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UNITED STATES SECURITIES AND EXCHANGE COMMISSION
WASHINGTON, D.C. 20549
FORM 10-K
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[X] ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES
EXCHANGE ACT OF 1934
FOR THE FISCAL YEAR ENDED DECEMBER 31, 1998
OR
[ ] TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES
EXCHANGE ACT OF 1934
For the transition period from to___________
COMMISSION FILE NUMBER 0-21123
SRS LABS, INC.
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(EXACT NAME OF REGISTRANT AS SPECIFIED IN ITS CHARTER)
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DELAWARE 33-0714264
(STATE OR OTHER JURISDICTION OF (I.R.S. EMPLOYER
INCORPORATION OR ORGANIZATION) IDENTIFICATION NO.)
2909 DAIMLER STREET, SANTA ANA, CALIFORNIA 92705
(ADDRESS OF PRINCIPAL EXECUTIVE OFFICES) (ZIP CODE)
(949) 442-1070
(REGISTRANT'S TELEPHONE NUMBER, INCLUDING AREA CODE)
SECURITIES REGISTERED PURSUANT TO SECTION 12(b) OF THE ACT: NONE
SECURITIES REGISTERED PURSUANT TO SECTION 12(g) OF THE ACT:
COMMON STOCK, PAR VALUE $.001 PER SHARE
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. [X] Yes [ ] No
Indicate by check mark if disclosure of delinquent filers pursuant to Item
405 of Regulation S-K is not contained herein, and will not be contained to the
best of the registrant's knowledge, in definitive proxy or information
statements incorporated by reference in Part III of this Form 10-K or any
amendment to this Form 10-K. [ ]
The aggregate market value of the registrant's voting Common Stock held by
non-affiliates of the registrant was approximately $19,848,273 (computed using
the closing price of $3.50 per share of Common Stock on March 26, 1999 as
reported by NASDAQ). There were 11,697,944 shares of the registrant's Common
Stock, par value $.001 per share, outstanding on March 26, 1999.
DOCUMENTS INCORPORATED BY REFERENCE
Portions of the registrant's Proxy Statement prepared in connection with
the Annual Meeting of Stockholders to be held in 1999 are incorporated by
reference in Part III of this Form 10-K.
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SRS LABS, INC.
TABLE OF CONTENTS
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PART I
Item 1. Business. 3
Item 2. Properties. 12
Item 3. Legal Proceedings. 12
Item 4. Submission of Matters to a Vote of Security Holders. 12
PART II
Item 5. Market for Registrant's Common Equity and Related Stockholder Matters. 13
Item 6. Selected Financial Data. 14
Item 7. Management's Discussion and Analysis of Financial Condition
and Results of Operations. 15
Item 7A. Quantitative and Qualitative Disclosures About Market Risk. 25
Item 8. Financial Statements and Supplementary Data. 26
Item 9. Changes in and Disagreements With Accountants on Accounting
and Financial Disclosure. 49
PART III
Item 10. Directors and Executive Officers of the Registrant. 49
Item 11. Executive Compensation. 49
Item 12. Security Ownership of Certain Beneficial Owners and Management. 49
Item 13. Certain Relationships and Related Transactions. 49
PART IV
Item 14. Exhibits, Financial Statement Schedules, and Reports on Form 8-K. 50
SIGNATURES 55
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PART I
ITEM 1. BUSINESS
SRS Labs, Inc. (the "Company" or "SRS Labs") was incorporated in the State
of California on June 23, 1993 and reincorporated in the State of Delaware on
June 28, 1996. The Company's executive offices are located at 2909 Daimler
Street, Santa Ana, California 92705. Its telephone number is (949) 442-1070, and
its address on the World Wide Web is http://www.srslabs.com.
SRS Labs, Inc. is a developer and provider of technology solutions for the
consumer electronics, computer, game and telecommunications markets. The
Company's principal business activities in these markets include:
o Developing and licensing audio and voice technologies to original equipment
manufacturers ("OEMs") and semiconductor manufacturers around the world;
and
o Through its subsidiary, Valence Technology Inc. and its foreign
subsidiaries, designing and selling technology solutions through custom
application specific integrated circuits ("ASICs") to OEMs; and designing,
distributing and manufacturing components, sub-assemblies and finished
goods for the OEM and retail communities within the Company's targeted
markets.
The Company was formed in 1993 by purchasing all rights and assets of
various audio and speaker technologies from the Hughes Aircraft Company. The
Company successfully completed its initial public offering in August 1996,
raising approximately $22 million. From the Company's inception in 1993 until
February 1998, the Company derived substantially all of its revenues from audio
technology licensing activities for the consumer electronics, computer and game
markets. The primary technologies that contributed to revenue were SRS(R) (Sound
Retrieval System(R)), which produces a 3D sound-enhanced stereo image from any
mono or stereo source, and TruSurround(TM), a "virtual" audio technology which
processes multi-channel surround sound through any standard pair of stereo
speakers.
On March 2, 1998, the Company acquired 100% of the outstanding stock of
Valence Technology Inc. ("Valence"), a British Virgin Islands holding company
with its principal business operations in Hong Kong and China. This acquisition
significantly expanded the Company's business activities from the original
licensing model to include the design, manufacture and marketing of chips,
components and products. Valence and its subsidiaries operate five offices, two
of which are located in Hong Kong and three of which are located in China
(Chengdu, Shanghai and Shenzhen).
In addition to the acquisition of Valence, during the fiscal year ended
December 31, 1998 ("Fiscal 1998"), the Company acquired two additional
technologies. In the first quarter of Fiscal 1998, the Company acquired certain
rights to Voice Intelligibility Processor ("VIP"), a patented voice processing
technology that improves the intelligibility of the spoken voice, especially in
high ambient noise environments and, in the following quarter, acquired certain
rights to Circle Surround, a patented audio delivery system that allows
multi-channel surround sound to be encoded into a two-channel stereo format and
allows an encoded two-channel audio source to be decoded into a multi-channel
surround format.
SRS currently operates in two business segments: (a) the development and
marketing of technology in the forms of integrated circuits designed and
distributed through Valence and the licensing of technologies developed by the
Company to OEMs and semiconductor manufacturers, and (b) the sale of consumer
electronic products and components. A summary of the Company's operations and
activities by business segment and geographic area is set forth below.
TECHNOLOGY SOLUTIONS AND LICENSING
During the years ended December 31, 1996 and 1997 ("Fiscal 1996" and
"Fiscal 1997," respectively), chip and licensing revenue accounted for all of
the Company's revenue while in Fiscal 1998, chip and licensing revenue accounted
for 35% of consolidated revenue and product and component sales revenues
accounted for 65% of consolidated revenue. See Item 7, "Management's Discussion
and Analysis of Financial Condition and Results of Operations," herein.
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Design and Sale of Technology Solutions
The Company, through Valence and its subsidiaries, designs and sells
technology solutions through custom analog, digital and mixed-signal ASICs for
OEM manufacturers worldwide in the consumer electronics, computer, game and
telecommunications markets. Applications for these integrated circuits ("ICs")
include personal computer chipsets, radio pager decoders, micro-controllers,
audio/video products, cordless telephones, USB speakers, educational toys and
voice synthesis products. Based in China and Hong Kong, over 20 engineers, with
state-of-the-art equipment and software, support the Company's custom chip
design capabilities. The Company sells these custom designed chips to its
contracted customers, outsourcing the manufacturing to a network of fabrication
partners throughout Asia Pacific, including Chartered Semiconductor, Samsung
Electronics Co., LTD and Signetics KP Co. Limited.
The Company's customers are industry leading consumer electronics,
telecommunications, game and personal computer manufacturers in North America
and Europe, as well as in Asia Pacific. Due to nondisclosure agreements,
specific current customers cannot be disclosed, but previous design projects
have been performed for such international companies as Creative Technology
Limited, Innovision Research and Technology Limited, National Semiconductor
Corporation, Raytron Inc., Toshiba Corporation, System LSI Division and Utron
Technology Inc. Under many of the design contracts, the Company negotiates to
retain ownership of the specific designs. These designs form a significant
library of intellectual property that can be used in future projects.
In addition to performing contract design work, the Company designs,
produces and sells ICs to OEMs of consumer electronics, games, telecommunication
and personal computer equipment in Asia Pacific under the brand name ASP
Microelectronics. The general purpose integrated circuits offered include
micro-controllers, PROM and ROMs for DVD Players, set-top box receivers and
audio/video equipment; ICs for telecommunication and game equipment; small
signal transistors and ICs used mainly in the manufacture of consumer products
such as television sets, radios, telephones, computer mother boards, add-on
boards and audio hi-fi systems. The products created are based upon senior
management's analysis of trends in the market, long standing relationships with
customers and overall business experience. Many of these products are developed
by capitalizing upon the Company's custom design libraries.
Technologies and Licensing
The Company's technology portfolio covers a wide range of audio, voice and
speaker technologies. The Company licenses these technologies to OEMs and
semiconductor manufacturers, as well as develops and markets implementation
options and finished goods that feature these proprietary and patented
technologies.
The Company's technology strategy continues to be the development,
acquisition and license of audio and voice technologies to OEMs and
semiconductor manufacturers in the consumer electronics, computer, game and
telecommunications markets around the world. By providing a continuous stream of
patented audio and voice technologies, enhancing relationships with existing
licensees and attracting new licensees, the Company believes that it will
strengthen its market position as a world leader in audio and voice technology.
The Company's technologies may be implemented in a variety of methods,
including discrete analog components, chip modules, analog semiconductors,
digital signal processors and software. These various implementation options
offer customers significant flexibility when incorporating the Company's
technologies into products. The markets which the Company's technologies address
include a wide variety of audio and voice-related consumer products such as TVs,
computers, stereo receivers, VCRs, video games, musical instruments, cellular
phones, cordless phones, public address equipment and car audio equipment. The
markets for these consumer electronics products are highly competitive and
generally dominated by large manufacturers. The Company provides technology to
these manufacturers who need to differentiate their products by continually
adding new features and increasing product performance.
License agreements with OEMs have terms which typically range from one to
ten years and require per unit royalty payments for all products implementing
the Company's technologies. Certain agreements provide for a fixed annual or
quarterly royalty payment. License agreements also specify the use of the
Company's trademarks and logos and provide for product review and approval by
the Company. The agreements do not have volume requirements and may be
terminated by the OEM or the Company without substantial financial penalty.
The Company has primarily followed the Dolby licensing model whereby
licensees are free to choose a semiconductor solution from a number of choices
and, regardless of the semiconductor choice, the licensee pays a royalty
directly to the Company after the licensee's product has been shipped. However,
this methodology is not well established in the computer multimedia industry or
the Chinese consumer electronics marketplace so the
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Company has implemented a different royalty collection method, whereby the
royalty is "bundled" into the cost of the semiconductor product. This
methodology simplifies the business process for the OEM, the semiconductor
manufacturer and the Company. Under this model, the royalty is remitted directly
to the Company by the semiconductor manufacturer after the chip has been
delivered to the OEM customer.
The Company has experienced significant concentration and fluctuations in
the use of the Company's technologies by certain licensees. For Fiscal 1996,
Packard Bell and NEC accounted for 28% and 10%, respectively, of the Company's
license revenues. In June 1997, Packard Bell and NEC merged to form Packard
Bell/NEC. For Fiscal 1997, Packard Bell/NEC and Crystal Semiconductor accounted
for 25% and 14%, respectively, of the Company's license revenues. For Fiscal
1998, Crystal Semiconductor accounted for 30% of the Company's license revenues.
In light of the significant amount of revenues derived from these customers, the
loss of any such customer or the uncollectibility of related receivables could
have a material adverse effect on the Company's financial condition and results
of operations.
Portfolio of Audio and Voice Technologies
The portfolio of audio, voice and speaker technologies offered by the
Company include SRS, TruSurround(TM), FOCUS(R), Baser(R), ORB(R), AVT, VIP(TM),
CircleSurround(R), SRS Headphone(TM), WOW(TM) and TruBass(TM). SRS, FOCUS and
TruSurround are currently the subject of numerous license agreements and are
actively marketed by the Company. Baser, ORB and AVT are speaker technologies
that were included in the original technology acquisition from Hughes Aircraft
and have not been actively promoted. VIP and CircleSurround were acquired during
the first and second quarters of 1998, respectively, and did not contribute
significantly to revenue in 1998. SRS Headphone, WOW and TruBass were developed
internally and were introduced to the marketplace in 1998. Licensing royalties
associated with SRS, TruSurround, FOCUS and ORB, and technology transfer fees
for new technologies have accounted for virtually all of the Company's licensing
revenues to date.
o SRS 3D SOUND
SRS 3D Sound is one of the world's leading 3D audio enhancement
technologies. The patented technology broadens any mono or stereo audio signal
and creates a realistic 3D sound image from just two standard stereo speakers.
SRS is based on the fundamentals of the human hearing system and recreates the
multitude of spatial cues that are present in a live listening environment but
are lost in recording and playback. SRS eliminates the "sweet spot" associated
with traditional stereo; thus it does not require the listener to be positioned
in a specific location to experience the immersive 3D sound image.
The technology can also be encoded onto CDs, cassettes or videotapes during
the recording process and reproduced through a conventional stereo system,
multimedia computer, radio and television broadcast, or the Internet. SRS was
originally developed by Hughes Aircraft, which spent significant resources to
develop and patent SRS and related audio technologies. Since acquiring the SRS
technology from Hughes Aircraft in June 1993, the Company has improved the
performance of SRS, reduced the cost for OEMs to implement the technology,
secured licensing relationships with various semiconductor manufacturers who
offer the technology in various analog and digital chip options, and introduced
the technology to a wider variety of consumer applications.
To date, over 34 million products have been shipped with SRS technology
from more than 180 manufacturers including Acer Peripherals, Ltd., Apple
Computer, Inc., AST Research, Inc., Daewoo Telecom Ltd., Hitachi Ltd., IBM,
Kawai Musical Instruments Mfg. Co., Ltd., Kenwood Corporation, Young Chang
America, Inc. (Kurzweil), LG Electronics, Inc., Nakamichi Corporation, Packard
Bell/NEC, Pioneer Electronic Corporation, Thomson Consumer Electronics, Inc.
(RCA), Samsung Electronics Co., Ltd., Sharp Electronics Corporation, Smart
Devices, Inc., Sony Corporation and Toshiba Corporation. Semiconductor
manufacturers who offer SRS technology in their chip offerings include Cirrus
Logic (Crystal Semiconductor), Fujitsu Semiconductor Corporation, Mitsubishi
Electric Corporation, New Japan Radio Co. Ltd., Philips Semiconductors,
STMicroelectronics, Toshiba Semiconductor Corporation and Zoran Corporation.
o TRUSURROUND
With its heritage traced to the patented SRS technology, TruSurround is a
Dolby-certified virtual audio technology, which creates an immersive surround
sound experience from just two standard speakers from a multi-
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channel audio source, such as Dolby Digital or Dolby Pro Logic. It was
originally designed to take advantage of the 5.1 channel audio standard for DVD,
Dolby Digital, without requiring the use of six speakers. TruSurround processes
the six discrete channels of digital audio into just two channels, retaining all
of the original audio information and giving the listener the perception that
they are surrounded by additional "phantom" speakers.
TruSurround has been successfully introduced to the consumer electronics
marketplace and is featured in a wide variety of products, including televisions
from Sony Corporation and audio/video receivers from Pioneer Electronic
Corporation. Several manufacturers of DVD-equipped computers that have
incorporated TruSurround include Compaq Computer Corporation, Dell Computer
Corporation, Gateway 2000, Inc. and Micron. Semiconductor companies who offer
TruSurround in analog or digital implementation options for various applications
in consumer electronics currently include AKM Semiconductor, Chromatic Research,
Inc., New Japan Radio Co., Ltd., STMicroelectronics and Zoran. The Company
believes that the eventual worldwide use of the DVD format will offer
opportunities for revenue growth.
o FOCUS
In many audio environments, speakers are not placed directly in front of a
listener making it difficult to achieve a realistic sound experience from
speakers that are below the plane of the listener's ear. The Company developed
FOCUS as a technology solution for this problem. Originally designed for use in
automobiles where front speakers are often placed under the dashboard or facing
each other in the door panels, the patented FOCUS technology electronically
repositions the sound image to create the appropriate perception of image
height. In addition to automobiles, FOCUS is ideally suited for any product
application where speakers cannot be placed in optimal locations for either
space or aesthetic reasons, such as big screen TVs, home in-wall speakers and
commercial applications such as drive-through restaurant communications. The
first analog and digital chip options of FOCUS became available for sampling to
OEMs from Mitsubishi Electric Corporation, New Japan Radio Co., Ltd. and
STMicroelectronics during the last half of 1998.
o SPEAKER TECHNOLOGIES
The Company holds patents for speaker technologies originally developed
at Hughes Aircraft. One such technology, ORB, provides a unique approach to the
physical design of speakers by incorporating a baffle that creates a
180(Degree) dispersion of sound. Another speaker technology, referred to as
AVT, projects the listening material so that the human ear can more easily
identify the direction of ambient sounds. A third speaker technology, BASER, is
a high-efficiency design for a subwoofer product.
o VIP - VOICE INTELLIGIBILITY PROCESSOR TECHNOLOGY
VIP is a patented audio processing technology that improves the
intelligibility of the spoken voice in a variety of challenging listening
situations. VIP selectively processes only those portions of the speech signal
that the brain uses for cognition, without requiring increase in gain or volume.
SRS inventor Arnold Klayman, who is now the principal audio scientist at the
Company, originally developed the VIP technology at Hughes Aircraft. During a
divestiture in 1994, Hughes sold this non-core business division to VIP Labs.
From 1994 until the acquisition by the Company, VIP Labs further developed the
technology as well as selectively marketed a stand-alone signal processor for
use in the professional sound reinforcement industry.
The Company believes that the market opportunities for VIP are significant
and include cellular phones, wireless products, hearing aids, public address and
emergency warning systems, talking toys, voice recognition products, Voice Over
IP (Internet protocol) and other Internet applications. The Company directly
offers both software and hardware implementation options for VIP. VIP software
is available as digital code that may be ported to DSP chips used by
manufacturers of cellular phones, paging systems, digital televisions, sound
reinforcement equipment and hearing aids. VIP is also available as software that
may be executed on computer platforms to improve a variety of voice-related
processes. Hardware options are marketed by the Company as a DSP chip and
subassembly board for sale to OEMs of sound reinforcement equipment.
During the first quarter of the year ending December 31, 1999 ("Fiscal
1999"), the Company announced the first licensing contracts for VIP. On January
26, 1999, the Company announced that Samsung Electronics Co., Ltd. has licensed
VIP for use in cellular and wireless products and that Samsung anticipates the
introduction of the first cellular phone with VIP in the third quarter of 1999.
On February 2, 1999, the Company announced the license of
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VIP by Lucent Technologies. It is anticipated that in the second quarter of 1999
Lucent will introduce the first VIP-based DSP chip for sale to manufacturers of
cellular phones worldwide.
o CIRCLESURROUND
CircleSurround ("CS") is a patented audio delivery system that allows
multi-channel surround sound to be encoded into a two-channel stereo format and
then allows an encoded two-channel audio source or traditional audio source to
be decoded into a multi-channel surround format.
CircleSurround can be used in the recording process of music or movies and
then implemented in a decoding playback device, such as a home audio receiver,
DVD player or car audio product. When used as an encoding/decoding technology,
CS encodes five discrete channels of sound through only two channels (the same
space required for stereo). In the playback device, CS then takes the two
channels of encoded material and decodes them back into the original five
recorded channels for playback through a multi-channel (surround sound) home
theater or cinema system equipped with four or five speakers plus a subwoofer.
In addition, CS creates multiple channel surround sound from the wealth of
legacy stereo and surround encoded material available on traditional music CDs,
VHS tapes, television or AM/FM broadcast.
CircleSurround technology is available for OEMs worldwide in the following
formats: analog ICs through a relationship with Analog Devices; digital software
code from the Company; and reference boards, sub-systems and finished products
for the home and car audio market from Valence. Current manufacturers who have
announced products with CircleSurround include Rocktron Corporation, Haitai
Electronics Co., Ltd. (Sherwood) and Theta Digital. Smart Devices, Inc. has
included CircleSurround in a line of movie theater audio processors that are
marketed to cinemas around the world. Hundreds of music CDs have been encoded
with CS by audiophile record labels such as Telarc, DMP and Northsound, which
market the CDs through traditional retail channels and online music sites.
o SRS HEADPHONE, WOW AND TRUBASS
In 1998, the Company developed and began marketing three additional audio
technologies to the consumer electronics, computer and game markets. Introduced
in early 1998, SRS Headphone is based on the core SRS 3D sound technology and
provides 3D sound enhancement to a mono, stereo or surround sound signal, but is
optimized to work with any pair of headphones. In January 1999, Mitsubishi
Semiconductor announced the availability of the M62458FP, the first analog IC
implementation of this technology. In November 1998, at COMDEX in Las Vegas, the
computer industry's leading tradeshow, the Company introduced two additional
technologies, the WOW Thing (TM) (WOW) and TruBass (TM). WOW is the Company's
next generation audio enhancement for speakers and headphones. It significantly
improves the spatial imaging and bass response from traditional loudspeakers and
headphone products. The TruBass (TM) technology is a psycho-acoustic process
that creates the perception of dramatically increased bass performance in
smaller speaker systems and headphones without requiring additional physical
components.
Product applications for these technologies include multimedia speakers,
powered home audio speakers, mini stereo systems, portable "boom boxes", car
radios, portable headset audio systems, televisions and other products in the
consumer audio, car audio and professional sound markets.
In addition to licensing these technologies to OEMs, the Company
anticipates using its chip design expertise and network of manufacturing
partners to market chip modules of these technologies to OEMs around the world
during Fiscal 1999. Software versions of these technologies are also in
development for use with Internet audio and voice applications.
PRODUCT AND COMPONENT SALES
The Company, through Valence and its subsidiaries, is an authorized
non-exclusive distributor in Hong Kong and/or China for semiconductor products
from Lucent Technologies International Inc., Molex Hong Kong/China Ltd.,
National Semiconductor Hong Kong Ltd., Oak Technology Inc., OPTI, Philips Hong
Kong Ltd., Rockwell and Samsung Electronics HK Co. Ltd., as well as its own
ASP-brand. Access to multiple suppliers of similar ICs provides value to
customers by insuring an adequate supply of components and "just in time
delivery" of goods to meet their production schedules.
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In addition to distributing semiconductor products, Valence and its
subsidiaries incorporate these components in assembly kits and reference boards
for use in audio products, video compact disc ("VCD") players and
telecommunication and wireless infrastructure equipment. Asia Pacific customers
include Acer, Daeyoung, Huawei Technologies Co., Ltd., Idall, Konka and SAST.
Consumer electronic home entertainment products offered under the Valence brand
name that include state-of-the-art technology with unique features are VCD and
karaoke players, audio/video receivers, game products and home entertainment
amplifiers. The Company anticipates offering new products to the China market
during Fiscal 1999 with CircleSurround, TruSurround and TruBass.
The Company's team of software, hardware and application engineers in
offices throughout mainland China offers value-added engineering services, such
as the design of application software in FPGAs (field programmable gate arrays),
ASICs and system design. Local support is very valuable to many Chinese
manufacturers who have limited experience in the design and manufacturing of
products, especially handling surface mount technology equipment. The Company's
qualified engineers can solve its customers' manufacturing and design problems
locally and on a timely basis.
SALES AND MARKETING
Integrated Circuits and Licensing
The Company's sales and marketing strategies target the consumer
electronics, computer, game and telecommunications industries. To implement its
strategy, the Company has established a direct sales force and a worldwide
network of independent sales agents and distributors. The Company has
established distributors in Korea, Taiwan, Japan, Singapore, Hong Kong and
China. The Company actively promotes the use of its trademarks and logos and
directs customers to prominently display the appropriate SRS technology logo on
products, packaging and in advertising.
The Company's corporate communications program includes press releases and
sales informational mailings to its customers around the world. The Company also
distributes audio CD/CD ROMs that demonstrate SRS technology and provides
technical assistance and general consumer-related information on the World Wide
Web. The Company conducts tours and presentations for the press and other media
outlets to promote the Company's technologies and products.
The Company regularly participates in tradeshows and conferences to
increase awareness of its technologies and to market its technologies and
products. The Company also works closely with its OEM and semiconductor partners
to actively explore other opportunities to utilize the Company's technologies in
new products and/or markets.
Product and Component Sales
The consumer electronics market in China is an important market for the
Company. One way the Company participates in this market is through the design
and distribution of components and assembly kits to VCD manufacturers. VCD
allows the playing of digital video on a compact disc and is well suited for a
broad range of applications, including music, video, education, training, movies
and Karaoke. In a few short years, it has become the standard video format and
received mass-market adoption in China.
Through its distribution agreements and close relationships with leading
VCD chipset suppliers in China, such as Oak Technology, Inc. and Philips Hong
Kong Ltd, the Company designs, develops and markets complete VCD players, as
well as assembly kits and reference boards, at very competitive prices.
During Fiscal 1998, through a network of manufacturing partners in China,
the Company also produced and began offering home entertainment products under
the brand name "Valence." The consumer electronics market in China is highly
competitive with many leading companies marketing to consumers in the larger
cities in China; therefore, the Company focuses its sales efforts on secondary
markets. The Company has established a network of eight to ten regional
distributors in various cities in China, who then sell the Valence-branded
products to smaller distributors, dealers and retail establishments.
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RESEARCH AND DEVELOPMENT
The Company has spent approximately 15.8%, 11.2% and 17.1% of total
expenses on research and development in Fiscal 1996, 1997 and 1998. The
percentage calculation for 1998 excludes expense related to acquired in-process
research and development.
The Company's research and development group includes 55 software, hardware
and application engineers who focus on developing intellectual property,
technology solutions and consumer products. Five engineers are based in the U.S.
with the remainder based in Hong Kong and China.
The U.S.-based engineering group is focused upon developing new audio and
voice technologies, improving the performance of existing technologies and
reducing the implementation cost of the Company's technologies. These engineers
also are focused on assisting customers to implement the Company's technologies
and supporting the Company's sales and marketing efforts on a worldwide basis.
Through Valence and its subsidiaries, the Company operates one of the
largest independent IC design houses in Hong Kong, whose activities are
primarily engaged in working on custom design ASIC projects for clients in the
consumer electronics, game and telecommunications industries. These clients
range from local producers to large, multi-national manufacturers around the
world. The product development group, based in China, includes software and
hardware engineers, as well as applications engineers, who design the
Valence-branded consumer electronics products. In 1998, ASP Microelectronics,
one of Valence's subsidiaries, was awarded the Hong Kong Industry Award's HKITCC
Technological Achievement Award.
The market for the Company's technologies and products is subject to rapid
and significant changes and frequent new technology and product introductions.
The Company believes that its future success will depend on its ability to
continue to enhance its existing technologies and to introduce or acquire new
technologies on a competitive basis. There can be no assurance, however, that
the Company will be able to successfully enhance existing technologies and
products or introduce or acquire new technologies and products.
COMPETITION
The Company competes in each of its business segments with a number of
companies which produce a variety of audio and voice enhancement technologies,
processes and products. These technologies, processes and products include:
THX(R), a certification program that indicates if a movie theater or particular
piece of audio equipment meets certain specifications; Dolby(R) A-type, B-type
and C-type noise reduction; Dolby SR(R), which provides noise reduction and
encodes analog sound using four sound channels; ProLogic(TM), a surround sound
system incorporating an active center channel; DolbySRD(R), which encodes a six
channel digital sound track on a movie print; DTS(R), which uses CDs to
reproduce six channels of digital sound synchronized with a movie print; and
SDDS(R), which encodes six or eight channels of digital sound on both sides of a
movie print. Because SRS works with any existing recorded material whether mono,
stereo, surround sound or other encoding process, SRS can be used either as an
alternative or as a complement and enhancement to almost any competing audio
technology. As a multi-channel encode/decode technology, CircleSurround competes
more directly with the various surround sound technologies listed above.
The Company also directly competes in the field of 3D audio enhancement
with other 3D audio providers, including Aureal, Qsound Labs, Inc., Sensaura and
Spatializer. The Company is not aware of any direct competing technologies to
its voice intelligibility technology, VIP. The Company believes that TruBass
might directly compete with several technologies, including MaxxBass from Waves,
Ltd. and non-proprietary bass enhancement circuits, such as Bass Boost, that are
included on a variety of electronics products, including televisions, audio
systems and speaker products.
In addition, the Company's technologies may, in the future, compete with
audio technologies developed by other companies, some of whom may be current
licensees of the Company.
Certain of these companies have, or may have, substantially greater
resources than the Company to devote to further technologies and new product
developments. The Company believes that it will compete based primarily on the
quality and performance of its proprietary technologies, brand name awareness,
the ease and cost of implementing its technologies, the ability to meet OEMs'
needs to differentiate their products, and the strength of its licensee
relationships. There can be no assurance that based on these factors the Company
will continue to be competitive with existing or future products or technologies
of its competitors.
9
<PAGE> 10
Although the Chinese semiconductor industry is dominated by several major
chip suppliers, such as Motorola, National Semiconductor and Texas Instruments,
within every major market there is need for local, niche participants, such as
the Company. Smaller participants are more flexible in their strategy of
enhancing new products, as well as more responsive and flexible in the service
provided to clients. With thirteen years of background in the Chinese
semiconductor market, the Company's personnel has expertise in local business
practices and a strong franchise of relationships with clients that the Company
believes gives it a competitive advantage over newcomers to the industry or the
large multi-national firms.
The Company's (through Valence and its subsidiaries) chip and component
distribution contracts to distribute products for third party semiconductor
manufacturers in the domestic Chinese market are not exclusive, and the Company
competes with other distributors, such as Arrow Electronics, Future Electronics
and Avnet Inc. In addition, the semiconductor companies who manufacture the
components and chips also sell directly to manufacturers within China.
Through a network of manufacturing partners in China, the Company produces
and offers home entertainment products for wholesale and distribution through
retailers, under the brand name "Valence". Although the overall consumer
electronics market in China is vast, it is highly competitive with many large
manufacturers competing in the retail channel with established brand names.
While most of these established companies, such as Idall Electrical Appliance
(China) Co. and Jiangsu Shinco Electronic Group Co., Ltd., market to consumers
in China's larger cities, the Company focuses its sales efforts on secondary
markets with products that have unique features and technologies.
The markets in which the Company sells its products are subject to extreme
price competition, thus the Company expects to continue to experience declines
in the selling prices of its products over the life cycle of each product. In
order to offset declines in the selling prices of its products, the Company must
continue to reduce the costs of products through product design changes,
manufacturing process changes, volume discounts and other savings negotiated
with its manufacturing subcontractors. Since the Company does not operate its
own manufacturing facilities with respect to ASICs or product or component
sales, it may not be able to reduce its costs as rapidly as its competitors who
perform their own manufacturing. The failure of the Company to design and
introduce, in a timely manner, lower cost versions of existing products or
higher gross margin new products, or to successfully manage its manufacturing
subcontractor relationships could have a material adverse effect on the
Company's gross margins.
INTELLECTUAL PROPERTY RIGHTS AND PROPRIETARY INFORMATION
The Company operates in industries where innovation, investment in new
ideas and protection of its resulting intellectual property rights are important
for success. The Company relies on a variety of intellectual property
protections for its products and services, including patent, copyright,
trademark and trade secret laws, and contractual obligations, and pursues a
policy of enforcing such rights. There can be no assurance, however, that the
Company's intellectual property rights will be adequate to ensure the Company's
competitive position, or that competitors will not be able to produce a
non-infringing competitive product or service. There can be no assurance that
third parties will not assert infringement claims against the Company, or that
if required to obtain any third party licenses as a result of an infringement
dispute the Company will be able to obtain such licenses. Although the Company
believes that its patents and trademarks are important to each of its two
business segments, such patents and trademarks are especially important to the
business segment focused in licensing the Company's technologies or developing
and marketing of its technologies in the form of integrated circuits.
SRS is the subject of five U.S. patents containing a combined total of 276
claims. The expiration dates for these U.S. patents are May 31, 2005, June 20,
2006, September 12, 2006, October 5, 2010 and April 27, 2015, respectively. In
addition, the Company has 56 issued foreign patents relating to SRS and over 50
additional foreign patents pending. The expiration dates for these foreign
patents varies depending on the particular patent and the particular country,
but in most cases the duration of such foreign patents will extend into the year
2006.
The Company also owns four U.S. patents for speaker technologies and has 30
issued foreign patents for these technologies with several other foreign patents
pending. The expiration dates for these U.S. patents are April 4, 2006, June 6,
2006, January 10, 2010 and October 7, 2016, respectively. The expiration dates
for these foreign patents varies depending on the particular patent and the
particular country, but in most cases the duration of such foreign patents will
extend into the year 2006.
10
<PAGE> 11
The Company owns U.S. patents for VIP, FOCUS, TruSurround and
CircleSurround with numerous foreign patents pending for each of these
technologies. In addition, the Company has multiple new audio technology patents
pending in the U.S. and worldwide for improvements to SRS and for its FOCUS,
TruSurround and TruBass technologies.
The Company is the owner of the following federally registered trademarks:
SRS(R), the SRS symbol "(o)(R)", Sound Retrieval System(R), ORB(R), BASER(R),
"everything else is only stereo", and "CircleSurround". Trademark applications
are pending for TruSurround(TM), AVT(TM), 3D Stereo(TM), 3D Stereo II(TM), 3D
Cinema Sound(TM), Mega Wide(TM), Mega Space(TM), ORS(TM), VIP(TM), SRS
Headphone, TruBass(TM), WOW Thing(TM) and NuVoice(TM). The duration of the
federally registered trademarks can be maintained indefinitely, provided proper
maintenance fees are paid and the trademarks are continually used or licensed by
the Company. The Company also has foreign trademarks either registered or
pending for many of the aforementioned trademarks.
SEASONALITY
Due to the Company's dependence on the consumer electronics market, the
substantial seasonality of sales in the market could impact the Company's
revenues and net income. In particular, the Company believes that there is
seasonality relating to the Christmas season as well as the Chinese New Year
within the Asia Pacific region, which fall into the fourth and first quarters,
respectively. As a result, the Company believes that period-to-period
comparisons of its results of operations are not necessarily meaningful and
should not be relied upon as indications of future performance.
EMPLOYEES
The Company and its subsidiaries employed 72 persons and 135 persons,
respectively, in its IC Chip and Licensing and Product and Component Sales
business segments as of December 31, 1998. Of the aggregate number of employees,
178 are employed by Valence and its subsidiaries and are located overseas. None
of the Company's employees are covered by a collective bargaining agreement or
are presently represented by a labor union. The Company has not experienced any
work stoppages and considers its employee relations to be good.
OPERATIONS BY BUSINESS SEGMENT AND GEOGRAPHIC AREA
The financial information for business segments and geographic areas is
included in Note 10 to the Notes to Consolidated Financial Statements, included
herein under Item 8 of this Report.
11
<PAGE> 12
BUSINESS RISKS
Reference is made to "Item 7, Management's Discussion and Analysis of
Financial Condition and Results of Operations, Forward-Looking Information and
Certain Facts" for a discussion relating to certain business risks relating to
the business of the Company and its subsidiaries.
ITEM 2. PROPERTIES
The Company's corporate headquarters are located in Santa Ana, California,
in a 23,400 square foot facility consisting of office and warehouse space. The
Company leases the facility from Daimler Commerce Partners, L.P. (the
"Partnership"), an affiliated partnership. The general partner of the
Partnership is Conifer Investments, Inc. ("Conifer"). The sole shareholders of
Conifer are Thomas C.K. Yuen and Misako Yuen, as co-trustees of the Thomas Yuen
Family Trust (the "Trust"), and the executive officers of Conifer include Mr.
and Mrs. Yuen. Mr. and Mrs. Yuen, as co-trustees of the Trust, also beneficially
own a significant amount of the Company's outstanding shares of common stock.
Mr. Yuen is the Chairman of the Board and Chief Executive Officer of the
Company.
The original lease with the Partnership, pursuant to which the Company
leased 11,700 square feet of space, commenced on June 1, 1994, and expired on
May 31, 1997. Upon the expiration of the original lease, the Company entered
into a new lease agreement with the Partnership to lease 23,400 square feet of
space at the same facility. The lease term commenced on June 1, 1997 and will
expire on May 31, 2000. At the time of expiration, the Company will have an
option to renew the lease for two additional years commencing on June 1, 2000
and terminating on May 31, 2002. Rent for the year beginning June 1, 1997 was
$.59 per square foot per month plus common area expenses, real property taxes,
utilities, insurance premiums and maintenance. Pursuant to the leases with the
Partnership, the Company paid the Partnership rent of $63,430 during Fiscal
1996, $129,369 during Fiscal 1997 and $165,672 during Fiscal 1998.
The Company, through Valence and its subsidiaries, leases several offices
and warehouses in Hong Kong and China. Valence's principal operations are
conducted at two leased facilities located in Hong Kong. The principal executive
offices of Valence are located in Kowloon Tong, Hong Kong, in a 3,726 square
foot office facility under a lease which expires in August 2000. Valence's other
principal office is located in Kwun Tong, Kowloon, Hong Kong, in a 7,453 square
foot office facility under a lease which expires in December 2000. Pursuant to
these leases the Company paid rent of $461,044 during Fiscal 1998.
The Company's corporate headquarters house personnel responsible for the
development of the Company's technologies, as well as the administration of the
Company's license program, while the Valence facilities are used in connection
with the design and marketing of ASICs and the sale of consumer electronic
products and components.
The Company believes that the current facilities of the Company and its
subsidiaries will be adequate to meet the Company's needs for the foreseeable
future. Should the Company need further additional space, management believes
that the Company will be able to secure additional space at reasonable rates.
ITEM 3. LEGAL PROCEEDINGS
As of March 26, 1999, neither the Company nor any of its subsidiaries was a
party to any pending legal proceeding.
ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS
Not applicable.
12
<PAGE> 13
PART II
ITEM 5. MARKET FOR COMMON EQUITY AND RELATED STOCKHOLDER MATTERS
MARKET FOR COMMON STOCK
The common stock of the Company, par value $.001 per share (the "Common
Stock"), trades on the Nasdaq Stock Market as a National Market System Security
under the symbol SRSL. The table below reflects the high and low sales prices of
the Common Stock as reported by The Nasdaq Stock Market, Inc. for the periods
indicated.
<TABLE>
<CAPTION>
HIGH LOW
------- -------
<S> <C> <C>
FISCAL 1997
First Quarter $11 1/8 $ 7 1/4
Second Quarter 11 7/8 9 1/8
Third Quarter 10 3/4 4 5/8
Fourth Quarter 8 5/8 5
FISCAL 1998
First Quarter $10 1/4 $ 6 1/4
Second Quarter 9 5/8 4 7/8
Third Quarter 7 5/8 3 3/8
Fourth Quarter 5 3/8 2 3/8
</TABLE>
At March 26, 1999, the last sale price of the Common Stock was $3.50 per
share.
HOLDERS
At March 26, 1999, there were 410 stockholders of record.
DIVIDEND POLICY
The Company has never paid cash dividends on the Common Stock. The Company
currently intends to retain its available funds from earnings for future growth
and, therefore, does not anticipate paying any dividends in the foreseeable
future.
USE OF PROCEEDS
The effective date of the Company's initial public offering of shares of
Common Stock was August 8, 1996 (SEC Registration No. 333-4974-LA). Since the
Company's Quarterly Report on Form 10-Q for the period ended September 30, 1998
filed pursuant to Section 13(a) of the Security Exchange Act of 1934, as
amended, there has been no change to the Company's use of its aggregate net
offering proceeds of $22,052,955. As noted in such Quarterly Report, the Company
utilized an aggregate of $8,394,222, excluding acquisition expenses in
connection with three acquisitions (See Note 2 to the Consolidated Financial
Statements herein) with the remaining funds being temporarily invested in cash
and municipal bonds, pending application.
13
<PAGE> 14
ITEM 6. SELECTED CONSOLIDATED FINANCIAL DATA
The following table sets forth selected financial data of the Company for
the fiscal years ended December 31, 1994, 1995, 1996, 1997 and 1998, which has
been derived from the Company's consolidated audited financial statements. The
following information should be read in conjunction with the Consolidated
Financial Statements and Notes thereto included elsewhere in this Report.
<TABLE>
<CAPTION>
Fiscal Year Ended December 31,
-------------------------------------------------------------
1994 1995 1996 1997 1998
--------- --------- --------- --------- --------
(in thousands except per share data)
<S> <C> <C> <C> <C> <C>
Revenues:
Chip and licensing revenues $ 987 $ 844 $ 5,392 $ 10,081 $ 15,762
Product and component sales -- -- -- -- 28,963
--------- --------- --------- --------- --------
Total revenues 987 844 5,392 10,081 44,725
Cost of sales 678 15 95 210 29,819
--------- --------- --------- --------- --------
Gross margin 309 829 5,297 9,871 14,906
Operating costs and expenses
Sales and marketing 674 937 1,163 2,112 6,846
Research and development 340 384 522 596 2,555
General and administrative 1,079 1,107 1,616 2,615 5,531
Acquired in-process research
and development -- -- -- -- 18,510
--------- --------- --------- --------- --------
Total operating costs and expenses 2,093 2,428 3,301 5,323 33,442
--------- --------- --------- --------- --------
Income (loss) from operations (1,784) (1,599) 1,996 4,548 (18,536)
Other income (expense), net (92) (41) 366 1,088 705
--------- --------- --------- --------- --------
Income (loss) from operations before
income tax expense (benefit) (1,876) (1,640) 2,362 5,636 (17,831)
Income tax expense (benefit) 1 1 501 1,863 (273)
--------- --------- --------- --------- ---------
Net income (loss) $ (1,877) $ (1,641) $ 1,861 $ 3,773 $(17,558)
========= ========= ========= ========= =========
Net income (loss) per common share:
Basic $ (0.38) $ (0.28) $ 0.24 $ 0.39 $ (1.54)
========= ========= ========= ========= ========
Diluted $ (0.38) $ (0.28) $ 0.21 $ 0.35 $ (1.54)
========= ========= ========= ========= ========
Weighted average number of shares used in the
calculation of net income per common share:
Basic 4,942 5,928 7,625 9,556 11,410
Diluted 4,942 5,928 8,686 10,852 11,410
Balance sheet data:
Working capital $ (645) $ 431 $ 3,375 $ 9,075 $ 7,644
Total assets 927 1,698 26,674 31,542 45,535
Short-term debt and current portion
of long-term obligations 492 180 180 82 8,000
Long-term obligations,
net of current portion 340 211 69 -- --
Stockholders' equity (deficit) (227) 888 25,151 29,420 26,072
</TABLE>
14
<PAGE> 15
ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND
RESULTS OF OPERATIONS
OVERVIEW
SRS Labs, Inc. is a developer and provider of technology solutions for the
consumer electronics, computer, game and telecommunications markets. The
Company's principal business activities in these markets include:
o Developing and licensing audio and voice technologies to original
equipment manufacturers ("OEMs") and semiconductor manufacturers around
the world; and
o Through its subsidiary, Valence Technology Inc. and its foreign
subsidiaries, designing and selling technology solutions through custom
application specific integrated circuits ("ASICs") to OEMs; and
designing, distributing and manufacturing components, sub-assemblies and
finished goods for the OEM and retail communities within the Company's
targeted markets.
From the Company's inception in 1993 until February 1998, the Company
derived substantially all of its revenue from royalties received from technology
licenses. On March 2, 1998, the Company acquired all of the outstanding capital
stock of Valence Technology, Inc., a British Virgin Islands holding company with
its principal business operations in Hong Kong and China ("Valence") for an
aggregate purchase price, excluding non-compete agreements and acquisition
costs, of $19,500,000 consisting of approximately $7,400,000 in cash and
approximately 1,680,611 shares of the Company's common stock, $.001 par value
per share (the "Common Stock"). The acquisition was accounted for as a purchase
with an effective date of February 1, 1998. The acquisition of Valence has had,
and will continue to have, a material impact on the Company's Fiscal 1998
financial statements and for the reporting periods thereafter; accordingly,
current and future financial statements may not be directly comparable to the
Company's historical financial statements.
During the first quarter of Fiscal 1998, the Company acquired certain
rights to Voice Intelligibility Processor ("VIP"), which is a patented voice
processing technology that improves the intelligibility of the spoken voice,
especially in high ambient noise environments. Aggregate consideration,
including acquisition costs, was $1,138,710 and was comprised of $620,178 in
cash, 25,000 shares of Common Stock and warrants to purchase 100,000 shares of
Common Stock at $9.47 per share.
During the second quarter of Fiscal 1998, the Company acquired certain
rights to Circle Surround, which is a patented audio delivery system that allows
multi-channel surround sound to be encoded into a two-channel stereo format and
allows an encoded two-channel audio source or a traditional stereo audio source
to be decoded into a multi-channel surround format. The aggregate purchase
price, including acquisition costs, was $834,985 and was comprised of $534,985
in cash and 35,294 shares of Common Stock.
SRS currently operates in two business segments: (a) the development and
marketing of technology in the forms of integrated circuits designed and
distributed through Valence and the licensing of technologies developed by the
Company to OEMs and semiconductor manufacturers and (b) the sale of consumer
electronic products and components. A summary of the Company's operations and
activities by business segment and geographic area is set forth below.
15
<PAGE> 16
RESULTS OF OPERATIONS
The following table sets forth certain consolidated operating data as a
percentage of total revenues for the years ended December 31, 1996, 1997 and
1998:
<TABLE>
<CAPTION>
Percentage of Total Revenue
Years Ended December 31,
----------------------------
1996 1997 1998
---- ---- ----
<S> <C> <C> <C>
Chip and licensing revenue 100% 100% 35%
Product and component sales - - 65
--- --- ---
Total revenue 100 100 100
Cost of sales 2 2 67
--- --- ---
Gross margin 98 98 33
Sales and marketing 21 21 15
Research and development 10 6 6
General and administrative 30 26 12
Acquired in-process research
and development 0 0 41
--- --- ---
Total operating expense 61 53 74
Operating income (loss) 37 45 (41)
Other income, net 7 11 2
--- --- ---
Income (loss) before income taxes 44 56 (39)
Income tax expense (benefit) 9 18 -
--- --- ---
Net income (loss) 35% 38% (39)%
=== === ====
</TABLE>
YEAR ENDED DECEMBER 31, 1998 COMPARED TO YEAR ENDED DECEMBER 31, 1997
Revenues
Chip and licensing revenue consists of design fees and sales of custom
application specific integrated circuits (ASICs) by Valence to OEM manufacturers
and sales of general purpose ICS designed by the Company under the brand name
ASP Microelectronics. Licensing revenues are royalties generated primarily from
the license of the Company's audio technologies. License and royalty agreements
generally provide for the license of technologies for a specified period of time
for either a single fee or a fee based on the number of units distributed by the
licensee. Product and component sales represent (a) the manufacture and sale of
Valence's own branded product line of VCD players, amplifiers and game products
and (b) the distribution of semiconductor products, manufacturing components and
sub-assemblies to OEMs for the Hong Kong and China markets.
Total revenues for Fiscal 1998 were $44,725,040, which includes revenues
generated by Valence since February 1, 1998. This contrasts with Fiscal 1997
where revenues were $10,081,283 and were generated solely from licensing
activities. Excluding chip design revenue, licensing revenue decreased 45.8%
from the same period last year due to the following factors: (a) the shift in
the PC market to lower cost models, which cannot bear the cost of performance
enhancement technologies such as those offered by SRS Labs; (b) the Asian
financial crisis which reduced demand for consumer electronics products in the
region and negatively impacted the sales of semiconductor ICs that include the
Company's audio technologies; and (c) the trend by consumer electronic
manufacturers to adopt the Company's technologies into their higher end models
has limited volume growth of models using the Company's licensed audio
technologies. The licensing revenue decrease was offset by the custom ASIC chip
design and chip sales of $10,294,851 related to Valence's activities. Revenue
generated from product and component sales is attributable to Valence and
therefore is not comparable to last year. Revenues in future quarters are
expected to consist primarily of ASIC design and product and electronic
component sales.
16
<PAGE> 17
Gross Margin
Cost of sales for Fiscal 1998 consists primarily of fabrication costs,
assembly and test costs, and the cost of materials and overhead from operations.
Cost of sales for Fiscal 1997 consisted primarily of fees paid to third party
representatives for sales administration and support. Gross margin for the
twelve months ended December 31, 1998 decreased to 33.3% from 97.9% for the same
period in 1997. The decrease resulted from the shift in the Company's revenue
base towards product and electronic component sales, which have significantly
lower margins than the Company's historic licensing revenue base. Gross margins
in future quarters will primarily reflect the cost of manufacturing products for
sale as opposed to licensing transactions which typically have higher gross
margins.
Sales and Marketing
Sales and marketing expenses consist primarily of employee-related
expenses, sales commissions and product promotion. Sales and marketing expenses
were $6,845,674 in Fiscal 1998 compared to $2,111,839 in Fiscal 1997, an
increase of 224.2% which was attributable to the Valence acquisition and an
increase in domestic staffing to promote new technologies. As a percentage of
total revenues, sales and marketing expenses decreased to 15.3% in Fiscal 1998
from 20.9% in Fiscal 1997, as a result of the higher revenue base.
Research and Development
Research and development expenses consist of salaries and related costs of
employees engaged in ongoing research, design and development activities and
costs for engineering materials and supplies. Research and development expenses
were $2,554,883 in Fiscal 1998 compared to $595,689 in Fiscal 1997, an increase
of 328.9%, primarily attributable to the Valence acquisition. As a percentage of
total revenues, research and development expenses decreased to 5.7% in Fiscal
1998 from 5.9% in Fiscal 1997, as a result of the higher revenue base.
Management believes research and development expenses will increase in the
future as a result of the Company's continual product development efforts.
General and Administrative
General and administrative expenses consist primarily of employee-related
expenses, legal costs associated with the administration of intellectual
property and other professional fees. General and administrative expenses were
$5,530,957 in Fiscal 1998 compared to $2,615,706 in Fiscal 1997, an increase of
111.5%, primarily attributable to the Valence acquisition and increased staffing
at corporate headquarters to support new business development. As a percentage
of total revenues, general and administrative expenses decreased to 12.4% in
Fiscal 1998 from 25.9% in Fiscal 1997 as a result of the higher revenue base.
As part of the Valence acquisition, the Company allocated a portion of the
purchase price to various intangible assets totaling approximately $5,910,400.
This amount was capitalized and is being amortized on a straight line basis over
periods ranging from three to eleven years with the related amortization expense
of $1,180,489 included in general and administrative expenses for the year ended
December 31, 1998. See Note 2 of the Notes to the Consolidated Financial
Statements for more information concerning the purchase price allocation
associated with the Valence acquisition.
Acquired In-Process Research and Development
The Company's Consolidated Statement of Operations for the year ended
December 31, 1998 includes the one-time charge of $18,510,378 for the write-off
of acquired in-process research and development expenses associated with the
Valence acquisition and the acquisition of certain assets associated with the
VIP technology. The in-process research and development expenses arose from new
product projects that were under development at the date of the acquisition and
expected to eventually lead to new products but had not yet established
technological feasibility and for which no future alternative use was
identified. The valuation of the in-process research and development projects
was based upon the discounted expected future net cash flows of the products
over the products' expected lives, reflecting the estimated stages of completion
of the projects and the estimated costs to complete the projects.
17
<PAGE> 18
New product development projects underway at Valence at the time of the
Valence acquisition included, among others, ASICs for consumer electronics,
computing and voice and audio applications, home entertainment systems, digital
multimedia players and digital power amplifiers. The Company estimated that
these projects were approximately 63% complete at the date of acquisition and
estimated that the cost to complete these projects will aggregate approximately
$7 million and will be incurred over a three-year period.
New product development projects utilizing the VIP technology at the time
of the VIP acquisition included, among others, digital and analog sound
reinforcement, wireless and non-wireless telecommunications applications,
hearing aid applications, headphone and microphone applications. The Company
estimated that these projects were approximately 62% complete at the date of
acquisition and estimated that the cost to complete these projects will
aggregate approximately $525,000 and will be incurred over a two-year period.
Uncertainties that could impede the progress of converting a development
project to a developed technology include the availability of financial
resources to complete the project, failure of the technology to function
properly, continued economic feasibility of developed technologies, customer
acceptance, customer demand and customer qualification of such new technology
and general competitive conditions in the industry. There can be no assurance
that the acquired in-process research and development projects will be
successfully completed and commercially introduced.
Other Income, net
Other income, net consists primarily of interest income, interest expense,
realized gains and losses on the sale of investments and foreign currency
transaction gains and losses. Net interest income was $694,760 in Fiscal 1998
compared to $1,088,718 in Fiscal 1997, a decrease of 36.2%. The decrease is
primarily attributable to lower average cash and investment balances during the
current year as compared to the prior year due to the $7,894,222 paid in
conjunction with the acquisitions of Valence and VIP and interest expense on the
outstanding borrowings under the Company's line of credit obtained during Fiscal
1998. The Company also recognized $86,337 of realized gains on the sale of
investments available for sale and a foreign exchange transaction loss related
to the Valence operations of $76,105 in Fiscal 1998.
Provision for Income Taxes
The income tax benefit for Fiscal 1998 was $273,156 compared to income tax
expense of $1,863,200 for Fiscal 1997. The Company recognized a tax benefit in
Fiscal 1998 primarily due to a taxable loss recognized for U.S. federal income
tax purposes related to domestic operations. In addition, the Company benefited
from certain tax credits and statutory tax rates in the Asian countries where
Valence has its principal business operations which are lower than United States
statutory rates.
YEAR ENDED DECEMBER 31, 1997 COMPARED TO YEAR ENDED DECEMBER 31, 1996
Revenues
Revenues for Fiscal 1996 and Fiscal 1997 consisted primarily of royalties
generated from the license of audio technologies. License and royalty agreements
generally provide for the license of audio technologies for a specified period
of time for either a single fee or a fee based on the number of units
distributed by the licensee. Total revenue in Fiscal 1997 was $10,081,283
compared to $5,392,280 in Fiscal 1996, an increase of 87.0%. This increase
resulted primarily from increased shipments of products incorporating SRS
technologies on which licensees pay royalties. Of the $10,081,283 in revenues in
Fiscal 1997, $1,410,000 related to one-time license fees and $8,671,283 related
to on-going royalties, as compared to $5,392,280 in revenues in Fiscal 1996,
which included $772,180 in one-time license fees and $4,620,100 related to
on-going royalties. The number of licensees as of December 31, 1997 was 170
compared to 82 as of December 31, 1996.
18
<PAGE> 19
Gross Margin
Gross margin was 97.9% in Fiscal 1997 compared to 98.2% in Fiscal 1996.
Cost of sales during those periods consisted primarily of fees paid to third
party representatives for sales administration and support. Cost of sales in
Fiscal 1997 was $210,348 compared to $95,378 in Fiscal 1996, an increase of
120.5%. As a percentage of total revenues, cost of sales increased to 2.1% in
Fiscal 1997 from 1.8% in Fiscal 1996. This increase resulted from the increase
in license revenue on which the Company pays fees to third party
representatives.
Sales and Marketing
Sales and marketing expenses consisted primarily of employee-related
expenses, sales commissions and product promotion. Sales and marketing expenses
were $2,111,839 in Fiscal 1997 compared to $1,163,409 in Fiscal 1996, an
increase of 81.5%. This increase was primarily attributable to increased
staffing to promote new technologies, increased travel costs to support the
Company's global presence and an increase in marketing and promotional
activities aimed at establishing SRS as an international standard. As a
percentage of total revenues, sales and marketing expenses decreased to 20.9% in
Fiscal 1997 from 21.6% in Fiscal 1996 as the Company leveraged its expenses on
higher sales volumes.
Research and Development
Research and development expenses consisted of salaries and related costs
of employees engaged in ongoing research, design and development activities and
costs for engineering materials and supplies. Research and development expenses
were $595,689 in Fiscal 1997 compared to $521,482 in Fiscal 1996, an increase of
14.2%. This increase was primarily attributable to an increase in expenses
associated with the internal development of new and existing technologies. As a
percentage of total revenues, research and development expenses decreased to
5.9% in Fiscal 1997 from 9.7% in Fiscal 1996 as the Company leveraged its
expenses on higher sales volumes.
General and Administrative
General and administrative expenses consisted primarily of employee-related
expenses, legal costs associated with the administration of intellectual
property and other professional fees. General and administrative expenses were
$2,615,706 in Fiscal 1997 compared to $1,615,648 in Fiscal 1996, an increase of
61.9%. This increase was primarily attributable to increased staffing, increased
professional fees associated with maintaining patent and trademark rights in the
U.S. and foreign countries, costs associated with being a public company and
general management expenses for the support of licensing activities and new
business development. As a percentage of total revenues, general and
administrative expenses decreased to 25.9% in Fiscal 1997 from 30.0% in Fiscal
1996 as the Company leveraged its expenses on higher sales volumes.
Other Income, net
Interest income was $1,088,718 in Fiscal 1997 compared to $365,583 in
Fiscal 1996, an increase of 197.8%. The increase represents the difference in
earned interest for a full year in Fiscal 1997 as opposed to a partial year's
worth of earnings in Fiscal 1996. The interest was earned on investment of the
proceeds from the Company's initial public offering, which took place on August
8, 1996.
Provision for Income Taxes
The effective tax rate for Fiscal 1997 was 33.1% compared to 21.2% for
Fiscal 1996. Higher pre-tax earnings for Fiscal 1997 and the full utilization of
the net operating loss carryforwards in Fiscal 1996 were responsible for the
increase in the effective rate.
SELECTED QUARTERLY OPERATING RESULTS (UNAUDITED)
The following table sets forth certain quarterly financial data for the
eight quarters in the period ended December 31, 1998. The quarterly information
is based upon unaudited financial statements prepared by the Company on a basis
consistent with the Company's audited consolidated financial statements and, in
management's opinion, includes all adjustments, consisting only of normal
recurring adjustments necessary for a fair presentation of the information for
the periods presented. This information should be read in conjunction with the
Company's
19
<PAGE> 20
audited Consolidated Financial Statements and Notes thereto appearing elsewhere
in this Report. During the first quarter of 1998, the Company acquired all of
the outstanding capital stock of Valence Technology Inc. The acquisition of
Valence has had and will continue to have a material impact on the Company's
Fiscal 1998 financial statements and for the reporting periods thereafter;
accordingly, the operating results for any quarter are not necessarily
indicative of results for any future period. The Company's quarterly operating
results have varied significantly in the past and are expected to vary
significantly in the future.
<TABLE>
<CAPTION>
Three Months Ended
------------------------------------------------------------------------------------
(In thousands, except Mar 31, Jun 30, Sep 30, Dec 31, Mar 31, Jun 30, Sep 30, Dec 31,
per share amounts) 1997 1997 1997 1997 1998 1998 1998 1998
------ ------ ------ ------ ------ ------ ------ ------
<S> <C> <C> <C> <C> <C> <C> <C> <C>
Revenues:
Chip and licensing $2,212 $2,116 $2,505 $3,248 $ 2,882 $ 4,524 $ 3,936 $ 4,420
Product and component - - - - 4,175 7,101 7,382 10,305
------ ------ ------ ------ ------- ------- ------- -------
Total revenues 2,212 2,116 2,505 3,248 7,057 11,625 11,318 14,725
Gross margin 2,173 2,040 2,434 3,224 2,659 4,238 3,507 4,502
Operating expenses 1,327 966 1,153 1,877 21,351(a) 3,480 3,291 5,320
------ ------ ------ ------ ------- ------- ------- -------
Operating income (loss) 846 1,074 1,281 1,347 (18,692) 758 216 (818)
Net income (loss) 695 848 1,083 1,147 (18,211) 720 192 (259)
Net income (loss) per
common share:
Basic $ .07 $ .09 $ .11 $ .12 $(1.68) $ .06 $ .02 $(.02)
Diluted $ .07 $. .08 $ .11 $ .11 $(1.68) $ .06 $ .02 $(.02)
</TABLE>
- ----------------
(a) Operating expenses for the three month period ended March 31, 1998 included
$18,510 related to the write-off of acquired in-process research and
development
LIQUIDITY AND CAPITAL RESOURCES
In August 1996, the Company completed an initial public offering of
3,107,452 shares of Common Stock at $8.00 per share. Net proceeds to the Company
were approximately $22 million.
From inception through August 1996, the Company financed its operations
primarily through the private placement of equity securities. As of December 31,
1997 and 1998, cash, cash equivalents, and investments totaled $26,013,790 and
$24,430,859, respectively. Net cash provided by operating activities during
Fiscal 1998 was $5,022,088 and was generated primarily from decreases in
accounts receivable and inventory and increases in accounts payable, offset by
increases in prepaid expense and other assets. During Fiscal 1998, net cash
provided by investing activities of $1,499,433 resulted primarily from the sale
of the Company's investments, offset by cash used in the acquisition of Valence
and the acquisition of new technologies. Net cash provided by financing
activities of $1,372,968 resulted primarily from borrowings under the Company's
credit line offset by payments on Valence's current debt. Cash of $1,829,621
provided by operating activities in Fiscal 1997 primarily reflected net income.
The Company's principal source of liquidity at December 31, 1998 consisted
of cash, cash equivalents and investments. The Company has adopted investment
guidelines which restrict the types and minimum quality of investments the
Company is authorized to purchase. At December 31, 1998, the Company had cash
and cash equivalents of $12,341,242 and investments of $12,089,617. Investments
consist of municipal bonds rated a minimum of A1.
On March 2, 1998, the Company acquired all of the outstanding shares of
capital stock of Valence for an aggregate purchase price of $19,500,000,
excluding acquisition costs and non-compete agreements, consisting of
approximately $7,400,000 in cash and approximately 1,680,611 shares of the
Company's common stock.
On March 4, 1998, the Company obtained a revolving line of credit with a
bank which expires on June 1, 2000 and is secured by certain of the Company's
investments. The total availability under the line of credit is the lesser of
$10 million or a percentage of the fair market value of the collateral. The line
of credit bears interest at the bank's prime rate (7.75% as of December 31,
1998) or LIBOR plus 0.75% (6.06% as of December 31, 1998). The Company had $8.0
million outstanding under the line of credit as of December 31, 1998. As a
result of the acquisition of Valence, the Company provided Valence $8.0 million
to pay off its short-term debt and other obligations. These funds were provided
by borrowings on the above-referenced line of credit.
20
<PAGE> 21
Based on current plans and business conditions, the Company expects that
its cash, cash equivalents, investments and/or available borrowings under its
line of credit together with any amounts generated from operations will be
sufficient to meet the Company's cash requirements for at least the next 12
months. However, there can be no assurance that the Company will not be required
to seek other financing sooner or that such financing, if required, will be
available on terms satisfactory to the Company.
YEAR 2000 READINESS DISCLOSURE
The Company is currently in the process of addressing a problem that is
facing all users of automated information systems. The "Year 2000 issue" arises
out of the fact that many of the world's computer systems currently record years
in a two-digit format. Such computer systems will be unable to properly
interpret dates beyond the year 1999, which could lead to business disruptions
in the U.S. and internationally.
The Company and its subsidiaries have identified the following areas which
could be impacted by the Year 2000 issue. They are: Company products; internally
used systems and software; products or services provided by key third parties;
and the inability of chip partners, licensees or customers to process business
transactions relating to chip design and licensing revenue and product and
component sales.
During Fiscal 1998, the Company and its subsidiaries reviewed its internal
systems including those which support manufacturing process control and
financial and general business operations. The review consisted of an evaluation
of significant internal hardware systems and major software application programs
for their ability to accurately recognize and process dates properly in the Year
2000 and beyond. As a result of this evaluation, the Company has identified
certain systems which require upgrades to be Year 2000 ready, including certain
business software applications. The Company is in the process of installing a
new computer system in its overseas operation and has been assured by the
software and hardware providers that these systems will be fully compliant with
the Year 2000. The Company's products do not have any material Year 2000
problems.
In addition, the Company and its subsidiaries are in the process of
assessing the compliance of their major customers, suppliers and vendors.
Management believes that third-party relationships upon which the Company relies
represent the greatest risk with respect to the Year 2000 issue, because the
Company cannot guarantee that third parties will be able to adequately assess
and address their Year 2000 compliance issues in a timely manner. As a
consequence, the Company can give no assurances that issues related to Year 2000
would not have a material adverse effect on future results of operations or
financial condition.
Total costs relating to the Company's compliance efforts, based on
management's best estimates, were previously estimated to be as high as
$1,000,000; however, based upon more current facts, the Company has revised its
cost estimate range to be as high as $350,000.
Should the Company not be completely successful in mitigating internal and
external Year 2000 risks, the likely worst case scenario could be a system
failure causing disruptions of operations, including, among other things, a
temporary inability to process transactions, manufacture products, send invoices
or engage in similar normal business activities at the Company or its vendors
and suppliers. The Company currently does not have a contingency plan with
respect to potential Year 2000 failures of its suppliers or customers and at the
present time does not intend to develop one. If these failures would occur,
depending upon their duration and severity, they could have a material adverse
effect on the Company's business, results of operations and financial condition.
The information set forth above under this caption "Year 2000 Readiness
Disclosure" relates to the Company's efforts to address the Year 2000 concerns
regarding the Company's (a) operations, (b) products and technologies licensed
or sold to third parties and (c) major suppliers and customers. Such statements
are intended as Year 2000 Statements and Year 2000 Readiness Disclosures and are
subject to the Year 2000 Information Readiness Act."
21
<PAGE> 22
RECENT ACCOUNTING PRONOUNCEMENTS
In June 1997, the Financial Accounting Standards Board ("FASB") issued
Statement of Financial Accounting Standards ("SFAS") No. 130, Reporting
Comprehensive Income, and FAS No. 131, Disclosures about Segments of an
Enterprise and Related Information. SFAS No. 130 establishes standards for
reporting and display of comprehensive income and its components in a full set
of general-purpose financial statements. SFAS No. 131 establishes standards of
reporting by publicly-held business enterprises and disclosure of information
about operating segments in annual financial statements and, to a lesser extent,
in interim financial reports issued to stockholders. SFAS Nos. 130 and 131 were
adopted by the Company on January 1, 1998. In accordance with SFAS No. 130, the
Company has disclosed information about comprehensive income in the Consolidated
Statements of Comprehensive Income (Loss) and Stockholders' Equity. In
accordance with SFAS No. 131, the Company has disclosed in Note 10 to the
Consolidated Financial Statements certain information about operating segments
and geographic areas in which the Company sells its products.
In June 1998, the FASB issued SFAS No. 133, Accounting for Derivative
Instruments and Hedging Activities, which is effective for fiscal years
beginning after June 15, 1999. This standard establishes accounting and
reporting standards for derivative instruments and for hedging activities and
requires that an entity recognize all derivatives as either assets or
liabilities in the statement of financial position and measure those instruments
at fair value. The Company does not believe that the adoption of this new
standard will have a material impact on its financial position or results of
operations.
FORWARD-LOOKING INFORMATION AND CERTAIN FACTORS
Included in Part I, Item 1. Business, this Item 7 and elsewhere in this
Report are certain forward-looking statements within the meaning of the Private
Securities Litigation Reform Act of 1995, reflecting management's current
expectations. Examples of such forward-looking statements include the
expectations of the Company with respect to its strategy. Although the Company
believes that its expectations are based upon reasonable assumptions, there can
be no assurances that the Company's financial goals will be realized. Such
forward-looking statements involve known and unknown risks, uncertainties and
other factors that may cause the actual results, performance or achievements of
the Company, or industry results, to be materially different from any future
results, performance or achievements expressed or implied by such
forward-looking statements. Numerous factors may affect the Company's actual
results and may cause results to differ materially from those expressed in
forward-looking statements made by or on behalf of the Company. Such factors
include, among others, those set forth below. The Company assumes no obligation
to update the forward-looking information to reflect actual results or changes
in the factors affecting such forward-looking information.
Quarterly Fluctuations
The Company's operating results may fluctuate from those in prior quarters
and will continue to be subject to quarterly and other fluctuations due to a
variety of factors, including the extent to which the Company's licensees
incorporate the Company's technologies into their products, the timing of orders
from and the shipments to major customers, the timing of new product
introductions by the Company, the gain or loss of significant customers,
competitive pressures on selling prices, the market acceptance of new or
enhanced versions of the Company's technologies, the rate that the Company's
semiconductor licensees manufacture and distribute chips to original equipment
manufacturers ("OEMs"), and fluctuations in general economic conditions,
particularly those affecting the consumer electronics market. Due to the
Company's dependence on the consumer electronics market, the substantial
seasonality of sales in the market could impact the Company's revenues and net
income. In particular, the Company believes that there is seasonality relating
to the Christmas season as well as the Chinese New Year within the Asia region,
which fall into the fourth and first quarters, respectively. As a result, the
Company believes that period-to-period comparisons of its results of operations
are not necessarily meaningful and should not be relied upon as indications of
future performance.
Changes to the Business Model/Integration of Valence/Refinement of Asian
Strategy
From the Company's inception in 1993 to 1997, the Company derived
substantially all of its revenues from licensing activities. As a result of the
acquisition of Valence, the Company has added business operations engaged in the
design and sale of ASICs and other semiconductor products; the design,
manufacture and sale of consumer electronics products; and the distribution of
components and products within mainland China and throughout Asia.
22
<PAGE> 23
These operations differ substantially from the Company's previous business
model, and future operating results could be affected by a variety of factors,
including the timing of customer orders, the timing of development revenue,
changes in the mix of products distributed and the mix of distribution channels
employed, the emergence of new industry standards, product obsolescence and
changes in pricing policies by the Company, its competitors or its suppliers.
The integration of certain operations following the Valence acquisition has
required, and will continue to require, the dedication of management and other
personnel resources which may temporarily distract them from the day-to-day
business of the combined company. The geographic separation of these operations
is likely to place additional strain on the Company's resources. In addition,
the Company's significant operations in China and Asia have required refinement
to adapt to the changing market conditions in that region. This refinement may
impact certain of the Company's current business directions, including Valence,
as the Company attempts to position itself to maximize penetration of selected
growth segments in that region. The Company's operations in Asia, and
internationally in general, also are subject to risks of unexpected changes in,
or impositions of, legislative or regulatory requirements.
The acquisition of Valence has added significant diversity to the Company's
overall business structure and the Company's opportunities. The Company
recognizes that in the presence of such corporate diversity, and in particular
with regard to the semiconductor industry, there will always exist a potential
for a conflict among sales channels between the Company and certain of the
Company's technology licensees. Although the operations of the Company's
licensing business and those of Valence are generally complementary, there can
be no assurances that sales channel conflicts will not arise. If such potential
conflicts do materialize, the Company may or may not be able to mitigate the
effect of such perceived conflicts, which, if not resolved, may impact the
results of operations.
Currency Risk/Stability of Asian Markets
The Company expects that international sales will continue to represent a
significant portion of total revenues. To date, all of the Company's licensing
revenues have been denominated in U.S. dollars and most costs have been incurred
in U.S. dollars. It is the Company's expectation that licensing revenues will
continue to be denominated in U.S. dollars for the foreseeable future. With its
acquisition of Valence and the Company's anticipated expansion of its business
in China and other parts of Asia, the Company's consolidated operations and
financial results could be significantly affected by risks associated with
international activities, including economic and labor conditions, political
instability, tax laws (including U.S. taxes on foreign subsidiaries) and changes
in the value of the U.S. dollar versus the local currency in which the products
are sold. In addition, the Company's valuation of assets recorded as a result of
the Valence acquisition may also be adversely impacted by the currency
fluctuations relative to the U.S. dollar. The Company intends to actively
monitor its foreign exchange exposure and to implement strategies to reduce its
foreign exchange risk at such time that the Company determines the benefits of
such strategies outweigh the associated costs. However, there is no guarantee
that the Company will take steps to insure against such risks, and should such
risks occur, there is no guarantee that the Company will not be significantly
impacted. Countries in the Asia Pacific region have recently experienced
weakness in their currency, banking and equity markets. These weaknesses could
adversely affect consumer demand for Valence's products, the U.S. dollar value
of the Company's and its subsidiaries' foreign currency denominated sales, the
availability and supply of product components to Valence and ultimately, the
Company's consolidated results of operations.
Competitive Pressures
The Company's existing and potential competitors include both large and
emerging domestic and international companies that have substantially greater
financial, manufacturing, technical, marketing, distribution and other
resources. The Company's present or future competitors may be able to develop
products and technologies comparable or superior to those offered by the
Company, and to adapt more quickly than the Company to new technologies or
evolving market needs. The Company believes that the competitive factors
affecting the market for the Company's products and technologies include product
performance, price and quality; product functionality and features, the ease of
integration and implementation of the products and technologies with other
hardware and software components in the OEM's products. In addition, the markets
in which the Company competes are intensely competitive and are characterized by
rapid technological changes, declining average sales prices and rapid product
obsolescence. Accordingly, there can be no assurance that the Company will be
able to continue to compete effectively in its respective markets, that
competition will not intensify or that future competition will not have a
material adverse effect on the Company's business, operating results, cash flows
and financial condition.
23
<PAGE> 24
Importance of Intellectual Property
The Company's ability to compete may be affected by its ability to protect
its proprietary information. The Company has filed several U.S. and foreign
patent applications and to date has a number of issued U.S. and foreign patents
covering various aspects of its technologies. There can be no assurance that the
steps taken by the Company to protect its intellectual property will be adequate
to prevent misappropriation of its technology or that the Company's competitors
will not independently develop technologies that are substantially equivalent or
superior to the Company's technology. In addition, the laws of certain foreign
countries may not protect the Company's intellectual property rights to the same
extent, as do the laws of the U.S. The semiconductor industry is characterized
by frequent claims and litigation regarding patent and other property rights.
The Company is not currently a party to any claims of this nature. There can be
no assurances that third parties will not assert additional claims or initiate
litigation against the Company or its customers with respect to existing or
future products. In addition, the Company may initiate claims or litigation
against third parties for infringement of the Company's proprietary rights or to
determine the scope and validity of the proprietary rights of the Company or
others.
Management of Growth; Dependence on Key Personnel
The Company has recently experienced rapid growth and expansion with the
acquisition of Valence. This acquisition has placed, and will continue to place,
a significant strain on its administrative, operational and financial resources,
and has increased, and will continue to increase, the level of responsibility
for both existing and new management personnel. The Company's future success
depends in part on the continued service of its key engineering, sales,
marketing and executive personnel, including highly skilled semiconductor design
personnel. The Company anticipates that any future growth will require it to
recruit and hire a number of new personnel in engineering, operations, finance,
sales and marketing. Competition for such personnel is intense, and there can be
no assurance that the Company can retain and recruit necessary personnel to
operate its business and support future growth. The Company's ability to manage
its growth successfully also will require the Company to continue to expand and
improve its administrative, operational, management and financial systems and
controls.
Volatility of Stock Price
The trading price of the Common Stock has been, and will likely continue to
be, subject to wide fluctuations in response to quarterly variations in the
Company's operating results, announcements of new products or technological
innovations by the Company or its competitors, general market fluctuations and
other events and factors. Changes in earnings estimates made by brokerage firms
and industry analysts relating to the markets in which the Company does
business, or relating to the Company specifically, have in the past resulted in,
and could in the future result in, an immediate and adverse effect on the market
price of the Common Stock.
Acquisitions
From time-to-time, the Company expects to make acquisitions of businesses
or technologies that are complementary to its business strategy. Such future
acquisitions would expose the Company to risks commonly encountered in
acquisitions of businesses. Such risks include, among others, difficulty of
assimilating the operations, information systems and personnel of the acquired
businesses, the potential disruption of the Company's ongoing business; and the
inability of management to maximize the financial and strategic position of the
Company through successful incorporation of the acquired technologies, employees
and customers. There can be no assurance that any potential acquisition will be
consummated or, if consummated, that it will not have a material adverse effect
on the Company's business, financial condition and results of operations.
24
<PAGE> 25
Acquired In-Process Research and Development
Uncertainties that could impede the progress of converting a development
project to a developed technology include the availability of financial
resources to complete the project, failure of the technology to function
properly, continued economic feasibility of developed technologies, customer
acceptance, customer demand and customer qualification of such new technology
and general competitive conditions in the industry. There can be no assurance
that the acquired in-process research and development projects associated with
the acquisitions of Valence and VIP will be successfully completed and
commercially introduced.
ITEM 7A. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK
The Company is exposed to a variety of risks, including foreign currency
fluctuations and changes in interest rates affecting the cost of its debt.
Foreign Currency
The Company has subsidiary operations in Hong Kong and China, and
accordingly, the Company is exposed to transaction gains and losses that could
result from changes in foreign currency exchange rates. The Company uses the
local currency (Hong Kong dollars) as the functional currency for its
subsidiaries. Translation adjustments resulting from the process of translating
foreign currency financial statements into U.S. dollars were nil in Fiscal 1998
due to the fact that the value of the Hong Kong dollar is currently pegged to
the U.S. dollar, and the exchange rate remained constant throughout the year.
Under the current circumstances, the Company believes that the foreign currency
market risk is not material. The Company actively monitors its foreign exchange
exposure and, should circumstances change, intends to implement strategies to
reduce its risk at such time that it determines that the benefits of such
strategies outweigh the associated costs. There can be no assurance that
management's efforts to reduce foreign exchange exposure will be successful.
Interest Rates
The Company's line of credit bears interest based on the lending bank's
prime rate or LIBOR. The interest rate on the balance of $8 million outstanding
at December 31, 1998 was 6.06%. The Company believes that if interest rates were
to increase by as much as 10%, the impact on the Company's consolidated
financial statements would not be material.
25
<PAGE> 26
ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA
INDEX TO FINANCIAL STATEMENTS
<TABLE>
<CAPTION>
Page
----
<S> <C>
CONSOLIDATED FINANCIAL STATEMENTS:
Independent Auditors' Report 27
Consolidated Balance Sheets as of December 31, 1997 and 1998 28
Consolidated Statements of Operations for the years ended
December 31, 1996, 1997 and 1998 29
Consolidated Statements of Comprehensive Income (Loss)
for the years ended December 31, 1996, 1997 and 1998 30
Consolidated Statements of Stockholders' Equity for the years ended
December 31, 1996, 1997 and 1998 31
Consolidated Statements of Cash Flows for the years ended
December 31, 1996, 1997 and 1998 32
Notes to Consolidated Financial Statements 34
FINANCIAL STATEMENT SCHEDULE:
Schedule II - Valuation and Qualifying Accounts and Reserves for the year
ended December 31, 1998 48
</TABLE>
26
<PAGE> 27
INDEPENDENT AUDITORS' REPORT
To the Board of Directors
and Stockholders of
SRS Labs, Inc.:
We have audited the accompanying consolidated balance sheets of SRS Labs,
Inc. (the "Company") as of December 31, 1997 and 1998, and the related
consolidated statements of operations, comprehensive income (loss),
stockholders' equity and cash flows for each of the three years in the period
ended December 31, 1998. Our audits also included the financial statement
schedule listed in the Index at Item 14(a)(2). These financial statements and
financial statement schedule are the responsibility of the Company's management.
Our responsibility is to express an opinion on these financial statements and
financial statement schedule based on our 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 SRS Labs, Inc. as of December
31, 1997 and 1998, and the results of its operations and its cash flows for each
of the three years in the period ended December 31, 1998, in conformity with
generally accepted accounting principles. Also, in our opinion, such financial
statement schedule, when considered in relation to the basic financial
statements taken as a whole, presents fairly in all material respects the
information set forth therein.
/s/ Deloitte & Touche LLP
March 12, 1999
Costa Mesa, California
27
<PAGE> 28
SRS LABS, INC.
CONSOLIDATED BALANCE SHEETS
<TABLE>
<CAPTION>
December 31, December 31,
1997 1998
-------------- --------------
<S> <C> <C>
ASSETS
CURRENT ASSETS
Cash and cash equivalents $ 4,446,753 $ 12,341,242
Investments available for sale 2,010,775 1,519,425
Accounts receivable, net of allowance for doubtful
accounts of $0 in 1997 and $422,138 in 1998 3,989,927 5,320,686
Inventories, net of reserve of $653,370 in 1998 -- 4,632,968
Prepaid expenses and other current assets, including
other receivables of $2,131,352 in 1998 578,957 3,244,233
Deferred income taxes 170,674 17,456
-------------- --------------
TOTAL CURRENT ASSETS 11,197,086 27,076,010
Investments available for sale 19,556,262 10,570,192
Furniture, fixtures and equipment, net 245,779 1,219,433
Intangible assets, net 313,673 6,669,671
Deferred income taxes 229,223 --
-------------- --------------
TOTAL ASSETS $ 31,542,023 $ 45,535,306
============== ==============
LIABILITIES AND STOCKHOLDERS' EQUITY
CURRENT LIABILITIES
Accounts payable $ 202,352 $ 10,632,505
Accrued liabilities 826,242 422,843
Line of credit -- 8,000,000
Income taxes payable 1,011,426 376,545
Current portion of consideration due on asset purchase 81,804 --
-------------- --------------
TOTAL CURRENT LIABILITIES 2,121,824 19,431,893
Deferred income taxes -- 31,240
Commitments and contingencies
STOCKHOLDERS' EQUITY
Preferred stock - $.001 par value; 2,000,000 shares authorized;
no shares issued and outstanding -- --
Common stock - $.001 par value; 56,000,000 shares authorized;
9,609,867 (1997) and 11,688,893 (1998) shares
issued and outstanding 9,610 11,689
Additional paid-in capital 25,022,437 39,170,103
Deferred stock option compensation 231,087 313,302
Cumulative other comprehensive income 163,600 141,389
Retained earnings (deficit) 3,993,465 (13,564,310)
-------------- --------------
TOTAL STOCKHOLDERS' EQUITY 29,420,199 26,072,173
-------------- --------------
TOTAL LIABILITIES AND STOCKHOLDERS' EQUITY $ 31,542,023 $ 45,535,306
============== ==============
</TABLE>
See accompanying notes to consolidated financial statements
28
<PAGE> 29
SRS LABS, INC.
CONSOLIDATED STATEMENTS OF OPERATIONS
<TABLE>
<CAPTION>
Year Ended December 31,
--------------------------------------------------
1996 1997 1998
------------- ------------- ---------------
<S> <C> <C> <C>
REVENUES
Chip and licensing revenue $ 5,392,280 $ 10,081,283 $ 15,762,369
Product and component sales -- -- 28,962,671
------------- ------------- ---------------
TOTAL REVENUES 5,392,280 10,081,283 44,725,040
COST OF SALES 95,378 210,348 29,819,071
------------- ------------- ---------------
GROSS MARGIN 5,296,902 9,870,935 14,905,969
EXPENSES
Sales and marketing 1,163,409 2,111,839 6,845,674
Research and development 521,482 595,689 2,554,883
General and administrative 1,615,648 2,615,706 5,530,957
Acquired in-process research and development -- -- 18,510,378
------------- ------------- ---------------
TOTAL EXPENSES 3,300,539 5,323,234 33,441,892
INCOME (LOSS) FROM OPERATIONS 1,996,363 4,547,701 (18,535,923)
OTHER INCOME, NET 365,583 1,088,718 704,992
------------- ------------- ---------------
INCOME (LOSS) BEFORE INCOME TAX EXPENSE (BENEFIT) 2,361,946 5,636,419 (17,830,931)
INCOME TAX EXPENSE (BENEFIT) 500,937 1,863,200 (273,156)
------------- ------------- ---------------
NET INCOME (LOSS) $ 1,861,009 $ 3,773,219 $ (17,557,775)
============= ============= ===============
Net income (loss) per common share:
Basic $ 0.24 $ 0.39 $ (1.54)
============= ============= ===============
Diluted $ 0.21 $ 0.35 $ (1.54)
============= ============= ===============
Weighted average shares used in the calculation of
net income (loss) per common share:
Basic 7,625,075 9,556,015 11,410,346
============= ============= ===============
Diluted 8,686,408 10,852,281 11,410,346
============= ============= ===============
</TABLE>
See accompanying notes to consolidated financial statements
29
<PAGE> 30
SRS LABS, INC.
CONSOLIDATED STATEMENTS OF COMPREHENSIVE INCOME (LOSS)
<TABLE>
<CAPTION>
Year Ended December 31,
-------------------------------------------------
1996 1997 1998
------------- ------------- --------------
<S> <C> <C> <C>
Net income (loss) $ 1,861,009 $ 3,773,219 $ (17,557,775)
Other comprehensive income (loss)
Unrealized gain (loss) on investments available
for sale, net of tax 87,688 75,912 (22,211)
------------- ------------- --------------
Comprehensive income (loss) $ 1,948,697 $ 3,849,131 $ (17,579,986)
============= ============= ==============-
</TABLE>
See accompanying notes to consolidated financial statements
30
<PAGE> 31
SRS LABS, INC.
CONSOLIDATED STATEMENTS OF STOCKHOLDERS' EQUITY
<TABLE>
<CAPTION>
Cumulative
Common Stock Deferred Retained Other
---------------------- Additional Stock Option Earnings Comprehensive
Shares Amount Paid-In Capital Compensation (Deficit) Income (Loss) Total
--------- --------- --------------- ------------ --------- ------------- -----------
<S> <C> <C> <C> <C> <C> <C> <C>
BALANCE, 1/1/96 5,999,032 $ 6,000 $ 2,500,475 $ 21,965 $(1,640,763) $ -- $ 887,677
Issuance of common stock 3,107,452 3,107 22,049,848 -- -- -- 22,052,955
Proceeds from exercise
of stock options 362,064 362 99,638 -- -- -- 100,000
Deferred stock
option compensation -- -- -- 132,421 -- -- 132,421
Ascribed value of
services contributed -- -- 29,000 -- -- -- 29,000
Unrealized gain on
investments available
for sale, net of tax -- -- -- -- -- 87,688 87,688
Net income -- -- -- -- 1,861,009 -- 1,861,009
--------- -------- ----------- -------- ------------ -------- ------------
BALANCE, 12/31/96 9,468,548 9,469 24,678,961 154,386 220,246 87,688 25,150,750
Proceeds from exercise
of stock options 141,319 141 144,461 -- -- -- 144,602
Tax benefit associated with
exercise of stock options -- -- 199,015 -- -- -- 199,015
Deferred stock
option compensation -- -- -- 76,701 -- -- 76,701
Unrealized gain on
investments available
for sale, net of tax -- -- -- -- -- 75,912 75,912
Net income -- -- -- -- 3,773,219 -- 3,773,219
--------- -------- ----------- -------- ------------ -------- ------------
BALANCE, 12/31/97 9,609,867 9,610 25,022,437 231,087 3,993,465 163,600 29,420,199
Proceeds from exercise
of stock options 213,121 213 311,199 -- -- -- 311,412
Tax benefit associated with
exercise of stock options -- -- 13,623 -- -- -- 13,623
Deferred stock
option compensation -- -- -- 82,215 -- -- 82,215
Unrealized loss on
investments available
for sale, net of tax -- -- -- -- -- (22,211) (22,211)
Issuance of common stock to
acquire Valence 1,680,611 1,681 12,104,097 -- -- -- 12,105,778
Issuance of common stock for
noncompetition agreements 125,000 125 900,275 -- -- -- 900,400
Issuance of common stock and
warrants to acquire VIP 25,000 25 518,507 -- -- -- 518,532
Issuance of common stock to
acquire Circle Surround 35,294 35 299,965 -- -- -- 300,000
Net loss -- -- -- -- (17,557,775) -- (17,557,775)
--------- -------- ----------- -------- ----------- -------- ------------
BALANCE, 12/31/98 11,688,893 $ 11,689 $39,170,103 $313,302 $(13,564,310) $141,389 $ 26,072,173
========== ======== =========== ======== ============ ======== ============
</TABLE>
See accompanying notes to consolidated financial statements
31
<PAGE> 32
SRS LABS, INC.
CONSOLIDATED STATEMENTS OF CASH FLOWS
<TABLE>
<CAPTION>
Year Ended December 31,
--------------------------------------------------
1996 1997 1998
------------- ------------- --------------
<S> <C> <C> <C>
CASH FLOWS FROM OPERATING ACTIVITIES:
Net income (loss) $ 1,861,009 $ 3,773,219 $ (17,557,775)
Adjustments to reconcile net income (loss) to net cash
provided by operating activities:
Depreciation and amortization 285,063 341,152 1,888,635
Deferred income taxes (405,512) 5,615 (298,205)
Write-off of acquired in-process research and development -- -- 18,510,378
Realized gain on sales of investments available for sale -- -- (86,337)
Amortization of premium on investments available for sale 27,300 109,817 62,534
Accretion of consideration due on asset purchase 38,064 23,844 8,196
Increase in deferred stock option compensation 132,421 76,701 82,215
Ascribed value of services contributed 29,000 -- --
Changes in operating assets and liabilities, net of the
effect of acquisitions:
Accounts receivable (648,044) (3,286,961) 1,941,777
Inventories 1,144 -- 1,998,818
Prepaid expenses and other current assets 137,867 (127,186) (2,212,510)
Accounts payable 121,642 (73,202) 1,878,303
Accrued liabilities 301,140 260,103 (403,399)
Income taxes payable 374,226 726,519 (790,542)
------------- ------------- --------------
Net cash provided by operations 2,255,320 1,829,621 5,022,088
CASH FLOWS FROM INVESTING ACTIVITIES:
Purchase of furniture, fixtures and equipment (157,654) (64,582) (466,368)
Proceeds from sales of investments available for sale 1,200,000 -- 9,467,572
Purchases of investments available for sale (22,050,602) (580,256) --
Cash paid for acquisitions, less cash acquired -- -- (6,911,216)
Expenditures related to patents (114,641) (103,877) (590,555)
------------- -------------- --------------
Net cash (used in) provided by investing activities (21,122,897) (748,715) 1,499,433
CASH FLOWS FROM FINANCING ACTIVITIES:
Proceeds from line of credit -- -- 8,000,000
Payments on subsidiary debt -- -- (6,846,737)
Issuance of common stock 22,052,955 -- --
Payment of consideration due on asset purchase (213,468) (234,752) (91,707)
Exercise of stock options 100,000 144,602 311,412
------------- ------------- --------------
Net cash provided by (used in) financing activities 21,939,487 (90,150) 1,372,968
------------- ------------- --------------
NET INCREASE IN CASH AND CASH EQUIVALENTS 3,071,910 990,756 7,894,489
CASH AND CASH EQUIVALENTS, BEGINNING OF PERIOD 384,087 3,455,997 4,446,753
------------- ------------- --------------
CASH AND CASH EQUIVALENTS, END OF PERIOD $ 3,455,997 $ 4,446,753 $ 12,341,242
============= ============= ==============
SUPPLEMENTAL DISCLOSURES OF CASH FLOW INFORMATION:
Cash paid during the period for:
Interest $ -- $ -- $ 488,732
Income taxes $ 126,711 $ 811,700 $ 640,079
</TABLE>
See accompanying notes to consolidated financial statements
32
<PAGE> 33
SRS LABS, INC.
CONSOLIDATED STATEMENTS OF CASH FLOWS
<TABLE>
<CAPTION>
Year Ended December 31,
--------------------------------------
1996 1997 1998
--------- ---------- ----------
<S> <C> <C> <C>
SUPPLEMENTAL DISCLOSURE OF NON-CASH INVESTING AND
FINANCING ACTIVITIES:
Additional consideration accrued for asset purchase $33,080 $ 44,077 $ 8,196
Unrealized gain (loss) on investments, net $87,688 $ 75,912 $(22,211)
Tax benefit associated with exercise of stock options $ -- $199,015 $ 13,623
</TABLE>
The Company acquired the stock of Valence Technology Inc. ("Valence") during
February 1998 (Notes 2 and 9) and issued 1,680,611 shares of common stock in
payment of $12,105,778 of the acquisition price.
In conjunction with the acquisition, certain liabilities were assumed as
follows:
<TABLE>
<S> <C>
Fair value of assets acquired $ 14,076,279
Acquired in-process research and development costs 17,471,668
Acquired intangible assets 5,910,400
Total consideration, including acquisition costs (21,879,033)
------------
Liabilities assumed $ 15,579,314
============
</TABLE>
The Company issued 125,000 shares of common stock in consideration for certain
non-competition agreements with the key employees of Valence. The shares have an
ascribed fair value of $900,400 (Notes 2 and 9).
The Company issued 25,000 shares of common stock and warrants to purchase
100,000 shares of common stock in conjunction with the acquisition of Voice
Intelligibility Processor ("VIP"). The shares and warrants have an ascribed fair
value of $176,575 and $341,957, respectively (Notes 2 and 9).
The Company issued 35,294 shares of common stock in conjunction with the
acquisition of certain rights associated with the Circle Surround technology.
The shares have an ascribed fair value of $300,000 (Notes 2 and 9).
See accompanying notes to consolidated financial statements
33
<PAGE> 34
SRS LABS, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
FOR THE YEARS ENDED DECEMBER 31, 1996, 1997 AND 1998
1. ORGANIZATION AND SIGNIFICANT ACCOUNTING POLICIES
Organization
SRS Labs, Inc. (the "Company" or "SRS") was incorporated under the laws of
the State of California on June 23, 1993 and reincorporated under the laws of
the State of Delaware on June 28, 1996.
The Company is a developer and provider of technology solutions for the
consumer electronics, computer, game and telecommunications markets. The
Company's principal business activities in these markets include:
o Developing and licensing audio and voice technologies to original equipment
manufacturers ("OEMs") and semiconductor manufacturers around the world;
and
o Through its subsidiary, Valence Technology Inc. and its foreign
subsidiaries, designing and selling technology solutions through custom
application specific integrated circuits ("ASICs") to OEMs; and designing,
distributing and manufacturing components, sub-assemblies and finished
goods for the OEM and retail communities within the Company's targeted
markets.
Basis of Presentation
The consolidated financial statements include the Company and its wholly
owned subsidiary, Valence Technology, Inc. ("Valence"), after elimination of all
intercompany accounts and transactions.
Cash Equivalents
Cash and cash equivalents generally consist of cash, money market funds and
other money market instruments with original or remaining maturities of three
months or less at the date of purchase.
Investments
The Company accounts for investments in accordance with Statement of
Financial Accounting Standards (SFAS) No. 115. Investments, consisting primarily
of municipal bonds, have been classified as available for sale and are reported
at fair value, based on quoted market prices, in the accompanying consolidated
balance sheets. Unrealized gains and losses, net of applicable income taxes, are
reported as a separate component of stockholders' equity.
Inventories
Inventories, which consist of finished goods, are stated at the lower of
cost or net realizable value. Cost is calculated using the weighted average
method and is comprised of material costs and, where applicable, subcontracting
and overhead costs that have been incurred in bringing the inventories to their
present location and condition. Net realizable value represents the estimated
selling price less estimated costs to completion and costs to be incurred in
selling and distribution.
Furniture, Fixtures and Equipment
Furniture, fixtures and equipment are stated at cost, net of accumulated
depreciation and amortization. Depreciation and amortization are provided for
using the straight-line method, which amortizes cost over the estimated useful
lives of the respective assets or as to leasehold improvements, the term of the
related lease if less than the estimated service life ranging from three to five
years.
34
<PAGE> 35
SRS LABS, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
FOR THE YEARS ENDED DECEMBER 31, 1996, 1997 AND 1998
Patents
Costs paid by the Company related to the establishment and transfer of
patents, primarily legal costs, are capitalized and amortized over periods
ranging from five to ten years, depending on the estimated life of the
technology patented.
Other Intangible Assets
Consideration for the purchase of assets in excess of the fair market value
of specifically identified tangible assets has been capitalized as other
intangible assets in the accompanying consolidated balance sheets. These assets
are being amortized over periods ranging from three to eleven years depending on
the useful life of the asset. The Company annually evaluates the recoverability
of its intangible assets based on the estimated future undiscounted cash flows.
Should the carrying value of intangible assets exceed the estimated operating
incomes for the expected periods of benefit, impairment for the excess is
recorded at that time.
Use of Estimates
The preparation of financial statements in conformity with generally
accepted accounting principles necessarily 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 revenues and expenses during the reporting periods.
Actual results could differ from these estimates.
Revenue Recognition
Royalty revenues associated with ongoing royalty license agreements are
recognized when license payments are due upon receipt of reports from licensees
stating the number of products implementing SRS patented technologies on which
royalties are due. Licensing revenues for one-time technology transfer fees are
recognized in the period in which the license agreement is consummated and the
related technology is transferred.
Revenue from product sales is generally recognized upon shipment. Design
revenue under design contracts is recognized on the percentage-of-completion
method. Estimates are reviewed and revised periodically throughout the lives of
the contracts. Any revisions are recorded in the accounting period in which the
revisions are made.
Commission income derived from the Company's distribution activities is
recognized on an accrual basis in the period when earned.
Research and Development
Research and development expenses include costs and expenses associated
with the development of the Company's design methodology and the design and
development of new products, including initial nonrecurring engineering and
product verification charges from foundries. Research and development is
expensed as incurred.
Income Taxes
The Company accounts for income taxes in accordance with SFAS No. 109,
Accounting for Income Taxes. Deferred taxes on income result from temporary
differences between the reporting of income for financial statement and tax
reporting purposes.
Foreign Currency Translation
The Company's reporting currency is the U.S. dollar, while the functional
currency of Valence is the Hong Kong dollar. Assets and liabilities of Valence
are translated at the rate of exchange on the balance sheet date. Revenues and
expenses are translated using the average exchange rate for the period.
Translation adjustments resulting from the process of translating foreign
currency financial statements into U.S. dollars are included as a
35
<PAGE> 36
SRS LABS, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
FOR THE YEARS ENDED DECEMBER 31, 1996, 1997 AND 1998
separate component of stockholders' equity (other comprehensive income).
Translation adjustments were nil during the year ended December 31, 1998.
Transaction gains and losses arising on exchange are recognized as incurred in
the statements of operations and aggregated $76,000 (loss) during the year ended
December 31, 1998.
Net Income (Loss) Per Common Share
Effective December 31, 1997, the Company adopted SFAS No. 128, Earnings per
Share, which requires the disclosure of basic and diluted earnings per share for
all current and prior periods. Basic net income (loss) per common share is
computed by dividing income available to common stockholders by the
weighted-average number of common shares outstanding during each year. Diluted
net income per common share reflects the maximum dilution, based on the average
price of the Company's common stock each period and is computed similar to basic
income (loss) per share except that the denominator is increased to include the
number of additional shares that would have been outstanding if potentially
dilutive stock options had been exercised.
The following is an illustration of the reconciliation of the numerators
and the denominators of the basic and diluted net income (loss) per common share
computations:
<TABLE>
<CAPTION>
For year Ended December 31, 1996 For year Ended December 31, 1997 For year Ended December 31, 1998
------------------------------------- ----------------------------------- -------------------------------------
Income Shares Per Share Income Shares Per Share Income Shares Per Share
(Numerator) (Denominator) Amount Numerator (Denominator) Amount (Numerator) (Denominator) Amount
----------- ------------- --------- --------- ------------- --------- ----------- ------------- ---------
<S> <C> <C> <C> <C> <C> <C> <C> <C> <C>
Basic:
Income (loss)
available to
common
stockholders $1,861,009 7,625,075 $ 0.24 $3,773,219 9,556,015 $ 0.39 $(17,557,775) 11,410,346 $(1.54)
======= ======= ======
Diluted:
Effect of
dilutive
securities:
Stock options 1,061,333 1,296,266
---------- --------- ---------- ---------- ------------ ----------
Income available
to common
stockholders
plus assumed
conversion $1,861,009 8,686,408 $ 0.21 $3,773,219 10,852,281 $ 0.35 $(17,557,775) 11,410,346 $(1.54)
========== ========= ======= ========== ========== ======= ============ ========== ======
</TABLE>
Initial Public Offering
In August 1996, the Company completed an initial public offering of
3,107,452 shares of its common stock at an offering price of $8 per share for
net proceeds of approximately $22 million.
Reverse Stock Split and Reincorporation
On June 27, 1996, the Company effected a .7241279-for-one stock split of
its authorized and outstanding shares of common stock. On June 28, 1996, the
Company reincorporated in the State of Delaware and increased its authorized
shares of common stock to 56,000,000 shares and shares of preferred stock to
2,000,000 shares. All share and per share data relating to periods prior to the
reverse stock split and reincorporation have been restated to give effect to the
reverse stock split.
36
<PAGE> 37
SRS LABS, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
FOR THE YEARS ENDED DECEMBER 31, 1996, 1997 AND 1998
Stock-Based Compensation
The Company accounts for stock-based awards to employees using the
intrinsic value method in accordance with Accounting Principles Board (APB)
Opinion No. 25, Accounting for Stock Issued to Employees.
Fair Value of Financial Instruments
Management believes the carrying amounts of cash and cash equivalents,
accounts receivable and accounts payable approximate fair value due to the short
period of time between origination of the instruments and their expected
realization of these financial instruments. Management also believes the
carrying amounts of investments available for sale approximate fair value as
investments are recorded at fair value based on quoted market prices (Note 3).
Management believes the carrying amount of balances outstanding under the line
of credit approximate fair value as the underlying interest rates reflect market
rates.
Customer Concentration
During the years ended December 31, 1996, 1997 and 1998, two customers (not
necessarily the same customers each year) accounted for 38%, 39% and 40%,
respectively, of revenues. Given the significant amount of revenues derived from
these customers, the loss of any such customer or the uncollectibility of
related receivables could have a material adverse effect on the Company's
financial condition and results of operations.
Concentrations of Credit Risk
Financial instruments, which potentially subject the Company to
concentrations of credit risk, consist primarily of cash equivalents,
investments, trade accounts receivable and the bank credit line. The Company
places its cash in banks and its cash equivalents in commercial paper.
Investments consist primarily of short-term and long-term municipal bonds. The
Company has not experienced any significant losses on its cash equivalents or
investments. Market risk on the bank credit line relates to changes in the
bank's lending rates, including the bank's reference rate and LIBOR, on which
interest charges on the Company's borrowings under the line are based.
The Company's trade receivables are derived from sales to manufacturers and
distributors in the consumer electronics, computer and communications markets
primarily in Asia, North America and Europe. The Company makes periodic
evaluations of the creditworthiness of its customers and manages its exposure to
losses from bad debts by limiting the amount of credit extended whenever deemed
necessary and generally does not require collateral. The Company maintains a
provision for potential credit losses and such losses have historically been
within management's expectations.
Geographic Risk
The Asian consumer electronics markets accounted for approximately 92% of
total Company sales in 1998 and are expected to continue to account for a
substantial percentage of sales in the future. The recent economic crisis in
Asia has been characterized by declines in consumer spending, currency
devaluation, unemployment and bank failures. Any of these factors, should they
continue, could significantly reduce the demand for the end user goods in which
the Company's products are used.
Recent Accounting Pronouncements
In June 1997, the Financial Accounting Standards Board ("FASB") issued SFAS
No. 130, Reporting Comprehensive Income, and SFAS No. 131, Disclosures about
Segments of an Enterprise and Related Information. SFAS No. 130 establishes
standards for reporting and display of comprehensive income and its components
in a full set of general-purpose financial statements. SFAS No. 131 establishes
standards of reporting by publicly-held business enterprises and disclosure of
information about operating segments in annual financial statements and, to a
lesser extent, in interim financial reports issued to stockholders. SFAS Nos.
130 and 131 were adopted by the Company on January 1, 1998. In accordance with
SFAS No. 130, the Company has disclosed information about
37
<PAGE> 38
SRS LABS, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
FOR THE YEARS ENDED DECEMBER 31, 1996, 1997 AND 1998
comprehensive income in the consolidated statements of comprehensive income
(loss) and stockholders' equity. In accordance with SFAS No. 131, the Company
has disclosed in Note 10 certain information about operating segments and
geographic areas in which the Company sells its products.
In June 1998, the FASB issued SFAS No. 133, Accounting for Derivative
Instruments and Hedging Activities, which is effective for fiscal years
beginning after June 15, 1999. This standard establishes accounting and
reporting standards for derivative instruments and for hedging activities and
requires that an entity recognize all derivatives as either assets or
liabilities in the statement of financial position and measure those instruments
at fair value. The Company does not believe that the adoption of this new
standard will have a material impact on its financial position or results of
operations.
Reclassifications
Certain amounts as previously reported have been reclassified to conform to
the current year presentation.
2. ACQUISITIONS
On March 2, 1998, the Company acquired (the "Acquisition") all of the
outstanding shares of capital stock of Valence Technology Inc., a British Virgin
Islands holding company with its principal business operations in Hong Kong and
China ("Valence"). Valence, which conducts its operations through its
subsidiaries based in Hong Kong and China, is engaged in the following business
activities: (i) the development and marketing of technology in the form of
integrated circuits (ASICs) to original equipment manufacturers and (ii) the
sale of consumer electronic and telecommunications products and components.
The Valence acquisition included certain assets and liabilities and all
intellectual property rights to the products as well as in-process research and
development activities. The aggregate purchase price of $19,500,000, excluding
acquisition costs and non-compete agreements, consisted of approximately
$7,400,000 in cash, of which the Company utilized its existing cash balances and
1,680,611 shares of the Company's common stock with a fair value of $12,105,778.
The acquisition was accounted for as a purchase having an effective date of
February 1, 1998, and accordingly, the total purchase price was allocated to the
assets acquired and liabilities assumed at their estimated fair values in
accordance with APB Opinion No. 16. The Company's consolidated statement of
operations for the year ended December 31, 1998 includes a charge of $17.5
million for the write-off of acquired in-process research and development
expense associated with the Valence acquisition. In connection with the
acquisition, three of the four management shareholders and their respective sole
shareholders, each of whom was a key employee of Valence or one of its
subsidiaries, entered into non-competition agreements with the Company. In
consideration for these agreements and for a nominal cash payment equal to the
par value of the shares, the Company issued 125,000 additional shares of its
common stock, with a fair value of $900,400 in aggregate, to such three
shareholders. The following summarizes the consideration granted for the
acquisition of Valence and non-compete agreements, the allocation of the
purchase price and other purchase accounting adjustments:
<TABLE>
<S> <C>
Cash $ 7,394,222
Common stock 13,006,178
-------------
Total purchase price 20,400,400
Deficiency in net assets acquired 1,503,035
Acquisition costs 1,478,633
-------------
Excess of purchase price over net
assets acquired $ 23,382,068
=============
Allocation to:
In-process research and development $ 17,471,668
Developed technology 1,200,000
Cell library 1,150,000
Customer list 1,000,000
Workforce 1,000,000
Non-compete agreement 900,400
Brand name 660,000
-------------
$ 23,382,068
=============
</TABLE>
38
<PAGE> 39
SRS LABS, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
FOR THE YEARS ENDED DECEMBER 31, 1996, 1997 AND 1998
The in-process research and development expenses arose from new product
projects that were under development at the date of the acquisition and expected
to eventually lead to new products, but had not yet established technological
feasibility and for which no future alternative use was identified. The
valuation of the in-process research and development projects was based upon the
discounted expected future net cash flows of the products over the products'
expected life, reflecting the estimated stages of completion of the projects and
the estimated costs to complete the projects.
New product development projects underway at Valence at the time of the
acquisition included, among others, ASICs for consumer electronics, computing
and voice and audio applications, home entertainment systems, digital multimedia
players and digital power amplifiers. The Company estimated that these projects
were approximately 63% complete at the date of acquisition and estimated that
the cost to complete these projects will aggregate approximately $7 million and
will be incurred over a three-year period.
Uncertainties that could impede the progress of converting a development
project to a developed technology include the availability of financial
resources to complete the project, failure of the technology to function
properly, continued economic feasibility of developed technologies, customer
acceptance, customer demand and customer qualification of such new technology
and general competitive conditions in the industry. There can be no assurance
that the in-process research and development projects will be successfully
completed and commercially introduced.
The following unaudited pro forma consolidated condensed statement of
operations for the year ended December 31, 1997 has been prepared by combining
the statement of operations of SRS for the year ended December 31, 1997 with the
consolidated statement of operations of Valence for the year ended March 31,
1998. Pro forma results for the year ended December 31, 1998 do not differ
materially from the results of operations set forth in the accompanying
statement of operations. The pro forma information is presented for information
purposes only and is not necessarily indicative of what actually would have
occurred if the acquisition had been in effect for the entire period presented,
or of future operations of the combined companies.
<TABLE>
<CAPTION>
Proforma
Year ended
December 31, 1997
-----------------
<S> <C>
Revenues $47,377,020
Costs and expense 45,369,225
-----------
Net income $ 2,007,795
===========
Net income per share $ 0.16
===========
</TABLE>
On February 28, 1998, the Company acquired certain rights to a proprietary
technology, Voice Intelligibility Processor ("VIP"), from a third party. The
aggregate consideration, including acquisition costs, was $1,138,710 and was
comprised of $620,178 in cash, 25,000 shares of the Company's common stock with
a fair value of $176,575 and warrants to purchase 100,000 shares of the
Company's common stock at $9.47 per share with a fair value of $341,957. The
portion of the purchase price allocated to acquired in-process research and
development, $1,038,710, was charged to the Company's operations. The remainder
of the purchase price was allocated to an intangible asset and is being
amortized over eight years.
39
<PAGE> 40
SRS LABS, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
FOR THE YEARS ENDED DECEMBER 31, 1996, 1997 AND 1998
The following summarizes the consideration granted for the acquisition of
VIP, the allocation of the purchase price and other purchase accounting
adjustments:
<TABLE>
<S> <C>
Cash $ 500,000
Common stock and warrants 518,532
Acquisition costs 120,178
----------
Total purchase price $1,138,710
==========
Allocation to:
In-process research and development $1,038,710
Intangible assets 100,000
----------
$1,138,710
==========
</TABLE>
The in-process research and development expenses arose from new product
projects that were under development at the date of the acquisition and expected
to eventually lead to new products, but had not yet established technological
feasibility and for which no future alternative use was identified. The
valuation of the in-process research and development projects was based upon the
discounted expected future net cash flows of the products over the products'
expected life, reflecting the estimated stages of completion of the projects and
the estimated costs to complete the projects.
New product development projects utilizing the VIP technology at the time
of the acquisition included, among others, digital and analog sound
reinforcement, wireless and non-wireless telecommunications applications,
hearing aid applications, and headphone and microphone applications. The Company
estimated that these projects were approximately 62% complete at the date of
acquisition and estimated that the cost to complete these projects will
aggregate approximately $525,000 and will be incurred over a two-year period.
Uncertainties that could impede the progress of converting a development
project to a developed technology include the availability of financial
resources to complete the project, failure of the technology to function
properly, continued economic feasibility of developed technologies, customer
acceptance, customer demand and customer qualification of such new technology
and general competitive conditions in the industry. There can be no assurance
that the in-process research and development projects will be successfully
completed and commercially introduced.
The Company's financial statements for the year ended December 31, 1998,
reflect one-time charges related to in-process research and development expenses
of $17,471,668 associated with the Valence acquisition and $1,038,710 associated
with the VIP acquisition.
On May 21, 1998, the Company acquired certain rights to a proprietary
technology, Circle Surround, from a third party. The aggregate consideration,
including acquisition costs, was $834,985 and was comprised of $534,985 in cash
and 35,294 shares of the Company's common stock with a fair value of $300,000.
The purchase price was allocated to an intangible asset and is being amortized
over ten years.
3. INVESTMENT SECURITIES AVAILABLE FOR SALE
The following table summarizes the Company's investment securities
available for sale as of December 31, 1997 and 1998:
<TABLE>
<CAPTION>
December 31,
-------------------------------
1997 1998
------------- -------------
<S> <C> <C>
Municipal bonds available for sale:
Cost $21,293,741 $11,849,972
Unrealized gains 273,296 239,645
----------- -----------
Estimated fair value $21,567,037 $12,089,617
=========== ===========
</TABLE>
40
<PAGE> 41
SRS LABS, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
FOR THE YEARS ENDED DECEMBER 31, 1996, 1997 AND 1998
The contractual maturities of investments at December 31, 1997 and 1998,
are shown below. Actual maturities may differ from contractual maturities.
<TABLE>
<CAPTION>
1997 1998
------------------------------ -----------------------------
Estimated Estimated
Cost Fair Value Cost Fair Value
------------- ------------- ------------- --------------
<S> <C> <C> <C> <C>
Municipal bonds:
Due in one year or less $ 2,007,939 $ 2,010,775 $ 1,505,168 $ 1,519,425
Due in one to five years 18,285,802 18,556,262 9,344,804 9,570,192
Due in five to ten years -- -- -- --
Due after ten years 1,000,000 1,000,000 1,000,000 1,000,000
------------- ------------- ------------- --------------
$ 21,293,741 $ 21,567,037 $ 11,849,972 $ 12,089,617
============= ============= ============= ==============
</TABLE>
4. FURNITURE, FIXTURES AND EQUIPMENT
Furniture, fixtures and equipment, net,consist of the following at December
31, 1997 and 1998:
<TABLE>
<CAPTION>
December 31,
-------------------------------
1997 1998
------------- -------------
<S> <C> <C>
Furniture, fixtures and equipment $ 397,112 $ 753,446
Computer equipment 121,280 1,008,751
Leasehold improvements 4,641 138,900
------------- -------------
523,033 1,901,097
Less accumulated depreciation
and amortization (277,254) (681,664)
------------- -------------
$ 245,779 $ 1,219,433
============= =============
</TABLE>
5. INTANGIBLE ASSETS
Intangible assets consist of the following:
<TABLE>
<CAPTION>
December 31,
-------------------------------
1997 1998
------------- -------------
<S> <C> <C>
Goodwill $ 918,131 $ 711,886
Patents 277,617 1,786,497
Developed technology -- 1,200,000
Cell library -- 1,150,000
Customer list -- 1,000,000
Workforce -- 1,000,000
Non-compete agreement -- 900,400
Brand name -- 660,000
------------- -------------
1,195,748 8,408,783
Less accumulated amortization (882,075) (1,739,112)
------------- -------------
$ 313,673 $ 6,669,671
============= =============
</TABLE>
Amortization periods range from three to eleven years depending on the
estimated useful life of the asset.
6. FINANCING ARRANGEMENTS
On March 4, 1998, the Company obtained a revolving line of credit with a
bank which expires on June 1, 2000 and is secured by certain of the Company's
investments. The total availability under the line of credit is the lesser of
$10 million or a percentage of the fair market value of the collateral. The line
of credit bears interest at the
41
<PAGE> 42
SRS LABS, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
FOR THE YEARS ENDED DECEMBER 31, 1996, 1997 AND 1998
bank's prime rate (7.75% as of December 31, 1998) or LIBOR plus 0.75% (6.06% as
of December 31, 1998). The Company had $8.0 million outstanding under the line
of credit as of December 31, 1998. As a result of the acquisition of Valence,
the Company provided Valence $8.0 million to pay off its short-term debt and
other obligations. These funds were provided by borrowings on the
above-referenced line of credit.
7. COMMITMENTS AND CONTINGENCIES
The Company leases office space and certain equipment under noncancelable
operating leases expiring through 2001.
The Company leases its corporate office and storage facilities located in
Santa Ana, California, under a lease agreement with a partnership which is
affiliated with a stockholder and officer of the Company. The lease is for a
term of three years, commencing June 1, 1997, with an option to extend the term
for an additional two years thereafter. Additionally, the Company leases several
offices and warehouses in Hong Kong and China from unrelated parties. Total rent
expense incurred on office facilities was $63,430, $129,369 and $646,498 for the
years ended December 31, 1996, 1997 and 1998, respectively, of which $63,430,
$129,369 and $165,672 was paid to related parties, respectively. Future annual
minimum lease payments under noncancelable operating leases at December 31,
1998, are as follows:
<TABLE>
<CAPTION>
Year ending Office
December 31, Facility Equipment Total
------------ ----------- ----------- -----------
<S> <C> <C> <C>
1999 $ 543,950 $ 11,892 $ 555,842
2000 349,493 9,306 358,799
2001 -- 7,000 7,000
----------- ----------- -----------
$ 893,443 $ 28,198 $ 921,641
=========== =========== ===========
</TABLE>
As of December 31, 1998, the Company had employment agreements with seven
employees, including three executives of Valence. Minimum aggregate compensation
remaining under those employment agreements is $918,796 (1999) and $592,129
(2000).
8. INCOME TAXES
For the years ended December 31, 1996, 1997 and 1998, the provision
(benefit) for income taxes consists of the following:
<TABLE>
<CAPTION>
December 31,
------------------------------------------------
1996 1997 1998
------------- ------------- -------------
<S> <C> <C> <C>
Current:
Federal $ 574,970 $ 1,078,637 $ (679,205)
State 168,256 482,791 35,963
Foreign 163,223 296,157 668,291
------------- ------------- -------------
906,449 1,857,585 25,049
Deferred:
Federal 371,428 (15,724) (161,286)
State 47,884 21,339 (136,919)
Valuation allowance (824,824) -- --
------------- ------------- -------------
(405,512) 5,615 (298,205)
------------- ------------- -------------
$ 500,937 $ 1,863,200 $ (273,156)
============= ============= =============
</TABLE>
42
<PAGE> 43
SRS LABS, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
FOR THE YEARS ENDED DECEMBER 31, 1996, 1997 AND 1998
The reconciliation of the provision (benefit) for income taxes computed at
U.S. federal statutory rates to the provision for income taxes for the years
ended December 31, 1996, 1997 and 1998 is as follows:
<TABLE>
<CAPTION>
December 31,
------------------------------------------------
1996 1997 1998
------------- ------------- -------------
<S> <C> <C> <C>
Tax at U.S. federal statutory rates $ 803,062 $ 1,916,382 $ (6,240,826)
State income taxes 142,653 334,079 (75,645)
Tax exempt interest (105,862) (365,194) (150,766)
Restoration of deferred income tax
assets in connection with the
Company's conversion to a
C corporation 126,123 -- --
Change in valuation allowance (824,824) -- --
Intangibles -- -- 5,940,367
Other 359,785 (22,067) 253,714
------------- ------------- -------------
Total income tax expense $ 500,937 $ 1,863,200 $ (273,156)
============= ============= =============
</TABLE>
Deferred income taxes reflect the net tax effects of temporary differences
between the carrying amounts of assets and liabilities for financial reporting
purposes and the amounts used for income tax purposes. Significant components of
the Company's deferred tax assets and liabilities are as follows:
<TABLE>
<CAPTION>
December 31,
------------------------------------------------
1996 1997 1998
------------- ------------- -------------
<S> <C> <C> <C>
Deferred tax assets (liabilities):
State income taxes $ 30,816 $ 121,952 $ (54,085)
Depreciation and amortization 186,576 247,038 (13,810)
Accruals not currently deductible 188,120 30,907 5,383
Other -- -- 22,016
Net operating losses -- -- 26,712
------------- ------------- -------------
Total net deferred tax assets
(liability) $ 405,512 $ 399,897 $ (13,784)
============= ============= ==============
</TABLE>
In connection with the Company's acquisition of Valence, the total purchase
price was allocated, for financial statement purposes, to the assets acquired,
including various identifiable intangible assets for which the Company has no
tax basis. SFAS No. 109 requires a deferred tax liability be recognized for the
difference between the assigned value and the tax basis of the assets acquired,
other than goodwill. Accordingly, a deferred tax liability and additional
goodwill in the amount of $711,886 was recorded during the year ended December
31, 1998.
9. STOCKHOLDERS' EQUITY
Issuance of Common Stock
During the year ended December 31, 1996, the Company recorded $29,000 of
additional paid-in capital related to the estimated fair value of services
performed by a Company officer for which no cash consideration was paid by the
Company.
In August 1996, the Company completed an initial public offering of
3,107,452 shares of its common stock at an offering price of $8.00 per share for
net proceeds of approximately $22 million.
On March 2, 1998, the Company issued 1,680,611 shares of common stock in
conjunction with the acquisition of Valence (Note 2). On February 28, 1998, the
Company issued 25,000 shares of common stock in conjunction with the acquisition
of the VIP technology (Note 2). On May 29, 1998, the Company issued 35,294
shares of common stock in conjunction with the acquisition of the Circle
Surround technology (Note 2).
43
<PAGE> 44
SRS LABS, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
FOR THE YEARS ENDED DECEMBER 31, 1996, 1997 AND 1998
Stock Award/Option Plans
On December 10, 1993, the Company's Board of Directors and shareholders
adopted an Incentive Stock Option, Nonqualified Stock Option and Restricted
Stock Purchase Plan (the "1993 Plan"). Under the 1993 Plan, 801,971 shares of
the Company's common stock are reserved for issuance to executives, employees
and non-employee directors of the Company at the discretion of the Board of
Directors or the committee administering the 1993 Plan. The Compensation
Committee of the Board or, in the absence of a Compensation Committee, the Board
has been appointed to administer the 1993 Plan. Options issued under the 1993
Plan vest in the manner prescribed by the Compensation Committee or the Board,
as applicable. As of December 31, 1998, options to purchase 801,971 shares of
the Company's common stock were granted under the 1993 Plan.
In June 1997, the Company's Board of Directors adopted and the Company's
stockholders approved the Amended and Restated 1996 Long-Term Incentive Plan
(the "1996 Plan"), for which 2,000,000 shares of the Company's common stock are
reserved for issuance to officers, employees and consultants of the Company. In
June 1998, the Company's Board of Directors adopted and the Company's
stockholders approved an amendment to the 1996 Plan to increase the number of
shares in the plan by 2,500,000. Also in June 1998, in a separate amendment, the
Company's Board of Directors and the Company's stockholders approved an
amendment to allow all directors of the Company and any subsidiary of the
Company to participate in the 1996 Plan. The Compensation Committee or, in the
absence of a Compensation Committee, the Board of Directors has been appointed
to administer the 1996 Plan. Options issued under the 1996 Plan vest in the
manner prescribed by the Compensation Committee or the Board, as applicable. As
of December 31, 1998, options to purchase 4,029,801 shares of the Company's
common stock were granted under the 1996 Plan.
In July 1996, the Company's Board of Directors adopted and the Company's
stockholders approved the 1996 Non-employee Directors Stock Option Plan (the
"Non-employee Directors Plan"), a non-discretionary formula plan for which
120,000 shares of the Company's common stock are reserved for issuance to the
Company's non-employee directors. The Non-employee Directors Plan is
administered by a committee consisting of all directors who are not eligible to
participate in the Non-employee Directors Plan and the Chief Financial Officer
of the Company. With the exception of the initial option granted to a
non-employee director, which vests immediately, options granted under the
Non-employee Directors Plan vest over a three-year period, the first installment
vesting on the date of grant. As of December 31, 1998, options to purchase
75,000 shares of common stock were granted under the Non-employee Directors
Plan.
On February 28, 1998, warrants were granted for the purchase of up to
100,000 common shares of the Company at a price of $9.47 to certain parties in
connection with the acquisition of VIP ("VIP Warrants") (Note 2).
44
<PAGE> 45
SRS LABS, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
FOR THE YEARS ENDED DECEMBER 31, 1996, 1997 AND 1998
The following table summarizes stock option activity under all of the
Company's stock option plans and the VIP warrants (Note 2) for the periods
indicated:
<TABLE>
<CAPTION>
Weighted
Options Average
Outstanding Exercise Price
----------- --------------
<S> <C> <C>
Outstanding at January 1, 1996 1,875,618 $ 2.04
Granted 688,386 $ 8.11
Stock options exercised (362,064) $ 0.28
Forfeited (25,344) $ 10.36
-----------
Outstanding at December 31, 1996 2,176,596 $ 4.16
Granted 1,366,801 $ 5.70
Stock options exercised (141,319) $ 1.02
Forfeited (1,017,582) $ 7.68
-----------
Outstanding at December 31, 1997 2,384,496 $ 3.69
Granted 2,898,500 $ 5.06
Stock options exercised (213,121) $ 1.44
Forfeited (150,667) $ 4.88
-----------
Outstanding at December 31, 1998 4,919,208 $ 4.54
===========
</TABLE>
The following table summarizes information concerning currently outstanding and
exercisable options:
<TABLE>
<CAPTION>
Weighted
Number of Average Weighted Weighted
Options Remaining Average Number Average
Outstanding Contractual Life Exercise Price Exercisable Exercise Price
----------- ---------------- -------------- ----------- --------------
<S> <C> <C> <C> <C> <C>
Range of exercise prices:
$0.14 - $0.69 304,281 62 months $ 0.29 304,281 $ 0.29
$2.62 - $4.56 1,624,889 84 months $ 3.29 902,194 $ 3.59
$5.00 - $10.36 2,990,038 84 months $ 5.65 544,768 $ 5.86
---------- ----------
4,919,208 $ 4.54 1,751,243 $ 3.72
========== ==========
</TABLE>
On December 1, 1995, options were granted for the purchase of up to 300,875
common shares at prices of $4.14 to $4.56 per share, which the Company's Board
of Directors deemed the fair market value of the common stock at the date of
grant. The Company records compensation expense resulting from the difference
between the option price per share and the estimated fair market value of the
common stock ($4.99) determined by a third-party appraisal completed in May
1996, totaling $236,456. This amount is recorded ratably over the vesting period
of the respective options. During the years ended December 31, 1996, 1997 and
1998, the Company recorded $132,421, $56,397 and $26,828, respectively, of
deferred compensation expense associated with these stock option grants. In
addition, during the years ended December 31, 1997 and 1998, the Company
recorded $20,304 and $55,387, respectively, of deferred compensation expense
related to stock options granted to non-employee contractors.
SFAS No. 123, Accounting for Stock-Based Compensation, 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 No.
123, the fair value of stock-based awards to employees is calculated through the
use of option pricing models, even though such models were developed to estimate
the fair value of freely tradable, fully transferable options without vesting
restrictions, which 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 calculations were made using the Black-Scholes
option-pricing model with the following weighted average assumptions:
45
<PAGE> 46
SRS LABS, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
FOR THE YEARS ENDED DECEMBER 31, 1996, 1997 AND 1998
<TABLE>
<CAPTION>
December 31,
-----------------------------------
1996 1997 1998
--------- --------- ---------
<S> <C> <C> <C>
Expected life 60 months 60 months 60 months
Stock volatility 1% 69% 57%
Risk-free interest rate 5.50% 5.45% 5.50%
</TABLE>
The Company's calculations are based on a single option valuation approach
and forfeitures are recognized as they occur. If the computed fair values of the
1996, 1997 and 1998 awards had been amortized to expense over the vesting period
of the awards, pro forma net income (loss) would have been $1,762,497, or $.21
per share in 1996; $3,429,526, or $.32 per share in 1997; and ($18,684,945), or
($1.77) per share in 1998. However, the impact of outstanding nonvested stock
options granted prior to 1995 has been excluded from the pro forma calculation;
accordingly, the 1996, 1997 and 1998 pro forma adjustments are not indicative of
future period pro forma adjustments, when the calculation will apply to all
applicable stock options.
10. SEGMENT INFORMATION
The Company operates in two business segments: (i) the development and
marketing of technology either in the form of integrated circuits through
Valence (ASICs) or the licensing of technologies developed by the Company to
original equipment manufacturers and semiconductor manufacturers and (ii) the
sale of consumer electronic products and components. The Company does not
allocate operating expenses or specific assets to these segments. Therefore,
segment information includes only net revenues, cost of sales and gross margin.
Prior to the acquisition of Valence, the Company operated in the single business
segment of licensing audio technologies. Therefore, segment information is
presented for 1998 only.
<TABLE>
<CAPTION>
Business Segments
Chips and Product and
Licensing Component Sales Total
------------- ----------------- -------------
<S> <C> <C> <C>
Net revenues $ 15,762,369 $ 28,962,671 $ 44,725,040
Cost of sales 4,084,805 25,734,266 29,819,071
------------- ------------- -------------
Gross margin $ 11,677,564 $ 3,228,405 $ 14,905,969
============= ============= =============
</TABLE>
The following schedule presents the Company's revenue by geographic area.
For product sales, revenue is allocated based on the country to which product
was shipped. For licensing-related revenue, the allocation is based on the
location of the licensee's corporate headquarters. The Americas region includes
North, Central and South America.
<TABLE>
<CAPTION>
Region Revenue
------ -------
<S> <C>
Asia Pacific $ 41,502,348
Americas 3,017,596
Europe 205,096
-------------
Total $ 44,725,040
=============
</TABLE>
11. RELATED-PARTY TRANSACTIONS
The Company shares certain general and administrative expenses with an
affiliated company which is 100% owned by a Company officer/stockholder.
Pursuant to a written agreement which was terminated on December 31, 1997,
one-half of these expenses were allocated to the Company during 1996 and 1997.
The Company leases its corporate office and storage facilities located in
Santa Ana, California, under a lease agreement with a partnership which is
affiliated with a stockholder and officer of the Company. The original lease
46
<PAGE> 47
SRS LABS, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
FOR THE YEARS ENDED DECEMBER 31, 1996, 1997 AND 1998
term commenced on June 1, 1994 and expired on May 31, 1997. Upon expiration, the
Company entered into a new lease agreement for additional space at the same
facility with the same lessor. The new lease is for a term of three years,
commencing June 1, 1997, with an option to extend the term for an additional two
years thereafter.
During the years ended December 31, 1996, 1997 and 1998, total revenue from
an affiliated company which is 100% owned by a Company officer/stockholder,
amounted to $28,449, $17,779 and $6,834, respectively. As of December 31, 1997
and 1998 accounts receivable from this affiliated company were $4,395 and
$9,646, respectively. Amounts due to this affiliated company were $18,266 and
$1,747 as of December 31, 1997 and 1998, respectively.
A stockholder of the Company paid $1,500,000 and $2,500,000 in license
royalties to the Company during the years ended December 31, 1996 and 1997,
respectively. There were no license royalties from this stockholder during the
year ended December 31, 1998.
12. EMPLOYEE BENEFIT PLAN
The Company's employees based in the United States may participate in a
salary deferral plan (the "401(k) Plan") in which eligible employees can
contribute up to 15% of their eligible compensation. The Company also may
contribute on a discretionary basis. During the years ended December 31, 1996,
1997 and 1998, the Company did not contribute to the 401(k) Plan.
47
<PAGE> 48
SCHEDULE II
VALUATION AND QUALIFYING ACCOUNTS AND RESERVES
FOR THE YEAR ENDED DECEMBER 31, 1998
<TABLE>
<CAPTION>
Additions
Additions (reductions)
Balance due to charged to Balance
beginning business costs and at end
of period acquisitions expense Deductions of period
--------- ------------ ----------- ---------- ---------
<S> <C> <C> <C> <C> <C>
For the year ended December 31, 1998:
Allowance for doubtful accounts $ -- $ 647,600 $ (82,785) $ (142,677) $422,138
======== ========== ========= ========== ========
Inventory reserve $ -- $ 1,275,097 $ 353,814 $ (975,541) $653,370
======== =========== ========= ========== ========
</TABLE>
48
<PAGE> 49
ITEM 9. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND
FINANCIAL DISCLOSURE
Not Applicable.
PART III
ITEM 10. DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANT
The information set forth under the captions "ELECTION OF DIRECTORS" and
"TRANSACTIONS WITH MANAGEMENT AND OTHERS -- Section 16(a) Beneficial Ownership
Reporting Compliance" in the Company's definitive proxy statement (the "Proxy
Statement") for the Annual Meeting of Stockholders scheduled to be held in June
1998, is incorporated herein by reference. The Proxy Statement will be filed
with the U.S. Securities and Exchange Commission (the "Commission") not later
than 120 days after the close of Fiscal 1998.
ITEM 11. EXECUTIVE COMPENSATION
Except as specifically provided, the information set forth under the
captions "COMPENSATION OF EXECUTIVE OFFICERS" and "INFORMATION ABOUT THE BOARD
OF DIRECTORS AND COMMITTEES OF THE BOARD -- Compensation of Directors" in the
Proxy Statement is incorporated herein by reference. The Proxy Statement will be
filed with the Commission not later than 120 days after the close of Fiscal
1998. The Report of the Board of Directors on Executive Compensation and the
Performance Graph set forth under the caption "COMPENSATION OF EXECUTIVE
OFFICERS" in the Proxy Statement shall not be deemed incorporated by reference
herein and shall not otherwise be deemed "filed" as part of this Annual Report
on Form 10-K.
ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT
The information set forth under the caption "SECURITY OWNERSHIP OF CERTAIN
BENEFICIAL OWNERS AND MANAGEMENT" in the Proxy Statement is incorporated herein
by reference. The Proxy Statement will be filed with the Commission not later
than 120 days after the close of Fiscal 1998.
ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS
The information set forth under the caption "TRANSACTIONS WITH MANAGEMENT
AND OTHERS" in the Proxy Statement is incorporated herein by reference. The
Proxy Statement will be filed with the Commission not later than 120 days after
the close of Fiscal 1998.
49
<PAGE> 50
PART IV
ITEM 14. EXHIBITS, FINANCIAL STATEMENT SCHEDULES AND REPORTS ON FORM 8-K
(a) DOCUMENTS FILED AS PART OF THIS REPORT:
(1) Financial Statements
The financial statements included in Part II, Item 8 of this document
are filed as part of this Report.
(2) Financial Statement Schedules
The financial statement schedule included in Part II, Item 8 of this
document is filed as part of this Report.
All other schedules are omitted as the required information is
inapplicable or the information is presented in the consolidated financial
statements or related notes.
(3) Exhibits
The exhibits listed below are filed as part of this Report.
<TABLE>
<CAPTION>
EXHIBIT NO. DESCRIPTION
- ----------- -----------
<C> <S>
2.1 Stock Purchase Agreement dated as of February 24, 1998, by and among
the Company, Valence Technology Inc., Thomrose Holdings (BVI)
Limited, Rayfa (BVI) Limited, Cape Spencer International Limited,
and Anki (BVI) Limited, previously filed with the Commission as
Exhibit 2.1 to the Company's Current Report on Form 8-K filed with
the Commission on March 13, 1998 (the "Form 8-K"), which is
incorporated herein by reference.
2.2 Stock Purchase Agreement dated as of February 24, 1998, by and
between the Company and North 22 Capital Partners 2, Inc.,
previously filed with the Commission as Exhibit 2.2 to the Form 8-K,
which is incorporated herein by reference.
2.3 Asset Purchase Agreement dated as of January 28, 1998, between the
Company and R.G.A. & Associates, Ltd. d/b/a ToteVision and VIP
Labs(R) previously filed with the Commission as Exhibit 2.3 to the
Company's Annual Report on Form 10-KSB for the fiscal year ended
December 31, 1997 filed with the Commission on March 31, 1998 (the
"1997 Annual Report"), which is incorporated herein by reference.
2.4 Asset Purchase Agreement dated as of May 21, 1998 by and between
Rocktron Corporation and the Company, previously filed with the
Commission as Exhibit 2.1 to the Company's Quarterly Report on Form
10-Q for the period ended June 30, 1998 (the "June 1998 10-Q"),
which is incorporated herein by reference.
3.1 Certificate of Incorporation of the Company, previously filed with
the Commission as Exhibit 3.1 to the Company's Registration
Statement on Form SB-2, specifically included in Amendment No. 1 to
such Registration Statement filed with the Commission on July 3,
1996 (File No. 333-4974-LA) (the "Registration Statement Amendment
No. 1"), which is incorporated herein by reference.
3.2 Bylaws of the Company, previously filed with the Commission as
Exhibit 3.2 to the Registration Statement Amendment No. 1, which is
incorporated herein by reference.
</TABLE>
50
<PAGE> 51
Material Contracts Relating to Management Compensation Plans or Arrangements
<TABLE>
<C> <S>
10.1 Employment Agreement dated July 1, 1996, between the Company and
Thomas C.K. Yuen, previously filed with the Commission as Exhibit
10.8 to the Registration Statement Amendment No. 1, which is
incorporated herein by reference.
10.2 Amendment to Employment Agreement dated as of March 14, 1997,
between the Company and Thomas C.K. Yuen, previously filed with the
Commission as Exhibit 10.2 to the Company's Annual Report on Form
10-KSB for the fiscal year ended December 31, 1996, filed with the
Commission on March 31, 1997 (the "1996 Annual Report"), which is
incorporated herein by reference.
10.3 Employment Agreement dated July 1, 1996, between the Company and
Stephen V. Sedmak, previously filed with the Commission as Exhibit
10.9 to the Registration Statement Amendment No. 1, which is
incorporated herein by reference.
10.4 Employment Agreement dated July 1, 1996, between the Company and
Arnold I. Klayman, previously filed with the Commission as Exhibit
10.10 to the Registration Statement Amendment No. 1, which is
incorporated herein by reference.
10.5 Amendment to Employment Agreement dated as of March 14, 1997,
between the Company and Arnold I. Klayman, previously filed as
Exhibit 10.5 to the 1996 Annual Report, which is incorporated herein
by reference.
10.6 Employment Agreement dated July 1, 1996, between the Company and
Alan D. Kraemer, previously filed with the Commission as Exhibit
10.11 to the Registration Statement Amendment No. 1, which is
incorporated herein by reference.
10.7 Letter Agreement of Employment dated September 6, 1996, between the
Company and Robert A. Veri, previously filed as Exhibit 10.7 to the
1996 Annual Report, which is incorporated herein by reference.
10.8 SRS Labs, Inc. Incentive Stock Option, Nonqualified Stock Option and
Restricted Purchase Plan -- 1993, as amended and restated,
previously filed with the Commission as Exhibit 10.12 to the
Company's Registration Statement on Form SB-2 filed with the
Commission on June 3, 1996 (File No. 333-4974-LA) (the "Registration
Statement"), which is incorporated herein by reference.
10.9 Stock Option Agreement dated January 19, 1994, between the Company
and Stephen V. Sedmak, as amended, previously filed with the
Commission as Exhibit 10.13 to the Registration Statement, which is
incorporated herein by reference.
10.10 Stock Option Agreement dated January 19, 1994, between the Company
and James S. Lucas, previously filed with the Commission as Exhibit
10.14 to the Registration Statement, which is incorporated herein by
reference.
10.11 SRS Labs, Inc. Amended and Restated 1996 Long-Term Incentive Plan,
previously filed with the Commission as Appendix A to the Company's
Definitive Proxy Statement dated April 30, 1998, filed with the
Commission on April 30, 1998, which is incorporated herein by
reference.
10.12 SRS Labs, Inc. 1996 Nonemployee Directors Stock Option Plan,
previously filed with the Commission as Exhibit 10.16 to the
Registration Statement Amendment No. 1, which is incorporated herein
by reference.
10.13 Annual Incentive Bonus Plan, previously filed with the Commission as
Exhibit 10.18 to the Registration Statement Amendment No. 1, which
is incorporated herein by reference.
10.14 SRS Labs, Inc. Supplemental Executive Incentive Bonus Plan,
previously filed with the Commission as Exhibit 10.14 to the 1996
Annual Report, which is incorporated herein by reference.
10.15 Form of Indemnification Agreement, previously filed with the
Commission as Exhibit 10.20 to the Registration Statement Amendment
No. 1, which is incorporated herein by reference.
</TABLE>
51
<PAGE> 52
<TABLE>
<C> <S>
10.16 Employment Agreement dated as of March 2, 1998, by and among the
Company, Valence Technology Inc., and Thomas Wah Tong Wan,
previously filed with the Commission as Exhibit 10.16 to the 1997
Annual Report, which is incorporated herein by reference.
10.17 Employment Agreement dated as of March 2, 1998, by and among the
Company, Valence Semiconductor Design Limited, and Choi Yat Ming,
previously filed with the Commission as Exhibit 10.17 to the 1997
Annual Report, which is incorporated herein by reference.
10.18 Employment Agreement dated as of March 2, 1998, by and among the
Company, LEC Electronic Components Limited, and Wong Yin Bun,
previously filed with the Commission as Exhibit 10.18 to the 1997
Annual Report, which is incorporated herein by reference.
10.19 Noncompetition Agreement dated as of March 2, 1998, by and among the
Company, Thomrose Holdings (BVI) Limited, and Thomas Wah Tong Wan,
previously filed with the Commission as Exhibit 2.5 to the Company's
Current Report on Form 8-K filed with the Commission on March 13,
1998 (the "Form 8-K"), which is incorporated herein by reference.
10.20 Noncompetition Agreement dated as of March 2, 1998, by and among the
Company, Cape Spencer International Limited and Wong Yin Bun,
previously filed with the Commission as Exhibit 2.6 to the Form 8-K,
which is incorporated herein by reference.
10.21 Noncompetition Agreement dated as of March 2, 1998, by and among the
Company, Rayfa (BVI) Limited and Choi Yat Ming, previously filed
with the Commission as Exhibit 2.7 to the Form 8-K, which is
incorporated herein by reference.
10.22 Employment Agreement dated as of July 1, 1998 by and between the
Company and John AuYeung, previously filed with the Commission as
Exhibit 10.1 to the Company's Quarterly Report on Form 10-Q for the
period ended September 30, 1998, which is incorporated herein by
reference.
Other Material Contracts
10.23 Shareholders Agreement dated as of January 27, 1994, between the
Company and the Shareholders of the Company named therein,
previously filed with the Commission as Exhibit 9.3 to the Company's
Registration Statement on Form SB-2, specifically included in
Amendment No. 2 to such Registration Statement filed with the
Commission on August 2, 1996 (File No. 333-4974-LA) (the
"Registration Statement Amendment No. 2"), which is incorporated
herein by reference.
10.24 Shareholders Agreement II dated as of January 9, 1995, between the
Company and the Shareholders of the Company named therein,
previously filed with the Commission as Exhibit 9.1 to the
Registration Statement, which is incorporated herein by reference.
10.25 Shareholders Agreement III dated as of April 21, 1995, between the
Company and the Shareholders of the Company named therein,
previously filed with the Commission as Exhibit 9.2 to the
Registration Statement, which is incorporated herein by reference.
10.26 Asset Purchase Agreement dated as of June 30, 1993, between the
Company and Hughes Aircraft, previously filed with the Commission as
Exhibit 10.1 to the Registration Statement, which is incorporated
herein by reference.
10.27 First Amendment to Security Agreement dated as of September 14,
1994, by and among the Company, Hughes Aircraft, Cruttenden &
Company, Walter W. Cruttenden III, Pacific National Bank and The
Thomas Yuen Family Trust, previously filed with the Commission as
Exhibit 10.2 to the Registration Statement, which is incorporated
herein by reference.
10.28 Stock Purchase Agreement dated as of January 9, 1995, between the
Company and Packard Bell Electronics, Inc. d/b/a Packard Bell
Corporation, previously filed with the Commission as Exhibit 10.3 to
the Registration Statement Amendment No. 2, which is incorporated
herein by reference.
</TABLE>
52
<PAGE> 53
<TABLE>
<C> <S>
10.29 Amended and Restated Stock Option Agreement dated as of January 9,
1995, between the Company and Packard Bell Electronics, Inc. d/b/a/
Packard Bell Corporation, previously filed with the Commission as
Exhibit 10.4 to the Registration Statement, which is incorporated
herein by reference.
10.30 License Agreement dated as of January 9, 1995, between the Company
and Packard Bell Electronics, Inc. d/b/a/ Packard Bell Corporation,
previously filed with the Commission as Exhibit 10.5 to the
Company's Registration Statement on Form SB-2, specifically included
in Amendment No. 3 to such Registration Statement filed with the
Commission on August 7, 1996 (File No. 333-4974-LA) (the
"Registration Statement Amendment No. 3"), which is incorporated
herein by reference.
10.31 License Agreement dated as of June 27, 1988, between Hughes Aircraft
and Sony Corporation, as amended and assigned to the Company,
previously filed with the Commission as Exhibit 10.6 to the
Registration Statement Amendment No. 3, which is incorporated herein
by reference.
10.32 Real Property Lease dated June 1, 1994, between the Company and
Daimler Commerce Partners, L.P., a California Limited Partnership,
previously filed with the Commission as Exhibit 10.7 to the
Registration Statement, which is incorporated herein by reference.
10.33 Industrial Real Estate Lease dated May 30, 1997, between the Company
and Daimler Commerce Partners, L.P., previously filed with the
Commission as Exhibit 10.1 to the Company's Form 10-QSB for the
quarterly period ended June 30, 1997, filed with the Commission on
August 13, 1997, which is incorporated herein by reference.
10.34 Tenancy Agreement dated September 1, 1995, by and between Hong Kong
Industrial Technology Centre Corporation and Valence Semiconductor
Design Limited relating to the premises located at Unit 413 on the
Fourth Floor of the Hong Kong Industrial Technology Centre,
previously filed with the Commission as Exhibit 10.33 to the 1997
Annual Report, which is incorporated herein by reference.
10.35 Tenancy Agreement commencing January 1, 1998, by and between Jugada
Company Limited and Valence Semiconductor Design Limited relating to
the premises located at Workshops Nos. 1, 2, 3, 4, 5, 6, 7 and 8 on
the 19th Floor of APEC Plaza, No. 49 Hoi Yuen Road, Kwun Tong, Hong
Kong, previously filed with the Commission as Exhibit 10.34 to the
1997 Annual Report, which is incorporated herein by reference.
10.36 Stock Divestment Agreement dated July 1, 1996, between the Company,
Thomas C.K. Yuen, Stephen V. Sedmak and Walter W. Cruttenden III,
previously filed with the Commission as Exhibit 10.17 to the
Registration Statement Amendment No. 2, which is incorporated herein
by reference.
10.37 Services Agreement dated July 1, 1996, between the Company and
Sierra Digital Productions, Inc., previously filed with the
Commission as Exhibit 10.19 to the Registration Statement Amendment
No. 1, which is incorporated herein by reference.
10.38 Registration Rights Agreement dated as of January 28, 1998, by and
between the Company and R.G.A. & Associates, Ltd., d/b/a ToteVision
and VIP Labs(R) and William S. Taraday, previously filed with the
Commission as Exhibit 10.37 to the 1997 Annual Report, filed with
the Commission on March 31, 1998, which is incorporated herein by
reference.
10.39 Warrant to Purchase 94,000 Shares of Common Stock of the Company
dated February 26, 1998, held by R.G.A. & Associates, Ltd., d/b/a
ToteVision and VIP Labs(R), previously filed with the Commission as
Exhibit 10.38 to the 1997 Annual Report, which is incorporated
herein by reference.
10.40 Warrant to Purchase 2,500 Shares of Common Stock of the Company
dated February 26, 1998, held by Herbert H. Wax, previously filed
with the Commission as Exhibit 10.39 to the 1997 Annual Report,
which is incorporated herein by reference.
10.41 Warrant to Purchase 2,500 Shares of Common Stock of the Company
dated February 26, 1998, held by Steven E. Loyd, previously filed
with the Commission as Exhibit 10.40 to the 1997 Annual Report,
which is incorporated herein by reference.
</TABLE>
53
<PAGE> 54
<TABLE>
<C> <S>
10.42 Warrant to Purchase 1,000 Shares of Common Stock of the Company
dated February 26, 1998, held by the Van Valkenberg Furber Law
Group, P.L.L.C., previously filed with the Commission as Exhibit
10.41 to the 1997 Annual Report, which is incorporated herein by
reference.
10.43 Business Loan Agreement dated March 4, 1998, between the Company and
Bank of America National Trust and Savings Association, previously
filed with the Commission as Exhibit 10.42 to the 1997 Annual
Report, which is incorporated herein by reference.
10.44 Registration Rights Agreement dated as of May 21, 1998, previously
filed with the Commission as Exhibit 10.1 to the June 1998 Form
10-Q, which is incorporated herein by reference.
21 Subsidiaries.
23 Consent of Deloitte & Touche LLP dated March 30, 1999.
24 Power of attorney (included on page 55 of the Form 10-K).
27 Financial Data Schedule.
</TABLE>
(b) REPORTS ON FORM 8-K.
No reports on Form 8-K were filed during the fourth quarter of the fiscal
year covered by this Form 10-K.
54
<PAGE> 55
SIGNATURES
Pursuant to the requirements of Section 13 or 15(d) of the Securities
Exchange Act of 1934, the registrant has duly caused this report to be signed on
its behalf by the undersigned, thereunto duly authorized.
SRS LABS, INC., a Delaware corporation
Date: March 30, 1999 By: /s/ THOMAS C.K. YUEN
--------------------------------
Thomas C.K. Yuen
Chairman of the Board and
Chief Executive Officer
POWER OF ATTORNEY
KNOW ALL MEN BY THESE PRESENTS, that such person whose signature appears
below constitutes and appoints Thomas C.K. Yuen and Janet M. Biski, and each of
them his true and lawful attorneys-in-fact and agents, with full power of
substitution and resubstitution, for him and in his name, place and stead, in
any and all capacities, to sign any and all amendments to this Form 10-K and to
file the same, with all exhibits thereto, and other documents in connection
therewith, with the U.S. Securities and Exchange Commission, granting unto said
attorneys-in-fact and agents, and each of them, full power and authority to do
and perform each and every act and thing requisite and necessary to be done in
and about the premises, as fully to all intents and purposes as he might or
could do in person, hereby ratifying and confirming all that said
attorneys-in-fact and agents, or any of them, or their or his substitute or
substitutes, may lawfully do or cause to be done by virtue hereof.
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.
<TABLE>
<CAPTION>
NAME CAPACITY DATE
---- -------- ----
<S> <C> <C>
/s/ THOMAS C.K. YUEN Director, Chairman of the Board March 30, 1999
- ------------------------------------------------ and Chief Executive Officer
Thomas C.K. Yuen (Principal Executive Officer)
/s/ JANET M. BISKI Vice President, Chief Financial Officer, March 30, 1999
- ------------------------------------------------ Secretary and Treasurer
Janet M. Biski (Principal Financial and Accounting Officer)
/s/ JOHN AUYEUNG Director and Executive March 30, 1999
- ------------------------------------------------ Vice President
John AuYeung
/s/ THOMAS W.T. WAN Director and Vice President March 30, 1999
- ------------------------------------------------
Thomas W.T. Wan
/s/ ROBERT PFANNKUCH Director March 30, 1999
- ------------------------------------------------
Robert Pfannkuch
/s/ STEPHEN V. SEDMAK Director March 30, 1999
- ------------------------------------------------
Stephen V. Sedmak
/s/ JEFFREY I. SCHEINROCK Director March 30, 1999
- ------------------------------------------------
Jeffrey I. Scheinrock
/s/ JOHN TU Director March 30, 1999
- ------------------------------------------------
John Tu
</TABLE>
55
<PAGE> 56
EXHIBIT INDEX
<TABLE>
<CAPTION>
EXHIBIT NO. DESCRIPTION
- ----------- -----------
<C> <S>
2.1 Stock Purchase Agreement dated as of February 24, 1998, by and among
the Company, Valence Technology Inc., Thomrose Holdings (BVI)
Limited, Rayfa (BVI) Limited, Cape Spencer International Limited,
and Anki (BVI) Limited, previously filed with the Commission as
Exhibit 2.1 to the Company's Current Report on Form 8-K filed with
the Commission on March 13, 1998 (the "Form 8-K"), which is
incorporated herein by reference.
2.2 Stock Purchase Agreement dated as of February 24, 1998, by and
between the Company and North 22 Capital Partners 2, Inc.,
previously filed with the Commission as Exhibit 2.2 to the Form 8-K,
which is incorporated herein by reference.
2.3 Asset Purchase Agreement dated as of January 28, 1998, between the
Company and R.G.A. & Associates, Ltd. d/b/a ToteVision and VIP
Labs(R) previously filed with the Commission as Exhibit 2.3 to the
Company's Annual Report on Form 10-KSB for the fiscal year ended
December 31, 1997 filed with the Commission on March 31, 1998 (the
"1997 Annual Report"), which is incorporated herein by reference.
2.4 Asset Purchase Agreement dated as of May 21, 1998 by and between
Rocktron Corporation and the Company, previously filed with the
Commission as Exhibit 2.1 to the Company's Quarterly Report on Form
10-Q for the period ended June 30, 1998 (the "June 1998 10-Q"),
which is incorporated herein by reference.
3.1 Certificate of Incorporation of the Company, previously filed with
the Commission as Exhibit 3.1 to the Company's Registration
Statement on Form SB-2, specifically included in Amendment No. 1 to
such Registration Statement filed with the Commission on July 3,
1996 (File No. 333-4974-LA) (the "Registration Statement Amendment
No. 1"), which is incorporated herein by reference.
3.2 Bylaws of the Company, previously filed with the Commission as
Exhibit 3.2 to the Registration Statement Amendment No. 1, which is
incorporated herein by reference.
Material Contracts Relating to Management Compensation Plans or Arrangements
10.1 Employment Agreement dated July 1, 1996, between the Company and
Thomas C.K. Yuen, previously filed with the Commission as Exhibit
10.8 to the Registration Statement Amendment No. 1, which is
incorporated herein by reference.
10.2 Amendment to Employment Agreement dated as of March 14, 1997,
between the Company and Thomas C.K. Yuen, previously filed with the
Commission as Exhibit 10.2 to the Company's Annual Report on Form
10-KSB for the fiscal year ended December 31, 1996, filed with the
Commission on March 31, 1997 (the "1996 Annual Report"), which is
incorporated herein by reference.
10.3 Employment Agreement dated July 1, 1996, between the Company and
Stephen V. Sedmak, previously filed with the Commission as Exhibit
10.9 to the Registration Statement Amendment No. 1, which is
incorporated herein by reference.
10.4 Employment Agreement dated July 1, 1996, between the Company and
Arnold I. Klayman, previously filed with the Commission as Exhibit
10.10 to the Registration Statement Amendment No. 1, which is
incorporated herein by reference.
10.5 Amendment to Employment Agreement dated as of March 14, 1997,
between the Company and Arnold I. Klayman, previously filed as
Exhibit 10.5 to the 1996 Annual Report, which is incorporated herein
by reference.
10.6 Employment Agreement dated July 1, 1996, between the Company and
Alan D. Kraemer, previously filed with the Commission as Exhibit
10.11 to the Registration Statement Amendment No. 1, which is
incorporated herein by reference.
</TABLE>
<PAGE> 57
<TABLE>
<C> <S>
10.7 Letter Agreement of Employment dated September 6, 1996, between the
Company and Robert A. Veri, previously filed as Exhibit 10.7 to the
1996 Annual Report, which is incorporated herein by reference.
10.8 SRS Labs, Inc. Incentive Stock Option, Nonqualified Stock Option and
Restricted Purchase Plan -- 1993, as amended and restated,
previously filed with the Commission as Exhibit 10.12 to the
Company's Registration Statement on Form SB-2 filed with the
Commission on June 3, 1996 (File No. 333-4974-LA) (the "Registration
Statement"), which is incorporated herein by reference.
10.9 Stock Option Agreement dated January 19, 1994, between the Company
and Stephen V. Sedmak, as amended, previously filed with the
Commission as Exhibit 10.13 to the Registration Statement, which is
incorporated herein by reference.
10.10 Stock Option Agreement dated January 19, 1994, between the Company
and James S. Lucas, previously filed with the Commission as Exhibit
10.14 to the Registration Statement, which is incorporated herein by
reference.
10.11 SRS Labs, Inc. Amended and Restated 1996 Long-Term Incentive Plan,
previously filed with the Commission as Appendix A to the Company's
Definitive Proxy Statement dated April 30, 1998, filed with the
Commission on April 30, 1998, which is incorporated herein by
reference.
10.12 SRS Labs, Inc. 1996 Nonemployee Directors Stock Option Plan,
previously filed with the Commission as Exhibit 10.16 to the
Registration Statement Amendment No. 1, which is incorporated herein
by reference.
10.13 Annual Incentive Bonus Plan, previously filed with the Commission as
Exhibit 10.18 to the Registration Statement Amendment No. 1, which
is incorporated herein by reference.
10.14 SRS Labs, Inc. Supplemental Executive Incentive Bonus Plan,
previously filed with the Commission as Exhibit 10.14 to the 1996
Annual Report, which is incorporated herein by reference.
10.15 Form of Indemnification Agreement, previously filed with the
Commission as Exhibit 10.20 to the Registration Statement Amendment
No. 1, which is incorporated herein by reference.
10.16 Employment Agreement dated as of March 2, 1998, by and among the
Company, Valence Technology Inc., and Thomas Wah Tong Wan,
previously filed with the Commission as Exhibit 10.16 to the 1997
Annual Report, which is incorporated herein by reference.
10.17 Employment Agreement dated as of March 2, 1998, by and among the
Company, Valence Semiconductor Design Limited, and Choi Yat Ming,
previously filed with the Commission as Exhibit 10.17 to the 1997
Annual Report, which is incorporated herein by reference.
10.18 Employment Agreement dated as of March 2, 1998, by and among the
Company, LEC Electronic Components Limited, and Wong Yin Bun,
previously filed with the Commission as Exhibit 10.18 to the 1997
Annual Report, which is incorporated herein by reference.
10.19 Noncompetition Agreement dated as of March 2, 1998, by and among the
Company, Thomrose Holdings (BVI) Limited, and Thomas Wah Tong Wan,
previously filed with the Commission as Exhibit 2.5 to the Company's
Current Report on Form 8-K filed with the Commission on March 13,
1998 (the "Form 8-K"), which is incorporated herein by reference.
10.20 Noncompetition Agreement dated as of March 2, 1998, by and among the
Company, Cape Spencer International Limited and Wong Yin Bun,
previously filed with the Commission as Exhibit 2.6 to the Form 8-K,
which is incorporated herein by reference.
</TABLE>
<PAGE> 58
<TABLE>
<C> <S>
10.21 Noncompetition Agreement dated as of March 2, 1998, by and among the
Company, Rayfa (BVI) Limited and Choi Yat Ming, previously filed
with the Commission as Exhibit 2.7 to the Form 8-K, which is
incorporated herein by reference.
10.22 Employment Agreement dated as of July 1, 1998 by and between the
Company and John AuYeung, previously filed with the Commission as
Exhibit 10.1 to the Company's Quarterly Report on Form 10-Q for the
period ended September 30, 1998, which is incorporated herein by
reference.
Other Material Contracts
10.23 Shareholders Agreement dated as of January 27, 1994, between the
Company and the Shareholders of the Company named therein,
previously filed with the Commission as Exhibit 9.3 to the Company's
Registration Statement on Form SB-2, specifically included in
Amendment No. 2 to such Registration Statement filed with the
Commission on August 2, 1996 (File No. 333-4974-LA) (the
"Registration Statement Amendment No. 2"), which is incorporated
herein by reference.
10.24 Shareholders Agreement II dated as of January 9, 1995, between the
Company and the Shareholders of the Company named therein,
previously filed with the Commission as Exhibit 9.1 to the
Registration Statement, which is incorporated herein by reference.
10.25 Shareholders Agreement III dated as of April 21, 1995, between the
Company and the Shareholders of the Company named therein,
previously filed with the Commission as Exhibit 9.2 to the
Registration Statement, which is incorporated herein by reference.
10.26 Asset Purchase Agreement dated as of June 30, 1993, between the
Company and Hughes Aircraft, previously filed with the Commission as
Exhibit 10.1 to the Registration Statement, which is incorporated
herein by reference.
10.27 First Amendment to Security Agreement dated as of September 14,
1994, by and among the Company, Hughes Aircraft, Cruttenden &
Company, Walter W. Cruttenden III, Pacific National Bank and The
Thomas Yuen Family Trust, previously filed with the Commission as
Exhibit 10.2 to the Registration Statement, which is incorporated
herein by reference.
10.28 Stock Purchase Agreement dated as of January 9, 1995, between the
Company and Packard Bell Electronics, Inc. d/b/a Packard Bell
Corporation, previously filed with the Commission as Exhibit 10.3 to
the Registration Statement Amendment No. 2, which is incorporated
herein by reference.
10.29 Amended and Restated Stock Option Agreement dated as of January 9,
1995, between the Company and Packard Bell Electronics, Inc. d/b/a/
Packard Bell Corporation, previously filed with the Commission as
Exhibit 10.4 to the Registration Statement, which is incorporated
herein by reference.
10.30 License Agreement dated as of January 9, 1995, between the Company
and Packard Bell Electronics, Inc. d/b/a/ Packard Bell Corporation,
previously filed with the Commission as Exhibit 10.5 to the
Company's Registration Statement on Form SB-2, specifically included
in Amendment No. 3 to such Registration Statement filed with the
Commission on August 7, 1996 (File No. 333-4974-LA) (the
"Registration Statement Amendment No. 3"), which is incorporated
herein by reference.
10.31 License Agreement dated as of June 27, 1988, between Hughes Aircraft
and Sony Corporation, as amended and assigned to the Company,
previously filed with the Commission as Exhibit 10.6 to the
Registration Statement Amendment No. 3, which is incorporated herein
by reference.
10.32 Real Property Lease dated June 1, 1994, between the Company and
Daimler Commerce Partners, L.P., a California Limited Partnership,
previously filed with the Commission as Exhibit 10.7 to the
Registration Statement, which is incorporated herein by reference.
10.33 Industrial Real Estate Lease dated May 30, 1997, between the Company
and Daimler Commerce Partners, L.P., previously filed with the
Commission as Exhibit 10.1 to the Company's Form 10-QSB for the
quarterly period ended June 30, 1997, filed with the Commission on
August 13, 1997, which is incorporated herein by reference.
</TABLE>
<PAGE> 59
<TABLE>
<C> <S>
10.34 Tenancy Agreement dated September 1, 1995, by and between Hong Kong
Industrial Technology Centre Corporation and Valence Semiconductor
Design Limited relating to the premises located at Unit 413 on the
Fourth Floor of the Hong Kong Industrial Technology Centre,
previously filed with the Commission as Exhibit 10.33 to the 1997
Annual Report, which is incorporated herein by reference.
10.35 Tenancy Agreement commencing January 1, 1998, by and between Jugada
Company Limited and Valence Semiconductor Design Limited relating to
the premises located at Workshops Nos. 1, 2, 3, 4, 5, 6, 7 and 8 on
the 19th Floor of APEC Plaza, No. 49 Hoi Yuen Road, Kwun Tong, Hong
Kong, previously filed with the Commission as Exhibit 10.34 to the
1997 Annual Report, which is incorporated herein by reference.
10.36 Stock Divestment Agreement dated July 1, 1996, between the Company,
Thomas C.K. Yuen, Stephen V. Sedmak and Walter W. Cruttenden III,
previously filed with the Commission as Exhibit 10.17 to the
Registration Statement Amendment No. 2, which is incorporated herein
by reference.
10.37 Services Agreement dated July 1, 1996, between the Company and
Sierra Digital Productions, Inc., previously filed with the
Commission as Exhibit 10.19 to the Registration Statement Amendment
No. 1, which is incorporated herein by reference.
10.38 Registration Rights Agreement dated as of January 28, 1998, by and
between the Company and R.G.A. & Associates, Ltd., d/b/a ToteVision
and VIP Labs(R) and William S. Taraday, previously filed with the
Commission as Exhibit 10.37 to the 1997 Annual Report, filed with
the Commission on March 31, 1998, which is incorporated herein by
reference.
10.39 Warrant to Purchase 94,000 Shares of Common Stock of the Company
dated February 26, 1998, held by R.G.A. & Associates, Ltd., d/b/a
ToteVision and VIP Labs(R), previously filed with the Commission as
Exhibit 10.38 to the 1997 Annual Report, which is incorporated
herein by reference.
10.40 Warrant to Purchase 2,500 Shares of Common Stock of the Company
dated February 26, 1998, held by Herbert H. Wax, previously filed
with the Commission as Exhibit 10.39 to the 1997 Annual Report,
which is incorporated herein by reference.
10.41 Warrant to Purchase 2,500 Shares of Common Stock of the Company
dated February 26, 1998, held by Steven E. Loyd, previously filed
with the Commission as Exhibit 10.40 to the 1997 Annual Report,
which is incorporated herein by reference.
10.42 Warrant to Purchase 1,000 Shares of Common Stock of the Company
dated February 26, 1998, held by the Van Valkenberg Furber Law
Group, P.L.L.C., previously filed with the Commission as Exhibit
10.41 to the 1997 Annual Report, which is incorporated herein by
reference.
10.43 Business Loan Agreement dated March 4, 1998, between the Company and
Bank of America National Trust and Savings Association, previously
filed with the Commission as Exhibit 10.42 to the 1997 Annual
Report, which is incorporated herein by reference.
10.44 Registration Rights Agreement dated as of May 21, 1998, previously
filed with the Commission as Exhibit 10.1 to the June 1998 Form
10-Q, which is incorporated herein by reference.
21 Subsidiaries.
23 Consent of Deloitte & Touche LLP dated March 30, 1999.
24 Power of attorney (included on page 55 of the Form 10-K).
27 Financial Data Schedule.
</TABLE>
<PAGE> 1
EXHIBIT 21
SRS LABS, INC.
SUBSIDIARIES
On March 2, 1998, SRS Labs, Inc. acquired all of the outstanding capital
stock of Valence Technology, Inc., a British Virgin Islands company ("Valence").
Valence, in turn, beneficially owns all of the capital stock of the following
companies:
<TABLE>
<CAPTION>
Name Jurisdiction of Incorporation
---- -----------------------------
<S> <C>
Valence Semiconductor Design Limited Hong Kong
ASP Microelectronics Limited ("ASP") Hong Kong
LEC Electronic Components Limited ("LEC") Hong Kong
VSD Electronics Limited Hong Kong
</TABLE>
ASP, in turn, beneficially owns all of the outstanding shares of capital
stock of LEC Microelectronics Limited, a Hong Kong company, and LEC, in turn,
beneficially owns (a) all of the outstanding shares of capital stock of LEC
Electronics Limited, a Hong Kong company, and (b) all of the capital interests
in VSD Electronics (Hui Yang) Ltd., a wholly-owned foreign enterprise
established under the laws of the Peoples Republic of China.
<PAGE> 1
EXHIBIT 23
INDEPENDENT AUDITORS' CONSENT
The Board of Directors
SRS Labs, Inc.
We consent to the incorporation by reference in Registration Statements Nos.
333-18981, 333-18983, 333-18985, 333-18987, 333-18989, 333-29153 and 333-63493
on Form S-8 of SRS Labs, Inc. of our report dated March 12, 1999, appearing in
SRS Labs, Inc.'s Annual Report on Form 10-K for the year ended December 31,
1998.
/s/ Deloitte & Touche LLP
Costa Mesa, California
March 30, 1999
<TABLE> <S> <C>
<ARTICLE> 5
<S> <C>
<PERIOD-TYPE> YEAR
<FISCAL-YEAR-END> DEC-31-1998
<PERIOD-START> JAN-01-1998
<PERIOD-END> DEC-31-1998
<CASH> 12,341,242
<SECURITIES> 12,089,617
<RECEIVABLES> 5,742,824
<ALLOWANCES> 422,138
<INVENTORY> 4,632,968
<CURRENT-ASSETS> 27,076,010
<PP&E> 1,901,097
<DEPRECIATION> 681,664
<TOTAL-ASSETS> 45,535,306
<CURRENT-LIABILITIES> 19,431,893
<BONDS> 0
0
0
<COMMON> 11,689
<OTHER-SE> 26,161,724
<TOTAL-LIABILITY-AND-EQUITY> 45,535,306
<SALES> 38,754,127
<TOTAL-REVENUES> 44,725,040
<CGS> 29,819,071
<TOTAL-COSTS> 14,931,514
<OTHER-EXPENSES> 0
<LOSS-PROVISION> (82,785)
<INTEREST-EXPENSE> (704,992)
<INCOME-PRETAX> (17,830,931)
<INCOME-TAX> (273,156)
<INCOME-CONTINUING> (17,557,775)
<DISCONTINUED> 0
<EXTRAORDINARY> 0
<CHANGES> 0
<NET-INCOME> (17,557,775)
<EPS-PRIMARY> (1.54)
<EPS-DILUTED> 0
</TABLE>
