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UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
Washington, D.C. 20549
FORM 10-K
(Mark One)
[_] ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE
ACT OF 1934
FOR THE YEAR ENDED _____________
[x] TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES
EXCHANGE ACT OF 1934
FOR THE TRANSITION PERIOD FROM APRIL 1, 1997 TO JUNE 30, 1997
COMMISSION FILE NUMBER 1-4278
WEBTV NETWORKS, INC.
(Exact name of registrant as specified in its charter)
CALIFORNIA 77-0406905
(State of incorporation of organization) (I.R.S. Employer Identification No.)
305 LYTTON AVENUE, PALO ALTO, CALIFORNIA 94301
(Address of principal executive offices) (Zip Code)
(415) 326-3240
(Registrant's telephone number, including area code)
Securities registered pursuant to Section 12(b) of the Act:
TITLE OF EACH CLASS NAME OF EACH EXCHANGE ON WHICH REGISTERED
------------------- -----------------------------------------
None None
Securities registered pursuant to Section 12(g) of the Act:
NONE
(Title of class)
Indicate by check mark whether the registrant (1) has filed all reports
required to be filed by Section 13 or 15(d) of the Securities Exchange Act of
1934 during the preceding 12 months (or for such shorter period that the
registrant was required to file such reports), and (2) has been subject to such
filing requirements for the past 90 days. Yes [x] No [_]
Indicate by check mark if disclosure of delinquent filers pursuant to Item
405 of Regulation S-K is not contained herein, and will not be contained, to the
best of registrant's knowledge, in definitive proxy or information statements
incorporated by reference in Part III of this Form 10-K. [_]
There is no public market for the Company's Class A Common Shares, but such
shares are convertible, when vested, into Common Shares of Microsoft
Corporation. The aggregate market value of Class A Common Shares held by non-
affiliates (380,621 Class A Common Shares) at September 30, 1997, on an as-if-
converted to Microsoft Common Shares basis, was approximately $50,360,916. As
of September 30, 1997 there were 1,672,801 Class A Common Shares and 7,170,512
Class B Common Shares outstanding.
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PART I
ITEM 1. BUSINESS
BACKGROUND TO TRANSITION REPORT
On April 5, 1997, WebTV Networks, Inc. ("WNI" or the "Company") and three
principal shareholders of WNI entered into an Agreement and Plan of
Recapitalization with Microsoft Corporation ("Microsoft"), pursuant to which WNI
agreed to undergo a recapitalization (the "Recapitalization") that would cause
it to become a controlled subsidiary of Microsoft, subject to certain terms and
conditions thereof. The Recapitalization closed on August 1, 1997, and,
effective as of such date, WNI became a controlled subsidiary of Microsoft.
Effective August 13, 1997, WNI determined to change its fiscal year end from
March 31 to June 30, to conform to the June 30 fiscal year end of Microsoft.
This Transition Report covers WNI's April 1, 1997 to June 30, 1997 transition
period (the "Transition Period").
GENERAL
WNI offers an on-line service that enables consumers to experience the
Internet through their televisions. WNI has developed a set-top terminal (the
"WebTV set-top terminal") that attaches to a television and telephone line and
enables consumers to access WNI's subscription-based on-line service (the "WebTV
Network"). WNI has licensed the design for its set-top terminal to consumer
electronics manufacturers, currently Sony Electronics ("Sony"), Philips Consumer
Electronics ("Philips") and Pace Microtechnology ("Pace"), who offer the set-top
terminal to consumers, while WNI operates the WebTV Network. By attempting to
reduce the cost and complexity barriers to Web access, WNI's goal is to make the
Internet available to a wider audience than has previously been possible.
PRODUCTS, SERVICES AND TECHNOLOGY
WNI offers an Internet on-line service that can be accessed by consumers
via the WebTV set-top terminal which connects to a television and a telephone
line. Once the WNI set-top terminal is connected, the user pays a flat monthly
fee (currently $19.95/month) for unlimited access to the Internet via the WebTV
Network, which performs all of the underlying operations necessary to provide
the consumer with access to the Internet. In addition, the WebTV Network offers
the user a remote-controlled browser, an e-mail interface and aggregated
content. WNI's solution for connecting consumers to the Internet via a
television and a telephone line is composed of the WNI set-top terminal and the
WebTV Network.
THE WEBTV SET-TOP TERMINAL
The WebTV set-top terminal connects to a television and a telephone line to
enable the user to access the Internet via the WebTV Network. In addition to
the power cord, the set-top terminal has two cables: one connects to the
consumer's television (or VCR), and the other plugs into the telephone line.
The front panel of the set-top terminal is equipped with an infrared receiver
for the remote control, a smart card slot, and three different LED displays: a
POWER LED to indicate when the terminal is on or off, a CONNECTED LED to
indicate when the terminal is connecting to the WebTV Network or receiving new
information, and a MESSAGE LED to indicate when the user has unread e-mail. The
back panel of the set-top terminal comes with several ports for optional
enhancements, including an S-video connector, a keyboard connector for standard
PC keyboards, audio and video out connectors, and an RF out DC connector for use
with an RF adaptor. The WebTV set-top terminals incorporate the following
features:
. Simple Installation and Operation: The WebTV set-top terminal utilizes
standard electrical and telephone connections to enable consumers to attach
the unit to a television and telephone line. Once the WebTV set-top
terminal is connected to the television and telephone line, the user turns
the unit on by pressing the power button on the remote control, bringing up
a brief on-screen registration form, which includes name, address, phone
number, credit card information and preference information.
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. High Resolution Viewing: WNI has developed TVLens technology which reduces
the interlace flicker and blurring which has traditionally been associated
with the projection of computer-based images onto a television monitor. In
addition, WNI's Worldscan technology formats Web content to help optimize
appearance in all television broadcast standards.
. Call-Waiting Compatibility: The WebTV set-top terminal allows a user to
receive incoming telephone calls when the set-top terminal is used on a
telephone line that is equipped with a standard call-waiting service.
Thus, when a user receives an incoming call while browsing the World Wide
Web (the "Web"), the WebTV set-top terminal automatically disconnects and
allows the user to answer the call. Upon completion of the incoming
telephone call, the set-top terminal automatically reconnects the user to
the same Web page that he or she was visiting prior to the call. This
function is provided by WNI's LineShare technology but can be disabled if
uninterrupted Web browsing is desired.
. Browsing Speed and Reliability: WNI utilizes a variety of hardware,
software and network technologies to provide consumers with fast and
reliable Internet access, Web-based content and e-mail communication. The
WebTV set-top terminal comes standard with a 33.6 Kbps v.34bis modem.
Browsing speed is enhanced through the use of advanced caching, the process
of storing popular Web content on the WebTV Network and delivering it
directly in response to user requests rather than requiring the user to
retrieve the information from the original Web site. In addition, WNI
employs network management technology that connects the user to any one of
several alternative ISPs to help provide a reliable and efficient
connection to the Internet even if a particular ISP's network is overloaded
or shut down.
. Remote Control: The WebTV set-top terminal comes standard with a
television-like remote control for interface with the WebTV Network. In
addition, the remote control can access the WebTV Network's on-line
keyboard which allows users to enter characters for a particular universal
resource locator ("URL"), conduct Web searches or create short e-mail
messages. The remote control also serves as a standard television remote
control for basic operation of a user's television, including volume and
channel selection for most standard makes or models, as well as allowing
the user to switch between the WebTV Network and regular television.
. Infrared Keyboard (Optional): Consumers may purchase a wireless keyboard
sold as an optional accessory for approximately $70 that contains similar
keys and browsing functions as the remote control, as well as offering the
data entry functionality of a traditional computer keyboard.
. Smart Card Capabilities: A smart card reader is built into the face of the
WebTV set-top terminal. The initial implementation of the smart card's
capabilities will be limited to enabling consumers to use smart cards to
access their own WebTV Network accounts through any WebTV set-top terminal.
As electronic commerce becomes more common, the uses of smart cards with
the WebTV set-top terminal may expand.
. Upgrading of WebTV Set-Top Terminals and Client Software: The WebTV
Network's applications framework supports applications download and
upgrades. Thus, existing applications can be upgraded and entirely new
applications can be delivered on-line to existing users.
THE WEBTV NETWORK
The WNI Network is accessed through the set-top terminal and consists of
three primary components: user interface and functionality, network content and
features, and network operations technology.
User Interface and Functionality
WNI designed the WebTV browser for consumer viewing on a television by
incorporating certain video techniques such as scrolling screens to indicate
vertical page movement and fading to new pages as well as
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substantially eliminating certain effects such as the piecemeal construction of
Web pages typical of PC-based browsers, resizable windows and horizontal scroll
bars. The WebTV browser resides on the set-top terminal, but is periodically
upgraded through the WebTV Network. The WebTV browser is compatible with HTTP,
MIME, HTML 3.0 and nearly all Netscape Navigator 3.0 and Microsoft Internet
Explorer 3.0 extensions. In addition, the WebTV Network offers an on-line Help
function which guides users through certain aspects of the browsing process and
introduces the user to certain of the WebTV Network's features.
The WebTV Network includes features designed to help integrate the Web into
the user's everyday life. The WebTV Network provides for up to five users per
household by assigning each user a WebTV "account." Each account has a personal
Internet e-mail address and customized settings and may be protected by a
password. Parental control options utilizing SurfWatch software are provided
for children's accounts, enabling concerned parents to block access to
inappropriate content and e-mail from strangers. It is possible for each user
to save selected Web site locations in a personalized "Favorites" location.
"Favorites" saves not only the site address but also a miniature view of the
page, so individual subscribers can see an overview of their preferred sites and
readily return to such sites in the future.
In addition, the WebTV Network allows consumers to experience some of the
Web's multimedia functionality, including general MIDI-compatibility with
enhanced eMIDI instrument download capability, studio-quality video MPEG 1 and 2
audio compatibility, JPEG, GIF89a animation, and RealAudio compatibility.
Network Content and Features
The WebTV Network acts primarily as a content aggregator, attempting to
provide an organizational structure that aids in locating content on the Web.
To locate relevant content for its users, WNI's editorial staff reviews and
culls information from the millions of sites that are already available on the
Web.
The WebTV Network currently offers basic services, including unlimited
access to the Web for a single monthly subscription price. Key features of the
WebTV Network's basic services include the following:
. The WebTV Home Page. The first page seen by the user of the WebTV Network
is the WebTV home page. Represented on the WebTV home page are icons that
symbolize the Explore Directory, the search feature, the mail service,
Around Town, and "Favorites." The body of the Home Page also contains a
selection of icons with links to certain sites on the Web.
. Explore Directory. WNI's editorial staff locates high quality, engaging
and pertinent content from the Web and organizes it for WebTV Network
subscribers into a topical directory called Explore. This "best of"
directory currently includes a substantial number of Web sites and provides
assistance to the consumer by categorizing information into subject areas
such as news, entertainment, sports and travel and then makes selections
for the directory from among the best Web sites that WNI's editorial staff
has discovered.
. Around Town. WNI's editorial staff aggregates local content in an area of
the network called "Around Town." This area is currently available with
limited functionality which WNI intends to enhance over time.
. Search Capability. The WebTV Network subscribers can search the Web
through third-party Web search technology that is integrated into the WebTV
Network. This search capability allows users to search Web sites for
information on selected topics by key words input by the user. WNI
currently has an agreement with Excite, Inc. ("Excite") for the
incorporation of a modified version of Excite's Internet search engine into
the WebTV Network.
. E-mail. The WebTV Network has e-mail capability called "Mail." Users can
send HTML and multimedia enhanced messages to, and receive messages from,
anyone with an address on the Internet. In addition, subscribers to the
WebTV Network are allocated designated storage space on the WebTV Network
in order to save e-mail messages for future reference. The WebTV set-top
terminal will also
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indicate to the user when Mail has arrived through a LED display on the
outside of the box. The WebTV Network allows a user to type a message or a
URL using either the software keyboard controlled by the remote control,
the optional infrared keyboard, or a standard PC keyboard plugged into the
set-top terminal.
Network Operations Technology
WNI's network operations are based in WNI's facilities located in Palo
Alto, California. The technology utilized by the WebTV Network includes the
following:
. Internet Access and Load-Balancing Technology: The WebTV Network provides
users with Internet access service through the use of multiple ISP
relationships which currently provides Internet connectivity to
approximately 90% of the United States, as well as redundant access in
certain major metropolitan areas. WNI currently utilizes a number of
different ISPs in providing Internet access to its subscriber base. WNI's
network management technology enables the WebTV Network to perform load
balancing among various ISPs and to employ a form of least-cost routing
across multiple ISPs.
. Proxy Caching: WNI's TransCache technology caches, transcodes, reformats,
streams and reorders Web data from individual Web sites for downloading to
the user's set-top terminal. The WebTV Network determines the timing for
content updates from standard periodicity data incorporated in many Web
sites or from learning algorithms where the periodicity data is not
included. The WebTV Network currently has many Web pages cached on its
servers resulting in a substantial number of user requests for Web data
being downloaded directly from WNI's servers rather than from the original
web site.
. Modular Scalablity: WNI currently maintains the WebTV Network through the
use of multiple workstations. The WebTV Network is designed so that it can
be scaled to accommodate increased volumes of activity by adding additional
workstations to WNI's existing inventory.
. Security Encryption: Client/server encryption technology is employed to
help maintain a secure connection between the WebTV Network server and the
WebTV set-top terminal client.
SALES, MARKETING AND DISTRIBUTION
To aid in its sales, marketing and distribution efforts, WNI has entered
into relationships with Sony, Philips and Pace which contemplate the
manufacture, marketing and distribution of the WebTV set-top terminal. The
relationships with these consumer electronics licensees are designed to enable
the consumer electronics licensees to leverage their consumer brand names and
mass market distribution channels, and to provide direct product advertising and
marketing in order to sell their specific branded product. WNI supplements this
effort with its own marketing of the WebTV brand name.
WNI has granted Sony, Philips and Pace non-exclusive licenses to WNI's
technology for incorporation into the WebTV set-top terminals they manufacture
and distribute. In addition, WNI and each of such licensees have agreed to
cooperate with respect to the development of product enhancements, as well as
joint marketing efforts.
WNI has executed a licensing agreement with Mitsubishi Electric
("Mitsubishi") pursuant to which Mitsubishi will license WNI's technology for
incorporation into WebTV set-top terminals to be sold under the Mitsubishi
brand. WNI has also announced plans to enter into a licensing arrangement with
Hitachi for WebTV set-top terminals.
The WebTV set-top terminal is distributed primarily through the normal
consumer electronics distribution channels to retail stores by the consumer
electronics licensees. WNI complements this distribution effort by installing
the WebTV Network for demonstration purposes and training the dealers to
demonstrate the use of the WebTV Network.
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MANUFACTURING
WNI expects that manufacture of its set-top terminals will be performed by
its consumer electronics licensees. To facilitate timely introduction of the
WebTV set-top terminal, portions of the set-top terminal have been manufactured
under WNI's supervision in Sunnyvale, California pursuant to purchase orders
from Sony and Philips. It is WNI's intention to transition responsibility for
manufacturing operations to its consumer electronics licensees in the future.
CUSTOMER SERVICE
WNI has retained a third-party customer service and technical support
organization to provide first-level customer support services to subscribers to
the WebTV Network. Complex customer support issues that cannot be addressed by
the third-party customer service organization are escalated to WNI's internal
customer care team. The third-party customer service organization and the
internal WNI customer care team respond to customer service and technical
support issues received via e-mail or telephone. The third-party customer
service organization also offers pre-subscription support to potential WebTV
Network subscribers who are contemplating the purchase of a WebTV set-top
terminal.
PROPRIETARY TECHNOLOGY
WNI's proprietary hardware and client and network software incorporate a
number of technologies designed to simplify and enhance the process of
experiencing the Internet through a television set and telephone line. WNI's
principal proprietary technologies are described briefly below.
HARDWARE
WNI's custom designed ASIC uses WNI's TVLens image enhancement technology
to reduce interlace flicker, without blurring, while perceptually enhancing
image detail. WNI's ASIC utilizes custom PhosphoRam on-the-fly image
decompression technology, minimizing memory consumption, and thereby reducing
the set-top terminal's need for additional and costly RAM devices.
WNI's LineShare technology allows incoming calls to be received by a WebTV
Network subscriber while the WebTV Network is on a call-waiting-equipped phone
line. LineShare also automatically determines whether other extensions of a
shared telephone line are active, and prevents network activation when such
extensions are in use.
WNI also offers universal remote control with One Thumb Browsing
technology. This WebTV set-top terminal technology allows the user to navigate
between hypertext links in Web pages displayed on the user's television screen,
view Web pages, as well as download and listen to audio files (through the
television's speakers) all by way of a remote control device similar to the
typical television set remote control unit.
CLIENT SOFTWARE
The WNI browser is compatible with HTTP, MIME, HTML 3.0 and virtually all
Netscape Navigator 3.0 and Microsoft Internet Explorer 3.0 extensions, producing
quality television images from virtually all Web pages. WNI browser software is
implemented in the processing system housed in the WebTV set-top terminal to
facilitate communications over a wide-area network among the WebTV set-top
terminal client and one or more servers. Document prefetching is used to
enhance system responsiveness. Additionally, the WebTV browser enables secure,
MIME-compatible, multimedia e-mail with graphics and sound capability and Flash
ROM auto-update technology keeps the WebTV browser current with the latest HTML
expansions and plug-ins.
NETWORK SYSTEM SOFTWARE
WNI's TransCache technology caches, transcodes, reformats, compresses,
streams and reorders Web site data for optimal download to the set-top terminal.
TransCache first examines an HTML data stream for
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compressibility. If compressible, the data stream is then attached to a
compression stream, and compression is performed immediately to generate a
compressed data stream. The compressed data stream is transmitted continuously
as it is generated, as an HTML stream, improving the speed and reliability of
WebTV Network data traffic. WNI's client/server encryption software maintains a
secure connection between the WebTV Network server and set-top terminal using a
physically secure channel.
WNI's other network technologies include MessageWatch and AutoAccess.
MessageWatch technology periodically wakes up the set-top terminal when it is
off-line, dials in and checks for new e-mail and lights a message LED on the
set-top terminal, which notifies the user of new mail. AutoAccess technology
automatically determines local access numbers for optimal Internet access
providers.
PATENTS, COPYRIGHTS AND TRADEMARKS
WNI regards its patents, copyrights, trademarks, trade dress, trade secrets
and similar intellectual property as critical to its success and WNI relies upon
patent law, copyright law, trademark law, trade secret protection and
confidentiality and/or license agreements with its employees, customers,
licensees and others to protect its proprietary rights. WNI has filed United
States and foreign patent applications relating to its hardware, client software
and network system software inventions. WNI pursues the registration of its
copyrights and trademarks in the United States and internationally. Effective
patent, copyright, trademark and trade secret protection may not be available in
every country in which WNI's products and services are distributed or made
available through the Internet. There can be no assurance that any pending
registration or application will be granted or that the denial of any such
registration or application would not have a material adverse effect on WNI's
business.
WNI has, in the past, and it expects that it may in the future, license
elements of its distinctive trademarks, trade dress and similar proprietary
rights to third parties. Although WNI attempts to ensure that the quality of
its brand is maintained by such licensees, no assurances can be given that such
licensees will not take actions that might materially and adversely affect the
value of WNI's proprietary rights or the reputation of its products and
services, either of which could have a material adverse effect on WNI's
business.
There can be no assurance that the steps taken by WNI to protect any of its
proprietary rights will be adequate or that third parties will not infringe or
misappropriate WNI's patents, copyrights, trademarks, trade dress and similar
proprietary rights. In addition, there has been substantial litigation in the
technology industry regarding rights to intellectual property, and WNI is
subject to the risk of claims against it for alleged infringement of the
intellectual property rights of others. The existence of any such claim by a
third party may not become known to WNI until well after it has committed
significant resources to the development of a potentially infringing product.
From time to time, WNI has received claims that it has infringed third parties'
intellectual property rights, and there is no assurance that third parties will
not claim infringement by WNI in the future. Any such claims, with or without
merit, could be time-consuming, result in costly litigation, cause product
shipment delays, or require WNI to enter into royalty or licensing agreements,
any of which could have a material adverse effect on WNI. There can be no
assurance that such royalty or licensing agreements, if required, will be
available on terms acceptable to WNI, or at all.
COMPETITION
The business of providing Internet access services is new, extremely
competitive, rapidly evolving and subject to rapid technological change. WNI
expects that such competition will intensify significantly in the near future.
A large number of companies are developing or have introduced devices and
technologies to facilitate access to the Internet via a television. Such
competitors include suppliers of low-cost Internet access technologies, such as
"network computer" devices promoted by Oracle and others, "set top" boxes
developed by Scientific Atlanta and others, the Apple Pippin, the Viewcall
Webster and devices that are proposed or under development by companies such as
Navio and Diba, as well as video game devices that provide Internet access such
as the Sega Saturn, the Sony Playstation and the Nintendo 64. In addition,
manufacturers of television sets have announced plans to introduce Internet
access and Web browsing capabilities into their products or through set-top
boxes, using technology supplied by NetChannel, Diba and others. Personal
computer manufacturers
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such as Gateway 2000 are introducing PCs that offer full-fledged television
viewing combined with Internet access. Operators of cable television systems
also plan to offer Internet access in conjunction with cable service. WNI also
competes with internet service providers, such as AT&T, MCI, the RBOCs, Netcom
and others, and commercial on-line services such as AOL, Compuserve, ICTV and
@Home, Inc. There can be no assurance that WNI's competitors will not develop
Internet access products and services that are superior to, and priced
competitively with, those of WNI, thereby achieving greater market acceptance
than WNI's offerings. Many of WNI's existing competitors, as well as potential
competitors, have longer operating histories, greater name recognition, larger
installed customer bases and significantly greater financial, technical and
marketing resources than WNI. In addition, certain of WNI's current and
prospective competitors may be acquired by, receive investments from or enter
into other commercial relationships with larger, more well-established and well-
funded companies. Such competition could have a material adverse effect on WNI's
business, operating results and financial condition.
WNI believes that the principal competitive factors in its business are
quality and variety of content, consumer acceptance, reliability, ease of use
and installation, technological superiority, brand recognition, product timing,
third party manufacturing and distribution relationships and price. Although
WNI believes that its products and services compete favorably with respect to
the factors outlined above, there can be no assurance that WNI will be able to
compete successfully against current or future competitors or that the
competitive pressures faced by WNI will not have a material adverse effect on
WNI's business, operating results and financial condition.
EMPLOYEES
As of June 30, 1997, WNI had 249 employees, including 95 in engineering and
product development, 28 in network operations, 22 in customer care, 39 in
marketing and sales, 29 in content/editorial and 36 in finance and
administration.
None of WNI's employees is represented by a labor organization, and WNI is
not a party to any collective bargaining agreement. WNI has never had any
employee strike or work stoppage and considers its relations with its employees
to be good.
ITEM 2. PROPERTIES
WNI's headquarters, including its executive offices, network operations
center, and engineering, marketing and sales facilities are located in Palo
Alto, California, and certain operations are in the process of being moved to
facilities in Mountain View, California. The Palo Alto and Mountain View
facilities occupy an aggregate of approximately 134,000 square feet. WNI
occupies these facilities under leases that expire in one to five years and
certain of these leases provide options for up to an additional one to five
years. WNI believes that its existing facilities are adequate to meet its
requirements for the foreseeable future and that suitable additional or
substitute space will be available as needed.
ITEM 3. LEGAL PROCEEDINGS
WNI is not currently subject to any material legal proceedings. From time
to time WNI has been, and expects to continue to be, subject to legal
proceedings and claims in the ordinary course of its business, including claims
of alleged infringement of the trademarks and other intellectual property rights
of third parties by WNI and its licensees. Such claims, even if not
meritorious, could result in the expenditure of significant financial and
managerial resources.
ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS
No matters were submitted to a vote of security holders during the three
months ended June 30, 1997.
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PART II
ITEM 5. MARKET FOR REGISTRANT'S COMMON EQUITY AND RELATED STOCKHOLDER MATTERS
None of the Company's capital shares were traded publicly at any time
during the Transition Period or thereafter. The Company had 133 shareholders of
record as of June 30, 1997, of which 90 were holders of Common Stock and 14, 12,
23 and 1 were holders of Series A redeemable convertible preferred stock, Series
B redeemable convertible preferred stock, Series C convertible preferred stock
and Series D convertible preferred stock, respectively. No cash dividends have
been declared on the Company's capital shares to date and the Company does not
intend to pay a cash dividend on its capital shares in the foreseeable future.
Future earnings will be used as a source to finance the growth and development
of the Company.
During the period of April 1, 1997 through June 30, 1997, the Company
issued 17,250 shares of common stock upon the exercise of stock options for
total proceeds of $2,638, pursuant to Rule 701 of the Securities Act of 1933.
Such proceeds were used for general corporate purposes, including working
capital. During the same period, the Company issued 4,500 shares of common
stock to one individual in satisfaction of a $43,235 claim against the Company,
pursuant to a private transaction not involving a public offering made in
reliance upon the exemption from registration provided by Section 4(2) of the
Securities Act of 1933, as amended.
<TABLE>
<CAPTION>
ITEM 6. SELECTED FINANCIAL DATA
PERIOD FROM
INCEPTION
(JUNE 30,
1995) TO YEAR ENDED THREE MONTHS ENDED
MARCH 31, MARCH 31, JUNE 30,
----------------------------
1996 1997 1996(1) 1997
------------ ------------- -------------- -------------
<S> <C> <C> <C> <C>
STATEMENT OF OPERATIONS DATA:
Revenues:
On-line service...................................... $ - $ 3,456,120 $ - $ 4,146,899
Licensing and manufacturing.......................... - 38,949,810 141,667 5,606,463
----------- ------------ ----------- ------------
Total revenues.............................. - 42,405,930 141,667 9,753,362
Cost of revenues:
On-line service...................................... - 12,384,056 - 9,996,980
Licensing and manufacturing.......................... - 36,968,200 - 4,346,341
----------- ------------ ----------- ------------
Total cost of revenues...................... - 49,352,256 - 14,343,321
Gross margin (loss).................................... - (6,946,326) 141,667 (4,589,959)
Operating expenses:
Research and development............................. 2,117,852 11,273,081 1,733,382 5,382,250
Sales and marketing.................................. 258,865 18,688,022 705,614 4,979,400
General and administrative........................... 853,373 6,528,030 781,949 2,463,035
----------- ------------ ----------- ------------
Total operating costs and expenses.......... 3,230,090 36,489,133 3,220,945 12,824,685
----------- ------------ ----------- ------------
Loss from operations................................... (3,230,090) (43,435,459) (3,079,278) (17,414,644)
Interest income........................................ 8,383 925,531 63,605 172,553
Interest expense....................................... (10,703) (257,966) (29,894) (167,727)
Other expense.......................................... - - - (62,773)
----------- ------------ ----------- ------------
Net loss............................................... $(3,232,410) $(42,767,894) $(3,045,567) $(17,472,591)
=========== ============ =========== ============
Pro forma net loss per share........................... $(0.22) $(1.51) $(0.14) $(0.53)
=========== ============ =========== ============
Shares used in computing pro forma net loss per share.. 14,546,887 28,253,713 21,960,768 33,255,784
=========== ============ =========== ============
</TABLE>
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(1) This information was derived from unaudited financial statements that have
been prepared by the Company.
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<TABLE>
<CAPTION>
MARCH 31,
--------------------------------------- JUNE 30,
1996 1997 1997
------------------- ------------------- --------------------
<S> <C> <C> <C>
BALANCE SHEET DATA:
Cash and cash equivalents............................ $ 4,501,745 $20,715,502 $ 5,034,702
Working capital (deficiency)......................... $ 2,473,015 $ 9,118,056 $ (9,813,241)
Total assets......................................... $ 5,931,650 $39,386,574 $ 25,547,106
Capital lease obligations, net of current portion... $ 524,013 $ 5,062,640 $ 4,374,306
Redeemable convertible preferred stock............... $ 6,500,001 $12,359,999 $ 12,359,999
Total shareholders' equity (net capital deficiency).. $(3,217,410) $ 2,462,384 $(14,775,834)
</TABLE>
ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS
OF OPERATIONS
The following discussion and analysis should be read in conjunction with
the Company's Financial Statements and Notes thereto included elsewhere in this
Form 10-K. This Form 10-K contains, in addition to historical information,
forward-looking statements that involve risks and uncertainties. The Company's
actual results could differ materially from the results discussed in the
forward-looking statements. Factors that could cause or contribute to such
differences include those discussed below.
OVERVIEW
WNI, which was formed in June 1995, operates an on-line service that
enables consumers to experience the Internet through their televisions. From its
inception to September 1996, WNI's activities related primarily to recruiting
personnel, raising capital and developing technology for the WebTV set-top
terminal and the WebTV Network. In October 1996, WNI delivered initial shipments
of the WebTV set-top terminal through its consumer electronics licensees and
activated the WebTV Network.
Though WNI licenses the WebTV set-top terminal reference design to consumer
electronics manufacturers, it expects its revenues and profits to be derived
from the WebTV Network. WNI expects that its future revenues will be derived
predominantly from monthly subscription fees to the WebTV Network as well as
from the sale of advertising space on the WebTV Network.
WNI has an extremely limited operating history. WNI's business must be
considered in light of the risks, expenses and problems frequently encountered
by companies in their early stage of development, particularly companies in new
and rapidly evolving markets, such as the Internet. The market for WNI's
products and services has recently begun to develop, is rapidly evolving and is
characterized by an increasing number of market entrants with products and
services for use on the Internet. As a result, WNI's mix of products and
services may undergo substantial changes as WNI reacts to competitive and other
developments in the overall Internet market. WNI has recorded limited revenues
to date, has incurred net losses since inception and expects to continue to
operate at a loss in the near term. As of June 30, 1997, WNI had an accumulated
deficit of approximately $63.5 million.
As a result of WNI's extremely limited operating history, WNI has no
meaningful historical financial data upon which to base planned operating
expenses. Accordingly, WNI's expense levels are based in part on its
expectations as to future revenues, particularly future subscriber and
advertising revenues. WNI's expenses to a large extent are fixed. As a result,
any significant shortfall in revenues, whether caused by less than expected
growth in subscribers and subscription revenues or the failure to obtain paying
advertisers, would have an immediate adverse impact on WNI's business, results
of operations and financial condition. In addition, WNI plans to significantly
increase its operating expenses. WNI expects to experience significant
fluctuations in future
9
<PAGE>
quarterly operating results and believes that period-to-period comparisons of
its results of operations are not necessarily meaningful and should not be
relied upon as any indication of future performance.
RESULTS OF OPERATIONS
Amounts from inception (June 30, 1995) to March 31, 1996 are not comparable
to the amounts for the year ended March 31, 1997 due to the different duration
of the periods and the acceleration of WNI's activities and related expenses
throughout fiscal 1997. The sections below compare the three months ended June
30, 1997 to the three months ended June 30, 1996.
REVENUES
WNI derives its revenues principally from on-line service, licenses and
manufacturing. On-line service revenue consists primarily of fees charged to
subscribers to the WebTV Network, which are recognized when services are
provided. Advance payments for on-line services are deferred until the services
are provided. Manufacturing revenue, which is described below, is recognized at
the time the product is shipped. Prepayments for manufacturing revenue from
licensees are deferred until the related product is shipped. License revenue
consists of certain fees paid by licensees and is recognized ratably over the
term of the license agreements.
Licensing and Manufacturing Revenues
Licensing and manufacturing revenues were approximately $5.6 million for
the three months ended June 30, 1997 and $142,000 for the three months ended
June 30, 1996. This increase in revenues was primarily derived from WNI's
activities in coordinating the manufacture of the WebTV set-top terminal for
WNI's consumer electronics licensees. Licensing and manufacturing revenues were
approximately $38.9 million for the year ended March 31, 1997. Two licensees
represented 21% and 79% of licensing and manufacturing revenues for the three
months ended June 30, 1997 and 61% and 39% of licensing and manufacturing
revenues for the year ended March 31, 1997. These revenues were effectively
recorded at WNI's cost and therefore WNI's gross profit on these sales was
nominal.
On-Line Service Revenues
On-line service revenues were approximately $4.1 million for the three
months ended June 30, 1997. The WebTV Network was launched in September of 1996,
accordingly, there were no on-line service revenues for the three months ended
June 30, 1996. For the year ended March 31, 1997, WNI recorded approximately
$3.5 million of revenue from the WebTV Network. Substantially all of the on-line
service revenue recorded to date is from on-line service subscription fees. WNI
expects to derive the principal portion of its future revenues from the
operation of the WebTV Network. These revenues currently include subscription
fees and limited advertising revenues and may include transaction fees and pay
per use services in the future.
COST OF REVENUES
Cost of licensing and manufacturing revenues consists of the associated
component and labor costs of the manufactured goods sold to WNI's licensees.
Cost of licensing and manufacturing revenues was approximately $4.3 million for
the three months ended June 30, 1997. There was no cost of licensing and
manufacturing for the three months ended June 30, 1996 because all for the
revenue for that period was derived from licensing agreements. Cost of licensing
and manufacturing revenues was approximately $37.0 million for the year ended
March 31, 1997.
Cost of on-line service revenues consists of expenses related to the
maintenance and support of the WebTV Network, data communications costs,
customer support costs and royalties and commissions paid to information and
service providers and licensees. Data communications costs are affected
primarily by the number of subscribers and the amount of time those subscribers
use the WebTV Network. Customer support costs, which consist primarily of
employee costs, costs of contracted personnel and communication costs, are
affected primarily by the number of existing and new subscribers in any
particular period. Cost of on-line service revenues
10
<PAGE>
for the three months ended June 30, 1997 was approximately $10.0 million. There
was no cost of on-line service for the three months ended June 30, 1996. Cost of
on-line service revenues for the year ended March 31, 1997 was approximately
$12.4 million.
OPERATING EXPENSES
WNI's operating expenses have increased significantly since WNI's inception
as a result of growth in the costs associated with technology development and
efforts to commercialize WNI's products and services. WNI believes that
continued expansion of its operations will be essential to enhance and extend
the WebTV brand, deliver products and services to targeted markets and expand
WNI's subscriber and advertising base. Accordingly, WNI expects to incur
increased expenses in all operating areas.
Research and Development
Research and development expenses consist primarily of salaries, consulting
fees, materials, depreciation and facilities to support product and network
development. WNI incurs development costs for the design of hardware and
software contained in the WebTV set-top terminal, development of network service
software and development of network programming. Research and development
expenses were approximately $5.4 million for the three months ended June 30,
1997, as compared to $1.7 million for the three months ended June 30, 1996. For
the year ended March 31, 1997, research and development expenses were
approximately $11.3 million, as compared to $2.1 million for the period from
inception to March 31, 1996. To date, all software development costs have been
expensed as incurred. The increase in research and development comes primarily
from the increase in personnel to develop new products and services. WNI
believes that significant investments in research and development are required
to remain competitive in the markets it is serving. Accordingly, WNI intends to
increase the absolute amount of its research and development expenditures in the
future.
Sales and Marketing
Sales and marketing expenses consist primarily of salaries, consulting fees
and costs of public relations services, advertising and marketing literature.
Sales and marketing expenses were approximately $5.0 million for the three
months ended June 30, 1997, as compared to $706,000 for the three months ended
June 30, 1996. For the year ended March 31, 1997, sales and marketing expenses
were approximately $18.7 million as compared to $259,000 for the period from
inception to March 31, 1996.The increases in sales and marketing reflects the
ramp-up in marketing efforts to promote the WebTV Network. WNI intends to
increase the level of sales and marketing activity in future periods to build
WNI's brand value and develop future revenue sources.
General and Administrative
General and administrative expenses consist primarily of salaries,
professional services and legal fees. General and administrative expenses were
approximately $2.5 million for the three months ended June 30, 1997, as compared
to $782,000 for the three months ended June 30, 1996. For the year ended March
31, 1997, general and administrative expenses were approximately $6.5 million as
compared to $853,000 for the period from inception to March 31, 1996. The higher
levels of expense reflects an increase in personnel and professional fees
necessary to manage the financial, legal, and administrative aspects of the
business. WNI intends to increase the level of general and administrative
expenses to support its operational growth, its efforts to develop strategic
business relationships and its plans for securing its intellectual property
rights.
INCOME TAXES
At June 30, 1997, WNI had federal net operating loss carry forwards of
approximately $61.4 million. The federal net operating loss carry forwards will
expire beginning in 2011 through 2012, if not utilized. An ownership change, as
defined in the Tax Reform Act of 1986, may restrict the utilization of carry
forwards. A valuation allowance has been recorded for the entire deferred tax
asset as a result of uncertainties regarding the realization of the asset due to
the lack of earnings history of WNI. See Note 8 of Notes to Financial
Statements.
11
<PAGE>
LIQUIDITY AND CAPITAL RESOURCES
From inception through June 30, 1997, WNI has financed its operations and
met its capital expenditure requirements primarily from proceeds of the private
sale of equity securities totaling approximately $60.6 million and equipment
leasing activities.
Operating activities used cash of approximately $17.9 million for the three
months ended June 30, 1997, as compared to $1.7 million for the three months
ended June 30, 1996. The net cash used during this period was primarily due to
the net loss and the increase in accounts receivable, which were partially
offset by increases in accounts payable and a decrease in inventory. Investing
activities used net cash of approximately $2.2 million during the three months
ended June 30, 1997, compared to 1.5 million for the three months ended June 30,
1996, to purchase equipment to support WNI's business and develop the
infrastructure for the WebTV Network. Financing activities generated cash of
approximately $4.4 million during the three months ended June 30, 1997, compared
to $3.7 million for the three months ended June 30, 1996, primarily from the
borrowings against long term debt.
At June 30, 1997, WNI's principal commitments consisted of obligations
under operating and capital leases of approximately $16.4 million. Future
capital expenditures are anticipated to be primarily for facilities and
equipment to support expansion of the WebTV Network, business operations and
management information and internal network systems. Although WNI has no
material capital commitments, WNI anticipates that its planned purchases of
capital equipment over the next twelve months will require additional
expenditures of approximately $20 million to $25 million. Additionally, WNI
believes that it is likely that WNI will enter into a joint venture with Fujitsu
Limited ("Fujitsu"). The parties are currently negotiating a letter of intent
that reflects the addition of Microsoft as a principal party to the joint
venture.
WNI expects to require at least $100.0 million to fund its current
operating plan through June 1998. At June 30, 1997, WNI had approximately $5.0
million in cash and cash equivalents. WNI's cash assets and currently available
credit line are not sufficient to meet its current operating plan requirements
through June 1998. On August 1, 1997, WNI consummated a recapitalization in
which it became a controlled subsidiary of Microsoft, and WNI believes that its
financial requirements will be satisfied through the support of Microsoft.
OUTLOOK: ISSUES AND UNCERTAINTIES
The Company does not provide forecasts of future financial performance.
While the Company's management is optimistic about the Company's long-term
prospects, the following issues and uncertainties, among others, should be
considered in evaluating its growth outlook.
Developing market and dependence on the Internet. The market for WNI's set-
top terminal and WebTV Network has only recently begun to develop, is rapidly
evolving and is characterized by an increasing number of market entrants with
products and services for use on the Internet. WNI's success will depend in
large part upon the continued growth in the use of the Internet and in
particular the use of the Internet for commercial purposes.
Unproven acceptance of Internet advertising. The WNI's future success is
highly dependent upon the increased use of the Internet for information
publication, distribution and commerce. In particular, because WNI expects to
derive a significant portion of its revenues in the foreseeable future from
sales of Internet advertising, the future success of WNI is highly dependent on
the development of the Internet as an advertising medium.
Competition. The market for consumer electronics and Web access services
is new, extremely competitive, rapidly evolving and subject to rapid
technological change, and WNI expects that such competition will intensify
significantly in the near future. One result of such increasing competition may
be pricing pressure. WNI's competitors may be grouped into two principal
categories: (i) providers of low-cost Internet access devices, such as proposed
network computer devices, the Apple Pippin, the Viewcall Webster and proposed
devices from companies such as Navio and Diba, as well as video game devices
such as the Sega Saturn, the Sony Playstation and the Nintendo 64, and (ii)
commercial on-line services such as America On-line, Inc., Compuserve, Inc., and
@Home, Inc.
12
<PAGE>
Substantial dependence upon third parties. WNI depends substantially upon
third parties for several critical elements of its business including, among
others, manufacturing and distribution of the set-top terminal and data
communications capacity to support the WebTV Network. To achieve mass market
penetration and consumer acceptance of the WebTV Network, WNI has established
strategic alliances with Sony and Philips to manufacture, market and distribute
the set-top terminal. WNI currently has two independent contract manufacturers,
Pragmatech and Flextronics, which together will account for all of WNI's
materials' procurement, assembly, system integration, testing and quality
assurance. Although WNI's agreements with Sony and Philips contemplate that
each will manufacture set-top terminals and certain components, to date, neither
has begun such manufacturing. Each, however, has preformed some assembly, but
relies upon WNI for the manufacture of certain components and subassemblies.
WNI is dependent on sole-source suppliers for certain key components used in its
products, including its proprietary FIDO and SOLO ASICs, manufactured by NEC and
Toshiba, and certain CPUs, manufactured by Integrated Device Technology. WNI
purchases these sole-source components pursuant to purchase orders placed from
time to time, will not carry significant inventories of these components and
will have no guaranteed supply arrangements. WNI relies on local telephone
companies and other companies to provide data communications capacity via local
telecommunications lines and leased long-distance lines. In addition, WNI
depends on certain third-party Internet service providers.
Risk of capacity constraints; system or security failures. A key element
of WNI's strategy is to generate a high volume of use of its set-top terminal
and the WebTV Network, the performance of each of which is critical to WNI's
reputation, its ability to attract subscribers to its WebTV Network and market
acceptance of the set-top terminal and WebTV Network. Any system capacity
constraint or failure that causes interruption of or increases in response time
of the Company's WebTV Network service would reduce the attractiveness of the
combined company's set-top terminal and services to existing and potential
subscribers and content providers. Additionally, WNI's network operations are
dependent in part upon its ability to protect its operating systems against
physical damage from fire, floods, earthquakes, power loss, telecommunications
failures, break-ins and similar events. WNI currently does not have redundant,
multiple site capacity in the event of any such occurrence. Despite the
implementation of network security measures by WNI, its servers are also
vulnerable to computer viruses, break-ins and similar disruptions from
unauthorized tampering with the combined company's computer systems.
Intellectual property rights. WNI regards its patents, copyrights,
trademarks, trade dress, trade secrets and similar intellectual property as
critical to its success and the Company will rely upon patent law, copyright
law, trademark law, trade secret protection and confidentiality and/or license
agreements with its employees, customers, partners and others to protect its
proprietary rights. There can be no assurance that the steps taken by WNI to
protect any of its proprietary rights will be adequate or that third parties
will not infringe or misappropriate WNI's patents, copyrights, trademarks, trade
dress and similar proprietary rights. In addition, there can be no assurance
that other parties will not assert infringement claims against WNI.
Government regulation. Certain Federal Communications Commission ("FCC")
regulations provide mandatory guidelines for the electronic emissions of certain
consumer products. Changes in the regulatory environment relating to the
telecommunications and media industry could affect WNI's business. Also, the
Internet and commercial Internet services are currently regulated by several
federal and state governmental agencies, legislative bodies and courts,
including the FCC, the Federal Trade Commission and the Internal Revenue
Service. Additionally, federal export regulations restrict the export and
resale of certain sensitive computer technologies such as certain encryption and
authentication software.
Litigation. Litigation regarding intellectual property rights, patents,
and copyrights occurs in the Company's business. Also, because materials may be
downloaded from network services operated or facilitated by WNI and subsequently
distributed to others, there is a potential that claims will be made against WNI
for defamation, negligence, copyright or trademark infringement or other
theories based on the nature and content of such materials. In addition, there
are other general corporate legal risks.
13
<PAGE>
ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA
INDEX TO FINANCIAL STATEMENTS AND FINANCIAL STATEMENT SCHEDULE
<TABLE>
<CAPTION>
PAGE
<S> <C>
Report of Deloitte & Touche LLP, Independent Auditors.......................................... 15
Report of Ernst & Young LLP, Independent Auditors.............................................. 16
Balance Sheets................................................................................. 17
Statements of Operations....................................................................... 18
Statement of Shareholders' Equity (Net Capital Deficiency)..................................... 19
Statements of Cash Flows....................................................................... 20
Notes to Financial Statements.................................................................. 21
Financial Statement Schedule................................................................... 32
</TABLE>
ITEM 9. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND
FINANCIAL DISCLOSURE
Effective October 3, 1997, WNI dismissed its prior certifying accountants,
Ernst & Young LLP, and retained as its new accountants, Deloitte & Touche LLP.
Ernst & Young LLP's report on WNI's financial statements during the two most
recent fiscal years contained no adverse opinion or disclaimer of opinion, and
was not qualified as to uncertainty, audit scope or accounting principles. The
decision to change accountants was approved by WNI's Board of Directors.
During the last two fiscal years and the subsequent interim periods to the
date hereof, there were no disagreements between WNI and Ernst & Young LLP on
any matters of accounting principles or practices, financial statement
disclosure, or auditing scope or procedure, which disagreements, if not resolved
to the satisfaction of Ernst & Young LLP, would have caused it to make a
reference to the subject matter of the disagreements in connection with its
reports. There were no events that have occurred pursuant to Item 304(a)(l)(v)
with respect to WNI within the last two fiscal years and the subsequent interim
periods to the date hereof.
Effective October 3, 1997, WNI engaged Deloitte & Touche LLP as its
principal accountants. During the last two fiscal years and the subsequent
interim periods to October 3, 1997, WNI did not consult Deloitte & Touche LLP
regarding any of the matters or events set forth in Item 304(a)(2)(i) and (ii)
of Regulation S-K.
14
<PAGE>
REPORT OF DELOITTE & TOUCHE LLP, INDEPENDENT AUDITORS
The Board of Directors and Shareholders
WebTV Networks, Inc.:
We have audited the accompanying balance sheet of WebTV Networks, Inc. as of
June 30, 1997 and the related statements of operations, shareholders' equity
(net capital deficiency), and cash flows for the three months ended June 30,
1997. Our audit also included the financial statement schedule for the three
months ended June 30, 1997 listed in the Index at Item 14(a)(2). These
financial statements and 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 generally accepted auditing standards.
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, the financial statements referred to above present fairly, in
all material respects, the financial position of WebTV Networks, Inc. at June
30, 1997 and the results of its operations and its cash flows for the three
months ended June 30, 1997 in conformity with generally accepted accounting
principles. Also, in our opinion, the related financial statement schedule,
when considered in relation to the basic financial statements taken as a whole,
presents fairly in all material respects the information set forth therein.
On August 1, 1997, the Company became a controlled subsidiary of Microsoft
Corporation, as described in Note 9.
/s/ Deloitte & Touche LLP
- -----------------------------
Deloitte & Touche LLP
San Jose, California
October 24, 1997
15
<PAGE>
REPORT OF ERNST & YOUNG LLP, INDEPENDENT AUDITORS
The Board of Directors and Shareholders
WebTV Networks, Inc.:
We have audited the accompanying balance sheets of WebTV Networks, Inc. as of
March 31, 1996 and 1997 and the related statements of operations, shareholders'
equity (net capital deficiency), and cash flows for the period from inception
(June 30, 1995) to March 31, 1996 and the year ended March 31, 1997. Our audits
also included the financial statement schedule for the period from inception
(June 30, 1995) to March 31, 1996 and the year ended March 31, 1997 listed in
the Index at Item 14(a)(2). These financial statements and schedule are the
responsibility of the Company's management. Our responsibility is to express an
opinion on these financial statements and schedule based on our audits.
We conducted our audits in accordance with generally accepted auditing
standards. 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 audits provide a reasonable basis for our opinion.
In our opinion, the financial statements referred to above present fairly, in
all material respects, the financial position of WebTV Networks, Inc. at March
31, 1996 and 1997 and the results of its operations and its cash flows for the
period from inception (June 30, 1995) to March 31, 1996 and the year ended March
31, 1997 in conformity with generally accepted accounting principles. Also, in
our opinion, the related financial statement schedule, when considered in
relation to the basic financial statements taken as a whole, presents fairly in
all material respects the information set forth therein.
/s/ ERNST & YOUNG LLP
- -----------------------------
ERNST & YOUNG LLP
Palo Alto, California
May 2, 1997
16
<PAGE>
WEBTV NETWORKS, INC.
BALANCE SHEETS
<TABLE>
<CAPTION>
MARCH 31, JUNE 30,
---------------------------
1996 1997 1997
------------ ------------- -------------
<S> <C> <C> <C>
ASSETS
Current assets:
Cash and cash equivalents.......................................................... $ 4,501,745 $ 20,715,502 $ 5,034,702
Accounts receivable (net of reserves of $50,000 and $92,000 at March 31,
1997 and June 30, 1997)........................................................... - 2,807,741 5,764,396
Inventory.......................................................................... - 4,309,713 1,937,374
Other current assets............................................................... 96,316 786,651 1,038,922
----------- ------------ ------------
Total current assets..................................................... 4,598,061 28,619,607 13,775,394
Property and equipment, net......................................................... 1,140,958 10,332,709 11,353,775
Other assets........................................................................ 192,631 434,258 417,937
----------- ------------ ------------
Total assets........................................................................ $ 5,931,650 $ 39,386,574 $ 25,547,106
=========== ============ ============
LIABILITIES AND SHAREHOLDERS' EQUITY (NET CAPITAL DEFICIENCY)
Current liabilities:
Accounts payable................................................................... $ 836,506 $ 10,934,896 $ 9,330,930
Accrued payroll and related obligations............................................ 86,642 711,963 564,166
Notes payable...................................................................... - - 5,000,000
Convertible note payable due to director........................................... 150,000 - -
Notes payable due to founders...................................................... 401,500 - -
Convertible notes payable.......................................................... 500,000 - -
Deferred revenue and other......................................................... - 5,468,165 6,249,481
Current portion of capital lease obligations....................................... 150,398 2,386,527 2,444,058
----------- ------------ ------------
Total current liabilities................................................. 2,125,046 19,501,551 23,588,635
Capital lease obligations, net of current portion................................... 524,013 5,062,640 4,374,306
Commitments
Redeemable convertible preferred stock, no par value, issuable in series:
Series A redeemable convertible: 1,510,533 shares designated, 1,510,533
shares issued and outstanding at March 31, 1996 and 1997 and June 30,
1997 (aggregate liquidation preference of $1,500,000 at June 30, 1997)............ 1,500,000 1,500,000 1,500,000
Series B redeemable convertible: 6,567,484 shares designated, 3,067,484
shares issued and outstanding at March 31, 1996 and 6,316,707 shares
issued and outstanding at March 31 and June 30, 1997 (aggregate
liquidation preference of $10,859,999 at June 30, 1997)........................... 5,000,001 10,859,999 10,859,999
Shareholders' equity (net capital deficiency):
Preferred stock, no par value, 25,000,000 shares authorized, issuable in series:
Series C convertible: 4,920,568 shares designated, 4,819,538 shares
issued and outstanding at March 31 and June 30, 1997 (none at
March 31, 1996) (aggregate liquidation preference of $34,281,374)................ - 34,281,374 34,281,374
Series D convertible: 9,596,928 shares designated, 1,343,570 shares
issued and outstanding at March 31 and June 30, 1997 (none at
March 31, 1996) (aggregate liquidation preference of $13,999,999)................ - 13,999,999 13,999,999
Common stock, no par value, 100,000,000 shares authorized, 15,000,000, 19,106,373
and 19,123,123 shares issued and outstanding at March 31, 1996 and 1997
and June 30, 1997, respectively................................................... 15,000 3,406,954 3,452,027
Shareholder notes receivable....................................................... - (301,639) (299,839)
Deferred compensation.............................................................. - (2,924,000) (2,736,500)
Accumulated deficit................................................................ (3,232,410) (46,000,304) (63,472,895)
----------- ------------ ------------
Total shareholders' equity (net capital deficiency)...................... (3,217,410) 2,462,384 (14,775,834)
----------- ------------ ------------
Total liabilities and shareholders' equity
(Net capital deficiency)........................................................... $ 5,931,650 $ 39,386,574 $ 25,547,106
=========== ============ ============
</TABLE>
See notes to financial statements.
17
<PAGE>
WEBTV NETWORKS, INC.
STATEMENTS OF OPERATIONS
<TABLE>
<CAPTION>
PERIOD FROM
INCEPTION
(JUNE 30, THREE MONTHS ENDED
1995) TO YEAR ENDED JUNE 30,
MARCH 31, MARCH 31, ---------------------------
1996 1997 1996 1997
------------ ------------- ------------ -------------
(UNAUDITED)
<S> <C> <C> <C> <C>
Revenues:
On-line service...................................... $ - $ 3,456,120 $ - $ 4,146,899
Licensing and manufacturing.......................... - 38,949,810 141,667 5,606,463
----------- ------------ ----------- ------------
Total revenues.............................. - 42,405,930 141,667 9,753,362
Cost of revenues:
On-line service...................................... - 12,384,056 - 9,996,980
Licensing and manufacturing.......................... - 36,968,200 - 4,346,341
----------- ------------ ----------- ------------
Total cost of revenues...................... - 49,352,256 - 14,343,321
Gross margin (loss).................................... - (6,946,326) 141,667 (4,589,959)
Operating expenses:
Research and development............................. 2,117,852 11,273,081 1,733,382 5,382,250
Sales and marketing.................................. 258,865 18,688,022 705,614 4,979,400
General and administrative........................... 853,373 6,528,030 781,949 2,463,035
----------- ------------ ----------- ------------
Total operating costs and expenses.......... 3,230,090 36,489,133 3,220,945 12,824,685
----------- ------------ ----------- ------------
Loss from operations................................... (3,230,090) (43,435,459) (3,079,278) (17,414,644)
Interest income........................................ 8,383 925,531 63,605 172,553
Interest expense....................................... (10,703) (257,966) (29,894) (167,727)
Other expense.......................................... - - - (62,773)
----------- ------------ ----------- ------------
Net loss............................................... $(3,232,410) $(42,767,894) $(3,045,567) $(17,472,591)
=========== ============ =========== ============
Pro forma net loss per share........................... $(0.22) $(1.51) $(0.14) $(0.53)
=========== ============ =========== ============
Shares used in computing pro forma net loss per share.. 14,546,887 28,253,713 21,960,768 33,255,784
=========== ============ =========== ============
</TABLE>
See notes to financial statements.
18
<PAGE>
<TABLE>
<CAPTION>
WEBTV NETWORKS, INC.
STATEMENT OF STOCKHOLDERS' EQUITY (NET CAPITAL DEFICIENCY)
TOTAL
SERIES C SERIES D SHAREHOLDERS'
CONVERTIBLE CONVERTIBLE SHAREHOLDER EQUITY
PREFERRED PREFERRED COMMON NOTES DEFERRED ACCUMULATED (NET CAPITAL
STOCK STOCK STOCK RECEIVABLE COMPENSATION DEFICIT DEFICIENCY)
----------- ----------- ---------- ------------ ----------- ------------ -------------
<S> <C> <C> <C> <C> <C> <C> <C>
Issuance of 15,000,000 shares
of common stock................. $ - $ - $ 15,000 $ - $ - $ - $ 15,000
Net loss......................... - - - - - (3,232,410) (3,232,410)
----------- ----------- ---------- ------------ ----------- ------------ ------------
Balances, March 31, 1996......... - - 15,000 - - (3,232,410) (3,217,410)
Issuance of 4,819,538 shares
of Series C convertible
preferred stock................. 34,281,374 - - - - - 34,281,374
Issuance of 4,106,373 shares
of common stock................. - - 391,954 (301,639) - - 90,315
Issuance of 1,343,570 shares
of Series D convertible
preferred stock................. - 13,999,999 - - - - 13,999,999
Deferred compensation related
to stock options, net of
amortization.................... - - 3,000,000 - (2,924,000) - 76,000
Net loss......................... - - - - - (42,767,894) (42,767,894)
----------- ----------- ---------- ------------ ----------- ------------ ------------
Balances, March 31, 1997......... 34,281,374 13,999,999 3,406,954 (301,639) (2,924,000) (46,000,304) 2,462,384
Issuance of 21,750 shares of
common stock.................... - - 45,873 - - - 45,873
Repurchase of 5,000 shares of
common stock.................... - - (800) - - - (800)
Proceeds from shareholder notes
receivable...................... - - - 1,800 - - 1,800
Amortization of deferred
compensation.................... - - - - 187,500 - 187,500
Net loss......................... - - - - - (17,472,591) (17,472,591)
----------- ----------- ---------- ------------ ----------- ------------ ------------
Balances, June 30, 1997.......... $34,281,374 $13,999,999 $3,452,027 $(299,839) $(2,736,500) $(63,472,895) $(14,775,834)
=========== =========== ========== ============ =========== ============ ============
</TABLE>
See notes to financial statements.
19
<PAGE>
<TABLE>
<CAPTION>
WEBTV NETWORKS, INC.
STATEMENTS OF CASH FLOWS
PERIOD FROM
INCEPTION
(JUNE 30, THREE MONTHS ENDED
1995) TO YEAR ENDED JUNE 30,
MARCH 31, MARCH 31, ----------------------------------
1996 1997 1996 1997
------------ ------------- ------------------- -------------
(UNAUDITED)
<S> <C> <C> <C> <C>
Cash flows used in operating activities:
Net loss......................................................... $(3,232,410) $(42,767,894) $(3,045,567) $(17,472,591)
Adjustments to reconcile net loss to net cash used in operating
activities:
Amortization of deferred compensation........................... - 76,000 - 187,500
Depreciation and amortization................................... 126,963 1,996,602 202,383 1,144,974
Loss on disposal of property and equipment...................... - - - 62,773
Changes in operating assets and liabilities:
Accounts receivable............................................ - (2,807,741) (1,558,605) (2,956,655)
Inventory...................................................... - (4,309,713) - 2,372,339
Other current assets and other assets.......................... (288,947) (934,443) (225,354) (235,950)
Accounts payable............................................... 836,506 10,098,390 563,882 (1,603,966)
Accrued payroll and related obligations........................ 86,642 625,321 (25,557) (147,797)
Deferred revenue and other..................................... - 5,468,165 2,358,333 781,316
----------- ------------ ----------- ------------
Net cash used in operating activities................. (2,471,246) (32,555,313) (1,730,485) (17,868,057)
----------- ------------ ----------- ------------
Cash flows used in investing activities -
Capital expenditures............................................ (581,626) (3,646,567) (1,453,907) (2,228,813)
----------- ------------ ----------- ------------
Cash flows provided by financing activities:
Proceeds from issuance of preferred stock....................... 6,500,001 53,991,371 4,089,998 -
Proceeds from issuance of common stock.......................... 15,000 90,315 45,568 46,873
Proceeds from notes payable..................................... - - - 5,000,000
Proceeds from convertible note payable due to director.......... 150,000 - - -
Proceeds from (payments on) notes payable to founders........... 401,500 (401,500) (401,500) -
Proceeds from (payments on) convertible notes payable........... 500,000 (500,000) - -
Principal payments of capital lease obligations................. (11,884) (764,549) (18,159) (630,803)
----------- ------------ ----------- ------------
Net cash provided by financing activities............. 7,554,617 52,415,637 3,715,907 4,416,070
----------- ------------ ----------- ------------
Net increase (decrease) in cash and cash equivalents............. 4,501,745 16,213,757 531,515 (15,680,800)
Cash and cash equivalents at beginning of period................. - 4,501,745 4,501,745 20,715,502
----------- ------------ ----------- ------------
Cash and cash equivalents at end of period....................... $ 4,501,745 $ 20,715,502 $ 5,033,260 $ 5,034,702
=========== ============ =========== ============
Supplemental disclosure of cash flow information -
Cash paid for interest........................................... $ 10,703 $ 257,966 $ 29,894 $ 167,727
=========== ============ =========== ============
Supplemental schedule of noncash investing and financing
activities:
Property and equipment acquired under capital lease
obligations.................................................... $ 686,295 $ 7,539,305 $ - $ -
=========== ============ =========== ============
Conversion of convertible note payable due to director to
preferred stock................................................ $ - $ 150,000 $ 150,000 $ -
=========== ============ =========== ============
Issuance of common stock in return for shareholder notes
receivable..................................................... $ - $ 301,639 $ 235,127 $ -
=========== ============ =========== ============
</TABLE>
See notes to financial statements.
20
<PAGE>
WEBTV NETWORKS, INC.
NOTES TO FINANCIAL STATEMENTS
JUNE 30, 1997
1. NATURE OF BUSINESS AND SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES
NATURE OF OPERATIONS
WebTV Networks, Inc. (the "Company") was incorporated in California on June
30, 1995 and operates an on-line service that enables consumers to experience
the Internet through their televisions. Through September 1996, the Company
was in the development stage.
On August 1, 1997, the Company consummated a recapitalization (the
"Recapitalization"), pursuant to an Agreement and Plan of Recapitalization
("the Recapitalization Agreement") dated April 5, 1997, among the Company,
certain shareholders thereof and Microsoft Corporation ("Microsoft"), whereby
the Company became a controlled subsidiary of Microsoft. See further
discussion regarding the recapitalization in Note 9. Effective August 13,
1997, the Company changed its year end to June 30 to conform to Microsoft's
fiscal year end.
Basis of Presentation
The preparation of financial statements in conformity with generally accepted
accounting principles requires management to make estimates and assumptions
that affect the amounts reported in the financial statements. Actual results
could differ from these estimates.
SIGNIFICANT ACCOUNTING POLICIES
Cash Equivalents
The Company considers all highly liquid investments with an original maturity
from date of purchase of three months or less to be cash equivalents. The
Company's excess cash is invested in an uninsured money market account with a
major international bank. Carrying value of cash and cash equivalents
approximates market value.
Inventories
Inventories consist primarily of raw materials, which are stated at the lower
of standard cost (which approximates actual cost on a first-in, first-out
cost method) or market value.
Revenue Recognition and Concentration of Credit Risk
The Company derives its revenues principally from on-line service, license
and manufacturing revenue. On-line revenue consists primarily of fees charged
to subscribers to the Company's on-line service and are recognized when
services are provided. Advance payments for on-line services are deferred
until the services are provided.
In 1996, the Company entered into five-year license agreements with two
consumer electronics manufacturers, Sony Electronics and Philips Consumer
Electronics (together, "licensees"). In April 1997, the Company entered into
a five year agreement with Pace Microtechnology ("Pace"). As of June 30,
1997, no revenues have been recorded pursuant to the agreement with Pace.
Pursuant to these agreements, the Company licensed the technology and
reference design for its set-top terminal to the licensees. The licensees are
responsible for the promotion, sale, support and maintenance of the set-top
terminals, which they offer to customers. The Company is responsible for
providing the on-line service to users of the set-top terminals. Pursuant
these agreements, the Company has the right to receive up-front license and
marketing fees. In addition, the Company will share a portion of the future
revenues from its on-line service with the licensees.
Manufacturing revenue is recognized at the time products are shipped.
Prepayments for manufacturing revenue from licensees are deferred until the
related product is shipped. License revenue consists of certain fees paid by
21
<PAGE>
WEBTV NETWORKS, INC.
NOTES TO FINANCIAL STATEMENTS (Continued)
licensees and is recognized ratably over the term of the agreements. All
product and license revenue is generated by two parties which accounted for
56% and 36%, respectively, of total revenue for the year ended March 31, 1997
and 12% and 46%, respectively, of total revenues for the three months ended
June 30, 1997.
The Company's accounts receivable are from on-line service subscribers and
licensees. The Company generally does not require collateral on accounts
receivable. The Company maintains reserves for potential credit losses and
such losses have been within management's expectations. The concentration of
credit risk with respect to on-line service accounts receivable is limited
due to the large number of subscribers comprising the Company's subscriber
base. Licensee accounts receivable consists of two multinational consumer
electronics companies who have made timely payments to date. These two
companies accounted for 77% and 18%, respectively, of accounts receivable at
March 31, 1997 and 27% and 30%, respectively, of accounts receivable at June
30, 1997.
The Company generates all of its revenues in the United States.
Cost of Revenues
Cost of on-line service revenues consist of expenses related to the
maintenance and support of the Company's network, data communications costs,
customer support costs and royalties and commissions paid to information and
service providers and licensees. Licensing and manufacturing cost of revenue
consists primarily of the associated component and labor costs of the
manufactured goods sold.
Depreciation and Amortization
Property and equipment are depreciated on a straight-line basis over the
estimated useful lives of the assets which approximates three years.
Equipment purchased under capital lease obligations is amortized over the
shorter of the lease term or the estimated useful lives of the related
assets.
Advertising Costs
Costs related to advertising are expensed the first time an advertisement
appears. Advertising expense was approximately $11,190,000 for the year ended
March 31, 1997 and $463,000 for the three months ended June 30, 1997 (none
for the period from inception (June 30, 1995) to March 31, 1996).
Research and Development and Software Development Costs
Research and development costs incurred to develop software and hardware
products are charged to operations as incurred.
Software development costs have been expensed in accordance with Statement of
Financial Accounting Standards No. 86, "Accounting for the Costs of Computer
Software to be Sold, Leased or Otherwise Marketed" ("SFAS 86"). Under SFAS
86, capitalization of software development costs begins upon the
establishment of technological feasibility and ends when a product is
available for general release to customers. Such costs have been immaterial
to date.
Stock Compensation
The Company has elected to follow Accounting Principles Board Opinion No. 25,
"Accounting for Stock Issued to Employees" ("APB 25") and related
Interpretations in accounting for its employee and director stock options
because, as discussed below, the alternative fair value accounting provided
for under FASB Statement No. 123, "Accounting for Stock-Based Compensation"
("FAS 123"), requires use of option valuation models that were not developed
for use in valuing employee stock options. Under APB 25, when the exercise
price of the Company's employee stock options equals the market price of the
underlying stock on the date of grant, no compensation expense is recognized.
Option grants to all others are accounted for under the fair value method
prescribed by FAS 123.
22
<PAGE>
WEBTV NETWORKS, INC.
NOTES TO FINANCIAL STATEMENTS (Continued)
Net Loss Per Share
Except as noted below, historical net loss per share is computed using the
weighted-average number of common shares outstanding. Common equivalent
shares from stock options, convertible preferred stock and warrants are
excluded from the computation as their effect is antidilutive.
Historical net loss per share information is as follows:
<TABLE>
<CAPTION>
PERIOD FROM
INCEPTION YEAR THREE MONTHS ENDED
(JUNE 30, 1995) ENDED JUNE 30,
TO MARCH 31, MARCH 31, -------------------------
1996 1997 1996 1997
----------- ----------- ----------- -----------
(UNAUDITED)
<S> <C> <C> <C> <C>
Net loss per share........................... $ (0.24) $ (2.38) $ (0.20) $ (0.91)
=========== =========== =========== ===========
Shares used in computing net loss per share.. 13,462,963 17,934,964 15,063,961 19,114,332
=========== =========== =========== ===========
</TABLE>
Pro forma net loss per share has been computed as described above and also
gives effect to the conversion of convertible preferred shares issued using
the as if-converted method. Such shares are included from the original date
of issuance.
Earnings Per Share Calculation
In February 1997, the Financial Accounting Standards Board issued Statement
No. 128, earnings per share, which is required to be adopted on December 31,
1997. At that time, the Company will be required to change the method
currently used to compute earnings per share and to restate all prior
periods. Under the new requirements for calculating primary earnings per
share, the dilutive effect of stock options will be excluded. The impact of
Statement 128 is expected to result in no change to the Company's primary or
fully diluted net loss per share for any periods presented herein, as stock
options have been excluded from the current computation as they are
antidilutive.
Unaudited Interim Financial Information
The unaudited interim financial information for the three months ended June
30, 1996 has been prepared on the same basis as the audited financial
statements. In the opinion of management, such unaudited information
includes all adjustments (consisting only of normal recurring accruals)
necessary for a fair presentation of this interim information.
2. OTHER FAIR VALUE DISCLOSURES
At June 30, 1997, the carrying value of notes receivable from shareholders
approximates their fair value. The fair values of notes receivable from
shareholders are estimated using discounted cash flow analysis, based on
interest rates currently being offered for loans with similar terms to
borrowers of similar credit quality.
23
<PAGE>
WEBTV NETWORKS, INC.
NOTES TO FINANCIAL STATEMENTS (Continued)
3. PROPERTY AND EQUIPMENT
Property and equipment is recorded at cost and consists of:
<TABLE>
<CAPTION>
MARCH 31,
------------------------- JUNE 30,
1996 1997 1997
----------- ------------ ------------
<S> <C> <C> <C>
Computer equipment.............................. $ 756,248 $ 8,875,652 $10,315,174
Office equipment, furniture and fixtures........ 175,984 1,095,230 1,109,087
Purchased software.............................. 279,548 1,769,102 2,299,623
Leasehold improvements.......................... 56,141 713,809 881,578
---------- ----------- -----------
1,267,921 12,453,793 14,605,462
Less accumulated depreciation and amortization.. (126,963) (2,121,084) (3,251,687)
---------- ----------- -----------
Property and equipment, net..................... $1,140,958 $10,332,709 $11,353,775
========== =========== ===========
</TABLE>
4. NOTES PAYABLE
In April 1997, in conjunction with the Recapitalization Agreement, Microsoft
and the Company entered into a Line of Credit Agreement, pursuant to which
Microsoft agreed to loan the Company, on a revolving basis, up to $30,000,000
(the "Loan"). Interest on the outstanding balance on the Loan accrues at a
rate of ten percent (10%). The Loan is secured by a security interest granted
by the Company to Microsoft, pursuant to a Security Agreement, covering all
of the Company's Intellectual Property (as defined in the Recapitalization
Agreement). The balance on June 30, 1997 was $5,000,000.
5. COMMITMENTS
In December 1995, the Company entered into a $1,000,000 equipment lease line
of credit, of which approximately $374,000 remains available at June 30,
1997. In addition, the Company entered into equipment lease lines totaling
$3,000,000 in 1996 and $4,539,000 in 1997 which were fully drawn down as of
June 30, 1997. The arrangements are secured by the leased property and
equipment of the Company.
In conjunction with the 1996 and 1997 equipment lease lines, the Company
issued warrants to purchase preferred stock (see Note 7).
Included in property and equipment are assets acquired under capital lease
obligations with a cost and related accumulated amortization of approximately
$686,000 and $12,000, $8,226,000 and $1,288,000, and $8,226,000 and
$2,196,000 at March 31, 1996 and 1997 and June 30, 1997, respectively.
24
<PAGE>
WEBTV NETWORKS, INC.
NOTES TO FINANCIAL STATEMENTS (Continued)
Future payments under operating and capital lease arrangements at June 30,
1997 are as follows:
<TABLE>
<CAPTION>
OPERATING CAPITAL
YEARS ENDING JUNE 30, LEASES LEASES
----------------------------------- ---------- ----------
<S> <C> <C>
1998............................... $2,222,521 $3,094,864
1999............................... 2,149,102 2,590,181
2000............................... 1,750,916 1,986,150
2001............................... 1,048,928 151,306
2002............................... 985,358 -
Thereafter......................... 384,813 -
---------- ----------
Total minimum payments............. $8,541,638 7,822,501
==========
Less amount representing interest.. 1,004,137
----------
Present value of minimum payments.. 6,818,364
Less current portion............... 2,444,058
----------
Long-term portion.................. $4,374,306
==========
</TABLE>
Subsequent to June 30, 1997, the Company entered into three new operating
leases which expire on various dates through October 2000. Future payments
under these leases total approximately $3,800,000.
Rent expense was approximately $62,000, $906,000 and $373,000 for the period
from inception to March 31, 1996, the year ended March 31, 1997 and the three
months ended June 30, 1997, respectively.
6. NOTES FROM FOUNDERS, SHAREHOLDERS AND OTHER PARTIES
During the year ended March 31, 1996, the Company issued demand promissory
notes to two founders totaling $401,500, net of repayments, for purposes of
initial funding of the Company. These notes were repaid in April 1996.
In February 1996, the Company issued convertible notes to four parties
including a member of the Board of Directors and relatives of an officer of
the Company for a total of $680,000. In March 1996, the Company repaid one of
the notes totaling $30,000. In April and July 1996, the Company repaid the
remaining notes (with the exception of the note due to the director) totaling
$500,000. In April 1996, the note due to the director was converted into
92,025 shares of Series B redeemable convertible preferred stock at a per
share price of $1.63.
In conjunction with the issuance of certain of these notes, the Company
issued warrants to purchase common stock (see Note 7).
7. SHAREHOLDERS' EQUITY
PREFERRED STOCK
In September and October 1995, under a stock purchase agreement, the Company
issued 1,510,533 shares of Series A redeemable convertible preferred stock
("Series A preferred stock") at a price of $0.993 per share. In March and
April 1996, under a stock purchase agreement, the Company issued 5,576,682
shares of Series B redeemable convertible preferred stock ("Series B
preferred stock") at a price of $1.63 per share. Additionally in April 1996,
a $150,000 convertible note due to a member of the Board of Directors was
converted into 92,025 shares of Series B redeemable convertible preferred
stock. Also, in July and August of 1996, warrants issued in April 1996 were
exercised to purchase 648,000 Series B redeemable convertible preferred
shares at an exercise price of $2.50 per share. In September 1996, under a
stock purchase agreement, the Company issued 4,819,538 shares of Series C
convertible preferred stock ("Series C preferred stock") at a price of $7.113
per share. In March
25
<PAGE>
WEBTV NETWORKS, INC.
NOTES TO FINANCIAL STATEMENTS (Continued)
1997, under a stock purchase agreement, the Company issued 1,343,570 shares
of Series D convertible preferred stock ("Series D preferred stock") at a
price of $10.42 per share.
Each share of Series A, Series B, Series C and Series D preferred stock is
convertible, at the option of the holder, into common stock, as determined by
dividing $0.993, $1.63, $7.113 and $10.42, respectively, plus an amount equal
to all declared but unpaid dividends on each share into the number of
outstanding shares. The price at which common stock shall be deliverable upon
conversion of the Series A, Series B, Series C and Series D is $0.9027,
$1.63, $7.113 and $10.42, respectively, subject to certain adjustments for
dilution, if any, resulting from future stock issuances. The outstanding
shares of preferred stock automatically convert into common stock upon the
close of business on the day immediately preceding the closing of an
underwritten public offering of common stock under the Securities Act of 1933
in which the Company receives at least $10,000,000 in gross proceeds and the
price per share is at least $7.50, in the case of Series A, Series B and
Series C preferred stock, and at least $40,000,000 in gross proceeds and the
per share price is at least $11.50, in the case of Series D preferred stock.
Series A, Series B, Series C and Series D preferred shareholders are entitled
to noncumulative dividends of $0.0794, $0.1141, $0.4979 and $0.7294,
respectively, per share. Dividends will be paid only when declared by the
Board of Directors out of legally available funds. No dividends have been
declared as of June 30, 1997.
The Series A, Series B, Series C and Series D preferred shareholders are
entitled to receive, upon liquidation, an amount per share equal to the
issuance price, plus all declared but unpaid dividends. Thereafter, the
remaining assets and funds, if any, shall be distributed pro rata among the
common shareholders. If the assets or property were not sufficient to allow
full payment to the Series A, Series B, Series C and Series D shareholders,
the available assets shall be distributed ratably among the Series A, Series
B, Series C and Series D shareholders.
The Series A, Series B, Series C and Series D preferred shareholders have
voting rights equal to the common shares issuable upon conversion.
The Company is required to redeem the outstanding Series A and Series B
preferred shares at an amount equal to the issuance price plus all declared
but unpaid dividends in four annual installments beginning in March 2003.
COMMON STOCK
In April 1997, the Company amended existing shareholder agreements with its
founding shareholders/officers ("Founders"). The revised terms provide the
Company a repurchase right for 488,538 shares of Common Stock held by the
Founders with such repurchase right lapsing over periods of two to three
years. At June 30, 1997, 488,538 shares are subject to repurchase under
these agreements.
At June 30, 1997, the Company has reserved 14,141,451 shares of its common
stock for issuance upon conversion of its Series A, Series B, Series C and
Series D preferred stock, 3,929,377 common shares for issuance under the 1996
Stock Incentive Plan and 122,553 shares for issuance of common stock upon the
exercise of outstanding warrants to purchase common stock and convertible
preferred stock.
STOCK WARRANTS
In connection with the issuance of convertible notes in February 1996 as
discussed in Note 6, the Company issued warrants to purchase a total of
53,000 shares of common stock, subject to adjustments for stock splits and
other reclassifications in capitalization, at an exercise price of $0.05 per
share. The warrants will be delivered on or before the respective maturity
dates of the convertible promissory notes and may be exercised at any time on
or before the expiration of one year following the issuance to the respective
holders. Shares issued upon exercise of warrants will be subject to the
Company's right of first refusal to purchase these shares prior to an initial
public offering by the Company. The shares of common stock issuable to the
holders pursuant to the exercise of these warrants are subject to the
Company's right of first refusal to purchase the shares, at the market price,
prior to the Company's initial public offering. These warrants were exercised
during the year ended March 31, 1997.
26
<PAGE>
WEBTV NETWORKS, INC.
NOTES TO FINANCIAL STATEMENTS (Continued)
In connection with equipment lease line financing in June 1996, as discussed
in Note 5, the Company issued warrants to purchase a total of 86,000 shares
of Series B redeemable convertible preferred stock, subject to adjustments
for stock splits and other recapitalization, at an exercise price of $2.50,
$5.00 and $7.113 per share for 46,000, 20,000 and 20,000 shares,
respectively.
In connection with equipment lease line financing in January 1997, as
discussed in Note 5, the Company issued warrants to purchase a total of
36,553 shares of Series C convertible preferred stock, subject to adjustments
for stock splits and other recapitalization, at an exercise price of $7.113
per share.
The value ascribed to these warrant issuances was determined by the Company
to be immaterial for financial statement purposes.
Warrants outstanding at March 31 and June 30, 1997 were 122,553.
1996 STOCK INCENTIVE PLAN
Under the 1996 Stock Incentive Plan (the "Plan"), which was adopted in
February 1996, options may be granted for common stock or common stock may be
issued, pursuant to actions by the Board of Directors, to directors,
consultants, advisors, and employees of the Company. Options granted are
either incentive stock options or nonstatutory stock options and are
exercisable within the times or upon the events determined by the Board of
Directors as specified in each option agreement. Incentive stock options
granted under the Plan are at prices not less than 100% of the fair value at
the date of grant. Nonstatutory options granted under the Plan are at prices
not less than 85% of the fair value on the date of the grant, as determined
by the Board of Directors. Stock options granted to a 10% shareholder shall
not be less than 110% of the fair value at the date of grant. Options vest
over a period of time as determined by the Board of Directors, generally four
years. The term of the Plan is ten years.
Plan transactions were as follows:
<TABLE>
<CAPTION>
OUTSTANDING STOCK OPTIONS WEIGHTED
-------------------------- AVERAGE
SHARES NUMBER OF PRICE PER PRICE PER
AVAILABLE SHARES SHARE SHARE
----------- ----------- ------------- ---------
<S> <C> <C> <C> <C>
Original authorization of shares........... 3,180,188 - - -
Additional shares authorized for issuance.. 1,819,812 - - -
Options granted............................ (2,660,849) 2,660,849 $ 0.05 $0.05
---------- ---------- ------------- -----
Balance at March 31, 1996.................. 2,339,151 2,660,849 $ 0.05 $0.05
Additional shares authorized for issuance.. 3,000,000 - - -
Options granted............................ (4,317,832) 4,317,832 $0.05 - $2.50 $0.76
Options exercised.......................... - (4,053,373) $0.05 - $0.50 $0.09
Options canceled........................... 306,518 (306,518) $0.05 - $1.75 $0.15
---------- ---------- ------------- -----
Balance at March 31, 1997.................. 1,327,837 2,618,790 $0.05 - $2.50 $1.14
Options exercised.......................... - (17,250) $0.05 - $1.75 $0.15
Options canceled........................... 22,400 (22,400) $0.50 - $2.50 $1.68
---------- ---------- ------------- -----
Balance at June 30, 1997................... 1,350,237 2,579,140 $0.05 - $2.50 $1.14
========== ========== ============= =====
Weighted-average fair value of options
granted during the year ended March 31,
1997..................................... $0.20
=====
</TABLE>
27
<PAGE>
WEBTV NETWORKS, INC.
NOTES TO FINANCIAL STATEMENTS (Continued)
The Company has elected to follow Accounting Principles Board Opinion No. 25,
"Accounting for Stock Issued to Employees" ("APB 25"), and related
interpretations in accounting for its employee stock options (see Note 1).
Under APB 25, when the exercise price of the Company's stock options equals
the market price of the underlying stock on the date of grant, no
compensation expense is recognized.
Pro forma information regarding net loss and loss per share is required by
FAS 123, and has been determined as if the Company had accounted for its
employee stock options granted after December 31, 1994 under the fair value
method of that Statement. The fair value of these options was estimated at
the date of grant using the Black-Scholes option pricing model with the
following weighted-average assumptions for the years ended March 31, 1996 and
1997: risk-free interest rate of 6%; no dividends paid; volatility factor of
the expected market price of the Company's common stock of zero; and a
weighted-average expected life of the option of five years. The forfeiture
rate was assumed to be zero. After the Recapitalization (see Note 9),
replacement and new stock options granted to employees of the Company will
likely experience substantially greater forfeiture rates as is typical in
post-acquisition environments. The effects of applying FAS 123 for the
recognition of compensation expense and provision of pro forma disclosures in
the years ended March 31, 1996 and 1997 and the three months ended June 30,
1997 are not likely to be representative of the effects on reported and pro
forma net income in future years.
The Black-Scholes option valuation model was developed for use in estimating
the fair value of traded options which have no vesting restrictions and are
fully transferable. In addition, option valuation models require the input of
highly subjective assumptions including the expected stock price volatility.
Because the Company's employee stock options have characteristics
significantly different from those of traded options, and because changes in
the subjective input assumptions can materially affect the fair value
estimate, in management's opinion, the existing model does not necessarily
provide a reliable single measure of the fair value of its employee stock
options.
For purposes of pro forma disclosures, the estimated fair value of the
options is amortized to expense over the option's vesting period. The
Company's pro forma information is as follows:
<TABLE>
<CAPTION>
PERIOD FROM
INCEPTION YEAR THREE MONTHS ENDED
(JUNE 30, 1995) ENDED JUNE 30,
TO MARCH 31, MARCH 31, ----------------------------------
1996 1997 1996 1997
--------------- ------------- ------------------- -------------
(UNAUDITED)
<S> <C> <C> <C> <C>
Pro forma net loss............................................ $(3,232,664) $(42,832,550) $(3,047,555) $(17,526,153)
=========== ============ =========== ============
Pro forma net loss per share.................................. $ (0.22) $ (1.52) $(0.14) $ (0.53)
=========== ============ =========== ============
</TABLE>
The weighted-average contractual life of options outstanding and exercisable at
June 30, 1997 is as follows:
<TABLE>
<CAPTION>
OPTIONS WEIGHTED OPTIONS
OUTSTANDING AVERAGE EXERCISABLE
AT REMAINING AT
JUNE 30, CONTRACTUAL JUNE 30,
1997 LIFE 1997
-------- ---- -------
EXERCISE PRICES (IN YEARS)
<S> <C> <C> <C>
$0.05 125,000 8.75 125,000
$0.16 90,250 8.99 24,625
$0.50 607,600 9.20 150
$0.75 293,300 9.32 5,000
$1.00 573,400 9.43 -
$1.75 441,850 9.55 115,000
$2.00 147,500 9.64 25,000
$2.50 300,240 9.71 15,625
-------- ---- -------
2,579,140 9.38 310,400
========= ==== =======
</TABLE>
28
<PAGE>
WEBTV NETWORKS, INC.
NOTES TO FINANCIAL STATEMENTS (Continued)
At June 30, 1997, there were 2,462,775 shares of common stock subject to
repurchase under the Plan.
DEFERRED COMPENSATION
The Company has recorded deferred compensation of $3,000,000 to reflect the
difference between the exercise price and deemed fair value for financial
reporting purposes of certain options to purchase common stock of the Company
granted by the Company during the year ended March 31, 1997. This amount is
being amortized over the vesting period of the individual options, generally
a 48-month period. Compensation expense recognized in the year ended March
31, 1997 and in the three months ended June 30, 1997 totaled $76,000 and
$187,500, respectively.
8. INCOME TAXES
As of June 30, 1997, the Company had federal and state net operating loss
carryforwards of approximately $61,400,000 and $61,500,000 respectively. The
federal net operating loss carryforwards will expire at various dates
beginning in 2011 through 2012, if not utilized. The state net operating loss
carryforwards will expire in 2003. An ownership change, as defined in the
Tax Reform Act of 1986, may restrict the utilization of carryforwards.
Deferred income taxes reflect the net tax effects of temporary differences
between the carrying amounts of assets and liabilities for financial
reporting purposes and the amount used for income tax purposes.
Significant components of the Company's deferred tax assets are as follows:
<TABLE>
<CAPTION>
MARCH 31,
--------------------------- JUNE 30,
1996 1997 1997
------------ ------------- -------------
<S> <C> <C> <C>
Net operating loss carryforwards............. $ 1,200,000 $ 17,200,000 $ 24,700,000
Research credits............................. - 500,000 500,000
Capitalized research expenses and other...... - 900,000 500,000
----------- ------------ ------------
Total deferred tax assets.................... 1,200,000 18,600,000 25,700,000
Valuation allowance for deferred tax assets.. (1,200,000) (18,600,000) (25,700,000)
----------- ------------ ------------
Net deferred tax assets...................... $ - $ - $ -
=========== ============ ============
</TABLE>
Because of the Company's lack of earnings history, the deferred tax assets
have been fully offset by a valuation allowance. The valuation allowance
increased by $1,200,000 during the period from inception (June 30, 1995) to
March 31, 1996.
9. SUBSEQUENT EVENTS
On August 1, 1997 (see Note 1), the closing of the Recapitalization (the
"Closing"), the following occurred:
. Holders of vested common shares of the Company who so elected received
$11.381 per share in cash directly from Microsoft, and otherwise received
in the Recapitalization the equivalent value per share in new Class A
common shares of the Company, which are exchangeable for Microsoft common
shares initially on a one-to-one basis. In either case, in addition to
such consideration, approximately $1.460 per share of cash or the
equivalent value per share in Class A common shares of the Company
(approximately 11.4% of the total consideration to be received by each
shareholder) was placed in an escrow fund that will be used to satisfy any
claims of Microsoft that arise within 18 months of the Closing pursuant to
the Recapitalization Agreement. If none of this amount is used to satisfy
such claims of Microsoft, approximately $1.460 per common share of the
Company in cash or the equivalent value per share in Class A common shares
of the Company will be distributed to each such holder, who in such event
ultimately will receive $12.841 per share in cash or Class A common shares
of the Company. Should Microsoft successfully assert claims under the
Recapitalization
29
<PAGE>
WEBTV NETWORKS, INC.
NOTES TO FINANCIAL STATEMENTS (Continued)
Agreement to which the escrow fund is subject, some or
all of such additional amount would not be released to holders of common
shares of the Company.
. Holders of unvested common shares of the Company received in the
Recapitalization $11.381 in value per share in new Class A common shares
of the Company, which are exchangeable for Microsoft common shares
initially on a one-to-one basis, in each case with vesting terms
equivalent to the vesting terms of their existing common shares of the
Company. In addition to such shares, approximately $1.460 per common
share of the Company worth of Class A common shares of the Company
(approximately 11.4% of the total consideration to be received by each
shareholder) was placed in an escrow fund that will be used to satisfy any
claims of Microsoft that arise within 18 months of the Closing pursuant to
the Recapitalization Agreement. If none of this amount is used to satisfy
such claims of Microsoft, approximately $1.460 per common share of the
Company worth of Class A common shares of the Company will be distributed
to each such holder, who in such event ultimately will receive $12.841 per
share in Class A common shares of the Company. Should Microsoft
successfully assert claims under the Recapitalization Agreement to which
the escrow fund is subject, some or all of such additional amount would
not be released to holders of common shares of the Company.
. Holders of options to purchase common shares of the Company received
replacement nonqualified options to purchase Microsoft common shares.
. Holders of preferred shares of the Company who so elected received $12.130
per share (determined on an as-if-converted to common shares of the
Company basis) in cash directly from Microsoft, and otherwise received the
same cash payment from the Company in the Recapitalization. In either
case, in addition to such cash, approximately $1.556 per share of cash
(approximately 11.4% of the total consideration to be received by each
shareholder) was placed in an escrow fund that will be used to satisfy any
claims of Microsoft that arise within 18 months of the Closing pursuant to
the Recapitalization Agreement. If none of this amount is used to satisfy
such claims of Microsoft, approximately $1.556 per share in cash will be
distributed to each such holder, who in such event ultimately will receive
$13.686 per share (determined on an as-if-converted to common shares of
the Company basis) in cash. Should Microsoft successfully assert claims
under the Recapitalization Agreement to which the escrow fund is subject,
some or all of such additional amount would not be released to holders of
preferred shares of the Company.
. Holders of warrants to purchase capital shares of the Company who so
elected received $12.130 per share (determined on an as-if-net exercised
and an as-if-converted to common shares of the Company basis) in cash
directly from Microsoft, and otherwise received the same cash payment from
the Company in the Recapitalization. In either case, in addition to such
cash, approximately $1.556 per share of cash (approximately 11.4% of the
total consideration to be received by each warrant holder) was placed in
an escrow fund that will be used to satisfy any claims of Microsoft that
arise within 18 months of the Closing pursuant to the Recapitalization
Agreement. If none of this amount is used to satisfy such claims of
Microsoft, approximately $1.556 per share in cash will be distributed to
each such holder, who in such event ultimately will receive $13.686 per
share (determined on an as-if-net exercised and an as-if-converted to
common shares of the Company basis) in cash. Should Microsoft successfully
assert claims under the Recapitalization Agreement to which the escrow
fund is subject, some or all of such additional amount would not be
released to holders of warrants.
Pursuant to the Recapitalization Agreement, Microsoft granted additional
options to purchase Microsoft common shares to the Company's employees so
that those employees (other than the principal shareholders) who held common
shares of the Company or options to purchase common shares of the Company on
April 5, 1997 received additional aggregate consideration of not more than
$31,886,000.
As of the effective date of the recapitalization, the Company became a
controlled subsidiary of Microsoft and the Company expects that its existing
operations will be the same in all material respects. Although each director
of the Company resigned following the Recapitalization, and three Microsoft
employees have been appointed to serve on the Board of Directors and elected
to be the President, Chief Financial Officer, Treasurer and Secretary of the
30
<PAGE>
WEBTV NETWORKS, INC.
NOTES TO FINANCIAL STATEMENTS (Continued)
Company, current management expects that it will continue to manage the
Company after the Recapitalization. In addition, the Company will be engaged
in the same lines of business with the same assets.
* * * * *
31
<PAGE>
SCHEDULE II
WEBTV NETWORKS, INC.
VALUATION AND QUALIFIING ACCOUNTS
<TABLE>
<CAPTION>
BALANCE AT ADDITIONS BALANCE AT
BEGINNING OF CHARGED TO END OF
PERIOD EXPENSE WRITE-OFFS PERIOD
<S> <C> <C> <C> <C>
Allowance for doubtful accounts
Inception to March 31, 1996 $ - $ - $ - $ -
Year ended March 31, 1997 - 50,000 - 50,000
Three months ended June 30, 1997 50,000 42,000 - 92,000
</TABLE>
32
<PAGE>
PART III
ITEM 10. DIRECTORS AND EXECUTIVE OFFICERS OF REGISTRANT
The executive officers and directors of WNI are as follows:
<TABLE>
<CAPTION>
NAME AGE POSITION
- --------------------------------------------- --- -----------------------------------------------------
<S> <C> <C>
Stephen G. Perlman........................... 35 Chief Executive Officer
Bruce A. Leak................................ 34 Chief Operating Officer and Executive Vice President
Phillip Y. Goldman........................... 32 Senior Vice President, Engineering
Gregory B. Maffei............................ 37 President and Director
Jean-Francois Heitz.......................... 47 Chief Financial Officer, Treasurer and Director
Robert A. Eshelman........................... 44 Secretary and Director
Phillip Y. Goldman........................... 32 Senior Vice President, Engineering
Gregory B. Maffei............................ 37 President and Director
Jean-Francois Heitz.......................... 48 Chief Financial Officer, Treasurer and Director
Robert A. Eshelman........................... 44 Secretary and Director
</TABLE>
Mr. Perlman co-founded WNI in June 1995 and has served as its Chief
Executive Officer since June 30, 1995. From March 1994 to March 1995, he was
Chief Technology Officer of Catapult Entertainment, Inc. ("Catapult"), a company
Mr. Perlman co-founded in 1994 to develop and market technology to enable video
games to be played in real-time over computer networks. Prior to founding
Catapult, from December 1990 to March 1994, Mr. Perlman was a Principal and
Managing Director of Advanced Products at General Magic, Inc. ("General Magic").
At General Magic, he was responsible for its personal communicator and
interactive television projects. He spent the six years prior to joining
General Magic as an engineer at Apple Computer, Inc. ("Apple").
Mr. Leak co-founded WNI and has served as its Chief Operating Officer since
June 30, 1995. From September 1993 to June 1995, he was Vice President,
Engineering at Rocket Science Games, Inc. ("RSG"), a company he co-founded to
develop and market multiplatform, realtime CD-ROM authoring tools and systems.
Prior to RSG, from July 1992 to September 1993 he was a member of the MagicCap
development team at General Magic. From February 1987 to July 1992, Mr. Leak
served as Engineering Lead for Apple.
Mr. Goldman co-founded WNI and has served as its Senior Vice President,
Engineering since June 30, 1995. From November 1990 to June 1995, he was
Director of Communicating Products at General Magic. Prior to General Magic,
from July 1986 to November 1990, he was Technical Engineering Lead at Apple.
Mr. Maffei has served as WNI's President and as a director since September
1997. Mr. Maffei has been employed by Microsoft since April 1993, where he has
served as Director, Business Development & Investment and Treasurer and Vice
President, Corporate Development; Treasurer, and currently is Vice President,
Finance; Chief Financial Officer, in which capacity he is responsible for
Microsoft's external financial activities, including capital markets,
acquisitions and strategic investments, credit use management, SEC reporting,
investor relations and strategic business decisions. Prior to joining
Microsoft, Mr. Maffei was a consultant for several companies, including
Microsoft. From April 1991 to September 1992, Mr. Maffei was Executive Vice
President and Chief Financial Officer of Pay'N Pak Stores, Inc. Mr. Maffei was
also a director of Pay'N Pak.
Mr. Heitz has served as WNI's Chief Financial Officer and Treasurer and as
a director since September 1997. Mr. Heitz joined Microsoft France in May 1989
as Deputy General Manager, and became General Manager, Business Operations in
July 1991, as well as Director F&A for Microsoft Southern Europe. In August
1994, Mr. Heitz was transferred to Microsoft Corporation as Assistant Treasurer
and is now responsible for all capital markets, global cash management, foreign
exchange, corporate finance, credit and risk management activities.
Mr. Eshelman has served as WNI's Secretary and as a director since
September 1997. Mr. Eshelman joined Microsoft in April 1993 as a Senior
Corporate Attorney and is currently General Counsel, Finance and Administration.
Prior to joining Microsoft, he was a partner at Preston Gates & Ellis LLP,
Microsoft's primary outside law firm.
33
<PAGE>
ITEM 11. EXECUTIVE COMPENSATION
Summary Compensation
The following salary amounts constitute all compensation received for
services rendered to WNI in all capacities for the three months ended June 30,
1997 by Mr. Perlman, WNI's Chief Executive Officer, and Mr. Goldman and Mr.
Leak, WNI's two other most highly compensated executive officers following
consummation of the Recapitalization (collectively, the "Named Officers"): Mr.
Perlman, $40,385; Mr. Goldman, $40,385; Mr. Leak, $40,385.
Messrs. Maffei, Heitz and Eshelman were not employees of WNI during the
fiscal year ended June 30, 1997 and have received no compensation to date from
WNI.
Option Grants
No stock options were granted to any of the Named Officers during the three
months ended June 30, 1997.
Option Exercises during Three Months Ended June 30, 1997 and Holdings and
Fiscal Year-End Option Values
No stock options were exercised by any Named Officers during the three
months ended June 30, 1997, and no stock options were held by any Named Officers
as of June 30, 1997.
DIRECTORS' COMPENSATION
Directors of WNI receive no compensation for their services, but will be
reimbursed for certain expenses in connection with attendance at board and
committee meetings.
EMPLOYMENT CONTRACTS AND TERMINATION OF EMPLOYMENT AND CHANGE-IN-CONTROL
ARRANGEMENTS
Effective as of August 1, 1997, Mr. Perlman, Mr. Leak and Mr. Goldman each
entered into employment agreements (the "Employment Agreements") with WNI and
Microsoft, which became the parent corporation of WNI. Each of the Employment
Agreements provides that the respective employee thereunder will be employed by
WNI or Microsoft for three years from the effective date thereof, after which
time such employees shall be employed on an at-will basis. Such agreements
provide that Mr. Perlman, Mr. Leak and Mr. Goldman shall continue to receive the
salaries that they received from WNI prior to the effectiveness of such
agreements, and adjustments thereto shall be determined on the same basis
applicable to employees of Microsoft in similar positions or salary levels.
Under such agreements, Mr. Perlman, Mr. Leak and Mr. Goldman also are entitled
to full benefits of employees of WNI. Further, the vesting rates of the
unvested capital shares of WNI of each of Mr. Perlman, Mr. Leak and Mr. Goldman
shall be accelerated under certain conditions, such as death, disability and
material breach of such employee's respective Employment Agreement by WNI or
Microsoft.
In addition, each Employment Agreement contains restrictions on the ability
of Mr. Perlman, Mr. Leak and Mr. Goldman to engage in a "competing business"
with Microsoft. The Employment Agreements generally define "competing business"
as a business engaged in software and hardware development in connection with a
wide variety of platforms, hardware, applications and operating systems. The
term of such restriction is three years from the effective date of such
agreements or one year after the termination of employment with WNI or
Microsoft, whichever is later.
Each of the Employment Agreements contain restrictions on the ability of
Mr. Perlman, Mr. Leak and Mr. Goldman to solicit or assist in the solicitation
of any employees or agents of Microsoft to terminate any contract or working
relationship with Microsoft. As with the noncompetition provisions described
above, the term of such restrictions is three years from the effective date of
such agreements or one year after the termination of employment with WNI or
Microsoft, whichever is later.
During the Transition Period, the Company did not have a compensation
committee and its Board of Directors did not make an evaluation of executive
compensation. Consequently, the Board of Directors has not prepared a
34
<PAGE>
compensation committee report with respect to executive compensation during the
Transition Period. Because none of the Company's securities trade publicly, no
performance graph is included herein.
ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT
The following table sets forth certain information regarding beneficial
ownership of WNI as of September 30, 1997 (i) by each person known by WNI to own
beneficially more than 5% of an outstanding class of capital shares of WNI, (ii)
by each of the directors of WNI, (iii) each of the Named Officers, and (iv) by
all of WNI's directors and officers as a group.
<TABLE>
<CAPTION>
NUMBER OF SHARES CLASS OF PERCENT OF CLASS
BENEFICIALLY OWNED SECURITIES BENEFICIALLY OWNED(1)
------------------ -------------- ---------------------
<S> <C> <C> <C>
Microsoft Corporation........................ 7,170,512 Class B 100.0%
One Microsoft Way Common Shares
Redmond, WA 98052
Gregory B. Maffei............................ -- N/A N/A
c/o Microsoft Corporation
One Microsoft Way
Redmond, WA 98052
Jean-Francois Heitz.......................... -- N/A N/A
c/o Microsoft Corporation
One Microsoft Way
Redmond, WA 98052
Robert A. Eshelman........................... -- N/A N/A
c/o Microsoft Corporation
One Microsoft Way
Redmond, WA 98052
Phillip Y. Goldman........................... 468,997 Class A 28.0%
WebTV Networks, Inc. Common Shares
305 Lytton Avenue
Palo Alto, CA 94301
Bruce A. Leak................................ 468,997 Class A 28.0%
WebTV Networks, Inc. Common Shares
305 Lytton Avenue
Palo Alto, CA 94301
Stephen G. Perlman........................... 354,186 Class A 21.2%
WebTV Networks, Inc. Common Shares
305 Lytton Avenue
Palo Alto, CA 94301
All officers and directors as a group
(6 persons).................................. 1,292,180 Class A 77.2%
Common Shares
</TABLE>
ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS
Each of Mr. Perlman, Mr. Leak and Mr. Goldman entered into, as of April 5,
1997, an Amended and Restated Shareholder Agreement with the Company. Such
agreements amend agreements previously entered into by the Company and each of
Mr. Perlman, Mr. Leak and Mr. Goldman in connection with the issuance of capital
shares of the Company to such individuals as founders of the Company (the
"Founders Shares"). In addition to deleting various provisions that became
irrelevant, each agreement establishes a new vesting schedule with respect to
the Founders
35
<PAGE>
Shares. Under the revised agreement, Mr. Leak and Mr. Goldman each have 166,103
unvested Class A Common Shares of which 33 1/3% will vest April 5 of 1998, 1999
and 2000, respectively, and Mr. Perlman will have 156,332 unvested Class A
Common Shares of which 50% will vest on April 5 of 1998 and 1999, respectively.
WNI has agreed to pay certain fees associated with certain patents licensed
to WNI by Mr. Perlman.
PART IV
ITEM 14. EXHIBITS, FINANCIAL STATEMENT SCHEDULES, AND REPORTS ON FORM 8-K
(A) (1) FINANCIAL STATEMENTS
The financial statements included in Item 8, Financial Statements and
Supplementary Data, are set forth in the Index to Financial Statements and
Financial Statement Schedule listed on page 14 of this Form 10-K.
(2) FINANCIAL STATEMENT SCHEDULES
The financial statement schedule is set forth in the Index to Financial
Statements and Financial Statement Schedules listed on page 14 of this Form 10-
K.
(3) EXHIBITS
<TABLE>
<CAPTION>
EXHIBIT NO. DESCRIPTION FOOTNOTE
- ----------- ----------- --------
<C> <S> <C>
2.1 Articles of Incorporation of WebTV Networks, Inc................................. (1)
2.2 Bylaws of WebTV Networks, Inc.................................................... (1)
10.1 Lease dated September 1, 1995 for facilities located at 275 Alma Street in Palo
Alto, California................................................................. (1)
10.2 Lease dated August 10, 1996 for facilities located at 325 Lytton Avenue in Palo
Alto, California................................................................. (1)
10.3 Sublease dated June 14, 1996 for facilities located at 305 Lytton Avenue and 335
Bryant Avenue in Palo Alto, California........................................... (1)
10.4 Lease dated January 6, 1997 for facilities located at 151 Lytton Avenue in Palo
Alto, California................................................................. (1)
10.5 Sublease dated December 10, 1996 for facilities located at 361 Lytton Avenue in
Palo Alto, California............................................................ (1)
11.1 Calculation of Net Loss Per Share
16.1 Letter of Ernst & Young LLP to the Securities and Exchange Commission pursuant
to Item 304(a)(3) of Regulation S-K.............................................. (2)
27.1 Financial Data Schedule
</TABLE>
- ---------------------------
(1) Incorporated by reference to the registrant's registration statement on
Form S-4 (Commission File No. 333-26411).
(2) Incorporated by reference to the registrant's current report on Form 8-K
(Commission File No. 1-4278) dated October 3, 1997
(b) REPORTS ON FORM 8-K
No reports on Form 8-K were filed during the quarter ended June 30, 1997.
36
<PAGE>
SIGNATURES
Pursuant to the requirements of Section 13 or Section 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 on this
12th day of November, 1997.
WEBTV NETWORKS, INC.
By /s/ Gregory B Maffei
-------------------------------------
Gregory B Maffei, President
Pursuant to the requirements of the Securities Exchange Act of 1934, this
report has been signed below by the following persons on behalf of the
registrant and in the capacities indicated on this 12th day of November, 1997.
<TABLE>
<CAPTION>
SIGNATURES TITLE
---------- -----
<S> <C>
/s/ Stephen G. Perlman
- ---------------------------------------------- Chief Executive Officer (Principal
Stephen G. Perlman Executive Officer)
/s/ Jean-Francois Heitz
- ---------------------------------------------- Chief Financial Officer and Treasurer, and
Jean-Francois Heitz Director (Principal Financial Officer)
/s/ Albert A. Pimentel
- ---------------------------------------------- Principal Accounting Officer
Albert A. Pimentel (Principal Accounting Officer)
/s/ Gregory B. Maffei
- ---------------------------------------------- Director
Gregory B. Maffei
/s/ Robert A. Eshelman
- ---------------------------------------------- Director
Robert A. Eshelman
</TABLE>
37
<PAGE>
EXHIBIT 11.1
WEBTV NETWORKS
STATEMENT RE COMPUTATION OF EARNINGS PER SHARE
(IN THOUSANDS, EXCEPT PER SHARE AMOUNTS)
<TABLE>
<CAPTION>
PERIOD FROM
INCEPTION THREE
(JUNE 30, YEAR MONTHS ENDED
1995) TO ENDED JUNE 30,
MARCH 31, MARCH 31, ----------------------------
1996 1997 1996 1997
------------- ------------ ------------- -------------
(UNAUDITED)
<S> <C> <C> <C> <C>
Weighted average common shares
outstanding during the period 13,462,963 17,934,964 15,063,961 19,114,333
Convertible preferred stock 1,083,924 10,318,749 6,896,807 14,141,451
----------- ------------ ----------- ------------
Total 14,546,887 28,253,713 21,960,768 33,255,784
=========== ============ =========== ============
Net loss $(3,232,410) $(42,767,894) $(3,045,567) $(17,472,591)
=========== ============ =========== ============
Pro forma net loss per share $ (0.22) $ (1.51) $ (0.14) $ (0.53)
=========== ============ =========== ============
</TABLE>
38
<TABLE> <S> <C>
<PAGE>
<ARTICLE> 5
<S> <C>
<PERIOD-TYPE> 3-MOS
<FISCAL-YEAR-END> JUN-30-1997
<PERIOD-START> APR-01-1997
<PERIOD-END> JUN-30-1997
<CASH> 5,034,702
<SECURITIES> 0
<RECEIVABLES> 5,764,396
<ALLOWANCES> 92,000
<INVENTORY> 1,937,374
<CURRENT-ASSETS> 13,775,394
<PP&E> 11,353,775
<DEPRECIATION> 3,251,687
<TOTAL-ASSETS> 25,547,106
<CURRENT-LIABILITIES> 23,588,635
<BONDS> 0
12,359,999
48,281,373
<COMMON> 3,452,027
<OTHER-SE> (3,036,339)
<TOTAL-LIABILITY-AND-EQUITY> 25,547,106
<SALES> 5,606,463
<TOTAL-REVENUES> 9,753,362
<CGS> 4,346,341
<TOTAL-COSTS> 14,343,321
<OTHER-EXPENSES> 12,882,632
<LOSS-PROVISION> 42,000
<INTEREST-EXPENSE> 167,727
<INCOME-PRETAX> (17,472,591)
<INCOME-TAX> 0
<INCOME-CONTINUING> (17,472,591)
<DISCONTINUED> 0
<EXTRAORDINARY> 0
<CHANGES> 0
<NET-INCOME> (17,472,591)
<EPS-PRIMARY> (0.53)
<EPS-DILUTED> (0.53)
</TABLE>
