the Company's net revenues, respectively. Substantially all of the Company's international sales were to customers in Hong Kong, Taiwan, Japan, Korea and Singapore. The Company expects that international sales will continue to represent a significant portion of its net revenues for the foreseeable future. In addition, substantially all of the Company's products are manufactured, assembled and tested by independent third parties in Asia. Due to its reliance on international sales and foreign third-party manufacturing, assembly and testing operations, the Company is subject to the risks of conducting business outside of the United States. These risks include unexpected changes in, or impositions of legislative or regulatory requirements, delays resulting from difficulty in obtaining export licenses for certain technology, tariffs, quotas and other trade barriers and restrictions, longer payment cycles, greater difficulty in accounts receivable collection, potentially adverse taxes, the burdens of complying with a variety of foreign laws and other factors beyond the Company's control. The Company is also subject to general geopolitical risks in connection with its international trade relationships. Although the Company has not to date experienced any material adverse effect on its business, financial condition or results of operations as a result of such regulatory, geopolitical and other factors, there can be no assurance that such factors will not have a material adverse effect on the Company's business, financial condition and results of operations in the future or require the Company to modify its current business practices. 21

23 In addition, the laws of certain foreign countries in which the Company's products are or may be manufactured or sold, including various countries in Asia, may not protect the Company's products or intellectual property rights to the same extent as do the laws of the United States and thus make the possibility of piracy of the Company's technology and products more likely. Currently, all of the Company's product sales and all of its arrangements with foundries and assembly and test vendors provide for pricing and payment in U.S. dollars. In 1997, the effect of significant currency fluctuations in Asia had no material impact on the Company. There can be no assurance that future fluctuations in currency exchange rates will not have a material adverse effect on the Company's business, financial condition and results of operations. To date the Company has not engaged in any currency hedging activities, although the Company may do so in the future. Further, there can be no assurance that one or more of the foregoing factors will not have a material adverse effect on the Company's business, financial condition and results of operations or require the Company to modify its current business practices. Semiconductor Industry. The semiconductor industry has historically been characterized by rapid technological change, cyclical market patterns, significant price erosion, periods of over-capacity and production shortages, variations in manufacturing costs and yields and significant expenditures for capital equipment and product development. In addition, the industry has experienced significant economic downturns at various times, characterized by diminished product demand and accelerated erosion of product prices. Although the semiconductor industry in recent periods has experienced increased demand, it is uncertain how long these conditions will continue. The Company may experience substantial period-to-period fluctuations in operating results due to general semiconductor industry conditions. Uncertainty Regarding Patents and Protection of Proprietary Rights. The Company relies on a combination of patents, trademarks, copyrights, trade secret laws and confidentiality procedures to protect its intellectual property rights. See "Item 1. Business -- Patents and Proprietary Rights," "Item 3. Legal Proceedings." Dependence on Key Personnel. The Company's success depends to a significant degree upon the continued contributions of Fred S.L. Chan, the Company's Chief Executive Officer and Chairman of the Board of Directors. As of February 27, 1998, Mr. Chan, together with his spouse, Annie M.H. Chan, a director of the Company and certain trusts for the benefit of the Chan's children and certain charities beneficially owned in the aggregate, approximately 37% of the Company's Common Stock. The present and future success of the Company depends on its ability to continue to attract, retain and motivate qualified senior management, sales and technical personnel, particularly highly skilled semiconductor design personnel and software engineers, for whom competition is intense. The loss of Mr. Chan, other key executive officers, key design personnel or software engineers or the inability to hire and retain sufficient qualified personnel could have a material adverse effect on the Company's business, financial condition and results of operations. There can be no assurance that the Company will be able to retain these employees. The Company currently does not maintain any key man life insurance on the life of any of its key employees. Control by Existing Shareholders. As of February 27, 1998, Fred S.L. Chan, the Company's Chief Executive Officer and Chairman of the Board of Directors, together with his spouse, Annie M.H. Chan, a director of the Company, and certain other shareholders related to Mr. and Mrs. Chan owned, in the aggregate, 37% of the Company's outstanding Common Stock. As a result, these shareholders, acting together, possess significant voting power over the Company, giving them the ability among other things to influence significantly the election of the Company's Board of Directors and approve significant corporate transactions. Such control could delay, defer or prevent a change in control of the Company, impede a merger, consolidation, takeover or other business combination involving the Company, or discourage a potential acquirer from making a tender offer or otherwise attempting to obtain control of the Company. Possible Volatility of Stock Price. The price of the Company's Common Stock has in the past and may continue in the future to fluctuate widely. Future announcements concerning the Company, its competitors or its principal customers, including quarterly operating results, changes in earnings estimates by analysts, technological innovations, new product introductions, governmental regulations or litigation may cause the market price of the Common Stock to continue to fluctuate substantially. Further, in recent years the stock 22

24 market has experienced extreme price and volume fluctuations that have particularly affected the market prices of equity securities of many high technology companies and that often have been unrelated or disproportionate to the operating performance of such companies. These fluctuations, as well as general economic, political and market conditions such as recessions or international currency fluctuations, may materially adversely affect the market price of the Common Stock. Year 2000 Compliance. Many currently installed computer systems and software products are coded to accept only two digit entries in the date code field. These date code fields will need to accept four digit entries to distinguish 21st century dates from 20th century dates. As a result, many companies' software and computer systems may need to be upgraded or replaced in order to comply with such "Year 2000" requirements. Certain of the Company's internal computer systems are not Year 2000 compliant, and the Company utilizes third-party equipment and software that may not be Year 2000 compliant. Failure of the Company's internal computer systems or of such third-party equipment or software, or of systems maintained by the Company's suppliers, to operate properly with regard to the Year 2000 and thereafter could require the Company to incur unanticipated expenses to remedy any problems, which could have a material adverse effect on the Company's business, operating results and financial condition. Furthermore, the purchasing patterns of customers or potential customers may be affected by Year 2000 issues as companies expend significant resources to correct their current systems for Year 2000 compliance. These expenditures may result in reduced funds available to purchase the Company's products, which could have a material adverse effect on the Company's business, operating results and financial condition. Patent Litigation with Creative Technology, Ltd. On March 11, 1998, Creative Technology Ltd. and its subsidiary E-mu Systems, Inc. (together, "Creative") filed a lawsuit against the Company and one of its customers, Diamond Multimedia Systems, Inc. ("Diamond"), alleging infringement of U.S. Patent No. 5,698,803 (the "803 patent"), by the Company's Maestro products, one of which is included in products sold by Diamond. The complaint requests preliminary and permanent injunctions, and unspecified damages. Creative also claims willful infringement and requests treble damages and attorney's fees. The lawsuit, entitled Creative Technology Ltd. et al v. ESS Technology, Inc. et al, is pending in the U.S. District Court for the Central District of California. No date has been set for any hearing or for trial of the matter. The Company is still engaged in investigating the claim. Although the Company believes that it does not infringe any valid claim of the 803 patent, the Company cannot predict the ultimate resolution of the lawsuit. The grant of a preliminary or permanent injunction enjoining the sale of Maestro products could result in a material adverse effect on the Company's business, financial condition and results of operations, including a reduction in the Company's revenues and income, losses for an extended period of time and a depletion in the Company's financial resources. In addition, the Company could be required to pay monetary damages to Creative, which are subject to trebling in the event of a finding of willful infringement. Further, the Company may have to indemnify Diamond from liability with respect to claimed infringements of the 803 patent and, in the event of a determination of infringement and the grant of an injunction, the Company may have to compensate Diamond for damages related to such determination and secure a license for Diamond to continue using the enjoined chips, replace the chips with non-infringing chips or remove the chips and refund the purchase price of such chips. Such indemnification could increase the Company's exposure to, and amount of, potential costs and liability in such event, and could have a material adverse effect on the Company's business, financial condition and results of operations. In connection with the Creative litigation, the Company may incur substantial legal and other expenses. In addition, the Creative litigation may divert the efforts and attention of the Company's management and technical personnel. Patent litigation is highly complex and can extend for a protracted period of time, which can substantially increase the cost of such litigation. Accordingly, the expenses and diversion of resources associated with the Creative litigation could have a material adverse effect on the Company's business, financial condition and results of operations. See "Item 1. Business -- Patents and Proprietary Rights." 23

25 ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA (a) The following documents are filed as part of this Report. (1) Financial Statements: <TABLE> <CAPTION> <S> <C> Report of Independent Accountants Consolidated Balance Sheets as of December 31, 1996 and 1997 Consolidated Statements of Operations for the years ended December 31, 1995, 1996 and 1997 Consolidated Statements of Shareholders' Equity for the years ended December 31, 1995, 1996 and 1997 Consolidated Statements of Cash Flows for the years ended December 31, 1995, 1996 and 1997 Notes to Consolidated Financial Statements </TABLE> (2) Financial Statement Schedules: Financial Statement Schedules have been omitted because they are not required or applicable, or the information required to be set forth therein is included in the Financial Statements or notes thereto. 24

26 REPORT OF INDEPENDENT ACCOUNTANTS To the Board of Directors and Shareholders of ESS Technology, Inc. In our opinion, the accompanying consolidated balance sheets and the related consolidated statements of operations, shareholders' equity and cash flows present fairly, in all material respects, the financial position of ESS Technology, Inc. and its subsidiaries at December 31, 1996 and 1997, and the results of their operations and their cash flows for each of the three years in the period ended December 31, 1997, in conformity with generally accepted accounting principles. These financial statements are the responsibility of the Company's management; our responsibility is to express an opinion on these financial statements based on our audits. We conducted our audits of these statements in accordance with generally accepted auditing standards 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 the opinion expressed above. PRICE WATERHOUSE LLP San Jose, California January 21, 1998, except as to Note 11, which is as of March 23, 1998 25

27 ESS TECHNOLOGY, INC. CONSOLIDATED BALANCE SHEETS DECEMBER 31, 1996 AND 1997 (AMOUNTS IN THOUSANDS) ASSETS <TABLE> <CAPTION> DECEMBER 31, -------------------- 1996 1997 -------- -------- <S> <C> <C> Current assets: Cash and cash equivalents................................. $ 49,055 $ 27,760 Short-term investments.................................... 20,149 14,524 Accounts receivable, net.................................. 22,054 36,265 Inventories............................................... 33,150 47,285 Deferred income taxes..................................... 3,270 4,898 Prepaid expenses and other assets......................... 6,338 4,053 -------- -------- Total current assets.............................. 134,016 134,785 Property and equipment, net................................. 22,366 32,922 Other assets................................................ 55,603 63,947 -------- -------- $211,985 $231,654 ======== ======== LIABILITIES AND SHAREHOLDERS' EQUITY Current liabilities: Accounts payable and accrued expenses..................... $ 58,433 $ 50,858 Income taxes payable...................................... 4,964 183 Deferred income taxes..................................... 5,412 9,506 -------- -------- Total current liabilities......................... 68,809 60,547 -------- -------- Commitments and Contingencies (Notes 9 and 11) Shareholders' equity: Preferred stock, no par value, 10,000 shares authorized; none issued and outstanding............................ -- -- Common stock, no par value, 100,000 shares authorized; 38,127 and 40,674 shares issued and outstanding at December 31, 1996 and 1997, respectively............... 98,655 137,452 Retained earnings......................................... 44,521 33,655 -------- -------- Total shareholders' equity........................ 143,176 171,107 -------- -------- Total liabilities and shareholders' equity........ $211,985 $231,654 ======== ======== </TABLE> The accompanying notes are an integral part of these financial statements. 26

28 ESS TECHNOLOGY, INC. CONSOLIDATED STATEMENTS OF OPERATIONS YEARS ENDED DECEMBER 31, 1995, 1996 AND 1997 (AMOUNTS IN THOUSANDS, EXCEPT PER SHARE AMOUNTS) <TABLE> <CAPTION> YEAR ENDED DECEMBER 31, -------------------------------- 1995 1996 1997 -------- -------- -------- <S> <C> <C> <C> Net revenues............................................... $105,744 $226,455 $249,517 Cost of revenues........................................... 39,584 106,818 171,859 -------- -------- -------- Gross profit............................................. 66,160 119,637 77,658 Operating expenses: Research and development................................. 8,665 20,270 29,471 Research and development in-process...................... -- 30,355 22,200 Selling, general and administrative...................... 9,758 16,814 25,198 -------- -------- -------- Operating income........................................... 47,737 52,198 789 Interest income, net....................................... 1,348 2,276 2,117 Gain on short-term investments............................. 1,346 965 66 -------- -------- -------- Income before provision for income taxes................... 50,431 55,439 2,972 Provision for income taxes................................. (20,545) (33,813) (13,838) -------- -------- -------- Net income (loss).......................................... $ 29,886 $ 21,626 $(10,866) ======== ======== ======== Net income (loss) per share -- basic....................... $ 0.96 $ 0.57 $ (0.27) ======== ======== ======== Net income (loss) per share -- diluted..................... $ 0.79 $ 0.52 $ (0.27) ======== ======== ======== Shares used in calculating net income (loss) per share -- basic........................................... 31,265 37,702 39,593 ======== ======== ======== Shares used in calculating net income (loss) per share -- diluted......................................... 37,775 41,588 39,593 ======== ======== ======== </TABLE> The accompanying notes are an integral part of these financial statements. 27

29 ESS TECHNOLOGY, INC. CONSOLIDATED STATEMENTS OF SHAREHOLDERS' EQUITY YEARS ENDED DECEMBER 31, 1995, 1996 AND 1997 (AMOUNTS IN THOUSANDS) <TABLE> <CAPTION> COMMON STOCK ----------------- DEFERRED RETAINED SHARES AMOUNT COMPENSATION EARNINGS TOTAL ------ -------- ------------ --------- -------- <S> <C> <C> <C> <C> <C> Balance at December 31, 1994............. 30,248 $ 6,087 $(120) $ 8,491 $ 14,458 Issuance of common stock in initial public offering, net of issuance costs of $1,081..................... 4,428 60,682 -- -- 60,682 Issuance of common stock upon exercise of options.......................... 797 122 -- -- 122 Amortization of deferred compensation........................ -- -- 60 -- 60 Net income............................. -- -- -- 29,886 29,886 ------ -------- ----- ------- -------- Balance at December 31, 1995............. 35,473 66,891 (60) 38,377 105,208 Issuance of common stock upon exercise of options.......................... 3,667 3,152 -- -- 3,152 Issuance of common stock for acquisitions........................ 743 23,352 -- -- 23,352 Issuance of common stock for employee stock purchase plan................. 47 621 -- -- 621 Amortization of deferred compensation........................ -- -- 60 -- 60 Repurchase of common stock............. (1,803) (4,249) -- (15,482) (19,731) Income tax benefit on disqualifying disposition of common stock options............................. -- 8,888 -- -- 8,888 Net income............................. -- -- -- 21,626 21,626 ------ -------- ----- ------- -------- Balance at December 31, 1996............. 38,127 98,655 -- 44,521 143,176 Issuance of common stock upon exercise of options.......................... 886 2,294 -- -- 2,294 Issuance of common stock for acquisition......................... 1,586 32,703 -- -- 32,703 Issuance of common stock for employee stock purchase plan................. 75 817 -- -- 817 Income tax benefit on disqualifying disposition of common stock options............................. -- 2,983 -- -- 2,983 Net loss............................... -- -- -- (10,866) (10,866) ------ -------- ----- ------- -------- Balance at December 31, 1997............. 40,674 $137,452 -- $33,655 $171,107 ====== ======== ===== ======= ======== </TABLE> The accompanying notes are an integral part of these financial statements. 28

30 ESS TECHNOLOGY, INC. CONSOLIDATED STATEMENTS OF CASH FLOWS YEARS ENDED DECEMBER 31, 1995, 1996 AND 1997 (AMOUNTS IN THOUSANDS) <TABLE> <CAPTION> YEAR ENDED DECEMBER 31, ---------------------------- 1995 1996 1997 ------- ------- -------- <S> <C> <C> <C> CASH FLOWS FROM OPERATING ACTIVITIES: Net income (loss)......................................... $29,886 $21,626 $(10,866) Adjustments to reconcile net income (loss) to net cash provided by (used in) operating activities: Depreciation and amortization.......................... 934 3,234 7,865 Charges for research and development in-process........ -- 30,355 22,200 Gain on sale of short-term investments................. (1,346) (965) (66) Deemed compensation expense and compensation related to stock options........................................ 60 60 -- Change in assets and liabilities (net of effect of acquisitions) Accounts receivable.................... (5,935) (11,818) (14,197) Inventories.......................................... (15,140) (13,969) (14,038) Deferred income taxes................................ (1,061) (1,430) (2,739) Prepaid expenses and other assets.................... (41,837) (15,969) 4,645 Accounts payable and accrued expenses................ 31,073 24,082 (8,359) Long-term advances payable to foundries.............. 15,960 -- -- Income taxes payable................................. 906 1,242 (4,781) ------- ------- -------- Net cash provided by (used in) operating activities...................................... 13,500 36,448 (20,336) ------- ------- -------- CASH FLOWS FROM INVESTING ACTIVITIES: Acquisition of property and equipment..................... (8,386) (14,015) (15,207) Sale of marketable equity securities...................... 1,346 17,435 24,916 Purchase of short-term investments........................ (26,243) (10,376) (19,291) Payments associated with capacity commitments............. -- (15,960) -- Cash received from (paid for) acquisitions................ -- (9,288) 2,529 ------- ------- -------- Net cash used in investing activities............. (33,283) (32,204) (7,053) ------- ------- -------- CASH FLOWS FROM FINANCING ACTIVITIES: Repurchase of common stock................................ -- (19,731) -- Issuance of common stock.................................. 60,804 3,773 3,111 Income tax benefit on disqualifying disposition of common stock options.......................................... -- 8,888 2,983 ------- ------- -------- Net cash provided by (used in) financing activities...................................... 60,804 (7,070) 6,094 ------- ------- -------- Net increase (decrease) in cash and cash equivalents........ 41,021 (2,826) (21,295) Cash and cash equivalents at beginning of period............ 10,860 51,881 49,055 ------- ------- -------- Cash and cash equivalents at end of period.................. $51,881 $49,055 $ 27,760 ======= ======= ======== SUPPLEMENTAL DISCLOSURES OF CASH FLOW INFORMATION: Common stock issued for acquisitions...................... $ -- $23,352 $ 32,703 Cash paid for income taxes................................ $20,702 $23,576 $ 18,300 ======= ======= ======== </TABLE> The accompanying notes are an integral part of these financial statements. 29

31 ESS TECHNOLOGY, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS 1. THE COMPANY AND ITS SIGNIFICANT ACCOUNTING POLICIES ESS Technology, Inc. (the "Company") was incorporated in California in February 1984. The Company and its wholly-owned subsidiaries design, develop and market highly integrated mixed signal semiconductor products for PC and consumer marketplaces. In October 1995, the Company completed its initial public offering of 8,050,000 shares of common stock including the shares from an over-allotment option. Of the total shares offered, 4,427,500 shares were sold by the Company and 3,622,500 shares were sold by shareholders. Net proceeds to the Company were $61,763,000 before deducting offering expenses of $1,081,000. Use of Estimates The preparation of financial statements in accordance 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 reported amounts of revenue and expenses during the reporting period. Actual results could differ from those estimates. Principles of Consolidation The consolidated financial statements include the accounts of the Company and its wholly-owned subsidiaries. All significant intercompany accounts and transactions have been eliminated. Cash and Cash Equivalents and Short-Term Investments The Company considers all highly liquid investments with an initial maturity of 90 days or less to be cash equivalents and investments with original maturity dates of greater than 90 days to be short-term investments. All of the Company's short-term investments, comprising primarily debt instruments with contractual maturities of less than two years, have been classified as available for sale. Management determines the appropriate classification of securities at the time of purchase and reevaluates the classification at each reporting date. Interest income is accrued as earned. At December 31, 1997, the fair value of the Company's investments approximated their cost. Inventories Inventories are stated at the lower of cost or market, with cost being determined by the first-in, first-out (FIFO) method. Property and Equipment Property and equipment are stated at cost. Depreciation of property and equipment is provided using the straight-line method over estimated useful lives that range from 3 to 5 years for machinery and equipment and furniture and fixtures and 4 to 30 years for buildings and building improvements. Technical Infrastructure and Covenants not to Compete Technical infrastructure and covenants not to compete are amortized over estimated useful lives that range from 3 to 4 years. Impairment of Long-Lived Assets Pursuant to Statement of Financial Accounting Standards No. 121, "Accounting for the Impairment of Long-lived Assets and for Long-Lived Assets to be Disposed of" ("SFAS 121"), the Company reviews long- 30

32 ESS TECHNOLOGY, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED) lived assets based upon a gross cash flow basis and will reserve for impairment whenever events or changes in circumstances indicate the carrying amount of the assets may not be fully recoverable. Based on its most recent analysis, the Company believes that there was no impairment of its long-lived assets as of December 31, 1997. Revenue Recognition Revenue from products sales is recognized at the time of shipment except for certain shipments to distributors with rights of return and allowances, in which case revenue is deferred until the distributor resells the product. For sales recognized at the time of shipment, reserves for estimated returns and price adjustments are provided at the time of shipment. Research and Development Research and development costs are expensed as incurred. Income Taxes The Company accounts for income taxes under an asset and liability approach that requires the recognition of deferred tax liabilities and assets for the expected future tax consequences of timing differences between the carrying amounts and the tax bases of assets and liabilities. U.S. deferred income taxes are provided on unremitted earnings of the Company's foreign subsidiaries to the extent that such earnings are not considered permanently invested. Stock Based Compensation The Company accounts for stock based employee compensation arrangements using the intrinsic value method as prescribed in Accounting Principles Board Opinion No. 25, "Accounting for Stock Issued to Employees" and related interpretations thereof. Accordingly, compensation costs for stock options is measured as the excess, if any, of the market price of the Company's stock at the date of grant over the stock option exercise price. In addition, the Company complies with the disclosure provisions of Statement of Financial Accounting Standard No. 123, "Accounting for Stock-Based Compensation" ("SFAS 123"). Net Income per Share Basic net income per share is computed using the weighted average number of common shares outstanding during the period. Diluted net income per share is computed using the weighted average number of common and potential common shares outstanding during the period, except if anti-dilutive. Potential common shares consist of the incremental common shares issuable upon the exercise of stock options (using the treasury stock method). Recent Accounting Pronouncements In June 1997, the Financial Accounting Standards Board issued Statement of Financial Accounting Standards No. 130 (SFAS No. 130), "Reporting Comprehensive Income" and No. 131 (SFAS No. 131), "Disclosures About Segments of an Enterprise and Related Information."SFAS No. 130 establishes standards for reporting and display of comprehensive income and its components in a full set of general-purpose financial statements. SFAS No. 130 is effective for fiscal years beginning after December 15, 1997. Reclassification of financial statements for earlier periods provided for comparative purposes is required. SFAS No. 131 supersedes SFAS No. 14 and requires segment information be reported on the basis that it is used internally for evaluating segment performance and deciding how to allocate resources to segments in quarterly and annual reports. SFAS No. 131 is effective for annual reports for fiscal years beginning after December 15, 31

33 ESS TECHNOLOGY, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED) 1997 and applicable to interim financial statements beginning in the second year of application, along with comparative information for interim periods in the initial year of applications. The Company believes that adoption of the new standards will not have a material impact on the Company's consolidated financial statements. 32

34 ESS TECHNOLOGY, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED) 2. BALANCE SHEET COMPONENTS (IN THOUSANDS) <TABLE> <CAPTION> DECEMBER 31, ------------------ 1996 1997 ------- ------- <S> <C> <C> Cash and cash equivalents: Cash and money market accounts......................... $46,569 $23,318 Municipal notes and bonds.............................. 2,386 4,342 Certificates of deposit................................ 100 100 ------- ------- $49,055 $27,760 ======= ======= Short-term investments: Municipal notes and bonds.............................. $20,149 $14,524 ======= ======= Accounts receivable: Accounts receivable.................................... $22,540 $37,251 Less: allowance for doubtful accounts.................. (486) (986) ------- ------- $22,054 $36,265 ======= ======= Inventories: Raw materials.......................................... $ 2,192 $ 2,989 Work-in-process........................................ 14,302 27,416 Finished goods......................................... 18,797 37,664 ------- ------- Gross inventories...................................... 35,291 68,069 Less: inventory reserves............................... (2,141) (20,784) ------- ------- $33,150 $47,285 ======= ======= Property and equipment: Land................................................... $ 4,128 $ 3,899 Buildings and building improvements.................... 11,809 15,838 Machinery and equipment................................ 10,601 22,080 Furniture and fixtures................................. 618 824 ------- ------- Cost of property and equipment......................... 27,156 42,641 Less: accumulated depreciation and amortization........ (4,790) (9,719) ------- ------- $22,366 $32,922 ======= ======= Other assets: Foundry prepayments and investments.................... $50,057 $44,733 Prepaid license fees................................... 1,350 1,725 Covenants not to compete............................... 3,507 10,262 Technical infrastructure............................... -- 6,339 Other.................................................. 689 888 ------- ------- $55,603 $63,947 ======= ======= Accounts payable and accrued expenses: Accounts payable....................................... $22,597 $42,373 Accrued compensation costs............................. 2,513 2,449 Advances payable to vendors............................ 28,929 -- Accrued commission and royalties....................... 2,074 1,196 Other accrued liabilities.............................. 2,320 4,840 ------- ------- $58,433 $50,858 ======= ======= </TABLE> 33

35 ESS TECHNOLOGY, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED) 3. DEBT The Company has an unsecured short-term line of credit agreement with a foreign bank of $20 million which expires on May 31, 1999. Under the terms of the agreement, the Company may borrow at a fixed rate of LIBOR plus 1% or a variable rate at the foreign bank's reference rate minus 1%. The Company also has a second unsecured short-term line of credit agreement with another bank for $10 million, which expires on June 10, 1998. Under the terms of the agreement, the Company may borrow at a variable rate of either LIBOR plus 1% or at the bank's reference rate minus 1%. Both lines of credit require the Company to achieve certain financial ratios and operating results. A covenant of one of the lines was not met in the fourth quarter of 1997. A waiver has been obtained during the first quarter of 1998. There were no borrowings under the lines of credit as of December 31, 1997. 4. INCOME TAXES Income before provision for income taxes consisted of the following: <TABLE> <CAPTION> YEAR ENDED DECEMBER 31, ------------------------------ 1995 1996 1997 ------- ------- -------- (IN THOUSANDS) <S> <C> <C> <C> Domestic..................................... $50,363 $55,191 $ 13,947 Foreign...................................... 68 248 (10,975) ------- ------- -------- $50,431 $55,439 $ 2,972 ======= ======= ======== </TABLE> Provision for income taxes consisted of the following: <TABLE> <CAPTION> YEAR ENDED DECEMBER 31, ----------------------------- 1995 1996 1997 ------- ------- ------- (IN THOUSANDS) <S> <C> <C> <C> Current: Federal..................................... $18,382 $29,406 $15,011 State....................................... 3,200 3,955 1,769 Foreign..................................... 24 42 38 ------- ------- ------- 21,606 33,403 16,818 ------- ------- ------- Deferred: Federal..................................... (1,056) 330 (2,550) State....................................... (5) 80 (430) ------- ------- ------- (1,061) 410 (2,980) ------- ------- ------- Total............................... $20,545 $33,813 $13,838 ======= ======= ======= </TABLE> 34

36 ESS TECHNOLOGY, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED) A reconciliation between the provision for income taxes computed at the federal statutory rate of 35% for the years ended December 31, 1995, 1996 and 1997 and the provision for income taxes is as follows: <TABLE> <CAPTION> YEAR ENDED DECEMBER 31, ----------------------------- 1995 1996 1997 ------- ------- ------- (IN THOUSANDS) <S> <C> <C> <C> Provision at statutory rate................... $17,651 $19,404 $ 1,040 Taxes (benefits)/costs of earnings of foreign subsidiary.................................. -- -- 4,275 State income taxes, net of federal tax benefit..................................... 3,048 1,843 94 Tax-exempt interest income.................... -- (509) (333) General business credit....................... -- (371) (643) Nondeductible research and development costs....................................... -- 12,758 8,480 Other......................................... (154) 688 925 ------- ------- ------- Provision for income taxes.................... $20,545 $33,813 $13,838 ======= ======= ======= </TABLE> Deferred tax assets (liabilities) are comprised of the following: <TABLE> <CAPTION> YEAR ENDED DECEMBER 31, ------------------ 1996 1997 ------- ------- (IN THOUSANDS) <S> <C> <C> State income taxes....................................... $ 974 $ 533 Accounts receivable and inventory reserves............... 1,006 3,680 Accrued expenses......................................... 754 370 Legal reserves and other................................. 536 315 ------- ------- Total deferred tax assets...................... 3,270 4,898 Unremitted earnings of foreign subsidiary................ (4,069) (4,069) Covenants not to compete and technical infrastructure.... (1,343) (5,437) ------- ------- Net deferred tax liabilities................... $(2,142) $(4,608) ======= ======= </TABLE> 5. SHAREHOLDERS' EQUITY Common Stock On July 15, 1996, the Company's Board of Directors authorized repurchase at management's discretion of up to 2.0 million of the Company's shares of Common Stock over the subsequent 12 months at market prices and as the market and business conditions warrant. At December 31, 1996, the Company had repurchased 1,802,500 shares at market prices ranging from $9.41 to $16.75 per share. On April 29, 1997, the Company's Board of Directors authorized repurchase at management's discretion of up to 2 million of the Company's shares of Common Stock over the subsequent 12 months at market prices and as the market and business conditions warrant. There were no repurchases under this program as of December 31, 1997. 1986 Stock Option Plan In February 1986, the Company adopted the 1986 Stock Option Plan (the "1986 Plan"). Under the 1986 Plan, 3,600,000 shares of Common Stock were reserved for issuance to employees, consultants and investors as approved by the Board of Directors. The 1986 Plan provides for incentive stock options and the Board may terminate the 1986 Plan at any time. Options under the 1986 Plan are granted, subject to certain conditions, at estimated fair value as determined by the Board of Directors. Options granted under the 1986 Plan generally 35

37 ESS TECHNOLOGY, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED) vest 25% each year after the date of grant. Options are adjusted on a pro rata basis for certain changes in the capitalization of the Company, such as stock splits and stock dividends. In addition, the outstanding options issued under the 1986 Plan terminate within 90 days after termination of an option holder's employment with the Company. 1992 Stock Option Plan In January 1992, the Company adopted the 1992 Stock Option Plan (the "1992 Plan"). The 1992 Plan authorized 6,966,000 shares to be reserved for issuance. The terms of the 1992 Plan are generally similar to those of the 1986 Plan outlined above. Executive Plan In January 1990 and March 1991, the Company granted 5,400,000 and 1,080,000 options, respectively, outside of the 1986 Plan to officers of the Company under the Executive Plan. The options were granted at the then fair value of $0.083 per share, as determined by the Board of Directors. The options generally vested over periods of one to four years. Equity Incentive Plan In August 1995, the Company adopted the 1995 Equity Incentive Plan (the "Incentive Plan"), which provides for the grant of stock options and stock bonuses and the issuance of restricted stock by the Company to its employees, directors and others. The Company has reserved 3,000,000 shares of the Company's Common Stock for issuance under the Incentive Plan. In September 1996, the Company canceled 326,000 shares under the Incentive Plan with exercise prices greater than $14.75 and reissued the options with an exercise price of $14.75. In May 1997, the Company canceled 720,000 shares under the Incentive Plan with exercise prices greater than $13.94 and reissued the options with an exercise price of $13.94. Employee Stock Purchase Plan In August 1995, the Company adopted the 1995 Employee Stock Purchase Plan (the "Purchase Plan") and reserved a total of 225,000 shares of the Company's Common Stock for issuance thereunder. The Purchase Plan permits eligible employees to acquire shares of the Company's Common Stock through payroll deductions. Directors Plan In August 1995, the Company adopted the Directors Plan and reserved a total of 300,000 shares of the Company's Common Stock for issuance thereunder. The Directors Plan allows for granting of stock options to members of the Board of Directors of the Company. 1997 Equity Incentive Plan In May 1997, the Company adopted the 1997 Equity Incentive Plan (the "1997 Incentive Plan") and reserved a total of 3,000,000 shares of the Company's Common Stock for issuance thereunder. The terms of the 1997 Incentive Plan are generally similar to those of the Incentive Plan outlined above. Platform Stock Option Plan In June 1997, in connection with the acquisition of Platform Technologies, Inc. ("Platform"), the Company assumed the Platform Stock Option Plan (the "Platform Plan"). The Company does not plan to 36

38 ESS TECHNOLOGY, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED) issue any additional options under the Platform Plan and has reserved approximately 954,000 shares of Common Stock for issuance under the Platform Plan pursuant to the exercise of options that were outstanding at the time of the Platform acquisition. The Platform options vest ratably over four years. Stock Based Compensation: Transactions under the Company's various Stock Option Plans are summarized as follows (in thousands except per share amounts): <TABLE> <CAPTION> AVAILABLE FOR OPTIONS WEIGHTED AVERAGE GRANT OUTSTANDING EXERCISE PRICE --------- ----------- ---------------- <S> <C> <C> <C> Balance at December 31, 1994........................... 2,324 5,813 $ 0.65 Authorized........................................... 3,300 -- -- Granted.............................................. (2,048) 2,048 $ 5.88 Exercised............................................ -- (799) $ 0.15 Canceled............................................. 295 (295) $ 4.97 ------ ------ ------ Balance at December 31, 1995........................... 3,871 6,767 $ 2.11 Granted.............................................. (2,595) 2,595 $15.79 Exercised............................................ -- (3,666) $ 0.85 Canceled............................................. 863 (863) $13.79 ------ ------ ------ Balance at December 31, 1996........................... 2,139 4,833 $ 8.30 Authorized........................................... 3,000 -- -- Reserved for Platform acquisition.................... 954 -- -- Granted.............................................. (4,129) 4,129 $11.78 Exercised............................................ -- (886) $ 2.59 Canceled............................................. 1,426 (1,426) $17.70 ------ ------ ------ Balance at December 31, 1997........................... 3,390 6,650 $ 9.20 ====== ====== ====== </TABLE> The options exercisable at December 31, 1997 was 1,719,000 shares. The weighted average grant date fair value of options granted during the years ended December 31, 1995, 1996 and 1997 were $2.16, $8.68 and $8.91, respectively. The following table summarizes information about stock options outstanding at December 31, 1997: <TABLE> <CAPTION> OPTIONS OUTSTANDING OPTIONS EXERCISABLE -------------------------------------------------------- ------------------------------------ NUMBER NUMBER OUTSTANDING AT AVERAGE REMAINING EXERCISABLE AT RANGE OF DECEMBER 31, 1997 CONTRACTUAL LIFE WEIGHTED AVERAGE DECEMBER 31, 1997 WEIGHTED AVERAGE EXERCISE PRICES (IN THOUSANDS) (YEARS) EXERCISE PRICE (IN THOUSANDS) EXERCISE PRICE --------------------- ----------------- ----------------- ---------------- ----------------- ---------------- <S> <C> <C> <C> <C> <C> $ 0.03 - $ 1.40...... 1,796 6.71 $ 0.57 1,060 $ 0.48 2.67 - 5.33...... 760 5.44 3.15 249 1.05 7.56 - 12.88...... 826 6.40 10.78 136 10.62 12.94 - 16.00...... 2,934 7.26 14.39 191 14.96 $16.25 - $30.88...... 334 6.54 19.83 83 19.13 ----- ---- ------ ----- ------ 6,650 6.76 $ 9.20 1,719 $ 4.15 ===== ==== ====== ===== ====== </TABLE> 37

39 ESS TECHNOLOGY, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED) Fair Value Disclosures The Company's pro forma net income (loss) and pro forma net income (loss) per share would have been as follows had compensation costs for options granted since 1995 under the Company's option plans been determined based on the fair value at the grant dates, as prescribed in SFAS 123, (in thousands except per share amounts): <TABLE> <CAPTION> YEAR ENDED DECEMBER 31, ---------------------------- 1995 1996 1997 ------- ------- -------- <S> <C> <C> <C> Net income (loss): As reported............................ $29,886 $21,626 $(10,866) Pro forma.............................. $29,454 $18,902 $(17,278) Net income (loss) per share -- basic: As reported............................ $ 0.96 $ 0.57 $ (0.27) Pro forma.............................. $ 0.94 $ 0.50 $ (0.44) Net income (loss) per share -- diluted: As reported............................ $ 0.79 $ 0.52 $ (0.27) Pro forma.............................. $ 0.78 $ 0.45 $ (0.44) </TABLE> The fair value of each option grant is estimated on the date of grant using the Black-Scholes model with the following assumptions used for grants during the years ended December 31, 1995, 1996 and 1997: dividend yield of 0.0% for these periods; expected volatility of 0% for the period between January 1, 1995 through October 5, 1995 (the date of the initial public offering), expected volatility of 67% for the period between October 6, 1995 and December 31, 1995, 64% for the year ended December 31, 1996 and 70% for the year ended December 31, 1997; risk-free interest rates of 6.20%, 6.30% and 6.23% for the years ended December 31, 1995, 1996 and 1997, respectively; and a weighted average expected option term of 5 years for these periods. Sales under the Purchase Plan in 1996 and 1997 were approximately 47,000 shares and 75,000 shares, respectively, at an average price per share of $13.19 and $10.89, respectively. Compensation cost (included in pro forma net income (loss) and net income (loss) per share amounts) for the grant date fair value, as defined by SFAS 123, of the purchase rights granted under the Purchase Plan was calculated using the Black-Scholes model with the following assumptions for 1995, 1996 and 1997: an expected life of six months for these periods; expected volatility of 63%, 69% and 70%, respectively; expected dividend yield of 0% for these periods and risk-free interest rates of 5.81%, 5.31% and 6.00%, respectively. The weighted average estimated grant date fair value, as defined by SFAS 123, of rights to purchase stock under the Purchase Plan in 1995, 1996 and 1997 were $7.50, $5.34 and $5.00 per share, respectively. Because additional option grants are expected to be made each year, the above pro forma disclosures are not representative of pro forma effects of reported net income for future years. 38

40 ESS TECHNOLOGY, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED) 6. EARNINGS PER SHARE Earnings per share are calculated in accordance with the provisions of Statement of Financial Accounting Standards No. 128 -- "Earnings per Share" (SFAS No. 128), effective for 1997. SFAS No. 128 requires the Company to report both basic earnings per share, which is based on the weighted-average number of common shares outstanding, and diluted earnings per share, which is based on the weighted average number of common shares outstanding and all dilutive potential common shares outstanding. All prior years' earnings per share data in this report have been recalculated to reflect the provisions of SFAS No. 128. All earnings per share data in this report reflect basic earnings per share, unless otherwise indicated. <TABLE> <CAPTION> PER SHARE INCOME SHARES AMOUNT -------- ------- --------- <S> <C> <C> <C> YEAR ENDED DECEMBER 31, 1995 Earnings per share of common stock.......................... $ 29,886 31,265 $ 0.96 ------- Effect of dilutive securities: Stock options............................................. -- 3,225 Cheap stock............................................... -- 3,285 -------- ------- Earnings per share of common stock -- assuming dilution..... $ 29,886 37,775 $ 0.79 -------- ------- ------ YEAR ENDED DECEMBER 31, 1996 Earnings per share of common stock.......................... $ 21,626 37,702 $ 0.57 ------- Effect of dilutive securities: Stock options............................................. -- 3,886 -------- ------- Earnings per share of common stock -- assuming dilution..... $ 21,626 41,588 $ 0.52 -------- ------- YEAR ENDED DECEMBER 31, 1997 Loss per share of common stock.............................. $(10,866) 39,593 $(0.27) -------- Effect of dilutive securities: Stock options............................................. -- -- -------- ------- Loss per share of common stock -- assuming dilution......... $(10,866) 39,593 $(0.27) ======== ======= ====== </TABLE> 7. INDUSTRY SEGMENT AND FOREIGN OPERATIONS The Company and its wholly-owned subsidiaries are engaged in the design, manufacture and marketing of semiconductor products for the PC and consumer marketplaces. Sales and purchase transactions are generally denominated in U.S. dollars. Most of the Company's revenues outside the U.S. are made in the Far East. Most of the identified assets located outside the U.S. are in the Far East. The following is a summary of the Company's geographic operations: <TABLE> <CAPTION> DOMESTIC FOREIGN TOTAL -------- -------- -------- (IN THOUSANDS) <S> <C> <C> <C> Year ended December 31, 1995: Net revenues............................................. $ 29,024 $ 76,720 $105,744 Income from operations................................... 47,737 -- 47,737 Identifiable assets...................................... 161,873 830 162,703 Year ended December 31, 1996: Net revenues............................................. $ 18,790 $207,665 $226,455 Income from operations................................... 52,198 -- 52,198 Identifiable assets...................................... 210,964 1,021 211,985 Year ended December 31, 1997: Net revenues............................................. $ 26,793 $222,724 $249,517 Income from operations................................... 10,025 (9,236) 789 Identifiable assets...................................... 194,053 37,601 231,654 </TABLE> 39

41 ESS TECHNOLOGY, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED) In October 1997, the Company established a wholly owned subsidiary in the Cayman Island, British West Indies. The Cayman Island subsidiary and its branch offices are responsible for the manufacturing and for the international sales of the Company's products. 8. SIGNIFICANT CUSTOMERS AND CONCENTRATION OF RISK Financial instruments that potentially subject the Company to concentration of credit risk consist primarily of cash equivalents, short-term investments and trade accounts receivable. Cash equivalents and short-term investments, which primarily comprised of investments in money market funds and municipal debt instruments, are maintained with high quality institutions and the composition and maturities are regularly monitored by management. The following table summarizes the percentage of net revenues accounted for by the Company's significant customers for any year in which a customer or distributor accounts for 10% or more of revenues. <TABLE> <CAPTION> YEAR ENDED DECEMBER 31, ------------------------ 1995 1996 1997 ---- ---- ---- <S> <C> <C> <C> Compaq Computer............................. 17% 12% -- Dynax....................................... -- -- 13% Eastbase.................................... -- -- 13% Universe Electron........................... 17% 13% -- </TABLE> A majority of the Company's trade receivables are derived from sales to manufacturers of computer systems. The Company generally extends 30-day credit terms to its customers, which is consistent with industry business practices. The Company performs ongoing credit evaluations of its customers' financial condition and generally, requires letters of credit from international customers. The Company maintains an allowance for doubtful accounts on its receivables based upon the expected collectibility of all accounts receivable. To date, the Company has not incurred any significant losses due to uncollectible accounts receivable. At December 31, 1996 and 1997, approximately 30% and 35%, respectively, of trade accounts receivable represent amounts due from two customers. 9. WAFER CAPACITY COMMITMENTS In November 1995, the Company entered into agreements with two wafer foundries, TSMC and UMC, in which the Company secured access to additional manufacturing capacity and to certain technology. Under the TSMC agreement, in exchange for TSMC's increased wafer capacity commitments, the Company committed to pay approximately $32 million over two years as deposits for wafers through 1999. The cash requirements associated with this agreement were paid by the Company in the form of two $16 million payments in 1996 and 1997. The payments can be applied to offset wafers purchased from 1996 to 1999 provided that the Company purchases not less than a certain specified number of wafers during each of the four years ending December 31, 1999. As of December 31, 1997, $11.8 million of the payment was applied and $20.1 million was included in other assets. Under the UMC agreement, the Company entered into a joint venture arrangement with UMC, together with other US semiconductor companies, to build a separate semiconductor manufacturing facility located in Taiwan at an estimated cost of $1 billion. The Company has invested approximately $24.6 million in the joint venture. Under the terms of the agreement, the Company will receive a 5% equity ownership in the joint venture company and certain capacity rights. The facility was scheduled to open during 1998, but several fires during construction have delayed construction. UMC has stated that it expects insurance will cover its recent fire losses at the joint venture foundry. 40

42 ESS TECHNOLOGY, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED) 10. ACQUISITIONS AND RELATED CHARGES On June 11, 1997, the Company completed its acquisition of Platform Technologies, Inc. ("Platform"), a California based company, pursuant to which the Company acquired all of the outstanding capital stock of Platform in exchange for approximately 2.54 million shares of the Company's Common Stock including approximately 954,000 options with a value of $32.7 million. Platform, a wholly owned subsidiary of the Company, is developing integrated circuits for the PC audio market incorporating the PCI standard. On January 3, 1996, the Company completed its acquisition of VideoCore Technology, Inc. ("VideoCore"), a California based company, pursuant to which the Company acquired all of the outstanding capital stock of VideoCore in exchange for approximately 525,000 shares of the Company's Common Stock and $5.7 million in cash. VideoCore, a wholly owned subsidiary of the Company, is developing integrated circuits which incorporates advanced compression technology for digital video products. On March 29, 1996, the Company completed its acquisition of OSEE Technology, Inc. ("OSEE"), a California based company, pursuant to which the Company acquired all of the outstanding capital stock of OSEE in exchange for approximately 217,000 shares of the Company's Common Stock and $3.6 million in cash. Also outstanding stock options of OSEE were exchanged for 85,000 stock options of the Company. OSEE, a wholly owned subsidiary of the Company, is a developer of advanced fax/modem algorithm technology which enables the Company to provide modem and computer fax/modem applications on the Company's multimedia processor. The purchase price of these companies was allocated to assets acquired and liabilities assumed based upon the book value of VideoCore's, OSEE's and Platform's current assets, equipment and liabilities, which management believes approximates their fair value, and independent appraisal for all other identifiable assets as follows: <TABLE> <CAPTION> VIDEOCORE & OSEE PLATFORM --------- -------------- (IN THOUSANDS) <S> <C> <C> Research and development in-process................. $30,355 $22,200 Technical infrastructure............................ -- 7,245 Covenants not to compete............................ 4,600 6,100 Current assets...................................... 12 3,209 Property and equipment.............................. 120 222 Current liabilities assumed......................... (607) (369) Other liabilities assumed........................... (1,541) (5,204) ------- ------- $32,939 $33,403 Acquisition costs................................... (299) (700) ------- ------- Value of consideration issued for acquisition....... $32,640 $32,703 ======= ======= </TABLE> These acquisitions were recorded using the purchase method of accounting and accordingly, the results of operations and cash flows of such acquisitions have been included from the applicable dates of acquisition. Acquired research and development in-process aggregating $22.2 million for the Platform acquisition and $30.4 million for the VideoCore and OSEE acquisitions were charged in the second quarter of 1997 and in the first quarter of 1996, respectively. Additionally, the pro forma effect of the 1996 and 1997 acquisitions were not significant on the Company's reported operating results for the fiscal years 1995, 1996 or 1997. 11. SUBSEQUENT EVENTS On February 11, 1998, the Company announced that it had renegotiated certain inventory purchases made prior to December 31, 1997. As a result, the Company reported a net loss for the year of $10.9 million versus a net loss of $16.2 million, as reported in the Company's January 22, 1998 press release. 41

43 ESS TECHNOLOGY, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED) On February 13, 1998, the Compensation Committee of the Company's Board of Directors announced that it had reviewed the status of outstanding options issued to non-officers and officers of the Company and offered to exchange those options held by non-officers with an exercise price exceeding the closing price of the Company's Common Stock on February 13, 1998 (the "New Price") for options with an exercise price equal to the New Price and with the same original vesting start date and vesting schedule as the exchanged option, but with a restriction on the exercisability of such repriced options until February 13, 1999. In addition, the Compensation Committee offered to exchange those options held by the executive officers of the Company (excluding Mr. Chan) with an exercise price exceeding the New Price for options with an exercise price equal to the New Price but with a restriction on the exercisability of such repriced options until the later of February 17, 1999 or the earlier of the day following the tenth consecutive trading day in which the closing price of the Company's Common Stock is at or above $15.00 per share or February 17, 2001. Pursuant to the offer, those repriced options held by officers that were not vested as of February 17, 1998 will have a new vesting schedule of one-third of such unvested repriced options at the end of each year commencing on February 17, 1998. If a non-officer or officer voluntarily terminates his or her employment prior to the end of the term of the applicable restriction on exercisability, the exchanged options will be forfeited. Pursuant to the repricing, approximately 3,380,000 options with an exercise price greater than $7.69 were exchanged for options with an exercise price of $7.69. In March 1998, Creative Technology, Ltd. ("Creative") and E-mu Systems Incorporated ("E-mu") filed a lawsuit against the Company and Diamond Multimedia Incorporated alleging that the Company's Maestro family of products infringe upon an E-mu patent which has been exclusively licensed by Creative. The complaint seeks an injunction against future infringement, damages for past infringement, fees and costs. If the Company were found to be infringing a valid E-mu patent, then the Company could be required to cease sales of the infringing products. The Company is vigorously contesting Creative's claims. In connection with the Creative litigation, the Company has incurred and will continue to incur legal and other expenses. While the outcome of such lawsuits cannot be accurately predicted, based on the facts currently known, management does not believe the ultimate resolution of this matter will have a material adverse impact on the Company's financial position or results of operation. 42

44 SELECTED QUARTERLY OPERATING RESULTS (UNAUDITED) The following table presents unaudited quarterly financial information for each of the Company's last eight quarters. This information has been derived from the Company's unaudited financial statements and has been prepared on the same basis as the audited Consolidated Financial Statements appearing elsewhere in this Form 10-K. In the opinion of management, all necessary adjustments, consisting only of normal recurring adjustments, have been included to present fairly the quarterly results. <TABLE> <CAPTION> 1996 1997 ---------------------------------------- ---------------------------------------- MAR. 31 JUNE 30 SEPT. 30 DEC. 31 MAR. 31 JUNE 30 SEPT. 30 DEC. 31 -------- ------- -------- -------- ------- -------- -------- -------- (IN THOUSANDS, EXCEPT PER SHARE DATA) <S> <C> <C> <C> <C> <C> <C> <C> <C> Net revenues............................. $ 41,188 $48,450 $60,138 $ 76,679 $81,468 $ 45,142 $52,172 $ 70,735 Cost of revenues......................... 17,637 21,889 29,540 37,752 41,772 27,220 35,200 67,668 -------- ------- ------- -------- ------- -------- ------- -------- Gross profit........................... 23,551 26,561 30,598 38,927 39,696 17,922 16,972 3,067 Operating expenses: Research and development............... 3,631 4,551 5,577 6,511 5,571 7,057 8,343 8,501 Research and development in-process.... 30,355 -- -- -- -- 22,200 -- -- Selling, general and administrative.... 2,935 3,253 4,352 6,274 5,611 5,560 6,303 7,722 -------- ------- ------- -------- ------- -------- ------- -------- Operating income (loss).................. (13,370) 18,757 20,669 26,142 28,514 (16,895) 2,326 (13,156) Nonoperating income, net................. 699 640 418 1,484 640 806 417 320 -------- ------- ------- -------- ------- -------- ------- -------- Income (loss) before income taxes........ (12,671) 19,397 21,087 27,626 29,154 (16,089) 2,743 (12,836) Provision for (benefit from) income taxes.................................. 7,250 7,565 8,224 10,774 11,327 2,284 1,025 (798) -------- ------- ------- -------- ------- -------- ------- -------- Net income (loss)........................ $(19,921) $11,832 $12,863 $ 16,852 $17,827 $(18,373) $ 1,718 $(12,038) ======== ======= ======= ======== ======= ======== ======= ======== Net income (loss) per share -- basic..... $ (0.55) $ 0.31 $ 0.34 $ 0.45 $ 0.46 $ (0.47) $ 0.04 $ (0.30) ======== ======= ======= ======== ======= ======== ======= ======== Net income (loss) per share -- diluted... $ (0.55) $ 0.28 $ 0.31 $ 0.41 $ 0.43 $ (0.47) $ 0.04 $ (0.30) ======== ======= ======= ======== ======= ======== ======= ======== Shares used in calculating net income (loss) per share -- basic.............. 36,234 38,660 38,050 37,821 38,440 38,990 40,376 40,537 ======== ======= ======= ======== ======= ======== ======= ======== Shares used in calculating net income (loss) per share -- diluted............ 36,234 42,414 41,128 41,011 41,469 38,990 43,390 40,537 ======== ======= ======= ======== ======= ======== ======= ======== </TABLE> The following table sets forth the above quarterly financial information as a percentage of net revenues: <TABLE> <CAPTION> 1996 1997 -------------------------------------- -------------------------------------- MAR. 31 JUNE 30 SEPT. 30 DEC. 31 MAR. 31 JUNE 30 SEPT. 30 DEC. 31 ------- ------- -------- ------- ------- ------- -------- ------- <S> <C> <C> <C> <C> <C> <C> <C> <C> Net revenues......................... 100.0% 100.0% 100.0% 100.0% 100.0% 100.0% 100.0% 100.0% Cost of revenues..................... 42.8 45.2 49.1 49.2 51.3 60.3 67.5 95.7 ----- ----- ----- ----- ----- ----- ----- ----- Gross margin....................... 57.2 54.8 50.9 50.8 48.7 39.7 32.5 4.3 Operating expenses: Research and development........... 8.8 9.4 9.3 8.5 6.8 15.6 16.0 12.0 Research and development in-process....................... 73.7 -- -- -- -- 49.2 -- -- Selling, general and administrative................... 7.2 6.7 7.2 8.2 6.9 12.3 12.1 10.9 ----- ----- ----- ----- ----- ----- ----- ----- Operating income (loss).............. (32.5) 38.7 34.4 34.1 35.0 (37.4) 4.4 (18.6) Nonoperating income, net............. 1.7 1.3 0.7 1.9 0.8 1.8 0.8 0.5 ----- ----- ----- ----- ----- ----- ----- ----- Income (loss) before income taxes.... (30.8) 40.0 35.1 36.0 35.8 (35.6) 5.2 (18.1) Provision for (benefit from) income taxes.............................. 17.6 15.6 13.7 14.0 13.9 5.1 2.0 (1.1) ----- ----- ----- ----- ----- ----- ----- ----- Net income (loss).................... (48.4)% 24.4% 21.4% 22.0% 21.9% (40.7)% 3.2% (17.0)% ===== ===== ===== ===== ===== ===== ===== ===== </TABLE> ITEM 9. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL DISCLOSURES Not applicable. PART III Certain information required by Part III is omitted from this Report since the Company plans to file with the Securities and Exchange Commission the definitive proxy statement for its 1998 Annual Meeting of 43

45 Shareholders (the "Proxy Statement") not later than 120 days after the end of the fiscal year covered by this Report, and certain information included therein is incorporated herein by reference. ITEM 10. DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANT The information concerning the Company's directors required by this Item is incorporated by reference to the section in the Company's Proxy Statement entitled "Proposal No. 1 -- Election of Directors -- Directors/ Nominees." The information concerning the Company's executive officers required by this Item is incorporated by reference herein to Part I, Item 4A, entitled "Executive Officers of the Registrant" on page 11 of this Report. The information concerning compliance with Section 16 of the Securities Exchange Act of 1934 is incorporated by reference to the section in the Company's proxy statement entitled "Compliance under Section 16(a) of the Securities Exchange Act of 1934." ITEM 11. EXECUTIVE COMPENSATION The information required by this Item is incorporated by reference to the sections in the Company's Proxy Statement entitled "Executive Compensation," "Compensation of Directors and "Compensation Committee Interlocks and Insider Participation." ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT The information required by this Item is incorporated by reference to the section in the Company's Proxy Statement entitled "Security Ownership of Certain Beneficial Owners and Management." ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS The information required by this Item is incorporated by reference to the section in the Company's Proxy Statement entitled "Certain Transactions." PART IV ITEM 14. EXHIBITS, FINANCIAL STATEMENT SCHEDULES, AND REPORTS ON FORM 8-K (a)(1)(2)FINANCIAL STATEMENTS. The financial statements and schedules filed as part of this report are listed in Item 8 on page 24. 3. EXHIBITS <TABLE> <CAPTION> EXHIBIT NUMBER EXHIBIT TITLE ------- ------------- <C> <S> 2.01 Agreement and Plan of Reorganization dated December 12, 1995 among Registrant, ESS Acquisition Corporation and VideoCore Technology, Inc. ("VideoCore") (Incorporated herein by reference to Exhibit 2.1 to the Registrant's Current Report on Form 8-K dated January 17, 1996 (the "Form 8-K")). 2.02 Agreement of Merger dated as of January 3, 1996 among Registrant, ESS Acquisition Corporation and VideoCore. (Incorporated herein by reference to Exhibit 2.2 to the Form 8-K). 2.03 First Amended and Restated Agreement and Plan of Reorganization dated as of April 27, 1997 among Registrant, EP Acquisition Corporation and Platform Technologies, Inc. (Incorporated herein by reference to Exhibit 2.1 to the Registrant's Current Report on Form 8-K dated April 30, 1997). </TABLE> 44

46 <TABLE> <CAPTION> EXHIBIT NUMBER EXHIBIT TITLE ------- ------------- <C> <S> 3.01 Registrant's Articles of Incorporation (Incorporated herein by reference to Exhibit 3.01 to the Registrant's Form S-1 registration statement (File No. 33-95388) declared effective by the Securities and Exchange Commission on October 5, 1995 (the "Form S-1")). 3.02 Registrant's Bylaws (Incorporated herein by reference to Exhibit 3.02 to the Form S-1). 4.01 Form of Specimen Certificate for Registrant's Common Stock (Incorporated herein by reference to Exhibit 4.01 to the Form S-1). 4.02 Reference is made to Exhibit 3.01. 4.03 Registrant's Rights Agreement dated May 28, 1993 among the Registrant and certain security holders (Incorporated herein by reference to Exhibit 10.07 to the Form S-1). 10.01 Registrant's 1986 Stock Option Plan and related documents (Incorporated herein by reference to Exhibit 10.01 to the Form S-1).* 10.02 Registrant's 1992 Stock Option Plan and related documents (Incorporated herein by reference to Exhibit 10.02 to the Form S-1).* 10.03 Registrant's 1995 Equity Incentive Plan and related documents (Incorporated herein by reference to Exhibit 10.03 to the Form S-1).* 10.04 Registrant's 1995 Directors Stock Option Plan and related documents (Incorporated herein by reference to Exhibit 10.04 to the Form S-1).* 10.05 Registrant's 1995 Employee Stock Purchase Plan and related documents (Incorporated herein by reference to Exhibit 10.05 to the Form S-1).* 10.06 Registrant's Amended 401(k) Plan (Incorporated herein by reference to Exhibit 10.06 to the Form S-1).* 10.07 Registrant's Rights Agreement dated May 28, 1993 among the Registrant and certain security holders (Incorporated herein by reference to Exhibit 10.07 to the Form S-1). 10.08 Stock Transfer Agreement dated May 22, 1995 among WK Technology Fund, WK Technology Fund II, WK Technology Fund III, Fred S.L. Chan, Annie M.H. Chan and Fred S.L. and Annie M.H. Chan Charitable Trust, dated November 20, 1992 (Incorporated herein by reference to Exhibit 10.08 to the Form S-1). 10.09 Stock Transfer Agreement dated May 22, 1995 among Technology Associates Corporation, Tekkang Management Consulting Inc., Kummell Investments Limited, Fred S.L. Chan, Annie M.H. Chan and Fred S.L. and Annie M.H. Chan Charitable Trust, dated November 20, 1992 (Incorporated herein by reference to Exhibit 10.09 to the Form S-1). 10.10 Stock Transfer Agreement dated May 22, 1995 among Universe Electron Corporation, Fred S.L. Chan, Annie M.H. Chan and Fred S.L. and Annie M.H. Chan Charitable Trust, dated November 20, 1992 (Incorporated herein by reference to Exhibit 10.10 to the Form S-1). 10.11 Form of Indemnity Agreement entered into by Registrant with each of its directors and executive officers (Incorporated herein by reference to Exhibit 10.11 to the Form S-1). 10.12 Sublease dated October 15, 1992 between Raychem Corporation (as successor in interest to Remtek Corporation) and Registrant, as amended November 1, 1993, and September 1, 1994; Master Lease dated April 11, 1986 between Renco Equities III and Remtek Corporation, as amended January 29, 1994; and Option to Renew Lease dated January 25, 1989 between Renco Equities III and Remtek Corporation (Incorporated herein by reference to Exhibit 10.12 to the Form S-1). 10.13 Standard Industrial/Commercial Multi-Tenant Lease -- Modified Net dated April 3, 1995 between Gagos Living Trust and Registrant, as amended May 1, 1995; and Addendum thereto dated as of April 8, 1995 (Incorporated herein by reference to Exhibit 10.13 to the Form S-1). </TABLE> 45

47 <TABLE> <CAPTION> EXHIBIT NUMBER EXHIBIT TITLE ------- ------------- <C> <S> 10.14 Real Property Purchase Agreement and Deposit Receipt dated July 5, 1995 between King & Lyons and Registrant (Incorporated herein by reference to Exhibit 10.14 to the Form S-1). 10.15 License Agreement dated November 12, 1987 among Forrest S. Mozer, Registrant and Sharp Kabushiki Kaisha (Incorporated herein by reference to Exhibit 10.15 to the Form S-1).** 10.16 License Agreement dated September 20, 1991 between Registrant and Zilog, Inc. (Incorporated herein by reference to Exhibit 10.16 to the Form S-1).** 10.17 Software License Agreement dated July 18, 1995 among Registrant, Sensory Circuits, Inc. and Forrest Mozer (Incorporated herein by reference to Exhibit 10.17 to the Form S-1).** 10.18 Foundry Agreement dated March 29, 1993 between Registrant and Integrated Circuit Works Incorporated (Incorporated herein by reference to Exhibit 10.18 to the Form S-1).** 10.19 Purchase Agreement dated June 17, 1994 between Compaq Computer Corporation and Registrant (Incorporated herein by reference to Exhibit 10.19 to the Form S-1).** 10.20 International Distributorship Agreement dated July 1, 1994 between Registrant and Universe Electron Corporation (Incorporated herein by reference to Exhibit 10.20 to the Form S-1). 10.21 Option I Agreement between Registrant and Taiwan Semiconductor Manufacturing Co., Ltd. ("TSMC") dated November 30, 1995, as amended December 28, 1995. (Incorporated herein by reference to Exhibit 10.21 to the Registrant's Annual Report on Form 10-K, dated February 29, 1996 as amended March 29, 1996 (the "1995 Form 10-K").*** 10.22 Option II Agreement between Registrant and TSMC dated November 30, 1995. (Incorporated herein by reference to Exhibit 10.22 to the 1995 Form 10-K).*** 10.23 Foundry Venture Agreement between Registrant and United Microelectronics Corporation ("UMC") dated November 28, 1995, as amended January 31, 1996. (Incorporated herein by reference to Exhibit 10.23 to the 1995 Form 10-K).*** 10.24 FabVen Foundry Capacity Agreement among FabVen, UMC and Registrant dated November 28, 1995. (Incorporated herein by reference to Exhibit 10.24 to the 1995 Form 10-K).*** 10.25 Form of Employment and Non-Competition Agreement among the Registrant, VideoCore and Jan Fandrianto dated December 12, 1995. (Incorporated herein by reference to Exhibit 2.1 to the Form 8-K).* 10.26 Form of Employment and Non-Competition Agreement among the Registrant, VideoCore and Chi-Shin Wang dated December 12, 1995. (Incorporated herein by reference to Exhibit 2.1 to the Form 8-K).* 10.27 Form of Employment Agreement and Promissory Note among the Registrant and John H. Barnet dated August 22 and September 16, 1996, respectively. (Incorporated herein by reference to Exhibit 10.27 to the Registrant's Report on Form 10-Q, dated November 14, 1996.)* 10.28 Form of Consulting and Employment Agreements among the Registrant and Herbert J. Martin dated October 23, 1996 (Incorporated herein by reference to Exhibit 10.28 to the Registrant's Annual Report Form 10-K, dated March 18, 1997 as amended on March 20, 1997 (the "1996 Form 10-K")).* 10.29 Form of Termination and Consulting Agreements among the Registrant and Herbert J. Martin dated February 13, 1997 (Incorporated herein by reference to Exhibit 10.29 to the 1996 10-K).* 10.30 1997 Equity Incentive Plan and related agreements (Incorporated herein by reference to Appendix I filed in the Registrant's Proxy Statement for the 1997 Annual Meeting of Shareholders, filed on April 30, 1997).* 10.31 Form of Exit Agreement between the Registrant and Bo Ericsson dated November 26, 1997.* </TABLE> 46

48 <TABLE> <CAPTION> EXHIBIT NUMBER EXHIBIT TITLE ------- ------------- <C> <S> 21.01 List of Registrant's subsidiaries. 23.01 Consent of Independent Accountants. 27.01 Financial Data Schedule. </TABLE> --------------- * Represents a management contract or compensatory plan of arrangement. ** Confidential treatment has been granted with respect to certain portions of this agreement. *** Confidential treatment has been requested with respect to certain portions of this agreement. (b) Reports on Form 8-K: The Company did not file a report on Form 8-K during the quarter ended December 31, 1997. With the exception of the information incorporated by reference to the Company's Proxy Statement for the 1998 Annual Meeting of Shareholders in Items 10, 11, 12 and 13 of Part III, the Proxy Statement is not deemed to be filed as part of this Report. 47

49 SIGNATURES Pursuant to the requirements of Section 13 or 15(d) of the Securities Exchange Act of 1934, ESS Technology, Inc. has duly caused this Annual Report on Form 10-K to be signed on its behalf by the undersigned, thereunto duly authorized, in the City of Fremont, State of California, on March 31, 1998. ESS TECHNOLOGY, INC. By: /s/ JOHN H. BARNET ------------------------------------ John H. Barnet Vice President, Finance and Chief Financial Officer POWER OF ATTORNEY KNOW ALL PERSONS BY THESE PRESENTS, that each person whose signature appears below hereby constitutes and appoints Fred S.L. Chan and John H. Barnet, jointly and severally, his or her true and lawful attorneys-in-fact, each with full power of substitution, for him or her in any and all capacities, to sign any and all amendments to this Annual Report or Form 10-K, and to file the same, with all exhibits thereto and all documents in connection therewith, with the Securities and Exchange Commission, hereby ratifying and confirming all that each of said attorneys-in-fact or any of them, or his or their substitute or substitutes, may lawfully do or cause to be done or by virtue hereof. Pursuant to the requirements of the Securities Exchange Act of 1934, this registration statement has been signed by the following persons in the capacities and on the dates indicated. <TABLE> <CAPTION> SIGNATURE TITLE DATE ------------------------------------------------ ------------------------------------ -------------- <S> <C> <C> /s/ FRED S.L. CHAN President, Chief Executive Officer March 31, 1998 ------------------------------------------------ and Chairman of the Board of Fred S.L. Chan Directors (Principal Executive Officer) /s/ JOHN H. BARNET Vice President, Finance and March 31, 1998 ------------------------------------------------ Chief Financial Officer John H. Barnet (Principal Financial Officer) /s/ HOWARD N. HIDESHIMA Controller March 31, 1998 ------------------------------------------------ (Principal Accounting Officer) Howard N. Hideshima /s/ ANNIE M.H. CHAN Director March 31, 1998 ------------------------------------------------ Annie M.H. Chan Director March , 1998 ------------------------------------------------ Michael A. Aymar Director March , 1998 ------------------------------------------------ Ilbok Lee /s/ PETER T. MOK Director March 31, 1998 ------------------------------------------------ Peter T. Mok </TABLE> 48

50 INDEX TO EXHIBITS <TABLE> <CAPTION> EXHIBIT NUMBER EXHIBIT TITLE ------- ------------- <S> <C> <C> 2.01 -- Agreement and Plan of Reorganization dated December 12, 1995 among Registrant, ESS Acquisition Corporation and VideoCore Technology, Inc. ("VideoCore") (Incorporated herein by reference to Exhibit 2.1 to the Registrant's Current Report on Form 8-K dated January 17, 1996 (the "Form 8-K")). 2.02 -- Agreement of Merger dated as of January 3, 1996 among Registrant, ESS Acquisition Corporation and VideoCore. (Incorporated herein by reference to Exhibit 2.2 to the Form 8-K). 2.03 -- First Amended and Restated Agreement and Plan of Reorganization dated as of April 27, 1997 among Registrant, EP Acquisition Corporation and Platform Technologies, Inc. (Incorporated herein by reference to Exhibit 2.1 to the Registrant's Current Report on Form 8-K dated April 30, 1997). 3.01 -- Registrant's Articles of Incorporation (Incorporated herein by reference to Exhibit 3.01 to the Registrant's Form S-1 registration statement (File No. 33-95388) declared effective by the Securities and Exchange Commission on October 5, 1995 (the "Form S-1")). 3.02 -- Registrant's Bylaws (Incorporated herein by reference to Exhibit 3.02 to the Form S-1). 4.01 -- Form of Specimen Certificate for Registrant's Common Stock (Incorporated herein by reference to Exhibit 4.01 to the Form S-1). 4.02 -- Reference is made to Exhibit 3.01. 4.03 -- Registrant's Rights Agreement dated May 28, 1993 among the Registrant and certain security holders (Incorporated herein by reference to Exhibit 10.07 to the Form S-1). 10.01 -- Registrant's 1986 Stock Option Plan and related documents (Incorporated herein by reference to Exhibit 10.01 to the Form S-1).* 10.02 -- Registrant's 1992 Stock Option Plan and related documents (Incorporated herein by reference to Exhibit 10.02 to the Form S-1).* 10.03 -- Registrant's 1995 Equity Incentive Plan and related documents (Incorporated herein by reference to Exhibit 10.03 to the Form S-1).* 10.04 -- Registrant's 1995 Directors Stock Option Plan and related documents (Incorporated herein by reference to Exhibit 10.04 to the Form S-1).* 10.05 -- Registrant's 1995 Employee Stock Purchase Plan and related documents (Incorporated herein by reference to Exhibit 10.05 to the Form S-1).* 10.06 -- Registrant's Amended 401(k) Plan (Incorporated herein by reference to Exhibit 10.06 to the Form S-1).* 10.07 -- Registrant's Rights Agreement dated May 28, 1993 among the Registrant and certain security holders (Incorporated herein by reference to Exhibit 10.07 to the Form S-1). 10.08 -- Stock Transfer Agreement dated May 22, 1995 among WK Technology Fund, WK Technology Fund II, WK Technology Fund III, Fred S.L. Chan, Annie M.H. Chan and Fred S.L. and Annie M.H. Chan Charitable Trust, dated November 20, 1992 (Incorporated herein by reference to Exhibit 10.08 to the Form S-1). 10.09 -- Stock Transfer Agreement dated May 22, 1995 among Technology Associates Corporation, Tekkang Management Consulting Inc., Kummell Investments Limited, Fred S.L. Chan, Annie M.H. Chan and Fred S.L. and Annie M.H. Chan Charitable Trust, dated November 20, 1992 (Incorporated herein by reference to Exhibit 10.09 to the Form S-1). </TABLE>

51 <TABLE> <CAPTION> EXHIBIT NUMBER EXHIBIT TITLE ------- ------------- <S> <C> <C> 10.10 -- Stock Transfer Agreement dated May 22, 1995 among Universe Electron Corporation, Fred S.L. Chan, Annie M.H. Chan and Fred S.L. and Annie M.H. Chan Charitable Trust, dated November 20, 1992 (Incorporated herein by reference to Exhibit 10.10 to the Form S-1). 10.11 -- Form of Indemnity Agreement entered into by Registrant with each of its directors and executive officers (Incorporated herein by reference to Exhibit 10.11 to the Form S-1). 10.12 -- Sublease dated October 15, 1992 between Raychem Corporation (as successor in interest to Remtek Corporation) and Registrant, as amended November 1, 1993, and September 1, 1994; Master Lease dated April 11, 1986 between Renco Equities III and Remtek Corporation, as amended January 29, 1994; and Option to Renew Lease dated January 25, 1989 between Renco Equities III and Remtek Corporation (Incorporated herein by reference to Exhibit 10.12 to the Form S-1). 10.13 -- Standard Industrial/Commercial Multi-Tenant Lease -- Modified Net dated April 3, 1995 between Gagos Living Trust and Registrant, as amended May 1, 1995; and Addendum thereto dated as of April 8, 1995 (Incorporated herein by reference to Exhibit 10.13 to the Form S-1). 10.14 -- Real Property Purchase Agreement and Deposit Receipt dated July 5, 1995 between King & Lyons and Registrant (Incorporated herein by reference to Exhibit 10.14 to the Form S-1). 10.15 -- License Agreement dated November 12, 1987 among Forrest S. Mozer, Registrant and Sharp Kabushiki Kaisha (Incorporated herein by reference to Exhibit 10.15 to the Form S-1).** 10.16 -- License Agreement dated September 20, 1991 between Registrant and Zilog, Inc. (Incorporated herein by reference to Exhibit 10.16 to the Form S-1).** 10.17 -- Software License Agreement dated July 18, 1995 among Registrant, Sensory Circuits, Inc. and Forrest Mozer (Incorporated herein by reference to Exhibit 10.17 to the Form S-1).** 10.18 -- Foundry Agreement dated March 29, 1993 between Registrant and Integrated Circuit Works Incorporated (Incorporated herein by reference to Exhibit 10.18 to the Form S-1).** 10.19 -- Purchase Agreement dated June 17, 1994 between Compaq Computer Corporation and Registrant (Incorporated herein by reference to Exhibit 10.19 to the Form S-1).** 10.20 -- International Distributorship Agreement dated July 1, 1994 between Registrant and Universe Electron Corporation (Incorporated herein by reference to Exhibit 10.20 to the Form S-1). 10.21 -- Option I Agreement between Registrant and Taiwan Semiconductor Manufacturing Co., Ltd. ("TSMC") dated November 30, 1995, as amended December 28, 1995. (Incorporated herein by reference to Exhibit 10.21 to the Registrant's Annual Report on Form 10-K, dated February 29, 1996 as amended March 29, 1996 (the "1995 Form 10-K").*** 10.22 -- Option II Agreement between Registrant and TSMC dated November 30, 1995. (Incorporated herein by reference to Exhibit 10.22 to the 1995 Form 10-K).*** 10.23 -- Foundry Venture Agreement between Registrant and United Microelectronics Corporation ("UMC") dated November 28, 1995, as amended January 31, 1996. (Incorporated herein by reference to Exhibit 10.23 to the 1995 Form 10-K).*** 10.24 -- FabVen Foundry Capacity Agreement among FabVen, UMC and Registrant dated November 28, 1995. (Incorporated herein by reference to Exhibit 10.24 to the 1995 Form 10-K).*** 10.25 -- Form of Employment and Non-Competition Agreement among the Registrant, VideoCore and Jan Fandrianto dated December 12, 1995. (Incorporated herein by reference to Exhibit 2.1 to the Form 8-K).* </TABLE>

52 <TABLE> <CAPTION> EXHIBIT NUMBER EXHIBIT TITLE ------- ------------- <S> <C> <C> 10.26 -- Form of Employment and Non-Competition Agreement among the Registrant, VideoCore and Chi-Shin Wang dated December 12, 1995. (Incorporated herein by reference to Exhibit 2.1 to the Form 8-K).* 10.27 -- Form of Employment Agreement and Promissory Note among the Registrant and John H. Barnet dated August 22 and September 16, 1996, respectively. (Incorporated herein by reference to Exhibit 10.27 to the Registrant's Report on Form 10-Q, dated November 14, 1996.)* 10.28 -- Form of Consulting and Employment Agreements among the Registrant and Herbert J. Martin dated October 23, 1996 (Incorporated herein by reference to Exhibit 10.28 to the Registrant's Annual Report Form 10-K, dated March 18, 1997 as amended on March 20, 1997 (the "1996 Form 10-K")).* 10.29 -- Form of Termination and Consulting Agreements among the Registrant and Herbert J. Martin dated February 13, 1997 (Incorporated herein by reference to Exhibit 10.29 to the 1996 10-K).* 10.30 -- 1997 Equity Incentive Plan and related agreements (Incorporated herein by reference to Appendix I filed in the Registrant's Proxy Statement for the 1997 Annual Meeting of Shareholders, filed on April 30, 1997).* 10.31 -- Form of Exit Agreement between the Registrant and Bo Ericsson dated November 26, 1997.* 21.01 -- List of Registrant's subsidiaries. 23.01 -- Consent of Independent Accountants. 27.01 -- Financial Data Schedule. </TABLE> --------------- * Represents a management contract or compensatory plan of arrangement. ** Confidential treatment has been granted with respect to certain portions of this agreement. *** Confidential treatment has been requested with respect to certain portions of this agreement. (b) Reports on Form 8-K: The Company did not file a report on Form 8-K during the quarter ended December 31, 1997. With the exception of the information incorporated by reference to the Company's Proxy Statement for the 1998 Annual Meeting of Shareholders in Items 10, 11, 12 and 13 of Part III, the Proxy Statement is not deemed to be filed as part of this Report.

1 Exhibit 10.31 ESS To: Fred Chan From: Bo Ericsson Date: November 26, 1997 Re: EXIT AGREEMENT 1. Ericsson's last date of full time employment will be Dec 12 1997. Ericsson will serve as a consultant, reporting to Nicholas Aretakis, on a part time basis for an additional four weeks (max 20 hours a week). Ericsson's salary will end on Dec 12. 2. Ericsson's primary responsibility during his remaining time with ESS will be a) generating candidates for the open VP marketing position, b) transfer of the marketing organization to Nicholas Aretakis and c) developing a business plan for ESS' personal computer business 3. On Dec 12 1997, ESS will pay Ericsson his 1997 bonus of 37.5K plus 60K in severance payment, plus remaining salary balance. Upon receipt on Dec 12 of these payments, ESS will have fulfilled all of its obligations to Ericsson, per Ericsson's amended employment agreement, and Ericsson will have no further claims against ESS. /s/ Fred Chan /s/ Bo Ericsson ------------------------- ------------------------- Fred Chan, CEO Bo Ericsson

1 EXHIBIT 21.01 LIST OF REGISTRANT'S SUBSIDIARIES <TABLE> <CAPTION> PERCENTAGE OWNED NAME JURISDICTION OF ORGANIZATION BY REGISTRANT ---- ---------------------------- ---------------- <S> <C> <C> ESS (Far East) Ltd...................................... Hong Kong 100% ESS Technology International, Inc....................... Cayman Islands 100% OSEE Technology, Inc.................................... US 100% VideoCore Technology, Inc............................... US 100% Platform Technologies, Inc.............................. US 100% </TABLE>

1 EXHIBIT 23.01 CONSENT OF INDEPENDENT ACCOUNTANTS We hereby consent to the incorporation by reference in the Registration Statement on Form S-8 (No. 33-97830) of ESS Technology, Inc. of our report dated January 21, 1998, appearing on page XX of this Form 10-K. PRICE WATERHOUSE LLP San Jose, California March 20, 1998

<TABLE> <S> <C>

<ARTICLE> 5
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<CGS>                                          171,859
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<OTHER-EXPENSES>                                76,869
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