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UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
Washington, D.C. 20549
_____________________________
FORM 10-K
(Mark one)
X Annual Report Pursuant to Section 13 or 15(d) of the Securities Exchange
---- Act of 1934 for the fiscal year ended December 31, 1998.
OR
Transition Report Pursuant to Section 13 or 15(d) of the Securities
Exchange Act of 1934.
Commission File Number:
000-24643
_____________________________
DIGITAL RIVER, INC.
(Exact name of registrant as specified in its charter)
DELAWARE 41-1901640
(State or other jurisdiction of (I.R.S. Employer
incorporation or organization) Identification No.)
9625 WEST 76TH STREET, SUITE 150
EDEN PRAIRIE, MINNESOTA 55344
(address of principal executive offices)
(612) 253-1234
(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 $0.01 par value
_____________________________
Indicate by check mark whether the registrant (1) has filed all reports required
to be filed by Section 13 or 15(d) of the Securities Exchange act of 1934 during
the preceding 12 months (or for such shorter period that the registrant was
required to file such reports), and (2) has been subject to filing requirements
for the past 90 days.
Yes X No
----- -----
Indicate by check mark if disclosure of delinquent filers pursuant to Item
405 of Regulation S-K is not contained herein, and will not be contained, to
the best of registrant's knowledge, in definitive proxy or information
statements incorporated by reference in Part III of this Form 10-K or any
amendment to this Form 10-K [X].
The aggregate market value of the Common Stock of the registrant held by
non-affiliates as of March 5, 1999 was $421,828,254.
The number of shares of Common Stock outstanding at March 5, 1999 was
19,696,663 shares.
DOCUMENTS INCORPORATED BY REFERENCE
Certain sections of the Registrant's definitive Proxy Statement for the 1999
Annual Meeting of Stockholders are incorporated by reference in Part III of
this Form 10-K to the extent stated herein.
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PART I
ITEM 1. BUSINESS.
OVERVIEW
Digital River is a leading provider of comprehensive electronic commerce
outsourcing solutions to software publishers and online retailers. The
Company has developed a technology platform that allows it to provide a suite
of electronic commerce services to its software publisher and online retailer
clients, including electronic software delivery ("ESD"). The Company also
provides data mining and merchandising services to assist clients in
increasing Internet page view traffic to, and sales through, their Web
stores. Rather than maintaining its own branded Web store that would compete
with its clients, Digital River provides an outsourcing solution that allows
its clients to promote their own brands while leveraging Digital River's
investment in infrastructure and technology. As of March 5, 1999, the Company
had contracts with 1,621 software publisher clients and 1,174 online retailer
clients, including Corel Corporation, Cyberian Outpost, Inc., Lotus
Development Corporation, Micro Warehouse, Inc., Network Associates, Inc.,
Symantec Corporation, Kmart Corporation, CompUSA, Inc. and Wal-Mart Stores,
Inc., and maintained a database of more than 100,000 software products from
its various software publisher clients, including more than 30,000 software
titles and more than 70,000 digital images and fonts. Through March 5, 1999,
the Company had completed more than 610,000 transactions for more than
490,000 unique end-users.
Digital River's proprietary commerce network server ("CNS") technology
serves as the platform for the Company's solutions. The CNS incorporates
custom software applications that enable ESD, Web store authoring, fraud
prevention, export control, merchandising programs and online registration,
and features a database of more than 100,000 software products. Using its CNS
platform, the Company creates Web stores for its clients that replicate the
look and feel of each client's Web site. End-users enter the client site and
are then seamlessly transferred to the Company's system. End-users can then
browse for products and make purchases online, and, once purchases are made,
the Company delivers the products directly to the end-user, primarily through
ESD. The Company also provides transaction processing services and collects
and maintains critical information about end-users. This information can
later be used by the Company's clients to facilitate add-on or upgrade sales
and for other direct marketing purposes. The Company actively manages direct
marketing campaigns for its clients, and also delivers purchase information
and Web store traffic statistics to its clients on a regular basis.
INDUSTRY BACKGROUND
GROWTH OF THE INTERNET AND ELECTRONIC COMMERCE. The Internet has emerged
as a significant global communications medium, enabling millions of people to
share information and conduct business electronically. A number of factors
have contributed to the growth of the Internet and its commercial use,
including: (i) the large and growing installed base of personal computers in
homes and businesses; (ii) improvements in network infrastructure and
bandwidth; (iii) easier and cheaper access to the Internet; (iv) increased
awareness of the Internet among consumer and business users; and (v) the
rapidly expanding availability of online content and commerce which increases
the value to users of being connected to the Internet.
The increasing functionality, accessibility and overall usage of the
Internet have made it an attractive commercial medium. Online retailers can
interact directly with end-users and can frequently adjust their featured
selections, shopping interfaces and pricing. The ability to reach and serve a
large and global group of end-users electronically from a central location
and the potential for personalized low-cost customer interaction provide
additional economic benefits for online retailers. Unlike traditional retail
channels, online retailers do not have the burdensome costs of managing and
maintaining a significant physical retail store infrastructure or the
continuous printing and mailing costs of catalog marketing. Because of these
advantages, online retailers have the potential to build large, global
customer bases quickly and to achieve superior economic returns over the long
term. An increasingly broad base of products is being sold successfully
online, including computers, travel services, brokerage services, automobiles
and music, as well as software products.
THE RETAIL SOFTWARE MARKET. The Company believes that the market for
retail software is large and will continue to grow. According to the Software
Publishers Association, sales of PC applications software in the United
States and Canada reached $10.6 billion in 1996. The traditional channels for
the retail sale of software products are highly fragmented and include
regional and national superstore retail chains, catalog companies and small
single location stores. The superstores and catalog companies carry hundreds
to thousands of software products, while the single location stores generally
carry only a limited number.
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Traditional sales channels have inherent limitations and disadvantages for
software publishers, retailers and end-users. A significant limitation of
physical retail stores is the limited amount of available shelf space. As a
result, competition for shelf space is intense, and often only the major
software publishers are able to effectively distribute their software
products. Even these publishers usually cannot offer their total available
product offerings in retail stores. In addition, software publishers
typically must grant generous rights of return because of the high cost of
inventory and the risk of inventory obsolescence. As a result, software
publishers effectively bear the risk of any difference between projected and
actual sales, creating uncertainty as to future sales and revenue recognition
risks. Physical retailers must also make significant investments in real
estate, personnel and inventories. Similarly, direct mail distribution is
constrained by practical catalog size limitations, which restrict both the
number of products and the information about those products that can be
included in a catalog. Direct mail distribution also involves printing
expenses, mailing costs, inherent delays in reacting to price and product
changes and low response rates. With both physical retail and direct mail
distribution, there is a significant lead time between the development or
upgrading of software and its introduction into the market. Finally,
traditional sales channels are typically characterized by low end-user
registration rates, and provide software publishers little information on
end-user behavior, demographics and product demand.
ADVANTAGES OF ESD. The Internet provides a compelling solution that
addresses many of the limitations of traditional distribution methods. The
Internet is particularly well-suited for the distribution of most software
because software products can be purchased and delivered quickly,
conveniently and cost-effectively to an end- user's home or office computer
through ESD. The Company believes that ESD is an effective means of delivery
today for most software applications. Although current Internet bandwidth
restrictions currently render ESD less effective as a means of delivery for
large software applications (delivery of software applications of greater
than 10 megabytes can be impractical at slower modem speeds), the Company
believes that as Internet bandwidth increases, ESD will become increasingly
attractive even for such software titles. Accordingly, the Company believes
that ESD will represent an increasing share of online software sales and will
be critical to online retailers' success. In addition, unlike physical retail
stores or catalogs, shelf space on the Internet is virtually unlimited,
enabling software publishers to offer the full range of their software
products. ESD significantly reduces or eliminates many of the costs in the
distribution chain, including manufacturing, packaging, shipping and
warehousing costs, such as costs related to returns and inventory management.
OPPORTUNITY FOR ELECTRONIC COMMERCE OUTSOURCING. The Company believes
that the market for software sales online continues to grow rapidly.
However, unlike established physical distribution channels for shrink-wrapped
software, there is currently no established, comprehensive electronic
distribution source for online retailers. The Company believes that the
distribution of software products via ESD is complex and requires up-front
and ongoing investments in secure, reliable and scaleable systems.
Accordingly, the Company believes that a substantial market opportunity
exists for a comprehensive, cost-effective, outsourced electronic commerce
solution that provides software publishers and online retailers with access
to a critical mass of software products and a robust distribution and
transaction network.
THE DIGITAL RIVER SOLUTION
The Company has developed a technology platform that enables it to provide
a comprehensive suite of electronic commerce services to its software
publisher and online retailer clients, including ESD. The Company also
leverages its merchandising expertise to increase traffic and sales for its
clients. Rather than maintaining its own branded Web store that would compete
with its clients, Digital River provides an outsourcing solution for ESD and
merchandising services that enables its clients to promote their own brands
while leveraging Digital River's investment in infrastructure. In addition,
this approach enables Digital River to leverage its clients' brand
investments and the traffic at its clients' sites to maximize the number of
transactions completed through Digital River.
BENEFITS TO SOFTWARE PUBLISHERS. The Company's electronic commerce
solution enables software publishers to offer the complete library of their
software products directly to end-users from their Web stores and through the
Company's network of online retailers. This benefit is particularly
significant for smaller software publishers who have limited market access
through traditional distribution methods. The Company's solution also
provides major software publishers a channel for their underdistributed
products permitting them to offer online their complete product catalog. In
addition, through its 100% end-user registration and data warehousing,
Digital River provides software publishers with valuable end-user information
that can facilitate targeted marketing, upgrade notification and
sophisticated merchandising strategies. Finally, by exploiting the
distribution relationships Digital River has developed with a large network
of online retailers, software publishers can reduce or eliminate the need for
multiple
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retailer relationships, thereby lowering administrative costs and reducing
the number of master copies of their software in existence for distribution.
BENEFITS TO ONLINE RETAILERS. Online retailers can use Digital River's
robust CNS technology to sell software products online, without having to
build and maintain their own electronic commerce infrastructure. In addition,
Digital River enables online retailers to offer their end-users access to
virtually all of Digital River's inventory of software products, without the
burden of developing and maintaining relationships with hundreds of software
publishers. Like software publishers, online retailers enjoy the cost savings
from online fulfillment and the database marketing benefits offered by
Digital River. Online retailers can effectively outsource electronic commerce
functionality while building their own brands online. Online retailers also
eliminate the cost and risk associated with carrying inventory and the risk
of inventory obsolescence. The Company also allows niche market and high
traffic Web sites to become online retailers at minimal cost.
BENEFITS TO END-USERS. Digital River's solution emphasizes convenience by
allowing end-users to purchase and receive software products online
distributed through ESD twenty-four hours a day, seven days a week ("24x7"),
from their home or office. End-users are not required to make a trip to the
store, can act immediately on a purchase impulse, and can locate software
products that are difficult to find. Because Digital River has a global
reach, it can deliver an extremely broad selection to end-users in rural,
international or other locations that cannot support retail stores. Software
products purchased online can either be quickly and conveniently downloaded
and installed through ESD or delivered physically. Using the Company's
sophisticated search engine technology, end-users visiting retailers' online
Web stores can access virtually all of Digital River's inventory of software
products. End-users also benefit from the protection of Digital River's
archiving service, through which the Company guarantees replacement of
software in the event of accidental destruction through computer error or
malfunction. End-users also benefit from Digital River's 24x7 ESD support and
readily available upgrades.
STRATEGY
The Company's objective is to become the leading provider of comprehensive
electronic commerce outsourcing solutions to software publishers and online
retailers. The Company intends to achieve its objective through the following
key strategies:
DEVELOP AND EXPAND RELATIONSHIPS WITH SOFTWARE PUBLISHERS. The Company
plans to continue to build its inventory of software products through
additional contractual relationships with software publishers. As of March 5,
1999, the Company had signed contracts with 1,621 software publishers,
representing more than 100,000 software products and 1,300 Web stores. The
Company believes that its ability to develop Web hosting relationships with
its software publisher clients increases its reach to end-users and provides
the basis for a long term relationship with its software publisher clients.
The Company further believes that the large number of software products
offered by the Company from its software publisher clients will be critical
to the Company's ability to deliver a compelling inventory of products to
online retailer clients.
AGGRESSIVELY EXPAND NETWORK OF ONLINE RETAILERS. The Company believes
that by increasing the number of points of entry to its CNS, Digital River
will increase the number of transactions over its network. Accordingly, in
addition to expanding and developing relationships with software publishers,
the Company seeks to expand aggressively its network of online retailer
clients. Online retailer clients include traditional store-based and mail
order retailers with a Web presence, online retailers dedicated to online
commerce, as well as high traffic or niche Web site operators desiring to add
electronic commerce functionality. The Company had contracts with 1,174
online retailers as of March 5, 1999. The Company's model enables it to
leverage its clients' marketing resources to direct traffic to its software
distribution network. The Company expects online retailers to represent an
increasing percentage of its sales.
PROVIDE COMPLEMENTARY SOLUTIONS. Digital River intends to continue to be
a neutral provider of cost-effective outsourcing solutions that complement
the business models of its software publisher and online retailer clients.
The Company does not maintain its own branded Web store. Instead, the Company
provides an outsourcing solution that enables its clients to promote their
own brands while leveraging Digital River's investment in infrastructure and
technology. Digital River therefore leverages its clients' investments in
their brands to generate sales. The Company may co-invest with its clients
from time to time to help drive traffic to its clients' Web stores and to
Digital River-assisted transactions.
PROVIDE CLIENTS VALUE-ADDED SERVICES. The Company believes its growing
data warehouse of end-user purchasing information provides it with a powerful
tool to assist clients with value-added services, such as targeted
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advertising, promotions and direct response merchandising. The Company offers
merchandising and marketing programs, customer support and communications
programs, advertising placement services, and Web store design services. The
Company intends to continue to expand its programs and believes that these
programs help build stronger partnerships with its software publisher and
online retailers, while enabling its clients to increase sales of software on
their sites.
MAINTAIN TECHNOLOGY LEADERSHIP. The Company believes that its CNS
technology has given it a competitive advantage in the market for ESD
outsourcing solutions. The Company will continue to invest in and enhance its
CNS technology in order to increase redundancy, reliability and bandwidth, to
expand services and to reduce costs. For example, The Company has begun to
use its CNS technology with non-software companies to provide them with
electronic commerce marketing and data communication solutions. By
leveraging its fixed-cost infrastructure, Digital River will improve its
ability to provide low cost, high value services to its clients while
utilizing the latest technology.
EXPAND INTERNATIONALLY. Digital River will continue to expand
internationally to gain access to additional software publishers, online
retailers and end-users. The Company intends to replicate its domestic
strategy by building its inventory of international and foreign language
software products and expanding its distribution through software publishers
and online retailers. The Company believes that significant opportunities
exist internationally to increase sales and to further leverage its scaleable
infrastructure.
SERVICES
The Company provides a broad range of services to its software publisher
and online retailer clients, including Web store hosting, ESD, physical
fulfillment and merchandising services.
WEB STORE HOSTING. The Company hosts the Web stores for all of its online
retailer clients and for those software publisher clients that choose this
option. The Company's outsourcing solution is mission-critical for many of
its software publisher and online retailer clients. Therefore, the Company
has a data center that is designed to provide its clients with the
performance they require for continuous Web store operations. The data center
features redundant, high speed connections to the Internet, 24x7 security and
monitoring, back-up generators and dedicated power.
Digital River can quickly and efficiently create Web stores for its
clients, which can be accessed easily by clicking on a "buy button" on a
client's existing Web site. The end-user is then transferred to a Web store
hosted on Digital River's CNS, which replicates the look and feel of the
client Web site. The end-user can then shop for products and make purchases
online. By replicating the look and feel of its clients' Web sites, Digital
River supports clients in conducting electronic commerce under their own
brands. Digital River's solution allows clients to choose either ESD or
physical delivery, and clients also benefit from Digital River's 24x7 ESD
customer support and archiving services. The transaction information is
captured and added to Digital River's data warehouse. The Company's ability
to retrieve and manipulate this information creates a powerful data mining
tool, which can be used for targeted merchandising to end-users through
e-mails, banner presentations and special offers.
ESD. The Company offers clients access to its ESD capabilities to permit
delivery of software products to an end-user's computer via the Internet. ESD
eliminates many of the costs that exist in the physical distribution chain,
such as manufacturing, packaging, shipping, warehousing and inventory
carrying and handling costs. Delivery is fulfilled when a copy is made from
the master on the Company's CNS and is then securely downloaded to the
end-user via the Internet. Digital River's ESD distribution model not only
reduces costs, thereby increasing margins available to software publishers
and online retailers, but also solves the shelf space problem constraining
product availability and sales. While most software publishers use the
Company's Web hosting services, certain software publishers use only the
Company's ESD services, which provide them with online distribution through
the Company's extensive network of online retailers.
PHYSICAL FULFILLMENT. In addition to distribution through ESD, the
Company offers clients physical distribution services. The Company maintains
an inventory of physical products, generally on consignment from its clients
that select this option, for shipment to end-users. The Company believes
physical fulfillment services are important to its ability to provide a
comprehensive electronic commerce outsourcing solution.
MERCHANDISING SERVICES. The Company offers a range of merchandising
services to its clients to help them drive additional traffic to their Web
stores. Software publisher and online retailer clients are provided with
detailed electronic and hard copy reports of transactions on their Web
stores, as well as end-user marketing information
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about visits to their Web stores. The CNS captures Web page visits, banner
and pricing information and other data that can be used by the software
publishers and online retailers to analyze their Web stores' success.
The Company also offers advanced merchandising services to assist software
publishers and online retailers in increasing response rates for their
marketing efforts. These services include e-mail campaigns for special
promotions, upgrade notification programs, and the presentation of
complementary products, bundled products or other programs designed to
increase average order size based on a targeted end-user profile. The Company
participates in co-op dollar and market development fund programs with its
clients and buys selected banner placements in bulk to support clients'
promotional campaigns. In addition, Digital River tests and analyzes
merchandising techniques, such as promotional pricing and banner advertising,
based on information gathered in the CNS data warehouse.
CLIENTS
The Company distributes software products through a network of software
publishers and online retailers. Online retailer clients include traditional
store-based and direct mail retailers with a Web presence, online retailers
dedicated to online commerce, as well as high traffic or niche Web site
operators desiring to add electronic commerce functionality. In a typical
online retailer contract, the Company is responsible for (i) a payment to the
online retailer based on a percentage of net sales of software products that
the Company distributes through the online retailer's Web site, (ii) the
processing of payments made by end-users, (iii) the delivery of the software
products to end-users, (iv) the payment of applicable credit card transaction
fees, (v) the payment and filing of applicable sales taxes and (vi) the
distribution of a report to the online retailer detailing sales activity
processed by the Company. The Company expects to support traditional physical
retailers in developing their online stores for the sale of software products
online. While most software publishers use the Company's Web hosting
services, certain software publishers use only the Company's "channel
services," whereby the software publishers are provided with ESD and physical
fulfillment capability through the Company's extensive network of online
retailers. In a typical software publisher contract, the Company is
responsible for (i) the maintenance of master copies of software products in
a secure format for distribution to end-users, (ii) a payment to the software
publisher for the cost of software products that the Company distributes
through either a retailers' Web site or through the publisher's host Web
site, (iii) the processing of payments made by end-users, (iv) the delivery
of software products to end-users, (v) the payment of applicable credit card
transaction fees, (vi) the payment and filing of applicable sales taxes and
(vii) the distribution of a report to the software publisher detailing sales
activity processed by the Company.
As of March 5, 1999, the Company had 1,621 contracts with software
publishers and 1,174 contracts with online retailers. Typically, there is
some delay between signing contracts and gathering the necessary materials to
bring a new client online. As of March 5, 1999, the Company had 1,295
software publishers and 936 online retailers activated within its CNS. During
the year ended December 31, 1998, the Company completed transactions for
1,149 software publishers and 426 online retailers. The Company's clients
include:
<TABLE>
<CAPTION>
SOFTWARE PUBLISHERS ONLINE RETAILERS
- ------------------------------------- -----------------------------------
<S> <C>
WEB HOSTING AND CHANNEL SERVICES BuySafe, Inc.
Adaptec, Inc. CompUSA, Inc.
Corel Corporation Cyberian Outpost, Inc.
JASC, Inc. Kmart Corporation
PowerQuest Corporation Micro Warehouse, Inc.
Ulead Systems, Inc. Multiple Zones International, Inc.
Shopping.com
CHANNEL SERVICES ONLY Software Warehouse plc
Cendant Corporation US WEST Internet
Lotus Development Corporation Wal-Mart Stores, Inc.
Network Associates, Inc.
QUALCOMM Incorporated
Symantec Corporation
</TABLE>
SALES AND MARKETING
The Company markets its services directly to software publishers and
online retailers. The Company does not operate its own Web store because of
its strategy to serve as a neutral provider of electronic commerce
outsourcing
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solutions. This strategy allows the Company to avoid competing with its
clients. Generally, the Company's direct marketing to end-users focuses on
supporting the marketing and promotional efforts of its clients in driving
traffic to their Web stores. This direct marketing effort leverages the
Company's extensive data warehouse, which enables the Company to create and
quickly implement marketing programs targeted at specific end-user segments.
By providing consistent quality service, branding client order pages with its
name and logo, billing credit card transactions under the Digital River name
and engaging in brand positioning, advertising and promotion, the Company
intends to establish the Digital River brand as a trusted name for ESD and
electronic commerce outsourcing solutions among software publishers, online
retailers and end-users.
The Company's sales and marketing organization is divided into three
groups: the Strategic Sales Group, the Product Management Group and the
Account Development Group. The Strategic Sales Group focuses on large
software publishers and online retailers, including traditional physical
retailers, with significant online revenue potential. These sales are
typically complex in nature and involve a lengthy sales cycle. Contracts with
these larger clients often involve certain incentives, principally pricing
concessions. The Company makes decisions with respect to such contract
incentives on a case by case basis. The Product Management Group focuses on
all other software publishers and online retailers. Generally, these sales
involve a much shorter sales cycle, are managed primarily through a telesales
effort and result in the new client selecting one of the Company's standard
programs. The Account Development Group serves existing clients and provides
them with merchandising and database marketing assistance designed to
increase revenues. The Company leverages its extensive inventory of software
products and large number of end-users to create opportunities for targeted
marketing and bundled sales. As of March 5, 1999, the Company had 59
employees engaged in sales and marketing.
The Company currently markets its services to clients via direct
marketing, print advertising, trade show participation and other media
events. The Company plans to increase its expenditures on direct marketing
and print advertising, as well as introducing online advertising efforts
directed at potential clients. In addition, the Company recently opened a
sales office in the United Kingdom.
TECHNOLOGY
Digital River delivers its electronic commerce outsourcing solution using
its proprietary CNS technology, which enables the sale and distribution of
software products via the Internet.
ARCHITECTURE. The Company's scaleable CNS is designed to handle tens of
thousands of different Web stores and millions of software products. The CNS
consists of a pool of network servers and a proprietary software application
that serves dynamic Web pages using an Oracle database. The Company's CNS was
designed to scale to support growth by adding CPUs, memory, disk drives and
bandwidth without substantial changes to the application. The CNS software
code is written in modular layers, enabling the Company to quickly adapt in
response to industry changes, including bandwidth opportunities, payment
processing changes, international requirements for taxes and export
screening, new technologies such as Java, XML, DHTML, VRML, SET, banking
procedures and encryption technologies. The CNS product search system allows
end-users to search for items across millions of potential products and
thousands of categories specific to various product specifications, while
maintaining a fast page response that is acceptable to the end-user. The
Company uses sophisticated database indexing coupled with a dynamic cache
system to provide flexibility and speed. These caches help increase the
overall speed of each page and facilitate complex searches across the entire
inventory of software products. The CNS has also been designed to index,
retrieve and manipulate all transactions that flow through the system,
including detailed commerce transaction and end-user interaction data. This
enables the Company to create proprietary market profiles of each end-user
and groups of end-users that can be used to create merchandising campaigns.
The Company's CNS is also used for internal purposes, including reporting and
maintenance for fraud detection and prevention, physical shipping, return
authorizations, back order processing and full transaction auditing and
reporting capabilities for all commerce functions.
WEB STORE MAINTENANCE. Clients' Web stores are built and maintained using
the CNS centralized management system. Global changes that affect all Web
stores or groups of Web stores can be made as easily as changes to an
individual Web store. Client Web stores include a main store and may
optionally include several "focus stores" and "channel sites" to which highly
targeted traffic may be routed. Clients may also link specific locations on
their Web stores to detailed product or category areas of the stores, in
order to better target their end-users' interests.
SECURITY. Digital River's security systems apply both to access to
internal systems and to illegal access to commerce data via the Internet.
Internally, logins and passwords are maintained for all systems, with
additional logins, passwords and IP access control granted on an individual
basis to only the required commerce areas the
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person is responsible for. Firewalls prevent unauthorized access from
outside. The Company relies on certain encryption and authentication
technology licensed from third parties to provide secure transmission of
confidential information, such as end-user credit card numbers. Unix, Oracle
and Web server security additionally restrict access from the outside to the
appropriate transaction data. The CNS security system is designed not to
interfere with the end-user experience. Product wrappers, clearing-house
processing, and additional password mechanisms that negatively impact ESD
performance are not needed. The CNS security system never allows direct
access to the clients' products and ensures that an end-user requests ESD
through a valid page and has purchased the product.
DATA CENTER OPERATIONS. Continuous data center operations are crucial to
the Company's success. All transaction data is backed up periodically and all
inventory data is archived and kept in fireproof storage facilities. The
Company's network software constantly monitors clients' Web stores and
internal system functions and notifies systems engineers if any unexpected
conditions arise. The Company currently leases six T1 lines from multiple
vendors and maintains a policy of adding additional lines if more than 50% of
its bandwidth capacity is utilized. Accordingly, if one line fails the other
lines are able to assume the capacity of the failed line. The Company's data
center is located in a single location at the Company's main facilities in
Eden Prairie, Minnesota. In the case of electrical power failure, the Company
has a back-up power supply system. The Company has also installed a FM-200
automatic fire suppression system in the data center. The data center
currently incorporates redundant systems consisting of additional servers and
arrays. The Company currently has no automatic switchover in the case of
equipment or software failure, although it has plans to implement further
redundancy in the future.
PRODUCT DEVELOPMENT
Digital River's product development strategy is to enhance the technology
and features of its CNS. To this end, the Company has numerous development
projects in process including, but not limited to, Internet optimization
tools, end-user profiling and collaboration technologies and online
interactive customer service. Product development and operations expenses
(which include customer service, data center operations and
telecommunications infrastructure) were $230,000, $1.5 million and $5.4
million in 1996, 1997 and 1998, respectively. As of March 5, 1999, the
Company employed 32 persons in product development.
To remain competitive, the Company must continue to enhance and improve
the responsiveness, functionality and features of the CNS and the underlying
network infrastructure. The Internet and the online commerce industry are
characterized by rapid technological change, changes in user and client
requirements and preferences, frequent new product and service introductions
embodying new technologies and the emergence of new industry standards and
practices that could render the Company's existing CNS proprietary technology
and systems obsolete. The Company's success will depend, in part, on its
ability to both license and internally develop leading technologies useful in
its business, enhance its existing services, develop new services and
technology that address the increasingly sophisticated and varied needs of
its clients, and respond to technological advances and emerging industry
standards and practices on a cost-effective and timely basis. The development
of the CNS technology and other proprietary technology entails significant
technical and business risks. There can be no assurance that the Company will
successfully use new technologies effectively or adapt its proprietary
technology and transaction-processing systems to customer requirements or
emerging industry standards. If the Company is unable, for technical, legal,
financial or other reasons, to adapt in a timely manner to changing market
conditions, client requirements or emerging industry standards, its business,
financial condition and results of operations could be materially adversely
affected.
COMPETITION
The electronic commerce market is new, rapidly evolving and intensely
competitive, and the Company expects competition to intensify in the future,
particularly in the area of electronic sale and distribution of software
products. The Company currently competes directly with other providers of
electronic commerce solutions, including CyberSource Corporation, Preview
Systems, Inc., Release Software Corporation and TechWave, Inc. The Company
also competes indirectly with software companies that offer tools and
services for electronic commerce, including companies that provide a broad
range of Internet and server solutions such as Microsoft Corporation and
Netscape Communications Corporation, as well as a large number of companies
that provide tools and services enabling one or more of the transaction
processing functions of electronic commerce, such as transaction control,
data security, customer interaction and database marketing. In addition to
direct competition with other transaction processing providers and enablers
and indirect competition with other providers of electronic commerce software
and systems, the Company competes with companies that sell and distribute
software products via the Internet, including Amazon.com, Inc., beyond.com
Corporation, Ingram Micro Inc. and Tech Data Corporation. The Company also
competes with companies such as AltaVista (a subsidiary of Compaq Computer
Corporation), America Online, Inc.,
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Excite, Inc., Infoseek Corporation, Lycos, Inc. and Yahoo! Inc., which
specialize in electronic commerce or derive a substantial portion of their
revenues from electronic commerce and may themselves offer, or provide means
for others to offer, software products.
The Company believes that the principal competitive factors in its market
are breadth of services and software product offerings, software publisher
and online retailer relationships, brand recognition, system reliability and
capacity, price, customer service, speed and accessibility and ease of use,
convenience and speed of fulfillment. There can be no assurance that the
online retailers and the other companies listed above will not compete
directly with the Company by adopting a similar business model. Moreover,
while certain of these companies are also clients or potential clients of the
Company, they may compete with the Company's electronic commerce outsourcing
solution to the extent that they develop electronic commerce systems or
acquire such systems from other software vendors or service providers.
Many of the Company's current and potential competitors have longer
operating histories, larger customer bases, greater brand recognition and
significantly greater financial, marketing and other resources than the
Company. In addition, larger, well-established and well-financed entities may
acquire, invest in or form joint ventures with online competitors as the use
of the Internet and other online services increases. In addition, new
technologies and the expansion of existing technologies, such as price
comparison programs that select specific titles from a variety of Internet
Web sites may direct end-users to online retailers that compete with the
Company, which would increase competitive pressures on the Company. Increased
competition may result in reduced operating margins, as well as a loss of
market share. Further, as a strategic response to changes in the competitive
environment, the Company may from time to time make certain pricing, service
or marketing decisions or acquisitions that could have a material adverse
effect on its business, financial condition and results of operations. There
can be no assurance that the Company will be able to compete successfully
against current and future competitors, and any inability to do so could have
a material adverse effect on the Company's business, financial condition and
results of operations.
INTELLECTUAL PROPERTY
The Company regards trademarks, copyrights, trade secrets and other
intellectual property as critical to its success, and relies on trademark,
trade secret protection and confidentiality and/or license agreements with
its employees, clients, partners and others to protect its proprietary
rights. The Company's policy is to seek to protect its proprietary position
by, among other methods, filing United States and foreign patent applications
related to its proprietary technology, inventions and improvements that are
important to the development of its business. Proprietary rights relating to
the Company's technologies will be protected from unauthorized use by third
parties only to the extent that they are covered by valid and enforceable
patents or are effectively maintained as trade secrets. While the Company
currently has twelve patent applications pending in the United States, none
have yet been issued and there can be no assurance that any pending patent
applications now or hereafter filed by, or licensed to, the Company will
result in patents being issued. The Company has filed certain petitions to
correct certain fee deficiencies for its pending patent applications and
there can be no assurance that such petitions can be granted or that the
Company will elect to pursue these applications. In addition, the laws of
certain foreign countries do not protect the Company's intellectual property
rights to the same extent as do the laws of the United States. The patent
position of high technology companies involves complex legal and factual
questions and, therefore, their validity and enforceability cannot be
predicted with certainty. There can be no assurance that any of the Company's
patent applications, if issued, will not be challenged, invalidated, held
unenforceable or circumvented, or that the rights granted thereunder will
provide proprietary protection or competitive advantages to the Company
against competitors with similar technology. Furthermore, there can be no
assurance that others will not independently develop similar technologies or
duplicate any technology developed by the Company. The Company has one
registered trademark for "Digital River." Effective trademark and trade
secret protection may not be available in every country in which the
Company's products and services are made available online. There can be no
assurance that the steps taken by the Company to protect its proprietary
rights will be adequate or that third parties will not infringe or
misappropriate the Company's trade secrets, trademarks, trade dress and
similar proprietary rights. In addition, there can be no assurance that
others will not independently develop substantially equivalent intellectual
property. A failure by the Company to protect its intellectual property in a
meaningful manner could have a material adverse effect on the Company's
business, financial condition and results of operations. In addition,
litigation may be necessary in the future to enforce the Company's
intellectual property rights, to protect the Company's trade secrets or to
determine the validity and scope of the proprietary rights of others. Such
litigation could result in substantial costs and diversion of management and
technical resources, which could have a material adverse effect on the
Company's business, financial condition and results of operations.
8.
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In addition, there can be no assurance that other parties will not assert
infringement claims against the Company. From time to time, the Company may
receive notice of claims of infringement of other parties' proprietary
rights. There can be no assurance that such claims will not be asserted or
prosecuted against the Company in the future or that any past or future
assertions or prosecutions will not materially adversely affect the Company's
business, financial condition and results of operations. The defense of any
such claims, whether such claims are with or without merit, could be
time-consuming, result in costly litigation and diversion of technical and
management personnel, cause product shipment delays or require the Company to
develop non-infringing technology or enter into royalty or licensing
agreements. Such royalty or licensing agreements, if required, may not be
available on terms acceptable to the Company, or at all. In the event of a
successful claim of infringement against the Company and the failure or
inability of the Company to develop non-infringing technology or license the
infringed or similar technology on a timely basis, the Company's business,
financial condition and results of operations could be materially adversely
affected.
EMPLOYEES
As of March 5, 1999, the Company employed 148 people, including 15 in
administration, 74 in product development and operations and 59 in sales and
marketing. The Company also employs independent contractors and other
temporary employees. None of the Company's employees is represented by a
labor union, and the Company considers its employee relations to be good.
Competition for qualified personnel in the Company's industry is intense,
particularly among software development and other technical staff. The
Company believes that its future success will depend in part on its continued
ability to attract, hire and retain qualified personnel.
EXECUTIVE OFFICERS OF THE REGISTRANT.
The following table sets forth information regarding the Company's
executive officers as of December 31, 1998:
<TABLE>
<CAPTION>
NAME AGE POSITION
- --------------------- ------ --------------------------------------
<S> <C> <C>
Joel A. Ronning 42 Chief Executive Officer
Perry W. Steiner 33 President
Robert E. Strawman 39 Chief Financial Officer and Treasurer
Kelly J. Wical 42 Chief Technology Officer
Draper M. Jaffray 36 Vice President of Business Development
Terence M. Strom 54 Vice President of Marketing
Gregory R.L. Smith 32 Secretary and Controller
Randy J. Womack 34 Chief Information Officer
</TABLE>
Mr. Ronning founded the Company in February 1994 and has been President
and Chief Executive Officer and a director of the Company since that time.
From February 1994 to July 1998, Mr. Ronning was also President of the
Company. Since May 1995, Mr. Ronning has served as Chairman of the Board of
Directors of Tech Squared Inc., a direct catalog marketer of software and
hardware products. From May 1995 to July 1998, Mr. Ronning served as Chief
Executive Officer, Chief Financial Officer and Secretary of Tech Squared.
From May 1995 to August 1996, Mr. Ronning also served as the President of
Tech Squared. Mr. Ronning is the founder of MacUSA, Inc., a wholly-owned
subsidiary of Tech Squared, and has served as a director of MacUSA, Inc.
since April 1990. From April 1990 to July 1998, Mr. Ronning also served as
the Chief Executive Officer of MacUSA, Inc. Mr. Ronning also serves as a
director of the Software Publishers Association and JASC, Inc.
Mr. Steiner joined the Company in July 1998 as President and has served as
a director of the Company since April 1998. From January 1997 to July 1998,
Mr. Steiner served as Vice President of Wasserstein Perella & Co., Inc., an
investment banking firm, and as Vice President of Wasserstein Perella
Ventures, Inc., the general partner of Wasserstein Adelson Ventures, L.P., a
venture capital fund. From June 1993 to December 1996, Mr. Steiner was a
principal of TCW Capital, a group of leveraged buyout funds managed by Trust
Company of the West. Mr. Steiner also serves as a director of Tech Squared.
Mr. Strawman joined the Company in April 1998 as Chief Financial Officer
and Treasurer. From September 1995 to April 1998, Mr. Strawman served as
Director of Finance and Vice President of Finance for Caribou Coffee Company,
Inc., a gourmet coffee retailer. From 1989 to 1995, Mr. Strawman held various
financial positions at Software Etc. Stores, Inc., a specialty retailer of
software, most recently as Chief Financial Officer.
9.
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Mr. Wical joined the Company in April 1997 as Chief Technology Officer.
From 1992 to April 1997, Mr. Wical was Director of Development and Chief
Scientist/Architect of the ConText Server Division of Oracle Corporation.
From 1987 to 1992, Mr. Wical was co-founder and Vice President of Research
and Development for Artificial Linguistics, Inc., a developer of text
management software.
Mr. Jaffray joined the Company in December 1996 as Vice President of
Business Development. From January 1996 to December 1996, Mr. Jaffray was a
partner in The Firm, a computer products manufacturers representative. From
1991 to 1995, Mr. Jaffray served as Director of Sales for Tech Squared.
Mr. Strom joined the Company as Vice President of Marketing in August
1998. From June 1993 to February 1997, Mr. Strom held various positions at
Egghead, Inc., a computer software retailer, most recently as Chief Executive
Officer. From January 1990 to June 1993, Mr. Strom held various positions at
Best Buy Co., Inc., a consumer electronics retailer, most recently as Senior
Vice President of Marketing.
Mr. Smith joined the Company as Controller in June 1997 and has served as
Secretary and Controller since December 1997. From November 1995 to June
1997, Mr. Smith was Manager, External Reporting and Investor Relations at
Secure Computing Corporation, a developer of network and Internet security
products. From June 1988 to November 1995, Mr. Smith held various positions
with Ernst & Young LLP.
Mr. Womack joined the Company in October 1997 as Chief Information
Officer. From May 1997 to September 1997, Mr. Womack was Director of
Engineering at Xerox Corporation. From 1992 to 1997, Mr. Womack held various
positions, including Development Manager at Oracle Corporation. From 1989 to
1992, Mr. Womack was Director of Technical Services at Artificial
Linguistics, Inc.
RISK FACTORS
In addition to the other information provided in this report, the
following risk factors should be considered carefully in evaluating the
Company and its business.
LIMITED OPERATING HISTORY
We have a very limited operating history. We were incorporated in February
1994 and were considered a development stage company through August 1996. We
conducted our first online sale through a client's Web store in August 1996,
and we are still in the early stages of development. Our business and
prospects must be considered in light of the risks encountered by companies
in their early stages of development, particularly companies in new and
rapidly evolving markets such as electronic commerce. Some of these risks
relate to our ability to:
- maintain or develop relationships with software publishers and
online retailers;
- execute our business and marketing strategy;
- continue to develop and upgrade our technology and
transaction-processing systems;
- provide superior customer service and order fulfillment;
- respond to competitive developments; and
- retain and motivate qualified personnel.
We may not be successful in addressing these risks, and if we are not
successful, our business, financial condition and operating results could be
adversely affected. Our current and future expense levels are based largely
on our planned operations and our estimates of future sales. It is difficult,
however, for us to accurately forecast future sales, because our business is
still new and our market is still developing. We may be unable to adjust
spending in a timely manner to compensate for any unexpected revenue
shortfall. As a result, any significant shortfall in sales would immediately
and adversely affect our business, financial condition and operating results.
As a result of our rapidly evolving business and our limited operating
history, we believe that period-to-period comparisons of our operating
results are not necessarily meaningful and investors should not rely upon our
historical results as an indication of future performance.
HISTORY OF LOSSES AND EXPECTATION OF FUTURE LOSSES
We have incurred significant losses since we were formed. As of December
31, 1998, we had an accumulated deficit of approximately $18.1 million. We
intend to continue to expend significant financial and management resources
on the development of additional services, sales and marketing, improved
technology and expanded
10.
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operations. As a result, we expect operating losses and negative cash flows
to continue for the foreseeable future. In addition, we anticipate our
operating losses to increase significantly from current levels. Our sales may
not increase or even continue at their current level, and we may not be
profitable or generate cash from operations in future periods.
POTENTIAL FLUCTUATIONS IN OPERATING RESULTS
Our quarterly and annual operating results are likely to fluctuate
significantly in the future due to a variety of factors, many of which are
outside our control. Some of these factors include:
- our ability to retain existing software publishers and online
retailers as clients;
- our ability to attract new software publishers and online retailers
as clients;
- the introduction of new Web sites, Web stores, services or products
by us or by others;
- price competition and margin erosion;
- the rate at which the online market for the purchase of software
products continues to emerge;
- our ability to continue to upgrade and develop our systems and
infrastructure to meet emerging market needs and remain competitive
in our service offerings;
- termination of any account that represents a significant portion of
our sales;
- technical difficulties or system downtime;
- our ability to attract new personnel as needed as our business grows;
- our ability to increase the proportion of sales from online retailers,
which sales generally carry higher gross margins;
- the failure of Internet bandwidth to increase over time or any
increase in the cost of Internet bandwidth; and
- U.S. and foreign regulations relating to our business.
We also may offer favorable economic terms to certain software publishers
and online retailers in order to attract or retain their business, which
would reduce our gross margins. In addition, we may experience a decline in
sales in the month of December due to a potential reduction in the number of
hours business end-users spend online over the holidays. Due to these
factors, our annual or quarterly operating results may not meet the
expectations of securities analysts and investors. If this happens, the
trading price of our Common Stock would likely significantly decline.
CLIENT CONCENTRATION; LENGTHY SALES CYCLE
Sales initiated through the Web stores of three software publisher clients
collectively accounted for approximately 29% and 25% of our sales in 1997 and
1998, respectively. We expect that a small percentage of our clients will
continue to account for a substantial portion of our sales for the
foreseeable future. Contracts with these clients are generally short term in
nature. If any one of these contracts is not renewed or otherwise ends, our
business, financial condition and operating results could be materially
adversely affected.
We market our services directly to software publishers and online
retailers. These relationships are typically complex and take time to
finalize. Due to operating procedures in many large organizations, a
significant amount of time may pass between selection of our products by key
decision makers and the signing of a contract. As a result, the period
between the initial sales call and this signing of a contract with a software
publisher or online retailer with significant sales potential typically
ranges from six to twelve months, and can be longer. Therefore, the timing of
sales from these software publisher and online retailer clients is difficult
to predict. Delays in signing contracts with significant software publisher
or online retailer clients could materially adversely affect our business,
financial condition and operating results.
RISKS ASSOCIATED WITH ESD; MARKET ACCEPTANCE OF ESD
Our success will depend in large part on growth in end-user acceptance of
ESD as a method of distributing software products. ESD is a relatively new
method of distributing software products and the growth and market acceptance
of ESD is highly uncertain and subject to a number of risks. Factors that
will influence market acceptance of ESD include:
11.
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- the availability of sufficient bandwidth to enable purchasers to
rapidly download software products;
- the cost of time-based Internet access;
- the number of software products that are available for purchase
through ESD as compared to those available through physical delivery;
and
- the level of end-user comfort with the process of downloading software
via the Internet, including the ease of use and lack of concern about
transaction security.
If ESD does not achieve widespread market acceptance, our business,
financial condition and operating results would be materially adversely
affected. Even if ESD achieves widespread acceptance, we cannot be certain
that we will overcome the substantial existing and future technical
challenges associated with electronically delivering software reliably and
consistently on a long-term basis. Our failure to do so would materially
adversely affect our business, financial condition and operating results.
DEPENDENCE ON CONTINUED GROWTH IN ELECTRONIC COMMERCE AND INTERNET
INFRASTRUCTURE DEVELOPMENT
Sales of software products using the Internet do not currently represent a
significant portion of overall software sales. We depend on the growing use
and acceptance of the Internet as an effective medium of commerce by
end-users. Rapid growth in the use of and interest in the Internet and other
online services is a recent development. No one can be certain that
acceptance and use of the Internet and other online services will continue to
develop or that a sufficiently broad base of consumers will adopt, and
continue to use, the Internet and other online services as a medium of
commerce. We rely on purchasers of software who have historically used
traditional means of commerce to purchase software products. If we are to be
successful, these software purchasers must accept and use the Internet as a
means of purchasing software and exchanging information and we cannot predict
the rate at which purchasers will do so.
The Internet may fail as a commercial marketplace for a number of reasons,
including potentially inadequate development of the necessary network
infrastructure or delayed development of enabling technologies and
performance improvements. If the number of Internet users or their use of
Internet resources continues to grow, it may overwhelm the existing Internet
infrastructure. Delays in the development or adoption of new standards and
protocols required to handle increased levels of Internet activity or
increased governmental regulation could also have a similar effect. In
addition, growth in Internet usage which is not matched by comparable growth
in the infrastructure supporting Internet usage could result in slower
response times or adversely affect usage of the Internet.
DEPENDENCE ON SOFTWARE PUBLISHERS
We are entirely dependent upon the software publishers that supply us with
software, and the availability of such software is unpredictable. Our
contracts with our software publisher clients are generally one year in
duration, with an automatic renewal provision for additional one-year
periods, unless we are provided with a written notice at least 90 days before
the end of the contract. As is common in our industry, we have no long-term
or exclusive contracts or arrangements with any software publishers that
guarantee the availability of software products. We cannot be certain that
the software publishers that currently supply software to us will continue to
do so or that we will be able to establish new relationships with software
publishers. If we cannot develop and maintain satisfactory relationships with
software publishers on acceptable commercial terms, if we are unable to
obtain sufficient quantities of software, if the quality of service provided
by such software publishers falls below a satisfactory standard or if
software returned to us exceeds our clients' expectations, our business,
financial condition and results or operations could be materially adversely
affected.
DEPENDENCE ON ONLINE RETAILERS
Our strategy is dependent upon increasing our sales of software products
through online retailers. We have historically generated substantially all of
our sales from the sale of software to end-users that were initiated through
the Web stores of our software publisher clients. In 1997 and 1998, less than
6% of our sales were generated through the Web stores of our online retailer
clients. We do not know if we will be successful in establishing
relationships with additional online retailers or if our current
relationships will continue. If we are unable to expand our relationships
with online retailers, we will likely be unable to continue to grow our
business and establish meaningful market share.
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RISK OF LACK OF CAPACITY; RISK OF SYSTEM FAILURE; SYSTEM DEVELOPMENT RISKS
We provide commerce, marketing and delivery services to software
publishers, online retailers and end-users through our CNS
transaction-processing and client management systems. The systems also
maintain an electronic inventory of products and gather consumer marketing
information. The satisfactory performance, reliability and availability of
the CNS and the underlying network infrastructure are critical to our
operations, our level of customer service, and our reputation and ability to
attract and retain clients. Our systems and operations are vulnerable to
damage or interruption from:
- fire, flood and other natural disasters; and
- power loss, telecommunications failure, break-ins and similar events.
We presently have no offsite back-up facilities and do not carry
sufficient business interruption insurance to fully compensate us for losses
that may occur. Despite the use of network security devices, our servers are
vulnerable to computer viruses, physical or electronic break-ins and similar
disruptions, which could lead to interruptions, delays, loss of data or the
inability to accept and fulfill end-user orders. Any systems interruption
that impairs our ability to accept and fill customer orders reduces the
attractiveness of our product and service offerings to software publishers,
online retailers and end-users, which could materially adversely affect our
business, financial condition and operating results.
We have experienced periodic interruptions, affecting all or a portion of
our systems, which we believe will continue to occur from time to time. We
periodically enhance and expand our technology and transaction-processing
systems, and network infrastructure and other technologies to accommodate
increases in the volume of traffic on the CNS. We may not be successful in
our efforts to improve and increase the capacity of our network
infrastructure. We may not be able to anticipate increases, if any, in the
use of the CNS or to expand and upgrade its systems and infrastructure to
accommodate such increases. Our inability to add software and hardware or to
develop and upgrade existing technology, transaction-processing systems or
network infrastructure to handle increased traffic on the CNS may cause
unanticipated system disruptions, slower response times and poor customer
service, including problems filling customer orders, any of which could
materially adversely affect our business, financial condition and operating
results. In addition, additional network capacity may not be available from
third-party suppliers when we need it. Our network and our suppliers'
networks may be unable to maintain an acceptable data transmission
capability, especially if demands on the CNS increase. Our failure to
maintain an acceptable data transmission capability could significantly
reduce demand for our services, which would significantly impair our
business, financial condition and operating results.
ELECTRONIC COMMERCE SECURITY RISKS
A significant barrier to electronic commerce and communications is the
secure transmission of confidential information over public networks. We rely
on encryption and authentication technology licensed from third parties to
provide the security and authentication necessary for secure transmission of
confidential information, such as customer credit card numbers. A party who
is able to circumvent our security measures could misappropriate proprietary
information or interrupt our operations. Any such compromise or elimination
of our security could materially adversely affect our business, financial
condition and operating results.
We may be required to expend significant capital and other resources to
protect against such security breaches or to address problems caused by such
breaches. Concerns over the security of the Internet and other online
transactions and the privacy of users may also inhibit the growth of the
Internet and other online services generally, and the Web in particular,
especially as a means of conducting commercial transactions. To the extent
that activities of the Company or third-party contractors involve the storage
and transmission of proprietary information, such as credit card numbers,
security breaches could damage our reputation and expose us to a risk of loss
or litigation and possible liability. Our security measures may not prevent
security breaches and failure to prevent such security breaches may
materially adversely affect our business, financial condition and operating
results.
COMPETITION
The electronic commerce market is new, rapidly evolving and intensely
competitive. We expect competition to intensify in the future, particularly
in the area of electronic sale and distribution of software products. We
currently compete directly with other providers of electronic commerce
solutions, including CyberSource Corporation, Preview Systems, Inc., Release
Software Corporation and TechWave, Inc. We compete indirectly with software
companies that offer tools and services for electronic commerce, including
companies that provide a broad range of
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Internet and server solutions such as Microsoft Corporation and Netscape
Communications Corporation. We also compete indirectly with a large number of
companies that provide tools and services enabling one or more of the
transaction processing functions of electronic commerce, such as transaction
control, data security, customer interaction and database marketing.
In addition, we compete with companies that use their own systems to sell
and distribute software products via the Internet, including Amazon.com,
Inc., beyond.com Corporation, Ingram Micro Inc. and Tech Data Corporation. We
also compete with companies such as AltaVista (a subsidiary of Compaq
Computer Corporation), America Online, Inc., Excite, Inc., Infoseek
Corporation, Lycos, Inc. and Yahoo! Inc., which specialize in electronic
commerce or derive a substantial portion of their revenues from electronic
commerce and may themselves offer, or provide means for others to offer,
software products.
- We believe that the principal competitive factors in our market
include:
- breadth of service and software product offerings;
- software publisher and online retailer relationships;
- brand recognition;
- system reliability and capacity;
- price;
- customer service;
- speed, accessibility and ease of use;
- convenience; and
- speed of fulfillment.
The online retailers and the other companies listed above may compete
directly with us by adopting a similar business model. Moreover, while some
of these companies are also clients or potential clients of ours, they may
compete with our electronic commerce outsourcing solution if they develop
electronic commerce systems or acquire such systems from other software
vendors or service providers. Many of our current and potential competitors
have longer operating histories, larger customer bases, greater brand
recognition and significantly greater financial, marketing and other
resources than do we. In addition, larger, well-established and well-financed
entities may acquire, invest in or form joint ventures with online
competitors as the use of the Internet and other online services increases.
In addition, new technologies and the expansion of existing technologies,
such as price comparison programs that select specific titles from a variety
of Internet Web sites, may direct end-users to online retailers that compete
with us, which would increase competitive pressures on us. Increased
competition may result in reduced operating margins, as well as a loss of
market share. Further, in response to changes in the competitive environment,
we may from time to time make pricing, service or marketing decisions or
acquisitions that could materially adversely affect our business, financial
condition and operating results. We may not be able to compete successfully
against current and future competitors, and any inability to do so could
materially adversely affect our business, financial condition and operating
results.
RAPID TECHNOLOGICAL CHANGE
To remain competitive, we must continue to enhance and improve the
responsiveness, functionality and features of the CNS and the underlying
network infrastructure. The Internet and the electronic commerce industry are
characterized by rapid technological change, changes in user requirements and
preferences, frequent new product and service introductions embodying new
technologies and the emergence of new industry standards and practices that
could render our technology and systems obsolete. Our success will depend, in
part, on our ability to both license and internally develop leading
technologies to enhance our existing services, develop new services and
technology that address the increasingly sophisticated and varied needs of
our clients, and respond to technological advances and emerging industry
standards and practices on a cost-effective and timely basis. The development
of the CNS technology and other proprietary technology involves significant
technical and business risks. We may fail to use new technologies effectively
or adapt our proprietary technology and systems to customer requirements or
emerging industry standards. If we are unable to adapt to changing market
conditions, client requirements or emerging industry standards, our business,
financial condition and operating results could be materially adversely
affected.
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MANAGEMENT OF POTENTIAL GROWTH; NEW MANAGEMENT TEAM; LIMITED EXECUTIVE
OFFICER RESOURCES
We have rapidly and significantly expanded our operations and anticipate
that further significant expansion will be required to address potential
growth in our client base and market opportunities. From January 1, 1997 to
March 5, 1999, we increased our number of employees from 11 to 148. This
expansion is placing a significant strain on our managerial, operational and
financial resources. Most of our existing senior management personnel joined
us within the last two years, including our President, who joined us in July
1998, our Vice President of Marketing, who joined us in August 1998 and our
Chief Financial Officer, who joined us in April 1998. Joel A. Ronning, our
Chief Executive Officer, also serves as the Chairman of the Board of Tech
Squared Inc., a principal stockholder of ours. Our new employees include a
number of key managerial, technical and operations personnel who we have not
yet fully integrated. We expect to add additional key personnel in the near
future, including direct sales and marketing personnel. To manage the
expected growth of our operations and personnel, we will be required to:
- improve existing and implement new operational, financial and
management controls, reporting systems and procedures;
- install new management information systems; and
- train, motivate and manage our employees.
We may not be able to install management information and control systems
in an efficient and timely manner, and our current or planned personnel,
systems, procedures and controls may not be adequate to support our future
operations. In addition, we may not be able to hire, train, retain, motivate
and manage required personnel or to successfully identify, manage and exploit
existing and potential market opportunities. If we are unable to manage
growth effectively, our business, financial condition and operating results
will be materially adversely affected.
DEPENDENCE ON KEY PERSONNEL; NEED FOR ADDITIONAL PERSONNEL
Our future success significantly depends on the continued services and
performance of our senior management, particularly Joel A. Ronning, our Chief
Executive Officer, and Kelly J. Wical, our Chief Technology Officer. Our
performance also depends on our ability to retain and motivate our other
executive officers and key employees. The loss of the services of any of our
executive officers or other key employees could materially adversely affect
our business, financial condition and operating results. We have long-term
employment agreements only with Mr. Ronning and Perry W. Steiner, our
President. We only maintain a "key person" life insurance policy on Mr.
Ronning. Our future success also depends on our ability to identify, attract,
hire, train, retain and motivate other highly skilled technical, managerial,
operations, merchandising, sales and marketing and customer service
personnel. Competition for such personnel is intense, and we may not
successfully attract, assimilate or retain sufficiently qualified personnel.
The failure to retain and attract the necessary personnel could materially
adversely affect our business, financial condition and operating results.
INTELLECTUAL PROPERTY
Trademarks, patents, copyrights, trade secrets and other intellectual
property are critical to our success, and we rely on trademark, trade secret
protection and confidentiality and/or license agreements with our employees,
clients, partners and others to protect our proprietary rights. We seek to
protect our proprietary position by, among other methods, filing United
States and foreign patent applications related to our proprietary technology,
inventions and improvements that are important to the development of our
business. Proprietary rights relating to our technologies will be protected
from unauthorized use by third parties only to the extent that they are
covered by valid and enforceable patents or copyrights or are effectively
maintained as trade secrets. While we currently have twelve patent
applications pending in the United States, none has been issued. Pending
patent applications may not result in patents being issued. We have filed
certain petitions to correct certain fee deficiencies for our pending patent
applications but these petitions may not be granted. In addition, the laws of
some foreign countries do not protect our intellectual property rights to the
same extent as do the laws of the United States. The patent position of high
technology companies involves complex legal and factual questions and,
therefore, we cannot predict their validity and enforceability with
certainty. Even if issued, our patent applications may be challenged,
invalidated, held unenforceable or circumvented. Further, rights granted
under future patents may not provide proprietary protection or competitive
advantages to us against competitors with similar technology. Others may
independently develop similar technologies or duplicate technologies
developed by us. We have one registered trademark for "Digital River."
Effective trademark and trade secret protection may not be available in every
country in which our products and services are made available online. The
steps we have taken to protect our proprietary rights may not be adequate,
and third parties may infringe or misappropriate our trade secrets,
trademarks, trade dress and similar proprietary rights. In addition, others
may independently develop substantially equivalent intellectual property. Any
15.
<PAGE>
significant failure to protect our intellectual property in a meaningful
manner could materially adversely affect our business, financial condition
and operating results. In addition, litigation may be necessary in the future
to enforce our intellectual property rights, to protect our trade secrets or
to determine the validity and scope of the proprietary rights of others. Such
litigation could result in substantial costs and diversion of management and
technical resources, which could materially adversely affect our business,
financial condition and operating results. From time to time we may receive
notice of claims of infringement of other parties' proprietary rights. Any
future assertions or prosecutions of such claims may materially adversely
affect our business, financial condition and operating results. Defending any
such claim, whether such claims are valid or not, could be time-consuming,
result in costly litigation and diversion of technical and management
personnel, cause product shipment delays or require us to develop
non-infringing technology or enter into royalty or licensing agreements. Such
royalty or licensing agreements, if required, may not be available on terms
acceptable to us, or at all. If a third party succeeds in any infringement
action against us and we fail or are unable to develop non-infringing
technology or license the infringed or similar technology on a timely basis,
our business, financial condition and operating results could be materially
adversely affected.
LIABILITY FOR SOFTWARE PRODUCTS CONTENT
Claims may be made against us for negligence, copyright or trademark
infringement or other theories based on the nature and content of software
products that are delivered electronically and subsequently distributed to
others. Although we carry general liability insurance, our insurance may not
cover potential claims of this type or may not be adequate to cover all costs
incurred in defense of potential claims or to indemnify us for all liability
that may be imposed. Any costs or imposition of liability that is not covered
by insurance or in excess of insurance coverage could materially adversely
affect our business, financial condition and operating results.
FUTURE CAPITAL NEEDS; UNCERTAINTY OF ADDITIONAL FUNDING
We require substantial working capital to fund our business. We have had
significant operating losses and negative cash flow from operations since
inception and expect to continue to do so for the foreseeable future. We
believe our existing capital resources, will be sufficient to meet our
capital requirements for at least the next 24 months. Our capital
requirements depend on several factors, including the rate of market
acceptance of our products, the ability to expand our client base, the growth
of sales and marketing and other factors. If capital requirements vary
materially from those currently planned, we may require additional financing
sooner than anticipated. If additional funds are raised through the issuance
of equity securities, the percentage ownership of the stockholders of the
Company will be reduced, stockholders may experience additional dilution, or
such equity securities may have rights, preferences or privileges senior to
those of the holders of the Company's Common Stock. Additional financing may
not be available when needed on terms favorable to us or at all. If adequate
funds are not available or are not available on acceptable terms, we maybe
unable to develop or enhance our services, take advantage of future
opportunities or respond to competitive pressures, which could materially
adversely affect the Company's business, financial condition and operating
results.
GOVERNMENT REGULATION AND LEGAL UNCERTAINTIES
We are not currently subject to direct regulation by any domestic or
foreign governmental agency, other than regulations applicable to businesses
generally, export control laws and laws or regulations directly applicable to
electronic commerce. However, due to the increasing popularity and use of the
Internet, it is possible that a number of laws and regulations may be adopted
with respect to the Internet covering issues such as:
- user privacy;
- pricing;
- content;
- copyrights;
- distribution; and
- characteristics and quality of products and services.
Furthermore, the growth and development of the market for electronic
commerce may prompt calls for more stringent consumer protection laws that
may impose additional burdens on those companies conducting business online.
The adoption of additional laws or regulations may decrease the growth of the
Internet or other online services, which could, in turn, decrease the demand
for our products and services and increase our cost of doing business, or
otherwise adversely affect our business, financial condition and operating
results.
16.
<PAGE>
The applicability of existing laws governing issues such as property
ownership, copyrights, encryption and other intellectual property issues,
taxation, libel, export or import matters, obscenity and personal privacy to
the Internet is uncertain. The vast majority of such laws were adopted prior
to the advent of the Internet and related technologies. As a result, they do
not contemplate or address the unique issues of the Internet and related
technologies. Changes to such laws intended to address these issues,
including some recently proposed changes, could create uncertainty in the
Internet marketplace. Such uncertainty could reduce demand for our services
or increase the cost of doing business due to increased costs of litigation
or increased service delivery costs.
In addition, as our services are available over the Internet in multiple
states and foreign countries, such jurisdictions may claim that we are
required to qualify to do business as a foreign corporation in each such
state of foreign country. We are qualified to do business only in Minnesota,
Iowa and Washington. Failure to qualify as a foreign corporation in a
jurisdiction where we are required to do so could subject us to taxes and
penalties and could result in our inability to enforce contracts in such
jurisdictions. New legislation or regulation, the application of laws and
regulations from jurisdictions whose laws do not currently apply to our
business, or the application of existing laws and regulations to the Internet
and other electronic services could materially adversely affect our business,
financial condition and operating results.
RISK OF INTERNATIONAL SALES
Although we sell software products to end-users outside the United States,
we might not succeed in expanding our international presence. Conducting
business outside of the United States is subject to certain risks, including:
- changes in regulatory requirements and tariffs;
- reduced protection of intellectual property rights;
- difficulties in distribution;
- the burden of complying with a variety of foreign laws; and
- political or economic constraints on international trade or
instability.
In addition, some software exports from the United States are subject to
export restrictions as a result of the encryption technology in such software
and we may become liable to the extent we violate such restrictions. We might
not successfully market, sell and distribute our products in local markets
and we cannot be certain that one or more of such factors will not materially
adversely affect our future international operations, and consequently, our
business, financial condition and operating results.
SALES AND OTHER TAXES
We do not currently collect sales, use or other similar taxes with respect
to ESD or shipments of software products into states other than Minnesota.
However, one or more local, state or foreign jurisdictions may seek to impose
sales or use tax collection obligations on out of state companies, such as
Digital River, which engage in electronic commerce. In addition, any new
operation in states outside Minnesota could subject shipments into such
states to state sales or use taxes under current or future laws. A successful
assertion by one or more states or any foreign country that we should collect
sales, use or other taxes on the sale of merchandise could materially
adversely affect our business, financial condition and operating results.
CONTROL BY EXISTING STOCKHOLDERS
As of February 1, 1999, our executive officers, directors and affiliates
beneficially own approximately 33% of the outstanding shares of Common Stock.
As a result, they may have the ability to effectively control us and direct
our affairs and business, including the election of directors and approval of
significant corporate transactions. Such concentration of ownership may also
have the effect of delaying, deferring or preventing a change in control of
Digital River, and make some transactions more difficult or impossible
without the support of such stockholders, including proxy contests, mergers
involving Digital River, tender offers, open-market purchase programs or
other purchases of Common Stock that could give our stockholders the
opportunity to realize a premium over the then-prevailing market price for
shares of Common Stock.
17.
<PAGE>
VOLATILITY OF STOCK PRICE
The trading price of our Common Stock has been and is likely to continue
to be highly volatile and could be subject to wide fluctuations in response
to factors such as:
- actual or anticipated variations in quarterly operating results;
- announcements of technological innovations;
- new products or services offered by Digital River or our competitors;
- changes in financial estimates by securities analysts;
- conditions or trends in the Internet and online commerce industries;
- changes in the economic performance and/or market valuations of other
Internet, online service industries;
- changes in the economic performance and/or market valuations of other
Internet, online service or retail companies;
- announcements by the Company of significant acquisitions, strategic
partnerships, joint ventures or capital commitments;
- additions or departures of key personnel;
- sales of Common Stock; and
- other events or factors, many of which are beyond our control.
In addition, the stock market in general, and the Nasdaq National Market
and the market for Internet-related and technology companies in particular,
has experienced extreme price and volume fluctuations that have often been
unrelated or disproportionate to the operating performance of such companies.
The trading prices of many technology companies' stocks are at or near
historical highs and these trading prices and multiples are substantially
above historical levels. These trading prices and multiples may not be
sustained. These broad market and industry factors may materially, adversely
affect the market price of the Common Stock, regardless of our actual
operating performance. In the past, following periods of volatility in the
market price of a company's securities, securities class-action litigation
has often been instituted against such companies. Such litigation, if
instituted, could result in substantial costs and a diversion of management's
attention and resources, which would materially adversely affect the
Company's business, financial condition and operating results.
YEAR 2000 COMPLIANCE
Like many other companies, Year 2000 computer issues create certain risks
for Digital River. If our internal management information systems and
external electronic commerce information systems do not correctly recognize
the process date information beyond the year 1999, it could have a
significant adverse impact on the Company's ability to process client and
end-user transactions, which could create significant potential liability for
the Company. To address potential Year 2000 issues with its internal and
external systems, we have evaluated these systems. Remediation is proceeding,
and we currently plan to have changes to these systems completed and tested
by March 31, 1999. These activities are intended to encompass all of our
major systems, including electronic commerce, sales processing, sales and
financial systems. The initial assessment indicated that certain internal
systems should be upgraded or replaced as part of a solution to the Year 2000
problem. The costs incurred to date related to these programs have not been
material. The estimated cost to be incurred by us in the future is not
expected to exceed $10,000. These estimates do not include potential costs
related to any customer or other claims or the cost of internal software and
hardware replaced in the normal course of business. These estimates are based
on our current assessment of the projects and may change as the project
progresses.
We are also working with key suppliers of products and services to monitor
their progress toward Year 2000 compliance. The failure of a major supplier
to become Year 2000 Compliant on a timely basis, or any system conversion by
a supplier that is incompatible with our systems could materially adversely
affect our business, financial condition and operating results. In addition
our business, financial condition and operating results may be materially
adversely affected if our end-users are unable to use their credit cards due
to the Year 2000 issues that are not rectified by their credit card vendors.
We have begun internal discussions concerning contingency planning to
address potential problem areas with internal systems and with suppliers and
other third parties. We expect assessment, remediation and contingency
planning activities to continue throughout calendar year 1999 with the goal
of resolving all material internal and external systems and third party
issues.
18.
<PAGE>
We deem "Year 2000 Compliant" to mean software that can individually, and
in combination with all other systems, products or processes with which the
software is designed to interface, continue to operate successfully (both in
functionality and performance in all material respects) over the transition
into the twenty first century when used in accordance with the documentation
relating to such software. Year 2000 Compliance includes being able to,
before, on and after January 1, 2000 substantially conform to the following:
- use logic pertaining to dates which allow users to identify and/or use
the century portion of any date fields without special processing;
- respond to all date elements and date input to resolve any ambiguity
as to century in a disclosed, defined and pre-determined manner; and
- provide date information in ways which are unambiguous as to century.
This may be achieved by permitting or requiring the century to be specified
or where the data element is represented without a century, the correct century
is unambiguous for all manipulations involving that element.
ITEM 2. PROPERTIES.
The Company currently subleases approximately 32,900 square feet of office
and warehouse space in Eden Prairie, Minnesota. The sublease agreement
expires on July 31, 2003. The Company also leases on a month to month basis
approximately 7,000 square feet of warehouse space from Tech Squared, Inc. in
Edina, Minnesota. Rent for the warehouse space is calculated pursuant to a
formula based on square footage utilized. In addition, the Company has a
month to month lease for approximately 900 square feet of office space in
suburban London that houses its European sales office. The Company believes
that its facilities will be adequate to accommodate the Company's needs for
the foreseeable future.
ITEM 3. LEGAL PROCEEDINGS.
From time to time, the Company may be involved in litigation relating to
claims arising out of its ordinary course of business. The Company presently
is not subject to any material legal proceedings.
ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS.
None.
PART II
ITEM 5. MARKET FOR REGISTRANT'S COMMON EQUITY AND RELATED STOCKHOLDER MATTERS.
The Company's Common Stock is traded on the Nasdaq National Market under
the symbol "DRIV." Public trading of the Common Stock commenced on August 11,
1998. Prior to that, there was no public market for the Common Stock. The
following table sets forth, for the periods indicated, the high and low sale
price per share of the Common Stock on the Nasdaq National Market.
<TABLE>
<CAPTION>
1998 HIGH LOW
<S> <C> <C>
Third Quarter (from August 11, 1998) $ 13.25 $ 5.00
Fourth Quarter $ 44.00 $ 5.63
1999
First Quarter (through March 5, 1999) $ 61.38 $ 27.44
</TABLE>
As of March 5, 1999 there were approximately 190 holders of record of the
Company's Common Stock. On March 5, 1999, the last sale price reported on
the Nasdaq National Market System for the Company's Common Stock was $31.13
per share.
The Company has never declared or paid any cash dividends on its capital
stock. The Company intends to retain any future earnings to support
operations and to finance the growth and development of the Company's
business and does not anticipate paying cash dividends for the foreseeable
future.
19.
<PAGE>
The effective date of the Company's first registration statement, filed on
Form S-1 under the Securities Act of 1933 (File No. 333-56787), was August
11, 1998 (the "Registration Statement"). The class of securities registered
was Common Stock and all securities registered were sold in this initial
public offering (the "IPO"). The managing underwriters for the offering were
BT Alex. Brown, BancAmerica Robertson Stephens and Bear, Stearns & Co. Inc.
Pursuant to the Registration Statement, the Company sold 3,000,000 shares of
its Common Stock for an aggregate gross offering price of $25.5 million.
In connection with the IPO, the Company incurred expenses of approximately
$2.8 million, of which approximately $1.8 million represented underwriting
discounts and commissions and approximately $1 million represented other
expenses related to the offering. All such expenses were direct or indirect
payments to others. The net offering proceeds to the Company were $22.7
million.
Through December 31, 1998, the Company has used $1.7 million of the net
proceeds from the IPO to purchase equipment and software and $4.3 million of
the net proceeds for working capital and general corporate purposes. The
Company has invested the net proceeds in short-term, investment-grade,
interest bearing financial instruments. The use of the proceeds from the
offering does not represent a material change in the use of the proceeds
described in the Registration Statement.
Since January 1, 1998, the Company has sold and issued the following
unregistered securities:
From January 1, 1998 to June 2, 1998, the Company sold an aggregate of
3,471,834 shares of Common Stock to certain investors for an aggregate
purchase price of $9,792,000.
From January 1, 1998 to November 10, 1998, the Company granted stock
options to employees, directors and consultants covering an aggregate of
1,678,285 shares of the Company's Common Stock (net of cancellations), at
exercise prices varying from $3.00 to $11.75. Through November 10, 1998 (the
date of filing of the Company's Form S-8), a total of 16,666 shares were
exercised in accordance with Rule 701.
From January 1, 1998 to June 2, 1998, the Company has issued warrants to
purchase 539,176 shares of Common Stock with a weighted average exercise
price of $3.00.
In April 1998, the Company sold 1,500,000 shares of the Company's Series A
Preferred Stock (which converted into 1,000,000 shares of Common Stock upon
consummation of the Company's IPO) to Wasserstein Adelson Ventures, L.P. for
an aggregate purchase price of $3,000,000.
The sales and issuances of the unregistered securities in the transactions
described above were deemed to be exempt from registration under the Act in
reliance upon Section 4(2) of the Act, Regulation D promulgated thereunder,
Regulation S promulgated thereunder, or Rule 701 promulgated under Section
3(b) of the Act, as transactions by an issuer not involving any public
offering or transactions pursuant to compensatory benefit plans and contracts
relating to compensation as provided under Rule 701. The recipients of
securities in each such transaction represented their intentions to acquire
the securities for investment only and not with a view to or for sale in
connection with any distribution thereof and appropriate legends were affixed
to the securities issued in such transactions. All recipients had adequate
access, through their relationship with the Company, to information about the
Company.
There were no underwritten offerings employed in connection with the sales
and issuances of the unregistered Securities in any of the transactions set
forth above.
20.
<PAGE>
ITEM 6. SELECTED FINANCIAL DATA.
<TABLE>
<CAPTION>
PERIOD FROM
INCEPTION
(FEBRUARY 9,
YEAR ENDED DECEMBER 31, 1994) TO
--------------------------------------------------------- DECEMBER 31,
1998 1997 1996 1995 1994
------------ ------------- ------------ ------------ -------------
(in thousands, except per share data)
<S> <C> <C> <C> <C> <C>
STATEMENT OF OPERATIONS DATA:
Sales .................................... $ 20,911 $ 2,472 $ 111 $ - $ -
Cost of sales............................. 17,487 2,052 95 - -
----------- ----------- ---------- ---------- ---------
Gross profit........................... 3,424 420 16 - -
Operating expenses:
Sales and marketing.................... 9,514 1,501 68 3 -
Product development and operations..... 5,432 1,528 230 130 -
General and administrative............. 3,171 929 415 32 13
----------- ----------- ---------- ---------- ---------
Total operating expenses.......... 18,117 3,958 713 165 13
----------- ----------- ---------- ---------- ---------
Loss from operations...................... (14,693) (3,538) (697) (165) (13)
Interest income........................ 895 53 8 22 5
----------- ----------- ---------- ---------- ---------
Net loss.................................. $ 13,798) $ (3,485) $ (689) $ (143) $ (8)
----------- ----------- ---------- ---------- ---------
----------- ----------- ---------- ---------- ---------
Basic and diluted net loss per share (1).. $ (1.01) $ (0.46) $ (0.13) $ (0.03) $ (0.00)
----------- ----------- ---------- ---------- ---------
----------- ----------- ---------- ---------- ---------
Shares used in per share computation (1).. 13,691 7,514 5,333 5,333 5,333
</TABLE>
<TABLE>
<CAPTION>
DECEMBER 31,
------------------------------------------------------------------
1998 1997 1996 1995 1994
---------- ---------- ---------- ---------- ---------
(in thousands)
<S> <C> <C> <C> <C> <C>
BALANCE SHEET DATA:
Cash and cash equivalents . . . . $ 63,503 $ 2,126 $ 800 $ 487 $ 679
Short-term investments . . . . . 10,894 - - - -
Working capital (deficit) . . . . 70,563 1,244 (451) 478 667
Total assets . . . . . . . . . . 80,328 3,405 1,202 635 783
Accumulated deficit . . . . . . . (18,123) (4,325) (840) (152) (8)
Total stockholders' equity
(deficit) . . . . . . . . . . . . 74,587 2,329 (58) 627 770
</TABLE>
________________
(1) See Note 1 of Notes to Consolidated Financial Statements for an explanation
of the method employed to determine the number of shares used to compute per
share amounts.
ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND
RESULTS OF OPERATIONS
THE FOLLOWING DISCUSSION AND ANALYSIS SHOULD BE READ IN CONJUNCTION WITH
"SELECTED FINANCIAL DATA" AND THE COMPANY'S FINANCIAL STATEMENTS AND NOTES
THERETO INCLUDED ELSEWHERE IN THIS REPORT. EXCEPT FOR THE HISTORICAL
INFORMATION CONTAINED HEREIN, THE DISCUSSION IN THIS REPORT CONTAINS CERTAIN
FORWARD-LOOKING STATEMENTS THAT INVOLVE RISKS AND UNCERTAINTIES, SUCH AS
STATEMENTS OF THE COMPANY'S PLANS, OBJECTIVES, EXPECTATIONS AND INTENTIONS.
THESE FORWARD-LOOKING STATEMENTS ARE BASED ON THE CURRENT EXPECTATIONS OF THE
COMPANY, AND THE COMPANY ASSUMES NO OBLIGATION TO UPDATE THIS INFORMATION. THE
CAUTIONARY STATEMENTS MADE IN THIS REPORT SHOULD BE READ AS BEING APPLICABLE TO
ALL RELATED FORWARD-LOOKING STATEMENTS WHEREVER THEY APPEAR IN THIS REPORT. THE
COMPANY'S ACTUAL RESULTS COULD DIFFER MATERIALLY FROM THOSE DISCUSSED HERE.
OVERVIEW
Digital River is a leading provider of comprehensive electronic commerce
outsourcing solutions to software publishers and online retailers. The
Company was incorporated in February 1994 and commenced offering products for
sale through its clients' Web stores in August 1996. From inception through
August 1996, the Company had no sales, and its activities related primarily
to the development of its Commerce Network Server ("CNS") technology related
to electronic commerce. In 1996, the Company began to focus its business
development efforts on building its inventory of software products through
contracts with software publishers and had contracts with a total of 1,479
and 953 software publishers as of December 31, 1998 and 1997, respectively.
In 1997, the Company began to develop distribution relationships with online
retailers and had contracts with a total of 1,095 and 105 online retailers as
of December 31, 1998 and 1997, respectively. During the year ended December
31, 1998, the Company completed transactions for 1,149 software publishers
and 426 online retailers.
21.
<PAGE>
The Company derives its revenue primarily from sales of third-party
software. The Company has contractual relationships with its software
publisher and online retailer clients which obligate the Company to pay to
the client a specified percentage of each sale. Revenues from the sale of
software products, net of estimated returns, are recognized upon either
delivery through electronic software delivery ("ESD") or shipment of the
physical product to the end-user. The amount payable to the software
publisher or online retailer is reported as cost of sales. The Company bears
full credit risk with respect to substantially all sales. Sales of software
products that are delivered through ESD accounted for 63% of sales for the
year ended December 31, 1998. The Company maintains a supply of packaged
software to meet the physical delivery requirements of its clients, which
supply is primarily held on consignment. In late 1998, the Company began
development of a transaction fee-based e-commerce service. Although there can
be no assurance that the Company will derive any revenue from this service,
the Company expects to begin offering this service in 1999.
The Company has a limited operating history upon which investors may
evaluate its business and prospects. Since inception, the Company has
incurred significant losses, and as of December 31, 1998 had an accumulated
deficit of approximately $18.1 million. The Company intends to continue to
expend significant financial and management resources on the development of
additional services, sales and marketing, improved technology and expanded
operations. As a result, the Company expects to incur additional losses and
continued negative cash flow from operations for the foreseeable future, and
such losses are anticipated to increase from current levels. There can be no
assurance that the Company's sales will increase or even continue at their
current level or that the Company will achieve or maintain profitability or
generate cash from operations in future periods. The Company's prospects must
be considered in light of the risks, expenses and difficulties frequently
encountered by companies in their early stages of development, particularly
companies in new and rapidly evolving markets such as electronic commerce. To
address these risks, the Company must, among other things, maintain existing
and develop new relationships with software publishers and online retailers,
implement and successfully execute its business and marketing strategy,
continue to develop and upgrade its technology and transaction-processing
systems, provide superior customer service and order fulfillment, respond to
competitive developments, and attract, retain and motivate qualified
personnel. There can be no assurance that the Company will be successful in
addressing such risks, and the failure to do so would have a material adverse
effect on the Company's business, financial condition and results of
operations. The Company's current and future expense levels are based largely
on its planned operations and estimates of future sales. Sales and operating
results generally depend on the volume and timing of orders received, which
are difficult to forecast. The Company may be unable to adjust spending in a
timely manner to compensate for any unexpected revenue shortfall.
Accordingly, any significant shortfall in sales would immediately and
adversely affect the Company's business, financial condition and results of
operations. In view of the rapidly evolving nature of the Company's business
and its limited operating history, the Company is unable to accurately
forecast its sales and believes that period-to-period comparisons of its
operating results are not necessarily meaningful and should not be relied
upon as an indication of future performance.
RESULTS OF OPERATIONS
The following table sets forth consolidated statement of operations data
for the periods indicated as a percentage of revenues:
<TABLE>
<CAPTION>
YEAR ENDED DECEMBER 31,
----------------------------
1998 1997 1996
------- ------ -------
<S> <C> <C> <C>
Sales. . . . . . . . . . . . . . . . . . . . . 100.0% 100.0% 100.0%
Cost of sales. . . . . . . . . . . . . . . . . 83.6 83.0 85.6
------ ------ ------
Gross profit . . . . . . . . . . . . . . . 16.4 17.0 14.4
Operating expenses:
Sales and marketing. . . . . . . . . . . . 45.5 60.7 61.2
Product development and operations . . . . 26.0 61.8 207.2
General and administrative . . . . . . . . 15.2 37.6 373.9
------ ------ ------
Total operating expenses . . . . . . . 86.7 160.1 642.3
------ ------ ------
Loss from operations . . . . . . . . . . . . . (70.3) (143.1) (627.9)
Interest income. . . . . . . . . . . . . . 4.3 2.1 7.2
------ ------ ------
Net loss . . . . . . . . . . . . . . . . . . . (66.0)% (141.0)% (620.7)%
------ ------ ------
------ ------ ------
</TABLE>
22.
<PAGE>
YEARS ENDED DECEMBER 31, 1998, 1997 AND 1996
SALES. The Company derives its revenue primarily from sales of
third-party software. The Company recognizes revenue from the sale of
software products upon delivery through ESD or shipment of the physical
product to the end-user. Sales are comprised of the gross selling price of
software sold by the Company, net of estimated returns, plus any outbound
shipping and handling charges, as well as gross revenue generated by certain
merchandising activities. The Company bears credit risk with respect to
substantially all sales. The Company's sales increased to $20.9 million for
the year ended December 31, 1998, from $2.5 million for the year ended
December 31, 1997 and $111,000 for the year ended December 31, 1996. The
sales increases in 1998 and 1997 were a result of significant growth in the
number of the Company's software publisher and online retailer clients as
well as the increasing market acceptance of ESD. The 1998 sales growth was
also a function of merchandising activities implemented during 1998 which
increased the average sales volume generated by the Company's software
publisher clients. International sales accounted for 24%, 31% and 32% of
total sales in the years ended December 31, 1998, 1997 and 1996,
respectively.
GROSS PROFIT. Cost of sales consists primarily of the amount payable to
the software publishers and online retailers for product sold to the end-user
and outbound and inbound shipping and distribution costs for physical
product. Cost of sales increased substantially during 1998 and 1997,
reflecting the Company's growth in sales. During the years ended December
31, 1998, 1997 and 1996, the Company's gross profit margins were 16.4%, 17.0%
and 14.4%. The gross profit margin declined in 1998 primarily as a result of
the addition of certain lower margin software publishers in the second half
of 1997 and the higher cost impact of a greater proportion of sales in 1998
involving physical shipments. The Company has historically generated higher
gross margins on sales through online retailer client Web stores compared to
sales through software publisher client Web stores. There can be no
assurance, however, that the Company will continue to generate higher gross
margins on sales through online retailer client Web stores. In each of the
years ended December 31, 1998 and 1997, less than 6% of the Company's sales
were generated through online retailer client Web stores. The Company expects
that an increasing percentage of its sales will be generated through online
retailers. The Company believes that Internet commerce and related services
will become more competitive in the near future. Accordingly, the Company may
reduce or alter its pricing structure and policies in the future and any such
change would reduce gross margins.
SALES AND MARKETING. Sales and marketing expense consists primarily of
personnel and related expenses, advertising and promotional expenses, bad
debt expense and credit card transaction fees. Sales and marketing expense
increased to $9.5 million from $1.5 million and $68,000 for the years ended
December 31, 1998, 1997 and 1996, respectively, resulting from additional
sales and marketing personnel and related expenses, increased advertising and
promotional expense, increased bad debt expense and increased credit card
transaction fees due to the increased sales. The primary components of the
increase in 1998 from 1997 were an increase in advertising and marketing
expenditures of $3.2 million and an increase in wages and benefits of $1.5
million. As a percentage of sales, sales and marketing expense decreased to
45.5% in the year ended December 31, 1998, from 60.7% in the year ended
December 31, 1997, primarily reflecting the Company's growth in sales. The
primary components of the increase in 1997 from 1996 were an increase in
wages and benefits of $799,000 and an increase in advertising and marketing
expenditures of $315,000. As a percentage of sales, sales and marketing
expense decreased to 60.7% in the year ended December 31, 1997, from 61.2% in
the year ended December 31, 1996, primarily reflecting the Company's growth
in sales. The Company expects that sales and marketing expense will continue
to increase in absolute dollars as the Company continues to build its sales
and marketing infrastructure and to develop marketing programs.
PRODUCT DEVELOPMENT AND OPERATIONS. Product development and operations
expense consists primarily of personnel and related expenses and consulting
associated with developing, enhancing and maintaining the Company's CNS and
related facilities, internal systems and telecommunications infrastructure as
well as customer service and phone order functions. Product development and
operations expense increased to $5.4 million from $1.5 million and $230,000
for the years ended December 31, 1998, 1997 and 1996, respectively. The
increase was primarily related to increased personnel and consulting costs
related to developing, enhancing and maintaining the Company's CNS, customer
service and related facilities on a 24 hour a day, seven day per week basis.
The primary components of the increase in 1998 from 1997 were an increase in
consulting costs of $1.4 million and an increase in wages and benefits of
$1.2 million. As a percentage of sales, product development and operations
expense decreased to 26.0% in the year ended December 31, 1998, from 61.8% in
the year ended December 31, 1997, primarily reflecting the Company's growth
in sales. The primary components of the increase in 1997 from 1996 were an
increase in wages and benefits of $653,000 and an increase in consulting
costs of $233,000. As a percentage of sales, product development and
operations expense decreased to 61.8% in the year ended December 31, 1997,
from 207.2% in the year ended December 31, 1996, primarily reflecting the
Company's growth in sales.
23.
<PAGE>
The Company believes that continued investment in product development and
operations is critical to attaining its strategic objectives and, and as a
result, expects product development and operations expenses will continue to
increase significantly in absolute dollars.
GENERAL AND ADMINISTRATIVE. General and administrative expense consists
principally of executive, accounting and administrative personnel and related
expenses, including deferred compensation expense, professional fees, and
recruiting expense. General and administrative expense increased to $3.2
million from $929,000 and $415,000 for the years ended December 31, 1998,
1997 and 1996, respectively, primarily due to increased personnel related
expense and professional fees. The primary components of the increase from
1998 to 1997 were an increase in deferred compensation expense of $1.2
million and an increase in wages and benefits of $346,000. As a percentage of
sales, general and administrative expense decreased to 15.2% in the year
ended December 31, 1998, from 37.6% in the year ended December 31, 1997,
primarily reflecting the Company's growth in sales. As a percentage of sales,
general and administrative expense decreased to 37.6% in the year ended
December 31, 1997, from 373.9% in the year ended December 31, 1996, primarily
reflecting the Company's growth in sales. The Company expects general and
administrative expense, excluding the impact of deferred compensation
expense, to increase in absolute dollars in the future, particularly as the
Company continues to build infrastructure to support growth and incurs
additional costs associated with being a public company. As a percentage of
sales, these expenses are expected to decrease as sales increase.
INTEREST INCOME. Interest income consists of earnings on the Company's
cash, cash equivalents and short-term investments. Interest income increased
to $895,000 from $53,000 and $8,000 for the years ended December 31, 1998,
1997 and 1996, respectively, resulting from changes in average cash and cash
equivalent balances. The Company expects interest income to increase in the
first quarter of 1999, reflecting a full quarter of interest income on the
proceeds from the December 1998 public stock offering, and then begin to
decrease as cash is used to fund operations and is used for investments in
infrastructure.
INCOME TAXES. The Company has incurred a net loss for each period since
inception. As of December 31, 1998, the Company had approximately $19.4
million of net operating loss carryforwards for federal income tax purposes,
which expire beginning in 2009. Due to the uncertainty of future
profitability, a valuation allowance equal to the deferred tax asset has been
recorded. Certain changes in ownership resulting from the sales of Common
Stock will limit the future annual realization of the tax net operating loss
carryforwards to a specified percentage of the Company under Section 382 of
the Internal Revenue Code. The Company paid no income taxes in the years
ended December 31, 1998, 1997 and 1996.
LIQUIDITY AND CAPITAL RESOURCES
In August 1998, the Company completed its initial public offering in which
the Company sold 3,000,000 shares of Common Stock. Net proceeds to the
Company were $22.7 million after expenses. In December 1998, the Company
completed a follow-on public offering in which the Company sold 2,200,000
shares of Common Stock. Net proceeds to the Company were $48.1 million after
expenses. Prior to the Company's initial public offering and follow-on
offering, the Company financed its operations primarily through the private
placement of equity securities, which yielded an aggregate of $19.3 million
of net proceeds.
Net cash used in operating activities in the years ended December 31,
1998, 1997 and 1996 was $9.0 million, $2.6 million and $409,000,
respectively. Net cash used for operating activities in each of these periods
was primarily the result of net losses, offset in part by increases in
accounts payable, accrued expenses and non-cash expenses.
Net cash used in investing activities in the years ended December 31,
1998, 1997 and 1996 was $14.5 million, $984,000 and $133,000, respectively.
Net cash used in investing activities in each of these periods was related to
the purchases of property and equipment and patent acquisition costs and the
purchase of short-term investments in 1998. The property and equipment
purchased consisted primarily of computer hardware and software.
Net cash provided by financing activities in the years ended December 31,
1998, 1997 and 1996 was $84.9 million, $4.9 million and $855,000,
respectively. The cash provided by financing activities was the result of
proceeds from sales of the Company's Common Stock in 1998, 1997 and 1996 and
the sale of the Company's Series A Preferred Stock in April 1998.
As of December 31, 1998 the Company had approximately $63.5 million of
cash and cash equivalents and $10.9 million of short-term investments. The
Company's principal commitments consisted of obligations
24.
<PAGE>
outstanding under operating leases. Although the Company has no material
commitments for capital expenditures, it anticipates it will expend
approximately $9.0 million over the next 24 months on capital expenditures
based on the Company's current anticipated growth rate. The Company
anticipates that it will continue to add computer hardware resources, deploy
additional commerce servers worldwide, and expand its primary office facility
during the next twelve months. The Company further anticipates that it will
expend approximately $19.0 million over the next 24 months on product
development based on the Company's current anticipated growth rate in
operations. There can be no assurance, however that the Company's growth rate
will continue at current levels or that it will meet the Company's current
expectations. The Company may also use cash to acquire or license technology,
products or businesses related to the Company's current business. The Company
also 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 the Company's cash resources.
The Company believes that existing 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 24 months,
although the Company may seek to raise additional capital during that period.
The sale of additional equity or convertible debt securities could result in
additional dilution to the Company's stockholders. There can be no assurance
that financing will be available in amounts or on terms acceptable to the
Company, if at all.
YEAR 2000 COMPLIANCE
Like many other companies, Digital River faces risks associated with Year
2000 computer issues. If the Company's internal management information
systems and external electronic commerce information systems do not correctly
recognize the process date information beyond the year 1999, it could have a
significant adverse impact on the Company's ability to process client and
end-user transactions, which could create significant potential liability for
the Company. To address potential Year 2000 issues with its internal and
external systems, the Company has evaluated such systems. Remediation is
proceeding, and the Company currently plans to have changes to these systems
completed and tested by March 31, 1999. These activities are intended to
encompass all major categories of systems used by the Company, including
electronic commerce, sales processing, sales and financial systems. The
initial assessment indicated that certain internal systems should be upgraded
or replaced as part of a solution to the Year 2000 problem. The costs
incurred to date related to these programs have not been material. The
estimated cost to be incurred by the Company in the future is not expected to
exceed $10,000. These estimates do not include potential costs related to any
customer or other claims or the cost of internal software and hardware
replaced in the normal course of business. These estimates are based on the
current assessment of the projects and is subject to change as the project
progresses.
The Company is also working with key suppliers of products and services to
determine that their operations and products are Year 2000 Compliant or to
monitor their progress toward Year 2000 compliance, as appropriate. The
failure of a major supplier to become Year 2000 Compliant on a timely basis,
or any system conversion by a supplier that is incompatible with the
Company's systems could have a material adverse effect on the Company's
business, financial condition and operating results. In addition the
Company's business, financial condition and operating results may be
materially adversely affected to the extent its end-users are unable to use
their credit cards due to the Year 2000 issues that are not rectified by
their credit card vendors.
In addition, the Company has begun internal discussions concerning
contingency planning to address potential problem areas with internal systems
and with suppliers and other third parties. It is expected that assessment,
remediation and contingency planning activities will be on-going throughout
calendar year 1999 with the goal of appropriately resolving all material
internal and external systems and third party issues.
As used by the Company, "Year 2000 Compliant" shall mean software that can
individually, and in combination and in conjunction with all other systems,
products or processes with which they are required or designed to interface,
continue to be used normally and to operate successfully (both in
functionality and performance in all material respects) over the transition
into the twenty-first century when used in accordance with the documentation
relating to such software, including being able to, before, on and after
January 1, 2000 substantially conform to the following: (i) use logic
pertaining to dates which allow users to identify and/or use the century
portion of any date fields without special processing; (ii) respond to all
date elements and date input so as to resolve any ambiguity as to century in
a disclosed, defined and pre-determined manner; and (iii) provide date
information in ways which are unambiguous as to century. This may be achieved
by permitting or requiring the century to be specified or where the data
element is represented without a century, the correct century is unambiguous
for all manipulations involving that element.
25.
<PAGE>
ITEM 7a. QUALITATIVE AND QUANTITATIVE DISCLOSURE ABOUT MARKET RISK.
The Company does not enter into financial instruments for trading or
speculative purposes and does not currently utilize derivative financial
instruments. The operations of the Company are conducted primarily in the
United States and as such are not subject to material foreign currency
exchange rate risk. The Company has no long-term debt.
ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA.
The Company's Financial Statements and Notes thereto appear beginning at page
F-1 of this report.
ITEM 9. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND
FINANCIAL DISCLOSURE.
None.
PART III
Certain information required in Part III of this Report is incorporated by
reference to the Company's Proxy Statement in connection with the Company's
1999 Annual Meeting to be filed in accordance with Regulation 14A under the
Securities Exchange Act of 1934, as amended.
ITEM 10. Directors and Executive Officers of the Registrant.
(a) Identification of Directors:
The information concerning the Company's directors and nominees
is incorporated by reference to the Company's Proxy Statement in
connection with the Company's 1999 Annual Meeting to be in accordance
with Regulation 14A under the Securities Exchange Act of 1934, as
amended.
(b) Identification of Executive Officers:
Please refer to the section entitled "Executive Officers" in part
I, Item 1 hereof.
(c) Compliance with Section 16(a) of the Exchange Act:
Based solely upon a review of Forms 3 and 4 and amendments
thereto furnished to the Company pursuant to Rule 16a-3(e) during the
1998 fiscal year and Form 5 and amendments thereto furnished to the
Company with respect to fiscal year 1998, no director, officer, or
beneficial owner of more than 10 percent of any class of equity
security of the Company has failed to file on a timely basis, as
disclosed by the above forms, reports required by Section 16(a) of the
Securities Exchange Act of 1934, as amended during the 1998 fiscal
year, except for one initial report of ownership covering one
transaction was filed late by Mr. Lansing.
ITEM 11. EXECUTIVE COMPENSATION.
The information required in Item 11 of Part III of this report is
incorporated by reference to the Company's Proxy Statement in connection with
the Registrant's 1999 Annual Meeting to be filed in accordance with Regulation
14A under the Securities Exchange Act of 1934, as amended.
ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT.
The information required in Item 12 of Part III of this report is
incorporated by reference to the Company's Proxy Statement in connection with
the Registrant's 1999 Annual Meeting to be filed in accordance with Regulation
14A under the Securities Exchange Act of 1934, as amended.
ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS.
The information required in Item 13 of Part III of this Report is
incorporated by reference to the Company's Proxy Statement in connection with
the Registrant's 1999 Annual Meeting to be filed in accordance with Regulation
14A under the Securities Exchange Act of 1934, as amended.
26.
<PAGE>
PART IV
ITEM 14. EXHIBITS, FINANCIAL STATEMENT SCHEDULES AND REPORTS ON FORM 8-K.
(a) The following documents are filed as part of this report:
(1) Index to Consolidated Financial Statements and Report of Independent
Public Accountants.
The consolidated financial statements required by this item are submitted
in a separate section beginning on page F-1 of this report.
<TABLE>
<CAPTION>
PAGE
----
<S> <C>
Report of Independent Public Accountants F-1
Consolidated Balance Sheets F-2
Consolidated Statements of Operations F-3
Consolidated Statements of Stockholders' Equity (Deficit) F-4
Consolidated Statements of Cash Flows F-5
Notes to Consolidated Financial Statements F-6
</TABLE>
(2) Financial Statement Schedules.
Schedules not listed above have been omitted because the information
required to be set forth therein is not applicable or is included in the
financial statements or notes thereto.
(3) Exhibits.
<TABLE>
<CAPTION>
EXHIBIT
NUMBER DESCRIPTION OF DOCUMENT
- ------- -------------------------------------------------------
<S> <C>
3.1 (1) Amended and Restated Certificate of Incorporation of the
Registrant, as currently in effect.
3.2 (1) Bylaws of the Registrant, as currently in effect.
4.1 (1) Specimen Stock Certificate.
10.1 (1) Form of Indemnity Agreement between Registrant and each of its
directors and executive officers.
10.2 (1) 1998 Stock Option Plan.
10.3 (1)+ Distributor Agreement dated April 23, 1997 by and between Corel
Corporation and the Registrant.
10.4 (1) Employment and Non-Competition Agreement effective May 25, 1998
by and between Joel A. Ronning and the Registrant.
10.5 (1) Fujitsu Modification Agreement dated December 11, 1997 by and
between Joel A. Ronning, the Registrant, Fujitsu Limited and
MacUSA, Inc.
10.6 (1) Heads of Agreement for International Agreement dated February 25,
1998 by and between Christopher J. Sharples, David A. Taylor and
the Registrant.
10.7 (1) Stock Subscription Warrant for Shares of Common Stock dated
February 26, 1998 by and between Christopher Sharples and
Registrant.
10.8 (1) Termination of Lease Letter dated April 30, 1998 by and between
Tech Squared, Inc. and Registrant.
10.9 (1) Services Agreement dated July 30, 1998 by and between Tech
Squared, Inc. and Registrant.
10.10 (1) Stock Option Agreement dated December 28, 1995 by and between
Joel A. Ronning and MacUSA, Inc.
10.11 (1) Form of Registration Rights Agreement by and between Wasserstein
Adelson Ventures, L.P., certain other investors and Registrant.
27.
<PAGE>
10.12 (1) Form of Conditional Warrant to Purchase Common Stock dated April
22, 1998 by and between Wasserstein Adelson Ventures, L.P. and
Registrant.
10.13 (1) Form of Warrant to Purchase Common Stock by and between certain
investors and Registrant.
10.14 (1) Form of Registration Rights Agreement by and between certain
investors and Registrant.
10.15 (1) Consent to Assignment and Assumption of Lease dated April 22,
1998 by and between CSM Investors, Inc., IntraNet Integration
Group, Inc. and Registrant.
10.16 (1) Employment Agreement effective July 30, 1998 by and between Perry
W. Steiner and the Registrant.
21.1 (1) Subsidiaries of Digital River, Inc.
23.1 Consent of Independent Public Accountants.
24.1 Power of Attorney. Reference is made to the signature page.
27.1 Financial Data Schedule.
</TABLE>
__________________
+ Confidential treatment has previously been granted for portions of this
exhibit.
(1) Incorporated by reference to the indicated exhibit in the Company's
Registration Statement on Form S-1 (File No. 333-56787), declared effective
on August 11, 1998.
(b) The Registrant filed no reports on Form 8-K in the fourth quarter of
1998.
(c) See Exhibits listed under Item 14(a)(3).
(d) The financial statement schedules required by this item are listed
under 14(a)(2).
28.
<PAGE>
SIGNATURES
Pursuant to the requirements of Section 13 or 15(d) of the Securities Exchange
Act of 1934, the Registrant has caused this report on Form 10-K to be signed on
its behalf by the undersigned, thereunto duly authorized, in the City of Eden
Prairie, State of Minnesota, on the 19th day of March 1999.
DIGITAL RIVER, INC.
By: /s/ JOEL A. RONNING
-------------------------------------------
Joel A. Ronning
CHIEF EXECUTIVE OFFICER AND DIRECTOR
POWER OF ATTORNEY
KNOW ALL THESE PERSONS BY THESE PRESENTS, that each person whose
signature appears below constitutes and appoints Joel A. Ronning and Robert E.
Strawman and each of them, jointly and severally, his attorneys-in-fact, each
with full power of substitution, for him in any and all capacities, to sign any
and all amendments to this Form 10-K, and to file the same, with exhibits
thereto and other documents in connection therewith, with the Securities and
Exchange Commission, hereby ratifying and confirming all that each said
attorneys-in-fact or his substitute or substitutes, may do or cause to be done
by virtue hereof.
Pursuant to the requirements of the Securities Exchange Act of 1934,
this Form 10-K has been signed below 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/ JOEL A. RONNING Chief Executive Officer and March 19, 1999
- --------------------------- Director (Principal Executive
Joel A. Ronning Officer)
/s/ ROBERT E. STRAWMAN Chief Financial Officer and March 19, 1999
- --------------------------- Treasurer (Principal Financial
Robert E. Strawman and Accounting Officer)
/s/ PERRY W. STEINER President and Director March 19, 1999
- ---------------------------
Perry W. Steiner
/s/ WILLIAM LANSING Director March 19, 1999
- ---------------------------
William Lansing
/s/ THOMAS F. MADISON Director March 19, 1999
- ---------------------------
Thomas F. Madison
/s/ CHARLES E. REESE, JR. Director March 19, 1999
- ---------------------------
Charles E. Reese, Jr.
/s/ CHRISTOPHER J. SHARPLES Director March 19, 1999
- ----------------------------
Christopher J. Sharples
/s/ J. PAUL THORIN Director March 19, 1999
- ----------------------------
J. Paul Thorin
/s/ TIMOTHY C. CHOATE Director March 19, 1999
- ----------------------------
Timothy C. Choate
</TABLE>
29.
<PAGE>
REPORT OF INDEPENDENT PUBLIC ACCOUNTANTS
To Digital River, Inc.:
We have audited the accompanying consolidated balance sheets of Digital
River, Inc. and Subsidiaries as of December 31, 1998 and 1997, and the related
consolidated statements of operations, stockholders' equity and cash flows for
each of the three years in the period ended December 31, 1998. These financial
statements are the responsibility of the Company's management. Our
responsibility is to express an opinion on these financial statements based on
our audits.
We conducted our audits in accordance with generally accepted auditing
standards. Those standards require that we plan and perform the audit to obtain
reasonable assurance about whether the financial statements are free of material
misstatement. An audit includes examining, on a test basis, evidence supporting
the amounts and disclosures in the financial statements. An audit also includes
assessing the accounting principles used and significant estimates made by
management, as well as evaluating the overall financial statement presentation.
We believe that our audits provide a reasonable basis for our opinion.
In our opinion, the financial statements referred to above present fairly,
in all material respects, the financial position of Digital River, Inc. and
Subsidiaries as of December 31, 1998 and 1997, and the results of their
operations and their cash flows for each of the three years in the period ended
December 31, 1998, in conformity with generally accepted accounting principles.
ARTHUR ANDERSEN LLP
Minneapolis, Minnesota,
January 27, 1999
F-1
<PAGE>
DIGITAL RIVER, INC.
CONSOLIDATED BALANCE SHEETS
AS OF DECEMBER 31
(IN THOUSANDS, EXCEPT SHARE DATA)
<TABLE>
<CAPTION>
1998 1997
-------- --------
<S> <C> <C>
ASSETS
CURRENT ASSETS:
Cash and cash equivalents $63,503 $2,126
Short-term investments 10,894 -
Accounts receivable, net allowance of $129 and $20 1,487 94
Prepaid expenses and other 420 100
------- -------
Total current assets 76,304 2,320
------- -------
PROPERTY AND EQUIPMENT:
Property and equipment 4,539 1,035
Less- Accumulated depreciation (625) (132)
------- -------
Net property and equipment 3,914 903
OTHER ASSETS 110 182
------- -------
Total assets $80,328 $3,405
------- -------
------- -------
LIABILITIES AND STOCKHOLDERS' EQUITY
CURRENT LIABILITIES:
Accounts payable $3,880 $720
Accrued payroll 807 197
Due to related party 175 46
Other accrued liabilities 879 113
------- -------
Total current liabilities 5,741 1,076
------- -------
COMMITMENTS AND CONTINGENCIES (Notes 3 and 7)
STOCKHOLDERS' EQUITY:
Preferred Stock, $.01 par value, 5,000,000 shares
authorized; no shares issued or outstanding - -
Common stock, $.01 par value, 45,000,000 shares
authorized; 19,544,791 and 9,241,881 shares issued and
outstanding 195 92
Additional paid-in capital 93,883 6,562
Deferred compensation (1,368) -
Accumulated deficit (18,123) (4,325)
------- -------
Total stockholders' equity 74,587 2,329
------- -------
Total liabilities and stockholders' equity $80,328 $3,405
------- -------
------- -------
</TABLE>
The accompanying notes are an integral part of these consolidated financial
statements.
F-2
<PAGE>
DIGITAL RIVER, INC.
CONSOLIDATED STATEMENTS OF OPERATIONS
FOR THE YEARS ENDED DECEMBER 31
(IN THOUSANDS, EXCEPT PER SHARE DATA)
<TABLE>
<CAPTION>
1998 1997 1996
--------- -------- --------
<S> <C> <C> <C>
SALES $ 20,911 $ 2,472 $ 111
COST OF SALES 17,487 2,052 95
-------- ------- -------
Gross profit 3,424 420 16
OPERATING EXPENSES:
Sales and marketing 9,514 1,501 68
Product development and operations 5,432 1,528 230
General and administrative 3,171 929 415
-------- ------- -------
Total operating expenses 18,117 3,958 713
-------- ------- -------
LOSS FROM OPERATIONS (14,693) (3,538) (697)
INTEREST INCOME 895 53 8
-------- ------- -------
Net loss $(13,798) $(3,485) $ (689)
-------- ------- -------
-------- ------- -------
BASIC AND DILUTED NET LOSS PER SHARE $ (1.01) $ (0.46) $(0.13)
-------- ------- -------
-------- ------- -------
BASIC AND DILUTED WEIGHTED AVERAGE COMMON
SHARES OUTSTANDING 13,691 7,514 5,333
-------- ------- -------
-------- ------- -------
</TABLE>
The accompanying notes are an integral part of these consolidated financial
statements.
F-3
<PAGE>
DIGITAL RIVER, INC.
CONSOLIDATED STATEMENTS OF STOCKHOLDERS' EQUITY (DEFICIT)
(IN THOUSANDS)
<TABLE>
<CAPTION>
Total
Preferred Stock Common Stock Deferred Stockholder's
------------------ ----------------- Paid-In Compen- Accumulated Equity
Shares Amount Shares Amount Capital sation Deficit (Deficit)
--------- ------ ------ ------ ------- ------ ------- -----------
<S> <C> <C> <C> <C> <C> <C> <C> <C>
BALANCE, December 31, 1995 $ - 5,333 $ 53 $ 725 $- $ (151) $ 627
Issuance of warrant in exchange for
financing services - - - - 4 - - 4
Net loss - - - - - - (689) (689)
------- ----- ------- ----- ------- ------ ------- -------
BALANCE, December 31, 1996 - - 5,333 53 729 - (840) (58)
Convertible debentures exchanged for
common stock - - 1,018 10 987 - - 997
Sales of common stock - - 2,831 28 4,746 - - 4,774
Common stock issued in Fujitsu
agreement - - 60 1 100 - - 101
Net loss - - - - - - (3,485) (3,485)
------- ----- ------- ----- ------- ------ ------- -------
BALANCE, December 31, 1997 - - 9,242 92 6,562 - (4,325) 2,329
Sales of common stock - - 8,679 87 80,581 - - 80,668
Sales of preferred stock 1,500 15 - - 2,810 - - 2,825
Conversion of preferred stock to
common stock (1,500) (15) 1,000 10 5 - - -
Exercise of options and warrants - - 624 6 1,346 - - 1,352
Deferred compensation related to
stock options and warrants - - - - 2,579 (2,579) - -
Deferred compensation expense - - - - - 1,211 - 1,211
Net loss - - - - - - (13,798) (13,798)
------- ----- ------- ----- ------- ------ ------- -------
BALANCE, December 31, 1998 - $ - 19,545 $195 $93,883 $(1,368) $(18,123) $74,587
------- ----- ------- ----- ------- ------ ------- -------
------- ----- ------- ----- ------- ------ ------- -------
</TABLE>
The accompanying notes are an integral part of these consolidated financial
statements.
F-4
<PAGE>
DIGITAL RIVER, INC.
CONSOLIDATED STATEMENTS OF CASH FLOWS
FOR THE YEARS ENDED DECEMBER 31
(IN THOUSANDS)
<TABLE>
<CAPTION>
1998 1997 1996
----------- ------------ -----------
<S> <C> <C> <C>
OPERATING ACTIVITIES:
Net loss $ (13,798) $ (3,485) $ (689)
Adjustments to reconcile net loss to net cash used in operating
activities:-
Depreciation and amortization 604 195 35
Deferred compensation expense 1,211 - -
Common stock granted to Fujitsu - 101 -
Change in operating assets and liabilities:
Accounts receivable and prepaid expenses (1,713) (184) (9)
Accounts payable 3,160 607 108
Accrued payroll and other accrued liabilities 1,376 227 79
Due to related party 129 (21) 67
---------- ---------- ---------
Net cash used in operating activities (9,031) (2,560) (409)
---------- ---------- ---------
INVESTING ACTIVITIES:
Purchases of short-term investments (15,894) - -
Proceeds from sales of short-term investments 5,000 - -
Purchases of equipment (3,531) (920) (105)
Patent acquisition costs (62) (64) (28)
---------- ---------- ---------
Net cash used in investing activities (14,487) (984) (133)
---------- ---------- ---------
FINANCING ACTIVITIES:
Sales of preferred and common stock 83,543 4,774 -
Exercise of options and warrants 1,352 - -
Proceeds from convertible debentures - 147 998
Payment of debt issuance costs and other - (51) (143)
---------- ---------- ---------
Net cash provided by financing activities 84,895 4,870 855
---------- ---------- ---------
NET INCREASE IN CASH AND CASH EQUIVALENTS 61,377 1,326 313
CASH AND CASH EQUIVALENTS, beginning of year 2,126 800 487
---------- ---------- ---------
CASH AND CASH EQUIVALENTS, end of year $ 63,503 $ 2,126 $ 800
---------- ---------- ---------
---------- ---------- ---------
NONCASH INVESTING AND FINANCING ACTIVITIES:
Convertible debentures exchanged for common stock, net of direct
costs $ - $ 998 $ -
---------- ---------- ---------
---------- ---------- ---------
Preferred stock converted to common stock $ 2,825 $ - $ -
---------- ---------- ---------
---------- ---------- ---------
</TABLE>
The accompanying notes are an integral part of these consolidated financial
statements.
F-5
<PAGE>
DIGITAL RIVER, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
DECEMBER 31, 1998 AND 1997
1. NATURE OF OPERATIONS AND SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES:
Digital River, Inc., a Delaware corporation, and its wholly owned
subsidiaries (collectively, the Company) have developed a technology platform
that allows it to provide a suite of electronic commerce services to its
software publisher and online retailer clients, including electronic software
delivery. Through contractual relationships with software publishers and
online retailers, the Company offers software products for sale via the
Internet.
The Company was incorporated in February 1994, and was considered a
development stage company through August 1996. The Company conducted its
first online sale through a client's Web store in August 1996 and is still in
the early stages of development. The Company has experienced significant
losses since inception and has experienced significant negative cash flows
from operations. The Company anticipates that operating expenses will
continue to increase, resulting in continuing net losses and negative cash
flows from operations for the foreseeable future.
The Company's prospects must be considered in light of the risks
frequently encountered by companies in their early stage of development,
particularly companies in new and rapidly evolving markets such as electronic
commerce. To address these risks, the Company must, among others things,
maintain existing and develop new relationships with independent software
publishers and online retailers, maintain and increase its client base,
implement and successfully execute its business and marketing strategy,
continue to develop and upgrade its technology and transaction-processing
systems, provide superior customer service and order fulfillment, respond to
competitive developments, and attract, retain and motivate qualified
personnel. There can be no assurances that the Company will be successful in
addressing such risks, and the failure to do so could have a material adverse
effect on the Company's business, financial condition and results of
operations.
PRINCIPLES OF CONSOLIDATION
The consolidated financial statements include the accounts of Digital
River, Inc. and its wholly owned subsidiaries. All intercompany balances and
transactions have been eliminated in consolidation.
CASH AND CASH EQUIVALENTS
The Company considers all short-term, highly liquid investments, primarily
high grade commercial paper and money market accounts, that are readily
convertible into known amounts of cash and that have original maturities of
three months or less to be cash equivalents.
SHORT-TERM INVESTMENTS
At December 31, 1998, short-term investments represent high grade
commercial paper maturing in less than one year and classified as
available-for-sale. At December 31, 1998, amortized cost approximated fair
value and unrealized gains and losses were insignificant.
PROPERTY AND EQUIPMENT
Property and equipment is stated at cost and is being depreciated under
the straight-line method using lives of three to seven years. Impairment
losses are recorded on long-lived assets in operations when indicators of
impairment are present and the undiscounted cash flows estimated to be
generated by those assets are less than the assets' carrying amount.
Impairment losses are measured by comparing the fair value of assets, as
determined by discounting the future cash flows at a market rate of interest,
to their carrying amount.
F-6
<PAGE>
PATENTS AND ORGANIZATION COSTS
The costs of developing patents are amortized over a three-year period
utilizing the straight-line method of amortization once the patent
application is filed. Organization costs are being amortized using the
straight-line method over five years. Patents and organization costs are
included in other assets on the accompanying consolidated balance sheets, net
of accumulated amortization of $174,000 and $104,000 as of December 31, 1998
and 1997.
REVENUE RECOGNITION
The Company derives its revenue primarily from sales of third-party
software. The Company has contractual relationships with its software
publisher and online retailer clients which obligate the Company to pay to
the client a specified percentage of each sale. Revenues from the sale of
software products, net of estimated returns, are recognized upon either the
electronic delivery or shipment of the physical product to the end-user. The
amount payable to the software publisher or online retailer is reported as
cost of sales. The Company bears full credit risk with respect to
substantially all sales. For sales on consignment, the Company takes title
to merchandise, charges the customer's credit card and arranges for a third
party to complete delivery to the customer. The Company is at risk of loss
for collecting all sales proceeds, delivery of the merchandise and returns
from customers. The Company records the full sales amount as revenue upon
verification of credit card authorization and shipment of the merchandise.
Sales to foreign customers accounted for 24%, 31% and 32% of sales for the
years ended December 31, 1998, 1997 and 1996, respectively. One client
accounted for 18% of sales for the year ended December 31, 1997. No clients
accounted for more than 10% of sales for the year ended December 31, 1998.
ADVERTISING COSTS
The costs of advertising are charged to sales and marketing expense as
incurred. For the years ended December 31, 1998, 1997 and 1996, the Company
incurred advertising expense of $2,569,000, $292,000 and $7,000, respectively.
PRODUCT DEVELOPMENT
Costs associated with the development of new products and services are
charged to operations as incurred. Those costs totaled $3,392,000,
$1,393,000 and $230,000, for the three years ended December 31, 1998, 1997
and 1996, respectively.
NET LOSS PER SHARE
Basic loss per common share is computed by dividing net loss by the
weighted average number of shares of common stock outstanding during the
year. The computation of diluted earnings per common share is similar to the
computation of basic loss per common share, except that the denominator is
increased for the assumed conversion of convertible securities and the
exercise of dilutive options using the treasury stock method. The weighted
average shares used in computing basic and diluted loss per share were the
same for the three years ended December 31, 1998, 1997 and 1996. Options,
warrants and the Series A Preferred Stock totaling 2,883,059, 1,056,642 and
344,210 for the three years ended December 31, 1998, 1997 and 1996,
respectively, were excluded from the computation of loss per share as their
effect is antidilutive.
USE OF ESTIMATES
The preparation of financial statements in accordance with generally
accepted accounting principles requires management to make estimates and
assumptions that affect the reported amounts of assets and liabilities and
disclosure of contingent assets and liabilities at the date of the financial
statements and the reported amounts of revenues and expenses during the
reporting period. Ultimate results could differ from those estimates.
F-7
<PAGE>
RECENT ACCOUNTING PRONOUNCEMENTS
The Company adopted Statement of Financial Accounting Standards (SFAS) No.
130, "Reporting Comprehensive Income," on January 1, 1998. SFAS No. 130
establishes standards for reporting and display in the financial statements
of total net income and the components of all other nonowner changes in
equity, referred to as comprehensive income. The Company adopted SFAS No.
130 on January 1, 1998. Adoption of SFAS No. 130 had no impact to the
Company.
The Company also adopted SFAS No. 131 "Disclosures about Segments of an
Enterprise and Related Information," in 1998. SFAS No. 131 requires
disclosure of business and geographic segments in the consolidated financial
statements of the Company. The adoption of the disclosure requirements of
SFAS No. 131 had no impact to the Company's financial statements as there is
only one reportable segment.
The Accounting Standards Executive Committee of the American Institute of
Certified Public Accountants Statement of Position (SOP) 98-1, "Accounting
for the Costs of Computer Software Developed or Obtained for Internal Use,"
is effective for fiscal years beginning after December 15, 1998. SOP 98-1
provides guidance on accounting for the costs of computer software developed
or obtained for internal use. The Company believes that the adoption of SOP
No. 98-1 will not have a material impact on its financial condition or
results of operations.
2. INCOME TAXES:
Deferred tax assets and liabilities are determined based on the difference
between the financial statement and tax bases of assets and liabilities using
currently enacted tax rates. No income taxes were paid in any of the years
presented.
As of December 31, 1998, the Company had net operating loss carryforwards
of approximately $19,400,000. Included in this amount is approximately
$2,600,000 of deductions resulting from disqualifying dispositions of stock
options. When these deductions are realized for financial statement
purposes, they will not result in a reduction in income tax expense, rather
the benefit will be recorded as additional paid-in-capital. These income tax
net operating loss carryforwards expire beginning in the year 2009. Because
of the uncertainty of future realization, a valuation allowance equal to the
deferred tax asset has been recorded.
The components of deferred income taxes are as follows:
<TABLE>
<CAPTION>
1998 1997
------------- --------------
<S> <C> <C>
Net operating loss carryforwards $ 6,739,000 $ 1,489,000
Nondeductible reserves and accruals 71,000 11,000
Depreciation and amortization (35,000) 5,000
Valuation allowance (6,775,000) (1,505,000)
-------------- --------------
$ - $ -
-------------- --------------
-------------- --------------
</TABLE>
Ownership changes resulting from the issuance of additional equity will limit
future annual realization of the tax net operating loss carryforwards to a
specified percentage of the value of the Company under Section 382 of the
Internal Revenue Code.
F-8
<PAGE>
3. LEASE COMMITMENTS:
The Company leases its main facility under a sublease agreement. Total rent
expense, including common area maintenance charges, recognized under this lease
was $172,000 for the year ended December 31, 1998. The minimum annual rents
under this lease at December 31, 1998 are as follows:
<TABLE>
<CAPTION>
Years ending December 31:
<S> <C>
1999 $ 246,000
2000 246,000
2001 246,000
2002 246,000
2003 144,000
--------------
$ 1,128,000
--------------
--------------
</TABLE>
4. STOCKHOLDERS' EQUITY:
STOCK SPLITS
The Company effected an 8-for-1 split of its common stock in September
1997 in the form of a stock dividend and on July 14, 1998 the Company
declared a 2-for-3 reverse stock split of its common stock, which was
effected on August 11, 1998. All common share, per share and weighted
average share information has been restated to reflect the splits.
COMMON STOCK SALES
In August 1998, the Company completed its initial public offering in which
the Company sold 3,000,000 shares of common stock at $8.50 per share. Net
proceeds to the Company after underwriting and other offering expenses were
$22.7 million.
In December 1998, the Company completed a secondary offering in which the
Company sold 2,200,000 shares of common stock at $23.50 per share. Net
proceeds to the Company after underwriting and other offering expenses were
$48.1 million.
The proceeds from the offerings will be used for general corporate
purposes, including continued investment in product development, expansion of
sales and marketing activities and working capital.
PREFERRED STOCK
During April 1998, the Company sold 1,500,000 shares of its $.01 par value
Series A Preferred Stock in a private placement transaction. Net proceeds
to the Company totaled $2,825,000. The preferred stock was converted to
common stock on a 2-for-3 basis in conjunction with the closing of the
Company's initial public offering of common stock in August 1998.
CONVERTIBLE DEBENTURES
During 1996 the Company issued convertible debentures totaling $998,000.
These debentures were converted to common stock in February 1997 at a
conversion rate of $1.13 per share.
F-9
<PAGE>
WARRANTS
Warrants to purchase 426,820 shares of common stock issued principally in
conjunction with sales of common stock at exercise prices ranging from $1.69
to $3.00 per share were outstanding as of December 31, 1998. All warrants
are exercisable for a period of five years from their respective purchase
dates.
In connection with certain advisory services provided by a stockholder of
the Company, the Company issued a conditional warrant (the "Advisory
Warrant"). Upon consummation of the Company's initial public offering in
August 1998, the Advisory Warrant ceased to be conditional as certain terms
were met. The Advisory Warrant represents the right to purchase 100,000
shares of Common Stock at $3.00 per share and is exercisable for a period of
five years from the date of the Company's initial public offering.
5. STOCK OPTIONS:
The Company's 1998 Stock Option Plan (the "Option Plan") was adopted by
the Board of Directors in June 1998 as an amendment and restatement of the
Amended and Restated 1995 Stock Option Plan which had been adopted in 1997.
The Option Plan provides for the granting of stock options to purchase up to
2,333,333 shares of common stock. Options granted to employees under the
plan expire no later than ten years after the date of grant. The exercise
price must be at least 100% of the fair market value of the shares at the
date of grant for incentive options. The Option Plan covers both incentive
and nonstatutory stock options. Incentive stock options granted to employees
who immediately before such grant owned stock directly or indirectly
representing more than 10% of the voting power of all the stock of the
Company, expire no later than five years from the grant date unless the
option exercise price is at least 110% of the fair market value of the stock.
In addition to shares granted under the Option Plan, during 1998 the
Company granted options to purchase 605,882 shares of common stock at an
exercise price of $8.50 per share to certain members of management outside of
the Option Plan.
A summary of change in outstanding options under the Option Plan is as
follows:
<TABLE>
<CAPTION>
Options Weighted
Outstanding Average $/Share
------------- ---------------
<S> <C> <C>
Balance, December 31, 1995 - -
Grants 338,665 0.60
--------- ------
Balance, December 31, 1996 338,665 0.60
Grants 496,817 1.66
Canelled (42,672) 1.69
--------- ------
Balance, December 31, 1997 792,810 1.20
Grants 1,389,570 8.93
Exercised (220,350) 1.63
Cancelled (91,673) 5.10
--------- ------
Balance, December 31, 1998 1,870,357 6.70
--------- ------
--------- ------
</TABLE>
F-10
<PAGE>
A summary of information about stock options outstanding at December 31, 1998
is as follows:
<TABLE>
<CAPTION>
Options Outstanding Options Exercisable
----------------------------- ----------------------------
Number Weighted Ave. Number Weighted
Exercise Price Outstanding Life Remaining Exercisable Ave. Price
---------------- ------------- -------------- ------------- ------------
<S> <C> <C> <C> <C>
$ 0.38 146,666 3 years 146,666 $ 0.38
1.13-1.69 458,125 8 years 150,192 1.30
3.00 655,275 9 years 49,469 3.00
7.00-9.63 813,006 9.5 years 118,500 8.45
11.75-23.40 383,167 10 years 10,000 12.50
----------- --------- --------- ------- -----
0.38-23.40 2,456,239 9 years 474,827 3.21
----------- --------- --------- ------- -----
----------- --------- --------- ------- -----
</TABLE>
The Company recorded deferred compensation for the difference between the
grant price and the deemed fair value of the Company's common stock on options
to purchase 454,468 shares at exercise prices of $3.00 to $7.50 during May and
June 1998.
The Company has elected to apply the disclosure-only provisions of SFAS No.
123, "Accounting for Stock-Based Compensation." Accordingly, the Company
accounts for stock-based compensation using the intrinsic value method
prescribed in Accounting Principles Board Opinion (APB) No. 25, "Accounting for
Stock Issued to Employees," and related interpretations. Compensation cost for
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. Had compensation costs for these plans been determined consistent with
SFAS No. 123, the Company's net loss would have been adjusted to the following
pro forma amounts:
<TABLE>
<CAPTION>
1998 1997 1996
------------ ----------- ------------
<S> <C> <C> <C>
Net loss:
As reported $(13,798,000) $(3,485,000) $(689,000)
Pro forma (15,037,000) (3,565,000) (704,000)
Basic and diluted loss per share:
As reported (1.01) (0.46) (0.13)
Pro forma (1.10) (0.47) (0.13)
</TABLE>
The fair value of each option grant is estimated on the date of grant
using the Black-Scholes option pricing model with the following weighted
average assumptions used: risk-free interest rates of 5.5%, 6% and 6%; no
expected dividends; expected lives of five years; and a volatility factor of
1.3, 1.1 and .7 in 1998, 1997 and 1996, respectively. The weighted average
fair value of the options granted in 1998, 1997 and 1996 was $8.36, $1.04 and
$0.48, respectively.
6. RELATED-PARTY TRANSACTIONS:
As of December 31, 1998, the Company's CEO owned 46% of Tech Squared Inc.
(Tech Squared) where he spends a portion of his time working as Tech
Squared's Chairman. Tech Squared, through a wholly owned subsidiary, held an
option to purchase 3,200,000 shares of the Company's common stock for $1.00
from the Company's CEO. In December 1998, Tech Squared partially exercised
this option and as of December 31, 1998 held the option to purchase 3,000,000
shares. The Company currently conducts certain of its operations in leased
facilities of Tech Squared and will continue to pay Tech Squared on the basis
of square footage utilized. Rent and other direct expenses, including direct
labor costs, paid to Tech Squared totaled $207,000, $160,000 and $52,000 in
1998, 1997 and 1996, respectively.
F-11
<PAGE>
During 1997, Tech Squared began performing fulfillment services for
Digital River on physical shipments of products, for which Digital River pays
Tech Squared a fulfillment fee. Tech Squared billed Digital River $246,000
and $8,000 for these services in 1998 and 1997, respectively.
In February 1998, two stockholders, one of which is a director of the
Company, entered into an agreement with the Company whereby the stockholders
will help establish and oversee the international operations for the Company
for a term of three years. As consideration for entering into the agreement,
the stockholders each received warrants to purchase 100,000 shares of common
stock, at $3.00 per share. Deferred compensation has been reflected for the
estimated fair value of the services and is being recognized over the term of
the agreement.
7. COMMITMENTS AND CONTINGENCIES:
In connection with an investment in the Company in 1994, Fujitsu Limited
(Fujitsu) obtained certain rights with respect to the Company's common stock
and the operations of the Company's business. In December 1997, in exchange
for the issuance of 60,000 shares of the Company's common stock, Fujitsu
agreed to relinquish its rights with certain exceptions. Fujitsu retained
the right to designate one member to the Company's board of directors as long
as its ownership percentage is not less than 10% of the Company's common
stock, retained its prior share registration rights and retained certain
technology rights. In 1997, the Company recorded a charge to expense for the
fair value of the Common shares issued totaling $101,250, based upon the most
recent private placement price per share of $1.69. As of December 31, 1998,
Fujitsu held 11% of the common stock of the Company.
The United States Department of State and Department of Commerce restrict
the export of encrypting technology outside the United States. Although
Digital River does not currently believe its method of conducting business is
impacted to any significant degree by these restrictions, any significant
change in these rules or interpretations or any failure by Digital River to
comply with existing or future restrictions could have a material adverse
impact on the business of Digital River.
F-12
<PAGE>
EXHIBIT 23.1
CONSENT OF INDEPENDENT PUBLIC ACCOUNTANTS
As independent public accountants, we hereby consent to the incorporation
of our report included in this Form 10-K, into the Company's previously filed
Registration Statement File No. 333-67085.
ARTHUR ANDERSEN LLP
Minneapolis, Minnesota
March 19, 1999
<TABLE> <S> <C>
<PAGE>
<ARTICLE> 5
<MULTIPLIER> 1,000
<S> <C>
<PERIOD-TYPE> YEAR
<FISCAL-YEAR-END> DEC-31-1998
<PERIOD-END> DEC-31-1998
<CASH> 63,503
<SECURITIES> 10,894
<RECEIVABLES> 1,616
<ALLOWANCES> 129
<INVENTORY> 108
<CURRENT-ASSETS> 76,304
<PP&E> 4,539
<DEPRECIATION> 625
<TOTAL-ASSETS> 80,328
<CURRENT-LIABILITIES> 5,741
<BONDS> 0
0
0
<COMMON> 195
<OTHER-SE> 74,392
<TOTAL-LIABILITY-AND-EQUITY> 80,328
<SALES> 20,911
<TOTAL-REVENUES> 20,911
<CGS> 17,487
<TOTAL-COSTS> 17,487
<OTHER-EXPENSES> 17,669
<LOSS-PROVISION> 448
<INTEREST-EXPENSE> 0
<INCOME-PRETAX> (13,798)
<INCOME-TAX> 0
<INCOME-CONTINUING> (13,798)
<DISCONTINUED> 0
<EXTRAORDINARY> 0
<CHANGES> 0
<NET-INCOME> (13,798)
<EPS-PRIMARY> (1.01)
<EPS-DILUTED> (1.01)
</TABLE>
