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Filed Pursuant to Rule 424(b)(4)
Registration No. 333-91541
PROSPECTUS
3,000,000 Shares
[LIQUID AUDIO LOGO]
Common Stock
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Liquid Audio is offering 2,496,076 of the shares to be sold in the offering.
The selling stockholders identified in this prospectus are offering an
additional 503,924 shares. Liquid Audio will not receive any of the proceeds
from the sale of shares being sold by the selling stockholders.
The common stock is quoted on the Nasdaq National Market under the symbol
"LQID." The last reported sale price of the common stock on December 14, 1999
was $34.00 per share.
Investing in the shares involves risks. Risk Factors begin on page 7.
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Per Share Total
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Public Offering Price.................................. $33.63 $100,875,000
Underwriting Discount.................................. 1.68 5,040,000
Proceeds, before expenses, to Liquid Audio............. 31.95 79,737,148
Proceeds, before expenses, to the selling
stockholders.......................................... 31.95 16,097,852
</TABLE>
To the extent the underwriters sell more than 3,000,000 shares of common
stock, the underwriters have the option to purchase up to an additional
450,000 shares from Liquid Audio at the public offering price less the
underwriting discount.
Neither the Securities and Exchange Commission nor any other regulatory body
has approved or disapproved of these securities or passed upon the accuracy or
adequacy of this prospectus. Any representation to the contrary is a criminal
offense.
Lehman Brothers expects to deliver the shares on or about December 20, 1999.
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Lehman Brothers
Robertson Stephens
U.S. Bancorp Piper Jaffray
Dain Rauscher Wessels
Fidelity Capital Markets
a division of National Financial
Services Corporation
Facilitating Electronic Distribution
December 14, 1999
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[INSIDE FRONT COVER]
[LIQUID AUDIO LOGO]
software and services for digital music delivery
liquifier pro and liquid server create and publish music
Software and services to encode, host and digitally deliver music over the
Internet.
1.6 million previews available and 175,000 songs committed from 6,000 artists
for sample and sale.
liquid music network syndicate music
Music is syndicated through the Liquid Music Network to more than 300 retail and
music websites.
liquid player promote and sell music
Consumers preview, purchase and download music using the Liquid Player.
Music can be transferred to recordable compact disk.
[GRAPHIC OF SCREEN SHOT DEPICTING OUR SOFTWARE AND SERVICES]
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TABLE OF CONTENTS
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Page
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Prospectus Summary....................................................... 3
Risk Factors............................................................. 7
Use of Proceeds.......................................................... 18
Price Range of Common Stock.............................................. 18
Dividend Policy.......................................................... 18
Capitalization........................................................... 19
Dilution................................................................. 20
Selected Financial Data.................................................. 21
Management's Discussion and Analysis of Financial Condition and Results
of Operations........................................................... 22
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Page
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Business................................................................... 34
Management................................................................. 52
Related Party Transactions................................................. 60
Principal and Selling Stockholders......................................... 61
Description of Capital Stock............................................... 63
Shares Available for Future Sale........................................... 65
Underwriting............................................................... 66
Legal Matters.............................................................. 68
Experts.................................................................... 68
Where You May Find Additional Information.................................. 68
Index to Financial Statements.............................................. F-1
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ABOUT THIS PROSPECTUS
You should rely only on the information contained in this prospectus. We
have not authorized anyone to provide you with information different from that
contained in this prospectus. We are offering to sell, and seeking offers to
buy, shares of common stock only in jurisdictions where offers and sales are
permitted. The information contained in this prospectus is accurate only as of
the date of this prospectus, regardless of the time of delivery of this
prospectus or of any sale of common stock.
See the section of this prospectus entitled "Risk Factors" for a discussion
of certain factors that you should consider before investing in the common
stock offered in this prospectus.
Certain statements under the captions "Prospectus Summary," "Risk Factors,"
"Use of Proceeds," "Management's Discussion and Analysis of Financial
Condition and Results of Operations" and "Business" and elsewhere in this
prospectus are forward-looking statements. These forward-looking statements
include, but are not limited to, statements about our plans, objectives,
expectations and intentions and other statements contained in the prospectus
that are not historical facts. When used in this prospectus, the words
"expects," "anticipates," "intends," "plans," "believes," "seeks" and
"estimates" and similar expressions are generally intended to identify
forward-looking statements. Because these forward-looking statements involve
risks and uncertainties, there are important factors that could cause actual
results to differ materially from those expressed or implied by these forward-
looking statements, including our plans, objectives, expectations and
intentions and other factors discussed under "Risk Factors."
All trademarks and trade names appearing in this prospectus are the property
of their respective holders.
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PROSPECTUS SUMMARY
You should read the following summary together with the more detailed
information regarding our company and the common stock being sold in this
offering and our financial statements and notes to those statements appearing
elsewhere in this prospectus.
Except as otherwise indicated, all information in this prospectus assumes
that the underwriters do not exercise the option granted by Liquid Audio to
purchase additional shares in this offering. See "Underwriting."
Liquid Audio
We provide a leading open platform that enables the digital delivery of music
over the Internet. Our open platform is a comprehensive, flexible solution
comprised of software products and services that gives artists, record
companies, websites and retailers the ability to create, syndicate and sell
recorded music with copy protection and copyright management. Through our
Liquid Music Network website affiliates, we help artists and record companies
promote and sell their recorded music. From our growing catalog of syndicated
music, consumers can preview and purchase digital music. Consumers then can
transfer downloaded music to recordable compact discs and to digital consumer
devices following release by consumer electronics manufacturers.
Our solution is based on an open technical architecture, which means that it
is designed to support multiple leading digital music formats, including mp3
(an audio compression format developed by the Fraunhofer Institut) and Dolby
AC-3 (an audio compression format developed by Dolby Laboratories, Inc.). These
formats use compression technology to reduce the size of audio files,
facilitating the digital delivery of music over the Internet. Numerous record
companies and recording artists have used our platform to promote music
releases, including Atlantic Records, BMG North America, Capitol Records,
Columbia House, Dreamworks Records, EMI Music Group, Epic Records, Mammoth
Records, Rounder Records, Tommy Boy Records, Warner Music Group, Tori Amos,
David Bowie, Bruce Hornsby, The Dave Matthews Band, Sarah McLachlan and Alanis
Morissette.
The recorded music industry, which was approximately $38.7 billion worldwide
in 1998, represents one of the largest opportunities for online digital
delivery and commerce. The growing popularity of music on the Internet,
combined with recent technology advances, has made the Internet a compelling
medium for digital music delivery. Forrester Research has estimated that sales
of recorded music through digital transmission will grow from less than 1% of
all recorded music sales in the United States in 1999 to 7% of these sales in
2003.
We believe we are the first company to offer a complete, commercially
available solution for the digital delivery of music over the Internet. Our
"end-to-end" solution facilitates the digital delivery of music from the point
where a musician prepares music for delivery over the Internet, through
transmission, to the point where the consumer downloads and listens to it. We
began licensing our software in March 1997, and our comprehensive solution,
which incorporates the Liquid Music Network, became commercially available in
July 1998. Our platform has generated approximately $6.1 million of total net
revenues from inception through September 30, 1999 and provides the following
benefits:
. Superior Consumer Experience. We make it simple for consumers to search
for, sample and buy digital music recordings from our growing catalog of
syndicated music.
. Global Reach. Our platform allows artists, record companies and retailers
to use the Internet as an additional global distribution channel to reach
more consumers.
. Increased Revenues and Lower Costs. Record companies and artists can
increase their revenues by offering consumers their entire catalog of
music online and achieve significant cost savings by reducing costs
associated with manufacturing, warehousing and shipping.
. Security and Compliance. Our platform protects against piracy by offering
copyright management and copy protection for songs. Our services are able
to restrict digital sales to consumers within specified geographic areas,
enabling resellers to comply with distribution restrictions.
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We offer artists, record companies and websites a range of products and
services for creating, syndicating and selling music digitally over the
Internet.
. Create Music. Our Liquifier Pro software product encodes, or prepares,
music for delivery over the Internet. Encoded music is published to our
Liquid Server software product, which manages the secure digital transfer
and sale of music to consumers. We also offer complete turnkey digital
music encoding and hosting services to artists and record companies.
. Syndicate Music. We help artists reach more consumers and sell more music
by syndicating their music for sale through our growing network of Liquid
Music Network affiliates, which is a group of over 300 music-related
websites and music retailer websites.
. Sell Music. Using our Liquid Player desktop software product, consumers
can preview, purchase and digitally download music to their computers.
Music can then be transferred to a recordable compact disc or, in the
future, to portable digital consumer devices. We also provide e-commerce
and reporting services for artists and labels for digital music sales.
Our objective is to be the premier enabling platform for the digital delivery
of music over the Internet. Our strategies include:
.Providing a Superior Consumer Experience;
. Continuing to Broaden our Distribution Reach;
. Expanding Syndicated Music Content;
. Extending Technology Leadership; and
. Generating Multiple Revenue Streams.
Since early 1999, we have increased our emphasis on developing and marketing
our digital delivery services. Many independent record labels have chosen to
use our solution for promotion and sale of their music, including Beggars
Banquet, Rounder Records, Rykodisc, Sub Pop Records and Twin/Tone Records. We
have increased the number of these syndicated music recordings for sale from
approximately 5,000 at the beginning of 1999 to more than 175,000 committed as
of November 19, 1999. In addition, in August 1999, our Liquid Music Network
began offering syndicated music through music retailer websites.
We have established relationships with industry leaders to build brand
recognition and enhance our content creation, syndication and sales
opportunities worldwide. Our relationships include: Amazon.com; BMG North
America; CDnow Inc.; Dolby Laboratories; EMI Recorded Music; Intel; Muze;
RealNetworks; Sanyo; Texas Instruments; Toshiba; Towerrecords.com; Virgin
Records and Yahoo!. We have also established international alliances in Korea
and Japan to build our presence and infrastructure outside the United States.
We currently generate the majority of our revenues from software product
licensing fees and business development agreements to establish our presence
internationally. As we expand our music delivery services, we expect to
generate increasing revenues from the following areas:
. Digital music downloads to consumers;
. Hosting and e-commerce services for artists; and
. Advertising and sponsorships.
Digital music sales and transaction fees from our music delivery services
accounted for less than 1% of our total net revenues in the year ended December
31, 1998 and approximately 1.5% of our total net revenues for the nine months
ended September 30, 1999. Our accumulated deficit as of September 30, 1999 was
approximately $32.1 million. In addition, we had net losses of approximately
$8.5 million in 1998 and $16.0 million for the nine months ended September 30,
1999. Given our planned operating and capital expenditures, we expect to
continue to incur losses and negative cash flows through at least 2002.
We incorporated in California in January 1996 and reincorporated in Delaware
in April 1999. Our principal executive offices are located at 810 Winslow
Street, Redwood City, California 94063. Our phone number is (650) 549-2000 and
our Internet address is www.liquidaudio.com. Information contained on our
website does not constitute a part of this prospectus.
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The Offering
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Common stock offered by Liquid Audio.. 2,496,076 shares
Common stock offered by the selling
stockholders......................... 503,924 shares
Common stock outstanding after the
offering............................. 21,364,831 shares
Use of proceeds....................... We estimate that we will receive net
proceeds from this offering of
$79,237,000, or $93,612,000 if the
underwriters exercise their over-
allotment option in full. We expect to
use the net proceeds for general
corporate purposes, including working
capital and capital expenditures,
enhancing research and development,
attracting key personnel and, if
appropriate opportunities arise, the
acquisition of, or investment in,
businesses or technologies. See "Use
of Proceeds."
Nasdaq National Market symbol......... "LQID"
</TABLE>
In addition to the 21,364,831 shares of common stock to be outstanding after
the offering, as of September 30, 1999 we may issue additional shares of common
stock under the following plans and arrangements:
. 2,450,706 shares issuable under our 1996 Equity Incentive Plan,
consisting of:
. 1,335,873 shares underlying options outstanding at a weighted average
exercise price of $5.94 per share, of which 1,335,873 were exercisable
at September 30, 1999; and
. 1,114,833 shares available for future grant;
. 608,730 shares issuable upon the exercise of warrants outstanding at a
weighted average exercise price of $13.81 per share; and
. 500,000 shares available for issuance under our 1999 Employee Stock
Purchase Plan.
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Summary Financial Data
The following table summarizes the financial data of our business. See
"Management's Discussion and Analysis of Financial Condition and Results of
Operations." The financial results as of September 30, 1999 and for the nine
months ended September 30, 1998 and 1999 are unaudited.
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Period From
January 30,
1996 (inception) Year Ended Nine Months
Through December 31, Ended September 30,
December 31, --------------------- ---------------------
1996 1997 1998 1998 1999
---------------- --------- ---------- --------- ----------
(in thousands, except share and per share data)
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Statement of Operations
Data:
Total net revenues...... $ -- $ 256 $ 2,803 $ 1,727 $ 3,061
Gross profit (loss)..... -- (137) 2,249 1,382 2,188
Net loss................ (1,264) (6,216) (8,539) (5,946) (16,035)
Basic and diluted net
loss per share......... $(14.93) $ (4.95) $ (3.60) $ (2.67) $ (2.07)
Shares used in per share
calculation............ 84,635 1,256,114 2,370,564 2,227,000 7,755,000
Pro forma basic and
diluted net loss per
share.................. $(0.85) $ (1.10)
Shares used in pro forma
per share
calculation............ 10,041,546 14,561,000
</TABLE>
The following table provides a summary of our balance sheet as of September
30, 1999. The as adjusted column reflects the sale of 2,496,076 shares of
common stock by us in this offering at the public offering price of $33.63 per
share and after deducting the underwriting discount and estimated offering
expenses payable by us. See "Use of Proceeds" and "Capitalization."
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As of September 30, 1999
--------------------------
Actual As Adjusted
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(in thousands)
<S> <C> <C>
Balance Sheet Data:
Cash, cash equivalents and short-term investments... $ 70,516 $ 149,753
Working capital..................................... 66,055 145,292
Total assets........................................ 76,995 156,232
Long-term debt, less current portion ............... 1,535 1,535
Total stockholders' equity ......................... 68,957 148,194
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RISK FACTORS
You should carefully consider the risks described below before making a
decision to buy our common stock. The risks and uncertainties described below
are not the only ones we face. Additional risks and uncertainties not presently
known to us or that we currently deem immaterial may also impair our business
operations. If any of the following risks actually occurs, our business could
be harmed. In that case, the trading price of our common stock could decline,
and you might lose all or part of your investment. You should also refer to the
other information set forth in this prospectus, including our financial
statements and the related notes.
Risks Related to Our Business
Our Limited Operating History in the New Market of Digital Delivery of Music
Over the Internet Increases the Possibility That the Value of Your Investment
Will Decline
We incorporated in January 1996. We did not start generating revenues until
the first quarter of 1997. In early 1999, we began to place greater emphasis on
developing and marketing our digital music delivery services. Accordingly, we
are still in the early stages of development and have only a limited operating
history upon which you can evaluate our business. You should evaluate our
chances of financial and operational success in light of the risks,
uncertainties, expenses, delays and difficulties associated with starting a new
business, many of which may be beyond our control.
Fluctuations in Our Quarterly Revenues and Operating Results Might Lead to
Reduced Prices for Our Stock
Our quarterly results of operation have varied in the past, and you should
not rely on quarter-to-quarter comparisons of our results of operations as an
indication of our future performance. In some future periods, our results of
operations are likely to be below the expectations of public market analysts
and investors. In this event, the price of our common stock would likely
decline. Factors that have caused our results to fluctuate in the past and that
are likely to affect us in the future include the following:
. competition for consumers from traditional retailers as well as providers
of online music services;
. the announcement and introduction of new products and services by us and
our competitors;
. our ability to increase the number of websites that will use our platform
for digital music delivery;
. the timing of our partners' introduction of new products and services for
digital music sales; and
. variability and length of the sales cycle associated with our product and
service offerings.
In addition, other factors may also affect us, including:
. market adoption and growth of sales of digitally downloaded recorded
music over the Internet;
. our ability to attract significant numbers of music recordings to be
syndicated in our format;
. market acceptance of new and enhanced versions of our products and
services;
. our ability to provide reliable and scalable service, including our
ability to avoid potential system failures; and
. the price and mix of products and services we offer.
Some of these factors are within our control and others are outside of our
control.
We Have a History of Losses, We Expect Losses to Continue and We Might Not
Achieve or Maintain Profitability
Our accumulated deficit as of September 30, 1999 was approximately $32.1
million. We had net losses of approximately $8.5 million in 1998 and $16.0
million for the nine months ended September 30, 1999. Given
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the level of our planned operating and capital expenditures, we expect to
continue to incur losses and negative cash flows through at least 2002. Even if
we ultimately do achieve profitability, we may not be able to sustain or
increase profitability on a quarterly or annual basis. If our revenues grow
more slowly than we anticipate, or if our operating expenses exceed our
expectations and cannot be adjusted accordingly, our business will be harmed.
See "Selected Financial Data" and "Management's Discussion and Analysis of
Financial Condition and Results of Operations."
If We Do Not Increase the Number of Websites That Use Our Platform, Our
Business Will Not Grow
In order to grow our business, we need to increase the number of websites,
including websites operated by music retailers, that use our technology and our
syndicated content to digitally deliver recorded music. To increase the number
of websites, we must do the following:
. offer competitive products and services that meet industry standards;
. attract more music content;
. make it easy and cost-effective for music-related websites to sell
digital music;
. develop relationships with online retailers, music websites, online
communities, broadband providers and Internet broadcasters; and
. develop relationships with international music websites, retailers and
broadband providers.
Any failure to achieve one or more of these objectives would harm our
business. We may not be successful in achieving any of these objectives.
We also intend to increase our expenditures on marketing the Liquid Audio
brand because we believe brand awareness will be critical to increasing our
affiliates and end-user awareness. If we do not increase our revenues as a
result of our branding and other marketing efforts or if we otherwise fail to
promote our brand successfully, our business would be harmed.
If Artists and Record Labels Are Not Satisfied That They Can Securely,
Digitally Deliver Their Music Over the Internet, We Might Not Have Sufficient
Content to Attract Consumers
Our success depends on our ability to aggregate a sufficient amount and
variety of digital recorded music for syndication. In particular, until a
significant number of artists and their record labels adopt a strategy of
digitally delivering music over the Internet, the growth of our business might
be limited. We currently do not create our own content; rather, we rely on
record companies and artists for digital recorded music to be syndicated using
our format. We believe record companies will remain reluctant to distribute
their recorded music digitally unless they are satisfied that the digital
delivery of their music over the Internet will not result in the unauthorized
copying and distribution of that music. If record companies do not believe that
recorded music can be securely delivered over the Internet, they will not allow
the digital distribution of their recorded music and we might not have
sufficient content to attract consumers. If we cannot offer a sufficient amount
and variety of digital recorded music for syndication, our business might be
harmed.
Due to the Many Factors That Influence Market Acceptance, Consumers Might Not
Accept Our Platform
Our success will depend on growth in consumer acceptance of our platform as a
method for digital delivery of recorded music over the Internet. Factors that
might influence market acceptance of our platform include the following, over
which we have little or no control:
. the availability of sufficient bandwidth on the Internet to enable
consumers to download digital recorded music rapidly and easily;
. the willingness of consumers to invest in computer technology that
facilitates the downloading of digital music;
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. the cost of time-based Internet access;
. the number and variety of digital recordings available for purchase
through our system relative to those available through other online
digital delivery companies, digital music websites or through traditional
physical delivery of recordings;
. the availability of portable devices to which digital recorded music can
be transferred;
. the fidelity and quality of the sound of the digital recorded music; and
. the level of consumer comfort with the process of downloading and paying
for digital music over the Internet, including ease of use and lack of
concern about transaction security.
The Market for Digital Delivery of Music Over the Internet is Highly
Competitive, and if We Cannot Compete Effectively, Our Revenues Might Decline
Competition among companies in the business of digital delivery of music over
the Internet is intense. If we do not compete effectively or if we experience
pricing pressures, reduced margins or loss of market share resulting from
increased competition, our business might be harmed.
Competition is likely to increase as new companies enter the market and
current competitors expand their products and services. Many of these potential
competitors are likely to enjoy substantial competitive advantages, including
the following:
. larger audiences;
. larger technical, production and editorial staffs;
. greater brand recognition;
. access to more recorded music content;
. a more established Internet presence;
. a larger advertiser base; and
. substantially greater financial, marketing, technical and other
resources.
See "Business--Competition."
If Standards for the Secure, Digital Delivery of Recorded Music Are Not
Adopted, the Piracy Concerns of Record Companies and Artists Might Not Be
Satisfied, and They Might Not Use Our Platform for Digital Delivery of Their
Music
Because other digital recorded music formats, such as mp3, do not contain
mechanisms for tracking the source or ownership of digital recordings, users
are able to download and distribute unauthorized or "pirated" copies of
copyrighted recorded music over the Internet. This piracy is a significant
concern to record companies and artists, and is the reason many record
companies and artists are reluctant to digitally deliver their recorded music
over the Internet. The Secure Digital Music Initiative (SDMI) is a committee
formed by the Recording Industry Association of America (RIAA) to propose a
standard format for the secure digital delivery and use of recorded music. If a
standard format is not adopted, however, unsecure copies of recorded music may
continue to be available on the Internet, and record companies and artists
might not permit the digital delivery of their music. Additionally, as long as
pirated recordings are available, many consumers will choose free pirated
recordings rather than paying for legitimate recordings. Accordingly, if a
standard format for the secure digital delivery of music is not adopted, our
business might be harmed.
We have designed our current products to be adaptable to different music
industry and technology standards. Numerous standards in the marketplace,
however, could cause confusion as to whether our products
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and services are compatible. If a competitor were to establish the dominant
industry standard, our business would be harmed.
If Our Platform Does Not Provide Sufficient Rights Reporting Information,
Record Companies and Artists Are Unlikely to Digitally Deliver Their Recorded
Music Using Our Platform
Record companies and artists must be able to track the number of times their
recorded music is downloaded so that they can make appropriate payments to
music rights organizations, such as the American Society of Composers, Authors
and Publishers, Broadcast Music Incorporated and SESAC, Inc. If our products
and services do not accurately or completely provide this rights reporting
information, record companies and artists might not use our platform to
digitally deliver their recorded music, and our business might be harmed.
Our Business Might Be Harmed if We Fail to Price Our Products and Services
Appropriately
The price of Internet products and services is subject to rapid and frequent
change. We may be forced for competitive or technical reasons to reduce or
eliminate prices for certain of our products or services. If this happens, our
business might be harmed.
If Our Relationships With Our International Partners Terminate, Our Revenues
Might Decline
We derive a portion of our revenues from business development fees from
relationships with our international partners, Liquid Audio Korea, Liquid Audio
Japan, SK Group and Super Stage. These relationships vary in size and scope. If
one of these relationships does not generate a similar amount of revenue in
subsequent periods, then our business could be harmed. Furthermore, the
commercial terms for these relationships could cause our revenues to vary from
period-to-period, which might result in unpredictability of our revenues.
Our Revenues Would Be Negatively Affected by the Loss of a Significant Customer
We have derived, and we believe that we will continue to derive, a
substantial portion of our net revenues from a limited number of customers and
projects. Our ten largest customers for 1998 and the nine months ended
September 30, 1999 represented approximately 70% and 91%, respectively, of our
total net revenues. The loss of any significant customer or any significant
reduction of total net revenues generated by significant customers, without an
increase in revenues from other sources, would harm our business. The volume of
products or services we sell to specific customers is likely to vary year to
year, and a major customer in one year may not use our services in a subsequent
year. A customer's decision not to use our services in a subsequent year might
harm our business.
We Might Not Be Able to Scale Our Technology Infrastructure to Meet Demand for
Our Products and Services
Our success will depend on our ability to scale our technology infrastructure
to meet the demand for our products and services. Adding this new capacity will
be expensive, and we might not be able to do so successfully. In addition, we
might not be able to protect our new or existing data centers from unexpected
events as we scale our systems. To the extent that we do not address any
capacity constraints effectively, our business would be harmed.
We Might Not Be Successful in Our Attempts to Keep Up With Rapid Technological
Change and Evolving Industry Standards
The markets for our products and services are characterized by rapidly
changing technology, evolving industry standards, changes in customer needs,
emerging competition, and frequent new product and service introductions. Our
future success will depend, in part, on our ability to:
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. use leading technologies effectively;
. continue to develop our strategic and technical expertise;
. enhance our current products and services;
. develop new products and services that meet changing customer needs;
. advertise and market our products and services; and
. influence and respond to emerging industry standards and other
technological changes.
This must be accomplished in a timely and cost-effective manner. We may not
be successful in effectively using new technologies, developing new products or
services or enhancing our existing products or services on a timely basis.
These new technologies or enhancements may not achieve market acceptance. Our
pursuit of necessary technological advances may require substantial time and
expense. Finally, we may not succeed in adapting our services to new
technologies as they emerge.
Companies Might Not Develop or Consumers Might Not Adopt Devices That Will Play
Digitally Downloaded Music
We believe that the market for digitally recorded music delivered over the
Internet will not develop significantly until consumers are able to enjoy this
music other than solely through the use of a personal computer. Several
consumer electronics companies have introduced or announced plans to introduce
devices that will allow digital music delivered over the Internet to be played
away from the personal computer. If companies fail to introduce additional
devices, consumers do not adopt these devices or our products and services are
incompatible with these devices, our business would be harmed. In addition,
digital music can be transferred to a compact disc, but that transfer requires
a compact disc recorder (CD-R). Many desktop computer manufacturers offer CD-Rs
in their computers. If companies do not continue to offer CD-Rs in their
computers, consumers do not adopt CD-Rs or our products and services are
incompatible with CD-Rs, our business might be harmed.
We Might Not Be Successful in the Development and Introduction of New Products
and Services
We depend in part on our ability to develop new or enhanced products and
services in a timely manner and to provide new products and services that
achieve rapid and broad market acceptance. We may fail to identify new product
and service opportunities successfully and develop and bring to market new
products and services in a timely manner. In addition, product innovations may
not achieve the market penetration or price stability necessary for
profitability.
As the online medium continues to evolve, we plan to leverage our technology
by introducing complementary products and services as additional sources of
revenue. Accordingly, we may change our business model to take advantage of new
business opportunities, including business areas in which we do not have
extensive experience. For example, we recently focused on, and will continue to
devote significant resources to, the development of digital music delivery
services, as well as our software licensing business. If we fail to develop
these or other businesses successfully, our business would be harmed.
We Might Experience Delays in the Development of New Products and Services
We must continue to innovate and develop new versions of our software to
remain competitive in the market for digital delivery of recorded music
solutions. Our software products and services development efforts are
inherently difficult to manage and keep on schedule. Our failure to manage and
keep those development projects on schedule might harm our business.
Our Products and Services Might Contain Errors
We offer complex products and services. They may contain undetected errors
when first introduced or when new versions are released. If we market products
and services that have errors or that do not function
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<PAGE>
properly, then we may experience negative publicity, loss of or delay in market
acceptance, or claims against us by customers, any of which might harm our
business.
We Might Have Liability for the Content of the Recorded Music That We Digitally
Deliver
Because we digitally deliver recorded music to third parties, we might be
sued for negligence, copyright or trademark infringement or other reasons.
These types of claims have been brought, sometimes successfully, against
providers of online products and services in the past. Others could also sue us
for the content that is accessible from our website through links to other
websites. These claims might include, among others, claims that by hosting,
directly or indirectly, the websites of third parties, we are liable for
copyright or trademark infringement or other wrongful actions by these third
parties through these websites. Our insurance may not adequately protect us
against these types of claims and, even if these claims do not result in
liability, we could incur significant costs in investigating and defending
against these claims.
We have taken steps to prevent these claims. For example, we have
arrangements with companies that use our hosting services that will allow us to
delete potentially infringing or misappropriating materials quickly and
securely. We also have put into place indemnification agreements with music
content providers, where practicable. Under the Digital Millenium Copyright Act
of 1999, Internet service providers are insulated from several types of these
claims, upon compliance with the requirement that they appoint an agent to
receive claims relating to their service, and we intend to appoint an agent.
In 1998, Congress passed the Internet Freedom Act, which imposes a three-year
moratorium on state and local taxes on Internet-based transactions. We cannot
assure you that this moratorium will be extended. Failure to renew this
moratorium would allow various states to impose taxes on e-commerce, which
might harm our business.
Several of Our Customers Have Had Limited Operating Histories, are Unprofitable
and Might Have Difficulty Meeting Their Payment Obligations to Us
Several of our significant customers, including our international partners
Liquid Audio Japan and Liquid Audio Korea, have had limited operating histories
and have not achieved profitability. We believe that this will be true of other
customers in the future. You should evaluate the ability of these companies to
meet their payment obligations to us in light of the risks, expenses and
difficulties encountered by companies with limited operating histories. If one
or more of our customers were unable to pay for our services in the future, or
paid more slowly than we anticipate, our business might be harmed. As of
September 30, 1999, 46% of our trade accounts receivable, or $155,000, was more
than 30 days past due. We believe that we have provided adequate reserves for
past due amounts.
System Failures or Delays Might Harm Our Business
Our operations depend on our ability to protect our computer systems against
damage from fire, water, power loss, telecommunications failures, computer
viruses, vandalism and other malicious acts, and similar unexpected adverse
events. Interruptions or slowdowns in our services have resulted from the
failure of our telecommunications providers to supply the necessary data
communications capacity in the time frame we required, as well as from
deliberate acts. Despite precautions we have taken, unanticipated problems
affecting our systems could in the future cause temporary interruptions or
delays in the services we provide. Our customers might become dissatisfied by
any system failure or delay that interrupts our ability to provide service to
them or slows our response time. Sustained or repeated system failures or
delays would affect our reputation, which would harm our business. Slow
response time or system failures could also result from straining the capacity
of our software or hardware due to an increase in the volume of products and
services delivered through our servers. While we carry business interruption
insurance, it might not be sufficient to cover any serious or prolonged
emergencies, and our business might be harmed.
12
<PAGE>
We Might Be Unable to License or Acquire Technology
We rely on certain technologies that we license or acquire from third
parties, including Dolby Laboratories Licensing Corporation, Fraunhofer
Institut and RSA Data Security, Inc. These technologies are integrated with our
internally developed software and used in our products, to perform key
functions and to enhance the value of our platform. These third-party licenses
or acquisitions may not continue to be available to us on commercially
reasonable terms or at all. Any inability to acquire these licenses or software
on commercially reasonable terms might harm our business.
Our Future Success Depends on Our Key Personnel
Our future success depends to a significant extent on the continued service
of our key technical, sales and senior management personnel and their ability
to execute our growth strategy. The loss of the services of any of our senior
level management, or other key employees, could harm our business. Our future
performance will depend, in part, on the ability of our executive officers to
work together effectively. Our executive officers may not be successful in
carrying out their duties or running our company. Any dissent among executive
officers could impair our ability to make strategic decisions quickly in a
rapidly changing market.
Our future success also depends on our ability to attract, retain and
motivate highly skilled employees. Competition for employees in our industry is
intense. Although we provide compensation packages that include incentive stock
options, cash incentives and other employee benefits, the volatility and
current market price of our common stock may make it difficult for us to
attract, assimilate and retain highly qualified employees in the future. We
have from time to time in the past experienced, and we expect to continue to
experience in the future, difficulty in hiring and retaining highly skilled
employees with appropriate qualifications.
Our Management and Internal Systems Might Be Inadequate to Handle the Potential
Growth of Our Personnel
To manage future growth, our management must continue to improve our
operational and financial systems and expand, train, retain and manage our
employee base. Our management may not be able to manage our growth effectively.
If our systems, procedures and controls are inadequate to support our
operations, our expansion would be halted and we could lose our opportunity to
gain significant market share. Any inability to manage growth effectively may
harm our business.
We Depend on Proprietary Rights to Develop and Protect Our Technology
Our success and ability to compete substantially depends on our internally
developed technologies and trademarks, which we protect through a combination
of patent, copyright, trade secret and trademark laws. Patent applications or
trademark registrations may not be approved. Even if they are approved, our
patents or trademarks may be successfully challenged by others or invalidated.
If our trademark registrations are not approved because third parties own these
trademarks, our use of these trademarks would be restricted unless we enter
into arrangements with the third-party owners, which might not be possible on
commercially reasonable terms or at all.
The primary forms of intellectual property protection for our products and
services internationally are patents and copyrights. Patent protection
throughout the world is generally established on a country-by-country basis. To
date, we have not applied for any patents outside the United States. We may do
so in the future. Copyrights throughout the world are protected by several
international treaties, including the Berne Convention for the Protection of
Literary and Artistic Works. Despite these international laws, the level of
practical protection for intellectual property varies among countries. In
particular, United States government officials have criticized countries such
as China and Brazil for inadequate intellectual property protection. If our
intellectual property is infringed in any country without a high level of
intellectual property protection, our business could be harmed.
13
<PAGE>
We generally enter into confidentiality or license agreements with our
employees, consultants and corporate partners, and generally control access to
and distribution of our technologies, documentation and other proprietary
information. Despite our efforts to protect our proprietary rights from
unauthorized use or disclosure, parties may attempt to disclose, obtain or use
our solutions or technologies. The steps we have taken may not prevent
misappropriation of our solutions or technologies, particularly in foreign
countries where laws or law enforcement practices may not protect our
proprietary rights as fully as in the United States. See "Business--
Intellectual Property."
We have licensed, and we may license in the future, certain proprietary
rights to third parties. While we attempt to ensure that the quality of our
brand is maintained by our business partners, they may take actions that could
impair the value of our proprietary rights or our reputation. In addition,
these business partners may not take the same steps we have taken to prevent
misappropriation of our solutions or technologies.
We Face and Might Face Intellectual Property Infringement Claims That Might Be
Costly to Resolve
In May 1999, Microtome, Inc. notified us that it believes our Liquifier Pro
Encoding Tool, when used in conjunction with our Liquid Music Player, infringes
two of its patents. In June 1999 and July 1999, we received letters from three
other corporations, each separately suggesting that we review patents to which
they claim rights. We are aware that one of these corporations has sued several
parties and these claims may result in our being involved in litigation.
Although we have no reason to believe we infringe the valid proprietary rights
of Microtome, Inc. or any other party, we cannot assure you that we do not
infringe the valid intellectual property rights of others, or that third
parties will not assert additional claims in the future or that any claims will
not be successful. We could incur substantial costs and diversion of management
resources to defend any claims relating to proprietary rights, which could harm
our business. In addition, we are obligated under certain agreements to
indemnify the other party for claims that we infringe on the proprietary rights
of third parties. If we are required to indemnify parties under these
agreements, our business could be harmed. If someone asserts a claim against us
relating to proprietary technology or information, we might seek licenses to
this intellectual property. We might not be able to obtain licenses on
commercially reasonable terms, or at all. The failure to obtain the necessary
licenses or other rights might materially harm our business. See "Business--
Litigation and Patent Infringement Claims."
Difficulties Presented by International Economic, Political, Legal, Accounting
and Business Factors Could Harm Our Business in International Markets
A key component of our strategy is to expand into international markets. The
following risks are inherent in doing business on an international level and we
have little or no control over them:
. unexpected changes in regulatory requirements;
. export restrictions;
. export controls relating to encryption technology;
. longer payment cycles;
. problems in collecting accounts receivable;
. political and economic instability; and
. potentially adverse tax consequences.
In addition, other factors that may also affect us and over which we have
some control include the following:
. difficulties in staffing and managing international operations;
. differences in music rights reporting structures; and
. seasonal reductions in business activity.
14
<PAGE>
We have entered into individual agreements in Japan and Korea, and we may
enter into similar arrangements in the future in other countries. One or more
of the factors listed above may harm our present or future international
operations and, consequently, our business.
We Might Need Additional Capital in the Future and Additional Financing Might
Not Be Available
We currently anticipate that our available cash resources, combined with the
net proceeds from this offering and financing available under existing lease
agreements, will be sufficient to meet our anticipated working capital and
capital expenditure requirements for the foreseeable future. However, we may
need to raise additional funds through public or private debt or equity
financing in order to:
. take advantage of opportunities, including more rapid international
expansion or acquisitions of complementary businesses or technologies;
. develop new products or services; or
. respond to competitive pressures.
Any additional financing we may need may not be available on terms favorable
to us, or at all. If adequate funds are not available or are not available on
acceptable terms, we might not be able to take advantage of unanticipated
opportunities, develop new products or services, or otherwise respond to
unanticipated competitive pressures, and our business could be harmed. Our
forecast of the period of time through which our financial resources will be
adequate to support our operations is a forward-looking statement that involves
risks and uncertainties, and actual results could vary materially as a result
of a number of factors, including those set forth in this "Risk Factors"
section. See "Management's Discussion and Analysis of Financial Condition and
Results of Operations."
Potential Year 2000 Risks Might Harm Our Business
Many currently installed computer systems and software products worldwide are
coded to accept only two-digit entries to identify a year in the date code
field. Consequently, on January 1, 2000, many of these systems could fail or
malfunction because they are not able to distinguish between the year 1900 and
the year 2000. Accordingly, many companies, including Liquid Audio and our
customers, potential customers, vendors and strategic partners, may need to
upgrade their systems to comply with applicable year 2000 requirements.
Because we and our customers depend, to a very substantial degree, upon the
proper functioning of computer systems, a failure of these systems to correctly
recognize dates beyond January 1, 2000 could disrupt operations. Any
disruptions could harm our business. Additionally, our failure to provide year
2000 compliant solutions to our customers could result in financial loss,
reputational harm and legal liability to us. See "Management's Discussion and
Analysis of Financial Condition and Results of Operations--Year 2000
Compliance."
Risks Related to Our Industry
Internet Security Concerns Could Hinder E-Commerce
A significant barrier to e-commerce and communications over the Internet has
been the need for secure transmission of confidential information. Internet
usage may not increase at the rate we expect unless some of those concerns are
adequately addressed and found acceptable by the market. Internet usage could
also decline if any well-publicized compromise of security occurs. We may incur
significant costs to protect against the threat of security breaches or to
alleviate problems caused by these breaches. Protections may not be available
at a reasonable price or at all. If a third person were able to misappropriate
a user's personal information, users could bring claims against us.
Imposition of Sales and Other Taxes On E-Commerce Transactions Might Hinder E-
Commerce
We do not collect sales and other taxes when we sell our products and
services over the Internet. States or local governments may seek to impose
sales tax collection obligations on out-of-state companies, such as ours,
15
<PAGE>
which engage in or facilitate e-commerce. A number of proposals have been made
at the state and local level that would impose additional taxes on the sale of
products and services through the Internet. These proposals, if adopted, could
substantially impair the growth of e-commerce and could reduce our opportunity
to derive profits from e-commerce. Moreover, if any state or local government
or foreign country were to successfully assert that we should collect sales or
other taxes on the exchange of products and services on our system, our
business might be harmed.
Demand for Our Products and Services Might Decrease if Growth in the Use of the
Internet Declines
Our future success substantially depends upon the continued growth in the use
of the Internet. The number of users on the Internet may not increase and
commerce over the Internet may not become more accepted and widespread for a
number of reasons, including the following, over which we have little or no
control:
. actual or perceived lack of security of information, such as credit card
numbers;
. lack of access and ease of use;
. inconsistent quality of service and lack of availability of cost-
effective, high speed service;
. possible outages due to year 2000 difficulties or other damage to the
Internet;
. excessive governmental regulation; and
. uncertainty regarding intellectual property rights.
If the necessary infrastructure, products, services or facilities are not
developed, or if the Internet does not grow as a commercial medium, our
business would be harmed.
Government Regulation of the Internet Might Harm Our Business
The applicability to the Internet of existing laws governing issues such as
property ownership, libel and personal privacy is uncertain. In addition,
governmental authorities may seek to further regulate the Internet with respect
to issues such as user privacy, pornography, acceptable content, e-commerce,
taxation, and the pricing, characteristics and quality of products and
services. Finally, the global nature of the Internet could subject us to the
laws of a foreign jurisdiction in an unpredictable manner. Any new legislation
regulating the Internet could inhibit the growth of the Internet and decrease
the acceptance of the Internet as a communications and commercial medium, which
might harm our business.
In addition, the growing use of the Internet has burdened the existing
telecommunications infrastructure and has caused interruptions in telephone
service. Telephone carriers have petitioned the government to regulate the
Internet and impose usage fees on Internet service providers. Any regulations
of this type could increase the costs of using the Internet and impede its
growth, which could in turn decrease the demand for our services or otherwise
harm our business.
Risks Related to This Offering
The Price of Our Common Stock is Likely to Be Volatile and Subject to Wide
Fluctuations
The market prices of the securities of Internet-related companies have been
especially volatile and these securities may be overvalued. Thus, the market
price of our common stock has been, and will likely continue to be, subject to
wide fluctuations. If our revenues do not grow or grow more slowly than we
anticipate, or if operating or capital expenditures exceed our expectations and
cannot be adjusted accordingly, or if some other event adversely affects us,
the market price of our common stock could decline. In addition, if the market
for Internet-related stocks or the stock market in general experiences a loss
in investor confidence or otherwise fails, the market price of our common stock
could fall for reasons unrelated to our business, results of
16
<PAGE>
operations and financial condition. Investors might be unable to resell their
shares of our common stock at or above the offering price. In the past,
companies that have experienced volatility in the market price of their stock
have been the subject of securities class action litigation. If we were to
become the subject of securities class action litigation, it could result in
substantial costs and a diversion of management's attention and resources.
Provisions in Our Charter Documents Might Deter Acquisition Bids for Us
We have adopted a classified board of directors and our stockholders are
unable to call special meetings of stockholders, to act by written consent, to
remove any director or the entire board of directors without cause, or to fill
any vacancy on the board of directors, and must meet advance notice
requirements for stockholder proposals. Our board of directors may also issue
preferred stock without any vote or further action by the stockholders. These
provisions and other provisions under Delaware law could make it more difficult
for a third party to acquire us, even if doing so would benefit our
stockholders. See "Description of Capital Stock."
Our Officers and Directors Exert Substantial Influence Over Us
We anticipate that our executive officers, our directors and entities
affiliated with them together will beneficially own approximately 34.4% of our
outstanding common stock following the completion of this offering. As a
result, these stockholders will be able to exercise substantial influence over
all matters requiring approval by our stockholders, including the election of
directors and approval of significant corporate transactions. This
concentration of ownership may also have the effect of delaying or preventing a
change in our control.
Management Could Invest or Spend the Proceeds of This Offering in Ways With
Which the Stockholders Might Not Agree
We have no specific allocations for the net proceeds of this offering.
Consequently, management will retain a significant amount of discretion over
the application of these proceeds. Because of the number and variability of
factors that will determine our use of these proceeds, our applications may
vary substantially from our current intentions to invest the net proceeds of
the offering in short-term, interest bearing, investment grade marketable
securities.
Sales of a Substantial Amount of Our Common Stock After This Offering Could
Cause Our Stock Price to Fall
Our common stock began trading on the Nasdaq National Market on July 8, 1999;
however, to date there has been only a limited number of shares trading in the
public market. This offering will result in an additional 3,000,000 shares of
our common stock being available on the open market. Further, our current
stockholders hold 9,940,892 shares that they will be able to sell in the public
market beginning on January 5, 2000, when the lock-up agreements signed in
connection with our initial public offering expire. In addition, on the 91st
day following this offering, our selling stockholders will be able to sell an
additional 3,623,939 shares of our common stock. Sales of a substantial number
of shares of our common stock in this offering and thereafter could cause our
stock price to fall. In addition, the sale of shares by our stockholders could
impair our ability to raise capital through the sale of additional stock. See
"Underwriting" and "Shares Available for Future Sale."
You Will Incur Immediate and Substantial Dilution
The public offering price is substantially higher than the net book value per
share of our outstanding common stock. As a result, investors purchasing common
stock in this offering will incur immediate substantial dilution. In addition,
we have issued options and warrants to acquire common stock at prices
significantly below the public offering price. To the extent these outstanding
options and warrants are exercised, there will be further dilution to investors
in this offering.
17
<PAGE>
USE OF PROCEEDS
We estimate the net proceeds from the offering to be approximately
$79,237,000, or $93,612,000 if the underwriters exercise their over-allotment
option in full, at the public offering price of $33.63 per share and after
deducting the underwriting discount and estimated offering expenses. We will
not receive any of the proceeds from the sale of shares by the selling
stockholders.
We are conducting this offering primarily to increase our equity capital, to
create a larger public float for our common stock, to facilitate future access
to public equity markets and to allow for the orderly liquidation of the
investments made by some of our stockholders. We expect to use the net proceeds
from the offering for general corporate purposes, including working capital and
capital expenditures, enhancing research and development, attracting key
personnel and, if appropriate opportunities arise, the acquisition of, or
investment in, businesses or technologies. We are not, however, currently
discussing any potential acquisition or investment with any third party. As of
the date of this prospectus, we cannot specify the particular uses for the net
proceeds. Accordingly, our management will have broad discretion in the
application of the net proceeds. Until we use the net proceeds, we intend to
invest them in short-term, interest bearing, investment grade marketable
securities.
PRICE RANGE OF COMMON STOCK
Our common stock has been quoted on the Nasdaq National Market under the
symbol "LQID" since July 8, 1999. Before then, there was no public market for
our common stock. The following table presents, for the periods indicated, the
high and low closing prices per share of the common stock as reported on the
Nasdaq National Market.
<TABLE>
<CAPTION>
High Low
------ ------
<S> <C> <C>
Third Quarter (since July 8, 1999)........ $40.44 $20.88
Fourth Quarter (through December 14,
1999).................................... 45.13 29.75
</TABLE>
On December 14, 1999, the reported last sale price of the common stock on the
Nasdaq National Market was $34.00. As of September 30, 1999, there were
approximately 99 stockholders of record.
DIVIDEND POLICY
We have never declared or paid any dividends on our common stock. We do not
anticipate paying any cash dividends in the foreseeable future. We currently
intend to retain future earnings, if any, to finance operations and the
expansion of our business. Any future determination to pay cash dividends will
be at the discretion of the board of directors and will depend upon our
financial condition, operating results, capital requirements and other factors
the board of directors deems relevant.
18
<PAGE>
CAPITALIZATION
The following table sets forth our short-term debt and capitalization as of
September 30, 1999. Our capitalization is presented:
. on an actual basis; and
. on an as adjusted basis to reflect our receipt of the estimated net
proceeds from the sale of the 2,496,076 shares of common stock offered by
us in the offering at the public offering price of $33.63 per share and
after deducting the underwriting discount and estimated offering
expenses.
<TABLE>
<CAPTION>
As of September 30, 1999
-----------------------------
Actual As Adjusted
------------ ---------------
(in thousands, unaudited)
<S> <C> <C>
Short-term debt................................... $ 774 $ 774
============ ============
Long-term debt, less current portion.............. $ 1,535 $ 1,535
Stockholders' equity:
Preferred stock, $0.001 par value; 5,000,000
shares authorized; none issued or outstanding,
actual or as adjusted........................... -- --
Common stock, $0.001 par value; 50,000,000 shares
authorized; 18,868,755 shares issued and
outstanding, actual; 21,364,831 shares issued
and outstanding, as adjusted.................... 19 21
Additional paid-in capital....................... 102,362 181,597
Unearned compensation............................ (1,370) (1,370)
Accumulated deficit.............................. (32,054) (32,054)
------------ ------------
Total stockholders' equity...................... 68,957 148,194
------------ ------------
Total capitalization........................... $ 70,492 $ 149,729
============ ============
</TABLE>
In addition to the shares of common stock to be outstanding after the
offering, as of September 30, 1999 we may issue additional shares of common
stock under the following plans and arrangements:
. 2,450,706 shares issuable under our 1996 Equity Incentive Plan,
consisting of:
. 1,335,873 shares underlying options outstanding at a weighted average
exercise price of $5.94 per share, of which 1,335,873 were exercisable
at September 30, 1999; and
. 1,114,833 shares available for future grant;
. 608,730 shares issuable upon the exercise of warrants outstanding at a
weighted average exercise price of $13.81 per share; and
. 500,000 shares available for issuance under our 1999 Employee Stock
Purchase Plan.
Please read the capitalization table together with the sections of this
prospectus entitled "Selected Financial Data" and "Management's Discussion and
Analysis of Financial Condition and Results of Operations" and the financial
statements included in this prospectus.
19
<PAGE>
DILUTION
As of September 30, 1999, our net tangible book value was $68,957,000, or
$3.65 per share of common stock. "Net tangible book value" per share represents
the amount of our total tangible assets reduced by the amount of our total
liabilities, divided by the number of shares of common stock outstanding. As of
September 30, 1999, our net tangible book value on a pro forma basis to reflect
the sale of the 2,496,076 shares offered in this offering at the public
offering price of $33.63 per share and after deducting the underwriting
discount and estimated offering expenses, would have been approximately $6.94
per share. This represents an immediate increase of $3.29 per share to existing
stockholders and an immediate dilution of $26.69 per share to new investors.
The following table illustrates this per share dilution:
<TABLE>
<S> <C> <C>
Initial public offering price per share........................ $33.63
Net tangible book value per share as of September 30, 1999... $3.65
Increase per share attributable to new investors............. 3.29
-----
Pro forma net tangible book value per share after the
offering...................................................... 6.94
------
Dilution per share to new investors............................ $26.69
======
</TABLE>
20
<PAGE>
SELECTED FINANCIAL DATA
The following selected financial data should be read in conjunction with our
financial statements and related notes and "Management's Discussion and
Analysis of Financial Condition and Results of Operations" included elsewhere
in this prospectus. The statement of operations data for the period from
January 30, 1996 (inception) through December 31, 1996 and for the years ended
December 31, 1997 and 1998, and the balance sheet data at December 31, 1997 and
1998, are derived from financial statements that PricewaterhouseCoopers LLP,
independent accountants, have audited and are included elsewhere in this
prospectus. The balance sheet data at December 31, 1996 are derived from
audited financial statements not included in this prospectus. The statement of
operations data for the nine-month periods ended September 30, 1998 and 1999,
and the balance sheet data at September 30, 1999, are derived from unaudited
interim financial statements included elsewhere in this prospectus. The
unaudited financial statements have been prepared on substantially the same
basis as the audited financial statements and, in the opinion of management,
include all adjustments, consisting only of normal recurring adjustments,
necessary for a fair presentation of the results of operations for such
periods. Historical results are not necessarily indicative of the results to be
expected in the future, and results of interim periods are not necessarily
indicative of results for the entire year.
<TABLE>
<CAPTION>
Period From
January 30,
1996
(inception) Year Ended Nine Months Ended
Through December 31, September 30,
December 31, --------------------- ---------------------
1996 1997 1998 1998 1999
------------ --------- ---------- --------- ----------
(in thousands, except share and per share data)
<S> <C> <C> <C> <C> <C>
Statement of Operations
Data:
Net revenues:
License................ $ -- $ 246 $1,235 $808 $ 1,129
Services............... -- 10 268 169 367
Business development
(related party)....... -- -- 1,300 750 1,565
------- --------- ---------- --------- ----------
Total net revenues..... -- 256 2,803 1,727 3,061
------- --------- ---------- --------- ----------
Cost of net revenues:
License................ -- 302 310 175 156
Services............... -- 91 242 170 649
Business development
(related party)....... -- -- 2 -- 68
------- --------- ---------- --------- ----------
Total cost of net reve-
nues.................. -- 393 554 345 873
------- --------- ---------- --------- ----------
Gross profit (loss)..... -- (137) 2,249 1,382 2,188
Operating expenses:
Sales and marketing.... 237 2,820 4,035 2,676 6,449
Research and develop-
ment.................. 692 1,880 4,109 2,666 7,710
General and administra-
tive.................. 327 898 1,642 1,155 1,741
Strategic marketing eq-
uity instruments...... -- -- -- -- 2,190
Stock compensation ex-
pense................. 31 534 1,241 882 1,119
------- --------- ---------- --------- ----------
Total operating ex-
penses................ 1,287 6,132 11,027 7,379 19,209
------- --------- ---------- --------- ----------
Loss from operations.... (1,287) (6,269) (8,778) (5,997) (17,021)
Interest income......... 24 125 379 151 1,172
Interest expense........ (1) (72) (140) (100) (138)
Other income (expense),
net.................... -- -- -- -- (48)
------- --------- ---------- --------- ----------
Net loss................ $(1,264) $(6,216) $(8,539) $(5,946) $(16,035)
======= ========= ========== ========= ==========
Basic and diluted net
loss per share......... $(14.93) $(4.95) $(3.60) $(2.67) $ (2.07)
Shares used in per share
calculation............ 84,635 1,256,114 2,370,564 2,227,000 7,755,000
Pro forma basic and
diluted net loss per
share.................. $(0.85) $ (1.10)
Shares used in pro forma
per share calculation.. 10,041,546 14,561,000
</TABLE>
<TABLE>
<CAPTION>
December 31,
-------------------------- September 30,
1996 1997 1998 1999
------- ------- -------- -------------
(in thousands)
<S> <C> <C> <C> <C>
Balance Sheet Data:
Cash and cash equivalents........... $ 864 $ 2,387 $ 14,143 $62,913
Short-term investments.............. -- -- 3,001 7,603
Working capital..................... 660 858 15,060 66,055
Total assets........................ 1,086 3,335 20,026 76,995
Long-term debt, less current
portion............................ 103 218 969 1,535
Mandatorily redeemable convertible
preferred stock and warrants....... 2,001 8,247 29,801 --
Total stockholders' equity
(deficit).......................... (1,228) (6,879) (14,133) 68,957
</TABLE>
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<PAGE>
MANAGEMENT'S DISCUSSION AND ANALYSIS
OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS
The following discussion of our financial condition and results of operations
should be read together with the financial statements and related notes that
are included later in this prospectus. This discussion contains forward-looking
statements that involve risks and uncertainties. Our actual results may differ
materially from those anticipated in these forward-looking statements as a
result of various factors, including those set forth under "Risk Factors" or in
other parts of this prospectus.
Overview
We are a leading provider of software products and services that enable
artists, record companies and retailers to create, syndicate and sell music
digitally over the Internet. Our products and services are based on an open
technical architecture that is designed to support a variety of digital music
formats. From our inception in January 1996 through early 1997, we devoted
substantially all of our efforts to product development, raising capital and
recruiting personnel. We first generated revenues in the first quarter of 1997
through the licensing of our Liquifier Pro, Liquid Server and Liquid Player
software products. In November 1997, we introduced a subscription-based hosting
service for digital recorded music utilizing our technology. In July 1998, to
enhance consumer access to the music we were hosting, we launched the Liquid
Music Network (LMN), a syndicated network that currently links over 300
affiliated music-related and music retailer websites.
In early 1999, we began to place greater emphasis on developing and marketing
our digital music delivery services. Since that time, we have invested
significant resources to increase our distribution reach by expanding the LMN,
building our syndicated music catalog available for sale, actively
participating in standards initiatives and establishing our international
presence. We also have established international initiatives within the Pacific
Rim to lay the groundwork for offering digital music download services to
consumers in these markets. As a provider of digital music delivery services,
we expect our revenue sources to expand beyond software license sales to
include sales of digital recorded music and hosting service fees. Revenues from
digital music sales and transaction fees from our music delivery services
represented less than 1% of total net revenues in 1998 and approximately 1.5%
for first nine months of 1999. Our Liquid Music Network began offering
syndicated music through music retailer websites in the third quarter of 1999.
To date, we have derived our revenues principally from the licensing of
software products and services fees associated with business development
contracts. We license our software products to record companies, artists and
websites. Software license revenues, net of a provision for estimated sales
returns, are recognized upon shipment of the product to the customer. We also
generate services revenues from maintenance fees related to our licensed
software products and hosting fees from record companies and artists. We defer
and recognize maintenance and hosting fees as service revenue ratably over the
life of the related contract, which is typically one year. We intend to
increase our services revenues by significantly expanding our hosting and music
delivery services. Revenues derived from hosting services include subscription
fees from artists for encoding and storing music files, e-commerce services and
transaction reporting. Music delivery services revenues include sales of
digital recorded music through our LMN website affiliates and transaction fees
from music retailers and websites related to the Liquid Muze Previews service
for sample music clips. Business development revenues primarily consist of fees
from agreements under which we assist strategic partners with the development
of businesses that use our digital recorded music delivery technology. These
U.S. dollar-denominated, nonrefundable fees are based upon agreements under
which the strategic partners are contractually obligated to pay us consulting
services fees and software license fees related to the establishment of
businesses in various countries. We recognize the fees as they are earned; the
specific timing of this recognition depends on the terms and conditions of the
particular contractual arrangements. We bear full credit risk with respect to
substantially all sales.
We expense all research and development as incurred. Development costs
incurred in the period from achievement of technological feasibility, which we
define as the establishment of a working model, until the general availability
of this software to customers, have been short, and therefore software
development costs
22
<PAGE>
qualifying for capitalization have been insignificant. Accordingly, we have not
capitalized any software development costs to date.
We have a limited operating history upon which investors may evaluate our
business and prospects. Since inception we have incurred significant losses,
and as of September 30, 1999 we had an accumulated deficit of approximately
$32.1 million. We intend to continue to expend significant financial and
management resources on the development of additional products and services,
sales and marketing, improved technology and expanded operations. As a result,
we expect to incur additional losses and continued negative cash flow from
operations through at least 2002. Our revenues may not increase or even
continue at their current levels or we may not achieve or maintain
profitability or generate cash from operations in future periods. Our prospects
must be considered in light of the risks, expenses and difficulties frequently
encountered by companies in their early stages of development, particularly
companies in new and rapidly evolving markets such as the digital delivery of
recorded music. We may not be successful in addressing these risks, and our
failure to do so would harm our business.
Results of Operations
The following table presents our statement of operations data expressed as a
percentage of total net revenues:
<TABLE>
<CAPTION>
Nine Months
Year Ended Ended
December September
31, 30,
------------- -------------
1997 1998 1998 1999
------ ---- ----- -----
<S> <C> <C> <C> <C>
Statement of Operations
Data:
Net revenues:
License.................. 96% 44% 47% 37%
Services................. 4 10 10 12
Business development
(related party)......... -- 46 43 51
------ ---- ----- -----
Total net revenues...... 100 100 100 100
Cost of net revenues:
License.................. 118 11 10 5
Services................. 36 9 10 21
Business development
(related party)......... -- -- -- 2
------ ---- ----- -----
Total cost of net
revenues............... 154 20 20 28
------ ---- ----- -----
Gross profit (loss)....... (54) 80 80 72
Operating expenses:
Sales and marketing...... 1,101 144 155 211
Research and
development............. 734 146 154 252
General and
administrative.......... 351 59 67 57
Strategic marketing--
equity instruments...... -- -- -- 72
Stock compensation
expense................. 209 44 51 36
------ ---- ----- -----
Total operating
expenses............... 2,395 393 427 628
------ ---- ----- -----
Loss from operations...... (2,449) (313) (347) (556)
Interest income........... 49 13 9 39
Interest expense.......... (28) (5) (6) (5)
Other income (expense),
net...................... -- -- -- (2)
------ ---- ----- -----
Net loss.................. (2,428)% (305)% (344)% (524)%
====== ==== ===== =====
</TABLE>
23
<PAGE>
Nine Months Ended September 30, 1998 and 1999
Total Net Revenues
Total net revenues increased 77% from $1.7 million for the nine months ended
September 30, 1998 to $3.1 million for the nine months ended September 30,
1999.
License. License revenues increased 40% from $808,000 for the nine months
ended September 30, 1998 to $1.1 million for the nine months ended September
30, 1999. This increase is largely a result of additional Liquid Player license
fees received under an agreement with a single customer. Under this agreement,
which terminates on December 31, 1999, we received total fees of $1.5 million.
The timing of these payments was based on the delivery of a single Liquid
Player license. Upon delivery of this Liquid Player license in November 1998,
we received $1.0 million, which is being recognized ratably over the 14 months
ending December 31, 1999. We received the remaining $500,000 in May 1999, which
is being recognized ratably over the eight months ending December 31, 1999. Due
to our shift in marketing emphasis from software licensing to the delivery of
digital music services, however, revenues from licensing of our Liquifier Pro
and Liquid Server software decreased in the first nine months of 1999 compared
to the first nine months of 1998, which partially offset the increase in Liquid
Player revenues described above. After the final revenues are recognized from
the Liquid Player license described above, we expect our license revenues to
decline for at least the first and second quarters of 2000.
Services. Services revenues increased 117% from $169,000 for the nine months
ended September 30, 1998 to $367,000 for the nine months ended September 30,
1999. This increase was due to increased maintenance and hosting fees and the
addition of revenues from selling advertising and sponsorships, the Liquid Muze
Previews service and music sales in the 1999 period.
Business Development (Related Party). Business development revenues increased
109% from $750,000 for the nine months ended September 30, 1998 to $1.6 million
for the nine months ended September 30, 1999. Services fees of $500,000 and
$250,000 in the first nine months of 1998 were earned under an agreement with
our strategic partners in Korea and Japan, respectively. Of the total business
development fees in the first nine months of 1999, $583,000 were earned from
our strategic partner in Japan under a separate agreement and related to a non-
refundable fee of $1.0 million that was received and is being recognized as
services revenue ratably over the 12-month term of the related agreement,
$500,000 in services fees were earned from our strategic partner in Japan
related to the signing of a letter of intent to develop a local business in
Taiwan and Hong Kong, $372,000 were earned from Liquid Audio Korea for
consulting services fees, software licensing and equipment sales and $110,000
were from software license sales to Liquid Audio Japan.
For the nine months ended September 30, 1998, approximately 42% of total net
revenues came from sales to two customers, SK Group and Super Stage. For the
nine months ended September 30, 1999, approximately 78% of total net revenues
came from sales to three customers, Super Stage, Adaptec and Liquid Audio
Korea. International revenues represented approximately 62% and 52% of total
net revenues for the nine months ended September 30, 1998 and 1999,
respectively.
Total Cost of Net Revenues
Our gross profit decreased from approximately 80% of total net revenues for
the nine months ended September 30, 1998 to approximately 72% of total net
revenues for the nine months ended September 30, 1999.
License. Cost of license revenues primarily consists of royalties paid to
third-party technology vendors and costs of documentation, duplication and
packaging. Cost of license revenues was $175,000 for the nine months ended
September 30, 1998 and $156,000 for the nine months ended September 30, 1999, a
decrease of 11%. Cost of license revenues decreased due to product mix
differences and the cancellation of certain third-party technology licenses.
Services. Cost of services revenues primarily consists of compensation for
customer service and encoding personnel and an allocation of our occupancy
costs and other overhead. Cost of services revenues
24
<PAGE>
increased 282% from $170,000 for the nine months ended September 30, 1998 to
$649,000 for the nine months ended September 30, 1999. The increase in cost of
services revenues was due primarily to the addition of encoding and customer
service personnel.
Business Development (Related Party). Cost of business development revenues
primarily consists of equipment and royalties paid to third-party technology
vendors. Cost of business development revenues was $0 for the nine months ended
September 30, 1998 and $68,000 for the nine months ended September 30, 1999.
Operating Expenses
Sales and Marketing. Sales and marketing expenses consist primarily of
compensation for our sales, marketing and business development personnel,
advertising, trade show and other promotional costs, design and creation
expenses for marketing literature and our website and an allocation of our
occupancy costs and other overhead. Sales and marketing expenses increased 141%
from $2.7 million for the nine months ended September 30, 1998 to $6.4 million
for the nine months ended September 30, 1999. This increase was primarily due
to increases in the number of sales and marketing personnel and in our
advertising and promotional programs. The nine months ended September 30, 1999
include a $378,000 impairment loss on our investment in Liquid Audio Japan. We
expect that sales and marketing expenses will increase in future periods due to
expanded efforts to market and promote our products and services both
domestically and internationally.
Research and Development. Research and development expenses consist primarily
of compensation for our research and development, network operations and
product management personnel and payments to outside contractors and, to a
lesser extent, of depreciation on equipment used for research and development
and an allocation of our occupancy costs and other overhead. Research and
development expenses increased 189% from $2.7 million for the nine months ended
September 30, 1998 to $7.7 million for the nine months ended September 30,
1999. This increase was primarily due to increases in the number of personnel
and outside contractors needed to enhance our existing software products,
develop and enhance our online services, develop new products and services and
build our external network and computer data center infrastructure. We expect
that research and development expenses will increase in absolute dollars in
future periods due to expanded investments in the development of enhanced and
new products and online services.
General and Administrative. General and administrative expenses consist
primarily of compensation for personnel and payments to outside contractors for
general corporate functions, including finance, information systems, human
resources, facilities, legal and general management, fees for professional
services, bad debt expense and an allocation of our occupancy costs and other
overhead. General and administrative expenses increased 51% from $1.2 million
for the nine months ended September 30, 1998 to $1.7 million for the nine
months ended September 30, 1999. This increase was primarily due to increases
in the number of personnel and outside contractors needed to support the growth
of our business and professional fees. General and administrative expenses
declined as a percentage of total net revenues. We expect that general and
administrative expenses will increase in absolute dollars as we hire additional
personnel and incur additional expenses relating to the anticipated growth of
our business, such as costs associated with increased infrastructure and our
public company status.
Strategic Marketing--Equity Instruments. Strategic marketing--equity
instruments consist of expenses associated with the value of common stock and
warrants issued to partners as part of our strategic marketing agreements.
Common stock expense is based on the fair market value of our stock at the time
it was issued. Warrant expense is based on the estimated fair value of the
warrants based on the Black-Scholes option pricing model and the provisions of
EITF 96-18. Strategic marketing--equity instruments expense was $0 for the nine
months ended September 30, 1998 and $2.2 million for the nine months ended
September 30, 1999. For the nine months ended September 30, 1999, $1.1 million
relates to 100,000 shares of common stock issued to Virgin Holdings, Inc., an
affiliate of EMI Recorded Music, in exchange for the right to create digitally
encoded copies of EMI sound recordings using the Liquid Audio and Genuine mp3
formats and $95,000 relates to fully vested warrants issued to other record
companies as part of our content and distribution agreements with them.
25
<PAGE>
In June 1999, we signed an advertising agreement with Amazon.com, Inc. to
collaborate on event-based advertising using our digital delivery services. In
connection with this agreement, we issued a fully vested warrant to purchase
approximately 254,000 shares of common stock to Amazon.com. The warrant was
valued at approximately $2.0 million and is being recognized ratably over the
one-year term of the agreement; as a result, $675,000 was recognized as
strategic marketing--equity instruments expense in the nine months ended
September 30, 1999. Under the advertising agreement with Amazon.com, an
additional warrant to purchase approximately 127,000 shares of common stock
will be granted to Amazon.com and will vest over a 12-month period, if and when
we sign a definitive agreement with Amazon.com to utilize our technology for a
specific business program. These shares will be valued at the then fair market
value of our common stock, if and when a commitment for performance by
Amazon.com has been reached, or at a date when Amazon.com has performed its
contractual obligations under the agreement. In August 1999, we signed an
agreement with Yahoo! Inc. to promote the distribution of digital music on its
website. In connection with this agreement, we agreed to grant Yahoo! three
warrants totaling 250,000 shares of common stock. The first warrant for 83,334
shares vested immediately, and was valued at $903,000, which is being
recognized ratably over the one-year term of the agreement. The second warrant
for 83,333 shares vests in August 2000, and will be remeasured each quarter
until the warrant vests, based on the fair market value of our common stock at
the end of the period. At September 30, 1999, this warrant was valued at $1.9
million, which is being recognized ratably over the one-year term of the
agreement. For the nine months ended September 30, 1999, $104,000 and $216,000
were recognized as strategic marketing--equity instruments expense for the
first and second warrants, respectively. The third warrant for 83,333 shares,
which may be issued if the relationship with Yahoo! is extended beyond the
first year, would begin to vest in August 2000, at which time the warrant would
be valued.
Stock Compensation Expense. Stock compensation expense relates to stock-based
employee compensation arrangements. Stock compensation expense is based on the
difference between fair market value of our common stock and the exercise price
of options to purchase that stock on the date of the grant, and is being
recognized on an appropriate accelerated basis over the vesting periods of the
related options, usually four years. The total unearned compensation recorded
by us from inception to September 30, 1999 was $4.3 million. We recognized
$882,000 and $1.1 million of stock compensation expense for the nine months
ended September 30, 1998 and 1999. We expect quarterly amortization related to
those options to be approximately $250,000 for the fourth quarter of 1999 and
between $200,000 and $130,000 per quarter during 2000 and annual amortization
to be $330,000 during 2001 and $100,000 during 2002. These future compensation
charges would be reduced if any employee terminates employment prior to the
expiration of the employee's option vesting period.
Interest Income. Interest income consists of earnings on our cash, cash
equivalents and short-term investments. Interest income increased from $151,000
for the nine months ended September 30, 1998 to $1.2 million for the nine
months ended September 30, 1999. This increase was primarily due to interest
received on higher average cash, cash equivalent and short-term investment
balances resulting from proceeds of the initial public offering of our common
stock in July 1999.
Interest Expense. Interest expense consists of expenses related to our
financing obligations, which include borrowings under equipment loans, short-
term loans and capital lease obligations. Interest increased from $100,000 for
the nine months ended September 30, 1998 to $138,000 for the nine months ended
September 30, 1999. This increase was primarily due to higher average financing
obligation balances resulting from additional capital leases and borrowings
under our equipment loans during 1998 and 1999.
Other Income (Expense), Net. Other income (expense), net consists of expenses
related to the Japanese yen denominated loan used to fund our purchase of
shares in Liquid Audio Japan. Other income (expense), net was $0 for the nine
months ended September 30, 1998 and $48,000 for the nine months ended September
30, 1999.
26
<PAGE>
Period From January 30, 1996 (inception) Through December 31, 1996 and Years
Ended December 31, 1997 and 1998
Total Net Revenues
We had no revenues in 1996, as we were still in an early development stage.
Total net revenues increased 995% from $256,000 in 1997 to $2.8 million in
1998.
License. License revenues increased 402% from $246,000 in 1997 to $1.2
million in 1998. This increase was due to higher sales of software product
licenses, resulting from the introduction in 1998 of new versions of our
software products and expansion to international markets.
Services. Services revenues increased from $10,000 in 1997 to $268,000 in
1998. This increase was due to higher maintenance fees related to the increase
in license revenues and increased sales of hosting services, which were
introduced in November 1997.
Business Development (Related Party). Business development revenues were $0
in 1997 and $1.3 million in 1998. Business development revenues were recorded
when contracts with related parties in Korea and Japan were executed and
related contractual obligations were satisfied. Business development fees
totalling $950,000 and $250,000 were earned from our strategic partners in
Korea and Japan, respectively. For the year ended December 31, 1998, we
recognized our proportionate share (40%) of losses recorded by Liquid Audio
Korea. Our share of the equity losses amounted to $400,000, which equaled our
total investment in Liquid Audio Korea. These equity losses were offset against
the revenue earned in 1998 from our strategic partner in Korea in order to more
clearly reflect the substance of the business development transactions with our
strategic partner. Other fees of $100,000 relate to the delivery of products to
the Korean joint-venture entity.
For the year ended December 31, 1997, approximately 71% of total net revenues
came from sales to three customers, Music.co.jp, Columbia House and DreamNet.
For the year ended December 31, 1998, approximately 34% of total net revenues
came from sales to one customer, SK Group. International revenues represented
approximately 65% and 66% of total net revenues for the years ended December
31, 1997 and 1998.
Total Cost of Net Revenues
Our gross profit (loss) increased from approximately (54)% for the year ended
December 31, 1997 to approximately 80% for the year ended December 31, 1998.
Total cost of net revenues increased 41% from $393,000 in 1997 to $554,000 in
1998.
License. Cost of license revenues was $302,000 in 1997 and $310,000 in 1998,
an increase of 3%. Cost of license revenues remained relatively constant
because, while we decided not to renew certain third-party software licenses,
the resulting reductions were offset by higher royalties paid due to the
increase in license revenues in the 1999 period.
Services. Cost of services revenues was $91,000 in 1997 and $242,000 in 1998,
an increase of 166%. This increase was primarily due to the addition of
customer service and encoding personnel.
Business Development (Related Party). Cost of business development revenues
was $0 in 1997 and $2,000 in 1998.
Operating Expenses
Sales and Marketing. Sales and marketing expenses increased from $237,000 to
$2.8 million to $4.0 million for the period from January 30, 1996 (inception)
through December 31, 1996 and the years ended December 31, 1997 and 1998,
respectively. The increases from period to period were primarily due to the
addition of marketing personnel starting in the first quarter of 1998,
increased expenses associated with
27
<PAGE>
promotion and marketing efforts, and the addition of a direct sales force,
which we began building in the second half of 1997.
Research and Development. Research and development expenses increased 172%
and 119% from $692,000 to $1.9 million to $4.1 million for the period from
January 30, 1996 (inception) through December 31, 1996 and the years ended
December 31, 1997 and 1998, respectively. The increases from period to period
were primarily due to increased personnel and outside contractors needed to
enhance our existing software products, develop and enhance online services,
develop new products and services and build our external network and computer
data center infrastructure.
General and Administrative. General and administrative expenses increased
175% and 83% from $327,000 to $898,000 to $1.6 million for the period from
January 30, 1996 (inception) through December 31, 1996 and the years ended
December 31, 1997 and 1998, respectively. The increases from period to period
were primarily due to increases in the number of personnel and outside
contractors, the higher level of professional services required to support the
growth of our operations and increased infrastructure costs.
Stock Compensation Expense. We recognized $31,000, $534,000 and $1.2 million
of stock compensation expense for the period from January 30, 1996 (inception)
through December 31, 1996 and the years ended December 31, 1997 and 1998.
Interest Income. Interest income increased 421% and 203% from $24,000 to
$125,000 to $379,000 for the period from January 30, 1996 (inception) through
December 31, 1996 and the years ended December 31, 1997 and 1998, respectively.
The increases from period to period were primarily due to interest received on
higher average cash and cash equivalent balances resulting from private sales
of preferred stock in the second quarter of 1997 and the third quarter of 1998.
Interest Expense. Interest expense increased from $1,000 to $72,000 to
$140,000 for the period from January 30, 1996 (inception) through December 31,
1996 and the years ended December 31, 1997 and 1998, respectively. The
increases were primarily due to higher average financing obligation balances
resulting from borrowings under short-term loan agreements in 1997 and 1998,
additional capital leases in 1997 and 1998, and borrowings under the equipment
line of credit during 1998.
Income Taxes. At December 31, 1998, we had $13.0 million of federal and $12.9
million of state net operating loss carryforwards available to offset future
taxable income, which will expire in varying amounts beginning in 2011 and
2004, respectively. At December 31, 1998, we had $210,000 of federal and
$170,000 of state research and development credit carryforwards available to
offset future taxable income. The federal carryforwards expire in varying
amounts beginning in 2011. Under the Tax Reform Act of 1986, the amounts of and
benefits from net operating loss carryforwards may be impaired or limited in
certain circumstances. Management has estimated that the net operating loss
carryforwards from inception are currently limited to $7.5 million annually.
See note 8 of notes to financial statements.
28
<PAGE>
Quarterly Results of Operations
The following table sets forth statement of operations data for the three
months ended March 31, June 30, September 30 and December 31, 1998, and March
31, June 30 and September 30, 1999. The information for each of these quarters
has been prepared on substantially the same basis as the audited financial
statements included elsewhere in this prospectus and, in our opinion, includes
all adjustments, consisting only of normal recurring adjustments, necessary for
a fair presentation of the results of operations for these periods. Historical
results are not necessarily indicative of the results to be expected in the
future, and results of interim periods are not necessarily indicative of
results for the entire year.
<TABLE>
<CAPTION>
Three Months Ended
---------------------------------------------------------------
June Sept. Dec. June Sept.
March 31, 30, 30, 31, March 31, 30, 30,
1998 1998 1998 1998 1999 1999 1999
--------- ------- ------- ------- --------- ------- -------
(in thousands, unaudited)
<S> <C> <C> <C> <C> <C> <C> <C>
Net revenues:
License................ $ 192 $ 242 $ 374 $ 427 $ 259 $ 394 $ 476
Services............... 32 33 104 99 89 101 177
Business development
(related party)....... -- 225 525 550 183 250 1,132
------- ------- ------- ------- ------- ------- -------
Total net revenues.... 224 500 1,003 1,076 531 745 1,785
Cost of net revenues:
License................ 49 63 63 135 46 52 58
Services............... 53 47 70 72 153 172 324
Business development
(related party)....... -- -- -- 2 2 -- 66
------- ------- ------- ------- ------- ------- -------
Total cost of net
revenues............. 102 110 133 209 201 224 448
------- ------- ------- ------- ------- ------- -------
Gross profit............ 122 390 870 867 330 521 1,337
Operating expenses:
Sales and marketing.... 787 1,002 887 1,359 2,119 1,797 2,533
Research and
development........... 775 863 1,028 1,443 1,560 2,701 3,449
General and
administrative........ 278 329 548 487 502 498 741
Strategic marketing--
equity instruments.... -- -- -- -- -- 1,364 826
Stock compensation
expense............... 259 284 339 359 425 364 330
------- ------- ------- ------- ------- ------- -------
Total operating
expenses............. 2,099 2,478 2,802 3,648 4,606 6,724 7,879
------- ------- ------- ------- ------- ------- -------
Loss from operations.... (1,977) (2,088) (1,932) (2,781) (4,276) (6,203) (6,542)
Interest income......... 12 1 138 228 184 158 830
Interest expense........ (20) (46) (34) (40) (51) (32) (55)
Other income (expense),
net.................... -- -- -- -- -- 5 (53)
------- ------- ------- ------- ------- ------- -------
Net loss................ $(1,985) $(2,133) $(1,828) $(2,593) $(4,143) $(6,072) $(5,820)
======= ======= ======= ======= ======= ======= =======
</TABLE>
Our total net revenues increased in each quarter of 1998, declined in the
quarter ended March 31, 1999 and increased in subsequent quarters. The
increases in license revenues through the quarter ended December 31, 1998 were
due to higher sales of our software product licenses and sales expansion in
international markets. License revenues declined in the quarter ended March 31,
1999 due to the shift of our marketing efforts towards the development of our
digital music delivery services business. License revenues increased in the
quarters ended June 30, 1999 and September 30, 1999 due to additional license
fees under a single Liquid Player license. The increases in services revenues
through the quarter ended September 30, 1998 included consulting fees from non-
recurring projects. The decreases in services revenues from the quarter ended
September 30, 1998 to the quarter ended March 31, 1999 were due to decreases in
software maintenance revenues. The increases in services revenues in the
quarters ended June 30, 1999 and September 30, 1999 were due to increases in
hosting fees and the addition of revenues from promotion and advertising
services, Liquid
29
<PAGE>
Muze Previews service and music sales. Business development revenues fluctuated
from quarter to quarter due to the terms and conditions of the contractual
arrangements with our strategic partners in Korea and Japan. The increase in
business development revenues in the third quarter of 1999 was primarily due to
the signing of a new customer, as well as the recognition of revenues in
accordance with existing contracts.
Total cost of net revenues declined in the quarter ended June 30, 1998 and
increased in succeeding quarters through the quarter ended September 30, 1999.
Cost of license revenues fluctuated with total net revenues for the
corresponding periods and the timing of adding and terminating third-party
software licenses. Cost of services revenues has increased since June 30, 1998
primarily due to the addition of customer service and encoding personnel.
Total operating expenses have increased in each of the quarters presented
reflecting the growth of our operations. The increase in sales and marketing
expenses for the quarter ended March 31, 1999 included the write-off of our
$378,000 investment in Liquid Audio Japan.
Our quarterly and annual operating results are likely to fluctuate
significantly in the future due to a variety of factors, many of which are
outside our control. Additionally, as a result of our limited operating history
and the emerging nature of the digital delivery of recorded music market in
which we compete, it is difficult for us to forecast our revenues or earnings
accurately. Our current and future expense levels are based largely on our
investment plans and estimates of future revenues and are, to a large extent,
fixed. We may be unable to adjust spending in a timely manner to compensate for
any unexpected revenue shortfall. Any significant shortfall in revenues
relative to our planned expenditures would harm our business. Due to these
factors, our quarterly revenues and operating results are difficult to
forecast. We believe that period to period comparisons of our operating results
may not be meaningful and should not be relied upon as an indication of future
performance. In addition, it is likely that in one or more future quarters our
operating results will fall below the expectations of securities analysts and
investors. In that event, the trading price of our common stock would likely
fall. See "Risk Factors--Our Limited Operating History in the New Market of
Digital Delivery of Music Over the Internet Increases the Possibility That the
Value of Your Investment Will Decline" and "--Fluctuations in Our Quarterly
Revenues and Operating Results Might Lead to Reduced Prices for Our Stock."
Liquidity and Capital Resources
Since inception, we have financed our operations primarily through the
initial public offering of our common stock, private placements of our
preferred stock, equipment financing, lines of credit and short-term loans. As
of September 30, 1999, we had raised $65.9 million through our initial public
offering of common stock and $29.8 million through sales of our preferred stock
and had approximately $70.5 million of cash, cash equivalents and short-term
investments.
Net cash used in operating activities in the period from January 30, 1996
(inception) through December 31, 1996, the years ended December 31, 1997 and
1998 and the nine months ended September 30, 1998 and 1999 was $1.1 million,
$4.8 million, $5.8 million, $4.2 million and $9.6 million, respectively. Net
cash used for operating activities in each of these periods was primarily the
result of net losses before non-cash charges, which include strategic
marketing--equity instruments expense, amortization of unearned compensation
and equity investment losses in Liquid Audio Korea and Liquid Audio Japan,
offset by increases in deferred revenue and accrued expenses and other current
liabilities. We established an allowance for doubtful accounts based on our
estimate of customer accounts that may not be collected by us. The allowance
for doubtful accounts decreased from $231,000 at December 31, 1998 to $156,000
at September 30, 1999, representing 38% and 46% of gross accounts receivable,
respectively. This decrease in the allowance is due to a lower gross accounts
receivable balance at September 30, 1999.
Net cash used in investing activities in the period from January 30, 1996
(inception) through December 31, 1996, the years ended December 31, 1997 and
1998 and the nine months ended September 30,
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1998 and 1999 was $83,000, $319,000, $4.4 million, $1.5 million and $8.0
million, respectively. Net cash used in investing activities was related to the
acquisition of property and equipment, the purchase of short-term investments
and the equity investment in Liquid Audio Korea in 1998 and the sale of short-
term investments in the nine months ended September 30, 1999.
Net cash provided by financing activities in the period from January 30, 1996
(inception) through December 31, 1996, the years ended December 31, 1997 and
1998 and the nine months ended September 30, 1998 and 1999 was $2.0 million,
$6.6 million, $21.9 million, $21.1 million and $66.4 million, respectively. The
net cash provided by financing activities for the period from January 30, 1996
(inception) through December 31, 1996, the years ended December 31, 1997 and
1998 and the nine months ended September 30, 1998 was due primarily to the
sales of shares of our preferred stock. Net cash was also provided by
borrowings under a line of credit in 1997 that was repaid in 1998, and proceeds
from an equipment loan in 1998 and the nine months ended September 30, 1999.
The net cash provided for the nine months ended September 30, 1999 was due
primarily to the sale of our common stock in our initial public offering.
We had a bank revolving line of credit for up to $1.0 million based on 80% of
eligible accounts receivable that expired on November 15, 1999. As of September
30, 1999, we had no borrowings under the revolving line of credit. We may renew
this revolving line of credit. We had a bank equipment loan facility that
provided for advances of up to $3.0 million through November 1999. Borrowings
under the equipment loan facility are repayable in monthly installments over
three years and bear interest at the bank's prime interest rate plus 0.25%,
8.5% at September 30, 1999. Borrowings are secured by the related equipment and
other assets. Under the equipment loan facility, we had borrowed amounts
totaling $1.8 million through September 30, 1999. We also have lease financing
agreements that provide for the lease of computers and office equipment of up
to $1.0 million. As of September 30, 1999, we had borrowed $737,000 under the
lease financing agreements. Our other significant commitments consist of
obligations under non-cancelable operating leases, which totaled $880,000 as of
December 31, 1998 and are payable in monthly installments through 2002, and a
related party note in the amount of $425,000 that was issued in the three
months ended March 31, 1999. The related party note payable was issued to Super
Factory, Inc., an entity affiliated with our Japanese strategic partner, Super
Stage, is repayable in Japanese yen and bears interest at 0.5% above a Japanese
bank's prime rate (approximately 3.1% at September 30, 1999). The principal is
due on December 31, 2003, with quarterly interest payments.
For the year ended December 31, 1998, we recorded equity losses of $400,000
related to our investment in Liquid Audio Korea and, for the nine months ended
September 30, 1999, we recorded an impairment loss of $378,000 related to our
investment in Liquid Audio Japan. Although high risk in nature, we believe that
these types of investments outside of the United States are important to
establish a complementary international distribution infrastructure. In Korea,
we have partnered with the SK Group to have Liquid Audio Korea focus on kiosk-
based retail applications of our technology. These applications are intended to
allow consumers to preview and purchase compact discs and other transportable
media from retail entertainment centers. Liquid Audio Korea released these
kiosks in the first retail entertainment center in October 1999. In Japan, we
have partnered with Super Stage, Itochu, Hikari Tsushin and Hapinet to have
Liquid Audio Japan exclusively resell and distribute a Japanese version of our
software technology.
Although we have no material commitments for capital expenditures or
strategic investments, we anticipate an increase in the rate of capital
expenditures consistent with our anticipated growth in operations,
infrastructure and personnel. We anticipate that we will continue to add
computer hardware resources, deploy additional computer data centers worldwide
and expand our primary office facility during the next 12 months. We may also
use cash to acquire or license technology, products or businesses related to
our current business. In addition, we anticipate that we will continue to
experience significant growth in our operating expenses for the foreseeable
future and that our operating expenses will be a material use of our cash
resources.
We believe that the net proceeds from this offering, together with existing
cash, cash equivalents and short-term investments and financing available under
lease agreements will be sufficient to meet our anticipated
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cash needs for working capital and capital expenditures for the foreseeable
future, although we may seek to raise additional capital during that period.
The sale of additional equity or convertible debt securities could result in
additional dilution to our stockholders. There can be no assurance that
financing will be available in amounts or on terms acceptable to us, if at all.
Market Risk Disclosure
At September 30, 1999, we had an investment portfolio of cash, money market
funds, commercial securities and U.S. Government bonds, including those
classified as short-term investments, of $70.5 million. We had a related party
loan outstanding at September 30, 1999 of $425,000, which was denominated in
Japanese yen and bore interest at 3.1%. These instruments, like all fixed
income instruments, are subject to interest rate risk. The fixed income
portfolio will fall in value and the related party note payable interest would
increase if there were an increase in interest rates. If market interest rates
were to increase immediately and uniformly by 10% from levels as of December
31, 1998 and September 30, 1999, the decline of the fair value of the fixed
income portfolio and related party note payable would not be material. See
notes 1 and 2 of notes to financial statements.
Recent Accounting Pronouncements
In March 1998, the Accounting Standards Executive Committee of the American
Institute of Certified Public Accountants (AICPA) issued Statement of Position
98-1, "Accounting for the Costs of Computer Software Developed or Obtained for
Internal Use" (SOP 98-1). SOP 98-1 requires all costs related to the
development of internal use software other than those incurred during the
application development stage to be expensed as incurred. Costs incurred during
the application development stage are required to be capitalized and amortized
over the estimated useful life of the software. SOP 98-1 is effective for our
fiscal year ending December 31, 1999. We do not expect its adoption to have a
material effect on our financial statements.
In June 1998, the Financial Accounting Standards Board (FASB) issued
Statement of Financial Accounting Standards No. 133, "Accounting for Derivative
Instruments and Hedging Activities" (SFAS No. 133). SFAS No. 133 is effective
for fiscal years beginning after June 15, 1999. SFAS No. 133 requires that all
derivative instruments be recorded on the balance sheet at their fair value.
Changes in the fair value of derivatives are recorded each period in current
earnings or other comprehensive income, depending on whether a derivative is
designed as part of a hedge transaction and, if so, the type of hedge
transaction. We do not expect that the adoption of SFAS No. 133 will have a
material effect on our financial statements.
In December 1998, the AICPA issued Statement of Position 98-9, "Modification
of SOP 97-2, Software Revenue Recognition, with Respect to Certain
Transactions" (SOP 98-9). SOP 98-9 amends certain elements of SOP 97-2 and
provides additional authoritative guidance on software revenue recognition. SOP
98-9 is effective for fiscal years beginning after March 15, 1999. We do not
expect its adoption to have a material effect on our financial statements. See
note 1 of notes to financial statements.
Year 2000 Compliance
Many currently installed computer systems and software products worldwide are
coded to accept only two-digit entries to identify a year in the date code
field. Consequently, on January 1, 2000, many of these systems could fail or
malfunction because they are not able to distinguish between the year 1900 and
the year 2000. Accordingly, many companies, including ourselves and our
customers, potential customers, vendors and strategic partners, may need to
upgrade their systems to comply with applicable year 2000 requirements.
Because we and our customers depend, to a very substantial degree, upon the
proper functioning of computer systems, a failure of these systems to correctly
recognize dates beyond January 1, 2000 could disrupt operations. Any
disruptions could harm our business. Additionally, our failure to provide year
2000 compliant solutions to our customers could result in financial loss,
reputational harm and legal liability to us. We believe that our products and
services are year 2000 compliant; however, our products and services are often
integrated with other systems that may not be compliant.
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In 1998, we formed a year 2000 assessment and contingency planning committee
to review both our information technology systems and our non-information
technology systems, and where necessary to plan for and supervise the
remediation of those systems. The committee is headed by our Chief Technology
Officer. We believe the committee has identified all of our critical hardware
and software systems. The providers of these systems have confirmed that they
are year 2000 compliant. We have conducted tests and expect to conduct
additional tests of these systems as part of our year 2000 efforts.
We have contacted our significant vendors to determine the extent to which
they are vulnerable to year 2000 issues. Based on the information that we have
received from these vendors, we do not believe that they will be vulnerable to
year 2000 issues.
We estimate that our cost to become year 2000 compliant has been $150,000,
and we believe that any additional costs related to becoming year 2000
compliant will not be material.
We have not made a full assessment of the extent to which our customers might
be vulnerable to year 2000 issues. Likewise, we have not made a full assessment
of the extent to which other third parties with which we transact business have
determined their vulnerability to year 2000 issues.
We are developing contingency plans for critical individual information
technology systems and non-information technology systems to address year 2000
risks not fully resolved by our year 2000 program. We believe that the year
2000 risk will not present significant operational problems for us. However,
there can be no assurance that our year 2000 program will prevent any harm to
our business.
If our Year 2000 program is inadequate and our business operations are
materially impacted, we could incur additional costs to recover any lost
information and replace affected systems. We believe that these systems could
be replaced without significant difficulty as replacement systems are generally
available on commercially reasonable terms. We also have regular data back-up
procedures that would assist in the recovery of lost business information.
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BUSINESS
We provide a leading open platform that enables the digital delivery of music
over the Internet. Our software products and services give artists, record
companies, websites and retailers the ability to create, syndicate and sell
recorded music with copy protection and copyright management. Through our
Liquid Music Network website affiliates, we help artists and record companies
promote and sell their recorded music. From our growing catalog of syndicated
music, consumers can preview and purchase digital music. Consumers then can
transfer downloaded music to recordable compact discs and to digital consumer
devices following release by consumer electronics manufacturers. Our solution
is based on an open technical architecture that is designed to support multiple
leading digital music formats, including mp3 and Dolby AC-3. Numerous record
companies and recording artists have used our platform to promote music
releases including Atlantic Records, BMG North America, Capitol Records,
Columbia House, Dreamworks Records, EMI Music Group, Epic Records, Mammoth
Records, Rounder Records, Tommy Boy Records, Warner Music Group, Tori Amos,
David Bowie, Bruce Hornsby, The Dave Matthews Band, Sarah McLachlan and Alanis
Morissette.
Industry Background
The Recorded Music Industry
The recorded music industry represents one of the largest opportunities for
online digital delivery and commerce. According to the International Federation
of the Phonographic Industry (IFPI), worldwide recorded music sales represented
a $38.7 billion market in 1998. The United States music industry, which
represents nearly one-third of worldwide recorded music sales, encompasses more
than 200,000 professional musicians, 7,500 record labels, 100 distributors,
4,000 independent retailers and millions of consumers. The recorded music
industry has operated under the same basic business model for many years.
Typically, record companies sign artists to exclusive contracts under which the
record companies develop and promote artists' music. The companies then sell
this recorded music through wholesale and retail distribution channels to
consumers. In addition, there are millions of amateur musicians who do not have
access to distribution through traditional channels.
The Major Labels. Five major global record companies--BMG Entertainment, EMI
Music, Sony Corporation, Universal Music Group and Warner Communications Inc.--
and their numerous affiliated labels account for more than 80% of all recorded
music sales worldwide. Each of these companies is organized worldwide on a
geographic basis, with each local subsidiary having control over distribution
within its territory. These companies invest significant resources in
infrastructure to support their operations. They are vertically integrated and
operate recording, manufacturing, distribution, warehousing, and sales and
marketing organizations.
Each of the major record companies signs and introduces only a small number
of new artists each year. New artists are generally required to sign exclusive,
long-term agreements that do not obligate the record company to release any
records. In return, artists receive a royalty, typically based on a percentage
of the suggested retail list price of a record, but only after the record
company recoups production costs and other advances. For new artists in the
United States, this royalty generally ranges from 7% to 12%. Record companies
engage in large-scale promotional and marketing programs that utilize local
offices and staff in major cities to coordinate these programs through radio,
television and other traditional media. Each of these companies supports
multiple manufacturing plants, distribution centers and warehouses and uses
ground transportation to ship recorded music to retailers and wholesalers.
Independent Labels and Artists. In addition to the five major record
companies, there are thousands of independent record companies. Some of the
better-known independent labels are Beggars Banquet, Platinum Entertainment,
Rounder Records and Rykodisc. These independent labels account for a large
portion of the
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sound recordings published each year in the United States, and represent a
rapidly growing revenue segment of the United States recorded music industry.
These companies differ significantly from the major record companies in a
number of ways, including:
. they usually pay higher royalties to artists and offer shorter-term
recording agreements;
. they have more limited capital resources available for recording,
manufacturing and promotion costs; and
. they find national distribution difficult to obtain and expensive when
available.
The inherent difficulties and costs associated with this model have caused
many independent record companies to begin marketing programs to sell recorded
music directly to consumers. One notable example is The Artist Formerly Known
As Prince, who markets his recordings on his own label through his website and
through independent distributors.
Traditional Retail Distribution and Sales. The distribution channels for and
the retail sales of recorded music are becoming concentrated due to increased
competition and consolidation. Retail sales are primarily "hit" driven, with a
small number of titles accounting for the majority of retail sales in most
periods. In addition, in order to offer consumers a wide variety of music,
retailers bear the infrastructure costs necessary to stock recordings that are
not currently hits, known as catalog recordings. Current hits and catalog
recordings sold through retail stores represent only a small fraction of all
recorded music. In addition, distributors of recorded music are subject to
territorial restrictions, which limit the countries in which they can
distribute and sell.
The Recorded Music Industry and the Internet
The Internet presents a significant opportunity for the rapid and cost-
effective distribution, promotion and sale of recorded music. Music is one of
the most popular topics on the Internet as reflected by the increasing number
of music-related websites and the growth of online sales of compact discs. To
date, online recorded music sales have occurred primarily through the purchase
of compact discs through online retailers. Forrester Research expects online
vendors such as Amazon.com Inc. and CDnow Inc. to drive total online sales of
compact discs in the United States from an estimated $890 million in 1999 to an
estimated $6.7 billion in 2003. These online retailers generally do not take
physical custody of recordings, but rather refer their orders to fulfillment
houses that are responsible for shipping the compact discs to customers. The
popularity of online buying is also forcing traditional retailers to sell
recorded music using the Internet, either through their own websites or in the
future through in-store kiosks.
Advances in digital compression technologies now allow the transmission of
near-compact disc quality audio over the Internet. Due to the size of the
transmitted files, most digital music transmitted to date has been song samples
used by online retailers to allow shoppers to preview music. More recently,
however, many websites have begun to offer "full length," three to four minute,
single music recordings for transmission and storage in compressed formats.
Several audio compression standards are currently used, including AAC, AC-3 and
mp3. To date, most digital music downloads have been promotional in nature.
Recorded music sales delivered through digital transmission have been minimal,
but are expected to reach 7% of all United States recorded music sales by 2003,
according to Forrester Research. Several manufacturers have introduced or
announced plans to introduce portable devices, such as the Rio from Diamond
Multimedia and the Lyra from Thomson Consumer Electronics, that will play
downloaded digital music.
Challenges of Digital Music Delivery and Commerce over the Internet
Music consumers increasingly want both to hear recorded music in real time on
their computers and to store these recordings for later playback on portable
devices as well as computers. But, as downloading music from the Internet has
become increasingly popular, music content copyright owners, including the
major record
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companies, have expressed concerns about unauthorized copying, or "pirating,"
of copyrighted sound recordings. Many compression technologies, including the
basic mp3 standard specification, lack copy protection. This can result in the
unauthorized downloading and replication of digital music. The major recording
industry association, the Recording Industry Association of America (RIAA), has
formed a committee, the Secure Digital Music Initiative (SDMI), to propose a
standard for the secure digital distribution and use of recorded music.
The e-commerce market for downloadable recorded music is just emerging and
there is limited availability of digital music on the Internet. The major
record companies to date have engaged only in limited efforts to sell recorded
music through digital transmission. The Internet as a commerce medium presents
several challenges to the record companies, including the ability to comply
with geographical territorial restrictions and copyright and trading concerns.
Most artists, restricted by their existing contracts with record companies,
have not been able to take advantage of selling their music over the Internet
directly to consumers. Retailers have had success selling compact discs online,
but have not had a way to integrate the sale of digital recorded music into
existing online stores.
We believe that there is a need for a comprehensive solution to create,
syndicate and sell music over the Internet. This solution must address the
following:
. Systems Optimized for Music Creation. Systems for encoding digital music
recordings must be easy to use, capable of being integrated into the
creative tools that recording producers use every day, create high
fidelity recordings, and be scalable--capable of encoding a significant
volume of material in a relatively short time.
. Copy Protection and Copyright Management. Systems must provide the
ability to limit and track the number of copies made of a particular
sound recording. A successful system must also have utilities for
cataloging, auditing and reporting sales and uses in a manner that is
consistent with existing industry practices. In addition, it must be
capable of distinguishing and reporting purchasers based on their
geographic location.
. Syndication. Systems must have an open architecture that will allow for a
large number of retailers and websites to easily integrate and offer a
large number of digital music recordings for promotion and sale.
. Standards-based. Systems must be compatible with existing technical
standards and be adaptable to emerging industry standards for the secure
digital delivery of music.
. Consumer Experience. Systems must provide consumers with a large variety
of digital music that is high fidelity and easy to acquire, catalog,
access and transfer to personal devices such as stand-alone players.
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The Liquid Audio Solution
We provide a leading open platform for the digital delivery of music over the
Internet. Our products and services enable the creation, syndication and sale
of digital recorded music through an open technical architecture that is
designed to support leading standards and formats. Our solutions enable
artists, record companies, music websites and retailers to promote and sell
high quality digital recorded music, while providing copy protection, copyright
management, syndication and e-commerce services. Our products and services give
consumers easy access to a large and growing volume of digital recorded music
that is high fidelity and accessible through a variety of sources, including
personal computers and portable devices.
The Liquid Audio Platform
[Graphic depicting our platform]
We provide a variety of products and services to enable the creation and
publication, syndication, and promotion and sale of downloadable digital music
over the Internet:
. Creation and Publication. We offer software tools to encode digital
music, and services that can encode up to approximately 20,000 individual
music samples per day. We also offer server software that hosts and
distributes encoded music files.
. Syndication. Our delivery service, the Liquid Music Network, makes
syndicated music content available to websites, including websites
operated by music retailers. We also offer Internet hosting services for
artists and record labels. In addition, we are developing software
applications to enable digital music delivery through kiosks located in
retail stores.
. Promotion and Sale. We offer server software and services to manage the
secure transfer and sale of digital music and report and audit digital
music sales. Our Liquid Player software, a desktop software application,
also allows the consumer to preview or purchase and download digital
recorded music. Our next version of the Liquid Player, targeted for final
release in December 1999, will enable the output of digital music to
portable consumer devices. We also provide a set of e-commerce services,
including credit card processing, the remittance of royalty payments and
detailed transaction reports.
Our solution provides the following benefits:
. Superior Consumer Experience. Our solution enables consumers to purchase
and download a wide variety of near compact-disc quality music online. We
make it simple to search for, sample and buy selected digital recorded
music from a rapidly growing inventory. Our Liquid Player also enables
digital music to be transferred to a compact disc by means of a
recordable compact disc device.
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. Global Reach. Our platform allows the Internet to be used as a global
distribution channel for artists, record companies and retailers. This is
particularly significant to independent record labels and amateur
musicians who have limited access to traditional retail distribution
channels.
. Increased Revenues and Lower Costs. Through our solution, record
companies and artists can generate increased revenues by offering their
entire catalog of existing music as well as singles and periodic
releases. Our products and services provide a cost-effective way to
digitally offer entire music catalogs to consumers by reducing the costs
associated with physical manufacturing, warehousing and shipping.
. Security and Compliance. Our platform protects against piracy by
authenticating, limiting and tracking the number of copies made of a
digitally delivered sound recording. Our platform also enables the sale
over the Internet of digital recorded music in compliance with geographic
distribution limitations.
Strategy
Our objective is to be the leading open platform for the creation,
syndication and sale of digital recorded music on the Internet. We seek to
achieve this objective through the following key strategies:
Provide a Superior Consumer Experience. In order to facilitate and promote
consumer adoption of digital music delivered over the Internet, we plan to
continue to improve the consumer experience. We are pioneers in providing music
consumers with a media rich music experience. Our Liquid Player not only
provides high quality audio delivery but also offers consumers music
information such as song lyrics, album liner notes and graphics. We believe
that by continuing to improve music search capabilities, we will enhance the
consumer experience and increase digital recorded music sales.
Continue to Broaden our Distribution Reach. We intend to expand our
distribution capabilities to reach greater numbers of consumers and to increase
the number of digital music purchase transactions. Since its launch in July
1998, the Liquid Music Network has grown to encompass more than 300 music-
related and music retailer websites. To enhance our ability to attract more
music content, we will continue to broaden this effort to music-related and
other websites that use our technology for digital distribution. We also have
agreements with strategic partners to distribute our Liquid Player with their
products.
Expand Syndicated Music Content. We plan to increase the amount of music
content available through our delivery services to stimulate demand for digital
music by consumers and to further increase the number of digital music purchase
transactions. Currently, there are more than 1.6 million individual songs and
song samples that have been encoded using our technology and are available
through our Liquid Music Network and our Liquid Muze Previews service for
streaming or downloading. This compares to approximately 50,000 at the
beginning of 1999. We also offer a variety of hosting and software licensing
packages in order to provide content owners flexibility in the ways they make
their content available to consumers.
Leverage Strategic Industry Relationships. We have established strategic
relationships with a variety of partners including software and computer
hardware vendors, music copyright societies, entertainment and media companies,
consumer electronics manufacturers and music-oriented website companies. We
have also assembled an experienced management team with strong relationships in
the traditional music industry.
We intend to leverage our relationships to achieve a variety of goals
including:
. maximizing the distribution and adoption of our platform;
. solidifying our position as the technology leader in digital delivery of
music;
. acquiring premium content for syndication; and
. developing international markets.
Extend Technology Leadership. We intend to play a leadership role in
developing standards that will shape the digital music industry. We believe
that we are the first to market a comprehensive solution for digital music
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delivery, and our software products are already in their fourth generation of
commercial release. In accordance with our strategy, we have taken an active
role in SDMI, and are leaders in the Genuine Music coalition.
Generate Multiple Revenue Streams. We believe that we can leverage our market
penetration, technology leadership and industry position to diversify our
revenue base. We believe that the potential market for digital music delivery
over the Internet is substantial, and will present multiple revenue
opportunities for the leading companies. In early 1999, we increased our
emphasis on digital delivery services in order to take advantage of these
opportunities, leveraging our software licensing business. We anticipate
increasing the percentage of our revenues generated from multiple sources in
the future, including digital recorded music sales, hosting services and
advertising and sponsorship revenues.
Strategic Relationships and Customers
We currently have relationships in four principal areas: music syndication;
player distribution; technology and international.
Music Syndication Relationships. We plan to continue to build relationships
with key third parties engaged in the distribution, promotion and syndication
of digital music. We believe that these relationships will enhance our ability
to provide a rich variety of music to consumers.
. Amazon.com. In June 1999, we entered into an advertising agreement with
Amazon.com. Under that agreement, we are collaborating with Amazon.com on
event-based advertising using our digital delivery services and providing
promotional music downloads for Amazon.com's music website.
[Graphic of screen shot Amazon.com website]
. BMG Entertainment. In November 1999, we entered into a digital music
distribution agreement with BMG Entertainment whereby BMG will utilize
Liquid Audio's technology and distribution services to promote and sell
songs from BMG's recording artists through music destination sites and
retail sites within the Liquid Music Network.
. CDnow. We have entered into an agreement with CDnow to provide digital
delivery of music titles for promotion and sale to consumers through its
online retail website, cdnow.com. Through our Liquid Music Network, we
will enable the website to offer for sale syndicated music content.
. EMI Recorded Music. In June 1999, we entered into a letter agreement with
Virgin Holdings, Inc., an affiliate of EMI Recorded Music. Under this
agreement, we are granted the right, for a period of 3 years, to create
digitally encoded copies of designated EMI sound recordings using the
Liquid Audio and Genuine mp3 formats. We are in the process of encoding
these designated EMI sound recordings.
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. Muze Inc. We are collaborating with Muze Inc. to jointly market and
operate the Liquid Muze Previews service. The Liquid Muze Previews
service offers online music retailers a database of more than 1.6 million
sample audio clips to enhance the promotion and sale of music. We
launched the Liquid Muze Previews service in the second quarter of 1999.
. Towerrecords.com. We have entered into an agreement with MTS, Inc., the
parent company of Tower Records, to provide digital delivery of music
titles for promotion and sale to consumers through its online retail
website, towerrecords.com. Through our Liquid Music Network, the
Towerrecords.com website began offering for sale syndicated music content
in October 1999.
[Graphic of screen shot TowerRecords.com website]
. Virgin JamCast. We have entered into an agreement with Virgin JamCast to
provide digital delivery of music titles for promotion and sale to
consumers through its online retail website, virginjamcast.com. Through
our Liquid Music Network, the website began offering for sale syndicated
music content in November 1999.
. Yahoo! We have entered into an agreement with Yahoo! Inc. to provide our
full catalog of syndicated music to the Yahoo! Digital website. Music
fans visiting the Yahoo! Digital website are able to preview, purchase
and download our syndicated music catalog. Yahoo! has also integrated
audio samples from our Liquid Muze Previews service on the Yahoo!
Shopping and Yahoo! Music websites.
In addition, many independent record labels have chosen to make their
catalogs available using our solution, including Beggars Banquet, Del-Fi
Records, Rounder Records, Sub Pop Records, Twin/Tone Records and Vanguard
Records. As of October 31, 1999, record labels have chosen to promote and sell
more than 50,000 digital music recordings through our Liquid Music Network and,
once available, to music retailer websites. This compares to approximately
5,000 digital music recordings at the beginning of 1999.
Player Distribution Relationships. We have entered into several strategic
relationships to promote the distribution of our Liquid Player software.
Companies that have agreed to distribute our Liquid Player with certain of
their product lines include Intel and Iomega.
. Intel. We are working with Intel to distribute our Liquid Player software
to members of the Intel WebOutfitter Service, which enables Pentium(R)
III processor-based personal computer owners to access the latest
Internet plug-ins and applications. Our Liquid Player is included on the
Intel WebOutfitter Service tool kit compact disc that is delivered to
Pentium III processor-based owners that join the service.
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. Iomega. We are collaborating with Iomega to offer consumers a way to
securely download music from the Internet directly onto Iomega's Zip(R)
disks. As part of this initiative, Iomega bundles the Liquid Music Player
with selected Zip drives.
Technology Relationships. We have established relationships with many of the
companies providing innovative technologies for the distribution of digitally
recorded music. These include the following:
. Dolby Laboratories Inc. and Fraunhofer Institut. We have licensed Dolby's
AC-3 and Fraunhofer's AAC and mp3 audio compression technologies. These
technologies are used in our Liquifier Pro, Liquid Server and Liquid
Player products.
. RealNetworks Inc. We have developed software "plug-ins" that enable
RealNetwork's RealPlayer G2 and RealJukebox software to play music
encoded in our format. The plug-ins, which are distributed by
RealNetworks, enable syndicated music in our Liquid Music Network to be
previewed by RealPlayer G2 users and securely downloaded by RealJukebox
users.
. Texas Instruments Inc. We collaborated with Texas Instruments to develop
a reference design based on our SP3 specification for secure music
delivery. Texas Instruments uses our SP3 reference design in chipsets to
enable future flash memory-based consumer electronics devices to be
compatible with our platform.
. Portable Digital Music Devices. We are collaborating with the following
companies to develop portable digital music playback devices that
interoperate with our SP3 specification:
<TABLE>
<S> <C>
Digitalw@y Company, Ltd. RHAS TEL Company, Ltd.
e.Digital Corporation Saewon Telecom Ltd.
Haitai Electronics Co., Ltd. Sanyo Corporation
Jungmyung Telecom Toshiba Corporation
</TABLE>
We are also collaborating with Sony to integrate Open MG/Memory Stick Walkman
with our SP3 specification.
International Relationships. We believe that relationships with key partners
outside the United States are important to establish a complementary
international distribution infrastructure. Because personal computers have not
achieved high levels of penetration in most international markets, our emphasis
in these markets has been and will continue to be on enabling the distribution
of digital music through physical kiosks and other consumer-oriented
technologies. In Korea, Liquid Audio and the SK Group have established Liquid
Audio Korea. Liquid Audio Korea is currently focused on kiosk-based retail
applications of our technology. These applications allow consumers to preview
and purchase compact discs and other transportable media from retail
entertainment centers. Liquid Audio Korea released these kiosks in the first
retail entertainment center in October 1999. In Japan, along with Super Stage,
Itochu, Hikari Tsushin and Hapinet, we have established Liquid Audio Japan.
Liquid Audio Japan is the exclusive reseller and distributor of our software
products in Japan. We plan to expand Liquid Audio Japan's operations to include
music distribution services in Japan. We are in the process of establishing a
partnership for Hong Kong and Taiwan. We expect this partnership to be the
exclusive reseller of our software products and the music distribution services
provider in those local markets.
Customers. We license our software products and offer services to a variety
of customers from various market segments. A selected list of our customers
includes the following, each of which accounted for more than $10,000 of our
revenues for the nine months ended September 30, 1999:
<TABLE>
<S> <C>
Avanti Communications EMI Music Distribution
BMG North America Etown.com
Cell Ventures Fastband
The Content Group Nonstop Music
Earful of Books Web Music Company
</TABLE>
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In 1997, Music.co.jp, Columbia House and DreamNet accounted for 49%, 12% and
10% of our total net revenues, respectively. In 1998, SK Group accounted for
34% of our total net revenues. In the first nine months of 1999, Super Stage,
Adaptec and Liquid Audio Korea accounted for 35%, 31% and 12% of our total net
revenues, respectively.
Promotional Relationships. Numerous recording artists and record labels have
used our products and services to promote new releases and create consumer
awareness. These mutually beneficial promotional efforts have generated little
or no direct revenue for us, individually or in the aggregate. The following
table represents a partial list of artists and record labels for whom we have
provided promotional services:
Record Labels
- --------------------------------------------------------------------------------
<TABLE>
<S> <C> <C>
Alligator Records Almo Records Angel Records
Arista Records Inc. Atlantic Records Atomic Pop
Aware Records Beyond Records Blue Note Records
Capitol Records Dreamworks Records Elektra Records
EMI Christian Epic Records Fuel 2000 Records
Geffen Records Giant/Revolution Hollywood Records
Interscope Records Island Records LaFace Records
Lightyear Entertainment Mammoth Records Maverick Records
MCA Records Navarre Distribution RCA Records
Reprise Records Rhino Records Rounder Records
Smithsonian Folkways Tommy Boy Records TVT Records
V2 Records Virgin Classics Warner Records
Windham Hill Records Wind-up Entertainment 32 Jazz
- -------------------------------------------------------------------------------------------
Recording Artists
- -------------------------------------------------------------------------------------------
Alanis Morissette Alison Krauss and Union Station Beck
Beth Orton Brian Setzer Orchestra Bruce Hornsby
Carlos Santana Crash Test Dummies Creed
Crosby, Stills, Nash &
Young Dar Williams The Dave Matthews Band
David Bowie Duran Duran Elton John
Emmylou Harris Essence Faith Hill
Fastball Herbie Hancock Hole
Jesus and Mary Chain Jimi Hendrix Julian Lennon
Kenny G Natalie Merchant Primus
Queen Rage Against the Machine Sarah McLachlan
Tori Amos Yes
</TABLE>
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Products and Services
Our platform includes a suite of software products and services that enable
the secure digital delivery and sale of recorded music over the Internet. Our
products and services can be represented graphically as follows:
[GRAPHIC OF LIQUID OPERATIONS CENTER]
Create and Publish
Liquifier Pro. This product is an audio mastering and encoding software tool
that enables the user to encode and publish music files for distribution on the
Internet. Our Liquifier Pro software is also used to set rules by which the
content can be used by consumers. It utilizes security features, including
encryption and watermarking, in order to provide copy protection. Our Liquifier
Pro software also enables the user to attach descriptive text, such as lyrics
or album liner notes, graphics such as compact disc cover art, and copyright
information to the music file. We include Liquifier Pro Software with various
hosted service offerings.
Encoding Services. These services prepare music for publishing through our
Liquid Server for artists and record companies that do not license our
Liquifier Pro software. These are scalable services and we have developed an
automated high capacity encoding production service that is currently able to
encode up to approximately 20,000 individual sample sound recordings per day.
Liquid Server. Our Liquid Server software manages and delivers encoded music
files for streaming or downloading. We have built transaction, security and
copyright management functionality into the Liquid Server. Users can integrate
this product with a variety of e-commerce and database software applications so
that a large volume of digital music and associated information can be securely
sold or distributed through the
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Internet. Licenses for our Liquid Server start at $10,000 and are priced based
on the number of concurrent streams licensed and digital music "tracks"
available for sale.
Liquid Hosting Services. Through our Liquid Platinum Program, we can store
and serve digital music for both professional and amateur recording artists and
labels. Artists can use our service to feature music links on their websites
and sell music without buying our software products. Since launching these
services in December 1997, more than 6,000 artists have used our hosting
services. These artists have made more than 50,000 songs available for
downloading through the Liquid Music Network and their own websites.
Syndicate
Liquid Music Network (LMN). The LMN, launched in July 1998, is a distributed
music network of more than 300 music-related and music retailer websites. The
LMN provides the music-related websites with a ready-made online music store
through which consumers can preview, purchase and download digital recorded
music. LMN participants sign up for the service and add hyperlinks to their
home page to begin selling digital music. Our LMN music-related website
affiliates include Atomic Pop, The Ultimate Band List, Towerrecords.com, Virgin
JamCast and Yahoo! Digital. The LMN provides music retailer websites with the
ability to sell our syndicated music catalog through their existing e-commerce
websites. Retailer participants may choose any of the music titles encoded in
our Liquid Music format.
Kiosks. We provide retailers with the ability to digitally deliver music
using the Liquid Audio platform through in-store physical kiosks located in
entertainment centers or other retail locations. With our partners in Korea, we
developed Total Music Centers where consumers can preview music through
individual kiosks and then purchase songs which can be transferred on-site to a
compact disc. The first Total Music Center opened in Korea in October 1999.
Promote and Sell
Liquid Player. Our Liquid Player is a consumer desktop software application
that communicates with our Liquid Server to manage playback streaming, display
data in the media fields, and manage the downloading of music content. Once
content is downloaded, our Liquid Player can be used to organize the content
into playlists for listening from the computer, to transfer the digital music
to a recordable compact disc or, in the future, to output to other consumer
electronics devices for later playback. Our Liquid Player can be downloaded
free of charge from our website and currently is distributed by a number of
third parties either in combination with their own products or as downloads
from their websites.
Liquid Muze Previews. The Liquid Muze Previews service assists retailers in
promoting and selling both physical compact discs and digital downloads by
providing a comprehensive database of sample music recordings. Retailers and
music sites are also able to offer digital music samples provided by the Liquid
Muze Previews service to let customers preview and learn about music and
potentially transform browsers into buyers.
Liquid Promotions. Liquid Promotions are event-based, Internet music
marketing and promotional services that help build awareness of artists and
increase consumer traffic to retail and music sites. Liquid Promotions include
Internet advertisements, promotional Internet events such as Liquid Live
performances and featured placement of artists' music on hundreds of websites.
Liquid Operations Center (LOC). The LOC operates primarily as a security and
copyright management center. The LOC issues digital certificates for our Liquid
Server and our Liquid Player so that both of these pieces of software can be
used to deliver music securely. In addition, the LOC is in direct communication
with every Liquid Server and transmits streaming, downloading and purchase
information through tamper-resistant logs. This information is used for
commerce management and to generate reports and invoices for the appropriate
copyright owners.
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Standards
We believe that a successful solution for digital music commerce must
incorporate technical and industry standards. We have participated in or are
leading standard-setting initiatives.
Secure Digital Music Initiative (SDMI). The SDMI is sponsored by the RIAA to
develop an open standard for the secure digital delivery and use of recorded
music. Over 200 companies are participating in this effort. To date, this
effort has focused on requirements for consumer portable music devices, such as
the Diamond Rio hand-held player. We are actively participating in these
efforts, and our Chief Technical Officer has been active as a technical editor.
Genuine Music. We have led an industry initiative to develop a standard for
an open form of the mp3 format that supports authentication functions. These
functions will protect consumers by providing visual confirmation that
downloaded mp3 or other digitally recorded music files are authentic. Digitally
recorded music formatted in this manner will play on all standard mp3 players
and will additionally contain information identifying the copyright owner and
the encoder. The copyright owner can also provide Internet links for additional
promotions. These features are not found in standard mp3 files. This initiative
has received support from 48 other companies, including mp3.com, Diamond
Multimedia, MediaOne Group, Inc. and Fraunhofer Institut.
Rights Reporting Organizations. A major portion of worldwide music industry
revenues is based on the reporting of sales and music performance information.
For example, the individuals and companies that administer the copyrights in
musical compositions receive payment each time a composition is publicly
performed. These individuals and companies believe that both the delivery of a
streaming digital music file and the downloading of a digital music file are
"performances" entitling them to receive a payment. These companies are
represented by several international rights reporting organizations. We are
engaged in the following initiatives with these organizations to simplify
rights information reporting:
. United States. ASCAP, BMI and SESAC--We have entered into agreements with
the American Society of Composers, Authors and Publishers, Broadcast
Music Incorporated and SESAC, the major rights reporting organizations in
the United States. Under each of these agreements, we have developed
technology to provide information regarding digital music delivered using
our products. This technology will enable the accurate payment of fees
based on Internet transmissions. We are also conducting a trial of
digital watermarking technologies with BMI.
. Europe. Imprimatur project--The Imprimatur project is an effort by the
major rights reporting organizations in Europe to integrate standardized
reporting efforts in a common data reporting format. We are providing
technology for the infrastructure for this effort focused on the
MusicTrial.com initiative website.
Secure Portable Player Protocol (SP3). Our SP3 initiative is intended to
provide an open technical architecture and reference specification for portable
digital music playback devices that satisfy music industry and technology
industry requirements. Any SP3-compatible digital music would be able to be
played on any compliant device while unauthorized copies would not be able to
be played. We are colloborating with Texas Instruments on a reference design
for a consumer playback device based on this specification. We are also
collaborating with Fraunhofer, the developer of the leading digital audio
encoder and encoding technology, on the specifications for the SP3 standard.
Technology
We have developed a technology base that is designed to optimize the digital
delivery of music. Our architecture is based on four principal technology
layers: component technologies, system technologies, network services and
content syndication. We have developed technology in all of these layers to
provide specific advantages for our music delivery products and services. The
implementation of our component and system
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<PAGE>
technologies enables us to provide our network services and content syndication
offerings. Our network services include the LOC and processing and rights
reporting. Our content syndication services encompass the LMN and kiosks. We
have invested significant amounts toward research and development to date. Our
expenses in this area totaled approximately $692,000, $1.9 million, $3.1
million and $7.7 million in the period from January 30, 1996 (inception)
through December 31, 1996, the years ended December 31, 1997 and 1998, and the
nine months ended September 30, 1999, respectively.
The Liquid Audio Architecture
[Graphic depicting our architecture.]
CONTENT SYNDICATION
NETWORK SERVICES
SYSTEM TECHNOLOGIES
Open Interfaces
Secure Protocols
Territory Restrictions
Device Interfaces
Digital Rights
Managemenet
COMPONENT TECHNOLOGIES
Compression (AC-3, AAC, MP3)
Liquid Audio Watermarking
Multi-Format Media
Container
Component Technologies. Our architecture begins with component technologies,
which include watermarking, audio compression and a multi-format distribution
container.
. Watermarking. Watermarking embeds indelible and inaudible digital
information into the audio waveform. We have developed our own
watermarking technology that is specifically designed to operate in
conjunction with compression technologies. The embedded information is
useful for identifying and tracking audio usage and cannot be removed
without destroying the recorded music.
. Audio Compression. Audio compression reduces the bandwidth required to
stream and download music over network connections. We have developed a
version of Dolby Digital technology (AC-3) that is optimized for online
music distribution. We have also implemented the AAC audio compression
technology, to which we have added extensions that further improve audio
quality. In addition, we have developed an exclusive, proprietary
lossless compression algorithm that is useful for professional audio
applications.
. Multi-format Distribution Container. We have developed a master media
container format that facilitates the delivery of media throughout our
system. This container structure is designed to permit extension to other
media types such as video. The container is optimized for music
distribution and includes multiple images that can be used to preview and
purchase media content in multiple formats and at multiple resolutions.
The multi-format nature of the container also facilitates compatibility
across systems.
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<PAGE>
System Technologies. Our system technologies build on top of the base
features provided through our component technologies to enable our digital
music delivery services.
. Open Interfaces. We have developed interfaces to third-party systems for
commerce, databases and general purpose media delivery. Our commerce
interfaces allow our platform to take advantage of many payment methods
from credit cards to micro-payment solutions. The database interfaces
allow our system to dynamically update time sensitive information, such
as pricing, without requiring expensive re-encoding of content. Our
third-party system interfaces permit us to connect and provide
compatibility with general purpose media delivery systems such as those
provided by RealNetworks and Microsoft Corporation.
. Secure Protocols. We have created secure protocols for communication
between all parts of the system. Secure communications are necessary to
prevent theft of content as it moves through the system. Secure links
exist between the Liquid Server and content creation tools for
publishing, the server and Liquid Player for consumer downloading, and
the server and the LOC for transaction reporting.
. Territory Restrictions. We have developed specific technology that
identifies the approximate geographic location of consumers. We use this
technology to enforce rules for content access related to territory. This
enforcement is necessary since some content can only be sold in specific
territories.
. Device Interfaces. We have developed the SP3, which provides a set of
security interfaces and techniques for next generation portable devices.
SP3 has been developed as an open specification for use by many device
manufacturers. SP3 is consistent with the goals of the SDMI and is
intended to be compatible with the specification that results from the
SDMI.
. Digital Rights Management. We have developed several technologies that
enable digital rights management. These technologies include a digital
identification system, Liquid Passport, that permits consumers to move
their music to multiple machines while still providing anti-piracy
protections.
We believe that our technology architecture and our advanced stage of
development and deployment provide distinct competitive advantages. We are
currently developing the fifth generation of our digital music delivery
products. The advantages of our technology are summarized below:
. Open Technical Architecture. An open system design is important because
standard formats are not yet available for online music distribution. Our
technology has been designed to provide an open and flexible solution
that can adapt to many competing formats, including MPEGII Layer 3 (mp3)
and the MPEG Advanced Audio Codec (AAC), as well as future changes that
may occur in digital music distribution. Our open system design allows
the integration of new technologies while maintaining compatibility with
existing content. In addition, our flexible architecture allows us to
continue to integrate technologies such as audio compression and audio
watermarking as they continue to improve in the future.
. Robust and Scalable System Architecture. A comprehensive and robust
system architecture is important to meet the demands that may result from
large scale consumer adoption. We have developed a broad range of
technologies that enables efficient music distribution services. We have
developed specific technologies that permit our system to scale across
multiple systems and locations. This technology provides unique
advantages for efficiently delivering music and other media to a global
audience. We have also developed technology that allows us to extend our
system beyond online applications to include physical locations for sales
of music via kiosks, broadening our reach to include both online and
traditional consumers.
. Superior Audio Quality. We believe consumers will pay for quality music,
and we believe that we have consistently provided superior audio quality
for digital music. We employ specific techniques and optimize industry
algorithms to improve sound quality. We believe that our use of
standardized compression algorithms such as MPEG AAC and mp3 provides
greater compatibility than proprietary audio compression solutions.
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. Effective Copyright Management. Artists and labels have been reluctant to
embrace digital distribution of music given the current lack of copyright
management technologies. We have developed technology to address the
copyright management issue for online music distribution. Our security
technologies protect content from the time it is created to the time it
is consumed. These technologies include secure communication protocols
that allow content creators to publish and manage their content in the
distribution system. We have also developed specific anti-piracy
technology such as watermarking that embeds unique identification
information in the recorded music.
. Automated Production and Publication. We have created technologies that
improve the efficiency of online music distribution and reduce operating
costs. Our content encoding system allows us to format large amounts of
quality audio content for online use in a timely and cost effective
manner. We also have automated services, such as account creation, that
are necessary for content creators to publish and manage their content.
This automation avoids manual intervention for the publishing of content.
We have also developed database technology that permits us to manage the
large volume of content in our distribution system.
Sales and Marketing
Our sales and marketing efforts are principally concentrated on aggregating
digital music recordings for syndication and sale, and broadening our content
syndication reach by expanding the number of Liquid Music Network music-related
and music retailer website affiliates. We sell our products and services to
artists, record companies, websites and online retailers through a 38-person
sales and marketing organization. These employees are located in Redwood City,
Los Angeles and New York. Our software products and services are also bundled
and distributed by third-party manufacturers of various computer hardware,
software and musical instrument products.
We use a variety of marketing programs to create market awareness and
generate demand for our products and services. Our marketing activities include
event-based promotions with popular recording artists and record labels, web
advertising and sponsorships, press tours, participation in trade events and
conferences, and other public relations activities.
In addition to maintaining relationships with worldwide rights societies and
expanding the distribution opportunities for our products and services, our
business development group works to develop new international markets and
business opportunities for our products and services. We believe that
establishing strategic relationships in each of the major international markets
will accelerate the international deployment of our products and services.
Intellectual Property
Our success will depend in part on our ability to protect our proprietary
software and other intellectual property. To protect our proprietary rights, we
rely generally on patent, copyright, trademark and trade secret laws,
confidentiality agreements with employees and third parties, and license
agreements with consultants, vendors and customers. Despite these protections,
a third party could, without authorization, copy or otherwise obtain and use
our products or technology to develop similar technology independently.
Our agreements with employees, consultants and others who participate in
product and service development activities may be breached, we may not have
adequate remedies for any breach, and our trade secrets may become known or
independently developed by competitors.
We currently have 18 patents pending in the United States relating to our
product architecture and technology and hold one patent. That patent expires in
October 2015. We have had claims allowed on five of our patent applications.
Any pending or future patent applications may not be granted, existing or
future patents may be challenged, invalidated or circumvented, and the rights
granted under a patent that has issued or any
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patent that may issue may not provide competitive advantages to us. Many of our
current and potential competitors dedicate substantially greater resources to
protection and enforcement of intellectual property rights, especially patents.
If a blocking patent has issued or issues in the future, we would need either
to obtain a license or to design around the patent. We may not be able to
obtain a required license on acceptable terms, if at all, or to design around
the patent. See "--Litigation and Patent Infringement Claims."
We pursue the registration of our trademarks and service marks in the United
States and in other countries, although we have not secured registration of all
our marks. A significant portion of our marks begin with the word "Liquid." We
are aware of other companies that use "Liquid" in their marks, alone or in
combination with other words, and we do not expect to be able to prevent all
third-party uses of the word "Liquid." In addition, the laws of some foreign
countries do not protect our proprietary rights to the same extent as do the
laws of the U.S., and effective patent, copyright, trademark and trade secret
protection may not be available in these jurisdictions. We license our
proprietary rights to third parties, and these licensees may fail to abide by
compliance and quality control guidelines with respect to our proprietary
rights or take actions that would harm our business.
To license many of our products, we rely in part on "shrinkwrap" and
"clickwrap" licenses that are not signed by the end user and, therefore, may be
unenforceable under the laws of certain jurisdictions. As with other software
products, our products are susceptible to unauthorized copying and uses that
may go undetected. Policing unauthorized use is difficult.
We attempt to avoid infringing known proprietary rights of third parties in
our product and service development efforts. We have not, however, conducted
and do not conduct comprehensive patent searches to determine whether the
technology used in our products infringes patents held by third parties. In
addition, it is difficult to proceed with certainty in a rapidly evolving
technological environment in which there may be numerous patent applications
pending, many of which are confidential when filed, with regard to similar
technologies. If we were to discover that our products violate third-party
proprietary rights, we might not be able to obtain licenses to continue
offering these products without substantial reengineering. Effort to undertake
this reengineering might not be successful, licenses might be unavailable on
commercially reasonable terms, if at all, and litigation might not be avoided
or settled without substantial expense and damage awards.
Any claims relating to the infringement of third-party proprietary rights,
even if not meritorious, could result in the expenditure of significant
financial and managerial resources and could result in injunctions preventing
us from distributing certain products and services. These claims could harm our
business. We also rely on technology that we license from third parties,
including software that is integrated with internally developed software and
used in our products and services, to perform key functions. Third-party
technology licenses may not continue to be available to us on commercially
reasonable terms. The loss of any of these technologies could harm our
business. Moreover, although we are generally indemnified against claims that
third-party technology infringes the proprietary rights of others, this
indemnification may be unavailable for all types of intellectual property
rights, for example, patents may be excluded, and in some cases the scope of
indemnification is limited. Even if we receive broad indemnification, third-
party indemnitors are not always well capitalized and may not be able to
indemnify us in the event of infringement, resulting in substantial exposure to
us. Infringement or invalidity claims may arise from the incorporation of
third-party technology, and our customers may make claims for indemnification.
These claims, even if not meritorious, could result in the expenditure of
significant financial and managerial resources in addition to potential product
and service redevelopment costs and delays, all of which could harm our
business. Microtome, Inc., has recently claimed that our products infringe its
patent rights. Additionally, in late June 1999 and July 1999, we received
letters from two other corporations, each separately suggesting that we review
patents to which they claim rights. See "--Litigation and Patent Infringement
Claims."
Competition
Competition among companies in the business of delivering digital music over
the Internet is intense. We compete against a number of technology companies
that are offering or plan to offer products, services or technologies for the
delivery of digital music over the Internet. The number of websites competing
for the
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attention and spending of consumers and advertisers has increased, and we
expect it to continue to increase. We may also compete with consumer
electronics companies as they begin to market Internet music player devices.
See "Risk Factors--The Market for Digital Delivery of Music Over the Internet
is Highly Competitive, and if We Cannot Compete Effectively, Our Revenues Might
Decline."
We compete with providers of infrastructure technology, products and services
such as Microsoft, IBM, AT&T/a2b, Preview Systems and Audiosoft and aggregators
of digital music content for delivery over the Internet and kiosks such as
MusicMaker, eMusic, Amplify.com and RedDot.net.
We believe that the primary competitive factors in our market are the
following:
. quantity and variety of digital recorded music content;
. ease of consumer experience;
. the number and quality of music-related and retail websites;
. brand awareness;
. ability to adapt to changes in component technologies and consumer
preferences;
. fidelity and quality of sound of digital recorded music; and
. ability to ensure secure digital delivery of recorded music.
We believe our products and services offer significant advantages over those
of our competitors:
. our Liquid Music Network features over 6,000 artists and 1,000 individual
record labels. We believe that we offer more artists and more labels than
most digital music distribution services;
. through our Liquid Music Network, we believe we have the potential to
reach more music consumers than other digital music delivery solutions;
. our platform offers better copy-protection and copyright management than
mp3-based solutions;
. our open architecture will allow us to adapt to changing component
technologies; and
. the fidelity and sound quality of music encoded by our products and
services are superior to competitive systems due to optimizations we
perform on audio compression technologies used in our products and
services.
Additionally, there are music community websites, such as mp3.com, that may
attract consumers who want to download music from the Internet. Although we do
not compete directly with these websites, our LMN affiliates do compete with
them. To the extent that consumers download digital music from these websites
rather than from our LMN affiliates, our business may be harmed. Finally, there
are other companies, such as InterTrust Technologies Corporation, that provide
component software technologies that facilitate the digital delivery of goods
over the Internet, including music. To the extent that the market standardizes
on these technologies and we are unable to incorporate these components into
our music delivery services, our business may be harmed.
Employees
As of September 30, 1999, we had 114 full-time employees including 38 in
sales and marketing, 47 in research and development, 15 in general and
administrative, and 14 in operations. We consider our relationships with
employees to be good. None of our employees is covered by collective bargaining
agreements.
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Facilities
Our headquarters are located in 18,200 square feet of leased office space in
Redwood City, California. The lease term extends to November 15, 2002 with two
five-year renewals, at our option. We lease an office suite adjacent to our
headquarters in Redwood City on a month to month basis, for additional office
space and storage needs. We lease an additional 11,400 square feet of office
space near our headquarters. The lease term for this additional space extends
to April 14, 2002 with a three-year renewal at our option. We have recently
leased an additional 20,000 square feet of office space near our headquarters.
The lease term for this additional space extends to August 31, 2002 with a
three-year renewal at our option.
Litigation and Patent Infringement Claims
On April 23, 1999, Arne Frager and Rose G. Frager filed a complaint against
us and our president, Gerald Kearby, in the Superior Court of the State of
California for the County of Marin (case number CV 991826). The complaint
alleges breach of contract and related claims. In particular, plaintiffs allege
that in January 1996, in connection with the formation of Liquid Audio, we
agreed to issue plaintiffs 750,000 shares of common stock. Plaintiffs further
allege that Liquid Audio entered into a consulting agreement with Mr. Frager
under which we allegedly agreed not to terminate Mr. Frager without good cause.
Plaintiffs allege that we breached each of these agreements, and seek 587,870
shares of our common stock, the portion of the 750,000 shares that have not
previously been issued. We believe, after consultation with counsel, that
plaintiffs' claims are without merit, and intend to vigorously defend the
lawsuit. However, should we have to issue additional shares to the plaintiffs,
then-existing stockholders would experience dilution of their ownership
interests and we would need to record an accounting charge in our statement of
operations equal to the fair market value of the shares at the time of
issuance.
On May 13, 1999, John Hempe filed a complaint against us, our president,
Gerald W. Kearby, our chief technical officer, Philip R. Wiser, and other
defendants not employed by us, in the San Mateo Superior Court (case number
409032). The defendants not employed by us have been dismissed. The complaint
alleges, among other things, discrimination under the provisions of the
California Fair Employment and Housing Act, breach of contract and breach of
covenant of good faith and fair dealing, in connection with his termination,
and seeks unspecified damages. We believe, after consultation with counsel,
that plaintiff's claims are without merit and intend to vigorously defend the
lawsuit. However, should this litigation be decided adversely to us, we may be
required to pay damages to plaintiff.
On May 25, 1999, Microtome, Inc. notified us that it believes our Liquifier
Pro Encoding Tool, when used in conjunction with our Liquid Music Player,
infringes United States Patents Nos. 5,734,823 and 5,734,891, in which
Microtome asserts it has rights, and asked us to cease and desist the
manufacture, sale and use of these products. To our knowledge, Microtome has
not yet filed a lawsuit alleging infringement of these patents, but it has
indicated an intention to do so if our response is not satisfactory. Microtome
has also indicated that it is willing to grant us a non-exclusive license to
these patents. In the event that we cannot come to an agreement with Microtome,
we might be drawn into litigation with them. We believe, after consultation
with counsel, that we have meritorious defenses to any claim that the
identified products infringe the claims of these patents and intend to
vigorously defend any lawsuit asserting infringement of those patents. However,
should any litigation be decided adversely to us, we might be required to pay
substantial damages to Microtome and could be enjoined from selling those of
our products that are held to infringe Microtome's patents unless and until we
are able to negotiate a license from them. See "Risk Factors--We Face and Might
Face Intellectual Property Infringement Claims That Might Be Costly to
Resolve."
On June 29, 1999, July 6, 1999 and July 27, 1999, three corporations each
suggested by letter that we review patents to which they claim rights. One of
these corporations also implies that we might wish to obtain a license from
them in connection with their patent rights.
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<PAGE>
MANAGEMENT
Directors and Executive Officers
The following table presents our directors and executive officers, their ages
and the positions held by them as of November 22, 1999:
<TABLE>
<CAPTION>
Name Age Position
---------------------------- --- -----------------------------------------
<C> <C> <S>
Gerald W. Kearby............ 52 President, Chief Executive Officer and
Director
Robert G. Flynn............. 45 Senior Vice President of Business
Development and Secretary
Philip R. Wiser............. 33 Senior Vice President of Engineering,
Chief Technical Officer and Director
Gary J. Iwatani............. 37 Senior Vice President and Chief Financial
Officer
Scott A. Steinberg.......... 35 Senior Vice President of Marketing
Richard W. Wingate.......... 47 Senior Vice President of Content
Development and Label Relations
Kevin M. Malone............. 34 Vice President of Sales
Mathieu "Charly" Prevost.... 51 Vice President of Promotions
Andrea Cook Fleming......... 32 Vice President of Corporate Marketing
Heather Furmidge............ 45 Vice President of Internet Business
Leon Rishniw................ 33 Vice President of Engineering
Ann Winblad................. 48 Director
Silvia Kessel............... 48 Director
Sanford R. Climan........... 43 Director
Eric P. Robison............. 39 Director
</TABLE>
Mr. Kearby co-founded Liquid Audio in January 1996. Since January 1996, Mr.
Kearby has served as our President and Chief Executive Officer and one of our
directors. From June 1995 to December 1995, Mr. Kearby was co-founder and Chief
Executive Officer of Integrated Media Systems, a manufacturer of computer-based
professional audio equipment. From January 1989 until June 1995, Mr. Kearby
served as Vice President of Sales and Marketing at Studer Editech Corporation,
a professional audio recording equipment company. Mr. Kearby holds a B.A. in
broadcast management and audio engineering from San Francisco State University.
Mr. Flynn co-founded Liquid Audio in January 1996. Since July 1999, Mr. Flynn
has served as our Senior Vice President of Business Development and Secretary.
From January 1996 to July 1999, Mr. Flynn served as our Vice President of
Business Development and Secretary. Mr. Flynn also served as our Chief
Financial Officer from January 1996 to August 1997 and as one of our directors
from January 1996 to June 1996. From March 1987 until November 1995, Mr. Flynn
served as a general partner of Entertainment Media Venture Partners I, L.P., an
institutional venture capital fund investing in the entertainment, media and
communications technology industries. During this time, Mr. Flynn also served
on the board of directors of Integrated Media Systems. Mr. Flynn holds a B.A.
in English from Stanford University and an M.B.A. from UCLA.
Mr. Wiser co-founded Liquid Audio in January 1996. Since July 1999, Mr. Wiser
has served as our Senior Vice President of Engineering and Chief Technical
Officer. From May 1996 to July 1999, Mr. Wiser served as our Vice President of
Engineering and from November 1998 to July 1999 as our Chief Technical Officer.
Since June 1996, he has also served as one of our directors. From July 1995 to
May 1996, Mr. Wiser served as a senior software engineer, directing audio
compression work at Chromatic Research, a multimedia semiconductor device
company. From October 1994 to July 1995, Mr. Wiser was a senior software
engineer and the director of
52
<PAGE>
digital signal processing research for Studer Editech Corporation. From June
1994 to October 1994, Mr. Wiser was a software engineer for Sonic Solutions, a
developer of digital media tools. Mr. Wiser holds a B.S. in electrical
engineering from the University of Maryland, College Park and an M.S. in
electrical engineering from Stanford University.
Mr. Iwatani has served as our Senior Vice President since July 1999 and as
our Chief Financial Officer since August 1997. From May 1995 to April 1997, Mr.
Iwatani was the Chief Financial Officer of Berkeley Systems, Inc., a developer
and marketer of multimedia entertainment consumer software. From May 1991 to
March 1995, Mr. Iwatani served as Director of Finance and Operations at
Insignia Solutions, Inc., a utility software company. Mr. Iwatani holds a B.S.
in accounting from Santa Clara University, as well as a C.P.A. from the State
of California.
Mr. Steinberg has served as our Senior Vice President of Marketing since July
1999. From September 1998 to July 1999, Mr. Steinberg was the Senior Vice
President of Marketing of Eidos Interactive, Inc., a developer and marketer of
multimedia entertainment consumer software. From August 1996 to September 1998,
Mr. Steinberg was the Vice President of Marketing of Crystal Dynamics, Inc., an
entertainment software studio. From October 1994 to August 1996, Mr. Steinberg
served as Director of Marketing of Crystal Dynamics, Inc. Prior to October
1994, Mr. Steinberg served as Product Marketing Manager for Crystal Dynamics,
Inc. Mr. Steinberg holds a B.S. in marketing from San Francisco State
University.
Mr. Wingate has served as our Senior Vice President of Content Development
and Label Relations since November 1999 and as our Vice President of Content
Development and Label Relations since August 1998. Mr. Wingate operated his own
new media marketing consulting company, Wingate Marketing, from July 1996 until
June 1998. From August 1997 to June 1998, Mr. Wingate was also a private music
industry consultant. From June 1994 to July 1996, Mr. Wingate was Senior Vice
President, Marketing for Arista Records Incorporated, a music recording
company. Prior to June 1994, Mr. Wingate held several senior management
positions with major music industry record labels, including Polygram, Inc. and
Columbia Records. Mr. Wingate holds a B.A. in communications from Brown
University.
Mr. Malone has served as our Vice President of Sales since February 1998.
From June 1997 to February 1998, Mr. Malone was our Director, International
Sales. From May 1993 to June 1997, Mr. Malone held a variety of positions at
Silicon Graphics, Inc., a manufacturer of work stations, servers and
supercomputing systems, including Manager, Strategic Marketing, Operations
Manager, Portugal and International Business Development Manager. Mr. Malone
holds a B.S. in business administration from the University of Arizona and an
M.B.A. in international business studies from the University of South Carolina.
Mr. Prevost has served as our Vice President of Promotions since December
1998. From April 1996 to November 1998, Mr. Prevost was Vice President, Retail
at The Album Network, a media company trade journal. Prior to April 1996, Mr.
Prevost was president of his own company, the Charly Prevost Company, a
multimedia management company. Mr. Prevost has also held several senior
management positions within the music recording industry, including president
of Island Records.
Ms. Fleming has served as our Vice President of Corporate Marketing since
June 1999. From February 1999 to June 1999, Ms. Fleming was our Director of
Corporate Marketing. From December 1995 to February 1999, Ms. Fleming served as
Public Relations Director at Netscape Communications Corporation, an Internet
services provider. From June 1994 to December 1995, Ms. Fleming was a Corporate
Public Relations Manager for Microsoft Corporation, a software company. Ms.
Fleming holds a B.A. in English from Stanford University.
Ms. Furmidge has served as our Vice President of Internet Business since June
1999. From January 1999 to June 1999, Ms. Furmidge was an Executive Producer
for ZD TV LLC, an Internet cable channel integrating television and Internet
programming. From June 1997 to January 1999, Ms. Furmidge was an Executive
Producer for Netscape Communications Corporation. From December 1995 to June
1997, Ms. Furmidge served as a Senior Producer for Netscape Communications
Corporation. Prior to December 1995, Ms. Furmridge served as an Engineering
Project Manager for Apple Computer, Inc., a software company. Ms. Furmidge
holds
53
<PAGE>
a B.A. in international relations from Stanford University and an M.B.A. in
telecommunications from the University of San Francisco.
Mr. Rishniw has served as our Vice President of Engineering since October
1999. He was originally employed by us as a software engineer in August 1996,
became one of our Development Managers in January 1997 and Director of
Engineering in November 1998. From May 1995 until August 1996, Mr. Rishniw
served as a senior software engineer for Studer Editech, a professional audio
recording equipment company. From August 1994 until May 1995, Mr. Rishniw
served as a software engineer for Signal Stream Technology, a medical imaging
technology provider. Mr. Rishniw holds a B.S. in engineering from Melbourne
Institute of Technology.
Ms. Winblad has served as one of our directors since May 1996. Ms. Winblad
has been a general partner of Hummer Winblad Venture Partners, a venture
capital investment firm, since 1989. She is a member of the board of trustees
of the University of St. Thomas and is an advisor to numerous entrepreneurial
groups such as the Software Development Forum, the Stanford/MIT Venture Forum
and the Massachusetts Computer Software Council, Software Industry Business
Practices. Ms. Winblad also serves on the boards of directors of Net
Perceptions Inc., a developer and supplier of realtime recommendation
technology for the Internet, and several private companies. Ms. Winblad holds a
B.S. in mathematics and business administration from the College of Saint
Catherine and an M.A. in education with an economics focus from the University
of St. Thomas.
Ms. Kessel has served as one of our directors since October 1998. Since
November 1995, Ms. Kessel has held several positions at Metromedia
International Group, Inc., a global communications and media company, including
Executive Vice President, Chief Financial Officer and Treasurer. From January
1993 to June 1997, Ms. Kessel was Executive Vice President and a director of
Orion Pictures Corporation, a movie production company. Since January 1994, Ms.
Kessel has served as Senior Vice President of Metromedia Company, a privately-
held partnership. Ms. Kessel has also served as President of Kluge & Company, a
privately-held company, for over five years. Ms. Kessel is currently a director
and Executive Vice President of Metromedia Fiber Network, Inc., a fiber optic
network provider, and Big City Radio, Inc., an owner and operator of radio
station combinations in New York City, Chicago and Los Angeles. Ms. Kessel
received an M.B.A. in finance from Columbia University.
Mr. Climan has served as one of our directors since April 1999. Since
February 1999, Mr. Climan has been President of Entertainment Media Ventures,
Inc., an investment and advisory company focused on traditional and new media.
From October 1995 to May 1997, Mr. Climan was Executive Vice President and
President of Worldwide Business Development for Universal Studios, Inc., a
media production company. From June 1997 to February 1999 and from June 1986 to
September 1995, Mr. Climan was a member of the senior management team at
Creative Artists Agency, a talent and literary representation firm. Mr. Climan
also serves on the boards of directors of Equity Marketing, Inc., a provider of
custom promotional programs, and Sunterra Corporation, a developer and operator
of vacation ownership resorts. Mr. Climan holds a B.A. in chemistry from
Harvard College, an M.S. in health policy and management from the Harvard
School of Public Health and an M.B.A. from Harvard Business School.
Mr. Robison has served as one of our directors since April 1999. Since
January 1994, Mr. Robison has been a business development associate for Vulcan
Northwest, Inc., the holding company that manages all personal and business
interests for new media investor Paul G. Allen. Mr. Robison serves as a
Business Development Associate for Vulcan Ventures, Inc., the venture fund
division of Vulcan. Mr. Robison also serves on the boards of directors of
C|NET, Inc., Egghead.com, Inc. and ARI Network Services, Inc. Mr. Robison holds
a B.A. in communication studies from California State University, Sacramento
and an M.A. from the University of California, Davis.
Board Composition
We currently have six directors. Our restated certificate of incorporation
divides our board of directors into three classes: Class I, whose term will
expire at the annual meeting of stockholders to be held in 2000; Class II,
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<PAGE>
whose term will expire at the annual meeting of stockholders to be held in
2001; and Class III, whose term will expire at the annual meeting of
stockholders to be held in 2002. The Class I directors are Sanford R. Climan
and Eric P. Robison, the Class II directors are Silvia Kessel and Ann Winblad
and the Class III directors are Gerald W. Kearby and Philip R. Wiser. At each
annual meeting of stockholders after the initial classification, the successors
to directors whose terms have expired will be elected to serve from the time of
election and qualification until the third annual meeting following their
election. In addition, our bylaws provide that the authorized number of
directors may be changed only by resolution of the board of directors. Any
additional directorships resulting from an increase in the number of directors
will be distributed among the three classes so that, as nearly as possible,
each class will consist of one-third of the total number of directors. This
classification of the board of directors may have the effect of delaying or
preventing changes in our control or management. See "Description of Capital
Stock."
Each officer is elected by, and serves at the discretion of, the board of
directors. Each of our officers and directors, other than nonemployee
directors, devotes his or her full time to our affairs. Our nonemployee
directors devote the amount of time necessary to discharge their duties to us.
There are no family relationships among any of our directors, officers or key
employees.
Board Committees
The audit committee of the board of directors reviews our internal accounting
procedures and consults with and reviews the services provided by our
independent accountants. The audit committee currently consists of Silvia
Kessel and Eric P. Robison.
The compensation committee of the board of directors reviews and recommends
to the board of directors the compensation and benefits of all of our executive
officers, administers our stock and option plans and establishes and reviews
general policies relating to compensation and benefits of our employees. The
compensation committee currently consists of Ann Winblad and Sanford R. Climan.
No interlocking relationships exist between our board of directors or
compensation committee and the board of directors or compensation committee of
any other company, nor has an interlocking relationship existed in the past.
Director Compensation
Our directors do not receive cash compensation for their service as members
of the board of directors, although they are reimbursed for certain expenses in
connection with attendance at board and committee meetings. We do not provide
additional compensation for committee participation or special assignments of
the board of directors. In April 1999, we granted Sanford R. Climan options to
purchase 20,000 shares of common stock under our 1996 Equity Incentive Plan.
See "--Stock Plans."
Change of Control Arrangements
We have sold shares of our common stock to each of Gerald W. Kearby, Robert
G. Flynn and Philip R. Wiser. These shares are subject to a vesting schedule
that accelerates with respect to the lesser of 25% of their total shares or
their remaining unvested shares upon certain corporate transactions, as
described in their individual Founders Restricted Stock Purchase Agreements and
the amendments to those agreements. We have also granted options to purchase
common stock to Gary J. Iwatani and Scott A. Steinberg. The shares underlying
the options are subject to a vesting schedule that accelerates with respect to
the lesser of 25% of the total number of shares subject to each option or the
remaining unvested shares upon certain corporate transactions, as described in
each individual option grant.
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<PAGE>
Executive Compensation
The following table sets forth the total compensation received for services
rendered to us during 1998 by our Chief Executive Officer and our four other
most highly compensated executive officers who received salary and bonus in
1998 in excess of $100,000 (Named Executive Officers).
<TABLE>
<CAPTION>
Annual
Compensation
-------------------
Name and Principal Position Salary Bonus
- ---------------------------------------------------------- -------- -------
<S> <C> <C>
Gerald W. Kearby, President and Chief Executive Officer... $158,077 $45,000
Robert G. Flynn, Senior Vice President of Business
Development.............................................. 118,077 26,250
Philip R. Wiser, Senior Vice President of Engineering and
Chief Technical Officer.................................. 118,077 26,250
Gary J. Iwatani, Senior Vice President and Chief Financial
Officer.................................................. 126,930 26,250
Kevin M. Malone, Vice President of Sales.................. 160,343(1) 26,250
</TABLE>
- --------
(1) Includes $34,694 earned as commissions.
We did not grant any stock options to any of the Named Executive Officers
during 1998. We have never granted any stock appreciation rights.
Fiscal Year End Option Values
The following table provides summary information concerning stock options
held as of December 31, 1998 by each of the Named Executive Officers. None of
these officers exercised options in 1998.
<TABLE>
<CAPTION>
Number of Securities
Underlying Unexercised Value of Unexercised
Options at Fiscal In-the-Money Options at
Year-End Fiscal Year-End(1)
------------------------- -------------------------
Name Exercisable Unexercisable Exercisable Unexercisable
- ---------------------------- ----------- ------------- ----------- -------------
<S> <C> <C> <C> <C>
Gerald W. Kearby............ -- -- -- --
Robert G. Flynn............. -- -- -- --
Philip R. Wiser............. -- -- -- --
Gary J. Iwatani............. 150,000 -- $271,000 --
Kevin M. Malone............. 112,500 -- 203,250 --
</TABLE>
- --------
(1) The value of unexercised in-the-money options at fiscal year-end is based
on a price per share of $2.00, as determined in good faith by the board of
directors, less the exercise price.
Stock Plans
1996 Equity Incentive Plan. Our 1996 Equity Incentive Plan provides for the
granting to employees of incentive stock options within the meaning of Section
422 of the Internal Revenue Code of 1986 (Code), and for the granting to
employees, directors and consultants of nonstatutory stock options and stock
purchase rights (SPRs). The 1996 Plan was approved by the board of directors
and the stockholders in September 1996. Unless terminated sooner, the 1996 Plan
will terminate automatically in 2009. A total of 3,272,354 shares of common
stock is reserved for issuance pursuant to the 1996 Plan, plus annual increases
on January 1st of each year equal to the least of (1) 1,500,000 shares, (2) 5%
of the outstanding shares on that date or (3) an amount determined by the
board.
The 1996 Plan may be administered by the board of directors or a committee of
the board, which committee must, in the case of options intended to qualify as
"performance-based compensation" within the meaning of Section 162(m) of the
Code, consist of two or more "outside directors" within the meaning of Section
162(m). The administrator has the power to determine the terms of the options
or SPRs granted,
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<PAGE>
including the exercise price, the number of shares subject to each option or
SPR, the exercisability of the option or SPR, and the form of consideration
payable upon exercise. The board has the authority to amend, suspend or
terminate the 1996 Plan, provided that no action may affect any share of common
stock previously issued and sold or any option previously granted under the
1996 Plan, unless the board and the option holder mutually agree otherwise.
Options and SPRs granted under the 1996 Plan are not generally transferable
by the optionee, and each option or SPR is exercisable during the lifetime of
the optionee only by the optionee. Options granted under the 1996 Plan must
generally be exercised within three months of the optionee's separation of
service from us, or within twelve months after the optionee's termination by
death or disability, but in no event later than the expiration of the option's
ten-year term. In the case of SPRs, unless the administrator determines
otherwise, the restricted stock purchase agreement must grant us a repurchase
option exercisable upon the voluntary or involuntary termination of the
purchaser's service to us for any reason, including death or disability. The
purchase price for shares repurchased under the restricted stock purchase
agreement must be the original price paid by the purchaser and may be paid by
cancellation of any indebtedness of the purchaser to us. The repurchase option
will lapse at a rate determined by the administrator. The exercise price of all
incentive stock options granted under the 1996 Plan must be at least equal to
the fair market value of the common stock on the date of grant. The exercise
price of nonstatutory stock options and SPRs granted under the 1996 Plan is
determined by the administrator, but with respect to nonstatutory stock options
intended to qualify as "performance-based compensation" within the meaning of
Section 162(m) of the Code, the exercise price must be at least equal to the
fair market value of the common stock on the date of grant. With respect to any
participant who owns stock possessing more than 10% of the voting power of all
classes of our outstanding capital stock, the exercise price of any incentive
stock option granted must equal at least 110% of the fair market value of the
common stock on the date of grant and its term must not exceed five years. The
terms of all other options granted under the 1996 Plan may not exceed ten
years.
The 1996 Plan provides that, in the event of a merger of us with or into
another corporation or a sale of substantially all of our assets, each
outstanding option and SPR must be assumed or an equivalent option or SPR
substituted by the successor corporation. If the successor corporation refuses
to assume or substitute each outstanding option or SPR, each option or SPR will
expire on the completion of the transaction, except as may otherwise be
determined by the administrator.
1999 Employee Stock Purchase Plan. Our 1999 Employee Stock Purchase Plan was
adopted by the board of directors in April 1999 and by the stockholders in June
1999. A total of 500,000 shares of common stock has been reserved for issuance
under the 1999 Purchase Plan, plus annual increases on January 1st of each year
equal to the least of (1) 750,000 shares, (2) 3% of the outstanding shares on
that date or (3) an amount determined by the board.
The 1999 Purchase Plan, which is intended to qualify under Section 423 of the
Code, contains consecutive, overlapping, 24-month offering periods. Each
offering period includes four six-month purchase periods. The offering periods
start on the first trading day on or after June 1 and December 1 of each year,
except for the first offering period, which commenced on July 8, 1999 and ends
on the last trading day on or before May 31, 2001.
Employees are eligible to participate if they are customarily employed by us
or any participating subsidiary for at least 20 hours per week and more than
five months in any calendar year. However, any employee who (1) immediately
after grant owns stock possessing 5% or more of the total combined voting power
or value of all classes of our capital stock, or (2) whose rights to purchase
stock under all of our employee stock purchase plans accrues at a rate that
exceeds $25,000 worth of stock for each calendar year may be not be granted an
option to purchase stock under the 1999 Purchase Plan. The 1999 Purchase Plan
permits participants to purchase common stock through payroll deductions of up
to 15% of the participant's "compensation." Compensation is defined as the
participant's base straight time gross earnings, bonuses, commissions, payments
for overtime, shift premium payments and other cash compensation, exclusive of
any
57
<PAGE>
non-cash compensation. The maximum number of shares a participant may purchase
during a single purchase period is 2,500 shares.
Amounts deducted and accumulated by the participant are used to purchase
shares of common stock at the end of each purchase period. The price of stock
purchased under the 1999 Purchase Plan is generally 85% of the lower of the
fair market value of the common stock (1) at the beginning of the offering
period or (2) at the end of the purchase period. In the event the fair market
value at the end of a purchase period is less than the fair market value at the
beginning of the offering period, the participants will be withdrawn from the
current offering period following exercise and automatically re-enrolled in a
new offering period. The new offering period will use the fair market value as
of the first date of the new offering period to determine the purchase price
for future purchase periods. Participants may end their participation at any
time during an offering period, and they will be paid their payroll deductions
to date. Participation ends automatically upon termination of employment with
us.
Rights granted under the 1999 Purchase Plan are not transferable by a
participant other than by will, the laws of descent and distribution, or as
otherwise provided under the 1999 Purchase Plan. The 1999 Purchase Plan
provides that, in the event of a merger of us with or into another corporation
or a sale of substantially all of our assets, each outstanding option may be
assumed or substituted for by the successor corporation. If the successor
corporation refuses to assume or substitute for the outstanding options, the
offering period then in progress will be shortened and a new exercise date will
be set. The 1999 Purchase Plan will terminate in 2009. The board of directors
has the authority to amend or terminate the 1999 Purchase Plan, except that no
action may adversely affect any outstanding rights to purchase stock under the
1999 Purchase Plan.
401(k) Plan
We maintain a tax-qualified employee savings and retirement plan, a 401(k)
Plan, which covers all of our eligible employees. Pursuant to the 401(k) Plan,
participants may elect to reduce their current compensation, on a pre-tax
basis, up to the maximum annual limit under the Code and have the amount of the
reduction contributed to the 401(k) Plan. Participants' salary reduction
contributions are fully vested at all times. We may make matching employer
contributions and additional employer contributions to the 401(k) Plan.
Participants' interests in their matching contributions and additional employer
contributions, if any, vest in accordance with a four-year graduated vesting
schedule. Participants are eligible for a distribution from the 401(k) Plan
upon their reaching age 59, death, disability or separation from service with
us. The 401(k) Plan is intended to qualify under Section 401(a) of the Code,
and its accompanying trust is intended to be a tax-exempt trust under Section
501(a) of the Code. Contributions made on behalf of participants, on a pre-tax
basis, to the 401(k) Plan, and income earned on these contributions, are not
currently taxable to participants. All contributions are tax deductible by us.
Limitation of Liability and Indemnification Matters
Our restated certificate of incorporation limits the liability of directors
to the maximum extent permitted by Delaware law. Delaware law provides that
directors of a corporation will not be personally liable for monetary damages
for breach of their fiduciary duties as directors, except liability for:
. breach of their duty of loyalty to the corporation or its stockholders;
. acts or omissions not in good faith or which involve intentional
misconduct or a knowing violation of law;
. unlawful payments of dividends or unlawful stock repurchases or
redemptions; and
. any transaction from which the director derived an improper personal
benefit.
This limitation of liability does not apply to liabilities arising under the
federal or state securities laws and does not affect the availability of
equitable remedies such as injunctive relief or rescission.
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<PAGE>
Our bylaws provide that we must indemnify our directors, officers, employees
and other agents to the fullest extent permitted by law. We believe that
indemnification under our bylaws covers negligence on the part of indemnified
parties. Our bylaws also permit us to secure insurance on behalf of any
officer, director, employee or other agent for any liability arising out of his
or her actions on behalf of us, regardless of whether our bylaws permit
indemnification under those circumstances.
We have entered into agreements to indemnify our directors and executive
officers, in addition to the indemnification provided for in our bylaws. These
agreements, among other things, indemnify our directors and executive officers
for certain expenses, including attorneys' fees, judgments, fines and
settlement amounts, incurred in any action or proceeding, including any action
on our behalf arising out of their services as a director, officer, employee,
agent or fiduciary, or on behalf of any of our subsidiaries or any other
company or enterprise to which the person provides services at our request. We
believe that these provisions and agreements are necessary to attract and
retain qualified persons as directors and executive officers.
At present, there is no material litigation or proceeding pending involving
any of our directors or officers in which indemnification is required or
permitted, and we are not aware of any threatened material litigation or
proceeding that may result in a claim for indemnification.
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<PAGE>
RELATED PARTY TRANSACTIONS
Since our inception in January 1996, we have never been a party to any
transaction or series of similar transactions in which the amount involved
exceeded or will exceed $60,000 and in which any director, executive officer or
holder of more than 5% of our common stock had or will have an interest, other
than as described under "Management" and the transactions described below.
Gerald W. Kearby, Philip R. Wiser and Robert G. Flynn, all current executive
officers, were involved in our founding and organization and may be considered
as our promoters. Following our inception in January 1996, we issued 937,500
shares of common stock to Mr. Kearby, 843,750 shares of common stock to
Mr. Wiser and 750,000 shares of common stock to Mr. Flynn. Mr. Kearby, Mr.
Wiser and Mr. Flynn each contributed a nominal amount of capital for our
initial capitalization.
From May to July 1996, we sold an aggregate of 3,049,989 shares of Series A
preferred stock to certain investors at a purchase price of $0.656 per share.
In May 1997, we sold an aggregate of 3,186,888 shares of Series B preferred
stock to certain investors at a purchase price of $1.96 per share. In July and
September 1998, we sold an aggregate of 3,507,322 shares of Series C preferred
stock to certain investors at a purchase price of $6.14 per share. The shares
of Series A, Series B and Series C preferred stock automatically converted into
9,744,199 shares of common stock upon the closing of our initial public
offering.
The holders of converted shares of common stock are entitled to demand and
piggy-back registration rights. See "Description of Capital Stock--Registration
Rights."
The investors in the preferred stock included the following entities, which
are 5% stockholders, affiliated with directors, or both:
<TABLE>
<CAPTION>
Shares of Shares of Shares of
Series A Series B Series C
Investor Preferred Stock Preferred Stock Preferred Stock
- ------------------------------- --------------- --------------- ---------------
<S> <C> <C> <C>
5% Stockholder Entities
Affiliated with Directors:
Entities affiliated with Ann
Winblad(1)................... 1,829,272 788,928 81,431
(Entities affiliated with
Hummer Winblad Venture
Partners)(2)
Entity affiliated with Eric P.
Robison(1)................... -- 510,204 488,599
(Vulcan Ventures, Inc.)
Entity affiliated with Silvia
Kessel(1).................... -- -- 977,198
(Metromedia Company)
Other 5% Stockholders:
Intel Corporation............. 763,398 612,245 1,140,065
Entities affiliated with The
Phoenix Partners(3).......... -- 637,756 162,866
</TABLE>
- --------
(1) Ann Winblad, Eric P. Robison and Silvia Kessel are each members of our
board of directors. Ms. Winblad is a general partner of Hummer Winblad
Venture Partners. Mr. Robison is a business development associate of Vulcan
Ventures, Inc. Ms. Kessel is a Senior Vice President of Metromedia Company.
(2) Hummer Winblad Venture Partners II, L.P. purchased 1,756,098 shares of
Series A preferred stock, 757,370 shares of Series B preferred stock and
80,943 shares of Series C preferred stock. Hummer Winblad Technology Fund
II, L.P. purchased 62,198 shares of Series A preferred stock and 26,825
shares of Series B preferred stock. Hummer Winblad Technology Fund IIA,
L.P. purchased 10,976 shares of Series A preferred stock, 4,733 shares of
Series B preferred stock and 488 shares of Series C preferred stock.
(3) The Phoenix Partners III Liquidating Trust purchased 177,154 shares of
Series B preferred stock and 45,241 shares of Series C preferred stock. The
Phoenix Partners IIIB Limited Partnership purchased 141,724 shares of
Series B preferred stock and 36,192 shares of Series C preferred stock. The
Phoenix Partners IV Limited Partnership purchased 318,878 shares of Series
B preferred stock and 81,433 shares of Series C preferred stock.
60
<PAGE>
PRINCIPAL AND SELLING STOCKHOLDERS
The following table presents information with respect to beneficial ownership
of our common stock as of September 30, 1999 and as adjusted to reflect the
sale of the shares offered by this prospectus by:
. each person who beneficially owns more than 5% of the common stock;
. each of our executive officers;
. each of our directors;
. all executive officers and directors as a group; and
. the selling stockholders.
Except as otherwise noted, the address of each 5% stockholder listed in the
table is c/o Liquid Audio, Inc., 810 Winslow Street, Redwood City, CA 94063.
The table includes all shares of common stock issuable within 60 days of
September 30, 1999 upon the exercise of options and other rights beneficially
owned by the indicated stockholders on that date. Beneficial ownership is
determined in accordance with the rules of the Securities and Exchange
Commission and includes voting and investment power with respect to shares. To
our knowledge, except under applicable community property laws or as otherwise
indicated, the persons named in the table have sole voting and sole investment
control with respect to all shares beneficially owned. The applicable
percentage of ownership for each stockholder is based on 18,868,755 shares of
common stock outstanding as of September 30, 1999, together with applicable
options for that stockholder. Shares of common stock issuable upon exercise of
options and other rights beneficially owned are deemed outstanding for the
purpose of computing the percentage ownership of the person holding those
options and other rights, but are not deemed outstanding for computing the
percentage ownership of any other person.
<TABLE>
<CAPTION>
Shares
Beneficially
Owned Prior to Shares Beneficially
Offering Shares Owned After Offering
----------------- to be -----------------------
Name of Beneficial Owner Number Percent Sold Number Percent
- ----------------------------- --------- ------- ------- ------------ ----------
<S> <C> <C> <C> <C> <C>
Entities affiliated with
Hummer Winblad Venture
Partners(1)................. 2,699,631 14.3% 0 2,699,631 12.6%
Two South Park, Second Floor
San Francisco, CA 94107
Intel Corporation............ 2,515,708 13.3 0 2,515,708 11.8
2200 Mission College
Boulevard
Santa Clara, CA 95052
Vulcan Ventures, Inc.(2)..... 998,803 5.3 0 998,803 4.7
110 110th Avenue NE, Suite
500
Bellevue, WA 98004
Metromedia Company(3)........ 977,198 5.2 97,720 879,478 4.1
1 Meadowlands Plaza East
Rutherford, NJ 07073
Gerald W. Kearby............. 937,500 5.0 93,400 844,100 4.0
Philip R. Wiser.............. 832,842 4.4 84,375 748,467 3.5
Robert G. Flynn.............. 750,000 4.0 75,000 675,000 3.2
Gary J. Iwatani(4)........... 200,000 1.0 30,000 170,000 *
Kevin M. Malone(5)........... 112,500 * 12,500 100,000 *
Richard W. Wingate(6)........ 111,000 * 10,000 101,000 *
Scott A. Steinberg(7)........ 100,000 * 0 100,000 *
Heather Furmidge(8).......... 95,000 * 0 95,000 *
Andrea Cook Fleming(9)....... 85,000 * 0 85,000 *
Leon Rishniw (10)............ 57,500 * 8,000 49,500 *
Mathieu Prevost(11).......... 40,000 * 0 40,000 *
Ann Winblad(1)............... 2,699,631 14.3 0 2,699,631 12.6
Eric P. Robison(2)........... 999,803 5.3 0 999,803 4.7
Silvia Kessel(3)............. 978,698 5.2 97,720 880,978 4.1
Sanford R. Climan(12)........ 26,700 * 0 26,700 *
All executive officers and
directors as a group
(15 persons)(13)............ 8,026,174 40.9 410,995 7,615,179 34.4
A. Robert Modeste............ 249,998 1.3 49,999 199,999 *
Other selling
stockholders(14)............ 324,500 1.7 42,930 281,570 1.3
</TABLE>
- --------
* Less than 1%
61
<PAGE>
(1) Consists of 2,594,411 shares of common stock owned by Hummer Winblad
Venture Partners II, L.P., 89,023 shares of common stock owned by Hummer
Winblad Technology Fund II, L.P. and 16,197 shares of common stock owned
by Hummer Winblad Technology Fund IIA, L.P. (collectively, the "Hummer
Winblad Funds"). John Hummer, Ann Winblad (one of our directors) and Mark
Gorenberg are general partners of Hummer Winblad Equity Partners II, L.P.
("HWII"), the general partner of each of the Hummer Winblad Funds.
Consequently, HWII and Mr. Hummer, Ms. Winblad and Mr. Gorenberg may each
be deemed to beneficially own all of the shares held by the Hummer Winblad
Funds. HWII, Mr. Hummer, Ms. Winblad and Mr. Gorenberg each disclaim
beneficial ownership of such shares, except to the extent of their
respective pecuniary interest therein.
(2) Paul Allen is the sole shareholder of Vulcan Ventures, Inc. and the
beneficial owner of the shares held by Vulcan Ventures, Inc. Mr. Robison,
one of our directors, is a business development associate of Vulcan
Ventures, Inc. Mr. Robison possesses no investment or voting power over
and disclaims beneficial ownership of the shares held by Vulcan Ventures,
Inc. Mr. Robison holds 1,000 shares of common stock in his own name.
(3) Ms. Kessel, one of our directors is Senior Vice President of Metromedia
Company. Ms. Kessel disclaims beneficial ownership of shares held by
Metromedia Company. Ms. Kessel holds 1,500 shares of common stock in her
own name, none of which are being sold in this offering.
(4) Consists of 200,000 shares of common stock issuable upon the exercise of
options exercisable within 60 days of September 30, 1999.
(5) Includes 92,500 shares of common stock issuable upon the exercise of
options exercisable within 60 days of September 30, 1999.
(6) Includes 101,000 shares of common stock issuable upon the exercise of
options exercisable within 60 days of September 30, 1999.
(7) Consists of 100,000 shares of common stock issuable upon the exercise of
stock options exercisable within 60 days of September 30, 1999.
(8) Consists of 95,000 shares of common stock issuable upon the exercise of
stock options exercisable within 60 days of September 30, 1999.
(9) Consists of 85,000 shares of common stock issuable upon the exercise of
stock options exercisable within 60 days of September 30, 1999.
(10) Includes 20,000 shares of common stock issuable upon the exercise of stock
options exercisable within 60 days of September 30, 1999.
(11) Consists of 40,000 shares of common stock issuable upon the exercise of
options exercisable within 60 days of September 30, 1999.
(12) Includes 20,000 shares of common stock issuable upon the exercise of stock
options exercisable within 60 days of September 30, 1999.
(13) Includes 753,500 shares of common stock issuable upon the exercise of
stock options exercisable within 60 days of September 30, 1999.
(14) Consists of 6 employees each selling between 450 and 15,000 shares.
62
<PAGE>
DESCRIPTION OF CAPITAL STOCK
General
Our restated certificate of incorporation authorizes the issuance of up to
50,000,000 shares of common stock, par value $0.001 per share, and
5,000,000 shares of preferred stock, par value $0.001 per share, the rights and
preferences of which may be established from time to time by our board of
directors. As of September 30, 1999, 18,868,755 shares of common stock were
outstanding. As of September 30, 1999, we had 99 stockholders of record.
Common Stock
Each holder of common stock is entitled to one vote for each share on all
matters to be voted upon by the stockholders and there are no cumulative voting
rights. Subject to preferences to which holders of preferred stock issued after
the sale of the common stock in this offering may be entitled, holders of
common stock will be entitled to receive ratably any dividends that may be
declared from time to time by the board of directors out of funds legally
available for that purpose. See "Dividend Policy." In the event of our
liquidation, dissolution or winding up, holders of common stock will be
entitled to share in our assets remaining after the payment of liabilities and
the satisfaction of any liquidation preference granted to the holders of any
outstanding shares of preferred stock. Holders of common stock have no
preemptive or conversion rights or other subscription rights and there are no
redemption or sinking fund provisions applicable to the common stock. All
outstanding shares of common stock are, and the shares of common stock offered
by us in this offering, when issued and paid for, will be, fully paid and
nonassessable. The rights, preferences and privileges of the holders of common
stock are subject to, and may be adversely affected by, the rights of the
holders of shares of any series of preferred stock that we may designate in the
future.
Preferred Stock
The board of directors has the authority, subject to any limitations
prescribed by law, without stockholder approval, from time to time to issue up
to an aggregate of 5,000,000 shares of preferred stock, par value $0.001 per
share, in one or more series, each series to have rights and preferences,
including voting rights, dividend rights, conversion rights, redemption
privileges and liquidation preferences, as may be determined by the board of
directors. The issuance of preferred stock, while providing desirable
flexibility in connection with possible acquisitions and other corporate
purposes, could have the effect of making it more difficult for a third party
to acquire, or of discouraging a third party from attempting to acquire, a
majority of our outstanding voting stock. We have no present plans to issue any
shares of preferred stock.
Warrants
As of September 30, 1999, we had outstanding a warrant to purchase 48,860
shares of common stock at an exercise price of $6.14 per share, warrants to
purchase a total of 393,203 shares of common stock at an exercise price of
$6.56 per share, a warrant to purchase 83,334 shares of common stock at an
exercise price of $26.36 per share and a warrant to purchase 83,333 shares of
common stock at an exercise price of $40.00 per share. Each warrant has a net
exercise provision under which the holder may, in lieu of payment of the
exercise price in cash, surrender the warrant and receive a net amount of
shares, based on the fair market value of our stock at the time of the exercise
of the warrant, after deducting the aggregate exercise price.
Registration Rights
Pursuant to our Second Amended and Restated Investor Rights Agreement dated
July 31, 1998, among us and our holders of preferred stock or warrants to
purchase preferred stock, the holders of approximately 9,663,624 shares of
common stock, will have rights to register those shares under the Securities
Act of 1933 after January 4, 2000. Subject to limitations in the Rights
Agreement, the holders of at least 25% of the outstanding shares of registrable
securities, or a lesser number of shares if the anticipated aggregate offering
price, before underwriting discounts and commissions, would exceed $5,000,000,
may require, on two
63
<PAGE>
occasions, that we use our best efforts to register their shares of registrable
securities for public resale. If we register any of our common stock for our
own account or for the account of other security holders, the parties to the
Rights Agreement may include their shares of common stock in the registration,
subject to the ability of the underwriters to limit the number of shares
included in the offering. Subject to limitations in the Rights Agreement, the
holders of at least 20% of our outstanding shares of registrable securities may
require us to register all or a portion of their registrable securities on Form
S-3 when we are eligible to use that form, provided that the proposed aggregate
price to the public would equal or exceed $500,000. We will bear all fees,
costs and expenses of any registration on Form S-3, other than underwriting
discounts and commissions. Upon the effectiveness of any registration statement
filed to register our common stock, all shares so registered would become
freely tradable, without any restrictions imposed by the Securities Act. The
holders of registration rights have agreed to waive their registration rights
with respect to this offering.
Effect of Provisions of Our Certificate of Incorporation and Bylaws and the
Delaware Anti-takeover Statute
Provisions of our restated certificate of incorporation and bylaws may have
the effect of making it more difficult for a third party to acquire, or of
discouraging a third party from attempting to acquire, control of us. These
provisions could limit the price that certain investors might be willing to pay
in the future for shares of our common stock. These provisions:
. divide our board of directors into three classes serving staggered three-
year terms;
. eliminate the right of stockholders to act by written consent without a
meeting;
. eliminate the right of stockholders to call special meetings;
. eliminate cumulative voting in the election of directors; and
. allow us to issue preferred stock without any vote or further action by
the stockholders.
The classification system of electing directors may tend to discourage a
third party from making a tender offer or otherwise attempting to obtain
control of us and may maintain the incumbency of our board of directors, as the
classification of the board of directors increases the difficulty of replacing
a majority of the directors. These provisions may have the effect of deferring
hostile takeovers, delaying changes in our control or management, or may make
it more difficult for stockholders to take certain corporate actions. The
amendment of any of these provisions would require approval by holders of at
least 66 2/3% of the outstanding common stock.
In addition, we are subject to Section 203 of the Delaware General
Corporation Law, which, subject to certain exceptions, prohibits a Delaware
corporation from engaging in any business combination with any interested
stockholder, unless:
. prior to the date of the proposed action, the board of directors of the
corporation approved either the business combination or the transaction
that resulted in the stockholder's becoming an interested stockholder;
. upon completion of the transaction that resulted in the stockholder's
becoming an interested stockholder, the interested stockholder owned at
least 85% of the voting stock of the corporation outstanding at the time
the transaction commenced, excluding for purposes of determining the
number of shares outstanding those shares owned by persons who are
directors and also officers and by employee stock plans in which employee
participants do not have the right to determine confidentially whether
shares held subject to the plan will be tendered in a tender or exchange
offer; or
. on or subsequent to the date of the proposed action, the business
combination is approved by the board of directors and authorized at an
annual or special meeting of stockholders, and not by written consent, by
the affirmative vote of at least 66 2/3% of the outstanding voting stock
that is not owned by the interested stockholder.
Transfer Agent and Registrar
The transfer agent and registrar for the common stock is Chase Mellon
Shareholder Services.
64
<PAGE>
SHARES AVAILABLE FOR FUTURE SALE
Sales of substantial amounts of our common stock in the public market
following the offering could cause the market price of our common stock to fall
and could affect our ability to raise capital on terms favorable to us.
Of the 21,364,831 shares to be outstanding after the offering, assuming that
the underwriters do not exercise their over-allotment option, the 3,000,000
shares of common stock sold in this offering and the 4,800,000 shares sold in
our initial public offering will be freely tradable without restriction in the
public market unless the shares are held by "affiliates," as that term is
defined in Rule 144(a) under the Securities Act of 1933. For purposes of Rule
144, an "affiliate" of an issuer is a person that, directly or indirectly
through one or more intermediaries, controls, or is controlled by or is under
common control with, the issuer.
The remaining shares of common stock to be outstanding after the offering are
"restricted securities" under the Securities Act of 1933 and may be sold in the
public market upon the expiration of the holding periods under Rule 144,
described below, subject to the volume, manner of sale and other limitations of
Rule 144. Of these shares, 9,940,892 shares will be released from lock-up
agreements from our initial public offering and will be freely tradable subject
to Rule 144 or 701 beginning January 5, 2000. An additional 3,623,939 shares
are subject to lock-up agreements that expire 90 days after the date of the
final prospectus for this offering.
In general, under Rule 144 as currently in effect, a person who has
beneficially owned shares for at least one year, including an "affiliate," is
entitled to sell, within any three-month period, a number of shares that does
not exceed the greater of:
. 1% of the then outstanding shares of our common stock (approximately
213,648 shares immediately following the offering); or
. the average weekly trading volume during the four calendar weeks
preceding filing of notice of the sale of shares of common stock.
Sales under Rule 144 are also subject to certain manner of sale provisions,
notice requirements and the availability of current public information about
us. A stockholder who is deemed not to have been an "affiliate" of ours at any
time during the 90 days preceding a sale, and who has beneficially owned
restricted shares for at least two years, would be entitled to sell shares
under Rule 144(k) without regard to the volume limitations, manner of sale
provisions or public information requirements.
In addition, as of September 30, 1999, there were outstanding warrants to
purchase 608,730 shares of common stock and options to purchase 1,335,873
shares of common stock, of which approximately 253,937 options were fully
vested. An additional 1,114,833 shares are reserved for issuance under our 1996
Equity Incentive Plan.
Holders of 9,663,624 shares of common stock are entitled to registration
rights with respect to these shares for resale under the Securities Act of
1933. If these holders, by exercising their registration rights, cause a large
number of shares to be registered and sold in the public market, these sales
could harm the market price for our common stock. These registration rights may
not be exercised before January 5, 2000 upon the expiration of the 180 days
lock-up agreements from our initial public offering. See "Description of
Capital Stock--Registration Rights."
Lock-Up Arrangements
Along with our officers and directors, all holders of our common stock,
warrants and options have agreed not to sell or otherwise dispose of any shares
of common stock until January 5, 2000, other than those sales made in this
offering, without prior written consent. In addition, each of the selling
stockholders and each of our officers have agreed not to sell or otherwise
dispose of any shares of common stock until 90 days after the date of this
prospectus.
65
<PAGE>
UNDERWRITING
Under the underwriting agreement, which is filed as an exhibit to the
registration statement relating to this prospectus, the underwriters named
below, for whom Lehman Brothers Inc., BancBoston Robertson Stephens Inc., U.S.
Bancorp Piper Jaffray Inc., Dain Rauscher Wessels, a division of Dain Rauscher
Incorporated, and Fidelity Capital Markets, a division of National Financial
Services Corporation, are acting as representatives, have each agreed to
purchase from us and the selling stockholders the respective number of shares
of common stock shown opposite its name below:
<TABLE>
<CAPTION>
Number of
Underwriters Shares
--------------------------------------------------------------- ---------
<S> <C>
Lehman Brothers Inc. .......................................... 1,595,000
BancBoston Robertson Stephens Inc. ............................ 435,000
U.S. Bancorp Piper Jaffray Inc. ............................... 435,000
Dain Rauscher Wessels, a division of Dain Rauscher Incorporated
.............................................................. 435,000
Fidelity Capital Markets, a division of National Financial
Services Corporation.......................................... 100,000
---------
Total......................................................... 3,000,000
=========
</TABLE>
The underwriting agreement provides that the underwriters' obligations to
purchase shares of common stock depend on the satisfaction of the conditions
contained in the underwriting agreement and that, if any of the shares of
common stock are purchased by the underwriters under the underwriting
agreement, all of the shares of common stock that the underwriters have agreed
to purchase under the underwriting agreement, must be purchased. The conditions
contained in the underwriting agreement include the requirement that the
representations and warranties made by us and the selling stockholders to the
underwriters are true, that there is no material change in the financial
markets and that we deliver to the underwriters customary closing documents.
The representatives have advised us that the underwriters propose to offer
the shares of common stock directly to the public at the public offering price
set forth on the cover page of this prospectus, and to dealers, who may include
the underwriters, at this public offering price less a selling concession not
in excess of $1.00 per share. The underwriters may allow, and the dealers may
reallow, a concession not in excess of $.10 per share to brokers and dealers.
After the offering, the underwriters may change the offering price and other
selling terms.
We have granted to the underwriters an option to purchase up to 450,000
additional shares of our common stock, exercisable solely to cover over-
allotments, if any, at the public offering price less the underwriting discount
shown on the cover page of this prospectus. The underwriters may exercise this
option at any time until 30 days after the date of the underwriting agreement.
If this option is exercised, each underwriter will be committed, so long as the
conditions of the underwriting agreement are satisfied, to purchase a number of
additional shares of common stock proportionate to the underwriter's initial
commitment as indicated in the table above and we will be obligated, under the
over-allotment option, to sell the shares of common stock to the underwriters.
We, the selling stockholders and our executive officers have agreed that,
without the prior consent of Lehman Brothers, we and they will not, directly or
indirectly, offer, sell or otherwise dispose of any shares of common stock or
any securities that may be converted into or exchanged for any shares of common
stock for a period of 90 days from the date of this prospectus. All of our
executive officers and directors and stockholders holding all of the shares of
our common stock, including all of the holders of the warrants, have agreed
under lock-up agreements that, without the prior written consent of Lehman
Brothers, they will not, directly or indirectly, offer, sell or otherwise
dispose of any shares of common stock or any securities that may be converted
into or exchanged for any shares of common stock until January 5, 2000. See
"Shares Available for Future Sale."
66
<PAGE>
The common stock is quoted on the Nasdaq National Market under the symbol
"LQID."
Fidelity Capital Markets, a division of National Financial Services
Corporation, is acting as an underwriter in this offering, and will be
facilitating electronic distribution of information through the Internet,
intranet and other proprietary electronic technology.
We and the selling stockholders have agreed to indemnify the underwriters
against liabilities, including liabilities under the Securities Act and
liabilities arising from breaches of the representations and warranties
contained in the underwriting agreement, and to contribute to payments that the
underwriters may be required to make for these liabilities.
Until the distribution of the common stock is completed, rules of the
Securities and Exchange Commission may limit the ability of the underwriters
and selling group members to bid for and purchase shares of common stock. As an
exception to these rules, the representatives are permitted to engage in
transactions that stabilize the price of the common stock. These transactions
may consist of bids or purchases for the purposes of pegging, fixing or
maintaining the price of the common stock.
The underwriters may create a short position in the common stock in
connection with the offering, which means that they may sell more shares than
are set forth on the cover page of this prospectus. If the underwriters create
a short position, then the representatives may reduce that short position by
purchasing common stock in the open market. The representatives also may elect
to reduce any short position by exercising all or part of the over-allotment
option.
In general, purchases of a security for the purpose of stabilization or to
reduce a syndicate short position could cause the price of the security to be
higher than it might otherwise be in the absence of these purchases.
None of Liquid Audio, the selling stockholders or any of the underwriters
makes any representation or prediction as to the direction or magnitude of any
effect that the transactions described above may have on the price of the
common stock. In addition, none of Liquid Audio, the selling stockholders or
any of the underwriters makes any representation that the representatives will
engage in these transactions or that these transactions, once commenced, will
not be discontinued without notice.
Any offers in Canada will be made only under an exemption from the
requirements to file a prospectus in the relevant province of Canada in which
the sale is made.
Purchasers of the shares of common stock offered in this prospectus may be
required to pay stamp taxes and other charges under the laws and practices of
the country of purchase, in addition to the offering price listed on the cover
page of this prospectus.
As permitted by Rule 103 of Regulation M promulgated by the Securities and
Exchange Commission under the Exchange Act, the underwriters, if any, that are
market makers, referred to as passive market makers, in the common stock, may
make bids for or purchases of the common stock on the Nasdaq National Market
until the time, if any, when a stabilizing bid for the securities has been
made. Rule 103 generally provides that:
. a passive market maker's net daily purchases of the common stock may not
exceed 30% of its average daily trading volume in the securities for the
two full consecutive calendar months (or any 60 consecutive days ending
within the 10 days) immediately preceding the filing date of the
registration statement of which this prospectus forms a part;
. a passive market maker may not effect transactions or display bids for
the common stock at a price that exceeds the highest independent bid for
the common stock by persons who are not passive market makers; and
. bids made by passive market makers must be identified as such.
67
<PAGE>
LEGAL MATTERS
Wilson Sonsini Goodrich & Rosati, P.C., Palo Alto, California will pass upon
the validity of the common stock that we are selling in this offering. Fenwick
& West LLP, Palo Alto, California will pass upon legal matters for the
underwriters. As of the date of this prospectus, Wilson Sonsini Goodrich &
Rosati and its partners beneficially owned 4,071 shares of our common stock,
and an investment partnership comprised of partners of Fenwick & West
beneficially owned 22,863 shares of our common stock.
EXPERTS
The financial statements as of December 31, 1997 and 1998 and for the period
from January 30, 1996 (inception) through December 31, 1996, and for the years
ended December 31, 1997 and 1998 included in this prospectus have been so
included in reliance upon the report of PricewaterhouseCoopers LLP, independent
accountants, given on the authority of said firm as experts in auditing and
accounting.
WHERE YOU MAY FIND ADDITIONAL INFORMATION
We have filed with the Securities and Exchange Commission a registration
statement on Form S-1, including the exhibits filed with the registration
statement, under the Securities Act of 1933 with respect to the shares to be
sold in this offering. This prospectus does not contain all the information set
forth in the registration statement. For further information with respect to us
and the shares to be sold in this offering, we refer you to the registration
statement. Statements contained in this prospectus as to the contents of any
contract, agreement or other document to which we make reference, are not
necessarily complete, and in each instance we refer you to the copy of the
contract, agreement or other document filed as an exhibit to the registration
statement, each statement being qualified in all respects by the more complete
description of the matter involved.
We file annual, quarterly and special reports, proxy statements and other
information with the SEC. You may read and copy any document we file at the
public reference facilities of the SEC located at 450 Fifth Street N.W.,
Washington D.C. 20549. You may obtain information on the operation of the SEC's
public reference facilities by calling the SEC at 1-800-SEC-0330. You can also
access copies of such material electronically on the SEC's home page on the
World Wide Web at http://www.sec.gov.
68
<PAGE>
LIQUID AUDIO, INC.
INDEX TO FINANCIAL STATEMENTS
<TABLE>
<CAPTION>
Page
----
<S> <C>
Report of Independent Accountants.......................................... F-2
Balance Sheet.............................................................. F-3
Statement of Operations.................................................... F-4
Statement of Stockholders' Deficit......................................... F-5
Statement of Cash Flows.................................................... F-6
Notes to Financial Statements.............................................. F-7
</TABLE>
F-1
<PAGE>
REPORT OF INDEPENDENT ACCOUNTANTS
To the Board of Directors and Stockholders of
Liquid Audio, Inc.
In our opinion, the accompanying balance sheet and the related statements of
operations, of stockholders' deficit and of cash flows present fairly, in all
material respects, the financial position of Liquid Audio, Inc. at December 31,
1997 and 1998, and the results of its operations and its cash flows for the
period from January 30, 1996 (inception) through December 31, 1996, and for the
years ended December 31, 1997 and 1998 in conformity with generally accepted
accounting principles. These financial statements are the responsibility of the
Company's management; our responsibility is to express an opinion on these
financial statements based on our audits. We conducted our audits of these
statements in accordance with generally accepted auditing standards which
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, assessing the accounting principles
used and significant estimates made by management, and evaluating the overall
financial statement presentation. We believe that our audits provide a
reasonable basis for the opinion expressed above.
PricewaterhouseCoopers LLP
San Jose, California
August 20, 1999
F-2
<PAGE>
LIQUID AUDIO, INC.
BALANCE SHEET
(in thousands except share data)
<TABLE>
<CAPTION>
December 31,
----------------- September 30,
1997 1998 1999
------- -------- -------------
Assets (unaudited)
<S> <C> <C> <C>
Current assets:
Cash and cash equivalents........................ $ 2,387 $ 14,143 $62,913
Short-term investments........................... -- 3,001 7,603
Accounts receivable, net......................... 84 376 183
Receivables from related parties................. -- 615 942
Other current assets............................. 136 314 917
------- -------- --------
Total current assets............................ 2,607 18,449 72,558
------- -------- --------
Property and equipment, net....................... 671 1,507 4,320
Other assets...................................... 57 70 117
------- -------- --------
Total assets.................................. $ 3,335 $ 20,026 $ 76,995
======= ======== ========
<CAPTION>
Liabilities, mandatorily redeemable convertible
preferred stock and warrants and stockholders'
equity (deficit)
<S> <C> <C> <C>
Current liabilities:
Accounts payable................................. $ 405 $ 802 $ 2,177
Accrued expenses and other current liabilities... 732 932 2,361
Deferred revenue................................. 90 1,177 1,191
Capital lease obligations, current portion....... 122 197 185
Equipment loan, current portion.................. -- 281 589
Line of credit................................... 400 -- --
------- -------- --------
Total current liabilities....................... 1,749 3,389 6,503
------- -------- --------
Capital lease obligations, non-current portion.... 218 330 231
Equipment loan, non-current portion............... -- 639 879
Note payable to related party..................... -- -- 425
------- -------- --------
Total liabilities............................. 1,967 4,358 8,038
------- -------- --------
Series A, B and C mandatorily redeemable
convertible preferred stock and warrants (note
5)............................................... 8,247 29,801 --
------- -------- --------
Commitments and contingencies (note 9)
Stockholders' equity (deficit):
Preferred stock, $0.001 par value; 5,000,000
shares authorized; none issued or outstanding
(unaudited)..................................... --
Common stock, $0.001 par value; 25,878,000 shares
authorized; 3,899,643, 3,916,045 and 18,868,755
(unaudited) shares issued
and outstanding................................. 4 4 19
Additional paid-in capital....................... 2,159 3,917 102,362
Unearned compensation............................ (1,562) (2,035) (1,370)
Accumulated deficit.............................. (7,480) (16,019) (32,054)
------- -------- --------
Total stockholders' equity (deficit).......... (6,879) (14,133) 68,957
------- -------- --------
Total liabilities, mandatorily redeemable
convertible preferred stock and warrants and
stockholders' equity (deficit)............... $ 3,335 $ 20,026 $ 76,995
======= ======== ========
</TABLE>
The accompanying notes are an integral part of these financial statements.
F-3
<PAGE>
LIQUID AUDIO, INC.
STATEMENT OF OPERATIONS
(in thousands, except share and per share amounts)
<TABLE>
<CAPTION>
Period From
January 30, Nine Months Ended
1996 (inception) Year Ended December 31, September 30,
Through December ------------------------- ---------------------
31, 1996 1997 1998 1998 1999
---------------- ----------- ------------ --------- ----------
(unaudited)
<S> <C> <C> <C> <C> <C>
Net revenues:
License................ $ -- $ 246 $ 1,235 $ 808 $ 1,129
Services............... -- 10 268 169 367
Business development
(related party)....... -- -- 1,300 750 1,565
------- ----------- ------------ --------- ----------
Total net revenues.... -- 256 2,803 1,727 3,061
------- ----------- ------------ --------- ----------
Cost of net revenues:
License................ -- 302 310 175 156
Services............... -- 91 242 170 649
Business development
(related party)....... -- -- 2 -- 68
------- ----------- ------------ --------- ----------
Total cost of net
revenues............. -- 393 554 345 873
------- ----------- ------------ --------- ----------
Gross profit (loss)..... -- (137) 2,249 1,382 2,188
------- ----------- ------------ --------- ----------
Operating expenses:
Sales and marketing.... 237 2,820 4,035 2,676 6,449
Research and
development........... 692 1,880 4,109 2,666 7,710
General and
administrative........ 327 898 1,642 1,155 1,741
Strategic marketing--
equity instruments.... -- -- -- -- 2,190
Stock compensation
expense............... 31 534 1,241 882 1,119
------- ----------- ------------ --------- ----------
Total operating
expenses............. 1,287 6,132 11,027 7,379 19,209
------- ----------- ------------ --------- ----------
Loss from operations.... (1,287) (6,269) (8,778) (5,997) (17,021)
Interest income......... 24 125 379 151 1,172
Interest expense........ (1) (72) (140) (100) (138)
Other income (expense),
net.................... -- -- -- -- (48)
------- ----------- ------------ --------- ----------
Net loss................ $(1,264) $ (6,216) $ (8,539) $ (5,946) $ (16,035)
======= =========== ============ ========= ==========
Net loss per share:
Basic and diluted...... $(14.93) $ (4.95) $ (3.60) $ (2.67) $ (2.07)
======= =========== ============ ========= ==========
Weighted average
shares................ 84,635 1,256,114 2,370,564 2,227,000 7,755,000
======= =========== ============ ========= ==========
Pro forma net loss per
share:
Basic and diluted
(unaudited)........... $ (0.85) $ (1.10)
============ ==========
Weighted average shares
(unaudited)........... 10,041,546 14,561,000
============ ==========
</TABLE>
The accompanying notes are an integral part of these financial statements.
F-4
<PAGE>
LIQUID AUDIO, INC.
STATEMENT OF STOCKHOLDERS' DEFICIT
(in thousands except share amounts)
<TABLE>
<CAPTION>
Common Stock Additional
------------------ Paid-in Unearned Accumulated
Shares Amount Capital Compensation Deficit Total
---------- ------ ---------- ------------ ----------- -------
<S> <C> <C> <C> <C> <C> <C>
Issuance of common stock
to founders............ 3,431,244 $ 3 $ 2 $ -- $ -- $ 5
Unearned compensation... -- -- 239 (239) -- --
Amortization of unearned
compensation........... -- -- -- 31 -- 31
Net loss................ -- -- -- -- (1,264) (1,264)
---------- ---- -------- ------- -------- -------
Balance at December 31,
1996................... 3,431,244 3 241 (208) (1,264) (1,228)
Exercise of stock
options................ 468,399 1 30 -- -- 31
Unearned compensation... -- -- 1,888 (1,888) -- --
Amortization of unearned
compensation........... -- -- -- 534 -- 534
Net loss................ -- -- -- -- (6,216) (6,216)
---------- ---- -------- ------- -------- -------
Balance at December 31,
1997................... 3,899,643 4 2,159 (1,562) (7,480) (6,879)
Repurchase of founders'
common stock........... (87,868) -- -- -- -- --
Repurchase of common
stock in connection
with unvested stock
options previously
exercised.............. (24,219) -- (2) -- -- (2)
Exercise of stock
options................ 90,173 -- 6 -- -- 6
Issuance of common stock
in connection with
marketing agreement.... 38,316 -- 40 -- -- 40
Unearned compensation... -- -- 1,714 (1,714) -- --
Amortization of unearned
compensation........... -- -- -- 1,241 -- 1,241
Net loss................ -- -- -- -- (8,539) (8,539)
---------- ---- -------- ------- -------- -------
Balance at December 31,
1998................... 3,916,045 4 3,917 (2,035) (16,019) (14,133)
Repurchase of common
stock in connection
with unvested stock
options previously
exercised (unaudited).. (36,486) -- (2) -- -- (2)
Issuance of common stock
for services rendered
(unaudited)............ 100,000 -- 1,100 -- -- 1,100
Issuance of common stock
warrants in connection
with a strategic
marketing agreement
(unaudited)............ -- -- 1,090 -- -- 1,090
Conversion of
mandatorily redeemable
convertible preferred
stock upon initial
public offering
(unaudited)............ 9,744,199 10 29,791 -- -- 29,801
Issuance of common stock
(unaudited)............ 4,821,216 5 65,892 -- -- 65,897
Exercise of stock
options (unaudited).... 323,781 -- 120 -- -- 120
Unearned compensation
(unaudited)............ -- -- 454 (454) -- --
Amortization of unearned
compensation
(unaudited)............ -- -- -- 1,119 -- 1,119
Net loss (unaudited).... -- -- -- -- (16,035) (16,035)
---------- ---- -------- ------- -------- -------
Balance at September 30,
1999 (unaudited)....... 18,868,755 $ 19 $102,362 $(1,370) $(32,054) $68,957
========== ==== ======== ======= ======== =======
</TABLE>
The accompanying notes are an integral part of these financial statements.
F-5
<PAGE>
LIQUID AUDIO, INC.
STATEMENT OF CASH FLOWS
(in thousands)
<TABLE>
<CAPTION>
Period From
January 30, Nine Months
1996 (inception) Year Ended Ended
Through December 31, September 30,
December 31, ---------------- -----------------
1996 1997 1998 1998 1999
---------------- ------- ------- ------- --------
Cash flows from operating
activities: (unaudited)
<S> <C> <C> <C> <C> <C>
Net loss................ $(1,264) $(6,216) $(8,539) $(5,946) $(16,035)
Adjustments to reconcile
net loss to net cash
used in operating
activities:
Depreciation and
amortization.......... 34 121 451 262 646
Amortization of
unearned
compensation.......... 31 534 1,241 882 1,119
Allowance for doubtful
accounts.............. -- 55 210 180 33
Equity investment
losses................ -- -- 400 -- 378
Strategic marketing-
equity instruments.... -- -- -- -- 2,190
Other.................. -- -- -- -- 49
Changes in assets and
liabilities:
Accounts receivable.... -- (139) (502) (278) 160
Receivables from
related parties....... -- -- (615) (57) (327)
Other assets........... (38) (155) (191) (197) (650)
Accounts payable....... 21 384 397 (60) 1,375
Accrued expenses and
other current
liabilities........... 142 590 259 291 1,429
Deferred revenue....... 15 75 1,087 684 14
------- ------- ------- ------- --------
Net cash used in
operating activities.. (1,059) (4,751) (5,802) (4,239) (9,619)
------- ------- ------- ------- --------
Cash flows from investing
activities:
Acquisition of property
and equipment.......... (83) (319) (982) (480) (3,422)
Purchases of short-term
investments............ -- -- (3,001) (1,005) (4,602)
Equity investment....... -- -- (400) -- --
------- ------- ------- ------- --------
Net cash used in
investing activities.. (83) (319) (4,383) (1,485) (8,024)
------- ------- ------- ------- --------
Cash flows from financing
activities:
Proceeds from issuance
of mandatorily
redeemable convertible
preferred stock........ 1,941 6,246 21,535 21,554 --
Proceeds from issuance
of common stock........ 5 31 4 4 66,013
Payments made under
capital leases......... -- (84) (118) (76) (148)
Proceeds from equipment
loan................... -- -- 920 -- 846
Payments made under
equipment loan......... -- -- -- -- (298)
Proceeds from borrowings
under line of credit... -- 400 -- -- --
Payments made under line
of credit.............. -- -- (400) (400) --
Proceeds from short-term
loan................... -- 400 1,330 1,160 --
Payments on short-term
loan................... -- (400) (1,330) (1,160) --
Proceeds from issuance
of convertible
promissory note to
related party.......... 60 -- -- -- --
------- ------- ------- ------- --------
Net cash provided by
financing activities.. 2,006 6,593 21,941 21,082 66,413
------- ------- ------- ------- --------
Net increase (decrease)
in cash and cash
equivalents............ 864 1,523 11,756 (15,358) 48,770
Cash and cash
equivalents at
beginning of period.... -- 864 2,387 2,387 14,143
------- ------- ------- ------- --------
Cash and cash
equivalents at end of
period................. $ 864 $ 2,387 $14,143 $17,745 $ 62,913
======= ======= ======= ======= ========
Supplemental disclosures:
Cash paid for interest.. $ 1 $ 72 $ 121 $ 101 $ 138
Non-cash investing and
financing activities:
Acquisition of property
and equipment through
capital leases......... $ 135 $ 289 $ 305 $ 177 $ 37
Issuance of common stock
for services rendered.. $ -- $ -- $ 40 $ -- $ 1,100
Issuance of warrants in
connection with a
strategic marketing
agreement.............. $ -- $ -- $ -- $ -- $ 1,090
Conversion of
convertible promissory
note to Series A
mandatorily redeemable
convertible preferred
stock.................. $ 60 $ -- $ -- $ -- $ --
Equity investment with
note payable........... $ -- $ -- $ -- $ -- $ 378
</TABLE>
The accompanying notes are an integral part of these financial statements.
F-6
<PAGE>
LIQUID AUDIO, INC.
NOTES TO FINANCIAL STATEMENTS
NOTE 1--THE COMPANY AND SUMMARY OF ITS SIGNIFICANT ACCOUNTING POLICIES:
The Company
Liquid Audio, Inc. (the "Company") was incorporated in California in January
1996 and reincorporated in Delaware in April 1999 with the goal of becoming the
premier provider of software applications and services that enable the secure
delivery and sale of digital music over the Internet. To this end, the Company
has developed an end-to-end solution for promoting and distributing music over
the Internet. The Company's solutions enable the secure distribution of high
quality music files while providing consumers with the ability to access,
preview and purchase that music via the Internet.
In July 1999, the Company completed its initial public offering of common
stock. A total of 4,800,000 shares were sold at $15.00 per share. Net proceeds
to the Company, after deducting the underwriting discount and offering
expenses, were $65.9 million.
Unaudited interim results
The interim financial statements as of September 30, 1999 and for the nine
months ended September 30, 1998 and 1999 are unaudited. The unaudited interim
financial statements have been prepared on the same basis as the annual
financial statements and, in the opinion of management, reflect all
adjustments, which include only normal recurring adjustments, necessary to
present fairly the Company's financial position, results of operations and cash
flows as of September 30, 1999 and for the nine months ended September 30, 1998
and 1999. The financial data and other information disclosed in these notes to
financial statements related to these periods are unaudited. The results for
the nine months ended September 30, 1999 are not necessarily indicative of the
results to be expected for the year ending December 31, 1999.
Use of estimates
The preparation of financial statements in conformity with generally accepted
accounting principles requires the Company's management to make estimates and
assumptions that affect the reported amounts of assets and liabilities and
disclosure of contingent assets and liabilities at the date of the financial
statements and the reported amounts of revenues and expenses during the
reporting period. Actual results could differ from those estimates.
F-7
<PAGE>
LIQUID AUDIO, INC.
NOTES TO FINANCIAL STATEMENTS--(Continued)
Cash and cash equivalents and short-term investments
All highly liquid investments with a maturity of three months or less when
purchased are considered to be cash equivalents, and those with maturities
greater than three months are considered short-term investments. Cash and cash
equivalents consist of cash on deposit with banks, money market funds and
commercial securities that are stated at cost, which approximates fair value.
The Company classifies all short-term investments as available-for-sale.
Accordingly, these investments are carried at fair value. The fair value of
such securities approximates cost, and there were no material unrealized gains
or losses at December 31, 1998 and September 30, 1999 (unaudited). The
following schedule summarizes the estimated fair value of the Company's cash,
cash equivalents and short-term investments (in thousands):
<TABLE>
<CAPTION>
December 31,
-------------- September 30,
1997 1998 1999
------ ------- -------------
(unaudited)
<S> <C> <C> <C>
Cash and cash equivalents:
Cash.............................................. $ 136 $ 1,034 $ 1,318
Money market funds................................ 2,251 3,102 533
Commercial securities............................. -- 10,007 61,062
------ ------- -------
$2,387 $14,143 $62,913
====== ======= =======
Short-term investments:
Commercial securities............................. $ -- $ -- $ 3,637
U.S. Government bonds............................. -- 3,001 3,966
------ ------- -------
$ -- $ 3,001 $ 7,603
====== ======= =======
</TABLE>
All short-term investments had a contractual maturity of one year or less.
Concentration of credit risk
Financial instruments that potentially subject the Company to significant
concentrations of credit risk consist primarily of cash and cash equivalents,
short-term investments and accounts receivable. Substantially all of the
Company's cash and cash equivalents are invested in a highly-liquid money
market fund and commercial securities with major financial institutions. Short-
term investments are invested in government bonds. The Company performs ongoing
credit evaluations of its customers and maintains an allowance for potential
credit losses. Credit losses to date have been within management's estimates.
The following table sets forth customers comprising 10% or more of the
Company's total net revenues for each of the periods indicated:
<TABLE>
<CAPTION>
Period from Nine Months
January 30, Ended
1996 (inception) Year Ended September
Through December 31, 30,
December 31, --------------- -------------
Customer 1996 1997 1998 1998 1999
-------- ---------------- ------ ------ ----- -----
(unaudited)
<S> <C> <C> <C> <C> <C>
A......................... -- 49% -- --
B......................... -- 12 -- -- --
C......................... -- 10 -- -- --
D......................... -- -- 34% 29% --
E......................... -- -- -- -- 31%
F......................... -- -- -- 13 35
G......................... -- -- -- -- 12
</TABLE>
F-8
<PAGE>
LIQUID AUDIO, INC.
NOTES TO FINANCIAL STATEMENTS--(Continued)
At December 31, 1997, two customers represented 17% and 16%, respectively, of
gross accounts receivable. At December 31, 1998, one customer represented 26%
of gross accounts receivable. At September 30, 1999, one customer represented
27% (unaudited) of gross accounts receivable.
Fair value of financial instruments
The Company's financial instruments, including cash and cash equivalents,
short-term investments, accounts receivable, accounts payable, capital lease
obligations, an equipment loan, a line of credit and a note payable to a
related party are carried at cost. The Company's short-term financial
instruments approximate fair value due to their relatively short maturities.
The carrying value of the Company's long-term financial instruments approximate
fair value as the interest rates approximate current market rates of similar
debt. The Company does not hold or issue financial instruments for trading
purposes.
Property and equipment
Property and equipment, including leasehold improvements, are stated at
historical cost. Depreciation and amortization are computed using the straight-
line method over the estimated useful lives of the assets, generally three
years, or for leasehold improvements, the term of the lease, whichever is
shorter. Assets held under capital leases are amortized using the straight-line
method over the shorter of the estimated useful life of the asset or the life
of the lease, generally three years.
Long-lived assets held and used by the Company, or to be disposed of, are
reviewed for impairment whenever events or changes in circumstances indicate
that their net book value may not be recoverable. An impairment loss is
recognized if the sum of the expected future cash flows (undiscounted and
before interest) from the use of the asset is less than the net book value of
the asset. The amount of the impairment loss will generally be measured as the
difference between net book value of the assets and their estimated fair
values. Based on its most recent analysis, the Company believes that no
impairment of long-lived assets existed at December 31, 1996, 1997 and 1998 and
September 30, 1999 (unaudited).
Revenue recognition
The Company's revenues are derived from the licensing of software products
(including maintenance), hosting, music delivery, encoding, integration and
installation services, and business development contracts. Revenues are
recognized for the various contract elements based upon vendor-specific
objective evidence of the fair value for each element, in accordance with
Statement of Position No. 97-2, "Software Revenue Recognition" ("SOP 97-2") and
related guidance. License revenues are recognized when persuasive evidence of
an agreement exists, delivery of the product has occurred, no significant
Company obligations with regard to implementation or integration exist, the fee
is fixed or determinable and collectibility is probable. Provisions for sales
returns are provided at the time of revenue recognition based upon estimated
returns.
Maintenance and hosting fees are deferred and recognized as service revenue
on a straight-line basis over the life of the related contract, which is
typically one year. Music delivery service revenue is recognized at the time
digital music is delivered. Encoding, integration and installation service fees
are deferred and recognized as service revenue over the period the services are
provided.
Business development revenue consists of business development fees derived
from contractual agreements with the Company's strategic partners. These U.S.
dollar denominated nonrefundable fees are based upon agreements whereby the
strategic partners are contractually obligated to pay to the Company a fixed
fee for the opportunity to develop businesses in various countries using the
Company's proprietary technology. The fees are recognized by the Company as
earned, the specific timing of which depends on the terms and conditions of the
particular contractual arrangements. In addition to the business development
fees recognized by the Company, other fees are recognized as products are
delivered (see note 2).
F-9
<PAGE>
LIQUID AUDIO, INC.
NOTES TO FINANCIAL STATEMENTS--(Continued)
Research and development costs
Expenditures for research and development are charged to expense as incurred.
Under Statement of Financial Accounting Standards No. 86, "Accounting for the
Costs of Computer Software to be Sold, Leased or Otherwise Marketed," certain
software development costs are capitalized after technological feasibility has
been established. Development costs incurred in the period from achievement of
technological feasibility, which the Company defines as the establishment of a
working model, until the general availability of such software to customers,
has been short, and therefore software development costs qualifying for
capitalization have been insignificant. Accordingly, the Company has not
capitalized any software development costs as of December 31, 1998 or September
30, 1999 (unaudited).
Advertising
Advertising costs are expensed as incurred. The following table sets forth
advertising costs (in thousands):
<TABLE>
<CAPTION>
Period from Nine Months
January 30, Ended
1996 (inception) Year Ended September
Through December 31, 30,
December 31, ------------- -----------
1996 1997 1998 1998 1999
---------------- ------ ------ ----- -----
(unaudited)
<S> <C> <C> <C> <C> <C>
Advertising costs.................... $ -- $ 53 $ 247 $ 151 $ 612
</TABLE>
Stock-based compensation
The Company accounts for stock-based employee compensation arrangements in
accordance with provisions of Accounting Principles Board Opinion No. 25,
"Accounting for Stock Issued to Employees" ("APB No. 25") and Financial
Accounting Standards Board Interpretation No. 28, "Accounting for Stock
Appreciation Rights and Other Variable Stock Option or Award Plans", and
complies with the disclosure provisions of Statement of Financial Accounting
Standards No. 123, "Accounting for Stock-Based Compensation" ("SFAS No. 123").
Under APB No. 25, compensation expense is based on the difference, if any, on
the date of the grant, between the fair value of the Company's stock and the
exercise price. The Company accounts for stock issued to non-employees in
accordance with the provisions of SFAS No. 123 and Emerging Issues Task Force
No. 96-18 "Accounting for Equity Instruments That Are Issued to Other Than
Employees for Acquiring, or in Conjunction with Selling, Goods or Services."
Income taxes
Income taxes are accounted for using the asset and liability approach, which
requires the recognition of taxes payable or refundable for the current year
and deferred tax liabilities and assets for the future tax consequences of
events that have been recognized in the Company's financial statements or tax
returns. The measurement of current and deferred tax liabilities and assets are
based on provisions of the enacted tax laws; the effects of future changes in
tax laws or rates are not anticipated. The measurement of deferred tax assets
is reduced, if necessary, by the amount of any tax benefits that, based on
available evidence, are not expected to be realized.
Net loss per share
The Company computes net loss per share in accordance with Statement of
Financial Accounting Standards No. 128, "Earnings per Share" ("SFAS No. 128")
and SEC Staff Accounting Bulletin No. 98 ("SAB No. 98"). Under the provisions
of SFAS No. 128 and SAB No. 98, basic and diluted net loss per share is
computed by dividing the net loss available to common stockholders for the
period by the weighted average
F-10
<PAGE>
LIQUID AUDIO, INC.
NOTES TO FINANCIAL STATEMENTS--(Continued)
number of common shares outstanding during the period. The calculation of
diluted net loss per share excludes potential common shares if the effect is
anti-dilutive. Potential common shares consist of unvested restricted common
stock, incremental common shares issuable upon the exercise of stock options,
shares issuable upon conversion of the Series A, Series B and Series C
mandatorily redeemable convertible preferred stock and common shares issuable
upon the exercise of common and mandatorily redeemable convertible preferred
stock warrants.
The following table sets forth the computation of basic and diluted net loss
per share for the periods indicated (in thousands, except per share amounts):
<TABLE>
<CAPTION>
Period from Nine Months
January 30, Year Ended Ended September
1996 (inception) December 31, 30,
Through December ---------------- -----------------
31, 1996 1997 1998 1998 1999
---------------- ------- ------- ------- --------
(unaudited)
<S> <C> <C> <C> <C> <C>
Numerator:
Net loss................ $(1,264) $(6,216) $(8,539) $(5,946) $(16,035)
------- ------- ------- ------- --------
Denominator:
Weighted average
shares................. 2,288 3,682 3,888 3,923 8,469
Weighted average
unvested common shares
subject to repurchase.. (2,203) (2,426) (1,517) (1,696) (714)
------- ------- ------- ------- --------
Denominator for basic
and diluted
calculation............ 85 1,256 2,371 2,227 7,755
======= ======= ======= ======= ========
Net loss per share:
Basic and diluted....... $(14.93) $ (4.95) $ (3.60) $ (2.67) $ (2.07)
======= ======= ======= ======= ========
</TABLE>
The following table sets forth potential shares of common stock that are not
included in the diluted net loss per share calculation above because to do so
would be anti-dilutive for the periods indicated (in thousands):
<TABLE>
<CAPTION>
December September
31, 30,
December 31, ----------- -----------
1996 1997 1998 1998 1999
------------ ----- ----- ----- -----
(unaudited)
<S> <C> <C> <C> <C> <C>
Series A mandatorily redeemable
convertible preferred stock............. 3,050 3,050 3,050 3,050 3,050
Series B mandatorily redeemable
convertible preferred stock............. -- 3,187 3,187 3,187 3,187
Series C mandatorily redeemable
convertible preferred stock............. -- -- 3,507 3,507 3,507
Mandatorily redeemable convertible
preferred stock warrants................ -- 9 18 20 20
Common stock options..................... 419 861 1,067 850 1,336
Common stock warrants.................... -- -- 49 49 695
</TABLE>
Pro forma net loss per share (unaudited)
Pro forma net loss per share for the year ended December 31, 1998 and
September 30, 1999 is computed using the weighted average number of common
shares outstanding, including the pro forma effects of the automatic conversion
of the Company's Series A, Series B and Series C mandatorily redeemable
convertible preferred stock into shares of the Company's common stock effective
upon the closing of the Company's initial public offering ("offering") as if
such conversion occurred on January 1, 1998, or at date of original issuance,
if later. The resulting pro forma adjustment includes an increase in the
weighted average shares used to compute basic and diluted net loss per share of
7,670,982 and 6,806,000 for the year ended December 31, 1998 and September 30,
1999, respectively. The calculation of diluted net loss per share excludes
potential common shares as the effect would be anti-dilutive. Pro forma common
equivalent shares are composed of unvested
F-11
<PAGE>
LIQUID AUDIO, INC.
NOTES TO FINANCIAL STATEMENTS--(Continued)
restricted common stock and incremental common shares issuable upon the
exercise of stock options and warrants.
Comprehensive income
The Financial Accounting Standards Board ("FASB") recently issued Statement
of Financial Accounting Standards No. 130, "Reporting Comprehensive Income"
("SFAS No. 130"). SFAS No. 130 establishes standards for reporting
comprehensive income and its components in financial statements. Comprehensive
income, as defined, includes all changes in equity (net assets) during a period
from non-owner sources. The Company adopted SFAS No. 130 on January 1, 1998. To
date, the Company has not had any significant transactions that are required to
be reported as other comprehensive income other than its net loss.
Segment information
The FASB recently issued Statement of Financial Accounting Standards No. 131,
"Disclosures about Segments of an Enterprise and Related Information" ("SFAS
No. 131"). SFAS No. 131 supersedes Statement of Financial Accounting
Standards No. 14, "Financial Reporting for Segments of a Business Enterprise,"
replacing the "industry segment" approach with the "management approach." The
management approach designates the internal organization that is used by
management for making operating decisions and assessing performance as the
source of the Company's reportable segments. SFAS No. 131 also requires
disclosures about products and services, geographic areas and major customers.
The Company adopted SFAS No. 131 on January 1, 1998. The Company has determined
that it does not have any separately reportable business or geographic
segments.
Recent accounting pronouncements
In March 1998, the Accounting Standards Executive Committee of the American
Institute of Certified Public Accountants ("AICPA") issued Statement of
Position 98-1, "Accounting for the Costs of Computer Software Developed or
Obtained for Internal Use" ("SOP 98-1"). SOP 98-1 requires all costs related to
the development of internal use software other than those incurred during the
application development stage to be expensed as incurred. Costs incurred during
the application development stage are required to be capitalized and amortized
over the estimated useful life of the software. SOP 98-1 is effective for the
Company's fiscal year ending December 31, 1999. Adoption is not expected to
have a material effect on the Company's financial statements.
In June 1998, the FASB issued Statement of Financial Accounting Standards No.
133, "Accounting for Derivative Instruments and Hedging Activities" ("SFAS No.
133"). SFAS No. 133 is effective for fiscal years beginning after June 15,
1999. SFAS No. 133 requires that all derivative instruments be recorded on the
balance sheet at their fair value. Changes in the fair value of derivatives are
recorded each period in current earnings or other comprehensive income,
depending on whether a derivative is designed as part of a hedge transaction
and, if so, the type of hedge transaction. The Company does not expect that the
adoption of SFAS No. 133 will have a material effect on its financial
statements.
In December 1998, the AICPA issued Statement of Position 98-9, "Modification
of SOP 97-2, Software Revenue Recognition, with Respect to Certain
Transactions" ("SOP 98-9"), which amends certain elements of SOP 97-2 and
provides additional authoritative guidance on software revenue recognition. SOP
98-9 is effective for fiscal years beginning after March 15, 1999. The Company
does not expect that the adoption of SOP 98-9 will have a material effect on
its financial statements.
F-12
<PAGE>
LIQUID AUDIO, INC.
NOTES TO FINANCIAL STATEMENTS--(Continued)
Reclassifications
Certain reclassifications have been made to the prior years' financial
statements to conform to current period presentation.
NOTE 2--RELATED PARTIES:
Investment in Liquid Audio Korea
In December 1998, the Company signed an agreement with a strategic partner
(the "strategic partner") to establish a Korean corporation, Liquid Audio Korea
Co. Ltd. ("LAK"), to develop a local business to enable the digital delivery of
music to customers in Korea. LAK is the exclusive reseller and distributor of
the Company's software products in Korea, under an agreement expiring on
December 31, 2003. The Company paid $400,000 for 40% of the outstanding common
stock of LAK and will account for its investment in LAK using the equity method
of accounting. As of December 31, 1998, the Company's investment in LAK is
recorded at zero due to the recognition of equity investee losses equal to the
investment balance. The equity investee losses of $400,000 were recorded as an
offset to the business development revenue recognized from LAK. The Company
will not record its share of additional losses during this development stage
since there is no obligation on the part of the Company to pay LAK or any other
party for those losses. If LAK generates sufficient profits to recoup its
initial operating losses, the Company will re-instate the equity method of
accounting.
Investment in Liquid Audio Japan
In April 1998, the Company signed an agreement with a strategic partner (the
"strategic partner") to establish a Japanese corporation, Liquid Audio Japan
("LAJ"). LAJ is the exclusive reseller and distributor of the Company's
software products in Japan. At December 31, 1998, the initial capitalization of
LAJ was provided by the strategic partner, and in March 1999, the Company
purchased 18% of the issued and outstanding shares in LAJ from the strategic
partner for $378,000. The Company retains the option, expiring on December 31,
2003, to purchase an additional 2% of the capital of LAJ from the strategic
partner, at the then fair market value of LAJ's shares. The Company also has a
put option whereby the Company can require the strategic partner to purchase
its shares in LAJ at the then fair market value, if certain performance
measures of LAJ, as defined, are not met. The Company's purchase of shares in
LAJ was funded by a loan from a related entity of the Japanese strategic
partner. This loan, denominated in Japanese yen, is repayable on December 31,
2003. Interest on the loan bears interest at 0.5% above a Japanese bank's prime
rate (3.1% at September 30, 1999 (unaudited)) and is payable quarterly. The
loan is classified in the balance sheet as a non-current note payable to a
related party and recorded at the prevailing exchange rate at September 30,
1999 (unaudited). The Company will use the equity method of accounting for this
investment due to the Company's ability to significantly influence the LAJ
operations. As of September 30, 1999 (unaudited), the Company's investment in
LAJ was deemed to be impaired due to substantial doubt regarding recoverability
and the significant losses that are expected to be incurred during LAJ's
initial operating periods. The impairment conclusion was based upon the lack of
sufficient earnings and cash flows for LAJ for the foreseeable future, the lack
of a commercially viable product to introduce into the Japan marketplace, the
lack of a proven business model that will sustain the competitive and
technological challenges inherent in the local environment, and the unstable
nature of the economy in Japan. The $378,000 (unaudited) write-off of this
investment was recorded in March 1999 and is included in sales and marketing
expenses for the three months ended March 31, 1999. The Company will not record
its share of those losses during this development stage since there is no
obligation on the part of the Company to pay LAJ or any other party for those
losses. The Company discontinued use of the equity method of accounting at
March 31, 1999. If LAJ generates sufficient profits to recoup its initial
operating losses, the Company will re-instate the equity method of accounting.
F-13
<PAGE>
LIQUID AUDIO, INC.
NOTES TO FINANCIAL STATEMENTS--(Continued)
Other transactions
During the year ended December 31, 1998 and the nine months ended September
30, 1999, the Company recorded business development revenues totaling
$1,300,000 and $1,565,000 (unaudited), respectively. The components of these
amounts are as follows (in thousands):
<TABLE>
<CAPTION>
Nine Months
Year Ended Ended
December 31, September 30,
1998 1999
------------ -------------
(unaudited)
<S> <C> <C>
Business development revenues:
Consulting and other services....................... $1,200 $1,243
License fees and other.............................. 100 322
------ ------
$1,300 $1,565
====== ======
</TABLE>
At September 30, 1999, fees received in advance of recognition as business
development revenues were $555,000 (unaudited). This amount is classified as
deferred revenue on the balance sheet and will be recognized ratably as revenue
over the five months ending February 28, 2000. The remaining balance represents
a deposit on future deliveries of products.
NOTE 3--BALANCE SHEET COMPONENTS (in thousands):
<TABLE>
<CAPTION>
December 31,
------------- September 30,
1997 1998 1999
----- ------ -------------
(unaudited)
<S> <C> <C> <C>
Accounts receivable, net:
Accounts receivable............................... $ 140 $ 607 $ 339
Allowance for doubtful accounts................... (56) (231) (156)
----- ------ -------
$ 84 $ 376 $ 183
===== ====== =======
Write-offs against the allowance for doubtful accounts were $34,000 and
$108,000 in the year ended December 31, 1998 and the nine months ended
September 30, 1999 (unaudited), respectively.
<CAPTION>
December 31,
------------- September 30,
1997 1998 1999
----- ------ -------------
(unaudited)
<S> <C> <C> <C>
Property and equipment:
Computer equipment and purchased software......... $ 595 $1,460 $ 4,673
Furniture and fixtures............................ 193 324 488
Leasehold improvements............................ 38 329 411
----- ------ -------
826 2,113 5,572
Less: accumulated depreciation and amortization... (155) (606) (1,252)
----- ------ -------
$ 671 $1,507 $ 4,320
===== ====== =======
</TABLE>
F-14
<PAGE>
LIQUID AUDIO, INC.
NOTES TO FINANCIAL STATEMENTS--(Continued)
Property and equipment includes $424,000, $729,000 and $766,000 (unaudited)
of equipment under capital leases at December 31, 1997 and 1998, and September
30, 1999, respectively. Accumulated depreciation and amortization for equipment
under capital leases was $129,000, $352,000 and $544,000 (unaudited) at
December 31, 1997 and 1998, and September 30, 1999, respectively.
<TABLE>
<CAPTION>
December
31,
--------- September 30,
1997 1998 1999
---- ---- -------------
(unaudited)
<S> <C> <C> <C>
Accrued expenses and other current liabilities:
Compensation and benefits.............................. $174 $345 $ 975
Consulting and professional services................... 172 147 449
Accrued marketing expenses............................. 251 162 389
Other.................................................. 135 278 548
---- ---- ------
$732 $932 $2,361
==== ==== ======
</TABLE>
NOTE 4--BORROWINGS:
Lines of credit
In 1996, the Company entered into a revolving credit agreement with a bank
(the "Bank") under which it could borrow up to $400,000. The Company had
$400,000 outstanding on this revolving line on December 31, 1997. The revolving
line of credit was collateralized by substantially all of the Company's assets,
bore interest at the Bank's prime rate plus 3% and expired on April 30, 1998,
at which time the principal was repaid.
In November 1998, the Company entered into a revolving line of credit with
the Bank which provides for borrowings of up to 80% of eligible accounts
receivable (as defined) up to a maximum of $1,000,000 through November 1999.
Any advances would bear interest at the Bank's prime interest rate (7.75% at
December 31, 1998 and 8.25% at September 30, 1999 (unaudited)). Borrowings
under the line of credit would be collateralized by substantially all of the
Company's assets. No advances have been obtained to date under the line of
credit.
Equipment loan
Pursuant to the terms of an equipment financing agreement with the Bank, the
Company has a $3,000,000 line of credit to be used specifically to purchase
computer and office equipment. The line expires in November 1999. Under the
line, the Company borrowed amounts totalling $920,000 and $1,766,000 from the
date of the agreement (November 1, 1998) through December 31, 1998 and
September 30, 1999 (unaudited), respectively. Borrowings under the line are
repayable in monthly installments over three years and bear interest at the
Bank's prime interest rate plus 0.25% (8.0% at December 31, 1998 and 8.5% at
September 30, 1999 (unaudited)). Borrowings are secured by the related
equipment and other assets of the Company.
Under the equipment line of credit, the Company is required to meet certain
monthly reporting and financial covenants, including minimum operating results
and certain liquidity, leverage and debt service ratios. At December 31, 1998
and September 30, 1999 (unaudited), the Company was in compliance with all such
covenants.
F-15
<PAGE>
LIQUID AUDIO, INC.
NOTES TO FINANCIAL STATEMENTS--(Continued)
Future minimum principal payments under the equipment line at December 31,
1998 are as follows (in thousands):
<TABLE>
<CAPTION>
Year Ending December 31,
------------------------
<S> <C>
1999.............................................................. $ 281
2000.............................................................. 307
2001.............................................................. 307
2002.............................................................. 25
-----
920
Less current portion............................................... (281)
-----
Non-current portion................................................ $ 639
=====
</TABLE>
Short-term loans
In May 1997, the Company entered into a short-term loan facility for
$1,000,000 with a bank. The company borrowed $400,000 during the year ended
December 31, 1997 under this facility. In April 1998, the company entered into
a short-term loan facility for $2,400,000 with a bank. The Company borrowed
$1,330,000 during the year ended December 31, 1998 under this facility. Both
short-term loans were repaid and the facilities have expired.
NOTE 5--MANDATORILY REDEEMABLE CONVERTIBLE PREFERRED STOCK:
Mandatorily redeemable convertible preferred stock, $0.001 par value at
December 31, 1998, was comprised of the following (in thousands):
<TABLE>
<CAPTION>
Liquidation
Shares and
---------------------- Redemption
Authorized Outstanding Amount
---------- ----------- -----------
<S> <C> <C> <C>
Series A................................ 3,050 3,050 $ 2,001
Series B................................ 3,355 3,187 6,246
Series C................................ 4,500 3,507 21,554
------ ----- -------
10,905 9,744 $29,801
====== ===== =======
</TABLE>
The rights of holders of mandatorily redeemable convertible preferred stock
with respect to voting, dividends, liquidation and conversion and redemption
are as follows:
Voting
Each share of Series A, Series B and Series C mandatorily redeemable
convertible preferred stock has voting rights equal to an equivalent number of
shares of common stock into which it is convertible.
Dividends
Holders of Series A, Series B and Series C mandatorily redeemable convertible
preferred stock are entitled to noncumulative, preferential dividends of
$0.059, $0.176 and $0.5526, respectively, per share per annum when and if
declared by the Board of Directors. The holders of Series A, Series B and
Series C mandatorily redeemable convertible preferred stock will also be
entitled to participate in dividends on common stock, when and if declared by
the Board of Directors, based on the number of shares of common stock into
which the
F-16
<PAGE>
LIQUID AUDIO, INC.
NOTES TO FINANCIAL STATEMENTS--(Continued)
mandatorily redeemable convertible preferred stock is convertible. As of March
31, 1999, no dividends on mandatorily redeemable convertible preferred stock or
common stock had been declared or paid.
Liquidation
In the event of any liquidation, dissolution, winding up, or consolidation or
merger of the Company resulting in an ownership change of greater than 50%,
distributions to stockholders are to be made in the following manner:
The holders of the Series A, Series B and Series C mandatorily redeemable
convertible preferred stock are entitled to receive, prior and in preference to
any distribution of the assets of the Company to the holders of the common
stock, the amounts of $0.656, $1.96 and $6.14 per share, respectively, for each
share of Series A, Series B and Series C mandatorily redeemable convertible
preferred stock then held plus all declared and unpaid dividends, if any, on
such shares. If the assets of the Company are insufficient to permit this
distribution, the assets of the Company would be distributed ratably, between
the holders of Series A, Series B and Series C mandatorily redeemable
convertible preferred stock on a pari passu basis according to the liquidation
preferences of each series and as between the holders of shares of a particular
series, in proportion to the amount of such stock of such series owned by such
holder.
Thereafter, mandatorily redeemable convertible preferred stock and common
stock stockholders would share proceeds pro rata, on an as-converted basis,
until holders of Series A and Series B mandatorily redeemable convertible
preferred stock have recovered an amount of $3.936 per share (excluding amounts
already paid) and holders of Series C mandatorily redeemable convertible
preferred stock have recovered an amount of $8.18 per share (excluding amounts
already paid). All further proceeds would be distributed to the common
stockholders.
Conversion
Each share of Series A, Series B and Series C mandatorily redeemable
convertible preferred stock is convertible at the option of the holder at any
time into shares of common stock based on a conversion rate as defined in the
amended and restated Certificate of Incorporation, which currently results in a
conversion rate of 1:1. Each share of Series A, Series B and Series C
mandatorily redeemable convertible preferred stock will automatically be
converted into shares of common stock at the then effective conversion rate
upon the closing of a firm commitment underwritten initial public offering of
the Company's common stock at a price not less than $8.33 per share with total
proceeds in excess of $15,000,000 or on the date upon which the Company obtains
the consent of the holders of 2/3's of the then outstanding shares of
mandatorily redeemable convertible preferred stock.
Redemption
At the option of the holders of the Series A, Series B and Series C
mandatorily redeemable convertible preferred stock, subsequent to six years
from the date of first issuance of Series C mandatorily redeemable convertible
preferred stock, but within 30 days of written request from holders of not less
than 2/3 of the then outstanding Series A, Series B and Series C mandatorily
redeemable convertible preferred stock, the Company will redeem the shares
specified in such request for a sum equal to $0.656, $1.96 and $6.14,
respectively, per share plus all declared but unpaid dividends.
Warrants
In connection with certain short-term loans received by the Company in 1997
and 1998 (see note 4), the Company issued warrants to purchase 15,306 shares of
Series B mandatorily redeemable preferred stock for
F-17
<PAGE>
LIQUID AUDIO, INC.
NOTES TO FINANCIAL STATEMENTS--(Continued)
$1.96 per share and 4,544 shares of Series C mandatorily redeemable preferred
stock for $6.14 per share respectively. The warrants expire on the earlier of
2002 and 2005, respectively, or two years after an initial public offering. The
Company determined the value of the warrants issued in 1997 and in 1998 to be
nominal, based on the Black-Scholes option pricing model.
NOTE 6--COMMON STOCK:
In April 1999, the Company's Certificate of Incorporation was amended and
restated to authorize the issuance of 25,878,000 shares of common stock at
$0.001 par value.
In February 1998, the Company's Board of Directors authorized a three-for-two
stock split (i.e., one existing share is equivalent to one and one-half post-
split shares). All share and per share data in these financial statements have
been restated to reflect this stock split.
In April 1996, the Company issued 3,431,000 shares of restricted common stock
at $0.00133 per share to the Company's founders. The restricted common stock
vests at a rate of 25% at the end of the first year and then 2.083% each month
thereafter until 100% vested. The Company has the right to repurchase unvested
shares, and in October 1998, approximately 88,000 shares of unvested founders'
common stock was repurchased. At December 31, 1997, December 31, 1998 and
September 30, 1999, approximately 1,644,000, 2,481,000 and 3,010,000
(unaudited) shares had vested, respectively.
As of December 31, 1998, the Company had reserved the following number of
shares of common stock for future issuance (in thousands):
<TABLE>
<CAPTION>
December 31,
1998
------------
<S> <C>
Conversion of Series A mandatorily redeemable convertible
preferred stock............................................ 3,050
Conversion of Series B mandatorily redeemable convertible
preferred stock and warrants............................... 3,202
Conversion of Series C mandatorily redeemable convertible
preferred stock and warrants............................... 3,512
Common stock warrant........................................ 49
Options under Stock Option Plan............................. 1,138
------
10,951
======
</TABLE>
Warrants
In February 1997, the Company entered into a marketing agreement whereby the
Company and another company jointly developed and marketed a certain feature
specification of the Company's software products. Pursuant to this agreement,
the Company issued 38,316 shares of the Company's common stock and a warrant to
purchase 48,860 shares of common stock at $6.14 per share. The warrant expires
on January 1, 2001. The Company accrued $107,000 during the year ended December
31, 1997 for the estimated fair value of the warrant, based on the Black-
Scholes option pricing model.
In March and April 1999, the Company granted fully vested common stock
warrants to purchase 15,000 shares at $6.56 per share. The warrants expire
through April 2004.
In June 1999, the Company signed a strategic marketing agreement with
Amazon.com, Inc. ("Amazon.com"). Pursuant to this agreement, the Company issued
warrants to purchase approximately 381,000 shares of the Company's common stock
at $6.56 per share, of which 254,000 shares vested
F-18
<PAGE>
LIQUID AUDIO, INC.
NOTES TO FINANCIAL STATEMENTS--(Continued)
immediately and 127,000 shares vest over a 12-month period commencing if and
when the Company and Amazon.com sign a definitive agreement to utilize the
Company's technology for a specific business program. The warrants expire
through June 2004. The Company has valued the immediately vested 254,000 shares
at approximately $2.0 million, based on the Black-Scholes pricing model and the
provisions of Emerging Issues Task Force No. 96-18 "Accounting for Equity
Instruments that are Issued to Other Than Employees for Acquiring, or in
Conjunction with Selling, Goods or Services" ("EITF 96-18"), which is being
recognized as strategic marketing-equity instruments expense over the 12-month
term of the initial marketing agreement. The 127,000 shares, which will vest
over a 12-month period, will be valued at the then fair market value of the
Company's common stock if and when a commitment for performance by Amazon.com
has been reached or at the date when Amazon.com has performed its contractual
obligations under the agreement.
In June 1999, the Company signed an agreement with Virgin Holdings, Inc., an
affiliate of EMI Recorded Music ("EMI"), to facilitate the production of music
for delivery over the Internet utilizing the Company's technology. Pursuant to
this agreement, the Company issued and delivered 100,000 shares of common stock
to EMI. These shares were valued at $1.1 million and immediately recognized as
strategic marketing-equity instruments expense during the three months ended
June 30, 1999.
In August 1999, the Company signed a marketing and distribution agreement
with an Internet portal to promote the digital distribution of digital music
and the Internet portal's web site. Under the agreement, the Company agreed to
grant the Internet portal three warrants totaling 250,000 shares of common
stock, which have been accounted for in accordance with EITF 96-18. The first
warrant for 83,334 shares at $26.36 per share vests immediately and has been
valued by the Company using the Black-Scholes pricing model at $903,000, which
is being recognized ratably as strategic marketing-equity instruments expense
over the 12-month term of the agreement. The second warrant for 83,333 shares
at $40.00 per share vests in August 2000. The value of the warrant is being
determined using the Black-Scholes pricing model, which was $1.9 million at
September 30, 1999, and is being recognized ratably as marketing-equity
instruments expense over the 12-month term of the agreement and is being
remeasured each quarter, using the market value of the Company's stock, until
the warrant vests. The third warrant, which may be issued if the relationship
with the Internet portal is extended beyond the first year, for 83,333 shares
at $50.00 per share would commence to vest in August 2000, at which time the
Company will determine the value of this warrant.
NOTE 7--EMPLOYEE BENEFIT PLANS:
401(k) Savings Plan
The Company sponsors a 401(k) defined contribution plan covering eligible
employees who elect to participate. The Company may elect to contribute
matching and discretionary contributions to the plan; however, no contributions
have been made by the Company since inception of the plan.
Stock Option Plan
In September 1996, the Board of Directors adopted the 1996 Equity Incentive
Plan (the "Plan") which initially provided for the granting of up to 1,144,000
incentive stock options and nonqualified stock options. In August 1997, October
1998 and April 1999, an additional 441,000, 88,000 and 1,600,000 shares,
respectively, were authorized for grants under the Plan. Under the Plan,
incentive stock options may be granted to employees of the Company and
nonqualified stock options and stock purchase rights may be granted to
consultants, employees, directors and officers of the Company. Options granted
under the Plan are for periods not to exceed ten years, and must be issued at
prices not less than 100% and 85%, for incentive and nonqualified stock
options, respectively, of the fair market value of the stock on the date of
grant as determined by the Board of
F-19
<PAGE>
LIQUID AUDIO, INC.
NOTES TO FINANCIAL STATEMENTS--(Continued)
Directors. Options granted under the Plan generally vest 25% after the first
year and then 2.083% each month thereafter until 100% vested. Options granted
to stockholders who own greater than 10% of the outstanding stock must be for
periods not to exceed five years and must be issued at prices not less than
110% of the estimated fair market value of the stock on the date of grant as
determined by the Board of Directors. In April 1999, the Plan was also amended
to provide for annual increases on January 1 equal to the lesser of 1,500,000
shares, 5% of the outstanding shares on such date or a lesser amount determined
by the Board of Directors.
The following table summarizes stock option activity under the Plan (shares
in thousands):
<TABLE>
<CAPTION>
Options Outstanding
----------------------
Weighted
Options Average
Available Exercise Price
for Grant Shares Per Share
--------- ------ --------------
<S> <C> <C> <C>
Authorized................................ 1,144 -- $ --
Options granted........................... (419) 419 0.067
------ -----
Balance at December 31, 1996.............. 725 419 0.067
Additional options authorized............ 441 -- --
Options granted.......................... (1,108) 1,108 0.154
Options exercised........................ -- (469) 0.067
Options canceled......................... 197 (197) 0.067
------ -----
Balance at December 31, 1997.............. 255 861 0.130
Additional options authorized............ 88 -- --
Repurchase of common stock in connection
with unvested stock options previously
exercised............................... 24 -- --
Options granted.......................... (512) 512 1.01
Options exercised........................ -- (90) 0.067
Options canceled......................... 216 (216) 0.11
------ -----
Balance at December 31, 1998.............. 71 1,067 0.68
Additional options authorized............ 1,600 -- --
Repurchase of common stock in connection
with unvested stock options previously
exercised (unaudited)................... 37 -- --
Options granted (unaudited).............. (773) 773 10.01
Options exercised (unaudited)............ -- (324) 2.70
Options canceled (unaudited)............. 180 (180) 1.34
------ -----
Balance at September 30, 1999
(unaudited).............................. 1,115 1,336 5.94
====== =====
</TABLE>
During the period from January 30, 1996 (inception) through December 31,
1996, the Company granted options to purchase 22,500 shares of common stock to
consultants in exchange for services at an exercise price of $0.067 per share.
The Company determined the value of the options granted to be nominal. During
the nine months ended September 30, 1999 (unaudited), the Company granted an
option to purchase 20,000 shares of common stock to a consultant in exchange
for services at an exercise price of $2.50 per share. The Company determined
the value of the option to be $142,000, based on the Black-Scholes option
pricing model. Of this amount, $71,000 was recognized as research and
development expense in the nine months ended September 30, 1999 (unaudited).
F-20
<PAGE>
LIQUID AUDIO, INC.
NOTES TO FINANCIAL STATEMENTS--(Continued)
The following table summarizes information concerning outstanding and
exercisable options as of December 31, 1998 (shares in thousands):
<TABLE>
<CAPTION>
Options Vested and
Options Outstanding Exercisable
--------------------------------- --------------------
Weighted Weighted
Weighted Average Average
Average Exercise Exercise
Remaining Price Price
Number Contractual Per Number Per
Range of Exercise Prices Outstanding Life (years) Share Outstanding Share
------------------------ ----------- ------------ -------- ----------- --------
<S> <C> <C> <C> <C> <C>
$0.067................. 129 7.65 $0.067 66 $0.067
0.194................. 534 8.63 0.194 152 0.194
0.333-0.40............ 154 9.24 0.393 -- --
1.50-2.00............. 250 9.76 1.750 30 1.50
----- ---
1,067 248
===== ===
</TABLE>
Fair value disclosures
Pro forma information regarding net loss and net loss per share is required
by FAS 123, which also requires that the information be determined as if the
Company has accounted for its employee stock options granted under the fair
value method. The fair value for these options was estimated using the Black-
Scholes option pricing model.
The Black-Scholes option pricing model was developed for use in estimating
the fair value of traded options that have no vesting restrictions and are
fully transferable. In addition, option pricing models require the input of
highly subjective assumptions, including the expected stock price volatility.
Because the Company's options have characteristics significantly different from
those of options of publicly traded companies and because changes in the
subjective input assumptions can materially affect the fair value estimate, in
the opinion of management, the existing models do not necessarily provide a
reliable single measure of the fair value of its options.
The Company calculated the minimum fair value of each option grant on the
date of grant using the Black-Scholes option pricing method as prescribed by
SFAS No. 123 using the following assumptions:
<TABLE>
<CAPTION>
Period From
January 30,
1996 (inception) Year Ended
Through December 31,
December 31, ---------------
1996 1997 1998
---------------- ------ ------
<S> <C> <C> <C>
Risk-free rates......................... 6.4% 6.2% 5.8%
Expected lives (in years)............... 4.0 4.0 4.0
Dividend yield.......................... 0.0% 0.0% 0.0%
Expected volatility..................... 0.0% 0.0% 0.0%
</TABLE>
F-21
<PAGE>
LIQUID AUDIO, INC.
NOTES TO FINANCIAL STATEMENTS--(Continued)
Had compensation costs been determined based upon the fair value at the grant
date for awards under these plans, consistent with the methodology prescribed
under SFAS No. 123, the Company's pro forma net loss attributable to common
stockholders and pro forma basic and diluted net loss per share under SFAS
No. 123 would have been:
<TABLE>
<CAPTION>
Period From
January 30,
1996 (inception) Year Ended
Through December 31,
December 31, -------------
1996 1997 1998
---------------- ------ ------
<S> <C> <C> <C>
Pro forma net loss (in thousands)........... $1,267 $6,229 $8,579
Pro forma net loss per share................ $14.91 $4.96 $3.62
</TABLE>
The weighted average minimum value of options granted with an exercise price
less than the fair market value of stock on the date of grant were:
<TABLE>
<CAPTION>
Period From
January 30,
1996 (inception) Year Ended
Through December 31,
December 31, -------------
1996 1997 1998
---------------- ------ ------
<S> <C> <C> <C>
Weighted average minimum value of options
granted during period................... $0.61 $ 1.80 $ 4.84
</TABLE>
Unearned stock-based compensation
In connection with certain stock option grants, the Company recognized
unearned compensation which is being amortized over the vesting periods of the
related options, usually four years, using an appropriate accelerated basis.
The total unearned compensation recorded by the Company from January 30, 1996
(inception) through September 30, 1999 was $4,295,000. The fair value per share
used to calculate unearned compensation was derived by reference to the
preferred stock values, reduced by a nominal discount factor (10%), since
inception. Future compensation charges are subject to reduction for any
employee who terminates employment prior to the expiration of such employee's
option vesting period.
The following table sets forth unearned compensation and the amortization of
unearned compensation (in thousands):
<TABLE>
<CAPTION>
Period From Nine Months
January 30, Ended
1996 (inception) Year Ended September
Through December 31, 30,
December 31, ------------- -----------
1996 1997 1998 1998 1999
---------------- ------ ------ ---- ------
(unaudited)
<S> <C> <C> <C> <C> <C>
Unearned compensation......... $239 $1,888 $1,714 $846 $ 454
Amortization of unearned
compensation................. $ 31 $ 534 $1,241 $882 $1,119
</TABLE>
Employee Stock Purchase Plan
In April 1999, the Board of Directors adopted the 1999 Employee Stock
Purchase Plan (the "Purchase Plan") and reserved 500,000 shares of common stock
for issuance thereunder. The Purchase Plan was approved by the stockholders in
June 1999. On each January 1, the aggregate number of shares reserved for
issuance under the Purchase Plan will be increased by the lesser of 750,000
shares, 3% of the outstanding
F-22
<PAGE>
LIQUID AUDIO, INC.
NOTES TO FINANCIAL STATEMENTS--(Continued)
shares on such date or a lesser amount determined by the Board of Directors.
The Purchase Plan will become effective on the first business day on which
price quotations for the Company's common stock are available on the Nasdaq
National Market. Employees are eligible to participate if they are customarily
employed by the Company or any participating subsidiary for at least 20 hours
per week and more than five months in any calendar year and do not (i)
immediately after grant own stock possessing 5% or more of the total combined
voting capital stock, or (ii) possess rights to purchase stock under all of the
employee stock purchase plans at an accrual rate which exceeds $25,000 worth of
stock for each calendar year. The Purchase Plan permits participants to
purchase common stock through payroll deductions up to 15% of the participant's
compensation, as defined in the Purchase Plan, but limited to 2,500 shares per
participant per purchase period. Each offering period includes four six-month
purchase periods which will begin on June 1 and December 1 of each year, except
for the offering period which starts on the first trading day on or after the
effective date of the public offering. The price at which the common stock is
purchased under the Purchase Plan is 85% of the lesser of the fair market value
at the beginning of the offering period or at the end of the purchase period.
The Purchase Plan will terminate after a period of ten years unless terminated
earlier as permitted by the Purchase Plan.
NOTE 8--INCOME TAXES:
The Company had approximately $13,000,000 of federal and $12,900,000 of state
net operating loss carryforwards available to offset future taxable income at
December 31, 1998, respectively. The federal and state net operating loss
carryforwards expire in varying amounts beginning in 2011 and 2004,
respectively. At December 31, 1998, the Company had approximately $210,000 of
federal and $170,000 of state research and development credit carryforwards
available to offset future taxable income, which, in the case of the federal
carryforwards, expire in varying amounts beginning in 2011. Under the Tax
Reform Act of 1986, the amounts of and benefits from net operating loss
carryforwards may be impaired or limited in certain circumstances. Events that
cause limitations in the amount of net operating loss carryforwards that the
Company may utilize in any one year include, but are not limited to, a
cumulative ownership change of more than 50%, as defined, over a three-year
period. As a result of this offering, such a change in ownership is expected to
occur. Management has estimated that the net operating loss carryforwards from
inception will be limited to $7,500,000 annually.
Deferred taxes are composed of the following (in thousands):
<TABLE>
<CAPTION>
December 31,
----------------
1997 1998
------- -------
<S> <C> <C>
Deferred tax assets (liabilities)
Depreciation and amortization........................... $ (17) $ 12
Other accruals and liabilities.......................... 151 102
Net operating loss and credit carryforwards............. 2,250 5,070
Research and development credit carryforwards........... 181 380
------- -------
Total deferred tax assets............................... 2,565 5,564
------- -------
Less: Valuation allowance............................... (2,565) (5,564)
------- -------
Net deferred tax assets.................................. $ -- $ --
======= =======
</TABLE>
The Company has incurred a loss in each period since its inception. Based on
the available objective evidence, including the Company's history of losses,
management believes it is more likely than not that the net deferred tax assets
will not be fully realizable. Accordingly, the Company has provided for a full
valuation allowance against its total deferred tax assets at December 31, 1997
and 1998 and September 30, 1999 (unaudited).
F-23
<PAGE>
LIQUID AUDIO, INC.
NOTES TO FINANCIAL STATEMENTS--(Continued)
NOTE 9--COMMITMENTS AND CONTINGENCIES:
Leases
The Company leases its office facilities and certain equipment under
noncancelable operating lease agreements which expire at various dates through
2002. The terms of the facility lease provide for rental payments on a
graduated scale. The Company recognizes rent expense on a straight-line basis
over the lease period, and has accrued for rent expense incurred but not paid.
The lease requires that the Company pay all costs of maintenance, utilities,
insurance and taxes. Rent expense under these leases is as follows (in
thousands):
<TABLE>
<CAPTION>
Period From
January 30, Nine Months
1996 Ended
(inception) Year Ended September
Through December 31, 30,
December 31, ------------- -----------
1996 1997 1998 1998 1999
------------ ------ ------ ----- -----
(unaudited)
<S> <C> <C> <C> <C> <C>
Rent expense........................ $32 $ 111 $ 294 $ 213 $ 355
</TABLE>
Future minimum lease payments under all noncancelable capital and operating
leases at December 31, 1998 are as follows (in thousands):
<TABLE>
<CAPTION>
Capital Operating
Year Ending December 31, Leases Leases
------------------------ ------- ---------
<S> <C> <C>
1999..................................................... $269 $241
2000..................................................... 188 234
2001..................................................... 86 216
2002..................................................... 19 189
---- ----
Total minimum payments............................... 562 $880
====
Less: amount representing interest....................... (35)
----
Present value of capital lease obligations............... 527
Less: Current portion.................................... (197)
----
Capital lease obligations, non-current portion........... $330
====
</TABLE>
Litigation
In April 1999, a former consultant of the Company filed a complaint against
the Company. The complaint alleges both breach of contract and fraud and seeks
approximately 588,000 shares of common stock. While there can be no assurances
as to the outcome of this litigation, the Company believes the complaint is
without merit, and intends to vigorously defend the complaint. No amount has
been accrued for any potential liability in relation to this matter.
In May 1999, a former employee of the Company filed a complaint against the
Company in connection with the employee's termination. While there can be no
assurances as to the outcome of this litigation, the Company believes the
complaint is without merit, and intends to vigorously defend the complaint. No
amount has been accrued for any potential liability in relation to this matter.
In May 1999, an entity advised the Company that it believes the use of
certain of the Company's software tools and client software products together
infringes two patents to which this entity asserts it has rights. In June and
July 1999, three separate entities each advised the Company that there may be
certain patents to which they claim rights. While there can be no assurances as
to the outcome of these claims, the Company believes the claims are without
merit, and intends to vigorously defend against the claims. No amount has been
accrued for any potential liabilities in relation to these matters.
F-24
<PAGE>
LIQUID AUDIO, INC.
NOTES TO FINANCIAL STATEMENTS--(Continued)
Contingencies
From time to time, in the normal course of business, various claims are made
against the Company. In the opinion of the management, there are no pending
claims the outcome of which is expected to result in a material adverse effect
on the financial position or results of operations of the Company.
F-25
<PAGE>
[INSIDE BACK COVER]
serious music.
serious players.
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music to go
<PAGE>
3,000,000 Shares
[LIQUID AUDIO LOGO]
Common Stock
-------------
PROSPECTUS
December 14, 1999
-------------
Lehman Brothers
Robertson Stephens
U.S. Bancorp Piper Jaffray
Dain Rauscher Wessels
Fidelity Capital Markets
a division of National Financial Services Corporation
Facilitating Electronic Distribution
