<PAGE>
UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
Washington, D.C. 20549
------------------------------
FORM 10-Q
Quarterly Report Pursuant To Section 13 or 15(d) of the Securities Exchange Act
Of 1934
For the quarterly period ended March 31, 2000
Commission File No. 0-24671
EMUSIC.COM INC.
(Exact Name of registrant as specified in its charter)
Delaware 65-0207877
(State or other jurisdiction of (I.R.S. Employer
incorporation or organization) Identification Number)
1991 Broadway, 2nd Floor 94063
Redwood City, California (Zip Code)
(Address of principal executive offices)
Registrant's telephone number, including area code: (650) 216-0200
Indicate by check mark whether the registrant (1) has filed all reports required
to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during
the preceding 12 months (or for such shorter period that the registrant was
required to file such reports), and (2) has been subject to such filing
requirements for the past 90 days.
Yes X No
--------- ---------
Indicate the number of shares outstanding of each of the issuer's classes of
Common Stock, as of the latest practicable date:
Common Stock, $0.001 Par Value 42,863,143
(Class) (Outstanding at April 30, 2000)
<PAGE>
EMUSIC.COM INC.
FORM 10-Q
INDEX
Page
----
PART I - FINANCIAL INFORMATION
Item 1. Condensed Consolidated Financial Statements
Condensed Consolidated Balance Sheets - March 31,
2000 and June 30, 1999................................. 3
Condensed Consolidated Statements of Operations - three
and nine months ended March 31, 2000 and 1999.......... 4
Condensed Consolidated Statements of Cash Flows - nine
months ended March 31, 2000 and 1999................... 5
Notes to Financial Statements........................... 6
Item 2. Management's Discussion and Analysis of Financial
Condition and Results of Operations.................... 10
Item 3. Quantitative and Qualitative Disclosures About Market
Risk................................................... 27
PART II - OTHER INFORMATION
Item 2. Changes in Securities and Use of Proceeds............... 28
Item 4. Acquisitions............................................ 28
Item 6. Exhibits and Reports on Form 8-K........................ 29
Signatures....................................................... 30
<PAGE>
- --------------------------------------------------------------------------------
PART I: FINANCIAL INFORMATION
ITEM 1. CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
- --------------------------------------------------------------------------------
EMUSIC.COM INC.
CONDENSED CONSOLIDATED BALANCE SHEETS
(in thousands)
(Unaudited)
<TABLE>
<CAPTION>
March 31, 2000 June 30, 1999
------------------------- -------------------------
Assets
<S> <C> <C>
Current Assets:
Cash and cash equivalents.................................... $ 46,914 $ 19,002
Accounts receivable, net..................................... 2,812 51
Prepaid expenses and other assets............................ 14,145 224
-------- --------
Total current assets...................................... 63,871 19,277
Property and equipment, net.................................... 4,792 1,076
Music content, net............................................. 23,019 8,758
Intangible assets, net......................................... 184,327 24,680
Other assets................................................... 512 430
-------- --------
Total assets............................................ $276,521 $ 54,221
======== ========
Liabilities, Redeemable Convertible Preferred Stock and
Stockholders' Equity
Current Liabilities:
Accounts payable............................................. $ 1,885 $ 637
Accrued liabilities.......................................... 5,555 1,679
Accrued compensation and related benefits.................... 1,600 368
Deferred revenue............................................. 1,407 -
-------- --------
Total current liabilities................................. 10,447 2,684
Capital lease obligation..................................... 289 -
-------- --------
Total liabilities....................................... 10,736 2,684
Mandatorily Redeemable Convertible Preferred Stock - 32,550
Stockholders' Equity:
Capital stock and additional paid-in capital................. 365,662 67,844
Accumulated deficit.......................................... (99,877) (48,857)
-------- --------
Total stockholders' equity................................. 265,785 18,987
-------- --------
Total liabilities, redeemable convertible preferred
Stock and stockholders' equity......................... $276,521 $ 54,221
======== ========
</TABLE>
The accompanying notes are an integral part of these financial statements.
<PAGE>
EMUSIC.COM INC.
CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS
(in thousands, except per share data)
(Unaudited)
<TABLE>
<CAPTION>
Three months Three months Nine months Nine months
ended ended ended ended
March 31, 2000 March 31, 1999 March 31, 2000 March 31, 1999
<S> <C> <C> <C> <C>
Revenues................................................ $ 2,100 $ 21 $ 2,703 $ 42
Cost of revenues........................................ 579 9 751 14
-------- -------- -------- --------
Gross profit............................................ 1,521 12 1,952 28
-------- -------- -------- --------
Operating expenses:
Product development (including stock compensation
charges for the quarters ended March 31, 2000 and
1999 of $2,072 and $865, respectively, and $8,987
and $1,496 for the nine months ended March 31, 2000
and 1999, respectively).............................. 6,994 1,654 18,895 3,246
Selling and marketing................................ 8,810 -- 19,218 --
General and administrative............................ 2,141 314 4,031 716
Amortization of intangible assets..................... 7,132 334 12,292 334
-------- -------- -------- --------
Total operating expenses.......................... 25,077 2,302 54,436 4,296
-------- -------- -------- --------
Operating loss.......................................... (23,556) (2,290) (52,484) (4,268)
Interest and other income, net.......................... 1,027 1 2,181 5
-------- -------- -------- --------
Net loss................................................ (22,529) (2,289) (50,303) (4,263)
-------- -------- -------- --------
Accretion of Preferred Stock............................ -- (8) (225) (33)
Beneficial conversion charge, Preferred Stock........... -- (31,577) (31,721)
Dividend on Preferred Stock (Note 3).................... -- (40) (492) (40)
-------- -------- -------- --------
Net loss applicable to Common shares.................... $(22,529) $(33,914) $(51,020) $(36,057)
======== ======== ======== ========
Net loss per Common share-basic and diluted............. $(0.62) $(2.31) $(1.92) $(2.48)
======== ======== ======== ========
Weighted average Common shares outstanding - basic and
diluted................................................ 36,201 14,674 26,615 14,561
======== ======== ======== =======
</TABLE>
The accompanying notes are an integral part of these financial statements.
<PAGE>
EMUSIC.COM INC.
CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS
(in thousands)
(Unaudited)
<TABLE>
<S> <C> <C>
Nine months ended Nine months ended
March 31, March 31,
2000 1999
-------- -------
Cash flows from operating activities:
Net loss.................................................................................... $(50,303) $(4,263)
Adjustments to reconcile net loss to net cash used in operating activities:
Depreciation................................................................................. 1,135 28
Amortization of intangible assets............................................................ 12,292 334
Loan interest converted into Preferred Stock................................................. - 34
Amortization of music content................................................................ 235 -
Fair value of equity instruments issued to advisors.......................................... 8,987 1,496
Changes in assets and liabilities, net of effects of acquisition:
Accounts receivable....................................................................... (572) (4)
Prepaid expenses and other assets......................................................... (12,373) (255)
Accounts payable.......................................................................... 843 263
Accrued liabilities....................................................................... (1,839) 2,564
Accrued compensation and related benefits................................................. 182 21
Deferred revenue........................................................................ 656 -
-------- -------
Net cash (used in) provided by operating activities...................................... (40,757) 218
-------- -------
Cash flows from investing activities:
Acquisitions, net of cash acquired........................................................... 1,500 (311)
Purchase of music content.................................................................... (12,388) -
Capital expenditures......................................................................... (3,143) (143)
-------- -------
Net cash used in investing activities.................................................... (14,031) (454)
-------- -------
Cash flows from financing activities:
Proceeds from issuance of Common Stock....................................................... 84,220 300
Issuance costs associated with secondary offering............................................ (1,137) -
Proceeds from issuance of convertible notes.................................................. - 1,744
Proceeds from issuance of Preferred Stock and warrants....................................... - 30,300
Payment of dividend on Preferred Stock....................................................... (1,061) -
Payment of capital lease (29) -
Exercise of stock options.................................................................... 707 -
-------- -------
Net cash provided by financing activities................................................ 82,700 32,344
-------- -------
Net increase in cash........................................................................... 27,912 32,108
Cash at beginning of period.................................................................... 19,002 510
-------- -------
Cash at end of period.......................................................................... $ 46,914 $32,618
======== =======
Supplemental disclosure of non-cash transactions:
Accretion of Preferred Stock to redemption value.............................................. $ 225 $ 33
Beneficial conversion charge, Preferred Stock................................................. $ - $31,721
Issuance of Common Stock options for assets................................................... $ - $ 45
Issuance of warrants for music content........................................................ $ 1,412 $ -
Issuance of Common Stock in conjunction with acquisitions..................................... $116,243 $ -
Conversion of Series B Preferred Stock into Common Stock...................................... $ 32,206 $ -
</TABLE>
The accompanying notes are an integral part of these financial
statements.
<PAGE>
NOTES TO UNAUDITED CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
Note 1--The Company and Summary of Significant Accounting Policies
The Company
Emusic.com Inc., a Delaware corporation (the "Company"), formerly known as
GoodNoise Corporation, was incorporated on January 8, 1998, and is an online
music network of Web sites (including EMusic.com, RollingStone.com, IUMA.com and
DownbeatJazz.com) that offers music consumers a repertoire of musical recordings
for sale by direct file transfer or "downloading," as well as extensive and
exclusive music content and interactive features and provides advertisers a
marketing channel to reach these consumers across both broad and targeted
demographic groups.
Basis of Presentation
In the opinion of management, the unaudited consolidated condensed financial
statements included herein have been prepared on a basis consistent with prior
periods reported consolidated financial statements and include all material
adjustments, consisting of normal recurring adjustments, necessary to fairly
present the information set forth therein.
All significant inter-company balances and transactions have been eliminated.
Certain information and footnote disclosures normally included in the financial
statements have been condensed or omitted pursuant to rules and regulations of
the Securities and Exchange Commission, although we believe that the disclosures
in the unaudited interim financial statements are adequate to ensure that the
information presented is not misleading. The results of operations for the
interim reporting periods presented herein are not necessarily indicative of any
future operating results.
The financial information as of June 30, 1999 is derived from our Annual Report
on Form 10-K for the Fiscal Year Ended June 30, 1999 as filed with the
Securities Exchange Commission. The interim financial statements presented
herein should be read in conjunction with the financial statements and the notes
thereto included in the Form 10-K.
The preparation of financial statements in conformity with generally accepted
accounting principles requires management to make estimates and assumptions that
affect the amounts reported in the financial statements and accompanying notes.
Actual results could differ materially from those estimates.
<PAGE>
Net Loss per Common Share
The weighted average shares used to compute basic net loss per share includes
outstanding shares of Common Stock from the date of issuance, and excludes
shares of Common Stock subject to our repurchase. The calculation of diluted
net loss per share for all periods presented excludes shares of Common Stock
issuable upon exercise of employee stock options and upon the conversion of
Preferred Stock, as their effect would be antidilutive. Therefore, the
weighted average number of shares used in the calculation of basic and
dilutive net loss per Common share is the same. The following table summarizes
the computation of basic and diluted net loss per share (in thousands, except
per share data):
<TABLE>
<CAPTION>
Three months Three months Nine months Nine months
ended ended ended ended
March 31, 2000 March 31, 1999 March 31, 2000 March 31, 1999
<S> <C> <C> <C> <C>
Net loss......................................... $(22,529) $ (2,289) $(50,303) $ (4,263)
-------- -------- -------- --------
Accretion of Preferred Stock..................... - (8) (225) (33)
Beneficial conversion charge, Preferred Stock.... - (31,577) (31,721)
Dividend on Preferred Stock (Note 3)............. - (40) (492) (40)
-------- -------- -------- --------
Net loss applicable to Common shares............. $(22,529) $(33,914) $(51,020) $(36,057)
======== ======== ======== ========
Net loss per Common share-basic and diluted...... $ (0.62) $(2.31) $ (1.92) $(2.48)
======== ======== ======== ========
Weighted average Common shares outstanding -
basic and diluted............................... 36,201 14,674 26,615 14,561
======== ======== ======== ========
</TABLE>
Warrants for 5,373,000 and 100,000 shares outstanding as of March 31, 2000 and
1999, respectively, were excluded from the above calculation, as their effect
would be antidilutive for the purposes of the calculation of diluted earnings
per share.
Options for 10,629,000 and 4,263,000 shares outstanding as of March 31, 2000
and 1999, respectively, were also excluded from the above calculation, as
their effect would be antidilutive for the purposes of the calculation of
diluted earnings per share.
Shares issuable upon the conversion of Preferred Stock of 11,757,000 as of March
31, 1999 were excluded from the above calculation, as their effect would be
antidilutive for the purposes of the calculation of diluted earnings per share.
There were no such shares outstanding as of March 31, 2000.
Comprehensive Net Loss
There are no differences between our net loss as reported for any of the periods
reported herein and our comprehensive loss, as defined by Statement of Financial
Accounting Standards No. 130, for each of these respective periods.
Segment information
We have adopted the provisions of SFAS No. 131, "Disclosures about Segments of
an Enterprise and Related Information" ("SFAS 131"). SFAS 131 establishes annual
and interim reporting standards for an enterprise's operating segments and
related disclosures about its products, services, geographic areas and major
customers. During all periods presented, we operated in a single business
segment, an online music network of Web sites (including EMusic.com,
RollingStone.com, IUMA.com and DownbeatJazz.com) that offers music consumers a
repertoire of musical recordings offered for sale by direct file transfer, or
"downloading," as well as extensive and exclusive music content
<PAGE>
and interactive features and provides advertisers a marketing channel to reach
these consumers across both broad and targeted demographic groups. Through March
31, 2000, foreign operations have not been significant.
Recent Accounting Pronouncements
In June 1998 the Financial Accounting Standards Board issued Statement of
Financial Accounting Standards No. 133, or SFAS 133, "Accounting for
Derivative Instruments and Hedging Activities" SFAS 133 requires that all
derivatives be recognized at fair value in the statement of financial
position, and that the corresponding gains or losses be reported either in the
statement of operations or as a component of comprehensive income, depending
on the type of hedging relationship that exists. SFAS 133 will be effective
for fiscal quarters beginning after June 15, 2000. We do not currently hold
derivative instruments or engage in hedging activities.
In December 1999, the Securities and Exchange Commission issued Staff Accounting
Bulletin No.101 (SAB 101), "Revenue Recognition in Financial Statements." SAB
101 provides guidance for revenue recognition under certain circumstances. We
are currently evaluating the impact of SAB 101 on our financial statements and
related disclosures, but do not expect that such impact, if any, will be
material. The accounting and disclosures prescribed by SAB 101 will be effective
for our fourth fiscal quarter ending June 30, 2000.
In March 2000, the FASB issued FASB Interpretation No. 44, or FIN 44,
"Accounting for Certain Transactions Involving Stock Compensation, an
interpretation of APB Opinion No. 25" ("Interpretation"). The Interpretation
is intended to clarify certain problems that have arisen in practice since the
issuance of APB 25. The Interpretation provides guidance, some of which is a
significant departure from current practice. The Interpretation generally
provides for prospective application for grants or modifications for existing
stock options. We are currently evaluating the impact of FASB Interpretation
No. 44 on our financial statements and related disclosures, but do not expect
that such impact, if any, will be material. FIN 44 will be effective for
fiscal quarters beginning July 1, 2000, but certain comments cover specific
events that occur after December 15, 1998 or January 12, 2000.
Note 2 - Mandatorily Redeemable Convertible Preferred Stock
On March 23, 1999 ("Issuance Date"), we completed a private placement of 117,570
shares of Series B Convertible Preferred Stock ("Series B"), which included the
conversion of outstanding convertible notes and shares of Series A Preferred
Stock into Series B Shares. Total proceeds, including proceeds from the
convertible notes were $31,577,000 net of issuance costs of $2,724,000. Each
share of Series B was convertible into 100 shares of our Common Stock.
During the quarter ended September 30, 1999, we recorded a charge of $224,000 to
accumulated deficit related to the accretion of the Series B shares to the
redemption value. In addition, we recorded a charge of $493,000 to accumulated
deficit for the 6% accrued dividends on the Series B shares.
On September 24, 1999, we completed an underwritten public offering, and
consequently the 117,570 shares of Series B were converted to 11,757,000 shares
of Common Stock. In conjunction with this conversion, we recorded an addition to
Common Stock of $12,000 and an increase to additional paid in capital of
$32,194,000. During the three months ended March 31, 2000, dividends on the
Series B shares of $1,061,000 were paid.
Note 3 - Acquisitions
On December 13, 1999, we acquired all of the stock of Group K, Inc. (dba
"Cductive"). The total purchase price of $36,612,000 consisted of 2,136,000
shares of our Common Stock valued at $30,975,000, assumption of outstanding
warrants and options valued at $5,322,000, and professional fees of $315,000.
The acquisition has been accounted for using the purchase method of accounting
and, accordingly, the results of operations have been included in our
condensed financial statements from the date of acquisition. The purchase
price was allocated to the acquired net assets of $743,000, goodwill of
$34,096,000 and other intangible assets of $1,773,000, pursuant to the review
by an independent valuations consultant. We are amortizing the goodwill and
intangible assets over their estimated life of three years using the straight-
line method.
On February 15, 2000, we acquired all of the outstanding stock of Tunes.com Inc.
The total purchase price of $136,121,000 consisted of 5,967,000 shares of our
Common Stock valued at $85,268,000, assumption of outstanding warrants and
options valued at $48,853,000, and professional fees of $2,000,000. The
acquisition has been accounted for using the purchase method of accounting and,
accordingly, the results of operations have been included in the consolidated
financial statements from the date of acquisition. The purchase price was
allocated to the acquired net assets of $51,000, goodwill of $63,182,000, the
RollingStone.com tradename of $71,470,000 and other intangible
<PAGE>
assets of $1,418,000, pursuant to the review by an independent valuations
consultant. We are amortizing, on a straight-line basis, the goodwill and
tradename over the estimated life of ten years and the other intangible assets
over the estimated life of one year.
The following table sets forth the Pro Forma Revenue, Pro Forma Net Loss and
Pro Forma Net Loss per Common share- basic and diluted, as though the
acquisition of Tunes.com Inc. occurred at the beginning of the periods
presented.
<TABLE>
<CAPTION>
Three months Three months Nine months ended Nine months ended
ended ended March 31, 2000 March 31, 1999
March 31, 2000 March 31, 1999
<S> <C> <C> <C> <C>
Pro Forma Revenue................................ 3,151 998 7,470 2,372
Pro Forma Net loss............................... $(25,800) $(9,259) $(75,496) $(26,774)
Pro Forma Net loss per Common share- basic and
diluted......................................... $ (0.66) $ (1.98) $ (2.41) $ (2.85)
</TABLE>
<PAGE>
- --------------------------------------------------------------------------------
ITEM 2. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS
OF OPERATIONS
- --------------------------------------------------------------------------------
EMusic.com Inc., a Delaware corporation (the "Company"), formerly known as
GoodNoise Corporation, was incorporated on January 8, 1998, and is an online
music network of Web sites (including EMusic.com, RollingStone.com, IUMA.com and
DownbeatJazz.com) that offers music consumers a repertoire of musical recordings
for sale by direct file transfer or "downloading," as well as extensive and
exclusive music content and interactive features and provides advertisers a
marketing channel to reach these consumers across both broad and targeted
demographic groups.
In addition to historical statements, this Quarterly Report on Form 10-Q
contains certain forward-looking statements that are subject to certain risks
and uncertainties, which could cause actual results to differ materially from
those stated or implied. Forward-looking statements are those that use the words
"expects," "estimates," "will," "may," "anticipates," "believes" or similar
expressions. These forward-looking statements reflect management's opinions only
as of the date hereof, and we assume no obligation to update this information.
Risks and uncertainties include, but are not limited to, those discussed below
and in the section entitled "Factors That May Affect Our Results." Other risks
and uncertainties are disclosed in our prior SEC filings.
The following discussion should be read in conjunction with our Condensed
Consolidated Financial Statements and Notes thereto, included elsewhere in this
report.
RESULTS OF OPERATIONS
We were incorporated on January 8, 1998, and through March 31, 2000, have
incurred significant costs to organize and develop an Internet website through
which we conduct our business. We began selling musical recordings over the
Internet in July 1998. We may experience significant fluctuations in operating
results in future periods due to a variety of factors, including, but not
limited to, market acceptance of the Internet as a medium for consumers to
obtain downloadable sound recordings, our ability to create, license, and
deliver compelling music-related content, our ability to obtain additional
financing in a timely manner and on terms favorable to us, our ability to
successfully integrate prospective asset or company acquisitions into our
existing business operations, the level of traffic on our websites, intense
competition from other providers of music-related content over the Internet, the
entrance of established music and/or software companies into the on-line music
industry, delays or errors in our ability to effect electronic commerce
transactions, our ability to upgrade and develop its systems and infrastructure
in a timely and effective manner, technical difficulties, system downtime or
Internet brownouts, our ability to attract customers at a steady rate and
maintain customer satisfaction, seasonality of the recorded music industry,
seasonality of advertising sales, our promotions and sales programs, the amount
and timing of operating costs and capital expenditures relating to expansion of
our business, operations and infrastructure and the implementation of marketing
programs, key agreements and strategic alliances, the number of recorded music
releases introduced during the period, the level of returns experienced by us
and general economic conditions and economic conditions specific to the
Internet, on-line commerce and the recorded music industry.
We have experienced significant growth since inception and in comparison to the
three months ended March 31, 1999. The following table (in thousands, except per
share data) and analysis sets forth a comparison of the three months and nine
months ended March 31, 2000 and 1999.
<PAGE>
<TABLE>
<CAPTION>
Three months Three months Nine months ended Nine months ended
ended ended March 31, 2000 March 31, 1999
March 31, 2000 March 31, 1999
<S> <C> <C> <C> <C>
Revenues............................................ $2,100 $ 21 $ 2,703 $ 42
Cost of revenues.................................... 579 9 751 14
------ ------ ------- ------
Gross profit........................................ 1,521 12 1,952 28
Gross Margin........................................ 72% 57% 72% 67%
Product development................................. 4,922 789 9,908 1,750
Stock compensation.................................. 2,072 865 8,987 1,496
------ ------ ------- ------
Total product development......................... 6,994 1,654 18,895 3,246
Selling and marketing............................... 8,810 19,218
General and administrative.......................... 2,141 314 4,031 716
Amortization of intangible assets................... 7,132 334 12,292 334
</TABLE>
Net Revenues
On February 15, 2000, we acquired all of the outstanding stock of Tunes.com
Inc., the Chicago, Illinois-based operator of RollingStone.com and
DownbeatJazz.com. We accounted for the acquisition using the purchase method of
accounting and included the results of Tunes.com in the consolidated financial
statements from the date of acquisition. Net revenues are primarily comprised
of advertising revenue and music sales. Revenues for the quarters ended March
31, 2000 and 1999 were $2,100,000 and $21,000, respectively. Revenues for the
nine months ended March 31, 2000 and 1999 were $2,703,000 and $42,000,
respectively. The increase in net revenues in these periods resulted from
increases in both advertising and downloadable music. Advertising revenues
increased significantly during these periods as a result of the addition of
Tunes.com and from increased page views across our entire network of sites.
Downloadable music sales were $450,000 and $2,600 in the quarters ended March
31, 2000 and 1999, respectively. Downloadable music sales for the nine months
ended March 31, 2000 and 1999 were $698,000 and $3,703, respectively.
Downloadable music sales increased principally as result of the increase in the
number of songs available for sale on our website from approximately 70,000 at
December 31, 1999 to over 100,000 at March 31, 2000. Sales also increased
because the number of affiliate sites selling our music increased from
approximately 1,000 at December 31, 1999 to over 6,000 at March 31, 2000.
To date, revenue from barter advertising and commissions has accounted for less
than 10% of our revenues. Barter transactions have been recognized at the fair
value of the advertising surrendered only when we have received cash for
comparable advertising transactions.
Cost of Revenues
Cost of revenues comprised principally license fees paid to the owners the
Rolling Stone Magazine and royalties paid to the owners of copyrighted songs
sold to customers as downloadable files. Other cost of revenues include the
cost of acquiring or creating editorial content, the cost to deliver advertising
on the company's websites, referral fees paid to affiliates and credit card
processing fees. Cost of revenues for the quarters ended March 31, 2000 and
1999 were $579,000 and $9,000, respectively. Cost of revenues for the nine
months ended March 31, 2000 and 1999 were $751,000 and $14,000, respectively.
Gross margins as a percentage of sales for the quarters ended March 31, 2000 and
1999 were 72% and 57%, respectively. Gross margins as a percentage of sales for
the nine months ended March 31, 2000 and 1999 were 72% and 67%, respectively.
Gross margins increased significantly when comparing the quarters and nine
months ended March 31, 2000 and 1999 due to increased proportion of revenues
from advertising and sponsorship, which have a higher margin than downloadable
music.
Product Development Expenses
<PAGE>
Product development expenses consist principally of website costs, software
maintenance audio production, graphic design, certain non-recoverable advances
to artists, artist development, content acquisition, telecommunications charges,
and the cost of development activities which support our music distribution
business, including related salaries, rent and depreciation. Product development
expenses for the quarters ended March 31, 2000 and 1999 were $6,994,000 and
$1,654,000, respectively. Product development expenses for the nine months ended
March 31, 2000 and 1999 were $18,895,000 and $3,246,000, respectively. The
increases for the three and nine month periods reflected an increase in stock
compensation and an increase in our product development efforts, particularly in
software engineering, graphic design, and development of the infrastructure and
"e-commerce" required to deliver downloadable music from our Internet website.
The increase also reflected costs incurred in connection with Tunes.com
operations subsequent to February 15, 2000. Product development expenses
included charges associated with stock warrants and stock options, granted to
advisors of $2,072,000 and $865,000 during the quarters ended March 31, 2000 and
1999, respectively, and $8,987,000 and $1,496,000 during the nine months ended
March 31, 2000 and 1999, respectively. We currently plan to continue aggregating
a compelling repertoire of musical recordings available for customer downloads,
and continue to develop the software necessary to manage such downloads.
However, we expect that product development expenses will decrease in future
periods particularly as we benefit from economies of scale, resulting from our
recent acquisitions.
Selling and Marketing Expenses
Selling and marketing expenses for the quarter and nine months ended March 31,
2000 were $8,810,000 and $19,218,000, respectively. There were no similar
expenses during the quarter and nine months ended March 31, 1999. The selling
and marketing expenses during the nine months ended March 31, 2000 reflect the
launch of an extensive marketing campaign to establish the brand name "EMusic"
as well as the execution on programs designed to promote our network of websites
through strategic alliances, targeted advertising, direct promotion, trade shows
and other such activities designed specifically to attract new customers and
traffic. In addition, the headcount in our sales and marketing departments
increased with the acquisition of Tunes.com in February 2000.
General and Administrative Expenses
General and administrative expenses consist primarily of executive management,
finance, legal, administrative and related overhead costs, such as rent,
insurance, and depreciation. General and administrative expenses for the
quarters ended March 31, 2000 and 1999 were $2,141,000 and $314,000,
respectively. General and administrative expenses for the nine months ended
March 31, 2000 and 1999 were $4,031,000 and $716,000, respectively. General and
administrative expenses increased principally as a result of additional
headcount required to manage our growing operations and as a result of the
acquisition of Tunes.com. We expect that general and administrative expenses
will decrease in future periods following the completion of the integration of
the two companies.
Amortization of Intangible Assets
Amortization of intangible assets for the quarters ended March 31, 2000 and 1999
were $7,132,000 and $334,000, respectively. Amortization of intangible assets
for the nine months ended March 31, 2000 and 1999 were $12,292,000 and $334,000,
respectively.
During 1999, we acquired the "EMusic," "IUMA" and certain other trade names for
a combined total of $26,362,000 in cash and stock. We began amortizing these
costs over three-year lives, resulting in an amortization expense of $2,283,000
per quarter.
On December 13, 1999, we acquired Cductive and began amortizing the goodwill and
intangible assets associated with this purchase of $35,869,000, over a three-
year life, resulting in an amortization expense of $2,989,000 per quarter.
On February 15, 2000, we acquired Tunes.com and began amortizing the goodwill
and tradename totaling $134,652,000 over a ten-year life and the other
intangible assets of $1,418,000 associated with this purchase over a one-year
life, resulting in an amortization expense of $3,721,000 per quarter.
Operating Expenses Exclusive of Certain Non-cash Charges
<PAGE>
Total operating expenses exclusive of certain non-cash charges for the quarters
ended March 31, 2000 and 1999 were $15,873,000 and $1,103,000, respectively.
Certain non-cash charges for the quarter ended March 31, 2000 included stock
compensation of $2,072,000 and amortization of intangible assets of $7,132,000.
During the quarter ended March 31, 1999 certain non-cash charges included stock
compensation of $865,000 and amortization of intangible assets of $334,000.
Total operating expenses exclusive of certain non-cash charges for the nine
months ended March 31, 2000 and 1999 were $33,157,000 and $2,466,000,
respectively. Certain non-cash charges for the nine months ended March 31, 2000
included stock compensation of $8,987,000 and amortization of goodwill and
intangible assets of $12,292,000. During the nine months ending March 31, 1999
certain non-cash charges included stock compensation of $1,496,000 and
amortization of goodwill and intangible assets of $334,000.
PRO FORMA RESULTS OF OPERATIONS
The following table sets forth a comparison of the Condensed Consolidated Pro
Forma Statement of Operations for the quarters ended March 31, 2000 and
December 31, 1999, as though the acquisition of Tunes.com occurred at the
beginning of the period ended March 31, 2000. These Pro Forma Results of
Operations are not part of the required Form 10-Q disclosures. Pro forma net
losses exclude certain non-cash charges related to stock compensation, the
amortization of intangibles and certain costs relating to the acquisition of
Tunes.com.
<TABLE>
<CAPTION>
Pro Forma Pro Forma
Three months Three months
ended ended
March 31, 2000 December 31, 1999
--------------------- ----------------------
<S> <C> <C>
Revenues................................................. $ 3,151 $ 423
Cost of revenues......................................... 805 147
-------- -------
Gross profit............................................. 2,346 276
-------- -------
Operating expenses:
Product development.................................... 5,645 2,935
Selling and marketing.................................. 9,778 5,637
General and administrative............................. 2,533 1,078
-------- -------
Total operating expenses............................ 17,956 9,650
-------- -------
Operating loss........................................... (15,610) (9,374)
Interest and other income, net........................... 1,011 948
-------- -------
Net loss................................................. $(14,599) $(8,426)
-------- -------
Net loss per Common share - basic and diluted............ $(0.37) $(0.28)
======== =======
Weighted average common shares outstanding - basic and
diluted................................................. 39,184 30,586
======== =======
</TABLE>
Pro Forma Net Revenues
The pro forma revenues primarily comprise advertising revenue and music sales,
and include the results of Tunes.com for the entire quarter ended in March 2000.
Pro forma revenues for the quarters ended March 31, 2000 and December 31, 1999
were $3,151,000 and $423,000, respectively. The increase resulted from resulted
from increases in both advertising and downloadable music. Advertising revenues
increased significantly during these periods as a result of the addition of
Tunes.com and from increased page views across our entire network of sites.
Revenue from barter advertising and commissions accounts for less than 10% of
our revenues.
<PAGE>
Downloadable music sales were $450,000 and $206,000 in the quarters ended March
31, 2000 and December 31, 1999, respectively. Downloadable music sales
increased principally as result of the increase in the number of songs available
for sale on our website from approximately 70,000 at December 31, 1999 to over
100,000 at March 31, 2000. Sales also increased because the number of affiliate
sites selling our music increased from approximately 1,000 at December 31, 1999
to over 6,000 at March 31, 2000.
Pro Forma Cost of Revenues and Gross Margin
Pro forma cost of revenues include the results of Tune.com for the entire
quarter ended in March 2000, and are comprised principally license fees paid to
the owners the Rolling Stone Magazine and of royalties paid to the owners of
copyrighted songs sold to customers as downloadable files. Other cost of
revenues include the cost of acquiring or creating editorial content, the cost
to deliver advertising on the company's websites, referral fees paid to
affiliates and credit card processing fees. Cost of revenues for the quarters
ended March 31, 2000 and December 31, 1999 were $805,000 and $147,000,
respectively. Gross margins as a percentage of sales for the quarters ended
March 31, 2000 and 1999 were 75% and 65%, respectively. Gross margins in the
March quarter were higher than those of prior quarters principally because the
greater proportion of revenues from advertising and sponsorship, which have a
higher margin than downloadable music.
Pro Forma Product Development Expenses
Pro Forma product development expenses include the results of Tunes.com for the
entire quarter ended March 31, 2000. These costs consist principally of website
costs, software maintenance, audio production, graphic design, certain non-
recoverable advances to artists, artist development, content acquisition,
telecommunications charges, and the cost of development activities which support
our music distribution business, including related salaries, rent and
depreciation. These pro forma costs exclude charges associated with stock
warrants and stock options, granted to advisors. Pro forma product development
expenses for the quarters ended March 31, 2000 and December 31, 1999 were
$5,645,000 and $2,935,000, respectively. The increase results principally from
the acquisition of Tunes.com.
Pro Forma Selling and Marketing Expenses
Pro Forma selling and marketing expenses include the results of Tunes.com for
the entire quarter ended March 31, 2000. Selling and marketing expenses for the
quarters ended March 31, 2000 and December 31, 1999 were $9,778,000 and
$5,637,000, respectively. The increase in selling and marketing expenses results
from increase in the headcount in our sales and marketing departments as a
result of the acquisition of Tunes.com and from additional advertising and
promotional activities related to the acquisition. .
Pro Forma General and Administrative Expenses
Pro Forma general and administrative expenses include the results of Tunes.com
for the entire quarter ended March 31, 2000. General and administrative expenses
consist primarily of executive management, finance, legal, administrative and
related overhead costs, such as rent, insurance, and depreciation. General and
administrative expenses for the quarters ended March 31, 2000 and December 31,
1999 were $2,533,000 and $1,078,000, respectively. The increase in general and
administrative expenses results principally from increase in the headcount as a
result of the acquisition of Tunes.com.
<PAGE>
Liquidity and Capital Resources
At March 31, 2000, we had a cash and cash equivalents balance of $46,914,000.
Net cash of $40,757,000 was used for operating activities for the nine months
ended March 31, 2000, principally as a result of net losses of $50,303,000
generated during the period and the increase of prepaid expenses and other
assets of $12,373,000, offset by non-cash expenses associated with stock options
and warrants granted to advisors of $8,987,000, amortization of intangible
assets of $12,292,000 and depreciation of $1,135,000. We expect to incur
negative cash flow from operations for the foreseeable future, as the market
continues to develop and we expand our operations.
Net cash used for investing activities totaled $14,031,000 for the nine months
ended March 31, 2000 as we spent $12,388,000 for the purchase of music content
and $3,143,000 on capital equipment, software and leasehold improvements.
Net cash provided by financing activities totaled $82,700,000 for the nine
months ended March 31, 2000 as proceeds from our public offering, net of
issuance costs, totaled $83,083,000. On September 24, 1999, we completed a
public offering of 5,270,000 shares of Common Stock for proceeds of $79,682,000,
net of issuance costs of $1,137,000. On October 27, 1999, we issued an
additional 300,000 shares of Common Stock for net proceeds of $4,538,000 in
connection with the exercise by the underwriters of their over-allotment option.
Under an agreement with Rolling Stone LLC we are required to purchase $1,100,000
of advertising and other services annually in Rolling Stone magazine until
February 2011 and to pay Rolling Stone an annual license fee of $1,000,000,
which increases to $1,250,000 in 2001 and $1,500,000 in 2006.
We believe our balances of cash, cash equivalents, short-term investments will
be sufficient to meet our cash requirements for at least the next twelve months.
However, if we should need to obtain additional capital or short-term
borrowings, there can be no assurance such capital or borrowings could be
obtained on favorable terms or at favorable rates, or at all.
YEAR 2000
We experienced a limited number of minor malfunctions in its information
technology systems as the result of the Year 2000 date change. None of these
failures had an impact on our financial performance or operations. We could
experience additional malfunctions not previously detected but we believe that
these additional malfunctions, if any, will not have a material impact on our
results of operations or financial condition.
We are in part dependent on third party suppliers. Through April of 2000, our
key third party suppliers have not reported any significant Year 2000 compliance
problems. However, because our continued Year 2000 compliance is in part
dependent on the continued compliance of third parties, there can be no
assurance that problems with third party suppliers will not have an adverse
affect on our results of operations or financial condition.
<PAGE>
FACTORS THAT MAY AFFECT OUR RESULTS
Investing in our Common Stock involves a high degree of risk. You should
carefully consider the following factors and other information contained in this
Form 10-Q and in our Form 10-K and other filings with the SEC before deciding to
invest in our stock.
Any of the following risks, if they actually occur, could materially and
adversely affect our business, financial condition or results of operations. In
such event, the trading price of our common stock could decline, and
stockholders could lose all or part of their investments.
We have a new and unproven business model and it may not generate sufficient
revenue for our business to survive or be successful.
Our model for conducting business and generating revenues is new and unproven
and if it fails to develop as we plan, our business may not succeed. Our
business model depends upon our ability to generate revenue streams from
multiple sources through our website, including:
. online sales of downloadable music;
. website advertising and sponsorship fees from third parties;
. licensing of musical recordings for use by others; and
. online sales of music-related merchandise.
It is uncertain whether a music-based website such as EMusic.com, that relies on
attracting people to purchase and download music, mostly from lesser-known
artists, can generate sufficient revenues to survive. This business model may
not succeed or it may not be sustainable as our business grows.
In order for our business to be successful, we must not only develop services
that directly generate revenue, but also provide content and services that
attract consumers to our website frequently. We will need to develop new
offerings as consumer preferences change and new competitors emerge. We may not
be able to provide consumers with an acceptable blend of products, services, and
informational and community offerings that will attract consumers to our website
frequently. We provide many of our products and services without charge, and we
may not be able to generate sufficient revenue to pay for these products and
services. Accordingly, we are not certain that our business model will be
successful or that we can sustain revenue growth or be profitable.
We are competing in a new market that may not develop sufficiently to support
our business.
The market for online music promotion and distribution is new and rapidly
evolving. As a result, demand and market acceptance for our products and
services are subject to a high degree of uncertainty and risk. We are attempting
to capitalize on a talent pool of artists underserved by the traditional
recording industry. Consumers may not continue to be interested in listening to,
or purchasing music from, these artists. If this new market fails to develop,
develops more slowly than expected or becomes saturated with competitors, or our
products and services do not achieve or sustain market acceptance, we may not
generate sufficient revenues to become profitable.
The future popularity of downloadable music will depend on consumer acceptance
of downloading music generally. We believe that consumer acceptance is, in part,
dependent on the availability of portable devices to store and play this music.
To the extent that devices are not available at affordable prices, or consumer
acceptance or distribution of these portable devices is delayed, our potential
market, and thus our ability to increase our revenues, may be reduced.
We have a limited operating history that makes an evaluation of our business
difficult.
We were incorporated in January 1998. During 1998, our operating activities
consisted largely of developing the infrastructure necessary to download music
on the Internet. Our limited operating history makes it difficult to evaluate
<PAGE>
our current business and prospects. As a result of our limited operating
history, we do not have meaningful historical financial data upon which to
forecast quarterly revenues and results of operations. Before investing in us,
you should evaluate the risks, expenses and problems frequently encountered by
companies such as ours that are in the early stages of development.
We have incurred substantial losses to date and we expect net losses in the
future.
From inception through March 31, 2000, we had an accumulated deficit of $99.9
million. We expect substantial net losses and negative cash flow for the
foreseeable future. We believe it is critical to our long-term success that we
continue to develop "EMusic" brand awareness and loyalty through marketing and
promotion, expand our artist and consumer networks, develop our online content
and expand our other services. We expect that our operating expenses will
increase significantly during the next several years, especially in sales and
marketing. With increased expenses, we will need to generate significant
additional revenues to achieve profitability. As a result, we may never
achieve profitability and, if we do achieve profitability in any period, we
may not be able to sustain or increase profitability.
Our quarterly revenues and operating results are subject to fluctuation, which
may result in volatility or a decline in the price of our stock.
We believe that period-to-period comparisons of our operating results are not
meaningful and should not be relied upon as indicators of future performance.
Our quarterly operating results are likely to fluctuate significantly in the
future as a result of a variety of factors, many of which are outside of our
control, including:
. the demand for downloadable music content and Internet advertising;
. the addition or loss of advertisers;
. the level of traffic on our Internet sites;
. amount and timing of capital expenditures and other costs relating to the
expansion of our operations;
. the introduction of new sites and services by us or our competitors;
. seasonal trends in Internet use, purchases of downloadable music, and
advertising placements;
. price competition or pricing changes in the industry;
. technical difficulties or system downtime; and
. general economic conditions, and economic conditions specific to the
Internet and Internet media.
In addition, while our revenues may vary significantly, portion of our expenses
are fixed. As a result, any decrease in revenues will not be accompanied by a
decrease in our fixed operating expenses and our operating results will suffer.
Our quarterly results may also be significantly impacted by the accounting
treatment of acquisitions, financing transactions or other matters. Particularly
at our early stage of development, such accounting treatment can have a material
impact on the results for any quarter. Because of these and other factors it is
likely that our operating results will fall below expectations in some future
quarter and the trading price of our stock may drop.
We depend on our exclusive relationship with the publisher of RollingStone
magazine for content and brand recognition and may not be able to attract
visitors to our RollingStone.com web site if this relationship is terminated or
becomes nonexclusive.
We depend significantly upon our relationship with the publisher and owner of
Rolling Stone magazine, for editorial content, access to the archives of
RollingStone and our use of the brand name "Rolling Stone," as well as for press
coverage, business and marketing opportunities, strategic relationships and
potential acquisitions. If we are unable to continue this relationship and to
utilize the Rolling Stone brand name and content on our Web sites, or if the
<PAGE>
RollingStone content or brand name is made accessible to our competitors, we may
generate less traffic, which would reduce our revenue. In addition, Rolling
Stone is not able to continue to obtain license rights for online distribution
of its magazine content from third-party contributors, we would not be able to
make this content available on our Web sites which could reduce the number of
visitors to our Web sites. Our agreement with Rolling Stone will terminate in
November 2005 unless we have a market capitalization of at least $150 million at
that time, in which case it will terminate in November 2010. Straight Arrow may
terminate the agreement earlier if we fail to maintain the technical reliability
reasonably required to keep our RollingStone.com web site available, other than
due to regularly scheduled maintenance and network and other outages that are
not due to our actions or that are not our fault.
This right to terminate also applies if the Web site is unavailable for more
than a total of 24 hours in any 60-day period or 12 consecutive hours. The
agreement may also be terminated earlier if we fail to comply with our other
obligations under the agreement, including our obligations to pay annual license
fees, royalty payments or other amounts due, or if we are acquired by a
competitor of RollingStone or another company that is unacceptable to Rolling
Stone.
Under our agreement with Rolling Stone, we obtained the right to use the
"Rolling Stone," "RollingStone Online" and "RollingStone.com" trademarks and
their derivatives in connection with the Internet and the right to use the
RollingStone.com domain name. If our agreement terminates, we will not be
entitled to use these trademarks or the RollingStone.com domain. The loss of
our right to use the Rolling Stone trademarks, domain or content would damage
our reputation and severely limit our ability to generate advertising, e-
commerce and other revenue.
Shares eligible for future sale in the open market may depress our stock price.
As of March 31, 2000, there were approximately 43,000,000 shares of Common Stock
outstanding, substantially all of which were tradable without restriction under
the Securities Act or pursuant to currently effective registration statements.
Our stock price has been and may continue to be volatile.
Our Common Stock is currently traded on the Nasdaq National Market under the
ticker symbol "EMUS." There can be no assurance that an active trading market
will be sustained in the future. In addition to fluctuations in our operating
results, the following factors could cause the price of our securities to be
volatile:
. development of the downloadable music market;
. technological innovations;
. legal development with respect to copyright law and downloadable music;
. new products;
. acquisitions or strategic alliances entered into by us or our competitors;
. failure to meet securities analysts' expectations;
. government regulatory action;
. patent or proprietary rights developments; and
. market conditions for Internet and technology stocks in general.
If our brand name is not accepted, our ability to attract content and customers
to our website will be harmed.
During the quarter ended June 30, 1999, we began to operate under the name
EMusic.com Inc. and launched a marketing campaign to establish the brand name
"EMusic." We believe that establishing and maintaining the EMusic brand is a
critical aspect of our efforts to attract and expand our Internet audience and
acquire new content and that the importance of brand recognition will increase
due to the growing number of Internet sites and the relatively low barriers to
entry in providing Internet content. We intend to incur significant expenses in
our brand building efforts. If these
<PAGE>
efforts do not generate increased revenues our operating results will suffer. If
we are unable to provide high quality content or otherwise fail to promote and
maintain our brand, our business will be harmed.
If we are unable to maintain or expand our contracts for music content, or if
the content we license does not sell, our popularity and business may suffer.
We believe that a primary draw to our EMusic.com website is the ability to
access music from known artists and independent record labels. Currently, we
have exclusive multi-year contracts for much of our music library. However, if
we are unable to sign contracts for new content, or if we are unable to extend
the terms of existing contracts as they expire, our website may fail to attract
new, or retain existing, customers which would harm our business.
For much of the content we license, we pay advances against future royalties,
which will be owed on sale of the content. If the content we license does not
sell in sufficient quantities, we may not be able to recover all or part of the
advances we have paid and our business could be harmed.
We rely on a third party for the hosting of our website and if this hosting
service becomes unavailable, our customers will not be able to access our
website.
We currently rely on a third party, which hosts our EMusic.com website at a
single location in Sunnyvale, California. We currently do not maintain a
redundant website. If for any reason our current website hosting services become
unavailable or if our hosting service experiences technical problems, customers
will not be able to access our website until these services are restored or
until we are able to make arrangements with an alternate provider.
If we fail to adequately manage our growth, we may not be successful as we may
miss market opportunities.
We expect the scope of our operations and the number of our employees to grow
rapidly. In particular, we intend to hire additional engineering, sales,
marketing, content acquisition and administrative personnel. Additionally,
acquisitions could increase our employee headcount and business activity. We
expect our rapid growth to continue to place significant stress on our
technology, operations, management and employee base. Any failure to
successfully address the needs of our growing enterprise would harm our
business.
Our technology systems must be expanded and enhanced for our business to grow.
In order to support a growing business, we will need to continue to enhance and
expand the technology infrastructure, which supports our business. We have
recently converted our central database to a new database based upon technology
licensed from Oracle Corporation and we are in the process of implementing a new
accounting system. As our business continues to grow, we will need to add
additional servers and other hardware and software systems as well as additional
sites for website hosting. If we fail to successfully implement these new and
enhanced systems, our operations could be disrupted, we may become less
competitive, our revenues could be reduced and we may need to incur additional
costs to address these issues.
We may have difficulty executing acquisitions and integrating the acquired
companies into our business.
Our business strategy includes entering into strategic alliances and acquiring
complementary businesses, technologies, content or products. Since 1999, we
completed the acquisitions of Creative Fulfillment, Inc., Internet Underground
Music Archive, Cductive and Tunes.com. These and any other future acquisitions
involve risks commonly encountered in acquisitions of companies, including:
. exposure to unknown liabilities of acquired companies;
. incurring acquisition costs and expenses in excess of what we anticipated;
. the occurrence of fluctuations in our quarterly and annual operating
results due to the costs and expenses of acquiring and integrating new
businesses or technologies;
<PAGE>
. experiencing difficulties and expenses in assimilating the operations and
personnel of the acquired businesses;
. disruption of our ongoing business and diversion of our management's time
and attention;
. a possible inability to integrate successfully or to complete the
development and application of acquired technology and a possible failure
to achieve the anticipated financial, operating, and strategic benefits
from these acquisitions;
. experiencing difficulties in establishing and maintaining uniform
standards, controls, procedures, and policies;
. impairment of our relationships with key employees and customers of
acquired businesses or the loss of these key employees and customers as a
result of changes in management and ownership of the acquired businesses;
and
. acquisitions using the purchase method of accounting, which may result in
goodwill, creating amortization charges in future periods.
In addition, our shareholders may be diluted if the consideration for future
acquisitions consists of equity securities. We may not overcome these risks or
any other problems encountered in connection with acquisitions. If we are
unsuccessful in doing so, our business could be harmed.
We expect competition to increase significantly in the future and we may not be
able to compete successfully.
The market for the online promotion and distribution of music and music-related
products and services is new, highly competitive and rapidly changing. The
number of websites on the Internet competing for the attention and spending of
consumers, users and advertisers has increased, and we expect it to continue to
increase, because there are few barriers to entry to Internet commerce. In
addition, the competition for advertising revenues, both on Internet websites
and in more traditional media, is intense. Currently, there are more than one
hundred music retailing websites on the Internet. We face competitive pressures
from numerous actual and potential competitors.
Most of the major record labels companies have announced initiatives with
respect to the sale of downloadable music or that they expect to make
announcements of their plans soon. If we are unable to obtain licenses to sell
or otherwise distribute content form major record label companies, our ability
to increase our sales will be limited to our ability to obtain licenses from the
independent record label segment of the music market, which has historically
represented approximately 20% of the total music market. To the extent that
other companies are able to obtain rights to content from major record labels,
such companies may have a significant competitive advantage over us.
Competition is likely to increase significantly as new companies enter the
market and current competitors expand their services. Many of our current and
potential competitors in the Internet and music entertainment businesses may
have substantial competitive advantages relative to us, including:
. longer operating histories;
. significantly greater financial, technical and marketing resources;
. greater brand name recognition;
. larger existing customer bases; and
. more popular content or artists.
These competitors may be able to respond more quickly to new or emerging
technologies and changes in customer requirements and devote greater resources
to the development, promotion, and sale of their products or services than we
can. Websites maintained by our existing and potential competitors may be
perceived by consumers, artists, talent management companies and other music-
related vendors or advertisers as being superior to ours. In addition, we may
not be able to maintain or increase our website traffic levels, purchase
inquiries and number of click-throughs on our
<PAGE>
online advertisement. Further, our competitors may experience greater growth in
these areas than we do. Increased competition could result in advertising price
reduction, reduced margins or loss of market share, any of which could harm our
business.
We may need to obtain additional funds to execute our business plan and if we
are unable to obtain such funds, we will not be able to expand our business as
planned.
We believe that our existing capital will be sufficient to fund our planned
level of operating activities, capital expenditures and other obligations
through the next 12 months. However, unless we raise additional capital, we may
need to reduce the scope of certain activities. In addition, we may need to
raise additional funds in order to:
. finance unanticipated working capital requirements;
. develop or enhance existing services or products;
. fund distribution relationships;
. advertise to build global brand recognition;
. respond to competitive pressures; or
. acquire complementary businesses, technologies, content or products.
Additional financing may not be available on terms favorable to us, or at all.
If adequate funds are not available or are not available on acceptable terms,
our ability to fund our expansion, take advantage of unanticipated
opportunities, develop or enhance services or products or otherwise respond to
competitive pressures would be significantly limited. If we raise additional
funds by issuing equity or convertible debt securities, the percentage ownership
of our then existing stockholders will be reduced, and these securities may have
rights, preferences or privileges senior to those of our stockholders.
Our business is dependent on the continued development and maintenance of the
Internet and the availability of increased bandwidth to consumers.
The success of our business will depend largely on the development and
maintenance of the Internet infrastructure. This includes maintenance of a
reliable network with the necessary speed, data capacity and security, as well
as timely development of complementary products such as high-speed modems, for
providing reliable Internet access and services. Because global commerce on the
Internet and the online exchange of information is new and evolving, we cannot
predict whether the Internet will prove to be a viable commercial marketplace in
the long term.
The success of our business will rely on the continued improvement of the
Internet as a convenient means of consumer interaction and commerce, as well as
an efficient medium for the delivery and distribution of music. Our business
will depend on the ability of our artists and consumers to continue to upload
and download mp3 and other music file formats, as well as to conduct commercial
transactions with us, without significant delays or aggravation that may be
associated with decreased availability of Internet bandwidth and slower access
to our website. Our penetration of a broader consumer market will depend, in
part, on continued proliferation of high speed Internet access. Even compressed
in mp3 format, a typical three-minute song file can occupy more than three
megabytes of storage space. This file could take approximately seven minutes to
download over a conventional 56 kbps modem compared to less than one minute over
an xDSL or cable modem.
The Internet has experienced, and is likely to continue to experience,
significant growth in the numbers of users and amount of traffic. As the
Internet continues to experience increased numbers of users, increased frequency
of use and increased bandwidth requirements, the Internet infrastructure may be
unable to support the demands placed on it. In addition, increases in users or
bandwidth requirements may harm the performance of the Internet. The Internet
has experienced a variety of outages and other delays as a result of damage to
portions of its infrastructure, and it could face outages and delays in the
future. This might include outages and delays resulting from denial of service
problems such as those recently experienced by major Internet sites, such as
Yahoo!. These outages and delays could reduce the level
<PAGE>
of Internet usage as well as the level of traffic, and could result in the
Internet becoming an inconvenient or uneconomical source of music and music-
related products and services. The infrastructure and complementary products or
services necessary to make the Internet a viable commercial marketplace for the
long term may not be developed successfully or in a timely manner. Even if these
products or services are developed, the Internet may not become a viable
commercial marketplace for the products or services that we offer.
We must maintain and establish strategic alliances to increase our customer base
and enhance our business.
In an attempt to increase our customer base and traffic on our website, build
brand recognition, attract paid advertising and enhance content, distribution
and commerce opportunities, we have entered into agreements with various media,
hardware device and Internet-related companies such as: Yahoo, America Online
and RealNetworks. Our failure to maintain or renew our existing strategic
alliances or to establish and capitalize on new strategic alliances could harm
our business. Our future success depends to a significant extent upon the
success of such alliances. Moreover, we are substantially dependent on our
ability to advertise on other Internet sites and the willingness of the owners
of other sites to direct users to our Internet sites through hypertext links. We
may not achieve the strategic objectives of these alliances, and parties to
strategic alliance agreements with us may not perform their obligations as
agreed upon. Such agreements also may not be specifically enforceable by us. In
addition, some of our strategic alliances are short term in nature and may be
terminated by either party on short notice. The termination or impairment of
these strategic alliances could reduce our ability to attract new customers.
Our success depends on our retention of key personnel.
Our performance is substantially dependent on the services of Robert H. Kohn,
our chairman, and Gene Hoffman, Jr., our chief executive officer, as well as on
our ability to recruit, retain and motivate other officers and key employees.
Competition for qualified personnel is intense and there are a limited number of
persons with knowledge of and experience in the Internet and music entertainment
industries. The loss of the services of any of our officers or senior managers
could harm our business.
We may not be able to hire and retain a sufficient number of qualified employees
to grow our business as planned.
Our future success will depend on our ability to attract, train, retain and
motivate other highly skilled technical, managerial, marketing and customer
support personnel. Competition for these personnel is intense, especially for
engineers, web designers and advertising sales personnel, and we may be unable
to successfully attract sufficiently qualified personnel. A large percentage of
our employees have joined us within the last 12 months and we expect that our
rate of hiring will continue at a very rapid pace. To manage the expected growth
of our operations, we will need to integrate these employees into our business.
Our inability to hire, integrate and retain qualified personnel in sufficient
numbers may reduce the quality of our programs, products and services, and could
harm our business. In addition, companies in the Internet and music industries
whose employees accept positions with competitive companies frequently claim
that their competitors have engaged in unfair hiring practices. We may be
subject to claims in the future as we seek to hire qualified personnel and those
claims may result in material litigation. Even if unsuccessful, these claims
could harm our business by damaging our reputation, requiring us to incur legal
costs and diverting management's attention away from our business.
Security concerns regarding credit card or other confidential information
transmitted over the web could limit our growth and subject us to liability.
A significant barrier to e-commerce and communications over the Internet has
been the need for secure transmission of confidential information over public
networks. Internet usage may not increase at the rate we expect unless some of
these concerns are adequately addressed and found acceptable by the market.
Internet usage could also decline if any well-publicized compromise of security
occurred. We may incur significant costs to protect against the threat of
security breaches or to alleviate problems caused by such breaches. Protections
against security breaches may not be available at a reasonable price or at all.
If a third party were able to circumvent our security measures and
misappropriate our users' personal information, it may cause interruptions to
our retail website operation, damage our
<PAGE>
reputation or subject us to claims by users. Any compromise of confidential data
during transmission over the Internet may harm our business.
Any failure of our internal security measures could cause us to lose customers
and subject us to liability.
Our business is dependent on maintaining a database of confidential user
information, including credit card numbers. If the security measures that we use
to protect personal information are ineffective, we may lose customers and our
business would be harmed. We rely on security and authentication technology
licensed from third parties. With this technology, we perform real-time credit
card authorization and verification. We cannot predict whether new technological
developments could allow these security measures to be circumvented.
In addition, our software, databases and servers may be vulnerable to computer
viruses, physical or electronic break-ins and similar disruptions. We may need
to spend significant resources to protect against security breaches or to
alleviate problems caused by any breaches and we may not be able to prevent all
security breaches.
Our intellectual property protection may be inadequate, and any loss or
reduction in intellectual property protection may harm our business.
Our intellectual property includes our trademarks and copyrights, proprietary
software, and other proprietary rights. We believe that our intellectual
property is important to our success and our competitive position, and we try to
protect it. However, our efforts to protect our intellectual property could be
inadequate. Use of the "EMusic" name by others could dilute our brand identity
and confuse the market. In addition, our ability to conduct our business may be
harmed if others claim we violate their intellectual property rights. For
example, Sightsound.com, Inc. has asserted that many online music providers,
including EMusic, violate patent rights that it allegedly owns covering the sale
of music over the Internet through digital downloads. If successful, these
claims, or similar claims by others, could seriously harm our business by
forcing us to cease using intellectual property that we depend on to operate our
business. Even if unsuccessful, these claims could harm our business by damaging
our reputation, requiring us to incur legal costs and diverting management's
attention away from our business.
Government regulation may require us to change the way we do business.
Laws and regulations directly applicable to Internet communications, commerce
and advertising are becoming more prevalent. The United States Congress has
enacted Internet laws regarding children's privacy, copyrights and taxation.
Such legislation could dampen the growth in use of the Internet generally and
decrease the acceptance of the Internet as a communications, commercial and
advertising medium. Although our transmissions originate in California, the
governments of other states or foreign countries might attempt to regulate our
transmissions or levy sales or other taxes relating to our activities. The
European Union recently enacted its own privacy regulations that may result in
limits on the collection and use of certain user information. The laws governing
the Internet, however, remain largely unsettled, even in areas where there has
been some legislative action. It may take years to determine whether and how
existing laws such as those governing intellectual property, privacy, libel and
taxation apply to the Internet and Internet advertising. In addition, the growth
and development of the market for Internet commerce may prompt calls for more
stringent consumer protection laws, both in the United States and abroad, that
may impose additional burdens on companies conducting business over the
Internet. Furthermore, the Federal Trade Commission has recently investigated
the disclosure of personal identifying information obtained from individuals by
Internet companies. Evolving areas of law that are relevant to our business
include privacy law, proposed encryption laws, content regulation and sales and
use tax. For example, changes in copyright law could require us to change the
manner in which we conduct business or increase our costs of doing business. In
addition, currently pending litigation involving copyright infringement claims
brought against MP3.com and Napster may result in decisions, which have a
significant impact on our business. If the unlicensed distribution of music is
held to be lawful, our ability to sell music could be materially harmed. Because
of this rapidly evolving and uncertain regulatory environment, we cannot predict
how these laws and regulations might affect our business. In addition, these
uncertainties make it difficult to ensure compliance with the laws and
regulations governing the Internet. These laws and regulations could harm us by
subjecting us to liability or forcing us to change how we do business. In the
event the Federal Trade Commission or other governmental authorities adopt or
modify laws or regulations applicable to our business, including those relating
to the Internet and copyright matters, our business could be harmed.
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We may have liability for content on our website and liability for other
materials, which we distribute.
We may be liable to third parties for content on our website and any other
materials we distribute if:
. the music, text, graphics or other content on our website violates their
copyright, trademark, or other intellectual property rights;
. our artists or labels violate their contractual obligations to others by
providing content on our website; or
. content we distribute is deemed obscene, defamatory or excessively
violent.
We may also be subject to these types of liability for content that is
accessible from our website through links to other websites.
Liability or alleged liability for content or other materials could harm our
business by damaging our reputation, requiring us to incur legal costs in
defense, exposing us to significant awards of damages, fines and costs and could
divert management's attention away from our business. In particular, in addition
to civil damages, liability for violations of copyright law currently can result
in penalties of up to $10,000 per occurrence.
Imposition of sales and other taxes on e-commerce transactions may impair our
ability to derive financial benefits from e-commerce.
Except for sales of tangible merchandise into certain states, we do not collect
sales or other taxes on sales of our products through our websites. Although
the Internet Tax Freedom Act precludes, for a period of three years ending
October 2001, the imposition of state and local taxes that discriminate against
or single out the Internet, it does not currently impact existing taxes.
However, one or more states may seek to impose sales tax collection obligations
on out-of-state companies such as us, which engage in or facilitate online
commerce. A number of proposals have been made at the state and local level that
would impose additional taxes on the sale of goods and services through the
Internet. Such proposals, if adopted, could substantially impair the growth of
electronic commerce and could adversely affect our opportunity to derive
financial benefit from electronic commerce. Moreover, if any state or foreign
country were to successfully assert that we should collect sales or other taxes
on the exchange of merchandise on its system, it could affect our cost of doing
business.
Legislation limiting the ability of states to impose taxes on Internet based
transactions has been proposed in the U.S. Congress. We cannot assure you that
this legislation will ultimately become law or that the tax moratorium in the
final version of this legislation will be ongoing. Failure to enact or renew
this legislation, if enacted, could allow various states to impose taxes on
Internet-based commerce, which could harm our business.
We may have difficulty expanding into international markets, which could limit
the growth of our business.
Our future growth and success will depend in part on our ability to generate
international sales. There can be no assurance, however, that we will be
successful in generating international sales of our products. Sales to customers
in certain international countries may be subject to a number of risks,
including: currency exchange rate risk; the risks that agreements may be
difficult or impossible to enforce and receivables difficult to collect through
an international country's legal system; foreign customers may have longer
payment cycles; or foreign countries could impose withholding taxes or otherwise
tax our foreign income, impose tariffs, embargoes, or exchange controls, or
adopt other restrictions on foreign trade. In addition, the laws of certain
countries do not protect our offerings and intellectual property rights to the
same extent as the laws of the United States. If we fail to compete successfully
or to expand the distribution of our offerings in international markets the
growth of our business could be limited.
Development of new standards for the electronic delivery of music may threaten
our business.
We currently rely on mp3 technology as a delivery method for the digital
distribution of music. Mp3 is an open standard adopted by the Moving Picture
Experts Group for the compression of audio files. We do not own or control
<PAGE>
mp3 technology and are dependent upon a license to obtain rights to certain
patents relating to the technology. The onset of competing industry standards
for the electronic delivery of music could significantly affect the way we
operate our business as well as the public's perception of EMusic as a company.
For example, in December 1998, the major recording studios announced a plan to
develop a universal standard for the electronic delivery of music, called the
Secured Digital Music Initiative. If new standards are developed and adopted by
consumers, we may not be able to obtain a license to such technology on
favorable terms or at all and our business could be harmed. Even if new
standards are not developed, delays with respect to proposed standards, such as
those which have occurred with respect to SDMI, can cause confusion in the
marketplace, slow the development of the market for downloadable music and
otherwise harm our business.
Mp3 technology is controversial within certain segments of the traditional music
industry and we may face continued opposition to our use of mp3, which may slow
market development and harm our business.
Certain segments of the traditional music industry have not embraced the
development of the mp3 format to deliver music, in part because users of mp3
technology can download and distribute unauthorized or "pirated" copies of
copyrighted recorded music over the Internet. We believe that our success is
largely dependent upon the ease with which customers can download and play
music. We may face opposition from a number of different music industry sources
including record companies and studios, the Recording Industry Association of
America and certain artists. The adoption of competing standards may slow the
development of the market for downloadable music or result in increased costs of
doing business, which could harm our business.
Our executive officers and directors control approximately 17% of our Common
Stock and have power to influence significant corporate matters, which may
delay, deter or prevent transactions that could benefit our stockholders.
Executive officers and directors, in the aggregate, beneficially own
approximately 17% of our outstanding Common Stock. These stockholders are able
to significantly influence all matters requiring approval by our stockholders,
including the election of directors and the approval of significant corporate
transactions. This concentration of ownership may also have the effect of
delaying, deterring or preventing a change in control of EMusic and may make
some transactions more difficult or impossible without the support of these
stockholders.
Anti-takeover provisions in our charter documents could negatively impact our
stockholders.
Our Board of Directors has the authority to issue up to 20,000,000 shares of
Preferred Stock without need for stockholder approval. The board may also
determine the economic and voting rights, of this Preferred Stock. The holders
of our Common Stock could be adversely affected by the issuance of Preferred
Stock. Issuance of Preferred Stock could impede or prevent transactions that
would cause a change in control of our company. This might discourage bids for
our Common Stock as a premium over the market price of our Common Stock and
adversely affect the trading price of our Common Stock. We have no current plans
to issue shares of Preferred Stock. In addition, other provisions in our charter
documents could make it more difficult for a third party to acquire us, even if
doing so would be beneficial to our stockholders.
Our data warehousing and web server systems are vulnerable to natural disasters,
failure of third-party services and other unexpected problems.
Since our data warehousing, web server and network facilities are all located in
California, an earthquake or other natural disaster could affect all of our
facilities simultaneously. An unexpected event such as a power or
telecommunications failure, fire, flood or earthquake at our on-site data
warehousing facility or at our Internet service providers' facilities could
cause the loss of critical data and prevent us from offering our services to
artists and consumers. Our business interruption insurance may not adequately
compensate us for losses that may occur. In addition, we rely on third parties
to securely store our archived data, house our web server and network systems,
and
<PAGE>
connect us to the Internet. A failure by any of these third parties to
provide these services satisfactorily could harm our business.
<PAGE>
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ITEM 3. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK
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Interest Rate Risk
We do not hold derivative or speculative financial instruments and substantially
all cash and cash equivalent balances are invested in money market accounts with
floating interest rates, therefore we are not subject to significant interest
rate risk.
Currency Exchange Rate Risk
During the period from inception through March 31, 2000, all of our revenues and
expenses have been denominated in U.S. dollars. As a result, we have not
incurred any realized or unrealized currency exchange rate gains or losses. We
do not expect to incur any significant gains and losses during the next twelve
months. We have not engaged in foreign currency hedging activities to date.
<PAGE>
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PART II - OTHER INFORMATION
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Item 2. Changes in Securities and Use of Proceeds
During the quarter, we granted warrants for the purchase of 1,600,000 shares to
advisors and in conjunction with the acquisition of musical content during
quarter. All of such warrants were granted to accredited investors pursuant to
Regulation D.
Use of Proceeds
During the quarter ended March 31, 2000, proceeds from our September 1999 public
offering and available cash have been used to purchase $1,012,000 in fixed
assets, and to pay operating expenses, primarily payroll and facilities related,
of $13,578,000. The remainder of the proceeds has been invested in money market
accounts as of March 31, 2000.
<PAGE>
ITEM 6. EXHIBITS AND REPORTS ON FORM 8-K
(a) Exhibits
None
(b) Reports on Form 8-K
None
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SIGNATURES
Pursuant to the requirements of the Securities Exchange Act of 1934, the
registrant has duly caused this report to be signed on its behalf by the
undersigned thereunto duly authorized.
Date: May 15, 2000 EMusic.com Inc.
/s/ Joseph Howell
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Joseph Howell,
Executive Vice President and
Chief Financial Officer
