Business Development

Pinnacle Data Systems, Inc. (“PDSi”) is a corporation incorporated under the laws of the State of Ohio in March 1989.

Business of Issuer

Pinnacle Data Systems, Inc. (“PDSi” or the “Company”) provides product lifecycle service solutions to Original Equipment Manufacturers (“OEMs”) in the medical, telecommunications, defense, imaging and computer equipment industries, among others. We offer a full range of computer and computer-related product development and manufacturing services to increase product speed to market and engineered product life, and to provide service and support to units in the field through comprehensive product lifecycle management programs encompassing depot repair, advanced exchange, contact center support and end-of-life control.

Our business model has a foundation of technical service and support programs (“Service”), such as the depot repair and logistics programs we provide the field service organizations of OEMs like Sun Microsystems. The service base provides resources for the development and sale of high-potential engineered computer solutions for specific customers and niche-industry applications

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(“Product”). For the 2005 year, we reported revenue of $44.6 million, net earnings of $937,000, and total assets of $24.4 million. Approximately 77% of our 2005 revenue was generated from Products and 23% from Services.

Our products are custom-engineered to meet specific customer or niche-industry requirements that generally cannot be met by an off-the-shelf solution. They are sold to OEMs and then typically resold to end-users as components of the OEMs’ final products. Our products are usually developed as a result of helping OEMs design, engineer, manufacture, assemble, modify, and/or integrate computer systems or components to fit their specific application needs. Many of our products are based on the high performance computer processing technologies of Sun Microsystems, Inc. (“Sun”), Intel Corporation (“Intel”) and Advanced Micro Devices, Inc. (“AMD”), three of world’s leading producers of computer components and systems. We combine their products and other vendor off-the-shelf computer components or peripherals with technologies that we engineer and develop, such as customized circuit boards, enclosures, power supplies and other engineered components and software. By leveraging our expertise and experience in engineering and integrating our internally developed products with Sun, Intel, AMD and other vendors’ technologies, we are able to offer product solutions with minimal product design and engineering costs to our customers.

Our end-of-life product management service allows our customers to maximize their investment in technology by providing continued support for products no longer in production or supported by the original manufacturer. This allows our customers to eliminate or delay the engineering, software development and re-certification charges required to integrate new technology into their products. For example, when a computer board manufacturer stops manufacturing a particular board, its customer OEMs are left with few alternative sources for the boards they need to continue building or repairing their products. We can provide the boards, purchased from a number of available sources, either new or refurbished, or we can redesign a new board with the same form, fit and function with components that are readily available at the time.

We are a SunSoft Master Distributor authorized to provide our customers with the right to use Solaris, Sun Microsystem’s UNIX operating system and we are a member of the Sun Partner Advantage Program. We are an authorized Intel Product Dealer and have earned Intel Channel Partner Premier Member status for our distinct level of competency with Intel technologies. We are an authorized AMD Gold Solution Provider. We are an authorized HP Business Development Partner. We are also licensed by Microsoft to distribute embedded Microsoft operating systems.

We also offer complete service and support for several OEMs’ products, as well as our own, including testing, repair, inventory and logistics services. Depot repair and testing services are provided for advanced technology systems, printed circuit board assemblies, and other computer peripherals and components, where the suspect non-functioning equipment is sent to our designated depot location for testing and repair, if required. We also manage “advanced-exchange” repair programs. Our highest volume testing and repair is performed on complex printed circuit boards and electro-mechanical data storage devices for Sun, Hewlett-Packard Company (H-P) and Silicon Graphics, Inc. (SGI), and on standard PC configurations for a

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home-based computer learning program. For our largest OEM customers, we maintain and share online information management systems that seamlessly connect our companies.

We consider our Products and Services segments to be complementary. New product development keeps our engineers and service technicians on the forefront of technologies being sold that generate new service opportunities. Our services provide a competitive advantage in selling our products since the entire infrastructure is already in place to provide high quality service and support before and after the sale.

Public Announcement Updates

During 2005, we made a number of public announcements. The current status of each is as follows:

Pinnacle Data Systems, Inc., announces exhibit at the AdvancedTCA Summit beginning December 6, 2005. - This showcased our extensive AdvancedTCA solutions. We showcased a compute cluster highlighting the scalability of the AdvancedTCA architecture. This demonstration adds Single Board Computers (SBCs), open-source middle-ware and a compute intensive application highlighting a new area of capability for this architecture. We exhibited and presented along side numerous market leaders with a common vision of making AdvancedTCA a driving force in next generation networks. Analysts predict that AdvancedTCA will be a multibillion-dollar market within a few years. The appeal of the technology extends far beyond telecom. Designers working on military/defense, industrial control, process control, instrumentation, medical equipment, storage, and enterprise networking applications are all considering the advantages of AdvancedTCA. The program is in the marketing stage.

Pinnacle Data Systems, Inc. announces development of the first AMD Opteron(TM) processor-based AdvancedTCA (ATCA) blade reference design kit specifically designed to meet the stringent demands of the ATCA specification for telecommunication equipment providers (TEPs) and carriers.—The intent of the ATCA reference design is to provide a simple to use model that OEMs can quickly and easily manufacture as is, modify themselves according to customer needs, or contract with us to modify and complete a unique design with feature requirements provided by the OEM or end customer. The development kit can reduce time-to-market and development costs as the intricacies of the system design according to the ATCA specification have been researched and resolved, resulting in a kit that is completely deployable without modifications. The prototype blade reference is scheduled to be completed by the end of Q1 2006 and generally available to the public by the end of Q2 2006. The program is in the marketing stage.

Competition

Competition for our custom-engineered products comes from three primary sources: (1) other electronic contract manufacturing companies (“ECMs”) that provide similar engineering and manufacturing services, (2) other value-added computer resellers (“VARs”) and (3) less expensive off-the-shelf products.

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We market our customized services and products to specific customers and niche-industries. This reduces competition from larger ECMs (Flextronics, Solectron, Plexus and others) because of the costs involved for them to run the smaller manufacturing volumes typical of these orders. The level of engineering complexity and after-the-sale service and support on some products reduces competition from VARs of all levels of size and geographic coverage. We believe we differentiate ourselves from other competitors through the strength of our close relationships with our very large OEM partners (Sun, Intel, AMD, H-P and others), our ability to offer and deliver complete turnkey solutions in relatively short development cycles, our unique product set and our full service-after-the-sale offering. However, a number of our competitors are more established and have substantially greater technical, manufacturing, marketing and financial resources to develop and market their engineering and manufacturing services or their off-the-shelf products.

The primary competitive factors in the electronic equipment service industry are price, quality and scope of services (based on in-house technical expertise). We compete with the in-house repair centers of OEMs, Third Party Maintenance providers (“TPMs”), ECMs and other independent depot repair organizations similar to ours. We believe we differentiate ourselves by offering complete packaged solutions backed up by a broad scope of repair and logistics service offerings, including our experience with a wide variety of technologies and very large, well-known and demanding OEM customers, flexibility in tailoring our operating procedures to fulfill stringent quality, documentation and reporting requirements, and offering the most cost-effective solutions to fulfill our customers’ service needs. However, a number of our competitors are more established and have substantially greater technical, manufacturing, marketing and financial resources to develop and market similar services.

Suppliers

During 2005, approximately 41% of all inventory purchased was manufactured by or for Sun and was purchased directly from Sun or through Sun’s distribution channel. We believe all critical production components and service parts, or suitable substitutes, are readily available in the marketplace from multiple manufacturers and/or suppliers, new or refurbished, as required by our current customers’ demands.

Customers

A significant amount of our sales come from a relatively small number of large customers. A major strategic focus continues to be further growth and diversification of our customer base. In 2005, we provided services and/or products to ten Fortune Global 500 companies and nine Fortune 500 companies compared to ten Fortune Global 500 companies and two Fortune 1000 companies in 2004.

Our three largest customers generated approximately 35%, 45% and 49% of sales, respectively, for the years 2005, 2004 and 2003. In 2005, no one customer generated more than 13% of our sales compared to 17% the prior year.

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Three customers generated approximately 44%, 52% and 44% of our product sales for the years 2005, 2004 and 2003, respectively. Four customers generated 80% of our service sales in 2005. Two customers generated 73% and 82% of total services sales, respectively, for the years 2004 and 2003.

We’ve made significant progress in diversifying our customer base. However, the Company’s relatively small number of customers can create significant sales volatility. If the sales generated by either of our top four service customers declined significantly, or if product sales of our three largest product customers declined significantly without additional service or product business to replace it, the results of our operations could be materially and adversely affected.

Patents and Trademarks

We own two patents we obtained in the acquisition of GNP Computers. One patent was granted for a telecommunication computer chassis. The other patent was granted for a distributed computing system clustering model that provides soft real-time responsiveness and continuous availability. However, we have deemed that the value of the patents is insignificant to the generation of future revenue.

In 2003, we received notice of the successful registration of the federal trade and service marks for the logo “PDSi” under Class 9 products and under Class 42 services.

The applications filed in 2001 for federal trade and service marks for “Pinnacle Data Systems” have been suspended and are awaiting the final disposition of other pending applications.

License and Royalty Agreements

In April 2004, we entered into a U.S. Business Development Partner Agreement with H-P to buy and resell or sublicense products, services and support including the select HP Care Pack Services. The agreement was for an original term expiring in May 2005. In February 2005, the agreement was extended until May 2006. At the time of expiration, orders already accepted shall be governed under the terms and conditions of the agreement. The agreement may also be terminated earlier upon default by either party as defined in the agreement. These products were required in an immaterial amount of product sales in 2005 and 2004, but are expected to be used in a more significant number of sales in future years.

In September 2003, by re-application, we renewed an OEM Customer License Agreement for Embedded Systems with Microsoft Licensing, Inc. (“Microsoft”) originally issued in 2002, pursuant to which we are licensed to embed binary copies of Microsoft operating systems (as delivered from Microsoft) in our products. The license agreement was for an original term of one year expiring in September 2004. The license is renewable by re-application. The license has been renewed for a term expiring in November 2006. The license can also be terminated earlier by Microsoft upon default by us as defined in the Agreement. These operating systems were required in product sales of approximately $5.8 million in 2005 and $900,000 in 2004 (approximately 17% and 3% of total product sales, respectively).

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In April 2003, we entered into a Regional Reseller Agreement with Agilent Technologies to buy and resell Agilent Remote Management Products in the United States and Canada. The agreement includes a license to use, execute, reproduce, display and distribute Agilent software in object code for the purpose of integrating Agilent’s products with our, or our customers’, products. The agreement was for an original term of one year expiring in March 2004. The agreement automatically renews for one-year periods unless written notice of non-renewal is given by either party before the current term ends. The agreement may also be terminated earlier upon default by either party as defined in the agreement. The agreement was renewed for a term expiring in March 2005. The agreement expired March 2005. These products were required in product sales of approximately $400,000 in 2005 and $2.3 million in 2004 (approximately 1% and 9% of total product sales, respectively). This agreement was entered into to increase product offerings to our current and prospective customers.

In March 2003, we entered into a Design License Agreement with Sun, pursuant to which we have a limited license to develop, manufacture and sell to one specific customer a product based upon and using the Sun SPARCengine Classic-II Motherboard. The license agreement was for an original term of one year expiring in March 2004. The license may only be renewed by mutual written agreement signed by both parties. The license can be terminated earlier, for any reason or for specific reasons, by either party as defined in the Agreement. The license was not renewed, but the agreement provides us the right to continue to use the technology for existing products. This technology, which was not required for any sales in 2004, was required in product sales of approximately $260,000 in 2005 (approximately 1% of total product sales).

In February 2003, by re-application, we renewed a Technology License and Distribution Agreement with Sun originally issued in 1994, pursuant to which we are licensed to distribute the Sun Solaris ^® operating system in our products. The license agreement is for an original term of three years expiring in February 2006. The license automatically renews for up to two one-year periods unless written notice of non-renewal is given by either party before the current term ends. The license can also be terminated earlier upon default by either party as defined in the Agreement. These operating systems were required in product sales of approximately $15.5 million in 2005 and $11.9 million in 2004 (approximately 45% and 42% of total product sales, respectively)

In August 2002, we were authorized by Sun to act as an OEM Technology Partner (“OTP”), pursuant to which we are authorized and licensed to buy Sun products at specific discount levels for the purpose of modifying them and/or integrating them into our products for resale to our OEM customers. This authorization can be terminated without cause or upon default by either party as defined in the terms and conditions of the General Terms and iForce Business Terms exhibits attached to the OTP Letter of Authorization. This designation or its predecessor Master Value-Added Integrator (MVAI) designation was required in product sales of approximately $18.0 million in 2005 and $11.9 million in 2004 (approximately 52% and 42% of total product sales, respectively).

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In July 2001, we entered into a Reference Design License Agreement with Sun, pursuant to which we are licensed to develop, manufacture and sell products based upon and using the Sun ULTRSPARC IIe technology. Training and support fees amounting to $35,000 were paid in connection with the license. The license agreement was for an original term of three years expiring in July 2004. The license automatically renews for up to two one-year periods unless written notice of non-renewal is given by either party before the current term ends. The license can also be terminated earlier upon default by either party as defined in the Agreement. The license agreement automatically renewed until July 2006. This technology was required in product sales of approximately $2.8 million in 2005 and $5.1 million in 2004 (approximately 8% and 20% of total product sales, respectively).

In May 1999, we entered into a Reference Design License Agreement with SME, pursuant to which we are licensed to develop, manufacture and sell products based upon and using the Sun AXmp technology. Training and support fees amounting to $40,000 were paid in connection with the license. The license agreement is for an original term of seven years expiring in May 2006. The license automatically renews for one-year periods unless written notice of non-renewal is given by either party before the current term ends. The license can also be terminated earlier upon default by either party as defined in the Agreement. This technology was required in product sales of approximately $180,000 in 2005 and $5.4 million in 2004 (approximately 1% of service sales and 21% of total product sales, respectively).

In October 1997, we entered into a Development and Manufacturing License Agreement with SME pursuant to which we are licensed to develop, manufacture and sell products based upon and using the Sun PCI card and Open Boot PROM technology. We do not anticipate that we will develop any new products based on the technology licensed under this agreement, although we will continue to sell products that we have developed under this license. The license agreement was for an original term of three years expiring in October 2000. However, the license automatically renews for one-year periods unless written notice of non-renewal is given by either party before the current term ends. The license can also be terminated earlier upon default by either party as defined in the Agreement. The license has been automatically renewed for an additional one-year term expiring October 2006. This technology was required in product sales of approximately $2.0 million in 2005 and $1.2 million in 2004 (approximately 6% and 5% of total product sales, respectively).

We have two outstanding royalty agreements with Pigeon Point Software and CSWL Inc. Both agreements are for products under development for customers. We have not yet made royalty payments under these agreements.

Labor Contracts

None of our employees are subject to collective bargaining agreements. We consider our relationship with our employees to be very good.

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Government Approval of Principal Products or Services

Our principal products and services do not generally require government approval, although some of our OEM customers’ products do require government approval. For example, medical-imaging equipment for which we sell components to our customers may require Food and Drug Administration (“FDA”) approval. This may slow the introduction of our customers’ new products and sometimes extends the time period between successful customer trials and the resulting production orders. We consider this in our business planning. When required, we help our customers get government approval. We also help them prolong the life of their products to delay costly government approval processes.

Governmental Regulation Costs

No federal, state or local laws or regulations in existence or proposed are expected to materially impact our operations or financial position.

Research and Development

Research and development costs are charged to operations when incurred. The Company incurred no research and development expense in 2005 that was not billed to its customers. The amount of research and development expense charged to operations in 2004 was immaterial.

Environmental Compliance Costs

Certain facets of our operations involve the use of substances regulated under various federal, state and local laws governing the environment. The liability for environmental remediation and related costs can be significant, although the Company has not incurred any to this date. Consequently, environmental costs and environmental regulations are not presently material to our operations or financial position. Similarly, no other federal, state or local laws or regulations are expected to materially impact our operations or financial position.

Employees

As of December 31, 2005, we had a total of 162 employees, all of whom were full-time.