10-K

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, 2005

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: 0-13470

NANOMETRICS INCORPORATED

(Exact name of registrant as specified in its charter)

California	94-2276314
(State or other jurisdiction of incorporation or organization)	(I.R.S. Employer Identification Number)

1550 Buckeye Drive Milpitas, California	95035
(Address of principal executive offices)	(Zip Code)

Registrant’s telephone number, including area code: (408) 435-9600

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

Indicate by check mark if the Registrant is a well-known seasoned issuer as defined in Rule 405 of the Securities Act. Yes ¨   No x.

Indicate by check mark if the Registrant is not required to file reports pursuant to Section 13 or Section 15(d) of the Act. Yes ¨   No x.

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

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

Indicate by check mark whether the Registrant is a large accelerated filer, an accelerated filer, or a non-accelerated filer. See definition of “accelerated filer and large accelerated filer” in Rule 12b-2 of the Exchange Act. (Check one):

Large accelerated filer ¨              Accelerated filer x              Non-accelerated filer ¨

Indicate by check mark whether the Registrant is a shell company (as defined by Rule 12b-2 of the Securities Exchange Act of 1934)    Yes ¨   No x.

As of July 2, 2005, the last business day of the Registrant’s most recently completed second fiscal quarter, the aggregate market value of the common stock of Registrant held by non-affiliates, based upon the closing sales price for the Registrant’s common stock, as quoted on the Nasdaq Stock Market, was $81,469,460. Shares of common stock held by each officer and director and by each person who owned 5% or more of the outstanding common stock have been excluded because such persons may be deemed to be “affiliates” as that term is defined under the rules and regulations of the Exchange Act. This determination of affiliate status is not necessarily a conclusive determination for any other purpose.

The number of shares of the Registrant’s common stock outstanding as of February 28, 2006 was 13,033,438.

DOCUMENTS INCORPORATED BY REFERENCE

The following documents (or parts thereof) are incorporated by reference into the following parts of this Form 10-K:

(1) Proxy Statement for the 2006 Annual Meeting of Shareholders — Part III Items 10, 11, 12, 13 and 14.

NANOMETRICS INCORPORATED

FORM 10-K

FOR THE FISCAL YEAR ENDED DECEMBER 31, 2005

TABLE OF CONTENTS

PART I
ITEM 1.	BUSINESS	4
ITEM 1A.	RISK FACTORS	19
ITEM 1B.	UNRESOLVED STAFF COMMENTS	30
ITEM 2.	PROPERTIES	31
ITEM 3.	LEGAL PROCEEDINGS	31
ITEM 4.	SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS	31
PART II
ITEM 5.	MARKET FOR REGISTRANT’S COMMON EQUITY, RELATED SHAREHOLDER MATTERS AND ISSUER PURCHASES OF EQUITY SECURITIES	32
ITEM 6.	SELECTED FINANCIAL DATA	33
ITEM 7.	MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS	34
ITEM 7A.	QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK	45
ITEM 8.	FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA	46
ITEM 9.	CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL DISCLOSURE	74
ITEM 9A.	CONTROLS AND PROCEDURES	74
ITEM 9B.	OTHER INFORMATION	78
PART III
ITEM 10.	DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANT	79
ITEM 11.	EXECUTIVE COMPENSATION	79
ITEM 12.	SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT AND RELATED SHAREHOLDER MATTERS	79
ITEM 13.	CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS	79
ITEM 14.	PRINCIPAL ACCOUNTANT FEES AND SERVICES	79
PART IV
ITEM 15.	EXHIBITS AND FINANCIAL STATEMENT SCHEDULES	80
SIGNATURES		83

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Forward-Looking Statements

This Annual Report on Form 10-K contains forward-looking statements that involve risks and uncertainties. These forward-looking statements include, but are not limited to, statements regarding trends in demand in our industry, the increased use of metrology in manufacturing, the drive toward integrated metrology and the broadening of our technology portfolio. Words such as “believe,” “expect,” “anticipate” or similar expressions, are indicative of forward-looking statements.

Our actual results may differ materially from the results discussed in the forward-looking statements. Factors that might cause such a difference include, but are not limited to, those outlined in Item 1A “Risks Factors” and “Management’s Discussion and Analysis of Financial Condition and Results of Operations,” below. The forward-looking statements contained herein are made as of the date hereof, and we assume no obligation to update such forward-looking statements or to update reasons actual results could differ materially from those anticipated in such forward-looking statements.

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PART I

ITEM 1. BUSINESS

Overview

We are a leader in the design, manufacture, and marketing of high-performance process control metrology systems used in the manufacture of semiconductors and integrated circuits. Our metrology systems (i) measure various thin film properties, critical circuit dimensions and layer-to-layer circuit alignment (overlay) and (ii) inspect for surface defects during various steps of the manufacturing process, enabling semiconductor and integrated circuit manufacturers to improve yields, increase productivity and lower their manufacturing costs.

We were incorporated as a California corporation in 1975 and have since been a pioneer and innovator in the field of optical metrology. We have been selling these systems since 1977 and have an extensive installed base with industry leading customers worldwide, including Applied Materials Inc., Samsung, Ebara, Hynix Semiconductor Inc., Powerchip, Intel Corporation, TSMC Ltd, Timbre Technologies, Hitachi, AU Optronics, Micron Technology Inc., Renesas, and Toshiba.

Additional information about Nanometrics is available on our website at http://www.nanometrics.com. Our investor relations website is located at http://www.nanometrics.com/investor.html We make available free of charge through our investor relations website our Annual Reports on Form 10-K, Quarterly Reports on Form 10-Q, Current Reports on Form 8-K and any amendments to those reports as soon as reasonably practicable after we electronically file or furnish such materials to the U.S. Securities and Exchange Commission (“SEC”). Further, a copy of this annual report on Form 10-K is located at the SEC’s Public Reference Room at 100 F Street, N.E., Washington, D.C. 20549. Information on the operation of the Public Reference Room can be obtained by calling the SEC at 1-800-SEC-0330. The SEC maintains an Internet site that contains reports, proxy and information statements and other information regarding our filings at http://www.sec.gov.

Our Business

We offer a complete line of systems to address the metrology requirements of our customers. Our metrology systems can be categorized as follows:

• Standalone, fully automated systems for high-volume manufacturing inspection;

• Integrated systems built into semiconductor processing equipment that provide real-time measurements and feedback to improve process control and increase throughput; and

• Tabletop systems used to provide manual or semi-automatic measurements for engineering and low-volume production environments.

We also provide systems that are used to measure the overlay accuracy of successive layers of semiconductor patterns on wafers in the photolithography process. The accurate alignment, or overlay, of successive film layers, relative to each other, across the wafer is critical for device performance and favorable production yields.

We believe that process control metrology is growing faster than other segments of the semiconductor equipment market. As films become thinner, film materials more exotic, and circuit dimension control and overlay requirements more demanding, metrology and inspection continue to grow in importance, especially as wafers become larger and more expensive to manufacture. We expect these factors will continue to drive the demand for our high-end, standalone and integrated metrology products.

Additional demands on process tool manufacturers for better film uniformity, tighter dimensional control, tool-to-tool matching and within-tool chamber uniformity is driving the need for integrated process control

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metrology. These new tool requirements will drive the need to place metrology inside the process tool for real-time, integrated, process control metrology, using both feed forward and feedback of the collected metrology data to control the process equipment.

We have made several strategic changes in our business model to enable us to further address these metrology trends. These changes include:

• The sale of our flat panel display, or FPD, metrology business in Japan effective October 2005;

• The introduction of a new 300 millimeter wafer platform for advanced overlay metrology;

• The continued outsourcing of certain system components, such as robotics, enabling us to leverage our technical resources;

• The maximum utilization of an in-house manufacturing strategy for our products; and

• The development of new measurement technologies for advanced chemical mechanical planarization, or CMP, and lithography.

Demand for our products is driven by the increasing use of multiple thin film technology by manufacturers of electronic products and, more recently, by the increased adoption of both integrated metrology and advanced process control, or APC, by semiconductor manufacturers. With feature sizes shrinking below 65 nanometers, or nm, well below the wavelength of light, the need for very tight process tolerances as well as productivity improvements in semiconductor fabrication, or fabs, are driving the need for integrated metrology and APC. Our innovative Optical Critical Dimension, or OCD^®, measurement system is being increasingly viewed not only as an enabling technology for APC, but also as a solution for critical dimension measurement for wafers as well as reticles and photomasks used for photolithography.

We extended the wavelength range of our deep ultraviolet, or DUV, reflectometry technology with the introduction of a new, integrated metrology module, the Nano9010T. The compact size and speed of this technology enables the measurement system to be fully integrated into the customer’s process tool, thus providing a complete, feed forward and feedback APC solution for wafer-to-wafer closed loop control. By measuring the critical dimensions of developed photoresist and then adjusting the final etched dimensions of a silicon gate-etch process by feeding this information back into the process and trimming the resist, the device manufacturer is able to achieve the shortest gatelength and the maximum possible microprocessor speed. In addition, new semiconductor process technologies, such as copper interconnects, require that new measurement technologies be developed in order to keep pace with the latest metrology demands. This integrated metrology module also provides a solution to the problem of measuring the remaining oxide film thickness as well as the loss of material over arrays of copper lines during the CMP process with the added capability of detecting residual films remaining after the polishing process.

Our OCD technology has also proven to be applicable to the emerging requirements for advanced lithography measurements such as the characterization of critical dimensions and film thicknesses on masks and reticles which are comprised of square glass substrates. In 2005, we successfully installed the Nanometrics Atlas-M, the first fully automated, standalone metrology system to use OCD technology for these square glass substrates at several key customer locations. This system is crucial to the suppliers and users of masks and reticles by providing the means for accurately determining line widths and analyzing complex profiles for a variety of structures found in today’s mask fabrication process.

We successfully introduced the Nanometrics Orion Overlay Control System, an advanced overlay metrology and analysis system for monitoring microlithography stepper performance. Orion provides exceptional throughput and measurement performance required by today’s demanding 200mm and 300mm overlay control applications.

We have continued the development the Universal Defect Inspection, or UDI, system in our facility in South Korea. The NanoUDI technology can be configured as either a standalone, fully automated 300-millimeter

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system or an integrated module for defect and contamination detection on a wide variety of films and surfaces. The system combines high efficiency illumination and high-resolution optics with sophisticated image processing to detect and classify particles and defects in the sub-micron range.

Many types of thin films are used in the manufacture of products such as semiconductor integrated circuits. These products require the precise electronic, optical and surface properties enabled by thin film metrology. The need for tighter process control and improved productivity has created increased demand for our advanced standalone and integrated metrology systems.

Industry Characteristics

Growth

The semiconductor industry continues to be driven by the need for increasingly higher performance chips as well as the need to produce these chips with increased production efficiencies with reduced costs. The semiconductor equipment industry has experienced cyclical growth with a compounded annual growth rate of approximately 11-12% over the past 20 years. The semiconductor industry recently emerged from an exceptionally long, cyclical downturn, and 2005 saw a growth in semiconductor equipment revenues of approximately 4.5% over 2004. We believe that the convergence of 300-millimeter wafer size, copper interconnects and more efficient 65 nm architecture will continue to drive the demand for new metrology solutions, such as those that we offer, and that the process control market segment will continue to outpace overall equipment growth.

In the past, demand for Internet access, personal computers, telecommunications, and new consumer electronic products and services has fueled growth of the semiconductor industry. New display technologies, consumer electronics, automotive electronics and personal electronics will likely continue as the primary drivers in the near-term for the semiconductor industry. We believe that consumer desire for high performance electronics drives technology advancement in semiconductor design and manufacturing and, in turn, promotes the purchasing of capital equipment featuring the latest advances in technology.

The two significant factors affecting demand for our measurement systems are new construction or refurbishment of semiconductor manufacturing facilities and the increasing complexity of the manufacturing process as a result of the demand for higher performance semiconductor devices and integrated circuits.

Semiconductor Manufacturing Process

Semiconductors are fabricated by a series of process steps on a wafer substrate made of silicon or other material. Our thin film, critical dimension, overlay metrology and defect inspection systems can be used at many points during the fabrication process to monitor and measure circuit dimensions, layer-to-layer registration and film uniformity as well as material properties in order to maximize the yield of acceptable semiconductors. Each wafer typically goes through a series of 100 to 500 process and metrology steps in generally repetitive cycles.

The four primary wafer film processing steps are:

• Deposition;

• Chemical Mechanical Planarization;

• Photolithography imaging and overlay; and

• Etching of circuit elements.

Deposition.    Deposition refers to placing layers of insulating or conducting materials on a wafer surface in thin films that make up the circuit elements of semiconductor devices. Common methods of deposition include

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chemical vapor deposition, or CVD, plasma-enhanced chemical vapor deposition, or PECVD, and physical vapor deposition, or PVD. Diffusion and oxidation are also used to create or define thin films. The control of uniformity and thickness during the formation of these films is critical to the performance of the semiconductor circuit.

Chemical Mechanical Planarization.    CMP flattens, or planarizes, the topography of the film surface to permit the multiple patterns of small features on the resulting smoothed surface by the photolithography process. The CMP process is a combination of chemical etching and mechanical polishing and commonly uses an abrasive liquid and polishing pad. Semiconductor manufacturers need metrology systems to control the CMP process by measuring the thin film layer to determine precisely when the appropriate thickness has been achieved.

Photolithography.    Photolithography is the process step that projects the patterns of the circuits on the chip. A wafer is pre-coated with photoresist, a light sensitive film that must have an accurate thickness and uniformity for exposure. Photolithography involves the optical projection of integrated circuit patterns onto the photoresist after which, the photoresist is developed, leaving unexposed areas available for etching. In order to precisely control the photolithography process, it is necessary to verify reflectivity, film thickness, critical dimensions and overlay registration.

Etch.    Etch is a dry or wet process for selectively removing unwanted areas that have been deposited on the surface of a wafer. A film of developed photoresist protects material that needs to be left untouched by the etch to make up the circuits. Thin film metrology systems are required to verify precision of material removal and critical dimension achievement.

Before and after deposition, CMP, photolithography and etch, the wafer surface is measured to determine the quality of the film or pattern and to find defects. Measurements taken to ensure process uniformity include thickness, width, height, roughness and other characteristics. Process control helps avoid costly rework or misprocessing and results in higher yields for semiconductor manufacturers.

These processing steps are typically repeated multiple times during the fabrication process, with alternating layers of insulating and conducting films. Depending on the specific design of a given integrated circuit, a variety of film types and thicknesses and a number of layers can be used to achieve desired electronic performance characteristics. The semiconductors are then tested, separated into individual circuits, assembled and packaged into an integrated circuit.

Increased Use of Metrology in Manufacturing

We believe that continually rising wafer costs are forcing semiconductor manufacturers to re-evaluate their manufacturing strategies at all levels, from individual process steps to fab-wide process optimization. Many major semiconductor manufacturers are adopting feed-forward and feedback of film thickness and critical dimensions, or CDs, based on real-time data from metrology systems. Major benefits of these new metrology strategies are higher manufacturing efficiencies from reduced rework, reduced headcount to perform at the same quality level and increased device performance. Additional benefits include process tool matching and more precise control of the overall manufacturing process.

Drive Toward Integrated Metrology

For many years, semiconductor manufacturers have sought to improve fab efficiency by choosing systems that integrate more than one process step into a single tool. Integrated metrology solutions increase productivity with higher throughput, smaller overall product footprints, reduced wafer handling and faster process development. This trend began in the mid-1980s, as leading manufacturers introduced a “cluster process tool” architecture that combined multiple processes in separate chambers around a central wafer-handling platform.

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Today, there is continued focus on increased productivity driving the adoption of integrated metrology, as well as an additional requirement for tighter process tolerances with advanced, sub-65nm technologies. This new requirement is driving integrated process control metrology as a necessity for many processes, such as mechanical planarization, deposition, lithography and etch. As a result, we continue to see the emergence of integrated metrology using both feed-forward and feedback process tool control in real time. Integrated metrology has already shown its ability to control key process parameters during the manufacturing process. Additional benefits include extended tool availability and improved utilization. Tighter control of the process means lower material and processing costs. Integrated metrology also provides rapid fault detection, improved excursion control and loss prevention, which can be elusive with only open-loop standalone metrology.

Before we introduced integrated metrology, semiconductor manufacturers were required to physically transport wafers from a process tool to a separate metrology system in order to make critical measurements such as film thickness and uniformity. Manufacturers of process equipment are increasingly seeking to offer their customers integrated metrology in their tools to lower costs and improve overall tool efficiency. Integrated metrology provides semiconductor manufacturers with several additional benefits, including a reduction in the number of test wafers, increased overall process throughput, faster detection of process excursions and faults, reduced wafer handling, faster process development and ultimately an improvement in overall equipment effectiveness.

Nanometrics Offerings

We offer a complete line of systems to address the broad range of metrology requirements of our customers.

Our metrology systems can be categorized as follows:

• Standalone, fully automated systems used for the characterization and measurement of thin films in high-volume manufacturing operations. We offer a broad line of fully automated thin film thickness, critical dimension, defect inspection and overlay measurement systems. These systems remove the dependence on human operators by incorporating reliable wafer handling robots and are designed to meet the speed, measurement, performance and reliability requirements that are essential for today’s semiconductor manufacturing facilities. Each of these measurement systems uses non-destructive, optical techniques to analyze and measure films. Our fully automated metrology product line also includes systems that are used to measure the critical dimensions and overlay registration accuracy of successive layers of semiconductor patterns on wafers in the photolithography process.

• Integrated systems used to measure in-process wafers automatically and quickly without having to leave the enclosed wafer processing system. In 1998, we introduced our high-speed integrated metrology system. Our integrated metrology systems are compact and monitor a multitude of small test points on the wafer using sophisticated pattern recognition. Our integrated systems can be attached to film deposition, planarization, lithography, etch and other process tools to provide rapid monitoring of films on each wafer immediately before or after processing. Integrated systems can offer customers significantly increased operating efficiency and equipment utilization, lower manufacturing costs and higher throughput. We anticipate continuing to ship integrated systems to many original equipment manufacturers for installation on their planarization, deposition, litho and etch tools.

• Tabletop systems used to manually or semi-automatically measure thin films in engineering and low-volume production environments. We have been a pioneer and leading supplier of tabletop thin film thickness measurement systems, which are mainly used in low-volume production environments such as failure analysis and engineering labs. Our tabletop models have multiple capabilities and several available configurations, depending on wafer handling, range of films to be measured, uniformity mapping and other customer needs.

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Strategy

Our strategy is to offer and support, on a worldwide basis, technologically advanced metrology solutions that meet the changing manufacturing requirements of the semiconductor industry. Key elements of our strategy include:

Maintaining Organically Developed Technology Leadership.    We are committed to developing advanced metrology systems that meet the requirements of advanced semiconductor manufacturing technology. We have an extensive array of proprietary technology and expertise in optics, software and systems integration. These technologies include polarized reflectometry, precision motion control, extreme dark field imaging, low distortion imaging and advanced algorithms.

Continuing to Offer Advanced Integrated Metrology Systems.    We were one of the first suppliers to offer products that integrate process metrology systems into wafer processing equipment. We supply integrated metrology systems for Applied Materials’ Mirra Mesa™ and 300mm Reflexion™ CMP systems and the Producer QA and SE ™ CVD systems. Our OCD metrology system is incorporated in the Applied Materials’ Transforma™ 300mm etch system for controlling critical dimensions. The introduction of the first combined film thickness and critical dimension measurement integrated metrology product has allowed us to penetrate additional original equipment manufacturers, or OEMs, of etch processing and CMP equipment, including Hitachi High Tech, or HHT, Dainippon Screen, or DNS, and Ebara. The introduction of the Nano 9010T enhanced integrated metrology product has led to additional design wins at TEL/Timbre. Our integrated metrology sales group continues to focus on sales of integrated metrology products to both OEMs and end-users.

Broadening Our Product Portfolio.    We intend to continue to add a wide range of new measurement technologies to our expanding base of intellectual property. Our highly successful integrated platform offers a single integrated module that combines OCD and DUV technologies, and enables us to perform critical erosion and film thickness/array measurements for the oxide and copper/metal CMP processes. In addition, our copper/metal profiler for CMP process control combines optical profile measurement or profilometry with our highly successful reflectometry technology to monitor metal removal during the CMP process. These metrologies are key requirements for the copper damascene process, which replaces the current subtractive aluminum process on newer semiconductor devices.

We also participate in the particle and defect inspection market with our Universal Defect Inspection, or UDI, technology. This technology has applications for inspection of semiconductor wafers for the purpose of detecting defects early in the process before they cause catastrophic yield loss.

Our OCD technology has also been applied to advanced photolithography processes with the introduction of the Nanometrics Atlas-M fully automated metrology system for mask and reticule measurement and characterization. This new product has already successfully correlated the interrelationships between film thickness and critical dimension parameters.

Leveraging Existing Customer and Industry Relationships.    We expect to continue to strengthen our existing customer relationships and foster working partnerships with semiconductor equipment manufacturers by providing technologically superior systems and high levels of customer support. Our strong industry relationships have allowed close customer collaboration which, in return, facilitates our ability to introduce new products and applications in response to customer needs. We believe that our large customer base will continue to be an important source of new product development ideas. Our large customer base also provides us with the opportunity for increased sales of additional metrology systems to our current customers.

Providing Worldwide Sales and Customer Support.    We believe that a direct sales and support capability is beneficial for developing and maintaining close customer relationships and for rapidly responding to changing customer requirements. Because a majority of our revenues come from sources outside of the United States, we have direct sales force in Japan, South Korea, Taiwan and China, and will expand into additional territories as customer requirements dictate. We use selected sales representatives in

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non-key territories. We intend to monitor our network by evaluating our existing and new offices, as well as developing additional relationships as needed. We believe that enhancing our sales and customer support network will improve our competitive position.

Addressing Multiple Markets.    There are broad applications of our technology beyond the semiconductor industry. We currently offer a comprehensive family of metrology systems that accurately measure thin films, critical dimensions and overlay registration used in manufacturing process. Newer products inspect for particles and defects and monitor critical metal loss during the copper removal process. We believe that diversification of our technology through applications across multiple industries increases the total available market for our products and reduces, to an extent, our exposure to the cyclicality of any particular market.

Acquisitions.    We expect to continue to evaluate the attractiveness of strategic transactions, including mergers and asset acquisitions, in order to address business challenges and opportunities. On January 25, 2006, we announced a definitive agreement to merge our business with Accent Optical Technologies Inc., a leading supplier of process control and metrology systems to the global semiconductor manufacturing industry headquartered in Bend, Oregon. The strategic business combination of Nanometrics and Accent will create one of the largest metrology and process control companies in the semiconductor capital equipment industry. On March 15, 2006, we announced our acquisition of Soluris Inc., a privately held corporation focused on overlay and CD measurement technology and headquartered in Concord, Massachusetts. The acquisition of Soluris provides us with superb optical and electron technology, a strong installed base of new customers, and an excellent team of individuals that we expect to make an outstanding contribution to the company

Technology

We believe that our engineering expertise, technology acquisitions, supplier alliances and short-cycle production strategies enable us to develop and offer advanced solutions that address industry trends. By offering common metrology platforms that can be configured with a variety of measurement technologies, our customers can (i) specify high performance systems not easily offered by other suppliers and (ii) narrowly configure a system for a specific application as a cost saving measure.

Spectroscopic Reflectometry.    We pioneered the use of micro-spot spectroscopic reflectometry for semiconductor film metrology in the late 1970s. Spectroscopic reflectometry uses multiple wavelengths (colors) of light to obtain an array of data for analysis of film thickness and other film parameters. Today’s semiconductor manufacturers still depend on spectroscopic reflectometry for most film metrology applications. Reflectometry is the measurement of reflected light. For film metrology, a wavelength spectrum in the visible region is commonly used. Light reflected from the surfaces of the film and the substrate is analyzed using computers and measurement algorithms. The analysis yields thickness information and other parameters without contacting or destroying the film.

In the mid-1980s, we introduced a DUV reflectometer for material analysis. In 1991, we were awarded a patent for the determination of absolute reflectance in the ultraviolet region. This technology provides enhanced measurement performance for thinner films and for films stacked on top of one another.

Spectroscopic Ellipsometry.    Like reflectometry, ellipsometry is a non-contact and non-destructive technique used to analyze and measure films. An ellipsometer analyzes the change in a polarized beam of light after reflection from a film’s surface and interface. Our systems are spectroscopic, providing ellipsometric data at many different wavelengths. Spectroscopic ellipsometry provides a wealth of information about a film, yielding very accurate and reliable measurements. In general, ellipsometers are used for thin films and complex film stacks, whereas reflectometers are used for thicker films and stacks.

Optical Critical Dimension Technology.    Our OCD technology is a critical dimension measurement technology that is used to precisely determine the dimensions on the semiconductor wafer that directly control the resulting performance of the integrated circuit devices. Our non-destructive, OCD measurement technology is compatible with the current 90nm manufacturing technology and can be extended below

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90nm for future requirements in both photo-lithography and etch applications. OCD combines non-contact optical technology with extremely powerful data analysis software to provide highly accurate measurement results for line width, height and sidewall angles. This technology is available in both standalone and integrated platforms.

Overlay Registration.    Overlay registration refers to the relative alignment of two layers in the thin film photolithographic process. Our microscope-based, measurement technology utilizes a high magnification, low distortion imaging system combined with proprietary software algorithms to numerically quantify the alignment.

Optical Profilometry.    We developed the optical profiler for the measurement of copper metal loss during the chemical mechanical planarization process. This technology uses the combination of an optical interferometer and our reflectometer technology to accurately determine metal loss, even over multiple layers during the final steps of metallization. Our technology is a unique method for precisely and accurately controlling this semiconductor manufacturing process step.

Extreme Dark Field (EDF) Imaging Technology.    Our new, extreme dark field inspection technology is used to detect and accurately locate particles and defects on the front and back sides of wafer surfaces, which could potentially lead to device failures and critical yield loss during the semiconductor manufacturing process. The technology combines a high efficiency, broadband light source with a high-resolution detection system and proprietary digital image processing for defect and contamination detection on a wide variety of films and surfaces. We believe that this technology can be readily extended to other manufacturing processes.

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Products

We operate in one reportable segment, which is the sale, design, manufacture, marketing and support of thin film, optical critical dimension and overlay dimension metrology systems. Our measurement systems use microscope-based, non-contact spectroscopic reflectometry, or SR. Some of our systems provide complementary spectroscopic ellipsometry, or SE, to measure the thickness and optical characteristics of films on a variety of substrates. In addition, we offer both integrated and standalone optical critical metrology systems to measure critical dimensions of patterns on semiconductor wafers. We also manufacture a line of optical overlay registration systems that are used to determine the alignment accuracy of successive layers of semiconductor patterns on wafers in the photolithography process. Our products can be divided into three groups: automated standalone systems, integrated systems and tabletop systems. See Note 15 of the Notes to Consolidated Financial Statements for an analysis of our net revenues by product group.

Platform	Market	Substrate Size	Applications	Technology
Automated/Standalone Systems
9100	Semiconductor	75-200mm	CVD, CMP, Etch, Litho, Film Thickness	SR, SE
FLX	Semiconductor	200mm 300mm	CVD, CMP, Etch, Litho, Film Thickness, CD	SR, OCD/SR, UDI
Atlas/Atlas-M	Semiconductor	200mm 300mm 6-inch masks/reticles	CVD, CMP, Etch, Litho, Film Thickness, Film Stress, CD	SR, SE, OCD/SE
Orion	Semiconductor	200mm 300mm	Overlay	Imaging
Integrated Systems
9000	Semiconductor	200mm	CVD, CMP, Film Thickness	SR
9000i	Semiconductor	300mm	CVD, CMP, Etch, Film Thickness, CD	SR, OCD
9000b	Semiconductor	300mm	CVD, CMP, Etch, Film Thickness	SR
9010/9010b	Semiconductor	300mm	CMP, CVD, Etch, Litho Film Thickness, CD	OCD/SR, CLP, UDI
9010T/9010T/b	Semiconductor	200mm 300mm	CMP, Etch, Litho CD	OCD/SR
Table Top Systems
3000	Semiconductor	75mm 150mm	Film Thickness	SR
6100	Semiconductor	75mm 150mm 200mm	Film Thickness	SR

Automated/Standalone Systems

Our standalone, fully automated metrology systems are employed in high-volume production environments. These systems incorporate automated material handling interface options for a variety of fab automation environments and implement multiple measurement technologies for a broad range of substrate sizes. Our automated systems range in price from approximately $200,000 to over $1,000,000, depending on substrate sizes, measurement technologies, material handling interfaces and other options.

Nanometrics Atlas and Atlas-M

The Nanometrics Atlas high-performance metrology system combines up to four metrology technologies on a single platform, providing increased measurement capabilities in a small footprint design

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for reduced cost of ownership. The Atlas-M further extends the versatility of this 300mm platform to provide fully automated mask and reticle measurements. The system is capable of housing up to four metrology technologies including polarized, normal incidence spectroscopic ellipsometry for linewidth profile and critical dimensions, spectroscopic reflectometry for films and film stacks, ultra-violet, or UV, and deep UV spectroscopic ellipsometry for ultra-thin films and film characterization, and film stress/wafer bow measurements. The Atlas offers high accuracy, high precision metrology for wafer characterization and can be configured for 200mm and 300mm wafer sizes or 6-inch masks and reticles. The system is also compatible with NanoNet, an optional software package that enables users to synchronize standalone and integrated metrology systems for remote process setup and monitoring.

Nanometrics FLX

The Nanometrics FLX flexible metrology system is based on the Atlas automation platform, and is designed to support up to four integrated metrology modules simultaneously—the tool can mix-and-match any combination of modules to form a complete metrology solution for lithography, planarization, etch and deposition processes. This capability accelerates process development through parallel development of integrated metrology solutions. The Nanometrics FLX is a flexible, cost-efficient, high-throughput 300-mm standalone metrology system based on Nanometrics’ proven integrated metrology solutions. The system offers industry-leading throughput of 250-500 wafers per hour fueled by dual multi-axis wafer-handling robots.

NanoSpec 9100

The NanoSpec 9100 standalone, automated thin film measurement system is capable of handling wafers ranging in size from 75 to 200 millimeters in diameter. The 9100 can be configured with a deep ultraviolet, or DUV, to near infrared spectroscopic ellipsometer for ultra-thin, multiple film stack and DUV lithography measurement applications. Other 9100 options include a standard mechanical interface with mini-environment enclosures for use in ultra-clean manufacturing facilities. The system also features a Windows XP software platform that conforms to the newly establish SEMI user interface standard. The 9100 can also be configured to handle the substrates. We developed the 9100 using technologies from the integrated film thickness systems to allow easy transfer of measurement recipes between the integrated and standalone film metrology systems.

Nanometrics Orion

The recently introduced Nanometrics Orion, Advanced Overlay Control System provides enhanced measurement performance and higher wafer throughput and replaces the original Metra line of products. The system is based on the highly successful Atlas platform and offers high throughput in excess of 180 wafers per hour. Orion utilizes a proprietary optical system to provide low total measurement uncertainty (TMU), enabling 1 nanometer, 3-sigma precision in overlay control applications. Orion’s aerial image metrology with proprietary digital image folding tolerates wide process variations and reduces the possibility of erroneous data. Both attributes are crucial elements in attaining high yields in 200mm and 300mm volume production.

Integrated Systems

Our integrated metrology systems are installed inside wafer processing equipment to provide near real-time measurements for improving process control and increasing throughput. Our integrated systems are available for wafer sizes up to 300 millimeters and offer DUV spectroscopic reflectometry and/or critical dimension measurement technologies. Our integrated metrology systems range in price from approximately $80,000 to $400,000 depending on features and technology.

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NanoSpec 9000

The NanoSpec 9000 is an ultra-compact measurement system designed for integration into semiconductor wafer processing equipment. The system can be used in several wafer film process steps, including metal deposition, planarization, chemical vapor photolithography and etch. In its basic configuration, the NanoSpec 9000 is equipped with visible wavelength spectroscopic reflectometry.

NanoSpec 9000i

The NanoSpec 9000i is a 300mm version of the NanoSpec 9000. This metrology platform can be integrated into multiple wafer film process steps including metal deposition, planarization, chemical vapor deposition, photolithography and etch. The NanoSpec 9000i is also equipped with visible wavelength spectroscopic reflectometry and can be extended into deep ultraviolet wavelengths.

NanoOCD 9010M

The NanoOCD 9010M utilizes our production-proven OCD metrology, and enables non-destructive, real-time measurement and profiling of critical features on photomasks and reticles without the limitations and drawbacks associated with critical dimension scanning electron microscope, or CD-SEM, metrology. Current CD-SEM technology appears to be reaching its theoretical limits for making critical dimension measurements on these substrates. Photoresist-on-chrome-on-glass features found on reticles and masks suffer severe charging during CD-SEM metrology making critical dimension measurements impossible. OCD is a non-destructive technology that provides information not available from CD-SEM measurements.

NanoOCD/DUV 9010

The NanoOCD/DUV 9010 is the first integrated metrology tool to combine two measurement technologies on a single platform. The NanoOCD/DUV 9010 incorporates both ultra violet optical critical dimension (OCD) spectroscopic ellipsometry and deep ultra violet (DUV) spectroscopic reflectometry. The NanoOCD/DUV 9010 provides thin film and film stack thickness measurements on pads as well as oxide, nitride and trench profile measurements on arrays in a single tool. The combined technologies provide a complete measurement solution over the entire range of measurement requirements for each process step. This complete metrology capability can be utilized across a number of lithography, deposition, copper planarization, dielectric planarization, poly-Si etch and dielectric etch applications.

NanoOCD/DUV 9010b

The NanoOCD/DUV 9010b is a SEMI BOLTS compatible, 300 millimeter based system that incorporates all the features of the NanoOCD/DUV 9010. By conforming to the industry standard BOLTS mounting system, the NanoOCD/DUV 9010b is interchangeable with industry conforming load ports for simplified mechanical integration.

Nano 9010T Integrated Metrology Platform

The 9010T is an advanced, integrated metrology platform for optical CD measurement and profiling. The 9010T system is designed to be incorporated into semiconductor equipment requiring leading-edge CD metrology for semiconductor applications. The 9010T offers an extended wavelength range down to 210nm, extending the CD measurement capabilities for line width structures down to 65nm. The system also incorporates the UV film thickness function, and its improved design offers a faster, more cost effective integrated CD measurement solution with increased throughput. The system is also offered as the 9010T - BOLTS, in the SEMI BOLTS configuration for easy installation directly onto the OEM process equipment’s standard 300mm loadport.

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Tabletop Systems

Our tabletop systems are used primarily in low-volume production environments and in engineering labs for which automated handling and high throughput are not required. Our tabletop product line encompasses both manual and semi automated models for film thickness measurements. Our tabletop system prices range from approximately $50,000 to $200,000.

NanoSpec 3000 and 6100

The NanoSpec tabletop systems provide a broad range of thin film measurement solutions at a lower entry price point. The NanoSpec 3000 is a basic, manual system while the 6100 models feature semiautomatic wafer handling or staging.

Customers

We sell our metrology systems worldwide to many of the major semiconductor manufacturers and equipment suppliers, as well as to producers of silicon wafers and photomasks. The majority of our systems are sold to customers located in Asia and the United States. Three customers, Applied Materials, Samsung and Ebara represented 20.6%, 15.9% and 12.5% of our total net revenues in 2005, respectively. See Note 14 of the Notes to Consolidated Financial Statements for information regarding our major customers.

The following is a list of our top ten customers (categorized by type of customer), based on revenues, during 2005:

Original Equipment Manufacturers (OEMs)	Integrated Device Manufacturers (IDMs)
Applied Materials, Inc.	Samsung
Ebara Technologies, Incorporated (ETI)	Hynix Semiconductor, Inc.
Tokyo Electron Ltd	Powerchip Semiconductor Corporation
	Intel
	Taiwan Semiconductor Manufacturing Corporation (TSMC)
	Hitachi
	AU Optronics Corporation

Sales and Marketing

We believe that the capability for direct sales and support is beneficial for developing and maintaining close customer relationships and for rapidly responding to changing customer requirements. We provide direct sales and support from our corporate office in California. We also have a direct sales presence in South Korea, Japan, Taiwan and China. We use selected sales representatives in the United States and other countries. We intend to continue monitoring our network, our existing and new offices as well as developing additional distribution relationships when needed. We believe that growing our international distribution network can enhance our competitive position. We maintain a direct sales force of highly trained, technically sophisticated sales engineers who are knowledgeable in the use of metrology systems generally and with the features and advantages of our specific products. Our sales engineers are supported by applications scientists. Together, these highly trained individuals work closely with our customers to solve complex measurement and process problems.

Direct exports of our metrology systems to our foreign customers and shipments to our subsidiaries require general export licenses. See Note 15 of the Notes to Consolidated Financial Statements for information regarding total net revenues and long-lived assets of our foreign operations. See Item 1A, “Risk Factors” for information regarding risks related to our foreign operations.

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Net revenues from customers located in the United States and in foreign countries, as a percentage of total net revenues, were as follows:

	2005	2004	2003
United States	33.3%	28.2%	25.2%
Japan	26.2%	29.6%	24.8%
South Korea	25.3%	19.3%	21.8%
Taiwan	10.9%	11.6%	21.5%
All other countries	4.3%	11.3%	6.7%

In order to raise market awareness of our products, we advertise in trade publications, distribute promotional materials, publish technical articles, conduct marketing programs, issue press releases regarding new products, work with a public relations firm and participate in industry trade shows and conferences. We also maintain a website at www.nanometrics.com.

Customer Service and Support

We believe that customer service and technical support are important factors to distinguish us from our competitors and are essential to building and maintaining close, long-term relationships with our customers. We provide support to our customers with factory technical support and globally deployed field service offices. The factory technical support operations provide both OEM and end-user customers with telephonic technical support access, direct training programs and operating manuals and other technical support information. We use our demonstration equipment for training programs, as well as for our sales and marketing efforts. Our technical training department has metrology systems that are used for customer training. We coordinate warranty and post-warranty field service and spare parts support from our corporate headquarters in Milpitas, California. We also have North America field service operations based in various locations throughout the United States. In Asia, service is provided by direct offices in Japan, South Korea, Taiwan and China.

We provide a standard one-year warranty on parts and labor for products sold domestically and in foreign markets and in certain instances, we will provide warranty periods in excess of one year but only upon customer request. Service revenue, including sales of replacement parts, represented 13.5%, 11.1% and 16.9% of total net revenues in 2005, 2004 and 2003, respectively.

Backlog

As of December 31, 2005 and January 1, 2005 our backlog was $6.3 million and $16.6 million, respectively. Backlog includes orders for products that we expect to ship within 12 months. Orders from our customers are subject to cancellation or delay by the customer without penalty. Historically, order cancellations and order rescheduling have not been significant. However, orders presently in backlog could be canceled or rescheduled. As only a portion of our revenues for any fiscal quarter represent systems in backlog, we do not believe that backlog is necessarily an accurate indication of our future revenues or financial performance.

Competition

The market for our metrology systems is intensely competitive. We compete on a global basis with both larger and smaller companies. Our products compete primarily with: standalone metrology products from KLA-Tencor Corporation, Therma-Wave, Inc. and Rudolph Technologies; integrated metrology products from Nova Measuring Instruments Ltd., KLA-Tencor and Therma-Wave; and overlay metrology products from KLA-Tencor and Accent Optical Technologies. Many of our competitors have substantially greater financial, engineering, manufacturing and marketing resources than we do. Significant competitive factors in our industry include: performance of proprietary measurement technology; system performance, including automation and software capability; ease of use; reliability; established customer bases; cost of ownership; price; and global customer service. We believe that we compete favorably with respect to these factors. Nevertheless, we must

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continue to develop and design new and improved products and evaluate the attractiveness of strategic transactions, including mergers and asset acquisitions, in order to maintain our competitive position, especially in light of the competitive advantage our larger competitors, such as KLA-Tencor Corporation may be able to exert in the marketplace.

Manufacturing

We manufacture our products primarily in the United States and, to a lesser extent, in Japan and South Korea. We combine proprietary measurement technology produced in our facilities with components and subassemblies obtained from outside suppliers. We currently do not expect our manufacturing operations to require us to make any additional major investments in capital equipment.

Although we have internalized the production of key parts and components, certain components, subassemblies and services necessary for the manufacture of our systems are obtained from a sole supplier or limited group of suppliers. We do not maintain long-term supply agreements with any of our suppliers.

Research and Development

Our research and development is directed towards enhancing existing products and developing and introducing new products to maintain technological leadership and to meet current and evolving customer needs. Our process, engineering, marketing, operations and management personnel have developed close collaborative relationships with many of our customers and have used these relationships to identify market demands and target our research and development to meet those demands. We are working to develop potential applications of new and emerging technologies, including improved metrology methods. We conduct research and development at our facilities in California, South Korea and Japan.

In the United States, our research and development efforts are focused on semiconductor metrology. In South Korea, our research and development efforts are focused on the overlay metrology market. In Japan, our research and development efforts were focused on flat panel display metrology, through October 2005.

Our research and development expenditures in 2005 in the United States, Japan and South Korea were as follows:

United States	$	10.9 million
Japan	$	1.2 million
South Korea	$	0.4 million
Total	$	12.5 million

We have extensive proprietary technology and expertise in such areas as spectroscopic reflectometry using our patented absolute reflectivity, robust pattern recognition and complex measurement software algorithms. We continue to add to our intellectual property portfolio, most recently in the areas of critical dimension measurement and integrated metrology. We also have extensive experience in systems integration engineering required to design compact, highly automated systems for advanced clean room environments. Expenditures for research and development during 2005, 2004 and 2003 were $12.5 million, $12.8 million and $13.4 million, respectively, and represented 17.8%, 18.3% and 32.2% of total net revenues, respectively.

Intellectual Property

Our success depends in large part on the technical innovation of our products and protecting such innovations through a variety of methods. We actively pursue a program of filing patent applications to seek protection of technologically sensitive features of our metrology systems. As of December 31, 2005, we held 40 United States patents with 25 patent applications pending, 6 of which were filed during 2005. Our United States patents, issued during the period 1988 to 2005, will expire between 2006 and 2024. We believe that our success

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will depend to a greater degree upon innovation, technological expertise and our ability to adapt our products to new technology. While we attempt to establish our intellectual property rights through patents and trademarks and protect intellectual property rights through non-disclosure agreements, we may not be able to protect our technology and competitors may be able to develop similar technology independently. Others may obtain patents and assert them against us. In addition, the laws of certain foreign countries may not protect our intellectual property to the same extent as do the laws of the United States. From time to time we receive communications from third parties asserting that our metrology systems may contain design features that are claimed to infringe their proprietary rights. We typically refer such matters to our legal counsel.

We have registered the following trademarks with the U.S. Patent and Trademark Office: Nanometrics^®, NanoSpec^®, Integrated Metrology^®, NanoOCD^®, Metra^®, NanoNet^®, OCD^® and others. Additionally, we use a variety of other trademarks and trade names such as Atlas, NanoCLP and the Nanometrics logo. All other brand names, trade names and trademarks mentioned herein are the property of their respective holders. The effect of registering our trademarks is to further protect Nanometrics’ brand and corporate identity.

Employees

At December 31, 2005, we employed 305 persons worldwide: 71 in research and development, 58 in manufacturing and manufacturing support, 79 in customer service, 60 in sales and marketing, and 37 in general administration and finance. None of our employees is represented by a union and we have never experienced a work stoppage as a result of union actions. Many of our employees have specialized skills that are of value to us. Our future success will depend in large part upon our ability to attract and retain highly skilled scientific, technical and managerial personnel, who are in great demand in our industry. We consider our employee relations to be good.

Executive Officers of the Registrant

The following are our current executive officers and their ages as of December 31, 2005:

Name	Age	Position
Vincent J. Coates	80	Chairman of the Board, Secretary
John D. Heaton	45	President, Chief Executive Officer and Director
Douglas J. McCutcheon	57	Executive Vice President, Finance and Administration and Chief Financial Officer
Quentin B. Wright	49	Chief Accounting Officer
Roger Ingalls Jr.	44	Senior Vice President of Standalone Sales

Mr. Vincent J. Coates has been Chairman of the Board since Nanometrics was founded in 1975. He has been our Secretary since February 1989. He has also served as our Chief Executive Officer through April 1998 and President from our founding through May 1996, except for the period of January 1986 through February 1987 when he served exclusively as Chief Executive Officer. Mr. Coates has also served as Chairman of the Board of Nanometrics Japan Ltd., one of our subsidiaries, since June 1998. Prior to his employment at Nanometrics, Mr. Coates co-founded Coates and Welter Instrument Corporation, a designer of electron microscopes, which company was subsequently acquired by Nanometrics. Mr. Coates also spent over twenty years working in engineering, sales and international operations for the Perkin-Elmer Corporation, a manufacturer of analytical instruments. In 1995, he received an award that recognized his contribution to the industry from Semiconductor and Equipment and Materials International, an industry trade organization.

Mr. John D. Heaton has served as a director of Nanometrics since July 1995. Since May 1996, he has served as our President. Since April 1998, he has also served as our Chief Executive Officer. From May 1996 to April 1998, he served as our Chief Operating Officer. Mr. Heaton has also served as President of Nanometrics Japan

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Ltd., one of our subsidiaries, since January 1998. Beginning in 1978, Mr. Heaton served in various technical positions at National Semiconductor, a semiconductor manufacturer, prior to joining us in 1990.

Mr. Douglas J. McCutcheon has served as Executive Vice President, Finance and Administration, and Chief Financial Officer of Nanometrics since September 2005. From January 2003 until December 2004, he served as Managing Director, Senior Vice President Finance and Chief Financial Officer of Metron Technology N.V., a manufacturer and distributor of semiconductor capital equipment and provider of fab facility services. In 2002, he served in a consulting role to Metron Technology. He also served as Senior Vice President Finance and Chief Financial Officer of Asyst Technologies, Inc., a semiconductor capital equipment automation company, from January 1996 until September 2001. From 1977 through 1995, Mr. McCutcheon held various financial management positions at Memorex Corporation, Diasonics, Inc., Toshiba America Medical Inc. and Cadence Design Systems.

Mr. Quentin B. Wright has served as Chief Accounting Officer of Nanometrics since April 2005. From November 2003 until April 2005 Mr. Wright provided financial consulting services for various technology clients in Silicon Valley. From May 1999 until November 2003 he server as Director of Accounting of Adaptec, Inc., a manufacturer of storage access solutions. He also served as corporate controller of Vascular Therapeutics, Inc., a start-up biopharmaceutical company focused on the discovery and development of novel drugs to prevent and treat cardiovascular disease from February 1998 until May 1999.

Mr. Roger Ingalls Jr. has served as our Senior Vice President of Standalone Sales since January 2002. Mr. Ingalls joined Nanometrics in March 1995, serving as Vice President and Director of Sales and Marketing from October 1997 to February 1998, and as Vice President and Director of Marketing from February 1998 to January 2002. Prior to joining Nanometrics, he served as a sales engineer for Nikon Inc., a precision optical company, from March 1993 to March 1995.

ITEM 1A. RISK FACTORS

Cyclicality in the semiconductor industry has led to substantial fluctuations in demand for our systems and may, from time to time, continue to do so.

Our operating results have varied significantly from period to period due to the cyclical nature of the semiconductor industry. The majority of our business depends upon the capital expenditures of semiconductor device and equipment manufacturers. These manufacturers’ capital expenditures, in turn, depend upon the current and anticipated market demand for semiconductors and products using semiconductors. The semiconductor industry is cyclical and has historically experienced periodic downturns. These downturns have often resulted in substantial decreases in the demand for semiconductor manufacturing equipment, including metrology systems. We have found that the resulting decrease in capital expenditures has typically been more pronounced than the downturn in semiconductor device industry revenues. We expect the cyclical nature of the semiconductor industry, and therefore, our business, to continue in the foreseeable future. Recently, the semiconductor industry emerged from a sustained downturn. Should this trend reverse and the downturn resume, our business and results of operations would suffer.

Because we derive a significant portion of our revenues from sales in Asia, our revenues and results of operations could be adversely affected by the instability of Asian economies.

Revenues from customers in Asian markets represented approximately 65.5%, 68.8% and 72.7% of our total net revenues in 2005, 2004 and 2003, respectively. Countries in the Asia Pacific region, including Japan, South Korea and Taiwan, each of which accounted for a significant portion of our business in that region, experienced general economic weaknesses in 2002 and 2003, which adversely affected our revenues at that time. We anticipate that we will continue to rely upon customers in Asia for a majority of our revenues and any future

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weaknesses or instabilities in the economies of countries in Asia may continue to have a material adverse effect on our results of operations and financial condition.

We depend on Applied Materials and other OEM suppliers for sales of our integrated metrology systems, and the loss of Applied Materials or any of our other OEM suppliers as a customer could harm our business.

We believe that sales of integrated metrology systems will continue to be an important source of our revenues. Sales of our integrated metrology systems depend upon the ability of Applied Materials to sell semiconductor equipment products that include our metrology systems as components. If Applied Materials is unable to sell such products, or if Applied Materials chooses to focus its attention on products that do not integrate our systems, our business could suffer. If we were to lose Applied Materials as a customer for any reason, our ability to realize sales from integrated metrology systems would be significantly diminished, which would harm our business.

Our largest customers account for a substantial portion of our revenue, and our revenue would materially decline if one or more of these customers were to purchase significantly fewer of our systems or if they delayed or cancelled a large order.

Historically, a significant portion of our revenues in each quarter and each year has been derived from sales to a relatively few number of customers, and we expect this trend to continue. There are only a limited number of large companies operating in the semiconductor industry. Accordingly, we expect that we will continue to depend on a small number of large customers for a significant portion of our revenues for the foreseeable future. If any of our key customers were to purchase significantly fewer systems, or if a large order were delayed or cancelled, our revenues could significantly decline. In 2005, sales to Applied Materials accounted for 20.6% and sales to Samsung accounted for 15.9% of our total net revenues, respectively. In 2004, sales to Applied Materials accounted for 21.4% and sales to Samsung accounted for 14.7% of our total net revenues, respectively. In 2003, sales to Applied Materials accounted for 15.4% and sales to Hynix accounted for 12.0% of our total net revenues, respectively.

The success of our product development efforts depends on our ability to anticipate market trends and the price, performance and functionality requirements of semiconductor device manufacturers. In order to anticipate these trends and ensure that critical development projects proceed in a coordinated manner, we must continue to collaborate closely with our customers. Our relationships with our customers provide us with access to valuable information regarding industry trends, which enables us to better plan our product development activities. If our current relationships with our large customers are impaired, or if we are unable to develop similar collaborative relationships with important customers in the future, our long-term ability to produce commercially successful systems could be adversely affected.

If we are unable to successfully address the material weakness in our internal controls, our ability to report our financial results on a timely and accurate basis may be adversely affected. As a result, current and potential stockholders could lose confidence in our financial reporting which could have a material adverse effect on our business, operating results and stock price.

Section 404 of the Sarbanes-Oxley Act of 2002 requires us to evaluate the effectiveness of our internal controls over financial reporting as of the end of each year, and to include a management report assessing the effectiveness of our internal controls over financial reporting in all annual reports. Section 404 also requires our independent registered public accounting firm to attest to, and report on, management’s assessment of our internal controls over financial reporting. Management’s report and our auditors’ attestation report are included in this report on Form 10-K under Item 9A.

A control system, no matter how well designed and operated, can provide only reasonable, not absolute, assurance that the control system’s objectives will be met. Further, the design of a control system must reflect the

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fact that there are resource constraints, and the benefits of controls must be considered relative to their costs. Because of the inherent limitations in all control systems, no evaluation of controls can provide absolute assurance that all control issues and instances of fraud, if any, involving Nanometrics have been, or will be, detected. These inherent limitations include the realities that judgments in decision making can be faulty and that breakdowns can occur because of simple error or mistake. Controls can also be circumvented by the individual acts of some persons, by collusion of two or more people, or by management override of the controls. The design of any system of controls is based in part on certain assumptions about the likelihood of future events, and we cannot assure you that any design will succeed in achieving its stated goals under all potential future conditions. Over time, controls may become inadequate because of changes in conditions or deterioration in the degree of compliance with policies or procedures. Because of the inherent limitations in a cost-effective control system, misstatements due to error or fraud may occur and not be detected.

For the year ended December 31, 2005, our management concluded that there was a material weakness regarding the internal controls of our Japanese operations. A material weakness means that there is more than a remote likelihood that a material misstatement to our annual or interim financial statements would not be detected or prevented. For example, on October 26, 2005, our Audit Committee, acting on a recommendation from management, determined that our audited financial statements for the fiscal year ended January 1, 2005, and our unaudited quarterly financial statements for the periods ended April 2, 2005 and July 2, 2005, should no longer be relied upon and should be restated to revise the accounting for certain post-sale warranty services and other issues. Our management has identified certain steps designed to address our material weakness, and has begun to execute remediation plans, as described in Item 9A of this report on Form 10-K, “Report of Management on Internal Control Over Financial Reporting.”

Any failure to implement in a timely manner and maintain the improvements in the controls over our financial reporting that we are currently putting in place, or difficulties encountered in the implementation of these improvements in our controls, could cause us to fail to meet our reporting obligations, to fail to produce reliable financial reports or to prevent fraud. Any failure to improve our internal controls to address this identified weakness could also cause investors to lose confidence in our reported financial information, which could have a negative impact on our business, operating results and stock price.

Our current and potential competitors have significantly greater resources than we do, and increased competition could impair sales of our products.

We operate in the highly competitive semiconductor industry and face competition from a number of companies, many of which have greater financial, engineering, manufacturing, marketing and customer support resources than we do. As a result, our competitors may be able to respond more quickly to new or emerging technologies or market developments by devoting greater resources to the development, promotion and sale of products, which could impair sales of our products. Moreover, there has been merger and acquisition activity among our competitors and potential competitors. These transactions by our competitors and potential competitors may provide them with a competitive advantage over us by enabling them to rapidly expand their product offerings and service capabilities to meet a broader range of customer needs. Many of our customers and potential customers in the semiconductor industry are large companies that require global support and service for their metrology systems. Some of our larger or more geographically diverse competitors might be better equipped to provide this global support.

If any of our systems fail to meet or exceed our internal quality specifications, we cannot ship them until such time as they have met such specifications. If we experience significant delays or are unable to ship our products to our customers as a result of our internal processes, or for any other reason, our business and reputation may suffer.

Our products are complex and require technical expertise to design and manufacture properly. Various problems occasionally arise during the manufacturing process that may cause delays and/or impair product quality. We must actively monitor our manufacturing processes to ensure that our products meet our internal

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quality specifications. Any significant delays stemming from the failure of our products to meet or exceed our internal quality specifications, or for any other reasons, would delay our shipments. Shipment delays could harm our business and reputation in the industry.

If we deliver systems with defects, our credibility will be harmed, revenue from, and market acceptance of, our systems will decrease and we could expend significant capital and resources as a result of such defects.

Notwithstanding our internal quality specifications, our systems have sometimes contained errors, defects and bugs when introduced. If we deliver systems with errors, defects or bugs, our credibility and the market acceptance and sales of our systems would be harmed. Further, if our systems contain errors, defects or bugs, we may be required to expend significant capital and resources to alleviate such problems. Defects could also lead to product liability as a result of product liability lawsuits against us or against our customers. We have agreed to indemnify our customers in some circumstances against liability arising from defects in our systems. In the event of a successful product liability claim, we could be obligated to pay damages significantly in excess of our product liability insurance limits.

Successful infringement claims by third parties could result in substantial damages, lost product sales and the loss of important intellectual property rights by us.

Our commercial success depends, in part, on our ability to avoid infringing or misappropriating patents or other proprietary rights owned by third parties. From time to time we may receive communications from third parties asserting that our metrology systems may contain design features which are claimed to infringe on their proprietary rights. For example, we announced on March 14, 2005 that we had received notice of a patent infringement lawsuit brought by Nova Measuring Instruments, Ltd., alleging infringement of United States Patent No. 6,752,689. In August 2005, we were served with a complaint by KLA-Tencor Corporation alleging that certain of our products infringe two of KLA’s patents, Patent No. 6,483,580 and Patent No. 6,590,656. In January 2006, KLA added Patent No. 6,611,330 to their claim. There can be no assurance that Nanometrics’ new or current products do not infringe any valid intellectual property rights. Even if our products do not infringe, we may be required to expend significant sums of money to defend against infringement claims, as in the Nova Measuring Instruments, Ltd. lawsuit described above, or to actively protect our intellectual property rights through litigation.

We obtain some of the components and subassemblies included in our systems from a single source or a limited group of suppliers, and the partial or complete loss of one of these suppliers could cause production delays and significant loss of revenue.

We rely on outside vendors to manufacture many components and subassemblies. Certain components, subassemblies and services necessary for the manufacture of our systems are obtained from a sole supplier or limited group of suppliers. We do not maintain any long-term supply agreements with any of our suppliers. We have entered into arrangements with J.A. Woollam Company for the purchase of the spectroscopic ellipsometer component incorporated in our advanced measurement systems. Our reliance on a sole or a limited group of suppliers involves several risks, including the following:

• we may be unable to obtain an adequate supply of required components;

• we have reduced control over pricing and the timely delivery of components and subassemblies; and

• our suppliers may be unable to develop technologically advanced products to support our growth and development of new systems.

Some of our suppliers have relatively limited financial and other resources. Because the manufacturing of certain of these components and subassemblies involves extremely complex processes and requires long lead times, we may experience delays or shortages caused by our suppliers. If we were forced to seek alternative sources of supply or to manufacture such components or subassemblies internally, we could be forced to redesign

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our systems, which could cause production delays and prevent us from shipping our systems to customers on a timely basis. Any inability to obtain adequate deliveries from our suppliers, or any other circumstance that would restrict our ability to ship our products, could damage relationships with current and prospective customers, harm our business and result in significant loss of revenue.

Variations in the amount of time it takes for us to sell our systems may cause fluctuations in our operating results, which could adversely affect our stock price.

Variations in the length of our sales cycles could cause our revenues to fluctuate widely from period to period. Our customers generally take long periods of time to evaluate our metrology systems. We expend significant resources educating and providing information to our prospective customers regarding the uses and benefits of our systems. The length of time that it takes for us to complete a sale depends upon many factors, including:

• the efforts of our sales force and our independent sales representatives;

• the complexity of the customer’s metrology needs;

• the internal technical capabilities and sophistication of the customer;

• the customer’s budgetary constraints; and

• the quality and sophistication of the customer’s current processing equipment.

Because of the number of factors influencing the sales process, the period between our initial contact with a customer and the time at which we recognize revenue from that customer, if at all, varies widely. Our sales cycles, including the time it takes for us to build a product to customer specifications after receiving an order, typically range from three to six months. Occasionally our sales cycles can be much longer, particularly with customers in Asia who may require longer evaluation periods. During the sales cycles, we commit substantial resources to our sales efforts in advance of receiving any revenue, and we may never receive any revenue from a customer despite our sales efforts.

If we do complete a sale, customers often purchase only one of our systems and then evaluate its performance for a lengthy period of time before purchasing additional systems. The purchases are generally made through purchase orders rather than through long-term contracts. The number of additional products that a customer purchases, if any, depends on many factors, including a customer’s capacity requirements. The period between a customer’s initial purchase and any subsequent purchases is unpredictable and can vary from three months to a year or longer. Variations in the length of this period could cause fluctuations in our operating results, which could adversely affect our stock price.

Relatively small fluctuations in our system sales volume may cause our operating results to vary significantly each quarter.

During any quarter, a significant portion of our revenue is derived from the sale of a relatively small number of systems. Our automated metrology systems range in price from approximately $200,000 to over $1,000,000 per system, our integrated metrology systems range in price from approximately $80,000 to $400,000 per system and our tabletop metrology systems range in price from approximately $50,000 to $200,000 per system. Accordingly, a small change in the number or mix of systems that we sell could cause significant changes in our operating results.

We depend on orders that are received and shipped in the same quarter, and therefore our results of operations may be subject to significant variability from quarter to quarter.

Our net sales in any given quarter depend upon a combination of orders received in that quarter for shipment in that quarter and shipments from backlog. Our backlog at the beginning of each quarter does not include all

23

systems sales needed to achieve expected revenues for that quarter. Consequently, we are dependent on obtaining orders for systems to be shipped in the same quarter that the order is received. Moreover, customers may reschedule shipments, and production difficulties could delay shipments. Accordingly, we have limited visibility into future product shipments, and our results of operations may be subject to significant variability from quarter to quarter.

Because of the high cost of switching equipment vendors in our markets, it is sometimes difficult for us to attract customers from our competitors even if our metrology systems are superior to theirs.

We believe that once a semiconductor customer has selected one vendor’s metrology system, the customer generally relies upon that system and, to the extent possible, subsequent generations of the same vendor’s system, for the life of the application. Once a vendor’s metrology system has been installed, a customer must often make substantial technical modifications and may experience downtime in order to switch to another vendor’s metrology system. Accordingly, unless our systems offer performance or cost advantages that outweigh a customer’s expense of switching to our systems, it will be difficult for us to achieve significant sales from that customer once it has selected another vendor’s system for an application.

If we are not successful in developing new and enhanced metrology systems we will likely lose market share to our competitors.

We operate in an industry that is subject to technological changes, changes in customer demands and the introduction of new, higher performance systems with short product life cycles. To be competitive, we must continually design, develop and introduce in a timely manner new metrology systems that meet the performance and price demands of semiconductor manufacturers and suppliers. We must also continue to refine our current systems so that they remain competitive. We may experience difficulties or delays in our development efforts with respect to new systems, and we may not ultimately be successful in developing them. Any significant delay in releasing new systems could adversely affect our reputation, give a competitor a first-to-market advantage or cause a competitor to achieve greater market share.

Lack of market acceptance for our new products may affect our ability to generate revenue and may harm our business.

We have recently introduced several products to the market including the Atlas-M and Orion. We have invested substantial time and resources into the development of these products. However, we cannot accurately predict the future level of acceptance of our new products by our customers. As a result, we may not be able to generate anticipated revenue from sales of these products. While we anticipate that our new products will become an increasingly larger component of our business, their failure to gain acceptance with our customers could materially harm our business. Additionally, if our new products do gain market acceptance, our ability to sell our existing products may be impeded. As a result, there can be no assurance that the introduction of these products will be commercially successful or that these products will result in significant additional revenues or improved operating margins in future periods.

Our intellectual property may be infringed upon by third parties despite our efforts to protect it, which could threaten our future success and competitive position and adversely affect our operating results.

Our future success and competitive position depend in part upon our ability to obtain and maintain proprietary technology for our principal product families, and we rely, in part, on patent, trade secret and trademark law to protect that technology. If we fail to adequately protect our intellectual property, it will be easier for our competitors to sell competing products. We own or may license patents relating to our metrology systems, and have filed applications for additional patents. Any of our pending patent applications may be rejected, and we may not in the future be able to develop additional proprietary technology that is patentable. In

24

addition, the patents we own, have been issued, or may license may not provide us with competitive advantages and may be challenged by third parties. Third parties may also design around these patents.

In addition to patent protection, we rely upon trade secret protection for our confidential and proprietary information and technology. We routinely enter into confidentiality agreements with our employees. However, in the event that these agreements may be breached, we may not have adequate remedies. Our confidential and proprietary information and technology might also be independently developed by or become otherwise known to third parties. We may be required to initiate litigation in order to enforce any patents issued to or licensed by us, or to determine the scope or validity of a third party’s patent or other proprietary rights. Any such litigation, regardless of outcome, could be expensive and time consuming, and could subject us to significant liabilities or require us to re-engineer our product or obtain expensive licenses from third parties, any of which would adversely affect our business and operating results.

If we choose to acquire new and complementary businesses, products or technologies instead of developing them ourselves, we may be unable to complete these acquisitions or may not be able to successfully integrate an acquired business in a cost-effective and non-disruptive manner.

Our success depends on our ability to continually enhance and broaden our product offerings in response to changing technologies, customer demands and competitive pressures. To achieve this, from time to time we have acquired complementary businesses, products, or technologies instead of developing them ourselves and may choose to do so in the future. For example, we recently announced our intent to merge with Accent, a leading supplier of process control and metrology systems to the global semiconductor manufacturing industry. We do not know if we will be able to complete any acquisitions, or whether we will be able to successfully integrate any acquired business, operate them profitably or retain their key employees. Integrating any business, product or technology that we acquire could be expensive and time consuming, disrupt our ongoing business and distract our management. In addition, in order to finance any acquisitions, we may be required to raise additional funds through public or private equity or debt financings. In that event, we could be forced to obtain financing on terms that are not favorable to us and, in the case of an equity financing, that result in dilution to our shareholders. If we are unable to integrate any acquired entities, products or technologies effectively, our business will suffer.

We must attract and retain key personnel with relevant industry knowledge to help support our future growth.

Our success depends to a significant degree upon the continued contributions of our key management, engineering, sales and marketing, customer support, finance and manufacturing personnel. We generally do not enter into employment contracts with any of our key personnel. The loss of any of these key personnel, who would be difficult to replace, could harm our business and operating results. To support our future growth, we will need to attract and retain additional qualified employees. Competition for such personnel in our industry is ongoing, and we may not be successful in attracting and retaining qualified employees.

We manufacture all of our systems at a limited number of facilities, and any prolonged disruption in the operations of those facilities could reduce our revenues.

We produce all of our systems in our manufacturing facilities located in Milpitas, California and, to a lesser extent, through our subsidiaries in Japan and South Korea. Our manufacturing processes are highly complex and require sophisticated, costly equipment and specially designed facilities. As a result, any prolonged disruption in the operations of our manufacturing facilities, such as those resulting from a severe fire or earthquake, could seriously harm our ability to satisfy our customer order deadlines. A significant portion of our operations is located in Japan, Taiwan and South Korea, which may be subject to regional political and economic instability.

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Our efforts to protect our intellectual property may be less effective in some foreign countries where intellectual property rights are not as well protected as in the United States.

In 2005, 2004 and 2003, 66.7%, 71.8% and 74.8%, respectively, of our total net revenues were derived from sales to customers in foreign countries, including certain countries in Asia, such as Japan, South Korea and Taiwan The laws of some foreign countries do not protect our proprietary rights to as great an extent as do the laws of the United States, and many U.S. companies have encountered substantial problems in protecting their proprietary rights against infringement in such countries. If we fail to adequately protect our intellectual property in these countries, it would be easier for our competitors to sell competing products.

Continuing economic and political instability could affect our business and results of operations.

The ongoing threat of terrorism targeted at the United States or other regions where we conduct business increases the uncertainty in our markets and the economy in general. This uncertainty is likely to result in economic stagnation, which would harm our business. In addition, increased international political instability may hinder our ability to do business by increasing our costs of operations. For example, our transportation costs, insurance costs and sales efforts may become more expensive as a result of geopolitical tension. These tensions may also negatively affect our suppliers and customers. If this international economic and political instability continues or increases, our business and results of operations could be harmed.

We will incur increased costs as a result of recent changes in laws and regulations affecting public companies.

Compliance with recent changes in laws and regulations affecting public companies, including the provisions of the Sarbanes-Oxley Act, has resulted in and, we expect, will continue to result in increased accounting, legal and administrative costs. In particular, Section 404 of the Sarbanes-Oxley Act of 2002 and the rules of the Securities and Exchange Commission and the Public Company Accounting Oversight Board impose new requirements with respect to the evaluation of the effectiveness of our internal controls. The cost of complying with these new requirements is substantial.

Changes in financial accounting standards or practices may cause adverse unexpected fluctuations and affect our reported business and financial results.

The Financial Accounting Standards Board, or FASB, recent change to mandate the expensing of stock options will require us to record charges to earnings for employee stock option grants and will adversely affect our financial results. In addition, the FASB requires certain valuation models to estimate the fair value of employee stock options. These models, including the Black-Scholes option-pricing model, use varying methods, inputs and assumptions selected across companies. If another party asserts that the fair value of our employee stock options are misstated, securities class action litigation could be brought against us or the market price of our common stock could decline or both could occur. As a result of these changes, we could incur losses and our operating results and gross margins may be below our expectations and those of investors and stock market analysts.

Our quarterly operating results have varied in the past and probably will continue to vary significantly in the future, which will cause volatility in our stock price.

Our quarterly operating results have varied significantly in the past and are likely to vary in the future, which volatility could cause our stock price to decline. Some of the factors that may influence our operating results and subject our stock to extreme price and volume fluctuations include:

• changes in customer demand for our systems;

• economic conditions in the semiconductor industries;

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• the timing, cancellation or delay of customer orders and shipments;

• market acceptance of our products and our customers’ products;

• competitive pressures on product prices and changes in pricing by our customers or suppliers;

• the timing of new product announcements and product releases by us or our competitors and our ability to design, introduce and manufacture new products on a timely and cost-effective basis;

• the timing of acquisitions of businesses, products or technologies;

• the levels of our fixed expenses, including research and development costs associated with product development, relative to our revenue levels; and

• fluctuations in foreign currency exchange rates, particularly the Japanese yen.

If our operating results in any period fall below the expectations of securities analysts and investors, the market price of our common stock would likely decline.

We are highly dependent on international sales and operations, which exposes us to foreign political and economic risks.

Sales to customers in foreign countries accounted for approximately 66.7%, 71.8% and 74.8% of our total net revenues in 2005, 2004 and 2003, respectively. We maintain facilities in Japan, Taiwan and South Korea. We anticipate that international sales will continue to account for a significant portion of our revenues. International sales and operations carry inherent risks such as: regulatory limitations imposed by foreign governments, obstacles to the protection of our intellectual property, political, military and terrorism risks, disruptions or delays in shipments caused by customs brokers or other government agencies, unexpected changes in regulatory requirements, tariffs, customs, duties and other trade barriers, difficulties in staffing and managing foreign operations, and potentially adverse tax consequences resulting from changes in tax laws. If any of these risks materialize and we are unable to manage them, our international sales and operations would suffer.

We are exposed to fluctuations in the exchange rates of foreign currency.

As a global concern, we face exposure to adverse movements in foreign currency exchange rates. With our ownership of subsidiaries in Japan and South Korea and a branch office in Taiwan, a significant percentage of our net sales are exposed to foreign currency risk. These exposures may change over time as business practices evolve and could have a material adverse impact on our financial results and cash flow.

We are subject to various environmental laws and regulations that could impose substantial costs upon us and may adversely affect our business, operating results and financial condition.

Some of our operations use substances regulated under various federal, state, local, and international laws governing the environment, including those relating to the storage, use, discharge, disposal, labeling, and human exposure to hazardous and toxic materials. We could incur costs, fines and civil or criminal sanctions, third-party property damage or personal injury claims, or could be required to incur substantial investigation or remediation costs, if we were to violate or become liable under environmental laws. Liability under environmental laws can be joint and several and without regard to comparative fault. Compliance with current or future environmental laws and regulations could restrict our ability to expand our facilities or require us to acquire additional expensive equipment, modify our manufacturing processes, or incur other significant expenses. There can be no assurance that violations of environmental laws or regulations will not occur in the future as a result of the inability to obtain permits, human error, equipment failure or other causes.

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Risks Relating to the Merger with Accent Optical Technologies, Inc.

Nanometrics and Accent Optical expect to incur significant costs in connection with the merger.

Nanometrics estimates that it will incur direct transaction costs of $1.5 million in connection with the merger of which approximately $0.6 million had been paid as of March 21, 2006. Certain of Nanometrics costs will be capitalized. Nanometrics and Accent Optical believe that the combined company will also incur charges to operations, but cannot reasonably estimate those costs at this time, in the quarter in which the merger is completed to reflect the costs of integrating the two companies. There can be no assurance that the combined company will not incur additional material charges in subsequent quarters to reflect additional costs associated with the merger.

The stock price and business of Nanometrics may be adversely affected if the merger is not completed, and, under certain circumstances, Nanometrics may be required to pay a termination fee.

If the merger is not completed, the trading price of Nanometrics common stock may decline to the extent that the current market prices reflect an assumption that the merger will be completed. In addition, Nanometrics business and operations may be harmed to the extent that customers, suppliers and others believe that the companies cannot effectively compete in the marketplace alone, or that uncertainty exists surrounding the future direction of the product and service offerings and strategy of the companies on a stand alone basis.

Nanometrics and Accent Optical will be required to pay significant costs incurred in connection with the merger, including legal, accounting and a portion of the financial advisory fees, regardless of whether the merger is completed.

In that regard, we have agreed to make a working capital loan to Accent Optical in two disbursements of $1.25 million each, the first on or after April 30, 2006 and the second on or after June 30, 2006. However, we and Accent Optical agreed to accelerate the date of the first disbursement and on March 13, 2006, we advanced $750,000 to Accent Optical.

In the event the merger is not completed, the working capital loans may continue as a debt obligation of Accent Optical or may be converted to Accent Optical common stock if certain events occur. In the event that the merger does not occur, Nanometrics may not receive repayment of the monies in a timely manner, if at all.

If either Nanometrics or Accent Optical fails to obtain shareholder approval, it may be required to pay the other party a termination fee equal to $5 million, plus any applicable costs, expenses and interest pursuant to the merger agreement.

Nanometrics and Accent Optical must continue to retain and motivate executives and key employees and recruit new employees, and failure to do so could seriously harm the combined company.

In order to be successful, each of Nanometrics and Accent Optical must continue to retain and motivate executives and other key employees and recruit new employees before the merger is completed. Employees of Nanometrics or Accent Optical may experience uncertainty about their future roles until or after strategies with regard to Nanometrics after the merger are announced or executed. These potential distractions related to the merger may adversely affect each company’s ability to attract, motivate and retain executives and key employees and keep such executives and key employees focused on strategic corporate goals. Any failure by Nanometrics or Accent Optical to retain and motivate executives and key employees during the period prior to the completion of the merger could seriously harm their respective businesses or the business of the combined company after the closing of the merger.

The combined company will need to retain and motivate key executives and employees after the merger in order to be successful. Uncertainty during the integration period after closing will pose retention challenges for the combined company after the closing. Failure to address these challenges could result in undesirable attrition, which would likely harm the combined company’s business.

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The announcement of the merger may cause customers, distributors, resellers and others to delay or defer decisions concerning purchases from Nanometrics and Accent Optical, which may harm their or the combined company’s results of operations.

Because the merger is subject to several closing conditions, uncertainty exists regarding whether and when the merger will be completed. In addition, customers, distributors, resellers and others may be uncertain about the combined company’s plans for each of Nanometrics’ and Accent Optical’s products. This uncertainty may cause customers, distributors, resellers and others to delay or defer purchasing decisions, or elect to switch to other suppliers, which could negatively affect the businesses and results of operations of Nanometrics, Accent Optical or the combined company. Prospective customers might also be reluctant to purchase the combined company’s products after the merger due to uncertainty about the direction of its products and its willingness to support and service existing products. Customers, distributors, resellers and others may also seek to change existing agreements with Nanometrics or Accent Optical as a result of the merger. These and other actions by customers, distributors, resellers and others could negatively affect the businesses and results of operations of Nanometrics and/or Accent Optical.

The merger may be completed even though Nanometrics or Accent Optical suffers a material adverse change.

In general, either party can refuse to complete the merger if the other party suffers from a material adverse change between January 25, 2006, the date of the signing of the merger agreement, and the closing of the merger. However, certain types of changes would not prevent the merger from going forward, even if the change would have a material adverse effect on Nanometrics or Accent Optical including:

• changes in the market price or trading volume of Nanometrics common stock;

• changes, circumstances or conditions affecting the economy as a whole or the industries in which Nanometrics and Accent Optical operate if those changes, circumstances or conditions do not disproportionately affect either or both parties;

• changes in laws or GAAP;

• any effects resulting primarily from the pendency of the merger;

• any litigation by Accent Optical stockholders or Nanometrics shareholders relating to the merger; and

• the impact of Nanometrics’ restatements of past financial statements as described in its Current Repot on Form 8-K dated October 25, 2005, as amended.

Governmental authorities could seek to block or challenge the merger.

The merger is exempt from the pre-merger notification filing requirements of the Hart-Scott-Rodino Act. However, even after completion of the merger, government authorities could seek to block or challenge the merger, impose conditions or require asset divestitures as they deem necessary or desirable in the public interest. In addition, in some jurisdictions, a competitor, customer or other third party could initiate a private action under the antitrust laws challenging or seeking to enjoin the merger, before or after it is completed. Nanometrics and Accent Optical may not prevail in such action, and significant legal fees and costs may be incurred even if they are ultimately successful.

Challenges involved in integrating Accent Optical’s finance organization may negatively impact Nanometrics efforts to evolve its financial and managerial control and reporting systems and processes, including with respect to its internal control over financial reporting.

The combined company’s ability to successfully offer its products and implement its business plan in a rapidly evolving market will require an effective planning and management process. The combined company will

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need to continue to improve its financial and managerial control and its reporting systems and procedures in order to manage its business effectively in the future.

Accent Optical has not been required to prepare a report on the effectiveness of its internal controls over financial reporting because it is not subject to the registration requirements of the Securities Exchange Act of 1934, as amended.

The merger will require significant integration efforts by management. Additionally, unanticipated factors may hinder the effectiveness or delay the integration of Nanometrics’ and Accent Optical’s control systems and as such, there can be no assurances regarding the combined company’s ability to remediate deficiencies in its internal controls over financial reporting. Unless the combined company is able to evolve its current capabilities with respect to control systems and procedures, its ability to file reports with the SEC in a timely manner may be adversely affected.

Accent Optical will need to obtain consents to the assignment of certain agreements it has with third parties as a result of the merger and if it cannot obtain these consents, Accent Optical and/or Nanometrics may lose the benefits of these relationships.

Accent Optical is currently attempting to obtain third-party consents for some agreements requiring consent upon a change of control. If Accent Optical is unable to do so, it may be forced to renegotiate these agreements or enter into new agreements with these various third parties. The agreements requiring consent include certain sales representative and distributor agreements, customer agreements, real property leases and license agreements. There can be no assurance that Accent Optical will be able to renegotiate or to negotiate new agreements on favorable terms, or at all.

ITEM 1B. UNRESOLVED STAFF COMMENTS

None.

ITEM 2. PROPERTIES

At December 31, 2005, our owned or leased facilities included those described below:

Type	Location	Square Footage	Use
Owned	Milpitas, California	133,000	Corporate headquarters and manufacturing
Owned(1)	Pyongtaek-city, South Korea	39,000	Sales, service, engineering and manufacturing
Owned	Chiba Ken, Japan	50,000	Sales, service, engineering and manufacturing
Owned	Milpitas, California	4,602	Corporate housing
Leased	Tokyo, Japan	7,200	Corporate headquarters, sales, service and engineering
Leased	Kumamoto, Japan	3,250	Sales, service and engineering
Leased	Osaka, Japan	1,000	Sales and service
Leased	Hsinchu, Taiwan	3,250	Sales and service
Leased	Shanghai, China	1,400	Sales and service
Leased	Austin, Texas	1,130	Sales and service

(1) Certain real estate improvements on this property are owned; the underlying land, however, is leased.

We believe that our existing facilities, which are currently utilized at or near capacity, are suitable and adequate for our current needs and anticipated growth.

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ITEM 3. LEGAL PROCEEDINGS

On March 9, 2005, Nova Measuring Instruments Ltd. (“Nova”) filed suit against us in the United States District Court for the Northern District of California. The complaint alleges that certain of our products infringe a Nova patent and seeks a preliminary and permanent injunction against their sale and unspecified damages. We do not believe any of our products infringe any valid claim of the Nova patent. We intend to vigorously and aggressively defend ourselves in the litigation. While the results of such litigation matters and claims cannot be predicted with certainty, we believe the final outcome of such matters will not have a material adverse impact on our financial position or results operations.

In August 2005, KLA-Tencor Corporation, or KLA, filed a complaint against us in the United States District Court for the Northern District of California. The complaint alleges that certain of our products infringe two of KLA’s patents. On January 30, 2006, KLA added a third patent to their claim. The complaint seeks a preliminary and permanent injunction against the sale of these products as well as the recovery of monetary damages and attorneys’ fees. We do not believe that any of our products infringe the intellectual property of any third party and we intend to vigorously and aggressively defend ourselves in the litigation. As part of such defense, we have filed a request for re-examination of two of the allegedly infringed KLA-Tencor patents with the U.S. Patent & Trademark Office (“PTO”). These requests for re-examination were recently accepted for review by the PTO. In March 2006, we filed a motion for and were granted a stay in the patent litigation case until such re-examination is completed.

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, 2005.

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PART II

ITEM 5. MARKET FOR REGISTRANT’S COMMON EQUITY, RELATED SHAREHOLDER MATTERS AND ISSUER PURCHASES OF EQUITY SECURITIES

Market Information for Common Stock

Our common stock is quoted on the Nasdaq Stock Market under the symbol “NANO.” The following table sets forth, for the periods indicated, the high and low bid prices per share of our common stock as reported on the Nasdaq Stock Market. These quotations represent prices between dealers and do not include retail markups, markdowns or commissions and may not necessarily represent actual transactions.

	High		Low
2005
First Quarter	$	16.39	$	11.07
Second Quarter	$	13.35	$	9.81
Third Quarter	$	12.88	$	10.85
Fourth Quarter	$	12.01	$	9.77
2004
First Quarter	$	23.50	$	13.86
Second Quarter	$	18.94	$	10.60
Third Quarter	$	12.20	$	7.50
Fourth Quarter	$	17.72	$	11.14

Shareholders

On February 28, 2006, the last reported sales price of our common stock on the Nasdaq Stock Market was $13.28 per share, and there were approximately 128 holders of record of our common stock.

Dividend Policy

We have never declared or paid any cash dividends on our capital stock. We currently expect to retain future earnings, if any, for use in the operation and expansion of our business and do not anticipate paying any cash dividends in the foreseeable future.

Equity Compensation Plan Information

The following table gives information about the common stock that may be issued under all of our existing equity compensation plans as of December 31, 2005.

Plan category	Number of securities to be issued upon exercise of outstanding options, warrants and rights	Weighted-average exercise price of outstanding options, warrants and rights		Number of securities remaining available for future issuance under equity compensation plans (excluding securities reflected in column (a))
	(a)	(b)		(c)
Equity compensation plans approved by security holders	1,773,702	$	10.78	1,864,927
Equity compensation plans not approved by security holders(1)	797,056	$	8.32	114,834
Total	2,570,758	$	10.01	1,979,761

(1) The material features of each plan adopted without the approval of security holders is set forth in Footnote 9 to the consolidated financial statements.

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Recent Sales of Unregistered Securities

None.

Issuer Purchases of Equity Securities

None.

ITEM 6. SELECTED FINANCIAL DATA

The selected consolidated financial data set forth below should be read in conjunction with “Management’s Discussion and Analysis of Financial Condition and Results of Operations” and the consolidated financial statements and related notes included elsewhere in this Form 10-K.

	Years Ended
	December 31, 2005			January 1, 2005		January 3, 2004(b)			December 28, 2002			December 29, 2001(a)
	(in thousands, except per share data)
Consolidated Statement of Operations Data:
Net revenues:
Products	$	61,012		$	62,147	$	34,592		$	28,669		$	42,653
Service		9,531			7,784		7,010			6,054			4,931
Total net revenues		70,543			69,931		41,602			34,723			47,584
Costs and expenses:
Cost of products		29,173			27,812		17,691			13,237			17,949
Cost of service		10,695			8,404		6,620			5,765			5,406
Research and development		12,533			12,827		13,399			13,765			10,760
Selling		10,945			11,748		11,496			10,862			9,523
General and administrative		11,882			5,137		4,689			5,104			4,177
Merger termination fee		(8,300	)		—		—			—			—
Asset impairment		2,232			—		—			1,077			—
Total costs and expenses		69,160			65,928		53,895			49,810			47,815
Income (loss) from operations		1,383			4,003		(12,293	)		(15,087	)		(231	)
Other income, net		346			122		686			589			1,973
Provision (benefit) for income taxes		218			426		5,860	(c)		(6,230	)		782
Net income (loss)	$	1,511		$	3,699	$	(17,467	)	$	(8,268	)	$	960
Basic net income (loss) per share	$	0.12		$	0.30	$	(1.45	)	$	(0.70	)	$	0.08
Diluted net income (loss) per share	$	0.11		$	0.28	$	(1.45	)	$	(0.70	)	$	0.08
Shares used in per share computation:
Basic		12,760			12,320		12,043			11,878			11,691
Diluted		13,471			13,364		12,043			11,878			12,161

(a) We adopted Statement of Financial Accounting Standards No. 142 “Goodwill and Other Intangible Assets” (SFAS 142), effective January 1, 2002. Included in the net income for the year ended December 29, 2001 was $68 for amortization of goodwill, net of tax.

(b) The fiscal year ended January 3, 2004 included 53 weeks, whereas the other periods presented included 52 weeks.

(c) The income tax provision for the fiscal year ended January 3, 2004 primarily represents a charge of $6,020 to record a valuation allowance against deferred income tax assets.

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	At
	December 31, 2005		January 1, 2005		January 3, 2004		December 28, 2002		December 29, 2001
	(in thousands)
Consolidated Balance Sheet Data:
Cash, cash equivalents and short-term investments	$	45,394	$	33,868	$	29,892	$	36,866	$	47,227
Working capital		76,731		68,588		59,587		74,776		80,171
Total assets		136,300		133,769		121,740		134,688		142,355
Long-term liabilities including current portion		1,796		4,164		4,350		4,761		3,942
Total shareholders’ equity		120,343		116,829		108,441		124,106		129,845

ITEM 7. MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS

The following Management’s Discussion and Analysis of Financial Condition and Results of Operations should be read in conjunction with our consolidated financial statements and the notes thereto included elsewhere in this Annual Report on Form 10-K. Our discussion contains forward-looking statements based upon current expectations that involve risks and uncertainties, such as our plans, objectives and intentions. In some cases, forward-looking statements can be identified by words such as “believe,” “expect,” “anticipate,” “plan,” “potential,” “continue” or similar expressions. Our actual results could differ materially from those anticipated in these forward-looking statements as a result of certain risk factors, including those set forth in Item 1A “Risk Factors” and elsewhere in this Annual Report on Form 10-K. We believe it is important to communicate our expectations to our investors. However, there may be events in the future that we are not able to predict accurately or over which we have no control. You should be aware that the occurrence of the events described in these risk factors and elsewhere in this Form 10-K could materially and adversely affect our business, operating results and financial condition. We disclaim any obligation to update information contained in any forward-looking statement.

Overview

We are an innovator in the field of metrology systems for the semiconductor manufacturing industries. Our systems are designed to precisely monitor film thickness and critical dimensions that are necessary to control the manufacturing process and provide increased production yields and performance.

Capital expenditures by manufacturers of semiconductors, especially in Asia, and their suppliers are critical to our success. The demand by these manufacturers and suppliers is driven by the expected market demand for new products and new applications. The increasing complexity of the 300mm manufacturing processes for semiconductors is an important factor in the demand for our innovative metrology systems. The incorporation of smaller features sizes, copper interconnect technology and optical critical dimension technology are expected to result in increased demand. Our strategy is to continue to innovate organically as well to evaluate strategic acquisitions in order to address business challenges and opportunities.

Our revenues are primarily derived from product sales, which includes sales of accessories, but also from customer service for the installed base of our products. In 2005, we derived 86.5% of our total net revenues from product sales and 13.5% of our total net revenues from services.

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Important Themes and Significant Trends

The semiconductor equipment industry is characterized by cyclical growth. Recently, the industry emerged from an exceptionally long, cyclical downturn. Changing trends in the semiconductor industry is increasing the need for metrology as a major component of manufacturing systems. These trends include:

• Conversion to 300mm Wafer Size.    Semiconductor manufacturers are converting to 300mm wafers to achieve better production efficiencies. Most facilities are incorporating this wafer size, and our newest products are well-positioned to serve these facilities. It is important that we are successful in product evaluations with these new 300mm facilities in order to continue to gain market share.

• Incorporation of Optical Critical Dimension Metrology in the Patterning Process.    Our customers use phototlithographic processes to create patterns on wafers. Critical dimensions must be carefully controlled during this process. Our proprietary optical critical dimension systems can provide the critical process control of these circuit dimensions that is necessary for successful manufacturing of these state of the art devices.

• Copper Interconnect Technology.    The need for ever increasing device circuit speed coupled with lower power consumption has pushed semiconductor device manufacturers to begin the replacement of the subtractive aluminum interconnect process with copper damascene technology. This new copper processing technology has driven the need for new metrology techniques such as non-destructive laser profiling and the use of optical critical dimension (OCD) technology for control of the copper process.

• Incorporation of 65nm and 45nm Feature Sizes.    In an effort to reduce costs and increase device performance, semiconductor manufacturers are decreasing both the dye size and feature size. Monitoring the increased tolerance requirements on smaller features sizes requires increased use of metrology systems. Our thin film and critical dimension metrology systems are well suited and are being adopted for these next generation processes.

• Reduced Number of Customers.    Because of the escalating cost of 300mm manufacturing facilities, fewer semiconductor manufacturers can afford the significant investment in these next generation facilities. Therefore, fewer opportunities for semiconductors equipment companies exist. Given that the available number of potential customers is decreasing, pre-existing customer relationships, product positioning and critical mass take on greater importance.

• Adoption of New Types of Thin Film Materials.    Manufacturers are adopting new processes and technologies that increase the importance and utilization of thin film metrology systems. To achieve greater semiconductor device speed, manufacturers are utilizing copper and new, low dielectric constant (low k) insulating materials. Our advanced metrology solutions are required in the manufacturing process to characterize these materials.

• Need for Improved Process Control to Drive Process Efficiencies.    Competitive forces influencing semiconductor device manufacturers, such as price-cutting and shorter product life cycles, place pressure on manufacturers to rapidly achieve production efficiency. Device manufacturers are using our integrated and standalone metrology systems throughout the fab to ensure that manufacturing processes scale rapidly, are accurate and can be repeated on a consistent basis.

Critical Accounting Policies

The preparation of our financial statements conforms with accounting principles generally accepted in the United States of America, which requires management to make estimates and judgments in applying our accounting policies that have an important impact on our reported amounts of assets, liabilities, revenue, expenses and related disclosures at the date of our financial statements. On an on-going basis, management evaluates its estimates including those related to bad debts, inventory valuations, warranty obligations and income taxes. Management bases its estimates and judgments on historical experience and on various other factors that are believed to be reasonable under the circumstances, the results of which form the basis for making

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judgments about the carrying values of assets and liabilities that are not readily apparent from other sources. Actual results may differ from management’s estimates. We believe that the application of the following accounting policies requires significant judgments and estimates on the part of management. For a summary of all of our accounting policies, including those discussed below, see Note 1 to the Consolidated Financial Statements.

Revenue Recognition – We recognize revenue when persuasive evidence of an arrangement exists, delivery has occurred or services have been rendered, the sales price is fixed or determinable, and collectibility is reasonably assured. Product revenue includes hardware and also software that is incidental to the products. For product sales to existing customers, revenue recognition generally occurs at the time of shipment, as our terms are FOB shipping point, if we have met defined customer acceptance experience levels with both the customer and the specific type of equipment. All other product revenue is recognized upon customer acceptance including deemed acceptances. In Japan, where risk of loss and title transfers to the customer upon customer technical acceptance, revenue is recognized upon customer technical acceptance.

All of our products are assembled prior to shipment to our customers. We often perform limited installation for our customers; however such installation is inconsequential and perfunctory as it is also performed by third parties. Revenue related to spare parts sales is recognized generally upon shipment and is included as part of service revenue. Service revenue also includes service contracts and non-warranty, billable repairs of systems. Whereas service revenue related to service contracts is recognized ratably over the period under contract, service revenue related to billable repairs of systems is recognized as services are performed. On occasion, customers request a warranty period longer than our standard 12 month warranty. In those instances where extended warranty services are separately quoted to the customer, we follow the guidance of Financial Accounting Standards Board Technical Bulletin 90-1, “Accounting for Separately Priced Extended Warranty and Product Maintenance Contracts,” associated revenue is deferred and recognized to income ratably over the term of the contract. Unearned maintenance and service contract revenue is included in deferred revenue. Furthermore, generally we do not provide our customers with any return rights. Service contracts may be purchased by the customer when the warranty period expires.

In limited situations we have multiple deliverables in our customer arrangements. Those situations arise with the sale of repair services and parts together. Revenues on such sales are recognized when both the services and parts have been delivered. We also provide technical support to our customers as part of our warranty program. Upon recognition of product revenue, a liability is recorded for anticipated warranty costs.

Allowance for Doubtful Accounts – We maintain allowances for estimated losses resulting from the inability of our customers to make required payments. Credit limits are established through a process of reviewing the financial history and stability of our customers. Where appropriate and available, we obtain credit rating reports and financial statements of customers when determining or modifying their credit limits. We regularly evaluate the collectibility of our trade receivable balances based on a combination of factors such as the length of time the receivables are past due, customary payment practices in the respective geographies and our historical collection experience with customers. We believe that our allowance for doubtful accounts reflects our risk associated with smaller rather than larger customers and that our reported allowances are adequate. If however, the financial conditions of customers were to deteriorate, resulting in their inability to make payments, we may need to record additional allowances which would result in additional general and administrative expenses being recorded for the period in which such determination was made.

Inventories – We are exposed to a number of economic and industry factors that could result in portions of our inventory becoming either obsolete or in excess of anticipated usage, or saleable only for amounts that are less than their carrying amounts. These factors include, but are not limited to, technological changes in our market, our ability to meet changing customer requirements, competitive pressures in products and prices, and the availability of key components from our suppliers. We have established inventory reserves when conditions exist that suggest that our inventory may be in excess of anticipated demand or is obsolete based upon our

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assumptions about future demand for our products and market conditions. We regularly evaluate our ability to realize the value of our inventory based on a combination of factors including the following: historical usage rates, forecasted sales of usage, product end-of-life dates, estimated current and future market values and new product introductions. For demonstration inventory, we also consider the age of the inventory and potential cost to refurbish the inventory prior to sale. When recorded, our reserves are intended to reduce the carrying value of our inventory to its net realizable value. If actual demand for our products deteriorates, or market conditions are less favorable than those that we project, additional reserves may be required. Inventories are stated at the lower of cost, using the first-in, first-out method, or market value.

Product Warranties – We sell the majority of our products with a twelve month repair or replacement warranty from the date of acceptance which generally represents the date of shipment. We provide an accrual for estimated future warranty costs based upon the historical relationship of warranty costs to the cost of products sold. The estimated future warranty obligations related to product sales are reported in the period in which the related revenue is recognized. The estimated future warranty obligations are affected by the warranty periods, sales volumes, product failure rates, material usage, labor and replacement costs incurred in correcting a product failure. If actual product failure rates, material usage, labor or replacement costs differ from our estimates, revisions to the estimated warranty obligations would be required. For new product introductions where limited or no historical information exists, we may use warranty information from other previous product introductions to guide us in estimating our warranty accrual. The warranty accrual represents the best estimate of the amount necessary to settle future and existing claims on products sold as of the balance sheet date. We periodically assess the adequacy of our recorded warranty reserve and adjust the amounts in accordance with changes in these factors.

Income Tax Assets and Liabilities – We account for income taxes based on Statement of Financial Accounting Standards (SFAS) No. 109 Accounting for Income Taxes, whereby deferred tax assets and liabilities must be recognized using enacted tax rates for the effect of temporary differences between the book and tax accounting for assets and liabilities. Also, deferred tax assets must be reduced by a valuation allowance if it is more likely than not that a portion of the deferred tax asset will not be realized in the future. We evaluate the deferred tax assets on a quarterly basis to determine whether or not a valuation allowance is appropriate. Factors used in this determination include future expected income and the underlying asset or liability which generated the temporary tax difference. Our income tax provision is primarily impacted by federal statutory rates, state and foreign income taxes and changes in our valuation allowance.

Stock-Based Compensation – We currently account for stock-based compensation issued to employees using the intrinsic value method in accordance with the provisions of Accounting Principles Board Opinion No. 25, Accounting for Stock Issued to Employees, as allowed by SFAS No. 123, Accounting for Stock Based Compensation as amended by SFAS No. 148, Accounting for Stock Based Compensation—Transition and Disclosures, an Amendment of FASB Statement No. 123. Under the intrinsic value method, we do not recognize any compensation expense, as the exercise price of all stock options is equal to the fair market value at the time the options are granted. We disclose the pro forma effect of recognizing compensation expense on stock options granted to employees in the footnotes to the consolidated financial statements. These pro forma effects are based on the fair value of the options using the Black-Scholes valuation model using assumptions which are based on our historical experience.

Our accounting treatment of stock options will significantly change in the first quarter of 2006 due to our planned adoption of SFAS No. 123R (SFAS 123(R)), Share-Based Payment, which is effective for fiscal years beginning after June 15, 2005. See Recent Accounting Pronouncements and Note 9 below for more information.

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Results of Operations

The following table presents our consolidated statements of operations data as a percentage of total net revenues for the years ended December 31, 2005, January 1, 2005, and January 3, 2004.

	Years Ended
	December 31, 2005		January 1, 2005		January 3, 2004
Net revenues:
Products	86.5	%	88.9	%	83.1	%
Service	13.5		11.1		16.9
Total net revenues	100.0		100.0		100.0
Cost and expenses:
Cost of products	41.4		39.8		42.5
Cost of service	15.2		12.0		15.9
Research and development	17.8		18.3		32.2
Selling	15.5		16.8		27.6
General and administrative	16.8		7.4		11.3
Merger termination fee	(11.8	)	—		—
Asset impairment	3.2		—		—
Total cost and expenses	98.0		94.3		129.5
Income (loss) from operations	2.0		5.7		(29.5	)
Other income (expense):
Interest income	1.4		0.4		1.0
Interest expense	(0.1	)	(0.1	)	(0.2	)
Other, net	(0.8	)	(0.1	)	0.9
Total other income, net	0.5		0.2		1.6
Income (loss) before provision for income taxes	2.5		5.9		(27.9	)
Provision for income taxes	0.3		0.6		14.1
Net income (loss)	2.1	%	5.3	%	(42.0	)%

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Years ended December 31, 2005, January 1, 2005, and January 3, 2004

Total net revenues.    Our net revenues were comprised of the following categories:

	Years Ended				Percentage Change
	December 31, 2005		January 1, 2005
Automated systems	$	34,270	$	38,100	(10.1	%)
Integrated systems		23,151		21,602	7.2
Tabletop systems		3,591		2,445	46.9
Service		9,531		7,784	22.4
Total net revenues	$	70,543	$	69,931	0.9
	Years Ended				Percentage Change
	January 1, 2005		January 3, 2004
Automated systems	$	38,100	$	25,620	48.7	%
Integrated systems		21,602		6,106	253.8
Tabletop systems		2,445		2,866	(14.7	)
Service		7,784		7,010	11.0
Total net revenues	$	69,931	$	41,602	68.1

In 2005, total net revenues increased slightly to $70.5 million from $69.9 million in 2004. Net revenues from automated systems decreased by 10.1% primarily due to decreased sales of our flat panel display, or FPD, products of approximately $7 million from 2004 (see “Sale of Flat Panel Display Business Unit”, below). Decreases in FPD revenues were offset by increases in other automated stand alone systems, particularly our Atlas automated metrology product as our customers continue to expand their capacity for 300mm production. Revenue from integrated systems increased by 7.2% from their 2004 level, primarily due to increased penetration in the Japanese market for our integrated metrology systems through our OEM relationship with Ebara. The increase in product revenues resulted from greater demand for semiconductor process control metrology equipment, particularly in the U.S. and Asia. We believe that this increased demand was attributable primarily to customers adding capacity in semiconductor production facilities as demand for semiconductors increased as a result of continuing favorable economic conditions in the U.S. and Asia in 2005.

Service revenue increased 22.4% to $9.5 million in 2005 from $7.8 million in 2004. The increase in service revenue was primarily attributable to higher sales of parts and services in the U.S. and Asia in 2005, which we believe was due to a growing installed base of systems that have passed their warranty periods. The weakening of the Japanese yen during the year reduced 2005 revenues by approximately $0.5 million.

In 2004, revenue from automated systems increased by 48.7% and integrated system revenue increased by 253.8% from their 2003 levels, primarily due to higher volume sales for each product group. The higher volume of sales for each product group is primarily due to our 300 mm products, such as the Atlas automated metrology

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product and 9010 integrated metrology system. The increase in product revenue resulted from greater demand for semiconductor process control metrology equipment and flat panel display equipment, particularly in the U.S. and Asia. We believe that this increased demand was attributable primarily to customers adding capacity in semiconductor production facilities as demand for semiconductors increased as a result of the continuing economic recoveries in the U.S. and Japan in 2004. Service revenue increased 11.0% from $7.0 million in 2003 to $7.8 million in 2004. The increase in service revenue was primarily attributable to higher sales of parts and services in the U.S. and Asia in 2004, which we believe is due to a growing installed base of systems that have passed their warranty periods. The strengthening of the Japanese yen accounted for approximately $1.4 million of total net revenues in 2004.

Cost of products.    Cost of product sales as a percentage of product sales increased to 47.8% in 2005 from 44.8% in 2004 due primarily to the decline in profitability of our FPD products (see “Sale of Flat Panel Display Business Unit”, below) and to a lesser extent, a higher provision for obsolete inventory as compared to the prior year. Cost of products as a percentage of product revenue decreased to 44.8% in 2004 from 51.1% in 2003 due primarily to increased product sales volume in 2004 resulting in lower per unit manufacturing costs. The decrease in cost of products as a percentage of product revenue in 2004 was partially offset by a write down of $0.8 million in slower moving inventory in 2004 based on our estimate that future forecasted sales for certain product lines had permanently declined. The warranty accrual at January 1, 2005 was $1.1 million, an increase of 106% compared to the same period in 2003. This increase resulted primarily from increased sales volume and the associated warranty costs.

Cost of service.    Cost of service as a percentage of service revenue increased slightly to 112.2% in 2005 from 108.0% in 2004 primarily as a result of higher customer service levels from our growing customer base, particularly in Asia. Cost of service as a percentage of service revenue increased from 94.4% in 2003 to 108.0% in 2004 primarily as a result of higher service costs from an increase in headcount and related overhead to provide additional support for our growing customer base, particularly in Asia. We could not fully recoup these costs in either year due to higher service demands from our customer base.

Research and development.    Research and development expenses were essentially flat with a slight decrease of 2.3% to $12.5 million in 2005 from $12.8 million in 2004. The decrease was primarily due to a research grant received from the Korean of $0.3 million and reflective of our cost cutting initiatives undertaken in the fourth quarter of 2005 including the sale of our FPD business unit in Japan. Research and development expenses decreased 4.3% from $13.4 million in 2003 to $12.8 million in 2004 primarily from lower materials expenses in 2004 resulting from cost cutting measures in the first half of the year. In the United States, our research and development efforts are focused on semiconductor metrology. In South Korea, our research and development efforts are focused on the overlay metrology. In Japan, our research and development efforts are focused on tabletop metrology. We are committed to the development of new and enhanced products and believe that new product introductions are required for us to maintain a competitive position. We expect research and development expenses to remain at current levels for the immediate future.

Selling.    Selling expenses decreased 6.8% to $10.9 million in 2005 from $11.7 million in 2004 primarily due to headcount reductions in sales and personnel-related expenses. Selling expenses increased slightly to $11.7 million in 2004 as compared to $11.5 million in 2003. The increase in selling expenses was due to higher sales commissions in 2004 over 2003 levels as a result of higher sales volume in 2004. This increase in 2004 was partially offset by the redeployment of some resources into service support, which resulted in a decrease of about 49.0% of our selling expenses in Japan.

General and administrative.    General and administrative expenses increased 131.3% to $11.9 million in 2005 from $5.1 million in 2004 as a result of professional services associated with compliance with regulatory requirements under the Sarbanes Oxley Act, legal expenses related to our ongoing patent infringement lawsuits, increased headcount as we have expanded and enhanced our finance function and expenses associated with the restatement of our financial results for 2004 and the first two quarters of 2005. General and administrative

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expenses increased 9.6% from $4.7 million in 2003 to $5.1 million in 2004 due in part to higher regulatory expenses.

Merger termination fee.    On January 21, 2005, we entered into a definitive merger agreement with August Technology Corporation. On June 28, 2005, we and August Technology Corporation announced the termination of the merger agreement. On that date, in accordance with the terms of the merger agreement, August Technology paid us a merger termination fee of $8.3 million and also paid us $2.6 million as reimbursement of our expenses associated with the merger agreement which we had capitalized in the first and second quarters of 2005.

Asset impairment.    In 2005, we recorded an asset impairment charge of $2.2 million related to certain assets in our FPD business unit. Under SFAS No. 144, Accounting for the Impairment or Disposal of Long-Lived Assets, we should assess the recoverability of assets when events become known which would indicate potential impairment. We evaluated the estimated future cash flows of certain asset groups in our FPD business unit and determined the undiscounted estimated future cash flows would be insufficient to recover the carrying value of those assets. The impairment charge was measured based on the excess carrying value of the asset groups in excess of the associated discounted future cash flows. Accordingly, we recorded an asset impairment charge during the second quarter of 2005.

Total other income, net.    Total other income, net, which primarily consists of interest income, interest expense and foreign currency transaction gains/losses, increased 183.6% to $346,000 in 2005 from $122,000 in 2004 primarily due to higher yields on cash investments and, to a lesser extent, higher cash investment balances. The increase in interest income was offset by higher currency transaction losses, primarily due to the weakening Japanese yen. Total other income decreased 82.2% from $686,000 in 2003 to $122,000 in 2004 primarily due to foreign currency transaction losses as well as lower interest income in 2004.

Provision for income taxes.    Our effective tax rate was 12.6%, 10.3% and 50.5% in 2005, 2004 and 2003 respectively. Our income tax expense in 2005 and 2004 was primarily a result of foreign income taxes as our U.S. federal income taxes were primarily offset by a reduction in deferred tax asset valuation allowances. The tax expense in 2003 resulted from a provision for income taxes of $6.0 million which primarily represented a charge to record a valuation allowance against deferred income tax assets. The charge was taken as a result of pretax losses incurred over the past several quarters coupled with uncertainty about future expected income in the then-existing market environment, making it more likely than not at that time that the deferred tax asset would not be realized. In the future, we will continue to review our expectations for future taxable income to determine the amount of valuation allowance necessary to reserve against deferred tax assets.

Sale of Flat Panel Display Business Unit

During 2005, our FPD business unit experienced a significant decline in net revenues and related gross profit as other competitors entered the market for these products. For 2005, flat panel sales declined to approximately $2 million, and less than 10% gross margin, from approximately $9 million of sales and gross margins of approximately 45% for the corresponding prior year. Because of the expected continued decline in profitability, we decided to exit this market.

In September 2005, we entered into an agreement to sell our FPD business unit to Toho Technology Corporation, or Toho, effective October 2005. Toho received a non-exclusive perpetual license to use and sell our Film Thickness Measurements Systems in the flat panel market in exchange for $1.5 million. In addition, Toho will pay us a 7% royalty on future sales in excess of ¥800 million. Toho also purchased certain other existing assets from us including $0.9 million of inventory and $0.1 million of equipment related to the FPD business unit. We did not recognize a gain or loss on this transaction as we had previously evaluated the estimated future cash flows of the FPD asset group and determined the undiscounted estimated future cash flows would be insufficient to recover the carrying value of those assets and we recorded an impairment charge in the second quarter of fiscal 2005 (see “Asset impairment” above).

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We have also agreed with Toho to continue to provide sales efforts for FPD products and maintenance service for installed units in certain Asian countries. We will receive a commission from Toho on their future sales of FPD products in certain designated countries. As a result of the sale of the FPD business unit, we do not expect this revenue will be replaced except to the extent that we receive future sales commissions from Toho. We expect the sale of the FPD business unit to have an accretive effect to future operating results and cash flows.

Liquidity and Capital Resources

At December 31, 2005, our cash, cash equivalents and short-term investments totaled $45.4 million compared to $33.9 million at January 1, 2005 and $29.9 million at January 3, 2004. The short-term investments consist of U.S. Treasury Bills. Our working capital of $76.7 million at December 31, 2005 increased from $68.6 million at January 1, 2005 and $59.6 million at January 3, 2004.

Operating activities provided net cash of $7.2 million in 2005. This source of cash in 2005 resulted primarily from net income, including the merger termination fee of $8.3 million, and non-cash charges for depreciation and amortization, asset impairment and a decrease in accounts receivable. The decrease in accounts receivable was due to lower sales in the fourth quarter of 2005 as compared to the fourth quarter of 2004. Operating activities provided net cash of $2.1 million in 2004. This source of cash in 2004 resulted primarily from net income and non-cash charges for depreciation and amortization and higher levels of current liabilities. These sources of cash were offset to a large extent by higher accounts receivable resulting from our revenue increase of 68.1% in 2004. The increase in accounts receivable was due to the higher concentration of revenue in the third and fourth quarters of 2004 as compared to 2003.

Investing activities provided net cash of $14.3 million in 2005, $3.2 million in 2004 and $6.0 million in 2003. The timing of purchases and the initial maturities of U.S. Treasury Bills result in their classification as cash and cash equivalents or short-term investments. The increase in cash from investing activities was primarily attributable to a net reduction in the maturities of our U.S. Treasury Bills such that they were classified as cash equivalents at December 31, 2005. Our capital expenditures were $0.3 million, $0.9 million and $1.0 million in 2005, 2004 and 2003, respectively. These expenditures in 2003 were used primarily to continue the process of internalizing our manufacturing capacity in the United States through, for example, the purchase of a machine shop, machining equipment and improvements to our building. This internalization process was completed in the first quarter of 2004 and as a result capital expenditures decreased in subsequent periods.

Financing activities provided net cash of $3.1 million in 2005, $2.3 million in 2004 and $0.7 million in 2003 primarily resulting from the sale of shares under our stock option plans, offset to some extent by the net repayment of debt obligations by our Japanese subsidiary.

We have evaluated and will continue to evaluate the acquisition of products, technologies or businesses that are complementary to our business. These activities may result in product and business investments, which may affect our cash position and working capital balances. Some of these activities might require significant cash outlays. However, we believe that our working capital, including cash, cash equivalents and short term investments, will be sufficient to meet our needs at least through the next twelve months.

Due to the cyclical nature of our business, we may seek outside financing opportunistically in the future. We believe our existing working capital, together with expected cash flows from operations and available sources of bank, equity and equipment financing, will be sufficient to support our operations in the future. On January 25, 2006, we entered into a definitive merger agreement with Accent Optical Technologies (“Accent”). We have agreed to loan Accent an aggregate of $2.5 million to fund its operating activities between the signing of the merger agreement and closing , which is expected to occur by the end of the second quarter of fiscal 2006, subject to customary closing conditions. As of March 22, 2006, we have advanced a total of $750,000 to Accent under this agreement. In addition, if the merger is consummated, it may result in cash outflows related to integration activities. Estimates of these outflows are not currently known. Our management and the management

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of Accent are in the process of making these assessments. Notwithstanding the cash outflows that may result from integrating the two companies, we believe the merger, if consummated, will enhance our liquidity and capital resources.

Contractual obligations

The following table summarizes our contractual cash obligations as of December 31, 2005, and the effect such obligations are expected to have on liquidity and cash flow in future periods (in thousands):

	Total		Payments due by period
			Less than 1 Year		1-3 Years		3-5 Years		More than 5 Years
Debt obligations(1)	$	1,796	$	400	$	705	$	691	$	—
Revolving line of credit		1,186		1,186		—		—		—
Operating lease obligations		697		354		196		142		5

(1) Our debt obligations primarily relate to the expansion of our Japanese facilities and do not include interest, which we are obligated to pay.

We maintain certain open inventory purchase commitments with our suppliers to ensure a smooth and continuous supply chain for key components. Our liability in these purchase commitments is generally restricted to a forecasted time-horizon as mutually agreed upon between the parties. This forecast time-horizon can vary among different suppliers. We estimate our open inventory purchase commitment as of December 31, 2005 was approximately $1.4 million. Actual expenditures will vary based upon the volume of the transactions and length of contractual service provided. In addition, the amounts paid under these arrangements may be less in the event that the arrangements are renegotiated or cancelled. Certain agreements provide for potential cancellation penalties.

We have no off-balance sheet financing arrangements.

Recent Accounting Pronouncements

In November 2004, the FASB issued SFAS No. 151, “Inventory Costs, An Amendment of ARB No. 43, Chapter 4.” This Statement amends ARB No. 43, Chapter 4, to clarify that abnormal amount of idle facility, freight, handling costs, and wasted materials (spoilage) should be recognized as current-period charges. In addition, SFAS No. 151 requires that allocation of fixed production overheads to the costs of conversion be based on the normal capacity of the production facilities. SFAS No. 151 is effective for inventory costs incurred during fiscal years beginning after June 15, 2005. Earlier application is permitted for inventory costs incurred during fiscal years beginning after November 23, 2004. The provisions of SFAS No. 151 should be applied prospectively. We do not believe that the adoption of SFAS No. 151 will have a material impact on our financial position or results of operations.

In December 2004, the Financial Accounting Standards Board (“FASB”) issued Statement of Financial Accounting Standards (“SFAS”) No. 123(R), “Share-Based Payment”, (“SFAS No. 123(R)”). This statement replaces SFAS No. 123, “Accounting for Stock-Based Compensation”, amends SFAS No. 95, “Statement of Cash Flows” and supersedes Accounting Principles Board (“APB”) Opinion No. 25 “Accounting for Stock Issued to Employees” (“APB No. 25”). SFAS No. 123(R) requires companies to apply a fair-value based measurement method in accounting for share-based payment transactions with employees and to record compensation expense for all stock awards granted, and to awards modified, repurchased or cancelled after the required effective date. In addition, we are required to record compensation expense (as previous awards continue to vest) for the unvested portion of previously granted awards that remain outstanding at the date of adoption. SFAS No. 123(R) will be effective for our fiscal year 2006, and requires one of two transition methods to be applied. We are in the process of determining which transition method we will apply. SFAS No. 123(R) will have a significant impact on our results of operations as we will be required to record compensation expense

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rather than disclose the impact on our results of operations within our footnotes (Please see our disclosure under Footnote 1 to our Consolidated Financial Statements addressing stock-based compensation).

In March 2005, the SEC staff issued guidance on SFAS No. 123(R). Staff Accounting Bulletin (“SAB”) No. 107 (“SAB No. 107”) was issued to assist preparers by simplifying some of the implementation challenges of SFAS No. 123(R) while enhancing the information that investors receive. SAB No. 107 creates a framework that is premised on two overarching themes: (a) considerable judgment will be required by preparers to successfully implement SFAS No. 123(R), specifically when valuing employee stock options; and (b) reasonable individuals, acting in good faith, may draw different conclusions regarding the fair value of employee stock options. Key topics covered by SAB No. 107 include: (a) valuation models – SAB No. 107 reinforces the flexibility allowed by SFAS No. 123(R) to choose an option-pricing model that meets the standard’s fair value measurement objective; (b) expected volatility – SAB No. 107 provides guidance on when it would be appropriate to rely exclusively on either historical or implied volatility in estimating expected volatility; and (c) expected term – the new guidance includes examples and some simplified approaches to determining the expected term under certain circumstances. We will apply the principles of SAB No. 107 in conjunction with our adoption of SFAS No. 123(R).

In March 2005, the FASB issued Interpretation No. 47, “Accounting for Conditional Asset Retirement Obligations—an interpretation of FASB Statement No. 143” (“FIN 47”). FIN 47 clarifies that the term conditional asset retirement obligation as used in FASB Statement No. 143, “Accounting for Asset Retirement Obligations,” refers to a legal obligation to perform an asset retirement activity in which the timing and (or) method of settlement are conditional on a future event that may or may not be within the control of the entity. The obligation to perform the asset retirement activity is unconditional even though uncertainty exists about the timing and (or) method of settlement. Thus, the timing and (or) method of settlement may be conditional on a future event. Accordingly, an entity is required to recognize a liability for the fair value of a conditional asset retirement obligation if the fair value of the liability can be reasonably estimated. This Interpretation is effective no later than the end of fiscal years ending after December 15, 2005. The adoption of FIN 47 did not have a material impact on our financial position or results of operations.

In May 2005, the FASB issued SFAS No. 154, Accounting Changes and Error Corrections (“SFAS 154”) which replaces APB 20 Accounting Changes and SFAS No. 3, Reporting Accounting Changes in Interim Financial Statements—An Amendment of APB Opinion. 28. SFAS 154 provides guidance on the accounting for and reporting of accounting changes and error corrections. It establishes retrospective application, or the latest practicable date, as the required method for reporting a change in accounting principle and the reporting of a correction of an error. SFAS 154 is effective for accounting changes and corrections of errors made in fiscal years beginning after December 15, 2005 and is required to be adopted in the first fiscal quarter of 2006. We do not anticipate any impact on our consolidated results of operations and financial condition upon adoption of SFAS 154.

In September 2005, the Emerging Issues Task Force reached consensus on EITF Issue No. 04-13, “Accounting for Purchases and Sales of Inventory with the Same Counterparty” (“Issue No. 04-13). In certain situations, a company may enter into nonmonetary transactions to sell inventory to another company in the same line of business from which it also purchases inventory. Under Issue No. 04-13, in general, an entity is required to treat sales and purchases of inventory between the entity and the same counterparty as one transaction for purposes of applying APB Opinion No. 29, “Accounting for Nonmonetary Transactions” when such transactions are entered into in contemplation of each other. When such transactions are legally contingent on each other, they are considered to have been entered into in contemplation of each other. The EITF also agreed on other factors that should be considered in determining whether transactions have been entered into in contemplation of each other. Issue No. 04-13 will be effective for all new arrangements entered into in reporting periods beginning after March 15, 2006. We do not anticipate any impact on our consolidated results of operations and financial condition upon adoption of the provisions of Issue No. 04-13.

44

ITEM 7A. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK

We are exposed to financial market risks related to foreign currency exchange rates and interest rates. We do not use derivative financial instruments.

Foreign Currency Risk

A substantial part of our business consists of sales made to customers outside the United States: 66.7%, 71.8% and 74.8% of sales in 2005, 2004 and 2003, respectively. A portion of the net revenues we receive from such sales is denominated in currencies other than the U.S. dollar. Additionally, portions of our costs of net revenues and our other operating expenses are incurred by our international operations and denominated in local currencies. Foreign currency transactions resulted in a loss of $0.6 million, and $0.1 million in 2005 and 2004, respectively and a gain of $0.4 million in 2003. In addition, our exposure to foreign exchange rate fluctuations arises in part from current intercompany accounts in which costs (primarily product costs) from the United States are charged to our foreign sales subsidiaries. These intercompany accounts are typically denominated in U.S. Dollars and the net payable to the United States parent amounted to $2.5 million as of December 31, 2005. A hypothetical 10% change in the foreign currency exchange rate at December 31, 2005 would result in less than $0.3 million increase or decrease in transaction gains or losses which would be included in our net income.

In foreign locations we have approximately $3.5 million of net assets, including long-term loans payable to the United States parent, and, as a result, a hypothetical 10% change in the foreign currency exchange rate at December 31, 2005 would result in approximately $0.4 million increase or decrease in the net assets and a corresponding increase or decrease in other comprehensive income.

Interest Rate Risk

Our investments in marketable securities are subject to interest rate risk. However, due to the short-term nature of these investments, interest rate changes would not have a material impact on their value at December 31, 2005 and January 1, 2005. We also have fixed rate yen denominated debt obligations in Japan that have no interest rate risk. At December 31, 2005 and January 1, 2005, our total debt obligation was $1.8 million and $3.2 million, respectively, with a long-term portion of $1.4 million and $2.1 million, respectively. In addition, at December 31, 2005, we have borrowed $1.2 million at 1.5% under a revolving line of credit. A hypothetical 10% change in interest rates at December 31, 2005 would not have a material impact on our results of operations.

45

ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA

The information required by Item 8 of Form 10-K is presented here in the following order:

INDEX TO CONSOLIDATED FINANCIAL STATEMENTS

	Page
Report of BDO Seidman, LLP, Independent Registered Public Accounting Firm	47
Report of Deloitte & Touche LLP, Independent Registered Public Accounting Firm	48
Consolidated Balance Sheets	49
Consolidated Statements of Operations	50
Consolidated Statements of Shareholders’ Equity and Comprehensive Income (Loss)	51
Consolidated Statements of Cash Flows	52
Notes to Consolidated Financial Statements	53
Selected Quarterly Financial Results (Unaudited)	72

46

REPORT OF BDO SEIDMAN, LLP, INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM

Board of Directors and Shareholders

Nanometrics, Incorporated

Milpitas, CA

We have audited the accompanying consolidated balance sheets of Nanometrics, Incorporated as of December 31, 2005 and January 1, 2005 and the related consolidated statements of operations, stockholders’ equity and comprehensive income (loss), and cash flows for the years then ended. We have also audited the consolidated financial statement schedule listed in Item 15 for the years ended December 31, 2005 and January 1, 2005. These financial statements and the schedule 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 in accordance with the standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements, assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall presentation of the financial statements and the schedule. We believe that our audits provide a reasonable basis for our opinion.

In our opinion, the consolidated financial statements referred to above present fairly, in all material respects, the financial position of Nanometrics, Incorporated at December 31, 2005 and January 1, 2005, and the results of its operations and its cash flows for the years then ended, in conformity with accounting principles generally accepted in the United States of America. Also, in our opinion, such information for the years ended December 31, 2005 and January 1, 2005 included in the consolidated financial statement schedule, when considered in relation to the basic consolidated financial statements taken as a whole, presents fairly in all material respects the information set forth therein.

We also have audited, in accordance with the standards of the Public Company Accounting Oversight Board (United States), the effectiveness of Nanometrics, Incorporated internal control over financial reporting as of December 31, 2005, based on criteria established in Internal Control – Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission (COSO) and our report dated March 14, 2006 expressed an unqualified opinion on management’s assessment of the effectiveness of internal controls over financial reporting and an adverse opinion on the effectiveness of internal controls over financial reporting.

BDO Seidman, LLP

San Francisco, CA

March 14, 2006

47

REPORT OF DELOITTE & TOUCHE LLP, INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM

To the Board of Directors and Shareholders of Nanometrics Incorporated:

We have audited the accompanying consolidated statements of operations, shareholders’ equity and comprehensive income (loss), and cash flows for the year ended January 3, 2004 of Nanometrics Incorporated and subsidiaries (the “Company”). Our audit also included the consolidated financial statement schedule for the year ended January 3, 2004 listed in Item 15. These financial statements and the financial statement schedule are the responsibility of the Company’s management. Our responsibility is to express an opinion on these financial statements and financial statement schedule based on our audit.

We conducted our audit in accordance with the standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audit provides a reasonable basis for our opinion.

In our opinion, such consolidated financial statements present fairly, in all material respects, the Company’s results of operations and cash flows for the year ended January 3, 2004, in conformity with accounting principles generally accepted in the United States of America. Also, in our opinion, such financial statement schedule for the year ended January 3, 2004, when considered in relation to the basic consolidated financial statements taken as a whole, presents fairly in all material respects the information set forth therein.

Deloitte & Touche LLP

San Jose, California

March 29, 2004

48

NANOMETRICS INCORPORATED

CONSOLIDATED BALANCE SHEETS

(In thousands, except share amounts)

	December 31, 2005		January 1, 2005
ASSETS
Current assets:
Cash and cash equivalents	$	40,445	$	15,949
Short-term investments		4,949		17,919
Accounts receivable, net of allowances of $592 and $603, as of December 31, 2005 and January 1, 2005, respectively		18,983		22,222
Inventories		25,656		25,494
Prepaid expenses and other		1,259		944
Total current assets		91,292		82,528
Property, plant and equipment, net		42,928		49,035
Intangible assets		639		924
Other assets		1,441		1,282
Total assets	$	136,300	$	133,769
LIABILITIES AND SHAREHOLDERS’ EQUITY
Current liabilities:
Revolving line of credit	$	1,186	$	—
Accounts payable		3,348		3,146
Accrued payroll and related expenses		1,540		2,512
Deferred revenue		3,448		3,506
Other current liabilities		3,869		2,097
Income taxes payable		770		1,515
Current portion of debt obligations		400		1,164
Total current liabilities		14,561		13,940
Deferred income taxes and other long-term liabilities		—		930
Debt obligations		1,396		2,070
Total liabilities		15,957		16,940
Commitments and contingencies (See Note 8)
Shareholders’ equity:
Common stock, no par value; 50,000,000 shares authorized; 12,990,894 and 12,566,636 outstanding as of December 31, 2005 and January 1, 2005, respectively		107,294		104,191
Retained earnings		12,218		10,707
Accumulated other comprehensive income		831		1,931
Total shareholders’ equity		120,343		116,829
Total liabilities and shareholders’ equity	$	136,300	$	133,769

See notes to consolidated financial statements.

49

NANOMETRICS INCORPORATED

CONSOLIDATED STATEMENTS OF OPERATIONS

(In thousands, except per share amounts)

	Years Ended
	December 31, 2005			January 1, 2005			January 3, 2004
Net revenues:
Products	$	61,012		$	62,147		$	34,592
Service		9,531			7,784			7,010
Total net revenues		70,543			69,931			41,602
Costs and expenses:
Cost of products		29,173			27,812			17,691
Cost of service		10,695			8,404			6,620
Research and development		12,533			12,827			13,399
Selling		10,945			11,748			11,496
General and administrative		11,882			5,137			4,689
Merger termination fee		(8,300	)		—			—
Asset impairment and disposition		2,232			—			—
Total costs and expenses		69,160			65,928			53,895
Income (loss) from operations		1,383			4,003			(12,293	)
Other income (expense):
Interest income		998			276			397
Interest expense		(73	)		(110	)		(96	)
Other, net		(579	)		(44	)		385
Total other income, net		346			122			686
Income (loss) before income taxes		1,729			4,125			(11,607	)
Provision for income taxes		218			426			5,860
Net income (loss)	$	1,511		$	3,699		$	(17,467	)
Basic net income (loss) per share	$	0.12		$	0.30		$	(1.45	)
Diluted net income (loss) per share	$	0.11		$	0.28		$	(1.45	)
Shares used in per share computation:
Basic		12,760			12,320			12,043
Diluted		13,471			13,364			12,043

See notes to consolidated financial statements.

50

NANOMETRICS INCORPORATED

CONSOLIDATED STATEMENTS OF SHAREHOLDERS’ EQUITY AND COMPREHENSIVE INCOME (LOSS)

(In thousands, except share amounts)

	Common Stock			Retained Earnings			Accumulated Other Comprehensive Income (Loss)			Total Shareholders’ Equity			Comprehensive Income (Loss)
	Shares	Amount
Balances, December 28, 2002	12,006,641	$	99,911	$	24,475		$	(280	)	$	124,106
Comprehensive loss:
Net loss	—		—		(17,467	)		—			(17,467	)	$	(17,467	)
Other comprehensive income, net of tax:
Foreign currency translation adjustments	—		—		—			614			614			614
Comprehensive loss	—		—		—			—			—		$	(16,853	)
Issuance of common stock under stock option plans	159,375		1,188		—			—			1,188
Balances, January 3, 2004	12,166,016		101,099		7,008			334			108,441
Comprehensive income:
Net income	—		—		3,699			—			3,699		$	3,699
Other comprehensive income, net of tax:
Foreign currency translation adjustments	—		—		—			1,597			1,597			1,597
Comprehensive income	—		—		—			—			—		$	5,296
Issuance of common stock under employee stock purchase plan	59,332		620		—			—			620
Issuance of common stock under stock option plans	341,288		2,432		—			—			2,432
Tax benefit of employee stock transactions	—		40		—			—			40
Balances, January 1, 2005	12,566,636		104,191		10,707			1,931			116,829
Comprehensive income:
Net income	—		—		1,511			—			1,511		$	1,511
Other comprehensive income, net of tax:
Foreign currency translation adjustments	—		—		—			(1,100	)		(1,100	)		(1,100	)
Comprehensive income	—		—		—			—			—		$	411
Issuance of common stock under employee stock purchase plan	61,153		616		—			—			616
Issuance of common stock under stock option plans	363,105		2,331		—			—			2,331
Tax benefit of employee stock transactions	—		156		—			—			156
Balances, December 31, 2005	12,990,894	$	107,294	$	12,218		$	831		$	120,343

See notes to consolidated financial statements.

51

NANOMETRICS INCORPORATED

CONSOLIDATED STATEMENTS OF CASH FLOWS

(In thousands)

	Years Ended
	December 31, 2005			January 1, 2005			January 3, 2004
Cash flows from operating activities:
Net income (loss)	$	1,511		$	3,699		$	(17,467	)
Reconciliation of net income (loss) to net cash provided by (used in) operating activities:
Depreciation and amortization		2,437			2,667			2,506
Asset impairment		2,232			—			—
Gain on disposal of asset		(6	)		—			—
Deferred income taxes		—			—			6,007
Changes in assets and liabilities:
Accounts receivable		1,717			(7,124	)		(4,630	)
Inventories		(731	)		(598	)		2,042
Prepaid income taxes		—			—			2,195
Prepaid expenses and other current assets		(555	)		(48	)		155
Accounts payable, accrued and other current liabilities		1,138			2,399			794
Deferred revenue		63			1,089			778
Income taxes payable		(558	)		6			1,374
Net cash provided by (used in) operating activities		7,248			2,090			(6,246	)
Cash flows from investing activities:
Proceeds from sale of assets		1,603			—			—
Purchases of short-term investments		(50,030	)		(35,976	)		(71,044	)
Sales/maturities of short-term investments		63,000			40,000			78,000
Purchases of property, plant and equipment		(322	)		(871	)		(990	)
Other assets		—			—			28
Net cash provided by investing activities		14,251			3,153			5,994
Cash flows from financing activities:
Proceeds from issuance of debt obligations		1,789			2,473			285
Repayments of debt obligations		(1,625	)		(3,177	)		(818	)
Proceeds from issuance of common stock under employee stock purchase and stock option plans		2,947			3,052			1,188
Net cash provided by financing activities		3,111			2,348			655
Effect of exchange rate changes on cash		(114	)		409			(421	)
Net change in cash and cash equivalents		24,496			8,000			(18	)
Cash and cash equivalents, beginning of year		15,949			7,949			7,967
Cash and cash equivalents, end of year	$	40,445		$	15,949		$	7,949
Supplemental disclosure of cash flow information:
Cash paid for interest	$	70		$	102		$	96
Cash paid (received) for income taxes, net	$	1,061		$	327		$	(3,955	)

See notes to consolidated financial statements.

52

NANOMETRICS INCORPORATED

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

Years Ended December 31, 2005, January 1, 2005 and January 3, 2004

1.    Significant Accounting Policies

Description of Business – Nanometrics Incorporated (Nanometrics or the Company) and its wholly owned subsidiaries design, manufacture, market, sell and support thin film, optical critical dimension and overlay dimension metrology systems for customers in the semiconductor and, until October 2005, flat panel display industries (See Note 12 “Asset Impairment and Disposition”). These metrology systems precisely measure a wide range of film types deposited on substrates during manufacturing in order to control manufacturing processes and increase production yields in the fabrication of integrated circuits. The thin film metrology systems use a broad spectrum of wavelengths, high-sensitivity optics, proprietary software, and patented technology to measure the thickness and uniformity of films deposited on silicon and other substrates as well as their chemical composition. The Company’s optical critical dimension technology is a patented critical dimension measurement technology that is used to precisely determine the dimensions on the semiconductor wafer that directly control the resulting performance of the integrated circuit devices. The overlay metrology systems are used to measure the overlay accuracy of successive layers of semiconductor patterns on wafers in the photolithography process. The corporate headquarters of Nanometrics is located in Milpitas, California.

Basis of Presentation – The consolidated financial statements include Nanometrics Incorporated and its wholly-owned subsidiaries. All significant intercompany accounts and transactions have been eliminated in consolidation.

Use of Estimates – The preparation of financial statements in conformity with accounting principles generally accepted in the United States of America requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities at the date of the financial statements and the reported amounts of revenues and expenses during the reporting period. Actual results could differ from those estimates.

Foreign Currency Translation – The assets and liabilities of foreign subsidiaries are translated from their respective functional currencies at exchange rates in effect at the balance sheet date and income and expense accounts are translated at average exchange rates during the reporting period. Resulting translation adjustments are reflected in “Accumulated other comprehensive income,” a component of shareholders’ equity. Foreign currency transaction gains and losses are reflected in “Other income” in the consolidated statement of operations in the period incurred and consist of a loss of $0.6 million in 2005, a loss of $0.1 million in 2004 and a gain of $0.4 million in 2003.

Revenue Recognition – The Company recognizes revenue when persuasive evidence of an arrangement exists, delivery has occurred or services have been rendered, the seller’s price is fixed or determinable, and collectibility is reasonably assured. Product revenue includes hardware and software that is incidental to the products. For product sales to existing customers, revenue recognition generally occurs at the time of shipment, as the Company’s terms are FOB shipping point, if defined customer acceptance experience levels have previously been met with both the customer and the specific type of equipment. All other product revenues are recognized upon customer acceptance including deemed acceptance. In Japan, where risk of loss and title transfers to the customer upon customer technical acceptance, revenue is recognized upon customer technical acceptance.

All products are assembled prior to shipment to customers. The Company often performs limited installation for its customers, however, such installation is inconsequential and perfunctory as it is also performed by third parties. Revenue related to spare parts sales is recognized generally upon shipment and is included as part of

53

NANOMETRICS INCORPORATED

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS—(Continued)

Years Ended December 31, 2005, January 1, 2005 and January 3, 2004

service revenue. Service revenue also includes service contracts and non-warranty, billable repairs of systems. Whereas service revenue related to service contracts is recognized ratably over the period under contract, service revenue related to billable repairs of systems not under contract is recognized as services are performed. On occasion, customers request a warranty period longer than the Company’s standard 12 month warranty. In those instances where extended warranty services are separately quoted to the customer, the Company follows the guidance of Financial Accounting Standards Board Technical Bulletin 90-1, “Accounting for Separately Priced Extended Warranty and Product Maintenance Contracts,” associated revenue is deferred and recognized to income ratably over the term of the contract. Unearned maintenance and service contract revenue is included in deferred revenue. Furthermore, generally the Company does not provide its customers with any return rights. Service contracts may be purchased by the customer when the warranty period expires.

In limited situations, multiple deliverables may be included in customer arrangements. Those situations arise with the sale of repair services and parts together. Revenues on such sales are recognized when both the services and parts have been delivered. The Company also provides technical support to its customers as part of its warranty program. Upon recognition of product revenue, a liability is recorded for anticipated warranty costs.

Fiscal Year – The Company uses a 52/53 week fiscal year ending on the Saturday nearest to December 31. Accordingly, fiscal year 2005 consisted of 52 weeks and ended on December 31, 2005, fiscal year 2004 consisted of 52 weeks and ended on January 1, 2005 and fiscal year 2003 consisted of 53 weeks and ended on January 3, 2004.

Cash and Cash Equivalents – Cash and cash equivalents include cash and highly liquid debt instruments with original maturities of three months or less when purchased.

Short-Term Investments – Short-term investments consist of United States Treasury Bills which are stated at fair value based on quoted market prices. Short-term investments are classified as available-for-sale based on Nanometrics’ intended use. The cost of securities sold is based on the specific identification method. The unrealized gains and losses from short-term investments are included in other comprehensive income (loss). Realized gains and losses and declines in value judged to be other than temporary are included in other income or expense. Such amounts have not been material during any of the periods presented. All of the short-term investments have a contractual maturity of one year or less.

Fair Value of Financial Instruments – Financial instruments include cash and cash equivalents, short-term investments, accounts receivable, accounts payable and debt obligations. Cash equivalents and short-term investments are stated at fair market value based on quoted market prices. The carrying values of accounts receivable, accounts payable and short-term debt obligations approximate their fair values because of the short-term maturity of these financial instruments. For long-term debt obligations, because the interest rates on such debt are fixed and the interest rates for long-term rates have not fluctuated significantly, the carrying values of long-term debt obligations approximate their fair values.

Allowance for Doubtful Accounts – The Company maintains an allowance for estimated losses resulting from the inability of its customers to make required payments. Customer credit limits are established through a process of reviewing their financial history and stability. Where appropriate and available, the Company obtains credit rating reports and financial statements of customers when determining or modifying their credit limits. The Company regularly evaluates the collectibility of its trade receivable balances based on a combination of factors such as the length of time the receivables are past due, customary payment practices in the respective geographies and historical collection experience with customers. The Company believes that the allowance for

54

NANOMETRICS INCORPORATED

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS—(Continued)

Years Ended December 31, 2005, January 1, 2005 and January 3, 2004

doubtful accounts reflects the risk associated with smaller rather than larger customers and that reported allowances are adequate. If however, the financial conditions of customers were to deteriorate, resulting in their inability to make payments, the Company may need to record additional allowances which would result in additional general and administrative expenses being recorded for the period in which such determination was made.

Inventories – Inventories are stated at the lower of cost, using the first-in, first-out method, or market. The Company is exposed to a number of economic and industry factors that could result in portions of its inventory becoming either obsolete or in excess of anticipated usage, or saleable only for amounts that are less than their carrying amounts. These factors include, but are not limited to, technological changes in the market, Nanometrics’ ability to meet changing customer requirements, competitive pressures in products and prices, and the availability of key components from its suppliers. The Company has established inventory reserves when conditions exist that suggest that its inventory may be in excess of anticipated demand or is obsolete based upon assumptions about future demand for its products and market conditions. The Company regularly evaluates its ability to realize the value of its inventory based on a combination of factors including the following: historical usage rates, forecasted sales of usage, product end-of-life dates, estimated current and future market values and new product introductions. For demonstration inventory, the age of the inventory and potential cost to refurbish the inventory prior to sale is also considered. When recorded, reserves are intended to reduce the carrying value of the inventory to its net realizable value. If actual demand for specified products deteriorates, or market conditions are less favorable than those projected, additional reserves may be required.

Property, Plant and Equipment – Property, plant and equipment are stated at cost. Depreciation is computed over the following estimated useful lives of the assets:

Building and improvements	6–40 years
Machinery and equipment	3–17 years
Furniture and fixtures	5–20 years

Fixed assets are depreciated using the straight–line method except for machinery and equipment and furniture and fixtures located in Japan, which are depreciated using an accelerated method.

Intangible Assets – Intangible assets consist primarily of technology purchased from a third-party. This technology is used in the manufacturing of current products. Costs related to internally developed intangible assets are expensed as incurred. Acquired intangible assets are amortized using the straight-line method over estimated useful lives of five to seven years.

Goodwill – On January 1, 2002, Nanometrics adopted Statement of Financial Accounting Standards (“SFAS”) No. 142, Goodwill and Other Intangible Assets. This Statement eliminates the amortization of goodwill and requires that goodwill be reviewed at least annually for impairment. Nanometrics had no goodwill on its balance sheet at December 31, 2005 or January 1, 2005.

Impairment of Long-Lived Assets – Long-lived assets are reviewed for impairment whenever events or changes in circumstances indicate that the carrying amount of such assets may not be recoverable such as a significant industry or economic downturn, significant changes in the manner of use of the acquired assets or changes to the overall business strategies are made. If indicators of impairment exist, recoverability is assessed by comparing the estimated undiscounted cash flows resulting from the use of the asset, or asset group, and their eventual disposition against their carrying amounts. If the aggregate undiscounted cash flows are less than the

55

NANOMETRICS INCORPORATED

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS—(Continued)

Years Ended December 31, 2005, January 1, 2005 and January 3, 2004

carrying amount of the assets, the resulting impairment charge to be recorded is calculated based on the excess of the carrying value of the assets over the fair value of such assets, with fair value generally determined based on an estimate of discounted future cash flows.

Income Tax Assets and Liabilities – The Company accounts for income taxes based on SFAS No. 109 Accounting for Income Taxes, whereby deferred tax assets and liabilities must be recognized using enacted tax rates for the effect of temporary differences between the book and tax accounting for assets and liabilities. Also, deferred tax assets must be reduced by a valuation allowance if it is more likely than not that a portion of the deferred tax asset will not be realized in the future. The Company evaluates the deferred tax assets on an annual basis to determine whether or not a valuation allowance is appropriate. Factors used in this determination include future expected income and the underlying asset or liability which generated the temporary tax difference. The income tax provision is primarily impacted by federal statutory rates, state and foreign income taxes and changes in the valuation allowance.

Accumulated Other Comprehensive Income – Accumulated other comprehensive income consists of the following (in thousands):

	At
	December 31, 2005		January 1, 2005
Accumulated unrealized gains on available-for-sale securities, net	$	—	$	—
Accumulated translation adjustments, net of income taxes		831		1,931
Accumulated other comprehensive income	$	831	$	1,931

Product Warranties – The Company sells the majority of its products with a 12 month repair or replacement warranty from the date of acceptance which generally represents the date of shipment. The Company provides an accrual for estimated future warranty costs based upon the historical relationship of warranty costs to the cost of products sold. The estimated future warranty obligations related to product sales are recorded in the period in which the related revenue is recognized. The estimated future warranty obligations are affected by the warranty periods, sales volumes, product failure rates, material usage, labor and replacement costs incurred in correcting a product failure. If actual product failure rates, material usage, labor or replacement costs differ from the Company’s estimates, revisions to the estimated warranty obligations would be required. For new product introductions where limited or no historical information exists, the Company may use warranty information from other previous product introductions to guide it in estimating its warranty accrual. The warranty accrual represents the best estimate of the amount necessary to settle future and existing claims on products sold as of the balance sheet date. The Company periodically assesses the adequacy of its reported warranty reserve and adjusts the amounts in accordance with changes in these factors.

A reconciliation of the changes to the Company’s warranty accrual for 2005, 2004 and 2003 was as follows (in thousands):

	Years Ended
	December 31, 2005			January 1, 2005			January 3, 2004
Balance as of beginning of period	$	1,055		$	513		$	261
Actual warranty costs		(1,170	)		(869	)		(463	)
Provision for warranty		1,555			1,411			715
Balance as of end of period	$	1,440		$	1,055		$	513

56

NANOMETRICS INCORPORATED

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS—(Continued)

Years Ended December 31, 2005, January 1, 2005 and January 3, 2004

Guarantees – In addition to product warranties, from time to time, in the normal course of business, the Company indemnifies certain customers with whom it enters into a contractual relationship. The Company has agreed to hold the other party harmless against third party claims that its products, when used for their intended purpose(s), infringe the intellectual property rights of such third party or other claims made against certain parties. It is not possible to determine the maximum potential amount of liability under these indemnification obligations due to the limited history of prior indemnification claims and the unique facts and circumstances that are likely to be involved in each particular claim. Historically, the Company has not made payments under these obligations and believes the estimated fair value of these agreements is minimal. Accordingly, no liabilities have been recorded for these obligations on the balance sheets as of December 31, 2005 and January 1, 2005.

Shipping and Handling Costs – Shipping and handling costs are included as a component of cost of sales.

Advertising Costs – The Company expenses advertising costs as incurred.

Stock-Based Compensation – The Company currently accounts for stock-based employee compensation arrangements using the intrinsic value method in accordance with the provisions of Accounting Principles Board Opinion No. 25 (APB 25), Accounting for Stock Issued to Employees, and Financial Accounting Standards Board (FASB) Interpretation (FIN) No. 44, Accounting for Certain Transactions Involving Stock Compensation, and comply with the disclosure provisions of SFAS No. 123, Accounting for Stock-Based Compensation and SFAS No. 148, Accounting for Stock-based Compensation – Transition and Disclosure. Under APB 25 and related interpretations, compensation is based on the difference, if any, on the date of the grant, between the fair value of the Company’s common stock and the exercise price.

The Company’s accounting treatment of stock options will significantly change during 2006 due to its planned adoption of SFAS No. 123R (SFAS 123(R)), Share-Based Payment, which is effective for the Company’s fiscal year beginning January 1, 2006. See Recently Issued Accounting Pronouncements below. The following table illustrates the effect on net income (loss) and net income (loss) per share if the fair value recognition provisions of SFAS No. 123 had been applied to employee stock benefits, including shares issued under the stock option plans and under the Employee Stock Purchase Plan (collectively “options”). For purposes of pro forma disclosures, the estimated fair value of the options is assumed to be amortized to expense over the options’ vesting periods. Pro forma information follows (in thousands, except per share amounts):

57

NANOMETRICS INCORPORATED

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS—(Continued)

Years Ended December 31, 2005, January 1, 2005 and January 3, 2004

	Years Ended
	December 31, 2005			January 1, 2005			January 3, 2004
Net income (loss):
As reported	$	1,511		$	3,699		$	(17,467	)
Deduct: Total stock-based employee compensation expense determined under fair value based method for all awards, net of related tax effects		(4,865	)		(5,304	)		(8,521	)
Pro forma net loss	$	(3,354	)	$	(1,605	)	$	(25,988	)
Basic net income (loss) per share:
As reported	$	0.12		$	0.30		$	(1.45	)
Pro forma	$	(0.26	)	$	(0.13	)	$	(2.16	)
Diluted net income (loss) per share:
As reported	$	0.11		$	0.28		$	(1.45	)
Pro forma	$	(0.26	)	$	(0.13	)	$	(2.16	)
Basic Shares:
As reported		12,760			12,320			12,043
Pro forma		12,760			12,320			12,043
Diluted Shares:
As reported		13,471			13,364			12,043
Pro forma		12,760			12,320			12,043

Under SFAS No. 123, the fair value of stock-based awards to employees is calculated through the use of option pricing models, even though such models were developed to estimate the fair value of freely tradable, fully transferable options without vesting restrictions, which differ significantly from the Company’s stock option awards. These models also require subjective assumptions, including future stock price volatility and expected time to exercise, which greatly affect the calculated values. The fair value calculations on stock-based awards under the 2005, 2000 and 1991 Stock Option Plans, the 2002 Nonstatutory Stock Option Plan and the 2000 and 1991 Director Plans were made using the Black-Scholes option pricing model with the following weighted average assumptions:

	2005			2004			2003
Stock Options:
Expected life		4.4 years			3.4 years			3 years
Volatility		87	%		90	%		90	%
Risk free interest rate		3.98	%		2.87	%		2.40	%
Dividends		—			—			—
Forfeiture rate		25	%		27	%		25	%
Weighted average fair value	$	8.31		$	7.81		$	2.70

58

NANOMETRICS INCORPORATED

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS—(Continued)

Years Ended December 31, 2005, January 1, 2005 and January 3, 2004

The Company’s fair value calculations on stock-based awards under the Employee Stock Purchase Plan were also made using the Black-Scholes option pricing model with the following weighted average assumptions:

	2005			2004
Employee Stock Purchase Plan:
Expected life		6 months			6 months
Volatility		60	%		90	%
Risk free interest rate		1.4	%		1.1	%
Dividends		—			—
Weighted average fair value	$	10.07		$	10.46

There were no options outstanding under the Employee Stock Purchase Plan in 2003.

Net Income Per Share – Basic net income (loss) per share excludes dilution and is computed by dividing net income (loss) by the number of weighted average common shares outstanding for the period. Diluted net income (loss) per share reflects the potential dilution from outstanding dilutive stock options (using the treasury stock method) and shares issuable under the employee stock purchase plan. For 2005 and 2004, stock options with exercise prices in excess of the fair market value of common stock were excluded from the diluted weighted average shares outstanding, as their effect is anti-dilutive. During 2003, diluted net loss per share excludes common equivalent shares outstanding, as their effect is antidilutive. The reconciliation of the share denominator used in the basic and diluted net income per share computations is as follows (in thousands):

	Years Ended
	December 31, 2005	January 1, 2005	January 3, 2004
Weighted average shares outstanding – shares used in basic net income per share computation	12,760	12,320	12,043
Dilutive effect of stock options, using the treasury stock method	711	1,044	—
Shares used in diluted net income per share computation	13,471	13,364	12,043

For 2005, 2004 and 2003, diluted net income (loss) per share excluded common equivalent shares outstanding of 1.2 million, 1.6 million and 2.9 million, respectively, as their effect was antidilutive.

Certain Significant Risks and Uncertainties – Financial instruments which potentially subject the Company to concentration of credit risk consist of cash and cash equivalents, short-term investments and accounts receivable (see Note 14). All cash equivalents at December 31, 2005 and January 1, 2005 were deposited with two financial institutions which the Company believes are of high credit quality. Cash equivalent deposits with financial institutions may, at times, exceed federally insured limits, however, the Company has not experienced any losses on such accounts.

For short-term investments, credit risk is limited by placing all investments with high credit quality issuers and limits the amount of investment with any one issuer. The Company only invests in United States Treasury Bills with maturities of one year or less. As of December 31, 2005, the fair value of those investments approximated cost.

59

NANOMETRICS INCORPORATED

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS—(Continued)

Years Ended December 31, 2005, January 1, 2005 and January 3, 2004

The Company sells its products primarily to end users in the United States and Asia, and generally does not require its customers to provide collateral or other security to support accounts receivable. Management performs ongoing credit evaluations of its customers’ financial condition and maintains an allowance for estimated potential bad debt losses. The Company’s customer base is highly concentrated and a relatively small number of customers have accounted for a significant portion of its revenues. Aggregate revenue from the Company’s top ten largest customers in 2005 and 2004 consisted of 74.2% and 65.9%, respectively, of its total net revenues.

The Company participates in a dynamic high technology industry and believes that changes in any of the following areas could have a material adverse effect on its future financial position, results of operations or cash flows: Advances and trends in new technologies and industry standards; competitive pressures in the form of new products or price reductions on current products; changes in product mix; changes in the overall demand for products offered; changes in third-party manufacturers; changes in key suppliers; changes in certain strategic relationships or customer relationships; litigation or claims against the Company based on intellectual property, patent, product, regulatory or other factors; fluctuations in foreign currency exchange rates; risk associated with changes in domestic and international economic and/or political regulations; availability of necessary components or subassemblies; disruption of manufacturing facilities; and its ability to attract and retain employees necessary to support its growth.

Certain components and subassemblies used in the Company’s products are purchased from a sole supplier or a limited group of suppliers. In particular, the Company currently purchases its spectroscopic ellipsometer and robotics used in its advanced measurement systems from a sole supplier or a limited group of suppliers located in the United States. Any shortage or interruption in the supply of any of the components or subassemblies used in its products or its inability to procure these components or subassemblies from alternate sources on acceptable terms could have a material adverse effect on its business, financial condition and results of operations.

Recently Issued Accounting Pronouncements

In November 2004, the FASB issued SFAS No. 151, “Inventory Costs, An Amendment of ARB No. 43, Chapter 4.” This Statement amends ARB No. 43, Chapter 4, to clarify that abnormal amount of idle facility, freight, handling costs, and wasted materials (spoilage) should be recognized as current-period charges. In addition, SFAS No. 151 requires that allocation of fixed production overheads to the costs of conversion be based on the normal capacity of the production facilities. SFAS No. 151 is effective for inventory costs incurred during fiscal years beginning after June 15, 2005. Earlier application is permitted for inventory costs incurred during fiscal years beginning after November 23, 2004. The provisions of SFAS No. 151 should be applied prospectively. Adoption of this statement is not expected to have a material impact on the Company’s consolidated results of operations and financial condition.

In December 2004, the Financial Accounting Standards Board (“FASB”) issued Statement of Financial Accounting Standards (“SFAS”) No. 123(R), “Share-Based Payment”, (“SFAS No. 123(R)”). This statement replaces SFAS No. 123, “Accounting for Stock-Based Compensation”, amends SFAS No. 95, “Statement of Cash Flows” and supersedes Accounting Principles Board (“APB”) Opinion No. 25 “Accounting for Stock Issued to Employees” (“APB No. 25”). SFAS No. 123(R) requires companies to apply a fair-value based measurement method in accounting for share-based payment transactions with employees and to record compensation expense for all stock awards granted, and to awards modified, repurchased or cancelled after the required effective date. In addition, the Company is required to record compensation expense (as previous awards continue to vest) for the unvested portion of previously granted awards that remain outstanding at the date of adoption. SFAS No. 123(R) will be effective for the Company’s fiscal year 2006, and requires one of two

60

NANOMETRICS INCORPORATED

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS—(Continued)

Years Ended December 31, 2005, January 1, 2005 and January 3, 2004

transition methods to be applied. The Company is in the process of determining which transition method it will apply. SFAS No. 123(R) will have a significant impact on the Company’s results of operations as the Company will be required to record compensation expense rather than disclose the impact on its consolidated results of operations within the footnotes.

In March 2005, the SEC staff issued guidance on SFAS No. 123(R). Staff Accounting Bulletin (“SAB”) No. 107 (“SAB No. 107”) was issued to assist preparers by simplifying some of the implementation challenges of SFAS No. 123(R) while enhancing the information that investors receive. SAB No. 107 creates a framework that is premised on two overarching themes: (a) considerable judgment will be required by preparers to successfully implement SFAS No. 123(R), specifically when valuing employee stock options; and (b) reasonable individuals, acting in good faith, may conclude differently on the fair value of employee stock options. Key topics covered by SAB No. 107 include: (a) valuation models – SAB No. 107 reinforces the flexibility allowed by SFAS No. 123(R) to choose an option-pricing model that meets the standard’s fair value measurement objective; (b) expected volatility – SAB No. 107 provides guidance on when it would be appropriate to rely exclusively on either historical or implied volatility in estimating expected volatility; and (c) expected term – the new guidance includes examples and some simplified approaches to determining the expected term under certain circumstances. The Company will apply the principles of SAB No. 107 in conjunction with its adoption of SFAS No. 123(R).

In March 2005, the FASB issued Interpretation No. 47, “Accounting for Conditional Asset Retirement Obligations—an interpretation of FASB Statement No. 143” (“FIN 47”). FIN 47 clarifies that the term conditional asset retirement obligation as used in FASB Statement No. 143, “Accounting for Asset Retirement Obligations,” refers to a legal obligation to perform an asset retirement activity in which the timing and (or) method of settlement are conditional on a future event that may or may not be within the control of the entity. The obligation to perform the asset retirement activity is unconditional even though uncertainty exists about the timing and (or) method of settlement. Thus, the timing and (or) method of settlement may be conditional on a future event. Accordingly, an entity is required to recognize a liability for the fair value of a conditional asset retirement obligation if the fair value of the liability can be reasonably estimated. This Interpretation is effective no later than the end of fiscal years ending after December 15, 2005. The adoption of FIN 47 did not have a material impact on the Company’s financial position or consolidated results of operations.

In May 2005, the FASB issued SFAS No. 154, Accounting Changes and Error Corrections (“SFAS 154”) which replaces APB 20 Accounting Changes and SFAS No. 3, Reporting Accounting Changes in Interim Financial Statements—An Amendment of APB Opinion. 28. SFAS 154 provides guidance on the accounting for and reporting of accounting changes and error corrections. It establishes retrospective application, or the latest practicable date, as the required method for reporting a change in accounting principle and the reporting of a correction of an error. SFAS 154 is effective for accounting changes and corrections of errors made in fiscal years beginning after December 15, 2005 and is required to be adopted in the first fiscal quarter of 2006. Adoption of SFAS 154 is not expected to have a material impact on the Company’s consolidated results of operations and financial condition.

In September 2005, the Emerging Issues Task Force reached consensus on EITF Issue No. 04-13, “Accounting for Purchases and Sales of Inventory with the Same Counterparty” (“Issue No. 04-13). In certain situations, a company may enter into nonmonetary transactions to sell inventory to another company in the same line of business from which it also purchases inventory. Under Issue No. 04-13, in general, an entity is required to treat sales and purchases of inventory between the entity and the same counterparty as one transaction for purposes of applying APB Opinion No. 29, “Accounting for Nonmonetary Transactions” when such transactions

61

NANOMETRICS INCORPORATED

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS—(Continued)

Years Ended December 31, 2005, January 1, 2005 and January 3, 2004

are entered into in contemplation of each other. When such transactions are legally contingent on each other, they are considered to have been entered into in contemplation of each other. The EITF also agreed on other factors that should be considered in determining whether transactions have been entered into in contemplation of each other. Issue No. 04-13 will be effective for all new arrangements entered into in reporting periods beginning after March 15, 2006. Adoption of the provisions of Issue No. 04-13 is not expected to have a material impact on the Company’s consolidated results of operations and financial condition.

2.    Inventories

Inventories consist of the following (in thousands):

	At
	December 31, 2005		January 1, 2005
Raw materials and subassemblies	$	14,175	$	14,391
Work in process		5,021		4,330
Finished goods		6,460		6,773
Total inventories	$	25,656	$	25,494

3.    Property, Plant and Equipment

Property, plant and equipment consists of the following (in thousands):

	At
	December 31, 2005			January 1, 2005
Land	$	16,759		$	16,934
Building and improvements		28,453			33,149
Machinery and equipment		7,379			7,332
Furniture and fixtures		1,924			1,918
		54,515			59,333
Accumulated depreciation and amortization		(11,587	)		(10,298	)
Total property, plant and equipment, net	$	42,928		$	49,035

Depreciation expenses were incurred of $2.2 million, $2.3 million and $2.1 million for 2005, 2004 and 2003, respectively.

62

NANOMETRICS INCORPORATED

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS—(Continued)

Years Ended December 31, 2005, January 1, 2005 and January 3, 2004

4.    Intangible Assets

Intangible assets are recorded at cost, less accumulated amortization. Intangible assets as of December 31, 2005 and January 1, 2005 consist of (in thousands):

December 31, 2005	Gross Carrying Amount		Accumulated Amortization		Net Intangible Assets
Purchased technology	$	1,790	$	1,151	$	639
Other		250		250		—
Total	$	2,040	$	1,401	$	639
January 1, 2005	Gross Carrying Amount		Accumulated Amortization		Net Intangible Assets
Purchased technology	$	2,290	$	1,395	$	895
Other		250		221		29
Total	$	2,540	$	1,616	$	924

In 2005, $0.5 million of purchased technology, which was fully amortized, was written off.

The estimated future amortization expense is as follows (in thousands):

Fiscal Years
2006	$	256
2007		256
2008		127
Total amortization	$	639

Amortization is computed using the straight-line method over a weighted average period of seven years for purchased technology and five years for other intangible items. Amortization for the years ended December 31, 2005, January 1, 2005 and January 3, 2004 was $0.3 million, $0.4 million and $0.4 million, respectively. Internally developed patent costs are expensed as incurred. No patents or other internally developed intangible assets have been capitalized.

5.    Other Current Liabilities

Other current liabilities consist of the following (in thousands):

	At
	December 31, 2005		January 1, 2005
Accrued warranty	$	1,440	$	1,055
Accrued professional services		1,518		235
Other		911		807
Total other current liabilities	$	3,869	$	2,097

63

NANOMETRICS INCORPORATED

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS—(Continued)

Years Ended December 31, 2005, January 1, 2005 and January 3, 2004

6.    Debt Obligations

Debt obligations consist of the following (in thousands):

	At
	December 31, 2005			January 1, 2005
1995 working capital bank loan	$	—		$	195
1996 working capital bank loan		47			148
2000 working capital bank loan		1,749			2,422
Other debt obligations		—			469
Total		1,796			3,234
Current portion of debt obligations		(400	)		(1,164	)
Debt obligations	$	1,396		$	2,070

The 1995 working capital bank loan was obtained by the Company’s Japanese subsidiary. The loan was collateralized by receivables of the Japanese subsidiary and was guaranteed by Nanometrics Incorporated. The loan was denominated in Japanese yen (¥20,000,000 at January 1, 2005) and carried interest at 2.9% per annum. The loan was payable in quarterly installments until May 2005.

The 1996 working capital bank loan was obtained by the Company’s Japanese subsidiary and is collateralized by land and building in Japan. The loan is denominated in Japanese yen (¥5,600,000 at December 31, 2005) and bears interest at 3.4% per annum. The loan is payable in quarterly installments with unpaid principal and interest due in May 2006.

The 2000 working capital bank loan was obtained by the Company’s Japanese subsidiary and is collateralized by land and building in Japan. The loan is denominated in Japanese yen (¥206,400,000 at December 31, 2005) and bears interest at 2.1% per annum. The loan is payable in quarterly installments with unpaid principal and interest due in November 2010.

Other debt obligations represented short-term borrowings by the Company’s Japanese subsidiary and were collateralized by the subsidiary’s accounts receivable. The borrowings were denominated in Japanese yen and carried interest at 2.74% per annum.

The Company is not in breach of any restrictive covenants in connection with its debt.

At December 31, 2005, future annual maturities of debt obligations were as follows (in thousands):

2006	$	400
2007		353
2008		352
2009		352
2010		339
Total	$	1,796

64

NANOMETRICS INCORPORATED

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS—(Continued)

Years Ended December 31, 2005, January 1, 2005 and January 3, 2004

7.    Line of Credit

During the second quarter 2005, the Company renewed a revolving line of credit with a Japanese bank. This revolver is an unsecured line of credit, and the Company may borrow up to ¥400 million through June 2006. Borrowings under the line of credit bear interest at a rate of 1.5%. There are no restrictive covenants under the line of credit agreement. As of December 31, 2005, outstanding borrowings were ¥140 million, or approximately $1.19 million translated at the spot rate effective as of December 31, 2005. As of January 1, 2005, there were no amounts drawn under the previous line of credit arrangement with the same bank.

8.    Commitments and Contingencies

The Company leases administrative facilities and certain equipment under noncancellable operating leases. Rent expense, which is recorded on a straight-line basis over the term of the respective lease, for 2005, 2004, and 2003 was approximately $0.4 million, $0.3 million and $0.4 million, respectively. Future minimum lease payments under its operating leases are as follows (in thousands):

2006	$	354
2007		109
2008		87
2009		81
2010		61
Thereafter		5
Total	$	697

Pursuant to a 1998 agreement, if Nanometrics’ Chairman of the Board, Vincent J. Coates, is involuntarily removed from his position, the Company is required to continue his salary and related benefits for a period of five years from such date.

Pursuant to a 1998 agreement, if Nanometrics’ President and Chief Executive Officer, John D. Heaton, is involuntarily removed from his position, the Company is required to continue his salary and related benefits for a period of one year from such date.

Pursuant to a 1995 agreement, if Nanometrics’ Senior Vice President of Sales and Standalone Products, Roger Ingalls Jr., is terminated from his position, the Company is required to continue his salary for 120 days.

On March 9, 2005, Nova Measuring Instruments Ltd. (“Nova”) filed suit against Nanometrics. The complaint alleges certain Company products infringe a Nova patent and seeks a preliminary and permanent injunction against their sale and unspecified damages. The Company does not believe any of its products infringe any valid claim of the Nova patent. Nanometrics intends to vigorously and aggressively defend itself in the litigation. While the results of such litigation matters and claims cannot be predicted with certainty, the Company believes the final outcome of such matters will not have a material adverse impact on its financial position or results operations.

In August 2005, Nanometrics was served with a complaint by KLA-Tencor alleging that certain Company products infringe two of KLA’s patents. On January 30, 2006, KLA added a third patent to their claim. The complaint seeks a preliminary and permanent injunction against the sale of these products and unspecified

65

NANOMETRICS INCORPORATED

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS—(Continued)

Years Ended December 31, 2005, January 1, 2005 and January 3, 2004

damages. The Company does not believe that any of its products infringe the intellectual property of any third party and intends to vigorously and aggressively defend itself in the litigation. As part of such defense, Nanometrics had filed a request for re-examination of the two allegedly infringed KLA-Tencor patents with the U.S. Patent & Trademark Office (“PTO”). These requests for re-examination were recently accepted for review by the PTO. In March 2006, the Company filed a motion for and was granted a stay in the patent litigation case until such re-examination is completed.

9.    Shareholders’ Equity

Common Stock

The authorized capital stock of Nanometrics consists of 50,000,000 common shares, of which 50,000,000 shares have been designated “Common Stock.”

Stock Option Plans

Options to acquire common stock generally vest at a rate of 33.3% upon each anniversary of the stock option grant, and generally expire between five and seven years from the date of grant. The Nanometrics option plans are as follows:

Plan Name	Participants	Shares Authorized
2005 Equity Incentive Plan	Employees and consultants	1,200,000
2002 Nonstatutory Stock Option Plan	Employees and consultants	1,200,000
2000 Employee Stock Option Plan	Employees and consultants	2,450,000
2000 Director Stock Option Plan	Non-employee directors	250,000
1991 Stock Option Plan	Employees and consultants	3,000,000
1991 Director Stock Option Plan	Non-employee directors	300,000

Under the 2002 Nonstatutory Stock Option Plan (the 2002 Option Plan), Nanometrics may grant options to acquire up to 1,200,000 shares of common stock to employees and consultants at prices determined by the 2002 Option Plan administrator at the date of grant. These options generally expire seven years from the date of grant, or a shorter term as provided by the stock option agreement and become exercisable as they vest as set forth in the stock option agreements.

66

NANOMETRICS INCORPORATED

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS—(Continued)

Years Ended December 31, 2005, January 1, 2005 and January 3, 2004

During the fourth quarter of 2002, the Company offered to cancel qualifying options to purchase up to 1,962,020 shares of Nanometrics common stock granted under the 2000 Employee Stock Option Plan and the 1991 Stock Option Plan. Qualifying options included only those options with an exercise price of greater than or equal to $10.00 per share. On December 16, 2002, the Company cancelled options to purchase 1,569,020 shares of Nanometrics common stock. On June 17, 2003, the Company granted all participating employees options equal to 90% of the options cancelled, or a total of 1,398,621 options, at the then fair value of the common stock.

	Outstanding Options
	Shares Available		Number of Shares		Weighted Average Exercise Price
Option activity under the plans is summarized as follows:
Balances, December 28, 2002	3,234,469		1,410,594		$	14.27
Exercised	—		(159,375	)		7.46
Granted	(2,030,495	)	2,030,495			6.67
Canceled	116,176		(366,518	)		10.16
Balances, January 3, 2004	1,320,150		2,915,196		$	9.86
Exercised	—		(341,288	)		7.12
Granted	(453,550	)	453,550			12.72
Canceled	305,749		(395,183	)		12.09
Balances, January 1, 2005	1,172,349		2,632,275		$	10.38
Shares added through the 2005 Equity Incentive Plan	1,200,000		—			—
Exercised	—		(363,105	)		6.43
Granted	(793,900	)	793,900			12.39
Canceled	401,312		(492,312	)		18.46
Balances, December 31, 2005	1,979,761		2,570,758		$	10.01

Additional information regarding options outstanding as of December 31, 2005 is as follows:

Range of Exercise Prices	Options Outstanding				Options Exercisable
	Number Outstanding	Weighted Average Remaining Contractual Life (Years)	Weighted Average Exercise Price		Number Exercisable	Weighted Average Exercise Price
$  3.14– $  5.70	914,797	4.38	$	5.61	900,959	$	5.64
$  5.71– $  8.51	291,803	4.55	$	7.49	199,171	$	7.44
$  8.52– $  17.01	1,243,958	5.53	$	12.76	285,181	$	13.95
$17.02– $29.20	120,200	2.92	$	21.20	108,064	$	21.31
$  3.14– $29.20	2,570,758	4.89	$	10.01	1,493,375	$	8.60

Employee Stock Purchase Plan

Under the 2003 Employee Stock Purchase Plan (the 2003 ESPP), eligible employees are allowed to have salary withholdings of up to 10% of their base compensation to purchase shares of common stock at a price equal to 85% of the lower of the market value of the stock at the beginning or end of each six-month offering period, subject to an annual limitation. Nanometrics may grant up to 750,000 shares under the 2003 ESPP. Shares issued

67

NANOMETRICS INCORPORATED

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS—(Continued)

Years Ended December 31, 2005, January 1, 2005 and January 3, 2004

under the 2003 ESPP were 61,153 in 2005 at a weighted average price of $10.07, and 59,332 in 2004 at a weighted average price of $10.46. There were no shares issued during 2003.

10. Merger Termination

On January 21, 2005, Nanometrics and August Technology Corporation entered into a definitive merger agreement. On June 28, 2005, August Technology Corporation and the Company announced the termination of the merger agreement. In accordance with the terms of the merger agreement, August Technology paid Nanometrics a merger termination fee of $8.3 million on June 28, 2005. Also in accordance with the terms of the merger agreement, August Technology paid to the Company $2.6 million as reimbursement of the Company’s expenses associated with the merger agreement on the same date.

11. Asset Impairment and Disposition

During the quarter ended July 2, 2005, Nanometrics recorded an asset impairment charge of $2.2 million related to certain assets of the flat panel display (“FPD”) business unit. Under SFAS No. 144, Accounting for the Impairment or Disposal of Long-Lived Assets, the Company should assess the recoverability of assets when events become known which would indicate potential impairment. The Company evaluated the estimated future cash flows of the FPD business unit and determined the undiscounted estimated future cash flows would be insufficient to recover the carrying value of those assets. The impairment charge was measured based on the excess carrying value of the asset group in excess of the associated discounted future cash flows. Accordingly, the Company recorded an asset impairment charge during the second quarter of fiscal 2005.

In September 2005, Nanometrics announced it had entered into an agreement to sell its FPD business unit to Toho Technology Corporation (“Toho”); the agreement became effective in October 2005. The Company decided to sell the FPD business unit as it had experienced a significant decline in revenues and related gross profit as other competitors have entered the market. Toho received a non-exclusive perpetual license to use and sell Nanometrics Film Thickness Measurements Systems in the flat panel market in exchange for $1.5 million. In addition, Toho will pay a 7% royalty on future sales in excess of ¥800 million. Toho also purchased certain other existing assets at net book value from Nanometrics including $0.9 million of inventory and $0.1 million of equipment related to the FPD business unit. The Company also agreed with Toho to continue to provide sales efforts for FPD products and maintenance service for installed units in certain Asian countries. The Company will receive a commission from Toho on their future sales of FPD products in designated countries. Due to this continuing involvement, the Company does not consider the FPD business unit to be a discontinued operation.

12. Income Taxes

Income (loss) before provision (benefit) for income taxes consists of the following (in thousands):

	Years Ended
	December 31, 2005			January 1, 2005		January 3, 2004
Domestic	$	9,265		$	3,255	$	(11,637	)
Foreign		(7,536	)		870		30
Income (loss) before income taxes	$	1,729		$	4,125	$	(11,607	)

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NANOMETRICS INCORPORATED

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS—(Continued)

Years Ended December 31, 2005, January 1, 2005 and January 3, 2004

The provision (benefit) for income taxes consists of the following (in thousands):

	Years Ended
	December 31, 2005			January 1, 2005			January 3, 2004
Current:
Federal	$	(34	)	$	(320	)	$	(553	)
State		37			4			4
Foreign		215			742			402
		218			426			(147	)
Deferred:
Federal		—			—			3,700
State		—			—			2,306
Foreign		—			—			1
		—			—			6,007
Provision for income taxes	$	218		$	426		$	5,860

Significant components of the Company’s deferred tax assets and liabilities are as follows (in thousands):

	At
	December 31, 2005			January 1, 2005
Deferred tax assets – current:
Reserves and accruals not currently deductible	$	3,689		$	3,470
Capitalized inventory costs		1,360			976
Total gross deferred tax assets – current		5,049			4,446
Valuation allowance		(5,049	)		(4,446	)
Total net deferred tax assets – current	$	—		$	—
Deferred tax assets (liabilities) noncurrent:
Tax credit carryforwards	$	5,518		$	5,340
Depreciation		(2,256	)		(2,851	)
Reserves and accruals		1,916			311
Intangible assets		1,762			1,907
Net operating loss carryforwards		406			3,226
Translation adjustments		161			(684	)
Total net deferred tax assets (liabilities) – noncurrent		7,507			7,249
Valuation allowance		(7,507	)		(7,924	)
Total net deferred tax assets (liabilities) – noncurrent	$	—		$	(675	)

During the year ended December 31, 2005 the valuation allowance increased $186,000 including $161,000 that was related to the translation adjustment which is reflected in other comprehensive income rather than the provision for income taxes. During the year ended January 1, 2004 the valuation allowance decreased by $1,226,000

69

NANOMETRICS INCORPORATED

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS—(Continued)

Years Ended December 31, 2005, January 1, 2005 and January 3, 2004

As of December 31, 2005, the Company had net operating loss carryforwards for federal income tax purposes of approximately $1.2 million, which expire after 2023. As of December 31, 2005, the Company did not have any net operating loss carryforwards for California income tax purposes.

As of December 31, 2005, the Company had available for carryforward research and experimental tax credits, minimum tax credits and foreign tax credits for federal income tax purposes of $2.6 million, $0.3 million and $1.0 million respectively. Federal credit carryforwards begin to expire after 2006.

As December 31, 2005, the Company had available for carryforward state research and experimental tax credits of $2.2 million. State research and experimental tax credits carryforward indefinitely.

Differences between income taxes computed by applying the statutory federal income tax rate to income before income taxes and the provision for income taxes consist of the following (in thousands):

	Years Ended
	December 31, 2005			January 1, 2005			January 3, 2004
Income taxes computed at U.S. statutory rate	$	605		$	1,139		$	(4,062	)
State income taxes		37			3			(1,394	)
Foreign tax provision higher than U.S. rates		300			131			426
Foreign sales corporation benefit		—			—			(11	)
Change in valuation allowance		(655	)		(1,226	)		13,405
Tax credits		(197	)		—			(1,323	)
Other, net		128			379			(1,181	)
Provision for income taxes	$	218		$	426		$	5,860

13.    Bonus Plans

The Company incurred $2.0 million and $1.2 million in 2005 and 2004, respectively, under the Company’s formal discretionary cash bonus plan, which covers all eligible employees. No amount was paid in 2003 pursuant to the plan.

14.    Major Customers

In 2005, three customers, Applied Materials, Samsung and Ebara represented 20.6%, 15.9% and 12.5% of our total net revenues, respectively. In 2004, sales to Applied Materials accounted for 21.4% and sales to Samsung accounted for 14.7% of total net revenues. In 2003, sales to Applied Materials accounted for 15.4% and sales to Hynix Semiconductor accounted for 12.0% of total net revenues.

At December 31, 2005, one customer accounted for 31.4% of total accounts receivable. At January 1, 2005, one customer accounted for 10.7% of total accounts receivable.

15.    Product, Segment and Geographic Information

The Company’s operating divisions consist of geographically based entities in the United States, Japan, South Korea and Taiwan. All such operating divisions have similar economic characteristics, as defined in SFAS No. 131, Disclosures About Segments of an Enterprise and Related Information, and accordingly, the Company

70

NANOMETRICS INCORPORATED

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS—(Continued)

Years Ended December 31, 2005, January 1, 2005 and January 3, 2004

operates in one reportable segment: the sale, design, manufacture, marketing and support of thin film, optical critical dimension and overlay dimension metrology systems. For the years ended December 31, 2005, January 1, 2005 and January 3, 2004, the Company recorded revenue from customers primarily in the United States and Asia. The following table summarizes total net revenues and long-lived assets (excluding intangible assets) attributed to significant countries (in thousands):

	Years Ended
	December 31, 2005		January 1, 2005		January 3, 2004
Total net revenues:
United States	$	23,520	$	19,707	$	10,504
Japan		18,419		20,685		10,319
South Korea		17,873		13,473		9,063
Taiwan		7,716		8,130		8,935
All other		3,015		7,936		2,781
Total net revenues*	$	70,543	$	69,931	$	41,602

* Net revenues are attributed to countries based on the customer’s deployment and service locations of systems.

	At
	December 31, 2005		January 1, 2005
Long-lived tangible assets:
United States	$	37,622	$	39,005
Japan		2,391		7,409
South Korea		4,333		3,870
Taiwan		23		33
Total long-lived assets	$	44,369	$	50,317

The Company’s product lines differ primarily based on the environment the systems will be used in. Automated systems are used primarily in high-volume production environments. Integrated systems are installed inside wafer processing equipment to provide near real-time measurements for improving process control and increasing throughput. Tabletop systems are used primarily in low-volume production environments and in engineering labs where automated handling and high throughput are not required. Revenues by product type were as follows (in thousands):

	Years Ended
	December 31, 2005		January 1, 2005		January 3, 2004
Automated systems	$	34,270	$	38,100	$	25,620
Integrated systems		23,151		21,602		6,106
Tabletop systems		3,591		2,445		2,866
Total product revenues	$	61,012	$	62,147	$	34,592

71

NANOMETRICS INCORPORATED

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS—(Continued)

Years Ended December 31, 2005, January 1, 2005 and January 3, 2004

16.    Selected Quarterly Financial Results (Unaudited)

The following table sets forth selected consolidated quarterly results of operations for the year ended December 31, 2005 and January 1, 2005 (in thousands, except per share amounts):

	Quarters Ended
	Dec. 31, 2005			Oct 1, 2005			Jul. 2, 2005		Apr. 2, 2005
Total net revenues	$	14,225		$	14,231		$	18,736	$	23,350
Gross profit		6,594			5,368			7,665		11,045
Income (loss) from operations		(2,504	)		(3,666	)		4,826		2,725
Net income (loss)		(2,060	)		(3,403	)		4,488		2,484
Net income (loss) per share:
Basic	$	(0.16	)	$	(0.26	)	$	0.36	$	0.20
Diluted	$	(0.16	)	$	(0.26	)	$	0.34	$	0.18
Shares used in per share computations:
Basic		12,981			12,854			12,629		12,575
Diluted		12,981			12,854			13,374		13,455
	Jan. 1, 2005			Oct 2, 2004			July 3, 2004		Apr. 3, 2004
Total net revenues	$	20,360		$	20,083		$	16,009	$	13,479
Gross profit		8,697			10,217			8,472		6,329
Income (loss) from operations		1,772			2,584			1,310		(1,663	)
Net income (loss)		2,130			2,156			1,095		(1,682	)
Net income (loss) per share:
Basic	$	0.17		$	0.17		$	0.09	$	(0.14	)
Diluted	$	0.16		$	0.17		$	0.08	$	(0.14	)
Shares used in per share computation:
Basic		12,495			12,331			12,262		12,189
Diluted		13,500			12,742			13,292		12,189

17.    Subsequent Events

Accent Optical Technologies

On January 25, 2006, Nanometrics announced a definitive agreement to merge with Accent Optical Technologies, Inc. (“Accent”), a supplier of process control and metrology systems to the global semiconductor manufacturing industry headquartered in Bend, Oregon. Under the terms of the merger agreement, which was unanimously approved by the boards of directors of both companies, the Company will issue 4.9 million shares of its common stock for all outstanding Accent capital stock and rights to acquire Accent capital stock. Nanometrics will also issue an additional number of shares of its common stock equal to the quotient of the aggregate exercise price of all Accent Optical stock options that are assumed pursuant to the merger agreement, divided by the average closing price of Nanometrics common stock for the ten (10) trading days ending two (2) days prior to the closing date of the merger. Nanometrics will also assume approximately $10.6 million in net debt obligations of Accent. Based on the closing price of Nanometrics common stock on January 25, 2006, the transaction values Accent at $80.9 million. Accent Optical stockholders will own approximately 27% of the outstanding shares of Nanometrics common stock immediately after the merger, and Nanometrics shareholders

72

NANOMETRICS INCORPORATED

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS—(Continued)

Years Ended December 31, 2005, January 1, 2005 and January 3, 2004

will own approximately 73% of the outstanding shares of Nanometrics common stock immediately after the merger. Completion of the transaction is subject to required approvals from Nanometrics and Accent shareholders. The merger is expected to be completed by the end of the second quarter of fiscal year 2006.

The merger will be accounted for under the purchase method of accounting in accordance with SFAS No. 141, Business Combinations. Under the purchase method of accounting, the total estimated purchase price is allocated to the net tangible and identifiable intangible assets of Accent acquired in connection with the merger, based on their respective estimated fair values. Pursuant to the terms of the merger agreement, either Nanometrics or Accent may terminate the merger agreement upon the occurrence of certain specified circumstances or events. In connection with such termination, either Nanometrics or Accent may be required to pay to the other party a termination fee of $5.0 million, plus expenses. Unless otherwise indicated, references to Nanometrics in this filing relate to Nanometrics as a stand-alone entity and do not reflect the impact of the potential business combinations transaction with Accent.

Soluris, Inc.

On March 15, 2006, Nanometrics announced it had acquired Soluris Inc., a privately held corporation focused on overlay and CD measurement technology and headquartered in Concord, Massachusetts. Its flagship product, the IVS 155, is a leading tool for 200mm semiconductor overlay and CD measurement. Under the terms of the merger agreement relating to the acquisition, the total consideration to purchase all the outstanding stock and to retire all the outstanding debt of Soluris was $7.0 million in an all-cash transaction. The merger will be accounted for under the purchase method of Accounting in accordance with SFAS No. 141, Business Combinations. Under the purchase method of accounting, the total estimated purchase price is allocated to the net tangible and identifiable intangible assets of Soluris acquired in connection with the merger, based on their respective estimated fair values.

* * * * *

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ITEM 9. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL DISCLOSURE

None.

ITEM 9A. CONTROLS AND PROCEDURES

Attached as exhibits to this Annual Report are certifications of the CEO and the CFO, which are required in accordance with Rule 13a-14 of the Securities Exchange Act of 1934, as amended (Exchange Act). This Controls and Procedures section includes the information concerning the controls evaluation referred to in the certifications, and it should be read in conjunction with the certifications for a more complete understanding of the topics presented.

Evaluation of Disclosure Controls and Procedures

We maintain disclosure controls and procedures that are designed to ensure that information required to be disclosed in our reports under the Exchange Act is recorded, processed, summarized and reported within the time periods specified in the SEC’s rules and forms, and that such information is accumulated and communicated to management, including our Chief Executive Officer and Chief Financial Officer, as appropriate, to allow timely decisions regarding required disclosure. Our management, with participation of our Chief Executive Officer and Chief Financial Officer, has evaluated the effectiveness of the Company’s disclosure controls and procedures as of the end of the fiscal year covered by this Annual Report on Form 10-K. As described below under “Report of Management on Internal Control Over Financial Reporting,” we have identified a material weakness in the internal control over financial reporting as of December 31, 2005. Our Chief Executive Officer and Chief Financial Officer have concluded that, as of the end of the period covered by this Annual Report on Form 10-K, the Company’s disclosure controls and procedures (as defined in Rules 13a-15(e) and 15d-15(e) under the Exchange Act) were not effective as a result of the reported material weakness.

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Report of Management on Internal Control over Financial Reporting

Our management is responsible for establishing and maintaining adequate internal control over financial reporting as defined in Rules 13a-15(f) and 15d-15(f) under the Exchange Act. Our internal control system has been designed to provide reasonable, not absolute, assurance to our management and Board of Directors that the objectives of our control system with respect to the integrity, reliability and fair presentation of published financial statements are met. A control system, no matter how well designed and operated, can provide only reasonable, not absolute, assurance that the control system’s objectives will be met. Further, the design of a control system must reflect the fact that there are resource constraints. Because of the inherent limitations in all control systems, no evaluation of controls can provide absolute assurance that all control issues and instances of fraud, if any, within our company have been detected. Under the supervision and with the participation of our management, including our Chief Executive Officer and Chief Financial Officer, we assessed the effectiveness of our internal control over financial reporting as of December 31, 2005. In making this assessment, we used the criteria established in the framework on Internal Control – Integrated Framework issued by the Committee of Sponsoring Organizations (“COSO”) of the Treadway Commission. Based on our assessment, which was conducted according to the COSO criteria, we have concluded that our internal control over financial reporting was not effective in achieving its objectives as of December 31, 2005 due to a material weakness that existed in our internal controls in our Japan operations as of that date.

A material weakness is a control deficiency or combination of control deficiencies that result in more than a remote likelihood that a material misstatement of the annual or interim financial statements will not be prevented or detected. Based on management’s assessment of our internal control over financial reporting as of December 31, 2005, the following material weakness existed as of that date:

Prior to October 2005, our finance function in Japan was located in our facility in Narita Japan. It was at this time we consummated the sale of our flat panel display business unit to Toho and it became necessary for us to relocate our Japanese finance function to our offices in Tokyo, the location of our semiconductor equipment operations. Because of the relocation, we incurred a significant interruption of the design, planning, and implementation of our internal control remediation efforts for our Japanese operations as well as significant employee turnover within our finance team. As a result of these circumstances, we had several internal control weaknesses in Japan which, in the aggregate, we believe constitute a material weakness in internal controls. Those specific internal control weaknesses in Japan included the lack of:

• sufficient sample size for testing before our year-end due to late remediation of controls,

• review of of Japanese language sales documentation by U.S. personnel,

• evidence regarding tracking of inventory movements,

• segregation of duties in cash disbursements, purchasing and inventory activities and posting of journal entries,

• availability of supporting documentation for non-inventory purchases due to our office move and personnel turnover,

• control over service/parts sales processing

These control weaknesses did not result in the recording of any year-end audit adjustments prior to the issuance of our consolidated financial statements.

Our independent registered public accounting firm has issued an attestation report on management’s assessment of our internal control over financial reporting which is included elsewhere within.

Remediation of Material Weakness in Internal Control over Financial Reporting

We have taken the following steps, which we believe are necessary to address the issues associated with our material weakness in Japan. We have been implementing and will continue to implement changes that are both

75

organizational and process-focused to improve the control environment in Japan. The changes made since year-end and through the date of this annual report include, among others:

• implementation of our fully integrated enterprise resource planning system, or ERP, at our Japan location to increase the efficiency of our business and financial processes, effective as of January 1, 2006,

• planned addition of Japanese financial personnel with experience in US GAAP reporting requirements,

• increased oversight and monitoring of accounting procedures and review of our Japanese operations,

• implementing a more detailed operational budgeting and planning function,

• increased segregation of duties for critical functions to include approval of certain transactions by U.S. personnel.

We expect the above mentioned changes in internal controls to be fully implemented by the quarter ended September 30, 2006 and testing of our internal controls subsequent to this date will determine the controls are operating effectively at our Japanese location.

Changes in Internal Controls

On October 26, 2005, our Audit Committee, acting on a recommendation from our management, determined that our audited financial statements for the fiscal year ended January 1, 2005, and our unaudited quarterly financial statements for the periods ended April 2, 2005 and July 2, 2005, should be restated. The need for such restatements resulted from a combination of control deficiencies that together the Company considered to be a material weakness as of September 30, 2005. The control deficiencies and restatements related to the Company’s (i) deferral of revenue associated with extended service contracts purchased by certain customers at the time of equipment sale, (ii) alignment of the warranty accrual with the actual warranty periods for certain customers and (iii) accrual of certain foreign sales commission expenses in the appropriate period.

The Company’s Chief Financial Officer and the Company’s Audit Committee discussed these matters disclosed above with the Company’s independent registered public accounting firm. We have concluded the circumstances that led to the restatements resulted primarily from certain accounting practices that were implemented several years ago. In the fourth quarter of 2005 we implemented additional detailed procedures to improve reporting in these areas including the following:

• Assembly of a management team that is responsible for reviewing terms and conditions of each significant sale to identify all key contract terms and accounting implications,

• Compilation of a database of all machines presently under warranty coverage reflecting warranty periods for such machines,

• Applying additional oversight to accounting procedures at foreign locations and review of liabilities recorded.

Based on our testing of these enhanced procedures, management determined that as of December 31, 2005, we had remediated the material weakness in internal control over financial reporting disclosed in the Form 10-Q for October 1, 2005.

We relocated our Japanese finance function during the fourth quarter of 2005 due to the sale of our flat panel display business unit. As a result of these circumstances, we experienced several internal control weaknesses in Japan which, in the aggregate, we believe constitute a material weakness in internal control as further described above in the Report of Management on Internal Control Over Financial Reporting.

76

REPORT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM

Board of Directors and Shareholders

Nanometrics Incorporated

Milpitas, California

We have audited management’s assessment, included in the accompanying Management’s Report on Internal Control over Financial Reporting, that Nanometrics Incorporated did not maintain effective internal control over financial reporting as of December 31, 2005, because of the effects of the material weaknesses identified in management’s assessment, based on criteria established in Internal Control – Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission (COSO). As described in Management’s Report on Internal Control over Financial Reporting, Nanometrics Incorporated management is responsible for maintaining effective internal control over financial reporting and for its assessment of the effectiveness of internal control over financial reporting. Our responsibility is to express an opinion on management’s assessment and an opinion on the effectiveness of the Company’s internal control over financial reporting based on our audit.

We conducted our audit in accordance with the standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform the audit to obtain reasonable assurance about whether effective internal control over financial reporting was maintained in all material respects. Our audit included obtaining an understanding of internal control over financial reporting, evaluating management’s assessment, testing and evaluating the design and operating effectiveness of internal control, and performing such other procedures as we considered necessary in the circumstances. We believe that our audit provides a reasonable basis for our opinion.

A company’s internal control over financial reporting is a process designed to provide reasonable assurance regarding the reliability of financial reporting and the preparation of financial statements for external purposes in accordance with accounting principles generally accepted in the United States of America. A company’s internal control over financial reporting includes those policies and procedures that (1) pertain to the maintenance of records that, in reasonable detail, accurately and fairly reflect the transactions and dispositions of the assets of the company; (2) provide reasonable assurance that transactions are recorded as necessary to permit preparation of financial statements in accordance with accounting principles generally accepted in the United States of America, and that receipts and expenditures of the company are being made only in accordance with authorizations of management and directors of the company; and (3) provide reasonable assurance regarding prevention or timely detection of material effect on the financial statements.

Because of its inherent limitations, internal control over financial reporting may not prevent or detect misstatements. Also, projections of any evaluation of effectiveness to future periods are subject to the risk that controls may become inadequate because of changes in conditions, or that the degree of compliance with the policies and procedures may deteriorate.

A material weakness is a control deficiency, or a combination of control deficiencies, that results in more than a remote likelihood that a material misstatement of the annual or interim financial statements will not be prevented or detected. Internal control weaknesses were identified for the Company’s Japan subsidiary, which in the aggregate constitute a material weakness. Those specific internal control weaknesses included the lack of:

• sufficient sample size for testing before year-end due to late remediation of controls,

• review of Japanese language sales documentation by U.S. personnel,

• evidence regarding tracking of inventory movements,

• segregation of duties in cash disbursements, purchasing and inventory activities and posting of journal entries,

77

• availability of supporting documentation for non-inventory purchases,

• control over service/parts sales processing

This material weakness resulted in more than a remote likelihood that a material misstatement to the Company’s annual or interim financial statements or misappropriation of assets would not be prevented or detected. However, this material weakness did not result in any adjustment to the consolidated balance sheet, statements of operations, equity, or cash flows for 2005. The material weakness was considered in determining the nature, timing, and extent of audit tests applied in our audit of the Company’s consolidated financial statements as of and for the year ended December 31, 2005, and this report does not affect our report dated March 14, 2006 on those financial statements.

In our opinion, management’s assessment that Nanometrics Incorporated did not maintain effective internal control over financial reporting as of December 31, 2005, is fairly stated, in all material respects, based on the criteria established in Internal Control – Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission (COSO). Also in our opinion, because of the effects of the material weaknesses described above on the achievement of the objectives of the control criteria, Nanometrics Incorporated has not maintained effective internal control over financial reporting as of December 31, 2005, based on the criteria established in Internal Control – Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission (COSO).

We also have audited, in accordance with the standards of the Public Company Accounting Oversight Board (United States), the accompanying consolidated balance sheet of Nanometrics Incorporated as of December 31, 2005 and January 1, 2005, and the related consolidated statements of operations, stockholders’ equity and comprehensive income (loss), and cash flows for the years then ended, and our report dated March 14, 2006 expressed an unqualified opinion thereon.

We do not express an opinion or any other form of assurance on management’s statements regarding corrective actions taken by the Company after December 31, 2005.

BDO Seidman, LLP

San Francisco, CA

March 14, 2006

ITEM 9B. OTHER INFORMATION

None.

78

PART III

ITEM 10. DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANT

The sections titled “Election of Nanometrics’ Directors,” “Executive Officers of Nanometrics,” “Certain Relationships,” “Audit Committee,” and “Section 16(a) Beneficial Ownership Reporting Compliance” to appear in the Registrant’s Proxy Statement for the 2006 Annual Meeting of Shareholders are to set forth certain information which is incorporated herein by reference. Certain information with respect to persons who are executive officers of the Registrant is set forth under the caption “Business—Executive Officers of the Registrant” in Part I of this report.

We have adopted a code of business conduct and ethics that applies to all officers and employees. We posted our code of business conduct and ethics on our website at www.nanometrics.com. We intend to disclose any amendment to the provisions of the code of business conduct and ethics that apply specifically to officers by filing such information on a Current Report on Form 8-K with the SEC, to the extent such filing is required by The Nasdaq Stock Market’s listing requirements; otherwise, we will disclose such waiver by posting such information on our website.

ITEM 11. EXECUTIVE COMPENSATION

The section titled “Compensation of Executive Officers” to appear in the Registrant’s Proxy Statement for the 2006 Annual Meeting of Shareholders is to set forth certain information with respect to the compensation of management of the Registrant and is incorporated herein by reference.

ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT AND RELATED SHAREHOLDER MATTERS

The section titled “Security Ownership of Management and Certain Beneficial Owners of Nanometrics” to appear in the Registrant’s Proxy Statement for the 2006 Annual Meeting of Shareholders is to set forth certain information with respect to the ownership of the Registrant’s Common Stock and is incorporated herein by reference.

ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS

The section titled “Certain Relationships and Related Transactions” to appear in the Registrant’s Proxy Statement for the 2006 Annual Meeting of Shareholders is to set forth certain information with respect to certain business relationships and transactions between the Registrant and its directors and officers and is incorporated herein by reference.

ITEM 14. PRINCIPAL ACCOUNTANT FEES AND SERVICES

The information required by this Item is incorporated herein by reference and is to be set forth under the heading “Ratification of Appointment of Independent Registered Public Accountants” to be included in the Registrant’s Proxy Statement for the 2006 Annual Meeting of Shareholders.

79

PART IV

ITEM 15. EXHIBITS AND FINANCIAL STATEMENT SCHEDULES

Consolidated Financial Statements.

See Index to Consolidated Financial Statements at Item 8 on page 46 of this Annual Report on Form 10-K.

Consolidated Financial Statement Schedules.

The following consolidated financial statement schedule of Nanometrics Incorporated is filed as part of this Annual Report on Form 10-K and should be read in conjunction with the Consolidated Financial Statements:

Schedule	Page
II – Valuation and Qualifying Accounts	84

Schedules not listed above have been omitted because they are not applicable or are not required or the information required to be set forth therein is included in the Consolidated Financial Statements or notes thereto.

Exhibits.

The following exhibits are filed or incorporated by reference with this Annual Report on Form 10-K:

Exhibit No.	Description
2	Plans of Acquisition, Reorganization, Arrangement, Liquidation or Succession
2.1(1)	Asset Purchase and License Agreement between the Registrant and Toho Technology Corporation dated September 14th, 2005
2.2(2)	Agreement and Plan of Merger and Reorganization dated January 25, 2006 by and among the Registrant, Alloy Merger Corporation, Accent Optical Technologies, Inc., and, solely with respect to Article IX, Sanford S. Wadler
2.3(2)	Form of Voting Agreement by and among the Registrant, Accent Optical Technologies, Inc. and certain shareholders of Accent Optical Technologies, Inc.
2.4(2)	Form of Shareholder Agreement by and between the Registrant and certain shareholders of Accent Optical Technologies, Inc.
3.(i)	Articles of Incorporation
3.1(3)	Amended and Restated Articles of Incorporation of the Registrant
3.(ii)	Bylaws
3.2(a)(4)	Certificate of Amendment of Amended and Restated Bylaws of the Registrant
3.2.(b)(5)	Restated Bylaws of the Registrant
4	Instruments Defining the Rights of Security Holders, Including Indentures
4.1(6)	Form of Common Stock Certificate
10	Material Contracts
	Management Contracts, Compensatory Plans, Contracts or Arrangements
10.1(7)	Agreement between Roger Ingalls, Jr. and the Registrant, effective as of March 7, 1995
10.2(5)	Form of Indemnification Agreement for Directors and Officers of the Registrant

80

Exhibit No.	Description
10.3(8)	Registrant’s 1991 Stock Option Plan, as amended effective May 15, 1997
10.4(9)	Registrant’s 1991 Director Option Plan
10.5(7)	Amendment to and Restatement of Salary Reduction Agreement between Vincent J. Coates and the Registrant dated as of April 16, 1998
10.6(7)	Agreement between John Davis Heaton and the Registrant dated as of April 20, 1998
10.7(10)	Registrant’s 2000 Employee Stock Option Plan and form of Stock Option Agreement
10.8(10)	Registrant’s 2000 Director Stock Option Plan and form of Stock Option Agreement
10.9(11)	Registrant’s 2002 Nonstatutory Stock Option Plan and form of Stock Option Agreement
10.10(12)	Registrant’s 2003 Employee Stock Purchase Plan
10.11	Registrant’s 2005 Equity Incentive Plan
10.12(13)	Compensation arrangements of the named executive officers of the Registrant for fiscal year 2005
10.13	Employment Agreement between Douglas McCutcheon and the Registrant dated September 27, 2005
	All Other Material Contracts
10.14(5)	Loan Agreement between Japan Development Bank and Nanometrics Japan k.k.
10.15(5)	Loan Agreement and Guarantee dated June 5, 1995 between Mitsubishi Bank, Limited and Nanometrics Japan Ltd.
10.16(7)	Lease Agreement by and between University Housing Corp. and the Registrant dated February 2, 2001, as amended
14	Code of Ethics
14(14)	Registrant’s Code of Business Conduct and Ethics
21	Subsidiaries
21(5)	Subsidiaries of the Registrant
23	Consents of Experts and Counsel
23.1	Consent of BDO Seidman, LLP, Independent Registered Public Accounting Firm
23.2	Consent of Deloitte & Touche, LLP, Independent Registered Public Accounting Firm
24	Power of Attorney
24	Power of Attorney (see page 83)
31	Rule 13a-14(a)/15d-14(a) Certifications
31.1	Certification of John D. Heaton, principal executive officer of the Registrant, pursuant to Section 302 of the Sarbanes-Oxley Act of 2002
31.2	Certification of Douglas J. McCutcheon, principal financial officer of the Registrant, pursuant to Section 302 of the Sarbanes-Oxley Act of 2002

81

Exhibit No.	Description
32	Section 1350 Certifications
32.1	Certification of John D. Heaton, principal executive officer of the Registrant, and Douglas J. McCutcheon, principal financial officer of the Registrant pursuant to Section 906 of the Sarbanes-Oxley Act of 2002

(1) Incorporated by reference to the Registrant’s Quarterly Report on Form 10-Q filed on November 21, 2005

(2) Incorporated by reference to the Registrant’s Current Report on Form 8-K/A filed February 21, 2006

(3) Incorporated by reference to the Registrant’s Annual Report on Form 10-K filed on March 28, 2003

(4) Incorporated by reference to Exhibit 3.10 of Registrant’s Annual Report on Form 10-K filed on March 30, 2001

(5) Incorporated by reference to the Registrant’s Annual Report on Form 10-K filed on April 1, 1998

(6) Incorporated by reference to exhibits filed with Registrant’s Registration Statement on Form S-1 (File No. 2-93949), which became effective November 28, 1984

(7) Incorporated by reference to the Registrant’s Annual Report on Form 10-K filed on March 23, 2005

(8) Incorporated by reference to Exhibit 4.1 filed with Registrant’s Registration Statement on Form S-8 (File No. 333-33583) filed on August 14, 1997

(9) Incorporated by reference to Exhibit 4.2 filed with Registrant’s Registration Statement on Form S-8 (File No. 33-43913) filed on November 14, 1991

(10) Incorporated by reference to exhibits filed with Registrant’s Registration Statement on Form S-8 (File No. 333-40866) filed on July 6, 2000

(11) Incorporated by reference to Exhibit 4.1 filed with Registrant’s Registration Statement on Form S-8 (File No. 333-101137) filed on November 12, 2002

(12) Incorporated by reference to Exhibit 4.1 filed with Registrant’s Registration Statement on Form S-8 (File No. 333-108474) filed on September 3, 2003

(13) Incorporated by reference to the Registrant’s Current Report on Form 8-K filed March 7, 2005

(14) Incorporated by reference to Registrant’s Annual Report on Form 10-K filed on April 1, 2004

82

SIGNATURES

Pursuant to the requirements of Section 13 or 15(d) of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned, thereunto duly authorized.

Dated: March 23, 2006

NANOMETRICS INCORPORATED
By:	/S/    DOUGLAS J. MCCUTCHEON
	Douglas J. McCutcheon
	Chief Financial Officer

POWER OF ATTORNEY

KNOW ALL PERSONS BY THESE PRESENTS, that each person whose signature appears below constitutes and appoints John D. Heaton and Douglas J. McCutcheon jointly and severally, his attorneys-in-fact, each with the power of substitution, for him in any and all capacities, to sign any and all amendments to this Report on Form 10-K, and to file the same, with exhibits thereto and other documents in connection therewith, with the Securities and Exchange Commission, hereby ratifying and confirming all that said attorneys-in-fact, or his substitute or substitutes, may do or cause to be done by virtue hereof.

Pursuant to the requirements of the Securities Exchange Act of 1934, this Report on Form 10-K has been signed below by the following persons on behalf of the registrant on the 23rd day of March, 2006 in the capacities indicated.

Signature	Title
/S/    JOHN D. HEATON         John D. Heaton	President, Chief Executive Officer and Director (Principal Executive Officer)
/S/    DOUGLAS J. MCCUTCHEON         Douglas J. McCutcheon	Chief Financial Officer (Principal Financial Officer)
/S/    QUENTIN B. WRIGHT         Quentin B. Wright	Chief Accounting Officer (Principal Accounting Officer)
/S/    VINCENT J. COATES         Vincent J. Coates	Chairman of the Board of Directors
/S/    STEPHEN SMITH         Stephen Smith	Director
William G. Oldham	Director
/S/    EDMOND R. WARD         Edmond R. Ward	Director
/S/    J. THOMAS BENTLEY         J. Thomas Bentley	Director
/S/    NORMAN V. COATES         Norman V. Coates	Director

83

SCHEDULE II

NANOMETRICS INCORPORATED

VALUATION AND QUALIFYING ACCOUNTS

Allowance for Doubtful Accounts Receivable

Our allowance for doubtful accounts receivable consists of the following (in thousands):

Year Ended	Balance at beginning of period		Charged to costs and expenses		Deductions – write-offs of accounts		Balance at end of period
December 31, 2005	$	603	$	0	$	11	$	592
January 1, 2005	$	576	$	27	$	0	$	603
January 3, 2004	$	566	$	10	$	0	$	576

84

EX-10.11

EXHIBIT 10.11

2005 EQUITY INCENTIVE PLAN

1. Purposes of the Plan. The purposes of this Plan are:

• to attract and retain the best available personnel for positions of substantial responsibility,

• to provide additional incentive to Service Providers, and

• to promote the success of the Company’s business.

Awards granted under the Plan may be Incentive Stock Options, Nonstatutory Stock Options, Restricted Stock, Stock Appreciation Rights, Performance Shares and Restricted Stock Units, as determined by the Administrator at the time of grant.

2. Definitions. As used herein, the following definitions shall apply:

(a) “Administrator” means the Board or any of its Committees as shall be administering the Plan, in accordance with Section 4 of the Plan.

(b) “Annual Revenue” means the Company’s or a business unit’s net sales for the Fiscal Year, determined in accordance with generally accepted accounting principles.

(c) “Applicable Laws” means the requirements relating to the administration of equity compensation plans under U.S. state corporate laws, U.S. federal and state securities laws, the Code, any stock exchange or quotation system on which the Common Stock is listed or quoted and the applicable laws of any other country or jurisdiction where Awards are, or will be, granted under the Plan.

(d) “Award” means, individually or collectively, a grant under the Plan of Options, Restricted Stock, Stock Appreciation Rights, Performance Shares or Restricted Stock Units.

(e) “Award Agreement” means the written or electronic agreement setting forth the terms and provisions applicable to each Award granted under the Plan. The Award Agreement is subject to the terms and conditions of the Plan.

(f) “Awarded Stock” means the Common Stock subject to an Award.

(g) “Board” means the Board of Directors of the Company.

(h) “Cash Position” means the Company’s level of cash and cash equivalents.

(i) “Change in Control” means the occurrence of any of the following events, in one or a series of related transactions:

(i) any “person,” as such term is used in Sections 13(d) and 14(d) of the Exchange Act, other than the Company, a subsidiary of the Company or a Company employee benefit plan, including any trustee of such plan acting as trustee, is or becomes the “beneficial owner” (as defined in Rule 13d-3 under the Exchange Act), directly or indirectly, of securities of the Company representing fifty percent (50%) or more of the combined voting power of the Company’s then outstanding securities entitled to vote generally in the election of directors; or

(ii) the consummation of a merger or consolidation of the Company or any direct or indirect subsidiary of the Company with any other corporation, other than a merger or consolidation which would result in the voting securities of the Company outstanding immediately prior thereto continuing to represent (either by remaining outstanding or by being converted into voting securities of the surviving entity) at least fifty percent (50%) of the total voting power represented by the voting securities of the Company or such surviving entity outstanding immediately after such merger or consolidation; or

(iii) the sale or disposition by the Company of all or substantially all the Company’s assets; or

(iv) a change in the composition of the Board, as a result of which fewer than a majority of the directors are Incumbent Directors. “Incumbent Directors” shall mean directors who either (A) are Directors as of the date this Plan is approved by the Board, or (B) are elected, or nominated for election, to the Board with the affirmative votes of at least a majority of the Incumbent Directors and whose election or nomination was not in connection with any transaction described in (i) or (ii) above or in connection with an actual or threatened proxy contest relating to the election of directors of the Company.

(j) “Code” means the Internal Revenue Code of 1986, as amended.

(k) “Committee” means a committee of Directors appointed by the Board in accordance with Section 4 of the Plan.

(l) “Common Stock” means the common stock of the Company.

(m) “Company” means Nanometrics Incorporated, a California corporation.

(n) “Consultant” means any person, including an advisor, engaged by the Company or a Parent or Subsidiary to render services and who is compensated for such services.

(o) “Continuous Status as a Service Provider” means the absence of any interruption or termination of the employment or service relationship with the Company or any Subsidiary. Continuous Status as a Service Provider shall not be considered interrupted in the case of (i) medical leave, military leave, family leave, or any other leave of absence approved by the Administrator, provided, in each case, that such leave does not result in termination of the employment and service relationship with the Company or any Subsidiary, as the case may be, under the terms of the respective Company policy for such leave; however, vesting may be tolled while a Service Provider is on an approved leave of absence under the terms of the respective Company policy for such leave; or (ii) in the case of transfers between locations of the Company or between

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the Company, its Parent or any Subsidiary, or any successor. For purposes of Incentive Stock Options, no such leave may exceed ninety days, unless reemployment upon expiration of such leave is guaranteed by statute or contract. If reemployment upon expiration of a leave of absence approved by the Company is not so guaranteed, then three (3) months following the 91st day of such leave any Incentive Stock Option held by the Participant shall cease to be treated as an Incentive Stock Option and shall be treated for tax purposes as a Nonstatutory Stock Option.

(p) “Director” means a member of the Board.

(q) “Disability” means total and permanent disability as defined in Section 22(e)(3) of the Code.

(r) “Dividend Equivalent” means a credit, payable in cash, made at the discretion of the Administrator, to the account of a Participant in an amount equal to the cash dividends paid on one Share for each Share represented by an Award held by such Participant.

(s) “Earnings Per Share” means as to any Performance Period, the Company’s or a business unit’s Net Income, divided by a weighted average number of common shares outstanding and dilutive common equivalent shares deemed outstanding, determined in accordance with generally accepted accounting principles.

(t) “Employee” means any person, including Officers and Directors, employed by the Company or any Parent or Subsidiary of the Company. Neither service as a Chairman nor as a Director nor payment of a director’s fee by the Company shall be sufficient to constitute “employment” by the Company.

(u) “Exchange Act” means the Securities Exchange Act of 1934, as amended.

(v) “Exchange Program” means a program under which (i) outstanding Awards are surrendered or cancelled in exchange for Awards of the same type (which may have lower exercise prices and different terms), Awards of a different type, and/or cash, and/or (ii) the exercise price of an outstanding Award is reduced. The terms and conditions of any Exchange Program will be determined by the Administrator in its sole discretion.

(w) “Fair Market Value” means, as of any date, the value of Common Stock determined as follows:

(i) If the Common Stock is listed on any established stock exchange or a national market system, including without limitation the Nasdaq National Market or The Nasdaq SmallCap Market of The Nasdaq Stock Market, its Fair Market Value shall be the closing sales price for such stock (or the closing bid, if no sales were reported) as quoted on such exchange or system, on the last market trading day prior to the date of determination, as reported in The Wall Street Journal or such other source as the Administrator deems reliable;

(ii) If the Common Stock is regularly quoted by a recognized securities dealer but selling prices are not reported, the Fair Market Value of a Share of Common Stock shall be the mean between the high bid and low asked prices for the Common Stock on the last market trading day prior to the date of determination; or

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(iii) In the absence of an established market for the Common Stock, the Fair Market Value shall be determined in good faith by the Administrator.

(x) “Fiscal Year” means a fiscal year of the Company.

(y) “Individual Performance Objective” means as to a Participant, the objective and measurable goals set by a “management by objectives” process and approved by the Committee (in its discretion).

(z) “Incentive Stock Option” means an Option intended to qualify as an incentive stock option within the meaning of Section 422 of the Code and the regulations promulgated thereunder and is expressly designated by the Administrator at the time of grant as an incentive stock option.

(aa) “Marketing and Sales Expenses as a Percentage of Sales” means as to any Performance Period, the Company’s or a business unit’s marketing and sales expenses stated as a percentage of sales, determined in accordance with generally accepted accounting principles.

(bb) “Net Income as a Percentage of Sales” means as to any Performance Period, the Company’s or a business unit’s Net Income stated as a percentage of sales, determined in accordance with generally accepted accounting principles.

(cc) “Net Income” means as to any Performance Period, the income after taxes of the Company or a business unit determined in accordance with generally accepted accounting principles, provided that prior to the beginning of the Performance Period, the Committee shall determine whether any significant item(s) shall be included or excluded from the calculation of Net Income with respect to one or more Participants.

(dd) “Nonstatutory Stock Option” means an Option that by its terms does not qualify or is not intended to qualify as an Incentive Stock Option.

(ee) “Officer” means a person who is an officer of the Company within the meaning of Section 16 of the Exchange Act and the rules and regulations promulgated thereunder.

(ff) “Operating Cash Flow” means the Company’s or a business unit’s sum of Net Income plus depreciation and amortization less capital expenditures plus changes in working capital comprised of accounts receivable, inventories, other current assets, trade accounts payable, accrued expenses, product warranty, advance payments from customers and long-term accrued expenses, determined in accordance with generally acceptable accounting principles.

(gg) “Operating Income” means the Company’s or a business unit’s income from operations determined in accordance with generally accepted accounting principles.

(hh) “Outside Director” means a Director who is not an Employee.

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(ii) “Option” means a stock option granted pursuant to the Plan.

(jj) “Participant” means the holder of an outstanding Award granted under the Plan.

(kk) “Parent” means a “parent corporation,” whether now or hereafter existing, as defined in Section 424(e) of the Code.

(ll) “Performance Goals” means the goal(s) (or combined goal(s)) determined by the Committee (in its discretion) to be applicable to a Participant with respect to an Award. As determined by the Committee, the Performance Goals applicable to an Award may provide for a targeted level or levels of achievement using one or more of the following measures: (a) Annual Revenue, (b) Cash Position, (c) Earnings Per Share, (d) Individual Performance Objectives, (e) Marketing and Sales Expenses as a Percentage of Sales, (f) Net Income as a Percentage of Sales, (g) Net Income, (h) Operating Cash Flow, (i) Operating Income, (j) Return on Assets, (k) Return on Equity, (l) Return on Sales, and (m) Total Shareholder Return. The Performance Goals may differ from Participant to Participant and from Award to Award. The Committee shall appropriately adjust any evaluation of performance under a Performance Goal to exclude (i) any extraordinary non-recurring items as described in Accounting Principles Board Opinion No. 30 and/or in management’s discussion and analysis of financial conditions and results of operations appearing in the Company’s annual report to shareholders for the applicable year, or (ii) the effect of any changes in accounting principles affecting the Company’s or a business units’ reported results. Any criteria used may be measured, as applicable, (i) in absolute terms, (ii) in relative terms (including, but not limited to, passage of time and/or against another company or companies), (iii) on a per-share basis, (iv) against the performance of the Company as a whole or of a business unit of the Company, and/or (v) to the extent not otherwise specified by the definition of the Performance Goal, on a pre-tax or after-tax basis.

(mm) “Performance Period” means the time period of any Fiscal Year or such longer period as determined by the Committee in its sole discretion during which the performance objectives must be met.

(nn) “Performance Share” means a performance share Award granted to a Participant pursuant to Section 14.

(oo) “Period of Restriction” means the period during which the transfer of Shares of Restricted Stock are subject to restrictions and therefore, the Shares are subject to a substantial risk of forfeiture. Such restrictions may be based on the passage of time (including the continuation of employment or service), the achievement of target levels of performance, or the occurrence of other events as determined by the Administrator.

(pp) “Plan” means this 2005 Equity Incentive Plan.

(qq) “Restricted Stock” means shares of Common Stock granted pursuant to Section 12 of the Plan, as evidenced by an Award Agreement.

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(rr) “Restricted Stock Unit” means a bookkeeping entry representing an amount equal to the Fair Market Value of one Share, granted pursuant to Section 13. Each Restricted Stock Unit represents an unfunded and unsecured obligation of the Company.

(ss) “Return on Assets” means the percentage equal to the Company’s or a business unit’s Operating Income before incentive compensation, divided by average net Company or business unit, as applicable, assets, determined in accordance with generally accepted accounting principles.

(tt) “Return on Equity” means the percentage equal to the Company’s Net Income divided by average shareholder’s equity, determined in accordance with generally accepted accounting principles.

(uu) “Return on Sales” means the percentage equal to the Company’s or a business unit’s Operating Income before incentive compensation, divided by the Company’s or the business unit’s, as applicable, revenue, determined in accordance with generally accepted accounting principles.

(vv) “Rule 16b-3” means Rule 16b-3 of the Exchange Act or any successor to Rule 16b-3, as in effect when discretion is being exercised with respect to the Plan.

(ww) “Section 16(b)” means Section 16(b) of the Exchange Act.

(xx) “Service Provider” means an Employee, Director or Consultant.

(yy) “Share” means a share of the Common Stock, as adjusted in accordance with Section 17 of the Plan.

(zz) “Stock Appreciation Right” or “SAR” means a stock appreciation right granted pursuant to Section 10 below.

(aaa) “Subsidiary” means a “subsidiary corporation”, whether now or hereafter existing, as defined in Section 424(f) of the Code.

(bbb) “Total Shareholder Return” means the total return (change in share price plus reinvestment of any dividends) of a share of the Company’s common stock.

3. Stock Subject to the Plan. Subject to the provisions of Section 17 of the Plan, the maximum aggregate number of Shares which may issued under the Plan is 1,200,000 Shares, plus an annual increase to be added on the first day of the Company’s Fiscal Year for three years beginning in 2006 and ending after the 2008 annual increase equal to the least of (i) 3% of the outstanding Shares on such date or (ii) an amount determined by the Board. The Shares may be authorized, but unissued, or reacquired Common Stock.

Any Shares subject to Options or SARs shall be counted against the numerical limits of this Section 3 as one Share for every Share subject thereto. Any Shares of Restricted Stock or Shares subject to Performance Shares or Restricted Stock Units with a per share or unit purchase price

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lower than 100% of Fair Market Value on the date of grant shall be counted against the numerical limits of this Section 3 as two Shares for every one Share subject thereto. To the extent that a Share that was subject to an Award that counted as two Shares against the Plan reserve pursuant to the preceding sentence is recycled back into the Plan under the next paragraph of this Section 3, the Plan shall be credited with two Shares.

If an Award expires or becomes unexercisable without having been exercised in full or is surrendered pursuant to an Exchange Program, or, with respect to Options, Restricted Stock, Performance Shares or Restricted Stock Units, is forfeited to or repurchased by the Company, the unpurchased Shares (or for Awards other than Options and SARs, the forfeited or repurchased shares) which were subject thereto shall become available for future grant or sale under the Plan (unless the Plan has terminated). With respect to SARs, Shares actually issued pursuant to an SAR as well as the Shares withheld to pay the exercise price shall cease to be available under the Plan. Shares that have actually been issued under the Plan under any Award shall not be returned to the Plan and shall not become available for future distribution under the Plan; provided, however, that if Shares of Restricted Stock, Performance Shares or Restricted Stock Units are repurchased by the Company at their original purchase price or are forfeited to the Company, such Shares shall become available for future grant under the Plan. Shares used to pay the exercise price of an Option or the purchase price of Restricted Stock shall not become available for future grant or sale under the Plan. Shares used to satisfy tax withholding obligations shall not become available for future grant or sale under the Plan. To the extent an Award under the Plan is paid out in cash rather than stock, such cash payment shall not reduce the number of Shares available for issuance under the Plan. Any payout of Dividend Equivalents, because they are payable only in cash, shall not reduce the number of Shares available for issuance under the Plan. Conversely, any forfeiture of Dividend Equivalents shall not increase the number of Shares available for issuance under the Plan.

4. Administration of the Plan.

(a) Procedure.

(i) Multiple Administrative Bodies. The Board or different Committees with respect to different groups of Service Providers may administer the Plan.

(ii) Section 162(m). To the extent that the Administrator determines it to be desirable to qualify Awards granted hereunder as “performance-based compensation” within the meaning of Section 162(m) of the Code, the Plan shall be administered by a Committee of two or more “outside directors” within the meaning of Section 162(m) of the Code.

(iii) Rule 16b-3. To the extent desirable to qualify transactions hereunder as exempt under Rule 16b-3, the transactions contemplated hereunder shall be structured to satisfy the requirements for exemption under Rule 16b-3.

(iv) Other Administration. Other than as provided above, the Plan shall be administered by (a) the Board or (b) a Committee, which committee shall be constituted to satisfy Applicable Laws.

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(b) Powers of the Administrator. Subject to the provisions of the Plan, and in the case of a Committee, subject to the specific duties delegated by the Board to such Committee, the Administrator shall have the authority, in its discretion:

(i) to determine the Fair Market Value;

(ii) to select the Service Providers to whom Awards may be granted hereunder;

(iii) to determine the number of shares of Common Stock or equivalent units to be covered by each Award granted hereunder;

(iv) to approve forms of Award Agreement for use under the Plan;

(v) to determine the terms and conditions, not inconsistent with the terms of the Plan, of any Award granted hereunder. Such terms and conditions include, but are not limited to, the exercise price, the date of grant, the time or times when Awards may be exercised (or are earned) (which may be based on performance criteria), any vesting acceleration or waiver of forfeiture restrictions, and any restriction or limitation regarding any Award or the Shares relating thereto, based in each case on such factors as the Administrator, in its sole discretion, shall determine;

(vi) to institute an Exchange Program; however, the Administrator may not institute an Exchange Program without shareholder approval.

(vii) to construe and interpret the terms of the Plan and Awards granted pursuant to the Plan;

(viii) to prescribe, amend and rescind rules and regulations relating to the Plan, including rules and regulations relating to sub-plans established for the purpose of satisfying applicable foreign laws and/or qualifying for preferred tax treatment under foreign tax laws;

(ix) to modify or amend each Award (subject to Section 19(c) of the Plan), including the discretionary authority to extend the post-termination exercisability period of Options and SARs longer than is otherwise provided for in the Plan;

(x) to allow Participants to satisfy withholding tax obligations by electing to have the Company withhold from the Shares or cash to be issued upon exercise of an Option, SAR or right to purchase Restricted Stock or upon vesting or payout of another Award, that number of Shares or cash having a Fair Market Value equal to the minimum amount required to be withheld. The Fair Market Value of the Shares to be withheld shall be determined on the date that the amount of tax to be withheld is to be determined. All elections by a Participant to have Shares or cash withheld for this purpose shall be made in such form and under such conditions as the Administrator may deem necessary or advisable;

(xi) to determine whether Awards will be adjusted for Dividend Equivalents;

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(xii) to authorize any person to execute on behalf of the Company any instrument required to effect the grant of an Award previously granted by the Administrator; and

(xiii) to make all other determinations deemed necessary or advisable for administering the Plan.

(c) Effect of Administrator’s Decision. The Administrator’s decisions, determinations and interpretations shall be final and binding on all Participants and any other holders of Awards.

5. Eligibility. Awards may be granted to Service Providers; provided, however, that Incentive Stock Options may be granted only to Employees.

6. No Employment Rights. Neither the Plan nor any Award shall confer upon a Participant any right with respect to continuing the Participant’s relationship as an Employee or other Service Provider with the Company or its Subsidiaries, nor shall they interfere in any way with the Participant’s right or the Company’s or Subsidiary’s right, as the case may be, to terminate such relationship at any time, with or without cause.

7. Code Section 162(m) Provisions.

(a) Option and SAR Annual Share Limit. No Participant shall be granted, in any Fiscal Year, Options and Stock Appreciation Rights to purchase more than 500,000 Shares; provided, however, that such limit shall be 250,000 Shares in the Participant’s first Fiscal Year of Company service.

(b) Restricted Stock, Performance Share and Restricted Stock Unit Annual Limit. No Participant shall be granted, in any Fiscal Year, more than 250,000 Shares in the aggregate of the following: (i) Restricted Stock, (ii) Performance Shares, or (iii) Restricted Stock Units; provided, however, that such limit shall be 125,000 Shares in the Participant’s first Fiscal Year of Company service.

(c) Section 162(m) Performance Restrictions. For purposes of qualifying grants of Restricted Stock, Performance Shares or Restricted Stock Units as “performance-based compensation” under Section 162(m) of the Code, the Administrator, in its discretion, may set restrictions based upon the achievement of Performance Goals. The Performance Goals shall be set by the Administrator on or before the latest date permissible to enable the Restricted Stock, Performance Shares or Restricted Stock Units to qualify as “performance-based compensation” under Section 162(m) of the Code. In granting Restricted Stock, Performance Shares or Restricted Stock Units which are intended to qualify under Section 162(m) of the Code, the Administrator shall follow any procedures determined by it from time to time to be necessary or appropriate to ensure qualification of the Award under Section 162(m) of the Code (e.g., in determining the Performance Goals).

(d) Changes in Capitalization. The numerical limitations in Sections 7(a) and (b) shall be adjusted proportionately in connection with any change in the Company’s capitalization as described in Section 17(a).

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(e) If an Award is cancelled in the same Fiscal Year in which it was granted (other than in connection with a transaction described in Section 17 of the Plan), the cancelled Award will be counted against the limits set forth in subsections (a) and (b) above. For this purpose, if the exercise price of an Option is reduced, the transaction will be treated as a cancellation of the Option and the grant of a new Option.

8. Term of Plan. Subject to Section 23 of the Plan, the Plan will become effective upon its adoption by the Board. It will continue in effect for a term of ten (10) years unless terminated earlier under Section 19 of the Plan.

9. Stock Options.

(a) Type of Option. Each Option shall be designated in the Award Agreement as either an Incentive Stock Option or a Nonstatutory Stock Option. However, not withstanding such designation, to the extent that the aggregate Fair Market Value of the Shares with respect to which Incentive Stock Options are exercisable for the first time by the Participant during any calendar year (under all plans of the Company and any Parent or Subsidiary) exceeds $100,000, such Options shall be treated as Nonstatutory Stock Options. For purposes of this Section 9(a), Incentive Stock Options shall be taken into account in the order in which they were granted. The Fair Market Value of the Shares shall be determined as of the time the Option with respect to such Shares is granted.

(b) Term. The term of each Option shall be stated in the Award Agreement. In the case of an Incentive Stock Option, the term shall be ten (10) years from the date of grant or such shorter term as may be provided in the Award Agreement. Moreover, in the case of an Incentive Stock Option granted to a Participant who, at the time the Incentive Stock Option is granted, owns stock representing more than ten percent (10%) of the total combined voting power of all classes of stock of the Company or any Parent or Subsidiary, the term of the Incentive Stock Option shall be five (5) years from the date of grant or such shorter term as may be provided in the Award Agreement.

(c) Option Exercise Price and Consideration.

(i) Exercise Price. The per Share exercise price for the Shares to be issued pursuant to exercise of an Option will be determined by the Administrator, subject to the following:

(1) In the case of an Incentive Stock Option granted to an Employee who, at the time the Incentive Stock Option is granted, owns stock representing more than ten percent (10%) of the voting power of all classes of stock of the Company or any Parent or Subsidiary, the per Share exercise price will be no less than 110% of the Fair Market Value per Share on the date of grant.

(2) In the case of all other Options, the per Share exercise price will be no less than 100% of the Fair Market Value per Share on the date of grant.

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(3) Notwithstanding the foregoing, Options may be granted with a per Share exercise price of less than 100% of the Fair Market Value per Share on the date of grant pursuant to a merger or other corporate transaction.

(ii) Waiting Period and Exercise Dates. At the time an Option is granted, the Administrator shall fix the period within which the Option may be exercised and shall determine any conditions which must be satisfied before the Option may be exercised.

(iii) Form of Consideration. The Administrator shall determine the acceptable form of consideration for exercising an Option, including the method of payment. In the case of an Incentive Stock Option, the Administrator shall determine the acceptable form of consideration at the time of grant. Subject to Applicable Laws, such consideration may consist entirely of:

(1) cash;

(2) check;

(3) promissory note;

(4) other Shares which have a Fair Market Value on the date of surrender equal to the aggregate exercise price of the Shares as to which said Option shall be exercised and which meet the conditions established by the Administrator to avoid adverse accounting consequences (as determined by the Administrator);

(5) consideration received by the Company under a cashless exercise program implemented by the Company in connection with the Plan;

(6) a reduction in the amount of any Company liability to the Participant, including any liability attributable to the Participant’s participation in any Company-sponsored deferred compensation program or arrangement;

(7) any combination of the foregoing methods of payment;

(8) such other consideration and method of payment for the issuance of Shares to the extent permitted by Applicable Laws; or

(9) any combination of the foregoing methods of payment.

10. Stock Appreciation Rights.

(a) Grant of SARs. Subject to the terms and conditions of the Plan, a SAR may be granted to Service Providers at any time and from time to time as will be determined by the Administrator, in its sole discretion.

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(b) Number of Shares. The Administrator will have complete discretion to determine the number of SARs granted to any Service Provider, subject to the limits set forth in Section 7.

(c) Exercise Price and Other Terms. The Administrator, subject to the provisions of the Plan, will have complete discretion to determine the terms and conditions of SARs granted under the Plan.

(d) Exercise of SARs. SARs will be exercisable on such terms and conditions as the Administrator, in its sole discretion, will determine.

(e) SAR Agreement. Each SAR grant will be evidenced by an Award Agreement that will specify the exercise price, the term of the SAR, the conditions of exercise, and such other terms and conditions as the Administrator, in its sole discretion, will determine.

(f) Expiration of SARs. An SAR granted under the Plan will expire upon the date determined by the Administrator, in its sole discretion, and set forth in the Award Agreement; provided, however, that no SAR will have a term of more than ten (10) years fom the date of grant.

(g) Payment of SAR Amount. Upon exercise of an SAR, a Participant will be entitled to receive payment from the Company in an amount determined by multiplying:

(i) The difference between the Fair Market Value of a Share on the date of exercise over the exercise price; times

(ii) The number of Shares with respect to which the SAR is exercised.

(h) Form of Payment. The Company’s obligation arising upon the exercise of a SAR may be paid in Common Stock or in cash, or in any combination of Common Stock and cash, as the Administrator, in its sole discretion, may determine. Shares issued upon the exercise of a SAR shall be valued at their Fair Market Value as of the date of exercise.

11. Exercise of Option or SAR.

(a) Procedure for Exercise; Rights as a Shareholder. Any Option or SAR granted hereunder shall be exercisable according to the terms of the Plan and at such times and under such conditions as determined by the Administrator and set forth in the Award Agreement. An Option may not be exercised for a fraction of a Share.

An Option or SAR shall be deemed exercised when the Company receives: (i) written or electronic notice of exercise (in accordance with the terms of the Option or SAR) from the person entitled to exercise the Option or SAR, and (ii) full payment for the Shares with respect to which the Option is exercised. Full payment may consist of any consideration and method of payment authorized by the Administrator and permitted by the Award Agreement and the Plan. Shares issued upon exercise of an Option or SAR shall be issued in the name of the Participant or, if requested by the Participant, in the name of the Participant and his or her spouse. Until the Shares are issued (as evidenced by the appropriate entry on the books of the Company or of a duly authorized transfer

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agent of the Company), no right to vote or receive dividends or any other rights as a shareholder shall exist with respect to the Awarded Stock, notwithstanding the exercise of the Option. The Company shall issue or cause to be issued (and which issuance may be in electronic entry form) such Shares promptly after the Option is exercised. No adjustment will be made for a dividend or other right for which the record date is prior to the date the Shares are issued, except as provided in Section 17 of the Plan.

Exercising an Option in any manner shall decrease the number of Shares thereafter available, both for purposes of the Plan and for sale under the Option, by the number of Shares as to which the Option is exercised. Exercise of a SAR in any manner shall, to the extent the SAR is exercised, result in a decrease in the number of Shares which thereafter shall be available for purposes of the Plan, and the SAR shall cease to be exercisable to the extent it has been exercised.

(b) Termination of Continuous Status as a Service Provider. Upon termination of a Participant’s Continuous Status as a Service Provider (other than termination by reason of the Participant’s death or Disability), the Participant may exercise his or her Option or SAR within such period of time as is specified in the Award Agreement to the extent that the Award is vested on the date of termination (but in no event later than the expiration of the term of such Award as set forth in the Award Agreement). In the absence of a specified time in the Option Agreement, the Option shall remain exercisable for three (3) months following the Participant’s termination. If the Option or SAR is not so exercised within the time specified herein, the Option or SAR shall terminate, and the Shares covered by such Option or SAR shall revert to the Plan. Unless otherwise provided by the Administrator, if on the date of termination the Participant is not vested as to his or her entire Option or SAR, the Shares covered by the unvested portion of the Option or SAR will revert to the Plan on the date one (1) month following the Participant’s termination. Notwithstanding the foregoing, in no event shall an Option or SAR be exercisable after the expiration of the term of the Award as provided in the Award Agreement.

(c) Disability of Participant. If a Participant terminates his or her Continuous Status as a Service Provider as a result of his or her Disability, the Participant may exercise his or her Option or SAR within such period of time as is specified in the Award Agreement to the extent the Option or SAR is vested on the date of termination (but in no event later than the expiration of the term of such Option or SAR as set forth in the Award Agreement). In the absence of a specified time in the Award Agreement, the Option or SAR shall remain exercisable for twelve (12) months following the Participant’s termination. If, after termination, the Participant does not exercise his or her Option or SAR within the time specified herein, the Option or SAR shall terminate, and the Shares covered by such Option or SAR shall revert to the Plan. Unless otherwise provided by the Administrator, if on the date of termination the Participant is not vested as to his or her entire Option or SAR, the Shares covered by the unvested portion of the Option or SAR will revert to the Plan on the date one (1) month following the Participant’s termination. Notwithstanding the foregoing, in no event shall an Option or SAR be exercisable after the expiration of the term of the Award as provided in the Award Agreement.

(d) Death of Participant. If a Participant dies while a Service Provider, the Option or SAR may be exercised following the Participant’s death within such period of time as is specified in the Award Agreement (but in no event may the option be exercised later than the expiration of the

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term of such Option or SAR as set forth in the Award Agreement), by the Participant’s designated beneficiary, provided such beneficiary has been designated prior to Participant’s death in a form acceptable to the Administrator. If no such beneficiary has been designated by the Participant, then such Option may be exercised by the personal representative of the Participant’s estate or by the person(s) to whom the Option or SAR is transferred pursuant to the Participant’s will or in accordance with the laws of descent and distribution. In the absence of a specified time in the Award Agreement, the Option or SAR shall remain exercisable for twelve (12) months following Participant’s death. If the Option or SAR is not so exercised within the time specified herein, the Option or SAR shall terminate, and the Shares covered by such Option or SAR shall revert to the Plan. Unless otherwise provided by the Administrator, if on the date of termination the Participant is not vested as to his or her entire Option or SAR, the Shares covered by the unvested portion of the Option or SAR will revert to the Plan on the date one (1) month following the Participant’s termination. Notwithstanding the foregoing, in no event shall an Option or SAR be exercisable after the expiration of the term of the Award as provided in the Award Agreement.

12. Restricted Stock.

(a) Grant of Restricted Stock. Subject to the terms and provisions of the Plan (including the limits set forth in Section 7), the Administrator, at any time and from time to time, may grant Shares of Restricted Stock to Service Providers in such amounts as the Administrator, in its sole discretion, will determine.

(b) Restricted Stock Agreement. Each Award of Restricted Stock will be evidenced by an Award Agreement that will specify the Period of Restriction, the number of Shares granted, and such other terms and conditions as the Administrator, in its sole discretion, will determine. Unless the Administrator determines otherwise, Shares of Restricted Stock will be held by the Company as escrow agent until the restrictions on such Shares have lapsed.

(c) Transferability. Unless determined otherwise by the Administrator, Shares of Restricted Stock may not be sold, pledged, assigned, hypothecated, transferred, or disposed of in any manner other than by will or by the laws of descent or distribution until the end of the applicable Period of Restriction.

(d) Other Restrictions. The Administrator, in its sole discretion, may impose such other restrictions on Shares of Restricted Stock as it may deem advisable or appropriate.

(i) General Restrictions. The Administrator may set restrictions based upon the achievement of Company-wide, departmental, business unit, or individual goals (including, but not limited to, continued employment or service), applicable federal or state securities laws, or any other basis determined by the Administrator in its discretion.

(ii) Section 162(m) Performance Restrictions. For purposes of qualifying grants of Restricted Stock as “performance-based compensation” under Section 162(m) of the Code, the Committee, in its discretion, may set restrictions based upon the achievement of Performance Goals. The Performance Goals shall be set by the Committee on or before the latest date permissible to enable the Restricted Stock to qualify as “performance-based compensation” under

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Section 162(m) of the Code. In granting Restricted Stock which is intended to qualify under Section 162(m) of the Code, the Committee shall follow any procedures determined by it from time to time to be necessary or appropriate to ensure qualification of the Restricted Stock under Section 162(m) of the Code (e.g., in determining the Performance Goals).

(e) Removal of Restrictions. Except as otherwise provided in this Section 12, Shares of Restricted Stock covered by each Restricted Stock grant made under the Plan will be released from escrow as soon as practicable after the last day of the Period of Restriction. The Administrator, in its discretion, may accelerate the time at which any restrictions will lapse or be removed.

(f) Voting Rights. During the Period of Restriction, Service Providers holding Shares of Restricted Stock granted hereunder may exercise full voting rights with respect to those Shares, unless the Administrator determines otherwise.

(g) Dividends and Other Distributions. During the Period of Restriction, Service Providers holding Shares of Restricted Stock will be entitled to receive all dividends and other distributions paid with respect to such Shares unless otherwise provided in the Award Agreement. If any such dividends or distributions are paid in Shares, the Shares will be subject to the same restrictions on transferability and forfeitability as the Shares of Restricted Stock with respect to which they were paid.

(h) Return of Restricted Stock to Company. On the date set forth in the Award Agreement, the Restricted Stock for which restrictions have not lapsed will revert to the Company and again will become available for grant under the Plan.

13. Restricted Stock Units.

(a) Grant. Restricted Stock Units may be granted at any time and from time to time as determined by the Administrator. Each Restricted Stock Unit grant shall be evidenced by an Award Agreement that shall specify such other terms and conditions as the Administrator, in its sole discretion, shall determine, including all terms, conditions, and restrictions related to the grant, the number of Restricted Stock Units (subject to the limitations set forth in Section 7) and the form of payout, which, subject to Section 13(d), may be left to the discretion of the Administrator.

(b) Vesting Criteria and Other Terms. The Administrator shall set vesting criteria in its discretion, which, depending on the extent to which the criteria are met, will determine the number of Restricted Stock Units that will be paid out to the Participant.

(i) General Restrictions. The Administrator may set vesting criteria based upon the achievement of Company-wide, departmental, business unit, or individual goals (including, but not limited to, continued employment or service), applicable federal or state securities laws, or any other basis determined by the Administrator in its discretion.

(ii) Section 162(m) Performance Restrictions. For purposes of qualifying grants of Restricted Stock Units as “performance-based compensation” under Section 162(m) of the Code, the Committee, in its discretion, may set performance objectives based upon the achievement

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of Performance Goals. The Performance Goals shall be set by the Committee on or before the latest date permissible to enable the Restricted Stock Units to qualify as “performance-based compensation” under Section 162(m) of the Code. In granting Restricted Stock Units that are intended to qualify under Section 162(m) of the Code, the Committee shall follow any procedures determined by it from time to time to be necessary or appropriate to ensure qualification of the Restricted Stock Units under Section 162(m) of the Code (e.g., in determining the Performance Goals).

(c) Earning Restricted Stock Units. Upon meeting the applicable vesting criteria, the Participant shall be entitled to receive a payout as specified in the Award Agreement. Notwithstanding the foregoing, at any time after the grant of Restricted Stock Units, the Administrator, in its sole discretion, may reduce or waive any vesting criteria that must be met to receive a payout.

(d) Form and Timing of Payment. Payment of earned Restricted Stock Units shall be made as soon as practicable after the date(s) set forth in the Award Agreement. The Administrator, in its sole discretion, may pay earned Restricted Stock Units in cash, Shares, or a combination thereof. Shares represented by Restricted Stock Units that are fully paid in cash again shall be available for grant under the Plan.

(e) Cancellation. On the date set forth in the Award Agreement, all unearned Restricted Stock Units shall be forfeited to the Company.

14. Performance Shares.

(a) Grant of Performance Shares. Subject to the terms and conditions of the Plan, Performance Shares may be granted to Service Providers at any time as shall be determined by the Administrator, in its sole discretion. Subject to Section 7 hereof, the Administrator shall have complete discretion to determine the number of Shares subject to a Performance Share Award granted to any Service Provider.

(b) Value of Performance Shares. Each Performance Share will have an initial value equal to the Fair Market Value of a Share on the date of grant.

(c) Performance Objectives and Other Terms. The Administrator will set performance objectives in its discretion which, depending on the extent to which they are met, will determine the number or value of Performance Shares that will be paid out to the Service Providers. Each Award of Performance Shares will be evidenced by an Award Agreement that will specify the performance period during which the applicable objectives must be met, and such other terms and conditions as the Administrator, in its sole discretion, will determine.

(i) General Restrictions. The Administrator may set performance objective based upon the achievement of Company-wide, departmental, business unit, or individual goals (including, but not limited to, continued employment or service), applicable federal or state securities laws, or any other basis determined by the Administrator in its discretion.

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(ii) Section 162(m) Performance Restrictions. For purposes of qualifying grants of Performance Shares as “performance-based compensation” under Section 162(m) of the Code, the Committee, in its discretion, may set performance objectives based upon the achievement of Performance Goals. The Performance Goals shall be set by the Committee on or before the latest date permissible to enable the Performance Shares to qualify as “performance-based compensation” under Section 162(m) of the Code. In granting Performance Shares that are intended to qualify under Section 162(m) of the Code, the Committee shall follow any procedures determined by it from time to time to be necessary or appropriate to ensure qualification of the Performance Shares under Section 162(m) of the Code (e.g., in determining the Performance Goals).

(d) Earning of Performance Shares. After the applicable Performance Period has ended, the holder of Performance Shares will be entitled to receive a payout of the number of Performance Shares earned by the Participant over the Performance Period, to be determined as a function of the extent to which the corresponding performance objectives have been achieved. After the grant of a Performance Share, the Administrator, in its sole discretion, may reduce or waive any performance objectives for such Performance Share.

(e) Form and Timing of Payment of Performance Shares. Payment of earned Performance Shares will be made as soon as practicable after the expiration of the applicable Performance Period. The Administrator, in its sole discretion, may pay earned Performance Shares in the form of cash, in Shares (which have an aggregate Fair Market Value equal to the value of the earned Performance Shares at the close of the applicable performance period) or in a combination thereof.

(f) Cancellation of Performance Shares. On the date set forth in the Award Agreement, all unearned or unvested Performance Shares will be forfeited to the Company, and again will be available for grant under the Plan.

15. Leaves of Absence. Unless the Administrator provides otherwise or except as otherwise required by Applicable Laws, vesting of Awards granted hereunder shall cease commencing on the first day of any unpaid leave of absence and shall only recommence upon return to active service.

16. Transferability of Awards. Unless determined otherwise by the Administrator or as otherwise provided in the Plan, an Award may not be sold, pledged, assigned, hypothecated, transferred, or disposed of in any manner other than by will or by the laws of descent or distribution, and may be exercised, during the lifetime of the Participant, only by the Participant. If the Administrator makes an Award transferable, such Award shall contain such additional terms and conditions as the Administrator deems appropriate.

17. Adjustments Upon Changes in Capitalization, Dissolution, Merger or Change in Control.

(a) Changes in Capitalization. Subject to any required action by the shareholders of the Company, the number of shares of Common Stock covered by each outstanding Award and the number of shares of Common Stock which have been authorized for issuance under the Plan but

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as to which no Awards have yet been granted or which have been returned to the Plan upon cancellation or expiration of an Award, as well as the price per share, if any, of Common Stock covered by each such outstanding Award and the 162(m) fiscal year share issuance limits under Sections 7(a) and (b) hereof shall, shall be proportionately adjusted for any dividend or other distribution (whether in the form of cash, Shares, other securities, or other property), recapitalization, stock split, reverse stock split, reorganization, merger, consolidation, split-up, spin-off, combination, repurchase, or exchange of Shares or other securities of the Company, or other change in the corporate structure of the Company affecting the Shares should the Committee (in its sole discretion) determine such an adjustment to be appropriate in order to prevent dilution or enlargement of the benefits or potential benefits intended to be made available under the Plan. Such adjustment shall be made by the Board or the Committee, whose determination in that respect shall be final, binding and conclusive. Except as expressly provided herein, no issuance by the Company of shares of stock of any class, or securities convertible into shares of stock of any class, shall affect, and no adjustment by reason thereof shall be made with respect to, the number or price of shares of Common Stock subject to an Award.

(b) Dissolution or Liquidation. In the event of the proposed dissolution or liquidation of the Company, all outstanding Awards will terminate immediately prior to the consummation of such proposed action, unless otherwise provided by the Administrator. The Administrator in its discretion may provide for a Participant to have the right to exercise his or her Option, SAR or right to purchase Restricted Stock until ten (10) days prior to such transaction as to all of the Awarded Stock covered thereby, including Shares as to which the Award would not otherwise be exercisable. In addition, the Administrator may provide that any Company repurchase option or forfeiture rights applicable to any Award shall lapse 100%, and that any Award vesting shall accelerate 100%, provided the proposed dissolution or liquidation takes place at the time and in the manner contemplated. To the extent it has not been previously exercised (with respect to Options, SARs and right to purchase Restricted Stock) or vested (with respect to other Awards), an Award will terminate immediately prior to the consummation of such proposed action.

(c) Merger or Change in Control. In the event of a merger or Change in Control, each outstanding Award shall be assumed or an equivalent award substituted by the successor corporation or a Parent or Subsidiary of the successor corporation. In the event that the successor corporation refuses to assume or substitute for the Award, the Participant shall (i) fully vest in and have the right to exercise the Option, SAR or right to purchase Restricted Stock as to all of the Awarded Stock, including Shares as to which it would not otherwise be vested or exercisable, and (ii) fully earn and receive a payout with respect to other Awards. If an Award is not assumed or substituted for in the event of a merger or Change in Control, the Administrator shall notify the Participant in writing or electronically that (i) the Option, SAR or right to purchase Restricted Stock shall be fully vested and exercisable for a period of fifteen (15) days from the date of such notice, and (ii) all outstanding Options, SARs and rights to purchase Restricted Stock shall terminate upon the expiration of such period and (iii) all other outstanding Awards shall be paid out immediately prior to the merger or Change in Control. For the purposes of this paragraph, the Award shall be considered assumed if, following the merger or Change in Control, the assumed Award confers the right to purchase or receive, for each Share of Awarded Stock subject to the Award immediately prior to the merger or Change in Control, the consideration (whether stock, cash, or other securities or property) received in the merger or Change in Control by holders of Common Stock for each

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Share held on the effective date of the transaction (and if holders were offered a choice of consideration, the type of consideration chosen by the holders of a majority of the outstanding Shares); provided, however, that if such consideration received in the merger or Change in Control is not solely common stock of the successor corporation or its Parent, the Administrator may, with the consent of the successor corporation, provide for the consideration to be received upon the exercise (or payout or vesting, as applicable) of the Award, for each Share of Awarded Stock subject to the Award, to be solely common stock of the successor corporation or its Parent equal in fair market value to the per share consideration received by holders of Common Stock in the merger or Change in Control.

18. Date of Grant. The date of grant of an Award shall be, for all purposes, the date on which the Administrator makes the determination granting such Award, or such other later date as is determined by the Administrator. Notice of the determination shall be provided to each Participant within a reasonable time after the date of such grant.

19. Amendment and Termination of the Plan.

(a) Amendment and Termination. The Board may at any time amend, alter, suspend or terminate the Plan.

(b) Shareholder Approval. The Plan will be subject to approval by the shareholders of the Company within twelve (12) months after the date the Plan is adopted. Such shareholder approval will be obtained in the manner and to the degree required under Applicable Laws. The Company shall obtain shareholder approval of any Plan amendment to the extent necessary and desirable to comply with Applicable Laws.

(c) Effect of Amendment or Termination. No amendment, alteration, suspension or termination of the Plan shall impair the rights of any Participant, unless mutually agreed otherwise between the Participant and the Administrator, which agreement must be in writing (or electronic format) and signed by the Participant and the Company. Termination of the Plan shall not affect the Administrator’s ability to exercise the powers granted to it hereunder with respect to Awards granted under the Plan prior to the date of such termination.

20. Conditions Upon Issuance of Shares.

(a) Legal Compliance. Shares shall not be issued pursuant to the exercise or payout, as applicable, of an Award unless the exercise or payout, as applicable, of such Award and the issuance and delivery of such Shares shall comply with Applicable Laws and shall be further subject to the approval of counsel for the Company with respect to such compliance.

(b) Investment Representations. As a condition to the exercise or payout, as applicable, of an Award, the Company may require the person exercising such Option, SAR or right to purchase Restricted Stock, or in the case of another Award, the person receiving the payout, to represent and warrant at the time of any such exercise that the Shares are being purchased only for investment and without any present intention to sell or distribute such Shares if, in the opinion of counsel for the Company, such a representation is required.

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21. Inability to Obtain Authority. The inability of the Company to obtain authority from any regulatory body having jurisdiction, which authority is deemed by the Company’s counsel to be necessary to the lawful issuance and sale of any Shares hereunder, shall relieve the Company of any liability in respect of the failure to issue or sell such Shares as to which such requisite authority shall not have been obtained.

22. Severability. Notwithstanding any contrary provision of the Plan or an Award to the contrary, if any one or more of the provisions (or any part thereof) of this Plan or the Awards shall be held invalid, illegal or unenforceable in any respect, such provision shall be modified so as to make it valid, legal and enforceable, and the validity, legality and enforceability of the remaining provisions (or any part thereof) of the Plan or Award, as applicable, shall not in any way be affected or impaired thereby.

23. Shareholder Approval. Subject to Section 19 of the Plan, the Plan will become effective upon its adoption by the Board. It will continue in effect for a term of five (5) years from the date of approval by the shareholders of the Company unless terminated earlier under Section 19 of the Plan.

24. Non-U.S. Employees. Notwithstanding anything in the Plan to the contrary, with respect to any employee who is resident outside of the United States, the Administrator may, in its sole discretion, amend the terms of the Plan in order to conform such terms to the requirements of local law or to meet the objectives of the Plan. The Administrator may, where appropriate, establish one or more sub-plans for this purpose.

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EX-10.13

EXHIBIT 10.13

AGREEMENT

BETWEEN

DOUGLAS McCUTCHEON

AND

NANOMETRICS INCORPORATED

This Agreement is made and entered into this 27th day of September 2005 by and between Douglas McCutcheon (“Mr. McCutcheon”), a California resident, and Nanometrics Incorporated (the “Company”), a California corporation.

WHEREAS, Mr. McCutcheon has been hired by the Company as its new Executive Vice President, Finance and Administration, and Chief Financial Officer effective September 14, 2005, and

WHEREAS, the Company wishes to allow Mr. McCutcheon to focus his attention upon his new duties by providing him with a degree of financial security and income protection in the event of an involuntary termination for certain reasons.

NOW, THEREFORE, the parties hereby agree as follows:

1. This Agreement is intended solely to set out the parties’ understanding with respect to the involuntary separation of Mr. McCutcheon and is not intended to constitute a contract of employment for any period of time. Mr. McCutcheon understands that he is, and following the execution of this Agreement, remains an at-will employee of the Company.

2. In the event that Mr. McCutcheon is required or requested for any reason not involving good cause to involuntary relinquish his positions with the Company and its subsidiaries including, but not limited to, Executive Vice President, Finance and Administration, and Chief Financial Officer of the Company, the Company agrees, as a separation payment, to pay to Mr. McCutcheon his usual annual salary with standard deductions, but no bonuses, on the Company’s normal paydays for a period of one (1) year from date of separation, provided Mr. McCutcheon executes a general release and promptly resigns from all positions as requested. If Mr. McCutcheon relinquishes his positions voluntarily or if his separation involves good cause, he shall be due no separation payment. Mr. McCutcheon’s separation shall be for good cause only if he commits misconduct, unjustifiably neglects his duties, or acts in a way that has a direct, substantial and adverse effect on Nanometrics or its reputation.

3. This Agreement constitutes the entire agreement between the parties pertaining to the separation of Mr. McCutcheon from Nanometrics and is intended to apply to the exclusion of all other remedies in the event of such separation.

4. This Agreement shall be governed by and construed in accordance with the laws of the State of California.

5. In the event of disagreement, the parties agree to attempt to work out their differences in good faith. In the event the parties are unable to so work out their differences, any controversy or claim arising out of or relating to this Agreement, or the breach thereof, shall be settled by arbitration in accordance with the Commercial Arbitration Rules of the American Arbitration Association, and judgment upon the award rendered by the arbitrator(s) may be entered in any court having jurisdiction thereof. The parties agree that such arbitration shall be held in Santa Clara County, California and that the Company shall reimburse Mr. McCutcheon’s reasonable costs and attorneys’ fees.

Executed as of the date first above written.

NANOMETRICS INCORPORATED
By:	/s/ John Heaton
	John Heaton
	Chief Executive Officer

AGREED TO AND ACCEPTED:

/s/ Douglas McCutcheon

Douglas McCutcheon

-2-

EX-23.1

Exhibit 23.1

CONSENT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM

We hereby consent to the incorporation by reference in the Registration Statements on Form S-8 (Nos. 333-33583, 333-40866, 333-91714, 333-101137, and 333-108474) of Nanometrics Incorporated of our reports dated March 14, 2006, relating to the consolidated financial statements, financial statement schedule and the effectiveness of Nanometrics Incorporated’s internal control over financial reporting, which appear in this Form 10-K.

BDO Seidman, LLP

San Francisco, California

March 23, 2006

EX-23.2

Exhibit 23.2

CONSENT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM

We consent to the incorporation by reference in Registration Statement Nos. 333-33583, 333-40866, 333-91714, 333-101137 and 333-108474 on Form S-8’s of our report dated March 29, 2004, relating to the financial statements and financial statement schedule of Nanometrics Incorporated for the year ended January 3, 2004 appearing in this Annual Report on Form 10-K of Nanometrics Incorporated for the year ended December 31, 2005.

Deloitte & Touche LLP

San Jose, California

March 23, 2006

EX-31.1

EXHIBIT 31.1

Certification of Chief Executive Officer Pursuant to Securities Exchange Act Rules 13a-14(a) or 15d-14(a) as Adopted Pursuant to Section 302 of the Sarbanes-Oxley Act of 2002

I, John D. Heaton, the Chief Executive Officer of Nanometrics Incorporated, certify that:

1. I have reviewed this annual report on Form 10-K of Nanometrics Incorporated;

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

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

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

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

(b) Designed such internal control over financial reporting, or caused such internal control over financial reporting to be designed under our supervision, to provide reasonable assurance regarding the reliability of financial reporting and the preparation of financial statements for external purposes in accordance with generally accepted accounting principles;

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

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

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

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

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

Date: March 23, 2006	By:	/S/    JOHN D. HEATON
		Name: John D. Heaton Title: Chief Executive Officer

EX-31.2

EXHIBIT 31.2

Certification of Chief Financial Officer Pursuant to Securities Exchange Act Rules 13a-14(a) or 15d-14(a) as Adopted Pursuant to Section 302 of the Sarbanes-Oxley Act of 2002

I, Douglas J. McCutcheon, the Chief Financial Officer of Nanometrics Incorporated, certify that:

1. I have reviewed this annual report on Form 10-K of Nanometrics Incorporated;

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

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

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

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

(b) Designed such internal control over financial reporting, or caused such internal control over financial reporting to be designed under our supervision, to provide reasonable assurance regarding the reliability of financial reporting and the preparation of financial statements for external purposes in accordance with generally accepted accounting principles;

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

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

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

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

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

Date: March 23, 2006	By:	/S/    DOUGLAS J. MCCUTCHEON
		Name: Douglas J. McCutcheon
		Title: Chief Financial Officer

EX-32.1

Exhibit 32.1

CERTIFICATION OF CHIEF EXECUTIVE OFFICER AND CHIEF FINANCIAL OFFICER

PURSUANT TO 18 U.S.C. SECTION 1350, AS ADOPTED

PURSUANT TO SECTION 906 OF THE SARBANES-OXLEY ACT OF 2002

Each of the undersigned hereby certifies, for purposes of Section 906 of the Sarbanes-Oxley Act of 2002, in his capacity as an officer of Nanometrics Incorporated (the “Company”) that based on his knowledge:

1. The Annual Report on Form 10-K of the Company for the annual period ended December 31, 2005 (the “Report”) fully complies with the requirements of Section 13(a) or 15(d), as applicable, of the Securities Exchange Act of 1934, as amended, and

2. The information contained in the Report fairly presents, in all material respects, the financial condition and results of operations of the Company.

Date: March 23, 2006	By:	/S/    JOHN D. HEATON
	Name:	John D. Heaton
	Title:	Chief Executive Officer
Date: March 23, 2006	By:	/S/    DOUGLAS J. MCCUTCHEON
	Name:	Douglas J. McCutcheon
	Title:	Chief Financial Officer