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SECURITIES AND EXCHANGE COMMISSION
Washington, D.C. 20549
FORM 10-K
[x] Annual Report Pursuant to Section 13 or 15(d) of the Securities Exchange
Act of 1934
For the fiscal year ended April 3, 1999
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[ ] Transition Report pursuant to Section 13 or 15(d) of the Securities
Exchange Act of 1934 for the transition period from ________ to _______
Commission file number __________
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VALLEY MEDIA, INC.
(Exact name of registrant as specified in its charter)
Delaware 94-2556440
(State or other jurisdiction (I.R.S. Employer Identification No.)
of incorporation or organization)
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1280 Santa Anita Court, Woodland, California 95776
(Address of principal executive offices)
Registrant's telephone number, including area code: (530) 661-6600
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Securities registered pursuant to Section 12(b) of the Act: None
Securities registered pursuant to Section 12(g) of the Act: Common Stock
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 ___ No x .
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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. [ ]
As of May 28, 1999, the aggregate market value of the voting stock held by
nonaffiliates of the registrant was $100,889,596. For purposes of this
information, the outstanding shares of Common Stock owned by directors and
executive officers of the registrant were deemed to be shares of Common Stock
held by affiliates.
The number of shares of Common Stock outstanding as of May 28, 1999, were
8,449,009 shares.
DOCUMENTS INCORPORATED BY REFERENCE:
Portions of the Registrant's definitive proxy statement to be filed pursuant to
Regulation 14A not later than 120 days after the end of the fiscal year (April
3, 1999) are incorporated by reference.
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This report on Form 10-K, including the discussion in Part I, Item 1
"Business" and Part II, Item 7 "Management's Discussion and Analysis of
Financial Condition and Results of Operation," contains forward-looking
statements that involve risks and uncertainties. Such forward-looking
statements include, among others, those statements including the words
"expects," "anticipates," "intends," "believes" and similar language. Our
actual results could differ materially from the results anticipated in these
forward-looking statements as a result of a variety of factors, including those
set forth in "Management's Discussion and Analysis of Financial Condition and
Results of Operations--Factors Affecting Operating Results."
PART I
ITEM 1. Business
We are a full-line distributor of music and video entertainment products.
We distribute product to retailers operating traditional storefronts and provide
product, data and value-added services to music and video Internet retailers.
With our advanced systems, technology and proprietary databases, we enable music
and video suppliers to more effectively reach a fragmented retail market and
provide value-added services to our customers and suppliers. Valley Media, Inc.
is a Delaware corporation, sometimes referred to in this document as Valley.
We have developed our proprietary databases, as well as our distribution and
data collection systems, to handle a "deep catalog" of approximately 260,000
stock keeping units, commonly referred to as skus, efficiently. In addition, we
have developed state-of-the-art fulfillment centers to ship very small orders
directly to customers ordering via on-line music retailers as well as large,
complex orders from traditional retailers. We believe we differentiate
ourselves by our commitment to a deep selection of music and video skus and our
ability to offer value-added systems, data and other capabilities.
We have benefited from retailers' efforts to outsource certain of their
distribution and purchasing functions. The music and video industries are
offering, and consumers are demanding, a growing product selection from
thousands of individual studios and labels. This demand for a larger variety of
titles has been particularly illustrated by Internet retailers, who
differentiate themselves from traditional stores by advertising the breadth of
their "virtual" selections. It is inefficient for many retailers to manage the
large number of supplier relationships necessary to satisfy their customers.
Accordingly, retailers turn to product aggregators such as Valley to simplify
their own operations and reduce costs.
We operate through three primary business groups, Full-line Distribution,
New Media and Independent Distribution.
Full-line Distribution
We are the largest full-line music distributor, one of the largest sell-
through video and DVD distributors and among the largest video rental
distributors in terms of net sales in the United States. In fiscal 1999, we
distributed music and videos to more than 6,600 traditional retailers operating
over 42,000 traditional storefronts. Working with Valley, a retailer can
increase sales by improving in-stock position while reducing inventory,
warehousing and other costs. Suppliers benefit from Valley's ability to
distribute their products through the full variety of retail channels.
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Operations and Technology
By combining state-of-the-art information systems and customized
distribution center automation equipment, we believe we have developed the most
efficient and advanced distribution capabilities in the full-line music and
video distribution industry. These capabilities enable us to:
. maintain a highly reliable inventory management system
. optimize product purchasing decisions
. minimize variable order processing costs
. increase accuracy and speed of order fulfillment
. provide other value-added services to both suppliers and retailers
Valley has designed its systems to be scaleable and has developed software
that can handle multiple warehouses and multiple sorters.
Our inventory system electronically accounts for, manages and maximizes
warehouse placement of more than 10.0 million units of inventory in our
California distribution center and 9.6 million units in the Louisville center.
To maximize distribution center space utilization, incoming products are scanned
and located "randomly" within the center utilizing "best fit" logic that
considers over 350,000 distinct potential locations in a single distribution
center. This logic considers, among other things, the size of the incoming
product and shipment as well as available locations within the center.
With inventory information derived from our systems, we utilize customized
inventory replenishment software and purchasing systems to adjust our inventory
levels quickly and strategically in response to changes in demand. Our
integrated systems evaluate daily inventory levels on each sku and make
recommendations regarding the optimal order replenishment based on several
factors, including historical seasonal demand, supplier discounts, payment
terms, return dates, supplier characteristics, carrying costs and warehouse
processing costs. Employing the extensive industry knowledge of our product
managers, we manually order new releases and adjust the purchasing system's
recommendations to accommodate volatile-demand skus.
We have high capacity automated sorting equipment and order processing
systems in our California and Kentucky distribution centers that reduce labor
costs and freight upgrade expenses, increase peak capacity and accuracy and
enable us to provide certain automated value-added services. Customer orders
are picked in batches of up to 100 or more, one batch representing one trip
through the distribution center. These batches are then placed in an advanced
sorting device, which uses high speed laser scanners to separate, sticker and
stack individual store orders at speeds of up to 12,000 units per hour.
Our information systems are an integral part of our operations. We are
constantly upgrading these systems and developing new applications. Our primary
information system is currently utilized for our audio and video operations in
our Woodland and Louisville distribution centers and certain of our smaller
facilities. We use an ancillary information system for our video facilities in
Massachusetts, New Jersey and Pennsylvania. In stages over the next two
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years, we intend to integrate this ancillary information system into our primary
information system. In addition, we use a separate information system for our
vendor managed inventory operations. During fiscal 1999, we licensed software to
replace our current vendor managed inventory system. We intend to complete this
upgrade during fiscal 2000. We cannot be certain that the integration or
replacement of these systems will be completed as scheduled or without
unanticipated costs or operational difficulties.
Deep Catalog
We believe we differentiate ourselves with both retailers and suppliers by
stocking one of the deepest catalogs of music and video skus of any full-line
distributor. Currently, we have an inventory of approximately 260,000 skus,
approximately 51,700 of which are video skus. By managing deep catalog for many
retailers, we believe we can optimize the tradeoff between availability and
inventory levels.
We believe marketing and stocking lower volume skus is a key competitive
advantage in developing and maintaining relationships with retailers and
suppliers. By providing customers an aggregated database describing all of our
products, we link suppliers and customers to the thousands of deep catalog skus.
The margins attainable on lower volume, deep catalog skus, such as older or less
popular titles, are generally higher than the hits. Retailers who do not have
access to these skus miss out on the opportunity for higher margin sales. Once
a retailer has retained Valley as its supplier for lower volume skus, it is
often convenient for that retailer to satisfy other product needs through Valley
as well.
Proprietary Data
Besides serving as the foundation of our traditional distribution
operations, our systems also accurately capture, compile and update product data
as inventory moves in and out of our fulfillment centers. We utilize this data
collection capability to develop a proprietary database, which we license to
customers for a fee or as part of a package of services. The data is used by
SoundScan, Inc., a leading provider of music and video information, as a
backbone for its own systems. It contains over 30 distinct fields of
information (e.g., genre, title, suggested retail price, catalog code numbers,
first sales date, vendor return dates and parental advisory information), which
can be sorted and analyzed by retailers to help them better manage their
purchasing and inventory requirements and service their customers. Using
SoundSearch, our electronic catalog system, a retailer can access our data from
a Windows-based platform and generate electronic data interchange orders without
an internal point-of-sale system.
New Media
Over the past five years, New Media has been our fastest growing business
group. Net sales grew from approximately $1.6 million in fiscal 1995 to $182.7
million in fiscal 1999.
New Media provides product and data to the fastest growing segment of the
music retail industry, Internet retailers. We fulfill customer orders for many
Internet retailers by shipping product directly to the individual customer.
These retailers have effectively outsourced their inventory procurement and
management functions and stock little or no product on their own. Other
customers, including Amazon.com, fulfill their own orders, and we provide
product to their internal distribution centers on a just-in-time basis. New
Media currently has more than
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100 customers, including specialty Internet retailers, such as Amazon.com,
Buy.com, CDnow, and DVD Express, record clubs and traditional retailers adding
online capabilities.
The infrastructure, market channels and supplier relationships developed
through our core Full-line Distribution business group are the foundation of New
Media. We believe our "first to market" position and strategic emphasis on
data, catalog depth and systems enhancements have enabled us to maintain our
leadership position.
Commitment to Deep Catalog
Our deep catalog commitment enables Internet retailers to offer their
customers fast, reliable access to an extensive selection of product, without
having to take possession of the inventory. Furthermore, industry sources have
observed that Internet retail customers buy a higher proportion of deep catalog
product relative to hit titles than do shoppers at traditional storefronts. Our
Internet retailers rely on our extensive inventory of product offerings to
supply the breadth of product selection that Internet shoppers demand.
Superior Product Data
Most Internet retailers served by New Media rely on our proprietary product
database to support their product information systems as well as the ordering
systems used by their customers. We believe our database is a key building
block for Internet retailers' websites because it would be prohibitively
expensive for most such retailers to build such a database independently. To
supplement this database, and for the greater convenience of retailers and their
customers, we recently have introduced two additional data products:
. audiotrax, which provides track-by-track information for music skus
. "stock-on-hand file," which provides current product-availability data for
music skus
We intend to continue adding additional data products and enhancements to
strengthen our role as an essential partner of Internet retailers, including
detailed customer oriented information on all DVD products.
Advanced Systems and Processing Capabilities
Many Internet retailers require that their fulfillment partner fill a very
large number of small orders quickly and accurately and ship them in the name of
such retailers at the lowest cost possible. We developed New Media's
fulfillment capabilities over a four-year period and incorporated the advanced
systems and equipment we had developed to support our Full-line Distribution
business group. Furthermore, New Media's systems are scaleable to support our
growth.
Complete Package of Services
Our New Media business group can provide Internet retailers with tailored
services that best meet their particular needs. Such services include:
. the provision of product data and order fulfillment
. marketing partnerships
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. complete turn-key packages, encompassing product data, credit card
processing, custom labeling and packaging, order fulfillment and returns
management
. monitoring and updating order status several times a day
Independent Distribution
Our Independent Distribution business group consists of Distribution North
America (DNA), an independent music distribution company, and Valley
Entertainment, a label. Each business was built to leverage our systems and
markets.
DNA represents approximately 160 independent suppliers and their labels in
the United States. DNA assumes retail and wholesale marketing responsibilities
for these labels and allows them to focus on their creative operations. DNA
represents several Grammy winning artists and has marketed and distributed gold
and platinum titles.
In seeking retail and wholesale marketing services, independent labels may
work with distribution companies owned by major labels. However, many
independent labels select independent distributors instead of a distribution
company owned by a major label because:
. the label is too small to work with the major labels
. the label's product mix does not match the major labels' emphasis on higher
volume and lower overall sku count
. several larger independent labels seek to maintain greater control over their
distribution than the major labels allow
. labels are concerned that the major labels will not provide adequate priority
to their titles, which may sell in lower volume than the major labels'
proprietary hit titles
. labels may feature established artists who do not wish to pay the fees
charged by the major labels for consumer marketing services
DNA serves the special needs of each client label and assists such labels in
maximizing their market penetration. In promoting a label's products among
retailers and full-line distributors, DNA utilizes its broad understanding of
industry activities and its intimate knowledge of the music wholesale and retail
marketplaces, developed through close relationships with product managers,
operational management and marketing coordinators of many music retailers. In
addition, DNA coordinates its sales and marketing efforts with retailers through
promotion and publicity of the labels themselves.
DNA complements our core Full-line Distribution business in a number of
ways:
. DNA sales increase the volume that passes through Valley's facilities
. cross-selling DNA and Full-line Distribution products to their respective
retail customers enables us to capture both the Independent Distribution and
wholesale margins on a single sale
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. by seeking out and promoting new and emerging labels, we are better able to
understand the trends in the emerging music industry and adjust our Full-line
Distribution business accordingly
Valley Entertainment is a two-year-old label developed to leverage our
markets and capabilities and bring new product to market effectively. Valley
Entertainment focuses on licensing and marketing existing product not currently
available in the United States. It typically offers relatively modest advances
with a greater revenue sharing than many labels.
We intend to sell a controlling interest in the Valley Entertainment
business to Barnet J. Cohen, the Chairman of our Board. Mr. Cohen is the
president of Valley Entertainment, which had net revenues in fiscal 1999 of
approximately $1.2 million and realized a small net loss. The terms of such
sale have been approved by the disinterested members of our Board, who
determined such terms to be no less favorable to Valley than could be obtained
by selling the Valley Entertainment business to an independent third party.
Sales and Marketing
A key element of our marketing strategy is the development and maintenance
of customer relationships with music and video retailers. This strategy is
implemented by a sales and marketing staff consisting of approximately 330
people. We organize our sales efforts around targeted customer groups.
Generally, sales to independently owned stores and small chains are serviced by
designated commissioned sales representatives. Smaller independent accounts are
serviced by a team of music and video specialists. We have established account
management teams to work with the large retail chains, which we refer to as
national accounts. New Media sales are also conducted through account
management teams equipped to meet the special needs of on-line retailers. Our
senior management also participates actively in sales and marketing activities.
Our marketing strategy employs the following customized programs and
services to further strengthen the partnerships we have developed with our
customers and suppliers:
. customized marketing initiatives
. new market development
. advanced vendor managed inventory services
Marketing Initiatives
We employ a number of marketing initiatives to build demand for music and
video, both among retailers and end consumers. These initiatives are generally
funded by our suppliers to promote their products among retailers and consumers.
Marketing initiatives to the music and video retail community include the
following:
. financial incentives, such as product discounts and advertising support
. in-house publications and our web site, which contain information that helps
retailers stay abreast of current industry developments
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. Schwann publications, which are the oldest and among the most popular music
reference guides in the United States
Additionally, we have designed marketing programs to increase demand for the
products of Valley's suppliers and customers. These include:
. co-op advertising support from suppliers for print and electronic media
advertisements
. listening stations that we place in certain stores, which allow consumers to
select and listen to songs from featured artists
. point of purchase displays
. consumer publications
. video promotions containing short descriptions and footage of selected
current and upcoming video releases, which retailers can play in monitors
throughout their stores.
New Market Development
Our special markets group develops new markets and channels for its music
and video product. Special markets include non-music and video specialty retail
stores, libraries, insurance replacement, and public television and radio
stations.
Advanced Vendor Managed Inventory Services
We operate an advanced vendor managed inventory service, commonly referred
to as racking, for retailers that wish to outsource a substantial portion of the
inventory management responsibility for their audio and video products. Racking
is typically provided to mass merchandise, drug, toy, grocery or other stores
not solely dedicated to audio or video. It involves managing the selection and
manually stocking the inventory in the retailer's dedicated video space.
Racking requires technological sophistication to select optimal product titles
and quantities for each storefront and generally entails the management of a
substantially lower sku count than is required of a full-line distributor. We
are significantly enhancing our vendor managed inventory capabilities and intend
to complete the upgrade during fiscal 2000.
Customers
Given the diversity in the size and operating philosophies of our customers,
we provide Full-line Distribution and New Media services under a range of
programs designed to best meet each customer's needs. We describe below our
principal dealings with our Full-line Distribution and New Media customers.
Independent Music Retailers
Independent music retailers typically do not have sufficient volume to deal
directly with the labels and studios, and therefore are supplied by a small
number of full-line distributors. For these customers, we are usually the
primary or secondary supply source for most or all of their inventory needs.
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National Music Retailers
We have developed different programs to capture the opportunities that are
available to provide product to national music retail customers. Through our
catalog program, these larger retailers rely on us to provide a range of
product, from virtually all of their music selections to certain designated
categories of product. They use our special order program to fill customer
orders quickly for products that the retailer has elected not to stock. Using
our emergency fill program, the retailer can obtain product on a fast turnaround
basis. Through our just-in-time replacement program, retailers can outsource
some or all of their distribution needs.
Sell-through Video Accounts
Our national video chain customers primarily use us to fill their needs for
sell-through video. Some of these stores buy product from us that is produced
by studios with which the stores have not established a supplier relationship.
Others may only carry video on a special promotional basis, such as during
holiday periods or to feature a selected hit, and rely on us to supply these
promotions. Other customers use our racking services, where we select product
mix and provide inventory management and in-store servicing.
Video Rental Retailers
We also sell video to independent video rental stores as well as chains.
For the independent video stores, we typically serve as the primary supplier.
For the video rental chains we typically serve as a secondary supplier.
Internet Retailers
We provide Internet retailers with tailored packages of services from which
they can select to meet their individual needs. These services range from the
provision of product data and order fulfillment to complete turn-key packages.
Set forth below are some of our largest Full-line Distribution and New Media
customers for fiscal 1999.
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National Music, Video, and Other Independent Music and Video Specialty
Specialty Chains Stores
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Best Buy Co., Inc. Altitunes
Hastings Amoeba
Transworld Entertainment, Inc. Easy Video
Wherehouse Entertainment, Inc. Fry's Electronics
The Wiz Joseph Beth Booksellers
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Drug, Grocery and Toy Stores Department Stores/Mass Merchants
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CVS/Revco BJ's Wholesale Club, Inc.
Pathmark Bradlees
RiteAid Kohl's
Shoprite Noodle Kidoodle
Toys "R" Us Sears
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On-line Music Retailers On-line Video Retailers
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Amazon.com Amazon.com
Best Buy Co., Inc. Ditgital Courier Technology, Inc.
CDnow DVD Express
CD World NetFlix
Total E Reel.com
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We believe customer service is an important factor in maintaining and
expanding our customer base. We have developed a sophisticated customer service
department with an experienced staff of approximately 20 customer service and
support professionals, and offer our customers toll-free telephone and facsimile
numbers. We have automated certain of the tools used by our customer service
and support team members. We intend to actively pursue enhancements and further
automate our customer service and support operations.
As is typical of the music and video businesses, we generally do not have
long term purchase and sale contracts with most of our Full-line Distribution
customers. We generally deal with these customers on a purchase order basis.
We permit our customers to return music and video product subject to certain
time limitations that vary based on a number of factors, including the product,
price and quantity ordered.
In October 1998, under a contract that expires in June 1999, we began
providing a significant distribution function for the Blockbuster Music stores
purchased by Wherehouse. Wherehouse was our largest customer during fiscal
1999. After June 1999, we anticipate that sales to Wherehouse will decline as
it handles more of its distribution functions internally.
Our New Media business group has fulfillment agreements with most of its
customers. These agreements generally have terms of two or more years and
contain provisions regarding the level of exclusivity of the retailer's
relationship with us and other negotiated terms. The agreements generally do
not contain minimum volume requirements or other terms establishing required
purchase and sale quantities.
DNA's distribution agreements with its customers specify such matters as the
term, DNA's level of exclusivity in distributing the product and inventory
ownership and management. These contracts generally do not specify any
particular volume of skus that will be purchased or sold.
Suppliers
Music and video are produced and supplied by a complex network of labels,
studios and distribution companies. Five large record companies and their
distribution companies, commonly referred to as the major labels, and six large
film studios and their distribution companies, commonly referred to as the major
studios, produce and supply products that represent a majority of the sales in
the music and video industries. The major labels (and their respective
distribution groups) are:
. Time Warner Inc. (WEA)
. The Seagram Company, Ltd. (Universal Music and Video Distribution)
. Bertelsmann AG (BMG Distribution)
. Sony Corp. (Sony Music Distribution)
. Thorne-EMI plc (EMI Distribution)
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The major studios (and their respective distribution groups) are:
. The Walt Disney Company (Buena Vista Home Entertainment)
. Time Warner Inc. (Warner Home Video)
. Sony Corp. (Columbia Tri-Star Home Video)
. News Corporation (Twentieth Century Fox Home Entertainment)
. Viacom Inc. (Paramount Home Video)
. The Seagram Company, Ltd. (Universal Music and Video Distribution)
The balance of music and video is produced by thousands of independent
labels and studios that either sell their product directly or, in the case of
music, distribute through one of the major labels or an independent distribution
company, such as DNA.
We purchase music and video product from each of the majors and from the
leading independent studios and labels. We believe we have good relationships
with each of the majors as well as with the leading independents.
The majors offer various financial incentives to distributors and retailers
that purchase their product, including timely payment discounts and advertising
revenues and allowances. In addition, extended payment terms, discounts and
volume rebates are sometimes available under seasonal and promotional plans.
Payment terms vary considerably among the independent labels and independent
studios. We are often able to negotiate favorable pricing, advertising and
discount programs with these suppliers. Consistent with other music and video
distributors, we do not have any long-term contracts with suppliers. We
purchase our inventory from our suppliers through purchase orders. However, DNA
maintains contracts with most of its suppliers. DNA supplier contracts
typically range in length from one to three years, with varied payment terms.
In the past two years, studios and full-line distributors have initiated
programs to increase the quantity of copies of popular video titles stocked by
retailers. These programs include providing retailers the opportunity to avoid
purchasing product by sharing their rental revenue with the studio or full-line
distributor. We believe that these programs have accelerated a shift of market
share away from independent video rental stores and small chains in favor of the
larger chains.
Since full-line distributors generally play a larger role with independent
retailers than the larger chains, we believe that the market may contract for
full-line distribution of video rental product. In addition, while most full-
line video distributors have elected to participate in revenue sharing
distribution arrangements to help increase their quantity of copies of titles
available from the major studios, we have not. For the time being, we have not
seen adequate demand from independent retailers to justify the expense. In
doing so, we risk losing market share to those distributors who adopt or have
adopted revenue sharing.
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Competition
Full-line Distribution
The full-line distribution of music and video is an intensely competitive
business. We face competition from national, regional and local full-line
distributors, vendor managed inventory firms, and from the majors and
independent distribution companies.
We believe the primary competitive factors in the full-line distribution of
music are:
. inventory breadth (actively stocked)
. fulfillment rate (the percentage of a customer's order that is filled on a
current basis)
. reliability
. accuracy, completeness and depth of data
. price
. delivery time
. information systems and electronic data interchange capabilities
. customer service
. vendor managed inventory capabilities
. advertising support
. financial strength
These factors are also the primary competitive factors in video, but because
video is more "hit" driven than music, with fewer skus and less demand for deep
catalog product, price is a relatively more important competitive factor.
The majors and the independent distribution companies sell substantial
amounts of their products directly to retailers and to date appear not to have
focused, to the same extent we have, on fulfilling the needs of smaller
independent stores or providing value-added services.
Several of our retail chain customers have chosen, from time to time, to buy
a substantial volume of product they had been purchasing through us directly
from the majors or the independent distribution companies. To the extent our
customers increase their direct purchasing from the majors or the independent
distribution companies, our business, financial condition and results of
operations could be adversely affected.
Our largest direct competitor in full-line music distribution, Alliance
Entertainment Corp., filed for Chapter 11 bankruptcy protection in July 1997 and
emerged from bankruptcy in August 1998. In addition to Alliance, we face
competition from dozens of other full-line distributors. Some of these
competitors generally sell to retailers nationwide and others are particularly
active in their respective geographic regions or in certain niche areas. We
believe our fiscal 1999 net
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sales of music to our full-line distribution customers were greater than those
of any of our full-line distribution competitors. We believe we compete
favorably with respect to each of the leading competitive factors in music
distribution relative to other full-line distributors.
In our full-line video distribution business, we compete with eight
companies of greater or comparable size, the largest of which, Ingram
Entertainment, Inc., has significantly greater sales than us. We believe we are
one of the two largest full-line distributors of video priced for sell-through.
In music and video full-line distribution, we also compete with two national
vendor managed inventory firms, Anderson Merchandising and Handleman Company, as
well as several smaller regional firms. Vendor managed inventory firms provide
their customers with inventory selection services for a limited selection of
high-volume product, management services and instore servicing in addition to
order fulfillment. Such services involve more direct physical services for the
retailer, are more labor intensive than wholesale distribution and generally
involve higher margins.
Record clubs also act as retailers for many labels. Record clubs license
selected titles directly from the major labels and independent labels and sell
them by mail order directly to consumers.
The delivery of music and video is subject to changes in market conditions
and to technological changes that can affect competitive conditions and give
rise to new forms of competition. Our business, financial condition and results
of operations could be adversely affected if such changes decrease suppliers' or
retailers' reliance on full-line distributors.
New Media
The New Media business group competes to provide product and fulfillment
services with several other full-line distributors. A number of companies
provide data to Internet retailers. In direct-to-consumer fulfillment, the
principle competitive factors are similar to those for full-line distribution,
although the ability to provide accurate and complete product data, deep catalog
and highly efficient processing is of even greater importance. Recently,
certain major music labels have announced their intention to commence direct-to-
consumer sales through the Internet.
Independent Distribution
There are a number of independent music distribution companies, certain of
which may conduct larger distribution operations than DNA. Several of the major
labels operate their own independent distribution arms, which also compete with
DNA. DNA faces additional competition from a number of smaller and niche
independent distribution companies. As a label or artist gains in popularity,
DNA may face new competition from the major labels to retain distribution rights
for that label or artist. The principal competitive factors in independent
music distribution are:
. effectiveness in marketing and selling independent label product
. efficiency in managing distribution logistics
. price
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. size and experience of sales staff
. financial strength
. industry relations and knowledge
. number and prestige of labels represented
ITEM 2. Properties
We lease all of the sites, including the buildings and improvements, where
our offices and distribution centers are located. Our business is operated
principally out of our executive offices and California distribution center,
both located in Woodland, California, and our Louisville distribution center,
located in Louisville, Kentucky, which we refer to as the LDC. A portion of the
lease for our corporate headquarters and existing California distribution center
in Woodland expires in 2000 and the remaining portion of the lease expires in
2003. We are relocating our California distribution center to a nearby 260,000
square foot facility in phases during the first and second quarters of fiscal
2000. We have leased this new facility. We are retaining the space where our
existing California distribution center is located and plan to convert this area
into additional office space. Our lease on the new Woodland distribution center
expires in 2009. The LDC building consists of approximately 330,000 square
feet. Our lease on the LDC expires in 2008. We also maintain smaller sales,
distribution or administrative offices in California, Connecticut,
Massachusetts, Minnesota, New Jersey, New Mexico, New York and Pennsylvania.
ITEM 3. Legal Proceedings
We are subject to various legal proceedings that arise in the ordinary
course of business. While the outcome of all of these proceedings cannot be
predicted with certainty, we believe that none of such proceedings, individually
or in the aggregate, will have a material adverse effect on our business or
financial condition.
ITEM 4. Submission Of Matters To A Vote Of Security Holders
On March 24, 1999, holders of a majority of our outstanding shares
authorized by written consent the formation of a California subsidiary to be
wholly-owned by Valley Media, Inc. They further authorized the transfer of
substantially all of our assets to that subsidiary.
13
<PAGE>
ITEM 4A. Executive Officers of the Registrant
Our executive officers are listed below, together with brief accounts of
their business experience and certain other information.
<TABLE>
<CAPTION>
==========================================================================================
Name Age Position and Office
- ------------------------------------------------------------------------------------------
<S> <C> <C>
Barnet J. Cohen 52 Chairman of the Board
Robert R. Cain 45 President, Chief Executive Officer and
Director
Kenneth Alterwitz 47 Senior Vice President, Sales and Marketing
J. Randolph Cerf 46 Senior Vice President, Chief Financial
Officer and Secretary
Melanie Cullen 47 Senior Vice President, Information
Services
Paige S. Dickow 39 Senior Vice President, Human Resources
John Kordic 39 Senior Vice President, Operations
Ronald A. Phillips 41 Senior Vice President, Purchasing
</TABLE>
Barnet J. Cohen is the founder of Valley and has been Chairman of the Board
from its formation. He served as Chief Executive Officer from March 1979 until
December 1997. Prior to founding Valley, he owned and operated retail record
stores. Mr. Cohen is Past-Chairman of the Board of Directors of NARM. He is a
graduate of Antioch College and received an Executive M.B.A. from Harvard
Business School.
Robert R. Cain has served as Valley's President since January 1993, as its
Chief Executive Officer since December 1997 and as a member of the Board of
Directors since February 1995. Mr. Cain has been employed by Valley since
November 1991. He is a graduate of Oregon State University with a B.S. in Food
Science, and received an M.B.A. from the University of California, Berkeley.
Kenneth Alterwitz has served as Valley's Senior Vice President, Sales and
Marketing since March 1998 and served as Vice President, Sales and Marketing
from January 1995 to March 1998. Prior to joining Valley, Mr. Alterwitz served
as Senior Vice President of Sales for Alliance Entertainment from November 1993
to August 1994. Mr. Alterwitz is a graduate of the New York Institute of
Technology with a B.A. in Communication Arts.
J. Randolph Cerf has served as Valley's Senior Vice President, Chief
Financial Officer and Secretary since March 1998 and served as Vice President
and Chief Financial Officer from October 1994 to March 1998. Prior to joining
Valley, Mr. Cerf was President of JRC
14
<PAGE>
Consulting, a financial and management consulting firm, from July 1991 to
October 1994. Mr. Cerf is a graduate of the University of Colorado with a B.A.
in Economics, Computer Science and Political Science, and received an M.B.A.
from Stanford University.
Melanie Cullen has served as Valley's Senior Vice President, Information
Services since March 1998 and served as Vice President, Information Systems from
February 1995 to March 1998. Ms. Cullen has been employed by Valley since
August 1993. Ms. Cullen is a graduate of California State University, Hayward
with a B.S. in Business Administration, and received an M.B.A. from Stanford
University.
Paige S. Dickow has served as Valley's Senior Vice President, Human
Resources since March 1998 and served as Vice President, Human Resources, from
February 1997 to March 1998. Prior to joining Valley, Ms. Dickow served as a
consultant with Hewitt Associates from August 1994 to February 1997, and with
KPMG Peat Marwick from February 1986 to July 1994. Ms. Dickow is a graduate of
the University of Georgia with a B.B.A. in Accounting.
John Kordic has served as Valley's Senior Vice President, Operations since
March 1998 and served as Vice President, Operations from February 1995 to March
1998. Mr. Kordic has been employed by Valley since November 1994. Prior to
joining Valley, Mr. Kordic served as Director of Distribution for Imaginarium, a
San Francisco-based distributor of creative toys, from November 1991 to November
1994. Mr. Kordic is a graduate of the University of California, Berkeley, with
a B.S. in Resource Economics.
Ronald A. Phillips has served as Valley's Senior Vice President, Purchasing
since March 1998 and served as Vice President, Purchasing from February 1995 to
March 1998. Mr. Phillips has been employed by Valley since February 1993.
PART II
ITEM 5. Market For Registrant's Common Equity And Related Stockholder Matters
Our common stock is listed for sale on the Nasdaq National Market under the
symbol "VMIX." Our stock was first listed for sale on that market on March 26,
1999. Since then, through April 3, 1999, the highest closing sales price for a
share of our common stock as reported on the Nasdaq National Market was $31.875
and the lowest closing sales price was $20.00. As of May 28, 1999, we had 48
shareholders of record of our common stock, although there were a larger number
of beneficial holders.
The holders of common stock are entitled to share ratably in any dividends
we declare on the common stock. On March 16, 1999, our Board declared a stock
split effected in the form of a stock dividend, payable on March 22, 1999, at a
rate of 8.04 shares of our common stock for every share of common stock
outstanding on the payment date. We did not declare any dividends on the common
stock during fiscal 1998, 1997 or 1996 and do not anticipate paying any
dividends in the foreseeable future. In addition, our credit facility contains
certain limitations on our ability to pay cash dividends.
Recent Sales of Unregistered Securities
In July 1998, in connection with Valley's reincorporation in Delaware,
Valley's predecessor, a California corporation, was merged into Valley and each
outstanding share of the
15
<PAGE>
predecessor's common stock was exchanged for one share of Valley's common stock.
This issuance of securities was deemed exempt from registration pursuant to Rule
145(a)(2) under the Securities Act.
Since March 31, 1996, Valley has issued and sold the following unregistered
securities:
(1) In December 1997, Valley issued 58,129 shares of its common stock to a
corporation, 90% of the outstanding shares of which are owned by Lawrence
Archibald, a member of the board. The shares were issued by Valley in
connection with the merger of Schwann Acquisition Corp. into Valley. Prior to
the merger, Valley owned 80% of the outstanding shares of Schwann, while the
other corporation owned the remaining 20%. The sale and issuance of securities
in this transaction was deemed exempt from registration under Section 4(2) of
the Securities Act.
(2) Since April 1, 1998, nine employees of Valley have exercised options to
purchase a total of 138,456 shares of common stock under Valley's 1994 Stock
Option Plan at a weighted average exercise price of $2.61 per share. These
issuances of securities were deemed exempt from registration under Rule 701 of
the Securities Act.
Use of Proceeds
On March 25, 1999 the registration statement (Registration No. 333-69329)
for the initial public offering of our common stock became effective. The
offering commenced and was completed on March 26, 1999. The managing
underwriters were J.P Morgan Securities Inc. and BancBoston Robertson Stephens
Inc. All securities registered were common stock. The following table presents
some information on the shares sold both by us and by two selling stockholders
in this offering:
<TABLE>
<CAPTION>
- --------------------------------------------------------------------------------------------
Aggregate Price
Party Selling Amount of Amount Aggregate Price
Shares Registered Registered Amount Sold of Amount Sold
- --------------------------------------------------------------------------------------------
<S> <C> <C> <C> <C>
Valley Media 3,500,000 $56,000,000 3,500,000 $56,000,000
- --------------------------------------------------------------------------------------------
Barnet J. Cohen 472,500 7,560,000 472,500 7,560,000
- --------------------------------------------------------------------------------------------
Robert R. Cain 52,500 840,000 52,500 840,000
- --------------------------------------------------------------------------------------------
</TABLE>
The underwriters received an underwriting discount of $1.12 per share, for a
total expense of $3,920,000 on the 3,500,000 shares that we sold in the
offering. Our other expenses of that offering were $1,136,360, including the
SEC registration fee, NASD filing fee, Nasdaq National Market listing fee, Blue
Sky expenses, printing expenses, legal fees, accounting fees, transfer agent and
registrar fees and miscellaneous expenses. Thus, total expenses were $5,056,360
None of these expenses represented a direct or indirect payment to directors,
officers, persons owning 10% or more of any class of our equity securities or
our affiliates.
Our net proceeds from the initial public offering were $50,943,640. We used
all of the net proceeds to repay a portion of the outstanding balance under our
revolving credit facility, which we expect will provide additional borrowing
capacity for working capital and general corporate purposes. None of this
payment represented a direct or indirect payment to directors, officers, persons
owning 10% or more of any class of our equity securities or our affiliates.
16
<PAGE>
ITEM 6. Selected Financial Data
Our fiscal year is a 52 or 53 week period ending on the Saturday nearest to
March 31. Fiscal 1999 contained a 53-week period while the 1998, 1997, 1996 and
1995 fiscal years each contained a 52-week period.
The fiscal years ending after May 20, 1997 include results of operations of
the video business we acquired at that time. The Supplemental Operating Data
includes earnings before interest, income taxes, depreciation and amortization,
or EBITDA, for the periods presented. We believe that EBITDA is a useful
measure of our financial performance. However, EBITDA should not be construed
as an alternative to operating income, net income or cash flows from operations
as determined in accordance with generally accepted accounting principles.
Further, our calculation of EBITDA may be different from the calculation used by
other companies, which may limit comparability.
<TABLE>
<CAPTION>
=================================================================
Fiscal Year
-----------------------------------------------------------------
1999 1998 1997 1996 1995
---------- ---------- ---------- ---------- ----------
<S> <C> <C> <C> <C> <C>
Dollars in thousands, except per
share data
Statement of Operations Data
Net sales........................... $ 888,966 $ 583,492 $ 199,231 $ 156,557 $ 140,916
Cost of goods sold.................. 791,154 516,627 175,706 137,847 126,585
---------- ---------- ---------- ---------- ----------
Gross profit........................ 97,812 66,865 23,525 18,710 14,331
Selling, general and administrative
expenses.......................... 78,059 55,948 20,552 14,033 9,501
---------- ---------- ---------- ---------- ----------
Operating income.................... 19,753 10,917 2,973 4,677 4,830
Equity in net loss of joint venture. - - 207 903 162
Interest expense.................... 10,928 6,627 1,745 1,305 735
---------- ---------- ---------- ---------- ----------
Income before taxes................. 8,825 4,290 1,021 2,469 3,933
Income taxes........................ 3,673 1,731 410 1,016 1,616
---------- ---------- ---------- ---------- ----------
Income before extraordinary loss.... 5,152 2,559 611 1,453 2,317
Extraordinary loss (net of income
taxes of $477).................... (723)(1) - - - -
---------- ---------- ---------- ---------- ----------
Net income.......................... $ 4,429 $ 2,559 $ 611 $ 1,453 $ 2,317
========== ========== ========== ========== ==========
Net income per share:
Basic:
Income before extraordinary loss.. $ 1.04 $ 0.53 $ 0.13 $ 0.29 $ 0.47
Extraordinary loss................ (0.15)(1) - - - -
---------- ---------- ---------- ---------- ----------
Basic net income per share........ $ 0.89 $ 0.53 $ 0.13 $ 0.29 $ 0.47
========== ========== ========== ========== ==========
Diluted:
Income before extraordinary loss.. $ 0.89 $ 0.49 $ 0.12 $ 0.28 $ 0.46
Extraordinary loss................ (0.12)(1) - - - -
---------- ---------- ---------- ---------- ----------
Diluted net income per share...... $ 0.77 $ 0.49 $ 0.12 $ 0.28 $ 0.46
========== ========== ========== ========== ==========
Weighted average shares used in
the calculation:
Basic............................. 4,950,753 4,791,864 4,797,193 4,965,375 4,917,393
Diluted........................... 5,781,840 5,263,870 5,131,341 5,224,040 4,984,626
Supplemental Operating Data
EBITDA.............................. $ 25,383 $ 15,030 $ 4,615 $ 5,070 $ 5,322
Net cash provided by (used in)
Operating activities.............. (116,261) (13,851) 12,855 (5,460) (1,384)
Net cash used in Investing
activities......................... (9,570) (37,554) (12,330) (1,762) (3,072)
Net cash provided by (used in)
Financing activities.............. 126,870 51,489 (359) 7,290 4,443
</TABLE>
<TABLE>
<CAPTION>
=================================================================
At Fiscal Year End
-----------------------------------------------------------------
Dollars in thousands 1999 1998 1997 1996 1995
---------- ---------- ---------- ---------- ----------
<S> <C> <C> <C> <C> <C>
Balance sheet data
Working capital (deficit)........... $ 35,607 $(17,310) $ (200) $ 4,397 $ 3,762
Total assets........................ 430,725 244,298 94,591 58,114 48,648
Total long-term obligations......... 3,918 3,166 2,257 3,157 961
Total short-term borrowings......... 150,635 75,715 21,705 20,280 11,703
Stockholders' equity................ 65,887 10,515 7,773 7,716 6,333
__________
</TABLE>
(1) Represents an extraordinary loss comprised of termination fees and write-
off of prepaid financing costs as a result of the termination of a prior
line of credit agreement.
17
<PAGE>
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
Item 6, "Selected Financial Data," and our consolidated financial statements,
and the respective notes thereto included elsewhere in this Annual Report on
Form 10-K.
Overview
We have been engaged in the full-line distribution of music since 1985 and
expanded our operations to include the full-line distribution of video with the
acquisition of substantially all of the assets of Star Video Entertainment, L.P
in May 1997. In addition to our core Full-line Distribution business group, we
conduct our music and video distribution business through two other business
groups, New Media and Independent Distribution. Our New Media business group
provides product, data and direct-to-consumer fulfillment services for Internet
retailers and currently represents our fastest growing business group. In
September 1994, we entered into a joint venture, Distribution North America,
which is known in the industry as DNA, to provide marketing, distribution and
related services for independent record labels. In January 1997, we acquired
our joint venture partner's interest in DNA, which now forms the largest
component of our Independent Distribution business group.
We generate most of our revenue from the sale of music and video. We also
receive revenue from providing certain services to customers such as direct-to-
consumer fulfillment and licensing our proprietary databases of product
information. Other revenues, which are immaterial in total dollar amount,
include direct-to-consumer fulfillment fees, sales of publications, fees for
applying retailers' customized stickers, preparation of videos for rental and
restocking fees. Our direct-to-consumer fulfillment customers reimburse us for
our shipping costs. Returns from our customers and to our suppliers occur in
the ordinary course of our business. Accordingly, sales and cost of goods sold
are recorded net of estimated returns and allowances.
Our fiscal year is a 52 or 53 week period ending on the Saturday nearest to
March 31. Our three most recently completed fiscal years ended April 3, 1999,
March 28, 1998 and March 29, 1997. Fiscal 1999 contained a 53 week period while
fiscal 1998 and 1997 each contained a 52 week period. The following table sets
forth net sales of each of our three principal business groups for fiscal 1999,
1998 and 1997. Intercompany sales consist primarily of sales of music by
Independent Distribution to Full-line Distribution and New Media.
<TABLE>
<CAPTION>
====================================================
Fiscal Years
----------------------------------------------------
Dollars in thousands 1999 1998 1997
----- ----- -----
<S> <C> <C> <C>
Full-line Distribution............... $668,385 $520,465 $184,721
New Media............................ 182,734 30,316 8,319
Independent Distribution............. 55,048 45,685 6,626
Eliminations......................... (17,201) (12,974) (435)
-------- -------- --------
Total net sales..................... $888,966 $583,492 $199,231
======== ======== ========
</TABLE>
18
<PAGE>
The following table sets forth quarterly net sales of each of our three
principal groups for fiscal 1999 and 1998. Intercompany sales consist primarily
of sales of music by the Independent Distribution business group to the Full-
line Distribution and the New Media business groups.
<TABLE>
<CAPTION>
=======================================================================================
Fiscal 1999 Fiscal 1998
---------------------------------------------------------------------------------------
Dollars in thousands Fourth (1) Third Second First Fourth Third Second First
---------- --------- --------- --------- --------- --------- --------- --------
<S> <C> <C> <C> <C> <C> <C> <C> <C>
Full-line Distribution..... $178,739 $214,733 $150,117 $124,796 $135,000 $173,645 $131,816 $80,004
New Media.................. 69,722 61,881 29,481 21,650 12,673 9,396 4,981 3,266
Independent Distribution... 14,022 15,191 13,252 12,583 12,269 13,341 11,198 8,877
Eliminations............... (4,619) (4,054) (3,872) (4,656) (3,730) (3,549) (3,341) (2,354)
-------- -------- -------- -------- -------- -------- -------- -------
Total net sales.......... $257,864 $287,751 $188,978 $154,373 $156,212 $192,833 $144,654 $89,793
======== ======== ======== ======== ======== ======== ======== =======
- ----------
(1) Represents a 14 week quarter
</TABLE>
Sales growth through the periods presented has been due primarily to
increases in unit volumes sold rather than price increases. Cost of goods sold
is comprised almost entirely of the average cost of product purchased. Supplier
incentives (including cash discounts, returns incentives, rebates and net
advertising support), freight expense and inventory carrying costs are included
in cost of goods sold, although in the aggregate these items represent a very
small portion of total cost of sales. The mix of product sales among higher
margin sales relative to lower margin sales is the most significant factor
affecting gross margins. The video distribution business typically generates
lower gross margins than the music business. Factors that can contribute to
gross margin fluctuations also include:
. the percentage of New Media customers for which we perform direct-to-consumer
fulfillment
. the percentage of lower margin, higher volume hits versus catalog product
sold
. competitive pricing conditions
. the level of purchase discounts, rebates and advertising support received
from our suppliers
. changes in freight costs
Our selling, general and administrative expenses are comprised primarily of
salaries and benefits. They also include rent expense, depreciation,
amortization and other items. Such expenses have increased in absolute dollars
with our growth in net sales and are expected to continue to do so. Over time,
we would expect the increase in selling, general and administrative expenses
generally to vary proportionally with the increase in net sales. These expenses
can be expected to increase as a percentage of sales in periods immediately
following the building of our infrastructure and to decrease as a percentage of
sales in periods in which we are growing faster than we are adding
infrastructure.
We are relocating our California distribution center to a nearby larger
facility. We leased the new facility and have retained the existing space for
expansion of administrative offices. The move will be completed in phases
during the first and second quarters of fiscal 2000. This move is causing us to
incur additional labor and freight costs as well as other expenses and is
adversely affecting our sales. The move will increase our rent expense by
approximately $800,000 per year. We also expect to incur approximately
$1,600,000 in year 2000 remediation costs in fiscal 2000.
19
<PAGE>
Results of Operations
The following discussion is based on the historical results of operations
for fiscal 1999, 1998 and 1997. We engaged in a number of acquisitions during
this period that enabled us to achieve scale efficiencies, add product lines,
acquire data and strengthen our relationship with certain customer segments and
suppliers. Each acquisition was accounted for as a purchase and the results of
the acquired companies are included in our results of operations from the date
of acquisition. These acquisitions included:
. certain assets of four regional full-line music distributors in Indianapolis,
Omaha, Baltimore and Connecticut in June, July and November 1996 and December
1997, respectively
. a music database and the rights to publish two music publications from
Stereophile, Inc. in December 1996
. the remaining 50% interest in DNA in January 1997 (the original investment in
the DNA joint venture was made in September 1994 and was accounted for on the
equity method)
. the Star acquisition, by which we entered the video distribution business, in
May 1997
The following table sets forth certain operating data as a percentage of net
sales for fiscal 1999, 1998 and 1997.
<TABLE>
<CAPTION>
=======================
Fiscal Years
-----------------------
1999 1998 1997
------ ------ ------
<S> <C> <C> <C>
Net sales.................................................... 100.0% 100.0% 100.0%
Gross profit................................................. 11.0 11.5 11.8
Selling, general and administrative expenses................. 8.8 9.6 10.3
Operating income............................................. 2.2 1.9 1.5
Net income................................................... 0.5% 0.4% 0.3%
Supplemental Data
EBITDA....................................................... 2.9% 2.6% 2.3%
</TABLE>
Fiscal 1999 Compared to Fiscal 1998
Our net sales increased $305.5 million, or 52%, from $583.5 million in
fiscal 1998 to $889.0 million in fiscal 1999.
Full-line Distribution sales increased $147.9 million, or 28%, from $520.5
million in fiscal 1998 to $668.4 million in fiscal 1999. Approximately $62
million of the increase was attributable to the inclusion of extraordinary
volume associated with supporting the transition of Blockbuster music stores
from Viacom Entertainment to Wherehouse Entertainment. In addition,
approximately $32.3 million of the increase was attributable to the inclusion of
twelve months of video sales in fiscal 1999 compared to ten months in fiscal
1998 as a result of the Star acquisition. Finally, the release of the Titanic
video and growth of DVD sales increased video sales in fiscal 1999. Net sales
of Titanic were approximately $21 million in fiscal 1999. The balance of the
growth was attributable to increased sales to existing and new Full-line
Distribution customers.
20
<PAGE>
New Media sales increased $152.4 million, or 503%, from $30.3 million in
fiscal 1998 to $182.7 million in fiscal 1999 due to (a) the addition of
Amazon.com as a new customer, (b) increased sales by our on-line customers and
(c) the addition of other new customers.
Independent Distribution sales increased $9.3 million, or 20%, from $45.7
million in fiscal 1998 to $55.0 million in fiscal 1999 due to (a) the
acquisition of new labels, (b) increased sales to our Full-line Distribution and
New Media business groups and (c) successful marketing of existing labels and
artists.
Our gross profit increased $30.9 million, or 46%, from $66.9 million in
fiscal 1998 to $97.8 million in fiscal 1999, with gross margin decreasing from
11.5% to 11.0%. Margins decreased primarily because of additional discounts
earned by high volume customers and increased inventory carrying costs.
Customer returns reserves, representing the gross profit associated with
product expected to be returned, increased $2.1 million, or 57%, from $3.7
million to $5.8 million primarily due to increased sales.
Selling, general and administrative expenses increased $22.2 million, or
40%, from $55.9 million in fiscal 1998 to $78.1 million in fiscal 1999,
primarily as a result of:
. sales growth
. inclusion of a full twelve months of the Star operations which increased
salaries and benefits
. additional employees due to the opening of the LDC and also additional staff
in our California facility
. increased rent expense as a result of the opening of the LDC and the Star
acquisition
. other start up costs in connection with the LDC's opening
. depreciation and amortization increased, primarily due to the Star
acquisition and the further development of our infrastructure
. costs associated with closing designated video sales offices and distribution
facilities
. bankruptcies of a small number of video customers and the deteriorating
financial condition of some others caused our allowance for doubtful accounts
to increase $3.6 million
Selling, general and administrative expenses for fiscal 1999 also include
the write-off of approximately $600,000 of offering costs and $900,000
associated with the consolidation of certain operations acquired in the Star
acquisition. In addition, we incurred a charge of $316,000 in the fourth
quarter of fiscal 1999 for costs associated with the move of our video
advertising group from New Jersey to California.
Selling, general and administrative expenses declined as a percentage of
sales from 9.6% in fiscal 1998 to 8.8% in fiscal 1999 due primarily to:
21
<PAGE>
. lower general and administrative costs as a percentage of sales for full-line
video distribution as compared to full-line music distribution
. our ability to take advantage of our infrastructure investment to grow full-
line music distribution and New Media sales without the requirement of
proportionate increases in our personnel and facilities.
Interest expense increased $4.3 million, or 65%, from $6.6 million in fiscal
1998 to $10.9 million in fiscal 1999 due to (a) growth in working capital
associated largely with increased sales and opening the LDC, (b) the Star
acquisition and (c) investment in systems and in the LDC. Partially offsetting
these factors was a reduction of our average interest rate from 9.9% in 1998 to
8.6% in 1999.
Our effective tax rate increased from 40.3% to 41.6% primarily due to the
write-off of non deductible offering costs partially offset by the true-up of
prior year tax returns.
In May 1998, termination fees from refinancing our revolving credit facility
resulted in an extraordinary loss of $723,000 (net of income taxes).
Net income increased $1.8 million, or 69%, from $2.6 million in fiscal 1998
to $4.4 million in fiscal 1999.
Fiscal 1998 Compared to Fiscal 1997
Our net sales increased $384.3 million, or 193%, from $199.2 million in
fiscal 1997 to $583.5 million in fiscal 1998.
Full-line Distribution sales increased $335.7 million, or 182%, in fiscal
1998. Approximately $234 million of this increase was attributable to the video
distribution business acquired from Star. Approximately $102 million was
attributable to growth in Full-line music Distribution, representing a 55%
growth rate in this business from fiscal 1997 to fiscal 1998. This growth was
due to increased sales to existing customers and the addition of new customers.
New Media sales increased $22.0 million, or 264%, in fiscal 1998 due to (a)
the overall growth of on-line sales to existing on-line customers and (b) the
addition of new customers.
Independent Distribution sales increased $39.1 million, or 592%, from $6.6
million in fiscal 1997 to $45.7 million in fiscal 1998. This growth primarily
was due to (a) the acquisition of the remaining 50% interest in DNA in the
fourth quarter of fiscal 1997 (fiscal 1998 includes net sales for a full year
versus two months in fiscal 1997) and (b) successful marketing and new labels
which provided strong growth in sales of independent labels.
Our gross profit increased $43.4 million, from $23.5 million in fiscal 1997
to $66.9 million in fiscal 1998, with gross margin declining slightly from 11.8%
to 11.5%. The changes in margin were impacted by changes in product and
customer mix and increases in reserves for obsolete inventory. The average cost
of product sold increased due to our entry into the video business with lower
gross margins. A portion of the video increase was offset by gross margin gains
associated with the growth in our New Media and Independent Distribution
business groups.
22
<PAGE>
Customer returns reserves increased $2.1 million from $1.6 million to $3.7
million. This increase was primarily due to increased sales.
Selling, general and administrative expenses increased $35.3 million, or
171%, from $20.6 million in fiscal 1997 to $55.9 million in fiscal 1998.
Salaries and benefits increased in fiscal 1998 primarily as a result of the Star
acquisition and personnel increases to support the growth in New Media and
Independent Distribution sales. Our rent expense increased as a result of the
facilities we acquired in the Star acquisition. Depreciation and amortization
also increased in fiscal 1998, primarily due to the Star acquisition and
continued investment in infrastructure. Selling, general and administrative
expenses also grew as a result of costs associated with planning and preparing
for the opening of the LDC. Selling, general and administrative expenses also
included $800,000 of offering costs that were written off.
Our allowance for doubtful accounts and receivable reserves increased 0.5%
of net sales due primarily to the bankruptcy of three video customers, the
deteriorating financial conditions of other customers and collection
complications associated with the Star acquisition.
Selling, general and administrative expenses declined as a percentage of
sales from 10.3% in fiscal 1997 to 9.6% in fiscal 1998.
Interest expense increased from $1.7 million in fiscal 1997 to $6.6 million
in fiscal 1998, reflecting borrowings incurred to fund the Star acquisition,
growth in working capital and investments in systems and the LDC.
Net income increased by $2.0 million from $611,000 in fiscal 1997 to $2.6
million in fiscal 1998 as a result of these factors.
Liquidity and Capital Resources
Our capital requirements relate primarily to working capital, the expansion
of our infrastructure to accommodate sales growth, and the funding of
acquisitions. Our working capital needs are seasonal and typically peak in the
second and third fiscal quarters due to increases in inventories purchased for
the holiday selling season and extension of credit terms to certain customers.
We maintain significant inventory levels to fulfill our operating commitment to
carry a deep catalog of music and video skus. Inventories generally can be
returned to suppliers. Historically, we have financed our cash requirements
primarily from short-term bank borrowings and cash from operations.
Net cash used in operating activities of $116.3 million in fiscal 1999
consisted primarily of increases of $66.4 million in accounts receivable and
$118.2 million in inventories. These were partially offset by an increase in
accounts payable of $51.6 million.
Net cash used in operating activities of $13.9 million in fiscal 1998 was
primarily attributable to increases of $43.5 million in accounts receivable and
$31.4 million in inventories. These were partially offset by an increase in
accounts payable of $51.7 million.
Net cash provided by operating activities of $12.9 million in fiscal 1997
was primarily attributable to an increase of $33.5 million in accounts payable,
partially offset by increases of $15.4 million in accounts receivable and $9.4
million in inventories.
23
<PAGE>
The large increases in the components of working capital in fiscal 1999,
1998 and 1997 were a result of overall growth in sales. In particular, fiscal
1999 working capital increased due to the Wherehouse contract which expires in
June 1999. In fiscal 1998, these increases were also a result of the Star
acquisition.
Net cash used in investing activities was $9.6 million, $37.6 million and
$12.3 million for fiscal 1999, 1998 and 1997, respectively. Cash used in fiscal
1999 consisted primarily of $8.8 million for property and equipment acquisitions
primarily at the LDC. Cash used in fiscal 1998 consisted of $33.1 million for
business and net asset acquisitions, primarily the Star acquisition, and $4.3
million for property and equipment acquisitions. Cash used in fiscal 1997
consisted of $9.3 million for business and net asset acquisitions and $2.9
million for property and equipment acquisitions, primarily for system
enhancements.
Cash used for the purchase of property and equipment has increased in each
of the past three fiscal years because of increasing investments in equipment
and technology required to facilitate overall sales growth. Capital
expenditures in fiscal 1999 were substantially above fiscal 1998 levels,
primarily as a result of the completion of the LDC and continued sales growth.
Financing activities provided net cash of $126.9 million in fiscal 1999 and
$51.5 million in fiscal 1998. Financing activities used net cash of $359,000 in
fiscal 1997. Cash provided by financing activities in fiscal 1999 consisted
primarily of additional borrowings under our credit facility to fund increased
working capital requirements and the proceeds from the initial public offering
of our common stock. Cash provided by financing activities in fiscal 1998
consisted primarily of additional borrowings under our previous credit facility
to fund the Star acquisition and working capital requirements generated by our
overall sales growth. The fiscal 1997 amount was primarily a result of the
repurchase of common stock for $554,000.
Effective April 5, 1999, our credit facility provides for borrowings up to
the lesser of $200.0 million or the amount of collateral availability.
Collateral availability is limited to certain percentages of eligible inventory
and accounts receivable, subject to certain limitations as to video and DNA
inventories. The credit facility bears interest, at our election, at either the
prime rate plus a margin of 0% to 0.5% or the Eurodollar Rate plus a margin of
2.0% to 2.75%, subject to monthly adjustments and certain terms and conditions
as stated in the credit facility.
Borrowings under the credit facility are secured by all accounts receivable,
inventory, certain equipment and other intangible property. The credit facility
expires on May 21, 2001 and renews annually thereafter unless notice of
termination is given by either party. The credit facility contains various
covenants, including among other things, compliance with:
. adjusted net worth requirements
. restrictions on sales of assets, consolidations, mergers, and dissolution
. limitations on encumbrances, indebtedness, loans, investments, and guarantees
. limitations on payment of cash dividends and redemptions
We believe that our cash on hand, together with our borrowing availability
under the credit facility, will be sufficient to meet our operating and capital
requirements through fiscal 2000. Our future operating and capital
requirements, however, will depend on numerous factors,
24
<PAGE>
including growth of the business, additional infrastructure needs, potential
acquisitions and/or joint ventures and future results of operations.
Seasonality in Operating Results
Our quarterly net sales and operating results have varied significantly in
the past and will likely continue to do so in the future as a result of seasonal
variations in the demand for music and video. Historically, our sales are
highest during the third fiscal quarter (the holiday season) and returns are
highest during the fourth fiscal quarter. Due to this seasonality, we typically
experience significant changes in cash flows and capacity needs during the year,
with the heaviest credit needs and highest capacity requirements typically
occurring during the third fiscal quarter.
New Accounting Standard
See Notes to our consolidated financial statements for a discussion of the
impact of Statement of Financial Accounting Standards No. 133, Accounting for
Derivative Instruments and Hedging Activities.
Year 2000 Matters
The year 2000 issue has arisen as a result of computer programs being
written using two digits rather than four to define the applicable year.
Certain information technology systems and their associated software, and
certain equipment that uses programmable logic chips to control aspects of their
operation, commonly referred to as embedded chip equipment, may recognize "00"
as a year other than the year 2000. Some information technology systems and
embedded chip equipment used by us and by third parties who do business with us
contain two-digit programming to define a year. The year 2000 issue could
result, for us and for others, in system failures or miscalculations causing
disruptions of operations, including, among other things, a temporary inability
to process transactions or to engage in other normal business activities.
Readiness for Year 2000
We are addressing year 2000 issues relating to:
. information technology systems and embedded chip equipment used by us
. third parties who do business with us that are not prepared for the year 2000
. contingency planning
We use a variety of information technology systems, internally developed and
third-party provided software and embedded chip equipment. For these
information technology systems, software and embedded chip equipment, we have
divided our year 2000 efforts into four phases:
(1) identification and inventorying of information technology systems and
embedded chip equipment with potential year 2000 problems
(2) evaluation of scope of year 2000 issues for, and assigning priorities
to, each item based on its importance to our operations
25
<PAGE>
(3) remediation of year 2000 issues in accordance with assigned priorities,
by correction, upgrade, replacement or retirement
(4) testing for and validation of year 2000 compliance on an application
basis
We have categorized as "mission critical" those information technology
systems and embedded chip equipment whose failure would cause cessation of
operations or significant detrimental financial impact on us. Phases (1) and
(2) are complete across all "mission critical" business functions and locations.
All mission critical information technology systems and embedded chip equipment
are currently in phase (3) or (4).
Our operations are also dependent on the year 2000 readiness of third
parties that do business with us. In particular, our information technology
systems interact with commercial electronic transaction processing systems of
customers. In addition, we are dependent on third-party suppliers of
infrastructure elements such as telecommunications services, electric power,
water and banking facilities. We do not depend to any significant degree on any
single merchandise supplier or upon electronic transaction processing with
individual suppliers for merchandise purchases.
We have identified and initiated formal communications with key third
parties to determine the extent to which we will be vulnerable to such parties'
failure to resolve their own year 2000 issues. As a follow-up, we plan to
determine whether our customers and suppliers are taking appropriate steps to
achieve year 2000 readiness and ensure continued functioning in accordance with
our business needs. We are assessing our risks with respect to failure by third
parties to be year 2000 compliant and intend to seek to mitigate those risks.
We are also developing contingency plans, discussed below, to address issues
related to third parties we determine are not making sufficient progress toward
becoming year 2000 compliant.
Costs
We estimate that our information technology systems and embedded chip
equipment will be year 2000 compliant by October 1999. Aggregate costs for work
related to year 2000 efforts currently are anticipated to total approximately
$2.4 million. Costs of $399,000 and $364,000 were incurred and expensed in
fiscal 1999 and 1998, respectively. These costs related entirely to
modifications of existing software and represented 3% and 5% of the information
technology expenses for the respective periods.
Of the remaining portion of our aggregate estimated year 2000 costs,
approximately $1.6 million will be incurred in fiscal 2000. Approximately
$470,000 of these costs is expected to be for capital investments in new systems
and applications. We anticipate that 6% of our fiscal 2000 information
technology budget will be used for year 2000 remediation. We anticipate our
year 2000 costs will be incurred in the following percentages among the
following types of remediation:
. 31% on modifications to existing software
. 12% on conversions to new software
. 57% on remediation of embedded chip equipment
26
<PAGE>
Certain information technology projects have been deferred and will continue
to be deferred as a result of the personnel we are devoting to our year 2000
remediation efforts. These projects relate to potential operational
enhancements such as additional value-added services and cost cutting projects.
We do not believe that the delay in these information technology projects will
have a material adverse affect on our financial condition or results of
operations.
Our estimate of the costs of achieving year 2000 compliance and the date by
which year 2000 compliance will be achieved are based on our best estimates,
which were derived using numerous assumptions about future events including the
continued availability of certain resources, third party modification plans and
other factors. However, there can be no assurance that these estimates will be
achieved, and actual results could differ materially from these estimates.
Specific facts that might cause such material differences include the
availability and cost of personnel trained in year 2000 remediation work, the
ability to locate and correct all relevant computer codes, the success achieved
by our customers and suppliers in reaching year 2000-readiness, the timely
availability of necessary replacement items and similar uncertainties.
Risks
We expect to implement the changes necessary to address the year 2000 issue
for information technology systems and embedded chip equipment we use. We
presently believe that, with modifications to existing software, conversions to
new software, and appropriate remediation of embedded chip equipment, the year
2000 issue with respect to our information technology systems and embedded chip
equipment is not reasonably likely to pose significant operational problems for
us. However, if unforeseen difficulties arise, such modifications, conversions
and replacements are not completed timely, or our customers' or suppliers'
systems are not modified to become year 2000 compliant, the year 2000 issue may
have a material impact on our results of operations and financial condition.
Presently, we are unable to assess the likelihood that we will experience
significant operational problems due to unresolved year 2000 problems of third
parties that do business with us. Although we have not been put on notice that
any known third party problem will not be timely resolved, we have limited
information. No assurance can be made concerning the year 2000 readiness of
third parties. The resulting risks to our business are very difficult to assess
due to the large number of variables involved.
If third parties fail to achieve year 2000 compliance, year 2000 problems
could have a material impact on our operations. Similarly, there can be no
assurance that we can timely mitigate the risks related to a third party's
failure to resolve its year 2000 issues. If such mitigation is not achievable,
year 2000 problems could have a material impact on our operations.
The worst case year 2000 scenarios that we believe are reasonably likely to
occur would involve:
. disruption in utilities, transportation and communications
. disruption to commerce between us and third parties
27
<PAGE>
Contingency Plans
We presently believe that the most reasonably likely worst-case year 2000
scenarios would relate to the possible failure in one or more geographic regions
of third party systems over which we have no control and for which we have no
ready substitute, such as, but not limited to, power and telecommunications
services. We have in place a business resumption plan that addresses recovery
from various kinds of disasters, including recovery from significant
interruptions to data flows and distribution capabilities at our major data
systems centers and major distribution centers. We are using that plan as a
starting point for developing specific year 2000 contingency plans, which will
emphasize locating alternate sources of supply, methods of distribution and ways
of processing information.
We anticipate this contingency planning will prepare our business for
disruptions but will not protect us fully from commercial impact. We are
currently initiating the following efforts:
. prioritizing all hardware, software and services across the enterprise
. developing contingency plans for top priority items, including:
. building an inventory of hardware and spare parts
. procurement of generators
. identification of alternatives for transportation of product and
communications with business partners
. increasing staff on call and on the job at the end of 1999 and beginning
of 2000
We expect our year 2000 contingency plans will be substantially complete by
September 1999. However, there can be no assurance that we will be able to
complete our contingency planning on that schedule.
Factors Affecting Operating Results
Certain statements contained or incorporated in this report are forward-
looking statements concerning our operations, economic performance and financial
condition. Forward-looking statements are included in the discussions about (i)
the market for music and video sales, (ii) our strengthening our role as a
partner to Internet retailers, (iii) enhancements of our customer service and
support systems, (iv) our information systems, (v) relocation of some of our
operations, (vi) year 2000 issues, and (vii) growth of Internet music and video
sales. Those forward-looking statements involve risks and uncertainties and
actual results may differ materially from those expressed or implied in those
statements. Factors that could cause differences include, but are not limited
to, those discussed below.
We May Be Unable to Compete with Other Businesses that Offer Similar Products
and Services
The full-line distribution of music and video is an intensely competitive
business. We compete with national, regional and local full-line distributors.
In addition, the major labels,
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<PAGE>
major studios and independent distribution companies sell substantial amounts of
their products directly to retailers. However, to date they have not focused, to
the same extent we have, on fulfilling the needs of smaller independent stores
or providing value-added services. If the major labels, major studios and
independent distribution companies start providing more responsive service to
underserved retail segments or value-added services at competitive costs, our
financial results could be adversely affected. We also compete with several
vendor managed inventory firms, including two national vendor managed inventory
firms that we believe have greater revenues than us.
From time to time, several of our retail chain customers have chosen to buy
a substantial volume of their inventory directly from the major labels and
studios that they had previously been purchasing from us. To the extent that
our customers increase their direct purchasing from the major labels and studios
or the independent distribution companies, our financial results could be
adversely affected.
In addition to competition from existing competitors, in the future we could
face competition from new competitors that may enter the business. If new
competitors enter the music and video distribution business, our financial
results could be adversely affected.
Our existing New Media competitors include Alliance Entertainment Corp.,
Baker & Taylor and Ingram Entertainment. Other distributors have announced an
interest in starting to service the on-line market. If one or more of the
leading on-line retailers that we service buys more of its inventory directly
from a label or studio or through an alternative distributor, our financial
results could be adversely affected. Amazon.com, one of our largest New Media
customers, has announced its intent to increase the proportion of product it
buys directly from the labels and studios. In addition, to the extent our
Internet customers utilize fewer value-added services, such as direct-to-
consumer fulfillment and data, our financial results could also be adversely
affected.
Distribution North America competes with several other independent
distribution companies. Some of these competitors conduct distribution
operations equal to or larger than Distribution North America and others operate
in niche markets. We also compete with several of the major labels' own
independent distribution groups. In addition, as a label or artist gains in
popularity, Distribution North America faces new competition from the major
labels to retain distribution rights for that label or artist.
We May Be Unable to Obtain Product from Labels or Studios
The major labels and studios produce most of the music and video product.
Our success depends upon our ability to obtain products in sufficient quantities
on competitive terms and conditions from each of the major labels and studios as
well as from thousands of smaller suppliers. We do not have long term contracts
with any supplier for our Full-line Distribution or New Media business groups.
If we cannot obtain sufficient quantities of product from the major labels or
studios or a significant number of other suppliers for our Full-line
Distribution and New Media operations, our financial results could be adversely
affected.
Distribution North America maintains contracts with most of the suppliers it
represents. These contracts typically range in length from one to three years.
If Distribution North America were unable to maintain its distribution
relationship with any of its large suppliers, our financial results would be
adversely affected.
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<PAGE>
If the Internet Does Not Continue to Grow, Our New Media Sales Will Not Grow
Our New Media business group's growth will largely depend on the development
and widespread acceptance of the Internet as a medium for commerce. Use of the
Internet by consumers is at an early stage of development, and market acceptance
of the Internet as a medium for commerce is subject to a high level of
uncertainty. If use of the Internet stops growing, our financial results could
be adversely affected. Additionally, we are not certain that growth in on-line
music and video retail businesses will continue or that such growth will not
adversely affect our Full-line Distribution business group.
Our Sales Could Be Adversely Affected if We Lose Any of Our Largest
Customers
If any of our largest customers were to stop or reduce their purchasing from
us, our financial results could be adversely affected. During fiscal 1999, our
top three customers accounted for approximately 28% of our net sales. In
October 1998, under a contract that expires in June 1999, we began providing a
significant distribution function for the Blockbuster Music stores purchased by
Wherehouse. For the six months ended April 3, 1999, approximately 17% of our
net sales were to Wherehouse. After June 1999, we anticipate that sales to
Wherehouse will decline as it handles more of its distribution functions
internally.
We May Be Unable to Integrate and Upgrade Our Information Systems
Over the next two years, we intend to integrate certain of our information
systems. In addition, we are constantly upgrading our systems and developing
new applications. We cannot be certain that the integration or replacement of
our systems will be completed as scheduled without unanticipated costs or
operational difficulties. The failure or inoperability of our systems, or
difficulties in integration of these systems, could have a material adverse
impact on our financial results.
Our Information Systems Could Fail Because of Problems Relating to the Year
2000
Our information systems could fail or provide erroneous output when
referencing dates subsequent to December 31, 1999 due to year 2000 processing
problems. In addition, as we provide electronic data interchange with our
suppliers and customers, difficulties with 21st century dates in our customers'
or suppliers' information systems could adversely affect our information
systems, and vice versa. Such failures or errors could occur prior to 2000. If
we or our electronic data interchange suppliers and customers are unable to
update our systems successfully to eliminate this problem, we may be prevented
from using some or all of our information systems or exchanging data with our
customers or suppliers. This, in turn, could disrupt our business and have a
material adverse impact on our financial results.
Trends in the Video Rental Market Could Hurt Our Sales
Studios and full-line distributors recently have instituted programs to
increase the quantity of copies of popular video rental titles stocked by
retailers. We believe that these programs have accelerated a shift in the
market away from independent video rental stores and small chains in favor of
the larger chains. Since, in general, full-line distributors play a larger role
with independent retailers than with the larger chains, we believe that the
market may contract for full-line distribution of video rental product. In
addition, while most full-line video distributors have elected to participate in
revenue sharing distribution arrangements to help increase the
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<PAGE>
quantity of copies of titles available from the major studios, we have not. In
doing so, we risk losing market share to other distributors.
New Product Formats Could Replace the Formats We Distribute
The recent introductions of new product formats may cause consumers to
exercise caution in building their libraries of video cassettes and music CDs,
thus decreasing our video sell-through and music sales. Within the past two
years, studios started selling DVD, which currently is being marketed as a
superior alternative to the video cassette and may eventually be marketed as a
superior replacement for the music CD.
New Delivery Technologies Could Diminish Our Role in the Distribution
Process
Music and video are currently marketed and distributed primarily on a
physical delivery basis through wholesale and retail distribution. In the
future, if products are marketed, sold and delivered by labels or studios
directly to stores or homes through electronic downloading or streaming, current
methods of wholesale and retail distribution could decrease or be eliminated.
Microsoft, RealNetworks and others offer streaming technology which allows users
to listen to, but not record, audio and video. In addition, digital
distribution has begun on the Internet utilizing a technology called MP3, a
coding compression technology that allows downloading and copying of any digital
audio product.
Today, much of this type of digital distribution is unauthorized and lacks
copyright protection. However, the major studios have recently announced a plan
to develop a universal standard for the electronic delivery of music and have
announced their intention to make this delivery method available by the end of
1999. If electronic distribution of music or video becomes widespread and
displaces significant demand for the formats we sell and we fail to play a
significant role in the electronic distribution market, our financial results
would be adversely affected.
In addition, cable television companies, satellite television companies and
others are beginning to offer movies on a "near-video-on-demand" or other basis
that allows subscribers to order selected videos for in-home viewing. To the
extent that these programs achieve a broad level of acceptance, the market for
physical video product sold or rented by retailers could decline. This would
reduce our sales of video product.
We Are Experiencing Inefficiencies in Moving to Our New Facility
We are relocating our California distribution center to a nearby facility in
Woodland, California during the first half of fiscal 2000. This move is causing
us to incur additional labor and freight costs as well as other expenses and is
adversely affecting our sales. We could also incur further unanticipated costs
or disruptions of our operations as a result of this move. Furthermore, this new
distribution center and the LDC have increased our fixed costs substantially.
As a result, a lack of growth or decline in sales would adversely affect our
earnings.
We Might Have Inventory Risk Due to an Inability to Return Products
We bear inventory risk associated with the financial viability of the
independent labels and studios from which we purchase product. If a label or
studio cannot provide refunds in cash for
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<PAGE>
the inventory we desire to return, we may be forced to expense such inventory
costs. Further, we often experience higher return rates for products of
financially troubled labels and studios. If we fail to manage our inventory to
avoid accumulating substantial product that cannot be returned, our financial
results could be adversely affected.
We May Be Liable if Our Suppliers Fail to Comply with Copyright Laws
Substantially all of the music and video products we sell are subject to
copyright laws and licenses that limit the manner and geographic area in which
such products may be sold and provide royalties to the copyright owners. Any
sales of product in violation of such laws and licenses by anyone in the chain
of distribution may subject us to monetary damages or confiscation of such
product. We distribute thousands of titles from different artists over numerous
jurisdictions and rely primarily on our suppliers to ensure compliance with the
copyright laws, some of which may be conflicting or not clearly developed, and
payment of appropriate royalties. Although we have not experienced a material
loss due to copyright violations, we could be damaged in the future by copyright
violations by someone in our distribution channel.
We May Be Prevented from Distributing Music Internationally
Most of the major labels have adopted policies restricting the export of
their merchandise by domestic distributors. However, consistent with industry
practice, we distribute music of the major labels internationally. Our
international net sales of music for fiscal 1999 were approximately $37.4
million. We would be adversely affected if a major label enforced any
restriction on our ability to sell music outside the United States. In
addition, although our international sales are denominated in dollars, our
international sales volume can be adversely affected by appreciation of the
dollar relative to foreign currencies.
We May Have Insufficient Access to Funds if We Fail to Comply with the Terms
of Our Credit Facility
We have a revolving credit facility that is secured by substantially all of
our assets. As of April 3, 1999, borrowings of approximately $148.7 million
were outstanding under the credit facility. The credit facility is used for
general working capital purposes.
As a result of our substantial leverage we will incur significant interest
expense and principal repayment obligations, our ability to obtain additional
financing in the future may be limited, and our ability to compete through
expansion, capital improvements and flexibility in response to changing industry
conditions may be limited. The credit facility contains numerous restrictive
covenants, including limitations on our ability to acquire or invest in other
businesses and requirements that we comply with certain financial covenants.
If we fail to comply with the terms of the credit facility or other
agreements related to the credit facility, or obtain waivers from such
obligations, we could trigger an event of default under the credit facility or
related agreements. An event of default could permit acceleration of
indebtedness under the credit facility or related agreements that contain cross-
acceleration or cross-default provisions.
Our cash flow and capacity needs change significantly during the year, with
the heaviest credit needs and highest capacity requirements typically occurring
during the third fiscal quarter.
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<PAGE>
If we do not have sufficient finances to purchase the inventory required or the
distribution capacity to distribute product in a timely and accurate manner
during such seasonal peak periods, our financial results could be adversely
affected.
The Market Price of Our Common Stock Could Fluctuate
Many factors could cause the market price of our common stock to fluctuate
substantially, including (i) future announcements concerning us or our
competitors, (ii) variations in operating results, (iii) loss of a key supplier
or customer, (iv) technological innovations such as changes in physical product
formats or delivery technologies, (v) changes in product pricing policies by us,
our suppliers or our competitors and (vi) changes in earnings estimates by
securities analysts. These fluctuations, as well as general economic, political
and market conditions, may have a material adverse effect on the market price of
our common stock.
ITEM 7A. Quantitative and Qualitative Disclosures About Market Risk
The Company is exposed to market risks primarily from changes in U.S.
interest rates. The Company does not engage in financial transactions for
trading or speculative purposes.
The interest payable on the Company's revolving line of credit is based on
variable interest rates and therefore affected by changes in market interest
rates. If interest rates on variable rate debt rose 0.72 percentage points (a
10% change from the average interest rate as of April 3, 1999), assuming no
change in the Company's outstanding balance under the line of credit
(approximately $149 million as of April 3, 1999), the Company's income before
taxes and cash flows from operating activities would decline by approximately $1
million.
33
<PAGE>
ITEM 8. Financial Statements And Supplemental Data
Index to Consolidated Financial Statements and Financial Statement Schedule
- ---------------------------------------------------------------------------
<TABLE>
<CAPTION>
Financial Statements: Page
----
<S> <C>
Valley Media, Inc.:
Independent Auditors' Report..................................................... 35
Consolidated Balance Sheets as of April 3, 1999 and March 28, 1998............... 36
Consolidated Statements of Operations for the Fiscal Years Ended April 3, 1999,
March 28, 1998 and March 29, 1997.............................................. 37
Consolidated Statements of Stockholders' Equity for the Fiscal Years Ended
April 3, 1999, March 28, 1998 and March 29, 1997............................... 38
Consolidated Statements of Cash Flows for the Fiscal Years Ended April 3, 1999,
March 28, 1998 and March 29, 1997.............................................. 39
Notes to Consolidated Financial Statements....................................... 40
Distribution North America:
Independent Auditors' Report..................................................... 53
Statement of Operations and Accumulated Deficit for the Ten Months Ended
January 31, 1997............................................................... 54
Statement of Cash Flows for the Ten Months Ended January 31, 1997................ 55
Notes to Financial Statements.................................................... 56
Financial Statement Schedule:
Schedule II - Valuation and Qualifying Accounts and Reserves..................... S-1
</TABLE>
All other schedules are omitted, because they are not required, are not
applicable, or the information is included in the consolidated financials
statements and notes thereto.
34
<PAGE>
Independent Auditors' Report
Board of Directors and Stockholders of
Valley Media, Inc.:
We have audited the accompanying consolidated balance sheets of Valley Media,
Inc. and its subsidiaries (the "Company") as of April 3, 1999 and March 28,
1998, and the related consolidated statements of operations, stockholders'
equity, and cash flows for each of the three fiscal years in the period ended
April 3, 1999. Our audits also included the financial statement schedule listed
in the Index at Item 14(a)2. These financial statements and financial statement
schedule are the responsibility of the Company's management. Our responsibility
is to express an opinion on these financial statements and financial statement
schedule based on our audits.
We conducted our audits in accordance with generally accepted auditing
standards. Those standards require that we plan and perform the audit to obtain
reasonable assurance about whether the financial statements are free of material
misstatement. An audit includes examining, on a test basis, evidence supporting
the amounts and disclosures in the financial statements. An audit also includes
assessing the accounting principles used and significant estimates made by
management, as well as evaluating the overall financial statement presentation.
We believe that our audits provide a reasonable basis for our opinion.
In our opinion, such consolidated financial statements present fairly, in all
material respects, the financial position of Valley Media, Inc. and its
subsidiaries as of April 3, 1999 and March 28, 1998, and the results of their
operations and their cash flows for each of the three fiscal years in the period
ended April 3, 1999 in conformity with generally accepted accounting principles.
Also, in our opinion, such financial statement schedule, when considered in
relation to the basic consolidated financial statements taken as a whole,
presents fairly, in all material respects, the information set forth therein.
/s/ Deloitte & Touche LLP
San Francisco, California
May 14, 1999
35
<PAGE>
Valley Media, Inc.
Consolidated Balance Sheets
<TABLE>
<CAPTION>
Dollars in thousands, except share data April 3, March 28,
1999 1998
---- ----
<S> <C> <C>
Assets
Current assets
Cash............................................................................................ $ 1,433 $ 394
Accounts receivable, less allowance for doubtful accounts of $8,892 at April 3, 1999 and $5,276
at March 28, 1998............................................................................. 167,925 108,429
Inventories, net of reserves of $2,823 at April 3, 1999 and $1,587 at March 28, 1998............ 216,807 95,365
Deferred income taxes........................................................................... 5,956 1,903
Prepaid expenses and other...................................................................... 1,551 2,626
-------- --------
Total..................................................................................... 393,672 208,717
Property and equipment, net...................................................................... 20,913 15,681
Goodwill and other intangibles, net.............................................................. 14,678 19,040
Deferred income taxes............................................................................ 399 525
Other assets..................................................................................... 1,063 335
-------- --------
Total assets..................................................................................... $430,725 $244,298
======== ========
Liabilities and stockholders' equity
Current liabilities
Accounts payable.............................................................................. $191,978 $140,380
Accrued liabilities........................................................................... 11,534 9,024
Revolving line of credit...................................................................... 148,730 73,381
Current portion of long-term debt............................................................. 1,905 2,334
Deferred income taxes......................................................................... 3,918 908
-------- --------
Total..................................................................................... 358,065 226,027
-------- --------
Deferred income taxes............................................................................ 2,855 4,590
Long-term debt................................................................................... 3,918 3,166
Commitments and contingencies (Notes 7 and 9)
Stockholders' equity
Preferred stock, $.001 par value, 2,000,000 shares authorized, none issued....................
Common stock, $.001 par value, 20,000,000 shares authorized, 8,449,009 and 4,810,553 shares
issued and outstanding....................................................................... 8 5
Additional paid-in capital.................................................................... 52,145 845
Stockholders' notes receivable................................................................ (360)
Retained earnings............................................................................. 14,094 9,665
-------- --------
Total stockholders' equity................................................................ 65,887 10,515
-------- --------
Total liabilities and stockholders' equity....................................................... $430,725 $244,298
======== ========
</TABLE>
See notes to consolidated financial statements.
36
<PAGE>
Valley Media, Inc.
Consolidated Statements of Operations
<TABLE>
<CAPTION>
==================================================================
Fiscal Years Ended
------------------------------------------------------------------
April 3, March 28, March 29,
Dollars in thousands, except share data 1999 1998 1997
---- ---- ----
<S> <C> <C> <C>
Net sales...................................... $ 888,966 $ $583,492 $ 199,231
Cost of goods sold............................. 791,154 516,627 175,706
---------- ---------- ----------
Gross profit................................... 97,812 66,865 23,525
Selling, general and administrative expenses... 78,059 55,948 20,552
---------- ---------- ----------
Operating income............................... 19,753 10,917 2,973
Equity in net loss of joint venture............ 207
Interest expense............................... 10,928 6,627 1,745
---------- ---------- ----------
Income before income taxes..................... 8,825 4,290 1,021
Income taxes................................... 3,673 1,731 410
---------- ---------- ----------
Income before extraordinary loss............... 5,152 2,559 611
Extraordinary loss (net of income taxes of (723)
$477)......................................... ---------- ---------- ----------
Net income..................................... $ 4,429 $ 2,559 $ 611
========== ========== ==========
Net income per share:
Basic:
Income before extraordinary loss............ $ 1.04 $ 0.53 $ 0.13
Extraordinary loss.......................... (0.15)
---------- ---------- ---------
Net income per share........................ $ 0.89 $ 0.53 $ 0.13
========== ========== ==========
Diluted:
Income before extraordinary loss............ $ 0.89 $ 0.49 $ 0.12
Extraordinary loss.......................... (0.12)
---------- --------- ---------
Net income per share........................ $ 0.77 $ 0.49 $ 0.12
========== ========== ==========
Weighted average shares used in the
calculation:
Basic......................................... 4,950,753 4,791,864 4,797,193
Diluted....................................... 5,781,840 5,263,870 5,131,341
</TABLE>
See notes to consolidated financial statements.
37
<PAGE>
<TABLE>
<CAPTION>
Valley Media, Inc.
Consolidated Statements of Stockholders' Equity
================================================================================
Common Stock Additional Stockholders' Retained
Shares Amount Paid-in Capital Notes Receivable Earnings Total
-------------------- ---------------- ---------------- -------- --------
<S> <C> <C> <C> <C> <C> <C>
Dollars in thousands, except share
data
Balance at March 31, 1996............. 4,939,566 $5 $ 1,216 $ 6,495 $ 7,716
Repurchase of common stock............ (154,701) (554) (554)
Net income............................ 611 611
-------- -- ------ ------- -------
Balance at March 29, 1997............. 4,784,865 5 662 7,106 7,773
Repurchase of common stock............ (32,441) (143) (143)
Issuance of common stock in
connection with acquisition.......... 58,129 326 326
Net income............................ 2,559 2,559
-------- -- ------ ------- -------
Balance at March 28, 1998............. 4,810,553 5 845 9,665 10,515
Initial public offering proceeds, net. 3,500,000 3 50,940 50,943
Exercise of stock options in exchange
for notes receivable................. 138,456 360 $(360)
Net income............................ 4,429 4,429
-------- -- ------ ----- ------- -------
Balance at April 3, 1999.............. 8,449,009 $8 $52,145 $(360) $14,094 $65,887
========= == ======= ================== ======= =======
</TABLE>
See notes to consolidated financial statements.
38
<PAGE>
Valley Media, Inc.
Consolidated Statements of Cash Flows
<TABLE>
<CAPTION>
===============================================================
Fiscal Years Ended
---------------------------------------------------------------
Dollars in thousands April 3, March 28, March 29,
1999 1998 1997
---- ---- ----
<S> <C> <C> <C>
Cash flows from operating activities
Income before extraordinary loss............................... $ 5,152 $ 2,559 $ 611
Adjustments to reconcile income before extraordinary loss to
net cash provided by (used in) operating activities:
Depreciation and amortization............................... 5,630 4,112 1,849
Bad debt expense............................................ 3,616 2,770 505
Equity in net loss of joint venture......................... 207
Deferred income taxes....................................... (2,652) 2,799 121
Extraordinary loss on debt refinancing...................... (723)
Changes in assets and liabilities (net of acquisitions):
Accounts receivable......................................... (66,396) (43,526) (15,401)
Inventories................................................. (118,158) (31,441) (9,412)
Prepaid expenses and other.................................. 1,075 (1,213) (441)
Accounts payable............................................ 51,598 51,748 33,532
Accrued expenses............................................ 4,597 (1,659) 1,284
--------- --------- ---------
Net cash provided by (used in) operating activities......... (116,261) (13,851) 12,855
--------- --------- ---------
Cash flows from investing activities
Purchases of property and equipment......................... (8,842) (4,346) (2,902)
Business and net asset acquisitions, net of cash acquired... (33,147) (9,346)
Other....................................................... (728) (61) (82)
--------- --------- ---------
Net cash used in investing activities....................... (9,570) (37,554) (12,330)
--------- --------- ---------
Cash flows from financing activities
Short-term borrowings under revolving line of credit........ 970,681 632,004 195,748
Repayment of short-term borrowings.......................... (895,332) (579,070) (194,246)
Issuance of long-term debt.................................. 2,350 3 7
Repayment of long-term debt................................. (1,772) (1,306) (1,314)
Net proceeds from initial public offering................... 50,943
Repurchase of common stock.................................. (142) (554)
--------- --------- ---------
Net cash provided by (used in) financing activities......... 126,870 51,489 (359)
--------- --------- ---------
NET INCREASE IN CASH........................................... 1,039 84 166
CASH, BEGINNING OF YEAR........................................ 394 310 144
--------- --------- ---------
CASH, END OF YEAR.............................................. $ 1,433 $ 394 $ 310
========= ========= =========
Supplemental disclosure of cash flow information
Cash paid for interest...................................... $ 10,121 $ 5,716 $ 1,676
Cash paid for income taxes.................................. 4,914 85
Noncash investing and financing activities
Net liabilities assumed in connection with acquisition of
partnership interest....................................... 1,328
Noncompete agreement issued in connection with business
acquisition................................................ 241
Net assets acquired......................................... 229
Purchase of equipment through capital leases................ 245 2,788 231
Payable to Star Video Entertainment, L.P. as a result of
acquisition................................................ 3,144
Issuance of common stock in connection with acquisition..... 326
Notes receivable from stockholders.......................... 360
</TABLE>
See notes to consolidated financial statements.
39
<PAGE>
Valley Media, Inc.
Notes to Consolidated Financial Statements
1. Description of Business
Valley Media, Inc. (a Delaware corporation) and its subsidiaries (the "Company")
is a full-line distributor of prerecorded music and video entertainment
products. The Company has distribution facilities in California, Kentucky,
Pennsylvania and Massachusetts, and sells its products primarily to retail
stores throughout the United States and worldwide, as well as through Internet
music and video retailers. The Company also provides certain services to
customers such as direct-to-consumer fulfillment and licensing the Company's
proprietary products and databases of product information.
On March 26, 1999, the Company issued 3,500,000 shares of common stock at $16.00
per share, for net proceeds of $50,943,000 in an initial public offering.
2. Summary of Significant Accounting Policies
Principles of Consolidation
The consolidated financial statements include the accounts of the Company and
its wholly owned subsidiaries. Prior to January 1997, the Company owned a 50%
partnership interest in Distribution North America ("DNA"), which was accounted
for on the equity method. On January 31, 1997, the Company acquired the
remaining 50% partnership interest in DNA (see Note 4). Significant
intercompany balances and transactions are eliminated in consolidation.
Fiscal Year
The Company's fiscal year is a 52 or 53 week period ending on the Saturday
closest to March 31. The fiscal year ended April 3, 1999 ("fiscal 1999")
contained a 53 week period. The fiscal years ended March 28, 1998 ("fiscal
1998") and March 29, 1997 ("fiscal 1997") each contained a 52 week period.
Use of Estimates
The preparation of financial statements in conformity with generally accepted
accounting principles requires management to make estimates and assumptions that
affect the reported amounts of assets and liabilities and disclosures of
contingent assets and liabilities at the date of the financial statements and
the reported amounts of revenues and expenses during the reporting period.
Significant estimates include allowances for doubtful accounts, vendor
receivables and customer returns. Actual results could differ from those
estimates.
Inventories
Inventories are valued at the lower of cost or market and are accounted for on
the average cost basis. The Company performs periodic assessments to determine
the existence of obsolete, slow-moving and non-salable inventories and records
necessary provisions to reduce such inventories to net realizable value.
40
<PAGE>
Property and Equipment
Property and equipment is stated at cost and depreciated or amortized on a
straight-line basis over the estimated useful lives of the assets or the lease
term, whichever is shorter. Estimated useful lives range from five to ten
years.
Capitalized Computer Software
Capitalized computer software included in property and equipment, reflects costs
related to internally developed or purchased software that are capitalized and
amortized on a straight-line basis over periods not exceeding five years.
Internally developed software costs are capitalized in accordance with Statement
of Position 98-1, Accounting for the Costs of Computer Software Developed or
Obtained for Internal Use. Amortization expense for fiscal 1999, fiscal 1998
and fiscal 1997 was $804,000, $490,000 and $339,000, respectively.
Goodwill and Other Intangibles
Goodwill is amortized on a straight-line basis over 15 years. Identifiable
intangible assets, consisting primarily of customer lists, are amortized on a
straight-line basis over five years.
Revenue Recognition
Sales of prerecorded music, video, music accessories, and other related products
are recognized upon shipment of the product, net of estimated returns and
allowances, which are based on historical experience and adjusted for current
situations. Certain of the Company's sales are made to customers under
agreements permitting rights of return.
Advertising Expense and Reimbursement
Advertising costs are expensed when incurred. Advertising reimbursements from
suppliers are recognized as earned. Net advertising reimbursements are reported
as a reduction of cost of goods sold and consist of the following:
<TABLE>
<CAPTION>
=====================================
Fiscal Years Ended
-------------------------------------
April 3, March 28, March 29,
Dollars in thousands 1999 1998 1997
----- ----- -----
<S> <C> <C> <C>
Advertising reimbursements................................................. $ 35,640 $15,239 $ 4,510
Advertising expenses....................................................... (27,086) (8,181) (2,822)
-------- ------- -------
Net advertising reimbursements............................................. $ 8,554 $ 7,058 $ 1,688
======== ======= =======
</TABLE>
Concentration of Credit Risk
The Company is subject to credit risk through sales and related trade
receivables to retailers. Approximately 28% of the Company's net sales and 35%
of accounts receivable were represented by three customers for the year ended
April 3, 1999. The Company routinely assesses the financial strength of
significant customers and this assessment, combined with the large number and
geographic diversity of its customers, limits the Company's concentration of
risk with respect to trade accounts receivable.
Stock-based Compensation
The Company accounts for stock-based awards to employees using the intrinsic
value method in accordance with Accounting Principles Board No. 25, Accounting
for Stock Issued to Employees ("APB 25").
41
<PAGE>
Income Taxes
The Company accounts for income taxes under the asset and liability approach
where deferred income tax assets and liabilities reflect the future tax
consequences, based on enacted tax laws, of the temporary differences between
financial and tax reporting at the balance sheet date.
Fair Value of Financial Instruments
At April 3, 1999, the carrying value of cash, accounts receivable, accounts
payable, revolving line of credit, and long-term debt approximates their
estimated fair values.
Asset Impairment
Statement of Financial Accounting Standards No. 121, Accounting for the
Impairment of Long-Lived Assets to be Disposed Of, requires periodic review of
long-lived assets and certain identifiable intangibles for impairment whenever
events or changes in circumstances indicate that the carrying amount of an asset
may not be recoverable. Impairment, if any, would be determined from a
comparison of undiscounted net cash flows to the carrying value of the assets.
Implementation of SFAS No. 121 in fiscal 1997 had no effect on the Company's
financial statements.
Net Income per Share
Basic net income per share is computed by dividing net income by the weighted
average of common shares outstanding for the period. Diluted net income per
share reflects the potential dilution that could occur if common stock was
issued through exercise of stock options.
Comprehensive Income
SFAS No. 130, Reporting Comprehensive Income established new rules for reporting
and display of comprehensive income and its components. This statement requires
that all items that are required to be recognized under accounting standards as
components of comprehensive income be reported in a financial statement that is
displayed with the same prominence as other financial statements. The Company
has no items of other comprehensive income and therefore comprehensive income is
the same as net income for all periods presented.
New Accounting Pronouncement
SFAS No. 133, Accounting for Derivative Instruments and Hedging Activities,
establishes accounting and reporting standards for derivative instruments,
including certain derivative instruments embedded in other contracts
(collectively referred to as derivatives) and for hedging activities. It
requires that an entity recognizes all derivatives as either assets or
liabilities in the statement of financial position and measures these
instruments at fair value. SFAS No. 133 is effective for all fiscal quarters of
fiscal years beginning after June 15, 1999, however required implementation is
expected to be delayed one year after such date. The Company is currently
evaluating what impact, if any, SFAS No. 133 may have on its financial
statements.
Stock Split
On March 22, 1999, the Company effected a 8.04-for-1 split of its common stock
in the form of a stock dividend. All share and per share amounts in the
accompanying consolidated financial statements have been restated to give effect
to the stock split.
42
<PAGE>
3. Acquisition of Business of Star Video Entertainment, L.P.
On May 20, 1997, the Company acquired certain of the assets and assumed certain
liabilities of Star Video Entertainment, L.P. ("Star Video"), a distributor of
prerecorded videocassettes. Consideration paid to the seller was $37,872,000,
of which $34,728,000 was paid in cash on May 20, 1997 and in August 1997 and the
remaining $3,144,000 was due in various installments over the next three years.
In connection with the acquisition, the Company incurred $1,080,000 of
transaction costs, comprised principally of legal fees.
As of May 20, 1997, the Company planned to (i) terminate certain Star Video
senior management in fiscal 1998, (ii) move virtually all Star Video
administrative functions to the Company's Woodland, California headquarters in
calendar 1998 and (iii) close three Star Video distribution facilities in fiscal
1998 and early fiscal 1999. Therefore, the Company recorded a liability of
$1,485,000 at May 20, 1997 for severance costs related to these planned
activities.
As of March 28, 1998, the Company had terminated certain Star Video senior
management and closed two distribution facilities. As a result, the Company
charged $606,000 against the severance liability in fiscal 1998 and at March 28,
1998 the remaining severance liability was $879,000.
In fiscal 1999, the Company moved the Star Video administrative functions to
Woodland, California and closed the third distribution facility. As a result,
the Company charged $595,000 against the severance liability and at April 3,
1999 had a remaining severance liability of $284,000, which will be paid through
May 2000.
The Company allocated the total purchase price of $40,437,000 to the fair value
of the net assets acquired as follows:
<TABLE>
<CAPTION>
Dollars in thousands ==============
<S> <C>
Cash..................................................................................... $ 3,697
Accounts receivable...................................................................... 58,025
Inventories.............................................................................. 20,513
Property and equipment................................................................... 1,472
Goodwill................................................................................. 15,540
Customer lists........................................................................... 2,300
Prepaid and other assets................................................................. 812
Accounts payable......................................................................... (43,061)
Accrued expenses......................................................................... (1,722)
Short-term borrowings.................................................................... (17,139)
--------
Total.................................................................................... $ 40,437
</TABLE>
During November 1998, the Company and Star Video settled an arbitration
proceeding relating to the acquisition of Star Video regarding the valuation of
certain accounts receivables and payables. The settlement resulted in the
reduction of approximately $1,500,000 of accounts payable and $500,000 of notes
payable no longer due to the previous owners of Star Video and a $2,000,000
decrease in goodwill.
The following unaudited pro forma information has been presented as if the
acquisition of business of Star Video had occurred at the beginning of each
fiscal year presented. The unaudited pro forma information is based on
historical results of operations adjusted for purchase price adjustments and, in
the opinion of management, is not necessarily indicative of what results would
have been if the acquisition had occurred at the beginning of each fiscal year
presented.
43
<PAGE>
<TABLE>
<CAPTION>
=============================
Fiscal Years Ended
-----------------------------
March 28, March 29,
1998 1997(1)
---- -------
<S> <C> <C>
(unaudited)
Dollars in thousands, except per share data
Net sales....................................................................... $616,034 $500,353
Net income...................................................................... 1,991 4,849
Net income per share:
Basic........................................................................ $ 0.42 $ 1.01
Diluted...................................................................... 0.38 0.94
</TABLE>
(1) Includes results of operations of Star Video for the fiscal year ended
December 31, 1996
4. Other Acquisitions
During fiscal 1998, the Company acquired inventories and accounts receivable
from a wholesale prerecorded music distributor for a purchase price of $798,000,
which was paid in cash.
In January 1997, the Company acquired the remaining 50% partnership interest in
DNA in exchange for assuming DNA's net liabilities of $1,328,000. Simultaneous
with the acquisition, the Company repaid DNA's line of credit balance of
$3,133,000 utilizing borrowings from the Company's line of credit. The
transaction resulted in goodwill of $747,000. The Company provided certain
services (including warehousing, data processing and order processing) to DNA
through January 1997. The Company received $2,403,000 from DNA for such
services during fiscal 1997. Additionally, the Company purchased products from
DNA totaling $4,274,000 during fiscal 1997.
Summarized financial information for DNA is as follows:
<TABLE>
<CAPTION>
==================
Ten Months Ended
January 31, 1997
------------------
Dollars in thousands
<S> <C>
Net sales.................................................................. $23,539
Gross profit............................................................... 5,176
Operating income........................................................... 108
Net loss................................................................... (414)
</TABLE>
During fiscal 1997, the Company acquired certain assets from three wholesale
prerecorded music distributors. The purchase prices totaled $9,346,000, paid in
cash. The purchases included inventory, accounts receivable, trademarks and
copyrights and a covenant not to compete, and resulted in goodwill and other
intangibles of $1,766,000.
In December 1996, the Company entered into an agreement to acquire certain
Stereophile, Inc. ("Stereophile") assets, a publisher of quarterly and annual
comprehensive classical music guides. Stereophile is owned by a Director of the
Company. The Company accounted for this transaction as an acquisition. The
total purchase price was $702,000, comprised of cash paid of $150,000, notes
payable and other liabilities assumed of $226,000 and common stock of $326,000
(58,129 shares of common stock which were issued in December 1997 at a fair
value of approximately $5.60 per share based upon an independent valuation of
the Company as of March 27, 1997, adjusted for changes in the Company's
business). The Company allocated the total purchase price to the fair
44
<PAGE>
value of the net assets acquired; $355,000 was allocated to identifiable
intangible assets (music databases based upon estimated costs to replicate the
databases) and $347,000 was allocated to goodwill.
The above acquisitions have been accounted for using the purchase method of
accounting and, accordingly, the operations of these businesses and net assets
have been included in the Company's consolidated financial statements from their
respective dates of acquisition and were not material to the results of
operations of the Company.
5. Property and Equipment
Property and equipment consist of the following:
<TABLE>
<CAPTION>
===================================
April 3, March 28,
Dollars in thousands 1999 1998
---- ----
<S> <C> <C>
Machinery and equipment............................................. $ 10,134 $ 9,682
Office furniture and equipment...................................... 11,757 6,733
Computer software................................................... 6,879 5,045
Leasehold improvements.............................................. 2,988 1,273
-------- -------
Total........................................................ 31,758 22,733
Less accumulated depreciation and amortization...................... (10,845) (7,052)
-------- -------
Property and equipment, net......................................... $ 20,913 $15,681
======== =======
</TABLE>
The Company leases some of its office furniture and equipment under capital
leases. At April 3, 1999 and March 28, 1998 property and equipment recorded
under capital leases were $4,606,000 and $3,850,000, respectively. Related
accumulated amortization was $1,093,000 and $518,000, respectively.
6. Goodwill and Other Intangibles
Goodwill and other intangibles consist of:
<TABLE>
<CAPTION>
=================================
April 3, March 28,
Dollars in thousands 1999 1998
---- ----
<S> <C> <C>
Goodwill............................................................... $15,578 $18,165
Identifiable intangible assets, primarily customer lists............... 2,554 2,554
------- -------
Total........................................................... 18,132 20,719
Less accumulated amortization.......................................... (3,454) (1,679)
------- -------
Goodwill and other intangibles, net.................................... $14,678 $19,040
======= =======
</TABLE>
7. Revolving Line of Credit
At April 3, 1999, the Company has a revolving line of credit agreement ("Credit
Facility") that provides for borrowings up to the lesser of $220,000,000
(reduced to $200,000,000 as of April 5, 1999) or the amount of collateral
availability. Collateral availability is limited to 77% of accounts receivable
plus the lesser of 62% of cost or 91% of net realizable value of inventories
(subject to certain limitations as to video and DNA inventories, as defined in
the Credit Facility).
45
<PAGE>
At April 3, 1999, the outstanding amount under the line of credit was
$148,730,000. The Credit Facility bears interest, at the Company's election, at
prime plus a margin of 0% to 0.5% or the Eurodollar Rate plus a margin of 2.0%
to 2.75%, subject to monthly adjustments and certain terms and conditions stated
in the Credit Facility. At April 3, 1999, the average interest rate on
outstanding borrowings was 7.22%. The Credit Facility requires a monthly fee of
0.38% on the amount by which 80% of the available borrowings exceeds the average
daily principal balance of outstanding loans and letters of credit. Borrowings
under the Credit Facility are secured by all eligible accounts receivable,
inventory, certain equipment, and other intangible property of the Company. The
Credit Facility contains various covenants, including among other things,
compliance with adjusted net worth requirements, restriction of encumbrances,
indebtedness, loans, investments and guarantees and restriction on the payment
of cash dividends. Dividends are restricted to 25% of fiscal year net income,
subject to certain borrowing availability requirements. The Credit Facility
expires on May 21, 2001 and renews annually thereafter unless notice is given by
either party.
As a result of terminating a prior line of credit agreement in the first quarter
of fiscal 1999, the Company incurred termination fees and wrote off prepaid
financing costs resulting in an extraordinary loss of $723,000 (net of income
tax benefit of $477,000) or $0.12 per diluted share.
8. Long-Term Debt
Long-term debt consists of the following:
<TABLE>
<CAPTION>
=================================
April 3, March 28,
Dollars in thousands 1999 1998
---- -----
<S> <C> <C>
Various notes payable in monthly installments of $50, interest at 8.8% to
9.5%, due January and July 2002, secured by equipment...................... $ 1,590
Note payable in monthly installments of $52, interest at the treasury rate
plus 3.2% (8.7% on April 3, 1999), due November 2000, secured by equipment. 974 $ 1,494
Capital lease obligations (see Note 9)...................................... 3,259 3,260
Other notes payable......................................................... 746
----- -------
Total.................................................................... 5,823 5,500
Less current portion........................................................ (1,905) (2,334)
------- -------
Total long-term debt........................................................ $ 3,918 $ 3,166
======= =======
</TABLE>
Scheduled principal maturities as of April 3, 1999 for fiscal years are as
follows:
<TABLE>
<CAPTION>
Dollars in thousands ==========
<S> <C>
2000.......................................................................................... $1,905
2001.......................................................................................... 1,686
2002.......................................................................................... 973
2003.......................................................................................... 504
2004.......................................................................................... 420
Thereafter.................................................................................... 335
------
Total..................................................................................... $5,823
======
</TABLE>
46
<PAGE>
9. Commitments and Contingencies
The Company has several capital leases for office furniture and equipment. The
Company also leases computer equipment and office and warehouse facilities and
equipment under noncancelable operating leases. During fiscal 1999, fiscal
1998, and fiscal 1997, total rent expense under all operating leases was
$4,603,000, $3,125,000 and $1,479,000 respectively. The Company was reimbursed
$231,000 by DNA related to these expenditures in fiscal 1997.
As of April 3, 1999, the Company had commitments to purchase property and
equipment of approximately $2,453,000.
Future minimum payments under capital leases and noncancelable operating leases
with terms of one year or more at April 3, 1999 for fiscal years consisted of
the following:
<TABLE>
<CAPTION>
=============================
Capital Operating
Dollars in thousands Leases Leases
------ ------
<S> <C> <C>
2000...................................................................... $1,152 $ 6,701
2001...................................................................... 982 5,549
2002...................................................................... 552 4,061
2003...................................................................... 505 3,057
2004...................................................................... 472 3,120
Thereafter................................................................ 385 8,758
------ -------
Total lease payments.................................................. 4,048 $31,246
=======
Less amounts representing interest........................................... (789)
------
Present value of net minimum lease payments.................................. $3,259
======
</TABLE>
In the ordinary course of its business the Company is a party to certain claims
and legal actions. After consulting with legal counsel, the management of the
Company believes that the ultimate resolution of these matters will not have a
material adverse effect on the consolidated financial statements of the Company
taken as a whole.
10. Income Taxes
The income tax provision consists of the following:
<TABLE>
<CAPTION>
====================================
Fiscal Years Ended
------------------------------------
April 3, March 28, March 29,
Dollars in thousands 1999 1998 1997
---- ---- ----
<S> <C> <C> <C>
Income tax expense (benefit):
Current
Federal........................................................................ $ 4,630 $ 98 $ 215
State.......................................................................... 1,182 3 74
------- ------ -----
Total......................................................................... 5,812 101 289
Deferred
Federal........................................................................ (1,747) 1,114 102
State.......................................................................... (392) 516 19
------- ------ -----
Total......................................................................... (2,139) 1,630 121
------- ------ -----
Income tax provision.............................................................. $ 3,673 $1,731 $ 410
======= ====== =====
</TABLE>
47
<PAGE>
The Company's effective tax rate differs from the federal statutory as follows:
<TABLE>
<CAPTION>
==========================================================
Fiscal Years Ended
----------------------------------------------------------
April 3, 1999 March 28, 1998 March 29, 1997
------------- -------------- --------------
<S> <C> <C> <C>
Federal tax at statutory rate................ 35.0% 34.0% 34.0%
State income taxes, net of Federal benefit... 5.8 5.8 6.1
True-up of prior year tax returns............ (2.2)
Write off of deferred offering costs......... 3.0
Other........................................ 0.5 0.1
----- ---- ----
Total........................................ 41.6% 40.3% 40.2%
==== ==== ====
</TABLE>
The significant components of the Company's deferred tax assets (liabilities)
are as follows:
<TABLE>
<CAPTION>
==================================
April 3, March 28,
Dollars in thousands 1999 1998
---- ----
Deferred tax assets
<S> <C> <C>
Allowance for doubtful accounts.......................................... $ 2,895 $ 1,086
Capitalized inventory costs.............................................. 484 117
Accrued vacation......................................................... 268 126
Nondeductible reserves................................................... 1,481 362
Deferred state taxes..................................................... 232 182
ESOP contributions....................................................... 150 70
Other.................................................................... 845 485
------- -------
Total deferred tax assets............................................... 6,355 2,428
------- -------
Deferred tax liabilities
Fair value adjustment on customer receivables............................ (2,881) (3,517)
Capitalized software..................................................... (889) (1,210)
Depreciation and amortization............................................ (1,964) (758)
Other.................................................................... (1,039) (13)
------- -------
Total deferred tax liabilities.......................................... (6,773) (5,498)
------- -------
Net deferred tax liability.................................................. $ (418) $(3,070)
======= =======
</TABLE>
11. Employee Benefit Plans
During fiscal 1997, the Company repurchased 139,777 shares of common stock at
approximately $3.58 per share from the principal shareholder. The repurchase
price was based upon an independent valuation of the Company and no compensation
was recorded. During fiscal 1999, the Company's principal shareholder sold
approximately 111,756 shares of common stock at $9.95 per share to certain
members of the Company's Board of Directors.
Stock Ownership Plan
The Company's employee stock ownership plan ("ESOP") is a defined contribution
plan covering substantially all full-time employees who meet minimum age and
length of service requirements. The ESOP requires annual Company contributions
of 1% of eligible employees' annual compensation in the form of common stock,
cash or any combination thereof. ESOP contribution expense, which represented 1%
of eligible compensation and was paid in cash, totaled $261,000, $216,000 and
$164,000 for fiscal 1999, fiscal 1998 and fiscal 1997, respectively.
Participant
48
<PAGE>
accounts become 20% vested upon completion of three years service and vest an
additional 20% in each succeeding year. At April 3, 1999 and March 28, 1998 the
ESOP held 798,234 shares. All of the shares at the end of each fiscal year were
allocated to participants. All ESOP shares are considered outstanding for net
income per share calculations.
Upon termination of employment or retirement, distributions to participants are
made based upon their vested account balances. Prior to the completion of the
Company's initial public offering, upon distribution of shares, participants
could, at their option, require the Company to repurchase ESOP shares
distributed, at fair value. The Company repurchased and retired 32,452 and
14,930 ESOP shares during fiscal 1998 and fiscal 1997, respectively. The
purchase price in each period was based upon an independent valuation of the
Company.
Stock Option Plans
Under the 1994 and 1997 Stock Option Plans, there are 2,090,400 shares of common
stock reserved for which the Company could grant options to eligible employees,
directors, and consultants at prices not less than the fair market value at the
date of grant for incentive stock options and not less than 85% of the fair
market value at the date of grant for nonqualified stock options. Options
granted under the Plans generally vest over four years, and expire 10 years from
the date of grant.
All stock options have been granted at fair market value. The fair market
values were determined by the Company's Board of Directors based upon
independent valuations of the Company as of March 28, 1998, March 29, 1997 and
March 30, 1996, adjusted for material changes in business circumstances, as
appropriate.
No compensation expense has been recognized in connection with any stock option
grants or sales of common stock by the Company's principal shareholder.
Outstanding options under both plans are summarized as follows:
<TABLE>
<CAPTION>
Weighted Weighted
Average Average
Exercise Options Exercise
Options Price Exercisable Price
------- ----- ----------- -----
<S> <C> <C> <C> <C>
Outstanding, March 31, 1996...................................... 751,447 $2.43
Granted (weighted average fair value of $1.04)................... 117,914 3.65
Forfeited........................................................ (67,552) 3.33
---------
Outstanding, March 29, 1997...................................... 801,809 2.53 200,397 $2.43
Granted (weighted average fair value of $1.07)................... 368,577 4.48
Forfeited........................................................ (22,753) 5.05
---------
Outstanding, March 28, 1998...................................... 1,147,633 3.11 759,386 2.54
Granted (weighted average fair value of $2.09)................... 249,033 9.83
Exercised........................................................ (138,456) 2.61
Forfeited........................................................ (83,916) 4.41
---------
Outstanding, April 3, 1999....................................... 1,174,294 $4.50 777,867 $3.02
=========
</TABLE>
At April 3, 1999, there were 777,650 shares available for future grant under
both plans.
During fiscal 1999, certain officers exercised options to purchase 138,456
shares of common stock. The exercise price was paid by $360,000 in stockholder
notes, with interest at 7.8%, due in one to three years. Subsequent to April 3,
1999, $127,000 in stockholder notes were repaid to the Company.
49
<PAGE>
The following table summarizes information about both plans at April 3, 1999:
<TABLE>
<CAPTION>
Range of Weighted Average
Exercise Options Remaining Weighted Average Options Weighted Average
Prices Outstanding Contractual Life Exercise Price Exercisable Exercise Price
------ ----------- ---------------- -------------- ----------- --------------
<S> <C> <C> <C> <C> <C>
$2.43 614,826 5.7 $ 2.43 614,826 $ 2.43
3.73 46,897 7.9 3.73 19,874 3.73
4.35 247,452 8.4 4.35 105,690 4.35
5.60 37,788 8.8 5.60 10,987 5.60
5.85 8,040 9.1 5.85 1,840 5.85
9.95 159,393 9.5 9.95 20,013 9.95
11.19 30,150 9.7 11.19 2,511 11.19
12.00 29,748 9.9 12.00 2,126 12.00
--------- -------
1,174,294 7.2 $ 4.50 777,867 $ 3.02
========= =======
</TABLE>
Additional Stock Plan Information
SFAS No. 123, Accounting for Stock-Based Compensation, requires the disclosure
of pro forma net income as if the Company had adopted the fair value method as
of the beginning of fiscal 1996. Under SFAS No. 123, the fair value of stock-
based awards to employees is calculated through the use of option pricing
models, even though such models were developed to estimate the fair value of
freely tradable, fully transferable options without vesting restrictions, which
significantly differ from the Company's stock option awards. These models also
require subjective assumptions, including future stock price volatility and
expected time to exercise, which greatly affect the calculated values. The
Company's calculations were made using the minimum value option pricing model
with the following weighted average assumptions: expected life, five years
following grant date; no volatility; risk free interest rates, 3.9%-7.0%; and no
dividends during the expected term. The Company's calculations are based on a
single option valuation approach and forfeitures are recognized as they occur.
If the computed fair values of the fiscal 1999, fiscal 1998 and fiscal 1997
awards had been amortized to expense over the vesting period of the awards, pro
forma net income would have been $4,334,000 or $0.75 diluted share in fiscal
1999, $2,517,000 or $0.48 per diluted share in fiscal 1998 and $610,000 or $0.12
per diluted share in fiscal 1997. The impact of outstanding nonvested stock
options granted prior to fiscal 1996 has been excluded from the pro forma
calculation; accordingly, the fiscal 1999, fiscal 1998 and fiscal 1997 pro forma
adjustment is not indicative of future period pro forma adjustments, when the
calculation will apply to all applicable stock options and an assumption as to
volatility will be included as a result of the Company's public offering.
Employee Retirement Plan
The Company has an employee retirement plan intended to be qualified under
Section 401(k) of the Internal Revenue Code. Participation in the plan is
available to substantially all employees. Generally, employees may contribute up
to 17% of their annual compensation to the plan on a pre-tax basis. Under the
plan, the Company makes matching contributions of 50% up to a maximum of 4% of
each participating employee's annual compensation. The Company's contributions
to the plan totaled $468,000, $282,000 and $164,000 in fiscal 1999, fiscal 1998
and fiscal 1997, respectively.
50
<PAGE>
12. Net Income Per Share
A reconciliation of basic to diluted weighted average shares used in the
calculation of net income per share is as follows:
<TABLE>
<CAPTION>
===========================================================
Fiscal Years Ended
-----------------------------------------------------------
April 3, March 28, March 29,
1999 1998 1997
---- ---- ----
<S> <C> <C> <C>
Weighted average shares used in the calculation-basic............ 4,950,753 4,791,864 4,797,193
Effect of dilutive stock options................................. 831,087 472,006 334,148
--------- --------- ---------
Weighted average shares used in the calculation-diluted..........
5,781,840 5,263,870 5,131,341
========= ========= =========
</TABLE>
13. Segment Information
The Company adopted SFAS No. 131, "Disclosure about Segments of an Enterprise
and Related Information," in fiscal 1999. SFAS No. 131 establishes standards
for reporting information about operating segments and related disclosures about
products, geographic information and major customers. Operating segment
information for fiscal 1998 and 1997 is also presented in accordance with SFAS
No. 131.
Management has determined that there are three reportable segments based on the
customers served by each segment: Full-line Distribution, New Media and
Independent Distribution. Such determination was based on the level at which
executive management reviews the results of operations in order to make
decisions regarding performance assessment and resource allocation.
Full-line Distribution serves music, video and other retailers worldwide with
customers ranging from independent stores to specialty chains to retailers who
sell music and video as an ancillary product line. New Media provides product
and data to Internet retailers. Independent Distribution serves independent
labels and studios. Independent Distribution sells products to Full-line
Distribution and New Media at market price, and accordingly, the intersegment
revenues are included in "intersegment eliminations" in the reconciliation of
operating income reported below.
Expenses of the advertising, distribution, information systems, finance and
administrative groups are not allocated to the operating segments and are
included in "other" in the reconciliation of operating income reported below.
The Company does not allocate equity in net loss of joint venture, interest
expense, income taxes or extraordinary items to operating segments. The Company
does not identify and allocate assets or depreciation by operating segment. The
accounting policies of the segments are the same as those described in the
summary of significant accounting policies (see Note 2).
51
<PAGE>
Information on reportable segments is as follows:
<TABLE>
<CAPTION>
=================================
Fiscal Years Ended
---------------------------------
April 3, March 28, March 29,
Dollars in thousands 1999 1998 1997
---- ---- ----
<S> <C> <C> <C>
Full-line Distribution
Net sales.............................. $668,385 $520,465 $184,721
Operating income....................... $ 52,503 $ 40,251 $ 19,707
New Media
Net sales.............................. $182,734 $ 30,316 $ 8,319
Operating income....................... $ 24,531 $ 4,022 $ 1,055
Independent Distribution
Net sales.............................. $ 55,048 $ 45,685 $ 6,626
Operating income....................... $ 5,184 $ 6,415 $ 47
Other
Unallocated expenses................... $(62,465) $(39,771) $(17,836)
Intersegment Eliminations
Net sales.............................. $(17,201) $(12,974) $ (435)
Total
Net sales.............................. $888,966 $583,492 $199,231
Operating income....................... $ 19,753 $ 10,917 $ 2,973
</TABLE>
In fiscal 1999, one customer accounted for approximately 11% of the Company's
net sales, substantially all of which were from Full-line Distribution. No
customer accounted for more than 10% of the Company's fiscal 1998 or 1997 net
sales.
Information concerning principal geographic areas, as determined by the location
of the customer, is as follows:
<TABLE>
<CAPTION>
================================
Fiscal Years Ended
--------------------------------
April 3, March 28, March 29,
Dollars in thousands 1999 1998 1997
---- ---- ----
<S> <C> <C> <C>
Sales by geographic area:
United States.......................... $851,545 $540,285 $183,513
Foreign countries...................... 37,421 43,207 15,718
-------- -------- --------
Consolidated net sales................. $888,966 $583,492 $199,231
======== ======== ========
</TABLE>
Foreign revenues were principally to Asia, Europe, Central America and South
America.
14. Quarterly Information (Unaudited)
<TABLE>
<CAPTION>
================================================
Fiscal 1999
------------------------------------------------
Dollars in thousands, except per share data
Fourth (1) Third Second First (2)
---------- ----- ------ ---------
<S> <C> <C> <C> <C>
Net sales................................................. $257,864 $287,751 $188,978 $154,373
Gross profit.............................................. 27,822 32,044 20,996 16,950
Selling, general and administrative expenses.............. 22,311 21,605 17,409 16,734
Total operating income.................................... 5,511 10,439 3,587 216
Net income (loss)......................................... $ 1,240 $ 4,759 $ 415 $ (1,985)
Basic net income (loss) per share......................... $ 0.24 $ 0.98 $ 0.09 $ (0.41)
Diluted net income (loss) per share....................... $ 0.21 $ 0.85 $ 0.07 $ (0.37)
<CAPTION>
=========================================
Fiscal 1998
-----------------------------------------
Dollars in thousands, except per share data
Fourth Third Second First
------ ----- ------ -----
<S> <C> <C> <C> <C>
Net sales................................................. $156,212 $192,833 $144,654 $89,793
Gross profit.............................................. 19,998 20,059 16,118 10,690
Selling, general and administrative expenses.............. 16,765 15,346 14,168 9,669
Total operating income.................................... 3,233 4,713 1,950 1,021
Net income (loss)......................................... $ 669 $ 1,722 $ 180 $ (12)
Basic net income (loss) per share......................... $ 0.14 $ 0.36 $ 0.04 -
Diluted net income (loss) per share....................... $ 0.13 $ 0.33 $ 0.03 -
</TABLE>
__________
(1) Represents a 14 week quarter.
(2) Includes extraordinary loss of $723,000 or $0.15 per basic share and $0.12
per diluted share.
52
<PAGE>
Independent Auditors' Report
Board of Directors of
Distribution North America
We have audited the accompanying statements of operations and accumulated
deficit, and cash flows of Distribution North America (The Partnership) for the
ten months ended January 31, 1997. These financial statements are the
responsibility of the Partnership's management. Our responsibility is to
express an opinion on these financial statements based on our audit.
We conducted our audit 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 audit provides a reasonable basis for our opinion.
In our opinion, such financial statements present fairly, in all material
respects, the results of Distribution North America's operations and its cash
flows for the ten month period ended January 31, 1997 in conformity with
generally accepted accounting principles.
As described in Note 1, immediately subsequent to January 31, 1997, a partner
acquired 100% ownership of the Partnership.
As described in Note 3, the Partnership has significant related party
transactions.
/s/ Deloitte & Touche LLP
San Francisco, California
June 18, 1997
53
<PAGE>
Distribution North America
Statements of Operations and Accumulated Deficit
Ten Months Ended January 31, 1997
<TABLE>
<CAPTION>
Dollars in thousands
<S> <C>
NET SALES (includes net sales to affiliates of $4,274)..................................... $23,539
COST OF GOODS SOLD (includes cost of goods sold from sales to affiliates of $3,334)........ 18,363
-------
GROSS PROFIT............................................................................... 5,176
EXPENSES:
Distribution............................................................................. 2,222
Selling, general and administrative...................................................... 2,791
Other.................................................................................... 55
-------
Total operating expenses.............................................................. 5,068
-------
OPERATING INCOME (LOSS).................................................................... 108
INTEREST EXPENSE........................................................................... 522
-------
NET LOSS................................................................................... ( 414)
ACCUMULATED DEFICIT, BEGINNING OF PERIOD................................................... (2,035)
-------
ACCUMULATED DEFICIT, END OF PERIOD......................................................... $(2,449)
=======
</TABLE>
See notes to financial statements.
54
<PAGE>
Distribution North America
Statements of Cash Flow
Ten Months Ended January 31, 1997
<TABLE>
<S> <C>
CASH FLOWS FROM OPERATING ACTIVITIES:
Net loss............................................................................. $ (414)
Adjustments to reconcile net loss to net cash provided
(used) by operating activities:
Depreciation and amortization...................................................... 16
Provision for doubtful accounts receivable......................................... 52
Provision for writedown of inventories............................................. 250
Changes in operating assets and liabilities:
Accounts receivable............................................................ (22)
Inventories.................................................................... 1,065
Prepaid expenses............................................................... 18
Accounts payable:
Trade...................................................................... 1,849
Affiliates................................................................. (267)
Accrued expenses............................................................... (132)
Other liabilities.............................................................. 538
-------
Net cash provided by operating activities............................................ 2,953
-------
CASH FLOWS FROM INVESTING ACTIVITIES:
Purchases of property and equipment.................................................. (1)
-------
CASH FLOWS FROM FINANCING ACTIVITIES:
Net line-of-credit repayments........................................................ (6,240)
Increase in amounts due affiliate.................................................... 3,133
-------
Net cash used by financing activities................................................ (3,107)
NET DECREASE IN CASH................................................................. (155)
-------
CASH, beginning of period............................................................ 451
-------
CASH, end of period.................................................................. $ 296
=======
Supplemental disclosure of cash flow information:
Cash paid during the period for interest............................................. $ 522
</TABLE>
See notes to financial statements.
55
<PAGE>
Distribution North America
Notes to Financial Statements
1. Organization and Summary of Significant Accounting Policies
Distribution North America (DNA or the Partnership) was formed in September 1994
as a Delaware general partnership between Valley Venturer, Inc., a wholly-owned
subsidiary of Valley Record Distributors, Inc. (Valley), and Distribution North
America, Inc., (DNA Inc.) a corporation owned by the members of the ILN Group
(ILN), an affiliate of Rounder Records Corporation (Rounder). The Partnership
is a distributor of independent label compact disks and cassettes sold primarily
in North America from Valley's distribution facility located in Woodland,
California.
Immediately subsequent to January 31, 1997, Valley Venturer, Inc. acquired
Rounder's partnership interest for a nominal amount and assumed the liabilities
of the Partnership. Subsequently, DNA is operated as a part of the independent
distribution group of Valley.
The preparation of financial statements in conformity with generally accepted
accounting principles requires management to make estimates and assumptions that
affect the reported amounts of assets and liabilities at the date of the
financial statements and the reported amounts of revenues and expenses during
the reporting period. Actual results could differ from those estimates.
Revenue Recognition - Revenue from the sale and distribution of pre-recorded
music, music accessories and other related products is recognized upon shipment
of the product. A reduction from sales is provided for estimated future
customer returns.
Advertising costs are expensed when incurred and totaled $93,230 for the ten
months ended January 31, 1997.
Concentration of Credit Risk - In addition to sales to Valley, as discussed in
Note 3, the Partnership had sales to a significant customer, which represented
12.5% of total sales for the ten months ended January 31, 1997.
The Partnership is subject to credit risk through trade receivables. The
Partnership routinely assesses the financial strength of significant customers
and this assessment, combined with the large number and geographic diversity of
its customers, limits the Partnership's concentration of risk with respect to
trade accounts receivable.
Income Taxes - The Partnership is not subject to income taxes. Taxable income
or loss from the Partnership's operations is recognized in the tax returns of
the partners. Accordingly, income taxes are not provided for in the
accompanying financial statements. Differences between the tax and book bases
of the Partnership's assets and liabilities exist due primarily to the
deductibility of allowances for doubtful accounts and sales returns and
inventory valuation reserves. This difference results in net assets for tax
purposes being $2,545,000 greater than net assets for book purposes at January
31, 1997.
56
<PAGE>
2. Bank Line of Credit
The Partnership had a revolving line of credit agreement with Fleet Bank of
Massachusetts, N.A. that provided for borrowings up to the lesser of $10,000,000
or the sum of 75% of eligible accounts receivable and 25% of eligible inventory.
The line of credit bore interest at either Fleet Bank prime rate or at LIBOR
plus 2.5% and was due to expire on September 1, 1997. The line of credit was
secured by all eligible accounts receivable, inventory, equipment and other
tangible property of the Partnership and guarantees from the partners and their
affiliates. Under the line of credit agreement, the Partnership was required to
maintain certain working capital and minimum tangible net worth ratios. As of
March 30, 1996, the Partnership was out of compliance with these financial
covenants.
Subsequent to Valley Venturer, Inc.'s acquisition of DNA, Inc.'s ownership
interest in the Partnership, Valley repaid the amount due under the line of
credit.
3. Related Party Transactions
The Partnership is charged certain operating expenses by Valley and Rounder in
accordance with operating agreements between the partners. The Partnership's
administrative offices are located within Valley's corporate headquarters. The
Partnership also utilizes Valley's warehouse distribution facilities. Valley
charges the Partnership a monthly fulfillment fee, typically 4% to 5% of net
sales revenue, primarily for shipping and receiving costs incurred in the
handling of Partnership inventory based on the terms of the operating
agreements. Fulfillment fees totaled $1,006,000 for the ten months ended
January 31, 1997. Valley charges other distribution expenses such as
information services, depreciation, other shipping and receiving costs, and
operating supplies to the Partnership based on the terms of the operating
agreements (primarily predetermined percentages and actual costs incurred).
Other distribution expenses totaled $999,000 for the ten months ended January
31, 1997. Valley also charges administrative expenses, including payroll and
benefits of shared employees and insurance expense, to the Partnership based on
the terms of the operating agreements (primarily actual costs incurred).
Administrative expenses totaled $398,000 for the ten months ended January 31,
1997. Management believes the administrative and distribution charges agreed to
by the partners are reasonable; however, it is not practicable to provide an
estimate of what the Partnership's expenses would have been on a stand-alone
basis had it operated as an unaffiliated entity.
Valley was the Partnership's largest customer. During the ten months ended
January 31, 1997, net sales to Valley totaled approximately $4,274,000. The
related cost of goods sold totaled approximately $3,334,000 for the ten months
ended January 31, 1997. Additionally, the Partnership makes significant
purchases from Rounder. Net purchases from Rounder totaled $11,250,000 during
the ten months ended January 31, 1997. The Partnership also makes significant
purchases from RAS Records (RAS), an affiliate of Rounder. Net purchases from
RAS totaled $595,102 during the ten-month period ended January 31, 1997.
4. Employee Retirement Plan
In April 1995, the Partnership adopted an employee retirement plan intended to
be qualified under Section 401(k) of the Internal Revenue Code. Participation
in the plan is available to substantially all employees. Generally, employees
may contribute up to 17% of their annual
57
<PAGE>
compensation to the plan on a pre-tax basis. Under the plan, the Partnership
makes elective matching contributions of up to 50% for a maximum of 4% of each
participating employee's annual compensation. The Partnership elected to make no
matching contributions to the plan for the ten-month period ended January 31,
1997.
5. Commitments and Contingencies
In the ordinary course of business, the Partnership is a party to certain claims
and legal actions. After consulting with legal counsel, the Partnership is of
the opinion that any liability that may ultimately be incurred as a result of
these claims or legal actions will not have a material adverse effect on the
financial statements of the Partnership taken as a whole.
58
<PAGE>
ITEM 9. Changes In And Disagreement With Accountants On Accounting And
Financial Disclosures
None.
PART III
ITEM 10. Directors And Executive Officers Of The Registrant
Information concerning our directors and executive officers is incorporated
by reference to the section entitled "Election of Directors" contained in our
definitive Proxy Statement with respect to our 1999 Annual Meeting of
Stockholders to be filed with the Securities and Exchange Commission not later
than 120 days after the end of the fiscal year covered by this Form 10-K (the
"Proxy Statement"). Information concerning compliance with Section 16(a) of the
Exchange Act of 1934 is incorporated by reference to the section entitled
"Section 16(a) Beneficial Ownership Reporting Compliance" contained in the Proxy
Statement.
ITEM 11. Executive Compensation
Information concerning executive compensation is incorporated by reference
to the section entitled "Executive Compensation" in the Proxy Statement.
ITEM 12. Security Ownership Of Certain Beneficial Owners And Management
Information concerning the security ownership of certain beneficial owners
and management is incorporated by reference to the section entitled "Principal
Stockholders" contained in the Proxy Statement.
ITEM 13. Certain Relationships And Related Transactions
Information concerning certain relationships and related transactions is
incorporated by reference to the section entitled "Certain Transactions" in the
Proxy Statement.
59
<PAGE>
PART IV
ITEM 14. Exhibits, Financial Statement Schedule, And Reports On Form 8-K
(a) 1. Financial Statements - See Index to Consolidated Financial
Statements and Financial Statement Schedule at page 34 of this Form
10-K.
2. Financial Statement Schedules - See Index to Consolidated Financial
Statements and Financial Statement Schedule at page 34 of this Form
10-K.
3. Exhibits
<TABLE>
<CAPTION>
===================================================================================================================
Exhibit Number Description of Document
- ----------------------- ------------------------------------------------------------------------------------------
<S> <C>
3.1 (1) Amended and Restated Certificate of Incorporation.
3.2 (1) Amended and Restated Bylaws.
4.3 (1) Stockholder Agreement, dated January 15, 1995, between Valley and Robert R. Cain.
4.4 (1) Reference is made to Exhibits 3.1 and 3.2.
10.1 (1) Loan and Security Agreement, dated May 21, 1998, between Valley, Congress Financial
Corporation (Northwest) and the institutions named therein.
10.2 (1) Asset Purchase Agreement, dated May 20, 1997, between Valley and Star Video Entertainment,
LP.
10.3 (1) Standard Industrial Lease - Net, dated October 6, 1988, between Valley and Betty Kuhn.
10.4 (1) Build-to-Suit Facility - Absolute Net Lease, dated October 3, 1989, between Valley and
Betty Kuhn.
10.5 (1) Industrial Real Estate Lease, dated May 21, 1992, between Valley and Panattoni Development
Company.
10.6 (1) Build to Suit Lease Agreement, dated October 1, 1997, between Valley and Pizzuti Equities
Inc.
10.7 (1) Form of Indemnification Agreement between Valley and each of its officers and directors.
10.8 (1) 1994 Stock Option Plan and form of Option Agreement under Plan.
10.8.1 (1) Amendment No. 1 to 1994 Stock Option Plan.
10.9 (1) 1997 Stock Option Plan and form of Option Agreement under Plan.
10.9.1 (1) Amendment No. 1 to 1997 Stock Option Plan.
10.10 (1) Employee Stock Ownership Plan.
10.10.1 (1) Amendment No. 4 to Employee Stock Ownership Plan.
10.10.2 (1) Amendment No. 5 to Employee Stock Ownership Plan.
10.10.3 (1) Amendment No. 6 to Employee Stock Ownership Plan.
10.11 (1) Form of Severance and Change in Control Agreement between Valley and its executive
officers.
10.12 Management Incentive Plan - Plan Summary.
10.13 Lease for 260 North Pioneer Avenue, dated March 30, 1999, between Valley and 33 North La
Salle, LLC.
27.1 Financial Data Schedule.
</TABLE>
- --------------
(1) Incorporated by reference to corresponding Exhibit included with
Registrant's Registration Statement on Form S-1 originally filed on
December 21, 1998 (File No. 333-69329).
(b) Reports On Form 8-K.
None.
60
<PAGE>
SIGNATURES
Pursuant to the requirements of Section 13 or 15(d) of the Securities Exchange
Act of 1934, the registrant has duly caused this report to be signed on its
behalf by the undersigned, thereunto duly authorized.
VALLEY MEDIA, INC.
By: /s/ Robert R. Cain
------------------------
Robert R. Cain
President and Chief Executive Officer
Date: June 23, 1999
POWER OF ATTORNEY
KNOW ALL PERSONS BY THESE PRESENTS, that each person whose signature appears
below constitutes and appoints Robert R. Cain and J. Randolph Cerf, and each of
them, as his or her true and lawful attorneys-in-fact and agents, with full
power of substitution for him or her in any and all capacities, to sign any and
all amendments to this Report on Form 10-K, and to file the same, with all
exhibits thereto, and other documents in connection therewith, as fully to all
intents and purposes as he or she might or could do in person, hereby ratifying
and confirming all that said attorneys-in-fact and agents, or any of them, or
their or his substitute or substitutes, may lawfully do or cause to be done by
virtue hereof.
Pursuant to the requirements of the Securities Exchange Act of 1934, this report
has been signed below by the following persons on behalf of the registrant and
in the capacities and on the dates indicated.
<TABLE>
<CAPTION>
Signature Title Date
--------- ----- ----
<S> <C> <C>
/s/ Barnet J. Cohen Chairman of the Board June 23, 1999
- ---------------------------------
Barnet J. Cohen
/s/ Robert R. Cain President, Chief Executive Officer and June 23, 1999
- --------------------------------- Director (Principal Executive Officer)
Robert R. Cain
/s/ J. Randolph Cerf Chief Financial Officer (Principal June 23, 1999
- --------------------------------- Financial and Accounting Officer)
J. Randolph Cerf
/s/ Lawrence Archibald Director June 23, 1999
- ---------------------------------
Lawrence Archibald
/s/ Christopher Mottern Director June 23, 1999
- ---------------------------------
Christopher Mottern
/s/ Wendy Paskin-Jordan Director June 23, 1999
- ---------------------------------
Wendy Paskin-Jordan
/s/ James Sha Director June 23, 1999
- ---------------------------------
James Sha
</TABLE>
61
<PAGE>
Schedule II
VALLEY MEDIA, INC.
VALUATION AND QUALIFYING ACCOUNTS AND RESERVES
For the Years Ended April 3, 1999, March 28, 1998 and March 29, 1997
<TABLE>
<CAPTION>
Balance at Charged to Balance at
Beginning Charged to Other End of
Description of Period Expense Accounts Deductions Period
- ----------- --------- ------- -------- ---------- ------
<S> <C> <C> <C> <C> <C>
Fiscal year ended March 29, 1997:
Inventory reserves $ 50,400 $ 788,140 $ 451,297 $ (897,913) $ 391,924
Allowance for doubtful accounts
receivable 320,500 327,262 275,300 (97,914) 825,148
Customer returns reserve 285,737 1,227,597 950,305 (855,016) 1,608,623
Vendor receivables reserve 424,915 165,311 44,564 (346,303) 288,487
----------- ----------- ---------- ------------ -----------
Total $ 1,081,552 $ 2,508,311 $1,721,466(1) $ (2,197,146) $ 3,114,182
=========== =========== ========== ============ ===========
Fiscal year ended March 28, 1998:
Inventory reserves $ 391,924 $ 1,273,409 $ 229,680 $ (308,177) $ 1,586,836
Allowance for doubtful accounts
receivable 825,148 6,077,164 1,833,357 (3,459,488) 5,276,181
Customer returns reserve 1,608,623 12,369,496 1,436,200 (11,693,043) 3,721,276
Vendor receivables reserve 288,487 152,680 1,695,326 (1,335,915) 800,579
----------- ----------- ---------- ------------ -----------
Total $ 3,114,182 $19,872,749 $5,194,563(2) $(16,796,622) $11,384,872
=========== =========== ========== ============ ===========
Fiscal year ended April 3, 1999:
Inventory reserves $ 1,586,836 $ 4,305,139 - $ (3,068,608) $ 2,823,367
Allowance for doubtful accounts
receivable 5,276,181 5,001,511 - (1,385,897) 8,891,795
Customer returns reserve 3,721,276 16,467,386 - (14,433,205) 5,755,457
Vendor receivables reserve 800,579 8,762,711 - (6,323,164) 3,240,126
----------- ----------- ------------ -----------
Total $11,384,872 $34,536,747 - $(25,210,874) $20,710,745
=========== =========== ============ ===========
</TABLE>
- ----------
(1) Represents increases in reserves related to inventories and receivables
resulting from DNA acquisition in January 1997.
(2) Represents increases in reserves related to inventories and receivables
resulting from Star Video acquisition in May 1997.
S-1
<PAGE>
Exhibit 10.12
Valley Media Inc.
Management Incentive Plan
Plan Summary Fiscal Year 2000
Purpose
Valley Media Inc. (the "Company") strives to provide a total compensation
program that compares favorably to the compensation provided by our principal
competitors, and enables us to attract and retain the high quality employees
needed to be successful over the long term. A key component of this
compensation program is the Management Incentive Plan or "MIP" (the "Plan").
The MIP is an annual cash incentive award program for eligible management staff
as determined by outstanding individual contributions and company performance.
Definitions
<TABLE>
<CAPTION>
<S> <C>
. Base Salary: Base compensation as determined on the last day of the Plan Year,
excluding without limitation, incentives, bonuses, overtime, expense
reimbursement, and employee and fringe benefits.
. Eligible Position: Manager, Director, Vice President, Senior Vice President and Chief
Executive Officer.
. Executive Staff: Senior management group made up of CEO, Sr. Vice Presidents and Vice
Presidents.
. Fiscal Year: The 12 month period commencing on April 4, 1999 and continuing
through April 1, 2000.
. Participant: A member of management who is eligible for an Incentive Award under
the Plan.
. Plan Year: Same as Fiscal Year.
. Net Income: Operating profit less interest, taxes and bonuses. May be adjusted
at the Executive Staff and Compensation Committee's discretion for
certain unplanned events.
. Incentive Award: The cash compensation paid to a Participant under the Plan.
. Incentive Opportunity: The amount of an Incentive Award for which a Participant is eligible,
expressed as a percent of Base Salary.
. Threshold: The minimum amount of Net Income that must be achieved before any
Incentive Award will be paid.
</TABLE>
<PAGE>
Eligibility
. Members of the management team at Valley Media Inc. in a position of manager
level or above as determined by the Sr. Vice President of the respective
function.
. Is not a participant in a sales incentive/commission plan or any other
incentive program.
. Is hired or promoted into an Eligible Position on or before October 1, 1999.
If an individual is hired or promoted into an Eligible Position after October
1, 1999, he/she will be eligible to participate in the MIP during the next
fiscal year.
. Participants must be actively employed at the time incentive awards are
disbursed in order to receive an award payout.
Incentive Award Opportunity and Performance Weighting
. A Participant's Incentive Opportunity is expressed and calculated as a
percentage of a Participant's Base Salary.
. The Incentive Award for a Participant who has not been in an Eligible
Position (either through being hired or promoted) for the entire Fiscal Year
shall be determined by pro-rating their Base Salary on the basis of the
portion of Plan Year spent in the eligible position.
. The incentive award payout is based on both corporate and individual
performance.
President & CEO 100% corporate
Sr. Vice Presidents 75% corporate/25% individual
Vice President, Corporate Development 75% corporate/25% individual
All other positions 50% corporate/50% individual
Performance Measures
Corporate
The corporate portion of the incentive award is directly linked to Valley's Net
Income. For the FY 2000 Plan Year, the Net Income target is $9.5 Million. The
following table shows the incentive award payout opportunity based on Net Income
results for the fiscal year.
<PAGE>
<TABLE>
<CAPTION>
- ------------------------------------------------------------------------------------------
Award Payout
Percentage of Target Incentive
Net Income Payable
- ------------------------------------------------------------------------------------------
<S> <C>
Less than $8.55 Million 0%
$8.55 Million 50%
$9.5 Million 100%
Greater than or =$11.4 Million 150%
- ------------------------------------------------------------------------------------------
</TABLE>
. The Company's Net Income must reach a threshold of $8.55 million for the
corporate portion of the award to payout. At the threshold, the corporate
portion is paid at 50% of the corporate target payout.
. Between $8.55 million and $9.5 million, the level of award payout is prorated
between 50% and 100% of the corporate target payout.
. At $9.5 million, the award payout is 100% of the corporate portion.
. If actual Net Income exceeds $8.55 million, the level of award payout
continues to increase up to a maximum payout of 150%.
Individual
The individual portion for the MIP is based upon individual performance against
pre-established goals. The actual payout may range from 0% to 100% of the
individual portion.
The Company must reach its Net Income threshold before any individual awards
will be paid.
Participants establish goals in support of the Company's annual objectives.
Individual goals are approved by each function's Senior Vice President and a
copy submitted to Human Resources. At year-end, the Participant's manager and
Senior Vice President recommend the individual's award percentage based upon
goal achievement. The Executive Staff reviews and approves actual award
payouts. The Table below indicates the Incentive Opportunity by organizational
level expressed as a percent of base salary.
<PAGE>
<TABLE>
<CAPTION>
- ---------------------------------------------------------------------------------------------
Incentive Opportunity Performance
Position % of Base Salary Weighting
- ---------------------------------------------------------------------------------------------
<S> <C> <C>
President & CEO 60% 100% Corporate
- ---------------------------------------------------------------------------------------------
Sr. Vice President 35% - 50% 75% Corporate
Varies by Position 25% Individual
- ---------------------------------------------------------------------------------------------
Vice President, 25% 75% Corporate
Corporate Development 25% Individual
- ---------------------------------------------------------------------------------------------
Vice President 20% 50% Corporate
50% Individual
- ---------------------------------------------------------------------------------------------
Director 15% 50% Corporate
50% Individual
- ---------------------------------------------------------------------------------------------
Manager 10% 50% Corporate
50% Individual
- ---------------------------------------------------------------------------------------------
</TABLE>
Valley Media Stock Component
. To strengthen the relationship between performance and pay and promote
employee stock ownership, participants may elect to receive up to 50% of
their incentive award in Valley Media stock rather than cash.
. Participants electing stock will receive a premium equal to 10% of the
portion of the award elected to be paid in Company stock based on the fair
market value at payout.
. Participants electing stock will be required to hold the stock for a minimum
of one year.
Approval and Payment of Awards
. As soon as practicable following the end of the Plan Year, the Executive
Committee, after taking into account evaluations and recommendations of the
CEO, shall evaluate the degree to which the performance objectives have been
achieved for purposes of determining the amounts of any Incentive Awards
payable under the Plan.
. Incentive Awards shall be payable to Participants no later than 30 days
following acceptance of the Company's year-end external audit report.
. Incentive Awards paid in cash and stock are subject to payroll deductions for
tax and other withholdings.
- --------------------------------------------------------------------------------
The MIP may be amended or terminated for any reason at any time by the Executive
Staff and Compensation Committee of the Board of Directors. The Plan is
specifically designed to guide the Company in granting incentive awards and does
not create any contractual right of any employee to any incentive award or
continued employment.
- --------------------------------------------------------------------------------
<PAGE>
Exhibit 10.13
LEASE FOR 260 NORTH PIONEER AVENUE
33 NORTH LaSALLE, LLC,
a Delaware limited liability company, Landlord
and
VALLEY MEDIA, INC.,
a Delaware corporation, Tenant
<PAGE>
LEASE
Table of Contents
-----------------
Page
ARTICLE I -- PREMISES.................................................. 1
ARTICLE 2 -- TERM...................................................... 1
ARTICLE 3 -- RENT...................................................... 3
ARTICLE 4 -- SECURITY DEPOSIT.......................................... 5
ARTICLE 5 -- OPERATING EXPENSES........................................ 5
ARTICLE 6 -- TAXES; ASSESSMENTS........................................ 7
ARTICLE 7 -- USE....................................................... 9
ARTICLE 8 -- SERVICES AND UTILITIES.................................... 10
ARTICLE 9 -- ALTERATIONS............................................... 11
ARTICLE 10 -- REPAIRS.................................................. 12
ARTICLE 11 -- TENANT INSURANCE......................................... 13
ARTICLE 12 -- LANDLORD INSURANCE....................................... 14
ARTICLE 13 -- ASSIGNMENT AND SUBLETTING................................ 15
ARTICLE 14 -- INDEMNIFICATION.......................................... 18
ARTICLE 15 -- DESTRUCTION OR DAMAGE.................................... 19
ARTICLE 16 -- ENTRY BY LANDLORD........................................ 21
ARTICLE 17 -- DEFAULT.................................................. 21
ARTICLE 18 -- LANDLORD'S RIGHT TO CURE DEFAULTS........................ 23
ARTICLE 19 -- ATTORNEYS' FEES.......................................... 23
ARTICLE 20 -- HOLDING OVER............................................. 23
ARTICLE 21 -- WAIVER................................................... 23
ARTICLE 22 -- EMINENT DOMAIN........................................... 24
ARTICLE 23 -- SALE BY LANDLORD......................................... 25
ARTICLE 24 -- SUBORDINATION............................................ 26
ARTICLE 25 -- NO MERGER................................................ 26
ARTICLE 26 -- SURRENDER OF PREMISES.................................... 27
ARTICLE 27 -- ABANDONMENT.............................................. 27
ARTICLE 28 -- ESTOPPEL CERTIFICATES.................................... 27
ARTICLE 29 -- NO LIGHT AND AIR EASEMENT................................ 28
ARTICLE 30 -- NOTICES.................................................. 28
i
<PAGE>
LEASE
Table of Contents
-----------------
continued
Page
ARTICLE 31 -- SUCCESSORS............................................... 28
ARTICLE 32 -- MISCELLANEOUS............................................ 29
Table of Exhibits
-----------------
EXHIBIT A LEGAL DESCRIPTION
EXHIBIT B SITE PLAN
EXHIBIT C WORK LETTER AGREEMENT
EXHIBIT D GENERAL BUILDING SPECIFICATIONS
EXHIBIT E CONSTRUCTION RULES
ii
<PAGE>
THIS LEASE ("Lease") is dated March 30, 1999, for reference purposes
only, and is made by and between 33 NORTH LaSALLE, LLC, a Delaware limited
liability company ("Landlord"), and VALLEY MEDIA, INC., a Delaware corporation
("Tenant").
Recitals
--------
A. Landlord is the owner of, and Tenant desires to lease that
certain real property and all improvements thereon (collectively, "Real
Property") located at, 260 North Pioneer Avenue, in the City of Woodland, County
of Yolo, State of California more particularly described on Exhibit A, The Real
-----------
Property, together with the building located thereon, which consists of
approximately 260,400 "Rentable Square Feet" (as hereinafter defined) of space
are collectively called "Premises". The Premises are shown on the site plan
attached hereto as Exhibit B.
B. Landlord and Tenant hereby agree as follows:
Article I -- Premises
---------------------
Section 1.01. Landlord hereby leases the Premises to Tenant, and
Tenant hereby leases the Premises from Landlord, for the term and subject to the
agreements, conditions and provisions hereinafter set forth; provided, however,
that Landlord hereby reserves for itself from the leasehold interest granted to
Tenant herein: (a) any easements for utilities and the right of ingress and
egress to such utilities for the purpose of installing, maintaining and
repairing such utilities; and (b) a nonexclusive right of access to the Premises
and the Real Property for the purpose of performing Landlord's maintenance and
other obligations under this Lease, including a nonexclusive right of ingress
and egress over the parking lots, entrances, exits and drive-aisles.
Section 1.02. The construction of tenant improvements shall be
governed by the Work Letter Agreement attached hereto as Exhibit C.
---------
Article 2 -- Term
-----------------
Section 2.01. The term of this Lease (the "Term") shall commence on
April 1, 1999 (the "Term Commencement Date"). Unless sooner terminated as
hereinafter provided, the Term shall end on March 31, 2009 (the "Term Expiration
Date"). If Landlord does not tender possession of the Premises to Tenant on or
before the Term Commencement Date, for any reason whatsoever, Landlord shall not
be liable for any damage thereby and this Lease shall not be rendered void or
voidable thereby.
Section 2.02. Landlord hereby grants to Tenant one (1) option to
extend the Term of this Lease for an additional period of five (5) years. The
option is expressly conditioned upon Tenant's not being in default under any
term or condition of this Lease after the expiration of any applicable cure
period granted by this Lease, either at the time the option is exercised or at
the time the option term would commence.
(a) Tenant may exercise the option only by giving Landlord written
notice not less than twelve (12) months, but not more than fifteen (15) months,
prior to the expiration of the Term. If Tenant fails to exercise the option
prior to such 12-month period, then the option automatically shall lapse and
thereafter Tenant shall have no right to exercise the option.
(b) If the option is exercised, then the Monthly Base Rent payable
during the first (1st) year of the option term shall be the fair market rent, as
determined below, for the Premises as of the commencement of the option term.
In subsequent years of the option term,
1
<PAGE>
Monthly Base Rent shall be increased by three percent (3%) per year. The fair
market rent for the Premises shall be determined taking into account all
relevant factors and shall be based on the highest and best use notwithstanding
Tenant's then current use. Determination of fair market rent shall also take
into consideration the three percent (3%) annual adjustment and whether such
adjustment is consistent with fair market rent at the time. The arbitrators
shall not have the right to delete or alter the three percent (3%) annual
adjustment; however, the fair market rent shall be adjusted based on whether
such annual adjustment reflects the then fair market rent. The fair market rent
shall be determined with reference to other comparable buildings within twenty
(20) miles of the Premises.
(c) The fair market rent for the option term shall be determined by
mutual agreement of the parties or, if the parties are unable to agree on the
fair market rent on or before ninety (90) days prior to commencement of the
option term, then fair market rent shall be determined pursuant to the procedure
set forth in Section 2.02(d) and Section 2.02(e).
---------------- --------
(d) If the parties are unable mutually to agree upon the fair market
rent pursuant to Section 2.02(g), then the fair market rent initially shall be
---------------
determined by Landlord by written notice ("Landlord's Notice") given to Tenant
promptly following the expiration of the 30-day period set forth in Section
----------
2.02(c). If Tenant disputes the amount of fair market rent set forth in
- -------
Landlord's Notice, then, within thirty (30) days after the date of Landlord's
Notice, Tenant shall send Landlord a written notice ("Tenant's Notice") which
clearly (i) disputes the fair market rent set forth in Landlord's Notice, (ii)
demands arbitration pursuant to Section 2.02(e), and (iii) states the name and
---------------
address of the person who shall act as arbitrator on Tenant's behalf. Tenant's
Notice shall be deemed defective, and deemed not given to Landlord, if it fails
strictly to comply with the requirements and time period set forth above. If
Tenant does not send Tenant's Notice within thirty (30) days after the date of
Landlord's Notice, or if Tenant's Notice fails to contain all of the required
information, then the fair market rent for the option term shall be the amount
specified in Landlord's Notice. If the arbitration is not concluded prior to
the commencement of the option term, then Tenant shall pay Monthly Base Rent at
125% of the rate payable immediately prior to the commencement of the option
term. If the fair market rent determined by arbitration differs from that paid
by Tenant pending the results of arbitration, then any adjustment required to
adjust the amount previously paid shall be made by payment by the appropriate
party within ten (10) days after the determination of fair market rent.
(e) The arbitration shall be conducted in the City of San
Francisco in accordance with the following procedure:
(i) Each arbitrator must be a commercial real estate broker with at least ten
(10) years of full-time experience who is familiar with the fair market rent of
similar commercial property located within twenty (20) miles of the Premises.
Within ten (10) business days after receipt of Tenant's Notice, Landlord shall
notify Tenant of the name and address of the person designated by Landlord to
act as arbitrator on Landlord's behalf. The two arbitrators chosen shall meet
within five (5) business days and shall simultaneously exchange their
determinations of fair market rent. If the higher of the two rent determinations
is less than one hundred ten percent (110%) of the lower rent determination,
then the two determinations shall be added together and divided by two. The
resulting quotient shall be the fair market rent. If the higher rent
determination equals or exceeds one hundred ten percent (110%) of the lower rent
determination, then the third party arbitrator shall determine fair market rent
as hereinafter provided.
(ii) Provided fair market rent is not determined pursuant to
subparagraph (i), the two arbitrators chosen pursuant to subparagraph (i) above
shall meet within ten
2
<PAGE>
(10) business days after the second arbitrator is appointed and shall appoint a
third arbitrator possessing the qualifications set forth in subparagraph (i)
above. If the two arbitrators are unable to agree upon the third arbitrator
within five (5) business days after the expiration of such ten (10) business day
period, the third arbitrator shall be selected by the parties themselves. If the
parties do not agree on the third arbitrator within five (5) business days after
the expiration of such five (5) business day period, then either party, on
behalf of both, may request appointment of the third arbitrator by a
representative of the San Francisco office of JAMS/Endispute. Each party shall
pay the fees and expenses of its respective arbitrator and both shall share the
fees and expenses of the third arbitrator. Each party shall pay its own
attorneys' fees and costs of witnesses.
(iii) The three arbitrators shall determine the fair market rent
in accordance with the following procedures. The role of the third arbitrator
shall be to select which of the two resolutions proposed by the first two
arbitrators more closely approximates his or her own determination of the fair
market rent. The third arbitrator shall have no right to propose a middle
ground or any modification of either of the two proposed resolutions. The
resolution he or she chooses as that more closely approximating his or her
determination of the fair market rent shall constitute the decision of the
arbitrators and shall be final and binding upon the parties. The arbitrator
selected by Landlord and the arbitrator selected by Tenant shall not attempt to
reach a mutual agreement of the fair market rent; such arbitrators shall
independently arrive at their proposed resolutions.
(iv) The arbitrators shall have the right to consult experts and
competent authorities for factual information or evidence pertaining to a
determination of fair market rent, but any such consultation shall be made in
the presence of both parties with full right on their part to cross-examine.
The arbitrators shall render their decision in writing with counterpart copies
to each party. The arbitrators shall have no power to modify the provisions of
this Lease. In the event of a failure, refusal or inability of any arbitrator
to act, his or her successor shall be appointed by him or her, but in the case
of the third arbitrator, his or her successor shall be appointed in the same
manner as that set forth herein with respect to the appointment of the original
third arbitrator.
Section 2.03. Tenant shall have the right to terminate this Lease as
of the end of the fiftieth (50th) month of the Term, by written notice to
Landlord given no later than the first (1st) day of the forty-first (41st) month
of the Term. If Tenant fails to give a termination notice by the first (1st)
day of the forty-first (41st) month of the Term, then Tenant's termination right
automatically shall be deemed forfeited.
Article 3 -- Rent
-----------------
Section 3.01. Tenant shall pay to Landlord, in lawful money of the
United States, Monthly Base Rent in the sums set forth in this Article 3,
---------
payable without notice or demand, in advance, on the first day of each calendar
month. All payments of Monthly Base Rent required to be made under this Article
-------
3, or payments to be made under any other Article of this Lease, shall be made
- -
without any deduction, setoff or counterclaim whatsoever, and shall be made
payable to and sent to Landlord at the office of Landlord or at such other place
as Landlord may designate from time to time.
Section 3.02. Upon execution of this Lease, Tenant shall pay to
Landlord the sum of $71,610.00 ("Advance Rent"). The Advance Rent shall be
applied to Tenant's obligation to pay Monthly Base Rent for the first month or
months in which Monthly Base Rent is due. Commencing on the Term Commencement
Date and continuing through September 30, 1999, Tenant shall not
3
<PAGE>
be required to pay Monthly Base Rent, but must pay Operating Expenses and all
other amounts required to be paid by Tenant under this Lease; provided, however,
that if Tenant defaults under this Lease during such period, then Monthly Base
Rent for such period shall be payable in the amount of $71,610.00 per month.
After September 30, 1999, Monthly Base Rent shall be adjusted pursuant to
Section 3.03. If the Term Commencement Date is a day other than the first day of
- ------------
a calendar month, then the Monthly Base Rent for the Premises for the first
fractional month shall be proportionately reduced.
Section 3.03. After September 30, 1999, Tenant shall pay Monthly
Base Rent pursuant to the following schedule:
Time Period Monthly Base Rent
----------- -----------------
October 1, 1999 through March 31, 2000 $71,610.00
April 1, 2000 through March 31, 2002 $80,724.00
April 1, 2002 through March 31, 2003 $66,402.00
April 1, 2003 through March 31, 2004 $68,225.00
April 1, 2004 through March 31, 2009 $72,652.00
Section 3.04. This shall be a "triple net lease" and, except as
otherwise expressly provided, the Monthly Base Rent shall be paid to Landlord
absolutely net of all costs and expenses of the ownership, operation, repair and
maintenance of the Premises. The provisions for payment of operating expenses,
taxes, assessments, utilities and maintenance are intended to pass on to Tenant,
and reimburse Landlord for, all costs and expenses of the ownership, operation,
repair and maintenance of the Premises, except as otherwise expressly provided.
Section 3.05. Every installment of rent and every other payment due
hereunder from Tenant to Landlord which shall not be paid when due and payable
shall bear interest at the highest rate legally permitted or twelve percent
(12%) per annum, whichever is less (the "Specified Rate"), from the date that
the same became due and payable until paid, whether or not demand be made
therefor; provided, the first two (2) times in any consecutive twelve (12) month
period that Tenant is delinquent, interest at the Specified Rate shall not be
assessed unless Tenant fails to pay the delinquent sum within five (5) days
after receipt of written notice of such delinquency. Tenant acknowledges that
late payment by Tenant to Landlord of rent will cause Landlord to incur costs
not contemplated by this Lease, the exact amount of such costs being extremely
difficult and impracticable to fix. Such costs include, without limitation,
processing and accounting charges, and late charges that may be imposed on
Landlord by the terms of any encumbrance and note secured by any encumbrance
covering the Premises. Therefore, if any installment of rent due from Tenant is
not received by Landlord when due and payable, Tenant shall pay to Landlord an
additional sum of three percent (3%) of the overdue rent as a late charge;
provided, the first two (2) times in any consecutive twelve (12) month period
that Tenant is delinquent the late charge shall not be assessed unless Tenant
fails to pay the delinquent sum within five (5) days after receipt of written
notice of such delinquency. The parties agree that this late charge represents
a fair and reasonable estimate of the costs that Landlord will incur by reason
of late payment by Tenant. Acceptance of any late charge shall not constitute a
waiver of Tenant's default with respect to the overdue amount or prevent
Landlord from exercising any of the other rights and remedies available to
Landlord.
4
<PAGE>
Article 4 -- Security Deposit
-----------------------------
Section 4.01. Tenant shall deposit with Landlord a security deposit
(the "Security Deposit") consisting of the cash sum of $71,610.00. Tenant shall
deliver the Security Deposit to Landlord upon the execution of this Lease. The
Security Deposit shall be security for the faithful performance and observance
by Tenant of the terms, covenants and conditions of this Lease, including the
surrender of possession of the Premises to Landlord as herein provided.
Tenant's delivery of the Security Deposit is a condition precedent for
Landlord's benefit which, if not satisfied, shall entitle Landlord to terminate
this Lease. Landlord shall deposit the Security Deposit in an interest-bearing
account. All interest shall be for the account of Tenant and shall be added to
the Security Deposit.
Section 4.02. If Tenant defaults in the payment or performance of any
of the terms, covenants or conditions of this Lease, including the payment of
Monthly Base Rent, then Landlord may apply or retain the whole or any part of
the Security Deposit, and use, apply or retain the whole or any part of such
proceeds to the extent required for the payment of (a) any Monthly Base Rent or
any other sum as to which Tenant is in default (including any sum which Landlord
may expend or may be required to expend by reason of Tenant's default) and/or
(b) any damages or deficiency to which Landlord is entitled pursuant to this
Lease or applicable requirements, whether such damages or deficiency accrues
before or after summary proceedings or other reentry by Landlord. If Landlord
applies or retains any part of the Security Deposit, Tenant, upon demand, shall
deposit with Landlord the amount so applied or retained so that Landlord shall
have the full Security Deposit on hand at all times during the Term. If Tenant
shall fully and faithfully comply with all of the terms, covenants and
conditions of this Lease, the Security Deposit shall be returned to Tenant after
the Term Expiration Date and after delivery of possession of the Premises to
Landlord in the manner required by this Lease.
Section 4.03. Upon a sale of the Premises, or any financing of
Landlord's interest therein, Landlord shall have the right to transfer the
Security Deposit to the vendee, lessee or lender. Tenant shall look solely to
the new landlord or lender for the return of the Security Deposit and the
provisions hereof shall apply to every transfer or assignment to a new landlord.
Tenant shall not assign or encumber or attempt to assign or encumber any portion
of the Security Deposit and neither Landlord nor its successors or assigns shall
be bound by any such action or attempted assignment or encumbrance.
Section 5.01. Commencing on the Term Commencement Date, and on the
first day of each calendar month thereafter, Tenant shall pay to Landlord, in
addition to Monthly Base Rent, all "Operating Expenses" (as defined below).
Landlord may, at or after the start of any calendar year, notify
Tenant of the amount that Landlord estimates will be the Tenant's monthly
Operating Expenses for such calendar year, and the amount thereof shall be added
to the Monthly Base Rent payments required to be made by Tenant in such year. A
Statement (the "Statement") of the Operating Expenses payable by Tenant for each
year shall be given to Tenant within a reasonable period of time after the end
of each calendar year. If Operating Expenses as shown on the Statement are
greater or less than the total amounts actually paid by Tenant during the year
covered by the Statement, then within fifteen (15) days after receipt of the
Statement, Tenant shall pay in cash any sums owed Landlord or, if
5
<PAGE>
applicable, Tenant shall receive a credit against any rent next accruing for any
sum owed Tenant. Within three (3) months after receipt of the annual statement,
Tenant shall be entitled, provided full payment on account thereof has been
made, upon ten (10) days prior written notice and during normal business hours
at Landlord's office or such other place as Landlord shall designate, to receive
from Landlord a response to any questions regarding Operating Expenses including
summary accounting information and selected backup regarding general expense
categories. If, after receiving Landlord's response, Tenant disputes the amount
of Operating Expenses charged by Landlord, Tenant may, by written notice to
Landlord, request an independent audit of such books and records. The
independent audit of the books and records shall be conducted by a certified
public accountant ("CPN') acceptable to both Landlord and Tenant. If, within
thirty (30) days after Landlord's receipt of Tenant's notice requesting an
audit, Landlord and Tenant are unable to agree on the CPA who will conduct such
audit, then Landlord shall designate a nationally recognized accounting firm not
then employed by Landlord or Tenant to conduct such audit. The audit shall be
limited to the determination of the amount of Operating Expenses for the subject
calendar year. If the audit discloses that the amount of Operating Expenses
billed to Tenant was incorrect, the appropriate party shall pay to the other
party the deficiency or overpayment, as applicable. All costs and expenses of
the audit shall be paid by Tenant unless the audit shows that Landlord
overstated Operating Expenses for the subject calendar year by more than five
percent (5%), in which case Landlord shall pay all reasonable costs and expenses
of the audit. The exercise by Tenant of its audit rights hereunder shall not
relieve Tenant of its obligation to timely pay all sums due hereunder,
including, without limitation, the disputed Operating Expenses. If this Lease
expires or is terminated on a day other than the last day of a calendar year,
the amount of Operating Expenses payable by Tenant during the year in which this
Lease expires or is terminated shall be prorated on the basis which the number
of days from the commencement of the calendar year to and including the date on
which this Lease expires or is terminated bears to three hundred sixty-five
(365), and shall be due and payable monthly in advance notwithstanding the
expiration or earlier termination of the Term. Following expiration of the
calendar year in which this Lease expired or was terminated, Landlord shall give
a final Statement to Tenant for such calendar year. If Operating Expenses as
shown on the final Statement are greater or less than the total amount of
Operating Expenses actually paid by Tenant during the year covered by the final
Statement, then within fifteen (15) days after receipt of the Statement, the
appropriate party shall pay to the other party any sums owed.
The term "Operating Expenses," as used herein, shall mean any and all
sums expended by Landlord for the management, ownership, maintenance, repair and
operation of the Premises, including, without limitation:
(a) Reasonable wages, salaries and other compensation and benefits, as
well as any adjustment thereto, for Landlord's employees and agents and any
independent contractors hired by Landlord to perform work related to the
Premises.
(b) Costs of service, maintenance and inspection contracts for
landscaping, parking lot maintenance, fire and life safety equipment, plumbing,
and the costs of purchasing or renting mechanical equipment, supplies, tools or
materials used in performance of work at the Premises.
(c) Premiums and other charges (including costs of claims
adjustments) for insurance and deductible amounts under the terms of such
insurance, including, without limitation, all risk, earthquake, flood, public
liability, environmental, property damage and workers' compensation insurance,
and such other insurance coverage in such amounts as other comparable owners
maintain on comparable properties.
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(d) Costs of restriping, resurfacing and sweeping parking areas,
planting and landscaping (including replacement planting and landscaping),
maintenance, repair and replacement of directional signs and other markers, as
well as lighting.
(e) Sales, use and excise taxes on goods and services purchased
by Landlord relating to the Premises.
(f) License, permit and inspection fees relating to the Premises.
(g) Fees for management services and costs incidental thereto,
whether provided by an independent management company, Landlord, or an affiliate
of Landlord in an amount not to exceed the greater of (1) two percent (2%) of
Monthly Base Rent; and (2) the then market rate for comparable management
services.
(h) The costs of any improvements, equipment or devices installed or
paid for by Landlord (i) to conform with any change in laws, rules, regulations
or requirements of any governmental or quasi-governmental authority having
jurisdiction not applicable to the Premises as of the date of original
construction (but excluding any improvements to the foundation, load bearing
walls and structural members of the roof) and (ii) to repair or restore portions
of the Premises damaged by the acts or neglect of Tenant including, without
limitation, deferred maintenance. Costs incurred hereunder shall be amortized
over the useful life together with interest on the unamortized balance at the
Specified Rate.
(i) Compliance with air, water and noise quality and/or control
statutes, laws, codes, rules and regulations including, without limitation,
statutes, laws, codes, rules and regulations relating to toxic substances or
hazardous wastes.
(j) Real Property Taxes (as defined in Article 6), unless Landlord
---------
elects to bill Real Property Taxes as provided in Section 6.03.
-------------
Article 6 -- Taxes: Assessments
-------------------------------
Section 6.01. Tenant shall pay before delinquency all taxes levied or
assessed against Tenant's personal property and all Real Property Taxes (as
defined below) levied or assessed against improvements made by Tenant or
Landlord installed or located in or on the Premises. On demand by Landlord,
Tenant shall furnish Landlord with satisfactory evidence of these payments.
Section 6.02. Tenant shall reimburse Landlord for all Real Property
Taxes (as defined below) levied or assessed against the Premises and/or the Real
Property. During the initial term of the Lease (i.e., the period after the Term
Commencement Date but before March 31, 2009), Tenant shall not be required to
pay that portion of the incremental increase in Real Property Taxes assessed
solely as a result of the second (or any subsequent) "change of ownership" (as
defined below) of the Premises during such initial term. Tenant shall, however,
be required to pay all other increases in Real Property Taxes (including,
without limitation, all increases assessed after
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the second, or any subsequent, change of ownership, as long as such increases
are not assessed because of a change of ownership). As used herein, the term
"change of ownership" means the voluntary sale of the Premises by Landlord to a
third party; "change of ownership" does not include the sale of the Premises at
foreclosure or by deed in lieu of foreclosure. If Tenant exercises its option to
extend the Term, then it shall pay the full amount of all Real Property Taxes
during such extension term, including any increases in Real Property Taxes
(either before or during such extension term) that may have resulted from a
change in ownership.
Section 6.03. Tenant's obligation to pay or reimburse Landlord for
Real Property Taxes provided in this Article 6 shall arise upon presentation of
---------
invoices therefor by Landlord, accompanied by a copy of the applicable bill or
bills of the tax authorities, and Tenant shall pay or reimburse Landlord for
same not later than ten (10) days after receipt. Alternatively, Landlord shall
have the option of billing Real Property Taxes to Tenant as part of Operating
Expenses pursuant to Article 5.
---------
Section 6.04. The term "Real Property Taxes" means all taxes,
assessments, fees and charges which may now or hereafter be levied or assessed
by the United States of America, the State of California, the County of Yolo,
the City of Woodland, or any political subdivision, public corporation, district
or other political or public entity, upon or with respect to the Premises or any
personal property of Landlord, or Landlord's interest in the Premises and/or
such personal property, including, without limitation: all ad valorem and other
real estate taxes; general and special assessments; charges, fees, levies or
assessments for transit, housing, police, fire or other governmental services or
purported benefits to the Premises; service payments in lieu of taxes; any tax,
fee or excise on the act of entering into this Lease or on the use or occupancy
of the Premises or any part thereof or on the rent payable under any lease or in
connection with the business of renting space in the Premises; relating to
transit impact and mitigation; and any other tax, fee or other excise, however
described, that may be levied or assessed as a substitute for, or as an addition
to (in whole or in part), any other property taxes, whether or not now customary
or in the contemplation of the parties as of the date of this Lease. In
addition, the term "Real Property Taxes" includes all costs and expenses of
contesting the amount or validity of Real Property Taxes and/or seeking a
reduction of Real Property Taxes by appropriate administrative or legal
proceedings. Real Property Taxes shall not include estate, inheritance, net
income, net franchise or documentary transfer taxes.
Section 6.05. If any general or special assessment is levied and
assessed against the Real Property, Landlord may elect to either pay the
assessment in full or allow the assessment to "go to bond." If Landlord pays the
assessment in full, Tenant shall pay to Landlord each time a payment of Real
Property Taxes is made a sum equal to that which would have been payable (as
both principal and interest) had Landlord allowed the assessment to "go to
bond."
Section 6.06. Tenant's liability to pay Real Property Taxes shall be
prorated on the basis of a 365-day year to account for any fractional portion of
a fiscal tax year included in the term at the Term Commencement Date and at the
expiration of the term.
Article 7 -- Use
----------------
Section 7.01. The Premises shall be used for warehousing,
distribution and associated office functions incidental thereto. Initial use of
the Premises shall be as a distribution center for videotapes, compact discs and
similar electronic media. Tenant may use up to three thousand (3,000) square
feet of the Premises as a facilities shop. Any changes in use from that
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designated as the initial use, but within the general use, shall be subject to
Landlord's consent, which shall not be unreasonably denied. It shall be
reasonable to withhold consent if any use would involve, to a material extent,
increased traffic, increased floor load, increased use of hazardous substances
and/or any other increase in general wear and tear. No other use shall be
permitted without Landlord's written consent, which consent may be withheld in
Landlord's sole discretion.
Section 7.02. Tenant shall not allow the Premises to be used for any
unlawful, illicit or nefarious purpose, nor shall Tenant cause or maintain or
permit any nuisance in, on or about the Premises. Tenant shall not commit or
suffer the commission of any waste in, on or about the Premises.
Section 7.03. Tenant shall not use the Premises or permit anything to
be done in or about the Premises which will in any way conflict with any law,
statute, ordinance, or governmental rule or regulation now in force or which may
hereafter be enacted or promulgated. Tenant shall, at its sole cost and
expense, promptly comply with all laws, statutes, ordinances, and governmental
rules, regulations, or requirements now in force or which may hereafter be in
force and with the requirements of any board of fire underwriters or other
similar body now or hereafter constituted relating to or affecting the
condition, use, or occupancy of the Premises. The judgment of any court of
competent jurisdiction or the admission of Tenant in an action against Tenant,
whether Landlord be a party thereto or not, that Tenant has so violated any law,
statute, ordinance, or governmental rule, regulation, or requirement, shall be
conclusive of such violation as between Landlord and Tenant. Landlord shall use
reasonable and diligent efforts to enforce any existing warranties which
Landlord has received relating to the Premises.
Section 7.04. All graphics of Tenant on the exterior of the Premises
shall be subject to Landlord's prior written approval, which approval shall not
be withheld unreasonably.
Section 7.05. Tenant shall not cause or permit the escape, disposal
or release of any biologically or chemically active or other hazardous
substances or materials (a "Release"). Landlord acknowledges that Tenant
intends to construct a facilities shop on the Premises which will include a
paint shop. Hazardous Substances or materials used by Tenant shall be
consistent with those used in warehouses and facilities/paint shops. Tenant
shall provide Landlord with notice in a form reasonably required by Landlord
listing each of the hazardous substances and materials used by Tenant on the
Premises. Landlord's prior consent shall not be required so long as such
materials or substances are customarily used or found in warehouses and/or
facilities/paint shops. Tenant shall not allow the storage or use of such
substances or materials in any manner not sanctioned by law or by the highest
standards prevailing in the industry for the storage and use of such substances
or materials, nor allow to be brought into the Premises or the Real Property any
such materials or substances except to use in the ordinary course of Tenant's
business, and then only after written notice is given to Landlord of the
identity of such substances or materials. Without limitation, hazardous
substances and materials shall include those described in the Comprehensive
Environmental Response, Compensation and Liability Act of 1980, as amended, 42
U.S.C. Section 9601 et seq., the Resource Conservation and Recovery Act, as
amended 42 U.S.C. Section 6901 et seq., any applicable state or local laws and
the regulations adopted under these acts. If any lender or governmental agency
requires testing to ascertain whether there has been any Release, then the
reasonable costs thereof shall be reimbursed by Tenant to Landlord upon demand
as additional charges if such requirement applies to the Premises. In addition
Tenant shall execute affidavits, representations and the like from time to time
at Landlord's request concerning Tenant's best knowledge and belief regarding
the presence of hazardous substances or materials on the Premises. In all
events, Tenant shall indemnify, defend, protect and hold Landlord, and
Landlord's agents,
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employees and constituent members, harmless from and against any and all losses,
damages, claims, causes of action, penalties, liabilities, costs and expenses
(including, without limitation, clean-up costs, monitoring costs, and attorneys'
and consultants' fees) resulting from, arising out of or related to: (i) any
Release, regardless of where located, if caused by Tenant or Tenant's agents,
employees or contractors; and/or (ii) any Release on the Premises or the Real
Property occurring while Tenant is in possession of the Premises. This indemnity
shall include, without limitation, and Tenant shall pay all costs relating to:
(i) losses, damages, claims, causes of action, penalties, liabilities, costs and
expenses arising from or out of any claim, action, suit or proceeding for
personal injury (including sickness, disease, or death), property damage,
nuisance, pollution, contamination, leak, spill, Release or other effect on the
environment; (ii) the cost of any investigation, repair, clean-up, treatment or
detoxification of the Premises and/or the Real Property; and (iii) the
preparation and implementation of any closure plan, remediation plan or other
required actions in connection with the Premises and/or the Real Property. The
covenants contained herein shall survive the expiration or earlier termination
of the Lease. California Health and Safety Code Section 25359.7(b) requires any
tenant of real property who knows, or has reasonable cause to believe, that any
release of a hazardous substance has come to be located on or beneath such real
property to give written notice of such condition to the owner. Tenant shall
comply with the requirements of Section 25359.7(b) and any successor statute
thereto and with all other statutes, laws, ordinances, rules, regulations and
orders of governmental authorities with respect to hazardous substances.
Landlord shall have the right to pursue all legal and equitable remedies
available to it in the event of failure of Tenant to comply with the
requirements of this Section.
Article 8 -- Services and Utilities
-----------------------------------
Section 8.01. Tenant shall make all arrangements for, and shall pay
all costs of, the installation and supply of utility facilities, telephone
service, janitorial services and all other utilities and services used by Tenant
at the Premises.
Section 8.02. Landlord shall not be liable for any failure to provide
access to the Premises, to assure the beneficial use of the Premises or to
furnish any services or utilities when such failure is caused by natural
occurrences, riots, civil disturbances, insurrection, war, court order, public
enemy, accidents, breakage, strikes, lockouts, other labor disputes, the making
of repairs, alterations or improvements to the Premises, the inability to obtain
an adequate supply of fuel, gas, steam, water, electricity, communication
services, labor or other supplies or by any other condition beyond Landlord's
reasonable control, and Tenant shall not be entitled to any damages resulting
from such failure, nor shall such failure relieve Tenant of the obligation to
pay all sums due hereunder or constitute or be construed as a constructive or
other eviction of Tenant. If any of the utility services described herein are
interrupted as a result of the active negligence or willful misconduct of
Landlord for a period in excess of five (5) consecutive days and if such
interruption materially interferes with the permitted use of the Premises, then,
to the extent Tenant, in fact, does not use the Premises, Monthly Base Rent
shall abate to the extent of such interference commencing on the sixth (6th )
day and continuing until such interruption is discontinued. If any governmental
entity promulgates or revises any statute, ordinance or building, fire or other
code, or imposes mandatory or voluntary controls or guidelines on Landlord or
the Premises, relating to the use or conservation of energy, water, gas, steam,
light, communication services or electricity or the provision of any other
utility or service provided with respect to this Lease, or if Landlord is
required or elects to make alterations to the Premises in order to comply with
such mandatory or voluntary controls or guidelines, Landlord may, in its sole
discretion, comply with such mandatory or voluntary controls or guidelines, or
make such alterations to the Premises. Neither such compliance nor the making
of such alterations shall in any event entitle Tenant to any damages, relieve
Tenant of the obligation to pay any of the sums due hereunder, or constitute or
be construed as a constructive or other eviction of Tenant.
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Article 9 -- Alterations
------------------------
Section 9.01. The provisions of this section relating to fees, bonds
and consents shall not be applicable to the construction of the initial
improvements to the Premises. Tenant shall neither make nor allow to be made
any alterations, additions or improvements (collectively "Alterations") in, on
or to any exterior portion of the Premises. The provisions hereof shall not
apply to personal property. Tenant shall not make or allow to be made any
Alterations in, on or to the Premises or any part thereof without the prior
written consent of Landlord, which consent will not be unreasonably withheld;
provided, however, that Landlord may withhold its consent in its sole discretion
if any proposed Alterations would adversely affect the structure or safety of
the Premises or its communications, electrical, plumbing, HVAC, mechanical or
life safety systems (collectively "Structural/Utility System Alterations").
With respect to all Alterations Tenant shall furnish complete plans and
specifications for the desired Alterations. Consent shall not be required for
any non-Structural/Utility System Alterations costing less than Twenty-Five
Thousand Dollars ($25,000.00). Prior to commencement of construction of any
Alterations, Tenant shall deliver to Landlord the building permit and a copy of
the executed construction contract covering the Alterations. Tenant shall pay to
Landlord upon demand a review fee in the amount of five percent (5%) of the
construction cost of the Alterations (not to exceed $15,000.00 with respect to
any particular Alteration) (excluding non-Structural/Utility System Alterations
costing less than Twenty-Five Thousand Dollars ($25,000.00) to compensate
Landlord for the cost of review and approval of the plans and specifications and
for additional administrative costs incurred in monitoring the construction of
the Alterations. The fee shall not apply to the Tenant Improvements described
in the Work Letter. All Alterations shall be made by Tenant, at Tenant's sole
cost and expense, and any contractor or person selected by Tenant to make the
same and the construction schedule must first be approved in writing by
Landlord; provided, contractors for non-Structural/Utility System Alterations
costing less than Twenty-Five Thousand Dollars ($25,000.00) shall not be subject
to approval. Tenant shall provide, at its expense, such completion, performance
and/or payments bonds as Landlord considers necessary with respect to such
construction work; provided, no bonds shall be required for non-
Structural/Utility System Alterations costing less than Twenty-Five Thousand
Dollars ($25,000.00). Tenant shall also require its contractor to maintain
insurance in amounts and in such form as Landlord may require. If Landlord
requires a bond Landlord shall bear one-half (1/2) of the cost thereof. Any
construction, alteration, maintenance, repair, replacement, installation,
removal or decoration undertaken by Tenant in connection with the Premises shall
be completed in accordance with the plans and specifications approved by
Landlord, shall be carried out in a good, workmanlike and prompt manner, shall
comply with all applicable statutes, laws, ordinances, regulations, rules,
orders and requirements of the authorities having jurisdiction thereof, and
shall be subject to monitoring by Landlord or its employees, agents or
contractors. All work shall be performed in strict compliance the Construction
Rules and Hazardous Product Use Requirements attached hereto as Exhibit E, which
Construction Rules may be reasonably modified by Landlord. Within ten (10) days
following completion of the construction of the Alterations Tenant shall submit
"as built" drawings to Landlord. "As built" drawings shall not be required for
paint or carpet replacement. If the Alterations which Tenant causes to be
constructed result in Landlord being required to make any alterations and/or
improvements to other portions of the Premises in order to comply with any
applicable statutes, laws, ordinances, regulations, rules, orders or
requirements (e.g. ordinances intended to provide full access to handicapped
persons), then Tenant shall reimburse Landlord upon demand for all costs and
expenses incurred by Landlord in making such alterations and/or improvements.
Any Alterations made by Tenant shall remain on and be surrendered with the
Premises upon the expiration or sooner termination of the Term, except that
Tenant shall upon demand by Landlord, at Tenant's sole cost and expense,
promptly and with all due diligence remove all or any portion of any Alterations
made by Tenant which are designated by Landlord to be removed, and Tenant shall
promptly and with all due diligence, and at its sole cost and expense, repair
and restore the Premises to their original condition, reasonable wear and tear
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excepted. At the time of seeking Landlord's approval, Tenant may request that
Landlord then designate which of the subject improvements Landlord may require
that Tenant remove upon expiration or earlier termination of the Lease.
Landlord shall timely respond to such request.
Section 9.02. Tenant shall give Landlord at least fifteen (15) days'
prior written notice of commencement of any work of construction, alteration,
maintenance, repair or replacement in order to enable Landlord to post and
record notices of nonresponsibility. Tenant shall keep the Premises and the
Real Property free from any liens arising out of any work performed, materials
furnished or obligations incurred by Tenant. Any lien not removed within
fifteen (15) days of recordation may be paid or "bonded off' by Landlord and all
costs incurred by Landlord in connection with removal of the lien shall be paid
within ten (10) days of invoice. Within ten (10) days after completion of any
Alterations, Tenant shall deliver to Landlord fully executed California Civil
Code Section 3262 lien releases from each contractor and subcontractor
performing work in the Premises.
Section 9.03. Tenant shall indemnify, defend, protect and hold
Landlord harmless from and against any and all loss, cost, damage, injury and
expense arising out of or in any way related to claims for work or labor
performed, or materials or supplies furnished, to or at the request of Tenant or
in connection with performance of any work done for the account of Tenant in the
Premises, whether or not Tenant obtained Landlord's permission to have such work
done, labor performed, or materials or supplies furnished.
Article 10 -- Repairs
---------------------
Section 10.01. At Landlord's sole cost and expense, Landlord shall
maintain the foundation and the load-bearing walls of the Premises and the
structural members of the roof of the Premises. Except as expressly provided
herein, Landlord shall have no other responsibility to maintain the Premises.
Section 10.02. No representations, except as contained herein, have
been made to Tenant respecting the condition of the Premises, and Tenant's
acceptance of possession of the Premises shall be conclusive evidence as against
Tenant that the Premises are in a tenantable and good condition. At Tenant's
sole cost and expense, Tenant shall maintain all parts of the Premises (except
as expressly required to be maintained by Landlord pursuant to Section 10.0 1
--------------
above) in the condition delivered and otherwise in a clean and secure condition,
promptly making all necessary repairs and replacements, including, but not
limited to,
the roof membrane, maintenance of roof coatings and repair of roof leaks,
windows, glass, doors and any special office entries, walls and wall finishes,
ceilings, floors, floor coverings, heating, ventilating and air conditioning
systems, truck doors, dock bumpers, dock plates and levelers, plumbing work and
fixtures, downspouts, skylights, smoke hatches, roof vents, boilers, fired or
unfired pressure vessels, fire sprinkler and/or standpipe and hose or other
automatic fire extinguishing system (including fire alarm and/or smoke detection
systems and equipment), fire hydrants and fixtures. Landlord, upon written
request by Tenant, shall use reasonable and diligent efforts, to enforce any and
all warranties related to Tenant's maintenance and repair obligations hereunder.
At Tenant's expense, Tenant shall perform necessary pest extermination and
regular removal of trash and debris. At Tenant's cost, Tenant shall maintain a
quarterly HVAC maintenance contract, in form and substance acceptable to
Landlord and with a contractor approved by Landlord. If Tenant requests that
the proposed railroad spur be extended to the Premises, and if required by any
applicable
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railroad company, Tenant shall sign a joint maintenance agreement governing the
use of the rail spur, if any, to the Premises. In keeping the Premises in the
required condition Tenant shall employ first-class maintenance practices
continuously throughout the Term, and shall not defer any maintenance or repair.
Tenant's obligations shall include making all replacements, restorations,
repairs and alterations as and when necessary to keep the Premises and all
improvements thereon and parts thereof in first-class order, condition and state
of repair. Landlord shall not be liable for, and, except as hereinafter
provided, there shall be no abatement of rent with respect to, any injury to or
interference with Tenant's business arising from any repairs, maintenance,
alteration or improvement in or to any portion of the Premises or in or to the
fixtures, appurtenances or equipment therein. If Landlord interferes with
Tenant's business for a period in excess of five (5) consecutive days as a
result of Landlord's active negligence or willful misconduct in the performance
of repairs, maintenance or alterations, and if such interference materially
interferes with the permitted use of the Premises, then, to the extent Tenant,
in fact, does not use the Premises, Monthly Base Rent shall abate equitably to
the extent of such interference commencing on the sixth (6th) day and continuing
until such interruption is discontinued. Tenant hereby waives all right to make
repairs at Landlord's expense under the provisions of Sections 1932(l), 1941 and
1942 of the California Civil Code, and instead, all improvements, repairs and/or
maintenance expenses incurred in connection with the Premises shall be at the
expense of Tenant, and shall be considered as part of the consideration for
leasing the Premises. All damage or injury done to the Premises by Tenant or by
any person who may be in or upon the Premises with Tenant's consent or at
Tenant's invitation, shall be paid for by Tenant, and Tenant shall, at the
termination of this Lease, surrender the Premises to Landlord in as good
condition and repair as when accepted by Tenant, reasonable wear and tear
excepted.
Article 11 --Tenant Insurance
-----------------------------
Section 11.01. Tenant, at its cost, shall maintain commercial general
liability insurance (maintained on an occurrence basis), including contractual
liability coverage, with a minimum combined single limit of bodily injury,
personal injury and property damage coverage of Five Million Dollars
($5,000,000.00), insuring against all liability arising out of or in connection
with Tenant's use or occupancy of the Premises. Tenant may provide a portion of
the required liability insurance using an umbrella policy, provided such
umbrella coverage at no time may result in coverage available exclusively to the
Premises of less than Five Million Dollars ($5,000,000.00). Such insurance
shall name Landlord, its members, lenders and property managers as additional
insureds, shall specifically include the liability assumed under this Lease by
Tenant (provided, however, that the amount of such insurance shall not be
construed to limit the liability of Tenant hereunder), and shall provide that it
is primary insurance and not "excess over" or contributory with any other valid,
existing and applicable insurance in force for or on behalf of Landlord. The
policy shall not eliminate cross-liability and shall contain a severability of
interest clause. Not more frequently than once each year, if, in the opinion of
Landlord's lender or of the insurance consultant retained by Landlord, the
amount of public liability and property damage insurance coverage at that time
is not adequate, Tenant shall increase the insurance coverage as required by
either Landlord's lender or Landlord's insurance consultant. The standard to be
applied by Landlord's insurance consultant shall be comparable levels and types
of insurance required by comparable owners of comparable buildings with
comparable tenants.
Section 11.02. Tenant, at its cost, shall maintain on all of its
personal property, tenant improvements (whether constructed by Landlord or
Tenant), and Alterations, in, on, or about the Premises, a policy of "Broad
Form" insurance, to the extent of at least full replacement value without any
deduction for depreciation. The proceeds from any such policy shall be used by
Tenant for the replacement of such personal property or the restoration of such
tenant improvements or Alterations. The "full replacement value" of the
improvements to be insured under this Article 11 shall
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be determined by the company issuing the insurance policy at the time the policy
is initially obtained. Not more frequently than once every three (3) years,
Landlord shall have the right to notify Tenant that it elects to have the
replacement value redetermined by an insurance company or insurance consultant.
The redetermination shall be made promptly and in accordance with the rules and
practices of the Board of Fire Underwriters, or a like board recognized and
generally accepted by the insurance company, and each party shall be promptly
notified of the results by the company. The insurance policy shall be adjusted
according to the redetermination. Tenant, at its cost, shall maintain such other
insurance as Landlord may reasonably require from time to time.
Section 11.03. All the insurance required under this Lease shall:
(a) Be issued by insurance companies authorized to do business in the
State of California, with a financial rating of at least an AXIII status as
rated in the most recent edition of Best's Insurance Reports.
(b) Be issued as a primary policy.
(c) Contain an endorsement requiring thirty (30) days' written notice
from the insurance company to both parties and to Landlord's lender before
cancellation or change in the coverage, scope, or amount of any policy.
Section 11.04. Each policy, and a certificate of the policy, together
with evidence of payment of premiums, shall be deposited with Landlord at the
commencement of the term, and on renewal of the policy not less than twenty (20)
days before expiration of the term of the policy.
Article 12 -- Landlord Insurance
--------------------------------
Section 12.01. A policy of standard fire and extended coverage or all
risk insurance (including earthquake insurance, at Landlord's election) with
vandalism and malicious mischief endorsements and such other insurance and
endorsements as Landlord deems reasonable or appropriate, to the extent of at
least full replacement value, may be maintained by Landlord (as part of
Operating Expenses) on the Premises. Such policy shall not cover the personal
property or trade fixtures of tenants, but shall cover alterations, improvements
and nontrade fixtures within the Premises.
Section 12.02. The parties release each other, and their respective
authorized representatives, to the extent of insurance proceeds actually
received, from any claims for damage to any person or to the Premises and to the
fixtures, personal property, tenant improvements, and alterations of either
Landlord or Tenant in or on the Premises that are caused by or result from risks
insured against under any insurance policies carried by the parties (or which
the parties are required to maintain) and in force at the time of any such
damage.
Each party shall cause each insurance policy obtained by it to provide
that the insurance company waives all right of recovery by way of subrogation
against either party in connection with any damage covered by any policy.
Neither party shall be liable to the other, to the
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extent of insurance proceeds actually received, for any damage caused by fire or
any of the risks insured against under any insurance policy required by this
Lease. If any insurance policy cannot be obtained with a waiver of subrogation,
or is obtainable only by the payment of an additional premium charge above that
charged by insurance companies issuing policies without waiver of subrogation,
the party undertaking to obtain the insurance shall notify the other party of
this fact. The other party shall have a period of ten (10) days after receiving
the notice either to place the insurance with a company that is reasonably
satisfactory to the other party and that will carry the insurance with a waiver
of subrogation, or to agree to pay the additional minimum if such a policy is
only obtainable at additional cost. If the insurance cannot be obtained or the
party in whose favor a waiver of subrogation is desired refuses to pay the
additional premium charged, the other party is relieved of the obligation to
obtain a waiver of subrogation rights with respect to the particular insurance
involved.
Article 13 -- Assignment and Subletting
---------------------------------------
Section 13.01. Tenant shall not, without the prior written consent of
Landlord, which consent shall not be unreasonably withheld: (a) assign,
mortgage, pledge, encumber or otherwise transfer this Lease, the term or estate
hereby granted, or any interest hereunder; (b) permit the Premises or any part
thereof to be utilized by anyone other than Tenant (whether as licensee,
permittee or otherwise); or (c) except as hereinafter provided, sublet the
Premises or any part thereof. Concurrently with any offer or advertisement for
subletting, Tenant shall submit to Landlord full and complete copies of any such
offer or advertisement. Any assignment, mortgage, pledge, encumbrance, transfer
or sublease without Landlord's consent shall be voidable and, at Landlord's
election, shall constitute a default. If Tenant is a corporation, any
dissolution, merger, consolidation or other reorganization of Tenant, or the
sale or other transfer of a controlling percentage of the capital stock of
Tenant or the sale of fifty percent (50%) or more of the value of the assets of
Tenant, shall be deemed a voluntary assignment of this Lease by Tenant. The
phrase "controlling percentage" shall mean the ownership of, and the right to
vote, stock possessing fifty percent (50%) or more of the total combined voting
power of all classes of Tenant's capital stock issued, outstanding, and entitled
to vote for the election of directors. The preceding two sentences shall not
apply to corporations, the stock of which is traded through an exchange or over
the counter. If Tenant is a partnership, a withdrawal or change, voluntary,
involuntary, or by operation of law of any partner or partners owning a total of
fifty percent (50%) or more of the partnership, or the dissolution of the
partnership, shall be deemed a voluntary assignment of this Lease by Tenant. If
Tenant consists of more than one person, a purported assignment, voluntary,
involuntary, or by operation of law, by any one of the persons executing this
Lease shall be deemed a voluntary assignment of this Lease by Tenant.
Section 13.02. If at any time or from time to time during the Term,
Tenant desires to assign or sublet all or any part of the Premises, then at
least thirty (30) days, but not more than one hundred twenty (120) days, prior
to the date when Tenant desires the assignment or subletting to be effective
(the "Transfer Date"), Tenant shall give Landlord a notice (the "Transfer
Notice") which shall set forth the name, address and business of the proposed
assignee or sublessee, information (including financial statements and
references) concerning the character of the proposed assignee or sublessee, a
detailed description of the space proposed to be assigned or sublet (the
"Space"), any rights of the proposed assignee or. sublessee to use Tenant's
improvements and the like, the Transfer Date, and the fixed rent and/or other
consideration and all other material terms and conditions of the proposed
assignment or subletting, all in such detail as Landlord may reasonably require.
If Landlord requests additional detail, the Transfer Notice shall not be deemed
to have been received until Landlord receives such additional detail. Landlord
shall have the option, exercisable by giving notice to Tenant at any time within
twenty (20) days after Landlord's receipt of the Transfer Notice in the case of
an assignment or sublease, to terminate this Lease as to the Space as of the
Transfer Date, in which event Tenant shall be relieved of all further
obligations hereunder as to the Space. No failure of Landlord to exercise the
option with respect to the Space shall be deemed to be
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Landlord's consent to the assignment or subletting of all or any portion of the
Space. Provided Landlord has consented to such assignment or subletting, Tenant
shall be free to assign or sublet the Space to any third party subject to the
following conditions:
(a) The assignment or sublease shall be on the same terms set forth in
the Transfer Notice given to Landlord;
(b) No assignment or sublease shall be valid and no assignee or
sublessee shall take possession of the Space until an executed counterpart of
the assignment or sublease has been delivered to Landlord;
(c) No assignee or sublessee shall have a right further to assign or
sublet; and
(d) Any proposed subletting would not result in more than two (2)
subleases of portions of the Premises being in effect at any one time during the
Term.
Section 13.03. Landlord shall be permitted to consider any reasonable
factor in determining whether to withhold its consent to a proposed assignment
or sublease. Without limiting the other instances in which it may be reasonable
for Landlord to withhold its consent to an assignment or sublease, it shall be
reasonable for Landlord to withhold its consent if any of the following
conditions are not satisfied:
(a) The proposed transferee shall be at least as creditworthy as is
Tenant as of the date hereof, shall satisfy Landlord's then-current credit
standards and shall have the financial strength and stability to perform all
obligations under this Lease to be performed by Tenant;
(b) The proposed use of the Space by the transferee shall (i) comply
with the use provisions hereof, (ii) not increase the likelihood of damage or
destruction, (iii) not increase the density of occupancy of the Premises, (iv)
not be likely to cause an increase in insurance premiums for insurance policies
applicable to the Premises, (v) not require new tenant improvements incompatible
with then-existing building systems and components and (vi) not otherwise have
or cause a material adverse impact on the Premises;
(c) Any ground lessor or mortgagee whose consent to such transfer is
required fails to consent thereto;
(d) Any proposed subletting would not result in more than two (2)
subleases of portions of the Premises being in effect at any one time during
the Term; and
(e) At the time of the request, no Event of Default under this Lease,
or under any other lease between Tenant and Landlord or any affiliate of
Landlord, shall have occurred and be continuing.
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Tenant shall have the burden of demonstrating that each of the foregoing
conditions has been satisfied.
Section 13.04. Regardless of Landlord's consent, no subletting or
assignment shall release Tenant's obligation or alter the primary liability of
Tenant to pay the rent and to perform all other obligations to be performed by
Tenant hereunder. The acceptance of rent by Landlord from any other person
shall not be deemed to be a waiver by Landlord of any provision hereof. Consent
to one assignment or subletting shall not be deemed consent to any subsequent
assignment or subletting. If any assignee of Tenant or any successor of Tenant
defaults in the performance of any of the terms hereof, Landlord may proceed
directly against Tenant without the necessity of exhausting remedies against
such assignee or successor. Landlord may consent to subsequent assignments or
subletting of this Lease or amendments or modifications to this Lease with
assignees of Tenant, without notifying Tenant, or any successor of Tenant, and
without obtaining its or their consent thereto, and such action shall not
relieve Tenant of its liability under this Lease. If Tenant assigns this Lease,
or sublets all or a portion of the Premises, or requests the consent of Landlord
to any assignment or subletting, or if Tenant requests the consent of Landlord
for any act that Tenant proposes to do, then Tenant shall pay Landlord's
reasonable attorneys' fees incurred in connection therewith.
Section 13.05. If a petition is filed by or against Tenant for relief
under Title 11 of the United States Code, as amended (the "Bankruptcy Code"),
and Tenant (including for purposes of this Section Tenant's successor in
bankruptcy, whether a trustee or Tenant as debtor in possession) assumes and
proposes to assign, or proposes to assume and assign, this Lease pursuant to the
provisions of the Bankruptcy Code to any person or entity who has made or
accepted a bona fide offer to accept an assignment of this Lease on terms
acceptable to Tenant, then notice of the proposed assignment setting forth (a)
the name and address of the proposed assignee, (b) all of the terms and
conditions of the offer and proposed assignment, and (c) the adequate assurance
to be furnished by the proposed assignee of its future performance under the
Lease, shall be given to Landlord by Tenant no later than twenty (20) days after
Tenant has made or received such offer, but in no event later than ten (10) days
prior to the date on which Tenant applies to a court of competent jurisdiction
for authority and approval to enter into the proposed assignment. Landlord
shall have the prior right and option, to be exercised by notice to Tenant given
at any time prior to the date on which the court order authorizing such
assignment becomes final and non-appealable, to receive an assignment of this
Lease upon the same terms and conditions, and for the same consideration, if
any, as the proposed assignee, less any brokerage commissions which may
otherwise be payable out of the consideration to be paid by the proposed
assignee for the assignment of this Lease. If this Lease is assigned pursuant
to the provisions of the Bankruptcy Code, Landlord: (i) may require from the
assignee a deposit or other security for the performance of its obligations
under the Lease in an amount substantially the same as would have been required
by Landlord upon the initial leasing to a tenant similar to the assignee; and
(ii) shall receive, as additional rent, the sums and economic consideration
described in Section 13.02. Any person or entity to which this Lease is
-------------
assigned pursuant to the provisions of the Bankruptcy Code shall be deemed,
without further act or documentation, to have assumed all of the Tenant's
obligations arising under this Lease on and after the date of such assignment.
Any such assignee shall, upon demand, execute and deliver to Landlord an
instrument confirming such assumption. No provision of this Lease shall be
deemed a waiver of Landlord's rights or remedies under the Bankruptcy Code to
oppose any assumption and/or assignment of this Lease, to require a timely
performance of Tenant's obligations under this Lease, or to regain possession of
the Premises if this Lease has neither been assumed nor rejected within sixty
(60) days after the date of the order for relief or within such additional time
as a court of competent jurisdiction may have fixed. Notwithstanding anything
in this Lease to the contrary, all amounts payable by Tenant to or on behalf of
Landlord under this Lease, whether or not expressly denominated as rent, shall
constitute rent for the purposes of Section 502(b)(6) of the Bankruptcy Code.
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Section 13.06. Tenant shall not be entitled to, and Tenant hereby
waives any right it may have to make any claim for, money damages (nor shall
Tenant claim any money damages by way of set-off, counterclaim or defense) based
upon any claim or assertion by Tenant that Landlord has unreasonably withheld or
unreasonably delayed its consent or approval to a proposed assignment or
subletting as provided for in this Article 13. Tenant's sole remedy shall be an
action or proceeding to enforce any provision hereof, or for specific
performance, injunction or declaratory judgment. Tenant acknowledges that
Tenant's rights under this Article 13 satisfy the conditions set forth in
Section 1951.4 of the California Civil Code with respect to the availability to
Landlord of certain remedies for a default by Tenant under this Lease.
Section 13.07. In the event of any permitted assignment or sublease
hereunder, Tenant shall pay to Landlord, immediately upon Tenant's receipt
thereof, fifty percent (50%) of any and all "consideration" (as defined below)
received by Tenant on account of such transaction, however the same may be
denominated or characterized (after deducting Tenant's reasonable brokerage
commissions, tenant improvement allowances, legal fees and the cost of any
modifications to the Premises required in connection with such transaction), to
the extent that such consideration exceeds: (i) in the case of an assignment of
Tenant's entire interest in the Lease or a sublease of the entire Premises, the
Monthly Base Rent and other charges payable by Tenant under the Lease; or (ii)
in the case of a sublease of less than the entire Premises, the pro rata portion
of the Monthly Base Rent and other charges payable by Tenant under the Lease and
attributable to the sublet portion of the Premises, based on the gross leasable
area of the Premises and the gross leasable area of the sublet portion of the
Premises. As used herein, "consideration" includes any and all consideration
received by Tenant on account of such assignment or subletting, but only to the
extent that such consideration reflects or is attributable (either directly or
indirectly) to the value of the Premises or Tenant's leasehold estate under this
Lease, including rent and all other amounts payable in connection with such
transaction, but specifically excluding the good will attributable to Tenant's
business operations in the Premises, to the extent that such good will does not
reflect the value of the Premises or Tenant's leasehold estate under this Lease.
Article 14 -- Indemnification
-----------------------------
Section 14.01. Landlord shall not be liable or responsible in any way
for, and Tenant hereby waives all claims against Landlord, its partners,
officers, employees and agents with respect to or arising out of: any death or
any injury of any nature whatsoever that may be suffered or sustained by Tenant
or any employee, licensee, invitee, guest, agent or customer of
Tenant or any other person, from any causes whatsoever; or for any loss or
damage or injury to any property outside or within the Premises belonging to
Tenant or its employees, agents, customers, licensees, invitees, guests or any
other person, except to the extent such death, injury, loss or damage is caused
by the active negligence or willful misconduct of Landlord, its partners,
officers, employees or agents. Without limiting the generality of the
foregoing, Landlord shall not be liable for any damage or damages of any nature
whatsoever, including, without limitation, consequential damages or loss of
profit or business opportunity, caused by explosion, fire, theft or breakage, by
sprinkler, drainage or plumbing systems, by failure for any cause to supply
adequate drainage, by the interruption of the telephone cable distribution
system, any public utility or service, by steam, gas, water, rain or other
substances leaking, issuing or flowing into any part of the Premises, by natural
occurrence, acts of the public enemy, riot, strike, insurrection, war, court
order, requisition or order of governmental body or authority, or for any damage
or inconvenience which may arise through repair,
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Maintenance or alteration of any part of the Premises, or by anything done or
omitted to be done by any tenant, occupant or person in the Premises. In
addition, Landlord shall not be liable for any loss or damage for which the
Tenant is required to insure, nor for any loss or damage resulting from any
construction, alterations or repair.
Section 14.02. To the fullest extent permitted by law, Tenant shall
indemnify, defend and hold Landlord, its partners, officers, employees, and
agents harmless from and against any and all losses, damages, claims, or
liability for any damage to any property or injury, illness or death of any
person occurring in, on, or about the Premises arising at any time and from any
cause whatsoever other than by reason of the active negligence or willful
misconduct of Landlord, its employees or agents. Tenant shall also indemnify,
defend and hold Landlord, its partners, officers, employees and agents harmless
from and against any and all losses, damages, claims and liability resulting
from Tenant's breach of any of its obligations under the Lease and any damage
caused by Tenant, its contractors, agents or employees. The provisions of this
Section shall survive the expiration or termination of this Lease with respect
to any accident, event, damage, injury, illness or death occurring prior to such
termination.
Section 14.03. Neither the partners nor members constituting
Landlord, nor the partners, members, directors or officers of any of the
foregoing (collectively, the "Parties") shall be liable for the performance of
Landlord's obligations under this Lease. Tenant shall look solely to Landlord
to enforce Landlord's obligations hereunder and shall not seek any damages
against any of the Parties. The liability of Landlord for Landlord's
obligations under this Lease shall not exceed and shall be limited to Landlord's
interest in the Premises and Tenant shall not look to the property or assets of
any of the Parties in seeking either to enforce Landlord's obligations under
this Lease or to satisfy a judgement for Landlord's failure to perform such
obligations.
Article 15 -- Destruction or Damage
-----------------------------------
Section 15.01. Tenant shall notify Landlord in writing immediately
upon the occurrence of any damage to the Premises. As used herein: (1) the term
"partial damage" means damage or destruction which does not result in the loss
of either (a) fifty percent (50%) or more of the total number of Rentable Square
Feet in the Premises or (b) fifty percent (50%) or more of the value of the
Premises; and (2) the term "substantial damage" means any damage or destruction
exceeding partial damage (including total destruction). All determinations as
to the amount of damage, the time required for repair and other issues relating
to damage and rebuilding shall be determined by Landlord's architect, whose
determination shall be final and binding on Tenant.
Section 15.02. If the Premises are partially or substantially
damaged, then this Lease shall remain in effect, and Landlord shall repair the
damage as soon as reasonably possible; provided, however, that if the insurance
proceeds received by Landlord with respect to such damage are not sufficient to
pay the entire cost of repair, or if the cause of the damage is not covered by
insurance policies, then Landlord may elect either to: (a) repair the damage as
soon as reasonably possible, in which case this Lease shall remain in effect; or
(b) terminate this Lease, as of the date the damage occurred, by notifying
Tenant, within ninety (90) days after Landlord's receipt of notice of the
occurrence of such damage, of such Landlord's election to terminate this Lease.
The foregoing provisions of this Section 15.02 notwithstanding, if substantial
-------------
damage to the Premises occurs during the last twelve (12) months of the Lease
Term, then each of Landlord and Tenant may elect to terminate this Lease, as of
the date the damage occurred, regardless of the sufficiency of any insurance
proceeds. In such event, Landlord shall not be obligated to repair the damage,
and Tenant
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shall have no right to continue this Lease. Notification of such election shall
be given by the electing party to the other party within thirty (30) days after
the occurrence of the damage.
Section 15.03. Notwithstanding the provisions of Section 15.02, if
the Premises are substantially damaged, then Landlord may terminate this Lease,
as of the date the damage occurred, whether or not Landlord receives any
insurance proceeds with respect to such damage, by notifying Tenant of such
termination within thirty (30) days after the occurrence of such damage. If
Landlord does not so elect to terminate this Lease, then Landlord shall repair
all such damage and this Lease shall remain in full force and effect.
Section 15.04. Notwithstanding the provisions of Section 15.02 and
-------------
Section 15.03, if the Premises are damaged (whether partially or substantially),
- -------------
and within thirty (30) days after the date of the damage Landlord determines
that repair and reconstruction cannot be completed to such extent as to make the
Premises functional although not completely restored within six (6) months after
issuance of a building permit, together with all other necessary governmental
approvals (for whatever reason), then each of Landlord and Tenant may terminate
this Lease by notifying the other party within thirty (30) days after
determination of the amount of time required for repair and reconstruction. In
any event Landlord shall substantially complete the repair and reconstruction
(excluding punchlist and minor corrective work) no later than twelve (12) months
after issuance of a building permit. If Landlord fails to substantially
complete the repair and reconstruction within with such twelve (12) month period
Tenant may terminate this Lease by written notice received by Landlord prior to
substantial completion. Any such termination shall be effective as of the date
of the damage. If reconstruction is delayed by reason of "force -majeure," the
period of completion of reconstruction shall be extended for the period of the
force majeure delay.
Section 15.05. If the Premises are damaged, and Landlord repairs the
damage pursuant to the provisions of this Article 15, Monthly Base Rent payable
----------
during the period of such damage, repair and/or restoration shall be reduced
proportionately based upon the percentage decrease in area of the Premises.
Except for such possible reduction in Monthly Base Rent, Tenant shall not be
entitled to any compensation, reduction or reimbursement from Landlord as a
result of any damage, destruction, repair or restoration of or to the Premises.
Section 15.06. Tenant waives any applicability to the Premises of the
provisions of California Civil Code Sections 1932(2) and 1933(4), and any
successor statutes thereto, with respect to any damage to or destruction of the
Premises.
Article 16 -- Entry by Landlord
-------------------------------
Section 16.01. Landlord may, upon twenty-four (24) hours prior notice
to Tenant (or at any time in the case of an emergency), enter the Premises at
reasonable hours to (a) inspect the same, (b) exhibit the same to prospective
purchasers, lenders or tenants, (c) determine whether Tenant is complying with
all its obligations hereunder, (d) post notices of nonresponsibility, and (e)
make repairs required of Landlord under the terms hereof or repairs to any
adjoining space or utility services or make repairs, alterations or improvements
to any other portion of the Real Property; provided, h however, that all such
work or entry shall be done as promptly as reasonably possible and so as to
cause as little interference to Tenant as reasonably possible. Tenant hereby
waives any claim for ' damages for any injury or inconvenience to or
interference with Tenant's business, any loss of occupancy or quiet enjoyment of
the Premises or any other loss occasioned by such entry. If Tenant's use of the
Premises for the permitted uses is materially interrupted during any Landlord
entry
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as a result of the active negligence or willful misconduct of Landlord for
a period in excess of five (5) consecutive days, then, to the extent Tenant, in
fact, does not use the Premises, Monthly Base Rent shall equitably abate to the
extent of such interference commencing on the sixth (6th) day and continuing
until such interruption is discontinued. In an emergency, Landlord shall have
the right to use any and all reasonable means as warranted by the nature of the
emergency to open any of the doors in, on or about the Premises (excluding
Tenant's vaults, safes and similar areas designated in writing by Tenant in
advance) in order to obtain entry to the Premises, and any entry to the Premises
obtained by Landlord by any of such means, or otherwise, shall not under any
circumstances be construed or deemed to be a forcible or unlawful entry into or
a detainer of the Premises or an eviction, actual or constructive, of Tenant
from the Premises, or any portion thereof.
Section 16.02. Landlord shall have the right from time to time to
alter the Premises and, without the same constituting an actual or constructive
eviction and without incurring any liability to Tenant therefor, to change the
arrangement or location of entrances or passageways, doors and doorways, and
corridors, elevators, stairs, toilets, or other public parts of the Premises and
to change the name, number or designation by which the Premises are commonly
known, provided any such change does not (a) unreasonably reduce, interfere with
or deprive Tenant of access to the Premises or (b) reduce the area (except by a
de minimus amount) of the Premises.
Article 17 -- Default
---------------------
Section 17.01. The occurrence of any one or more of the following
events ("Events of Default") shall constitute a breach of this Lease by Tenant
(a) if Tenant shall fail to pay any rental by the third day of the month;
provided, the first time in any consecutive twelve (12) month period that such
failure occurs, such failure shall not constitute an Event of Default unless
Tenant fails to pay the overdue sums in full within three (3) days after Tenant
receives written notice of the delinquency (which three (3)-day notice shall
constitute the statutory notice referred to in Section 17.02); or (b) if Tenant
shall fail to pay any other sum when and as the same becomes due and payable and
such failure shall continue for more than ten (10) days after notice thereof
from Landlord (which notice may, at Landlord's election, include the statutory
3-day notice referenced in Section 17.02); or (c) if Tenant shall fail to
perform or observe any other term hereof to be performed or observed by Tenant,
such failure shall continue for more than thirty (30) days after notice thereof
from Landlord, or Tenant shall not within such period commence with due
diligence and dispatch the curing of such default, or, having so commenced,
shall thereafter fail or neglect to prosecute or complete with due diligence and
dispatch the curing of such default; or (d) if Tenant shall make a general
assignment for the benefit of creditors, or shall admit in writing its inability
to pay its debts as they become due or shall file a petition in bankruptcy, or
shall be adjudicated a bankrupt or insolvent, or shall file a petition seeking
any reorganization, arrangement, composition, readjustment, liquidation,
dissolution or similar relief under any present or future statue, law or
regulation, or shall file an answer admitting or shall fail reasonably to
contest the material allegations of a petition filed against it in any such
proceeding, or shall seek or consent to or acquiesce in the appointment of any
trustee, receiver or liquidator of Tenant or any material part of its
properties; or (e) if within ninety (90) days after the commencement of any
proceeding against Tenant seeking any reorganization, arrangement, composition,
readjustment, liquidation, dissolution or similar relief under any present or
future statute, law or regulation, such proceeding shall not have been
dismissed, or if, within ninety (90) days after the appointment without the
consent or acquiescence of Tenant, of any trustee, receiver or liquidator of
Tenant or of any material part of its properties, such appointment shall not
have been vacated; or (f) if this Lease or any estate of Tenant hereunder shall
be levied upon under any attachment or execution and such attachment or
execution is not vacated within sixty (60) days.
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Section 17.02. If an Event of Default shall occur, Landlord at any
time thereafter may give a written termination notice specifying the nature of
the default to Tenant, and on the date specified in such notice (which shall be
not less than three (3) days after the giving of such notice) Tenant's right to
possession shall terminate and this Lease shall terminate, unless on or before
such date all arrears of rental and all other sums payable by Tenant under this
Lease (together with interest and late charges thereon as provided in Section
-------
3.01) and all costs and expenses incurred by or on behalf of Landlord hereunder
- -----
shall have been paid by Tenant and all other breaches of this Lease by Tenant at
the time existing shall have been fully remedied to the satisfaction of
Landlord. Upon such termination, Landlord may recover from Tenant: (a) the
worth at the time of award of the unpaid rental which had been earned at the
time of termination; (b) the worth at the time of award of the amount by which
the unpaid rental which would have been earned after termination until the time
of award exceeds the amount of such rental loss that Tenant proves could have
been reasonably avoided; (c) the worth at the time of award of the amount by
which the unpaid rental for the balance of the term of this Lease after the time
of award exceeds the amount of such rental loss that Tenant proves could be
reasonably avoided; and (d) any other amount necessary to compensate Landlord
for all the detriment proximately caused by Tenant's failure to perform its
obligations under this Lease or which in the ordinary course of things would be
likely to result therefrom. The phrase "time of award" shall have the same
meaning as used in California Civil Code Section 1951.2. The "worth at the time
of award" of the amounts referred to in clauses (a) and (b) above is computed by
allowing interest at the rate set forth in Section 3.01. The worth at the time
---------------
of award of the amount referred to in clause (c) above is computed by
discounting such amount at the discount rate of the Federal Reserve Bank of San
Francisco at the time of award plus one percent (1%).
Section 17.03. Even though Tenant has breached this Lease and
abandoned the Premises, this Lease shall continue in effect for so long as
Landlord does not terminate Tenant's right to possession, and Landlord may
enforce all its rights and remedies under this Lease, including the right to
recover the rental as it becomes due under this Lease. Acts of maintenance or
preservation or efforts to relet the Premises or the appointment of a receiver
upon the initiative of Landlord to protect Landlord's interest under this Lease
shall not constitute a termination of Tenant's right to possession.
Section 17.04. The remedies provided for in this Lease are in
addition to any other remedies available to Landlord at law or in equity by
statute or otherwise.
Article 18 -- Landlord's Right to Cure Defaults
-----------------------------------------------
Section 18.01. All agreements and provisions to be performed by
Tenant under any of the terms of this Lease shall be at its sole cost and
expense and without any abatement of rental or any other sums payable by Tenant
under this Lease. If Tenant shall fail to pay any sum of money, other than
rental, required to be paid by it hereunder or shall fail to perform any other
act on its part to be performed hereunder and such failure shall continue for
thirty (30) days after notice thereof by Landlord, Landlord may, but shall not
be obligated so to do, and without waiving or releasing Tenant from any
obligations of Tenant, make any such payment or perform any such other act on
Tenant's part to be made or performed, as in this Lease provided all sums so
paid by Landlord and all necessary incidental costs shall be deemed additional
rent hereunder and shall be payable to Landlord on demand, and Landlord shall
have (in addition to any other right or remedy of Landlord) the same rights and
remedies upon the nonpayment thereof by Tenant as in the case of default by
Tenant in the payment of rental.
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Article 19 -- Attorneys' Fees
-----------------------------
Section 19.01. If Landlord consults with its counsel regarding the
terms of this Lease, or enforcement thereof, Tenant shall pay to Landlord on
demand all attorneys' fees incurred in such consultation. In any action or
proceeding brought by either party against the other under this Lease, the
prevailing party shall be entitled to recover court and litigation costs and the
fees of its attorneys, consultants and experts, in such action or proceeding
(whether at the administrative, trial or appellate levels) in such amount as the
court or administrative body may adjudge reasonable.
Article 20 -- Holding Over
--------------------------
Section 20.01. If Tenant shall remain in possession after the
expiration or sooner termination of this Lease, all the terms, covenants and
agreements hereof shall continue to apply and bind Tenant so long as Tenant
shall remain in possession insofar as the same are applicable, except that if
Tenant remains in possession without Landlord's written consent, the Monthly
Base Rent shall be one hundred fifty percent (150%) of the Monthly Base Rent
payable for the last month of the term hereof, and Tenant shall continue to pay
its share of all expenses then payable by Tenant, including, but not limited to,
Operating Expenses, insurance premiums and Real Property Taxes, prorated on a
daily basis for each day that Tenant remains in possession, Tenant shall
indemnify, defend, protect and hold Landlord harmless from' any losses, costs,
damages, liability or expense (including reasonable attorneys' fees and costs of
suit) which Landlord may suffer or incur as a result thereby. If Tenant remains
in possession with Landlord's written consent, such tenancy shall be from month
to month, terminable by either party by not less than thirty (30) days' written
notice.
Article 21 -- Waiver
--------------------
Section 21.01. The failure of either party to exercise its rights in
connection with any breach or violation of any term, covenant or condition
herein contained shall not be deemed to be a waiver of such term, covenant or
condition or any subsequent breach of the same or any other term, covenant or
condition herein contained. The subsequent acceptance of rent hereunder by
Landlord shall not be deemed to be a waiver of any preceding breach by Tenant
of any term, covenant or condition of this Lease other than the failure of
Tenant to pay the particular rental so accepted, regardless of Landlord's
knowledge of such preceding breach at the time of acceptance of such rent.
Article 22 -- Eminent Domain
----------------------------
Section 22.01. As used in this Article 22, the following words and
----------
phrases shall have the following meaning:
23
<PAGE>
(a) "Condemnation" means (i) the exercise of any governmental power,
whether by legal proceedings or otherwise, by a condemnor and (ii) a voluntary
sale or transfer by Landlord to any condemnor, either under threat of
condemnation or while legal proceedings for condemnation are pending.
(b) "Date of taking" means the date the condemnor has the right
to possession of the property being condemned.
(c) "Award" means all compensation, sums, or anything of value
awarded, paid, or received on a total or partial condemnation.
(d) "Condemnor" means any public or quasi-public authority, or private
corporation or individual, having the power of condemnation.
Section 22.02. If, during the term or during the period of time
between the execution of this Lease and the Term Commencement Date, there is any
taking of all or any part of the Premises or any interest in this Lease, the
rights and obligations of the parties shall be determined pursuant to this
Article 22.
- -----------
Section 22.03. If the Premises are totally taken by condemnation,
this Lease shall terminate on the date of taking.
Section 22.04. Tenant may elect to terminate this Lease due to a
condemnation which takes part of the Premises only in the event of a taking of
twenty percent (20%) of the total number of Rentable Square Feet in the
building. This Lease shall otherwise remain in effect. Tenant must exercise
its right to terminate this Lease pursuant to this Section 22.04 (if at all) by
--------------
giving notice of such exercise to Landlord within thirty (30) days after the
nature and the extent of the taking have been finally determined and Tenant has
been notified of such determination by Landlord. If Tenant elects to terminate
this Lease as provided in this Section 22.04, then Tenant shall also notify
-------------
Landlord of the date of termination, which date shall not be earlier than thirty
(30) days prior to the date of taking. If Tenant does not terminate this Lease
by notice provided within such thirty (30) day period, then this Lease shall
continue in full force and effect, except that all sums payable by Tenant, if
not reduced pursuant to other provisions of this Lease, shall be reduced as
hereinafter provided. If a material portion of the available parking is taken
by condemnation, landlord shall use reasonable and diligent efforts to provide
replacement parking as promptly as reasonably practicable.
Section 22.05. If any portion of the Premises is taken by
condemnation, and this Lease remains thereafter in full force and effect, then,
on the date of taking, the Monthly Base Rent and any other sum payable by Tenant
hereunder shall, if not reduced pursuant to other provisions of this Lease, be
reduced by that amount which is determined by multiplying the Monthly Base Rent
or such other sum (as applicable) by a fraction, the numerator of which shall
be the total number of Rentable Square Feet in the building so taken, and the
denominator of which shall be the total number of Rentable Square Feet in the
building immediately before the date of taking.
24
<PAGE>
Section 22.06. If there is a partial taking of the Premises, and this
Lease remains thereafter in full force and effect, then Landlord, at its sole
cost, shall accomplish all necessary restoration. Monthly Base Rent and any
other sum payable by Tenant hereunder shall, if not reduced pursuant to other
provisions of this Lease, be abated or reduced during the period from the date
of taking, until the completion of restoration, but all other obligations of
Tenant under this Lease shall remain in full force and effect. The abatement or
reduction of Monthly Base Rent or such other sum shall be based on the extent to
which the restoration interferes with Tenant's use of the Premises.
Section 22.07. If a taking of more than twenty percent (20%) of the
total number of Rentable Square Feet of the building occurs during the last one
(1) full year of the Lease Term, then Landlord shall have the right, at its
option, to terminate this Lease, whether or not the Premises are affected by
such taking, by giving notice of such termination to Tenant not more than thirty
(30) days after the nature and extent of the taking have been finally
determined.
Section 22.08. The award shall belong to and be paid to Landlord,
except that Tenant shall receive from the award the sum attributable to: the
unamortized Value (depreciated on a straight-line basis, computed monthly) of
tenant improvements or alterations made to the Premises by Tenant in accordance
with this Lease, which improvements or alterations Tenant has the right to
remove from the Premises pursuant to the provisions of this Lease, but elects
not to remove; and any sum awarded to Tenant for Tenant's moving costs
(including moving equipment and fixtures within the Premises) which is
separately stated and does not reduce, diminish or otherwise affect the amount
of the award to Landlord.
Section 22.09. If there is a total or partial taking of the Premises,
for a period which is less than the remaining term of this Lease, then all of
the provisions of this Lease shall remain in full force and effect, except that
Monthly Base Rent and any other sum payable by Tenant hereunder shall, if not
reduced pursuant to other provisions of this Lease, be abated during such period
of taking, based upon the extent to which the taking interferes with Tenant's
use of the Premises, and Landlord shall be entitled to whatever award may be
paid for the taking of the Premises for the period involved; provided, however,
that, if there is a total taking of the Premises for a period of more than one
(1) year, either party may elect to terminate this Lease by giving notice to the
other party within thirty (30) days after the nature and the extent of the
taking have been finally determined. If this Lease terminates as provided in
this Section 22.09, the award shall be paid to Landlord and Tenant as set forth
-------------
in Section 22.08.
--------------
Article 23 -- Sale by Landlord
------------------------------
Section 23.01. If Landlord sells or conveys the Premises, provided
the successor assumes the obligations hereunder, the same shall operate to
release Landlord from any future liability upon any of the covenants or
conditions, express or implied, herein contained in favor of Tenant, and in such
event Tenant agrees to look solely to the responsibility of the successor in
interest of Landlord in and to this Lease. Notwithstanding the foregoing, if
Landlord sells or conveys the Premises, this Lease shall not be barred,
terminated or cut off nor shall the rights and possession of Tenant hereunder be
disturbed if Tenant shall not then be in default in the payment of rental or
other sums or be otherwise in default under the terms of this Lease. Upon a
sale of the Premises by Landlord, Tenant agrees to attorn to the purchaser or
25
<PAGE>
assignee, such attornment to be effective and self-oper6tive without the
execution of any further instruments on the part of any of the parties to this
Lease.
Article 24 -- Subordination
---------------------------
Section 24.01. This Lease shall be subject and subordinated at all
times to: (a) all ground or underlying leases which may hereafter be executed
affecting the Premises, and (b) the lien of all mortgages and deeds of trust in
any amount or amounts whatsoever now or hereafter placed on or against the
Premises, on or against Landlord's interest or estate therein, and on or against
all such ground or underlying leases, all without the necessity of having
further instruments executed on the part of Tenant to effectuate such
subordination. Notwithstanding the foregoing: (i) in the event of termination
for any reason whatsoever of any such ground or underlying lease, and if such
ground or underlying lease so provides, then this Lease shall not be barred,
terminated, cut off or foreclosed, nor shall the rights and possession of Tenant
hereunder be disturbed if Tenant shall not then be in default in the payment of
rent or other sums or be otherwise in default under the terms of this Lease, and
Tenant shall attorn to the landlord of any such ground or underlying lease, or,
if requested, enter into a new lease for the balance of the original or extended
Term then remaining, upon the same terms and provisions as are contained in this
Lease; (ii) in the event of a foreclosure of any such mortgage or deed of trust
or of any other action or proceeding for the enforcement thereof, or of any sale
thereunder, and if any such mortgage or deed of trust so provides, this Lease
will not be barred, terminated, cut off or foreclosed, nor will the rights and
possession of Tenant thereunder be disturbed if Tenant shall not then be in
default in the payment of rent or other sums or be otherwise in default under
the terms of this Lease, and Tenant shall attorn to the purchaser at such
foreclosure sale or other action or proceeding, or, if requested, enter into a
new lease with such purchaser for the balance of the original or extended Term
then remaining upon the same terms and provisions as are in this Lease
contained; and (iii) Tenant agrees to execute and deliver upon demand such
further instruments evidencing such subordination of this Lease to such deed, to
such ground or underlying leases, and to the lien of any such mortgages or deeds
of trust as may reasonably be required by Landlord. Tenant shall from time to
time on request from Landlord execute and deliver any documents or instruments
that may be required by any lender to effectuate any subordination. If Tenant
fails to execute and deliver any documents or instruments, Tenant irrevocably
constitutes and appoints Landlord as Tenant's special attorney in fact to
execute and deliver such documents or instruments.
Section 24.02. Notwithstanding anything to the contrary set forth
above, any beneficiary under any deed of trust may at any time subordinate its
deed of trust to this Lease in whole or in part, without any need to obtain
Tenant's consent, by execution of a written document subordinating such deed of
trust to the Lease to the extent set forth in such document and thereupon the
Lease shall be deemed prior to such deed of trust to the extent set forth in
such document without regard to their respective dates of execution, delivery
and/or recording. In that event, to the extent set forth in such document, such
deed of trust shall have the same rights with respect to this Lease as would
have existed if this Lease had been executed, and a memorandum thereof, recorded
prior to the execution, delivery and recording of the deed of trust.
Article 25 -- No Merger
-----------------------
Section 25.01. The voluntary or other surrender of this Lease by
Tenant, or a mutual cancellation thereof, shall not work a merger, and shall, at
the option of Landlord,
26
<PAGE>
terminate all or any existing subleases or subtenancies, or may, at the option
of Landlord, operate as an assignment to it of any or all such subleases or
subtenancies.
Article 26 -- Surrender of Premises
-----------------------------------
Section 26.01. At the end of the Term or any renewal thereof or other
sooner termination of this Lease, Tenant shall peaceably deliver up to Landlord
possession of the Premises, together with all improvements or additions thereon,
by whomsoever made, in the same condition as received by Tenant on the Term
Commencement Date, or first installed by Tenant on or after the Term
Commencement Date, ordinary wear and tear and damage by fire, earthquake, act of
God or the elements alone excepted. Provided Tenant is not in default under the
terms of this Lease, Tenant may, upon the termination of this Lease, remove from
the Premises, immediately before the termination of the Term, its tra0e fixtures
and movable personal property installed by Tenant, at Tenant's sole cost, title
to which shall be in Tenant until such termination, repairing any and all damage
to the Premises caused by such removal. Property not so removed shall be deemed
abandoned by the Tenant and title to the same shall thereupon pass to Landlord.
Upon request by Landlord, Tenant, at Tenant's sole cost and expense, shall
remove from the Premises any or all: (i) improvements, alterations and additions
made to the Premises by or at the request of Tenant; and (ii) trade fixtures,
equipment and personal property located on the Premises (including, without
limitation, telephone and data cabling). Tenant's obligation to remove shall be
subject to the provisions of Section 9.01. Tenant, at Tenant's sole cost and
expense, shall repair any and all damage to the Premises resulting from such
removal.
Article 27 -- Abandonment
-------------------------
Section 27.01. Tenant shall not vacate or abandon the Premises at any
time during the term, and if Tenant shall abandon, vacate, or surrender the
Premises or be dispossessed by process of law, or otherwise, any personal
property belonging to Tenant and left on the Premises shall be deemed to be
abandoned, at the option of Landlord.
Article 28 -- Estoppel Certificates
-----------------------------------
Section 28.01. At any time and from time to time, but in no event on
less than fifteen (15) days prior written request by Landlord, Tenant shall
execute, acknowledge and deliver to Landlord, promptly upon request, a
certificate certifying: (a) that Tenant has accepted the Premises (or, if Tenant
has not done so, that Tenant has not accepted the Premises, and specifying the
reasons therefor); (b) the commencement and expiration dates of this Lease; (c)
whether there are then existing any defaults by Landlord in the performance of
its obligations under this Lease (and, if so, specifying the same); (d) that
this Lease is unmodified and in full force and effect (or, if there have been
modifications, that this Lease is in full force and effect, as modified, and
stating the date and nature of each modification); (e) the capacity of the
person executing such certificate, and that such person is duly authorized to
execute the same on behalf of Tenant; (f) the date, if any, to which rent and
other sums payable hereunder have been paid; (g) that no notice has been
received by Tenant of any default which has not been cured, except as to
defaults specified in the certificate; (h) the amount of any security deposit
and prepaid rent; and (i) such other matters as may be reasonably requested by
Landlord. Any such certificate may be relied upon by any prospective purchaser,
mortgagee or beneficiary under any deed of trust affecting the Premises or any
part thereof. If Tenant fails to deliver the executed certificate within
fifteen (15) days after receipt thereof by Tenant, Tenant irrevocably
27
<PAGE>
constitutes and appoints Landlord as its special attorney in fact to execute and
deliver the certificate to any third party.
Article 29 -- No Light and Air Easement
---------------------------------------
Section 29.01. Any diminution or shutting off of light or air by any
structure which may be erected on lands adjacent to the Premises shall in no way
affect this Lease or impose any liability on Landlord.
Article 30 -- Notices
---------------------
Section 30.01. All notices and demands of any kind which either party
may be required or may desire to serve on the other in connection with this
Lease shall be in writing and shall be sent only by: personal delivery; United
States Mail (first-class, certified, return-receipt requested, postage prepaid);
or a national, overnight courier delivery service which keeps records of
deliveries (such as, by way of example but not limitation, Federal Express,
United Parcel Service and DHL. For purposes of giving notice hereunder, the
addresses of the parties are, until changed as hereinafter provided, the
following:
If to Tenant: Valley Media, Inc.
1280 Santa Anita Court
Woodland, CA 95776
Attention: John Kordic
Senior Vice President of Operations
If to Landlord: 33 North LaSalle, LLC
c/o The Lurie Company
555 California Street, Suite 5100
San Francisco, CA 94104
Attention: Eugene L. Valla
Copy to: Greene Radovsky Maloney & Share LLP
Four Embarcadero Center, Suite 4000
San Francisco, CA 94111
Attention: Mark S. Hennigh
Service of any notice or demand shall be deemed complete on the day of actual
delivery as shown by the addressee's registry or certification receipt or the
courier's delivery record. Either party hereto may from time to time, by notice
in writing served upon the other as aforesaid, designate a different mailing
address or a different person to which all such notices or demands are
thereafter to be addressed.
Article 31 -- Successors
------------------------
Section 31.01. All the terms, covenants, and conditions hereof shall
be binding upon and inure to the benefit of the heirs, executors,
administrators, successors and assigns of the parties
28
<PAGE>
hereto, provided that nothing in this Section shall be deemed to permit any
assignment, subletting, occupancy or use by Tenant contrary to the provision of
Article 13.
- -----------
Article 32 -- Miscellaneous
---------------------------
Section 32.01. The captions in this Lease are for convenience only
and shall not in any way limit or be deemed to construe or interpret the terms
and provisions hereof.
Section 32.02. Time is of the essence of this Lease and of all
provisions hereof, except in respect to the delivery of possession of the
Premises at the commencement of the term hereof.
Section 32.03. The words "Landlord" and "Tenant," as used herein,
shall include the plural as well as the singular. Words used in the masculine
gender include the feminine and neuter. If there be more than one Landlord or
Tenant the obligations hereunder imposed upon Landlord and Tenant shall be joint
and several.
Section 32.04. This Lease shall be construed and enforced in
accordance with the laws of the State of California.
Section 32.05. It is understood and agreed that the remedies herein
given to either party shall be cumulative, and the exercise of any one remedy by
either party shall not be to the exclusion of any other remedy.
Section 32.06. Each party represents to the other that no broker
other than John Fondale, Silva-Kirk Company and Jim Naekel, Jim Naekel Realty,
has been involved in this transaction. It is agreed that if any claims for
brokerage commissions or finder's fees or like payment arise out of or in
connection with this Lease, and in the event any claim is made, all such claims
shall be handled and paid by the party whose actions or alleged commitment form
the basis of such claim. It is further agreed that each party whose actions or
alleged commitment form the basis of a ' claim agrees to indemnify and hold
harmless the other party from and against any and all claims or demands with
respect to any brokerage fees or agent's commissions or other compensation
asserted by any person, firm, or corporation in connection with this Lease. An
initial lease commission will be paid by Panattoni Development Company in
accordance with the following terms: 5% of the Net Lease Consideration
calculated on the first fifty (50) months of the Lease term, paid 50% upon
binding, non-contingent mutual execution of this Lease agreement and 50% upon
payment of the first month's rent. If Tenant elects not to exercise its early
termination privilege and continue leasing the premises for the balance of the
ten (10) year term, an additional lease commission will be paid by Landlord (not
Panattoni Development Company) based on 5% of the Net Lease Consideration for
the fifty-first (51st) through sixtieth (60th) months of the Term plus 2.5% of
the Net Lease Consideration for the sixth (6th) through tenth (10th) years.
This commission shall be paid by Landlord upon written, binding confirmation
that Tenant has waived its right to early termination. The term "Net Lease
Consideration" shall mean Monthly Base Rent only, exclusive of triple-net
expenses. All lease commissions shall be paid to Jim Naekel Realty. Jim Naekel
Realty shall pay all sums due John Fondale of Silva-Kirk Company.
29
<PAGE>
Section 32.07. The Parties recognize that certain computer controlled
systems and equipment may be affected when the year changes from 1999 to 2000,
which could in turn affect building operations. Landlord will take reasonable
steps to provide that building computer controlled facility components, for
which Landlord is responsible, are Year 2000 compliant. Tenant will take
reasonable steps to provide that computer controlled facility components, which
Tenant has installed or for which Tenant is responsible, are Year 2000
compliant. As used herein, "Year 2000 compliant" means computer controlled
facility components which accurately process date/time data from, into, and
between the 20'h and 21st centuries, and the years 1999 and 2000. As used
herein, "computer controlled facility components" means software driven
technology and/or embedded microchip technology, such as (by way of example and
not necessarily applicable to or in use at "the Premises) programmable
thermostats, HVAC controllers, elevator controllers, utility monitoring and
control systems, fire detection and suppression systems, alarms, security
systems, and any other facilities control systems utilizing microcomputer,
minicomputer or programmable logic controllers. Notwithstanding the foregoing,
Landlord shall not be liable for failure to ensure that computer controlled
facility components are Year 2000 compliant, and Tenant shall not be entitled to
any damages arising from such failure, nor shall such failure constitute a
constructive or other eviction of Tenant.
Section 32.08. The unenforceability, invalidity, or illegality of any
provision of this Lease shall not render the other provisions unenforceable,
invalid or illegal.
Section 32.09. The terms of this Lease are intended by the parties as
a final expression of their agreement with respect to such terms as are included
in this Lease and may not be contradicted by evidence of any prior or
contemporaneous agreement. The parties further intend that this Lease
constitutes the complete and exclusive statement of its terms and that no
extrinsic evidence whatsoever may be introduced in any judicial proceedings, if
any, involving this Lease.
Section 32.10. For purposes of this Lease, the term "Landlord's
Lender" shall mean the beneficiary, mortgagee or secured party of any deed of
trust, mortgage or other written security device or agreement affecting the
Premises.
Section 32.11. If Tenant signs as a corporation or a partnership,
each of the persons executing this Lease on behalf of Tenant does hereby
covenant and warrant that Tenant is a duly authorized and existing entity, that
Tenant has and is qualified to do business in California, that Tenant has full
right and authority to enter into this Lease, and that each and both of the
persons signing on behalf of Tenant are authorized to do so. Upon Landlord's
request, Tenant shall provide Landlord with evidence reasonably satisfactory to
Landlord confirming the foregoing covenants and warranties.
Section 32.12. No contractual or other rights shall exist between
Landlord and Tenant with respect to the Premises until both have executed and
delivered this Lease, notwithstanding that rental deposits have been received by
Landlord and notwithstanding that Landlord has delivered to Tenant an unexecuted
copy of this Lease. The submission of this Lease to Tenant shall be for
examination purposes only, and does not and shall not constitute a reservation
of or an option for the Tenant to lease, or otherwise create any interest by
Tenant in the Premises. Execution of this Lease by Tenant and return to Landlord
shall not be binding upon Landlord,
30
<PAGE>
notwithstanding any time interval, until Landlord has in fact executed and
delivered this Lease to Tenant.
Section 32.13. Neither Landlord nor Landlord's agents or attorneys
have made any representations or warranties with respect to the Premises or this
Lease, except as expressly set forth herein, and no rights, easements or
licenses are or shall be acquired by Tenant by implication or otherwise.
Section 32.13 This lease shall not be recorded.
IN WITNESS WHEREOF, Landlord and Tenant have executed this Lease in
quadruplicate on the dates set forth below and this Lease is effective as of the
latter of such dates.
LANDLORD: TENANT:
- -------- ------
33 NORTH LaSALLE, LLC VALLEY MEDIA, INC.
a Delaware Limited Liability company a Delaware cororation
By: The Lurie Company, a California By: /s/ John Kordic
corporation --------------------------
Name: John Kordic
Its: Member Its: Senior Vice President
By: /s/ Eugene L. Valla By: /s/ Robert R. Cain
-------------------------- --------------------------
Eugene L. Valla Name: Robert R. Cain
Its: Executive Vice President
Its: CEO/President
-------------------------
Date: 4/20/99 Date: 4/13/99
----------------------------- ------------------------
As to Section 32.06 Only
PANATTONI DEVELOPMENT COMPANY
By: /s/ [ILLEGIBLE]
------------------------
31
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<PERIOD-TYPE> 12-MOS 12-MOS 12-MOS
<FISCAL-YEAR-END> MAR-29-1997 MAR-28-1998 APR-03-1999
<PERIOD-END> MAR-29-1997 MAR-28-1998 APR-03-1999
<CASH> 310 394 1,433
<SECURITIES> 0 0 0
<RECEIVABLES> 36,900 113,705 170,748
<ALLOWANCES> (825) (5,276) (2,823)
<INVENTORY> 44,351 95,365 216,807
<CURRENT-ASSETS> 82,746 208,717 393,672
<PP&E> 13,618 22,733 31,758
<DEPRECIATION> (4,533) (7,052) (10,845)
<TOTAL-ASSETS> 94,591 244,298 430,725
<CURRENT-LIABILITIES> 82,946 226,027 358,065
<BONDS> 2,257 3,166 3,918
0 0 0
0 0 0
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<SALES> 199,231 583,492 888,966
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<CGS> 175,706 516,627 791,154
<TOTAL-COSTS> 175,706 516,627 791,154
<OTHER-EXPENSES> 19,902 52,276 74,137
<LOSS-PROVISION> 650 3,672 3,922
<INTEREST-EXPENSE> 1,745 6,627 10,928
<INCOME-PRETAX> 1,021 4,290 8,825
<INCOME-TAX> 410 1,731 3,673
<INCOME-CONTINUING> 611 2,559 5,152
<DISCONTINUED> 0 0 0
<EXTRAORDINARY> 0 0 (723)
<CHANGES> 0 0 0
<NET-INCOME> 611 2,559 4,429
<EPS-BASIC> 0.13 0.53 0.89
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