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UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
WASHINGTON, D.C. 20549
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FORM 10-K
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ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(d)
OF THE SECURITIES EXCHANGE ACT OF 1934
FOR THE FISCAL YEAR ENDED DECEMBER 31, 1998
COMMISSION FILE NUMBER 0-23137
REALNETWORKS, INC.
(EXACT NAME OF REGISTRANT AS SPECIFIED IN ITS CHARTER)
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WASHINGTON 91-1628146
(STATE OF INCORPORATION) (I.R.S. EMPLOYER
IDENTIFICATION NUMBER)
1111 THIRD AVENUE, SUITE 2900
SEATTLE, WASHINGTON 98101
(ADDRESS OF PRINCIPAL EXECUTIVE (ZIP CODE)
OFFICES)
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(206) 674-2700
(REGISTRANT'S TELEPHONE NUMBER, INCLUDING AREA CODE)
SECURITIES REGISTERED PURSUANT TO SECTION 12(b) OF THE ACT:
NONE
SECURITIES REGISTERED PURSUANT TO SECTION 12(g) OF THE ACT:
COMMON STOCK, PAR VALUE $0.001 PER SHARE
(TITLE OF CLASS)
Indicate by check mark whether the registrant: (1) has filed all reports
required to be filed by Section 13 or 15(d) of the Securities Exchange Act of
1934 during the preceding 12 months (or for such shorter period that the
registrant was required to file such reports), and (2) has been subject to such
filing requirements for the past 90 days. Yes [X] No [ ]
Indicate by check mark if disclosure of delinquent filers pursuant to Item
405 of Regulation S-K is not contained herein, and will not be contained, to the
best of the registrant's knowledge, in definitive proxy or information
statements incorporated by reference in Part III of this Form 10-K or any
amendment to this Form 10-K. [X]
The aggregate market value of the Common Stock held by non-affiliates of
the registrant, based on the closing price on March 19, 1999, as reported on the
Nasdaq National Market, was $2,192,039,861.(1)
The number of shares of the registrant's Common Stock outstanding as of
March 19, 1999 was 33,100,518. In addition, there were 695,874 outstanding
shares of the registrant's Special Common Stock, par value $0.001 per share,
that automatically convert on a one-for-one basis into Common Stock on a bona
fide sale to a purchaser who is not an affiliate of the holder.
DOCUMENTS INCORPORATED BY REFERENCE
Portions of the registrant's Proxy Statement relating to the registrant's
1999 Annual Meeting of Shareholders to be held on May 21, 1999 are incorporated
by reference into Part III of this Report.
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(1) Excludes shares held of record on that date by directors, officers and 10%
shareholders of the registrant. Exclusion of such shares should not be
construed to indicate that any such person directly or indirectly possesses
the power to direct or cause the direction of the management of the policies
of the registrant.
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TABLE OF CONTENTS
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PART I
Item 1. Business.................................................... 2
Item 2. Properties.................................................. 11
Item 3. Legal Proceedings........................................... 11
Item 4. Submission of Matters to a Vote of Security Holders......... 13
Item 4A. Executive Officers of the Registrant........................ 13
PART II
Item 5. Market for Registrant's Common Equity and Related
Stockholder Matters......................................... 16
Item 6. Selected Consolidated Financial Data........................ 18
Item 7. Management's Discussion and Analysis of Financial Condition
and Results of Operations................................... 19
Item 7A. Quantitative and Qualitative Disclosures about Market
Risk........................................................ 36
Item 8. Financial Statements and Supplementary Data................. 37
Item 9. Changes in and Disagreements with Accountants on Accounting
and Financial Disclosure.................................... 56
PART III
Item 10. Directors and Executive Officers of the Registrant.......... 56
Item 11. Executive Compensation...................................... 56
Item 12. Security Ownership of Certain Beneficial Owners and
Management.................................................. 56
Item 13. Certain Relationships and Related Transactions.............. 56
PART IV
Item 14. Exhibits, Financial Statement Schedules, and Reports on Form
8-K......................................................... 57
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PART I
This Annual Report on Form 10-K and the documents incorporated herein by
reference contain forward-looking statements that have been made pursuant to the
provisions of the Private Securities Litigation Reform Act of 1995. These
forward-looking statements are based on current expectations, estimates and
projections about RealNetworks' industry, management's beliefs, and certain
assumptions made by management. Words such as "anticipates," "expects,"
"intends," "plans," "believes," "seeks" and "estimates" and similar expressions
are intended to identify forward-looking statements. These statements are not
guarantees of future performance and actual actions or results may differ
materially. These statements are subject to certain risks, uncertainties and
assumptions that are difficult to predict, including those noted in the
documents incorporated herein by reference. Particular attention should also be
paid to the cautionary language in the sections of Item 1 entitled "Intellectual
Property" and "Competition" and in Item 3 entitled "Legal Proceedings."
RealNetworks undertakes no obligation to update publicly any forward-looking
statements as a result of new information, future events or otherwise, unless
required by law. Readers should, however, carefully review the risk factors
included in other reports or documents filed by RealNetworks from time to time
with the Securities and Exchange Commission, particularly the Quarterly Reports
on Form 10-Q and any Current Reports on Form 8-K.
ITEM 1. BUSINESS
THE COMPANY
RealNetworks, Inc., a Washington corporation ("RealNetworks" or the
"Company"), is a leading provider of branded software products and services that
enable the creation and real-time delivery and playback, or "streaming," of
audio, video, text, animation and other media content over the Internet and
intranets on both a live and on-demand basis. RealNetworks' products and
services include its RealSystem G2, a streaming media solution released in
November 1998 that includes RealNetworks' popular RealAudio and RealVideo
technology, an electronic commerce Web site from which RealNetworks distributes,
sells and promotes streaming media products, services and programming and a
network of advertising-supported Web sites from which RealNetworks hosts and
promotes streaming media content. RealNetworks believes that streaming media
technology is essential to the evolution of the World Wide Web as a mass
communications medium because it enables a more compelling user experience,
allowing the Internet to compete more effectively with traditional media for
audience share.
INDUSTRY BACKGROUND
The Internet has grown rapidly in recent years, driven by the development
of the World Wide Web and graphically intuitive Web browsers, the proliferation
of multimedia PCs, increasingly robust network architectures and the emergence
of compelling Web-based content and commerce applications. The broad acceptance
of the standard Internet Protocol ("IP") has also led to the emergence of
corporate networks or "intranets" and the development of a wide range of non-PC
devices that allow more users to access the Internet and intranets, which has
expanded the potential audience for streaming media. As an interactive,
searchable, user-controlled medium, the Web provides for a highly engaging
experience and allows users to access an almost unlimited variety and supply of
content at their convenience. The Web also enables content providers and
advertisers to establish personalized experiences for and communications with
consumers. Streaming media technology has enhanced the graphical capabilities of
the Internet and intranets. Before streaming technology, users could not play
audio or video clips until they had been downloaded in their entirety, resulting
in significant waiting times. As a result, live broadcasts of audio and video
content over the Internet or intranets were not possible. 1998 was a momentous
year for streaming media on the Internet. Thousands of content providers are now
providing media over the Internet, and millions of new streaming media users are
accessing streaming media. As the audience for streaming media has grown
substantially, many new business models have emerged. Companies are generating
revenue by aggregating streaming media, developing streaming media authoring
tools, offering turnkey service, and offering media hosting services. Businesses
are generating revenue from incorporating streaming media into their Web sites
and advertising in a variety of new ways.
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MARKET OPPORTUNITY
RealNetworks believes that the emergence of rich multimedia capabilities,
such as streaming audio, video, text, animation and other media content, has
significantly enhanced the effectiveness and propelled the growth of the Web as
a global mass communications medium. More businesses are now using corporate
intranets and Web sites as a means to improve communications with their
employees, customers and suppliers, and more businesses and content providers
are offering interactive audio, video and other multimedia content to enrich
their Web sites and compete more effectively with traditional media. The Web has
provided a whole new way for businesses to reach potential customers and has
revolutionized the way that individuals communicate, learn and find
entertainment. RealNetworks believes that more than 300,000 hours per week of
live audio and video content are broadcast over the Web using its RealAudio and
RealVideo technology, with a substantially greater amount of recorded media
available on demand. RealNetworks also believes that 85% of streaming media is
broadcast using RealNetworks' technology.
RealNetworks believes that to capitalize successfully on the opportunity
afforded by the Web, streaming media providers must address the following
challenges:
DELIVER COMPELLING STREAMING MEDIA CONTENT IN BANDWIDTH-CONSTRAINED
ENVIRONMENTS. The Internet was designed to transmit discrete packets of data and
is not inherently well-suited to the delivery of continuous streams of
multimedia data without additional software. In addition, bandwidth is limited
in Internet and intranet environments, posing significant technological
challenges for delivery of high-quality streaming audio and video content.
ENABLE BROAD-BASED ACCESS TO STREAMING MEDIA TECHNOLOGY. Online content
providers, advertisers and merchants must make significant investments in
technology and content to create and deliver streaming media content, and they
need to reach a sufficiently large or clearly targeted audience to generate an
adequate return on their investments.
DRIVE CONSUMER USAGE. RealNetworks believes that consumer interest in
streaming media content is driven in large part by the ability to find and
experience such content easily. As a result, RealNetworks believes that the
development of well-marketed, compelling Web sites that aggregate streaming
media content is central to the continued growth of multimedia content on the
Web.
RealNetworks believes that a substantial opportunity exists to provide
software solutions, content aggregation, distribution and delivery services that
address these challenges and support the development of large and growing
advertising and electronic commerce markets on the Web.
THE REALNETWORKS SOLUTION
RealNetworks' products and services enable and promote the transmission of
real-time streaming media content over the Internet and intranets. RealNetworks'
products and services are designed to address the technological and market
development challenges that confront streaming media content providers and
users.
STREAMING MEDIA TECHNOLOGY. RealNetworks has been a pioneer in the
development of streaming media technology and it continues to offer cutting-edge
and market leading streaming media software solutions. RealNetworks' products
use advanced compression, decompression, transmission and error-correction
technologies to permit better delivery and playback of streamed content even in
bandwidth-constrained environments. In November 1998, RealNetworks released
RealSystem G2, its next generation media delivery system. RealSystem G2 provides
the highest quality streaming media, reliability and scalability for the
Internet and intranets. It supports Synchronized Multimedia Integration Language
("SMIL") and incorporates RealNetworks' SureStream transport technology for more
reliable and uninterrupted transmission at all connection rates. Moreover,
because RealSystem G2 is an open system, it is easier for users to take
advantage of its robust transport, management and display capabilities.
RealNetworks has won numerous awards for its RealSystem G2 technology, including
the Internet World '98 Best of Show Award in the Desktop Hardware and Software
category, two of NewMedia Magazine's 1998 Hyper Awards in the categories of
Streaming Media Server and Web Development Software of the Year, and Best
Multimedia Tool in CNET's 1998
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Builder.com Product Awards. RealNetworks was also included in PC Week's 1998
list of the 100 most influential companies.
PRODUCT UBIQUITY AND BRAND STRENGTH. RealNetworks has always given away its
RealPlayer software to individual users free of charge as part of its strategy
to drive consumer demand for and speed the acceptance of streaming media, while
achieving widespread use of the RealPlayer as the preferred way for users to
listen to and view content over the Internet and intranets. As of March 15,
1999, there were at least 56 million unique users of RealNetworks' products, and
RealNetworks believes that more than 85% of streaming media on the Web is
broadcast using RealNetworks' technology. In addition, approximately 850 new
third-party developers joined RealNetworks' Real Developer Program in 1998 to
develop products that work with RealNetworks' products or services. To promote
broad market use of its technology to deliver streaming media, RealNetworks also
offers its Basic Server free of charge. As a result of these activities and
RealNetworks' extensive promotional efforts, RealNetworks believes that the
"Real" brand has become one of the most widely recognized brands on the
Internet.
ELECTRONIC COMMERCE DISTRIBUTION. RealNetworks' electronic commerce
distribution program is designed to increase use of its products and services,
and to drive sales of upgrades, new RealNetworks products and services, and
other companies' products by tapping into RealNetworks' large installed user
base. The RealStore Web site is an online store through which RealNetworks sells
its products, other companies' streaming media products, and training products
for use on corporate intranets. RealNetworks believes that its strategy will
continue to facilitate the growth of the streaming media industry by providing a
centralized marketplace and a low-cost distribution mechanism for developers of
new and innovative streaming media tools and other products.
STREAMING MEDIA CONTENT PRESENTATION AND AGGREGATION. RealNetworks' Web
sites and Web offerings, including Real.com, LiveConcerts.com, Film.com,
RealGuide, Daily Briefing, and its Program Channels, Presets and Destination
Button services aggregate, organize and provide streaming media programming.
RealNetworks believes that these sites and services will stimulate demand for
and creation of streaming media content using its RealSystem G2 technology while
generating advertising revenues for RealNetworks and its customers and content
partners.
STRATEGY
RealNetworks' objective is to be the leading streaming media company,
providing software and services that enable the creation, delivery and playback
of, and easy access to, multimedia content over the Internet, intranets and
through hardware devices, thereby facilitating the Internet's evolution into the
broadest and most powerful mass communication and commerce medium. To achieve
this objective, RealNetworks' strategy includes the following key elements:
EXTEND TECHNOLOGY LEADERSHIP. RealNetworks has established a reputation as
the leader in streaming media technology and intends to continue to maintain its
reputation for leadership, quality and innovation in streaming media technology
by offering more and better products and services. In November 1998, it released
its RealSystem G2 streaming media solution, the next generation in Web media
delivery. RealSystem G2 represents the culmination of two years of software
development and engineering breakthroughs, and incorporates revolutionary
advances developed by RealNetworks together with leading industry partners such
as Intel Corporation. RealSystem G2 is designed to allow users to create rich
multimedia presentations on the Web and to more reliably deliver the best user
multimedia experience across all bandwidths. RealNetworks also continues to
promote the adoption of industry standards that are based on or compatible with
its technologies, such as the Real Time Streaming Protocol ("RTSP"), a proposed
industry standard protocol for the control and delivery of streaming media on
the Internet, and SMIL, a World Wide Web Consortium specification that allows
for synchronization of the playback of all different types of a media in a
single presentation to create a better streaming media experience, and which is
featured in RealSystem G2. In addition, RealNetworks' own RealMedia Architecture
platform allows developers access to RealNetworks' application programming
interfaces to promote rapid and improved development of streaming media software
and access to RealNetworks' base of RealPlayer users. RealNetworks has devoted
and will continue to
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commit significant resources to developing technologies that enhance the
streaming media experience for the content provider and the user.
MAXIMIZE MARKET PENETRATION AND BRAND NAME RECOGNITION. RealNetworks
believes that it is the recognized leader in streaming media technology and that
its "Real" brand is one of the most widely recognized brand names on the
Internet. Since its inception, RealNetworks has sought to achieve rapid and
broad adoption of its technologies and strong brand recognition. This strategy
has been pursued through various means, such as offering its RealPlayer and
Basic Server free of charge over the Internet, bundling its products with those
of other major vendors and distributing its products through multiple
distribution channels.
LEVERAGE MARKET POSITION TO EXPAND BUSINESS MODEL. RealNetworks believes
that it can leverage its technology leadership, market position and brand name
to maintain and increase its market share and diversify its revenue base. It
plans to leverage these assets as follows:
- GROW STREAMING MEDIA SOFTWARE BUSINESS. RealNetworks intends to
capitalize on the increasing demand for streaming media software
generally by continuing to develop, market and support industry-leading
products and services. It also plans to strengthen its marketing, sales
and customer support efforts as the size of the market and customer base
increases.
- TARGET LARGE INSTALLED BASE. RealNetworks plans to expand its electronic
commerce activities and revenue potential by marketing its own and other
companies' streaming media and other products, services and upgrades to
its growing customer base of more than 56 million unique users.
- EXPAND ELECTRONIC COMMERCE BUSINESS. RealNetworks' Web sites, such as
RealStore.com, provide product information, fulfillment resources and
promotion for the sale of RealNetworks' and other companies' products,
streaming media tools and utilities, and intranet-based training
products. RealNetworks plans to expand its own and other companies'
product and service offerings through these Web sites by marketing to its
large installed base of users.
CONNECT CONSUMERS TO STREAMING MEDIA CONTENT. RealNetworks' network of Web
sites aggregates links to third-party streaming media programming, making it
easy for consumers to quickly find and link to streaming media that interests
them. RealNetworks' Web sites and Web offerings, including Real.com,
LiveConcerts.com and Film.com, aggregate, organize and provide streaming media
programming. Its recently enhanced RealGuide provides users with instant access
to programming from thousands of Web sites, and its Daily Briefing services,
including Program Channels, Presets and Destination Buttons, provide one-click
access to popular third-party programming. RealNetworks plans to continue to
build Web site traffic through innovative aggregation strategies, such as its
RealGuide, to increase Web-site advertising revenues, strengthen its electronic
commerce platform and promote streaming media content on the Internet and
intranets.
DEVELOP AND MARKET STREAMING MEDIA SOLUTIONS FOR A VARIETY OF PLATFORMS AND
BANDWIDTHS. RealNetworks' software runs on a broad range of operating systems
and hardware platforms, enabling content providers to reach a broad audience and
businesses to deliver intranet content in heterogeneous computing environments.
RealNetworks' rapid growth is attributable in part to the wide acceptance of the
streaming media solutions it developed for PCs networked in low-bandwidth
environments. Significant efforts continue, however, to make access to the
Internet available on a wider range of platforms, including non-PC Internet
appliances and set-top boxes, and over higher-speed connections, including ISDN,
ASDL and cable modems, which high speed connections RealNetworks believes will
eventually be more widely available in homes. As a result, RealNetworks
continues to design its solutions to operate better in a range of bandwidth
environments and to be flexible enough to easily port to new platforms.
RealNetworks has also made advances in improving its infrastructure
technologies, such as caching and splitting, to enable content providers to
access greater bandwidth more cost effectively. Accordingly, RealNetworks
believes it is positioned to capitalize on possibly significant platform and
bandwidth changes.
STRENGTHEN STRATEGIC RELATIONSHIPS. RealNetworks has established strategic
relationships with a variety of companies, including software and hardware
vendors, entertainment companies, content publishers and broadcast media
companies. RealNetworks pursues these relationships to maximize rapid adoption
of its
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technologies; speed development of compelling streaming media content to build
consumer demand; expand the range of commercial activities based on its
technology and brand name; and foster the development of industry standard
software protocols. A sample of RealNetworks' relationships with participants in
various segments of the streaming media industry includes:
- PLAYER DISTRIBUTION. RealNetworks' RealPlayer is bundled with software
distributed by America Online, Inc., Netscape Communications Corporation,
and various PC manufacturers.
- CONTENT DELIVERY. RealNetworks has licensed its streaming media
technology to companies such as Cable News Network (CNN), ESPN, ABC,
Inc., Fox Entertainment Group, Inc. (Fox News), Bloomberg L.P., Warner
Brothers, SportsLine USA, Inc. (CBS SportsLine) and Broadcast.com, who
present their own or others' streaming media content on the Internet.
RealNetworks' RealGuide provides users with instant access to more than
1,700 live radio and television stations.
- TECHNOLOGY INNOVATION. RealNetworks has entered into strategic agreements
to develop and deploy its streaming technology with Intel Corporation,
Cable & Wireless plc, America Online, Inc., At Home Corporation, Enron
Communications, Inc. and Inktomi Corporation, among others.
- TOOL DEVELOPMENT. RealNetworks has agreements with Lotus Development
Corporation, CBT, Avid Technology, Inc., Adobe Systems Incorporated and
Macromedia, Inc., as well as a host of other developers, to develop and
deploy tools compatible with its RealSystem G2 technology.
- SERVER VENDORS. RealNetworks has agreements with companies such as
Silicon Graphics, Inc., IBM and Sun Microsystems, Inc. to integrate and
market the RealSystem Server technology with their product offerings.
STREAMING MEDIA PRODUCTS AND SERVICES
SERVER TECHNOLOGY. RealNetworks' server technology allows content providers
to encode audio, video and other multimedia programming into discrete data
packets that can be broadcast to large numbers of simultaneous users over
varying bit rate connections. RealNetworks helps content providers get started
with its Basic Server G2, available for free download, which supports 25
sessions of live and on-demand RealAudio, RealVideo, RealText, and RealPix
broadcasts. RealNetworks charges for its enhanced Basic Server Plus, a streaming
media solution for hobbyists and small to medium-sized businesses that includes
more streaming capacity, additional administrative capabilities, and content
creation tools. The RealServer Internet Solution, designed for professional
RealMedia streaming over the Internet, is for broadcasters, Internet Service
Providers ("ISPs"), distance learning providers and large Web sites, provides
more advanced administrative features, the ability to reach a larger audience,
and new in-stream advertising insertion and rotation capabilities to meet the
needs of commercial Web sites. Customized solutions are available with
authentication features to help ensure site security or enable pay-per-view
broadcasting and to support backend credit card and transaction processing
systems, or with features designed and priced specifically for educational
institutions or teachers, or to enable ISPs to host the streaming media content
of their customers. RealNetworks' RealSystem G2 Enterprise Solution is designed
for corporate intranets and allows businesses to deliver synchronized audio,
video, animation, images, slides, and text to employees' desktops, and to create
rich intranet-based training, presentations, and communications. Popular
applications include live executive broadcasts at company meetings, sales force
training, and enterprise learning.
PLAYER TECHNOLOGY. RealNetworks' player technology, which can be installed
easily by a nontechnical user, enables a user to listen to or view content from
Web sites that use RealNetworks' server products. RealNetworks offers its
RealPlayer, which provides basic functions such as play, stop, fast-forward,
rewind and volume adjustment, and the ability to program Preset, Channel and
Destination Buttons for free from its Web site and through bundling with
third-party products. RealNetworks charges for its premium RealPlayer Plus,
which provides additional features, such as clearer, sharper audio and video,
high fidelity audio quality with a graphic equalizer, picture quality controls
such as contrast, brightness and tint, additional programmable buttons and
content accessible only by RealPlayer Plus customers.
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TOOLS AND CONTENT CREATION. RealNetworks offers products to improve the
distribution and quality of customers' RealAudio, RealVideo and RealSystem G2
content and presentations. RealNetworks offers RealProducer G2, its basic
RealAudio and RealVideo creation and publishing tool, for free. It charges for
RealProducer Plus, a more advanced tool which offers Web designers and
production artists building RealAudio, RealVideo and RealSystem G2 presentations
the ability to reach a wider audience and produce higher quality content.
RealNetworks also offers RealProducer Pro G2 for professional Web authors and
production experts who seek timeline-based features for creating synchronized
multimedia, template-based features for SMIL layout and compression control.
CONTENT AGGREGATION AND HOSTING. In addition to its main Web site,
Real.com, RealNetworks offers Web sites that assemble and offer streaming media
programming through navigational and theme-oriented sites. RealGuide offers
programming information from and links to thousands of Web sites, including over
1,700 live radio and television stations. LiveConcerts.com offers live streamed
music concerts and services such as up-to-date concert schedules. Film.com
provides in-depth information about, and streaming media clips of, movies as
well as reviews and previews. Daily Briefing allows users to design and receive
customized daily streaming media newscasts in the areas of current events,
sports, entertainment, music and business/technology. RealNetworks has
collaborated with many infrastructure companies to host streaming media through
RealNetworks' Real Broadcast Network, or RBN. RealNetworks provides full turnkey
services, including the hardware, software, personnel, network connectivity and
bandwidth necessary to enable businesses to broadcast content to large audiences
on an as-needed basis. RBN incorporates RealNetworks' splitter and caching
technologies into MCI Communications Corporation's Internet backbone to
broadcast to up to 50,000 simultaneous users through IP multicasting or
traditional unicasting.
ELECTRONIC COMMERCE AND REALSTORE. RealStore is an online store for the
sale of RealNetworks' products, other companies' streaming media tools and
utilities, and training products for use on corporate intranets. Through this
distribution channel, RealNetworks is able to offer a broad selection of
products with little inventory risk or merchandising expense.
TECHNOLOGY
RealNetworks' client/server software system is designed to optimize the
delivery of streaming media over the Internet, intranets or any network based on
the Internet Protocol. The system is based on open industry standards and works
with a broad range of operating systems, hardware platforms and media types.
CODECS
RealNetworks' system uses multiple compression/decompression algorithms (or
"codecs") to translate time-based data-intensive content such as audio, video or
animation data into discrete data packets and then broadcast (or "stream") the
packets from a server to a client (or "player"). The player then reassembles the
packets in the correct order and allows a user to play back the streaming media
content in real time without waiting to download. The compression process
enables the data to be streamed to the player even in very low bandwidth (14.4
kbps) or congested network environments by reducing the amount of data to be
streamed. In 1998, RealNetworks began an important joint development project
with Intel Corporation to develop improved video codec technology, and
RealNetworks has integrated Intel Corporation's streaming Web video technology
into RealSystem G2, enabling up to four times faster video encoding than
previous streaming media delivery systems, and significantly improving the
decoding capabilities of streaming video. RealNetworks plans to continue to
develop proprietary codecs and license third party codec technology to improve
the capabilities of its products.
REALSYSTEM G2 TECHNOLOGY
To address the inherent limitations of the Internet with respect to
multimedia delivery, RealNetworks has developed its own client/server software
architecture based on advanced transmission technologies and protocols. Key
elements of RealNetworks' technology solution include buffering, bidirectional
communication, error-mitigation, smart networking and video-optimized
transmission. Buffering allows the player extra
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time to accumulate data packets and request retransmission of any missing
packets. Bidirectional communication permits the server and player to
communicate during transmission regarding the bandwidth and quality of the
user's connection to optimize the transmission. Error-Mitigation is designed to
improve the quality of the user experience by mitigating performance degradation
by reconstructing lost data packets based on approximations regarding adjacent
or closely related data packets. Smart Networking allows a server to
automatically select the appropriate transmission protocol depending on current
network conditions and the presence of firewalls or proxies when streaming
content to the player. Video-Optimized Transmission incorporates technologies
that reduce unnecessary repetition of redundant background data in neighboring
video frames, and reduces the amount of video content being streamed if video
performance is degraded during a given transmission, instead focusing on
maintaining the continuity of the audio stream, which is often more central to
the user experience.
NETWORKED MULTIMEDIA FOR LARGE-SCALE DELIVERY
RealNetworks' splitter and caching technologies allow broadcasters to
transmit large numbers of simultaneous streams instead of clogging bandwidth by
sending a separate signal to multiple users through the same network links, and
helps reduce the cost of bandwidth. RealNetworks' splitter technology enables
one "central" server to broadcast a signal to a set of servers distributed
around a network. Those servers then transmit the signal to the end user,
thereby minimizing the use of the network backbone and improving signal quality.
RealNetworks uses this technology in its Real Broadcast Network, and licenses it
to other Internet broadcasters, ISPs and networks.
RESEARCH AND DEVELOPMENT
RealNetworks devotes a substantial portion of its resources to developing
new products and product features, expanding and improving its fundamental
streaming technology, and strengthening its technological expertise. During the
fiscal years ended December 31, 1998, 1997 and 1996, RealNetworks expended
approximately 32%, 41% and 34%, respectively, of its total net revenues on
research and development activities. RealNetworks intends to continue to devote
substantial resources toward research and development for the next several
years. At December 31, 1998, RealNetworks had 189 employees, or approximately
44% of its work force, engaged in research and development activities.
RealNetworks must hire additional skilled software engineers to further its
research and development efforts. RealNetworks' business, financial condition
and results of operations could be adversely affected if it is not able to hire,
train and retain enough qualified engineers.
SALES, MARKETING AND DISTRIBUTION
RealNetworks believes that any individual or company that desires to send
or receive streaming media content over the Internet or intranets is a potential
customer. To reach as many of these potential customers as possible,
RealNetworks markets its products and services through several direct and
indirect distribution channels including over the Internet, through a direct
sales force, OEMs, VARs, and distributors. As of December 31, 1998, RealNetworks
had 147 employees, or approximately 34% of its work force, engaged in sales and
marketing activities.
ELECTRONIC COMMERCE. Substantially all of RealNetworks' products may be
downloaded directly and are available for sale from RealNetworks' Web sites.
RealNetworks also sells third-party products on its RealStore Web site.
Electronic distribution provides RealNetworks with a low-cost, globally
accessible, 24-hour sales channel.
DIRECT SALES FORCE. RealNetworks' direct sales force markets its products
and services primarily to corporate customers for deployment in commercial
Internet Web sites or intranets.
SALES THROUGH CONTENT AGGREGATORS AND HOSTING PARTNERS. RealNetworks sells
its software systems and services to content aggregators, ISPs and other hosting
providers who redistribute or provide end users access to RealNetworks'
streaming technology from their Web sites and systems.
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<PAGE> 10
OEMS AND VARS. RealNetworks has entered into various distribution
relationships with third parties pursuant to which its products and technologies
are incorporated into, bundled with, or offered with the third party's products
for delivery by the third party to end users.
ADVERTISING SALES. RealNetworks' advertising sales force markets and sells
advertising on RealNetworks' Web sites and within media streams that
RealNetworks hosts on behalf of its corporate customers.
INTERNATIONAL SALES. RealNetworks has subsidiaries in Japan, the United
Kingdom, France and Germany that market and sell RealNetworks' products outside
the United States. RealNetworks distributes and sells its products
internationally through a direct sales force, distribution arrangements and
electronically.
MARKETING PROGRAMS. RealNetworks participates in trade shows, conferences
and seminars, provides product information through its Web sites, promotes and
co-promotes special events, places advertising for RealNetworks' products and
services in print and electronic media, and sponsors special programs for
software developers, including its own RealNetworks Conference, a forum intended
help those interested in streaming media develop for, deploy and profit from
streaming media and related Web multimedia technologies.
CUSTOMERS
RealNetworks' customers consist primarily of businesses and individuals
located throughout the world. Sales to customers outside the U.S., primarily in
Asia and Europe, were approximately 23%, 27% and 19% of total net revenues,
excluding Microsoft license revenue, in the years ended December 31, 1998, 1997
and 1996, respectively. Software license fees under a license agreement with
Microsoft accounted for approximately 15% of total net revenues for the year
ended December 31, 1998.
CUSTOMER SUPPORT
RealNetworks' customers have a choice of support options depending on the
level of service desired. RealNetworks maintains a technical support hotline to
answer inquiries and provides an online database of technical information.
RealNetworks' support staff also responds to e-mail inquiries. As of December
31, 1998, RealNetworks employed 18 technical and customer support
representatives to respond to customer requests for support.
COMPETITION
As streaming media evolves into a central and necessary component of the
Internet experience, more companies are entering the market for, and expending
ever greater resources to develop, streaming media software and services, and
competition is thus intensifying. RealNetworks' principal competitors in the
development and distribution of streaming media solutions include Microsoft
Corporation and Apple Computer, Inc. Microsoft currently bundles its NetShow
Server with its Windows NT servers and offers the server from its Web site for
free. The Windows Media Player is available for download from Microsoft's Web
site for free, and is bundled by Microsoft with the Windows 98 operating system
and with Microsoft's browser, Internet Explorer. RealNetworks expects that Apple
Computer's QuickTime technology, long a popular format for downloading content,
will soon be available in streaming format. Because of Microsoft's aggressive
distribution strategies and leverage, and Apple computer's large installed base
of QuickTime users, and both companies' brand recognition and available
resources, both companies offer a serious potential threat to RealNetworks.
Other competitors include Cisco Systems, Inc./Precept Software,
PictureTel/Starlight Networks, and Oracle Corporation. As more companies enter
the market with products and services that compete with RealNetworks' servers,
players and tools, the competitive landscape could change rapidly. Competitive
factors include the quality and reliability of software; features for creating,
editing and adapting content; ease of use and interactive user features;
scalability and cost per user; pricing and licensing terms; and compatibility
with the user's existing network components and software systems.
While RealNetworks believes that it has the leading position for
conventional PC-based Internet streaming systems, no clear standards have
emerged with respect to non-PC, wireless, cable-based systems. Likewise, no one
company has gained a dominant position in the mobile device market because such
devices
9
<PAGE> 11
are not yet well architected to handle media. Another company or standard may
emerge in any of these areas to surpass RealNetworks. In addition, RealNetworks
faces competition to a lesser degree from non-streaming audio and video delivery
technologies such as AVI, QuickTime, and MP3. MP3, a current phenomenon in
IP-based media delivery that RealNetworks is not now participating in, is
emerging as a popular distribution mechanism for "fast download" of audio
content that does not require streaming. Other fast download, or non-streaming
IP-based content distribution methods, are likely to emerge.
RealNetworks also competes with a variety of companies that provide
streaming media hosting services, many of whom use RealNetworks' technology,
such as Broadcast.com, Intervu, Inc., and Enron Communications, Inc.
RealNetworks also competes with a variety of Web sites, such as Buydirect.Com
and Beyond.com, in the electronic distribution of certain of its products.
RealNetworks competes for user traffic and Internet advertising revenues with a
wide variety of Web sites, ISPs and especially audio, video and other media
aggregators, such as Broadcast.com and Microsoft's Web Events, which compete
with RealNetworks' RealGuide. While Internet advertising revenues across the
industry continue to grow, the number of Web sites competing for such revenue is
also growing rapidly.
For further discussion of the Microsoft Relationship, see "Management's
Discussion and Analysis of Financial Condition and Results of
Operations -- Microsoft Relationship." For further discussion of competition,
see "Management's Discussion and Analysis of Financial Condition and Results of
Operations -- Factors that May Affect RealNetworks' Business, Future Operating
Results and Financial Condition -- Intense Competition from Microsoft and Other
Product and Service Providers."
GOVERNMENTAL REGULATION
RealNetworks is not currently subject to direct regulation by any
governmental agency, other than laws and regulations generally applicable to
businesses, although certain U.S. export controls and import controls of other
countries, including controls on the use of encryption technologies, may apply
to RealNetworks' products. Few existing laws or regulations specifically apply
to access to or commerce on the Internet. However, it is likely that a number of
laws and regulations may be adopted with respect to the Internet relating to
content issues (such as obscenity, indecency and defamation), copyright and
other intellectual property rights, personal privacy, advertising, taxation,
electronic commerce liability, electronic mail, information security, and the
convergence of traditional communication services with Internet communications.
Other countries and political organizations are likely to impose or favor more
and different regulation than that which has been proposed in the U.S., thus
furthering the complexity of regulation. The adoption of such laws or
regulations, and uncertainties associated with their validity and enforcement,
may affect the available distribution channels for, and costs associated with,
RealNetworks' products and services, and may affect the growth of intranets,
extranets, and the Internet. Such laws or regulations may therefore have a
material adverse effect on RealNetworks' business, prospects, financial
condition and results of operations. In addition, it is not clear how existing
laws governing issues such as property ownership, copyright and other
intellectual property issues, taxation, libel, retransmission of media, and
personal privacy and data protection apply to the Internet. The vast majority of
such laws were adopted prior to the advent of the Internet and related
technologies and do not address the unique issues associated with the Internet
and related technologies. Changes to such laws could create uncertainty in the
marketplace that could reduce demand for RealNetworks' products and services,
increase its costs of doing business, including as a result costs of litigation
or increased product development costs, or otherwise impair RealNetworks'
finance or business prospects. For further discussion of government regulation,
see "Management's Discussion and Analysis of Financial Condition and Results of
Operations -- Factors that May Affect RealNetworks' Business, Future Operating
Results and Financial Condition -- Government Regulation and Legal
Uncertainties."
INTELLECTUAL PROPERTY
As of December 31, 1998, RealNetworks had 18 registered U.S. trademarks or
service marks, and had applications pending for an additional 35 U.S.
trademarks. In addition, RealNetworks has several foreign trademark
registrations and pending applications. A significant portion of RealNetworks'
marks begin with the word "Real" (such as RealSystem, RealAudio and RealVideo).
RealNetworks is aware of other companies
10
<PAGE> 12
that use "Real" in their marks alone or in combination with other words, and
RealNetworks does not expect to be able to prevent all third-party uses of the
word "Real" for all goods and services. In addition, the laws of some foreign
countries do not protect RealNetworks' 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 such jurisdictions. Many of
RealNetworks' 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,
RealNetworks would need to either obtain a license or design around the patent.
There can be no assurance that the Company would be able to obtain such a
license on acceptable terms, if at all, or to design around the patent. As with
other software products, RealNetworks' products are susceptible to unauthorized
copying and uses that may go undetected, and policing such unauthorized use is
difficult. In general, there can be no assurance that RealNetworks' efforts to
protect its intellectual property rights through patent, copyright, trademark
and trade secret laws will be effective to prevent misappropriation of its
technology, or to prevent the development and design by others of products or
technologies similar to or competitive with those developed by RealNetworks. For
a discussion of RealNetworks' efforts to protect its intellectual property and
to police the unauthorized use of its technology, and the risks associated
therewith, see "Management's Discussion and Analysis of Financial Condition and
Results of Operations -- Factors that May Affect RealNetworks' Business, Future
Operating Results and Financial Condition -- Proprietary Rights; Claims of
Infringement."
EMPLOYEES
At December 31, 1998, RealNetworks had 434 full-time employees and no
part-time employees, 387 of whom were based at RealNetworks' executive offices
in Seattle, Washington, 31 of whom were based at RealNetworks' offices in Japan,
England, France, Canada, Germany or Denmark and 16 of whom were sales personnel
based at other locations. None of RealNetworks' employees is subject to a
collective bargaining agreement, and RealNetworks believes that its relations
with its employees are good.
POSITION ON CHARITABLE RESPONSIBILITY
RealNetworks is strongly committed to charitable responsibility, as
evidenced by its donations of software to charitable organizations. If sustained
profitability is achieved, RealNetworks intends to donate approximately 5% of
its annual net income to charitable organizations. RealNetworks hopes to
encourage employee giving by using a portion of its intended contribution to
match charitable donations made by employees.
ITEM 2. PROPERTIES
RealNetworks' executive offices are located in downtown Seattle, Washington
in an office building in which, as of December 31, 1998, RealNetworks leases an
aggregate of 96,000 square feet at a monthly rental of $172,000. The lease
agreement terminates in May 1999. In January 1998, RealNetworks entered into a
lease agreement for a new location for its corporate offices. The lease is for
an aggregate of approximately 265,000 square feet at a monthly rental of
approximately $350,000. The lease commences on April 1, 1999 and expires on
April 1, 2011, with an option to renew for either a three or a ten year period.
ITEM 3. LEGAL PROCEEDINGS
On or about August 25, 1998, a lawsuit was filed against RealNetworks and
co-defendant, Broadcast.com, Inc., in the United States District Court for the
Northern District of Texas -- Dallas Division, by Venson M. Shaw and Steven M.
Shaw. The plaintiffs allege that RealNetworks, individually and in combination
with Broadcast.com, infringes on a certain patent by making, using, selling
and/or offering to sell software products and services directed to media
delivery systems for the Internet and corporate intranets. Plaintiffs seek to
enjoin RealNetworks from its alleged infringing activity and to recover damages
in an amount no less than a reasonable royalty. Although no assurance can be
given as to the outcome of this lawsuit, RealNetworks believes that the
allegations in this action are without merit, and RealNetworks intends to
vigorously defend against the complaint. RealNetworks may be required to
indemnify Broadcast.com under the terms of its license agreement with
Broadcast.com.
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<PAGE> 13
From time to time RealNetworks has been, and expects to continue to be,
subject to legal proceedings and claims in the ordinary course of its business,
including contract-related claims and claims of alleged infringement of
third-party patents, trademarks and other intellectual property rights by
RealNetworks and its licensees. Such claims, even if not meritorious, could
force RealNetworks to spend significant financial and managerial resources.
RealNetworks currently is not aware of any legal proceedings or claims that
RealNetworks believes will have, individually or taken together, a material
adverse effect on RealNetworks' business, prospects, financial condition and
results of operations.
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<PAGE> 14
ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS
No matters were submitted to a vote of RealNetworks' shareholders during
the fourth quarter of its fiscal year ended December 31, 1998.
ITEM 4A. EXECUTIVE OFFICERS OF THE REGISTRANT
The executive officers of RealNetworks are elected annually at the meeting
of the Board of Directors held in conjunction with the annual meeting of
shareholders. The following are the current executive officers of RealNetworks:
<TABLE>
<CAPTION>
NAME AGE POSITION
---- --- --------
<S> <C> <C>
Robert Glaser........................ 37 Chairman of the Board, Chief Executive
Officer and Treasurer
Phillip Barrett...................... 45 Senior Vice President -- Media Technologies
Paul Bialek.......................... 39 Senior Vice President -- Finance and
Operations and Chief Financial Officer
Maria Cantwell....................... 40 Senior Vice President -- Consumer and
E-Commerce
Thomas Frank......................... 35 Senior Vice President -- Programming and
Media Publishing
Len Jordan........................... 32 Senior Vice President -- Media Systems
Brian Aiken.......................... 46 Vice President -- Europe
Alex Alben........................... 40 Vice President -- Music Group
Mark Bretl........................... 40 Vice President -- Media Systems
Steve Haworth........................ 52 Vice President -- Communications
James Higa........................... 41 Vice President -- Asia/Rest of World ("ROW")
Mark Klebanoff....................... 37 Vice President -- Business Development
Kelly Jo MacArthur................... 34 Vice President, General Counsel and
Secretary
Jeff Mandelbaum...................... 39 Vice President -- North American Sales
Shelley Morrison..................... 49 Vice President -- Advertising Sales
Philip Rosedale...................... 30 Vice President -- Media Systems and Chief
Technology Officer
</TABLE>
ROBERT GLASER has served as Chairman of the Board, Chief Executive Officer
and Treasurer of RealNetworks since its inception in February 1994. He also
serves as RealNetworks' Policy Ombudsman, with the exclusive authority to adopt
or change the editorial policies of RealNetworks as reflected on its Web sites
or in other communications or media in which RealNetworks has a significant
editorial or media voice. From 1983 to 1993, Mr. Glaser was employed at
Microsoft, most recently as Vice President of multimedia and consumer systems,
where he focused on the development of new businesses related to the convergence
of the computer, consumer electronics and media industries. Mr. Glaser holds a
B.A. and an M.A. in Economics and a B.S. in Computer Science from Yale
University.
PHILLIP BARRETT has served as Senior Vice President -- Media Technologies
of RealNetworks since July 1998. From January 1997 to July 1998, Mr. Barrett
served as Senior Vice President -- Media Systems of RealNetworks, and from
November 1994 to January 1997 he served as Vice President-Software Development.
From March 1986 to October 1994, Mr. Barrett was a Development Group Manager at
Microsoft, where he led development efforts for Windows 386, Windows 3.0 and
Windows 3.1. Mr. Barrett holds an A.B. in Mathematics from Rutgers University
and an M.S. in Computer Sciences from the University of Wisconsin, Madison.
PAUL BIALEK has served as Senior Vice President -- Finance and Operations
and Chief Financial Officer of RealNetworks since June 1998. Mr. Bialek is
responsible for finance, human resources, facilities, MIS, customer service and
technical support functions. From March 1997 to June 1998, Mr. Bialek was Chief
Financial Officer and Vice President of Finance and Operations with Metapath
Software Corporation, a
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<PAGE> 15
provider of operational support systems for telecommunications companies. From
1993 to March 1997, Mr. Bialek was Chief Financial Officer and Vice President of
Finance and Administration for Edmark Corporation, a developer and publisher of
multimedia educational software products. Mr. Bialek started his career at KPMG
LLP where he was employed in a variety of positions for 11 years. Mr. Bialek
holds a B.A. in Business Administration from Seattle University and is a
Certified Public Accountant.
MARIA CANTWELL has served as Senior Vice President -- Consumer and
E-Commerce of RealNetworks since July 1997. From April 1995 to July 1997, Ms.
Cantwell served as Vice President -- Marketing of RealNetworks. From February
1995 to April 1995, Ms. Cantwell was a consultant to RealNetworks. From 1992 to
January 1995, Ms. Cantwell served as a member of the 103rd Congress. Ms.
Cantwell holds a B.A. in Public Administration from Miami University.
THOMAS FRANK has served as Senior Vice President -- Programming and Media
Publishing of RealNetworks since January 1999. From January 1995 to December
1998, Mr. Frank served as Senior Vice President of Dick Clark Productions,
responsible for television program development and production. From 1992 to
December 1995, Mr. Frank served as Vice President, Television Programming for
The Leo Burnett Company, and was responsible for client sponsored programming.
Mr. Frank previously held positions with Carolco Television and Proctor & Gamble
Company. Mr. Frank holds a B.A. in English Literature from the University of
Cincinnati.
LEN JORDAN has served as Senior Vice President -- Media Systems of
RealNetworks since January 1997. From November 1993 to November 1996, Mr. Jordan
was employed in a number of capacities at Creative Multimedia, Inc., a developer
and publisher of CD-ROM/Internet products, most recently serving as President.
From September 1989 to November 1993, Mr. Jordan was employed at Central Point
Software, Inc., a utility software publisher. Mr. Jordan graduated magna cum
laude from the Eccles School of Business at the University of Utah with B.S.
degrees in Finance and Economics.
BRIAN AIKEN has served as Vice President -- Europe since June 1998. From
February 1997 to June 1998, Mr. Aiken was General Manager, Europe for Intuit,
Inc., a provider of personal finance, small business accounting, and tax
preparation software. From June 1995 to January 1997 Mr. Aiken was General
Manager, Central Europe for Continuous Software, Inc., a maker of software
configuration management solutions. From February 1993 to June 1995, Mr. Aiken
served as General Manager, Central Europe for Sunsoft, a subsidiary of Sun
Microsystems, Inc. Mr. Aiken holds a B.A. with First Class Honours from Trinity
College, University of Oxford.
ALEX ALBEN has served as Vice President -- Music Group since August 1998
and Vice President -- Media Publishing of RealNetworks from February 1998 to
August 1998, with responsibility for RealNetworks' music and entertainment web
products. From March 1997 to February 1998, Mr. Alben was a consultant to
RealNetworks and to Film.com, Inc. From October 1993 to June 1995, Mr. Alben was
Director of Business Affairs, and from June 1995 to February 1997, Vice
President of Business Affairs of Starwave Corporation, a creator and producer of
online sports, news and entertainment services. Mr. Alben served as Associate
General Counsel in the feature film division of Warner Bros. from 1992 to 1993,
and previously served as Director of Business Affairs at Orion Pictures. Mr.
Alben graduated with distinction from Stanford University and holds a J.D. from
Stanford Law School.
MARK BRETL joined RealNetworks in March 1998 and has served as Vice
President -- Media Systems since June 1998. From 1994 to March 1998, Mr. Bretl
served as Chief Operating Officer for Vivo Software, Inc., a developer of
software based video conferencing systems and streaming media. From 1983 to
1991, Mr. Bretl held a variety of positions with Tecmar, Inc., a developer and
manufacturer of PC and Macintosh computer peripherals, where he most recently
served as President and Chief Operating Officer. Mr. Bretl graduated magna cum
laude from the University of Wisconsin, Platteville, with a B.S. in Physics and
Computer Science.
STEVE HAWORTH has served as Vice President -- Communications of
RealNetworks since January 1999. From 1987 to January 1999, Mr. Haworth was
first Director, then Vice President of Public Relations for the CNN News Group.
Previously, Mr. Haworth was Vice President of A. Brown-Olmstead Associates, an
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<PAGE> 16
Atlanta public relations firm; taught political science at Agnes Scott College
in Decatur, GA and Emory University, in Atlanta, GA; and was an economist at the
World Bank in Washington, DC. Mr. Haworth holds a B.A. in economics from Yale
University, an M.A. in International Affairs from George Washington University
and a Ph.D. in Government and Foreign Affairs from the University of Virginia.
JAMES HIGA has served as Vice President -- Asia/ROW of RealNetworks since
September 1996. From January 1989 to August 1996, Mr. Higa was the Director for
Asia/Pacific for NeXT Software, Inc. From 1986 to 1989, Mr. Higa served as
Director of Product Marketing at Apple Japan, Inc. Mr. Higa holds a B.A. in
Political Science from Stanford University.
MARK KLEBANOFF has served as Vice President -- Business Development of
RealNetworks since June 1998. Mr. Klebanoff joined RealNetworks in June 1996 and
served as Vice President -- Chief Financial Officer until June 1998. From May
1992 to June 1996, Mr. Klebanoff was Vice President of Finance and Operations of
Industrial Systems, Inc., a client/server process information management
software vendor, which merged with Aspen Technology, Inc. in 1995. From 1989 to
1992, Mr. Klebanoff worked in a number of general management capacities for the
Japanese trading company Itochu Corporation, and holds a Masters degree from the
Yale School of Management and a B.A. with Honors from Yale University.
KELLY JO MACARTHUR has served as Vice President and General Counsel of
RealNetworks since October 1996. From 1995 to 1996, Ms. MacArthur served as
General Counsel and Director of Business Affairs for Compton's NewMedia, Inc.,
which was acquired by Learning Co., Inc. in 1996. From 1989 to 1994, Ms.
MacArthur was an attorney at Sidley & Austin in Chicago. Ms. MacArthur graduated
summa cum laude from the University of Illinois at Champaign-Urbana and holds a
J.D. from Harvard Law School.
JEFF MANDELBAUM has served as Vice President -- North American Sales of
RealNetworks since April 1998. Mr. Mandelbaum is responsible for commercial,
government, channel and OEM sales in North America. From October 1996 to March
1998, Mr. Mandelbaum held a variety of positions in sales and sales management
with Sybase, Inc., a provider of software products and consulting services for
the delivery of integrated business solutions, most recently serving as Chief
Executive Officer and President of Sybase Financial Services, Inc. Mr.
Mandelbaum is a graduate of the Executive Program in Business Administration
from the Columbia University School of Business.
SHELLEY MORRISON has served as Vice President -- Advertising Sales of
RealNetworks since January 1999. From 1995 to 1998, Ms. Morrison served as Vice
President of Advertising for Buena Vista Internet Group, a division of Disney,
where she was responsible for managing the advertising operations, client
services and the creative departments. From 1990 to 1995, Ms. Morrison served as
President of Shelley Morrison & Associates, an advertising and marketing firm.
From 1984 to 1990, Ms. Morrison served as the Director of Marketing for the
Seattle Supersonics in the NBA. Ms. Morrison holds a B.A. in Communications from
the University of Washington.
PHILIP ROSEDALE has served as Vice President -- Media Systems of
RealNetworks since October 1997 and has served as its Chief Technology Officer
since December 1998. From February 1996 to October 1997, Mr. Rosedale served as
General Manager, Software Development of RealNetworks. From June 1986 to
February 1996, Mr. Rosedale was founder and Chief Executive Officer of Automated
Management Systems, a developer and marketer of software applications. Mr.
Rosedale graduated cum laude from the University of California, San Diego with a
B.S. in Physics.
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<PAGE> 17
PART II
ITEM 5. MARKET FOR REGISTRANT'S COMMON EQUITY AND RELATED STOCKHOLDER MATTERS
The Company's common stock has been traded on the Nasdaq National Market
under the symbol "RNWK" since the Company's initial public offering in November
1997. There is currently only a limited trading market for the shares of the
Company's common stock and accordingly there is no assurance that any quantity
of the common stock could be sold at or near reported trading prices.
The following table sets forth for the periods indicated the high and low
closing prices for the Company's common stock. These quotations represent prices
between dealers and do not include retail markups, markdowns or commissions and
may not necessarily represent actual transactions.
<TABLE>
<CAPTION>
HIGH LOW
------- ------
<S> <C> <C>
YEAR ENDED DECEMBER 31, 1998
First Quarter..................................... $29.750 13.500
Second Quarter.................................... 39.438 19.938
Third Quarter..................................... 48.250 15.250
Fourth Quarter.................................... 49.750 22.125
YEAR ENDED DECEMBER 31, 1997
Fourth Quarter.................................... $19.375 13.625
</TABLE>
The Company has not paid any cash dividends and does not intend to pay any
cash dividends in the foreseeable future.
As of March 15, 1999, there were approximately 404 holders of record of the
Company's common stock. Most shares of the Company's common stock are held by
brokers and other institutions on behalf of shareholders.
RECENT SALES OF UNREGISTERED SECURITIES
Since October 1, 1998, RealNetworks has issued and sold unregistered
securities as follows:
(1) An aggregate of 338,967 shares of Common Stock was issued to six
investors upon the exercise of warrants in October 1998. The aggregate
consideration received for such shares was $3,190,527.
(2) An aggregate of 15,161 shares of Common Stock was issued to one
investor upon the cashless exercise of warrants in October 1998. The
aggregate consideration received for such shares was the cancellation of
warrants to acquire 19,920 shares of Common Stock at an exercise price of
$9.41.
(3) An aggregate of 39,841 shares of Common Stock was issued to one
investor upon the exercise of warrants in November 1998. The aggregate
consideration received for such shares was $375,003.
(4) An aggregate of 10,890 shares of Common Stock was issued to two
investors upon the cashless exercise of warrants in November 1998. The
aggregate consideration received for such shares was the cancellation of
warrants to acquire 13,944 shares of Common Stock at an exercise price of
$9.41.
No underwriters were engaged in connection with these issuances and sales.
Each of the transactions noted above was made in reliance upon the exemption
from registration provided by either Section 3(b) or 4(2) of the Securities Act
of 1933, as amended (the "Securities Act").
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<PAGE> 18
USE OF PROCEEDS
RealNetworks' Registration Statement on Form S-1 (File No. 333-36553) filed
with the Securities and Exchange Commission in connection with RealNetworks'
initial public offering (the "Registration Statement") was declared effective on
November 20, 1997. Offering proceeds, net of aggregate expenses of approximately
$4.6 million, were approximately $38.5 million. RealNetworks has used all of the
net offering proceeds for the purchase of temporary investments consisting of
cash, cash equivalents and short-term investments. RealNetworks has not used any
of the net offering proceeds for the construction of any plant, building or
facilities; purchase or installation of machinery or equipment; purchases of
real estate; acquisition of other businesses; or repayment of indebtedness. None
of the expenses paid in connection with the issuance and distribution of the
common stock in the offering, and none of the net offering proceeds, were paid
directly or indirectly to directors, officers, general partners of RealNetworks
or their associates, persons owning ten percent (10%) or more of any class of
equity securities of RealNetworks, or affiliates of RealNetworks.
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ITEM 6. SELECTED CONSOLIDATED FINANCIAL DATA
The following selected consolidated financial data should be read in
conjunction with the Company's Consolidated Financial Statements and Notes
thereto and "Management's Discussion and Analysis of Financial Condition and
Results of Operations," included in this Form 10-K. The selected consolidated
financial data as of December 31, 1998, 1997, 1996, 1995 and 1994 and for the
years ended December 31, 1998, 1997, 1996, 1995 and the period from February 9,
1994 (inception) to December 31, 1994 are derived from the Consolidated
Financial Statements of the Company which have been audited by KPMG LLP,
independent accountants.
<TABLE>
<CAPTION>
PERIOD FROM
FEBRUARY 9, 1994
(INCEPTION)
TO DECEMBER 31,
1998 1997 1996 1995 1994
-------- -------- ------- ------- ----------------
(IN THOUSANDS, EXCEPT PER SHARE DATA)
<S> <C> <C> <C> <C> <C>
STATEMENT OF OPERATIONS DATA:
Net revenues:
Software license fees............................. $ 46,949 $ 25,494 $11,876 $ 1,782 $ --
Service revenues.................................. 14,742 4,972 1,120 30 --
Advertising....................................... 3,148 2,254 1,016 -- --
-------- -------- ------- ------- -------
Total net revenues........................ 64,839 32,720 14,012 1,812 --
Total cost of revenues.............................. 12,390 6,465 2,185 62 --
-------- -------- ------- ------- -------
Gross profit.............................. 52,449 26,255 11,827 1,750 --
-------- -------- ------- ------- -------
Operating expenses:
Research and development.......................... 20,828 13,268 4,812 1,380 202
Sales and marketing............................... 32,451 20,124 7,540 1,218 47
General and administrative........................ 9,841 6,024 3,491 747 296
Goodwill amortization(1).......................... 1,596 -- -- -- --
Acquisition charges(1)............................ 8,723 -- -- -- --
-------- -------- ------- ------- -------
Total operating expenses.................. 73,439 39,416 15,843 3,345 545
-------- -------- ------- ------- -------
Operating loss................................. (20,990) (13,161) (4,016) (1,595) (545)
-------- -------- ------- ------- -------
Other income, net................................... 4,576 1,992 227 94 --
-------- -------- ------- ------- -------
Net loss.................................. $(16,414) $(11,169) $(3,789) $(1,501) $ (545)
======== ======== ======= ======= =======
Basic and diluted net loss per share................ $ (0.51) $ (2.88) $(11.91) $(59.89) $(54.52)
Shares used to compute basic and diluted
net loss per share................................ 32,323 4,041 321 25 10
Pro forma basic and diluted net loss per share(2)... (0.40)
Shares used to compute pro forma basic and diluted
net loss per share(2)............................. 28,854
BALANCE SHEET DATA:
Cash, cash equivalents and short-term investments... $ 89,777 $ 92,537 $19,595 $ 6,116 $ --
Working capital (deficit)........................... 60,207 87,520 16,893 5,948 (49)
Total assets........................................ 128,059 116,704 26,468 7,574 64
Note payable........................................ 987 963 -- -- --
Redeemable, convertible preferred stock............. -- -- 23,153 7,655 --
Shareholders' equity (deficit)...................... 83,516 77,902 (3,320) (1,111) 15
</TABLE>
- ---------------
(1) During 1998, RealNetworks acquired Vivo Software, Inc. In connection with
the acquisition, RealNetworks incurred acquisition-related charges of $8,723
and recorded goodwill of $10,644. See Note 2 of Notes to Consolidated
Financial Statements.
(2) Because of the significance of the conversion of preferred stock to common
stock upon the closing of the Company's initial public offering, the Company
has presented pro forma basic and diluted net loss per share as if these
series of convertible preferred stock and redeemable convertible preferred
stock had been converted into common stock on January 1, 1997, or their date
of issuance if later.
18
<PAGE> 20
ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS
OF OPERATIONS
The discussion in this report contains forward-looking statements that
involve risks and uncertainties. RealNetworks' actual results could differ
materially from those discussed below. Factors that could cause or contribute to
such differences include, but are not limited to, those identified below, and
those discussed in the "Business" and "Legal Proceedings" sections in this Form
10-K. You should also carefully review the risk factors set forth in other
reports or documents RealNetworks files from time to time with the Securities
and Exchange Commission, particularly the Quarterly Reports on Form 10-Q and any
Current Reports on Form 8-K.
OVERVIEW
RealNetworks, Inc. and its subsidiaries (RealNetworks) is a leading
provider of software and services for the streaming media market. RealNetworks
develops and markets software products and services designed to enable users of
personal computers and other consumer electronic devices to send and receive
audio, video and other multimedia content over the Internet and corporate
intranets.
RealNetworks was incorporated in February 1994 and was in the development
stage until July 1995, when RealNetworks released the commercial version of
RealAudio Version 1.0. From inception through December 31, 1995, RealNetworks'
operating activities related primarily to recruiting personnel, raising capital,
purchasing operating assets, conducting research and development, building the
RealAudio brand and establishing the market for streaming audio. During 1996,
RealNetworks continued to invest heavily in research and development, marketing,
building domestic and international sales channels and general and
administrative infrastructure. In August 1996, RealNetworks began selling
RealPlayer Plus, a premium version of its RealPlayer product. RealPlayer
continues to be available for download free of charge from RealNetworks' Web
sites. In June 1997, RealNetworks released the commercial version of RealVideo
Version 4.0. In December 1997, RealNetworks released the commercial version of
RealSystem Version 5.0, a streaming media solution that includes RealAudio and
RealVideo technology. RealSystem G2, the next-generation media delivery system,
was released in commercial version in November 1998.
In March 1998, RealNetworks acquired Vivo Software, Inc. (Vivo), a leading
developer of streaming media creation tools.
RealNetworks has a limited operating history upon which an evaluation of
RealNetworks and its prospects can be based. RealNetworks' prospects must be
considered in light of the risks, expenses and difficulties frequently
encountered by companies in early stages of development, particularly companies
in rapidly changing markets such as media delivery and electronic commerce over
the Internet and intranets. There can be no assurance that RealNetworks will
achieve or sustain profitability. RealNetworks has incurred significant losses
since its inception, and as of December 31, 1998 had an accumulated deficit of
$33.9 million. RealNetworks believes that its success will depend largely on its
ability to extend its technological and market leadership and continue to build
its brand position. Accordingly, RealNetworks intends to invest heavily in
research and development and sales and marketing. Although RealNetworks has
experienced significant percentage growth in total net revenues, it does not
believe that its historical growth rates are sustainable or necessarily
indicative of future growth. See "Factors that May Affect RealNetworks'
Business, Future Operating Results and Financial Condition."
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<PAGE> 21
The following table sets forth certain financial data for the periods
indicated as a percentage of total net revenues:
<TABLE>
<CAPTION>
1998 1997 1996
----- ----- -----
<S> <C> <C> <C>
Net revenues:
Software license fees..................................... 72.4% 77.9% 84.8%
Service revenues.......................................... 22.7 15.2 8.0
Advertising............................................... 4.9 6.9 7.2
----- ----- -----
Total net revenues................................ 100.0 100.0 100.0
----- ----- -----
Cost of revenues:
Software license fees..................................... 12.4 9.6 9.6
Service revenues.......................................... 4.0 7.3 4.0
Advertising............................................... 2.7 2.8 2.0
----- ----- -----
Total cost of revenues............................ 19.1 19.7 15.6
----- ----- -----
Gross profit...................................... 80.9 80.3 84.4
----- ----- -----
Operating expenses:
Research and development.................................. 32.1 40.6 34.3
Sales and marketing....................................... 50.0 61.5 53.8
General and administrative................................ 15.2 18.4 24.9
Goodwill amortization..................................... 2.5 -- --
Acquisition charges....................................... 13.5 -- --
----- ----- -----
Total operating expenses.......................... 113.3 120.5 113.0
----- ----- -----
Operating loss.................................... (32.4) (40.2) (28.6)
----- ----- -----
Other income (expense):
Interest income........................................... 8.2 6.8 2.1
Other expense............................................. (1.1) (0.7) (0.5)
----- ----- -----
Other income, net................................. 7.1 6.1 1.6
----- ----- -----
Net loss.......................................... (25.3)% (34.1)% (27.0)%
===== ===== =====
</TABLE>
REVENUES
<TABLE>
<CAPTION>
1998 CHANGE 1997 CHANGE 1996
------- ------ ------- ------ -------
(DOLLARS IN THOUSANDS)
<S> <C> <C> <C> <C> <C>
Software license fees........................ $46,949 84% $25,494 115% $11,876
Service revenues............................. 14,742 197 4,972 344 1,120
Advertising.................................. 3,148 40 2,254 122 1,016
------- ------- -------
Total net revenues................. $64,839 98% $32,720 134% $14,012
======= ======= =======
</TABLE>
SOFTWARE LICENSE FEES. Software license fees include revenues from sales of
servers, tools, RealPlayer Plus, third party products and original equipment
manufacturers (OEM) licenses, including revenues recognized pursuant to a
license agreement with Microsoft Corporation (Microsoft). Software license fees
were $46.9 million in 1998, an increase of 84% from $25.5 million in 1997.
Software license fees were $25.5 million in 1997, an increase of 115% from $11.9
million in 1996. The increases during 1998 and 1997 were due primarily to a
greater volume of products sold as a result of growth in the demand for
streaming audio and video on the Internet, the introduction of new products,
including RealSystem G2 in November 1998, RealSystem Version 5.0 in December
1997, and RealVideo Version 4.0 in June 1997, successful product promotions,
increased sales from electronic distribution and the sale of third party
products. In June 1997, RealNetworks entered into a $30.0 million license
agreement with Microsoft which is being recognized over the three-year term of
RealNetworks' ongoing support obligations. Software license fees for 1998 and
1997 included $9.7 million and $4.8 million, respectively, related to the OEM
agreement with Microsoft.
20
<PAGE> 22
RealNetworks has used price and other promotions to increase the trial, purchase
and use of its software products.
SERVICE REVENUES. Service revenues include revenues from support and
maintenance agreements associated with servers, tools, and RealPlayer Plus,
streaming media hosting services offered through RealNetworks' RealBroadcast
Network, and consulting services. Service revenues were $14.7 million in 1998,
an increase of 197% from $5.0 million in 1997. The increase during 1998 was
primarily attributable to revenues from sales of support and upgrade contracts
on RealPlayer Plus, which RealNetworks began selling during the fourth quarter
of 1997, a larger installed base of RealNetworks server products and increases
in consulting and streaming media hosting. Service revenues were $5.0 million in
1997, an increase of 344% from $1.1 million in 1996. The 1997 increase was
primarily due to a greater installed base of RealNetworks server products. This
larger installed base leads to increased revenues from the sale of support and
maintenance contracts and other services performed by RealNetworks.
ADVERTISING REVENUES. Advertising revenues were $3.1 million in 1998, an
increase of 40% from $2.3 million in 1997. The increase in advertising revenues
for 1998 was due to a larger sales force and more traffic to RealNetworks' Web
sites. Advertising revenues were $2.3 million in 1997, an increase of 122% from
$1.0 million in 1996. RealNetworks began selling advertising space on its Web
sites in March 1996. Increased revenues in 1997 were due in part to a full year
of advertising sales and RealNetworks' success in attracting more advertisers.
GEOGRAPHIC REVENUES
<TABLE>
<CAPTION>
1998 CHANGE 1997 CHANGE 1996
------- ------ ------- ------ -------
(DOLLARS IN THOUSANDS)
<S> <C> <C> <C> <C> <C>
North America................................ $42,611 109% $20,346 80% $11,308
Europe....................................... 7,144 109 3,425 230 1,037
Asia......................................... 4,429 37 3,225 218 1,013
Rest of world................................ 987 11 890 36 654
------- ------- -------
Subtotal........................... 55,171 98 27,886 99 14,012
Microsoft license revenue.................... 9,668 100 4,834 n/a --
------- ------- -------
Total.............................. $64,839 98% $32,720 134% $14,012
======= ======= =======
</TABLE>
Excluding revenue from the Microsoft agreement, international revenues
represented 23% of total net revenues in 1998 and 27% in 1997. Revenues
generated in Europe were 13% and 12% of total net revenues excluding Microsoft
license revenue in 1998 and 1997, respectively, and revenues generated in Asia
were 8% and 12% of total net revenues excluding Microsoft license revenue in
1998 and 1997, respectively. At December 31, 1998, accounts receivable due from
European and Asian customers were not significant. The functional currency of
RealNetworks' foreign subsidiaries is the local currency of the country in which
the subsidiary is incorporated. Results of operations of RealNetworks' foreign
subsidiaries are translated from local currency into U.S. dollars based on
average monthly exchange rates. RealNetworks currently does not hedge its
foreign currency exposures and therefore is subject to the risk of changes in
exchange rates. RealNetworks expects that international revenues will increase
over time in both absolute dollars and as a percentage of total net revenues.
The cost structures of both domestic and international revenues are
substantially the same.
21
<PAGE> 23
COST OF REVENUES
<TABLE>
<CAPTION>
1998 CHANGE 1997 CHANGE 1996
------- ------ ------ ------ ------
(DOLLARS IN THOUSANDS)
<S> <C> <C> <C> <C> <C>
Software license fees.......................... $ 8,032 155% $3,153 135% $1,343
Service revenues............................... 2,631 10 2,392 332 554
Advertising.................................... 1,727 88 920 219 288
------- ------ ------
Total cost of revenues............... $12,390 92% $6,465 196% $2,185
======= ====== ======
As a percentage of total net revenues.......... 19% 20% 16%
</TABLE>
COST OF SOFTWARE LICENSE FEES. Cost of software license fees includes cost
of product media, duplication, manuals, packaging materials, amounts paid for
licensed technology and fees paid to third party vendors for order fulfillment.
Cost of software license fees was $8.0 million for 1998, an increase of 155%
from $3.2 million in 1997, and increased as a percentage of software license
fees to 17% from 12% in 1997. Cost of software license fees was $3.2 million in
1997, an increase of 135% from $1.3 million in 1996, and increased as a
percentage of software license fees to 12% from 11% in 1996. The increases in
absolute dollars were due primarily to higher sales volume. The increases in
percentage terms were due to a shift in product mix toward lower margin player
products, a greater percentage of sales through indirect channels and the
utilization of a third party order fulfillment agency.
COST OF SERVICE REVENUES. Cost of service revenues includes the cost of
in-house and contract personnel providing customer support and related services
and bandwidth expenses for streaming media hosting services. Cost of service
revenues was $2.6 million for 1998, an increase of 10% from $2.4 million in
1997, but decreased as a percentage of service revenues to 18% from 48% in 1997.
Cost of service revenues was $2.4 million for 1997, an increase of 332% from
$0.6 million in 1996, but decreased as a percentage of service revenues to 48%
from 49% in 1996. Cost of service revenues for 1997 includes $1.0 million of
costs associated with the RealNetworks Conference. Excluding the impact of the
RealNetworks Conference, cost of service revenues was $1.4 million in 1997, or
31% of service revenues. The 1998 and 1997 increases in absolute dollars,
excluding the RealNetworks Conference, were primarily due to increased staff and
contract personnel to provide services to a greater number of customers and
increases in bandwidth expenses. The cost decreases as a percentage of service
revenues were primarily due to economies of scale in providing support services
to a larger customer base. The net costs of the 1998 RealNetworks Conference are
included in sales and marketing expense.
COST OF ADVERTISING REVENUES. Cost of advertising revenues includes
personnel associated with content creation, bandwidth expenses and fees paid to
third parties for content included in RealNetworks' Web sites. Cost of
advertising revenues was $1.7 million for 1998, an increase of 88% from $0.9
million in 1997, and increased as a percentage of advertising revenues to 55%
from 41% in 1997. Cost of advertising revenues was $0.9 million for 1997, an
increase of 219% from $0.3 million in 1996, and increased as a percentage of
advertising revenues to 41% from 28% in 1996. The increases were primarily due
to increases in the quality and quantity of content available on RealNetworks'
Web sites and higher bandwidth costs.
RealNetworks' gross margins may be adversely affected by the mix of
distribution channels used by RealNetworks and the mix of products sold.
OPERATING EXPENSES
Research and Development
<TABLE>
<CAPTION>
1998 CHANGE 1997 CHANGE 1996
------- ------ ------- ------ ------
(DOLLARS IN THOUSANDS)
<S> <C> <C> <C> <C> <C>
Research and development...................... $20,828 57% $13,268 176% $4,812
As a percentage of total net revenues......... 32% 41% 34%
</TABLE>
Research and development expenses consist primarily of salaries and
consulting fees associated with product development and costs of technology
acquired from third parties incorporated into products currently under
development. To date, all research and development costs have been expensed as
incurred, as
22
<PAGE> 24
technological feasibility is generally not established until substantially all
development is complete. RealNetworks believes that significant investment in
research and development is a critical factor in attaining its strategic
objectives and, as a result, expects to increase research and development
expenditures in future periods. Research and development expenses were $20.8
million in 1998, an increase of 57% from $13.3 million in 1997, but decreased as
a percentage of total net revenues to 32% from 41% in 1997. The 1998 increase in
absolute dollars was primarily due to increases in internal development
personnel, consulting expenses and contract labor. The 1998 decrease in
percentage terms was a result of revenues growing at a faster rate than
expenses. Research and development expenses were primarily related to the
development of new technology and products including RealSystem G2, the
commercial version of which was released in November 1998, and enhancements made
to existing products. Research and development expenses were $13.3 million in
1997, an increase of 176% from $4.8 million in 1996, and increased as a
percentage of total net revenues to 41% from 34% in 1996. The 1997 increase was
due primarily to increases in internal development personnel, travel and
consulting expenses. Research and development expenses incurred in 1997 were
primarily related to development of new technology and products, including
RealVideo and RealSystem 5.0, and enhancements made to existing products.
SALES AND MARKETING
<TABLE>
<CAPTION>
1998 CHANGE 1997 CHANGE 1996
------- ------ ------- ------ ------
(DOLLARS IN THOUSANDS)
<S> <C> <C> <C> <C> <C>
Sales and marketing........................... $32,451 61% $20,124 167% $7,540
As a percentage of total net revenues......... 50% 62% 54%
</TABLE>
Sales and marketing expenses consist primarily of salaries, sales
commissions, consulting fees, trade show expenses, advertising and cost of
marketing collateral. RealNetworks intends to increase its branding and
marketing efforts and, therefore, expects sales and marketing expenses to
increase significantly in future periods. Sales and marketing expenses were
$32.5 million in 1998, an increase of 61% from $20.1 million in 1997, but
decreased as a percentage of total net revenues to 50% from 62% in 1997. Sales
and marketing expenses were $20.1 million in 1997, an increase of 167% from $7.5
million in 1996, and increased as a percentage of total net revenues to 62% from
54% in 1996. The increases in absolute dollars were due to the expansion of
RealNetworks' direct sales and marketing organization, the creation of
additional foreign and domestic sales offices, promotions and expenses related
to the continued development of the "Real" brand. Sales and marketing expenses
in 1998 also include net costs associated with the 1998 RealNetworks Conference.
The decrease in percentage terms in 1998 was a result of revenues growing at a
faster rate than expenses.
GENERAL AND ADMINISTRATIVE
<TABLE>
<CAPTION>
1998 CHANGE 1997 CHANGE 1996
------ ------ ------ ------ ------
(DOLLARS IN THOUSANDS)
<S> <C> <C> <C> <C> <C>
General and administrative...................... $9,841 63% $6,024 73% $3,491
As a percentage of total net revenues........... 15% 18% 25%
</TABLE>
General and administrative expenses consist primarily of salaries, fees for
professional services and bad debt expense. RealNetworks expects general and
administrative expenses to increase as RealNetworks expands its staff and incurs
additional costs related to growth of its business. General and administrative
expenses were $9.8 million in 1998, an increase of 63% from $6.0 million in
1997, but decreased as a percentage of total net revenues to 15% from 18% in
1997. General and administrative expenses were $6.0 million in 1997, an increase
of 73% from $3.5 million in 1996, but decreased as a percentage of total net
revenues to 18% from 25% in 1996. The increases in absolute dollars for 1998 and
1997 were primarily due to increased personnel and facility expenses necessary
to support RealNetworks' growth and costs associated with operating as a public
company. The decreases in percentage terms were due to revenues growing at a
rate faster than expenses.
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<PAGE> 25
GOODWILL AMORTIZATION AND ACQUISITION CHARGES
In March 1998, RealNetworks acquired Vivo Software, Inc., a developer of
streaming media creation tools. RealNetworks issued approximately 1.1 million
shares of its common stock in exchange for all outstanding shares of Vivo common
stock and assumed options to purchase approximately 48,000 shares of
RealNetworks common stock. The acquisition was accounted for using the purchase
method of accounting and, accordingly, the results of Vivo's operations are
included in RealNetworks' financial statements since the date of acquisition.
The purchase price was allocated to the fair value of the acquired assets
and assumed liabilities based on their fair values at the date of the
acquisition. A portion of the purchase price represents acquired in-process
research and development that has not yet reached technological feasibility and
has no alternative future use. Of the total purchase price, $8.6 million was
allocated to in-process research and development expense, $10.6 million was
allocated to goodwill, and $0.5 million was allocated to tangible assets.
Goodwill is amortized over its estimated life of five years.
In light of the Securities and Exchange Commission's recent interpretation
of accounting for acquired in-process research and development, RealNetworks has
voluntarily restated the amount of the charge taken in connection with the
acquisition of Vivo. Although RealNetworks had reported its first quarter
results in accordance with established accounting practices and the valuation
provided by an independent third party, RealNetworks voluntarily responded to
new guidance from the Securities and Exchange Commission revising the valuation
methodology used in determining charges associated with acquired in-process
research and development. As a result, RealNetworks reduced the in-process
research and development charge previously recognized in the first quarter of
1998 from $17.7 million to $8.6 million and increased the amount of goodwill
from $1.5 million to $10.6 million.
The in-process research and development projects acquired in the
acquisition of Vivo consisted of the development of encoder tools and server and
client codecs. The encoder tools allow users to create media content to be
streamed over the Internet or intranets. The server and client codecs enhance
the compression and decompression of multimedia content streamed over the
Internet or intranets.
The percentage completion of the projects at the time of acquisition was as
follows:
<TABLE>
<S> <C>
Encoder tools..................... 40%-70%
Server codec...................... 30%
Client codec...................... 30%
</TABLE>
RealNetworks completed the development of the encoder tools in 1998. The
total cost to complete development of the encoder tools was approximately $1.0
million. The server and client codec projects are expected to be complete in
1999. The expected aggregate cost to complete the server and client codecs is
approximately $0.7 million.
The fair value of the in-process technology was based on projected cash
flows which were discounted based on the risks associated with achieving such
projected cash flows upon successful completion of the acquired projects.
Associated risks include the inherent difficulties and uncertainties in
completing each project and achieving technological feasibility and risks
related to the impact of potential changes in market conditions and technology.
In developing cash flow projections, revenues were forecasted based on relevant
factors, including aggregate revenue growth rates for the business as a whole,
characteristics of the potential market for the technology and the anticipated
life of the underlying technology. Operating expenses and resulting profit
margins were forecasted based on the characteristics and cash flow generating
potential of the acquired in-process technology.
24
<PAGE> 26
The fair value of the in-process research and development was allocated to
the projects as follows (in thousands):
<TABLE>
<S> <C>
Encoder tools....................... $6,500
Server codec........................ 1,500
Client codec........................ 600
------
$8,600
======
</TABLE>
Projected annual revenues for each of the in-process development projects
were assumed to increase from product release through 2001, decline slightly in
2002 and decline significantly in 2003 and 2004. An insignificant amount of
revenue was projected for in-process technology in the first quarter of 2005,
which is estimated to be the end of the in-process technology's economic life.
Gross profit was assumed to be 80% for the encoder tools and client codec
and 94% for the server codec. The projected gross profit percentages were based
on estimated costs of revenues which include duplication, manuals, packaging
materials and third party order fulfillment costs. Gross profit projections were
based on RealNetworks' experience with similar products.
Estimated operating expenses, income taxes and capital charges to provide a
return on other acquired assets were deducted from gross profit to arrive at net
operating income for each of the in-process development projects. Operating
expenses were estimated as a percentage of revenue and included sales and
marketing expenses and development costs to maintain the technology once it has
achieved technological feasibility.
RealNetworks discounted the net cash flows of the in-process research and
development projects to their present values using a discount rate of 42%. This
discount rate approximates the overall rate of return for the acquisition of
Vivo as a whole and reflects the inherent uncertainties surrounding the
successful development of the in-process research and development projects and
the uncertainty of technological advances that may occur in the future.
Since the acquisition, RealNetworks has continued to market Vivo's existing
products on a limited basis and will continue to do so until the in-process
projects are completed.
The acquisition of Vivo was a tax-free reorganization under the Internal
Revenue Code. Therefore, the charge for in-process research and development and
amortization of acquired intangible assets is not deductible for income tax
purposes.
Although RealNetworks believes that the acquisition of Vivo is in the best
interests of RealNetworks and its shareholders, acquisitions involve a number of
special risks, including the integration of acquired products and technologies
in a timely manner; the integration of businesses and employees with
RealNetworks' business; adverse effects on RealNetworks' reported operating
results from acquisition-related charges and amortization of goodwill; potential
increases in stock compensation expense and increased compensation expense
resulting from newly-hired employees; distraction of RealNetworks' management
from the day-to-day business and operations of RealNetworks; the assumption of
unknown liabilities; and the possible failure to retain key acquired personnel.
Because most software business acquisitions involve the purchase of
significant amounts of intangible assets, acquisitions of such businesses
typically result in goodwill and amortization charges and may also involve
charges for acquired research and development projects. RealNetworks may, in the
future, acquire other complimentary businesses or technologies which may result
in significant charges for acquired in-process research and development and the
amortization of acquired intangible assets. Such charges could have a material
adverse effect on RealNetworks' business, financial condition and results of
operations.
OTHER INCOME, NET
<TABLE>
<CAPTION>
1998 CHANGE 1997 CHANGE 1996
------ ------ ------ ------ ----
(DOLLARS IN THOUSANDS)
<S> <C> <C> <C> <C> <C>
Other income, net................................ $4,576 130% $1,992 778% $227
</TABLE>
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<PAGE> 27
Other income, net consists primarily of earnings on RealNetworks' cash,
cash equivalents and short-term investments. The increases in 1998 and 1997 were
due primarily to investment earnings on higher average cash balances.
INCOME TAXES
RealNetworks has incurred net operating losses in each period from
inception through December 31, 1998. At December 31, 1998, RealNetworks has
provided a full valuation allowance on its deferred tax assets because of
uncertainties regarding recoverability. See Note 6 of Notes to Consolidated
Financial Statements.
LIQUIDITY AND CAPITAL RESOURCES
Since its inception, RealNetworks has financed its operations primarily
through sales of preferred stock and common stock. Net proceeds from these sales
totaled $94.0 million, including net proceeds of $38.5 million from
RealNetworks' initial public offering in November 1997. In addition, during 1997
RealNetworks entered into a strategic agreement with Microsoft pursuant to which
RealNetworks granted Microsoft a nonexclusive license to certain RealNetworks
technology and related RealNetworks trademarks for a license fee of $30.0
million.
Net cash provided by operating activities was $9.5 million and $8.6 million
in 1998 and 1997, respectively. Net cash used in operating activities was $0.6
million in 1996. Net cash provided by operating activities in 1998 resulted
primarily from a decrease in license fee receivable of $10.0 million, partially
offset by a net loss of $16.4 million, which was offset by a noncash acquisition
charge of $8.7 million. Net cash provided by operating activities in 1997 was
primarily attributable to an increase of $29.2 million in deferred revenue,
related primarily to the Microsoft license agreement, partially offset by a net
loss of $11.2 million, an increase of $1.9 million in trade accounts receivable
and an increase in license fee receivable of $10.0 million. Net cash used in
operating activities in 1996 was primarily due to a net loss of $3.8 million and
an increase in trade accounts receivable of $2.7 million, offset by increases in
accounts payable of $2.2 million and deferred revenue of $2.3 million.
Net cash used in investing activities of $25.5 million, $31.3 million, and
$4.8 million in 1998, 1997 and 1996, respectively, was primarily related to net
increases in short-term investments and purchases of equipment and leasehold
improvements. Purchases of equipment and leasehold improvements have primarily
related to supporting the increased number of employees.
Net cash provided by financing activities of $5.7 million in 1998 primarily
consisted of proceeds from the exercise of stock options and warrants. Net cash
provided by financing activities of $70.3 million in 1997 was primarily from net
proceeds of $29.9 million from sales of preferred stock and $38.5 million in net
proceeds from the sale of common stock associated with RealNetworks' initial
public offering. Net cash provided by financing activities of $17.1 million in
1996 was primarily due to net proceeds from sales of preferred stock.
As of December 31, 1998, RealNetworks had $103.5 million of cash and cash
equivalents, short-term investments and restricted cash equivalents. As of
December 31, 1998, RealNetworks' principal commitments consisted of obligations
outstanding under operating leases and a $1.0 million note payable.
During 1998, RealNetworks entered into a lease agreement for a new location
for its corporate headquarters. The lease commences on April 1, 1999 and expires
in April 2011, with an option to renew the lease for either a three- or ten-year
period. RealNetworks expects to occupy the new facilities in the second quarter
of 1999. RealNetworks is funding the tenant improvements, a portion of which may
be financed through equipment leases. In addition, RealNetworks is in the
process of upgrading and replacing its existing internal information systems.
The costs of the tenant improvements and information systems are anticipated to
total approximately $14 million in 1999.
RealNetworks does not hold derivative financial instruments or equity
securities in its investment portfolio. RealNetworks' cash equivalents and
short-term investments consist of high quality securities, as specified in its
investment policy guidelines. The policy limits the amount of credit exposure to
any one issue or issuer to a maximum of 5% of the total portfolio and requires
that all short-term investments mature in two
26
<PAGE> 28
years or less, with the average maturity being one year or less. These
securities are subject to interest rate risk and will decrease in value if
interest rates increase. If market interest rates were to increase immediately
and uniformly by 10 percent from levels at December 31, 1998, the fair value of
the portfolio would decline by an immaterial amount. Because RealNetworks has
historically held its fixed income investments until maturity, RealNetworks
would not expect its operating results or cash flows to be significantly
affected by a sudden change in market interest rates on its securities
portfolio.
RealNetworks conducts its operations in five primary functional currencies:
the United States dollar, the Japanese yen, the British pound, the French franc
and the German mark. Historically, neither fluctuations in foreign exchange
rates nor changes in foreign economic conditions have had a significant impact
on RealNetworks' financial condition or results of operations. RealNetworks
currently does not hedge its foreign currency exposures and is therefore subject
to the risk of exchange rates. RealNetworks invoices the customers of its
international subsidiaries primarily in U.S. dollars, except in Japan, where
RealNetworks invoices its customers primarily in yen. RealNetworks is exposed to
foreign exchange rate fluctuations as the financial results of foreign
subsidiaries are translated into U.S. dollars in consolidation. RealNetworks'
exposure to foreign exchange rate fluctuations also arises from intercompany
payables and receivables to and from RealNetworks' foreign subsidiaries. Foreign
exchange rate fluctuations did not have a material impact in 1998 and 1997.
On January 1, 1999, the participating member countries of the European
Union converted to a common currency, the euro. On that same date they
established fixed conversion rates between their existing sovereign currencies
and the euro. Even though legacy currencies are scheduled to remain legal tender
in the participating countries as denominations of the euro until January 1,
2002, the participating countries will no longer be able to direct independent
interest rates for the legacy currencies. The authority to set monetary policy
will now reside with the new European Central Bank. RealNetworks does not
anticipate any material impact from the euro conversion on its financial
information systems, which currently accommodate multiple currencies. Due to
numerous uncertainties, RealNetworks cannot reasonably estimate the effect that
the euro conversion issue will have on its pricing or market strategies or the
impact, if any, it will have on its financial condition and results of
operations.
Since its inception, RealNetworks has significantly increased its operating
expenses. RealNetworks currently anticipates that it will continue to experience
significant growth in its operating expenses for the foreseeable future and that
its operating expenses will be a material use of its cash resources.
RealNetworks believes that its current cash, cash equivalents and short-term
investments will be sufficient to meet its anticipated cash needs for working
capital and capital expenditures for at least the next 12 months.
MICROSOFT RELATIONSHIP
In June 1997, RealNetworks entered into a strategic agreement with
Microsoft pursuant to which RealNetworks granted Microsoft a nonexclusive
license to certain substantial elements of the source code of RealNetworks'
RealAudio/RealVideo Version 4.0 technology and related RealNetworks trademarks
for a license fee of $30.0 million. RealNetworks is recognizing revenue related
to the agreement ratably over the three-year term of its ongoing obligations.
Microsoft may sublicense its rights to the licensed source code to third
parties under certain conditions without further compensation to RealNetworks.
In addition, Microsoft was granted an option to receive two additional
deliveries of updated versions of the source code. Microsoft's right to receive
the first delivery expired unexercised in July 1998. Microsoft may elect to
acquire an updated version of the source code once before July 1999, upon
payment of a license fee of $35.0 million. Under certain conditions, if
RealNetworks licenses its source code to a third party, the agreement provides
for a partial refund of the license fee paid by Microsoft, based on a declining
scale over the three-year term of the agreement.
In connection with the agreement, Microsoft made a $30.0 million minority
investment in RealNetworks in the form of 3.3 million shares of nonvoting
preferred stock. These shares were converted into nonvoting special common stock
concurrent with RealNetworks' initial public offering in November 1997. All
shares of special common stock automatically convert into the same number of
shares of common stock upon sale or
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transfer by Microsoft to a third party not otherwise affiliated with Microsoft.
Microsoft has publicly indicated that it intends to sell its investment in
RealNetworks and, as of December 31, 1998, had sold a total of 752,000 shares.
On July 23, 1998, Robert Glaser, RealNetworks' Chief Executive Officer,
testified before the Senate Judiciary Committee that if a consumer had the
RealPlayer on his or her computer system, and then downloaded the Windows Media
Player, the Windows Media Player (in certain instances) disabled important
functions of RealNetworks' RealPlayer. As a result, some of RealNetworks'
customers who had downloaded the free RealPlayer, or paid for the RealPlayer
Plus, found that their players did not work. RealNetworks quickly incorporated a
workaround solution into its RealPlayer and RealPlayer Plus and also posted this
workaround solution on its Web site. RealNetworks believes the workaround
solution corrected the problem at the time and, as a result, RealNetworks
believes only a small number of customers were impacted by the situation.
RealNetworks believes there is a continued risk that future versions of
Microsoft's products, especially Internet Explorer and the Windows Media Player,
might likely negatively impact the experience of RealNetworks' customers by
displaying a Windows Media Player when the customer seeks to play RealAudio or
RealVideo content, or posting an error message when the customer tries to play
content available in RealNetworks' formats that may not be viewed through the
Windows Media Player without telling the customer how to obtain the latest
RealPlayer. Such actions by Microsoft could materially reduce market share for
the RealPlayer and have a negative effect on demand for RealNetworks' server
software and tools. RealNetworks has provided and will continue to seek to
provide useful input to Microsoft to address these situations to provide an
optimal experience for consumers. In light of these recent events, RealNetworks'
relationship with Microsoft has become more competitive.
See "Factors that May Affect RealNetworks' Business, Future Operating
Results and Financial Condition -- Intense Competition From Microsoft and Other
Product and Service Providers," below.
YEAR 2000
What is commonly referred to as the "Year 2000" problem arose because many
existing computer programs use only the last two digits to refer to a year. As a
result, date-sensitive computer programs may not be able to distinguish whether
a two-digit date designated as "00" refers to 1900 or 2000. This problem could
cause system failures or the creation of wrong information and disrupt
RealNetworks' operations.
RealNetworks has developed a phased plan to achieve Year 2000 compliance
for its internal processing and operational systems and the current versions of
its software products. During the first quarter of 1999, RealNetworks will
assess the state of its internal and external Year 2000 compliance. During the
second quarter of 1999, a plan to correct any problems found during the
assessment will be developed and tested. During the third quarter of 1999, this
remediation plan (consisting of upgrading and replacement of certain product
versions, if necessary) will be implemented and tested for compliance.
RealNetworks is planning to make Year 2000 readiness disclosures stating
that the current versions of its products are "Year 2000 Compliant." "Year 2000
Compliant" means that software products and systems are able to function
properly before, during and after the Year 2000 without loss of functionality
due to date changes. This assurance assumes that RealNetworks' products are
configured and used in accordance with the related documentation, that the
underlying operating system of the host machine for RealNetworks' products and
any other software used with or in such host machine are also Year 2000
Compliant, and that all other products (whether hardware, software, or firmware)
used with a RealNetworks product properly exchange data with it.
RealNetworks is currently testing and will continue to test its products
and systems and may find errors or defects associated with Year 2000 date
functions. RealNetworks has not tested its products on all platforms or all
versions of operating systems that RealNetworks currently supports. RealNetworks
believes that all of the current versions of its products will be Year 2000
Compliant by the end of 1999. RealNetworks has not specifically tested software
obtained from third parties (licensed software, shareware and freeware) that is
incorporated into RealNetworks' products, but RealNetworks is seeking assurances
from its vendors that licensed software is Year 2000 compliant. Despite
RealNetworks' testing, testing by RealNetworks' current
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and potential customers, and whatever assurances, if any, RealNetworks may
receive from developers of technology incorporated into RealNetworks' products,
RealNetworks' and vendors' products may contain undetected errors or defects
associated with Year 2000 date functions.
RealNetworks relies on third parties for services such as
telecommunications, Internet service, utilities and other key services and
supplies. RealNetworks is seeking confirmation from such service providers that
their systems are Year 2000 compliant. Interruption of those services or
supplies due to Year 2000 issues could adversely affect RealNetworks'
operations. RealNetworks is also subject to external forces that might generally
affect industry and commerce, such as utility or transportation company Year
2000 compliance failures and related service interruptions. RealNetworks is in
the process of updating and upgrading its internal information systems. Although
the replacement of information systems is not in direct response to Year 2000
concerns, RealNetworks expects that all new internal information systems
implemented in 1999 will be Year 2000 compliant.
Known or unknown Year 2000 errors or defects in RealNetworks' internal
systems and products, lack of Year 2000 compliance by third party software
incorporated in RealNetworks' products and/or interruption of services from
RealNetworks' external service providers due to Year 2000 problems could result
in failure or disruption of RealNetworks' products and operations, delay or loss
of revenue, diversion of development resources, damage to RealNetworks'
reputation, claims or litigation and increased service and warranty costs, any
of which could impair RealNetworks' finances or business prospects. Some
commentators have predicted significant litigation regarding Year 2000
compliance issues, and RealNetworks is aware of such lawsuits against other
software vendors. Because of the unprecedented nature of such litigation, it is
uncertain whether or to what extent RealNetworks may be affected by it.
RealNetworks currently responds to customer concerns about its products on
a case-by-case basis, but plans to post a Web page on its primary Web site
indicating the Year 2000 status of its products. RealNetworks believes that the
purchasing patterns of customers and potential customers may be affected by Year
2000 issues in a variety of ways, including the decision to delay purchasing
RealNetworks' products until the Year 2000. RealNetworks believes that it is not
possible to predict the overall impact of these decisions.
At this stage in RealNetworks' analysis and remediation process, it is
difficult to specifically identify the cause and the magnitude of any adverse
economic impact of the most reasonably likely worst case Year 2000 scenario.
RealNetworks' reasonably likely worst case scenario would include the
unavailability of RealNetworks' major internal systems to RealNetworks'
employees, and the failure of RealNetworks' products to operate properly,
causing customers' systems and/or operations to fail or be disrupted. Such worst
case scenario also would include the failure of key vendors and/or suppliers to
correct their own Year 2000 issues, which failures could cause failure or
disruption of RealNetworks' operations or products. If a worst case scenario
occurs, RealNetworks may incur expenses to repair its systems or upgrade its
products, face interruptions in the work of its employees, lose advertising,
service and product license revenue, not be able to support the broadcast of
other companies' content over the Internet, not be able to deliver downloads of
its products, incur increased warranty and service expenses and suffer damage to
its reputation. In addition, customers may sue RealNetworks or otherwise seek
compensation for their losses. RealNetworks has indemnified certain customers
for claims and losses if its products are not Year 2000 Compliant. Any or all of
the above events could have a material adverse economic impact on RealNetworks'
business, financial condition and results of operations.
RealNetworks has not yet fully developed a comprehensive contingency plan
to address situations that may result if RealNetworks is unable to achieve Year
2000 readiness of its critical operations. The cost of developing and
implementing such a plan may itself be material. To date, RealNetworks has not
incurred significant expenditures for its Year 2000 remediation efforts.
Although RealNetworks does not anticipate the costs to address its Year 2000
issues to be material, the costs of Year 2000 remediation work and the date on
which RealNetworks plans to complete such work are based on management's best
estimates, which are derived from assumptions about future events, including the
availability of certain resources, third-party remediation plans and other
factors. In addition, undetected errors or the failure of such systems to be
Year 2000 Compliant could create significant record-keeping and operational
deficiencies. Accordingly, if
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Year 2000 modifications, evaluations, assessments and conversions are not made,
or are not completed in time, the Year 2000 problem could have a material
adverse impact on RealNetworks' business, financial condition and results of
operations.
SHAREHOLDER RIGHTS PLAN
On October 16, 1998, RealNetworks' Board of Directors declared a dividend
of one preferred share purchase right (Right) in connection with its adoption of
a Shareholder Rights Plan dated December 4, 1998, for each outstanding share of
RealNetworks' common stock on December 14, 1998 (Record Date). Each share of
common stock issued after the Record Date will be issued with an attached Right.
The Rights will not immediately be exercisable and detachable from the common
stock. The Rights will become exercisable and detachable only following the
acquisition by a person or a group of 15 percent or more of the outstanding
common stock or ten days following the announcement of a tender or exchange
offer for 15 percent or more of the outstanding common stock (Distribution
Date). After the Distribution Date, each Right will entitle the holder to
purchase for $150 (Exercise Price), a fraction of a share of RealNetworks'
Series A preferred stock with economic terms similar to that of one share of
RealNetworks' common stock. Upon a person or a group acquiring 15 percent or
more of the outstanding common stock, each Right will allow the holder (other
than the acquiror) to purchase common stock or securities of RealNetworks having
a then current market value of two times the Exercise Price of the Right. In the
event that following the acquisition of 15 percent of the common stock by an
acquiror, RealNetworks is acquired in a merger or other business combination or
50 percent or more of RealNetworks' assets or earning power are sold, each Right
will entitle the holder to purchase for the Exercise Price common stock or
securities of the acquiror having a then current market value of two times the
Exercise Price. In certain circumstances, the Rights may be redeemed by
RealNetworks at a redemption price of $0.01 per Right. If not earlier exchanged
or redeemed, the Rights will expire on December 4, 2008.
NEW ACCOUNTING PRONOUNCEMENTS
In December 1998, the American Institute of Certified Public Accounts
(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, "Software Revenue Recognition" and is
effective for fiscal years beginning after March 15, 1999. RealNetworks believes
that the adoption of SOP 98-9 will not have a material effect on its results of
operations or financial position.
In June 1998, the Financial Accounting Standards Board issued Statement of
Financial Accounting Standards No. 133, "Accounting for Derivative Instruments
and Hedging Activities" (SFAS 133). SFAS 133 establishes a new model for
accounting for derivatives and hedging activities and supersedes and amends
existing accounting standards and is effective for fiscal years beginning after
June 15, 1999. SFAS 133 requires that all derivatives be recognized in the
balance sheet at their fair market value, and the corresponding derivative gains
or losses be either reported in the statement of operations or as a component of
other comprehensive income depending on the type of hedge relationship that
exists with respect to such derivative. RealNetworks does not expect the
adoption of SFAS 133 to have a material impact on its consolidated financial
statements.
In March 1998, the AICPA issued SOP 98-1, "Accounting for the Costs of
Computer Software Developed or Obtained for Internal Use" (SOP 98-1). SOP 98-1
will require the capitalization of certain costs incurred in connection with
developing or obtaining software for internal use. RealNetworks does not expect
the adoption of SOP 98-1 to have a material impact on its consolidated financial
statements. RealNetworks plans to adopt SOP 98-1 in 1999.
FACTORS THAT MAY AFFECT REALNETWORKS' BUSINESS, FUTURE OPERATING RESULTS AND
FINANCIAL CONDITION
In addition to the other information in this Annual Report on Form 10-K,
the following factors should be considered in evaluating RealNetworks' business
and prospects.
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LIMITED OPERATING HISTORY; HISTORY OF LOSSES; ANTICIPATION OF FUTURE LOSSES
RealNetworks was incorporated in February 1994 and did not recognize any
revenue until July 1995. RealNetworks' business of developing streaming media
software and its participation in the media delivery and electronic commerce
markets are relatively new. RealNetworks has had limited financial results upon
which you may base an assessment of its future success. It has had significant
losses since inception and, as of December 31, 1998, had an accumulated deficit
of approximately $33.9 million.
If RealNetworks is to become and remain profitable, it will need to, among
other things:
- establish and develop broad market acceptance of its products and
services
- respond quickly to new market developments
- successfully respond to competition from Microsoft and others
- expand sales and marketing operations
- continue to develop new products and product features
- broaden customer support capabilities
- control expenses
- attract, train and retain qualified employees
FUTURE REVENUES ARE UNPREDICTABLE; OPERATING RESULTS MAY FLUCTUATE SIGNIFICANTLY
As a result of RealNetworks' limited operating history and the rapidly
changing nature of the markets in which it competes, RealNetworks may be unable
to forecast its quarterly and annual revenues accurately. RealNetworks expects
its future operating results to fluctuate significantly based, in part, on the
following factors, several of which are outside of its control:
- the market success of RealNetworks' products and services
- how and when RealNetworks introduces new products and services and
enhances its existing products and services
- prices for RealNetworks' products and services
- how RealNetworks distributes its products
- how RealNetworks' competitors compete in the areas of new products and
services, pricing and distribution
- costs of litigation and intellectual property protection
- growth in Internet and intranet use
- the emergence of new competition
- varying operating costs and capital expenditures related to expansion of
RealNetworks' business operations and infrastructure
- technical difficulties with RealNetworks' products
- government regulations
- general economic conditions
Based on these factors, RealNetworks believes that its revenues, expenses
and operating results could vary significantly in the future and that
period-to-period comparisons should not be relied on as indications of future
results. RealNetworks may be unable to increase revenues or maintain its
historical growth rate. If future operating results are below the expectations
of securities analysts and investors, RealNetworks' stock price may decline.
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INTENSE COMPETITION FROM MICROSOFT AND OTHER PRODUCT AND SERVICE PROVIDERS
The market for software and services for the Internet and intranets is
relatively new, constantly changing and intensely competitive. As streaming
media evolves into a central and necessary component of the Internet experience,
more companies are entering the market for, and expending ever greater resources
to develop, streaming media software and services, and competition is thus
intensifying. Many of RealNetworks' current and potential competitors have
longer operating histories, greater name recognition, larger overall installed
bases, more employees and significantly greater financial, technical, marketing,
public relations and distribution resources than RealNetworks.
RealNetworks' principal competitor in the development and distribution of
streaming media technology is Microsoft Corporation. Microsoft currently
competes with RealNetworks in the market for streaming media server and player
software. RealNetworks believes that Microsoft's commitment to and presence in
the streaming media industry has significantly increased and will continue to
dramatically increase competitive pressure in the overall market for streaming
media software leading to, among other things, increased pricing pressure and
longer sales cycles. Such pressures may result in price reductions in
RealNetworks products and may also materially reduce RealNetworks' market share,
either of which could materially adversely affect RealNetworks' finances and
business prospects.
Microsoft provides its competing streaming media server products for free
by bundling them, with no separately stated additional cost, to customers
purchasing Windows NT servers and has made them available for download from its
Web site for free. While RealNetworks believes that its products have certain
technical advantages, Microsoft's practices may cause pricing pressure on
RealNetworks server products and may reduce RealNetworks' market share for
server software, tools and player software. In addition, RealNetworks believes
that Microsoft has used and may be able to use its dominant position in the
computer industry to secure preferential distribution and bundling contracts for
its streaming media products with third parties such as ISPs, online service
providers, content producers, VARs and OEMs, including third parties with whom
RealNetworks has relationships. Such arrangements, together with Microsoft's
aggressive marketing of Windows NT, may reduce RealNetworks' share of the
server, tools and player market. Microsoft's Windows Media Player, introduced in
mid-1998, competes with RealNetworks' RealPlayer. The Windows Media Player is
available for download from Microsoft's Web site for free, and is bundled by
Microsoft with the Windows 98 operating system and with Microsoft's browser,
Internet Explorer. In addition, Microsoft has bundled certain audio capabilities
into a radio toolkit for Internet Explorer 5.0, and the browser includes Web
Events, providing links to audio and video on the Internet. By leveraging its
dominant position in operating systems and tying streaming media into the
operating system and the browser, RealNetworks expects that Microsoft will
distribute substantially more copies of the Windows Media Player than in the
past and will be able to drive more users to its streaming media products.
Microsoft does not plan to distribute the RealPlayer with future versions of
Windows 98.
In addition to Microsoft, RealNetworks faces increased competition from
other companies that are developing and marketing streaming media product
offerings, most notably Apple Computer, Inc. Apple's QuickTime technology is a
popular format for downloading content, and Apple will soon be releasing
QuickTime 4.0, which will include a streaming media server. Because of Apple's
large installed base of QuickTime authors and users, brand recognition and
available resources, Apple, like Microsoft, poses a serious potential threat to
RealNetworks. Other competitors include Cisco Systems, Inc./Precept Software,
PictureTel/Starlight Networks, and Oracle Corporation. As more companies enter
the market with products and services that compete with RealNetworks' servers,
players and tools, the competitive landscape could change rapidly.
While RealNetworks believes that it has the leading position for
conventional PC-based Internet streaming systems, no clear standards have
emerged with respect to non-PC, wireless, cable-based systems. Likewise, no one
company has gained a dominant position in the mobile device market because such
devices are not yet well architected to handle media. Another company or
standard may emerge in any of these areas to surpass RealNetworks. In addition,
RealNetworks faces competition to a lesser degree from non-streaming audio and
video delivery technologies such as AVI, QuickTime, and MP3. MP3, a current
phenomenon in
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IP-based media delivery that RealNetworks is not now participating in, is
emerging as a popular distribution mechanism for "fast download" of audio
content that does not require streaming. Other fast download, or non-streaming
IP-based content distribution methods, are likely to emerge.
RealNetworks also competes with a variety of companies that provide
streaming media hosting services, many of whom use RealNetworks' technology,
such as Broadcast.com, Intervu, Inc., and Enron Communications, Inc. While
RealNetworks believes that its Real Broadcast Network is continuing to grow its
customer base and revenues, it also believes that Broadcast.com has been
successful in building perceived market position. RealNetworks also competes
with a variety of Web sites, such as Buydirect.Com and Beyond.Com, in the
electronic distribution of certain of its products. To compete successfully in
the electronic commerce market, RealNetworks must attract sufficient commercial
traffic to its Web sites by offering high quality, competitively priced
merchandise in a compelling, easy-to-purchase format. There can be no assurance
that RealNetworks will be able to compete successfully in the market for
electronic commerce, and any failure to do so could have a material adverse
effect on RealNetworks' business, financial condition and results of operations.
RealNetworks competes for user traffic and Internet advertising revenues
with a wide variety of Web sites, ISPs and especially audio, video and other
media aggregators, such as Broadcast.com and Microsoft's Web Events, which
compete with RealNetworks' RealGuide. While Internet advertising revenues across
the industry continue to grow, the number of Web sites competing for such
revenue is also growing rapidly. RealNetworks' advertising sales force and
infrastructure are still in early stages of development relative to
RealNetworks' competitors. There can be no assurance that advertisers will place
advertising with RealNetworks or that revenues derived from such advertising
will be material. In addition, if RealNetworks loses advertising customers,
fails to attract new customers, is forced to reduce advertising rates or
otherwise modify its rate structure to retain or attract customers, or loses Web
site traffic, RealNetworks business, financial condition and results of
operations may be materially adversely affected.
Competitive factors in the streaming media market include the quality and
reliability of software; features for creating, editing and adapting content;
ease of use and interactive user features; scalability and cost per user;
pricing and licensing terms; the emergence of new and better formats; and
compatibility with the user's existing network components and software systems.
To expand its user base and further enhance the user experience, RealNetworks
must continue to innovate and improve the performance of RealSystem G2.
RealNetworks anticipates that consolidation will continue in the streaming media
industry and related industries such as computer software, media and
communications. Consequently, competitors may be acquired by, receive
investments from or enter into other commercial relationships with, larger,
well-established and well-financed companies. There can be no assurance that
RealNetworks can establish or sustain a leadership position in this market
segment. RealNetworks is committed to the continued market penetration of its
brand, products and services, which, as a strategic response to changes in the
competitive environment, may require pricing, licensing, service or marketing
changes intended to extend its current brand and technology franchise. Price
concessions or the emergence of other pricing or distribution strategies by
competitors may have a material adverse effect on RealNetworks' business,
financial condition and results of operations.
For additional discussion of the Microsoft Relationship and competition,
see "Business -- Competition" and "Management's Discussion and Analysis of
Financial Condition and Results of Operations -- Microsoft Relationship."
LACK OF ESTABLISHED MARKET FOR PRODUCTS AND SERVICES; DEPENDENCE ON INTERNET AND
INTRANETS AS MEDIUMS OF COMMERCE AND COMMUNICATIONS
The market for RealNetworks' streaming media products and services is new
and evolving rapidly. It depends on increased use of the Internet and intranets.
If the Internet and intranets are not adopted as methods for commerce and
communications, or if the adoption rate slows, the market for RealNetworks'
products and services may not grow, or may develop more slowly than expected.
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RealNetworks believes that increased Internet use may depend on the
availability of greater bandwidth or data transmission speeds or on other
technological improvements, and RealNetworks is largely dependent on third party
companies to provide or facilitate these improvements. Changes in content
delivery methods and emergence of new Internet access devices such as TV set-top
boxes could dramatically change the market for streaming media products and
services if new delivery methods or devices do not use streaming media or if
they provide a more efficient method for transferring data than streaming media.
The electronic commerce market is relatively new and evolving. Sales of
RealNetworks' products depend in large part on the development of the Internet
as a viable commercial marketplace. There are now substantially more users and
much more "traffic" over the Internet than ever before, use of the Internet is
growing faster than anticipated, and the technological infrastructure of the
Internet may be unable to support the demands placed on it by continued growth.
Delays in development or adoption of new technological standards and protocols,
or increased government regulation, could also affect Internet use. In addition,
issues related to use of the Internet and intranets, such as security,
reliability, cost, ease of use and quality of service, remain unresolved and may
affect the amount of business that is conducted over the Internet and intranets.
PRODUCT DELAYS AND ERRORS
RealNetworks has experienced development delays and cost overruns
associated with its product development. It may encounter such problems in the
future. Delays and cost overruns could affect RealNetworks' ability to respond
to technological changes, evolving industry standards, competitive developments
or customer requirements. RealNetworks' products also may contain undetected
errors that could cause adverse publicity, reduced market acceptance of the
products, or lawsuits by customers.
DEPENDENCE ON KEY PERSONNEL
RealNetworks' success is substantially dependent upon the continued
employment of its executive officers and key employees, particularly Mr. Glaser,
RealNetworks' Chairman of the Board and Chief Executive Officer. The loss of the
services of Mr. Glaser or any of its other executive officers or key employees
could adversely affect RealNetworks' business. None of RealNetworks' executive
officers has a contract that guarantees employment. Other than the $2 million
insurance policy on the life of Mr. Glaser, RealNetworks does not maintain "key
person" life insurance policies.
RealNetworks' success also depends on its ability to attract, train and
retain qualified personnel, specifically those with management, technical,
product development and sales skills. Competition for such personnel is intense,
particularly in high technology centers such as the Pacific Northwest.
RealNetworks' failure to attract, train or retain highly qualified personnel
could have a material adverse effect on RealNetworks' business, financial
condition and results of operations.
PROPRIETARY RIGHTS; CLAIMS OF INFRINGEMENT
RealNetworks' success and ability to compete partly depend on the
superiority, uniqueness or value of its technology, including both internally
developed technology and the technology licensed from third parties. Others may
develop technologies that are similar or superior to those of RealNetworks. Such
development could impair RealNetworks' ability to compete. Patents, trademarks,
copyrights and other proprietary rights are important to RealNetworks' success
and competitive position. RealNetworks protects its intellectual property
through a combination of patent, trademark, copyright and trade secret laws.
Policing unauthorized use of RealNetworks' products is difficult and the steps
RealNetworks takes may not prevent the misappropriation or infringement of
technology or proprietary rights. In addition, litigation may be necessary to
enforce RealNetworks' intellectual property rights, to defend the validity of
patents, to protect trade secrets or to determine the validity and scope of the
proprietary rights of others. Such misappropriation or litigation could result
in substantial costs and diversion of resources and the potential loss of
intellectual property rights, any of which could impair RealNetworks' finances
or business prospects.
RealNetworks has received, and may continue to receive, notices of claims
of infringement of other parties' proprietary rights. Such claims may involve
RealNetworks' internally developed technology or
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technology and enhancements that RealNetworks licenses from third parties. Any
such claims could require RealNetworks to spend time and money defending against
them and, if they were decided adversely to RealNetworks, could cause
RealNetworks to pay damages, to be subject to injunctions, or to halt
distribution of its products while it re-engineers them or seeks licenses to
necessary technology (which might not be available on reasonable terms).
Moreover, RealNetworks could also be subject to claims for indemnification
resulting from infringement claims made against its customers, which could
increase RealNetworks' defense costs and potential damages. Any of these factors
could impair RealNetworks' finances and business prospects.
ONLINE COMMERCE SECURITY RISKS
Online commerce and communications depend on the ability to transmit
confidential information securely over public networks. Any compromise of
RealNetworks' ability to transmit confidential information securely, and costs
associated with the prevention or elimination of such problems, could have a
material adverse effect on RealNetworks' business. Online transmissions are
subject to the following risks, among others:
- RealNetworks' own or licensed encryption and authentication technology
may be subject to events or developments that could compromise or breach
the security of customer information
- a third party could circumvent RealNetworks' security measures and
misappropriate proprietary information or interrupt operations
- credit card companies could restrict online credit card transactions
- security breaches could damage RealNetworks' reputation and expose it to
litigation or liability
INTERNATIONAL OPERATIONS
RealNetworks operates subsidiaries in England, France, Germany and Japan,
and markets and sells its products in several other countries. As such, it is
subject to the normal risks of doing business abroad. Risks include unexpected
changes in regulatory requirements, export and import restrictions, tariffs and
trade barriers, difficulties in staffing and managing foreign operations, longer
payment cycles, problems in collecting accounts receivable, potential adverse
tax consequences, exchange rate fluctuations, increased risks of piracy, limits
on RealNetworks' ability to enforce its intellectual property rights,
discontinuity of RealNetworks' infrastructures, limitations on fund transfers
and other legal and political risks. Such limitations and interruptions could
have a material adverse effect on RealNetworks' business. RealNetworks does not
currently hedge its foreign currency exposures. See "Liquidity and Capital
Resources."
GOVERNMENT REGULATION AND LEGAL UNCERTAINTIES
RealNetworks is not currently subject to direct regulation by any
governmental agency other than laws and regulations generally applicable to
businesses. It is possible that a number of laws and regulations may be adopted
in the U.S. and abroad with particular applicability to the Internet.
Governments have and may continue to enact legislation applicable to
RealNetworks in areas such as content distribution, performance and copying,
other copyright issues, network security, encryption, the use of key escrow
data, privacy protection, caching of content by server products, electronic
authentication or "digital" signatures, illegal or obscene content, access
charges and retransmission activities. The applicability to the Internet of
existing laws governing issues such as property ownership, content, taxation,
defamation and personal privacy is also uncertain. Export or import
restrictions, new legislation or regulation or governmental enforcement of
existing regulations may limit the growth of the Internet, increase
RealNetworks' cost of doing business or increase its legal exposure. For a more
detailed discussion of government regulation and legal uncertainties, see
"Business -- Governmental Regulation" and "Legal Proceedings."
35
<PAGE> 37
ASSESSMENT OF TAXES FOR PRIOR PERIODS
RealNetworks currently does not collect sales or other taxes on the sale of
its products, license of technology, or provision of services in states and
countries other than those in which RealNetworks has offices or employees. In
October 1998, the Internet Tax Freedom Act (ITFA) was signed into law. Among
other things, the ITFA imposes a three year moratorium on discriminatory taxes
on electronic commerce. Nonetheless, foreign countries or, following the
moratorium, one or more states, may seek to impose sales or other tax
obligations on companies that engage in such activities within their
jurisdictions. If one or more states or any foreign country were able to require
RealNetworks to collect sales or other taxes from current or past sales of
products, licenses of technology, or provision of services, this would have a
material adverse effect on RealNetworks' business, especially because
RealNetworks would be unable to go back to customers to collect sales taxes for
past sales and may have to pay such taxes out of its own funds.
ITEM 7A. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK
Information relating to quantitative and qualitative disclosure about
market risk is set forth under the caption "Liquidity and Capital Resources" in
Item 7, Management's Discussion and Analysis of Financial Condition and Results
of Operations. Such information is incorporated herein by reference.
36
<PAGE> 38
ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA
REALNETWORKS, INC. AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF OPERATIONS AND COMPREHENSIVE LOSS
<TABLE>
<CAPTION>
YEARS ENDED DECEMBER 31,
-------------------------------------
1998 1997 1996
---------- ---------- ---------
(IN THOUSANDS, EXCEPT PER SHARE DATA)
<S> <C> <C> <C>
Net revenues:
Software license fees..................................... $ 46,949 $ 25,494 $11,876
Service revenues.......................................... 14,742 4,972 1,120
Advertising............................................... 3,148 2,254 1,016
-------- -------- -------
Total net revenues................................ 64,839 32,720 14,012
-------- -------- -------
Cost of revenues:
Software license fees..................................... 8,032 3,153 1,343
Service revenues.......................................... 2,631 2,392 554
Advertising............................................... 1,727 920 288
-------- -------- -------
Total cost of revenues............................ 12,390 6,465 2,185
-------- -------- -------
Gross profit........................................... 52,449 26,255 11,827
-------- -------- -------
Operating expenses:
Research and development.................................. 20,828 13,268 4,812
Sales and marketing....................................... 32,451 20,124 7,540
General and administrative................................ 9,841 6,024 3,491
Goodwill amortization..................................... 1,596 -- --
Acquisition charges....................................... 8,723 -- --
-------- -------- -------
Total operating expenses.......................... 73,439 39,416 15,843
-------- -------- -------
Operating loss......................................... (20,990) (13,161) (4,016)
-------- -------- -------
Other income (expense):
Interest income........................................... 5,325 2,225 296
Other expense............................................. (749) (233) (69)
-------- -------- -------
Other income, net...................................... 4,576 1,992 227
-------- -------- -------
Net loss.......................................... $(16,414) $(11,169) $(3,789)
======== ======== =======
Basic and diluted net loss per share........................ $ (0.51) $ (2.88) $(11.91)
Shares used to compute basic and diluted net loss per
share..................................................... 32,323 4,041 321
Comprehensive loss:
Net loss.................................................. $(16,414) $(11,169) $(3,789)
Translation adjustment.................................... 36 (151) (11)
-------- -------- -------
Comprehensive loss..................................... $(16,378) $(11,320) $(3,800)
======== ======== =======
</TABLE>
See accompanying notes to consolidated financial statements.
37
<PAGE> 39
REALNETWORKS, INC. AND SUBSIDIARIES
CONSOLIDATED BALANCE SHEETS
ASSETS
<TABLE>
<CAPTION>
DECEMBER 31,
----------------------
1998 1997
--------- ---------
(IN THOUSANDS,
EXCEPT PER SHARE DATA)
<S> <C> <C>
Current assets:
Cash, cash equivalents and short-term investments......... $ 89,777 $ 92,537
Trade accounts receivable, net of allowances for doubtful
accounts and sales returns of $1,166 in 1998 and $829
in 1997................................................ 4,941 5,270
License fee receivable.................................... -- 10,000
Prepaid expenses and other current assets................. 3,212 2,052
-------- --------
Total current assets.............................. 97,930 109,859
-------- --------
Equipment and leasehold improvements, at cost:
Equipment and software.................................... 10,914 6,549
Leasehold improvements.................................... 1,441 1,347
-------- --------
Total equipment and leasehold improvements........ 12,355 7,896
Less accumulated depreciation and amortization............ 6,082 2,753
-------- --------
Net equipment and leasehold improvements.......... 6,273 5,143
-------- --------
Restricted cash equivalents................................. 13,700 --
Other assets................................................ 1,108 1,702
Goodwill, net of accumulated amortization of $1,596 in
1998...................................................... 9,048 --
-------- --------
Total assets...................................... $128,059 $116,704
======== ========
LIABILITIES AND SHAREHOLDERS' EQUITY
Current liabilities:
Accounts payable.......................................... $ 3,563 2,136
Accrued liabilities....................................... 10,418 3,653
Deferred revenue, excluding non-current portion........... 23,742 16,550
-------- --------
Total current liabilities......................... 37,723 22,339
-------- --------
Deferred revenue, excluding current portion................. 5,833 15,500
Note payable................................................ 987 963
Shareholders' equity:
Preferred stock, $0.001 par value, no shares issued and
outstanding
Series A: authorized 200 shares........................ -- --
Undesignated series: authorized 59,800 shares.......... -- --
Common stock, $0.001 par value
Authorized 293,704 shares; issued and outstanding
30,988 shares in 1998 and 27,528 shares in 1997....... 31 28
Special common stock, $0.001 par value
Authorized 6,296 shares; issued and outstanding 2,586
shares in 1998 and
3,338 shares in 1997................................. 3 3
Additional paid-in capital................................ 117,546 95,557
Accumulated other comprehensive loss...................... (126) (162)
Accumulated deficit....................................... (33,938) (17,524)
-------- --------
Total shareholders' equity........................ 83,516 77,902
-------- --------
Commitments and contingencies
Total liabilities and shareholders' equity........ $128,059 $116,704
======== ========
</TABLE>
See accompanying notes to consolidated financial statements.
38
<PAGE> 40
REALNETWORKS, INC. AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF SHAREHOLDERS' EQUITY (DEFICIT)
<TABLE>
<CAPTION>
SPECIAL ACCUMULATED
PREFERRED STOCK COMMON STOCK COMMON STOCK ADDITIONAL OTHER
---------------- --------------- --------------- PAID-IN COMPREHENSIVE ACCUMULATED
SHARES AMOUNT SHARES AMOUNT SHARES AMOUNT CAPITAL INCOME (LOSS) DEFICIT
------- ------ ------ ------ ------ ------ ---------- ------------- -----------
(IN THOUSANDS)
<S> <C> <C> <C> <C> <C> <C> <C> <C> <C>
Balances at December 31, 1995..... 13,713 $ 14 37 $-- -- $-- $ 922 $ -- $ (2,047)
Exercise of common stock
options......................... -- -- 499 1 -- -- 43 -- --
Issuance of preferred stock
warrants........................ -- -- -- -- -- -- 1,579 -- --
Accretion of redemption value of
redeemable, convertible
preferred stock................. -- -- -- -- -- -- -- -- (31)
Translation adjustment............ -- -- -- -- -- -- -- (11) --
Net loss...................... -- -- -- -- -- -- -- -- (3,789)
------- ---- ------ --- ----- --- -------- ----- --------
Balances at December 31, 1996..... 13,713 14 536 1 -- -- 2,544 (11) (5,867)
Exercise of common stock
options......................... -- -- 1,144 1 -- -- 255 -- --
Issuance of common stock in
exchange for services........... -- -- 16 -- -- -- 55 -- --
Issuance of preferred stock
warrants........................ -- -- -- -- -- -- 4,068 -- --
Accretion of redemption value of
redeemable, convertible
preferred stock................. -- -- -- -- -- -- -- -- (488)
Exercise of common stock
warrants........................ -- -- 184 -- -- -- 37 -- --
Conversion of convertible
preferred stock into common
stock........................... (13,713) (14) 13,713 14 -- -- -- -- --
Conversion of redeemable,
convertible preferred stock into
common stock and special common
stock........................... -- -- 8,485 9 3,338 3 50,059 -- --
Sale of common stock for cash, net
of issuance costs of $4,582..... -- -- 3,450 3 -- -- 38,539 -- --
Translation adjustment............ -- -- -- -- -- -- -- (151) --
Net loss...................... -- -- -- -- -- -- -- -- (11,169)
------- ---- ------ --- ----- --- -------- ----- --------
Balances at December 31, 1997..... -- -- 27,528 28 3,338 3 95,557 (162) (17,524)
Exercise of common stock
options......................... -- -- 893 1 -- -- 745 -- --
Exercise of common stock
warrants........................ -- -- 666 1 -- -- 3,846 -- --
Common stock sold pursuant to
Employee Stock Purchase Plan.... -- -- 47 -- -- -- 873 -- --
Issuance of common stock and stock
options in business
combination..................... -- -- 1,102 1 -- -- 16,525 -- --
Conversion of special common stock
to common stock................. -- -- 752 -- (752) -- -- -- --
Translation adjustment............ -- -- -- -- -- -- -- 36 --
Net loss...................... -- -- -- -- -- -- -- -- (16,414)
------- ---- ------ --- ----- --- -------- ----- --------
Balances at December 31, 1998..... -- $ -- 30,988 $31 2,586 $ 3 $117,546 $(126) $(33,938)
======= ==== ====== === ===== === ======== ===== ========
<CAPTION>
TOTAL
SHAREHOLDERS'
EQUITY (DEFICIT)
----------------
(IN THOUSANDS)
<S> <C>
Balances at December 31, 1995..... $ (1,111)
Exercise of common stock
options......................... 44
Issuance of preferred stock
warrants........................ 1,579
Accretion of redemption value of
redeemable, convertible
preferred stock................. (31)
Translation adjustment............ (11)
Net loss...................... (3,789)
--------
Balances at December 31, 1996..... (3,319)
Exercise of common stock
options......................... 256
Issuance of common stock in
exchange for services........... 55
Issuance of preferred stock
warrants........................ 4,068
Accretion of redemption value of
redeemable, convertible
preferred stock................. (488)
Exercise of common stock
warrants........................ 37
Conversion of convertible
preferred stock into common
stock........................... --
Conversion of redeemable,
convertible preferred stock into
common stock and special common
stock........................... 50,071
Sale of common stock for cash, net
of issuance costs of $4,582..... 38,542
Translation adjustment............ (151)
Net loss...................... (11,169)
--------
Balances at December 31, 1997..... 77,902
Exercise of common stock
options......................... 746
Exercise of common stock
warrants........................ 3,847
Common stock sold pursuant to
Employee Stock Purchase Plan.... 873
Issuance of common stock and stock
options in business
combination..................... 16,526
Conversion of special common stock
to common stock................. --
Translation adjustment............ 36
Net loss...................... (16,414)
--------
Balances at December 31, 1998..... $ 83,516
========
</TABLE>
See accompanying notes to consolidated financial statements.
39
<PAGE> 41
REALNETWORKS, INC. AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF CASH FLOWS
<TABLE>
<CAPTION>
YEARS ENDED DECEMBER 31,
---------------------------------
1998 1997 1996
-------- --------- --------
(IN THOUSANDS)
<S> <C> <C> <C>
Cash flows from operating activities:
Net loss................................................ $(16,414) $ (11,169) $ (3,789)
Adjustments to reconcile net loss to net cash provided
by (used in) operating activities:
Depreciation and amortization........................ 5,053 2,132 699
Acquisition charges.................................. 8,723 -- --
Other................................................ -- 27 --
Equity in net losses of joint venture................ 448 182 --
Deferred income tax expense (benefit)................ 777 (777) --
Change in certain assets and liabilities:
Trade accounts receivable.......................... 512 (1,919) (2,665)
License fee receivable............................. 10,000 (10,000) --
Prepaid expenses and other current assets.......... (1,686) (1,119) (484)
Accounts payable................................... 853 (260) 2,220
Accrued liabilities................................ 4,267 2,340 1,118
Deferred revenue................................... (3,028) 29,163 2,266
-------- --------- --------
Net cash provided by (used in) operating
activities.................................... 9,505 8,600 (635)
-------- --------- --------
Cash flows from investing activities:
Purchases of equipment and leasehold improvements....... (4,373) (4,627) (2,784)
Purchases of short-term investments..................... (93,161) (203,046) (30,515)
Sales of short-term investments......................... 85,542 177,621 28,644
Investment in joint venture............................. -- (998) --
Increase in other assets................................ -- (251) (182)
Increase in restricted cash equivalents................. (13,700) -- --
Cash obtained through acquisition....................... 203 -- --
-------- --------- --------
Net cash used in investing activities........... (25,489) (31,301) (4,837)
-------- --------- --------
Cash flows from financing activities:
Proceeds from issuance of note payable.................. -- 991 --
Net proceeds from sales of preferred and common stock
and exercise of stock options and warrants........... 5,667 69,333 17,091
-------- --------- --------
Net cash provided by financing activities....... 5,667 70,324 17,091
-------- --------- --------
Effect of exchange rate changes on cash................... (62) (106) (11)
-------- --------- --------
Net increase (decrease) in cash and cash
equivalents................................... (10,379) 47,517 11,608
Cash and cash equivalents at beginning of year............ 62,255 14,738 3,130
-------- --------- --------
Cash and cash equivalents at end of year.................. $ 51,876 $ 62,255 $ 14,738
======== ========= ========
Supplemental disclosure of cash flow information:
Cash paid during the year for interest.................. $ -- $ 27 $ 4
Cash paid during the year for income taxes.............. $ 600 $ 700 $ --
Supplemental disclosure of noncash financing and investing
activities:
Accretion of preferred stock.............................. $ -- $ 488 $ 31
Conversion of redeemable, convertible preferred stock to
common stock and special common stock................... $ -- $ 50,071 $ --
Common stock issued in business combination............... $ 16,526 $ -- $ --
</TABLE>
See accompanying notes to consolidated financial statements.
40
<PAGE> 42
REALNETWORKS, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
YEARS ENDED DECEMBER 31, 1998, 1997 AND 1996
(IN THOUSANDS, EXCEPT PER SHARE DATA)
1. DESCRIPTION OF BUSINESS AND SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES
(a) Description of Business
RealNetworks, Inc. and subsidiaries (Company) is a leading provider of
software and services for the streaming media market. The Company develops and
markets software products and services designed to enable users of personal
computers and other consumer electronic devices to send and receive audio, video
and other multimedia content over the Internet and corporate intranets.
Inherent in the Company's business are various risks and uncertainties,
including its limited operating history and the limited history of commerce on
the Internet. The Company's success may depend in part upon the emergence of the
Internet and corporate intranets as a communications medium, the acceptance of
the Company's technology by the marketplace and the Company's ability to
generate license, service and advertising revenues from the use of its
technology on the Internet.
(b) Basis of Presentation
The consolidated financial statements include the accounts of the Company
and its wholly-owned subsidiaries. All significant intercompany balances and
transactions have been eliminated in consolidation.
(c) Cash, Cash Equivalents and Short-Term Investments
The Company considers all short-term investments with a remaining
contractual maturity at date of purchase of three months or less to be cash
equivalents.
The Company considers all short-term investments as available-for-sale.
Accordingly, these investments are carried at fair value. The fair value of such
securities approximated cost, and there were no unrealized holding gains or
losses at December 31, 1998 and 1997. At December 31, 1998 and 1997, all
short-term investments had original contractual maturities of two years or less.
The Company's cash, cash equivalents and short-term investments consist of
the following:
<TABLE>
<CAPTION>
DECEMBER 31,
------------------
1998 1997
------- -------
<S> <C> <C>
Cash and cash equivalents:
Cash................................................... $ 5,876 $ 4,679
Commercial paper....................................... 42,000 57,576
U.S. Government agency securities...................... 4,000 --
------- -------
Total cash and cash equivalents................ 51,876 62,255
------- -------
Short-term investments:
Corporate notes........................................ 30,602 6,717
U.S. Government agency securities...................... 5,300 21,065
Certificates of deposit................................ 1,999 2,500
------- -------
Total short-term investments................... 37,901 30,282
------- -------
Total cash, cash equivalents and short-term
investments.................................. $89,777 $92,537
======= =======
Restricted cash equivalents.............................. $13,700 $ --
======= =======
</TABLE>
Restricted cash equivalents represent a restricted escrow account
established in connection with a lease agreement for new corporate headquarters.
Under certain circumstances, $10,000 of the escrow account will be maintained
for the term of the lease. The remaining $3,700 will be released as the Company
funds tenant
41
<PAGE> 43
REALNETWORKS, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
YEARS ENDED DECEMBER 31, 1998, 1997 AND 1996
(IN THOUSANDS, EXCEPT PER SHARE DATA)
improvements. The Company expects to take occupancy of the new facilities during
the quarter ending June 30, 1999.
(d) Depreciation and Amortization
Depreciation and amortization of equipment and leasehold improvements is
computed using the straight-line method over the estimated useful lives of the
assets, generally three years, or the lease term if shorter.
Goodwill represents the excess of the purchase price over the fair value of
identifiable tangible and intangible assets acquired in a business combination
accounted for under the purchase accounting method. Goodwill is amortized using
the straight-line method over five years.
(e) Stock-Based Compensation
The Company has elected to apply the disclosure-only provisions of
Statement of Financial Accounting Standards No. 123, "Accounting for Stock-Based
Compensation" (SFAS 123). Accordingly, the Company accounts for stock-based
compensation transactions with employees using the intrinsic value method
prescribed in Accounting Principles Board Opinion No. 25, "Accounting for Stock
Options Issued to Employees," and related interpretations. Compensation cost for
employee stock options is measured as the excess, if any, of the fair value of
the Company's common stock at the date of grant over the stock option exercise
price.
(f) Revenue Recognition
On January 1, 1998, the Company adopted the provisions of Statement of
Position 97-2, "Software Revenue Recognition" (SOP 97-2), which provides
specific industry guidance and stipulates that revenue recognized from software
arrangements is to be allocated to each element of the arrangement based on the
relative fair values of the elements, such as software products, upgrades,
enhancements, post contract customer support, installation, or training. Under
SOP 97-2, the determination of fair value is based on objective evidence that is
specific to the vendor. If such evidence of fair value for each element of the
arrangement does not exist, all revenue from the arrangement is deferred until
such time that evidence of fair value does exist or until all elements of the
arrangement are delivered. The adoption of SOP 97-2 did not have a material
effect on revenue recognition or the Company's results of operations.
Revenue from software license fees is recognized upon delivery, net of an
allowance for estimated returns, provided all the requirements of SOP 97-2 have
been met. Prior to January 1, 1998, the Company recognized revenue from software
license fees upon delivery, net of an allowance for estimated returns, provided
that no significant obligations of the Company remained and collection of the
resulting receivable was deemed probable.
Revenue from software license agreements with original equipment
manufacturers (OEM) is recognized when the OEM delivers its product
incorporating the Company's software to the end user. In the case of prepayments
received from an OEM, the Company generally recognizes revenue based on the
actual products sold by the OEM. If the Company anticipates providing ongoing
support to the OEM in the form of future upgrades, enhancements or other
services over the term of the contract, revenue is recognized on the straight-
line method over the term of the contract.
Service revenues include payments under support and upgrade contracts, and
fees from consulting and streaming media content hosting. Support and upgrade
revenues are recognized ratably over the term of the contract, which typically
is twelve months. Other service revenues are recognized when the service is
performed.
42
<PAGE> 44
REALNETWORKS, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
YEARS ENDED DECEMBER 31, 1998, 1997 AND 1996
(IN THOUSANDS, EXCEPT PER SHARE DATA)
Revenues from advertising appearing on the Company's Web sites are
recognized ratably over the terms of the advertising contracts. The Company
guarantees to certain advertising customers a minimum number of page impressions
to be delivered to users of its Web sites for a specified period. To the extent
minimum guaranteed page impression deliveries are not met, the Company defers
recognition of the corresponding revenues until guaranteed page impression
delivery levels are achieved.
(g) Research and Development
Costs incurred in research and development are expensed as incurred.
Software development costs are required to be capitalized when a product's
technological feasibility has been established through the date the product is
available for general release to customers. The Company has not capitalized any
software development costs as technological feasibility is generally not
established until substantially all development is complete.
(h) Advertising Expenses
The Company expenses the cost of advertising and promoting its products as
incurred. Such costs are included in sales and marketing expense and totaled
approximately $783 in 1998, $1,110 in 1997, and $665 in 1996.
(i) Income Taxes
The Company computes income taxes using the asset and liability method,
under which deferred income taxes are provided for the temporary differences
between the financial reporting basis and the tax basis of the Company's assets
and liabilities. Deferred tax assets and liabilities are measured using enacted
tax rates expected to apply to taxable income in the years in which those
temporary differences are expected to be recovered or settled.
(j) Financial Instruments and Concentrations of Risk
The Company's financial instruments consist of cash, cash equivalents,
short-term investments, trade accounts receivable, accounts payable, accrued
liabilities, and note payable. The fair value of these instruments approximates
their financial statement carrying amount. Credit is extended to customers based
on an evaluation of their financial condition, and collateral is not required.
The Company performs ongoing credit evaluations of its customers and maintains
an allowance for potential credit losses.
The Company is subject to concentrations of credit risk and interest rate
risk related to its short-term investments. The Company's credit risk is managed
by limiting the amount of investments placed with any one issuer, investing in
high-quality investment securities and securities of the U.S. government, and
limiting the average maturity of the overall portfolio.
(k) Net Loss Per Share
Basic net loss per share is computed by dividing the sum of net loss plus
accretion of redemption value of redeemable preferred stock by the weighted
average number of common shares outstanding during the period. Diluted net loss
per share is computed by dividing the sum of net loss plus accretion of
redemption value of redeemable preferred stock by the weighted average number of
common and dilutive common equivalent shares outstanding during the period. As
the Company had a net loss attributable to common shareholders in each of the
periods presented, basic and diluted net loss per share are the same.
43
<PAGE> 45
REALNETWORKS, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
YEARS ENDED DECEMBER 31, 1998, 1997 AND 1996
(IN THOUSANDS, EXCEPT PER SHARE DATA)
The following table reconciles the Company's reported net loss to net loss
attributable to common shareholders used to compute basic and diluted net loss
per share:
<TABLE>
<CAPTION>
1998 1997 1996
-------- -------- -------
<S> <C> <C> <C>
Net loss.................................... $(16,414) $(11,169) $(3,789)
Accretion of redemption value of redeemable
preferred stock prior to conversion into
common stock.............................. -- (488) (31)
-------- -------- -------
Net loss attributable to common
shareholders.............................. $(16,414) $(11,657) $(3,820)
======== ======== =======
</TABLE>
Excluded from the computation of diluted net loss per share for 1998, 1997,
and 1996 are options to acquire 8,160, 6,931 and 5,334 shares of common stock,
respectively, with weighted average exercise prices of $12.11, $2.92 and $0.27,
respectively, because their effects would be anti-dilutive.
(l) Comprehensive Loss
On January 1, 1998, the Company adopted the provisions of Statement of
Financial Accounting Standards No. 130, "Reporting Comprehensive Income," (SFAS
130) which establishes standards for the reporting and disclosure of
comprehensive income and its components (revenues, expenses, gains and losses)
in a full set of financial statements. The Company's comprehensive loss for the
years ended December 31, 1998, 1997 and 1996 consisted of net loss and the gross
amount of foreign currency translation adjustments. The tax effect of the
translation adjustments was insignificant. Prior year financial statements have
been reclassified to conform to the requirements of SFAS 130.
(m) Foreign Currency
The functional currency of the Company's foreign subsidiaries is the local
currency of the country in which the subsidiary is incorporated. Assets and
liabilities of foreign operations are translated into U.S. dollars using rates
of exchange in effect at the end of the reporting period. Income and expense
accounts are translated into U.S. dollars using average rates of exchange. The
net gain or loss resulting from translation is shown as translation adjustment
and included in accumulated other comprehensive income (loss) in shareholders'
equity. Gains and losses from foreign currency transactions are included in the
consolidated statement of operations. There were no significant foreign currency
transaction gains or losses in 1998, 1997 or 1996.
(n) Use of Estimates
The preparation of financial statements in conformity with generally
accepted accounting principles requires management to make estimates and
assumptions that affect the reported amounts of assets and liabilities,
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.
(o) Impairment of Long-Lived Assets and Goodwill
The Company reviews its long-lived assets, including goodwill, for
impairment whenever events or changes in circumstances indicate that the
carrying amount of an asset may not be recoverable. Recoverability of assets
held and used, including goodwill, is measured by a comparison of the carrying
amount of an asset to future net cash flows expected to be generated by the
asset. If such assets are considered to be impaired, the impairment to be
recognized is measured by the amount by which the carrying amount of the assets
exceeds
44
<PAGE> 46
REALNETWORKS, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
YEARS ENDED DECEMBER 31, 1998, 1997 AND 1996
(IN THOUSANDS, EXCEPT PER SHARE DATA)
the fair value of the assets. Assets to be disposed of are reported at the lower
of their carrying amount or fair value less costs to sell.
(p) Reclassifications
Certain reclassifications have been made to the 1997 and 1996 consolidated
financial statements to conform with the 1998 presentation.
(q) New Accounting Pronouncements
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 is
effective for fiscal years beginning after March 15, 1999. The Company believes
that the adoption of SOP 98-9 will not have a material effect on the Company's
results of operations or financial position.
In June 1998, the Financial Accounting Standards Board issued SFAS No. 133,
"Accounting for Derivative Instruments and Hedging Activities" (SFAS 133). SFAS
133 establishes a new model for accounting for derivatives and hedging
activities and supersedes and amends existing accounting standards and is
effective for fiscal years beginning after June 15, 1999. SFAS 133 requires that
all derivatives be recognized in the balance sheet at their fair market value,
and the corresponding derivative gains or losses be either reported in the
statement of operations or as a component of other comprehensive income
depending on the type of hedge relationship that exists with respect to such
derivative. The Company does not expect the adoption of SFAS 133 to have a
material impact on its consolidated financial statements.
In March 1998, the AICPA issued SOP 98-1, "Accounting for the Costs of
Computer Software Developed or Obtained for Internal Use" (SOP 98-1). SOP 98-1
will require the capitalization of certain costs incurred in connection with
developing or obtaining software for internal use. The Company does not expect
the adoption of SOP 98-1 to have a material impact on its consolidated financial
statements. The Company plans to adopt SOP 98-1 in 1999.
2. ACQUISITION
In March 1998, the Company completed the acquisition of Vivo Software, Inc.
(Vivo), a developer of streaming media creation tools. Under terms of the
acquisition, the Company issued approximately 1,102 shares of its common stock
in exchange for all outstanding shares of Vivo common stock. In addition, the
Company issued options to purchase approximately 48 shares of the Company's
common stock in exchange for outstanding unvested options to purchase Vivo
common stock. The acquisition was accounted for using the purchase method of
accounting, and, accordingly, the results of Vivo's operations are included in
the Company's consolidated financial statements since the date of acquisition.
A summary of the purchase price for the acquisition is as follows:
<TABLE>
<S> <C>
Stock and stock options..................................... $16,526
Direct acquisition costs.................................... 445
Accrued liabilities assumed................................. 1,640
Other liabilities assumed................................... 1,057
-------
Total............................................. $19,668
=======
</TABLE>
45
<PAGE> 47
REALNETWORKS, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
YEARS ENDED DECEMBER 31, 1998, 1997 AND 1996
(IN THOUSANDS, EXCEPT PER SHARE DATA)
The purchase price was allocated as follows:
<TABLE>
<S> <C>
Cash acquired............................................... $ 203
Other current assets acquired............................... 148
Equipment................................................... 100
Goodwill.................................................... 10,644
In-process research and development......................... 8,573
-------
Total............................................. $19,668
=======
</TABLE>
In-process research and development represents the fair value of
technologies acquired for use in the Company's own development efforts. The
Company determined the amount of the purchase price to be allocated to
in-process research and development based on the time and cost to incorporate
the acquired technology into the Company's development projects, expected
incremental revenues and expenses associated with the development projects
utilizing the acquired technology, and risks and uncertainties associated with
the acquired technology. Such risks and uncertainties include inherent
difficulties and uncertainties in incorporating the acquired technology into the
Company's development projects and risks related to the viability of and
potential changes to target markets. The Company also concluded that the
acquired technology had no alternative future use.
Goodwill represents the excess of the purchase price over the fair value of
identifiable tangible and intangible assets acquired and is amortized using the
straight-line method over its estimated life of five years.
The acquisition of Vivo qualified as a tax-free reorganization under the
Internal Revenue Code (IRC). Therefore, the charge for in-process research and
development is not deductible for income tax purposes. The Company acquired net
operating loss carryforwards of approximately $16,000, which expire from 2008 to
2012. Under the provisions of the IRC, the amount of these net operating loss
carryforwards available annually to offset future taxable income is
significantly limited. No value has been attributed to these net operating
losses in the purchase price allocation due to these limitations. Any
utilization of the net operating loss carryforwards in the future will result in
a reduction of the carrying amount of goodwill.
In connection with the acquisition, approximately 220 shares of common
stock issued were placed in escrow to secure indemnification obligations of
former shareholders of Vivo. As of December 31, 1998, approximately 110 shares
remain in escrow.
The following table presents pro forma results of operations as if the
acquisition had occurred at the beginning of each of the years presented. The
pro forma results of operations exclude $8,723 of acquisition related charges as
the charges are not expected to have a continuing impact on the Company's
results of operations. The pro forma information is not necessarily indicative
of the combined results that would have occurred had the acquisition taken place
at the beginning of 1998 or at the beginning of 1997, nor is it necessarily
indicative of results that may occur in the future.
<TABLE>
<CAPTION>
1998 1997
------- --------
<S> <C> <C>
PRO FORMA BASIS
Total net revenues...................................... $65,492 $ 34,501
Net loss................................................ (9,279) (18,730)
Net loss per share -- basic and diluted................. (0.29) (3.82)
</TABLE>
46
<PAGE> 48
REALNETWORKS, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
YEARS ENDED DECEMBER 31, 1998, 1997 AND 1996
(IN THOUSANDS, EXCEPT PER SHARE DATA)
3. INVESTMENT IN JOINT VENTURE AND NOTE PAYABLE
The Company has a 24% interest in a Japanese limited liability company that
operates an Internet streaming business in Japan. The Company accounts for this
investment using the equity method. At December 31, 1998, the Company had
outstanding a note payable to one of its joint venture partners which is due in
May 2000. The note is denominated in Japanese yen, bears interest at a rate not
to exceed the Japanese Short Term Prime Rate (1.5% at December 31, 1998) and is
secured by the Company's shares in the joint venture. The Company may, under
certain circumstances, tender its shares in the joint venture as repayment of
the note. Equity in net losses of the joint venture was $448 in 1998 and $182 in
1997. The carrying amount of the Company's investment in joint venture was $368
and $816 at December 31, 1998 and 1997, respectively.
4. SHAREHOLDERS' EQUITY
(a) Initial Public Offering
On November 21, 1997, the Company completed its initial public offering and
all outstanding shares of preferred stock were converted to either common stock
or special common stock.
(b) Special Common Stock
Special common stock is not entitled to vote, except as required by law.
All other rights and preferences of the special common stock are identical to
common stock, except as otherwise required by law or expressly provided in the
Company's Articles of Incorporation. All shares of special common stock are held
by Microsoft Corporation (Microsoft) and automatically convert into the same
number of shares of common stock upon sale or transfer by Microsoft to an
unaffiliated third party. During 1998, Microsoft sold 752 shares which were
converted into an equivalent number of shares of common stock.
(c) Preferred stock
Each share of Series A preferred stock entitles the holder to one thousand
votes and dividends equal to one thousand times the aggregate per share amount
of dividends declared on the common stock.
Undesignated preferred stock will have rights and preferences that are
determinable by the Board of Directors when determination of a new series of
preferred stock has been established.
(d) Shareholder Rights Plan
On October 16, 1998, the Company's Board of Directors declared a dividend
of one preferred share purchase right (Right) in connection with its adoption of
a Shareholder Rights Plan dated December 4, 1998, for each outstanding share of
the Company's common stock on December 14, 1998 (Record Date). Each share of
common stock issued after the Record Date will be issued with an attached Right.
The Rights will not immediately be exercisable and detachable from the common
stock. The Rights will become exercisable and detachable only following the
acquisition by a person or a group of 15 percent or more of the outstanding
common stock or ten days following the announcement of a tender or exchange
offer for 15 percent or more of the outstanding common stock (Distribution
Date). After the Distribution Date, each Right will entitle the holder to
purchase for $150 (Exercise Price), a fraction of a share of the Company's
Series A preferred stock with economic terms similar to that of one share of the
Company's common stock. Upon a person or a group acquiring 15 percent or more of
the outstanding common stock, each Right will allow the holder (other than the
acquiror) to purchase common stock or securities of the Company having a then
current market value of
47
<PAGE> 49
REALNETWORKS, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
YEARS ENDED DECEMBER 31, 1998, 1997 AND 1996
(IN THOUSANDS, EXCEPT PER SHARE DATA)
two times the Exercise Price of the Right. In the event that following the
acquisition of 15 percent of the common stock by an acquiror, the Company is
acquired in a merger or other business combination or 50 percent or more of the
Company's assets or earning power are sold, each Right will entitle the holder
to purchase for the Exercise Price, common stock or securities of the acquiror
having a then current market value of two times the Exercise Price. In certain
circumstances, the Rights may be redeemed by the Company at a redemption price
of $0.01 per Right. If not earlier exchanged or redeemed, the Rights will expire
on December 4, 2008.
(e) Stock Warrants
In connection with the sales of preferred stock in 1997 and 1996, the
Company issued warrants to purchase additional shares of stock. During 1998 and
1997, 666 and 184 warrants were exercised, respectively. No warrants were
outstanding at December 31, 1998.
(f) Stock Option Plan
The Company has a stock option plan (Plan) to compensate employees for past
and future services and has reserved 14,900 shares of common stock for option
grants under the Plan. Generally, options vest based on continuous employment,
over a five year period. The options expire twenty years from the date of grant
and are exercisable at the fair market value of the common stock at the grant
date.
A summary of stock option related activity is as follows:
<TABLE>
<CAPTION>
OPTIONS OUTSTANDING
---------------------
WEIGHTED
SHARES AVERAGE
AVAILABLE NUMBER EXERCISE
FOR GRANT OF SHARES PRICE
--------- --------- --------
<S> <C> <C> <C>
Balances at December 31, 1995................. 737 2,832 $ 0.07
Plan introduction........................... 3,000 -- --
Options granted............................. (3,766) 3,766 0.34
Options exercised........................... -- (499) 0.09
Options canceled............................ 765 (765) 0.10
------ ------
Balances at December 31, 1996................. 736 5,334 0.27
Plan amendment.............................. 5,800 -- --
Options granted............................. (3,672) 3,672 5.50
Options exercised........................... -- (1,144) 0.22
Options canceled............................ 931 (931) 1.32
------ ------
Balances at December 31, 1997................. 3,795 6,931 2.92
Plan amendment.............................. 2,500 -- --
Options granted............................. (2,982) 2,982 28.21
Options assumed in acquisition.............. -- 48 0.23
Options exercised........................... -- (893) 0.83
Options canceled............................ 908 (908) 7.42
------ ------
Balances at December 31, 1998................. 4,221 8,160 $12.11
====== ======
</TABLE>
48
<PAGE> 50
REALNETWORKS, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
YEARS ENDED DECEMBER 31, 1998, 1997 AND 1996
(IN THOUSANDS, EXCEPT PER SHARE DATA)
The following table summarizes information about stock options outstanding
at December 31, 1998:
<TABLE>
<CAPTION>
OPTIONS OUTSTANDING
------------------------------------- OPTIONS EXERCISABLE
WEIGHTED ----------------------
AVERAGE WEIGHTED WEIGHTED
REMAINING AVERAGE AVERAGE
OPTIONS CONTRACTUAL EXERCISE OPTIONS EXERCISE
EXERCISE PRICES OUTSTANDING LIFE (YEARS) PRICE EXERCISABLE PRICE
--------------- ----------- ------------ -------- ----------- --------
<S> <C> <C> <C> <C> <C>
$ 0.07 - $ 1.50 3,134 17.06 $ 0.46 1,335 $0.31
2.00 - 7.25 1,317 18.52 4.91 191 3.48
8.50 - 15.00 1,068 18.90 10.89 1 8.50
15.38 - 32.88 1,617 19.44 24.82 -- --
33.00 - 42.13 1,024 19.70 36.35 -- --
----- -----
8,160 18.39 $12.11 1,527 $0.71
===== =====
</TABLE>
In accordance with the disclosure requirements of SFAS 123, if the Company
had elected to recognize compensation cost based on the fair value of options
granted at grant date as prescribed, net loss and net loss per share would have
been increased to the pro forma amounts indicated in the table below:
<TABLE>
<CAPTION>
1998 1997 1996
-------- -------- -------
<S> <C> <C> <C>
Net loss:
As reported............................... $(16,414) $(11,169) $(3,789)
Pro forma................................. (26,009) (11,643) (3,865)
Basic and diluted net loss per share:
As reported............................... (0.51) (2.88) (11.91)
Pro forma................................. (0.80) (3.00) (12.15)
</TABLE>
The per share weighted average fair value of stock options granted during
the years ended December 31, 1998, 1997 and 1996 was $16.54, $1.12 and $0.07
respectively, on the date of grant. Prior to the Company's initial public
offering, the fair value of each option grant was determined on the date of
grant using the minimum value method. Subsequent to the offering, the fair value
was determined using the Black-Scholes model. Except for the volatility
assumption which was only used under the Black-Scholes model, the following
weighted average assumptions were used to perform the calculations:
<TABLE>
<CAPTION>
1998 1997 1996
---- ---- ----
<S> <C> <C> <C>
Expected dividend yield................................ 0% 0% 0%
Risk-free interest rate................................ 5.15% 6.10% 6.10%
Expected life (years).................................. 3.5 3.5 4.5
Volatility............................................. 85% 60% n/a
</TABLE>
(g) Employee Stock Purchase Plan
Effective January 1998, the Company adopted an Employee Stock Purchase Plan
(ESPP), and has reserved 1,000 shares of common stock for issuance under the
ESPP. Under the ESPP, an eligible employee may purchase shares of common stock,
based on certain limitations, at a price equal to the lesser of 85% of the fair
market value of the common stock at the beginning or end of the respective
semi-annual offering periods. There were 47 shares purchased under the ESPP
during 1998. The weighted average fair value of the employee stock purchase
rights was $11.21 in 1998. The following assumptions were used to perform the
calculation: expected dividend yield -- 0%; risk-free interest rate -- 5.15%;
expected life -- six months; volatility -- 85%.
49
<PAGE> 51
REALNETWORKS, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
YEARS ENDED DECEMBER 31, 1998, 1997 AND 1996
(IN THOUSANDS, EXCEPT PER SHARE DATA)
5. SIGNIFICANT CUSTOMER
In June 1997, the Company entered into a strategic agreement with Microsoft
pursuant to which the Company granted Microsoft a nonexclusive license to
certain substantial elements of the source code of the Company's
RealAudio/RealVideo Version 4.0 technology. The $30,000 license fee is being
recognized ratably over the three-year term of the Company's ongoing support
obligations.
Under the agreement, Microsoft may sublicense its rights to the Standard
Code to third parties under certain conditions without additional compensation
to the Company. In addition, Microsoft has an option to receive two additional
deliveries of updated versions of the Standard Code. Microsoft's right to
receive the first delivery expired unexercised in July 1998. Microsoft may elect
to receive a delivery of the then current version of the Standard Code once
before July 1999, upon payment of a license fee of $35,000. If the Company
elects in its sole discretion to grant an Event License (as defined in the
agreement) to a third party, the agreement provides for a refund of a portion of
the license fee paid by Microsoft, based on a declining scale over the term of
the agreement.
In connection with the agreement, Microsoft made a $30,000 minority
investment in the Company in the form of 3,338 shares of nonvoting preferred
stock, which shares were converted into 3,338 shares of nonvoting special common
stock upon the completion of the Company's initial public offering in 1997.
Software license fees under the license agreement with Microsoft accounted
for approximately 15% of total net revenues in 1998 and 1997. No single customer
accounted for more than 10% of total net revenues in 1996.
6. INCOME TAXES
The components of loss before income taxes are as follows:
<TABLE>
<CAPTION>
1998 1997 1996
-------- -------- -------
<S> <C> <C> <C>
U.S. operations............................. $(16,208) $ (8,480) $(3,789)
Foreign operations.......................... (206) (2,689) --
-------- -------- -------
$(16,414) $(11,169) $(3,789)
======== ======== =======
</TABLE>
The components of income tax expense (benefit) are as follows:
<TABLE>
<CAPTION>
1998 1997 1996
----- ----- -----
<S> <C> <C> <C>
Current............................................. $(777) $ 777 $--
Deferred............................................ 777 (777) --
----- ----- ---
$ -- $ -- $--
===== ===== ===
</TABLE>
Income tax expense (benefit) differs from "expected" income tax expense
(benefit) (computed by applying the U.S. Federal income tax rate of 34%) in 1998
due to nondeductible acquisition charges and related amortization of goodwill
and an increase in the valuation allowance on deferred tax assets. The 1997 and
1996 effective rate differed principally due to the change in the valuation
allowance related to deferred tax assets.
50
<PAGE> 52
REALNETWORKS, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
YEARS ENDED DECEMBER 31, 1998, 1997 AND 1996
(IN THOUSANDS, EXCEPT PER SHARE DATA)
The tax effects of temporary differences that give rise to significant
portions of net deferred tax assets are comprised of the following at December
31:
<TABLE>
<CAPTION>
1998 1997
------- ------
<S> <C> <C>
Deferred tax assets:
Net operating loss carryforwards........................ $ 7,650 $ --
Deferred revenue........................................ 6,649 6,552
Allowances for doubtful accounts and sales returns...... 404 282
Depreciation............................................ 472 217
Other................................................... 1,121 167
------- ------
Gross deferred tax assets................................. 16,296 7,218
Less valuation allowance................................ 16,296 6,441
------- ------
Net deferred tax assets................................... $ -- $ 777
======= ======
</TABLE>
The valuation allowance for deferred tax assets increased by $9,855, $4,613
and $1,335 for the years ended December 31, 1998, 1997 and 1996, respectively.
Due to operating losses and the uncertainty regarding the recoverability of
deferred tax assets, the Company has provided a full valuation allowance at
December 31, 1998.
At December 31, 1998, the Company had net operating loss carryforwards for
Federal income tax purposes of approximately $22,500, expiring in the year 2013.
A majority of the net operating loss carryforward results from stock option
deductions, the realization of which would result in a credit to shareholders'
equity. This net operating loss carryforward excludes $16,000 of net operating
loss carryforwards acquired from Vivo which are subject to significant
limitations.
7. SEGMENT INFORMATION
During 1998, the Company adopted the provisions of SFAS No. 131,
"Disclosure About Segments of an Enterprise and Related Information" (SFAS 131).
SFAS 131 establishes standards for the way that public business enterprises
report information about operating segments.
The Company operates in one business segment, streaming media, for which
the Company receives revenues from its customers. The Company's Chief Operating
Decision Maker is considered to be the Company's Operating Committee (COC) which
is comprised of the Company's Chief Executive Officer and the Company's Senior
Vice Presidents. The COC reviews financial information presented on a
consolidated basis accompanied by disaggregated information about products and
services and geographical region for purposes of making decisions and assessing
financial performance. The COC does not review discrete financial information
regarding profitability of the Company's different products or services, and,
therefore, the Company does not have operating segments as defined by SFAS 131.
51
<PAGE> 53
REALNETWORKS, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
YEARS ENDED DECEMBER 31, 1998, 1997 AND 1996
(IN THOUSANDS, EXCEPT PER SHARE DATA)
The Company's customers consist primarily of end users located in the
United States and various foreign countries. Revenues by geographic region are
as follows:
<TABLE>
<CAPTION>
1998 1997 1996
------- ------- -------
<S> <C> <C> <C>
North America................................. $42,611 $20,346 $11,308
Europe........................................ 7,144 3,425 1,037
Asia.......................................... 4,429 3,225 1,013
Rest of world................................. 987 890 654
Subtotal............................ 55,171 27,886 14,012
Microsoft license revenue..................... 9,668 4,834 --
------- ------- -------
Total............................... $64,839 $32,720 $14,012
======= ======= =======
</TABLE>
Revenue from external customers by product type is as follows:
<TABLE>
<CAPTION>
1998 1997 1996
------- ------- -------
<S> <C> <C> <C>
Streaming media license revenue............... $37,281 $20,660 $11,876
Streaming media service revenue............... 14,742 4,972 1,120
Microsoft license revenue..................... 9,668 4,834 --
Advertising revenue........................... 3,148 2,254 1,016
------- ------- -------
Total net revenues.................. $64,839 $32,720 $14,012
======= ======= =======
</TABLE>
Long-lived assets by geographic location are as follows:
<TABLE>
<CAPTION>
1998 1997
------- -------
<S> <C> <C> <C>
United States................................. $14,538 $ 4,369
Japan......................................... 454 404
Europe........................................ 329 370
------- -------
Total............................... $15,321 $ 5,143
======= =======
</TABLE>
8. COMMITMENTS
(a) Lease Commitments
The Company leases its office facilities under terms of operating lease
agreements expiring through May 1999. During 1998, the Company entered into a
lease agreement for a new location for its corporate headquarters. The lease
commences on April 1, 1999 and expires in April 2011. Future minimum lease
payments are:
<TABLE>
<CAPTION>
MINIMUM
YEARS ENDING DECEMBER 31, LEASE PAYMENTS
------------------------- --------------
<S> <C>
1999................................................... $ 3,071
2000................................................... 3,294
2001................................................... 4,065
2002................................................... 4,633
2003................................................... 4,744
Thereafter............................................. 37,092
-------
Total minimum lease payments................. $56,899
=======
</TABLE>
Rent expense was approximately $2,600 in 1998, $1,800 in 1997 and $600 in
1996.
52
<PAGE> 54
REALNETWORKS, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
YEARS ENDED DECEMBER 31, 1998, 1997 AND 1996
(IN THOUSANDS, EXCEPT PER SHARE DATA)
(b) 401(k) Retirement Savings Plan
The Company has a salary deferral plan [401(k) Plan] that covers
substantially all employees. The Company, at its discretion, may make
contributions to the 401(k) Plan, although it has not made any contributions to
date. Employees can contribute a portion of their salary to the maximum allowed
by the federal tax guidelines. The Company currently does not provide matching
contributions. The Company has no other post-employment or post-retirement
benefit plans.
(c) Litigation
In August 1998, a lawsuit was filed against the Company and a co-defendant,
a customer of the Company, in the United States District Court for the Northern
District of Texas -- Dallas Division by Venson M. Shaw and Steven M. Shaw. The
plaintiffs allege that the Company, individually and in combination with
Broadcast.com, infringes on a certain patent by making, using, selling and/or
offering to sell software products and services directed to media delivery
systems for the Internet and corporate intranets. Plaintiffs seek to enjoin the
Company from its alleged infringing activity and to recover damages in an amount
no less than a reasonable royalty. Although no assurance can be given as to the
outcome of this lawsuit, the Company believes that the allegations in this
action are without merit and the Company intends to vigorously defend against
the complaint.
From time to time the Company has been, and continues to be, subject to
legal proceedings and claims in the ordinary course of its business, including
contract claims and claims of alleged infringement of third-party patents,
trademarks and other intellectual property rights by the Company and its
licensees. Such claims, even if not meritorious, could force the Company to
spend significant financial and managerial resources. The Company currently is
not aware of any legal proceedings or claims that the Company believes will
have, individually or taken together, a material adverse effect on the Company's
business, prospects, financial condition or results of operations.
9. QUARTERLY INFORMATION (UNAUDITED)
The following table summarizes the unaudited statement of operations for
each quarter of 1998 and 1997. In response to recent Securities and Exchange
Commission interpretative guidance surrounding the valuation methodology used in
determining charges associated with acquisition related in-process research and
development, the Company has revised the original accounting for the purchase
price allocation related to the 1998 acquisition of Vivo and the related
amortization of goodwill. This adjustment decreased the amount
53
<PAGE> 55
REALNETWORKS, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
YEARS ENDED DECEMBER 31, 1998, 1997 AND 1996
(IN THOUSANDS, EXCEPT PER SHARE DATA)
previously allocated to in-process research and development by $9,156, which has
been capitalized as goodwill and is being amortized using the straight-line
method over five years.
<TABLE>
<CAPTION>
QUARTER ENDED
------------------------------------------
MAR. 31 JUNE 30 SEPT. 30 DEC. 31 TOTAL
-------- ------- -------- ------- --------
<S> <C> <C> <C> <C> <C>
1998
As originally reported:
Net revenues........................... $ 12,502 $15,056 $17,244 $20,037 $ 64,839
Gross profit........................... 10,063 12,095 13,993 16,298 52,449
Operating loss......................... (21,165) (3,296) (2,602) (2,167) (29,230)
Net loss............................... (20,088) (2,104) (1,359) (1,103) (24,654)
Net loss per share..................... (0.65) (0.07) (0.04) (0.03) (0.76)
As restated:
Net revenues........................... 12,502 15,056 17,244 20,037 64,839
Gross profit........................... 10,063 12,095 13,993 16,298 52,449
Operating loss......................... (12,009) (3,754) (3,060) (2,167) (20,990)
Net loss............................... (10,932) (2,562) (1,817) (1,103) (16,414)
Net loss per share..................... (0.35) (0.08) (0.06) (0.03) (0.51)
1997
Net revenues........................... 6,356 7,010 9,051 10,303 32,720
Gross profit........................... 4,335 5,977 7,496 8,447 26,255
Operating loss......................... (3,911) (2,897) (2,951) (3,402) (13,161)
Net loss............................... (3,706) (2,666) (2,203) (2,594) (11,169)
Net loss per share..................... (6.35) (3.99) (2.15) (0.20) (2.88)
</TABLE>
54
<PAGE> 56
INDEPENDENT AUDITORS' REPORT
The Board of Directors and Shareholders
RealNetworks, Inc.:
We have audited the accompanying consolidated balance sheets of
RealNetworks, Inc. and subsidiaries as of December 31, 1998 and 1997, and the
related consolidated statements of operations and comprehensive loss,
shareholders' equity (deficit) and cash flows for each of the years in the
three-year period ended December 31, 1998. These consolidated financial
statements are the responsibility of the Company's management. Our
responsibility is to express an opinion on these consolidated financial
statements based on our audits.
We conducted our audits in accordance with generally accepted auditing
standards. Those standards require that we plan and perform the audit to obtain
reasonable assurance about whether the financial statements are free of material
misstatement. An audit includes examining, on a test basis, evidence supporting
the amounts and disclosures in the financial statements. An audit also includes
assessing the accounting principles used and significant estimates made by
management, as well as evaluating the overall financial statement presentation.
We believe that our audits provide a reasonable basis for our opinion.
In our opinion, the consolidated financial statements referred to above
present fairly, in all material respects, the financial position of
RealNetworks, Inc. and subsidiaries as of December 31, 1998 and 1997, and the
results of their operations and their cash flows for each of the years in the
three-year period ended December 31, 1998, in conformity with generally accepted
accounting principles.
/s/ KPMG LLP
Seattle, Washington
January 21, 1999
55
<PAGE> 57
ITEM 9. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND
FINANCIAL DISCLOSURE
Not applicable.
PART III
ITEM 10. DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANT
The information required by this Item is contained in part in the sections
captioned "Board of Directors-Nominees for Director," "Board of
Directors -- Continuing Directors -- Not Standing for Election This Year,"
"Board of Directors -- Contractual Arrangements" and "Voting Securities and
Principal Holders-Section 16(a) Beneficial Ownership Reporting Compliance" in
the Proxy Statement for RealNetworks' Annual Meeting of Shareholders scheduled
to be held on May 21, 1999, and such information is incorporated herein by
reference.
The remaining information required by this Item is set forth as Item 4A in
Part I of this report under the caption "Executive Officers of the Registrant."
ITEM 11. EXECUTIVE COMPENSATION
The information required by this Item is incorporated by reference to the
information contained in the section captioned "Compensation and Benefits" of
the Proxy Statement for RealNetworks' Annual Meeting of Shareholders scheduled
to be held on May 21, 1999.
ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT
The information required by this Item is incorporated by reference to the
information contained in the sections captioned "Voting Securities and Principal
Holders" of the Proxy Statement for RealNetworks' Annual Meeting of Shareholders
scheduled to be held on May 21, 1999.
ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS
The information required by this Item is incorporated by reference to the
information contained in the section captioned "Voting Securities and Principal
Holders -- Certain Transactions" of the Proxy Statement for RealNetworks' Annual
Meeting of Shareholders scheduled to be held on May 21, 1999.
56
<PAGE> 58
PART IV
ITEM 14. EXHIBITS, FINANCIAL STATEMENT SCHEDULES, AND REPORTS ON FORM 8-K
(a)(1) INDEX TO CONSOLIDATED FINANCIAL STATEMENTS
The following consolidated financial statements of RealNetworks, Inc. and
subsidiaries are filed as part of this report:
Consolidated Statements of Operations and Comprehensive Loss -- Years ended
December 31, 1998, 1997 and 1996
Consolidated Balance Sheets -- December 31, 1998 and 1997
Consolidated Statements of Shareholders' Equity (Deficit) -- Years ended
December 31, 1998, 1997 and 1996
Consolidated Statements of Cash Flows -- Years ended December 31, 1998,
1997 and 1996
Notes to Consolidated Financial Statements
Independent Auditors' Report
(a)(2) FINANCIAL STATEMENT SCHEDULES
Schedule II: Valuation and Qualifying Accounts
Schedules not listed above have been omitted because the information
required to be set forth therein is not applicable or is included in the
Consolidated Financial Statements or notes thereto.
(b) REPORTS ON FORM 8-K
On December 21, 1998, RealNetworks filed a report on Form 8-K with respect
to the adoption of a Shareholder Rights Plan and the related declaration of a
dividend of one preferred share purchase right for each outstanding share of
Common Stock of RealNetworks.
(c) EXHIBITS
The following exhibits are incorporated herein by reference or are filed
with this report as indicated below:
EXHIBIT NO. 2: PLAN OF ACQUISITION, REORGANIZATION, ARRANGEMENT, LIQUIDATION OR
SUCCESSION
<TABLE>
<C> <S>
2.1 Agreement and Plan of Merger among RealNetworks, Vivo
Software, Inc. and RN Acquisition Corp. dated as of February
20, 1998 (incorporated by reference from Exhibit 2.1 to the
Current Report on Form 8-K filed with the Securities and
Exchange Commission on April 8, 1998)
</TABLE>
EXHIBIT NO. 3: ARTICLES OF INCORPORATION AND BYLAWS
<TABLE>
<C> <S>
3.1 Amended and Restated Articles of Incorporation (incorporated
by reference from Exhibit 3.1 to RealNetworks' Quarterly
Report on Form 10-Q for the quarterly period ended September
30, 1998 filed with the Securities and Exchange Commission
on November 13, 1998)
3.2 Amended and Restated Bylaws (incorporated by reference from
Exhibit 3.2 to RealNetworks' Quarterly Report on Form 10-Q
for the quarterly period ended September 30, 1998 filed with
the Securities and Exchange Commission on November 13, 1998)
</TABLE>
57
<PAGE> 59
EXHIBIT NO. 4: INSTRUMENTS DEFINING THE RIGHTS OF SECURITY HOLDERS
<TABLE>
<C> <S>
4.1 Shareholder Rights Plan dated as of December 4, 1998 between
RealNetworks and ChaseMellon Shareholder Services, L.L.C.
(incorporated herein by reference to Exhibit 1 to
RealNetworks' Registration Statement on Form 8-A12G filed
with the Securities and Exchange Commission on December 14,
1998)
</TABLE>
EXHIBIT NO. 10: MATERIAL CONTRACTS
EXECUTIVE COMPENSATION PLANS AND AGREEMENTS
<TABLE>
<C> <S>
10.1 RealNetworks, Inc. 1995 Stock Option Plan (incorporated by
reference from Exhibit 99.1 to RealNetworks' Registration
Statement on Form S-8 filed with the Securities and Exchange
Commission on September 14, 1998)
10.2 RealNetworks, Inc. Amended and Restated 1996 Stock Option
Plan (incorporated by reference from Exhibit 10.1 to
RealNetworks' Quarterly Report on Form 10-Q for the
quarterly period ended September 30, 1998 filed with the
Securities and Exchange Commission on November 13, 1998)
10.3 Vivo Software, Inc. 1993 Equity Incentive Plan (incorporated
by reference from Exhibit 99.1 to RealNetworks' Registration
Statement on Form S-8 filed with the Securities and Exchange
Commission on May 20, 1998)
10.4 Form of Stock Option Agreement
10.5 1998 Employee Stock Purchase Plan (incorporated by reference
from Exhibit 10.4 to Amendment No. 4 of RealNetworks'
Registration Statement on Form S-1 filed with the Securities
and Exchange Commission on November 20, 1997 (File No.
333-36553))
10.6 Offer letter dated February 16, 1996 between RealNetworks
and Bruce Jacobsen (incorporated by reference from Exhibit
10.11 to Amendment No. 4 of RealNetworks' Registration
Statement on Form S-1 filed with the Securities and Exchange
Commission on November 20, 1997 (File No. 333-36553))
</TABLE>
OTHER MATERIAL CONTRACTS
<TABLE>
<C> <S>
10.7 Lease dated January 21, 1998 between RealNetworks as Lessee
and 2601 Elliott, LLC (incorporated by reference from
Exhibit 10.1 to RealNetworks' Quarterly Report on Form 10-Q
for the quarterly period ended March 31, 1998 filed with the
Securities and Exchange Commission on May 14, 1998)
10.8 Lease Agreement dated March 4, 1996 by and between
RealNetworks as Lessee and Wright Runstad Properties L.P. as
Lessor (incorporated by reference from Exhibit 10.7 to
Amendment No. 4 to RealNetworks' Registration Statement on
Form S-1 filed with the Securities and Exchange Commission
on November 20, 1997 (File No. 333-36553))
10.9 Sublease Agreement dated March, 1996 by and between
RealNetworks as Sublessee and Legent Corporation as
Sublessor (incorporated by reference from Exhibit 10.8 to
Amendment No. 4 of RealNetworks' Registration Statement on
Form S-1 filed with the Securities and Exchange Commission
on November 20, 1997 (File No. 333-36553))
10.10 Antenna Site License Agreement dated August 12, 1997 by and
between RealNetworks and Wright Runstad & Company
(incorporated by reference from Exhibit 10.9 to Amendment
No. 4 of RealNetworks' Registration Statement on Form S-1
filed with the Securities and Exchange Commission on
November 20, 1997 (File No. 333-36553))
10.11 Agreement between Microsoft Corporation and RealNetworks on
Media Streaming Technology dated June 17, 1997 (incorporated
by reference from Exhibit 10.10 to Amendment No. 4 of
RealNetworks' Registration Statement on Form S-1 filed with
the Securities and Exchange Commission on November 20, 1997
(File No. 333-36553))
</TABLE>
58
<PAGE> 60
<TABLE>
<C> <S>
10.12 Form of Director and Officer Indemnification Agreement
(incorporated by reference from Exhibit 10.14 to Amendment
No. 4 of RealNetworks' Registration Statement on Form S-1
filed with the Securities and Exchange Commission on
November 20, 1997 (File No. 333-36553))
10.13 Limited Proxy and Voting Agreement dated July 21, 1997 by
and between RealNetworks and Microsoft Corporation
(incorporated by reference from Exhibit 10.15 to Amendment
No. 4 of RealNetworks' Registration Statement on Form S-1
filed with the Securities and Exchange Commission on
November 20, 1997 (File No. 333-36553))
10.14 Voting Agreement dated September 25, 1997 by and among
RealNetworks, Robert Glaser, Accel IV L.P., Mitchell Kapor
and Bruce Jacobsen (incorporated by reference from Exhibit
10.17 to Amendment No. 4 of RealNetworks' Registration
Statement on Form S-1 filed with the Securities and Exchange
Commission on November 20, 1997 (File No. 333-36553))
10.15 Agreement dated September 26, 1997 by and between
RealNetworks and Robert Glaser (incorporated by reference
from Exhibit 10.18 to Amendment No. 4 of RealNetworks'
Registration Statement on Form S-1 filed with the Securities
and Exchange Commission on November 20, 1997 (File No.
333-36553))
10.16 Third Amended and Restated Investors' Rights Agreement dated
March 24, 1998 by and among RealNetworks and certain
shareholders of RealNetworks (incorporated by reference from
Exhibit 10.3 to RealNetworks' Quarterly Report on Form 10-Q
for the quarterly period ended March 31, 1998 filed with the
Securities and Exchange Commission on May 14, 1998)
10.17 Representative License Agreement -- License Agreement for
the RealPlayer Plus (incorporated by reference from Exhibit
10.21 to Amendment No. 4 of RealNetworks' Registration
Statement on Form S-1 filed with the Securities and Exchange
Commission on November 20, 1997 (File No. 333-36553))
</TABLE>
EXHIBIT NO. 21: SUBSIDIARIES OF THE REGISTRANT
<TABLE>
<C> <S>
21.1 Subsidiaries of RealNetworks
</TABLE>
EXHIBIT NO. 23: CONSENTS OF EXPERTS AND COUNSEL
<TABLE>
<C> <S>
23.1 Consent of KPMG LLP
</TABLE>
EXHIBIT NO. 24: POWER OF ATTORNEY
<TABLE>
<C> <S>
24.1 Power of Attorney (included on signature page)
</TABLE>
EXHIBIT NO. 27: FINANCIAL DATA SCHEDULE
<TABLE>
<C> <S>
27.1 Financial Data Schedule
</TABLE>
59
<PAGE> 61
SIGNATURES
Pursuant to the requirements of Section 13 or 15(d) of the Securities
Exchange Act of 1934, the Registrant has duly caused this Report to be signed on
its behalf by the undersigned, thereunto duly authorized, in the City of
Seattle, State of Washington, on March 29, 1999.
REALNETWORKS, INC.
By /s/ ROBERT GLASER
------------------------------------
Robert Glaser
Chief Executive Officer
POWER OF ATTORNEY
Each person whose signature appears below hereby constitutes and appoints
Robert Glaser and Paul Bialek, and each of them severally, his true and lawful
attorneys-in-fact and agents, with full power to act without the other and with
full power of substitution and resubstitution, to execute in his name and on his
behalf, individually and in each capacity stated below, any and all amendments
and supplements to this Report, and any and all other instruments necessary or
incidental in connection herewith, and to file the same with the Commission.
Pursuant to the requirements of the Securities Exchange Act of 1934, this
Report has been signed by the following persons on behalf of the Registrant and
in the capacities and on the dates indicated.
<TABLE>
<CAPTION>
SIGNATURE TITLE DATE
--------- ----- ----
<S> <C> <C>
/s/ ROBERT GLASER Chairman of the Board, Chief March 29, 1999
- ----------------------------------------------------- Executive Officer and Treasurer
Robert Glaser (Principal Executive Officer)
/s/ PAUL BIALEK Senior Vice President, Finance March 29, 1999
- ----------------------------------------------------- & Operations and Chief
Paul Bialek Financial Officer (Principal
Financial Officer)
/s/ KEITH ADAMS Controller March 29, 1999
- ----------------------------------------------------- (Principal Accounting Officer)
Keith Adams
/s/ JAMES W. BREYER Director March 29, 1999
- -----------------------------------------------------
James W. Breyer
/s/ MITCHELL KAPOR Director March 29, 1999
- -----------------------------------------------------
Mitchell Kapor
/s/ BRUCE JACOBSEN Director March 29, 1999
- -----------------------------------------------------
Bruce Jacobsen
</TABLE>
60
<PAGE> 62
INDEPENDENT AUDITORS' REPORT
The Board of Directors and Shareholders
RealNetworks, Inc.:
Under date of January 21, 1999, we reported on the consolidated balance
sheets of RealNetworks, Inc. and subsidiaries as of December 31, 1998 and 1997,
and the related consolidated statements of operations and comprehensive loss,
shareholders' equity (deficit), and cash flows for each of the years in the
three-year period ended December 31, 1998, which are included in the 1998 Annual
Report on Form 10-K of RealNetworks, Inc. In connection with our audits of the
aforementioned consolidated financial statements, we also audited the related
consolidated financial statement schedule of valuation and qualifying accounts.
This consolidated financial statement schedule is the responsibility of the
Company's management. Our responsibility is to express an opinion on this
consolidated financial statement schedule based on our audits.
In our opinion, such consolidated financial statement schedule, when
considered in relation to the basic consolidated financial statements taken as a
whole, presents fairly, in all material respects, the information set forth
therein.
/s/ KPMG LLP
Seattle, Washington
January 21, 1999
61
<PAGE> 63
SCHEDULE II -- VALUATION AND QUALIFYING ACCOUNTS
REALNETWORKS, INC. AND SUBSIDIARIES
YEARS ENDED DECEMBER 31, 1998, 1997 AND 1996
(IN THOUSANDS)
<TABLE>
<CAPTION>
BALANCE AT CHARGED TO BALANCE AT
BEGINNING COSTS AND COSTS AND END OF
DESCRIPTION OF PERIOD EXPENSES DEDUCTIONS PERIOD
----------- ---------- ---------- ---------- ----------
<S> <C> <C> <C> <C>
Year ended December 31, 1996:
Valuation accounts deduced from assets:
Allowance for doubtful accounts receivable and
sales returns.................................. $ 130 563 (310) 383
Valuation allowance for deferred tax assets...... 493 1,335 -- 1,828
====== ===== ====== ======
Year ended December 31, 1997:
Valuation accounts deduced from assets:
Allowance for doubtful accounts receivable and
sales returns.................................. 383 2,294 (1,848) 829
Valuation allowance for deferred tax assets...... 1,828 4,613 -- 6,441
====== ===== ====== ======
Year ended December 31, 1998:
Valuation accounts deduced from assets:
Allowance for doubtful accounts receivable and
sales returns.................................. 829 4,632 (4,295) 1,166
Valuation allowance for deferred tax assets...... 6,441 9,855 -- 16,296
====== ===== ====== ======
</TABLE>
62
<PAGE> 1
EXHIBIT 10.4
STOCK OPTION AGREEMENT
THIS STOCK OPTION AGREEMENT (this "Agreement") is entered into effective
as of __________ (the "Grant Date"), by REALNETWORKS, INC., a Washington
corporation (the "Company") and __________________ (the "Holder").
R E C I T A L S
A. The Company has adopted the RealNetworks, Inc. 1996 Stock Option Plan,
as amended and restated (the "Plan"), a copy of which has been provided to the
Holder (capitalized terms that are used but not defined in this Agreement will
have the meanings given those terms in the Plan).
B. The Holder is an employee of the Company, and has been designated by
the Administrative Committee to receive a stock option under the Plan.
NOW, THEREFORE, the Company and the Holder covenant and agree as follows:
1. GRANT OF THE OPTION. The Company hereby grants to the Holder a stock
option (the "Option") to acquire from the Company _________ (_______) shares of
the Common Stock, par value $.001, of the Company (the "Common Stock"), at the
price of $_____ per share (the "Option Price"). The Option is not intended to
qualify as an "incentive stock option," as that term is defined in Section 422
of the Internal Revenue Code of 1986, as amended.
2. TERM OF THE OPTION. Unless earlier terminated in accordance with the
provisions of the Plan, the Option will terminate on the earliest to occur of
(a) the expiration of Twenty (20) years from the Grant Date; (b) the expiration
of ninety (90) days following termination of the Holder's employment with the
Company for any reason other than death, Disability or cause (as defined in
Section 7.2(b) of the Plan); (c) the expiration of One (1) year following
termination of the Holder's employment with the Company on account of death or
Disability; and (d) the date of termination of the Holder's employment with the
Company for cause (as defined in Section 7.2(b) of the Plan).
3. VESTING. The vesting schedule applicable to the Option shall commence
on _________, 199_ (the "Vest Date"). The Option shall vest and become
exercisable in accordance with the following schedule:
<TABLE>
<CAPTION>
Cumulative Number
Date of Shares Vested (Percent)
---- ----------------- ---------
<S> <C>
18 MONTHS AFTER VEST DATE (30%)
24 MONTHS AFTER VEST DATE (40%)
30 MONTHS AFTER VEST DATE (50%)
36 MONTHS AFTER VEST DATE (60%)
42 MONTHS AFTER VEST DATE (70%)
48 MONTHS AFTER VEST DATE (80%)
54 MONTHS AFTER VEST DATE (90%)
60 MONTHS AFTER VEST DATE (100%)
</TABLE>
PROVIDED, HOWEVER, that, if the Holder's employment with the Company terminates
for any reason, the Option will not vest further following such termination. To
the extent the Option is vested, it shall be exercisable at any time and from
time to time prior to its termination as provided in Section 2.
<PAGE> 2
4. OTHER LIMITATIONS ON THE OPTION. The Option is subject to all of the
provisions of the Plan, including but not limited to Section 4.2 (which permits
adjustments to the Option upon the occurrence of certain corporate events such
as stock dividends, extraordinary cash dividends, reclassifications,
recapitalizations, reorganizations, split-ups, spin-offs, combinations,
exchanges of shares, and warrants or rights offerings), Section 6.10 (which
provides that the Company may repurchase any and all shares of Common Stock
issued upon exercise of the Option in the event the Holder's employment is
terminated for "cause"), and Section 7.1 (which applies in the event of an
Approved Transaction or Control Purchase).
5. EXERCISE OF THE OPTION. To exercise the Option, the Holder must do the
following:
(a) deliver to the Company a written notice, in the form attached to
this Agreement as Exhibit A, specifying the number of shares of Common Stock for
which the Option is being exercised;
(b) surrender this Agreement to the Company;
(c) tender payment of the aggregate Option Price for the shares for
which the Option is being exercised, which payment may be made (i) in cash or by
check; or (ii) by such other means as the Administrative Committee, in its sole
discretion, shall permit at the time of exercise;
(d) pay, or make arrangements satisfactory to the Administrative
Committee for payment to the Company of all federal, state and local taxes, if
any, required to be withheld by the Company in connection with the exercise of
the Option; and
(e) execute and deliver to the Company the documents required by the
Plan and any other documents required from time to time by the Administrative
Committee in order to promote compliance with applicable laws, rules and
regulations.
6. DELIVERY OF SHARE CERTIFICATE. As soon as practicable after the Option
has been duly exercised, the Company will deliver to the Holder a certificate
for the shares of Common Stock for which the Option was exercised. Unless the
Option has expired or been exercised in full, the Company and the Holder agree
to execute a new Stock Option Agreement, covering the remaining shares of Common
Stock that may be acquired upon exercise of the Option, which will be identical
to this Agreement except as to the number of shares of Common Stock subject
thereto. In lieu of replacing this Agreement in such manner, the Company may
affix to this Agreement an appropriate notation indicating the number of shares
for which the Option was exercised and return this Agreement to the Holder.
7. NONTRANSFERABILITY. The Option is not transferable other than by will
or the laws of descent and distribution, and the Option may be exercised during
the lifetime of the Holder only by the Holder or the Holder's court appointed
legal representative.
8. WARRANTIES AND REPRESENTATIONS OF THE HOLDER. By executing this
Agreement, the Holder accepts the Option, acknowledges receipt of a copy of the
Plan and the Prospectus, and agrees to comply with all of the provisions of this
Agreement and the Plan.
9. RIGHTS AS SHAREHOLDER. The Holder will have no rights as a shareholder
of the Company on account of the Option or on account of shares of Common Stock
which will be acquired upon exercise of the Option (but with respect to which no
certificates have been issued).
10. TAX WITHHOLDING. The Holder agrees to pay, or to make arrangements
satisfactory to the Administrative Committee for payment to the Company of, all
federal, state and local income and employment taxes, if any, required to be
withheld by the Company in connection with the exercise of the Option or any
sale, transfer or other disposition of any shares of Common Stock acquired upon
exercise of the Option. If the Holder fails to do so, then the Holder hereby
authorizes the Company to deduct all or any portion of such taxes from any
payment of any kind otherwise due to the Holder.
11. FURTHER ASSURANCES. The Holder agrees from time to time to execute
such additional documents as the Company may reasonably require to effectuate
the purposes of the Plan and this Agreement.
<PAGE> 3
12. BINDING EFFECT. This Agreement shall be binding upon the Holder and
the Holder's heirs, successors and assigns.
13. ENTIRE AGREEMENT; MODIFICATIONS. This Agreement, together with the
Plan and agreements referenced in this Agreement and/or the Plan, constitutes
the entire agreement and understanding between the Company and the Holder
regarding the subject matter hereof. Except as otherwise provided in the Plan,
no modification of the Option or this Agreement, or waiver of any provision of
this Agreement or the Plan, shall be valid unless in writing and duly executed
by the Company and the Holder. The failure of any party to enforce any of that
party's rights against the other party for breach of any of the terms of this
Agreement shall not be construed as a waiver of such rights as to any continued
or subsequent breach.
14. COST OF LITIGATION. In any action at law or in equity to enforce any
of the provisions or rights under this Agreement, the unsuccessful party to such
litigation, as determined by the court in a final judgment or decree, shall pay
the successful party or parties all costs, expenses and reasonable attorneys'
fees incurred by the successful party or parties (including without limitation
costs, expenses and fees in any appellate proceedings), and if the successful
party recovers judgment in any such action or proceeding, such costs, expenses
and attorneys' fees shall be included as part of the judgment.
15. GOVERNING LAW. This Agreement shall be governed by the laws of the
State of Washington.
IN WITNESS WHEREOF, the parties have executed this Agreement as of the day
and year first above written.
"COMPANY" REALNETWORKS, INC.
By_______________________________________
Its Vice President, General Counsel
and Secretary
"HOLDER" _________________________________________
<PAGE> 4
FORM OF EXERCISE OF OPTION
To: RealNETWORKS, INC.
1111 Third Avenue, Suite 2900
Seattle, WA 98101
The undersigned holds Option Number NQ-___ (the "Option"), represented by
a Stock Option Agreement dated effective as of _____________ (the "Agreement"),
granted to the undersigned pursuant to the RealNetworks, Inc. 1996 Stock Option
Plan, as Amended and Restated (the "Plan"). The undersigned hereby exercises the
Option and elects to purchase _______________ shares (the "Shares") of Common
Stock of RealNetworks, Inc. (the "Company") pursuant to the Option. This notice
is accompanied by full payment of the Option Price of $______ per share for the
Shares in cash or by check or in another manner permitted by Section 5(c) of the
Agreement. The undersigned has also paid, or made arrangements satisfactory to
the Administrative Committee administering the Plan for payment of, all federal,
state and local taxes, if any, required to be withheld by the Company in
connection with the exercise of the Option.
Date:______________________
Signature of Holder
_________________________________________
EXHIBIT A
<PAGE> 1
EXHIBIT 21.1
SUBSIDIARIES OF REALNETWORKS, INC.
<TABLE>
<CAPTION>
Entity Jurisdiction
- ------ ------------
<S> <C>
RealNetworks, Ltd. United Kingdom
RealNetworks K.K. Japan
RealNetworks, SARL France
RealNetworks GmbH Germany
</TABLE>
<PAGE> 1
EXHIBIT 23.1
CONSENT OF INDEPENDENT AUDITORS
The Board of Directors and Shareholders
RealNetworks, Inc.:
We consent to the incorporation by reference in the registration statements
(Nos. 333-42579, 333-53127 and 333-63333) on Form S-8 of RealNetworks, Inc. and
subsidiaries of our reports dated January 21, 1999, relating to the consolidated
balance sheets of RealNetworks, Inc. and subsidiaries as of December 31, 1998
and 1997, and the related consolidated statements of operations and
comprehensive loss, shareholders' equity (deficit) and cash flows for each of
the years in the three-year period ended December 31, 1998, and related
schedule, which reports appear in the December 31, 1998 Annual Report on Form
10-K of RealNetworks, Inc.
/s/ KPMG LLP
Seattle, Washington
March 29, 1999
<TABLE> <S> <C>
<ARTICLE> 5
<MULTIPLIER> 1,000
<S> <C>
<PERIOD-TYPE> YEAR
<FISCAL-YEAR-END> DEC-31-1998
<PERIOD-START> JAN-01-1998
<PERIOD-END> DEC-31-1998
<CASH> 51,876
<SECURITIES> 37,901
<RECEIVABLES> 6,107
<ALLOWANCES> 1,166
<INVENTORY> 180
<CURRENT-ASSETS> 97,930
<PP&E> 12,355
<DEPRECIATION> 6,082
<TOTAL-ASSETS> 128,059
<CURRENT-LIABILITIES> 37,723
<BONDS> 987
0
0
<COMMON> 34
<OTHER-SE> 83,482
<TOTAL-LIABILITY-AND-EQUITY> 128,059
<SALES> 0
<TOTAL-REVENUES> 64,839
<CGS> 0
<TOTAL-COSTS> 12,390
<OTHER-EXPENSES> 73,439
<LOSS-PROVISION> 0
<INTEREST-EXPENSE> 0
<INCOME-PRETAX> (16,414)
<INCOME-TAX> 0
<INCOME-CONTINUING> (16,414)
<DISCONTINUED> 0
<EXTRAORDINARY> 0
<CHANGES> 0
<NET-INCOME> (16,414)
<EPS-PRIMARY> (.51)
<EPS-DILUTED> (.51)
</TABLE>
