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UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
Washington, DC 20549
FORM 10-K
Mark One
[X] ANNUAL REPORT PURSUANT TO SECTION 13 OR 15 (d) OF THE SECURITIES
EXCHANGE ACT OF 1934
For the fiscal year ended December 31, 1999
[ ] TRANSITION REPORT PURSUANT TO SECTION 13 OR 15 (d) OF THE SECURITIES
EXCHANGE ACT OF 1934
For the transition period from _______________ to ______________
Commission File Number 000-28294
SILICON GAMING, INC.
(Exact Name of Registrant as Specified in Its Charter)
California 77-0357939
(State or Other Jurisdiction (I.R.S. Employer
of Incorporation or Organization) Identification No.)
2800 W. Bayshore Road, Palo Alto, CA 94303
(Address of Principal Executive Offices) (Zip Code)
(Registrant's Telephone Number, Including Area Code) 650-842-9000
Securities Registered Pursuant to Section 12(b) of the Act:
Title of Class Name of Each Exchange on Which Registered
- -------------- -----------------------------------------
None None
Securities Registered Pursuant to Section 12(g) of the Act:
Common Stock, $.001 par value
Indicate by check mark whether the registrant (1) has filed all reports required
to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during
the preceding 12 months (or for such shorter period that the registrant was
required to file such reports), and (2) has been subject to such filing
requirements for the past 90 days. Yes [X] No [ ].
Indicate by check mark if disclosure of delinquent filers pursuant to Item 405
of Regulation S-K is not contained herein, and will not be contained, to the
best of registrant's knowledge, in definitive proxy or information statements
incorporated by reference in Part III of this Form 10-K or any amendment to this
Form 10-K. [X]
Aggregate market value of the registrant's Common Stock held by non-affiliates
as of February 29, 2000: $5,013,226
Number of shares outstanding of the issuer's Common Stock, $.001 par value, as
of February 29, 2000: 30,949,273
DOCUMENTS INCORPORATED BY REFERENCE:
Portions of the definitive Proxy Statement for the Registrant's Annual Meeting
of Shareholders to be held on May 25, 2000, are incorporated by reference into
Part III of this Form 10-K.
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PART I
ITEM 1: BUSINESS
Silicon Gaming, Inc. ("SGI" or the "Company") is engaged in the design,
development, production, marketing and sale of interactive, software-based
products for the gaming industry. To date it has deployed its product in
video-based slot machines that it has designed and developed for use in casinos
and other gaming establishments. These machines combine a multimedia gaming
platform with the software-based games. The Company believes its products are
more engaging and entertaining than other gaming products currently available
and will, as a result, generate increased gaming revenue per device ("win per
machine") for the casino operator.
The Company's games feature high-quality animation, video clips, digital
sound and a level of visual appeal and interactivity that the Company believes
is not met by the current generation of slot machines. To take advantage of
these features, the Company's initial products were deployed in a product that
featured high resolution video presented across the full surface of a
distinctive, large touchscreen display. The Company is attempting to maximize
the entertainment value offered on the video screen by providing multiple levels
of achievement within certain games so that, through successful play over a
period of time, a player may advance to a bonusing sequence and win additional
jackpots. SGI believes that, by utilizing these features, its products will
encourage longer and more frequent periods of play by existing slot machine
customers and attract new gaming customers who are seeking greater entertainment
value than that offered by the current generation of slot machines. The Company
has also designed its machines with a number of unique player features, such as
play stoppage entertainmentTM. In addition, the product's modular components and
Machine Management SystemTM software provide easy-to-use diagnostics designed to
minimize player inconvenience and machine down time. The Company currently
offers several platforms for its games, including ODYSSEYTM, a multi-game
machine that can play up to six different games on the same machine, QUEST, a
single-game upright machine, and a traditional slant top machine.
The Company was granted product approval for ODYSSEY from the Nevada Gaming
Commission in March 1997, allowing the Company to commence commercial
distribution of its products. The Company typically places machines in casinos
for an evaluation period prior to sale, consistent with industry practice. The
Company sells machines outright to casinos and also places machines in casinos
and receives a predetermined percentage of the net win per machine. The Company
also sells new game titles periodically to existing customers which allows
customers to update their products.
As of December 31, 1999, the Company had 4,050 machines installed in
approximately 200 properties throughout Connecticut, Iowa, Louisiana, Michigan,
Mississippi, Missouri, Nevada, New Mexico, certain Canadian provinces and
Uruguay. Of these machines, 3,702 have been sold outright or placed on a
revenue-sharing basis. After returns, 348 machines remain installed on a trial
basis and the casino operators will be required to purchase the machine
outright, participate in SGI's revenue sharing plan or return the machine to the
Company within a defined trial period.
INDUSTRY BACKGROUND
According to industry sources, casino gaming revenue in the United States
in 1993, 1994, 1995, 1996, 1997 and 1998 was approximately $12.6 billion, $14.0
billion, $18.0 billion, $22.4 billion, $25.8 billion and $28.1 billion,
respectively, and continued growth was forecast for 1999 and 2000. Slot
machines, video gaming machines and similar devices are the dominant source of
gaming revenue for casino operators in most U.S. markets. Slot revenue as a
percentage of total gaming revenue in 1999 was 64 in Nevada and 71 in Atlantic
City. Jurisdictions where gaming has been legalized more recently have reported
similar statistics. For example, in 1999 slot machines accounted for 76 of
casino revenue in Indiana. In addition to constituting the largest portion of
gaming revenue, slot revenue is more profitable than table games for casino
operators, since slot machines require much lower labor costs.
The Company believes that slot machines offer their owners an attractive
return on investment. In 1998, the average win per machine per day, defined as
the average amount of money wagered on a machine less the average jackpot
payoffs, on the Las Vegas Strip was $101. A new slot machine from a major
manufacturer, equipped with player tracking and slot accounting software, costs
approximately $8,000 and generally has a useful life that can exceed five years.
At this price, a new slot machine earning the Las Vegas Strip average would
recoup its purchase price in 79 days. While certain markets have lower average
wins per day than the Las Vegas Strip, many other markets have win per day
figures that are significantly higher. For example, in 1998, Harrahs Marina
Hotel & Casino in Atlantic City reported win per machine per day of $255 and
Harrah's riverboat casino in Joliet, Illinois reported win per machine per day
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of $371. Many of the native American gaming establishments often have daily win
per machine numbers much higher than these levels, as evidenced by the two
native American casinos in Connecticut reporting win per machine per day during
December 1999 of $394.
All casino games offer the same underlying proposition: the opportunity to
win money in varying amounts and with varying frequency, but with the
statistical certainty of losing money to the casino operator over an extended
period of time. With slot machines, the prospect of winning can be varied across
the spectrum from many small jackpots won frequently to one very large jackpot
won very rarely. Players' risk/reward appetites will determine what type of
machine they will want to play, and the nature of the payoffs can be deduced
from the "pay table," a chart that graphically shows how much can be won based
on various outcomes and various amounts of money wagered. Notwithstanding the
differences in jackpot frequency and size, however, all slot machines retain a
net amount of the money wagered through them over time. This amount is referred
to as the "hold" and is generally expressed as a percentage of the amount of
money wagered on a machine, which is called the "handle." The hold percentage in
any given machine is preset by the manufacturer based on specifications from the
casino, subject to legal parameters in some jurisdictions, and may differ from
machine to machine on a casino floor.
The U.S. gaming machine market has traditionally been dominated by
reel-based slot machines. These were broadly introduced in the 1960s, when the
free-spinning reel was made possible by advances in electro-mechanical
circuitry. The free-spinning reel enabled manufacturers to create different
versions of the same product by varying such things as the number of reels, the
number of stops on each reel and the number and variety of payoff combinations.
The 1980s saw the introduction of virtual reel "stepper" technology which
allowed for a greater number of stops, or outcomes, on a reel, enabling casino
operators to offer larger jackpots due to the lower likelihood of their being
hit. Another significant development was the installation of electronic memory
in machines, allowing players to keep an "account" of credits on the machine
consisting of the initial amount inserted plus winnings minus losses. Since the
player did not have to reinsert coins for every pull of the handle, the number
of pulls per hour was increased significantly, and players tended to rewager
much of the amounts won, raising the total win per machine. Except for the
addition of features such as bill acceptors and player tracking systems, the
technology employed by slot machines in the 1970s and 1980s still predominates
in current-generation, reel-based slot machines.
In the 1980s, hardware and software advances allowed for application of
video graphics to gaming devices. Using these techniques, International Game
Technology, Inc. ("IGT") was the first company to introduce video poker. Video
poker offered slot players two important advantages. First, the game is
interactive, since the player has to decide which cards to hold or discard
during the hand. This feature allows the outcome to be influenced somewhat by
the player, an attribute unavailable on reel-based machines. Second, the use of
a video screen allows machine manufacturers to develop more interesting and
attractive graphics than are available on reel-based slot machines. Since the
mid-1990s, a number of slot machine manufacturers have introduced video-based
products that have expanded the capabilities of video-based devices, including
machines that offer the player a choice of up to twelve different games on a
single machine. Now video-based products actually constitute a majority of new
machines sales in the slot machine industry. The Company believes that the
increasing popularity of video poker and multi-game machines suggests that
customers may be receptive to a more complex and interactive slot experience.
In the mid 1980s, a category of slot machine games called "progressives"
was introduced and became very popular. The progressive configuration generally
consists of traditional reel-based machines linked together by a computer
network that allows them to share a common jackpot which is usually much larger
than the jackpot that a single, unlinked machine could support. Progressives now
include video based products as well. Progressive jackpots are typically several
million dollars, and recently have exceeded $35 million. Progressives may be
linked locally within a bank of a few machines, across an entire casino, or
across an entire state. IGT is the dominant competitor in the progressives
market.
Growth in demand for slot machines has historically been driven by the
opening of new casinos, including casinos in jurisdictions where gaming has
recently been legalized. However, in recent years, the number of new
jurisdictions that have legalized gaming has significantly declined; therefore,
demand based on new openings will be largely limited to new projects in existing
markets. Several new projects are under construction or have been announced in
Las Vegas, Atlantic City, on the Gulf Coast and in the Midwest.
While the physical useful life of a slot machine can be up to a decade or
more, casino operators have tended to replace machines on a cycle closer to
every five years. Also, the development of certain new features which offer the
prospect of significantly increased slot earnings, such as the advent of bill
acceptors in the early 1990s, or more recent developments such as tokenization
or cashless operating systems, can encourage operators to replace machines even
more rapidly.
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STRATEGY
Although the gaming industry as a whole has enjoyed significant growth over
the past decade, the Company believes that there has been very little growth in
the slot machine manufacturing segment. The Company believes that most of the
growth and new investment in the gaming industry over this period has come from
the investment made in assets such as large hotels and themed attractions, or
from the consolidation of property ownership, and that comparatively little has
been invested in further developing the actual casino games which, in the
aggregate, account for a majority of the average casino's revenue and profits.
In contrast, SGI has focused its resources primarily on developing what it
believes will be more rewarding and entertaining casino games. It has also
developed what it believes to be a new generation of interactive slot machines
on which to run its games. Since its inception, in addition to its game
development, the Company has developed and refined a gaming platform that takes
advantage of personal computer-based technology to offer a more visually
appealing and complex gaming experience. The Company believes that its games and
its machines will encourage casino patrons to play more frequently and for
longer periods of time and will also attract new gaming customers, particularly
younger patrons who typically are not attracted to current generation slot
machines. The Company believes that, as a result, its machines will outperform
most existing machines in win per machine and thus motivate casino operators to
supplement or replace existing slot machines with SGI products.
The market for slot machines has become increasingly competitive since the
Company was formed, and the number of new game and product introductions has
increased significantly from historical levels. The proliferation of new product
offerings has benefitted casino operators who are able to leverage their
position with slot machine manufacturers and who have demanded higher levels of
perfomance from new products. The casino operators are willing to try new
products or new games for existing products that offer the prospect of higher
win per machine per day. At the same time, operators are also much quicker to
remove or replace a slot machine whose performance is less than that of other
competing products. Casino operators have also been able to benefit from the
level of competition to keep the average selling price of new slot machines from
increasing significantly, despite the higher cost and complexity of
new-generation products. As a result, the slot machine manufacturing industry
can now be characterized by high competition and low levels of profitability.
Certain slot machine manufacturers have responded to this pressure from the
casino operators by placing machines in casinos and participating in the revenue
stream generated from the product, either by participating in the net win per
machine or in the gross amount wagered on the machine. This has allowed
manufacturers to achieve a higher revenue per machine than an outright sale to
the casino operator. Casino operators are increasingly reluctant to place
machines in their casinos on a participation basis in the belief that this
represents a profit shift from the casino operator to the manufacturer.
Manufacturers have responded by selling their newest and most successful games,
or games that they think will be highly successful, on a participation basis
only. Casino operators have only tolerated this where the game is highly
successful, as the net win to the casino is still attractive. This has also
contributed to the casino operators' willingness to remove non-performing slot
machines from their floors.
The Company believes that it is uniquely placed among slot machine
manufacturers because of the potential to leverage the technology that is
inherent in its products. The Company believes its products and platforms are
significantly more complex than competing products but at the same time are more
flexible so that new and innovative game types can be deployed on its game
platforms. This will allow the Company to develop game types and game themes
that can offer play characteristics that cannot be easily imitated by its
competitors and that take full advantage of the underlying technology of the
product. By doing so, the Company hopes to offer a richer, more entertaining
gaming experience for the casino customer and thereby generate a higher win per
day per machine. The Company believes that this will also assist it in placing
machines with casino operators on a participation basis, which should prove more
profitable for the Company than a one-time sale of the machine.
The flexibility of the Company's products allow it to customize or develop
new game content much quicker than its competitors. The Company believes that
this will allow it to partner directly with casino operators to develop games
for the exclusive use of that operator, affording the operator a competitive
advantage given the lack of product differentiation between most casinos.
Working directly with operators to develop products may also help the Company
overcome the operators concerns about participation games, as it aligns the
operator and the manufacturer to the benefits of product success. The Company
believes that there is greater profit potential in this type of collaborative
relationship than in the more traditional "build and sell" model of the typical
slot machine manufacturer.
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The Company believes that new slot machine sales in the replacement
category will surpass sales for new installations in the near future, due to the
slowing in demand from new casino projects, and because the large number of
machines installed during the high growth period of the early 1990s will soon be
reaching their normal replacement time.
The market for slot machines outside of North America is relatively small,
with the exception of Australia, and it is generally difficult to forecast. In
addition, international markets have often served as an outlet for used machines
for most slot machine operators. SGI is currently focussed on establishing and
solidifying its market position in North America. Given the relatively small
size of the Company compared to certain of its competitors, the Company does not
believe it has adequate resources to simultaneously develop products for both
the North American and international markets. As a result, SGI does not
currently contemplate entering any international markets with the exception of
certain Canadian provinces. SGI remains open to taking advantage of
opportunities in international markets, but only if this can be accomplished
without any adverse impact on its domestic business.
SGI currently sells its products outright to casino operators and other
potential purchasers offering several pricing programs. For the ODYSSEY this
consists of either (i) the sale of the hardware unit bundled with a single game
or a suite of games and other software for a fixed price, or (ii) the sale of
the hardware unit alone combined with a renewable one-year software license,
including access to the entire ODYSSEY game library for the term of the license.
The Company's single game upright machine, QUEST, and its slant top machine are
sold as a bundled package of the hardware unit and a single game for a fixed
price. The Company also offers a participation program where it will place its
product on a casino floor in exchange for a share in the aggregate win generated
by the machine. Typically, under this program 20% of the aggregate win, subject
to a predetermined minimum, or a fixed daily rental fee, goes to the Company.
SGI believes that with the ODYSSEY, it has achieved a leadership position
within the multi-game segment of the video slot machine market. Since 1997, the
Company has made a great deal of progress in defining and developing what the
industry refers to as a "successful game". The Company believes that it has been
able to improve its game content as a result of this experience, and now it has
one of the most successful blackjack games with TOP HAT 21, a successful poker
game with LUCKY DRAW POKER, and some of the more successful multi-line,
multi-coin games with EUREKA and BANANA RAMA. At the same time the Company
believes that it currently has not yet fully exploited the technological
potential of its game platform and that many of its game offerings are in fact
similar to competing products.
The introduction of QUEST during 1998 was designed to allow the Company to
increase its penetration of the casino floor by offering a wider array of
product and price points to the casino operator. The introduction of the
wide-area progressive products in December 1998 further increased the Company's
product offerings. In 1999 the Company also introduced a more traditional,
slant-top machine that is physically similar to competitors' products. The
Company intends to offer additional platform choices such as a new upright
machines during 2000 to further diversify its product offering.
The Company believes that its ultimate success will come not from the
breadth of platform offerings, but from the quality of play characteristics of
the individual games offered on those platforms, and from the total gaming
experience that it can provide to patrons playing its products. Developing
pricing models that will allow the Company to maximize the revenue from each of
its games will also be critical to the Company's future success.
PRODUCTS
The Company has developed a family of games and platforms that it believes
represents the next generation of interactive gaming devices for use in casinos
and other gaming establishments in the United States and worldwide. The
Company's products utilize multimedia technologies to present casino games that
it believes will be more engaging and entertaining than other gaming devices
currently available. The Company's games feature high-resolution video presented
across the full surface of a large touchscreen display. The touchscreen displays
used by the Company are larger and more distinctive than those on competitive
products, which has helped make the Company's platforms distinctive and easily
recognizable within a casino environment. The games themselves feature
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high-quality animation, video clips, digital sound and a level of game
attractiveness and interaction that the Company believes is unavailable from and
unachievable by current-generation slot machines. Unlike traditional
"hardware-dominant" slot machines, the Company's products run games that are
software based, allowing SGI to offer casino operators the benefit of
flexibility to adapt their game offerings to evolving technologies and changing
consumer tastes without structural change to, or replacement of, the gaming
platform.
GAMES AND OTHER SOFTWARE
While SGI believes that the design of its machines and its hardware
components are important to its operation and its ability to foster initial and
extended play, it believes that the most important factor affecting the success
of its platforms will be the games themselves and the software that controls
those games. The majority of the Company's development efforts to date have been
devoted to hardware, system software and game development, and the Company
expects that, in the future, game development will be its principal development
activity.
The Company's games have been designed to present traditional casino games
with the benefit of video and audio enhancements that are afforded by the
Company's use of high-end multimedia hardware. While the underlying game may
consist of a traditional casino game such as poker, keno or a reel-based slot
machine, the game itself is only one aspect of the entertainment experience.
The development cycle for the Company's games has been reduced
significantly since the Company's initial introduction of games in 1997. The
Company developed a standard "engine" for each game type that it introduced such
as video-reels, keno, poker, blackjack and multi-line, multi-coin. In addition,
for every game that is introduced the Company develops a number of different
percentaging models that each have a different hold percentage. The percentaging
models are developed to meet jurisdictional regulatory requirements, local
market conditions and to offer flexibility to the casino operators. The number
of percentaging models vary by game type. For example, ARABIAN RICHES, a
reel-based game introduced during 1998 has 38 different percentaging variations
and PHANTOM BELLE, a poker-based game, has 29 different percentaging variations.
The choice of gaming platform can also affect the development cycle for games;
however, to date the Company has used a common gaming platform for all of its
hardware products. Development of a new game engine is a lengthy process but one
that can be leveraged and used on subsequent game offerings. The ability to
leverage existing game engines and percentaging models allows the Company to
develop new game themes and to introduce these new game titles much faster than
if it had to develop a brand new game engine with unique percentaging
requirements. This has been reflected in the increase in the number of new game
titles that the Company introduced in 1999 as compared to 1998.
All of SGI's games embed an engaging and entertaining theme story to help
attract patrons to the Company's machines. Some of the games developed and
introduced during 1999 include the following:
EUREKA - This multi-line, multi-coin wagering experience takes players
deep inside a derelict coal mine on the way to hidden fortune. Featuring
two separate bonuses embedded in the basic 4 X 4 playing field, players can
follow a coal cart as it speeds its way into a long-sealed mine shaft on
their way to discovering riches. This game was named one of Casino
Journal's Top 20 Most Innovative Games of the Year in 1999.
HOT REELS - A new game type developed and patented by Silicon Gaming
during 1999, Hot Reels introduces the player-decision characteristics of
video poker into a 3-reel traditional game set to an engaging auto racing
theme. Players can select or hold game symbols from one reel across all of
the reels being played (up to 5 reels simultaneously), and then re-spin for
a second chance at a match, increasing their opportunities to win.
STRIKE-IT-RICH - A multi-line, multi-coin game based on the popular
pasttime of 10-pin bowling, this game offers players an unusual twist. The
opportunity to actually bowl a bowling ball for cash. Incorporating a track
ball, when bonus time comes around, the player can use the track ball to go
bowling for dollars. Also named one of Casino Journal's Top 20 Most
Innovative Games of the Year in 1999, this game is sold and distributed on
the Company's behlf by Anchor Gaming.
BANANA-RAMA DELUXE- A multi-line, multi-coin version of the Company's
traditional three-reel game BANANA RAMA, this game utilizes the same
infectious jungle rhythms and the on-screen antics of the game's two
animated host monkeys, Banana and Clyde. The characters interact with each
other and with the player and celebrate jackpots with the player. A bonus
feature takes the player to the Oyster Bar for a pick-till-you-win bonus
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game where players can select up to twelve oysters and collect the awards
lying inside each of the oysters. The players continue doing this until the
collect symbol appears at which time they return to the game.
CASH CRUISE - This multi-line, multi-coin game set to a cruise ship
theme takes the player across the oceans to either of a tropical or artic
destination to see the sights and win some cash. Cash Cruise is a nickel
game that allows the player to wager up to 50 coins a play. This game
features two instant bonuses that hit with varying frequencies. Players
select one of a selection of different destinations and collect prizes
based upon the amount wagered and then return to the game.
The Company believes that the combination of its attractive machines,
high-level graphics and sound, bonusing features and the pursuit of an
interesting and entertaining story will make SGI's product outperform
conventional slot machines. During the last few years, a number of the Company's
competitors have developed games based upon well known licensed brands that the
manufacturers have licensed from the holders of the brands. This has helped in
the "attract" stage of the wagering experience in bringing customers to a
machine as customers can readily identify with these brands. Many of these games
have been participation games, and have been highly successful for both the
casino operator and the slot machine manufacturer. The abilty to use licensed
brands as themes for slot games has to date been limited to the larger
competitors in the slot machine industry who have the necessary financial
resources to acquire those brands. Competition for well known and established
brands has intensified, which has increased the price that a manufacturer must
pay to acquire the licensed brand. The Company believes that opportunities exist
for it to partner with one or several of the larger casino operators to aquire
licensed brands during 2000 that will allow it to compete in this new, but
growing segment of the gaming industry.
The Company believes that the physical appearance of its machines is more
attractive than conventional machines and will entice customers to play. In
addition to the physical attributes of its machines, the Company has included a
suite of video images that run when the machine is not being played. These
include short, animated vignettes from the Company's games and "help" screens,
as well as a menu page identifying all of the games available on that particular
machine. Information regarding any game can be viewed through the push of a
"Help" button. These merchandising segments feature the same quality of
graphics, sound, video and animation that distinguish all of SGI's games.
In the initial play period, SGI believes it is necessary to quickly engage
the customer in the story line and to avoid any confusion, unfamiliarity or
negative experience which might cause the customer to discontinue play. For this
reason, many of the Company's game offerings to date consist of enhanced
versions of traditional casino games, including reel-based slot games, so that
the rules of the game will be well known. SGI intends to present these games
using enhanced graphics and sound to enrich the play experience, but will not
change the fundamental characteristics or objective of the game. In addition,
the machine will offer traditional game controls for those players unfamiliar or
uncomfortable with the touchscreen interface.
The Company believes that the enhancements it has made to traditional
casino games by the addition of high level graphics, sound, animation and
storyline will encourage extended play, as well as more frequent play, and
thereby generate greater win per machine than the unenhanced versions of these
games available in conventional machines. A significant feature which the
Company believes will contribute significantly to extended play is the
introduction of advanced play levels in which a player, by virtue of having
played a certain amount of time or achieved a certain number of jackpots at one
level, gains access to a bonus sequence in which larger jackpots become
available.
The Company believes that the principal events that lead to completion of
play include the player's running out of money, running out of time or achieving
a targeted jackpot level. The Company believes that the unique features and
entertainment value of its games will entice players to remain in the extended
play phase for longer periods of time than are generally fostered by current
generation slot machines. Moreover, the design of the Company's platform and
games is intended to provide an entertainment experience that will encourage
repeated play.
In addition to features that are designed to enhance the entertainment
value of SGI's machines and its ability to generate incremental revenue for the
casino, SGI's platform incorporates proprietary features that are designed to
overcome certain hurdles that may be involved in the licensing of a slot machine
design, as well as to facilitate easy maintenance and supervision by casino
personnel. These features are as follows:
RANDOM NUMBER GENERATOR. At the core of every gaming machine is a
random number generator that determines the outcome of every gaming
proposition. To eliminate what the Company believes are some of the
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impediments to randomness that characterize random number generators, SGI
engaged Dr. Evangelos A. Yfantis, a recognized authority in the field of
random number algorithms, to develop a proprietary random number generator
algorithm for the Company. The Company has filed and received a U.S. patent
with respect to its algorithm.
SOFTWARE AUTHENTICATION. A critical element of all gaming machines is
an authentication mechanism to determine that the software being used is
identical to the software that has been approved by regulatory authorities
and is operating correctly. This is necessary to ensure that the game being
played corresponds exactly to that designed by the manufacturer and
approved by regulatory authorities. Traditional slot machines need to be
authenticated manually, a process usually performed only after a sizable
jackpot award. The infrequency of checks offer greater opportunities to
breach the security of traditional machines. The Company has developed a
proprietary authentication process which leverages the advanced
capabilities of the Company's machine to verify the integrity of a game
each time it is selected for play. This process combines sophisticated
authentication routines developed by RSA Data Security, Inc. with a
proprietary methodology developed by the Company. The Company's
authentication process provides continual checking of the machine's
software for both accidental corruptions or malicious attempts to cheat the
machine. Any detected anomalies will cause the machine to signal the loss
of integrity immediately. The Company has filed for and received patent
protection for certain aspects of its authentication methodology.
MACHINE MANAGEMENT SYSTEM. The Company's Machine Management System is
designed to provide easy access to the configuration, accounting, and
diagnostic capabilities of the machine. The Machine Management System's
accounting functions are designed to provide a rapid, easy-to-interpret
report of all key machine metering data, as well as detailed accounting and
statistics, on a game-by-game basis. The Machine Management System uses the
full benefit of the machine's touchscreen to make installation and setup of
the machine easier than traditional slot machines. The diagnostic programs
comprise a user-friendly maintenance and troubleshooting system that allows
casino floor personnel to quickly and effectively assess the cause of a
play stoppage or other malfunctions or to examine transaction history where
the validity of a jackpot or other transaction must be verified. For
example, if a player asserts that the machine has not given full credit for
a jackpot or has not properly recorded a cash input, a floor manager, using
the touchscreen and a key, can access comprehensive data to review
transaction and event history. With this information, the floor manager can
rapidly evaluate the merit of the player's claim and take appropriate
action. In this way, disputes can be quickly resolved at the machine's
location without the operator having to consult back office records or
review surveillance videotape.
PLATFORM, HARDWARE AND OTHER PHYSICAL ATTRIBUTES
SGI's gaming platforms so far have been designed to resemble a traditional
slot machine in many respects. Its machines occupy the same footprint as a
traditional slot machine and are of roughly the same general size and shape,
enabling casino operators to replace traditional slot machines with SGI's
machines without any reconfiguration of the casino floor. The most distinctive
attribute of the upright products the Company has introduced so far are their
vertically-oriented, 26-inch-diagonal touchscreen video monitor. A player's
sense of interactivity is heightened by the ability to make all the required
decisions on the screen, within the game itself. However, for players who are
uncomfortable or unfamiliar with touchscreen devices, all of the traditional
slot machine controls have been included as well. Thus, a player can control the
game by using the touchscreen, by pushing a series of buttons similar to those
found on current slot or video poker machines, or by pulling a handle as on
traditional slot machines. Coin handling mechanisms, bill acceptors, card
readers and other devices related to cash deposit, credit and win payout are
similar to those used in current gaming machines. The music, voice and other
audible features of the Company's games are played on a digital sound system.
The products that the Company has introduced all share a common gaming
platform. The principal electronic hardware used in the SGI gaming platform
consists of multimedia and personal computer ("PC") components. The central
processing unit is an Intel 200-MHz Pentium chip. This processor is accompanied
by a variety of video and auxiliary controllers, some of which have been
developed exclusively for use with the Company's products. To achieve a high
level of multimedia performance from its system, the Company's machines use 64
megabytes of random access memory. Storage for the audio and visual media
elements of the games, as well as the product software itself, is provided by a
high-density 4 gigabyte hard disk drive for the multi-game machines and by a
smaller 2-gigabyte hard disk drive for single game machines. All of these
components are connected internally by a high-speed PCI bus. SGI's reliance on
sophisticated full-motion video and high-quality audio presentations requires
the use of state-of-the-art technology, and SGI expects to upgrade the
performance of its platform periodically as higher-performance components become
available. SGI machines are intended to be easily reconfigurable in the field
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through the replacement of hardware components such as computer motherboards and
video and auxiliary controllers, allowing casino operators to upgrade hardware
in a cost-effective manner.
SGI's gaming platforms employ modular construction at almost every level,
facilitating upgrades and minimizing machine down-time. Such modularity permits
the rapid exchange of components for upgrades or to replace defective parts.
Using SGI's proprietary Machine Management System, casino personnel can run a
variety of diagnostic programs or review detailed performance data directly from
the gaming platform itself. In the case of a malfunctioning component, a casino
technician can quickly restore play simply by swapping out the failed component
with a new one. The modularity of SGI's platform will also facilitate upgrades
of hardware components such as card readers and bill validators as new
components become available. The Company believes that these features may allow
casino operators to reduce platform down-time and shorten the time required to
fix any malfunction, thereby increasing the time the platform is available for
play and reducing the risk that a player will elect to terminate a gaming
session as a result of play stoppage.
The Company's gaming platforms are assembled almost entirely from
off-the-shelf hardware, which the Company anticipates will reduce the chance of
a parts shortage and will enable the Company to continue to manufacture its
devices using state-of-the-art components as PC and multimedia technologies
advance. The different platforms share many common components, making it easier
for the Company's games to be played on different platforms and for customer
technical staff to work on the Company's different product offerings. There can
be no assurance, however, that the Company will continue to use common
components or enjoy a reliable supply of hardware components. Moreover, certain
components such as the touchscreen display and monitor are manufactured by
single sources and may be particularly susceptible to interruptions in supply.
Although SGI does develop proprietary components in order to meet certain
specialized requirements of its platform, the Company intends to primarily use
commercially available computer hardware components as a regular part of its
product development process.
SGI's machines were designed to accept future hardware upgrades to take
advantage of networking capabilities. When networked, two or more machines can
be linked, facilitating activities such as group play, tournaments and
progressives. For example, a particular group of platforms can be configured to
announce to players that a tournament will begin at a particular time and allow
each player the option to participate. Similarly, platforms can be configured so
that when one machine hits a jackpot, a player at another machine can win a
bonus award; the two affected platforms can then display a coordinated
audio/video simulation of a coin flying out of one tray and into the other. The
Company believes that features of this kind will promote interaction among
players at adjacent platforms and thereby maintain player interest for longer
periods of time. The Company introduced its first product into the Nevada market
in December 1998, THE BIG WIN, that incorporated this networking capability in a
wide-area progressive system. The Company anticipates introducing products into
the market during 2000 that will incorporate group play and tournament
capabilities.
SGI has incorporated numerous features into its gaming platform that are
designed both to attract the player and to maintain his or her interest over an
extended period of time. For example, SGI's gaming platform can be programmed to
allow for a free spin following a specified number of unsuccessful attempts in
order to ensure a minimum level of reward to the player. Similarly, SGI's
machines are capable of running promotional or entertainment video programs
during play stoppages such as those caused by a hopper refill, malfunction or
request for change. These features have been designed to reduce the likelihood
that a player will leave the machine during a play stoppage event. These
features may also provide an additional revenue or promotional source to the
operator by providing a medium for commercial messages.
PRODUCT DEVELOPMENT
The Company's product development efforts, particularly its game
development and customization efforts, will be critical to its success in the
gaming market. Research and development (R&D) expenses have increased
significantly since inception. However, given the maturity of the game platform,
the development tools and the software code base, the Company anticipate higher
levels of productivity that will result in increased product output and an
overall reduction in the level of development expenses. Development efforts will
also likely be focussed on new or custom game development during 2000. During
the years ended December 31, 1999, 1998 and 1997, the Company's research and
development expenses were $4,410,000, $11,853,000 and $9,283,000, respectively.
The reductions in the Company's headcount in late 1998 and early 1999, driven by
efforts to reduce costs in light of continued losses, contributed to the lower
levels of R&D expense during 1999. At December 31, 1999, 23 of the Company's 90
full-time employees were engaged in research and development.
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Ideas for new games are derived from customer preferences as perceived by
the Company or ascertained through the Company's market research and direct
feedback from slot machine operators. The initial designs for the Company's
games are conceived by a design team, which outlines the appearance and features
of each game. A prototype is developed by a production team that includes a
producer, product manager, artists, computer graphics engineers and
entertainment software engineers. The game is then evaluated by SGI's marketing
and sales staff, after which it is modified into its final form. The Company
estimates that the development of a typical game takes approximately two to six
months and costs approximately $150,000 to $400,000.
SGI is seeking to develop a variety of specific games which management
believes will appeal to casino operators and their customers. Currently, the
Company is engaged in the development of games based on traditional slot machine
games such as animated reel slots and video poker, as well as developing its
first brand based products. The Company is also creating variations of the
multi-coin, multi-line, Australian type games which have proved popular and
successful in all of the US gaming markets since 1998.
Some of the games currently under development include the following:
HITSVILLE - The hits keep coming in this Motown inspired multi-line,
multi-coin game. Stylized characters and soulful sounds come together in
this nod to Barry Gordy `s "hit factory". The game features two unique
bonuses and stunning graphics, making it a pleasure to play.
KING PUTTT - Golf and gambling have long gone together and now players
can test their skills in a true "putt for money" contest. This five-reel,
nine-line payout game brings high hit frequency and a seemingly skill based
bonus game incorporating the animated antics of mini-golf with an
entertaining wagering experience.
3-REEL HOLDUP - This comic-book caper set to a 20's gangster theme,
complete with wise -cracking "tough guys", car chases, armored car heists
and a swinging soundtrack, is the Company's second unique "multi-spin" reel
based game. Targetted to be a quarter denomination game, success sees the
lucky particpant choosing a bag of loot from the back of an armored truck.
STOCK CARDS - This high-speed, single hand poker game has been set to
an auto racing theme and is designed to remind you how popular traditional
draw poker still is. Stock cards offers the added challenge of accelerated
play and experienced players can rev up the proposition rate to keep pace
with their thirst for action.
Completion of the games under development is subject to various risks and
uncertainties. Such games may be subject to further creative decisions that
could alter the game implementation or marketing considerations that could
result in a shift of the Company's development focus to different types of games
altogether. Successful completion of any game will also be subject to risks
typically associated with the creative process, such as the risk that the
Company's creative team will be unable to achieve the desired results in terms
of the game's entertainment quality.
The product development strategy to date has focussed on enhancing
traditional gaming experiences by offering variations of existing casino-type
games. Familiarity with these game types attracts customers to these games. The
company has also taken this strategy a step further by introducing games based
on familiar brands or activities, such as the EUREKA mining game. The next phase
in the Company's product development strategy , which it commenced in 1999 is to
introduce completely new types of wagering experiences such as the multi-spin
games offered with HOT REELS or the interactive bowling in STRIKE IT RICH. The
Company intends to introduce new game types that reflect a broader kind of
wagering experiences during 2000.
Over time, SGI expects to introduce additional games that offer a wider
range of gaming experiences as players become more familiar with the
capabilities of advanced video gaming platforms. For example, the Company may
introduce games that utilize new digital camera technology to transform the
player into the game during a bonus event, to enable the player to "participate"
in the game, rather than merely being a spectator to a predetermined random
outcome. The Company also anticipates developing more of its games for
progressive formats in which the Company's machines would be networked to
support a common jackpot that is significantly larger than that which a
stand-alone machine could offer, or to support additional networked features
such as tournaments and peer-to-peer play.
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As internet technolgies continue to evolve, the Company will continue to
monitor the changes in the legal environment surrounding on-line gaming. To the
extent that it will not jeopardize is existing gaming licenses, the Company will
look at leveraging its software content in the internet domain, either through
licensing its content to third parties, developing or operating its own internet
gaming site for cash or for prize, developing gaming sites for other third
parties, or any combination of the above. The Company believes that its
software-based games would translate easily into the internet world, and
continues to monitor the evolution of this online gaming market.
SALES AND MARKETING
The ultimate success of SGI's games and its gaming platforms depends on its
acceptance by casino operators and casino patrons. The Company believes that,
from the point of view of casino operators, the attractiveness of any game or
gaming platform depends on win per machine, ease of upgrade, maintenance and
game change and information management. The Company believes that, from the
casino patron's perspective, the attractiveness of a platform is a function of
entertainment value and the perceived likelihood of the customer winning. SGI's
sales and marketing strategy is to generate product sales by highlighting the
advantages presented by its gaming platform to casino operators, such as
potential for increased win per machine; and by developing processes focused on
key operator values. SGI's marketing strategy also targets casino players and
will focus on developing brand recognition for SGI's games, which the Company
believes can be accomplished through the development of proprietary games that
deliver greater entertainment value for the gaming dollar.
SGI intends to position itself as a partner with either casino operators or
other slot manufacturers in establishing the next generation of wagering
entertainment. The Company recognizes that it is a small player in the gaming
industry at this point and that it may have to leverage the skills and
experience of these third parties to help in the development or deployment of
new products. During 1999 the Company worked with Anchor Gaming to jointly
develop and introduce a new game, STRIKE-IT-RICH. Anchor is responsible for the
sale and support of the product which is manufactured by the Company.
Because SGI's games are software-based, SGI believes that there will be a
significant opportunity for game customization and the development of games for
the exclusive use of one or more casino customers. It is already commonplace for
casinos to ask that conventional slot machines be customized with the casino's
logo or theme. SGI believes that it can significantly exceed this level of
customization by inserting the casino's logo or theme right in the game, by
presenting images of the casino's other games and amenities, or by creating a
new game entirely based on the casino's theme. The Company expects that it would
charge fees for any customization or development work that it performs for any
other parties. The Company announced in February 2000 that it had entered into a
joint-development agreement with a Nevada-based casino operator to develop a
licensed brand into an exclusive game for that operator. The Company expects to
announce more of these type of arrangements in the future as a way to help
defray the cost and risks of new game development and to facilitate distribution
of its products.
The Company currently sells product through a direct sales force that is
based in Nevada, Mississippi and the mid-west. The Company is planning to
distribute product through third parties including other slot machine
manufacturers or casino operators to help in the penetration of new markets
without the need for additional hiring. As at December 31, 1999, 19 of the
Company's 90 full-time employees were engaged in sales and marketing.
The successful introduction of the Company's product is subject to
substantial risks and uncertainties, including the risk of technical or
manufacturing difficulties, the possibility that the SGI platform will not
receive the anticipated market acceptance and possible delays or hurdles
associated with licensing of the Company's product in various jurisdictions.
The Company is required to be licensed in each jurisdiction in which it
expects to sell product. As of December 31, 1999, the Company has received both
corporate approval and approval to sell its product in Colorado, Illinois,
Indiana, Iowa, Nevada, New Jersey, Missouri, Mississippi, and certain native
American jurisdictions in Connecticut, Louisiana, Michigan, Minnesota and New
Mexico. See "Gaming Regulation and Licensing."
Although the Company plans to file applications in other jurisdictions,
there can be no assurance that the Company will be ready to file future
applications or that any licenses will be granted on a timely basis, or at all.
PRICING
The Company sells its products to casino operators and other potential
purchasers offering several pricing programs. For the ODYSSEY this consists of
either (i) the sale of the hardware unit bundled with a single game or a suite
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of games and other software for a fixed price, or (ii) the sale of the hardware
unit alone combined with a renewable one-year software license, including access
to the entire game library for the term of the license. QUEST and the slant-top
product are sold as a bundled package of the hardware unit and a single game for
a fixed price.
Similar to several of its competitors, the Company also offers a revenue
sharing plan as an alternative to the above purchase pricing options. Under this
plan, the casino operator is not required to make an upfront capital investment;
rather, in exchange for placing the machines on the floor, the casino operator
agrees to share with the Company the aggregate win generated by the machines.
Under this plan, 20% of the aggregate win goes to the Company, subject to a
predetermined minimum. In certain jurisdictions where this type of arrangement
is not permitted, the operator agrees to pay a fixed daily fee for the use of
the machine. The Company's plan is unique because the Company also offers the
casino operator a buyout option at any point after the 90 day minimum evaluation
period, something not currently offered in the industry. Under the buyout
option, the operator receives a credit towards the purchase of the hardware and
must purchase its choice of software at list price. The Company believes that
licensing revenue from game software may eventually constitute a substantial
portion of its revenue.
COMPETITION
The current slot machine market is highly competitive and is dominated by a
small number of manufacturers, many of whom have significantly greater financial
and other resources than the Company. The Company believes that the principal
competitive factors in this market are the appeal of the machine to players,
knowledge of customer requirements and player preferences, price, ease of use,
service, support and training, distribution, and name and product recognition.
The principal competitors in the slot machine market are IGT and Williams
Industries. IGT may be viewed as a dominant competitor, with a 1999 market share
estimated at 70%; William Industries 1999 market share is estimated at 15%.
Additional competitors or potential competitors include Bally/Alliance Gaming,
Inc., Anchor Gaming, Inc., Aristocrat Leisure Industries, Universal
Distributing, Sigma Games, Casino Data Systems, Mikohn Systems, Inc. and Acres
Gaming Inc. There can be no assurance that other companies in the video game or
multimedia market will not successfully enter the market for video slot
machines, nor can there be any assurance that the manufacturers of traditional
slot machines will not develop products that are superior to, or that achieve
greater market acceptance than, the Company's product. A number of the Company's
larger customers who operate multiple casinos have also indicated that they may
become involved in the design, development and manufacture of slot machines,
although to date few have actually done so. In general, the Company's existing
competitors, as well as many potential new competitors, have significantly
greater financial and technical resources than the Company, as well as more
established customer bases and distribution channels, any of which could afford
them a competitive advantage. If any of the Company's products or specific game
titles display potential to capture a significant share of the gaming machine
market, the Company's competitors can be expected to employ a variety of tactics
to limit erosion of their market shares, including price reductions,
acceleration of technical development or acquisition of new, competitive
technologies. Any success the Company might have may benefit existing
competitors and induce new competitors to enter the market. There can be no
assurance that the Company will be a successful competitor in the gaming machine
industry.
PROPRIETARY RIGHTS AND LICENSES
The Company's computer programs and technical know-how are both novel and
proprietary, and management believes that they can best be protected by use of
technical devices to protect the computer programs and by enforcement of
contracts and covenants not to compete with certain employees and others with
respect to the use of the Company's proprietary information and trade secrets.
The Company has registered copyrights with respect to various aspects of its
games, and has filed several U.S. patent applications for protection of certain
technology it has created or licensed. These patent applications cover various
aspects of the gaming machine hardware and software. Although the Company has
received certain patents and trademarks with respect to its intellectual
property, no assurance can be given that the remaining pending applications will
be granted, nor can there be any assurance that the patents will not be
infringed or that others will not develop technology that does not violate such
patents.
SGI has developed a proprietary method of authentication for disk
drive-based gaming machines, for which it has submitted a patent application.
Since modern gaming technology requires the handling and processing of large
amounts of on-line data, establishing a method for storing and retrieving data
that meets the approval requirements of the regulatory authorities while meeting
adequate standards of internal performance requires use of a comprehensive
authentication system to assure both the casino operator and requisite gaming
authorities that the software is an exact copy of what was generated by SGI and
approved by such gaming authorities.
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In addition, SGI owns exclusive rights to the algorithm for its random
number generator, the key component of the Company's gaming machine that
determines the outcome of each proposition. SGI's algorithm, which may have uses
outside the gaming industry, was developed by Dr. Evangelos A. Yfantis, a
professor of Computer Science at the University of Nevada, Las Vegas.
In developing its games, the Company relies on certain software that it
licenses from Duck Corporation ("Duck") on a nonexclusive basis. This license
may be terminated by Duck only in the event of a material breach of its terms by
the Company or in the event of a bankruptcy petition with respect to the
Company. The Company believes that alternative products exist that accomplish
the same functionality as that licensed from Duck.
EMPLOYEES
As of December 31, 1999, the Company had 90 full-time employees, including
23 in research and development. The Company also retains independent contractors
to provide certain services, primarily in connection with its product
development activities. The Company and its full-time employees are not subject
to any collective bargaining agreements and the Company believes that its
relations with its employees are good. From time to time the Company has
retained actors and/or "voice over" talent to perform in certain of the
Company's games and expects to continue this practice in the future. The
Company's future success depends in large part on its ability to attract and
retain management and other key personnel.
MANUFACTURING
The Company's manufacturing process consists primarily of assembly of
components obtained from third-party suppliers and testing of software systems
and applications. This activity now takes place at the Company's Las Vegas,
Nevada facility. As the Company has introduced new product platforms, it has
increased its use of subcontractors and third party vendors to supply completed
sub-assemblies and components, which has decreased its need for direct
manufacturing labor. As of December 31, 1999, the Company had 30 full-time
employees engaged in manufacturing and support-related activities.
GAMING REGULATION AND LICENSING
GENERAL REGULATION OF SHAREHOLDERS OF PUBLICLY TRADED CORPORATIONS. In most
jurisdictions, any beneficial owner of the Company's Common Stock is subject on
a discretionary basis to being required to file applications with gaming
regulatory authorities, be investigated and found suitable or qualified as such.
In addition, shareholders whose holdings of Common Stock exceed certain
designated percentages are subject to certain reporting and qualification
requirements imposed by state and federal gaming regulators and, any
shareholder, if found to be unsuitable, may be required to immediately dispose
of its holdings of Common Stock.
NEVADA REGULATORY MATTERS. The Company must obtain a registration, license,
approval or finding of suitability, and equipment approval in all jurisdictions
before it can offer gaming devices for sale to licensed gaming operations within
those jurisdictions. The licensing process usually involves the licensing or
approval of certain officers, directors, and shareholders of the corporation,
and approval of the specific product that the Company wants to offer for sale.
On June 19, 1996 the Nevada Commission registered SGI as a publicly traded
corporation and licensed Silicon Gaming-Nevada ("SGI-Nevada"), a wholly-owned
subsidiary of SGI, as a manufacturer, distributor and operator of a slot machine
route. The Company's initial public offering was also approved by the Nevada
Commission on June 19, 1996. On March 20, 1997, the Nevada Commission granted
final approval of the Company's product for sale to licensed casinos in Nevada.
The manufacture, sale and distribution of gaming devices for use or play in
Nevada or for distribution outside of Nevada, the manufacture and distribution
of associated equipment for use in Nevada, and the ownership and operation of
slot machine routes in Nevada are subject to: (i) the Nevada Gaming Control Act
and the regulations promulgated thereunder (collectively, "Nevada Act"); and
(ii) various local ordinances and regulations. Such activities are subject to
the licensing and regulatory control of the Nevada Commission, the Nevada Board,
and various local, city and county regulatory agencies (collectively referred to
as the "Nevada Gaming Authorities").
The laws, regulations and supervisory procedures of the Nevada Gaming
Authorities are based upon declarations of public policy which are concerned
with, among other things: (i) the prevention of unsavory or unsuitable persons
from having a direct or indirect involvement with gaming, or manufacturing or
distribution of gaming devices at any time or in any capacity; (ii) the strict
regulation of all persons, locations, practices, associations and activities
related to the operation of licensed gaming establishments and the manufacture
or distribution of gaming devices and equipment; (iii) the establishment and
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maintenance of responsible accounting practices and procedures; (iv) the
maintenance of effective controls over the financial practices of licensees,
including the establishment of minimum procedures for internal fiscal affairs
and the safeguarding of assets and revenue, providing reliable record keeping
and requiring the filing of periodic reports with the Nevada Gaming Authorities;
(v) the prevention of cheating and fraudulent practices; and (vi) the provision
of a source of state and local revenue through taxation and licensing fees.
Change in such laws, regulations and procedures could have an adverse effect on
the Company's operations.
On June 19, 1996 the Company was registered by the Nevada Commission as a
publicly-traded corporation (a "Registered Corporation"), and SGI-Nevada was
approved as a manufacturer, distributor and operator of a slot machine route. On
March 20, 1997, the Nevada Commission granted final approval of the Company's
product. Such gaming approvals require the periodic payment of fees and taxes
and are not transferable. As a Registered Corporation, the Company is required
periodically to submit detailed financial and operating reports to the Nevada
Commission and furnish any other information which the Nevada Commission may
require. No person may become a shareholder of, or receive any profit from
SGI-Nevada without first obtaining licenses and approvals from the Nevada Gaming
Authorities. The Company and SGI-Nevada have applied for, and in some cases
received, the various registrations, approvals, permits and licenses in order to
engage in manufacturing, distribution and slot route activities in Nevada.
All gaming devices that are manufactured, sold or distributed for use or
play in Nevada, or for distribution outside of Nevada, must be manufactured by
licensed manufacturers and distributed or sold by licensed distributors. All
gaming devices manufactured for use or play in Nevada must be approved by the
Nevada Commission before distribution or exposure for play. The approval process
for gaming devices includes rigorous testing by the Nevada Board, a field trial
and a determination as to whether the gaming device meets strict technical
standards that are set forth in the regulations of the Nevada Commission.
Associated equipment must be administratively approved by the Chairman of the
Nevada Board before it is distributed for use in Nevada.
The Nevada Gaming Authorities may investigate any individual who has a
material relationship to, or material involvement with, a Registered Corporation
or its subsidiaries in order to determine whether such individual is suitable or
should be licensed as a business associate of a gaming licensee. Officers,
directors and certain key employees of the Company and SGI-Nevada are required
to file applications with the Nevada Gaming Authorities and may be required to
be licensed or found suitable by the Nevada Gaming Authorities. The Nevada
Gaming Authorities may deny an application for licensing for any cause which
they deem reasonable. A finding of suitability is comparable to licensing, and
both require submission of detailed personal and financial information followed
by a thorough investigation. The applicant for licensing or a finding of
suitability must pay all the costs of the investigation. Changes in licensed
positions must be reported to the Nevada Gaming Authorities and in addition to
their authority to deny an application for a finding of suitability or
licensure, the Nevada Gaming Authorities have jurisdiction to disapprove a
change in a corporate position. On June 19, 1996 SGI's Chief Executive Officer,
Chief Financial Officer, the required directors and SGI-Nevada's sole officer
and director were found suitable by the Nevada Commission.
If the Nevada Gaming Authorities were to find an officer, director or key
employee unsuitable for licensing or unsuitable to continue having a
relationship with SGI or SGI-Nevada, the Company would have to sever all
relationships with such person. In addition, the Nevada Commission may require
the Company or SGI-Nevada to terminate the employment of any person who refuses
to file appropriate applications. Determination of suitability or of questions
pertaining to licensing are not subject to judicial review in Nevada.
The Company and SGI-Nevada will be required to submit detailed financial
and operating reports to the Nevada Commission. Substantially all material
loans, leases, sales of securities and similar financing transactions by the
Company will be required to be reported to or approved by the Nevada Commission.
If it were determined that the Nevada Act was violated by the Company or
SGI-Nevada, the registration and gaming licenses it holds could be limited,
conditioned, suspended or revoked, subject to compliance with certain statutory
and regulatory procedures. In addition, the Company, SGI-Nevada and the persons
involved could be subject to substantial fines for each separate violation of
the Nevada Act at the discretion of the Nevada Commission. Limitation,
conditioning or suspension of any gaming license could (and revocation of any
gaming license would) materially adversely affect the Company's gaming
operations.
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Any beneficial holder of a Registered Corporation's voting securities,
regardless of the number of shares owned, may be required to file an
application, be investigated, and have his suitability determined as a
beneficial holder of the Registered Corporation's voting securities if the
Nevada Commission has reason to believe that such ownership would otherwise be
inconsistent with the declared policies of the State of Nevada. The applicant
must pay all costs of investigation incurred by the Nevada Gaming Authorities in
conducting any such investigation.
The Nevada Act requires any person who acquires beneficial ownership of
more than 5% of a Registered Corporation's voting securities to report the
acquisition to the Nevada Commission. The Nevada Act requires that beneficial
owners of more than 10% of a Registered Corporation's voting securities apply to
the Nevada Commission for a finding of suitability within thirty days after the
Chairman of the Nevada Board mails the written notice requiring such filing.
Under certain circumstances, an "institutional investor," as defined in the
Nevada Act, which acquires more than 10% but not more than 15%, of the
Registered Corporation's voting securities may apply to the Nevada Commission
for a waiver of such finding of suitability if such institutional investor holds
the voting securities for investment purposes only. An institutional investor
shall not be deemed to hold voting securities for investment purposes unless the
voting securities were acquired and are held in the ordinary course of business
as an institutional investor and not for the purpose of causing, directly or
indirectly, the election of a majority of the members of the board of directors
of the Registered Corporation, any change in the Registered Corporation's
corporate charter, bylaws, management, policies or operations of the Registered
Corporation, or any of its gaming affiliates, or any other action which the
Nevada Commission finds to be inconsistent with holding the Registered
Corporation's voting securities for investment purposes only. Activities which
are not deemed to be inconsistent with holding voting securities for investment
purposes only include: (i) voting on all matters voted on by shareholders; (ii)
making financial and other inquiries of management of the type normally made by
securities analysts for informational purposes and not to cause a change in its
management, policies or operations; and (iii) such other activities as the
Nevada Commission may determine to be consistent with such investment intent. If
the beneficial holder of voting securities who must be found suitable is a
corporation, partnership or trust, it must submit detailed business and
financial information including a list of beneficial owners. The applicant is
required to pay all costs of investigation.
Any person who fails or refuses to apply for a finding of suitability or a
license within thirty days after being ordered to do so by the Nevada Commission
or the Chairman of the Nevada Board, may be found unsuitable. The same
restrictions apply to a record owner if the record owner, after request, fails
to identify the beneficial owner. Any shareholder found unsuitable and who
holds, directly or indirectly, any beneficial ownership of the Common Stock
beyond such period of time as may be prescribed by the Nevada Commission may be
guilty of a criminal offense. The Company will be subject to disciplinary action
if, after it receives notice that a person is unsuitable to be a shareholder or
to have any other relationship with the Company or SGI-Nevada, the Company (i)
pays that person any dividend or interest upon voting securities of the Company,
(ii) allows that person to exercise, directly or indirectly, any voting right
conferred through securities held by that person, (iii) pays remuneration in any
form to that person for services rendered or otherwise, or (iv) fails to pursue
all lawful efforts to require such unsuitable person to relinquish his voting
securities including, if necessary, the immediate purchase of said voting
securities for cash at fair market value.
The Nevada Commission may, in its discretion, require the holder of any
debt security of a Registered Corporation to file applications, be investigated
and be found suitable to own the debt security of a Registered Corporation. If
the Nevada Commission determines that a person is unsuitable to own such
security, then pursuant to the Nevada Act, the Registered Corporation can be
sanctioned, including the loss of its approvals, if without the prior approval
of the Nevada Commission, it: (i) pays to the unsuitable person any dividend,
interest, or any distribution whatsoever; (ii) recognizes any voting right by
such unsuitable person in connection with such securities; (iii) pays the
unsuitable person remuneration in any form; or (iv) makes any payment to the
unsuitable person by way of principal, redemption, conversion, exchange,
liquidation, or similar transaction.
The Company will be required to maintain a current stock ledger in Nevada
which may be examined by the Nevada Gaming Authorities at any time. If any
securities are held in trust by an agent or by a nominee, the record holder may
be required to disclose the identity of the beneficial owner to the Nevada
Gaming Authorities. Failure to make such disclosure may be grounds for finding
the record holder unsuitable. The Company will also be required to render
maximum assistance in determining the identity of the beneficial owner. The
Nevada Commission has the power to require the stock certificates of the Company
to bear a legend indicating that the securities are subject to the Nevada Act.
However, the Nevada Commission has not imposed such a requirement on the Company
to date, but it is unknown whether the Nevada Commission will impose such a
requirement on the Company in the future.
15
<PAGE>
As a Registered Corporation, the Company may not make a public offering of
its securities, such as an IPO or follow-on offering, without the prior approval
of the Nevada Commission if the securities or proceeds therefrom are intended to
be used to construct, acquire or finance gaming facilities in Nevada, or to
retire or extend obligations incurred for such purposes. Approval of a public
offering, if given, does not constitute a finding, recommendation or approval by
the Nevada Commission or the Nevada Board as to the accuracy or adequacy of the
Offering Memorandum or the investment merits of the securities offered. Any
representation to the contrary is unlawful.
Changes in control of a Registered Corporation through merger,
consolidation, stock or asset acquisitions, management or consulting agreements,
or any act or conduct by a person whereby he obtains control, may not occur
without the prior approval of the Nevada Commission. Entities seeking to acquire
control of a Registered Corporation must satisfy the Nevada Board and the Nevada
Commission in a variety of stringent standards prior to assuming control of such
Registered Corporation. The Nevada Commission may also require controlling
shareholders, officers, directors and other persons having a material
relationship or involvement with the entity proposing to acquire control, to be
investigated and licensed as part of the approval process relating to the
transaction.
The Nevada legislature has declared that some corporate acquisitions
opposed by management, repurchases of voting securities and corporate defense
tactics affecting Nevada corporate gaming licensees, and Registered Corporations
that are affiliated with those operations, may be injurious to stable and
productive corporate gaming. The Nevada Commission has established a regulatory
scheme to ameliorate the potentially adverse effects of these business practices
upon Nevada's gaming industry and to further Nevada's policy to: (i) assure the
financial stability of corporate gaming licensees and their affiliates; (ii)
preserve the beneficial aspects of conducting business in the corporate form;
and (iii) promote a neutral environment for the orderly governance of corporate
affairs. Approvals are, in certain circumstances, required from the Nevada
Commission before the Registered Corporation can make exceptional repurchases of
voting securities above the current market price thereof and before a corporate
acquisition opposed by management can be consummated. The Nevada Act also
requires prior approval of a plan of recapitalization proposed by the Registered
Corporation's Board of Directors in response to a tender offer made directly to
the Registered Corporation's shareholders for the purposes of acquiring control
of the Registered Corporation.
License fees and taxes, computed in various ways depending on the type of
gaming or activity involved, are payable to the State of Nevada and to the
counties and cities in which gaming operations are to be conducted. Depending
upon the particular fee or tax involved, these fees and taxes are payable either
monthly, quarterly or annually and are based upon either: (i) a percentage of
the gross revenue received; or (ii) the number of gaming devices operated.
Annual fees are also payable to the State of Nevada for renewal of licenses as a
manufacturer, distributor and operator of a slot machine route.
Any person who is licensed, required to be licensed, registered, required
to be registered, or is under common control with such persons (collectively,
"Licensees"), and who proposes to become involved in a gaming venture outside of
Nevada, is required to deposit with the Nevada Board, and thereafter maintain, a
revolving fund in the amount of $10,000 to pay the expenses of investigation by
the Nevada Board of their participation in such foreign gaming. The revolving
fund is subject to increase or decrease in the discretion of the Nevada
Commission. Thereafter, Licensees are required to comply with certain reporting
requirements imposed by the Nevada Act. Licensees are also subject to
disciplinary action by the Nevada Commission if they knowingly violate any laws
of the foreign jurisdiction pertaining to the foreign gaming operation, fail to
conduct the foreign gaming operation in accordance with the standards of honesty
and integrity required of Nevada gaming operations, engage in activities that
are harmful to the state of Nevada or its ability to collect gaming taxes and
fees, or employ a person in the foreign operation who has been denied a license
or finding of suitability in Nevada on the ground of personal unsuitability.
In the future, SGI intends to seek the necessary registrations, licenses,
approvals, and findings of suitability for the Company, its product and its
personnel in other jurisdictions throughout the world. However, there can be no
assurances that such registrations, licenses, approvals or findings of
suitability will be obtained. Many other jurisdictions in which the Company
wishes to do business require various licenses, permits, and approvals in
connection with the manufacture and/or distribution of gaming devices, typically
involving restrictions similar in most respects to those of Nevada.
16
<PAGE>
MISSOURI REGULATORY MATTERS. Gaming was originally authorized in the state
of Missouri in November 1992. On April 29, 1993, new legislation (the "Missouri
Act") was enacted which replaced the 1992 legislation. In January 1994 the
Missouri Supreme Court handed down a decision which held that the operation of
certain games of chance such as traditional slot machines was prohibited by the
constitution of the state of Missouri. On November 8, 1994, the people of
Missouri voted in favor of an amendment to the Missouri constitution to allow
slot machine gaming in the state. The Missouri Act provides for the licensing
and regulation of excursion gambling boat operations on the Mississippi and
Missouri Rivers in the state of Missouri and the licensing and regulation of
persons who distribute gaming equipment and supplies to gaming licensees. An
excursion gambling boat is a boat, ferry or other floating facility on which
gaming is allowed. The Missouri Act limits the loss per individual on each
excursion to $500, but does not otherwise limit the amount which may be wagered
on any bet or the amount of space in the vessel which may be utilized for
gaming.
The Missouri Act is to be implemented and enforced by a five-member
Missouri Commission. The Missouri Commission is empowered to issue such number
of riverboat gaming licenses as it determines to be appropriate. A gaming
license cannot be granted to any gaming operator unless the voters in such
operator's "home dock" city or county have authorized gaming activities on
gaming riverboats.
On September 1, 1993, the Missouri Commission adopted rules and regulations
(the "Missouri Regulations") governing the licensing, operation and
administration of riverboat gaming in the state of Missouri and the form of
application for such licensure. The Missouri Regulations generally provide for
four types of licenses--a Class A owner's license; a Class B operator's license;
a supplier's license; and an occupational license. In addition, the Missouri
Regulations remain subject to amendment and interpretation, and may further
limit or otherwise adversely affect the Company and its Missouri gaming
operations.
Directors and certain officers and key persons of the Company and Silicon
Gaming-Missouri ("SGI-Missouri"), a wholly-owned subsidiary of SGI, must file
personal disclosure forms with the gaming license application and must be found
suitable by the Missouri Commission. Further, the Missouri Regulations require
that all employees of SGI-Missouri who are involved in gaming operations and who
are employed on the licensed premises must file applications for and receive
Missouri gaming occupational licenses. The Missouri regulations require
disclosure by the Company and SGI-Missouri of any person or entity holding any
direct or indirect ownership interest in SGI-Missouri. SGI-Missouri is also
required to disclose the names of the holders of all of the Company's and
SGI-Missouri's debt including a description of the nature and terms of such
debt. The Missouri Commission may, in its sole discretion, request additional
information with respect to such holders. Missouri suppliers' gaming licenses
must be renewed annually for a fee of $5,000 or such greater amount as may be
determined by the Commission. On November 8, 1996, SGI-Missouri was granted a
temporary supplier's license by the Missouri Commission.
Under Missouri law, gaming licenses are not transferable, and under the
Missouri Regulations the transfer of (i) any ownership interest in a privately
held business entity or (ii) a 5% or greater interest in a publicly traded
company directly or indirectly holding a Missouri gaming license is prohibited
without the approval of the Missouri Commission. Further, without the prior
approval of the Missouri Commission, the Missouri Regulations prohibit
withdrawals of capital, loans, advances or distribution of any assets in excess
of 5% of accumulated earnings by a license holder to anyone with an ownership
interest in the license holder.
The Missouri Regulations specifically provide that any action of the
Missouri Commission shall not indicate or suggest that the Missouri Commission
has considered or passed in any way on the marketability of the applicant or
licensee's securities, or on any other matter, other than the applicant or
licensee's suitability for licensure under Missouri law. A Missouri gaming
license holder can be disciplined in Missouri for gaming-related acts occurring
in another jurisdiction which result in disciplinary action in the other
jurisdiction.
The Missouri Commission has broad powers to require additional disclosure
by an applicant during the processing of a gaming application, to deny gaming
licensure and to administratively fine, suspend or revoke a gaming license for
failure to comply with or for violation of the Missouri Act or Missouri
Regulations.
17
<PAGE>
NEW JERSEY REGULATORY MATTERS. Casino gaming in New Jersey, including the
manufacture, distribution and operation of gaming devices, is subject to strict
regulation by the New Jersey Casino Control Commission (the "New Jersey
Commission") pursuant to the New Jersey Casino Control Act and the regulations
of the New Jersey Commission promulgated thereunder (collectively, the "New
Jersey Act"). The New Jersey Commission is authorized to decide all applications
for licensure or other approvals and to promulgate regulations. The New Jersey
Act also established the New Jersey Division of Gaming Enforcement (the "New
Jersey Division"), which is responsible for investigating all applications for
licensure or approval and for prosecuting violations of the New Jersey Act.
Under the New Jersey Act, a company must be licensed as a gaming related
casino service industry ("CSI") in order to manufacture or distribute gaming
devices to New Jersey casinos. In January of 1997, the applications of the
Company and its wholly-owned subsidiary, Silicon Gaming-New Jersey, Inc.
("SGI-NJ"), for CSI licensure were deemed complete and accepted for filling by
the New Jersey Commission. These applications consisted of extensive disclosure
forms by the Company, SGI-NJ, and certain of their officers, directors,
principal employees and security holders.
The New Jersey Commission has broad discretion regarding the issuance,
renewal, suspension or revocation of CSI licenses. In order to obtain a CSI
license, the Company and SGI-NJ must demonstrate to the New Jersey Commission by
clear and convincing evidence that they, any five percent or greater security
holders, certain officers, directors, and principal employees, and anyone else
whom the New Jersey Commission deems appropriate in its discretion, possess good
character, honesty and integrity, and financial stability and responsibility. If
a person who is required to be found qualified is found disqualified by the New
Jersey Commission, the license applications may be denied.
With respect to security holders, the New Jersey Commission may waive the
qualification requirement for "institutional investors," as defined in the New
Jersey Act, of the Company in the absence of a prima facie showing by the
Director of the New Jersey Division that there is any cause to believe that the
institutional investor may be unqualified, if the institutional investor holds
less than ten percent of the outstanding securities, provided the securities
were acquired for investment purposes only and the holder has no intention of
influencing the affairs of the Company, other than voting its securities. The
New Jersey Act defines an "institutional investor" as (i) any retirement fund
administered by a public agency for the exclusive benefit of federal, state or
local public employees, (ii) an investment company registered under the
Investment Company Act of 1940, (iii) a collective investment trust organized by
banks under Part Nine of the Rules of the Comptroller of the Currency, (iv) a
closed end investment trust, (v) a chartered or licensed life insurance company
or property and casualty insurance company, (vi) banking or other licensed or
chartered lending institutions, (vii) an investment advisor registered under the
Investment Advisors Act of 1940, or (viii) such other persons as the New Jersey
Commission may determine for reasons consistent with the policies of the New
Jersey Act.
The applications of the Company and SGI-NJ will be investigated by the New
Jersey Division. During the course of the investigation, the Company and SGI-NJ
are required to provide additional information to the New Jersey Division. At
the conclusion of its investigation, the New Jersey Division will file a report
with the New Jersey Commission stating its position on the license applications.
After receipt of the report of the New Jersey Division, the New Jersey
Commission will hold a public hearing on the license applications. No assurances
can be given as to the timing of the completion of the investigation by the New
Jersey Division and the public hearing by the New Jersey Commission on the
license applications or that the licenses will be obtained.
In its discretion, the New Jersey Commission may permit the Company and
SGI-NJ to transact business with New Jersey casinos prior to their licensure. In
order to do so, the Company and SGI-NJ must continue to have complete
applications for CSI licensure on file with the New Jersey Commission, petition
the New Jersey Commission for permission for each transaction, demonstrate that
good cause exists for granting the petition and the New Jersey Division must not
object to the petition.
The fee for a CSI license is a minimum of $5,000 and a maximum of $15,000,
with the actual cost depending upon the amount of time spent by the New Jersey
Commission and New Jersey Division in investigating an processing the
applications, plus the out of pocket expenses of the New Jersey Commission and
New Jersey Division.
18
<PAGE>
A CSI license is issued for an initial period of two years and, upon proper
application and satisfaction of the same standards applicable to the initial
issuance of a CSI license, is renewable for four year periods. The New Jersey
Commission may impose conditions on the issuance of a license. In addition, the
New Jersey Commission has the authority to impose fines or suspend or revoke a
license for violations of the New Jersey Act, including the failure to satisfy
the licensure requirements.
In addition, gaming devices manufactured or distributed by the Company or
SGI-NJ must be approved by the New Jersey Commission based on, at a minimum,
their quality, design, integrity, fairness, honesty and suitability in order to
be used in New Jersey casinos. The approval process includes the submission of a
model of the gaming device and relevant documentation to the New Jersey Division
for testing, examination and analysis. Only a licensed CSI or an applicant for
CSI licensure can submit a gaming device for approval. All costs of such
testing, examination and analysis are borne by the Company. Prior to deciding to
approve a particular model of gaming device, the New Jersey Commission may
require a test of up to 60 days of the gaming device in a licensed casino.
During the test period, the manufacturer or distributor of the gaming device
shall not be entitled to receive revenue of any kind whatsoever. Once a gaming
device is approved by the New Jersey Commission, all gaming devices of that
model placed in operation in licensed casinos shall operate in conformity with
the model approved by the New Jersey Commission. Any changes in the design,
function or operation of an approved gaming device are subject to prior approval
by the New Jersey Commission, after testing by the New Jersey Division. In March
of 1997, ODYSSEY was submitted to the New Jersey Division and New Jersey
Commission for testing and approval and approval was received in March, 1999, at
which time SGI-NJ commenced sales of its product.
MISSISSIPPI REGULATORY MATTERS. The manufacture, sale and distribution of
gaming devices for use or play in Mississippi are subject to the Mississippi
Gaming Control Act and the regulations promulgated thereunder (collectively, the
"Mississippi Act"). Such activities are subject to the licensing and regulatory
control of the Mississippi Gaming Commission (the "Mississippi Commission") and
the Mississippi State Tax Commission (collectively referred to as the
"Mississippi Gaming Authorities"). Although not identical, the Mississippi Act
is similar to the Nevada Gaming Control Act and regulations promulgated
thereunder.
On June 20, 1996 the Company was registered by the Mississippi Commission
as a publicly traded corporation (a "Registered Corporation") and the holding
company of Silicon Gaming-Mississippi, Inc. (the "Mississippi Subsidiary"). Also
on June 20, 1996 the Mississippi Subsidiary was licensed as a manufacturer and
distributor. SGI and the Mississippi Subsidiary are required to periodically
submit detailed financial and operating reports to the Mississippi Commission
and furnish any other information which the Mississippi Commission may require.
The Company and the Mississippi Subsidiary have received the various
registrations, approvals, permits and licenses in order to engage in
manufacturing, distribution and gaming activities as presently conducted in
Mississippi. Such licenses, registrations and approvals are not transferable,
are initially issued for a two-year period and must be renewed periodically
thereafter.
Similar to Nevada, the Mississippi Commission may investigate and find
suitable any individual who has a material relationship to, or material
involvement with, the Company or the Mississippi Subsidiary, including record or
beneficial holders of any of the voting securities of the Company, holders of
debt obligations, and officers, directors and employees of the Company and the
Mississippi Subsidiary. The Company and the Mississippi Subsidiary are required
to maintain a current stock ledger in Mississippi which may be examined by the
Mississippi Commission at any time. The Company believes that all required
findings of suitability currently required have been applied for or obtained.
Any application for a finding of suitability must pay all investigative fees and
costs of the Mississippi Commission in connection with such an investigation.
The Mississippi Act requires any person who acquires beneficial ownership
of more than 5% of a Registered Corporation's voting securities to report the
acquisition to the Mississippi Commission and such person may be required to be
found suitable. The Mississippi Act requires that beneficial owners of more than
10% of a Registered Corporation's voting securities apply to the Mississippi
Commission for a finding of suitability. The Mississippi Commission has
generally exercised its discretion to require a finding of suitability of any
beneficial owner of more than 5% of a Registered Corporation's Common Stock.
Under certain circumstances, an "institutional investor," as defined by
Mississippi Commission policy, which acquires more than 5%, but not more than
10%, of the Registered Corporation's voting securities may apply to the
Mississippi Commission for a waiver of such finding of suitability if such
institutional investor holds the voting securities for investment purposes only.
19
<PAGE>
The Company may not make a public offering of its securities without the
approval of the Mississippi Commission if the securities or proceeds therefrom
are intended to be used to construct, acquire or finance gaming facilities in
Mississippi, or to retire or extend obligations incurred for such purposes.
If it were determined that the Mississippi Act was violated by the
Mississippi Subsidiary, the licenses it holds could be limited, conditioned,
suspended or revoked, subject to compliance with certain statutory and
regulatory procedures, which action, if taken, could materially adversely affect
the Company's manufacturing and distribution.
FEDERAL REGULATION. The Federal Gambling Devices Act of 1962 (the "Federal
Act") makes it unlawful, in general, for a person to manufacture, deliver, or
receive gaming machines, gaming machine type devices and components across state
lines or to operate gaming machines unless that person has first registered with
the Attorney General of the United States. The Company is required to register
and renew its registration annually. The Company has complied with such
registration requirements. In addition, various record keeping equipment
identification requirements are imposed by the Federal Act. Violation of the
Federal Act may result in seizure and forfeiture of the equipment, as well as
other penalties.
NATIVE AMERICAN GAMING. Gaming on Native American lands, including the
terms and conditions under which gaming equipment can be sold or leased to
Native American tribes, is or may be subject to regulation under the laws of the
tribes, the laws of the host state, the Indian Gaming Regulatory Act or 1988
("IGRA"), which is administered by the National Indian Gaming Commission (the
"NIGC") and the Security of the U.S. Department of the Interior (the
"Secretary"), and also may be subject to the provisions of certain statutes
relating to contracts with Native American tribes, which are administered by the
Secretary. As a precondition to gaming involving gaming machines, IGRA requires
that the tribe and the state have entered into a written agreement (a
"tribal-state compact") that specifically authorizes such gaming, and that has
been approved by the Secretary, with notice of such approval published in the
Federal Registrar. Tribal-state compacts vary from state to state. Many require
that equipment suppliers meet ongoing registration and licensing requirements of
the state and/or the tribe and some impose background check requirements on the
officers, directors, and shareholders of gaming equipment supplies. Under IGRA,
tribes are required to regulate all commercial gaming under ordinances approved
by the NIGC. Such ordinances may impose standards and technical requirements on
gaming hardware and software, and may impose registration, licensing and
background check requirements to gaming equipment suppliers and their officers,
directors, and shareholders.
APPLICATION OF FUTURE OR ADDITIONAL REGULATORY REQUIREMENTS. In the future,
the Company intends to seek the necessary registrations, licenses, approvals and
findings of suitability for the Company, its product and its personnel in other
U.S. and foreign jurisdictions in which the Company identifies significant sales
potential for its product. However, there can be no assurance that such
registrations, licenses, approvals or findings of suitability will be obtained
and will not be revoked, suspended or conditioned or that the Company will be
able to obtain the necessary approvals for its future products as they are
developed in a timely manner, or at all. If a registration, license, approval or
finding of suitability is required by a regulatory authority and the Company
fails to seek or does not receive the necessary registration, license, approval
or finding of suitability, the Company may be prohibited from selling its
product for use in the respective jurisdiction or may be required to sell its
product through other licensed entities at a reduced profit to the Company.
20
<PAGE>
ITEM 2: PROPERTIES
The Company leases a 28,000 square foot facility in Palo Alto, California.
The Company subleases approximately 16,000 square feet of this facility and uses
the remainder for its development, marketing, sales and administrative
personnel. The lease expires in January 2006. The Company also leases a 27,000
square foot facility in Las Vegas, Nevada that houses its sales and support
organization, and a 4,000 square foot facility in Reno, Nevada that houses a
sales and support organization.
ITEM 3: LEGAL PROCEEDINGS
In March 2000 the Company was served papers in connection with a patent
infringement lawsuit filed against it and another slot machine manufacturer by
International Game Technology, Inc. (IGT). As disclosed in November 1999, IGT is
alleging infringement of a patent issued to IGT in September 1999 entitled "Game
Machine and Method Using Touch Screen". The Company has not yet responded to the
lawsuit and the Company's management denies the assertions of infringement. The
Company is presently unable to determine the financial impact, if any, of this
litigation.
In March 2000, a former distributor of the Company's products, filed suit
against the Company in the United States District Court for the District of
South Carolina. The distributor seeks repayment of $1 million, plus damages, in
connection with machines previously shipped to the distributor in 1998. The
Company is in the process of arbitration as required by the Distribution
Agreement, seeking to recover outstanding receivables from the distributor when
it received this lawsuit. The Company is in the preliminary stages of
investigating the allegations contained in the suit and has not yet responded to
the complaint.
ITEM 4: SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS
Inapplicable.
EXECUTIVE OFFICERS
The executive officers of the Company are as follows:
Name Age Position
---- --- --------
Andrew S. Pascal........ 34 Chief Executive Officer, Chief Financial Officer
Charles R. Berg......... 47 Vice President - Engineering
Michael R. Fields....... 39 Vice President - Sales
Paul D. Mathews......... 35 Vice President - Corporate Development &
Government Affairs
Paul D. Miltenberger.... 34 Vice President - Development
Betsy B. Sutter......... 39 Vice President - Human Resources
ANDREW S. PASCAL has served as Chief Executive Officer of the Company since
February, 1999 and as acting Chief Financial Officer since March, 1999. He had
previously held the title of Executive Vice President - Marketing and Game
Development since October 1994. He has over 14 years of gaming industry
experience with an emphasis in slot marketing, slot merchandising and slot
operations. He joined SGI in October 1994 from Mirage Resorts, Incorporated ,
where he worked from June 1985 to October 1994. Mr. Pascal held the position of
Director of Slot Operations and Marketing at The Mirage Hotel and Casino,
managing a division consisting of 350 employees and annual revenue in excess of
$110 million. Mr. Pascal served on The Mirage's eight-member Operating
Committee, which set operating policy and established the strategic direction
for The Mirage and its 7,300 employees, from September 1992 to October 1994.
Prior to the opening of The Mirage Hotel and Casino, Mr. Pascal served as the
Director of Slot Marketing for the Golden Nugget Casino-Hotel.
21
<PAGE>
CHARLES R. BERG joined SGI in August 1999 from as Vice president of
Engineering. Prior to joining SGI he was the founder of The Software Studio,
Inc., a designer of engineering based software applications where for seven
years he was the Director of Development. Prior to his work at the Software
Studio, Inc., Mr. Berg spent two years at Document Technologies, Inc. as
Software Development Manager, and prior to that three years at Anray, Inc.,
where he was founder and Vice President of Engineering.
MICHAEL R. FIELDS joined SGI in September 1999 as Vice President of Sales
from Mikohn Gaming, a diversified designer and manufacturer of casino products
and gaming devices, where he had worked for three years, most recently as the
Director of Western US sales. Prior to joining Mikohn, Mr. Fields was Vice
President and General Manager for Genasys USA, and prior to that, Director of
North American Sales for Spectravision, Inc. Both companies were involved in the
sale of entertainment products to hotels.
PAUL D. MATHEWS joined SGI in November 1995 from Casino Data Systems
("CDS"), a designer and manufacturer of casino management information systems
and gaming devices, where from March 1995 to November 1995 he was Director of
Regulatory Compliance responsible for corporate and product licensing in all
gaming jurisdictions. Prior to joining CDS, Mr. Mathews spent five years with
the Nevada State Gaming Control Board in the Corporate Securities and
Investigation Divisions. Mr Mathews now manages the Company's product sales
operations in addition to his duties with Corporate Development and Government
Affairs.
PAUL D. MILTENBERGER joined SGI in April, 1996 as Business Planning Manager
and in April 1997 became Director of Sales Planning, a position he held until
September 1998 when he was promoted to Vice President of Sales. Mr. Miltenberger
became Vice President - Development in August 1999. Prior to joining SGI, Mr.
Miltenberger worked at Tektronics, a high-technology manufacturer of color
printers and test equipment, where from June 1995 to April 1996 he held the
position of Strategic Analysis Manager. Prior to Tektronics, Mr. Miltenberger
worked at Conner Peripherals, Inc. between August 1990 and June 1995 as Manager
of Strategic Reporting.
BETSY B. SUTTER joined SGI in March 1997 from Digital Equipment
Corporation, where from 1989 she had been the Human Resources Manager for their
Research and Advanced Technology Division in Palo Alto. Between 1985 and 1989,
Ms. Sutter had been the Human Resources Manager at Aehr Test Systems. Prior to
this she had human resources experience with other high technology companies
including Hitachi America Ltd. and General Electric Corporation. Ms. Sutter was
promoted to Vice President -Human Resources in April, 1998.
PART II
ITEM 5: MARKET FOR REGISTRANT'S COMMON EQUITY AND RELATED SHAREHOLDER MATTERS
STOCK PRICE HISTORY
(Fiscal Year) 1999 1998
------------------- -------------------
High Low High Low
---- --- ---- ---
FIRST QUARTER 1 11/16 7/16 11 3/16 8 1/4
SECOND QUARTER 13/16 5/16 10 3/8 7 1/2
THIRD QUARTER 19/32 3/16 9 15/16 3 1/8
FOURTH QUARTER 11/32 5/64 3 7/8 1 3/8
======= ==== ======== =====
The preceding table sets forth the high and low closing sale prices as
reported for the Company during each of the quarters in 1999 and 1998. Until
February 1999 the Company's common stock was listed on the Nasdaq Stock Market
under the symbol `SGIC'. In February 1999 the Company's Common Stock was
delisted from the Nasdaq National Market and the Company's stock now trades on
the NASD Over-The-Counter (OTC) bulletin board system under the symbol `SGIC'.
22
<PAGE>
DIVIDEND POLICY
The Company has never paid cash dividends on its Common stock. The Company
presently intends to retain all cash for use in the operation and expansion of
the Company's business and does not anticipate paying any cash dividends in the
near future.
ITEM 6: SELECTED CONSOLIDATED FINANCIAL DATA
<TABLE>
<CAPTION>
Nine
Years Ended December 31, Months Ended
-------------------------------------------- December 31,
(in thousands except per share amounts) 1999 1998 1997 1996 1995 (1)
---- ---- ---- ---- --------
<S> <C> <C> <C> <C> <C>
Statement of Operations Data:
Net sales .................................. $17,115 $22,281 $ 9,550 $ -- $ --
Loss from operations ....................... 16,436 32,009 22,984 14,533 4,059
Loss before extraordinary gain ............. 24,081 -- -- -- --
Net loss ................................... 11,765 37,670 22,986 13,634 3,974
Basic and diluted net loss per share ....... $ 0.70 $ 2.75 $ 2.16 $ 2.54 $ 2.34
Loss before extraordinary gain per share ... $ 1.42 -- -- -- --
Shares used in computation ................. 16,906 13,696 10,666 5,364 1,695
December 31
---------------------------------------------------------
(in thousands) 1999 1998 1997 1996 1995
---- ---- ---- ---- ----
Balance Sheet Data:
Cash and equivalents ....................... $ 877 $ 8,399 $16,352 $25,583 $ 2,399
Short-term investments ..................... 1,000 -- 4,705 9,683 --
Working capital ............................ 6,394 10,772 25,087 34,203 2,027
Total assets ............................... 15,581 41,744 49,038 39,646 3,486
Long-term obligations ...................... 16,260 39,809 22,637 778 272
Redeemable Convertible Preferred Stock ..... -- 1,666 3,065 6,455 8,496
Total shareholders' equity (deficiency) .... (7,361) (18,452) 14,432 30,061 (5,946)
</TABLE>
- ----------
(1) Effective April 1, 1995, the Company changed its fiscal year end from March
31 to December 31.
23
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ITEM 7: MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS
OF OPERATIONS
OVERVIEW
The Company was incorporated on July 27, 1993 to design, develop,
manufacture and distribute interactive gaming devices that implement advanced
multimedia technologies using state-of-the-art, off-the-shelf components. In
1997 the Company successfully introduced its first product, ODYSSEYTM, a
multi-game, video-based slot machine, into the Nevada market. Since that time
the Company has rolled out ODYSSEY into other jurisdictions including
Connecticut, Illinois, Indiana, Iowa, Kansas, Louisiana, Michigan, Minnesota,
Mississippi, Missouri, New Jersey, New Mexico, certain Canadian provinces and
Uruguay. In 1998 the Company introduced QUEST, a single-game platform that
utilizes many of the same components as the ODYSSEY, and in 1999 the Company
introduced a slant-top, single-game platform, to increase its penetration of the
casino floor.
As of December 31, 1999, the Company has 4,050 machines installed in
approximately 200 properties. Of these machines, 3,702 have been sold outright
or placed on a revenue-sharing basis. After returns, 348 machines remain
installed on a trial basis and the casino operators are required to purchase the
machine outright, participate in SGI's revenue sharing plan or return the
machine to the Company within a defined trial period.
At December 31, 1999 the Company had cash and equivalents and short-term
investments of $1.9 million. The Company has incurred operating losses each year
since inception, and as of December 31, 1999 had an accumulated deficit of $92.0
million and a deficiency of shareholders' equity of $7.4 million. The Company
has been required to obtain additional financing each year to be able to fund
its ongoing operations. Based on historical levels of cash usage, the above
factors raise substantial doubt about the Company's ability to continue as a
going concern. In late 1998 and early 1999 the Company took steps to reduce the
level of operating expenses and made a number of management decisions which
resulted in total reductions of the Company's work force by approximately 70%
and made significant cuts in expenditures across the Company. Management also
announced the relocation of its manufacturing to its Las Vegas, Nevada facility
and the closure of its Mountain View, California manufacturing facility. In
November 1999, the Company, with the consent of the holders of its Senior
Discount Notes, was able to convert approximately $40 million principal amount
of debt plus $8.3 million in accrued interest into a 57% equity stake in the
Company, and to obtain commitments for additional financing from the debt
holders. The aforementioned actions resulted in the Company reducing its
operating expenses by approximately 40%, its interest obligations by
approximately 80%, and reduced the cash used in operations by approximately 80%
from the levels of the prior year. Management has recently renewed the terms of
a line of credit with a new bank on more favorable terms so that this financing
source remains available to the Company. Management is also reviewing financing
alternatives available to the Company such as additional share or debt offerings
in the Company or certain of its subsidiaries, joint ventures, alternative
distribution channels and sale of all or a portion of the Company's assets, to
improve the Company's liquidity position. Management believes that these steps,
plus sales related to new product introductions will provide sufficient cash and
working capital for the Company to meet its ongoing obligations and to allow it
to continue operating as a going concern through at least the end of 2000. See
Note 1 of Notes to Consolidated Financial Statements.
The Company spent much of 1999 addressing its poor liquidity position,
restructuring its balance sheet, retaining its key personnel and taking such
actions necessary to enable the Company to continue operating. The uncertainty
surrounding the Company's future, along with the reductions in the Company's
workforce, negatively impacted its ability to retain some senior management and
some key employees, especially in its engineering and sales organizations. These
factors also negatively impacted the Company's sales performance, especially in
the second half of 1999 as the Company was forced to rebuild its sales
24
<PAGE>
organization. Through these difficult times, and with less resources, the
Company has continued to introduce new game titles into the marketplace during
1999.
Prior to March 1997 the Company was in the development stage and its
primary activities were focussed on product development, including system
hardware and software, game concept development and software coding. Towards the
end of 1996 the Company began manufacturing slot machines for commercial
distribution. The Company sold its first product in May 1997 following
completion of a customer evaluation period. Prior to this time the Company did
not generate any revenue from product sales.
Silicon Gaming is headquartered in Palo Alto, California and has sales
offices in Reno and Las Vegas, Nevada, and in Gulfport, Mississippi. Product is
manufactured at the Company's location in Mountain View, California. At December
31, 1999 the Company had 90 employees.
RESULTS OF OPERATIONS
The Company had a net loss of $24.1 million for the year ended December 31,
1999 before the $12.3 million extraordinary gain recorded on the conversion of
debt in conjunction with a financial restructuring of the Company in November
1999 . This compared to net losses of $37.7 million and $23.0 million for the
years ended December 31, 1998 and 1997, respectively. The significant decrease
in net loss in 1999 was achieved on lower revenues largely due to the Company's
efforts at reducing its level of operating expenses in early 1999.
REVENUES
The Company generates hardware revenue from the sale of its products and
related parts and accessories. All products are sold with licensed software and
customers have the choice of either a paid-up or renewable annual license. The
Company places products in casinos under a participation program where it
receives 20% of the net win generated by the product as revenue. Total revenue
units include machines sold outright as well as machines placed under the
participation programs.
The Company generated revenues as follows:
Years Ended December 31,
(in $'000, except for -----------------------------------------------
machine numbers) 1999 1998 1997
-------------- -------------- -------------
Hardware sales $10,370 61% $14,126 63% $7,636 80%
Software sales 4,288 25% 4,657 21% 567 6%
Participation revenue 2,457 14% 3,498 16% 1,347 14%
------- --- ------- --- ------ ---
Total revenue $17,115 100% $22,281 100% $9,550 100%
======= ======= ======
Total revenue units 926 1,622 1,298
As can be seen from the above table, the Company had total revenue of
$17,115,000 for the year ended December 31, 1999. This was a decrease of
$5,166,000 or 23% from the $22,281,000 recorded in 1998. The decrease in revenue
was in part due to a 43% decrease in the total revenue units compared to 1998.
This was largely attributable to uncertainty surrounding the Company's future
due to its liquidity situation through much of 1999, which saw customers
deferring product purchases until the financial position of the Company became
clearer. The loss of the majority of the Company's sales organization during
1999 also exacerbated the decrease in sales and the Company spent much of the
second half of 1999 in rebuilding its sales organization. The average selling
price on machines sold outright decreased from $10,230 in 1998 to $8,343 in
1999, reflecting a higher level of sales of used machines, as well as the impact
of higher competition in the gaming-machine industry than in the previous year.
SGI sells its products outright to casino operators and other potential
purchasers offering several pricing programs. For the ODYSSEY this consists of
either (i) the sale of the hardware unit bundled with a single game or a suite
of games and other software for a fixed price, or (ii) the sale of the hardware
25
<PAGE>
unit alone combined with a renewable one-year software license, including access
to the entire ODYSSEY game library for the term of the license. The Company's
slant-top machine and the QUEST are sold as a bundled package of the hardware
unit and a single game for a fixed price. The Company also offers a
participation program where it will place its products on a casino floor in
exchange for a share in the aggregate win generated by the machine. Typically,
under this program, 20% of the aggregate win goes to the Company, subject to a
predetermined minimum. In December 1998, the Company introduced its first
wide-area progressive product, THE BIG WIN. Machines placed in casinos on the
progressive system are priced such that the Company receives a predetermined
share of the gross amount wagered on the machine. During 1999 the Company
modified the game in an attempt to improve the performance of the game, before
deciding in the fourth quarter of 1999 to remove all progressive machines from
casinos due to unsatisfactory product performance. Revenues generated from the
participation program and from the wide-area progressive product are included as
`Participation revenues' in the above table.
The decreases in participation revenue and in software revenue in 1999
compared to 1998 reflect decisions made by management during 1999 to remove poor
performing machines from the participation programs, which reduced the number of
machines on participation by almost 50%, and by a program in 1998 to convert
customers from the renewable annual license program, which caused a decrease in
software renewal revenues in 1999. Management believes that eliminating the
annual license program will bring the Company more into line with its
competitors and will result in increased future revenue opportunities as
customers will now purchase new game titles from the Company. The Company
believes that in the future participation revenues will increase in absolute as
well as relative terms as it places more of its new products on a participation
basis, and that in relative terms, hardware and software revenues will decrease
from current levels.
The Company was able to increase revenue during the year ended December 31,
1998 by 133% to $22,281,000 from the $9,550,000 recorded in the year ended
December 31, 1997. A large portion of this increase represents the increase in
volume in the number of machines sold or generating revenue for the Company,
which increased by 25%, or 324 units, from 1,298 in 1997 to 1,622 in 1998. The
average selling price on machines sold outright decreased from $11,050 in 1997
to $10,230 in 1998 reflecting the increased levels of competition in the
industry and a resulting higher level of discounts given to strategic corporate
customers during 1998.
The increases in participation revenue and in software revenue in 1998
compared to 1997 reflect the full year impact in 1998 of machines in the
participation programs, which were first offered in June 1997, and the larger
installed base from which the Company derives software license revenue. Software
revenue increased by $4,090,000 or 721% in 1998 as a result of these factors.
During 1999, one customer accounted for 16% of revenues. During 1998, two
different customers accounted for 11% and 10% of revenues. In 1997 three
different customers accounted for 27%, 12% and 12% of revenue. The Company
expects that a significant portion of its revenue will remain concentrated
within a limited number of strategic customers within the gaming industry due to
the increasing consolidation that is taking place among casino operators. As an
equipment vendor to the gaming industry, the Company sells infrequently to many
customers and the volume of sales to any particular customer may vary
significantly from period to period. As a result, there can be no assurance that
the above strategic customers will continue to account for a significant
percentage of the Company's revenue in the future. The loss of any strategic
customer could have a material adverse affect on the Company's business and
results of operations.
26
<PAGE>
COST OF SALES
Cost of sales includes the direct cost of product sales as well as the
unabsorbed costs of the Company's manufacturing operations. Cost of sales also
includes license fees and royalties paid to third parties, depreciation on
machines placed on the participation programs as well as the costs directly
associated with running the wide-area progressive system, including payments of
jackpot awards. Cost of sales were $13,213,000, $24,062,000, and $10,421,000 for
the years ended December 31, 1999, 1998, and 1997, respectively. The decrease in
cost of sales in 1999 of $10,849,000 or 45% from 1998 reflects a $3.5 million
reduction in manufacturing expenses as a result of closing the Company's
California manufacturing facility during 1999, the lower number of machines sold
, and significantly lower royalty expenses to third parties compared to the
prior year. This was offset partially by the higher costs of operating the
progressive system and a $2.5 million expense related to excess and obsolete
inventories in the fourth quarter of 1999 following certain product
configuration decisions by management which affected the salability of certain
parts.
The year-to-year increases in cost of sales between 1998 and 1997 was
largely driven by the higher number of machines sold or placed on one of the
Company's participation programs, the absence of product sales prior to May
1997, royalties of $2,200,000 paid to a third party in 1998 in connection with a
new game offering, as well as the cost of operating the wide-area progressive
system that was introduced in the fourth quarter of 1998. The Company also
recorded $5,200,000 in expense during 1998 related to lower of cost or market
and excess and obsolete inventories.
Cost of sales represented 77%, 108% and 109% of revenues in 1999, 1998 and
1997, respectively. The improvement in 1999 reflects the lower operating costs
of the Company and the absence of large one-time expenses such as those recorded
during 1998. The marginal decrease in cost of sales as a percentage of revenues
between 1998 and 1997 was a reflection of the charges that the Company booked
related to inventory write-offs and due to the royalty payments that the Company
agreed to pay to a third party during 1998. These charges offset the benefits of
efficiencies gained as manufacturing volumes increased, reflecting the fixed
cost of the manufacturing facility. The per-unit manufacturing cost has
decreased as the Company began to realize benefits from the tooling of certain
of its hardware components, and from cost reductions in many of the components
included in its machines. Through the end of 1998 the Company was able to reduce
the per-unit material cost of its products by approximately 50% from the first
products it produced in 1996. Due to significant levels of finished goods
inventory, the Company manufactured minimal product during 1999 and this has
prevented it from obtaining further cost reductions in its products. The Company
anticipates that as it introduces more unique, fully integrated specialty
products, per-unit costs may increase in future periods.
RESEARCH AND DEVELOPMENT
Research and development ("R&D") expenses include payroll and related costs
of employees engaged in the ongoing design and development activities of the
Company, costs paid to outside contractors and specialists, prototype
development expenses, overhead costs, equipment depreciation and costs of
supplies. To date, the Company has expensed all costs associated with the
research, design and development of its products. R&D expenses were $4,410,000,
$11,853,000 and $9,283,000 for the years ended December 31, 1999, 1998 and 1997,
respectively.
The significant decrease in R&D expenses in 1999 is primarily due to lower
salary expense as a direct result of the reductions in the Company's workforce
during 1999, and because of higher development costs in 1998 related to the
development of the wide-area progressive system that were not incurred in 1999.
The increase between 1998 and 1997 was largely the result of incremental hiring
of personnel, increased use of engineering consultants and license fees and
similar costs associated with the acquisition of outside technologies. Prior to
1997 the focus of R&D activities was in the successful development of the
Company's initial product, ODYSSEY, and the initial suite of games that the
Company offered. Since that time, R&D activities have focused on new game
development, the introduction of new product platforms, and in the development
of new game types such as the wide-area progressive system. The Company is
27
<PAGE>
focussed on ensuring that it can offer additional features into its products
that will fully capitalize the underlying technology used. This is expected to
require significant R&D resources to continue the development of the product
platform to facilitate the elaborate requirements of the game development
process and to enable it to introduce new game types into the slot machine
market.
SELLING, GENERAL & ADMINISTRATIVE
Selling, general and administrative ("SG&A") expenses include payroll and
related costs for executive and administrative personnel, sales and
customer-support organization personnel, and marketing and licensing personnel,
corporate overhead costs, legal and associated costs, costs associated with
obtaining and retaining corporate and product licenses in various jurisdictions,
and fees for professional services. Approximately 50% of SG&A expenses are
headcount related. SG&A expenses were $12,651,000, $18,375,000 and $12,830,000
for the years ended December 31, 1999, 1998 and 1997, respectively.
The decrease in SG&A expenses in 1999 reflects the lower number of
employees following the reductions in the Company's workforce in the first
quarter of 1999 and lower commissions reflecting the lower revenues. These
savings were offset by higher legal fees in connection with a number of patent
infringement cases that the Company was party to during 1999. Increases in SG&A
expenses between 1998 and 1997 were largely attributable to the hiring of
additional personnel and in costs associated with applying for corporate and
product licenses as the Company began selling product into new jurisdictions.
The Company also incurred costs as it created and established a customer-support
organization to support the rollout of its product, and as it established a
marketing organization upon the commercial distribution of its products in 1997.
A significant portion of these increases occurred during 1997 when the Company
commenced sales of the ODYSSEY and built its infrastructure in the Nevada and
Mississippi markets. Additional increases in SG&A expenses in 1998 were due to
severance payments made to senior management and increases in bad debt
provisions of $1,600,000 due to problems with customer collections. The Company
intends to restrict the growth in SG&A expenses as much as possible in future
periods and expects SG&A expenses in absolute dollars and as a percentage of
revenue to decline.
RESTRUCTURING
The Company recorded restructuring expenses of $3,277,000, in the first
quarter of 1999, following management decisions to reduce the size of the
Company's workforce and to close its California manufacturing facility and
relocate all of its manufacturing and production operations to its Las Vegas,
Nevada facility. This was done as the Company sought to reduce its operating
expenses to a level more appropriate to its revenue levels. Restructuring
expenses include employee severance costs of $595,000, costs of $2,424,000
relating to scrapping and abandonment of assets, and $258,000 for
lease-associated expenses. All costs were incurred prior to June 30, 1999.
INTEREST INCOME AND EXPENSE
Interest income was $99,000, $618,000 and $1,238,000 for the years ended
December 31, 1999, 1998 and 1997, respectively. Fluctuations in the level of
interest income are directly attributable to fluctuations in the level of
average cash and investment balances that the Company holds. The timing of share
offerings, issuance of Senior Discount Notes, and the rate of spending on
operations have impacted the average level of cash and investments held.
Interest expense was $7,241,000, $6,261,000 and $1,240,000 for the years
ended December 31, 1999, 1998 and 1997, respectively. The increases in interest
expense are due to increases in the Company's level of long-term indebtedness
over the period. The Company raised $25 million in September 1997 from the
issuance of Senior Discount Notes (the 1997 Notes) and raised an additional $15
million in June 1998 from the issuance of additional Senior Discount Notes (the
1998 Notes). The Company also raised approximately $3.6 million from equipment
financing borrowing during 1998. Interest expense was higher in 1999 due to the
full-year impact of interest expense on amounts borrowed during 1998. The
increase in interest expense in 1998 reflects the full year interest cost of the
1997 notes as well as the interest costs associated with the 1998 Notes, the
repricing of stock warrants and the equipment financing.
28
<PAGE>
GAIN ON CANCELLATION OF DEBT
In November 1999 the Company completed a restructuring of its balance sheet
with the cooperation of the holders of its Senior Discount Notes. The holders of
the Senior Discount Notes exchanged $39.75 million principal notes and accrued
interest of $8.3 million for Preferred Stock that is convertible into a 57%
voting interest in the Company. Concurrent with this conversion, the holders of
the Senior Discount Notes invested an additional $2 million of New Senior
Discount Notes in the Company. After accruing future interest payments on the
restructured debt (which will result in no interest expense being recorded for
these payments in future periods), recording certain expenses related to
issuance of warrants to the existing equity holders of the Company and the costs
of the restructuring, the Company recorded a gain of $12.3 million upon the
cancellation of the underlying debt.
INCOME TAXES
The Company has not been required to pay income taxes due to the fact that
it has had net operating losses in each period since the Company's inception.
The Tax Reform Act of 1986 and the California Act of 1987 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'
ability to utilize its net operating loss and tax credit carryforwards is
subject to limitation pursuant to these restrictions. The Company underwent an
ownership change as of the date of the debt restructuring in November, 1999. As
a result, the Company lost the potential tax benefits of the net operating loss
carryforwards and the tax credit carryfowards that existed at that time.
A valuation allowance has been recorded for any deferred tax assets due to
uncertainty regarding the ultimate realization of these assets resulting from
the lack of earnings history of the Company.
LIQUIDITY & FINANCIAL CONDITION
The Company was able to significantly reduce its level of debt as a result
of the debt restructuring completed in November 1999, but has continued to
operate under very tight liquidity constraints. Cash and equivalents and
short-term investments decreased by $6,522,000 and were $1,877,000 as at
December 31, 1999 compared to $8,399,000 at December 31, 1998. This decrease in
resources is primarily due to the ongoing losses from operations that the
Company has incurred and the need to repay outstanding borrowings that the
Company had previously incurred.
As of December 31, 1999 the Company had an accumulated deficit of
$92,035,000, a shareholder's deficiency of $7,361,000 and has had operating
losses every year since its inception. The Company has been required to obtain
additional financing each year to be able to fund its ongoing operations. Based
on historical levels of cash usage, the above factors raise substantial doubt
about the Company's ability to continue as a going concern. In late 1998 and
early 1999 the Company took steps to reduce the level of operating expenses and
made a number of management decisions which resulted in total reductions of the
Company's work force by approximately 70% and made significant cuts in
expenditures across the Company. Management also announced the relocation of its
manufacturing to its Las Vegas, Nevada facility and the closure of its Mountain
View, California manufacturing facility. In November 1999, the Company, with the
consent of the holders of its Senior Discount Notes, was able to convert
approximately $40 million principal amount of debt plus $8.3 million in accrued
interest into a 57% equity stake in the Company, and to obtain additional
financing from the debt holders. The aforementioned actions resulted in the
Company reducing its operating expenses by approximately 40% compared to the
prior year, its future interest obligations by approximately 80%, and reduced
the cash used in operations by approximately 80% from the levels of the prior
year. Management has recently entered into a $ 2 million accounts receivable
based line of credit with a new bank on more favorable terms than it previously
had. Management is also reviewing financing alternatives available to the
Company such as additional share or debt offerings in the Company or certain of
its subsidiaries, joint ventures, alternative distribution channels and sale of
all or a portion of the Company's assets, to improve the Company's liquidity
position. Management believes that these steps, plus sales related to new
29
<PAGE>
product introductions will provide sufficient cash and working capital for the
Company to meet its ongoing obligations and to allow it to continue operating as
a going concern through at least the end of 2000. However, the success of any
new product introductions is subject to various risks and uncertainties, and
there is no assurance that such new products will generate the amount of revenue
hoped for by the Company. In the event it is unable to generate sufficient cash
from operations or identify new sources of capital, the Company will be required
to significantly limit or shut down all or some of its operations.
The net cash used in operating activities was $3,836,000, $32,110,000 and
$29,909,000 for the years ended December 31, 1999, 1998 and 1997, respectively.
The large decrease in cash used during 1999 was due to the reduction in the
Company's operating losses and through improved management of the Company's
working capital. The Company reduced its level of inventories and receivables by
$8,845,000 in 1999 which helped provide cash for the ongoing daily operations of
the Company. The increase in cash used in operating activities in 1998 from 1997
was due to the increase in net operating losses and due to increases in the
Company's working capital requirements, predominantly in inventory and
receivables during 1998. This increase was offset partially by increases in
depreciation, amortization, bad debt provisions, and accrued interest. Inventory
levels, particularly raw materials and finished goods, increased significantly
in 1998. This increase occurred as the Company ramped up its level of operations
in anticipation of sales demand, and was unable to reduce these levels once the
anticipated sales levels did not materialize. The increase in receivables was
largely due to problems in collections from several customers, which also
resulted in the Company having to increase its bad debt reserves during 1998 by
approximately $1,600,000. The Company anticipates that in 2000 it will continue
to need to reduce its level of inventory and convert such inventory into cash to
be used for operations, if it is to have sufficient cash resources.
Net cash used in investing activities was $1,109,000 for the year ended
December 31, 1999 largely due to the timing of investment of the Company's
surplus operating cash, with $1 million being held in short-term investment as
at December 31, 1999. This was offset by the Company's investment in new capital
equipment. The Company has significantly reduced its investment in new equipment
because of the liquidity constraints that the Company was forced to operate
under for most of 1999. Net cash provided by investing activities of $1,245,000
for the year ended December 31, 1998 was due largely to the redemption of
short-term investments, offset by the amount of money spent on capital
expenditure. Net cash used in investing activities was $3,077,000 for the year
ended December 31, 1997. The decrease in 1998 from 1997 is due to the sale and
maturity of the Company's short-term investments that were redeemed during 1998.
This offset the Company's increased investment in fixed assets in 1998,
particularly in relation to the introduction of the Company's wide-area
progressive system. The Company anticipates continued investment in fixed assets
during 2000 as it continues to develop new delivery systems and channels for its
software based products.
Net cash used in financing activities was $2,577,000 for the year ended
December 31, 1999 compared to net cash provided by financing activities of
$22,912,000 and $23,755,000 for the years ended December 31, 1998 and 1997,
respectively. In 1999 the Company was required to repay borrowings under its
bank line of credit and its equipment financing of approximately $4.7 million.
This was offset by the $2 million received in New Senior Discount Notes in
November 1999 in connection with the restructuring of the Company's long-term
debt. Fluctuations in net cash provided by financing activities in 1998 and 1997
are due to the timing of the company's various share and debt offerings. In 1998
the Company raised net proceeds of $14,950,000 from the issuance of Senior
Discount Notes and $3,586,000 from the proceeds of new equipment financing
arrangements. In 1997 the Company financed its operations primarily through the
proceeds of $23,055,000 from the issuance of Senior Discount Notes plus
detachable warrants.
In November, 1999 the Company along with three other slot machine
manufacturers was named in a lawsuit filed by International Game Technology
(IGT) alleging infringement of a particular patent relating to the use of
electronic buttons on the game play field. The lawsuit has not been served upon
the Company by IGT. The Company, along with the other defendants, has provided
certain information to IGT that it believes invalidates IGT's patent claim. If
the patent is not served upon the Company in a timely manner it will lapse and
no further action will be required. The costs of defending such lawsuits may be
substantial and may require significant amounts of senior management time, and
an adverse result in any such litigation could materially and adversely affect
the Company's liquidity and capital resources.
30
<PAGE>
In March 2000 the Company received notification that it has been sued in
the Federal Court in the District of South Carolina by a former distributor of
the Company's products. The distributor seeks repayment of $1 million, plus
damages, in connection with machines previously shipped to the distributor in
1998. The Company was in the process of arbitration as required by the
Distribution Agreement, seeking to recover outstanding receivables from the
distributor. The Company has not yet responded to this lawsuit and the Company's
management vehemently deny the allegations of the lawsuit. The Company is not
yet able to determine the likely outcome of this litigation and the financial
impact, if any, on the Company's results of operations or liquidity position.
RECENTLY ISSUED ACCOUNTING STANDARDS
In June 1998, the FASB issued Statement of Financial Accounting Standards
No. 133, "Accounting for Derivative Instruments and Hedging Activities". This
statement requires companies to record derivatives on the balance sheet as
assets or liabilities measured at fair value. Adoption of this standard has no
impact upon the Company's consolidated financial position, results of operations
or cash flows as the Company does not currently have any derivative financial
instruments covered by this standard.
OUTLOOK
This outlook section and other sections in this Annual Report on Form 10-K
contain a number of forward-looking statements that reflect the Company's
current views with respect to future events and future financial performances.
Because they relate to future activities, there is a high degree of risk that
such events will not materialize and readers should not place undue influence
upon them as actual results may differ materially.
To date the Company has focussed many of its resources on creating a
business based on high-volume manufacturing and placement of slot machines with
a goal of capturing market share. The Company has struggled in its endeavors
against many competitors who are significantly larger and who have much greater
resources than the Company. The Company has historically emphasized selling game
platforms and strived to penetrate the market through frequent software releases
of new game titles. Changes in the competitive landscape since the Company was
formed have forced the Company to reevaluate its basic business strategy. The
Company has incurred significant expenses in developing a fully integrated, high
overhead business that assumed a much higher level of unit sales than the
Company has been able to achieve, resulting in unacceptable levels of
profitability for the Company.
Since the completion of the restructuring of its balance sheet in November
1999, management has spent time reviewing the basic business strategy of the
Company and intends to reorganize the business around the different product and
market opportunities that it has identified. Management also intends to simplify
the business and focus resources so that it can continue to reduce the level of
corporate overhead, minimize the level of cash usage, transition the business to
one that takes advantage of revenue-sharing opportunities and focus on achieving
profitability.
31
<PAGE>
The Company has sold over 3,700 machines to date and understands the need
to continue to support its products and the needs of its existing customers. At
the same time, the Company needs to focus on how to best exploit the technology
inherent in its game platforms and the development capabilities of its
development organization. This will allow it to provide game experiences and
game features that are unique to the Company that cannot be easily exploited or
imitated by its competitors. By emphasizing the quality of the wagering
attraction, including the game itself, rather than the volume of new game
titles, the Company hopes to be able to command premium floor locations in its
customers' casinos, and as a result achieve a premium level of performance and
revenue. The Company intends to partner with outside parties, including casino
operators, other slot manufacturers, and other intellectual property and
brand-based content holders, to accomplish these goals. By partnering with
outside parties the Company believes it can offset its development risk and
costs, achieve higher revenues and increase the likelihood of product success.
In 1999 the Company entered into a joint-product development and marketing
agreement with Anchor Gaming. This is the first example of where the Company
will seek external skills to complement its own resources. The Company
anticipates announcing more similar arrangement during 2000. In February 2000
the Company announced that it had entered into a product development arrangement
with a Nevada-based casino operator whereby the Company will develop an
exclusive, brand-based product for the operator. The Company expects to
introduce this product into the market in the Summer of 2000.
The Company also intends to continue its program of improving and
solidifying its financial position. This will require that the Company continue
to sell through its existing inventory to provide adequate working capital for
the Company to use in its day to day operations. The Company is also considering
raising additional capital in either the parent company or directly into certain
of its subsidiaries, in order to fund new product and system development.
The Company will continue to introduce new game title releases for sale and
to refresh the game offerings on its installed base of ODYSSEY, QUEST and
slant-top machines during 2000. The Company intends to change its focus from one
of frequent game releases to one that emphasizes the quality and feature content
of new game titles. It will also offer product extensions and variations of
existing successful game titles. The Company also understands that it must
emphasize more than selling a platform that has a variety of game applications
upon it. The Company hopes to partner with casino operators to provide a unique,
fully integrated gaming experience which encompasses packaging, merchandising,
signage systems and, in some cases, unique platform packaging as well. By doing
this, the Company aims to provide a more complete and feature rich experience
for the gaming patron that is unique to the Company. By partnering with casino
operators the Company hopes to achieve premium placement of its product.
The Company's future results of operations and the other forward-looking
statements contained in this outlook - in particular the statements regarding
potential partnerships with casino operators or other third parties, and
possible raising of additional capital- involve a number of risks and
uncertainties. In addition to the factors discussed above, among the other
factors that could cause actual results to differ materially are the following:
the success of the Company's game titles that it introduces into the market,
changes in customer order patterns, competitive factors such as new competitor
product or game introductions or changes in pricing strategies, reluctance of
casino operators to use participation-based products or to partner with the
Company in product development, the Company's level of financial resources and
adequate cash flows, the stability of the Company's management team and
workforce, and the ability of the Company to meet all initial and ongoing
licensing requirements in the jurisdictions in which it sells products.
The Company believes that it has the product offerings, facilities,
personnel, and competitive resources needed for business success, but future
revenue, costs, margins and profits are all influenced by a number of factors,
including those discussed above and the need for the Company to raise additional
funds, all of which are inherently difficult to predict.
32
<PAGE>
FACTORS AFFECTING FUTURE RESULTS
MANAGEMENT OF CHANGING BUSINESS - The Company has spent the last year
trying to shift its business strategy from one of high-volume manufacturing and
placement of slot machines with a goal of capturing market share, to a strategy
that emphasizes the quality and feature content of new game titles and takes
advantage of revenue-sharing opportunities. The Company plans on offering
product extensions and variations of successful existing games in 2000, however
the emphasis will shift from volume-based to one of providing a unique,
fully-integrated gaming experience. This transition represents a significant
challenge for the Company and its management and employees, and places increased
demand on its systems and controls. The Company's ability to manage this change
will require the Company to continue to change, expand and improve its
operational, management and financial systems and controls to manage any
outsourcing or relocation of existing activities. Key to effecting this change
in business is the ability of the Company to sell its existing inventory of
ODYSSEY and QUEST products in a timely manner and to resolve outstanding
collections issues with customers to provide sufficient working capital during
this transition process. If the Company is not able to generate adequate funds
from its working capital in a timely manner, the Company's business, operating
results and financial condition will be materially and adversely affected.
LIQUIDITY - The Company has funded its operations to date primarily through
private and public offerings of its equity securities, the issuance of Senior
Discount Notes, term and equipment loans and from bank borrowings. At December
31, 1999 the Company had an accumulated deficit of $92,035,000 and a deficiency
of shareholders' equity of $7,361,000 and was not in compliance with the terms
of its line of credit that expired in January 2000. The Company subsequently
repaid all amounts due under the line of credit and has negotiated a new line of
credit with a different financial institution on better terms. Management is
also reviewing financing alternatives available to the Company such as
additional share or debt offerings in the Company or certain of its
subsidiaries, joint ventures, alternative distribution channels and sale of all
or a portion of the Company's assets. If the plans that management has
undertaken to improve the Company's liquidity position are not successfully
completed in a timely manner it is probable that insufficient funds will exist
to satisfy the Company's operating requirements. The Company will be required to
make adjustments to its operating activities to operate within the restrictions
of its liquidity and this could have a material adverse affect upon the
Company's business, operating results and financial condition. To the extent
that the Company sells additional shares or issues any convertible debt
securities, this could result in additional dilution to existing shareholders.
There can be no assurance that the Company will be able to successfully
renegotiate its existing credit facility or be able to raise additional funds
when and if needed.
VOLATILITY OF STOCK - The market price of the Company's stock has been
highly volatile and subject to large fluctuations. The Company's stock price may
be affected by factors such as actual or unanticipated fluctuations in the
Company's results of operations, new product or technical introductions by the
Company or any of its competitors, developments with respect to patents,
copyrights or proprietary rights, conditions or trends in the gaming industry,
changes in or failure by the Company to meet securities analysts' expectations,
general market conditions and other factors. The Company's stock now trades on
the Over The Counter (OTC) Bulletin Board. This may affect the level of trading
activity in the Company's stock, result in higher bid/ask spreads, and increase
the cost of raising additional equity for the Company, as well as result in
higher levels of volatility in the price of the Company's stock.
RETENTION OF PERSONNEL - The operations of the Company depend to a great
extent on the management efforts of its officers and other key personnel, and on
the ability to attract new key personnel and retain existing key personnel. The
Company has experienced high turnover among its senior management during 1998
and 1999. In February 1999 the Company announced the appointment of a new Chief
Executive Officer. The Company also reduced its workforce by approximately 20%
in December 1998 and by a further 40% in March 1999. These factors, combined
with the Company's poor operating results and the significant decrease in the
price of the Company's Common Stock may have an adverse affect on the Company's
ability to retain and motivate its key employees. Competition is intense for
33
<PAGE>
highly skilled product development employees in particular. In addition, the
Company's officers and key employees are not bound by non-competition agreements
that extend beyond their employment at the Company, and there can be no
assurance that employees will leave the Company or compete against the Company.
The Company's failure to attract additional qualified employees or to retain its
existing employees could have a material adverse affect on the Company's
operating results and financial condition. Should the Company offer additional
stock option grants to its existing employees to encourage them to continue
their employment at the Company, this may result in additional dilution to
existing shareholders.
CUSTOMER RETENTION - The Company's ability to sell product may be hampered
due to the financial position of the Company which presents risks to customers
that the Company may not be able to fulfill its obligations under license
agreements or be available to provide warranty, repair or upgrade services on
products that it has already sold. The Company experienced negative reaction
from customers who held these views during 1999 and who have indicated that they
may not purchase additional product from the Company. Completion of the
Company's debt restructuring in November 1999 mitigates these risks however the
Company continues to experience these negative sentiments from its customers.
Certain of the Company's competitors who have significantly greater financial
and marketing resources than the Company are also trying to take advantage of
the Company's financial position and are fueling the speculation about the
Company's financial position. To the extent that this results in the loss of any
of the Company's strategic customers or results in a loss of sales
opportunities, the Company's business, operating results and financial condition
may be adversely affected.
INTELLECTUAL PROPERTY RIGHTS - The Company regards its product as
proprietary and relies primarily on a combination of patent, trademark,
copyright and trade secret laws and employee and third-party nondisclosure
agreements to protect its proprietary rights. Defense of intellectual property
rights can be costly, and there can be no assurance that the Company will be
able to effectively protect its technology from misappropriation by competitors.
As the number of software products in the gaming industry increases and the
functionality of these products further overlaps, software developers and
publishers or competitors may increasingly become subject to infringement
claims. The Company may also become subject to infringement claims, with or
without merit, that are brought by competitors who are motivated with a desire
to disrupt the Company's business. The Company and three of its competitors were
notified by one of its competitors, IGT, of a potential infringement claim
during November 1999. This required senior management to work with the other
defendants to provide information to IGT that it believes repudiates the claims
alleged by IGT. The Company has not been served with the actual lawsuit so it is
unable to ascertain the future impact, if any, of this claim. Any such claims or
litigation can be costly and result in a diversion of management's attention,
which could have a material adverse effect on the Company's business and
financial condition. Any settlement of such claims or adverse determinations in
such litigation could also have a material adverse effect on the Company's
business, operating results and financial condition.
CHANGING LEGISLATIVE ENVIRONMENT -The opening of new casinos, including
casinos in jurisdictions where gaming has recently been legalized historically
has driven growth for demand in slot machines. However, in recent years, the
legalization of gaming in new jurisdictions has been significantly reduced;
therefore demand based on new openings will be largely limited to new projects
in existing markets. Certain markets, which currently permit gaming, are
contemplating legislation to limit, reduce or eliminate gaming. If successful
such legislation could limit growth opportunities for the Company. As a result
of these factors, there can be no assurance that the slot machine market will
sustain the rate of growth that was possible in the first half of this decade.
34
<PAGE>
RAPIDLY CHANGING TECHNOLOGY - The Company's products utilize hardware
components that have been developed primarily for the personal computer and
multimedia industries. These industries are characterized by rapid technological
change and product enhancements. The Company's ability to remain competitive and
retain any technological lead may depend in part upon its ability to continually
develop new slot machine games that take full advantage of the technological
possibilities of state-of-the-art hardware. The Company has not updated its
product offering to take advantage of enhanced hardware components since 1998.
Should any current or potential competitor of the Company succeed in developing
a competing software-based gaming platform, such competitor could be in a
position to outperform the Company in its ability to exploit developments in
microprocessor, video or other multimedia technology. The emergence of a suite
of slot machine games that is superior to the Company's in any respect could
substantially diminish the Company's product sales and thereby have a material
adverse effect on the Company's operating results.
DEPENDENCE ON SINGLE-SOURCE SUPPLIERS - The Company currently obtains
certain systems components from single-source suppliers. In particular the
touchscreen and picture tube that comprise the video display are supplied by
MircoTouch Systems, Inc. and Philips Display Components Company, respectively.
The Company does not have long-term supply contracts with these suppliers but
rather obtains these components on a purchase order basis. Although the design
of these components is not unique or proprietary and the Company believes that
it could identify alternative sources of supply, if necessary, there can be no
assurance that the Company would be able to procure, substitute or produce such
components without a significant interruption in its assembly process in the
event that these single sources were unable to supply these components. Even
where the Company has multiple sources of supply for a component, industry-wide
component shortages, such as those that have occurred with various computer
components, could significantly delay productivity, increase costs or both. The
Company is also considering exclusive outsourcing arrangements whereby a single
third party contract manufacturer will assemble all or a significant portion of
new products that the Company is planning to introduce. The failure or delay by
any supplier to furnish the Company with the required components or products
would have a material adverse effect on the Company's business, financial
condition and results of operations.
ITEM 7A
MARKET RISK DISCLOSURES: The following discussion about the Company's
market risk disclosures involves forward-looking statements. Actual results
could differ materially from those projected in the forward-looking statements.
The Company is exposed to market risk related to changes in interest rates and
equity security price risk. The Company does not have derivative financial
instruments for speculative or trading purposes.
The Company has fixed rate long-term debt of approximately $9.5 million
outstanding at December 31, 1999 and a hypothetical ten percent increase or
decrease in interest rates would not have a material impact on the fair market
value of this debt. The fair value of the Company's Senior Discount Notes may be
lower than the recorded value, but the Company is unable to estimate the fair
value at this time. The Company does not hedge any interest rate exposures.
35
<PAGE>
FINANCIAL INFORMATION BY QUARTER (UNAUDITED)
<TABLE>
<CAPTION>
(in thousands, Three Months Ended
except per share amounts) -----------------------------------------
March 31 June 30 Sept. 30 Dec. 31 Total Year
-------- ------- -------- ------- ----------
<S> <C> <C> <C> <C> <C>
1999:
Sales ........................ $ 5,661 $ 5,928 $ 1,999 $ 3,527 $ 17,115
Operating loss ............... $(7,114) $(1,273) $ (3,005) $ (5,044) $(16,436)
Net income (loss) ............ $(9,040) $(3,199) $ (4,980) $ 5,454 $(11,765)
Basic and diluted net
income (loss) per share(1)... $ (0.64) $ (0.22) $ (0.34) $ 0.24 $ (0.70)
------- ------- -------- -------- --------
1998:
Sales ....................... $ 4,026 $ 8,261 $ 4,989 $ 5,005 $ 22,281
Net loss .................... $(6,764) $(5,428) $(14,702) $(10,776) $(37,670)
Basic and diluted net loss
per share(1) ............... $ (0.51) $ (0.39) $ (1.06) $ (0.77) $ (2.75)
------- ------- -------- -------- --------
</TABLE>
- ----------
(1) See Note 1 of Notes to Consolidated Financial Statements for an explanation
of the method used to determine the number of shares used in the
computation of basic and diluted net loss per share
ITEM 8: FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA
Index to Financial Statements and Supplementary Data
Financial Statements: Page
----
Consolidated Balance Sheets at December 31, 1999 and 1998 40
Consolidated Statements of Operations for the years ended
December 31, 1999, 1998 and 1997 41
Consolidated Statements of Shareholders's Deficiency for
the years ended December 31, 1999, 1998 and 1997 42
Consolidated Statements of Cash Flows for the years ended
December 31, 1999, 1998 and 1997 43
Notes to Consolidated Financial Statements 44
Independent Auditors' Report 56
ITEM 9: CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND
FINANCIAL DISCLOSURE
Not applicable.
36
<PAGE>
PART III
Portions of the information required by Part III of Form 10-K are
incorporated by reference to portions of the Company's definitive Proxy
Statement to be filed with the Commission in connection with the 2000 Annual
Meeting of Shareholders (the "Proxy Statement"), which the Company intends to
file not more than 120 days after the end of the fiscal year covered by this
Report.
ITEM 10: DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANT
The information set forth in the Proxy Statement under the captions
"Proposal One--Election of Directors-Nominees" and "Section 16(a) Beneficial
Ownership Reporting Compliance" in the Company's Proxy Statement to be filed in
connection with its 2000 annual meeting of shareholders (the "Proxy Statement")
and the information set forth in Item I of this Report under the caption
"Executive Officers" is incorporated herein by reference.
ITEM 11: EXECUTIVE COMPENSATION
The information set forth in the Proxy Statement under the caption
"Executive Compensation" is incorporated herein by reference.
ITEM 12: SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT
The information set forth in the Proxy Statement under the caption
"Security Ownership of Certain Beneficial Owners and Management" is incorporated
herein by reference.
ITEM 13: CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS
The information set forth in the Proxy Statement under the caption "Certain
Relationships and Related Transactions" is incorporated herein by reference.
PART IV
ITEM 14: EXHIBITS, FINANCIAL STATEMENT SCHEDULES, AND REPORTS ON FORM 8-K
(a) The following documents are filed as part of this Form 10-K:
(1) Consolidated Financial Statements. See the Index to Consolidated
Financial Statements and Supplementary data at page 38 of this
Form 10-K.
(2) Financial Statement Schedule.
Schedule II - Valuation and Qualifying Accounts and Reserves
(3) Exhibits. The exhibits listed in the accompanying Exhibit Index
are filed as part of, or incorporated by reference into, this
Report.
(b) Reports on Form 8-K:
During the quarter ended December 31, 1999 the Company filed a report
on Form 8-K that outlined the terms of a financial restructuring that the
Company completed with the holders of the $47.25 million principal
outstanding Senior Discount Notes. As a result of the restructuring, $39.75
37
<PAGE>
million of Notes and accrued interest thereon were exchanged for 39,750
shares of Series D Preferred Stock that is convertible into a 57% common
equity interest in the Company. The terms of the remaining $7.5 million of
outstanding Notes were modified to reduce the interest rate from 12.5% to
10% per annum (effective July 15, 1999) and to provide for interest to be
payable in-kind at the Company's option and subject to certain coverage
tests. The Notes will mature 5 years from the date of the restructuring.
Accrued and unpaid interest on the $7.5 million of Notes outstanding
following the restructuring was forgiven through July 15, 1999.
As a part of the restructuring, the holders of the Notes have agreed
to make an additional investment in the Company of up to $5 million in the
form of Senior Secured Notes (the New Notes). The New Notes are not
convertible and bear cash interest at 10% per annum and in-kind interest at
the rate of 3% per annum. The New Notes mature in five years and are
issuable in tranches. The first $2.0 million was issued at the closing of
the restructuring. To the extent required by the Company, the remaining
$3.0 million of New Notes will be issued upon the achievement of certain
operating and financial milestones as determined by the holders of the
Notes.
Effective upon the closing of the restructuring, a majority of the
members of the Company's Board of Directors resigned and two new members
were appointed.
In addition, the Company intends to conduct an Exchange Offer whereby
holders of common stock as of November 24, 1999 who elect to participate,
may exchange their shares of common stock for units consisting of a share
of common stock and a warrant to purchase 3.59662 additional shares of
common stock. The exercise price of the warrants will be at a premium to
fair market value and will be based on an enterprise value for the Company
of $70 million. In addition, the warrants would only be exercisable after
the first anniversary of issuance and would terminate four years after
their issuance. The warrants could terminate prior to their scheduled
expiration if the Company's enterprise value, as measured on the Nasdaq
national market or a national securities exchange, exceeds $100 million.
Holders of the warrants would have 180 days to exercise prior to such
termination.
The Company has allocated 38% of its equity (calculated prior to the
issuance of the out-of-the-money warrants described above) as of the
effective date of the restructuring to be issued as incentive compensation
to employees. Of the 116,190,084 shares of common stock issuable as
incentive, 15,657,490 shares were authorized for issuance on November 24,
1999.
38
<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 to be signed on
its behalf by the undersigned, in the City of Palo Alto, County of Santa Clara,
State of California, on the 30th day of March, 2000.
SILICON GAMING, INC.
By: /s/ Andrew S. Pascal
------------------------------------
Andrew S. Pascal
President, Chief Executive Officer,
Acting Chief Financial Officer
(Principal Financial and Chief
Accounting Officer)
Pursuant to the requirements of the Securities Exchange Act of 1934, this
report has been signed below by the following persons on behalf of the
registrant and in the capacities and on the dates indicated.
Signature Title Date
- --------- ----- ----
/s/ Andrew S. Pascal President ,Chief Executive March 30, 2000
- ---------------------------- Officer, Chief Financial Officer
Andrew S. Pascal (Principal Financial and
Accounting Officer) and director
/s/ Stanford Springel Director March 30, 2000
- ----------------------------
Stanford Springel
/s/ Robert Reis Director March 30, 2000
- ----------------------------
Robert Reis
39
<PAGE>
SILICON GAMING, INC.
CONSOLIDATED BALANCE SHEETS
(IN THOUSANDS, EXCEPT SHARE DATA)
December 31,
----------------------
1999 1998
-------- --------
ASSETS
CURRENT ASSETS:
Cash and equivalents ................................ $ 877 $ 8,399
Short-term investments .............................. 1,000 --
Accounts receivable (net of allowances of
$1,169 in 1999 and $1,650 in 1998) ................. 1,188 5,340
Inventories ......................................... 7,331 12,024
Prepaids and other .................................. 1,069 1,698
-------- --------
Total current assets ........................... 11,465 27,461
PROPERTY AND EQUIPMENT, NET .......................... 3,795 12,922
OTHER ASSETS, NET .................................... 321 1,361
-------- --------
$ 15,581 $ 41,744
======== ========
LIABILITIES AND SHAREHOLDERS' DEFICIENCY
CURRENT LIABILITIES:
Accounts payable .................................... $ 1,389 $ 1,480
Accrued liabilities ................................. 1,655 8,154
Deferred revenue .................................... 240 1,766
Line of credit ...................................... 622 4,000
Current portion of long-term obligations ............ 1,165 1,289
-------- --------
Total current liabilities ...................... 5,071 16,689
OTHER LONG-TERM LIABILITIES .......................... 1,611 2,032
LONG-TERM OBLIGATIONS ................................ 10,428 39,809
LONG-TERM ACCRUED INTEREST ........................... 5,832 --
REDEEMABLE CONVERTIBLE PREFERRED STOCK --
shares outstanding: December 31, 1999 -- 0;
December 31, 1998--1,474,641 ........................ -- 1,666
SHAREHOLDERS' DEFICIENCY:
Preferred Stock, $.001 par value;
6,884,473 shares authorized; 39,750 shares
outstanding at December 31, 1999; (liquidation
preference up to $39.75 million) ................... 20,000 --
Common Stock, $.001 par value; 750,000,000 shares
authorized; shares outstanding: December 31, 1999 --
30,949,273; December 31, 1998 -- 14,242,313 ........ 64,123 57,398
Warrants ............................................ 5,542 4,548
Notes receivable from shareholders .................. (345) (128)
Deferred stock compensation ......................... (4,646) --
Accumulated deficit ................................. (92,035) (80,270)
Accumulated other comprehensive income .............. -- --
-------- --------
Total shareholders' equity (deficiency) ........... (7,361) (18,452)
-------- --------
$ 15,581 $ 41,744
======== ========
See Notes to Consolidated Financial Statements.
40
<PAGE>
SILICON GAMING, INC.
CONSOLIDATED STATEMENTS OF OPERATIONS
(IN THOUSANDS, EXCEPT PER SHARE DATA)
Year Ended December 31,
--------------------------------
1999 1998 1997
-------- -------- --------
REVENUE:
Hardware .................................. $ 10,370 $ 14,126 $ 7,636
Software .................................. 4,288 4,657 567
Participation ............................. 2,457 3,498 1,347
-------- -------- --------
Total revenue ........................ 17,115 22,281 9,550
OPERATING EXPENSES:
Cost of sales and related manufacturing
expenses ................................. 13,213 24,062 10,421
Research and development .................. 4,410 11,853 9,283
Selling, general and administrative ....... 12,651 18,375 12,830
Restructuring ............................. 3,277 -- --
-------- -------- --------
Total costs and expenses ............. 33,551 54,290 32,534
-------- -------- --------
Loss from operations ................. 16,436 32,009 22,984
Interest income ........................... (99) (618) (1,238)
Interest expense .......................... 7,241 6,261 1,240
Other expense, net ........................ 503 18 --
-------- -------- --------
LOSS BEFORE EXTRAORDINARY ITEMS ............ 24,081 37,670 22,986
Extraordinary gain upon conversion of
debt (Note 7) ............................ (12,316) -- --
======== ======== ========
NET LOSS ................................... $ 11,765 $ 37,670 $ 22,986
======== ======== ========
BASIC AND DILUTED NET LOSS PER SHARE:
Loss before extraodinary items ............ $ 1.42 $ 2.75 $ 2.16
======== ======== ========
Net loss .................................. $ 0.70 $ 2.75 $ 2.16
======== ======== ========
SHARES USED IN COMPUTATION ................. 16,906 13,696 10,666
======== ======== ========
See Notes to Consolidated Financial Statements.
41
<PAGE>
SILICON GAMING, INC.
CONSOLIDATED STATEMENTS OF SHAREHOLDERS' EQUITY (DEFICIENCY)
(IN THOUSANDS, EXCEPT SHARE AMOUNTS)
<TABLE>
<CAPTION>
Preferred Stock Common Stock
------------------- ---------------------
Shares Amount Shares Amount Warrants
------ ------ ------ ------ --------
<S> <C> <C> <C> <C> <C>
BALANCES, January 1, 1997 ........ -- -- 10,608,105 49,848 25
Options exercised for cash ....... 49,083 200
Collection of notes receivable ...
Employee stock purchase plan
issuances ....................... 99,894 696
Repurchase of Common Stock ....... (17,377) (3)
Conversion of Series A1
Redeemable Preferred Stock ...... 1,219,032 1,371
Conversion of Series B1
Redeemable Preferred Stock ...... 1,191,000 2,019
Warrants issued in conjunction
with Senior Notes ............... 3,082
Other comprehensive income
(loss) ..........................
Net loss & comprehensive net
loss ............................
------ ------- ---------- -------- -------
BALANCES, December 31, 1997 ...... -- $ -- 13,149,737 $ 54,131 $ 3,107
Options exercised for cash ....... 97,400 217
Collection of notes receivable ...
Employee stock purchase plan
issuances ....................... 151,808 935
Repurchase of Common Stock ....... (54,130) (6)
Net exercise of warrants ......... 34,309 25 (25)
Conversion of Series A1
Redeemable Preferred Stock ...... 113,189 128
Conversion of Series B1
Redeemable Preferred Stock ...... 750,000 1,271
Warrants issued in conjunction
with Senior Notes ............... 1,466
Stock compensation arrangements... 697
Net loss .........................
Other comprehensive income
(loss) ..........................
Comprehensive loss ...............
------ ------- ---------- -------- -------
BALANCES, December 31, 1998 ...... -- $ -- 14,242,313 $ 57,398 $ 4,548
Debt restructuring transactions:
Conversion of Series B1
Preferred Stock ................ 983,093 468
Issuance of preferred stock 39,750 20,000
Issuance of warrants ............ 994
Options exercised for cash and
notes receivable ................ 15,722,830 6,202
Amortization of deferred stock
compensation ....................
Collection of notes receivable ...
Employee stock purchase plan
issuances ....................... 48,815 62
Repurchase of Common Stock ....... (47,778) (7)
Net loss and comprehensive loss...
------ ------- ---------- -------- -------
BALANCES, December 31, 1999 ...... 39,750 $20,000 30,949,273 $ 64,123 $ 5,542
====== ======= ========== ======== =======
Notes Accumulated
Receivable Deferred Other
From Stock Accumulated Comprehensive
Shareholders Compensation Deficit Income Total
------------ ------------ ------- ------ -----
BALANCES, January 1, 1997 ........ (221) -- (19,614) 23 30,061
Options exercised for cash ....... 200
Collection of notes receivable ... 14 14
Employee stock purchase plan
issuances ....................... 696
Repurchase of Common Stock ....... (3)
Conversion of Series A1
Redeemable Preferred Stock ...... 1,371
Conversion of Series B1
Redeemable Preferred Stock ...... 2,019
Warrants issued in conjunction
with Senior Notes ............... 3,082
Other comprehensive income
(loss) .......................... (22)
Net loss & comprehensive net
loss ............................ (22,986) (23,008)
---- ------- -------- ---- --------
BALANCES, December 31, 1997 ...... $(207) $ -- $(42,600) $ 1 $ 14,432
Options exercised for cash ....... 217
Collection of notes receivable ... 75 75
Employee stock purchase plan
issuances ....................... 935
Repurchase of Common Stock ....... 4 (2)
Net exercise of warrants ......... --
Conversion of Series A1
Redeemable Preferred Stock ...... 128
Conversion of Series B1
Redeemable Preferred Stock ...... 1,271
Warrants issued in conjunction
with Senior Notes ............... 1,466
Stock compensation arrangements... 697
Net loss ......................... (37,670)
Other comprehensive income
(loss) .......................... (1)
Comprehensive loss ............... (37,671)
---- ------- -------- ---- --------
BALANCES, December 31, 1998 ...... $(128) $ -- $(80,270) $ -- (18,452)
Debt restructuring transactions:
Conversion of Series B1
Preferred Stock ................ 468
Issuance of preferred stock 20,000
Issuance of warrants ............ 994
Options exercised for cash and
notes receivable ................ (235) (5,807) 160
Amortization of deferred stock
compensation .................... 1,161 1,161
Collection of notes receivable ... 11 11
Employee stock purchase plan
issuances ....................... 62
Repurchase of Common Stock ....... 7 --
Net loss and comprehensive loss... (11,765) (11,765)
---- ------- -------- ---- --------
BALANCES, December 31, 1999 ...... (345) $(4,646) $(92,035) $ -- $ (7,361)
==== ======= ======== ==== ========
</TABLE>
See Notes to Consolidated Financial Statements.
42
<PAGE>
SILICON GAMING, INC.
CONSOLIDATED STATEMENTS OF CASH FLOWS
(IN THOUSANDS)
<TABLE>
<CAPTION>
Year Ended December 31,
--------------------------------------
1999 1998 1997
-------- -------- --------
<S> <C> <C> <C>
CASH FLOWS FROM OPERATING ACTIVITIES:
Net loss .......................................... $(11,765) $(37,670) $(22,986)
Reconciliation to net cash used in
operating activities:
Gain on debt conversion ......................... (12,316) -- --
Depreciation and amortization ................... 4,775 4,700 2,623
Accrued interest ................................ 4,405 3,594 672
Accretion of debt discount ...................... 2,206 1,905 359
Deferred rent ................................... (98) 213 202
Restructuring expenses .......................... 3,277 -- --
Stock compensation .............................. 1,161 697 --
Loss (gain) on disposal of property ............. 131 (35) --
Changes in assets and liabilities:
Accounts receivable ............................. 4,152 (410) (4,930)
Inventory ....................................... 4,693 (5,689) (5,858)
Prepaids and other .............................. (146) (64) (133)
Participation units ............................. 2,252 (361) (5,325)
Accounts payable ................................ (591) (1,671) 1,993
Deferred revenue ................................ (1,526) 288 1,478
Accrued and other liabilities ................... (4,446) 2,389 1,996
-------- -------- --------
Net cash used in operating activities ........ (3,836) (32,110) (29,909)
-------- -------- --------
CASH FLOWS FROM INVESTING ACTIVITIES:
Acquisition of property and equipment ............. (397) (3,271) (7,817)
Proceeds from sale of assets ...................... -- 127 --
Purchases of short-term investments ............... (1,000) -- (6,725)
Sales and maturities of short-term
investments ...................................... -- 4,704 11,681
Other assets, net ................................. 288 (315) (216)
-------- -------- --------
Net cash provided by (used in)
investing activities ........................ (1,109) 1,245 (3,077)
-------- -------- --------
CASH FLOWS FROM FINANCING ACTIVITIES:
Proceeds from debt financing and
issuance of warrants, net of costs ............... 2,000 14,950 23,055
Sale of Common Stock, net ......................... 80 1,146 893
Collection of note receivable ..................... 11 79 14
Proceeds from notes payable ....................... -- 3,586 --
Repayment of notes payable ........................ (985) (564) --
Proceeds (repayment) from line of credi ........... (3,378) 4,000 --
Repayment of capital lease obligation ............. (305) (285) (207)
-------- -------- --------
Net cash provided by (used in)
financing activities ........................ (2,577) 22,912 23,755
-------- -------- --------
NET DECREASE IN CASH AND EQUIVALENTS ................ (7,522) (9,231) (7,953)
CASH AND EQUIVALENTS:
Beginning of period ............................... 8,399 16,352 25,583
-------- -------- --------
End of period ..................................... $ 877 $ 8,399 $ 16,352
======== ======== ========
SUPPLEMENTARY DISCLOSURES OF CASH FLOW INFORMATION--
Cash paid during the period for interest .......... $ 602 $ 360 $ 106
======== ======== ========
NONCASH INVESTING AND FINANCING ACTIVITIES:
Issuance of Common Stock for notes receivable...... $ 235 $ -- $ --
======== ======== ========
Issuance of Common Stock warrants ................. $ 994 $ 1,466 $ 3,082
======== ======== ========
Conversion of Preferred Stock to Common Stock...... $ 468 $ 1,399 $ 3,390
======== ======== ========
</TABLE>
See Notes to Consolidated Financial Statements.
43
<PAGE>
SILICON GAMING, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
1. BUSINESS AND SIGNIFICANT ACCOUNTING POLICIES
BUSINESS--Silicon Gaming, Inc. (the "Company") was incorporated on July 27,
1993 to develop and market innovative gaming devices through the use of advanced
multimedia and interactive technologies.
BASIS OF PRESENTATION - The accompanying consolidated financial statements
have been prepared assuming that the Company will continue as a going concern.
The Company has incurred operating losses every year since its inception and at
December 31, 1999 had an accumulated deficit of $92,035,000 and a shareholders'
deficiency of $7,361,000. The Company has been required to obtain additional
financing every year to be able to fund its ongoing operations. Based on
historical levels of cash useage, the above factors raise substantial doubt
about the Company's ability to continue as a going concern. In the fourth
quarter of 1999 the Company completed a substantial restructuring of its
capitalization whereby $39.75 million of Senior Discount Notes and approximately
$8.3 million of accrued interest were converted into Preferred Stock, and the
remaining terms of the Senior Discount Notes were modified to reduce the
interest rate thereon and extend the payment terms. Concurrent with the
restructuring, the Company borrowed $2 million under new Senior Discount Notes
and established a facility whereby up to an additional $3 million of new Senior
Discount Notes may be issued upon meeting certain financial and operational
milestones. Management continues to review financing and other strategic
alternatives available to the Company such as additional equity or debt
offerings in the Company or certain of its subsidiaries, joint ventures,
alternative distribution channels, direct investment by third parties into
several of the Company's strategic business opportunities and sale of all or
part of the Company's assets to improve the Company's liquidity position.
Management believes that these steps, plus sales related to proposed new product
introductions, will provide sufficient cash and working capital for the Company
to meet its ongoing obligations and to allow it to continue operating as a going
concern through at least the end of 2000. The accompanying consolidated
financial statements do not include any adjustments that might result from the
outcome of this uncertainty.
CONSOLIDATION--The consolidated financial statements include the Company
and its wholly-owned subsidiaries after elimination of intercompany accounts and
transactions.
ESTIMATES--The preparation of 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 financial
statements and the reported amounts of revenues and expenses during the
reporting period. Actual results could differ from those estimates.
CASH EQUIVALENTS--The Company considers all highly liquid debt instruments
purchased with an original maturity of three months or less to be cash
equivalents.
SHORT-TERM INVESTMENTS - Short-term investments represent debt securities
which are stated at fair value. To the extent there is a difference between
amortized cost (cost adjusted for amortization of premiums and accretion of
discounts which are recognized as adjustments to interest income) and fair value
representing the unrealized holding gains or losses, these will will be recorded
as a separate component of shareholders' equity until realized. While the
Company's intent is to hold debt securities to maturity, they are classified as
available-for-sale securities because the sale of such securities my be required
prior to maturity. Any gains or losses on the sale of debt securities are
determined on a specific identification basis.
FAIR VALUE OF FINANCIAL INSTRUMENTS--The estimated fair value of the
Company's financial instruments, which include cash equivalents and short-term
investments approximate their carrying value. The fair value of the Company's
Senior Discount Notes may be lower than the recorded value but the Company is
unable to estimate the fair value at this time.
44
<PAGE>
INVENTORIES--Inventories consist of raw materials, work-in-process and
finished goods and are stated at the lower of cost or market on a first-in,
first-out basis.
PROPERTY AND EQUIPMENT--Property and equipment are stated at cost.
Depreciation and amortization are computed using the straight-line method over
estimated useful lives between eighteen months and seven years. Leasehold
improvements are amortized using the straight-line method over the shorter of
the lease term or the asset's useful life. The Company places gaming machines
and related equipment in customer locations on its participation program and
receives a portion of the net win from each machine. Depreciation of units under
such arrangements is the greater of the ratio that current gross revenue bears
to total anticipated revenue for such unit or straight-line over three years.
Ancillary gaming equipment such as signs and chairs are depreciated over an
eighteen-month period.
REVENUE RECOGNITION--Revenue from hardware units and non-renewable software
licenses is recognized upon acceptance by the customer after completion of a
trial period, if applicable, or otherwise upon shipment of the unit. Renewable
software licenses are recognized ratably over the license period. Amounts due
the Company under revenue participation plans with its customers are recognized
ratably based on the Company's share of gaming machine play.
CONCENTRATION OF CREDIT RISK-- Financial instruments which potentially
subject the Company to concentrations of credit risk consist primarily of cash
equivalents, short-term investmements and trade accounts receivable. The Company
performs ongoing credit evaluations of its customers' financial condition and
limits the amount of credit extended when deemed necessary but generally
requires no collateral. The Company maintains reserves for estimated potential
credit losses. At December 31, 1999, one customer accounted for 19% of accounts
receivable. A significant portion of the Company's revenues are concentrated
with a small number of strategic customers. For the year ended December 31, 1999
one customer accounted for 16% of revenue and the Company's top 10 customers
represented 52% of revenue. For the year ended December 31, 1998, two customers
accounted for 11% and 10% of revenue and the Company's top 10 customers
represented 67% of revenue. In 1997 three different customers accounted for 27%,
12% and 12% of revenue.
RESEARCH AND DEVELOPMENT EXPENSES--Research and development expenses are
charged to operations as incurred. In connection with the Company's product
development efforts, it develops software applications which are integral to the
operation of the product. The costs to develop such software have not been
capitalized as the Company believes its current software development process is
essentially completed concurrent with the establishment of technological
feasibility and/or development of the related hardware.
INCOME TAXES--The Company accounts for income taxes in accordance with
Statement of Financial Accounting Standards No. 109, Accounting for Income
Taxes, which requires an asset and liability approach for financial reporting of
income taxes.
STOCK-BASED COMPENSATION--The Company accounts for stock-based awards to
employees using the intrinsic value method in accordance with APB No. 25
Accounting for Stock Issued to Employees ("APB 25"). The Company adopted the
disclosure requirements of Statement of Financial Accounting Standards No.123,
Accounting for Stock-Based Compensation, ("SFAS 123"), which require the
disclosure of pro forma net income and earnings per share as if the Company
adopted the fair value-based method in measuring compensation expense as of the
beginning of fiscal 1995.
NET LOSS PER SHARE--Basic EPS excludes dilution and is computed by dividing
net income by the weighted average of common shares outstanding for the period.
Diluted EPS reflects the potential dilution that would occur if securities or
other contracts to issue Common Stock were exercised or converted into Common
Stock. Common share equivalents including stock options, warrants and Preferred
Stock have been excluded for all periods presented, as their effect would be
antidilutive.
45
<PAGE>
The following is a reconciliation of the numerators and denominators of the
basic and diluted net loss per share computations (in thousands except per share
amounts):
Year Ended December 31,
---------------------------
1999 1998 1997
------- ------- -------
Net Loss (Numerator):
Net loss, basic and diluted ...................... $11,765 $37,670 $22,986
======= ======= =======
Shares (Denominator):
Weighted average common shares outstanding ....... 16,965 14,047 11,418
Weighted average common shares outstanding
subject to repurchase .......................... 59 351 752
------- ------- -------
Shares used in computation, basic and diluted .... 16,906 13,696 10,666
======= ======= =======
Net Loss Per Share, Basic and Diluted ............ $ 0.70 $ 2.75 $ 2.16
======= ======= =======
SEGMENT DISCLOSURES - Effective January 1, 1999 the Company adopted SFAS
No. 131, "Disclosures about Segments of an Enterprise and Related Information".
The Company organizes and manages its products and services as a single product
family, and accordingly, the required disclosures under SFAS No. 131 regarding
the Company's products and services are made to the face of the financial
statements. The adoption of SFAS No. 131 had no effect on the financial position
of the Company.
RECLASSIFICATIONS-- Certain prior year amounts have been reclassified to
conform to the current year presentation.
2. SHORT-TERM INVESTMENTS
Short-term investments consist of the following debt securities as of
December 31, 1999:
Amortized Market Unrealized Unrealized
(In Thousands) Cost Value Holding Gains Holding Losses
---- ----- ------------- --------------
Available-for-sale
corporate securities .... $1,000 $1,000 $ -- $ --
====== ====== ==== ====
3. INVENTORIES
Inventories are stated at the lower of cost (first-in, first-out) or market
and consist of the following :
December 31,
---------------------
(In Thousands) 1999 1998
------- -------
Raw materials .................................. $ 849 $ 4,294
Work in process ................................ 111 93
Finished goods ................................. 6,371 7,637
------- -------
$ 7,331 $12,024
======= =======
Finished goods includes units on trial of $ 2,397 and $ 3,462 at December
31, 1999 and 1998, respectively.
46
<PAGE>
4. PROPERTY AND EQUIPMENT
Property and equipment consists of:
December 31,
--------------------
(In Thousands) 1999 1998
-------- --------
Furniture, fixtures and office equipment .............. $ 453 $ 1,586
Computer equipment .................................... 6,876 9,292
Manufacturing equipment ............................... 69 1,954
Gaming machines & equipment ........................... 3,125 6,230
Leasehold improvements ................................ 737 1,445
------- -------
11,260 20,507
Accumulated depreciation and amortization (7,465) (7,585)
------- -------
$ 3,795 $12,922
======= =======
Included in property and equipment at December 31, 1999 and 1998 are assets
leased under capital leases of $1,000,000 net of accumulated depreciation of
$1,000,000 and $792,000 as of December 31, 1999 and 1998, respectively.
5. ACCRUED LIABILITIES AND RESTRUCTURING ACCRUAL
Accrued liabilities consists of:
December 31,
-------------------
(In Thousands) 1999 1998
------ ------
Accrued compensation benefits.......................... $ 363 $ 958
Accrued purchase arrangements.......................... 160 1,100
Accrued royalties ..................................... 60 1,811
Accrued tax obligations ............................... 550 --
Accrued interest expense .............................. 20 2,782
Other accrued liabilities ............................. 502 1,503
------ ------
$1,655 $8,154
====== ======
In March 1999 the Company announced the closure of its Mountain View, California
manufacturing facility and the relocation of all of its manufacturing operations
to its Las Vegas, Nevada facility. At the same time the Company announced a
reduction in size of its employee workforce by approximately 35%. The Company
recorded restructuring charges of $3,312,000 in the three-month period ended
March 31, 1999. The restructuring charges include severance costs, lease related
costs of excess facilities and the write down of specific fixed assets
associated with these facilities and assets rendered surplus as a result of the
reduction in force. Details of the restructuring charges are as follows (in
thousands):
Accrued
severance, Facility Write down
benefits & lease of
other costs obligations fixed assets Total
----------- ----------- ------------ -----
Restructuring provision ........ $ 595 $ 293 $ 2,424 $ 3,312
Adjustment to amounts
recorded ..................... -- (35) -- (35)
Non-cash items ................. -- -- (2,424) (2,424)
Amounts paid ................... (595) (258) -- (853)
----- ----- ------- -------
Balance at September 30, 1999 .. $ -- $ -- $ -- $ --
===== ===== ======= =======
Termination benefits were paid to 55 employees and all benefits were paid prior
to May 31, 1999. The Company completed all remaining restructuring activities,
including disposal of assets, before the end of 1999.
47
<PAGE>
6. LEASES
The Company leases its facilities under noncancellable operating lease
agreements. The accompanying statements of operations reflect rent expense on a
straight-line basis over the term of the leases. The difference between
straight-line rent expense and actual cash payments is recorded as deferred
rent.
Future minimum operating commitments at December 31, 1999 are as follows:
Operating
Leases
-------
(in thousands)
2000........................................................ $ 1,059
2001........................................................ 961
2002........................................................ 926
2003........................................................ 567
2004........................................................ 549
Thereafter.................................................. 566
-------
Total minimum lease payments................................ $ 4,628
=======
During 1999 the Company entered into a sublease with respect to a portion of its
Palo Alto facility. Pursuant to this agreement, which expires in 2005, the
Company will receive sublease income approximating $3,912,000.
Rent expense (including prorated common area maintenance charges and utilities)
for the years ended December 31, 1999, 1998 and 1997 was $859,000, $1,310,000
and $975,000, respectively. The 1999 rent expense was net of sublease income
received of $279,000.
7. LONG-TERM BORROWING OBLIGATIONS
The Company had a $4 million secured revolving line of credit agreement
based on the Company's eligible accounts receivable, which expired on December
31, 1999. As of December 31, 1999 the Company had $622,000 outstanding under
this agreement. As of December 31, 1999 the Company was not in compliance with
the minimum net worth covenants of the agreement, however the Company
subsequently repaid all outstanding balances under this agreement in February
2000.
Borrowing arrangements consist of the following (in thousands):
December 31,
----------------------
1999 1998
-------- --------
Senior Discount Notes ($9.5 million and $47.25
million principal obligation, respectively) ....... $ 9,500 $ 37,716
Capital lease obligations .......................... 55 360
Other long-term obligations ........................ 2,038 3,022
-------- --------
11,593 41,098
Current obligation ................................. (1,165) (1,289)
-------- --------
Long-term portion .................................. $ 10,428 $ 39,809
======== ========
48
<PAGE>
Future minimum debt commitments at December 31, 1999 are as follows (in
thousands):
<TABLE>
<CAPTION>
Senior Other
Discount Capital Long Term Total
Notes Leases Obligations Debt
-------- -------- -------- --------
<S> <C> <C> <C> <C>
2000 ............................................. $ 1,037 $ 56 $ 1,315 $ 2,408
2001 ............................................. 1,063 -- 788 1,851
2002 ............................................. 1,072 -- 230 1,302
2003 ............................................. 1,082 -- -- 1,082
2004 ............................................. 10,887 -- -- 10,887
Thereafter ....................................... -- -- -- --
-------- ----- ------- --------
Total minimum payments ........................ 15,141 56 2,333 17,530
Amount representing interest or future discount... (5,641) (1) (295) (5,937)
-------- ----- ------- --------
Present value of debt payments ................... 9,500 55 2,038 11,593
Current portion .................................. -- 55 1,110 1,165
-------- ----- ------- --------
Long-term portion ................................ $ 9,500 $ -- $ 928 $ 10,428
======== ===== ======= ========
</TABLE>
In November 1999 the Company completed a restructuring of its then
outstanding Senior Discount Notes whereby $39.75 million of principal plus
approximately $8.3 million of accrued interest was exchanged for 39,750 shares
of Series D Preferred Stock (see Note 8) which is convertible into 57% of the
fully diluted equity of the Company and warrants to purchase up to 60,807.7
shares of Series E Preferred Stock at $0.01 per share. The terms of the
remaining $7.5 million of Senior Discount Notes were modified to reduce the
interest rate from 12.5% to 10% per annum (effective July 15, 1999) and to
provide for interest to be payable in-kind through the issuance of additional
notes at the Company's option and subject to certain coverage ratio tests. The
maturity date of the remaining notes was extended to November 2004. Accrued and
unpaid interest on the $7.5 million of notes remaining outstanding following the
restructuring was forgiven through July 15, 1999.
As a part of the debt restructuring, the holders of the Senior Discount
Notes agreed to make an additional investment in the Company of up to $5 million
in the form of senior secured notes (the New Notes). The New Notes are not
convertible and bear cash interest at the rate of 10% per annum and in-kind
interest at the rate of 3% per annum. The New Notes mature in five years and are
issuable in tranches. The first $2 million was issued at the closing of the
restructuring on November 24, 1999. To the extent, required by the Company, the
additional $3 million of New Notes will be issued upon the achievement of
certain financial and operating milestones, as determined by the holders of the
Notes.
Also, as part of the debt restructuring, the Company entered into certain
other equity transactions: Holders of the outstanding Series B1 Redeemable
Preferred Stock were required to convert their shares into Common Stock. Holders
of outstanding shares of Common Stock (subject to the increase in authorized
common stock which was approved by the shareholders in February 2000) are to be
granted warrants to purchase additional shares of Common Stock for $0.1528 per
share, at a rate of 3.59662 additional shares for each share of Common Stock
held as of November 24, 1999 (54.9 million additional shares in total). See
additional information regarding these equity securities in Notes 8 and 9.
In accordance with Statement of Financial Accouting Standard No. 15,
"Accounting by Debtors and Creditors for Troubled Debt Restructurings", the gain
on cancellation of debt reflects these related equity transactions was reduced
to reflect all future cash payments due to the holders of the Senior Discount
Notes, as well as, future interest payments on these Notes and estimated amounts
under the New Notes. All such future interest payments have been recorded as a
liability as of the date of the Company's debt restructuring and are shown as
Long-Term Accrued Interest on the accompanying balance sheet. As a result, in
the future the Company will not record interest expense on its Senior Discount
Notes.
49
<PAGE>
The components of the gain on conversion of debt consist of (in thousands):
Carrying value of debt and related accrued interest ......... $ 39,098
Fair value of Series D Preferred Stock and Series E
Preferred Stock warrants issued ............................ (20,000)
Future expected interest on modified debt and New Notes ..... (5,832)
Gain on conversion of preferred stock to common stock ....... 1,198
Fair value of warrants issued to common stockholders ........ (994)
Legal and other costs of restructuring ...................... (1,154)
--------
Net gain .................................................... $ 12,316
========
In June 1998, the Company entered into a secured equipment loan. Borrowings
bear interest at 14% per annum for a term of 42 months. As of December 31, 1999,
the Company had borrowed $1,562,000 under this agreement. The agreement requires
the Company to comply with certain financial covenants, with which the Company
was in compliance as of December 31, 1999.
In March 1998, the Company entered into a secured equipment term.
Borrowings bear interest at 11% per annum for a term of 36 months. As of
December 31, 1999 the Company had borrowed $1,698,000 under this agreement. The
agreement requires the Company to comply with certain financial covenants, with
which the Company was not in in compliance as of December 31, 1999.
8. PREFERRED STOCK
At December 31, 1999, the Company had 39,750 shares of Series D Preferred
Stock and warrants to purchase up to 60,807.731 shares of Series E Preferred
Stock outstanding. In connection with the increase in authorized shares of
Common Stock approved by the shareholders in February 2000, the terms of the
preferred stock was amended. The significant terms of the Series D and E
Preferred Stock, as amended, are as follows:
* Each share of Series D Preferred Stock is convertible into 4,384.53 shares
of Common Stock (subject to adjustment for anti-dilution) and each share of
Series E Preferred Stock is convertible into 1,000 shares of Common Stock
(subject to adjustment for anti-dilution).
* The holders of the Series D and E Preferred Stock will have the right to
vote the number of shares of Common Stock into which all of such holder's
shares are convertible, only if such holder has first received all prior
approvals required under applicable gaming laws for conversion of all of
the shares of Series D held by such holder
* Dividends may be paid at the discretion of the Board of Directors, however,
cash dividends must be paid in an amount equal to the as-converted rate
based on any cash dividends paid on common stock.
* In the event of liquidation, the holders of the Series D are first entitled
to receive varying amounts based upon the aggregate transaction proceeds.
If such proceeds are less than $20 million, the Series D holders are
entitled to 100% of the proceeds. If such transaction proceeds exceed $30
million, the Series D holders would be entitled to the amount that would be
paid if such Series D stock were converted into Common Stock immediately
prior to the liquidation event. For aggregate transaction proceeds between
$20 and $30 million, a pro rata fomula applies. Notwithstanding this, the
holders of the Series D Preferred Stock shall not receive more than $1,000
per share as a result of a liquidation event. Series E holders will then
receive an amount equal to the as-converted amount to be received for each
share of Common Stock.
* The Company may redeem the outstanding shares of Series D, in whole or in
part, at any time for cash at a redemption price equal to the greater of
$1,000 per share or the amount which is equal to the fair market value of
the Common Stock into which a share of Series D could be converted.
* In the event of a Change in Control (as defined), the holders of a majority
of the Series D Preferred Stock may require the Company to redeem the
outstanding shares of Series D Preferred Stock at a redemption price equal
to the greater of $1,000 per share or the amount which is equal to the fair
market value of the Common Stock into which a share of Series D Preferred
Stock could be converted.
50
<PAGE>
* So long as at least 100 shares of Series D or 200 shares of Series E remain
outstanding, the prior written consent of the holders of the Series D and
Series E will be required prior to certain corporate actions including, but
not limited to, issuing additional capital stock or debt with a preference
to or equal to the Series D or E in the Company or any of its subsidiaries,
payment of dividends, incurring additional indebtedness (excluding
refinancing and the Company's bank borrowings), entering into transactions
with affiliates, issuing or disposing of the capital stock of its
subsidiaries, disposing of assets of the Company or its subsidiaries, and
merging or consolidating with any other entity or entering into any
transaction which would have the effect of a change in control.
The warrants to purchase up to 60,807.731 shares of Series E Preferred
Stock at $0.01 per share are to be issued in connection with the debt
restructuring and are directly related to the common stock warrants issued to
the Common Shareholders of record as of November 24, 1999 (see Note 7). The
Series E warrants become exercisable in proportion to the number of Common Stock
warrants exercised. The warrants expire in May 2004.
9. COMMON STOCK
In February 2000 the Company's shareholders approved an increase in the
authorized capital of the Company to 750,000,000 shares. This will provide
suffficient shares for the conversion of the Preferred Shares into Common Stock,
the issuance of warrants to the existing equity holders, and the granting of
stock options to management and employees of the Company as contemplated in the
November 1999 debt restructuring. At the same time the Board of Directors
increased the number of shares authorized in the 1999 Long-Term Compensation
Plan from 15,657,490 to 116,190,084.
At December 31, 1999, Common Stock (including the effect of the February
2000 increases noted above) was reserved for issuance as follows:
Conversion of outstanding shares of Series D Preferred Stock ..... 174,285,127
Conversion upon exercise of Series E Preferred Stock warrants .... 60,807,731
Common stock warrants issued to shareholders of record as of
November 24, 1999 in connection with the debt restructuring .... 54,985,667
Issuable under other stock purchase warrants ..................... 919,443
Stock Option Plans ............................................... 105,904,165
Employee Stock Purchase Plans .................................... 449,483
-----------
397,351,616
===========
WARRANTS
Holders of outstanding shares of Common Stock (subject to the increase in
authorized common stock which was approved by the shareholders in February 2000)
are to be granted warrants to purchase additional shares of Common Stock for
$0.1528 per share, at a rate of 3.59662 additional shares for each share of
Common Stock held as of November 24, 1999. These warrants become exercisable
beginning in February 2001 and expire in February 2004. In the event that the
Company's stock price exceeds $0.2346 per share for twenty consecutive days, the
expiration date of the warrant is accelerated to a date 180 days after that
event.
During 1998, the Company issued warrants to purchase 250,000 shares of
Common Stock at $8.00 per share in conjunction with the issuance and sale of the
Company's 1998 Senior Discount Notes. These warrants expire on September 30,
2002. During 1997, the Company issued warrants to purchase 375,000 shares of
Common Stock at $15.4375 per share in conjunction with the issuance and sale of
the Company's 1997 Senior Discount Notes. These warrants were repriced to $8.00
per share in connection with the issuance of the Company's 1998 Senior Discount
Notes. The warrants expire on September 30, 2002. During 1996, the Company
issued warrants to certain financial advisors in connection with its Series C
Redeemable Convertible Preferred Stock financing. These warrants are exercisable
for 116,666 shares of Common Stock at an exercise price of $7.50 per share and
expire in 2001. In connection with the initial public offering in 1996, the
Company issued 5-year warrants to purchase an aggregate of 177,777 shares of
Common Stock to other financial advisors at an exercise price of $12.60 per
share. All warrants remain outstanding after the debt restructuring that
occurred during the fourth quarter of 1999.
51
<PAGE>
STOCK OPTION PLANS
Under the 1994 Stock Option Plan (the "1994 Option Plan"), the Company may
grant incentive or nonstatutory stock options up to 4,563,077 shares of Common
Stock to employees, directors and consultants at prices not less than fair
market value for incentive stock options and not less than 85% of fair market
value for nonstatutory stock options. These options generally expire five to ten
years from the date of grant. Options normally vest at a rate of 25% on the
first anniversary of the grant date and 1/48 per month thereafter and may be
exercised at any time, subject to the Company's right to repurchase unvested
shares at the original exercise price upon termination.
In 1996, the Board of Directors adopted the 1996 Outside Directors Stock
Option Plan (the "Directors Plan"). Under this plan, non-employee directors of
the Company are automatically granted initial options to purchase 15,000 shares
of Common Stock and additional options to purchase 5,000 shares of Common Stock
in each subsequent year that such person remains a director of the Company.
Options under the Directors Plan have an exercise price equal to fair market
value at the grant date, vest ratably over three years and expire ten years from
the date of grant. The number of shares authorized under this plan is 200,000.
In 1997, the Board of Directors adopted the 1997 Nonstatutory Stock Option
Plan (the "1997 Option Plan"). Under this plan, the Company may grant
nonstatutory stock options for up to 2,350,000 shares of Common Stock to
employees and consultants at prices not less than 85% of fair market value on
the effective date of the grant. These options generally expire ten years from
the date of grant and are immediately exercisable.
In 1999, the Board of Directors adopted the 1999 Long-Term Compensation
Plan (the "1999 Plan") as a part of the debt restructuring. A total of
15,657,490 shares were authorized for issuance under this plan and 15,657,490
shares were sold to officers in the year ended December 31, 1999. Under the
terms of the restricted stock purchase agreement, the Company has the right to
repurchase up to 80% of these shares at the original sale price; this right
lapses over a four-year period based on continued employment. Under this plan,
the Company may grant options or restricted shares of Common Stock to employees,
and directors at prices not less than 85% of fair market value on the effective
date of the grant. The terms of the options may vary but generally expire ten
years from the date of grant and are immediately exercisable. In February 2000
the authorized number of shares in the 1999 Plan was increased to 116,190,094
shares following the increase in the Company's authorized capital. Also in
February, 2000 the Company issued an additional 85,090,492 shares to employees
and directors.
Option activity under the Company's option plans is as follows:
Weighted
Number Average
of Exercise
Shares Price
---------- -------
Outstanding, January 1, 1997 ...................... 835,403 $ 6.35
Granted (weighted average fair value of $7.49) .... 1,150,385 15.02
Exercised ......................................... (49,083) 4.13
Cancelled ......................................... (39,529) 12.01
----------- ------
Outstanding, December 31, 1997 .................... 1,897,176 11.36
Granted (weighted average fair value of $4.29) .... 3,759,563 5.85
Exercised ......................................... (97,400) 2.23
Cancelled ......................................... (3,605,166) 9.84
----------- ------
Outstanding, December 31, 1998 .................... 1,954,173 4.09
Granted at market value (weighted average fair
value of $0.13) .................................. 3,437,751 0.58
Granted below market value (weighted average fair
value of $0.01) .................................. 15,657,490 0.02
Exercised ......................................... (15,722,830) 0.45
Cancelled ......................................... (1,920,039) 2.69
----------- ------
Outstanding, December 31, 1999 .................... 3,406,545 $ 1.58
=========== ======
52
<PAGE>
Additional information regarding options outstanding as of December 31,
1999, is as follows:
Options Outstanding Options Exercisable
---------------------------------- ---------------------
Weighted
Number Average Weighted Number Weighted
Outstanding Remaining Average Exercisable Average
Range of as of Contractual Exercise as of Exercise
Exercise Prices 12/31/99 Life (yrs) Price 12/31/99 Price
--------------- -------- ---------- ----- -------- -----
$ 0.105 - $ 0.452 176,512 8.77 $ 0.43 176,512 $ 0.43
$ 0.500 - $ 0.500 1,337,375 2.98 0.50 1,337,375 0.50
$ 0.562 - $ 0.719 139,128 4.41 0.62 139,128 0.62
$ 0.750 - $ 0.750 804,500 9.2 0.75 804,500 0.75
$ 1.500 - $ 3.750 268,819 8.31 1.84 268,819 1.90
$ 4.000 - $ 4.000 576,445 7.57 4.00 576,445 4.00
$ 4.250 - $10.500 72,666 7.10 9.55 63,218 9.58
$11.750 - $11.750 1,100 7.38 11.75 1,100 11.75
$12.250 - $12.250 15,000 7.39 12.25 12,915 12.25
$18.750 - $18.750 15,000 7.18 18.75 13,750 18.75
----------------- ------ ---- ----- ------ -----
$ 0.105 - $18.750 3,406,545 6.13 $ 1.58 3,393,762 $ 1.55
================= ========= ==== ======= ========= =======
At December 31, 1999, 1,111,317, 105,000, and 748,699 shares were available
for future grants under the 1994 Option Plan, Directors Plan, and 1997 Option
Plan respectively. At December 31, 1999, 13,212 shares exercised were subject to
repurchase. As of December 31, 1998 and 1997, 1,915,974 and 1,826,896 shares
respectively were exercisable with a weighted average exercise price of $3.94
and $11.27, respectively.
EMPLOYEE STOCK PURCHASE PLAN
Under the 1998 Purchase Plan, eligible employees are permitted to purchase
shares of Common Stock through salary withholding at a price equal to 85% of the
lower of the market value of the stock at the beginning or the end of the
6-month offering period, subject to certain limitations. At December 31, 1999,
300,517 shares had been issued under both of the Purchase Plans and 449,483
shares were reserved for further issuance. The weighted average fair value of
those purchase rights granted in 1999, 1998 and 1997 was $1.28, $3.73 and $3.52,
respectively. The Company's calculations were made using the Black-Scholes
option pricing model with the following weighted average assumptions: expected
life of one year for all years; expected interest rate of 6.0%, 5.7% and 6.2%
for 1999, 1998 and 1997, respectively; expected volatility of 115% in 1999, 75%
in 1998 and 65% in 1997; and no dividends during the expected term.
ADDITIONAL STOCK PLAN INFORMATION
As discussed in Note 1, the Company continues to account for its
stock-based awards using the intrinsic value method in accordance with APB No.
25 and its related interpretations. Accordingly, no compensation expense has
been recognized in the financial statements for employee stock arrangements.
SFAS 123 requires the disclosure of pro forma net income and earnings per
share had the Company adopted the fair value method as of the beginning of
fiscal 1995. Under SFAS 123, the fair value of stock-based awards to employees
is calculated through the use of the minimum value method for all periods prior
to the initial public offering, and subsequently through the use of option
pricing models, even though such models were developed to estimate the fair
value of freely tradable, fully transferable options without vesting
restrictions, which significantly differ from the Company's stock option awards.
These models also require subjective assumptions, including future stock price
volatility and expected time to exercise, which greatly affect the calculated
values. The Company's stock option calculations were made using the
Black-Scholes option pricing model with the following weighted average
assumptions: expected life, 12 months following vesting; stock volatility, 115%
53
<PAGE>
in 1999, 75% in 1998 and 65% in 1997; risk-free interest rates, 6.0% in 1999,
5.7% in 1998, and 6.2% in 1997; and no dividends during the expected term. The
Company's calculations are based on a multiple option valuation approach and
forfeitures are recognized as they occur. If the computed fair values of the
stock-based awards (including awards under the Purchase Plan) had been amortized
to expense over the vesting period of the awards, pro forma net loss would have
been $13,763,000 ($0.81 loss per share) in 1999, $44,673,000 ($3.15 loss per
share) in 1998, and $26,815,000 ($2.51 loss per share) in 1997.
10. INCOME TAXES
The Company has had losses since inception and therefore has not provided
for income taxes.
Deferred income taxes reflect the net tax effects of temporary differences
between the carrying amount of assets and liabilities for financial reporting
purposes and the amounts used for income tax purposes, as well as operating loss
and tax credit carryforwards. Significant components of the Company's deferred
income tax assets as of December 31, 1999 and 1998 are as follows:
December 31,
----------------------
(in thousands) 1999 1998
-------- --------
Net deferred tax assets:
Net operating losses ............................. $ -- $ 25,596
Research and development credits ................. -- 1,140
Capitalized research and development costs ....... -- 895
Accruals deductible in different periods ......... 6,160 4,204
Depreciation and amortization .................... 258 (250)
-------- --------
6,418 31,585
Valuation allowance ................................ (6,418) (31,585)
-------- --------
Total $ -- $ --
======== ========
Due to the uncertainty surrounding the realization of the benefits of its
favorable tax attributes in future tax returns, the Company has fully reserved
its net deferred tax assets as of December 31, 1999 and 1998, respectively.
The Tax Reform Act of 1986 and the California Act of 1987 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's ability to utilize its net operating loss and tax
credit carryforwards is subject to limitation pursuant to these restrictions.
The Company underwent an ownership change as of the date of the debt
restructuring in November, 1999. As a result, the Company lost the potential tax
benefits of the net operating loss carryforwards and tax credit carryforwards
tha existed at that time.
11. SUBSEQUENT EVENTS
In March 2000 the Company entered into a secured revolving line of credit
with a new bank based upon eligible accounts receivable. Under the terms of this
borrowing arrangement which will expire in March 2001, the Company may borrow up
to $2 million. Borrowings will bear interest at the bank's prime rate plus
1.50%. The Company will issue the bank warrants to acquire 100,000 shares of
Common Stock at a per share price of $0.30 which may be exercised over a
five-year period.
54
<PAGE>
In March 2000 the Company was served papers in connection with a patent
infringement lawsuit filed against it and one other slot machine manufacturer by
International Game Technology, Inc. (IGT). As disclosed in November 1999, IGT is
alleging infringement of a patent issued to IGT in September 1999 entitled "Game
Machine and Method Using Touch Screen". The Company has not yet responded to the
lawsuit and the Company's management denies the assertions of infringement. The
Company is presently unable to determine the financial impact, if any, of this
litigation. The costs of defending this lawsuit may be substantial and may
require significant amounts of senior management time. Any adverse result from
such litigation could materially and adversely affect the Company's liquidity
and capital resources. No adjustments have been made in the accompanying
consolidated financial statements relating to this litigation.
In March 2000, a former distributor of the Company's products, filed suit
against the Company in the United States District Court for the District of
South Carolina. The distributor seeks repayment of $1 million, plus damages, in
connection with machines previously shipped to the distributor in 1998. The
Company is in the process of arbitration as required by the Distribution
Agreement, seeking to recover outstanding receivables from the distributor when
it received this lawsuit. The Company is in the preliminary stages of
investigating the allegations contained in the suit and has not yet responded to
the complaint.
55
<PAGE>
INDEPENDENT AUDITORS' REPORT
To the Board of Directors and Shareholders of Silicon Gaming, Inc.:
We have audited the accompanying consolidated balance sheets of Silicon Gaming,
Inc. and subsidiaries as of December 31, 1999 and 1998, and the related
consolidated statements of operations, shareholders' equity (deficiency) and
cash flows for each of the three years in the period ended December 31, 1999.
Our audits also included the consolidated financial statement schedule listed in
Item 14(a)2. These financial statements are the responsibility of the Company's
management. Our responsibility is to express an opinion on these financial
statements based on our audits.
We conducted our audits in accordance with generally accepted auditing
standards. Those standards require that we plan and perform the audit to obtain
reasonable assurance about whether the financial statements are free of material
misstatement. An audit includes examining, on a test basis, evidence supporting
the amounts and disclosures in the financial statements. An audit also includes
assessing the accounting principles used and significant estimates made by
management, as well as evaluating the overall financial statement presentation.
We believe that our audits provide a reasonable basis for our opinion.
In our opinion, such consolidated financial statements present fairly, in all
material respects, the financial position of Silicon Gaming, Inc. and
subsidiaries at December 31, 1999 and 1998, and the results of their operations
and their cash flows for each of the years in the period ended December 31, 1999
in conformity with generally accepted accounting principles.
The accompanying consolidated financial statements have been prepared assuming
that the Company will continue as a going concern. As discussed in Note 1 to the
consolidated financial statements, the Company's recurring losses from
operations and shareholders' deficiency raise substantial doubt about its
ability to continue as a going concern. Management's plans concerning these
matters are also described in Note 1. The financial statements do not include
any adjustments that might result from the outcome of this uncertainty.
/s/ Deloitte & Touche LLP
San Jose, California
February 15, 2000
(March 22, 2000
as to Note 11)
56
<PAGE>
SCHEDULE II
VALUATION AND QUALIFYING ACCOUNTS AND RESERVES
FOR THE YEARS ENDED DECEMBER 31,
(DOLLARS IN THOUSANDS)
Additions
Balance at charged to Balance at
Beginning costs and end of
Description of period expenses Deductions period
----------- --------- -------- ---------- ------
YEAR ENDED DECEMBER 31, 1999:
Allowance for doubtful accounts $1,650 $ 200 $681 $1,169
YEAR ENDED DECEMBER 31, 1998:
Allowance for doubtful accounts $ 50 $1,600 $ -- $1,650
YEAR ENDED DECEMBER 31, 1997:
Allowance for doubtful accounts $ -- $ 50 $ -- $ 50
<PAGE>
INDEX TO EXHIBITS
Exhibit Description
- ------- -----------
3.1 (1) Amended and Restated Articles of Incorporation of the Registrant.
3.2 (2) Bylaws of the Registrant.
4.1 (4) Amendment No. 2 to Securities Purchase Agreement, by and between
the Company and B III Capital Partners L.P., a Delaware
partnership dated as of September 30, 1997
4.2 (4) Form of Certificate of Determination for Series D Preferred Stock
dated as of November 24, 1999
4.3 (4) Form of Certificate of Determination for Series E Preferred Stock
dated as of November 24, 1999
4.4 (4) Series E Warrant Agreement dated November 24, 1999
4.5 (4) Securities Purchase Agreement by and between the Company and BIII
Capital Partners L.P., a Delaware partnership dated as of
November 24, 1999
4.6 (4) Form of Senior Discount Notes due November 24, 2004 dated as of
November 24, 1999
10.1 (2) Amended and Restated 1994 Stock Option Plan, as amended.
10.2 (2) Lease Agreement dated September 14, 1995, between the Registrant
and Demmon Family Partnership.
10.7 (2) Second Amended and Restated Rights Agreement dated as of
March 21, 1996.
10.8 (3) Master Equipment Lease Agreement dated October 6, 1995, between
the Registrant and Lighthouse Capital Partners, L.P.
10.10 (2) Side Letter Agreement dated March 21, 1996, between the
Registrant and the Interpublic Group of Companies, Inc.
10.11 (2) Side Letter Agreement dated March 21, 1996, between the
Registrant and Station Casinos, Inc.
10.15 (2) OEM Master License Agreement dated April 17, 1996, between the
Registrant and RSA Data Security, Inc.
10.19 (2) 1996 Employee Stock Purchase Plan.
10.20 (2) 1996 Outside Directors Stock Option Plan.
10.21 (3) Software License Agreement dated June 20, 1996 between the
Registrant and Duck Corporation.
10.22 (5) Lease Agreement dated August 14, 1996, between the Registrant and
Interactive Technologies, Inc.
10.24 (5) Lease Agreement dated January 23, 1997, between the Registrant
and Johnny Ribeiro
10.25 (5) Lease Agreement dated January 23, 1997, between the Registrant
and The Ribeiro Corporation
<PAGE>
10.26 (6) Lease Agreement dated October 7, 1997 between the Registrant and
Battle Born Development, LLC.
10.27 (6) 1997 Nonstatutory Stock Option Plan
10.41 (4) Restructuring Agreement by and between the Registrant and BIII
Capital Partners, L.P., a Delaware partnership, dated
November 24, 1999
10.42 (4) 1999 Long-Term Compensation Plan
10.43 (4) Stockholders Agreement by and between the Registrant, management
stockholders and BIII Capital Partners, L.P., a Delaware
partnership, dated November 24, 1999
21.1 Subsidiaries of the registrant.
23.1 Consent of Deloitte & Touche LLP.
27 Financial Data Schedule.
- ----------
(1) Incorporated by reference to Exhibit 3.3 to Registrant's Registration
Statement on Form S-1 (no.333-4793) which became effective on July 30, 1996
(the "Form S-1").
(2) Incoporated by reference to identically numbered exhibit to Registrant's
Registration Statement on Form 10 (No.0-28294) filed with the Commission on
April 24, 1996 (the "Form 10").
(3) Incorporated by reference to identically numbered exhibit to the Form S-1.
(4) Incoporated by reference to exhibits in the Registrants Form 8-K filed with
the Commision on November 24, 1999.
(5) Incorporated by reference to identically numbered exhibits to Registrant's
Annual Report on Form 10-K for the year ended December 31, 1996.
(6) Incorporated by reference to identically numbered exhibits to the
Registrant's Quarterly Report on Form 10-Q for the quarter ended June 30,
1998.
SILICON GAMING, INC.
LIST OF SUBSIDIARIES
Subsidiary Jurisdiction
---------- ------------
Silicon Gaming-Colorado, Inc. Colorado
Silicon Gaming-Louisiana Louisiana
Silicon Gaming-Michigan Michigan
Silicon Gaming-Minnesota Minnesota
Silicon Gaming-Mississippi, Inc. Mississippi
Silicon Gaming-Missouri, Inc. Missouri
Silicon Gaming-Nevada Nevada
Silicon Gaming-New Jersey, Inc. New Jersey
Silicon Gaming-Indiana, Inc. Indiana
Silicon Gaming-Illinois Illinois
Silicon Gaming-Iowa Iowa
Silicon Gaming-New Jersey, Inc. New Jersey
UBet.com., Inc. Delaware
INDEPENDENT AUDITORS' CONSENT
We consent to the incorporation by reference in Registration Statements
(333-30482, 333-92359, 333-80519 and 333-60309) on Form S-8 and Registration
Statements (333-69369 and 333-48393) on Form S-3 of our report dated February
15, 2000 (March 22, 2000 as to Note 11) (which expresses an unqualified opinion
and includes an explanatory paragraph relating to an uncertainty concerning the
Company's ability to continue as a going concern) included in the Annual Report
on Form 10-K of Silicon Gaming, Inc. for the year ended December 31, 1999.
/s/ DELOITTE & TOUCHE LLP
San Jose, California
March 29, 2000
<TABLE> <S> <C>
<ARTICLE> 5
<MULTIPLIER> 1,000
<S> <C>
<PERIOD-TYPE> YEAR
<FISCAL-YEAR-END> DEC-31-1999
<PERIOD-START> JAN-01-1999
<PERIOD-END> DEC-31-1999
<CASH> 877
<SECURITIES> 1,000
<RECEIVABLES> 1,188
<ALLOWANCES> 1,169
<INVENTORY> 7,331
<CURRENT-ASSETS> 11,465
<PP&E> 11,260
<DEPRECIATION> 7,465
<TOTAL-ASSETS> 15,581
<CURRENT-LIABILITIES> 5,071
<BONDS> 10,428
0
20,000
<COMMON> 69,665
<OTHER-SE> (97,026)
<TOTAL-LIABILITY-AND-EQUITY> 15,581
<SALES> 17,115
<TOTAL-REVENUES> 17,115
<CGS> 13,323
<TOTAL-COSTS> 33,661
<OTHER-EXPENSES> 18
<LOSS-PROVISION> 0
<INTEREST-EXPENSE> 7,212
<INCOME-PRETAX> (24,081)
<INCOME-TAX> 0
<INCOME-CONTINUING> (24,081)
<DISCONTINUED> 0
<EXTRAORDINARY> 12,316
<CHANGES> 0
<NET-INCOME> (11,765)
<EPS-BASIC> (0.70)
<EPS-DILUTED> (0.70)
</TABLE>
