DIVA SYSTEMS CORP, 10-K405, 2000-09-28

DIVA SYSTEMS CORP
10-K405, 2000-09-28
CABLE & OTHER PAY TELEVISION SERVICES

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UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
Washington, D.C. 20549

FORM 10-K

(Mark One)
[Y] Annual report pursuant to Section 13 or 15(d) of the Securities Exchange
Act of 1934.
For the fiscal year ended June 30, 2000

[_] Transition report pursuant to Section 13 or 15(d) of the Securities
Exchange Act of 1934.

For the transition period from to

Commission file no. 333-64483

______________

DIVA Systems Corporation
(Exact name of Registrant as specified in its charter)

______________

Delaware 94-3226532
(State or other jurisdiction of (I.R.S. Employer
incorporation or organization) Identification Number)

800 Saginaw Drive 94063
Redwood City, California (Zip Code)
(Address of principal executive offices)

Registrant's telephone number, including area code: (650) 779-3000

______________

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

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

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

The aggregate market value of the Registrant's Common Stock, par value
$.001 per share, held by non-affiliates of the Registrant, based upon the fair
market value as determined by our Board of Directors as of June 30, 2000 was
approximately $21,654,896. For purposes of this disclosure, shares of Common
Stock held by persons who hold more than 5% of the outstanding shares of Common
Stock and shares held by named officers and directors of the Registrant have
been excluded because such persons may be deemed to be affiliates. This
determination of affiliate status is not necessarily conclusive for other
purposes.

The number of shares of Registrant's classes of Common Stock outstanding at
August 31, 2000 was:

Title of each Class
-------------------
Common Stock, $.001 par value 17,828,002
Class C Common Stock, $.001 par value 857,370

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DIVA SYSTEMS CORPORATION

FORM 10-K

YEAR ENDED JUNE 30, 2000

TABLE OF CONTENTS

<TABLE>
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Page
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PART I

Item 1. Business............................................................................... 2
Item 2. Properties............................................................................. 12
Item 3. Legal Proceedings...................................................................... 12
Item 4. Submission of Matters to a Vote of Security Holders.................................... 12

PART II

Item 5. Market for the Registrant's Common Stock and Related Stockholder Matters............... 13
Item 6. Selected Financial Data................................................................ 13
Item 7. Management's Discussion and Analysis of Financial Condition and Results of Operations.. 15
Item 8. Financial Statements and Supplementary Data............................................ 31
Item 9. Changes in and Disagreements with Accountants on Accounting and Financial Disclosure... 56

PART III

Item 10. Directors and Executive Officers of the Registrant.................................... 57
Item 11. Executive Compensation................................................................ 60
Item 12. Security Ownership of Certain Beneficial Owners and Management........................ 63
Item 13. Certain Relationships and Related Party Transactions.................................. 64

PART IV

Item 14. Exhibits, Financial Statement Schedules, and Reports on Form 8-K...................... II-1
</TABLE>
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PART I

Item 1. Business

This Business section and other parts of this Annual Report on Form 10-K
contain forward-looking statements that involve risks and uncertainties. Our
actual results may differ materially from the results discussed in the forward-
looking statements. Factors that might cause such a difference include, but are
not limited to, those discussed below and in "Management's Discussion and
Analysis of Financial Condition and Results of Operations." The forward-looking
statements contained herein are made as of the date hereof, and we assume no
obligation to update such forward-looking statements or to update reasons actual
results could differ materially from those anticipated in such forward-looking
statements. Forward-looking statements are statements identified with an
asterisk (*). References to "DIVA", "we", "us", "our" or the "Company" in this
Annual Report refers to DIVA Systems Corporation.

Overview

Our video-on-demand service allows cable television digital subscribers to
select movies and other content for immediate viewing. Choosing from over 4,000
DIVA-licensed movie and video titles, network operators can offer their digital
subscribers in-home access to a selection of over 300 titles, including new
release feature films, classic films, children's programming and other special
interest programming, with pause, rewind and fast-forward control. Subscribers
generally pay on a per selection basis and can also subscribe on a fixed monthly
fee basis for some of our package offerings. Our interactive program guide
allows digital subscribers to navigate through the increasingly large selection
of viewing choices and services offered by today's network operators. We are
enhancing our core technology to support on-demand timeshifted television and
interactive targeted advertising. We believe that as the market for interactive
television services evolves, we can capitalize on these opportunities, as well
as on new services including television-based e-commerce.

We have current deployments of our video-on-demand services at selected
Insight Communications, MediaOne and Charter Communications systems. In May
2000, we entered into an agreement with Charter to deploy our video-on-demand
services in a number of its cable systems. The agreement covers Charter's Los
Angeles and Atlanta area systems, and provides incentives for Charter to deploy
our service in other markets. MediaOne, Charter and Insight are, respectively,
the fourth, fifth and eighth largest cable operators in the United States. Our
interactive program guide has recently been deployed on a limited basis at two
cable operators' systems. We are currently developing a video-on-demand
capability for NTL, the largest cable operator in the United Kingdom. We
continue to pursue discussions with major cable operators in the United States.
We are also pursuing other international opportunities, primarily in Western
Europe.

Market Opportunity

The home entertainment industry, which includes cable television, direct
broadcast satellite, pay-per-view and video rentals, is a large and growing
market. The market opportunity for interactive, on-demand television products
and services is being driven by:

. demand from cable operators for new services to increase their share of
home entertainment industry revenues, differentiate their product offerings
from direct broadcast satellite and further drive penetration of their
digital programming packages;

. the rollout of digital set-top boxes and upgraded cable plant, making
interactive services technically feasible; and

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. significant reductions in the cost of technology, making interactive on-
demand television products and services commercially viable.

The reach and popularity of television has increased substantially over time,
resulting in television becoming the primary form of home entertainment. This
popularity has largely been driven by the emergence of new technologies and
delivery systems for television programming which have provided consumers with
increased choice and control of their viewing options. According to Veronis,
Suhler & Associates, consumer spending on television-based home entertainment
has increased from $36 billion in 1994 to $57 billion in 1999 and is expected to
reach $76 billion in 2003. In 1999, approximately $18.7 billion of this market
was comprised of videotape rentals and sales and $1.9 billion was comprised of
pay-per-view.

In the United States, cable operators have been the traditional suppliers of
multi-channel video home entertainment services to consumers. However,
alternative providers such as direct broadcast satellite operators, cable
overbuilders, broadband telecommunications providers and even utility power
companies, have begun to challenge the cable industry monopolies. Today, the
primary competitors to cable operators are direct broadcast satellite operators
such as DirecTV and EchoStar, which offer consumers more programming choice, as
well as digital video and sound. The typical direct broadcast satellite offering
includes 100 video channels, 30 digital music channels and up to 55 channels
dedicated to near-video-on-demand services, as compared to the significantly
fewer number of channels that are offered on traditional analog cable systems.
In addition, direct broadcast satellite operators have begun to improve their
competitive position by carrying local television stations and introducing
interactive services. The increased choice and quality of direct broadcast
satellite offerings have attracted consumers. According to SkyREPORTS, there are
currently more than 11.8 million direct broadcast satellite subscribers in the
United States and an estimated 225,000 new subscribers are added each month. As
direct broadcast satellite providers and other competitors seek to increase
penetration of their services, they present a growing threat to the cable
television industry.

To compete with these alternative providers of multi-channel programming
services, cable operators have embarked on new service initiatives requiring
cable network upgrades and the wide-scale deployment of digital set-top boxes.
By the end of 2000, cable operators expect that 75% of their cable plant will be
upgraded to two-way-capable hybrid fiber coaxial plant. In addition, in 1999,
cable operators in the United States tripled their deployment of digital set-top
boxes to 3.5 million. Industry analysts predict that digital set-top box
deployment will grow from 10 million at the end of 2000 to 32 million at the end
of 2004. The deployment of digital set-top boxes coupled with these network
enhancements has enabled cable operators to offer new services, including
digital programming and interactive, on-demand television services such as
video-on-demand, to their subscribers. We believe digital programming coupled
with video-on-demand allows cable operators to offer subscribers a superior
product to that offered by the direct broadcast satellite operators. Direct
broadcast satellite operators cannot currently offer video-on-demand services
due to bandwidth and scalability limitations. Recently, several cable operators
have begun trials of video-on-demand services, and a few have begun initial
commercial deployments at selected locations. Paul Kagan estimates that services
enabled by digital set-top boxes and two-way upgraded cable plant will generate
$10.8 billion of revenue in 2004 over the next ten years, with video-on-demand
services generating 39% of this revenue.*

The widespread rollout of digital services and the increased choice in
programming is creating demand for interactive program guides. Due to digital
and compression technologies, digital cable viewers can access more than 100
broadcast channels, video-on-demand, Internet-to-the-television and other
enhanced service offerings. We believe interactive program guides will become
portals through which viewers can easily navigate this broad selection of
programming and service choices.* Forrester Research estimates that the average
interactive program guide user visits the interactive program guide four times
per hour of viewing. With the average household viewing television for seven
hours a day, interactive program guides offer opportunities for cable operators
to generate significant revenues from advertising.* Forrester Research estimates
that annual advertising-related revenues generated by electronic program guides
will reach $3.4 billion by 2004.*

The recent roll-out of digital set-top boxes and two-way cable plant have made
the deployment of video-on-demand and other interactive services possible.
Significant technology developments and reductions in costs over the last
several years have made wide-scale deployment of these services commercially
viable. Video-on-demand can be delivered through industry standard digital set-
top boxes now being deployed, eliminating the need to purchase additional in-
home equipment to provide these services. The economics of video-on-demand have
improved dramatically through advances in microprocessor power and the rapid
decline in storage costs, which have lowered the cost of set-top boxes and
video-on-demand hardware.

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DIVA Benefits

We believe that our interactive, on-demand television products and services
provide cable and other broadband network operators with the following benefits:

Compelling On-Demand Entertainment. Our video-on-demand services offer
subscribers immediate access to hundreds of viewing choices including feature
films, children's programming and specialty shows. This service combines anytime
start convenience, pause, fast forward and rewind control with high-quality
digital picture and sound at prices comparable to home video rentals. Our video-
on-demand service eliminates inconvenient trips to the video store, late return
fees and tape rewind charges. Our interactive program guide, which combines
programming information and full motion video, serves as an easy-to-use
television portal to help consumers navigate the myriad of channels and services
offered by digital cable.

Significant Revenue Opportunity. We believe our on-demand television products
and services provide a platform that enables cable operators to generate greater
revenue from customer penetration for their digital cable offering and
significant incremental revenue from ordering on-demand movies and other
programming. We believe our interactive program guide provides operators with
additional revenue opportunities from promotions and advertising. We believe
that cable operators can recover the incremental capital costs to implement the
DIVA video-on-demand solution in less than one year solely from the additional
revenues generated by movie purchases.

Comprehensive and Flexible Service Offering. Our comprehensive offering has
been field-proven and, accordingly, reduces both the time-to-market and the
operational challenges associated with implementing interactive television
services. We offer a core suite of software products and services that enable
and manage the network operator's video-on-demand system. These products and
services include:

. automated video asset management;

. a full-motion, easy-to-use, on-screen navigator;

. programming and entertainment services represented by over 4,000 licensed
video titles;

. the required hardware products including the video server; and

. the ability to provide a network operator-branded service.

Network operators can select either this end-to-end solution or any of the
individual components depending upon their needs. We believe that this
flexibility is attractive to a wide range of network operators.

Sophisticated Back-Office Solution. Our back-office solutions integrate
billing with an audit trail for network operator revenue recognition, studio
contract royalty reporting and market research. This gives the network operator
the ability to offer its customers a variety of subscriptions, packages and
promotions without requiring an overhaul of existing billing systems. We have
successfully integrated our on-demand television services with the systems
provided by the three largest cable billing companies. We also have developed a
highly automated video asset management system to track and manage a large array
of video content. This database system tracks a title from acquisition through
distribution and provides payment details and other information for content
providers.

Flexible Architecture. Our architecture is designed to scale to support
thousands of titles and serve even the largest cable systems. Our software and
hardware products can integrate with major digital broadcast platforms including
Motorola and Scientific-Atlanta in the United States and PACE in Europe. Our
video-on-demand application requires minimal processing power and memory. In
addition, our video-on-demand application can be activated remotely, eliminating
the need for an on-site installer visit. In addition, our application allows
the cable operator to offer multiple digital services on today's set-top boxes.
We are also integrating our services with set-top box software provided by
Liberate, Microsoft TV Platform, OpenTV and Power TV.

DIVA Strategy

Our objective is to be the leading provider of interactive, on-demand
television products and services for cable and other broadband network
operators. Our strategy includes the following key elements:

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Leverage our first mover advantage. Our goal is to leverage our position as
the first provider of a commercially deployed video-on-demand system to become
the leading provider of a wide range of interactive, on-demand television
services.* Our extensive field experience has allowed us to gather practical
feedback on our system and its technology and develop a solution that is not
only compelling to consumers, but also scalable and flexible from the network
operator's perspective.

Aggressively expand our customer base. We plan to continue to build
relationships with cable and other network operators in order to maximize our
share of video-on-demand subscribers.* We have designed our services to be
attractive to network operators seeking to increase their digital penetration.
Our ability to achieve significant market share will allow us to leverage our
platform in order to develop and offer new services.

Pursue commercial opportunities for our interactive program guide. We have
developed a scalable, visually rich and easy-to-use interactive program guide.
We have recently begun to market the interactive program guide as part of our
end-to-end video-on-demand service and as a stand-alone product. We may seek
industry partners to facilitate commercialization of the interactive program
guide.*

Enhance and expand our products and services. We have spent four years and
over $100 million to develop our comprehensive software and hardware solution
for interactive, on-demand television. We plan to continue to aggressively
invest in technology in order to enhance our current service offerings as well
as to develop additional new services, including timeshifted television.*

Pursue industry relationships. We will continue to develop industry
relationships with leading broadband network hardware and software vendors in
order to ensure interoperability of our services, as well as maintain and expand
relationships with our 38 content providers, including major Hollywood studios.*
We plan to establish commercial relationships with additional content providers
in order to provide the broadest array of programming to viewers.*

Adapt our technology and services for other broadband networks. We have
designed our video-on-demand services for the hybrid fiber/coaxial networks
deployed by the cable television industry. Recently, other telecommunications
companies have begun rapid deployment of broadband networks based on digital
subscriber line, or DSL, technology. We are currently developing an interface
for this technology to provide these companies with a video-on-demand solution
and an interactive program guide when their networks are prepared to support
high-capacity transmission. We also plan to expand our service offering to the
Internet environment as the Internet develops over time into a sufficiently
reliable transmission medium to deliver broadcast-quality video to both the
television and personal computer.*

Penetrate global markets. We believe there is a significant demand for our
products and services in Europe. The majority of Western European cable
networks are two-way capable. European cable operators are rapidly deploying
digital set-top boxes to provide interactive services to compete with direct
broadcast satellite operators. We plan to pursue international opportunities to
deploy our on-demand products and services and increase our worldwide customer
base.* We currently have a deployment agreement with NTL and we are in
discussion with other large broadband network operators, including providers of
cable television and DSL services. We are developing the interfaces to enable
our system to work with European standards.*

DIVA Products

Video-On-Demand

At the core of our video-on-demand system is a suite of software and hardware
products. Together, these products can be used to deliver a wide array of
interactive, on-demand television services. Our software is grouped into two
broad categories: system manager software through which the network operator
manages the video-on-demand system and navigation software that permits viewers
to search for and select video-on-demand content. Our hardware products include
video servers and network access equipment.

Our system manager software manages video servers and network access
equipment. It provides interfaces for billing, content management and an
operator's customer management system. We offer software applications that
manage video content from acquisition through encoding, distribution,
exhibition, archiving and destruction. We also provide detailed billing
information for the content providers.

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Our navigation software, the navigator, is a cable viewer's interface with our
video-on-demand system. Our navigator is operated through a standard television
remote control and allows a viewer to locate, browse and preview movies by
title, genre or new release prior to purchase. A viewer can access free movie
previews as well as movie information screens that display MPAA ratings, run-
time, lead actors and price. A movie-saver feature allows the viewer to exit a
title at any time, watch other video-on-demand programs or broadcast television
and return to the exact point of previous exit at a later time during the video-
on-demand rental period. Our navigator also allows a viewer the opportunity to
set parental controls and spending and rating limits.

Interactive Program Guide

An interactive program guide can be the subscriber's first screen, or portal,
when turning on the television. These guides array the multiple channel options
being broadcast at given times in a series of screens that are controllable by
the viewer and displayed in category-coded themes. Within the screens, the
viewer can make selections of specific programs to receive more detailed
information regarding such programs. Opportunities also exist to combine this
information with full-motion video to provide previews or targeted advertising.
Our interactive program guide product is a software and hardware solution
allowing viewers to search and access the large selection of viewing choices
offered by digital television. Our interactive program guide is easy to use and
quickly responds to viewer commands. The interactive program guide information
is streamed in real-time to the viewer and is instantly available to the viewer
whenever the set-top box is on, in contrast to other guides that provide the
information to the set-top box hourly or, in some cases, overnight. Our
interactive program guide also features sorting by categories like favorites,
movies, kids and sports to assist the viewer in quickly finding desired
programming. Our interactive program guide is fully customizable to feature an
operator's trademark, logo and color palette, enabling an operator to maintain a
strong brand identity. Because our interactive program guide uses a minimal
amount of processing power and memory, it allows a network operator to deploy
other set-top applications such as video-on-demand, interactive advertising and
Internet access.

New Product Developments

We are developing the capability to offer new on-demand television services.*
Our product developments include:

. Timeshifted television--taking advantage of the storage and streaming
capability of the video-on-demand server to store broadcast content. The
service will provide customers with on-demand access to individual programs
or entire channels at any time. When integrated with a program guide, the
service can provide equivalent functionality to a personal digital video
recorder without the need to plan ahead or purchase additional hardware.
Timeshifting would enable a viewer to start watching a television program
from the beginning, after its original broadcast had begun and, if desired,
fast forward to catch up to the live broadcast.*

. Interactive targeted advertising--the availability of digital set-top boxes
with a video-on-demand service platform supports many new and potentially
profitable advertising opportunities. Some examples include targeted
advertisements in broadcast programming, video advertising within our
navigator and interactive program guide and interactive infomercials.*

. Television-based electronic commerce--set-top boxes that include the
ability to browse the Web offer the opportunity to enable e-commerce on the
television. When combined with an on-demand service platform, television-
based e-commerce services can use full motion, full screen customer-
controlled video to create compelling interactive commerce sites. Examples
include the sale of movie tickets with video previews and purchase of CDs
while viewing music videos.*

Video-on-Demand Customer Support Services

We provide a suite of specific tools, management systems, software
applications and operational procedures to support our video-on-demand system.
Our customer support services have been developed over a number of years and
have been deployed in the field during the last three years.

Programming. We provide a wide variety of movies and videos to be used with
our video-on-demand delivery system. Selections include over 4,000 titles
licensed from 38 content providers. Our video library is comprised of new
releases, library titles, classics, children's programming and special interest
titles, as well as

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popular cable channel programming. We currently have commitments from studios to
receive new releases in the same window as direct broadcast satellite and pay-
per-view services, typically 30 to 60 days after release to the home video
market. Major studios typically release an aggregate of 15 to 25 new titles to
the pay-per-view window per month. In addition, we have agreements with
providers of popular video and television programming to provide a wide
selection of children's programming. These providers include The Disney Channel,
Animal Planet, Artisan, FUNimation Productions, Inc., HBO, Lancet Media
Productions, Nelvana Enterprises, Ltd. and The Discovery Channels. We also
provide encoding, quality assurance, content and preview preparation for
licensed programming.

Video Asset Management. We distribute our content on optical disks and support
content distribution over satellite and terrestrial networks and on digital
linear tape. Providing an effective video-on-demand service requires a
comprehensive service programming capability that supports distribution,
packaging and promotion of thousands of titles at multiple headends over a wide
geographic area. We have developed real-time tracking systems to monitor, manage
and report the various stages of video content from the supplier to the video-
on-demand server, including encoding, scheduling, distribution, content
introduction, play, removal/destruction and royalty calculations.

Back Office. We have developed integrated billing interfaces with all of the
major cable billing system providers in the United States. These interactive
interfaces provide the network operator with the flexibility to charge video-on-
demand purchases on a single integrated cable bill or to pass the purchase data
to another third party billing agency. Additionally, our sophisticated billing
product is the only video-on-demand product capable of commercially implementing
subscription video-on-demand. Another major feature of our billing interface is
the ability to offer video services based on selected combinations of cable
subscription packages. This feature, called contingent subscriptions, provides
the network operator with the ability to offer its cable subscribers video-on-
demand capabilities for the specific cable channels to which they subscribe. We
have also developed a data warehouse for the collection and analysis of key
video-on-demand activities. Our data warehouse gives the network operator the
ability to measure and modify its video-on-demand offerings to increase sales
performance and customer satisfaction.

Operations Support. We work with our customers to help specify technology
requirements for video-on-demand and to integrate our video-on-demand platform
with the operators' digital cable offering. Since video-on-demand system
reliability is a critical factor in sustaining a high level of customer
satisfaction, we offer secure and redundant data network connections to each of
the network operator's video-on-demand sites. Our Network Operations Center,
located in King of Prussia, Pennsylvania, provides the network operator with 24-
hour per day, seven days per week monitoring and problem resolution for all
video-on-demand server connections.

Customers/Deployments

We have entered into multi-year agreements with three domestic operators of
cable television systems: Charter, Insight and MediaOne and one international
operator, NTL. These agreements provide for deployment of our video-on-demand
software and hardware products, as well as video-on-demand support services, at
the following locations:

Cable Operator Location
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Insight.................... Rockford, IL; Columbus, OH; Evansville, IN

MediaOne................... Atlanta, GA

NTL........................ England

Charter.................... Atlanta area, GA; Los Angeles, CA

Our interactive program guide has been deployed on a limited test basis with
two network operators. We plan to introduce an enhanced version of the
interactive program guide at both systems.*

Our contracts with each network operator are different, reflecting their
selections from our suite of video-on-demand products and services. Under the
Insight and MediaOne contracts, the cable operators purchased the video-on-
demand hardware, license software and purchase support services. The Insight
contract has a term of five years

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and we receive a share of customer revenue. Under our MediaOne contract, we are
paid on a fee for service basis. The term of the MediaOne contract is four years
after system acceptance, which is not anticipated to occur until later this
calendar year.*

In May 2000, we entered into an agreement with Charter to launch our video-on-
demand service as part of its core digital cable package in a number of its
cable systems. The agreement covers Charter's Los Angeles and Atlanta area
systems, and provides incentives to Charter to deploy the service in other
markets. The Los Angeles deployment will use the Scientific-Atlanta Explorer's
digital platform. The Atlanta deployment, which expands our existing limited
deployment, will use Motorola's DCT digital platform. Under the agreement,
Charter will purchase video-on-demand hardware, license video-on-demand and
navigation software, and obtain the full range of our video-on-demand support
services, including content acquisition and management. The term of the Charter
agreement, depending on certain elections by Charter, will be either four years
from the launch of service in the first cable system or December 31, 2004.

Under the NTL agreement, we have a contract for multiple systems subject to
achieving certain milestones. NTL will purchase video-on-demand hardware and
license video-on-demand software from us. We will provide video-on-demand
support services to NTL on a fee for service basis. Because the cable systems in
the United Kingdom are different than those in the United States, NTL is paying
us to modify our video-on-demand hardware and software to work in its systems.
In May 2000, in a separate transaction, NTL made a $6.0 million investment in
our Company.

We are in active discussions with many large network operators that are
evaluating deployment of video-on-demand systems. We believe many of these
operators will deploy video-on-demand services at one or more of their systems,
and are likely to use multiple vendors.* Based on these initial deployments,
they will evaluate whether to do larger scale deployments in more of their
systems. We are discussing interactive program guide deployment with several
network operators. We are aggressively marketing our products and services to
expand our customer base worldwide.

Industry Relationships

We have established relationships with leading industry participants,
including content providers, manufacturers of digital set-top boxes, providers
of application managers and set-top box operating systems and billing system
providers. We received an investment of $7.0 million from General Instrument
(subsequently acquired by Motorola) in December 1999. We entered into
development arrangements with OpenTV in March and April 2000 to integrate our
video-on-demand system and our interactive program guide into OpenTV's
interactive television software platform. In conjunction with these
arrangements, OpenTV made a $5.0 million investment in our company. We also
entered into a development agreement with Liberate in May 2000 to integrate our
video-on-demand system into Liberate's interactive television software platform.
In a separate transaction, Liberate made a $4.0 million investment in our
company. In addition, in May 2000, we received an investment of $5.0 million
from Starz Encore Group LLC (Starz Encore), a wholly-owned subsidiary of Liberty
Media Group. Starz Encore is the largest provider of cable and satellite-
delivered premium movie channels in the United States.

Content Providers. We have agreements for content with 38 content providers
including Warner Bros. (including New Line Cinema, Turner and Warnervision),
Sony Pictures (including Columbia, Tristar and Sony Classics), Universal
Pictures (including Polygram), Walt Disney Pictures (including Miramax),
Twentieth Century Fox (and Fox Searchlight), MGM, Dreamworks, HBO, ESPN, PBS,
The Disney Channel and Discovery Networks.

Set-Top Box Manufacturers. We have agreements to facilitate integration of our
video-on-demand products and services and our interactive program guide with
digital set-top boxes being delivered by Motorola, Scientific-Atlanta and PACE
Technologies. However, we believe operators plan to obtain digital set-top boxes
from multiple vendors.* All of our current video-on-demand deployments are on
Motorola digital set-top boxes. However, we are integrating our video-on-demand
solution into other set-top boxes, including Scientific-Atlanta and PACE digital
platforms. In May 2000, we entered into a deployment agreement which calls for
deployment of our video-on-demand service on Scientific-Atlanta digital set-top
boxes.

Providers of Application Managers and Set-Top Box Operating Systems. We are
working with Liberate, Microsoft, OpenTV and Power TV to interface our video-on-
demand system with their technology. In March and April 2000, we entered into
development arrangements with OpenTV to integrate our video-on-demand service
and interactive program guide into OpenTV's interactive television software
platform. In May 2000, we also entered into

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a development agreement with Liberate to integrate our video-on-demand system
into Liberate's interactive television software platform. We are committed to
working with the leading companies developing technology for the digital cable
tiers so that our products and services can be implemented seamlessly with their
systems.

Billing System Providers. We have worked with each of Convergys, CSG and DST
Innovis (formerly CableData) to develop interfaces so that our services
integrate with their billing systems. We believe these companies provide billing
for all of the major cable operators in the United States and over 90% of the
subscriber base.

Sales and Marketing

Our primary sales objective is to secure long-term agreements with major
network operators. Our sales activities are conducted from our headquarters in
Redwood City, California, and from our office in London, England, and are
supported by our senior management and technical personnel.

Our sales efforts typically involve detailed business and technical
presentations and require us to respond to detailed requests for proposals from
our prospective customers who are evaluating a number of potential vendors. The
sales cycle is lengthy because of the level of customer analysis and long term
commitment required for our product implementations.

After a contract is entered into, our customer support organization is
responsible for the execution and project management of deploying our video-on-
demand system or interactive program guide at the local customer site. The local
account managers and their teams oversee the installation, integration, training
and marketing of all system deployments. Our marketing effort continues after
deployment, when we provide our customers with consultation and assistance in
designing consumer marketing tools, packaging and price strategies, market
research and developing local marketing efforts.

We use a variety of marketing programs to build market awareness of our
company, our brand name and our products and services, as well as to attract
potential customers. As a key marketing initiative, we participate at the major
industry trade shows and take an active role in the major industry standards
organizations. Our marketing programs also include advertising, market research,
product strategy updates with industry analysts, public relations activities,
direct mail programs, seminars and speaking engagements.

Technology

We have spent four years developing our video-on-demand service platform. Our
video-on-demand solution has an open architecture, which readily integrates with
the leading digital cable platforms. Our video-on-demand technology platform
includes, the DIVA System Manager, the DIVA Video Server, the DIVA Digital Link,
and the DIVA Programming Scheduler.

DIVA System Manager

Our DIVA System Manager is the suite of software that operates our on-demand
television services. Key features include:

. an interface that enables a video-based menu;

. content management with automated introduction and updates of content;

. remote operating, monitoring and troubleshooting;

. an intelligent billing module that recognizes different packages and
promotions;

. open billing interfaces to traditional cable billing companies;

. video streaming traffic management; and

. flexible advertisement insertion.

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<PAGE>

The DIVA Video Server

Our DIVA Video Server delivers unique video content streams to individual set-
top boxes on an on-demand basis. Each server installation is capable of scaling
up to 50,000 video-on-demand streams and storing up to 10,000 titles. Multiple
video servers can be networked with integrated optical fiber connections to
expand the content selection and provide traffic management within a single
cable system. Our DIVA Video Server has low power consumption needs and small
floor space requirements, making it well suited for co-location in cable
headends. Each server module provides high speed (1 gigabit per second)
streaming capacity and is comprised of commercially available processor modules
and storage modules. The storage modules contain state-of-the-art fibre channel
disk drives.

The DIVA Digital Link

Our modular DIVA Digital Link converts video streams from the server into a
format that can be distributed over a cable plant to viewers. It also limits
access to authorized users of on-demand television services. Some of the key
features include small size, low cost, scalability and compatibility with video-
on-demand encryption and conditional access standards.

The DIVA Programming Scheduler

We have developed a unique set of support applications that facilitate the
management of the programming to a large number of distributed video servers.
These elements include the programming scheduler, commerce software for managing
royalty payments, and title and rights management software.

Technology Development

Our technology development efforts are focused on developing and enhancing our
video-on-demand and interactive program guide solutions. We believe that we will
need to continue to make significant investments in engineering and development
to remain competitive, to assure our products and services are integrated with
industry standards and to offer new services and enhancements to our customers.*

We are continuing to devote substantial resources to improving our core
software and hardware technologies including:

. reductions in the size and cost, and increases in the storage capacity, of
our video servers*;

. increases in the number of simultaneous video streams that can be accessed
from each video server.*

We are working to ensure that our video-on-demand platform and interactive
program guide will interoperate with the broadband delivery platforms that we
believe will deliver video-on-demand services in the future, including next
generation digital set-top boxes.* Another key development area at this time is
the migration of our video-on-demand platform to support DSL providers and
Internet service providers as the Internet technology develops over time into a
sufficiently reliable transmission medium to deliver broadcast quality video.

We are also developing enhancements to provide the system capability to offer
new on-demand television services, including timeshifted television through
video servers with pause, fast forward and rewind functionality, interactive
targeted advertising and television-based e-commerce.

Our engineering and development expenses were $18.1 million, $24.3 million and
$27.1 million in fiscal years ended June 30, 1998, 1999 and 2000, respectively
and we currently have 105 employees engaged in engineering and development
activities.

Manufacturing and Production

We have an arrangement with a large contract manufacturer for the production
of our hardware products. Our contract manufacturer has several plants in the
United States and Europe. Using a contract manufacturing arrangement allows us
to concentrate our efforts on the design and development of our products and
services, and manage our capital resources. We currently do not have a contract
with this manufacturer and operate on a purchase order basis. The components
used in our hardware products are generally available from a number of sources.
While

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<PAGE>

we have not experienced any shortages to date, we could be subject to component
shortages in the future which could delay delivery of our hardware products or
increase costs.

We have an internal manufacturing department that develops the manufacturing
tests used by the contract manufacturer. Prior to customer shipment of our
hardware products, we perform system integration and quality assurance and load
content at our facilities. In the future, we plan to outsource system
integration and quality assurance. We outsource the encoding of the content we
provide to our customers to companies that specialize in the preparation of
digital content.

We believe that our current contract manufacturer has the capacity to meet our
anticipated increases in volume.* In the event that the current contract
manufacturer is unable or unwilling to continue to support our requirements, we
believe that there is ample capacity in the contract manufacturing industry to
meet our needs.* However, we could require time to transition to a new
manufacturer during which we may be unable to provide hardware products to our
customers on a timely basis.

Competition

The market for interactive, on-demand television products and services and in-
home video entertainment is very competitive, quickly evolving and subject to
rapid technological change. Principal competitive factors include the degree of
system integration, system performance, price, customer support, system
capacity, content availability, software availability, reliability and
integration with industry digital platforms.

Although other companies sell individual components that are similar to
specific DIVA products, we are not aware of any other company that sells all of
the components required to deliver end-to-end, interactive, on-demand
television. As a result, we believe a network operator using a competitor's
systems must buy hardware and software products from more than one source. In
addition, the operator must integrate these hardware and software components so
that they operate together as an end-to-end system capable of delivering
interactive services to viewers' homes.

We group our direct competitors into three categories: server manufacturers,
software providers and system integrators. Server manufacturers include
Concurrent Computer, nCUBE and SeaChange. Software providers that offer similar
products include Prasara and Scientific-Atlanta. Companies that provide system
integration services or perform their own integration include Time Warner and
Scientific-Atlanta.

We also face competition from indirect competitors, including personal video
recorder technology providers (for example, TiVo and Replay), direct broadcast
satellite providers (including BSkyB, DirecTV and EchoStar), companies
developing video streaming technologies and other service providers (for
example, Yes Television, Intertainer and VideoNet).

Our interactive program guide product competes with Gemstar (which recently
merged with TV Guide), Source Media's Interactive Channel, TV Guide and
WorldGate.

Our services depend on movies and video content, including our access window
for new releases. We face competition for timely access to content from the home
video rental market.

Viewers have several options for in-home video entertainment and interactive,
on-demand television. They can purchase content from their local cable
television or broadband telecommunications company, obtain content over
satellite, the Internet or regular telephone lines, rent or purchase videos or
use a personal video recorder to record and store television programming for
replay on-demand. We expect direct and indirect competition in the market for
video-on-demand services to intensify in the future.

Intellectual Property

Our ability to compete is based in part on our technology, which we regard as
proprietary. We rely on a combination of patent, trademark, trade secret,
copyright and contract law to establish and protect our technology. As of June
30, 2000 we have exclusive rights to 18 issued U.S. patents, have 95 pending
U.S. patent applications and 81 international applications. We believe our
patent portfolio represents a significant intellectual property position that
covers key aspects of our technology. In particular, the portfolio covers
aspects of our system architecture, server technology, navigation and user
interface technology, interactive program guide, video encoding

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<PAGE>

techniques, and network-related technology. We cannot be sure that any patents
will issue from any of the pending applications or that if they do, that they
will have claims of sufficient breadth to protect our technology. Additionally,
we cannot be sure that our issued patents will not be invalidated or designed-
around by competitors. If our patents fail to protect our technology, it may be
easier for competitors to offer equivalent or superior products and services.

We typically enter into confidentiality agreements with our employees,
consultants and independent contractors and, where possible and applicable, with
our customers, vendors and industry partners to control access to and
distribution of the information we consider confidential. It is possible that
despite these measures, a third party may copy or otherwise obtain and use our
confidential information without our authorization. In addition, it is possible
for a third party to develop similar technology through independent means.

Effective patent, trademark, trade secret and copyright protection may be
unavailable or limited in certain foreign countries. Also, litigation may be
necessary to enforce our intellectual property rights or to determine the scope
or validity of third party proprietary rights. Such litigation could cost a
substantial amount, divert our resources and harm our business.

From time to time, we receive notices of claims of infringement of third
parties proprietary rights, and it is possible that we could also receive claims
for indemnification resulting from infringement claims. Regardless of the
validity or successful assertion of such claims, we may incur significant costs
and a diversion of resources with respect to the defense of any claims brought,
which could have a material adverse effect on our business.

Government Regulation

In the United States, the Federal Communications Commission, or FCC, has broad
jurisdiction over network operators. The FCC does not regulate us, but
requirements imposed on network operators could force us to undertake
development that would consume significant resources and require changes to our
products and services. If we do not change our products so that they comply with
FCC rules, or if our products are not integrated with ones that comply with FCC
requirements, our products and services will not be broadly deployed, and our
business will suffer.

In addition, video-on-demand services in Canada and in the United Kingdom and
other European Union member countries are licensed in a variety of ways. We are
seeking to determine how best to offer our video-on-demand products and services
in these countries. We may not be able to obtain distribution rights to movie
titles in non-U.S. jurisdictions under regulatory and financial arrangements
acceptable to us.

Employees

As of June 30, 2000, we had 285 employees. None of our employees are currently
represented by a labor union. We believe that we have a good relationship with
our employees.

Item 2. Properties

Our principal facilities are located in Redwood City, California, where we
currently lease approximately 82,000 square feet. The term of this lease runs
through June 1, 2007 with two five-year renewal options. We lease 22,600 square
feet of office space in Princeton, New Jersey. The term of this lease runs
through November 1, 2001, with two five-year renewal options. We also maintain
small offices in King of Prussia, Pennsylvania and London, England. We believe
that suitable additional or alternative space adequate to serve our foreseeable
needs would be available on commercially reasonable terms, if necessary.

Item 3. Legal Proceedings

We are not a part to any material litigation at the present time.

Item 4. Submission of Matters to a Vote of Security Holders

On May 8, 2000, our stockholders approved by written consent an amendment to
our Certificate of Incorporation in order to increase our authorized shares of
common stock for issuance to 165,000,000 shares, and to increase our authorized
shares of preferred stock for issuance to 80,000,000. The amendment was approved
by a majority of the stockholders of our common stock voting as a class, a
majority of the stockholders of our Series A preferred stock, Series B preferred
stock, Series C preferred stock and Series D preferred stock voting as a single
class, and a majority of the stockholders of our common stock and preferred
stock voting as a class.

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<PAGE>

PART II

Item 5. Market for the Registrant's Common Stock and Related Stockholder
Matters

There is no established public trading market for our common Stock. As
of June 30, 2000 there were approximately 328 holders of our common stock
and approximately 200 holders of record of our preferred stock.

We have not paid any dividends since our inception and do not intend to pay
any dividends on our capital stock in the foreseeable future. We anticipate that
we will retain all future earnings, if any, for use in our operations and
expansion of the business. In addition, the terms of the indenture agreement
related to our 12-5/8% Senior Discount Notes due 2008 restrict our ability to
pay dividends on, or make distributions in respect to our capital stock.

During the fiscal year ended June 30, 2000, we issued and sold an aggregate of
1,171,215 shares of Common Stock to employees and consultants for an aggregate
purchase price of $1,485,000 and $79,000 pursuant to exercises of options under
our fiscal 1995 Stock Plan and our 1998 Stock Plan, respectively. These
issuances were deemed exempt from registration under the Securities Act of 1933,
as amended, in reliance upon Rule 701 promulgated thereunder. In addition,
during the year ended June 30, 2000 we issued and sold 777,778 shares of Series
E Preferred Stock, 1,666,668 shares of Series F Preferred Stock, and 555,556, of
Series G Preferred Stock for an aggregate purchase price of $27,000,000 to a
number of strategic investors. These issuances were deemed exempt from
registration under the Securities Act in reliance upon Section 4(2) thereof.

Item 6. Selected Financial Data:

<TABLE>
<CAPTION>
Year Ended June 30,
--------------------------------------------------
1998 1999 2000
-------- -------- --------
(in thousands, except per share data)
<S> <C> <C> <C>
Consolidated Statement of Operations Data:
Total revenue............................................. $ 82 $ 293 $ 1,957
-------- -------- --------
Operating Expenses:
Cost of product revenue.................................. -- -- 4,224
Programming.............................................. 5,370 8,159 4,300
Operations............................................... 4,542 8,162 6,684
Engineering and development.............................. 18,070 24,321 27,080
Sales and marketing...................................... 4,384 5,707 8,159
General and administrative............................... 8,552 15,843 21,380
Depreciation and amortization............................ 5,306 19,305 6,826
Warrant expense.......................................... -- -- 2,075
Amortization of stock compensation....................... -- 738 2,583
Acquired in-process research and development (1)......... 24,321 -- --
-------- -------- --------
Total operating expenses.................................. 70,545 82,235 83,311
-------- -------- --------
Operating loss............................................ 70,463 81,942 81,354
-------- -------- --------
Other (income) expense, net:
Equity in (income) loss of investee....................... 1,631 -- --
Interest income........................................... (5,632) (8,645) (6,057)
Interest expense.......................................... 13,730 33,967 39,016
-------- -------- --------
Total other (income) expense, net......................... 9,729 25,322 32,959
-------- -------- --------
Net loss before extraordinary item........................ 80,192 107,264 114,313
Extraordinary loss--early extinguishment of debt (2)...... 10,676 -- --
-------- -------- --------
Net loss.................................................. $ 90,868 $107,264 $114,313
Accretion of redeemable warrants and issuance of 763 969 16,888
redeemable put warrants.................................. -------- -------- --------
Net loss attributable to common stockholders.............. $ 91,631 $108,233 $131,201
======== ======== ========
Basic and diluted net loss per share:
Loss before extraordinary item............................ $ 4.92 $ 6.31 $ 7.29
Extraordinary loss--early extinguishment of debt (2)...... 0.65 -- --
-------- -------- --------
Net loss per share........................................ $ 5.57 $ 6.31 $ 7.29
======== ======== ========

Shares used in per share computation...................... 16,447 17,147 17,987
======== ======== ========
</TABLE>

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<PAGE>

<TABLE>
<CAPTION>
Year Ended June 30,
----------------------------------
1998 1999 2000
----------- ---------- ----------
(in thousands)
<S> <C> <C> <C>
Consolidated Balance Sheet Data:
Cash, cash equivalents, and short-term investments................................... $ 197,564 $ 130,737 $ 92,682
Property and equipment, net.......................................................... 19,349 9,792 12,648
Total assets......................................................................... 228,205 154,264 119,487
Notes payable........................................................................ 243,031 275,564 312,815
Redeemable warrants.................................................................. 1,139 2,108 7,007
Total stockholders' deficit.......................................................... (20,312) (127,413) (225,386)
</TABLE>

____________________

(1) In connection with the acquisition of Sarnoff Real Time Corporation in
April 1998, we wrote off acquired in-process research and development of
$24.3 million, as a one-time charge to operations for the fiscal year ended
June 30, 1998.

(2) In February 1998, we received $250.0 million in gross proceeds from an
offering of 463,000 units consisting of warrants to purchase common stock
and senior discount notes with an aggregate principal amount at maturity of
$463.0 million. In connection with this unit offering, we retired all of
our subordinated discount notes issued in a previous offering resulting in
an extraordinary loss of approximately $10.7 million, ($0.65 per share),
for the fiscal year ended June 30, 1998.

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<PAGE>

Item 7. Management's Discussion and Analysis of Financial Condition and Results
of Operations

The following discussion of our financial condition and results of operations
should be read in conjunction with the Consolidated Financial Statements and the
related notes included elsewhere in this Form 10-K. This discussion contains
forward-looking statements that involve risks and uncertainties. Our actual
results may differ materially from the results discussed in the forward-looking
statements. Factors that might cause such a difference include, but are not
limited to, those discussed below. The forward-looking statements contained
herein are made as of the date hereof, and we assume no obligation to update
such forward-look statements or to update the reason actual results could differ
materially from those anticipated in such forward-looking statements. Forward-
looking statements are statements identified with an asterisk (*). All forward-
looking statements attributable to us or persons acting on our behalf are
expressly qualified in their entirety by the cautionary statements set forth
below and in "Factors Affecting Operating Results."

Overview

We are a leading provider of interactive, on-demand television products and
services. We have commercially deployed our video-on-demand service with several
cable operators in North America. We have also recently introduced an
interactive program guide as a stand-alone product. Both our video-on-demand
service and interactive program guide operate on industry-standard digital set-
top boxes and operating systems and provide flexible and cost-effective
interactive television solutions for cable and other broadband operators, which
we refer to as network operators. DIVA was founded in June 1995. Since our
inception, we have devoted substantially all of our resources to developing our
video-on-demand products and services, establishing industry relationships,
carrying out initial marketing activities, negotiating deployment agreements and
establishing the operations necessary to support the commercial deployment of
our video-on-demand products and services.

Prior to June 1999, we offered our video-on-demand service only as an end-to-
end system solution for network operators. Under this approach, we own, install
and fund all hardware and software components of our system. We manage and
deliver the end-to-end video-on-demand service offering to cable subscribers. We
generate revenues from deployment agreements with network operators based on a
share of the revenues generated by the network operators from video-on-demand
revenues and other monthly subscriber fees.

Beginning in June 1999, we shifted our sales and marketing strategy to
emphasize selling our video-on-demand hardware products, licensing our system
software, and providing a suite of content acquisition and operational support
services on an a`la carte basis to network operators. Under this approach, the
network operator purchases the video-on-demand system hardware and takes the
capital and operating expense risk associated with such ownership. The network
operator licenses our system software and can then select the other video-on-
demand support services it wants to utilize. The network operator can select
either the entire package of content and operational support services and pay us
a portion of the revenues they receive from video-on-demand services, or select
some or all of these services on a fee-for-service basis. We expect that the
substantial majority of our future revenues will be derived from this new
strategy.*

Through June 30, 2000, we have generated minimal revenues and have incurred
significant losses and substantial negative cash flow, primarily due to
engineering and development expenditures and other costs required to develop our
video-on-demand products and services. Since inception through June 30, 2000, we
have an accumulated deficit of $357.7 million and have not achieved
profitability on a quarterly or annual basis. We expect to continue to incur
substantial net losses and negative cash flow for at least the next few years.
Our historical revenues and expenditures are not necessarily indicative of, and
should not be relied upon as an indicator of, revenues that may be attained or
expenditures that may be incurred by us in future periods.*

Revenue

Revenue is comprised of three components: product revenue resulting from the
sale of our video-on-demand hardware products; licensing revenue resulting from
the licensing of our systems software and on-screen video-on-demand navigator
applications; and service revenue resulting from programming service, and
operations support services. Through June 30, 2000, we have not recognized any
revenue from our interactive program guide.

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<PAGE>

Our contracts are generally multiple-element arrangements with a network
operator involving a combination of video-on-demand hardware products, licenses
for system software and selected content and operational services. As a result
we recognize revenue in accordance with the American Institute of Certified
Public Accountants Statement of Position 97-2, ``Software Revenue Recognition,''
and Statement of Position 98-9, ``Software Revenue Recognition, with Respect To
Certain Arrangements.'' Statement of Position 97-2 generally requires revenue
earned on software arrangements involving multiple elements to be allocated to
each element based on the relative fair values of the elements. The fair value
of an element must be based on vendor specific objective evidence of the
relative fair values of the elements. Vendor specific objective evidence is
determined by the price charged when the element is sold separately. Statement
of Position 98-9 requires recognition of revenue using the residual method in a
multiple element arrangement when fair value does not exist for one or more of
the delivered elements in the arrangement. Under the residual method, the total
fair value of the undelivered elements is deferred and subsequently recognized
in accordance with Statement of Position 97-2. Evidence of the relative fair
value of the individual elements in our current agreements does not exist.

As a result, upon the delivery of our video-on-demand hardware products,
revenue is recognized to the extent of the cost of these hardware products. Any
remaining product revenue is amortized on a straight-line basis over the
remaining term of the agreement. We recognize license revenues ratably over the
term of the agreement. If our services are provided on a fee-for-service basis,
service revenues are recognized as the services are performed. If the services
are provided on a revenue sharing basis, service revenues are recognized based
on program purchases by subscribers.

Operating Expenses

Cost of Product Revenue. Cost of product revenue consists of contract
manufacturing costs, component and material costs, and other direct product
expenditures associated specifically with our video-on-demand hardware products.

Programming. Programming expense includes license fees payable to content
providers, costs related to the acquisition and production of digitally encoded
programming content (including movies, videos, previews and promotions) and
content duplication and distribution expenses. Historically, programming expense
has represented a significant portion of our operating expenses, since we
provided all programming content as an integral component of our end-to-end
video-on-demand service. In the future, we expect that programming expense will
decrease as a percentage of total operating expenses because we anticipate that
some larger network operators will take responsibility for acquiring their own
content.* We expect to continue to incur programming expense for network
operators that elect to have us provide programming content or contract for an
end-to-end video-on-demand service from us.*

Operations. Operations expense includes the cost of field operations, both for
initial launches and for ongoing support of our installed video-on-demand base.
These costs include personnel and other costs for technical support, customer
service training, installation, launch support, and maintenance costs for our
video-on-demand system. In addition, operations expense includes personnel and
other costs which support our ongoing manufacturing relationships for our video-
on-demand hardware products with third-party manufacturers. We expect operations
expense to increase in the future due to an increase in the manufacture and sale
of our video-on-demand hardware.* To the extent network operators elect to
contract with us for operations support, operations expense would increase in
the area of field support and maintenance.

Engineering and Development. Engineering and development expense consists of
salaries, consulting fees, prototype hardware and other costs to support product
development. Our engineering and development efforts involve ongoing system
software development, system integration and new technology. To date, the most
substantial portion of our operating expenses have been engineering and
development expense. We expect to continue to incur significant engineering and
development expenditures for continued development and enhancements to our
video-on-demand products and services.* We believe these expenditures are
necessary to remain competitive, to assure our products and services are
integrated with industry standards and to offer new services, such as our
recently introduced interactive program guide, and enhancements to our
customers.*

Sales and Marketing. To date, our sales and marketing expense has consisted of
the costs of marketing our video-on-demand products and services to network
operators and their customers and has included business development and
marketing personnel, travel expenses, trade shows, consulting fees and
promotional costs. Historically, our sales and marketing expense has also
included telemarketing, direct mailings, targeted advertising

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<PAGE>

and promotional campaigns and other direct marketing costs related to acquiring
subscribers under our end-to-end video-on-demand service. In the future, we
expect that direct marketing costs will not represent a significant component of
total sales and marketing expense, as most network operators will take
responsibility for marketing video-on-demand services to their subscribers.* To
the extent we provide these services, they will likely be performed under
individual service agreements with the network operators and, accordingly, will
fluctuate with revenues. Our future sales and marketing costs will consist
primarily of market development and product management expenses.

General and Administrative. General and administrative expense consists
primarily of salaries and related expenses of management and administrative
personnel, professional fees and general corporate and administrative expense.
In addition, general and administrative expense includes costs associated with
the development, support and growth of our management information system
infrastructure. We expect general and administrative expense to increase over
time to support the expansion of our business activities.*

Warrant Expense. Warrant expense represents the cost of the warrants issued to
customers and a strategic business partner based on their estimated fair value,
as determined using the Black-Scholes model, at the earlier of the grant date or
the date it becomes probable that the warrants will be earned.

Amortization of Deferred Stock Compensation. Deferred stock compensation
represents the difference between the estimated fair value of our common stock
for accounting purposes and the option exercise price of such options at the
grant date.

Depreciation and Amortization. Depreciation and amortization expense includes
depreciation of property and equipment, including our video-on-demand hardware.
Generally, depreciation is calculated using the straight-line method over the
estimated useful lives of the assets, which range from three to five years.
Historically, depreciation expense has been a significant component of our
operating expenses. This resulted from the significant investment in capital
equipment necessary to deploy our end-to-end video-on-demand service. We expect
depreciation expense to decrease as a component of operating expense in the
future as network operators purchase the various video-on-demand hardware
components directly from us.*

Other Income and Expense. Other income and expense primarily consists of
interest income and interest expense. Interest income consists of earnings on
cash, cash equivalents and short-term investments. Interest expense consists
primarily of accreted interest on our outstanding debt.

Results of Operations

Comparison of Years Ended June 30, 2000, 1999, and 1998

Revenue

Total revenue was $2.0 million for the fiscal year ended June 30, 2000,
$293,000 for the fiscal year ended June 30, 1999 and $82,000 for the fiscal year
ended June 30, 1998.

Product Revenue. Product revenue was $1.4 million for fiscal 2000. Since we
did not begin selling our video-on-demand hardware products until fiscal 2000,
we did not record product revenue for fiscal 1999 and 1998. In addition, during
fiscal 2000 we received $1.0 million for the future delivery of certain video-
on-demand hardware, which was recorded as deferred revenue. This revenue will
be recognized when this hardware is delivered and installed.

License Revenue. License revenue was $46,000 for fiscal 2000. Since we did
not begin licensing our video-on-demand system software until fiscal 2000, we
did not record license revenues for fiscal 1999 and 1998.

Service Revenue. Service revenue was $531,000 for fiscal 2000, $293,000 for
fiscal 1999 and $82,000 for fiscal 1998. The increases between fiscal 1998,
1999 and 2000 were primarily due to increases in the number of video-on-demand
subscribers.

Operating Expenses

Cost of Product Revenue. Cost of product revenue was $4.2 million for fiscal
2000. Included in our cost of product revenue for fiscal 2000 was an inventory
write-down of $2.6 million related to our first generation video-on-demand
hardware. We did not record cost of product revenue for fiscal 1999 and fiscal
1998.

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<PAGE>

Programming. Programming expense was $4.3 million for fiscal 2000, $8.2
million for fiscal 1999 and $5.4 million for fiscal 1998. The decrease in
programming expense from fiscal 1999 to fiscal 2000 was primarily attributable
to reduced labor and personnel costs and other related program production
service costs. In addition, we have reduced the number of trailers, previews,
promotions, and other encoding related costs, resulting in a reduction of
overall expenditures in this area. The increase in programming expense from
fiscal 1998 to fiscal 1999 was primarily attributable to a significant increase
in the volume of encoded programming in our content library and our multiple
commercial deployments, including the coding of content in both the MPEG - 1 and
MPEG - 2 format, and an increased level of trailers, previews, promotions
produced in-house. In addition, we experienced increased personnel costs in the
area of program acquisition and program production services.

Operations. Operations expense was $6.7 million for fiscal 2000, $8.2 million
for fiscal 1999 and $4.5 million for fiscal 1998. The decrease in operations
expense from fiscal 1999 to fiscal 2000 was primarily the result of our decision
to discontinue the manufacture of our own proprietary set-top box in the third
quarter of fiscal 1999. As a result of that decision, our manufacturing
operations expenses were lower in fiscal 2000. The increase in operations
expense from fiscal 1998 to fiscal 1999 was primarily attributable to increased
personnel costs in both the operations and manufacturing areas as we
commercially introduced our video-on-demand products and services in multiple
network operators' plants. In addition, we increased our manufacturing
activities related to our VOD server and our prototype set-top boxes.
Operations expense, net of the manufacturing expenses related to our
discontinued set-top box activities, has increased over the fiscal years
presented primarily as a result of increased personnel costs in both field
operations and server based manufacturing operations.

Engineering and Development. Engineering and development expense was $27.1
million for fiscal 2000, $24.3 million for fiscal 1999 and $18.1 million for
fiscal 1998. The increases in engineering and development expense between
fiscal 1998, 1999 and 2000 were primarily attributable to the hiring of
additional engineering and development personnel, outside consultants and other
engineering expenses in connection with the further development and enhancement
of our video-on-demand technology. In addition, the increases included
expenditures for the development of new products and services such as our
interactive program guide and integration activities related to digital
broadcast platforms and middleware applications required for deployment by
network operators.

Sales and Marketing. Sales and marketing expense was $8.2 million for fiscal
2000, $5.7 million for fiscal 1999 and $4.4 million for fiscal 1998. The
primary items contributing to the increases in marketing expense between fiscal
1998, 1999 and 2000 were promotional expenditures in connection with our recent
commercial deployments, continued business development activities and product
management costs.

General and Administrative. General and administrative expense was $21.4
million for fiscal 2000, $15.8 million for fiscal 1999 and $8.6 million for
fiscal 1998. Overall, the increases in general and administrative expense
between fiscal 1998, 1999 and 2000 were a direct result of the growth in all
phases of our operations. In addition to the increase in personnel related
expenses, the increase between fiscal 1999 and fiscal 2000 in general and
administrative expense was the result of increased rent expense due to the
relocation of our corporate headquarters to a new facility in September, 1999
and international business development expenses, including the operations of an
office in the United Kingdom.

Depreciation and Amortization. Depreciation and amortization expense was $6.8
million for fiscal 2000, $19.3 million for fiscal 1999 and $5.3 million for
fiscal 1998. The decrease in depreciation and amortization expense between
fiscal 1999 and fiscal 2000 is primarily the result of approximately $9.1
million in write-downs recorded in the fourth quarter of fiscal 1999 related to
older, prototype video-on-demand hardware. In addition, approximately $2.7
million of previously capitalized equipment was transferred to inventory in the
fourth quarter of fiscal 1999. Each of these items also resulted in an increase
in depreciation and amortization expense between fiscal 1998 and fiscal 1999.

Warrant Expense. For fiscal 2000, we recorded $2.1 million of expenses
related to the costs associated with warrants issued to customers and a
strategic business partner. Charges for fiscal 2000 and future periods depends,
in part, on the other parties' achievement of specified performance milestones.
There were no similar warrant charges in fiscal 1999 and fiscal 1998.

Amortization of Deferred Stock Compensation. We recorded deferred
compensation expense of $2.6 million in fiscal 2000 and $738,000 in fiscal 1999.
The increase in compensation expense between fiscal 1999 and fiscal 2000 was
related to increased stock options granted to employees and consultants and
increase in the estimate of the

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fair value of our common stock for accounting purposes over the option exercise
price at the date of the grant. We expect to continue to grant options to
employees, which may result in an increase in deferred stock-based compensation
that will be amortized over the applicable vesting periods of the options. We
did not record deferred stock compensation expense in fiscal 1998.

Other Income and Expenses. Interest income was $6.1 million in fiscal 2000,
$8.6 million for fiscal 1999 and $5.6 million for fiscal 1998. The decrease in
interest income between fiscal 1999 and fiscal 2000 is the result of a decrease
in cash and cash equivalent balances which are invested in short-term interest
bearing accounts and a decrease in short-term investments. For similar reasons
interest income increased between fiscal 1999 and fiscal 1998 as the aggregate
balances of our cash and cash equivalents invested in short-term interest
bearing accounts and short-term investments increased. Interest expense was
$39.0 million for fiscal 2000, $34.0 million for fiscal 1999 and $13.7 million
for fiscal 1998. The increase in interest expense between fiscal 1998 and
fiscal 1999 represents approximately 4 months of interest charges.

Provision for Income Taxes

We have not provided for or paid federal income taxes due to our net losses.
As of June 30, 2000, we had net operating loss carryforwards of approximately
$214.3 million to offset future income subject to federal income taxes and
$112.3 million available to offset future California taxable income. As of June
30, 2000, we had $21.8 million in net operating losses to offset future New
Jersey taxable income and we had $11.0 million in net operating losses to offset
future Pennsylvania taxable income. The extent to which such loss carryforwards
can be used to offset future taxable income may be limited because of ownership
changes pursuant to Section 382 of the Internal Revenue Code of 1986, as
amended.

Liquidity and Capital Resources

From our inception through June 30, 2000, we have financed our operations
primarily through the gross proceeds of private placements totaling
approximately $103.3 million of equity and $250.0 million of high yield debt
securities, net of repayments. As of June 30, 2000, we had cash and cash
equivalents and short-term investments totaling $92.7 million.

Net cash used in our operating activities was $58.2 million for fiscal 2000,
$53.6 million for fiscal 1999 and $37.2 million for fiscal 1998. The net cash
used in operations during these periods was primarily due to net losses, offset
by the write-off of acquired in-process research and development in connection
with the acquisition of SRTC, depreciation and amortization expense,
amortization of debt issuance costs and the discount accretion on notes payable
and amortization of deferred stock compensation and warrants expense. In
addition, for fiscal 1998 net cash used in operations was off-set by a one time
charge for in-process research and development expense in connection with the
acquisition of SRTC, and as extraordinary loss in connection with the early
extinguishment of outstanding debt.

Net cash used for acquisitions of property and equipment was $8.0 million for
fiscal 2000, $13.5 million for fiscal 1999, and $15.0 million for fiscal 1998
and consisted primarily of video-on-demand hardware and general capital
equipment associated with our growth.

Net cash provided by financing activities for fiscal 2000 was $28.1 million
consisting primarily of $27.0 million raised by issuing preferred stock to
General Instrument (subsequently acquired by Motorola), OpenTV, NTL, Liberate,
and Starz Encore. For fiscal 1999, net cash provided by financing activities was
$291,000, primarily reflecting stock option exercises. For fiscal 1998, net cash
provided by financing activities was $245.9 million, provided by the net
issuance of $46.0 million of preferred stock and $199.7 million of senior
discount notes.

On February 19, 1998, we received $250.0 million in gross proceeds from an
offering of 463,000 units consisting of senior discount notes with an aggregate
principal amount at maturity of $463.0 million and warrants to purchase an
aggregate of 2,778,000 shares of common stock. The notes are senior unsecured
indebtedness, and rank pari passu with any future unsubordinated unsecured
indebtedness. The notes will be senior to any future subordinated indebtedness,
but effectively will be subordinated to any future secured indebtedness.

The indenture governing our senior discount notes imposes operating and
financial restrictions on us and our subsidiaries. These restrictions in certain
cases significantly limit or prohibit our ability directly and through our
subsidiaries to incur additional indebtedness, create liens upon assets, apply
the proceeds from the disposal of assets, make investments, make dividend
payments and other distributions on capital stock and redeem capital stock.
These covenants may limit our ability to finance our future operations or to
engage in other business activities that may be in our best interest.

The senior discount notes were sold at a significant discount, and must be
repaid at maturity on March 1, 2008. Commencing September 1, 2003, we are
required to make semi-annual interest payments of $29.2 million, based on

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the aggregate par value of $463.0 million. There are no principal payments due
on the senior discount notes prior to maturity on March 1, 2008.

Our gross proceeds from the issuance of the senior discount notes were
approximately $250.0 million. In connection with the offering, we allocated
approximately $18.1 million of the proceeds to the warrants. The net proceeds
from the offering of the notes were approximately $199.9 million, after
deducting placement fees and other offering costs, the extinguishment of all the
subordinated discount notes issued in a previous offering and a premium paid in
connection with the early extinguishment of these notes.

We expect to require significant working capital and incur significant
operating expenses in the future.* Working capital requirements include
inventory expenditures for our video-on-demand and interactive program guide
hardware and general capital expenditures associated with our anticipated
growth. Our working capital needs will, in part, be determined by the rate at
which network operators purchase and introduce our video-on-demand products and
services. In addition to working capital, we intend to make significant
expenditures for continued development and enhancement of our video-on-demand
technology, development of new services and other expenses associated with the
delivery of our video-on-demand products and services. Our actual cash
requirements may vary from expectations and will depend on numerous factors and
conditions, many of which are outside of our control. We may also use a portion
of our cash resources to purchase some of our outstanding indebtedness in the
open market from time to time depending on market conditions.

We believe our cash, cash equivalents and short-term investments will be
sufficient to satisfy our cash requirements at least through the next twelve
months.* Thereafter, we will need to raise significant additional funds to
support our operations. However, we may need to raise additional funds earlier
if our estimates of working capital and operating expenditure requirements
change or prove to be inaccurate. We may also need to raise significant
additional funds in order to respond to unforeseen technological or marketing
hurdles or to take advantage of unanticipated opportunities. We have no present
commitments or arrangements assuring us of any future equity or debt financing,
and there can be no assurance that we will be able to obtain any such equity or
debt financing on favorable terms or at all. In the event that we are unable to
obtain such additional capital, we will be required to delay the expansion of
our business or take other actions that would harm our business and our ability
to achieve sufficient cash flow to service our indebtedness. To the extent that
we raise additional cash by issuing equity securities, our existing stockholders
will be diluted.

Acquired In-Process Research and Development Expense

In April 1998, we acquired, in a stock-for-stock acquisition, 60% of the
issued and outstanding stock of SRTC not already owned by us. We issued
3,277,539 shares of Series AA Preferred Stock and assumed all outstanding SRTC
stock options. We accounted for the merger as a purchase, and, accordingly, the
operating results of SRTC have been included in our consolidated financial
statements since April 1, 1998. As a result of the SRTC acquisition, we
allocated $535,000 to intangible assets and $24.3 million to acquired in-process
research and development expenses as a charge to our operations for fiscal 1998.

All of the potential changes noted above are based on a sensitivity analysis
performed on our balances as of June 30, 2000.

Recent Accounting Pronouncements

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the statement of financial position and measure those instruments at fair value.
In June 2000, the FASB issued Statement of Financial Accounting Standards No.
138, "Accounting for Certain Derivative Instruments and Certain Hedging
Activities, and amendment to FASB Statement No. 133". Statement No. 138
addresses a limited number of issues causing implementation difficulties for
companies that are required to apply Statement No. 133. Statement 133, as
amended by SFAS No. 137, "Accounting for Derivative Instruments and Hedging
Activities--Deferral of the effective date of FASB Statement No. 133", and
Statement No. 138 are effective for all fiscal quarters of all fiscal years
beginning after June 15, 2000. We have not determined the impact that SFAS 133
and SFAS 138 will have on our financial statements and believe that such
determination will not be meaningful until closer to the date of initial
adoption.

In December 1999, the Securities and Exchange Commission issued SAB No. 101,
"Revenue Recognition in Financial Statements," which will be effective for us in
the first quarter of fiscal 2001. We believe that our current revenue
recognition principles comply with this bulletin.

In March 2000, the Financial Accounting Standards Board (FASB) issued
Interpretation No. 44 (Fin 44) "Accounting for Certain Transactions involving
Stock Compensation--an Interpretation of Accounting Principles Board (APB)
Opinion No. 25". FIN 44 clarifies the application of APB Opinion No. 25 and is
effective July 1, 2000. We believe that FIN 44 will not have a material effect
on our financial position or results of operations.

Factors Affecting Operating Results

We are an early stage company with limited revenues and a history of losses, we
expect to continue to incur substantial losses and negative cash flow and we may
never achieve or sustain profitability

We are an early stage company with limited commercial operating history. We
have generated revenues of $2.3 million and have incurred net losses of
approximately $357.7 million since our inception through June 30, 2000. We
expect to continue to incur substantial losses and experience substantial
negative cash flow for at least the next few years as we continue to develop our
video-on-demand service capability and sell and license our products and
services. We do not expect to generate substantial revenues unless and until our
video-on-demand products and services are deployed at a significant number of
additional cable systems and a significant number of viewers access our service.
If we do not achieve and sustain profitability in the future, then we may be
unable to continue our operations.

Our prospects should be considered in light of the risks, expenses and
difficulties frequently encountered by companies in their early stage of
development, particularly companies in new and rapidly evolving markets. Our
future success depends on a number of factors, including the following:

. our ability to enter into agreements for broad distribution of our
video-on-demand and interactive program guide products and services to
network operators;

. the extent to which cable operators upgrade their cable plant to enable
two-way operation and deploy digital set-top boxes;

. the extent to which viewers use our products and services for interactive,
on-demand television;

. our ability to continue integrating our software and hardware with other
digital applications and services selected by network operators in the
United States and internationally, including set-top boxes, application
managers and set-top box operating systems, cable system components and
electronic program guides;

. the extent to which third-party cable suppliers adapt their equipment to
integrate with our equipment and reduce the cost and physical space
requirements for their equipment;

. our ability to continue further technical development of our video server,
our access equipment, our service software and our other video-on-demand
system components in order to reduce their manufacturing cost and enhance
their functionality; and

. our ability to operate existing contracted video-on-demand deployments with
acceptable system performance and viewer acceptance.

Because we have a limited operating history, we have limited historical
financial data on which to base planned operating expenses, and investors may
find it difficult to evaluate our business and future prospects

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Our limited operating history makes it very difficult to evaluate our business
and future prospects. As a result of our limited operating history, it is
difficult for us to accurately forecast our revenues, and we have limited
meaningful historical financial data on which to base planned operating
expenses. We are unable to accurately forecast our revenues because:

. we participate in an emerging market;

. our current deployment agreements with network operators are for a single
system or a limited number of systems, and we are unable to predict whether
they will be expanded to cover additional systems;

. we cannot predict the rate at which cable subscribers will sign up for our
service;

. we expect to sign new sales, service and licensing agreements on an
irregular basis, if at all, and there may be long periods of time during
which we do not enter into new agreements or expanded arrangements; and

. we have a lengthy sales cycle, which makes it difficult to forecast the
quarter during which a sale will occur.

We have recently expanded our sales and marketing strategy, from one under
which we owned all hardware and software components of our video-on-demand
system and delivered the video-on-demand service offering to cable subscribers,
to include the option under which the network operator purchases, owns and
maintains all or part of the video-on-demand system hardware and takes the
capital and operating expense risk associated with such ownership. It is
difficult to predict the timing and amount of revenue that will be generated
following this change in strategy.

We expect our financial results to fluctuate significantly because we depend on
a small number of relatively large orders and other factors

Our quarterly operating results will fluctuate significantly in the future as
a result of a variety of factors, either alone or in combination. In the short
term, we expect our quarterly revenues to be significantly dependent on a small
number of relatively large orders for our products and services. As a result,
our quarterly operating results may fluctuate significantly if we are unable to
complete one or more substantial sales in any given quarter. Factors that will
affect our quarterly results, many of which are outside our control, include:

. the timing of deployments by network operators of our video-on-demand and
interactive program guide products and services;

. the terms of our contractual arrangements with network operators, who may
either contract to have us manage and operate an end-to-end solution or
purchase software and hardware components separately to create their own
video-on-demand systems;

. the mix of services revenues, which depends on the extent to which network
operators purchase services from us on a fee-for-service basis or a revenue
sharing basis;

. competitive pressure, which may cause us to change our pricing structures;
and

. demand for and viewer acceptance of our video-on-demand service.

A significant portion of our operating expenses are relatively fixed and
necessary to develop our business. These expenses are largely independent of the
revenue generated in any given quarter from sales of products and services to
network operators. To the extent that increased expenses are not subsequently
followed by increased revenues, our operating results will suffer. If revenue
falls below expectations in any quarter, the adverse impact of the revenue
shortfall on operating results in that quarter may be increased by our inability
to adjust fixed spending to compensate for the shortfall.

Due to these and other factors, we believe that period-to-period comparisons
of our operating results may not be meaningful or indicative of future
performance. You should not rely on our results for any one quarter as an
indication of our future performance. It is likely that in some future quarters
or years our operating results will fall below the expectations of securities
analysts or investors.

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If we do not achieve broad deployment of our video-on-demand and interactive
program guide products and services, our business will not grow

Our future success depends in large part on our ability to sell our products
and services and deploy our video-on-demand system in a broad base of cable
systems, on terms that will generate a profit. We believe that network operators
will initially be unwilling to commit to broad deployments of our video-on-
demand services and products until they have completed trials of our services as
well as those of competitors.* Our ability to achieve broad network operator
deployments will depend on our success in demonstrating that:

. our products and services are reliable and scalable and integrate with
products and services provided by other cable industry suppliers chosen by
the network operator;

. video-on-demand is a compelling consumer product and viewers will purchase
video-on-demand content at prices and in quantities that will justify the
network operator's investment in our video-on-demand products and services
rather than alternative entertainment services such as pay-per-view and
near-video-on-demand;

. our video-on-demand and interactive program guide products are compatible
with industry standards as they evolve; and

. our technology enables the network operator to add new revenue generating
services.

If we are unable to persuade network operators to purchase our products or
services and deploy video-on-demand broadly in their cable systems, the growth
of our business will suffer.

If the limited deployments of our video-on-demand service with network operators
are not expanded, our results of operations and our reputation will suffer

We have deployed our video-on-demand service in a single cable system owned by
Charter, a multiple-headend cable system owned by MediaOne, and three cable
systems owned by Insight. In May 2000, we entered into an agreement with Charter
to deploy our video-on-demand service in a number of additional cable systems.
The existing deployments with Charter, Insight, and MediaOne currently serve a
limited number of approximately 25,000 customers. These network operators may
not continue these deployments beyond the terms of our existing agreements, and
they may choose not to broadly deploy our video-on-demand service in existing or
additional cable systems. In the past, we had limited scope video-on-demand
trials with other network operators that did not result in broad deployments. If
we are unable to add a substantial number of cable systems to the existing
contracts with the network operators currently deploying our products and
services, our results of operations will suffer. In addition, our reputation and
our ability to enter into agreements with other network operators could be
impaired.

Our products and services will not achieve widespread adoption unless network
operators upgrade their cable plant, deploy digital set-top boxes, roll out our
service and market our services to subscribers, all of which are beyond our
control

Our video-on-demand service and interactive program guide require deployment
on cable systems upgraded to hybrid fiber/coaxial architecture with the return
path from the customer to the headend activated to enable two-way operation.
According to the Cablevision Blue Book, approximately 45% of the total U.S.
homes passed by cable had been upgraded to hybrid fiber/coaxial architecture
with return path capability at the end of 1998, but only a limited portion of
the upgraded plant is currently activated for two-way transmission. The failure
of network operators to complete planned upgrades in a timely and satisfactory
manner, and the lack of suitable cable plant, would harm our business.

Our ability to achieve widespread adoption of our video-on-demand and
interactive program guide products and services also depends on a number of
other factors, many of which are beyond our control, including:

. the rate at which network operators upgrade their cable infrastructures and
deploy digital set-top boxes;

. the ability of network operators to coordinate timely and effective
marketing campaigns with the availability of cable infrastructure upgrades;

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. the ability of network operators to maintain their cable infrastructure and
headends in accordance with system specifications provided by us;

. the success of network operators in marketing our video-on-demand service;

. the prices that network operators set for our video-on-demand service and
for its installation;

. the speed at which network operators can complete the installations
required to initiate service for new subscribers;

. the quality of customer and technical support provided by us and network
operators; and

. the quality of content delivered to subscribers through our video-on-demand
service.

We expect rapid technological developments to occur in our industry and,
accordingly, must continue to enhance our current products as well as develop
new technologies, or competitors could render our products and services obsolete

We expect rapid technological developments to occur in the market for
interactive home video entertainment products and services. As a result, we have
modified and expect to continue to modify our engineering and development plans.
These modifications have resulted in delays and increased costs. Furthermore, we
expect that we will be required to continue to enhance our current video-on-
demand products and services and develop and introduce increased functionality
and performance to keep pace with technological developments and consumer
preferences. In addition, we may not be successful in developing and marketing
product and service enhancements or new services that respond to technological
and market changes, and we may experience difficulties that could delay or
prevent the successful development, introduction and marketing of such new
product and service enhancements. Our failure to successfully develop these
projects could harm our business. We have encountered delays in product
development, service integration and field tests and other difficulties
affecting both software and hardware components of our system and our ability to
operate successfully over hybrid fiber/coaxial plant. In addition, many of our
competitors have substantially greater resources than we to devote to further
technological and new product development. Technological and market changes or
other significant developments by our competitors may render our video-on-demand
and interactive program guide products and services obsolete.

Our interactive program guide is a new product that has not been accepted by
network operators and competes with well-established products from competitors
having significantly greater resources

Our interactive program guide is a new product in a well-established market.
The market for electronic program guides has two major participants, TV Guide
and Gemstar, which have recently merged into one company. Our interactive
program guide competes with those companies' guides, which are already broadly
deployed by network operators. Our guide also competes with an interactive
program guide currently being deployed by Interactive Channel. We expect that
our interactive program guide will not be broadly deployed until its features
are fully developed and field tested. In addition, network operators' acceptance
of our interactive program guide will depend on the appeal of our business model
for the guide, which is unproven. As a result, network operators may not accept
our interactive program guide and may choose to use guides from more well-
established competitors. Our competitors have significantly greater resources
than we do, and TV Guide has an exclusive long-term agreement with the largest
cable operator, AT&T. Consequently, we may not be able to compete effectively or
at all in the electronic program guide market.

If we do not obtain substantial additional funds in the future, we may be unable
to continue to grow our business or repay our indebtedness

We will require substantial additional funds in order to continue the
development, sale, license and provision of our video-on-demand and interactive
program guide products and services and, commencing on September 1, 2003, to
make cash interest payments on our indebtedness. We have made and expect to
continue to make significant investments in working capital in order to fund
development activities, commercially deploy our video-on-demand service, sell
our products and services and fund operations. We expect to continue to incur
significant operating losses and expect that our operating cash flow will be
increasingly negative over at least the next few years. We believe our existing
cash, cash equivalents and short-term investments together will be sufficient to
meet our cash requirements at least through the next twelve months.* However, we
may need to raise additional funds earlier if our

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estimates of working capital or capital expenditure requirements change or prove
to be inaccurate. We may also need to raise significant additional funds in
order to respond to unforeseen technological, marketing or competitive hurdles
or to take advantage of unanticipated opportunities.

We have no present commitments or arrangements assuring us of any future
equity or debt financing, and we may not be able to obtain any equity or debt
financing on favorable terms or at all. In the event that we are unable to
obtain additional capital, we will need to delay the expansion of our business
or take other actions that could harm our business and may need to cease
operations. We may also not be able to pay interest and principal on our
indebtedness when due.

Our lengthy sales cycle may cause fluctuations in our operating results, which
could cause our stock price to decline

We believe that the purchase of our products and services involves a
significant commitment of capital and other resources by a network operator. In
many cases, the decision to purchase our products and services requires network
operators to change their established business practices and conduct their
business in new ways. As a result, we need to educate network operators on the
use and benefits of our products and services, which can require significant
time and resources without necessarily resulting in revenues. In addition,
network operators generally must consider a wide range of other issues before
committing to purchase and incorporate our technology into their offerings and
obtain approval at a number of levels of management. Our sales cycle has ranged
from six months to a number of years. Our lengthy sales cycle limits our ability
to forecast the timing and amount of specific sales, and the resulting
fluctuations in our operating results may cause our stock price to decline.

The market for our video-on-demand products and services is intensely
competitive, and our current and potential competitors have significantly
greater resources than we do. Consequently, we may not be able to compete
effectively, which would harm our operating results

Competition in both the video-on-demand market and the broader market for in-
home video entertainment is intense and subject to rapid technological change.
We expect competition in the market for video-on-demand products and services to
intensify in the future. We categorize our video-on-demand competitors as
follows:

. server manufacturers, such as Concurrent, nCUBE and SeaChange;

. software providers, such as Prasara and Scientific-Atlanta; and

. system integrators, such as Time Warner and Scientific-Atlanta.

We provide products and services that compete in all three categories.
Although none of our video-on-demand competitors offer products and services in
all of these categories, some of them may form alliances in order to develop an
integrated end-to-end video-on-demand system that may be more attractive to
network operators and their subscribers. Some of our video-on-demand competitors
have long standing business relationships with network operators and may be able
to use those relationships to gain a competitive advantage over us.

In addition to video-on-demand competitors, we compete in the market for in-
home video entertainment. We believe our competitors fall into three groups:

. companies that provide in-home video entertainment over cable networks,
including providers of pay-per-view and near-video-on-demand;

. companies that deliver in-home video entertainment over networks, such as
regular telephone lines, digital subscriber lines, or DSL, satellite or the
Internet, and some providers of video streaming technology; and

. companies that enable the viewer to store and access content on an "on-
demand" basis, including providers of personal video recorders, such as
TiVo and Replay, and companies that rent and sell videotapes.

Many of our competitors and potential competitors have longer operating
histories, greater name recognition and significantly greater financial,
technical, marketing and distribution resources than we have. As a result, they
may be able to respond to new or emerging technologies and changes in customer
requirements faster than we do. They may also be able to devote greater
resources to the development, promotion and sale of their products and

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services in a more effective manner. We may be unable to compete successfully
against current or future competitors, and competitive pressures that we face
may harm our business.

If we fail to manage our growth effectively, our ability to implement our
business strategies may be limited

In order to execute our business strategy, we must meet aggressive
engineering, integration, product delivery and installation targets. The growth
in our business has placed and is expected to continue to place significant
demands on our management, operating, development, third party manufacturing and
financial and accounting resources. Our ability to manage growth effectively
will require continued implementation of and improvements to our operating,
manufacturing, development and financial and accounting systems and will require
us to expand and continue to train and manage our employee base. These demands
likely will require the addition of new management personnel and the development
of additional expertise by existing management personnel. Our systems,
procedures or controls or financial resources may be inadequate to support our
operations, and our management may be unable to keep pace with this growth. If
we are unable to manage our growth effectively, our business ability to
successfully implement our business strategies will suffer.

If we are unable to adequately protect or enforce our intellectual property
rights, we could suffer competitively, incur costly litigation expenses or lose
valuable assets

Our future success depends, in part, on our ability to protect our
intellectual property and maintain the proprietary nature of our technology
through a combination of patents, licenses and other intellectual property
arrangements. We have been awarded patents and have filed applications and
intend to file additional applications for patents covering various aspects of
our video-on-demand and interactive program guide products and services. Any
patents issued may be challenged, invalidated or circumvented, and the rights
granted under any patents may not provide proprietary protection to us. We may
not be successful in maintaining these proprietary rights, and our competitors
may independently develop or patent technologies that are substantially
equivalent or superior to our technologies. To the extent we integrate our
products with those of third parties, we may be required to disclose or license
intellectual property to those companies, and these companies could appropriate
our technology or otherwise improperly exploit the information gained through
this integration. If we believe third parties are infringing upon our
intellectual property, we may be forced to expend significant resources
enforcing our rights or suffer competitive injury.

If third parties claim that we infringe their intellectual property, our ability
to use some technologies and products could be limited, and we may incur
significant costs to resolve these claims

From time to time, we have received notices from third parties claiming
infringement of intellectual property rights. Although we do not believe that we
infringe any third party's intellectual property rights, we could encounter
similar claims or litigation in the future.* Gemstar, a primary provider of
interactive program guides, has actively assembled and continues to acquire a
portfolio of intellectual property in the field of interactive program guides
and has aggressively sought recourse against any parties that it believes
infringes its intellectual property. Although we believe that we do not infringe
any published patents relating to our implementation of an interactive program
guide and have not been served notice of any potential infringement, this
provider may make such a claim in the future, which could result in legal
action.* Because patent applications in the United States are not publicly
disclosed until the patent has been issued, applications may have been filed
that, if issued as patents, would relate to our products. In addition, we have
not completed a comprehensive patent search relating to the technology used in
our video-on-demand and interactive program guide products and services.

Parties making claims of infringement may be able to obtain injunctive or
other equitable relief that could effectively block our ability to provide our
products and services in the United States and internationally and could result
in an award of substantial damages. In the event of a successful claim of
infringement, we and our customers may be required to obtain one or more
licenses from third parties, which may not be available at a reasonable cost or
at all. The defense of any lawsuit could result in time consuming and expensive
litigation regardless of the merits of such claims, and damages, license fees,
royalty payments and restrictions on our ability to provide our video-on-demand
or interactive program guide products or services, any of which could harm our
business.

We rely on several sole or limited source suppliers and manufacturers, and our
production will be seriously harmed if these suppliers and manufacturers are not
able to meet our demand and alternative sources are not available

-26-
<PAGE>

We subcontract manufacturing of our hardware to a single contract
manufacturer. We do not have a contract with this manufacturer and operate on a
purchase order basis. Because of the complexity of our hardware components,
manufacturing and quality control are time consuming processes. Our contract
manufacturer may be unable to meet our requirements in a timely and satisfactory
manner, and we may be unable to find or maintain a suitable relationship with
alternate qualified manufacturers. Our reliance on a third-party manufacturer
involves a number of additional risks, including the absence of guaranteed
capacity and reduced control over delivery schedules, quality assurance,
production yields and costs. In the event we are unable to obtain such
manufacturing on commercially reasonable terms, our production would be
seriously harmed.

Various subassemblies and components used in our video server and access
equipment are procured from single sources and others are procured only from a
limited number of sources. Consequently, we may be adversely affected by
worldwide shortages of components, significant price increases, reduced control
over delivery schedules, and manufacturing capability, quality and cost.
Although we believe alternative suppliers of products, services, subassemblies
and components are available, the lack of alternative sources could harm our
ability to deploy our video-on-demand and interactive program guide systems.*
Manufacturing lead times can be as long as nine months for some critical
components. Therefore, we may require significant working capital to pay for
such components well in advance of both hardware orders and revenues. Moreover,
a prolonged inability to obtain components could harm our business and could
result in damage to network operator relationships.

If we are unable to acquire programming content on reasonable terms, our ability
to derive revenues from deployments where we provide programming content will be
limited

In those network operator deployments where we provide programming content,
our success will depend, in part, on our ability to obtain access to sufficient
movies (including new releases and library titles), special interest videos and
other programming content on commercially acceptable terms. Although we have
entered into arrangements with most of the major movie studios and a number of
other content providers for our initial deployments, we may not be able to
continue to obtain the content during the segment of time available to video-
on-demand providers and others such as pay-per-view providers, to support our
video-on-demand service beyond the geographic area of our initial deployments.
Studios may require us to make prepayments prior to the time that customers pay
for viewing a title or require us to enter into long-term contracts with minimum
guarantees or payments. Further, studios may increase the license fees currently
charged to us. If we are unable to obtain timely access to content on
commercially acceptable terms, our ability to obtain revenue from deployments
where we provide content will be limited.

Competition for qualified personnel is intense in technology industries such as
ours, and we may not be able to maintain or expand our business if we are unable
to hire and retain sufficient technical, sales, marketing and managerial
personnel

Competition for qualified personnel in technology industries is intense,
particularly in Silicon Valley. We may not be able to attract and retain
qualified personnel in the future. If we are unable to hire and retain
sufficient technical, sales and marketing and managerial personnel, our business
will suffer. Our future success depends in part on the continued service of our
key engineering, sales, marketing, manufacturing, finance and executive
personnel. If we fail to retain and hire a sufficient number and type of
personnel, we will not be able to maintain and expand our business.

An important component of the compensation of our personnel is stock options,
which vest typically over a five-year period. We face a significant challenge in
retaining our employees if the value of these stock options is either not
substantial enough or so substantial that the employees leave after their
options have vested. To retain our employees, we expect to continue to grant new
options subject to vesting schedules, which could be dilutive to investors.

We intend to expand our international offering and operations, and these efforts
may not be successful in generating revenues sufficient to offset the associated
expense

Although we have yet to generate any international revenue, we plan to create
an international product offering and to increase our international sales and
operations. We expect to expend significant financial and managerial resources
to do so. If our revenues from international operations do not meet our
expectations, our operating results will be adversely affected. We face risks
inherent in conducting business internationally, including:

-27-
<PAGE>

. unexpected changes in regulatory requirements and tariffs that may be
imposed on our services;

. difficulties and costs of staffing and managing international operations;

. differing technology standards and difficulties in obtaining export and
import licenses;

. longer payment cycles, difficulties in collecting accounts receivable and
longer collection periods;

. political and economic instability;

. fluctuations in currency exchange rates;

. imposition of currency exchange controls;

. potentially adverse tax consequences; and

. reduced protection for intellectual property rights in some countries.

Any of these factors could adversely affect our international operations and,
consequently, our business and operating results. Specifically, our failure to
successfully manage our international growth could result in higher operating
costs than anticipated, or could delay or preclude our ability to generate
revenues in key international markets.

Network operators are subject to government regulations that could require us to
change our products and services

In addition, video-on-demand services in Canada and in the United Kingdom and
other European Union members are licensed in a variety of ways. We are seeking
to determine how best to offer our video-on-demand products and services in
Canada, the United Kingdom and other European Union countries. We may not be
able to obtain distribution rights to movie titles in non-U.S. jurisdictions
under regulatory and financial arrangements acceptable to us.

We will require a significant amount of cash to service our indebtedness, and
our ability to generate cash depends on many factors beyond our control

We expect to continue to generate substantial net losses and negative cash
flow for the next few years. We may be unable to achieve a level of cash flow
from operations sufficient to permit us to pay the principal and interest on our
current indebtedness and any additional indebtedness we may incur. The senior
discount notes were sold at a significant discount and must be repaid at
maturity on March 1, 2008. Commencing September 1, 2003, we are required to make
semi-annual interest payments of $29.2 million, based on the aggregate par value
of $463.0 million. Our ability to make scheduled debt service payments will
depend upon our ability to achieve significant and sustained growth in our cash
from operations and to complete necessary additional financings.

If we are unable to generate sufficient cash from operations to service our
indebtedness, we may have to forego or delay development and enhancement of our
video-on-demand system and service, restructure or refinance our indebtedness or
seek additional equity capital or debt financing. We may not be able to effect
any refinancing or new financing strategy on satisfactory terms, if at all. If
we fail to satisfy our obligations with respect to our indebtedness, this could
result in a default under the indenture governing our senior discount notes and
could cause a default under agreements governing our other indebtedness. In the
event of a default, the holders of indebtedness would have enforcement rights,
including the right to accelerate the debt and the right to commence an
involuntary bankruptcy proceeding against us. Absent successful commercial
deployments of our video-on-demand and interactive program guide services,
ongoing technical

-28-
<PAGE>

development and enhancement of our video-on-demand system and significant growth
of our cash flow, we will not be able to service our indebtedness.

Our leverage is substantial and will increase, making it more difficult to
respond to changing business conditions

We are highly leveraged. As of June 30, 2000, we had senior discount notes
payable of approximately $312.8 million. The senior discount notes were sold at
a significant discount and must be repaid at maturity on March 1, 2008 at the
aggregate par value of $463.0 million. The degree to which we are leveraged
could have important consequences to us and our investors, including, but not
limited to, the following:

. our ability to obtain additional financing in the future for working
capital, operating expenses in connection with system deployments,
development and enhancement of our video-on-demand system, capital
expenditures, acquisitions and other general corporate purposes may be
materially limited or impaired;

. our cash flow, if any, will not be available for our business because a
substantial portion of our cash flow must be dedicated to the payment of
principal and interest on our indebtedness;

. the terms of future permitted indebtedness may limit our ability to redeem
our outstanding senior discount notes in the event of a change of control;
and

. our high degree of leverage may make us more vulnerable to economic
downturns, may limit our ability to withstand competitive pressures and may
reduce our flexibility in responding to changing business and economic
conditions.

Our indebtedness contains restrictive covenants that could significantly limit
our ability to engage in business activities that may be in our best interest

The indenture governing our senior discount notes imposes operating and
financial restrictions on us and our subsidiaries. These restrictions in
specified cases significantly limit or prohibit our ability to:

. incur additional indebtedness;

. create liens upon assets;

. apply the proceeds from the disposal of assets;

. make investments;

. make dividend payments and other distributions on capital stock; and

. redeem capital stock. These covenants may limit our ability to finance our
future operations or to engage in other business activities that may be in
our best interest.

Control by Insiders

Our executive officers and named directors, together with entities affiliated
with such individuals, and Acorn Ventures, Inc. beneficially own approximately
34.7% of the Common Stock (assuming conversion of all outstanding Preferred
Stock into Common Stock). Accordingly, these stockholders have significant
influence over our affairs. This concentration of ownership could have the
effect of delaying or preventing a change in control of the Company.

Forward-Looking Statements

The statements contained in the "Factors Affecting Operating Results" section
that are not historical facts are "forward-looking statements," which can be
identified by the use of forward-looking terminology such as "estimates,"
"projects," "anticipates," "expects," "intends," "believes," or the negative
thereof or other variations thereon or comparable terminology, or by discussions
of strategy that involve risks and uncertainties. These forward-looking
statements, including statements regarding market opportunity, deployment plans,
market acceptance, business models, capital requirements, anticipated net
losses and negative cash flow, revenue

-29-
<PAGE>

growth, anticipated operating expenditures and product development plans are
only estimates or predictions and cannot be relied upon. No assurance can be
given that future results will be achieved; actual events or results may differ
materially as a result of risks facing us or actual results differing from the
assumptions underlying such statements. Such risks and assumptions include, but
are not limited to, those discussed in this "Factors Affecting Operating
Results" section, which could cause actual results to vary materially from the
future results indicated, expressed or implied in such forward-looking
statements. We disclaim any obligation to update information contained in any
forward-looking statement.

Item 7A. Quantitative and Qualitative Disclosures About Market Risk

Market Risk Disclosures

The following discussion about our market risk disclosures contains forward-
looking statements. Forward-looking statements are subject to risks and
uncertainties. Actual results could differ materially from those discussed in
the forward-looking statements. We are exposed to market risk related to
changes in interest rates, foreign currency exchange rates and derivatives.

Interest Rate Sensitivity

We maintain a short-term investment portfolio consisting mainly of income
securities with an average maturity of less than one year. These available-for-
sale securities are subject to interest rate risk and will fall in value if
market interest rates increase. We have the ability to hold our fixed income
investments until maturity and therefore, we would not expect our operating
results or cash flows to be affected to any significant degree by the effect of
a sudden change in market interest rates on its securities portfolio.

Our short-term investments have generally been available-for-sale. Gross
unrealized gains and losses were not significant as of June 30, 2000.

The following table presents the principal amounts and related weighted-
average yields for our fixed rate investment portfolio (in thousands, except
average yields) at June 30, 2000.

Carrying Average
Amount Yield
------------- ------------
U.S. government obligations $27,019 6.25%
Commercial paper 45,459 6.63%
Certificates of deposits 2,079 4.55%
Money market instruments 1,225 6.25%
Auction rate preferred stock certificates 16,900 6.65%
-------------

Total 92,682

Included in cash and cash equivalents 66,253
Included in short-term investments 26,429
-------------
Total 92,682
=============

Foreign Currency Risks

We believe that our exposure to currency exchange fluctuation risk is
insignificant because our transactions with international vendors are generally
denominated in U.S. dollars, which is considered to be the functional currency
for our company and subsidiaries.* The currency exchange impact on intercompany
transactions was immaterial in 2000.

-30-
<PAGE>

Item 8. Financial Statements and Supplementary Data

<TABLE>
<CAPTION>
Page
<S> <C>
Independent Auditors' Report.............................................. 32
Consolidated Balance Sheets............................................... 33
Consolidated Statement of Operations...................................... 34
Consolidated Statement of Stockholders' Deficit........................... 35
Consolidated Statement of Cash Flows...................................... 36
Notes to Consolidated Financial Statements................................ 37
</TABLE>

-31-
<PAGE>

Independent Auditors' Report

The Board of Directors
DIVA Systems Corporation:

We have audited the accompanying consolidated balance sheets of DIVA Systems
Corporation (the Company), and subsidiaries as of June 30, 1999 and 2000, and
the related consolidated statements of operations, stockholders' deficit, and
cash flows for each of the years in the three-year period ended June 30, 2000.
These consolidated financial statements are the responsibility of the Company's
management. Our responsibility is to express an opinion on these consolidated
financial statements based on our audits.

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

In our opinion, the consolidated financial statements referred to above present
fairly, in all material respects, the financial position of DIVA Systems
Corporation and subsidiaries as of June 30, 1999 and 2000, and the results of
their operations and their cash flows for each of the years in the three-year
period ended June 30, 2000, in conformity with accounting principles generally
accepted in the United States.

/s/ KMPG LLP

Mountain View, California
July 31, 2000

-32-
<PAGE>

DIVA SYSTEMS CORPORATION AND SUBSIDIARIES
Consolidated Balance Sheets
(in thousands, except per share data)

<TABLE>
<CAPTION>
June 30,
-----------------------------------------
Assets 1999 2000
------------------- ------------------
<S> <C> <C>
Current assets:
Cash and cash equivalents $ 89,239 $ 66,253
Short-term investments 41,498 26,429
Accounts receivable -- 264
Inventory 2,663 3,143
Prepaid expenses and other current assets 2,096 3,520
------------ -----------
Total current assets 135,496 99,609

Property and equipment, net 9,792 12,648
Debt issuance costs, net 8,114 6,500
Deposits and other assets 550 596
Intangible assets, net 312 134
------------ ------------
Total assets $ 154,264 $ 119,487
============ ============

Liabilities, Redeemable Warrants, and Stockholders' Deficit

Current liabilities:
Accounts payable $ 2,784 $ 5,121
Other current liabilities 1,221 4,441
Deferred revenue -- 1,015
Current portion of capital lease obligation -- 676
------------ ------------
Total current liabilities 4,005 11,253
------------ ------------
Notes payable 275,564 312,815
Redeemable put warrants -- 11,989
Long-term portion of lease payable -- 1,029
Deferred rent -- 780
------------ ------------
Total liabilities 279,569 337,866
------------ ------------
Redeemable warrants 2,108 7,007
------------ ------------

Commitments and contingencies

Stockholders' deficit:
Preferred stock, $0.001 par value; 80,000,000 shares authorized
in 1999 and 2000, respectively; 21,390,283, and 24,495,463
shares issued and outstanding as of June 30, 1999, and 2000,
respectively; (liquidation preference of $97,883 and
as of June 30, 1999 and 2000, respectively) 21 24
Common stock, $0.001 par value; 165,000,000 shares authorized
in 1999 and 2000, respectively; 17,463,574 and 18,615,618
shares issued and outstanding as of June 30, 1999 and
2000, respectively 17 19
Additional paid-in capital 117,170 138,211
Deferred compensation (1,248) (5,954)
Accumulated deficit (243,373) (357,686)
------------ ------------
Total stockholders' deficit (127,413) (225,386)
------------ -----------
Total liabilities, redeemable warrants, and stockholders' deficit $ 154,264 $ 119,487
============ ============
</TABLE>

See accompanying notes to consolidated financial statements.

-33-
<PAGE>

DIVA SYSTEMS CORPORATION AND SUBSIDIARIES
Consolidated Statements of Operations
(in thousands except per share data)

<TABLE>
<CAPTION>
Years ended June 30,
-----------------------------------------------------
1998 1999 2000
---------------- ---------------- ---------------
<S> <C> <C> <C>
Revenue:
Product $ -- $ -- $ 1,380
License -- -- 46
Service 82 293 531
---------------- ---------------- ---------------
Total revenue 82 293 1,957

Operating expenses:
Cost of product revenue -- -- 4,224
Programming 5,370 8,159 4,300
Operations 4,542 8,162 6,684
Engineering and development 18,070 24,321 27,080
Sales and marketing 4,384 5,707 8,159
General and administrative 8,552 15,843 21,380
Depreciation and amortization 5,306 19,305 6,826
Warrant expense -- -- 2,075
Amortization of stock compensation -- 738 2,583
Acquired-in-process research and
development 24,321 -- --
---------------- ---------------- ---------------
Total operating expenses 70,545 82,235 83,311
---------------- ---------------- ---------------
Operating loss 70,463 81,942 81,354
---------------- ---------------- ---------------

Other (income) expense, net:
Equity in loss of investee 1,631 -- --
Interest income (5,632) (8,645) (6,057)
Interest expense 13,730 33,967 39,016
---------------- ---------------- ---------------
Total other expense, net 9,729 25,322 32,959
---------------- ---------------- ---------------

Loss before extraordinary item 80,192 107,264 114,313

Extraordinary loss -- early
extinguishment of debt 10,676 -- --
---------------- ---------------- ---------------
Net loss 90,868 107,264 114,313

Accretion of redeemable warrants and
issuance of redeemable put warrants 763 969 16,888
---------------- ---------------- ---------------
Net loss attributable to
common stockholders $ 91,631 $ 108,233 $ 131,201
================ ================ ===============

Basic and diluted net loss per share:
Loss before extraordinary item $ 4.92 $ 6.31 $ 7.29
Extraordinary loss -- early
extinguishment of debt 0.65 -- --
---------------- ---------------- ---------------

Net loss per share $ 5.57 $ 6.31 $ 7.29
================ ================ ===============

Shares used in per share computation 16,447 17,147 17,987
================ ================ ===============
</TABLE>

See accompanying notes to the consolidated financial statements.

-34-
<PAGE>

DIVA SYSTEMS CORPORATION AND SUBSIDIARIES
Consolidated Statements of Stockholders' Deficit
(in thousands, except share data)

<TABLE>
<CAPTION>
Preferred stock Common stock
---------------------------- ----------------------------
Shares Amount Shares Amount
------------- ----------- ----------- -------------
<S> <C> <C> <C> <C>
Balances as of June 30, 1997 9,794,042 $ 10 16,549,874 $ 16

Accretion of redeemable warrants -- -- -- --
Sales of Series D preferred stock in August and September 1997 at
$5.72 per share, net of issuance costs of $1,379 8,279,590 8 -- --
Issuance of common stock warrants in connection with notes payable
issued in February 1998 -- -- -- --
Issuance of Series AA preferred stock at $6.50 per share and issuance
of Series AA preferred stock options in April 1998 in connection
with SRTC purchase 3,277,539 3 -- --
Exercise of Series AA preferred stock options associated with SRTC
purchase 21,116 -- -- --
Exercise of common stock options -- -- 565,050 1
Class A and B common stock assumed in connection with SRTC purchase -- -- (14,746) --
Issuance of common stock in May 1998 at $2.40 per share in connection
with research and development arrangement -- -- 100,000 --
Net loss -- -- -- --
----------- ---------- ---------- ---------
Balances as of June 30, 1998 21,372,287 21 17,200,178 17

Accretion of redeemable warrants -- -- -- --
Deferred compensation expense on stock option issuances -- -- -- --
Amortization of deferred compensation expense -- -- -- --
Exercise of common stock options -- -- 278,120 --
Issuance of common stock in June 1999 at $3.35 per share as
compensation for services -- -- 30,650 --
Repurchase of common stock -- -- (45,374) --
Exercise of Series AA preferred stock options 17,996 -- -- --
Net loss -- -- -- --
----------- ---------- ---------- ---------
Balances as of June 30, 1999 21,390,283 21 17,463,574 17

Accretion of redeemable warrants -- -- -- --
Issuance of redeemable put warrants associated with the 1996 notes -- -- -- --
Deferred compensation expense on stock option issuances -- -- -- --
Amortization of deferred compensation expense -- -- -- --
Exercise of common stock options -- -- 1,171,215 2
Sales of Series E, F and G preferred stock in December, April and May
2000 at $9.00 per share, net of issuance costs 3,000,002 3 -- --
Repurchase of common stock (57) -- (19,171) --
Exercise of Series AA preferred stock options 105,235 -- -- --
Issuance of warrants -- -- -- --
Net loss -- -- -- --
=========== ========== ========== =========
Balances as of June 30, 2000 24,495,463 $ 24 18,615,618 $ 19
=========== ========== ========== =========

<CAPTION>
Additional

paid-in Deferred Accumulated

capital compensation deficit
---------- ---------------- ------------
<S> <C> <C> <C>
Balances as of June 30, 1997 $ 28,934 $ -- $ (45,241)

Accretion of redeemable warrants (763) -- --
Sales of Series D preferred stock in August and September 1997 at
$5.72 per share, net of issuance costs of $1,379 45,972 -- --
Issuance of common stock warrants in connection with notes payable
issued in February 1998 18,057 -- --
Issuance of Series AA preferred stock at $6.50 per share and issuance
of Series AA preferred stock options in April 1998 in connection
with SRTC purchase 23,046 -- --
Exercise of Series AA preferred stock options associated with SRTC
purchase 3 -- --
Exercise of common stock options 270 -- --
Class A and B common stock assumed in connection with SRTC purchase -- -- --
Issuance of common stock in May 1998 at $2.40 per share in connection
with research and development arrangement 240 -- --
Net loss -- -- (90,868)
--------- -------- ---------
Balances as of June 30, 1998 115,759 -- (136,109)

Accretion of redeemable warrants (969) -- --
Deferred compensation expense on stock option issuances 1,986 (1,986) --
Amortization of deferred compensation expense -- 738 --
Exercise of common stock options 305 -- --
Issuance of common stock in June 1999 at $3.35 per share as
compensation for services 103 -- --
Repurchase of common stock (20) -- --
Exercise of Series AA preferred stock options 6 -- --
Net loss -- -- (107,264)
--------- -------- ---------
Balances as of June 30, 1999 117,170 (1,248) (243,373)

Accretion of redeemable warrants (4,899) -- --
Issuance of redeemable put warrants associated with the 1996 notes (11,989) -- --
Deferred compensation expense on stock option issuances 7,289 (7,289) --
Amortization of deferred compensation expense -- 2,583 --
Exercise of common stock options 1,562 -- --
Sales of Series E, F and G preferred stock in December, April and May
2000 at $9.00 per share, net of issuance costs 26,997 -- --
Repurchase of common stock (12) -- --
Exercise of Series AA preferred stock options 18 -- --
Issuance of warrants 2,075 -- --
Net loss -- -- (114,313)
=========== ======== =========
Balances as of June 30, 2000 $ 138,211 $ (5,954) $(357,686)
=========== ======== =========

<CAPTION>
Total

stockholders'

deficit
----------------
<S> <C>
Balances as of June 30, 1997 $ (16,281)

Accretion of redeemable warrants (763)
Sales of Series D preferred stock in August and September 1997 at
$5.72 per share, net of issuance costs of $1,379 45,980
Issuance of common stock warrants in connection with notes payable
issued in February 1998 18,057
Issuance of Series AA preferred stock at $6.50 per share and issuance
of Series AA preferred stock options in April 1998 in connection
with SRTC purchase 23,049
Exercise of Series AA preferred stock options associated with SRTC
purchase 3
Exercise of common stock options 271
Class A and B common stock assumed in connection with SRTC purchase --
Issuance of common stock in May 1998 at $2.40 per share in connection
with research and development arrangement 240
Net loss (90,868)

-----------
Balances as of June 30, 1998 (20,312)

Accretion of redeemable warrants (969)
Deferred compensation expense on stock option issuances --
Amortization of deferred compensation expense 738
Exercise of common stock options 305
Issuance of common stock in June 1999 at $3.35 per share as
compensation for services 103
Repurchase of common stock (20)
Exercise of Series AA preferred stock options 6
Net loss (107,264)

-----------
Balances as of June 30, 1999 (127,413)

Accretion of redeemable warrants (4,899)
Issuance of put warrants associated with the 1996 notes (11,989)
Deferred compensation expense on stock option issuances --
Amortization of deferred compensation expense 2,583
Exercise of common stock options 1,564
Sales of Series E, F and G preferred stock in December, April and May
2000 at $9.00 per share, net of issuance costs 27,000
Repurchase of common stock (12)
Exercise of Series AA preferred stock options 18
Issuance of warrants 2,075
Net loss (114,313)

-----------
Balances as of June 30, 2000 $ (225,386)
===========
</TABLE>

See accompanying notes to consolidated financial statements.

-35-
<PAGE>

DIVA SYSTEMS CORPORATION AND SUBSIDIARIES
Consolidated Statements of Cash Flows
(in thousands, except share data)

<TABLE>
<CAPTION> Years ended June 30,
---------------------------------------------
1998 1999 2000
------------- -------------- --------------
<S> <C> <C> <C>
Cash flows from operating activities:
Net loss $ (90,868) $(107,264) $(114,313)
Adjustments to reconcile net loss to net
cash used in operating activities:
Acquired in-process research and development 24,321 -- --
Depreciation and amortization 5,306 19,305 6,826
Equity in loss of investee 1,631 -- --
Loss on disposition of property and equipment -- 1,264 --
Inventory write down -- -- 2,626
Amortization of debt issuance costs and
Accretion of discount on notes payable 13,902 33,943 38,902
Issuance of stock for services 240 103 --
Amortization of deferred stock compensation -- 738 2,519
Warrants expense -- -- 2,075
Stock options issued for services -- -- 64
Extraordinary loss 10,676 -- --
Changes in operating assets and liabilities:
Accounts receivable -- -- (264)
Inventory -- -- (2,550)
Other assets (610) (1,368) (1,424)
Accounts payable (2,659) (263) 2,337
Other current liabilities 864 (79) 3,220
Deferred rent -- -- 780
Deferred revenue -- -- 1,015
--------- --------- ---------

Net cash used for operating activities (37,197) (53,621) (58,187)
--------- --------- ---------

Cash flows from investing activities:
Purchases of property and equipment (13,364) (13,497) (8,009)
Deposits on property and equipment (1,631) -- (46)
Purchase of short-term investments (30,015) (113,072) (27,749)
Proceeds from the sale of short-term
investments -- 101,589 42,818
Proceeds from the sale of assets -- -- 69
Cash acquired in business combination 402 -- --
Restricted cash released 3,230 -- --
--------- --------- ---------

Net cash provided (used) by investing activities (41,378) (24,980) 7,083
--------- --------- ---------

Cash flows from financing activities:
Issuance of preferred stock, net 45,980 -- 27,000
Exercise of stock options 274 311 1,582
Repurchase of stock -- (20) (12)
Proceeds from notes payable and warrants, net of issuance
costs 199,655 -- --
Payments on capital lease -- -- (415)
Payments on notes payable (19) -- (37)
--------- --------- ---------

Net cash provided by financing activities 245,890 291 28,118
--------- --------- ---------

Net increase (decrease) in cash and cash equivalents 167,315 (78,310) (22,986)

Cash and cash equivalents at beginning of year 234 167,549 89,239
--------- --------- ---------

Cash and cash equivalents at end of year $ 167,549 $ 89,239 $ 66,253
========= ========= =========

Supplemental disclosures of cash flow information:
Cash paid during the period for interest $ 7 $ 5 $ --
========= ========= =========
Noncash investing and financing activities:
Issuance of common stock in exchange for
investment in affiliate $ 23,049 $ -- $ --
========= ========= =========
Issuance of put warrants associated with the
1996 notes $ -- $ -- $ 11,989
========= ========= =========
Accretion of redeemable warrants $ 763 $ 969 $ 4,899
========= ========= =========
Deferred compensation associated with
stock option activity $ -- $ 1,986 $ 7,289
========= ========= =========
Transfer of property and equipment to
inventory $ -- $ 2,663 $ 556
========= ========= =========
Equipment acquired under capital lease
obligations $ -- $ -- $ 2,120
========= ========= =========
</TABLE>

See accompanying notes to consolidated financial statements.

-36-
<PAGE>

DIVA SYSTEMS CORPORATION AND SUBSIDIARIES

Notes to Consolidated Financial Statements

June 30, 1999 and 2000

(1) Description of Business and Summary of Significant Accounting Policies

(a) Description of Business

DIVA Systems Corporation (the Company) is a leading provider of
interactive, video-on-demand products and services. The Company was incorporated
on June 15, 1995. Since no activity occurred in the Company between June 15,
1995 and June 30, 1995, the Company has used July 1, 1995, as its inception
date.

For periods prior to October 1, 1999, the Company was considered to be in
the development stage.

(b) Principles of Consolidation

The accompanying consolidated financial statements include the accounts of
the Company and its wholly owned subsidiaries in the United States, Canada and
the United Kingdom. All significant intercompany accounts and transactions have
been eliminated in consolidation.

Cash and cash equivalents consist of cash and highly liquid investments
such as money market funds and commercial paper with maturities at date of
purchase of less than 90 days.

Management determines the appropriate classification of investment
securities at the time of purchase and reevaluates such designation as of each
balance sheet date. As of June 30, 1999 and 2000, all investment securities were
designated as "available-for-sale." Available-for-sale securities are carried at
fair value based on quoted market prices, with unrealized gains and losses, net
of related deferred income taxes, reported as a component of accumulated other
comprehensive income in stockholders' equity.

Realized gains and losses and declines in value judged to be other than
temporary on available-for-sale securities are included in the consolidated
statement of operations. There have been no declines in value judged to be other
than temporary through June 30, 2000. The cost of securities is based on the
specific identification method. Interest and dividends on securities classified
as available-for-sale are included in interest income.

(d) Inventories

Inventories are stated at the lower of cost or market. Cost is determined
using the first-in, first-out method. Provisions to reduce the carrying value of
obsolete, slow moving and nonusable inventory to net realizable value are
charged to operations.

(e) Property and Equipment

Property and equipment are recorded at cost less accumulated depreciation.
Depreciation is calculated using the straight-line method over the estimated
useful lives of the respective assets, generally three to five years. Leasehold
improvements are amortized over the shorter of the estimated useful life or the
related lease term.

-37-
<PAGE>

DIVA SYSTEMS CORPORATION AND SUBSIDIARIES

Notes to Consolidated Financial Statements

June 30, 1999 and 2000

(f) Debt Issuance Costs

Underwriting, legal and accounting fees associated with the issuance of the
notes payable are being amortized to interest expense using the effective
interest method over the term of the notes. Amortization expense in 1998, 1999,
and 2000 was $609,000, $1,409,000, and $1,613,000, respectively.

(g) Intangible Assets

Intangible assets consist principally of assembled workforce. Intangible
assets are amortized on a straight-line basis over three years. Accumulated
amortization as of June 30, 2000 was $401,000. The Company's policy is to
evaluate the excess of cost over the net assets of businesses acquired based on
an evaluation of such factors as the occurrence of a significant adverse event
or change in the environment in which the business operates or if the expected
future net cash flows (undiscounted and without interest) would become less than
the carrying amount of the asset. An impairment loss would be recorded in the
period such determination is made based on the fair value of the related
business.

(h) Impairment of Long-Lived Assets

The Company evaluates its long-lived assets for impairment whenever events
or changes in circumstances indicate that the carrying amount of an asset might
not be recoverable. Recoverability of assets to be held and used is measured by
a comparison of the carrying amount of an asset to future net cash flows
expected to be generated by the asset. If such assets are considered to be
impaired, the impairment to be recognized is measured by the amount by which the
carrying amount of the asset exceeds the fair value of the asset. Assets to be
disposed of are reported at the lower of the carrying amount or fair value less
costs to sell.

(i) Stock-Based Compensation

The Company uses the intrinsic value-based method to account for all of its
employee stock-based compensation plans. The Company uses fair value to account
for nonemployee stock-based transactions.

(j) Basic and Diluted Net Loss Per Share

Basic and diluted net loss per share is computed using net loss adjusted
for the accretion of the redeemable warrants and redeemable put warrants (see
Note 4) and the weighted-average number of outstanding shares of common stock.
Potential common and preferred shares that could dilute earnings per share in
future periods but have been excluded from the determination of diluted net loss
per share because the effect of such shares would have been anti-dilutive are as
follows:

<TABLE>
<CAPTION>
June 30,
--------------------------------------------------
1998 1999 2000
-------------- --------------- -------------
<S> <C> <C> <C>
Common stock options................... 5,200,260 7,875,745 7,915,921
Common stock warrants.................. 4,762,800 4,862,800 6,196,067
Preferred stock........................ 21,372,287 21,390,283 24,495,463
Preferred stock options................ ---- 243,592 102,016
Preferred stock warrants............... 2,023,906 2,298,906 3,087,794
</TABLE>

-38-
<PAGE>

DIVA SYSTEMS CORPORATION AND SUBSIDIARIES

Notes to Consolidated Financial Statements

June 30, 1999 and 2000

(k) Stock Split

In March 1998, the Company effected a two-for-one stock split. All
applicable share and per share data have been adjusted for the stock split.

(l) Revenue Recognition

The Company's contracts are generally multiple-element arrangements with a
network operator involving a combination of video-on-demand hardware products,
licenses for system software and selected content and operational services. As a
result, we recognize revenue in accordance with the American Institute of
Certified Public Accountants Statement of Position 97-2, "Software Revenue
Recognition," and Statement of Position 98-9, "Software Revenue Recognition,
with Respect to Certain Transactions." Statement of Position 97-2 generally
requires revenue earned on software arrangements involving multiple elements to
be allocated to each element based on the relative fair values of the elements.
The fair value of an element must be based on vendor specific objective evidence
("VSOE") of the relative fair values of the elements. VSOE is determined by the
price charged when the element is sold separately. Statement of Position 98-9
requires recognition of revenue using the residual method in a multiple element
arrangement when fair value does not exist for one or more of the delivered
elements in the arrangement. Under the residual method, revenue for the
undelivered elements is deferred and subsequently recognized in accordance with
Statement of Position 97-2. Evidence of the fair value of the individual
elements in our current agreements does not exist.

As a result, upon the delivery of the Company's video-on-demand hardware
products, revenue is recognized to the extent of the cost of these hardware
products. Any remaining product revenue is amortized on a straight-line basis
over the remaining term of the agreement. The Company recognizes license
revenues ratably over the term of the agreement. If the Company's services are
provided on a fee-for-service basis, service revenues are recognized as the
services are performed. If the services are provided on a revenue sharing basis,
service revenues are recognized based on program purchases by subscribers.

The Company provides limited warranty rights to its customers, which are
accounted for in accordance with SFAS No. 5, "Accounting for Contingencies."
Estimated warranty obligations are provided by charges to operations in the
period in which the related revenue is recognized. To date, the estimated
warranty obligations have not been considered significant.

(m) Engineering and Development

Engineering and development costs, including payments made in conjunction
with research and development arrangements, are charged to operations as
incurred.

-39-
<PAGE>

DIVA SYSTEMS CORPORATION AND SUBSIDIARIES

Notes to Consolidated Financial Statements

June 30, 1999 and 2000

(n) Use of Estimates

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

(o) Income Taxes

The Company accounts for income taxes using an asset and liability approach
that results in the recognition of deferred tax assets and liabilities for the
expected future tax consequences attributable to differences between the
financial statement carrying amounts of existing assets and liabilities and
their respective tax bases. Deferred tax assets and liabilities are measured
using enacted tax rates in effect for the year in which those temporary
differences are expected to be recovered or settled. The measurement of deferred
tax assets is reduced, if necessary, by a valuation allowance for any tax
benefits whose future realization is uncertain.

(p) Fair Value of Financial Instruments

The carrying amount of financial instruments, including cash, cash
equivalents, and short-term investments, approximated fair values as of June
30, 2000, due to the relatively short maturity of these instruments. The
Company's notes payable are held by a number of financial institutions and are
not publicly traded. The Company estimates that the fair value of the notes
payable as of June 30, 2000, based on limited dealer transactions, approximated
$245.4 million.

(q) Other Comprehensive Income

In June 1997, the Financial Accounting Standards Board issued Statement of
Financial Accounting Standards (SFAS) No. 130, Reporting Comprehensive Income.
SFAS No. 130 establishes standards for reporting and displaying comprehensive
income and its components in financial statements. The Company had no items of
other comprehensive income in all periods presented.

(r) New Accounting Pronouncements

In June 1998, SFAS No. 133, "Accounting for Derivative Instruments and
Hedging Activities" was issued. SFAS No. 133 establishes accounting and
reporting standards for derivative instruments, hedging activities, and exposure
definition. SFAS No. 133 requires that an entity recognize all derivatives as
either assets or liabilities in the statement of financial position and measure
those instruments at fair value. In June 2000, the FASB issued Statement of
Financial Accounting Standards No. 138, "Accounting for Certain Derivative
Instruments and Certain Hedging Activities, and amendment to FASB Statement
No. 133". Statement No. 138 addresses a limited number of issues causing
implementation difficulties for companies that are required to apply Statement
No. 133. Statement 133, as amended by SFAS No. 137, "Accounting for Derivative
Instruments and Hedging Activities--Deferral of the effective date of FASB
Statement No. 133", and Statement No. 138 are effective for all fiscal quarters
of all fiscal years beginning after June 15, 2000. We have not determined the
impact that SFAS 133 and SFAS 138 will have on our financial statements and
believe that such determination will not be meaningful until closer to the date
of initial adoption.

In December 1999, the Securities and Exchange Commission issued SAB
No. 101, "Revenue Recognition in Financial Statements," which will be effective
for us in the first quarter of fiscal 2001. We believe that our current revenue
recognition principles comply with this bulletin.

In March 2000, the Financial Accounting Standards Board (FASB) issued
Interpretation No. 44 (FIN 44) "Accounting for Certain Transactions Involving
Stock Compensation--an Interpretation of Accounting Principles Board (APB)
Opinion No. 25". FIN 44 clarifies the application of APB Opinion No. 25 and is
effective July 1, 2000. We believe that FIN 44 will not have a material effect
on our financial position or results of operations.

-40-
<PAGE>

DIVA SYSTEMS CORPORATION AND SUBSIDIARIES

Notes to Consolidated Financial Statements

June 30, 1999 and 2000

(2) Financial Statement Details

(a) Cash, Cash Equivalents and Short-Term Investments

As of June 30, 1999 and 2000, the fair value of the securities was at gross
amortized cost. The fair value of securities available-for-sale as of June 30,
1999 and 2000, are as follows (in thousands):

<TABLE>
<CAPTION>
June 30,
--------------------------------
1999 2000
------------ -----------
<S> <C> <C>
U.S. government obligations................................. $ 66,608 $ 27,019
Commercial paper............................................ 36,752 45,459
Certificates of deposits.................................... 1,002 2,079
Money market instruments.................................... 875 1,225
Auction rate preferred stock certificates................... 25,500 16,900
---------- -----------
Total.................................................. $ 130,737 $ 92,682
=========== ===========
Included in cash and cash equivalents....................... 89,239 66,253
Included in short-term investments.......................... 41,498 26,429
----------- -----------
Total.................................................. $ 130,737 $ 92,682
=========== ===========
</TABLE>

(b) Inventories

A summary of inventories at June 30, 2000 are as follows (in thousands):

<TABLE>
<CAPTION>
June 30,
--------------------------------
1999 2000
------------ ------------
<S> <C> <C>
Raw materials................................................ $ --- $ 911
Work-in-process.............................................. 773 2,232
Finished goods............................................... 1,890 ---
----------- ------------
Total.................................................. $ 2,663 $ 3,143
=========== ============
</TABLE>

-41-
<PAGE>

DIVA SYSTEMS CORPORATION AND SUBSIDIARIES

Notes to Consolidated Financial Statements

June 30, 1999 and 2000

A summary of property and equipment are as follows (in thousands):

<TABLE>
<CAPTION>
June 30,
--------------------------------
1999 2000
------------ ------------
<S> <C> <C>
Furnitures and fixtures............................ $ 806 $ 817
Office equipment................................... 318 819
Servers and related hardware....................... 10,672 10,110
Computer and other equipment....................... 11,943 16,564
Leasehold improvements............................. 1,363 4,147
Construction-in-progress........................... -- 507
----------- ----------
25,102 32,964
Less accumulated depreciation and amortization..... 15,310 20,316
----------- ----------
$ 9,792 $ 12,648
=========== ==========
</TABLE>

In June 1999, in conjunction with the shift in marketing strategy, the
Company wrote-down video servers and related hardware by $9,104,000 to reflect
the fair market value of this equipment. This charge is included in depreciation
and amortization expense for the year ended June 30, 1999. In addition, the
Company reclassified $2,663,000 from fixed assets to inventory at June 30, 1999.

(d) Other Current Liabilities

A summary of other current liabilities are as follows (in thousands):

<TABLE>
<CAPTION>
June 30,
--------------------------------
1999 2000
------------ ------------
<S> <C> <C>
Accrued compensation............................... $ 899 $ 1,989
Other accrued liabilities.......................... 322 2,452
---------- -----------
Total....................................... $ 1,221 $ 4,441
========== ===========
</TABLE>

-42-
<PAGE>

DIVA SYSTEMS CORPORATION AND SUBSIDIARIES

Notes to Consolidated Financial Statements

June 30, 1999 and 2000

(3) Affiliate Transactions

(a) Initial Investment

In December 1995, the Company entered into a joint equity investment and
license agreement (the License Agreement) with Sarnoff Real Time Corporation
(SRTC), whereby the Company acquired 8,067,074 shares of SRTC common stock,
representing approximately 40% ownership interest in the equity of SRTC on a
fully diluted basis, in exchange for 6,654,000 shares of the Company's common
stock, plus two shares of Class B common stock. This transaction was recorded at
the estimated fair value of the Company's common stock issued. The value of
DIVA's common stock was estimated at $0.075 per share and was determined by the
board of directors based on the current financial condition, business outlook,
status of product development efforts, preferences of outstanding senior
securities, book value, and business risks and opportunities relevant to the
Company. The Company had sold preferred stock in December 1995 at $0.825 per
share. There were no significant contemporaneous sales of common stock for cash
during this time. This investment was accounted for using the equity method. On
December 4, 1997, the Company and SRTC entered into a Development Services
Agreement. The Development Services Agreement required the Company to pay SRTC
$4,900,000 in development fees in exchange for SRTC's continued technology
development of the Sarnoff Server, for the Company's video-on-demand service. In
addition, the Company agreed to pay $2,300,000 for servers to be delivered in
fiscal 1998 and 1999. For the year ended June 30, 1998, the Company paid
$2,950,000 for engineering and development expense and $2,300,000 for servers
under the Development Services Agreement.

(b) Acquisition of SRTC

On January 15, 1998, the Company and SRTC executed an Agreement and Plan of
Reorganization setting forth their agreement to merge SRTC into the Company,
with the Company as the surviving corporation (the "SRTC Transaction"). On that
date, the Company held approximately 40% of the outstanding capital stock of
SRTC. In exchange for the remaining approximately 60% of the issued and
outstanding stock of SRTC, the Company issued 3,277,539 shares of Series AA
preferred stock valued at $6.50 per share. The fair value was determined by the
Board of Directors based on the most recent sales of preferred securities and
the then current financial condition of the Company, as well as other business
considerations. In addition, the Company reserved 276,792 shares of its Series
AA preferred stock for issuance upon exercise of options assumed by the Company
in the transaction. These options were valued at $1,744,000 using the Black-
Scholes option pricing model and were included in the purchase price.
Assumptions used were as follow: Expected life of 3 years; Volatility of 90%;
Dividend yield of 0%; Risk-free rate of 5.62%. The Company also reserved 380,767
shares of its common stock for use in connection with the future issuance of
options to SRTC employees (see Note 8). The purchase price of $23,049,000 is
comprised of the fair value of the preferred stock issued of $21,305,000 and the
fair value of options assumed of $1,744,000.

-43-
<PAGE>

DIVA SYSTEMS CORPORATION AND SUBSIDIARIES

Notes to Consolidated Financial Statements

June 30, 1999 and 2000

The Company completed the SRTC Transaction in April 1998. The Company
accounted for the merger as a purchase, and accordingly, the operating results
of SRTC have been included in the Company's consolidated financial statements
since the date of acquisition. The Company allocated the purchase price based on
an appraisal by an independent third party using the cost approach, which is the
approach often used to value an early stage technology. The allocation of the
purchase price is as follows: $2,886,000 to the fair value of acquired assets;
$4,693,000 to assumed liabilities; $535,000 to assumed work force; and
$24,321,000 to acquired in-process research and development.

The following unaudited pro forma consolidated results of operations has
been prepared as if the acquisition of SRTC had occurred as of the beginning of
fiscal 1998:

<TABLE>
<CAPTION>
Year ended June 30,
1998
-----------------------
<S> <C>
Net loss before extraordinary item.......................... $ 82,716
Net loss.................................................... 93,392
Basic and diluted net loss per share before extraordinary item 5.08
Basic and diluted net loss per share........................ 5.72
</TABLE>

The pro forma results include amortization of the assumed workforce of
$178,000 for the year ended June 30, 1998. The pro forma results are not
necessarily indicative of what actually would have occurred if the acquisition
had been completed as of the beginning of the fiscal period presented, nor are
they necessarily indicative of future consolidated results.

(4) Notes Payable

In May 1996, the Company completed a debt offering for $47,000,000 of
Subordinated Discount Notes (the "1996 Notes") due May 15, 2006. The 1996 Notes
consisted of 47,000 units of one note and one warrant to purchase 40.4 shares of
common stock at $0.005 per share (the 1996 Warrants). The 1996 Notes were
subordinated to all existing and future indebtedness of the Company.

Pursuant to a Warrant Agreement dated May 15, 1996 by and between the
Company and the Bank of New York as the warrant agent, in the event that the
Company did not complete an initial public offering prior to May 15, 2000, the
Company is required to issue on May 15, 2000 (to registered warrant holders as
of May 1, 2000) additional warrants exercisable in the aggregate into shares of
the Company's Common Stock representing 5% of the outstanding common stock of
the Company on a fully diluted basis, as defined in the Warrant Agreement.

The Company believes that the Warrant Agreement provides that the number of
additional warrants to be issued should be computed based on the Company's
capitalization on May 15, 1996. Accordingly, additional warrants totaling
1,333,268 with a fair value of $12.0 million will be issued to the warrant
holders. This has been recorded as an adjustment to additional paid in capital.
Since the warrants are redeemable by the Company, under certain conditions, a
corresponding liability of $12.0 million has been recorded in the financial
statements. As the value of the redeemable warrants change, a corresponding
charge or credit will be recorded in the income statement.

The Company has been advised by certain of the warrant holders that they
believe the Warrant Agreement should be interpreted to calculate the 5%
additional warrants based on the Company's capitalization at May 15, 2000. If a
May 15, 2000 calculation date were to be used, this would require the issuance
of an additional 1,730,593 warrants. The Company has had discussions with
representatives of the warrant holders regarding this claim, but has not reached
a

-44-
<PAGE>

DIVA SYSTEMS CORPORATION AND SUBSIDIARIES

Notes to Consolidated Financial Statements

June 30, 1999 and 2000

resolution. To the extent that such resolution, when reached, results in the
issuance of additional warrants, the Company would record an adjustment to
additional paid in capital and to the liability accordingly. Net loss
attributable to common stockholders would also be increased by such amount.

In connection with the Company's February 1998 debt offering discussed
below, all the outstanding 1996 Notes were exchanged. For the year ended June
30, 1998, the Company recorded an extraordinary loss of $10,676,000 resulting
from the exchange of the 1996 Notes.

On February 19, 1998, the Company completed a debt offering for
$463,000,000 of 12-5/8% Senior Discount Notes (the "1998 Notes") due March 1,
2008. The 1998 Notes consist of 463,000 units, of which 404,998 were offered for
sale and 58,002 were offered in exchange for all of the 1996 Notes. Each unit
consists of one 1998 Note due 2008 and three warrants each to purchase two
shares of the Company's common stock at $0.005 per share (the "1998 Warrants").
The 1998 Notes are senior unsecured indebtedness of the Company and rank pari
passu with any future unsubordinated unsecured indebtedness and will be senior
to any future subordinated indebtedness of the Company.

The 1998 Notes were issued at a substantial discount of $212,980,000. Cash
interest payments will commence on September 1, 2003 at the rate of 12 5/8% per
annum.

Pursuant to a warrant agreement dated as of February 19, 1998 by and
between the Company and The Bank of New York as the warrant agent, upon the
occurrence of certain consolidations and mergers and assets sales and subject to
certain conditions and limitations, the Company will be required to offer to
repurchase all outstanding 1998 Warrants at the Repurchase Price, as defined.

The gross proceeds to the Company from the debt offering were $250,020,000.
In connection with the offering, the Company recorded $18,057,000 in additional
paid-in capital representing the fair value of the warrants calculated using the
Black-Scholes option pricing model. Assumptions used were as follows: Expected
life of 10 years; Volatility of 50%; Dividend yield of 0%; Risk-free rate of 6%.
In addition, the Company recorded an extraordinary loss of $10,676,000,
consisting primarily of a cash premium paid to holders of the 1996 Notes,
resulting from the exchange of the 1996 Notes.

The effective interest rate of the 1998 Notes, reflecting the allocation
for warrants and costs associated with the debt offering, is 14.1%.

-45-
<PAGE>

DIVA SYSTEMS CORPORATION AND SUBSIDIARIES

Notes to Consolidated Financial Statements

June 30, 1999 and 2000

The 1998 Notes are callable at a declining premium after March 1, 2001,
after which the Company may redeem in whole or in part the 1998 Notes prior to
March 1, 2003, by paying a specified premium over the accreted principal value.
The redemption premiums are as follows, during the period commencing March 1 of
such year:

Year Percentage
---- ----------
2001 106.31%
2002 104.20%
2003 102.10%
2004 and thereafter 100.00%

In addition, at any time prior to March 1, 2001, the Company may redeem up
to 35% of the accreted value of the 1998 Notes with the proceeds of one or more
sales of the Company's stock, at any time or from time to time in part, at a
redemption price of 112.625% of the accreted value plus accrued and unpaid
interest provided that the 1998 Notes, representing at least $301,000,000
aggregate principal amount at maturity, remain outstanding after each such
redemption.

Notes payable consists of the following (in thousands):

<TABLE>
<CAPTION>
June 30,
--------------------------------------------
1999 2000
--------------------- ------------------
<S> <C> <C>
Principal - 1998 Notes..................................... $ 463,000 $ 463,000
Discount - 1998 Notes...................................... (231,037) (231,037)
Amortized Discount - 1998 Notes............................ 43,563 80,852
Other...................................................... 38 --
--------------------- ------------------
Total................................................. $ 275,564 $ 312,815
===================== ==================
</TABLE>

(5) Income Taxes

The reconciliation between the amount computed by applying the U.S. federal
statutory tax rate of 34% to income taxes and the actual provision for income
taxes as of June 30, 2000 and June 30, 1999 are as follows (in thousands):

<TABLE>
<CAPTION>
June 30,
--------------------------------------------
1999 2000
--------------------- ------------------
<S> <C> <C>
Income tax expense at statutory rate...................... $ (36,470) $ (38,928)
Net operating losses and temporary differences for which no
benefit was recognized................................. 36,211 38,916
Other permanent differences................................ 259 13
--------------------- ------------------
Total................................................. $ -- $ --
===================== ==================
</TABLE>

-46-
<PAGE>

DIVA SYSTEMS CORPORATION AND SUBSIDIARIES

Notes to Consolidated Financial Statements

June 30, 1999 and 2000

The tax effects of temporary differences that give rise to significant
portions of the deferred tax assets and deferred tax liabilities are as follows
(in thousands):

<TABLE>
<CAPTION>
June 30,
--------------------------------
1999 2000
---------- ----------
<S> <C> <C>
Deferred Tax assets:
Loss carryovers and deferred start-up expenditures........ $ 62,552 $ 87,866
Statue tax credit carryforwards........................... 6,360 6,000
Debt financing costs...................................... 18,944 35,717
Stock Compensation........................................ -- 1,448
Accruals, reserves, and other............................. 3,319 6,593
Fixed assets.............................................. 2,839 3,080
---------- ----------
Total gross deferred tax assets...................... 94,014 140,375
Valuation allowance......................................... (93,880) (140,317)
---------- ----------
Deferred tax assets, net of valuation allowance............. 134 58
Deferred tax liabilities.................................... (134) (58)
---------- ----------
Net deferred tax asset............................... $ -- $ --
========== ==========
</TABLE>

Because the Company has incurred significant net losses and the realization
of its deferred tax assets is dependent upon the Company's ability to
successfully develop and market its video-on-demand service, a valuation
allowance has been recorded against such deferred tax assets. The valuation
allowance increased $46,766,000 from June 30, 1999 to June 30, 2000

As of June 30, 2000, the Company has cumulative net operating loss
carryforwards for federal income tax purposes of approximately $215,739,000
available to reduce future income subject to income taxes. The federal net
operating loss carryforwards expire beginning in 2011 through 2020. As of June
30, 2000, the Company has cumulative California net operating losses of
approximately $112,973,000 which can be used to offset future income subject to
California taxes. The California tax loss carryforwards will expire beginning
in 2004 through 2005. As of June 30, 2000, the Company also has net operating
losses carryforwards in various states. These net operating losses
carryforwards will expire in various years.

As of June 30, 2000, the Company has federal research tax credit
carryforwards for income tax return purposes of approximately $3,951,000
available to reduce future income taxes. The federal research credit
carryforwards expire beginning in 2011 through 2020. As of June 30, 2000, the
Company has unused California research and development tax credits of
approximately $1,676,000. The California research credits carry forward
indefinitely until utilized.

Federal and state tax laws impose restrictions on the utilization of net
operating loss and tax credit carryforwards in the event of an "ownership
change" as defined by the Internal Revenue code. The Company has not yet
determined to what extent these provisions will restrict its ability to utilize
its net operating loss and tax credit carryforwards pursuant to these
provisions.

-47-
<PAGE>

DIVA SYSTEMS CORPORATION AND SUBSIDIARIES

Notes to Consolidated Financial Statements

June 30, 1999 and 2000

(6) Preferred Stock

The Company has authorized 80,000,000 shares of preferred stock as of June
30, 2000, of which the following are designated as issued and outstanding:

<TABLE>
<CAPTION>
Shares Issued and
Shares Designated Outstanding
------------------------ ----------------------
<S> <C> <C>
Series:
AA....................................... 3,750,000 3,421,830
A........................................ 205,600 205,600
B........................................ 4,493,748 3,419,842
C........................................ 6,918,600 6,168,600
D........................................ 8,517,352 8,279,589
E........................................ 1,166,666 777,778
F........................................ 2,500,000 1,666,668
G........................................ 5,000,000 555,556
------------------------ ----------------------
Totals........................... 32,551,966 24,495,463
======================== ======================
</TABLE>

The rights, preferences, and privileges of these series of preferred stock
are explained below.

(a) Conversion

Each share of preferred stock is convertible into common stock at the
option of the holder at a rate of one share of common stock for each share of
preferred stock, subject to adjustment to protect against dilution. Each share
of Series E, F, and G preferred stock shall automatically be converted into
shares of common stock immediately prior to the closing of an underwritten
public offering of at least $9.00 per share and an aggregate offering price of
not less than $15,000,000. Each share of Series D preferred stock shall
automatically be converted into shares of common stock immediately prior to the
closing of an underwritten public offering of at least $6.80 per share and an
aggregate offering price of not less than $15,000,000. Each share of Series C
preferred stock shall automatically be converted into shares of common stock
immediately prior to the closing of an underwritten public offering of at least
$5.00 per share and an aggregate offering price of not less than $15,000,000.
Each share of Series A and B preferred stock shall automatically be converted
into shares of common stock immediately prior to the closing of an underwritten
public offering of at least $2.00 per share and an aggregate offering price of
not less than $10,000,000. Each share of Series AA preferred stock shall
automatically be converted into shares of common stock immediately prior to the
closing of an underwritten public offering with an aggregate offering price of
not less than $15,000,000. The Company has reserved 24,495,463 shares of common
stock in the event of conversion.

(b) Liquidation Preferences

In the event of liquidation or sale of the Company, distributions to the
Company's stockholders shall be made in the following manner: first, $5.72 per
share for Series D preferred stock; then $4.205 per share for Series C
preferred stock; then $0.855 per share for Series B preferred stock; then $9.00
per share for Series E, F and G preferred stock; then $0.50 per share for Series
A preferred stock; and then $6.50 per share for Series AA preferred stock. The
holders of preferred stock are further entitled to any remaining assets which
will be distributed ratably among the holders of Class C common stock (see Note
7), common stock, and preferred stock on an "as if converted" basis after
payment of preferential amounts to the holders of Class C common stock, common
stock, and Class B common stock.

-48-
<PAGE>

DIVA SYSTEMS CORPORATION AND SUBSIDIARIES

Notes to Consolidated Financial Statements

June 30, 1999 and 2000

Holders of preferred stock are entitled to one vote for each share of
common stock into which such shares can be converted.

(d) Dividends

In any fiscal year, the Company's Board of Directors may declare
noncumulative cash dividends out of legally available assets at the rates of
$0.03, $0.055, $0.25, $0.345, $0.54, $0.54, $0.54 and $0.39 per share for Series
A, B, C, D, E, F, G and AA preferred stock, respectively. If declared, such
dividends must be paid before any dividends on common stock. The holders of
Series E, D and C preferred stock have preference and priority to any payment of
any dividend on Series A, B, and AA preferred stock and common stock. The
holders of Series B preferred stock have preference and priority to any payment
of any dividend on Series A and AA preferred stock and common stock. The holders
of Series A preferred stock have preference and priority to any payment of any
dividend on Series AA preferred stock and common stock. The holders of Series AA
preferred stock have preference and priority to any payment of any dividend on
common stock. As of June 30, 1999 and 2000, no dividends had been declared.

(7) Common Stock

The Company has authorized 165,000,000 shares of common stock as of June
30, 2000, of which two shares have been designated Class B common stock and
857,370 shares have been designated Class C common stock. As of June 30, 2000,
17,758,248 shares of common stock and 857,370 shares of Class C common stock
were issued and outstanding. The relative designations, rights, preferences, and
restrictions of the Class B and C common stock are as follows:

(a) Conversion

Each share of Class C common stock is convertible into common stock at the
option of the holder at a rate of one share of common stock for each share of
Class C common stock, subject to adjustment to protect against dilution. Each
share of Class C common stock shall automatically be converted into shares of
common stock immediately prior to the closing of an underwritten public offering
of at least $2.00 per share and an aggregate offering price of not less than
$10,000,000.

(b) Liquidation Preferences

In the event of any liquidation and after payment to all holders of
preferred stock of their full preferential amounts, the holders of Class C
common stock shall be paid $0.82 per share. If there are insufficient funds to
distribute among all holders of Class C common stock, then the entire remaining
assets shall be distributed among the holders of Class C common stock on a pro
rata basis. After payment to the holders of Class C common stock, then the
holders of common stock shall be entitled to $0.025 per share. After payment to
the holders of common stock, the holders of Class B common stock shall be
entitled to $5.00 per share. Any remaining assets shall be distributed to all
holders of Series A, B, and C preferred stock, Class C common stock, and common
stock on a pro rata basis, based on the number of shares of common stock on an
"as if converted" basis.

-49-
<PAGE>

DIVA SYSTEMS CORPORATION AND SUBSIDIARIES

Notes to Consolidated Financial Statements

June 30, 1999 and 2000

No dividends shall be paid on any share of common stock unless a dividend
is paid on shares of Series A, B, C, D, E and AA preferred stock.

In August and October 1995, in connection with a consulting agreement,
1,294,000 shares of the Company's common stock were sold at fair value, $0.005
per share, subject to repurchase by the Company. The Company's right to
repurchase lapsed through October 1997 for 360,000 shares. The Company's right
to repurchase the remaining 934,000 shares lapses based on the Company's ability
to secure financing. As of June 30, 2000, no shares remained subject to
repurchase.

(8) Options and Warrants

(a) Options and Warrants

In connection with the issuance of the 1996 Notes the fair value of the
Common Stock warrants was determined to be $285,000 using the Black-Scholes
option pricing model with the following assumptions: Expected life of 10 years;
Volatility of 50%; Dividend yield of 0%; Risk-free rate of 6% (see note 4). Each
warrant entitles the holder to purchase 40.4 shares of common stock for $0.005
per share. The warrants expire on the earlier of an exercise event, as defined,
or 10 years from the date of issuance. The initial carrying value of the
warrants is increased by periodic accretions so that the carrying amount will
equal the fair market value at the time the put option is exercisable.

Warrants to purchase 1,073,906 shares of Series B preferred stock at $0.855
and $1.50 per share were issued in October 1995 and May 1996, respectively, in
connection with bridge financings that were repaid in October 1995 and June
1996, respectively. The term of these warrants is five years from date of issue.
The fair value of these warrants, totaling approximately $207,000, was
calculated using the Black-Scholes option pricing model with the following
assumptions: Expected life of 3 years; Volatility of 50%; Dividend yield of 0%;
Risk-free rate of 6%.

In June 1996, the Company's Board of Directors granted warrants to key
contractors to purchase 71,000 shares of the Company's common stock at a price
of $2.00 per share. The term of these warrants is 10 years, and these warrants
only become exercisable upon the earlier of 5 years from the date of grant or
upon the closing of an initial public offering of the Company's stock or an
acquisition of the Company. The fair value of these warrants, totaling
approximately $1,000 was calculated using the Black-Scholes option pricing
model with the following assumptions: Expected life of 3 years; Volatility of
50%; Dividend yield of 0%; Risk-free rate of 6%. During the year ended June 30,
1998, warrants to purchase 5,000 shares of the Company's common stock were
canceled.

In October 1996, the Company issued warrants to an employee to purchase
1,000,000 shares of Series C preferred stock at $4.21 per share. These warrants
are immediately exercisable and expire in 5 years. In August 1997, warrants to
purchase 650,000 shares were canceled.

In October 1996, the Company also issued warrants to purchase 200,000
shares of Series C preferred stock at $4.21 per share to a vendor for
consideration of future marketing services. These warrants vest at a rate of 5%
every three months starting after October 1996. The term of these warrants is
five years from the date of issue. This determination was made based upon the
fair value of these warrants, totaling approximately $434,000, which would have
been amortized over the term of the warrant. Fair value was calculated using the
Black-Scholes option pricing model with the following assumptions: Expected life
of 5 years; Volatility of 50%; Dividend yield of 0%; Risk-free rate of 6%.

In October 1996, the Company also issued warrants to purchase 200,000
shares of Series C preferred stock at $4.21 per share to a customer. These
warrants are exercisable in full upon the occurrence of certain events. The term
of the

-50-
<PAGE>

DIVA SYSTEMS CORPORATION AND SUBSIDIARIES

Notes to Consolidated Financial Statements

June 30, 1999 and 2000

warrants are 10 years from the date of issue. This determination was based upon
the fair value of these warrants, totaling approximately $270,000, and was
calculated using the Black-Scholes option pricing model with the following
assumptions: Expected life of 2 years; Volatility of 50%; Dividend yield of 0%;
Risk-free rate of 6%.

In October 1997, the Company issued warrants to purchase 200,000 shares of
Series D preferred stock at $5.72 per share to a customer. The warrants are
immediately exercisable and expire 5 years from date of issue. The fair value of
these warrants, totaling approximately $590,000, was calculated using the Black-
Scholes option pricing model with the following assumptions: Expected life of 5
years; Volatility of 50%; Dividend yield of 0%; Risk-free rate of 6%.

In connection with the issuance of the 1998 Notes (see Note 4), $18,057,000
of the proceeds has been allocated to the common stock warrants. Such amount has
been included in debt discount and is being amortized to interest expense using
the effective interest method over the period that the 1998 Notes are
outstanding. Each warrant entitles the holder to purchase two shares of common
stock for $0.005 per share for an aggregate of 2,778,000 shares of common stock.
The warrants are exercisable beginning one year after the closing date of the
1998 Notes and expire upon maturity of the 1998 Notes.

In May 1998, the Company's Board of Directors granted warrants to
consultants to purchase 20,000 shares of the Company's common stock at a price
of $4.00 per share. The term of these warrants is 10 years, and these warrants
only become exercisable upon the earlier of 5 years from the date of grant or
upon the closing of an initial public offering of Company's common stock or an
acquisition of the Company. The fair value of these warrants, totaling
approximately $29,000 to be amortized over the vesting period, 4 years, was
calculated using the Black-Scholes option pricing model with the following
assumptions: Expected life of 10 years; Volatility of 50%; Dividend yield of 0%;
Risk-free rate of 6%.

In November 1998, the Company's Board of Directors granted warrants to an
employee to purchase 650,000 shares of the Company's common stock at a price of
$8.00 per share. The term of these warrants is 10 years from the date of issue.
These warrants vested at a rate of 50,000 shares every three months starting
August 1998. In March 1999, the employee was terminated and unvested warrants to
purchase 550,000 shares were canceled.

In December 1998, in connection with a deployment agreement, the Company
undertook to grant warrants to purchase a maximum of 2,200,000 shares of a new
series of preferred stock, convertible one for one to common stock upon the
earlier of either an initial public offering of the Company's stock or an
acquisition of the Company at an exercise price of $8.00 per share. The warrants
only become exercisable upon the customer meeting certain service deployment
milestones. The Company is valuing the warrants using the Black-Scholes model as
of each interim date until the achievement of certain milestones have been met.
The resulting valuation is being amortized over a period from granting of the
warrant and ending on the date of the expected achievement of the milestones. In
December 1999, the deployment agreement was terminated and the obligation to
grant these warrants terminated.

In June 1999, in connection with a deployment agreement, the Company
undertook to grant warrants to purchase 275,000 shares of a new series of
preferred stock to a customer at an exercise price of $8.00 per share. The
warrants become exercisable upon the customer's achievement of certain annual
milestones, over a period of 3 years. The Company is valuing these warrants
using the Black-Scholes model at each interim date until the criteria have been
met. As of June 30, 2000 the Company recognized expenses of $513,000 in
connection with this agreement, which represents the customer's progress towards
achieving the milestones.

In December 1999, the Company entered into a development agreement with a
strategic business partner. In conjunction with this agreement, the Company
granted a warrant to purchase 388,888 shares of Series E preferred stock
exercisable at $9.00 per share. The warrant expires the earlier of December 14,
2004 or under certain conditions as a result of a merger or acquisition of the
Company. The warrant becomes exercisable in accordance with the achievement of
certain milestones in the development agreement. As of June 30, 2000 the Company
has recognized expenses of

-51-
<PAGE>

DIVA SYSTEMS CORPORATION AND SUBSIDIARIES

Notes to Consolidated Financial Statements

June 30, 1999 and 2000

$891,000 in connection with these warrants, which represents the straight-line
amortization of the Black-Scholes value over the term of the development
contract of 1 year.

In May 2000, the Company undertook to grant warrants to purchase 400,000
shares of Series F preferred stock to a customer in connection with a deployment
agreement at a price of $9.00 per share. The life of the agreement is three
years. Warrants to purchase 50,000 shares of Series F preferred stock vested on
the execution of the deployment agreement in May 2000 and the Company recorded
expenses of $284,000 in fiscal 2000. The remaining 350,000 warrants become
exercisable upon the customer's achievement of certain milestones at the end of
the three year term. The Company is valuing these warrants using the Black-
Scholes model at each interim date until the criteria have been met. As of June
30, 2000 the Company recognized expenses of $125,000 in connection with this
agreement, which represents the customer's progress towards achieving the
milestones.

(b) Stock Plans

In August 1995, the Company adopted the 1995 Stock Plan (the 1995 Plan)
under which incentive stock options and nonstatutory stock options may be
granted to employees and consultants of the Company. An aggregate of 9,200,000
shares of common stock is reserved for issuance under the 1995 Plan. The
exercise price for incentive stock options is at least 100% of the fair market
value on the date of grant for employees owning less than 10% of the voting
power of all classes of stock and at least 110% of the fair market value on the
date of grant for employees owning more than 10% of the voting power of all
classes of stock. For nonstatutory stock options, the exercise price is at least
110% of the fair market value on the date of grant for employees owning more
than 10% of the voting power of all classes of stock and at least 85% for
employees owning less than 10% of the voting power of all classes of stock.
Options generally expire in 10 years; however, they may be limited to 5 years if
the optionee owns stock representing more than 10% of the Company. Vesting
periods are determined by the Company's Board of Directors and generally provide
for ratable vesting over 4 to 5 years.

In August 1995, the Company granted immediately exercisable nonstatutory
stock options to the founders of the Company, subject to repurchase by the
Company at a rate equivalent to the vesting schedule of each option. As of June
30, 1998, 1999 and 2000, 261,600, 277,380 and 119,206 shares, respectively, were
subject to repurchase.

In April 1998, in connection with the merger of SRTC, the Company assumed
the SRTC 1998 Stock Plan (the 1998 Plan) and reserved 380,767 shares of its
common stock for issuance through incentive stock options and nonstatutory stock
options granted pursuant to the 1998 Plan to employees, directors, and
consultants who formerly worked for SRTC. The terms of the 1998 Plan are
substantially identical to the terms of the 1995 Plan.

In April 1998, in connection with the merger of SRTC, the Company reserved
276,792 shares of its Series AA preferred stock for issuance upon exercise of
options to purchase common stock of SRTC, which were assumed by the Company.
Each option assumed by the Company continues to be subject to the terms and
conditions, including vesting, set forth in the original SRTC option plan. All
stock options have 10 year terms and vest ratably over 4 years from the date of
grant. During the year ended June 30, 1999 and 2000, 17,996 and 33,038 options
were exercised, respectively.

The Board of Directors is entitled in its discretion to grant options ("Out
of Plan Options") with vesting periods which are different from the standard
five year period and with variable exercise prices. In a limited number of
instances, the Compensation Committee has exercised its discretion and has
granted options with both shorter and longer vesting periods than the standard
five year period and at variable exercise prices (all of which were equal to or
greater than fair market value at date of grant). There were 1,880,000 options
outstanding as of June 30, 2000.

In January 1999 the President was granted Out of Plan options to purchase
600,000 shares of common stock at an exercise price of $3.35 per share (the
"First Option"), and additional options to purchase 600,000 shares of common

-52-
<PAGE>

DIVA SYSTEMS CORPORATION AND SUBSIDIARIES

Notes to Consolidated Financial Statements

June 30, 1999 and 2000

stock at an exercise price of $3.35 per share, an option to purchase 400,000
shares of common stock at an exercise price of $4.50 per share and an option to
purchase 200,000 shares of common stock at an exercise price of $8.00 per share,
which options vest over five years. All such options shall become fully
exercisable on the earlier of six months from the date of a "Change of Control"
(as defined in the agreement) or the termination of the President's employment
after a Change of Control without "Cause" (as defined in the agreement). The
President is entitled to return the First Option in exchange for a lump sum
payment beginning on the first anniversary of the commencement of his
employment. Should this election be made between February 2001 and 2004, he will
receive $1,920,000. As of June 30, 2000 the Company had accrued $1,267,000
relating to this obligation.

The Company uses the intrinsic value method in accounting for its common
stock option plans. Accordingly, no compensation cost has been recognized in the
accompanying consolidated financial statements because the exercise price of
each option approximated the fair value of the underlying common stock as of the
grant date for each stock option. The Company considered the cash sales of
preferred stock in determining the fair value of its common stock. Compensation
cost related to grants to nonemployees in 1998, 1999, and 2000 was not material.
Had compensation cost for the Company's stock-based compensation plan been
determined consistent with SFAS No. 123, the Company's pro forma net loss would
have been increased to approximately $91,081,000, $107,735,000 and $114,453,000
for the years ended June 30, 1998, 1999, and 2000.

Pro forma net loss reflects only options granted in 1998, 1999 and 2000.
Therefore, the full impact of calculating compensation cost for stock options
under SFAS No. 123 is not reflected in the pro forma net loss amounts presented
above because compensation cost is reflected over the options' vesting period of
five years and compensation cost for options granted prior to July 31, 1996, is
not considered.

The fair value of each option is estimated on the date of grant using the
minimum value method with the following weighted-average assumptions:

<TABLE>
<CAPTION>
Years ended June 30,
---------------------------------------------
1998 1999 2000
------------- ------------- -------------
<S> <C> <C> <C>
Expected life..................................... 3.18 years 3.18 years 3.50 years
Risk-free interest rate........................... 5.64% 4.99% 5.77%
</TABLE>

-53-
<PAGE>

DIVA SYSTEMS CORPORATION AND SUBSIDIARIES

Notes to Consolidated Financial Statements

June 30, 1999 and 2000

A summary of the status of the Company's common stock option plans follows:

<TABLE>
<CAPTION>
1998 1999 2000
----------------------- ----------------------- -----------------------
Weighted- Weighted- Weighted-
average average average
exercise exercise exercise
Shares price Shares price Shares price
---------- ----------- ---------- ----------- ---------- -----------
<S> <C> <C> <C> <C> <C> <C>
Outstanding at
beginning of year 3,118,500 $ 0.52 5,200,260 $ 1.13 7,875,745 $ 2.30
Granted 2,903,150 1.63 4,044,695 3.58 2,182,605 3.49
Exercised (565,050) 0.47 (278,120) 1.10 (1,171,215) 1.33
Canceled (256,340) 0.91 (1,091,090) 1.74 (971,214) 2.19
---------- ---------- ----------

Outstanding at
end of year 5,200,260 1.13 7,875,745 2.30 7,915,921 2.79
========== ========== ==========
Options exercisable
at end of year 1,135,868 0.63 2,051,175 1.23 2,616,184 2.13
========== ========== ==========
Weighted-average fair
value of options
granted during the
year at market 0.22 0.54 0.71
</TABLE>

The following table summarizes information about common stock options
outstanding as of June 30, 2000:

<TABLE>
<CAPTION>
Outstanding Exercisable
----------------------------------------------------------- --------------------------------------
Weighted-average
remaining
Number contractual life Weighted average Number Weighted-average
Exercise Prices Outstanding (years) exercise price exercisable exercise price
-------------------- --------------- ------------------- ------------------ ---------------- ----------------
<S> <C> <C> <C> <C> <C>
$0.05 - $1.25 2,029,300 6.69 $ 0.80 1,174,140 $ 0.73
2.40 - 3.35 5,015,201 8.67 3.15 1,287,169 2.98
4.50 - 8.00 871,420 9.03 5.30 154,875 5.63
--------- ---------
0.05 - 8.00 7,915,921 8.20 $ 2.79 2,616,184 $ 2.13
--------- ---------
</TABLE>

(9) Commitments and Contingencies

(a) Leases

The Company leases its facilities under operating leases. The future
minimum lease payments pursuant to these leases are as follows (in thousands):

Year Ending June 30,
-------------------
2001 $ 3,044
2002 2,636
2003 2,560
2004 2,631
2005 and thereafter 8,143

-54-
<PAGE>

DIVA SYSTEMS CORPORATION AND SUBSIDIARIES

Notes to Consolidated Financial Statements

June 30, 1999 and 2000

Total rent expense for the years ended June 30, 1998, 1999, and 2000 was
$597,000, $1,593,000 and $3,921,000, respectively.

(b) Litigation

The Company is a party to certain claims arising out of the normal conduct
of its business. While the ultimate resolution of such claims against the
Company cannot be predicted with certainty, management expects that these
matters will not have a material adverse effect on the consolidated financial
position, results of operations, or cash flows of the Company.

(10) Segment Information

The Company has adopted the provisions of SFAS No. 131, Disclosure About
Segments of an Enterprise and Related Information. SFAS 131 establishes
standards for the reporting by public business enterprises of information about
operating segments, products and services, geographic areas, and major
customers. The method for determining what information to report is based on the
way that management organizes the operating segments within the Company for
making operating decisions and assessing financial performance.

The Company's chief operating decision-maker is considered to be the
Company's Chief Executive Officer. The CEO reviews financial information
presented on a consolidated basis accompanied by disaggregated information about
revenue by geographic region for purposes of making operating decisions and
assessing financial performance. The consolidated financial information reviewed
by the CEO is identical to the information presented in the accompanying
consolidated statement of operations. Therefore, the Company has one reportable
segment.

As of June 30, 2000 essentially all of the Company's assets were located in
the United States, and all of its revenues were generated in the United States.

(11) Quarterly Data (unaudited) (in thousands, except per share amounts):

<TABLE>
<CAPTION>
2000 1/st/ Quarter 2/nd/ Quarter 3/rd/ Quarter 4/th/ Quarter
---- ------------- ------------- ------------- -------------
<S> <C> <C> <C> <C>
Revenue $ 68 $ 1,047 $ 584 $ 258
Net operating loss 15,908 17,259 22,937 25,250
Net loss attributable
to common stockholders 23,661 25,528 35,566 46,446
Net loss per share $ 1.36 $ 1.44 $ 1.95 $ 2.51

<CAPTION>
1999 1/st/ Quarter 2/nd/ Quarter 3/rd/ Quarter 4/th/ Quarter
---- ------------- ------------- ------------- -------------
<S> <C> <C> <C> <C>
Revenue $ 63 $ 57 $ 107 $ 66
Net operating loss 15,436 17,823 21,006 27,677
Net loss attributable
to common stockholders 21,168 24,030 27,924 35,111
Net loss per share $ 1.24 $ 1.40 $ 1.62 $ 2.03
</TABLE>

-55-
<PAGE>

Item 9. Changes in and Disagreements with Accountants on Accounting and
Financial Disclosure None.

-56-
<PAGE>

PART III

Item 10. Directors and Executive Officers of the Registrant

Set forth below are the names, ages, and positions of our directors and
executive officers as of September 15, 2000. All directors hold office until
their successors are duly elected and qualified and all executive officers hold
office at the pleasure of the Board of Directors.

<TABLE>
<CAPTION>
Name Age Position
--------------------------- ---- -------------------------------------------------
<S> <C> <C>
Paul M. Cook 76 Chairman of the Board
Hendrik A. Hanselaar 54 President and Chief Executive Officer
Christopher W. Goode 48 Executive Vice President, Development and Chief Technology Officer
F. Ray McDevitt 56 Executive Vice President, Business Development and Product Management
Tim N. Rea 45 Executive Vice President, Operations and Chief Operating Officer
Stephanie A. Storms 50 Senior Vice President, General Counsel and Secretary
William M. Scharninghausen 44 Senior Vice President, Finance and Administration, and Chief Financial Officer
Alan H. Bushell 53 Director
John W. Goddard (1) 59 Director
Jules Haimovitz (2) 49 Director
John A. Rollwagen (1)(2) 60 Director
David F. Zucker 38 Director
Barry E. Taylor 52 Director and Assistant Secretary
</TABLE>

(1) Member of our compensation committee
(2) Member of our audit committee

Paul M. Cook has served as our Chairman of the Board since he founded DIVA
in 1995. He was the Chief Executive Officer until February 1999. Mr. Cook
founded Raychem Corporation, a Fortune 500 industrial company, in 1957 and
served as Chief Executive Officer for 33 years before retiring in 1990. Mr. Cook
was Chairman of the board of SRI, a contract research firm, from December 1993
to July 1998 and has served as a member of its board of directors from 1987 to
1999. Mr. Cook is also Chairman of Sarnoff Corporation, a subsidiary of SRI. He
served on its board of directors until 1996.

Hendrik A. Hanselaar has served as our President and Chief Executive
Officer and as a director since September 2000. Prior to joining us, Mr.
Hanselaar served as Managing Partner at Hamilton Technology Ventures LLC and led
a strategic planning and development practice for broadband communications
companies including DIVA. From 1997 to 1998, Mr. Hanselaar served as Chief
Executive Officer of FUBA Communications Systems GmbH, a leading German supplier
of cable headend and transmission equipment acquired by General Instrument in
1998 and which is now a unit of Motorola. From 1991 to 1996, Mr. Hanselaar
served as Chief Executive Officer and director of TV/COM International, a major
global provider of digital broadband communications systems. From 1987 through
1991, Mr. Hanselaar was Senior Vice President of General Atomics, a San Diego
based super-computer firm. Additionally, Mr. Hanselaar's experience includes
sales, marketing and finance positions with NV Phillips and Citibank N.A. in
both Europe and the United States.

Christopher W. Goode has served as our Executive Vice President,
Development since April 1999 and Chief Technology Officer since July 1997. From
July 1997 to April 1999, Mr. Goode served as Senior Vice President, Engineering
and from October 1995 to July 1997 as Vice President, Development. Prior to
joining us, he was Executive Vice President, Research and Development at Raynet
Corporation, a developer of fiber-to-the-curb networks. Prior to joining Raynet,
Mr. Goode held senior technical positions at Alcatel and ITT Corporation over a
16-year period.

F. Ray McDevitt has served as our Executive Vice President, Business
Development and Product Management since April 1999. From July 1997 to April
1999, Mr. McDevitt served as Senior Vice President, Marketing and Product
Management and from September 1995 to July 1997 as Vice President, Marketing and
Product Management. From December 1992 to September 1995, Mr. McDevitt held
various positions at Ericsson Raynet, a joint venture between Ericsson and
Raychem, including Vice President of Product Line Management and Marketing and
Vice President of Broadband Research. Prior to joining Ericsson Raynet, Mr.
McDevitt served as Director of Broadband Development at Alcatel.

Tim N. Rea has served as our Executive Vice President, Operations and Chief
Operating Officer since April 1999. From July 1997 to April 1999, Mr. Rea served
as Senior Vice President, Operations, and from August 1996 to July 1997, he
served as Vice President, Operations. Prior to joining us, from December 1981 to
July 1996, Mr. Rea served in various marketing, operations and general
management positions with Viacom Cable, a large cable operator, most recently as
Senior Vice President/General Manager for Viacom's Northwest region.

-57-
<PAGE>

Stephanie A. Storms has served as our Senior Vice President, General
Counsel since July 1999, and Secretary since March 1998. From December 1996 to
July 1999, Ms. Storms served as Vice President, General Counsel. Prior to
joining DIVA, she was Deputy General Counsel of Viacom, Inc. and Vice President
of Viacom Cable, a division of Viacom, Inc. Ms. Storms held positions with
various cable industry trade groups in conjunction with her employment with
Viacom; she served on the board of directors of the California Cable Television
Association and the legal committee of the National Cable Television
Association. Prior to joining Viacom Cable in 1987, Ms. Storms was Vice
President and Assistant General Counsel of American Television and
Communications Corp., the cable television subsidiary of Time Inc. Prior to
that, Ms. Storms was an attorney with the law firm of Adams, Duque & Hazeltine
in Los Angeles, California.

William M. Scharninghausen has served as our Senior Vice President, Finance
and Administration since April 2000 and has served as Chief Financial Officer
since January 1999. From June 1997 to April 2000, Mr. Scharninghausen served as
our Vice President, Finance and Administration. Prior to joining DIVA, he was
Corporate Controller and Chief Accounting Officer of StarSight Telecast, Inc., a
developer of interactive television guides, from 1993 to June 1997. Prior to
joining StarSight Telecast, Mr. Scharninghausen held various finance and
accounting positions with Lucas Film Ltd./LucasArts Entertainment Company, Orion
Pictures Corporation and Twentieth Century Fox Film Corporation. Mr.
Scharninghausen is a certified public accountant.

Alan H. Bushell, who was a founder with Mr. Cook in 1995, has served as a
director since that time and served as President, Chief Operating Officer and
Chief Financial Officer until December 1998. Prior to 1995, Mr. Bushell served
as Senior Vice President, Chief Operating Officer and Chief Financial Officer of
CellNet Data Systems, a provider of wireless data networks for utilities. Prior
to joining CellNet, Mr. Bushell held various management positions with private
and public technology-based companies, including President of Advanced Polymer
Systems, Inc., Vice President of Operations at Everex Systems, Inc., President
of Zymogenetics Inc. and various strategic planning and product management
positions with Raychem. During the 1970s, he was also a consultant in the
Amsterdam office of McKinsey & Co.

John W. Goddard has served as a director since January 1997. From 1980 to
July 1996, he held the positions of President and Chief Executive Officer of
Viacom Cable, a division of Viacom, Inc. From 1966 to 1980, Mr. Goddard held
various management positions at Tele-Vue Systems, Viacom Cable's predecessor,
and then at Viacom Cable. Mr. Goddard has held various cable television industry
positions as an officer, including Chairman of the National Cable Television
Association and President of the California Cable Television Association, and
currently serves as a director of CableLabs, TCI Satellite Entertainment, Inc.,
Phoenix Star, Inc., Bend Cable Communications and the Walter Kaitz Foundation.

Jules Haimovitz has served as a director since December 1996 and has served
as President of MGM Networks, Inc. since June 1999. Mr. Haimovitz was employed
by us as an Executive Vice President from December 1996 to July 1997, and again
from August 1998 to March 1999. From June 1997 to July 1998, Mr. Haimovitz
served as President and Chief Operating Officer of King World Productions. Prior
to that he was President and Chief Executive Officer of ITC Entertainment Group.
Mr. Haimovitz has served on the board of directors of Video Jukebox Network and
Orion Pictures Corporation. From 1987 to 1992, Mr. Haimovitz served as President
and Chief Operating Officer of Spelling Entertainment Inc. and a member of its
board of directors. From 1976 to 1987, Mr. Haimovitz served in various senior
executive positions with Viacom, Inc.

John A. Rollwagen has served as a director since December 1995. He was
Chairman of SRTC prior to its acquisition by us in 1998. Mr. Rollwagen is an
investor and business advisor specializing in information technology. He is
currently a principal at Quatris Fund, a venture capital fund targeting early
stage IT companies. Mr. Rollwagen also served as a venture partner of St. Paul
Venture Capital, LLC from 1993 to 1999. From 1981 to 1993, Mr. Rollwagen served
as Chairman and Chief Executive Officer of Cray Research, Inc., a supplier of
supercomputers worldwide. From 1977 to 1981, Mr. Rollwagen served as Cray
Research's President. Mr. Rollwagen currently serves as a director of Computer
Network Technology, Inc., Sarnoff Corporation and Lexar Media, Inc.

David F. Zucker served as a director since February 1999, and serves as the
Chief Executive Officer of a new operating unit of Walker Digital, a privately
held invention and commercialization company that created the Priceline.com
internet pricing system. Mr. Zucker was our President and Chief Executive
Officer from February 1999 to September 2000. Prior to joining us, Mr. Zucker
served in a number of senior management positions with The Walt Disney Company
and its subsidiaries. He served as Executive Vice President of ESPN and Managing
Director, ESPN International from August 1998 to January 1999. From December
1995 to August 1998, Mr. Zucker served as Senior Vice President and General
Manager, ESPN International, and from September 1994 as Senior Vice President of
ESPN International. Prior

-58-
<PAGE>

to 1994, Mr. Zucker served as ESPN's Vice President, Programming for two years.
Before joining ESPN, Mr. Zucker served in a number of management positions
within Capital Cities/ABC, Inc.

Barry E. Taylor has served as a director since July 1995. Mr. Taylor has
been a member of the law firm of Wilson Sonsini Goodrich & Rosati, P.C., Palo
Alto, California, since 1984. In October 2000, Mr. Taylor will be joining E.M.
Warburg Pincus & Co., a venture capital and private equity firm, as Managing
Director in their Silicon Valley office.

In connection with its recent investment in our Company, we have agreed to
appoint a representative of Charter Communications to our Board Directors.

Board of Directors

Our Board of Directors currently consists of eight members. Each director
holds office until their term expires or until their successor is duly elected
and qualified. Effective upon an initial public offering of our common stock,
our certificate of incorporation and bylaws provides for the division of
our board of directors into three classes, each class being as nearly equal in
number as possible, with the directors in each class serving for a three-year
term, and one class being elected each year by our stockholders at the annual
shareholders' meeting.

Director Compensation

Except for grants of stock options, our directors generally do not receive
compensation for services provided as a director, for committee participation or
for special assignment of the Board of Directors. We reimburse expenses incurred
in attending board and committee meetings.

-59-
<PAGE>

Item 11. Executive Compensation

The following table sets forth, for the three fiscal years ended June 30,
2000, the compensation earned, awarded, or paid to our former Chief Executive
Officer and the four other most highly compensated executive officers who were
serving as executive officers as of June 30, 2000 who earned more than $100,000
in salary and bounues during the fiscal year ended June 30, 2000, whom we refer
to collectively, as the named executive officers.

Summary Compensation Table

<TABLE>
<CAPTION>
Long-Term
Compensation
Annual Compensation Awards
Fiscal ------------------------- ---------------------------------
Name and Principal Position Year Salary ($) Bonus ($) Underlying Securities Options (1)
---------------------------------------------------- ---------- ---------- ----------- ---------------------------------
<S> <C> <C> <C> <C>
David Zucker (2).................................... 2000 350,000 721,000 --
Former President and Chief Executive Officer 1999 129,397 850,000 1,800,000
1998 -- -- --

Christopher W. Goode................................ 2000 256,415 -- 20,000
Executive Vice President, Development, and Chief 1999 229,061 -- 48,900
Technology Officer 1998 199,168 -- 32,400

Timothy N. Rea...................................... 2000 250,000 -- 20,000
Executive Vice President, Operations and Chief 1999 222,282 -- 108,000
Operating Officer 1998 183,958 -- --

Fred R. McDevitt.................................... 2000 245,509 -- 18,000
Executive Vice President, Business Development and 1999 223,836 -- 58,900
Product Management 1998 199,375 -- 22,400

Stephanie A. Storms................................. 2000 206,249 -- 43,000
Senior Vice President, General Counsel and Secretary 1999 236,952 -- 9,300
1998 222,242 -- 11,200
</TABLE>

(1) No SARs were granted during the fiscal year.
(2) Mr. Zucker resigned as President and Chief Executive Officer effective
September 29, 2000.

Option Grants in Last Fiscal Year

The following table shows information regarding stock options granted to
the named executive officers during the fiscal year ended June, 30 2000.

Percent of
Number of Total Options/ Potential Realizable Value at
Securities SARs Granted Assumed Annual Rates of
Underlying To Employees Exercise or Stock Price Appreciation
Options/SARs In Fiscal Base Price Expiration For Option Term($)(3)
---------------------------
Name Granted (#)(1) Year(2) ($/sh) Date 5% 10%
---------------------------- -------------- ------------- -------------- ------------- ------------ ------------
<S> <C> <C> <C> <C> <C> <C>
Stephanie A. Storms 30,000 1.4% 3.35 7/14/09 63,204 160,171
Stephanie A. Storms 13,000 * 3.35 9/29/09 27,388 69,407
Christopher W. Goode 20,000 * 3.35 9/29/09 42,136 106,781
F. Ray McDevitt 18,000 * 3.35 9/29/09 37,922 96,103
Timothy N. Rea 20,000 * 3.35 9/29/09 42,136 106,781
</TABLE>

_____________________

* Less than 1%
(1) Options granted under the 1995 Stock Plan generally become exercisable at a
rate of 10% of the shares subject to the option at the end of the first six
months and 5% of the shares subject to the option at the end of each
three-month period thereafter, so long as the individual is employed by us.
(2) We granted options to purchase 2,182,605 shares of common stock during
fiscal year 2000.

-60-
<PAGE>

(3) Potential realizable value is based on the assumption that the price of our
common stock appreciates at the annual rate shown, compounded annually,
from the date of grant until the end of the option term. The values are
calculated in accordance with rules promulgated by the Securities and
Exchange Commission and do not reflect our estimate of future stock price
appreciation.

Aggregated Option Exercises in Fiscal Year 2000 and Fiscal Year-End Option
Values

The following table sets forth for the named executive officers'
exercisable and unexercisable options held by them as of June 30, 2000. All
options granted to these executive officers in the last fiscal year were granted
under our 1995 Stock Plan, as amended. All options were granted at a fair market
value as determined by our Board of Directors on the date of grant.

The value of unexercised in-the-money options is based on a price of $4.50
per share, the fair market value of our common stock on June 30, 2000, as
determined by our Board of Directors, minus the per share exercise price,
multiplied by the number of shares underlying the option.

Number of Securities Value of Unexercised
Shares Underlying Options/SARs In-the-Money Options/SARs
Acquired Value At Fiscal Year-End (#) At Fiscal Year-End ($)(1)
Name on Exercise (#) Realized ($) (1) Exercisable Unexercisable Exercisable Unexercisable
--------------------------- --------------- ---------------- ----------- ------------- ----------- -------------
<S> <C> <C> <C> <C> <C> <C>
David F. Zucker - - 450,000 1,350,000 345,000 1,035,000
Christopher W. Goode - - 148,935 82,365 564,369 155,585
Timothy N. Rea 40,514 148,605 912 63,274 1,048 75,540
Ray F. McDevitt 20,000 67,000 136,635 80,665 514,986 152,418
Stephanie A. Storms - - 80,865 82,635 284,032 202,802
</TABLE>
_______________________

(1) Based on the fair market value of our common stock at the time of exercise
less the exercise price payable for such shares.

Employment Agreements and Change-In-Control Arrangements

Pursuant to a written employment agreement with David Zucker, Mr. Zucker
was employed as President and Chief Executive Officer at a salary of $350,000
per year, subject to periodic increases by our Board of Directors. Mr. Zucker
also received an $850,000 acceptance bonus in connection with his initial
employment. Mr. Zucker announced that he resigned as President and Chief
Executive Officer effective September 29, 2000. Mr. Zucker was granted an option
to purchase 600,000 shares of our common stock at an exercise price of $3.35 per
share, which we refer to as the First Option, an additional option to purchase
600,000 shares of our common stock at an exercise price of $3.35 per share, an
option to purchase 400,000 shares of our common stock at an exercise price of
$4.50 per share and an option to purchase 200,000 shares of our common stock at
an exercise price of $8.00 per share, which options vest over a five-year period
from the date of initial employment. Mr. Zucker is entitled to return the First
Option in exchange for a lump sum payment of $960,000 beginning on the first
anniversary of the commencement of his employment.

Options granted under our 1995 Stock Plan provide that in the event of a
change of control, as defined in the underlying option agreement, the options
are accelerated and become fully exercisable six months after the change of
control or earlier in the event the optionee's employment is involuntarily
terminated without cause or the option is not assumed.

-61-
<PAGE>

Compensation Committee Interlocks and Insider Participation

The compensation committee consists of two outside directors, John W.
Goddard and John A. Rollwagen. The compensation committee reviews and recommends
to the Board of Directors the salaries incentive compensation and benefits of
our officers and administers our stock plans. Neither of the members of the
compensation committee is currently, or has ever been at any time since our
formation, one of our officers or employees, nor has served as a member of the
Board of Directors or compensation committee of any entity that has one or more
officers serving as a member of our Board of Directors or compensation
committee.

Incentive Stock Plans

1995 Stock Plan

Our 1995 Stock Plan has been approved by our Board of Directors and
stockholders. The 1995 Stock Plan provides for the granting to employees
(including officers) of qualified "incentive stock options" within the meaning
of Section 422 of the Code, and for the granting to employees (including
officers and directors) and consultants of nonqualified stock options. The 1995
Stock Plan also provides for the granting of restricted stock. As of June 30,
2000, options to purchase an aggregate of 5,743,945 shares were outstanding and
604,308 shares remained available for future grants.

The 1995 Stock Plan is administered by our Board of Directors or a
committee appointed by the Board. Options granted generally vest at a rate of
10% of the shares subject to the option at the end of the first six months and
5% of the shares subject to the option at the end of each three-month period
thereafter and generally expire ten years from the date of grant. Options
granted to outside directors vest at the rate of 25% of the shares at the end of
the first year and 6.25% of the shares at the end of each quarter thereafter.
Options granted to outside directors and certain other employees are immediately
exercisable, subject to a repurchase right held by DIVA that lapses in
accordance with the vesting schedule of the options.

In the event of a merger of DIVA with or into another corporation or the
sale of substantially all of our assets, all outstanding options shall be
assumed or an equivalent option substituted by the successor corporation. In the
event a successor corporation refuses to assume or substitute for the options,
the exercisability of shares subject to options under the 1995 Stock Plan shall
be accelerated. In such event, we will notify the holders of outstanding options
that such options are fully exercisable, and all options not exercised will then
terminate 15 days after the date of such notice. See "Employment Agreements
and Change-in-Control Arrangements."

1998 Stock Plan

In April 1998, in connection with the acquisition of SRTC, we assumed the
SRTC 1998 Stock Plan and reserved 380,767 shares of our common stock for
issuance through incentive stock options and nonstatutory stock options granted
pursuant to the 1998 Stock Plan to employees, directors, and consultants who
formerly worked for SRTC. In April 1998, all options under the 1998 Stock Plan
were granted at an exercise price of $2.40. As of June 30, 2000, options to
purchase 291,976 shares of common stock remained outstanding under the 1998
Stock Plan. The terms of the 1998 Stock Plan are substantially identical to the
terms of the 1995 Stock Plan.

In addition, in connection with the acquisition of SRTC, all options to
purchase shares of SRTC capital stock were assumed and converted into options to
purchase shares of DIVA capital stock. As of June 30, 2000, options to purchase
102,016 shares of Series AA preferred stock at a weighted average exercise price
of $0.34 remained outstanding.

-62-
<PAGE>

Item 12. Security Ownership of Certain Beneficial Owners and Management

The following table sets forth certain information regarding beneficial
ownership of our common and preferred stock as of June 30, 2000 by (i) each of
our directors, (ii) each of our named executive officers, (iii) each person who
beneficially owns more than 5% of our common stock or preferred stock and (iv)
all directors and executive officers as a group.

<TABLE>
<CAPTION>
Percent
Number of Percent Number of Percent Ownership
Shares of Ownership Shares of Ownership Of Total
Common Of Common Preferred Of Preferred Voting
Beneficial Owner Stock(1) Stock(2) Stock Stock(2) Stock(2)
------------------------------------------------ ------------- ------------- ------------ ------------- -----------
<S> <C> <C> <C> <C> <C>
Paul M. Cook(3)................................. 7,170,967 38.0% 1,406,120 5.6% 19.5%
800 Saginaw Drive
Redwood City, CA 94063

Acorn Ventures, Inc.(4)......................... 2,455,417 13.0% 2,896,982 11.6% 12.2%
1309 114th Avenue, S.E.
Suite 200
Bellevue, WA 98004

Merrill Lynch Global Allocation Fund, Inc....... -- -- 4,000,000 16.3% 9.3%
800 Scudder's Mill Road
Plainsboro, NJ 08530

Putnam Funds and Accounts(5).................... 1,612,616 8.0% 2,568,582 10.5% 9.3%
One Post Office Square
Boston, MA 02109

Chris Larson.................................... -- -- 3,300,000 13.5% 7.7%
655 So. Orcas St., Suite #210
Seattle, WA 98108

SRI(6).......................................... 2,413,084 13.5% -- -- 5.6%
333 Ravenswood Avenue
Menlo Park, CA 94025

Alan H. Bushell(7).............................. 1,533,750 8.2% 24,000 * 3.6%

Jules Haimovitz(8).............................. 139,642 * 450,000 1.8% 1.4%

David Zucker(9)................................. 510,000 2.7% -- -- 1.2%

John A. Rollwagen(10)........................... 210,552 1.0% 254,966 1.1% 1.1%

Timothy N. Rea (11)............................. 217,126 1.2% -- -- *

Christopher W. Goode(12)........................ 210,935 1.1% -- -- *

Ray F. McDevitt(13)............................. 208,635 1.1% -- -- *

Barry E. Taylor(14)............................. 82,000 * 17,070 * *

Stephanie A. Storms(15)......................... 87,365 * -- -- *

John W. Goddard(16)............................. 28,000 * -- -- *
</TABLE>

-63-
<PAGE>

<TABLE>
<CAPTION>
Percent
Number of Percent Number of Percent Ownership
Shares of Ownership Shares of Ownership Of Total
Common Of Common Preferred Of Preferred Voting
Beneficial Owner Stock(1) Stock(2) Stock Stock(2) Stock(2)
------------------------------------------------ ------------- ------------- ------------ ------------- -----------
<S> <C> <C> <C> <C> <C>
All directors and executive officers as a
Group (11 persons)(15) ......................... 10,398,972 52.5% 2,152,156 8.5% 27.7%
</TABLE>

___________________________
* Less than 1%.

(1) Does not include shares of common stock issuable upon conversion of
preferred stock.

(2) Based on 18,615,618 shares of common stock and 24,495,463 shares of
preferred stock outstanding as of June 30, 2000. Beneficial ownership is
determined in accordance with the rules of the Securities and Exchange
Commission. In computing the number of shares beneficially owned by a
person and the percentage ownership of that person, shares of common stock
subject to options or warrants held by that person that are currently
exercisable or exercisable within 60 days of June 30, 2000 are deemed
outstanding. Such shares, however, are not deemed outstanding for the
purposes of computing the percentage ownership of each other person. Except
as indicated in the footnotes to this table and pursuant to applicable
community property laws, the stockholder named in the table has sole voting
and investment power with respect to the shares set forth opposite such
stockholder's name.

(3) Includes (i) 6,926,700 shares of common stock beneficially owned by the
Paul and Marcia Cook Living Trust dated April 12, 1992 (the "Cook Trust"),
112,800 of which can be repurchased at cost, which rights lapse based on
continued performance of services; (ii) 140,000 shares of common stock
beneficially owned by two trusts of which Mr. Cook is trustee; (iii)
warrants to purchase 235,517 shares of common stock exercisable within 60
days of June 30, 2000; (iv) warrants to purchase 523,792 shares of Series B
preferred stock held by the Cook Trust and exercisable within 60 days of
June 30, 2000; and (v) options to purchase 8,750 shares of common stock
exercisable within 60 days of June 30, 2000.

(4) Includes (i) warrants to purchase 235,517 shares of common stock
exercisable within 60 days of June 30, 2000; (ii) warrants to purchase
521,778 shares of Series B preferred stock exercisable within 60 days of
June 30, 2000; and (iii) options to purchase 27,500 shares of common stock
exercisable within 60 days of June 30, 2000.

(5) Includes 1,006,330 shares of Series C preferred stock and 1,562,252 shares
of Series D preferred stock held by funds or accounts managed by Putnam
Investment Management, Inc., the Putnam Advisory Company, Inc., and Putnam
Fidelity Trust Company. Voting and dispositive power is shares between each
such fund or account and its respective advisor. Also includes warrants to
purchase 1,612,616 shares of common stock exercisable within 60 days of
June 30, 2000.

(6) Includes 413,084 shares of common stock and 1,998,851 shares of preferred
stock held by Sarnoff Corporation, a wholly-owned subsidiary of SRI.

(7) Includes (i) 54,000 shares of common stock that we can repurchase at cost,
which rights lapse based on continued performance of services; and (ii)
options to purchase 53,750 shares of common stock exercisable within 60
days of June 30, 2000. The shares are held on record by a trust for the
benefit of Mr. Bushell.

(8) Includes (i) warrants to purchase 450,000 shares of Series C preferred
stock exercisable within 60 days of June 30, 2000; and (ii) options to
purchase 11,250 shares of common stock exercisable within 60 days of June
30, 2000.

(9) Includes options to purchase 60,000 shares of common stock exercisable
within 60 days of June 30, 2000.

(10) Includes (i) 125,472 shares of Series B preferred stock held in the name of
Norwest Bank Minnesota, N.A., as trustees of the John A. Rollwagen Self-
Directed IRA; (ii) 10,500 shares of common stock that we can repurchase at
cost, which rights lapse based on continued performance of services.

(11) Includes options to purchase 912 shares of common stock exercisable within
60 days of June 30, 2000.

(12) Includes options to purchase 150,935 shares of common stock exercisable
within 60 days of June 30, 2000.

(13) Includes options to purchase 138,635 shares of common stock exercisable
within 60 days of June 30, 2000.

(14) Includes (i) 6,000 shares of common stock held by Mr. Taylor that we can
repurchase at cost, which rights lapse based on continued performance of
services by Mr. Taylor; (ii) 75,200 shares of common stock, 1,000 shares of
Series A preferred stock and 11,700 shares of Series B preferred stock held
by an investment partnership of which Mr. Taylor is a general partner and
with which he shares beneficial ownership; and (iii) 4,370 shares of Series
D preferred stock held in the name of Trustee, WSGR Retirement Plan FBO
Barry E. Taylor.

(15) Includes options to purchase 87,365 shares of common stock exercisable
within 60 days of June 30, 2000.

(16) Includes (i) warrants to purchase 2,500 shares of common stock exercisable
within 60 days of June 30, 2000; and (ii) options to purchase 1,500 shares
of common stock exercisable within 60 days of June 30, 2000.

(17) Includes (i) warrants to purchase 238,017 shares of common stock
exercisable within 60 days of June 30, 2000; (ii) warrants to purchase
523,792 shares of Series B preferred stock exercisable within 60 days of
June 30, 2000; (iii) warrants to purchase 450,000 shares of Series C
preferred stock exercisable within 60 days of June 30, 2000; and (iv)
options to purchase 963,097 shares of common stock exercisable within 60
days of June 30, 2000.

Item 13. Certain Relationships and Related Party Transactions

None.

-64-
<PAGE>

PART IV

Item 14. Exhibits, Financial Statement Schedules, and Reports on Form 8-K

(a) The following documents are filed as a part of this Report.

1. Financial Statements and Financial Statement Schedules.

See Index to Financial Statements at Item 8 on page 31 of this
report.

2. Exhibits

Exhibit
Number Description
--------- ---------------------------------------------------------------
3.1 Amended and Restated Certificate of Incorporation. (1)
3.2 Amended and Restated Bylaws. (1)
4.1 Indenture dated as of February 19, 1998 between the Company and
The Bank of New York, including form of Senior Discount Note
Due 2008. (1)
4.2 Specimen 12-5/8% Senior Discount Note Due 2008, Series B (1)
10.1* Form of Indemnification Agreement entered into between the
Company and all executive officers and directors. (1)
10.2* Employment Agreement dated as of January 16, 1999 between the
Company and David Zucker. (2)
10.3* 1995 Stock Plan and forms of agreements used thereunder. (1)
10.4 Registration Rights Agreement dated as of February 19, 1998
among the Company and the Initial Purchasers. (1)
10.5 Warrant Agreement dated as of February 19, 1998 between the
Company and The Bank of New York. (1)
10.6 Warrant Registration Rights Agreement dated as of February 19,
1998 among the Company and the Initial Purchasers. (1)
10.7 Warrant Registration Rights Agreement dated as of May 15, 1996,
as amended, by and among the Company, Smith Barney Inc. and
Toronto Dominion Securities (USA) Inc. (1)
10.8 Warrant Agreement dated as of May 15, 1996 between the Company
and The Bank of New York. (1)
10.9 Amended and Restated Stockholders Rights Agreement dated August
23, 2000 among the Company and certain of its stockholders.
10.10 Lease Agreement between Seaport Centre Associates, LLC and the
Company dated January 20, 1999. (3)
10.11 Warrant to purchase 175,000 shares of Series C Preferred Stock
issued to Jules Haimovitz. (4)
10.12 Warrant to purchase 650,000 shares of Common Stock issued to
Jules Haimovitz. (4)
21.1 Subsidiaries of the Company.
24.1 Power of Attorney (included on page II-2)
27.1 Financial Data Schedule

________________________
* Designated management contracts or compensatory plans, contracts or
arrangements required to be filed as exhibits pursuant to Item 14(c) of
Form 10-K
(1) Incorporated by reference our Registration Statement on Form S-4 filed
September 29, 1998, as amended (No. 333-64483)
(2) Incorporated by reference to our Quarterly Report on Form 10-Q for the
quarter ended March 31, 1999.
(3) Incorporated by references to our Quarterly Report on Form 10-Q for the
quarter ended December 31, 1999.
(4) Incorporated by reference to our Annual Report on Form 10-K for the fiscal
year ended Jul 30, 1999.

(b) Reports on Form 8-K.
None.

II-1
<PAGE>

SIGNATURES

Pursuant to the requirements of Section 13 or 15(d) of the Securities
Exchange Act of 1934, the Registrant has duly caused this Report on Form 10-K to
be signed on its behalf by the undersigned, thereunto duly authorized.

Dated: September 28, 2000

DIVA SYSTEMS CORPORATION

By: /s/ William M. Scharninghausen
---------------------------------------
William M. Scharninghausen
Senior Vice President, Finance and
Administration, and Chief
Financial Officer

POWER OF ATTORNEY

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

Pursuant to the requirements of the Securities Act of 1934, this Report on
Form 10-K has been signed below by the following persons on behalf of the
Registrant on the 28th day of September, 2000 in the capacities indicated.

<TABLE>
<CAPTION>
Signature Title
--------- ------
<S> <C>

/s/ Hendrick A. Hansalaar President and Chief Executive Officer (Principal Executive Officer)
------------------------------------------
Hendrick A. Hansalaar

/s/ William M. Scharninghausen Senior Vice President, Finance and Administration, and Chief
------------------------------------------
(William M. Scharninghausen) Financial Officer (Principal Financial and Accounting Officer)

/s/ Paul M. Cook Chairman of the Board and Director
------------------------------------------
(Paul M. Cook)

/s/ Alan H. Bushell Director
------------------------------------------
(Alan H. Bushell)

/s/ John W. Goddard Director
------------------------------------------
(John W. Goddard)

/s/ Jules Haimovitz Director
------------------------------------------
(Jules Haimovitz)

/s/ John A. Rollwagen Director
------------------------------------------
(John A. Rollwagen)

/s/ David F. Zucker Director
------------------------------------------
(David F. Zucker)
</TABLE>

II-2