PREVIEW SYSTEMS INC, 10-Q, 2000-11-03

PREVIEW SYSTEMS INC
10-Q, 2000-11-03
BUSINESS SERVICES, NEC

Previous: WORLD MONITOR TRUST II SERIES F, 424B3, 2000-11-03

Next: PREVIEW SYSTEMS INC, 10-Q, EX-10.2, 2000-11-03

QuickLinks -- Click here to rapidly navigate through this document

UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
WASHINGTON, D.C. 20549

FORM 10-Q

(Mark One)

/x/	QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934

For the quarterly period ended September 30, 2000

/ /	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 000-28329

PREVIEW SYSTEMS, INC.
(Exact name of registrant as specified in its charter)

Delaware (State or other jurisdiction of incorporation or organization)		770485517 (I.R.S. Employer Identification No.)
1195 West Fremont Boulevard Sunnyvale, California (Address of principal executive offices)		94087 (Zip Code)

Registrant's telephone number, including area code: 408-720-3500

Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days. Yes /x/ No / /

Indicate the number of shares outstanding of each of the issuer's classes of common stock, as of the latest practicable date.

Common stock $.0002 par value
(Class)

17,134,070
(Outstanding at October 25, 2000)

PREVIEW SYSTEMS, INC.
FORM 10-Q
INDEX

PART I—FINANCIAL INFORMATION		Page
Item 1.	Financial Statements
	Consolidated Balance Sheets—September 30, 2000 and December 31, 1999	2
	Consolidated Statements of Operations—Three and Nine Month Periods Ended September 30, 2000 and 1999	3
	Consolidated Statements of Cash Flows—Nine Months Ended September 30, 2000 and 1999	4
	Notes to Consolidated Financial Statements	5
Item 2.	Management's Discussion and Analysis of Financial Condition and Results of Operations	6
Item 3.	Quantitative and Qualitative Disclosures About Market Risk	21
PART II—OTHER INFORMATION
Item 1.	Legal Proceedings	22
Item 2.	Changes in Securities and Use of Proceeds	22
Item 6.	Exhibits and Reports on Form 8-K	22
Signatures		23

PART I—FINANCIAL INFORMATION

Item 1. Financial Information

PREVIEW SYSTEMS, INC. AND SUBSIDIARIES
CONSOLIDATED BALANCE SHEETS
(In thousands, except per share amounts)

				September 30, 2000			December 31, 1999
				(Unaudited)
Assets
Current assets:
	Cash and cash equivalents			$	43,722		$	71,437
	Short-term investments				40,108			17,914
	Accounts receivable, net of allowance for uncollectible accounts of $152, and $75, respectively				3,795			2,229
	Prepaid expenses				1,251			687
	Other current assets				873			407

			Total current assets		89,749			92,674
Property and equipment, net of accumulated depreciation of $1,690 and $1,168					2,842			1,521
Intangibles, net of accumulated amortization of $4,823 and $3,218					1,975			3,492
Long-term investments					3,923			364
Long-term receivables					300			—
Other assets					390			174

			Total assets	$	99,179		$	98,225

Liabilities and Stockholders' Equity
Current liabilities:
	Current portion of long-term debt			$	—		$	157
	Current portion of capital lease obligations				124			166
	Accounts payable				1,077			1,092
	Accrued liabilities				2,467			1,170
	Deferred revenue				2,991			1,916

			Total current liabilities		6,659			4,501
Long-term debt, less current portion					—			145
Capital lease obligations, less current portion					62			144
Deferred revenue, less current portion					1,273			627
Other liabilities					198			267

			Total liabilities		8,192			5,684
Commitments and contingencies
Stockholders' equity:
	Preferred stock, $0.0002 per share par value:
		Authorized—5,000 shares; none issued and outstanding			—			—
	Common stock, $0.0002 per share par value:
		Authorized—75,000 shares; issued and outstanding 17,134 and 16,207 shares			3			3
	Additional paid-in capital				143,004			125,493
	Stockholder notes receivable				(1,912	)		(1,912	)
	Deferred compensation				(1,462	)		(101	)
	Accumulated deficit				(48,646	)		(30,942	)

			Total stockholders' equity		90,987			92,541

			Total liabilities and stockholders' equity	$	99,179		$	98,225

The accompanying notes are an integral part of these consolidated balance sheets.

PREVIEW SYSTEMS, INC. AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF OPERATIONS
(In thousands, except per share data)
(Unaudited)

				Three Months Ended September 30,						Nine Months Ended September 30,
				2000			1999			2000			1999
Revenues:
	Network transaction fees			$	1,652		$	740		$	4,942		$	1,482
	Services				190			303			974			782

			Total revenues		1,842			1,043			5,916			2,264
Operating expenses:
	Research and development				3,344			1,860			9,394			5,181
	Sales and marketing				3,516			2,084			9,891			4,757
	General and administrative				1,288			872			3,328			2,356
	Stock based compensation				—			38			3,912			182
	Acquisition related costs				483			519			1,521			1,557

			Total operating expenses		8,631			5,373			28,046			14,033

Loss from operations					(6,789	)		(4,330	)		(22,130	)		(11,769	)
Other income (expense):
	Interest expense				(57	)		(27	)		(83	)		(91	)
	Interest income				1,503			271			4,606			336
	Other, net				(47	)		2			(97	)		4

		Total other income (expense)			1,399			246			4,426			249

Net loss				$	(5,390	)	$	(4,084	)	$	(17,704	)	$	(11,520	)

Basic and diluted net loss per share				$	(0.31	)	$	(1.32	)	$	(1.04	)	$	(3.95	)

Shares used in per share calculations					17,116			3,101			16,958			2,920

The accompanying notes are an integral part of these consolidated financial statements.

PREVIEW SYSTEMS, INC. AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF CASH FLOWS
(In thousands)
(Unaudited)

						Nine Months Ended September 30,
						2000			1999
Cash flows from operating activities:
		Net loss				$	(17,704	)	$	(11,520	)
	Adjustments to reconcile net loss to net cash used in operating activities:
			Depreciation and amortization				2,267			1,903
			Other non-cash revenues and expenses				3,472			184
			Loss on sale of fixed assets				29			—
			Changes in operating assets and liabilities:
				Accounts receivable			(1,566	)		(1,832	)
				Prepaid expenses and other current assets			(1,030	)		(507	)
				Long-term receivables and other assets			(555	)		(2	)
				Accounts payable			(15	)		304
				Accrued liabilities			1,297			129
				Deferred revenue			1,226			250
				Other liabilities			(69	)		—

					Net cash used in operating activities		(12,648	)		(11,091	)
Cash flows from investing activities:
	Purchase of investments						(40,182	)		—
	Sales or maturities of investments						15,364			—
	Purchases of intangibles						(91	)		—
	Purchases of property and equipment						(2,014	)		(524	)
	Proceeds from sale of equipment						44			—

					Net cash used in investing activities		(26,879	)		(524	)
Cash flows from financing activities:
	Borrowings under line of credit, notes payable and long-term debt						—			1,880
	Repayments under line of credit, notes payable and long-term debt						(302	)		(868	)
	Proceeds from obligations under capital leases						—			235
	Payment of obligations under capital leases						(124	)		(139	)
	Issuance of preferred stock, net of issuance costs						—			25,847
	Issuance of common stock in public offering, net of issuance costs						11,118			—
	Issuance of common stock pursuant to the exercise of options and warrants						539			325
	Issuance of common stock pursuant to the employee stock purchase plan						581			—

					Net cash provided by financing activities		11,812			27,280

Net decrease in cash and cash equivalents							(27,715	)		15,665
Cash and cash equivalents:
	Beginning of period						71,437			4,886

		End of period				$	43,722		$	20,551

The accompanying notes are an integral part of these consolidated financial statements.

PREVIEW SYSTEMS, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(In thousands)
(Unaudited)

Note 1. Basis of Presentation

The financial information included herein for the three and nine-month periods ended September 30, 2000 and 1999 is unaudited; however, such information reflects all adjustments consisting only of normal recurring adjustments, which are, in the opinion of management, necessary for a fair presentation of the consolidated financial position, results of operations and cash flows for the interim periods. The financial information as of December 31, 1999 is derived from Preview Systems, Inc.'s ("Preview" or the "Company") 1999 Annual Report on Form 10-K, but does not include all disclosures required by generally accepted accounting principles. The interim consolidated financial statements should be read in conjunction with the consolidated financial statements and the notes thereto included in Preview's 1999 Annual Report on Form 10-K. The results of operations for the interim periods presented are not necessarily indicative of the results to be expected for any subsequent quarter or for the full year.

Note 2. Investments in Licensees

Long-term investments as of September 30, 2000 include $935 associated with the value of equity investments in licensees. The equity in these licensees was received as partial consideration for entering into license arrangements with these licensees. These investments were recorded at the fair market value upon receipt or vesting of the equity instrument, using the Black Scholes method, as appropriate, and will be accounted for using the cost method. The carrying value of these investments is reviewed whenever circumstances occur which indicate that the carrying value may not be recoverable. The value of the investments was recorded as deferred revenue and is being amortized to network transaction fee revenue over the life of the license arrangement with the licensees.

Note 3. Line of Credit

Effective August 4, 2000, Preview obtained a $5.0 million line of credit with Silicon Valley Bank, which matures August 4, 2001 and is collateralized by all assets except cash, highly liquid investments, and intellectual property. Interest on the unpaid balance will accrue at the prime rate, 9.5% percent at September 30, 2000. Preview did not have any amounts outstanding under the line of credit at September 30, 2000. The line of credit agreement contains financial covenants, including covenants relating to maintenance of minimum levels of working capital and tangible net worth. Preview was in compliance with these covenants at September 30, 2000.

Note 4. Net Loss Per Share

Basic and diluted net loss per share are the same for all periods presented since Preview was in a loss position in all periods. Potentially dilutive securities that are not included in the diluted net loss per share calculation because they would be antidilutive are as follows:

	Three and Nine Months Ended September 30,
	2000	1999
Stock options and warrants	4,838	2,773
Convertible preferred stock	—	8,788

Total	4,838	11,561

Note 5. Issuance of Common Stock

In January 2000, Preview issued 570 shares of its common stock pursuant to the underwriters' over-allotment option for net proceeds to the Company of $11,118.

Note 6. Stock Option Plans

Pursuant to the terms of the plans, on January 1, 2000 the number of shares of the Company's Common Stock authorized for issuance under the 1998 Stock Option Plan, the 1999 Directors Stock Option Plan and the 1999 Employee Stock Purchase Plan were increased by 486, 150 and 324 shares, respectively.

Note 7. Reclassifications

Certain amounts in the prior period financial statements have been reclassified to conform to current presentation.

Note 8. Subsequent Event

On October 11, 2000, the Company entered into an agreement to lend $175 to the Chief Executive Officer. The note receivable is full recourse, unsecured and bears interest at 11% per annum. The principal and unpaid interest are due in full on October 11, 2001, however, the note may be prepaid at any time without penalty.

Item 2. Management's Discussion and Analysis of Financial Condition and Results of Operations (In Thousands)

Forward Looking Statements

This Form 10-Q contains forward-looking statements that involve risks and uncertainties. We use words like "anticipate," "believe," "plan," "expect," "future," "intend," and similar expressions to identify forward-looking statements. This Form 10-Q also contains forward-looking statements attributed to third parties relating to their estimates regarding the growth of Internet use and electronic distribution and licensing of digital goods. You should not place undue reliance on these forward-looking statements, which apply only as of the date of this Form 10-Q. Our actual results could differ materially from those anticipated in these forward-looking statements for many reasons, including the risks faced by us and described in our Registration Statement on Form S-1 and in our Form 10-K for the year ended December 31, 1999 and our quarterly reports on Form 10-Q, as filed with the Securities and Exchange Commission. Moreover, neither we nor any other person assumes responsibility for the accuracy and completeness of the forward-looking statements. We are under no duty to update any of the forward-looking statements after the date of this Form 10-Q to conform these statements to actual results or to changes in our expectations.

Company Overview

Preview Systems is a provider of an Internet-based infrastructure solution that enables networks for distribution and licensing of digital goods. Through our infrastructure solution and strategic relationships, we link software publishers and music labels to their channel partners and end-users worldwide, creating an end-to-end electronic distribution chain that manages the e-commerce of digital goods and associated licensing rights.

We generally provide rights to use our solution and ongoing customer support through licensing agreements. These agreements typically require the payment of network transaction fees based on a percentage of the sales fulfilled using our solution. Our customers typically commit to minimum network transaction fees that entitle them to fulfill an agreed amount of sales during the term of the

agreement. Some or all of the minimum network transaction fees are prepaid upon signing the agreement. We record deferred revenue related to these fees and recognize them on a straight-line basis over the license period. To the extent sales fulfilled using our solution exceed the agreed amount of sales, we recognize incremental network transaction fees. We recognize these incremental network transaction fees when the amounts due are known.

Service revenue generally consists of consulting, training and integration fees. We typically bill these services and recognize them as the related services are performed or when contract milestones are achieved.

Results of Operations

Revenue

The Company's revenue is comprised of network transaction fees and service revenue. Total revenue increased $799, or 77%, to $1,842 for the three months ended September 30, 2000 from $1,043 for the comparable period of 1999. Total revenue increased $3,652, or 161%, to $5,916 for the nine months ended September 30, 2000 from $2,264 for the comparable period of 1999. However, total revenue decreased $563 or 23% sequentially from the second quarter of 2000 to the third quarter of 2000. One customer, Sony Marketing of Japan, accounted for 17% of total revenues in the third quarter of 2000. In the third quarter of 1999, Sony Marketing of Japan and Ingram Micro accounted for 24% and 16%, respectively, of total revenues.

Network transaction fees increased $912, or 123%, to $1,652 for the three months ended September 30, 2000 from $740 for the comparable period of 1999. Network transaction fees increased $3,460, or 233%, to $4,942 for the nine months ended September 30, 2000 from $1,482 for the comparable period of 1999. However, network transaction fees decreased $403, or 20%, from $2,055 in the second quarter of 2000 to $1,652 in the third quarter of 2000. Network transaction fees are primarily the recognition of minimum commitments, which are recognized ratably over the term of the contract or until the sales that underlie the commitments are exceeded. Network transaction fees for the second and third quarter of 2000 also include $342 and $98, respectively, related to the amortization of the value of equity investments received as partial consideration for licensing arrangements with two licensees. The value of these investments is being amortized to revenue over the lives of the licensing arrangement. See Note 2.

The increase in network transaction fees in 2000 over 1999 is primarily the result of the growth in our customer base and increased sales by our customers that are fulfilled by our solution. During the third quarter of 2000, we added two direct customers and ten content providers who signed with distributors and service providers to add content to the network. In addition, two customers went live taking commercial transactions and another customer achieved sales in excess of their minimum commitment. However, the decrease in network transaction fees between the second and third quarter of 2000 primarily relates to the decrease in revenue related to equity investments and a number of contracts not closing within the third quarter due to our long and complex sales cycle.

Network transaction fees as a percentage of total revenue increased to 90% in the third quarter of 2000 from 71% in the third quarter of 1999. Although we expect transaction fees to remain in the range of 80% to 90% of our total revenue, future network transaction fee revenue growth will be dependent on continuing to expand our customer base, the timely and successful deployment of our solution by new customers and their distribution channel partners, and the generation of transaction volume by customers above their minimum commitments using our solution. To date, transaction volumes have been slower to develop than originally anticipated and in many cases have not exceeded minimum commitment levels. As a result, we are unable to predict if and when customers may generate significant transaction fees above their minimum commitments.

Service revenues generally consist of consulting, training and integration fees. Service revenue, totaling $190 for the three months ended September 30, 2000, decreased $113 from $303 for the three months ended September 30, 1999 and decreased $160 from $350 in the second quarter of 2000. The decreases in service revenue relate to implementation delays dictated by some existing licensees, some customers choosing to implement our solution internally, and fewer implementations and related services due to fewer contracts closing during the quarter. However, service revenue increased $192 to $974 for the nine months ended September 30, 2000 from $782 in the comparable period of 1999. Future service revenue levels are dependent on growth in our customer base and customer's deployment resource levels and schedules.

Operating Expenses

Research and development expenses consist principally of salaries and related personnel expenses, consultant fees and the cost of hardware and software used in product development. Research and development costs are expensed to operations as incurred. Research and development expenses increased $1,484, or 80%, to $3,344 for the three months ended September 30, 2000 from $1,860 for the comparable period of 1999. Research and development expenses increased $4,213, or 81%, to $9,394 for the nine months ended September 30, 2000 from $5,181 for the comparable period of 1999. These increases are primarily attributable to increases in salaries and related personnel expenses, consultant fees and facilities costs as we expand our platform to support multiple digital goods and expand our service engineering capabilities to support integration into our customer environments. An increase in royalties we pay related to the licensing of certain technology for the distribution of music also contributed to the increase. We believe that significant investments in research and development are critical to developing our software and music solutions and attaining our strategic objectives. Therefore, we anticipate that research and development expense will continue to increase in absolute dollars in future periods.

Sales and marketing expenses consist of salaries and related expenses for personnel engaged in direct sales, partner development and marketing. In addition, those costs include consultant fees, promotional materials, trade show exhibits, and other marketing program expenses. Sales and marketing expenses increased $1,432, or 69%, to $3,516 for the three month period ended September 30, 2000 from $2,084 for the comparable period of 1999. Sales and marketing expenses increased $5,134, or 108%, to $9,891 for the nine months ended September 30, 2000 from $4,757 for the comparable period of 1999. The increases are primarily attributable to increases in salaries and personnel expenses, recruiting costs and facilities costs resulting from the expansion of our sales force to support our growing customer base, as well as the growth in our marketing efforts as we expand our platform to address multiple digital goods. We expect to continue to grow sales and marketing costs as we expand into other digital goods markets or rights management areas, expand our presence in international markets and grow our customer base.

General and administrative expenses consist primarily of salaries and related expenses for executive, legal, accounting and administrative personnel, professional services and general corporate expenses. General and administrative expenses increased $416, or 48%, to $1,288 for the three months ended September 30, 2000 from $872 for the comparable period of 1999. General and administrative expenses increased $972, or 41%, to $3,328 for the nine months ended September 30, 2000 from $2,356 for the comparable period of 1999. The increases are primarily a result of increases in salaries and related costs, consultants and facilities costs. These increases were partially offset by a decrease in legal costs. Legal costs were higher in the first nine months of 1999 as a result of litigation related expenses.

Stock based compensation of $3,912 for the nine month period ended September 30, 2000, respectively, relates to the issuance of common stock warrants and options to non-employees or to employees at below the fair market value of the Company's common stock. There was no stock based compensation in the third quarter of 2000. Stock based compensation for the nine month period ended

September 30, 2000 includes $1,364 related to the vesting of a portion of the warrant issued to Virgin Holdings, Inc. based on achievement of pre-determined performance criteria related to market development activities. The final 133 shares of this warrant are scheduled to become exercisable upon achievement of a final milestone in the fourth quarter of 2000, and may have a material impact on our results of operations upon vesting.

Acquisition related costs consist of the amortization of patents and other intangibles and totaled $483 and $1,521 for the three and nine-month periods ended September 30, 2000, respectively, and $519 and $1,557 for the three and nine-month periods ended September 30, 1999, respectively. The $1,975 of intangibles on the balance sheet at September 30, 2000 will be fully amortized over the next four quarters.

Income Taxes

We have incurred net losses since inception for federal and state tax purposes and have not recognized any tax provision or benefit.

We are in a net deferred tax asset position, which has been fully reserved. We will continue to provide a valuation allowance for our net deferred tax assets until it becomes more likely than not, in our assessment, that our net deferred tax assets will be realized.

Interest Income

Interest income increased to $1,503 and $4,606 for the three and nine month periods ended September 30, 2000, respectively, from $271 and $336 for the comparable periods of 1999. The increases are a result of higher average cash and investment balances resulting primarily from our initial public offering of common stock in December 1999. In addition, interest rates have been higher in 2000 compared to 1999. We expect interest income in the coming quarters to decline as cash and investment balances are used for operations.

Liquidity and Capital Resources

We completed our initial public offering of common stock in December 1999, raising $71,425, net of offering expenses. Prior to the initial public offering, we financed our operations primarily through the sale of preferred stock, raising $39,699 in a series of offerings. In January 2000, the underwriters of our initial public offering exercised their over-allotment option, resulting in the sale of an additional 570 shares of common stock for net proceeds of $11,118. We have outstanding capital lease commitments of $186 as of September 30, 2000.

On September 30, 2000, we had working capital of $83,090, including $43,722 of cash and cash equivalents and $40,108 of short-term investments. We used $12,648 for operations during the nine months ended September 30, 2000 compared to $11,091 for the comparable period of 1999. We also used $24,818 for the net purchase of short and long-term investments during the nine months ended September 30, 2000. Long-term investments include $2,988 related to highly liquid investments with maturities beyond 12 months, but less than 24 months from September 30, 2000. Another $935 of the long-term investments relate to equity investments in licensees as more fully described in Note 2 above.

We have a $5.0 million line of credit with Silicon Valley Bank, which matures August 4, 2001 and is collateralized by all assets except cash, highly liquid investments, and intellectual property. The line of credit will be used for short-term working capital requirements and will allow us to issue letters of credit or enter into foreign exchange contracts as necessary to hedge any possible future foreign currency exposures. At September 30, 2000, we did not have any amounts outstanding under this line of credit.

Accounts receivable were $3,795 at September 30, 2000 compared to $2,229 at December 31, 1999. The increase was primarily attributable to the execution of new licensing agreements with customers. Days sales outstanding at September 30, 2000 were 188 compared to 167 at December 31, 1999. This increase is primarily due to the increase in unbilled receivables.

Deferred revenue increased to $4,264 at September 30, 2000 from $2,543 at December 31, 1999 as a result of growth in our customer base. Current deferred revenue at September 30, 2000 was $2,991.

We believe that cash on hand will be sufficient to meet our working capital needs through at least the next 12 months.

Risk Factors

You should carefully consider the risks described below in evaluating our company. In addition, you should keep in mind that the risks described below are not the only risks that we face. The risks described below are the risks that we currently believe are material risks. However, additional risks not presently known to us, or risks that we currently believe are not material, may also impair our business operations. Moreover, you should refer to the other information contained in this Form 10-Q and in our Form 10-K for the year ended December 31, 1999 as filed with the Securities and Exchange Commission for a better understanding of our business. All dollar references are in thousands.

Our business, financial condition, or results of operations could be adversely affected by any of the following risks. If we are adversely affected by these risks, then the trading price of our common stock could decline, and you could lose all or part of your investment.

Risks Related to Our Business

Because our business model is new and unproven, we may not succeed in generating sufficient revenues to sustain or increase our business.

Our success depends upon our ability to generate network transaction fees based on a percentage of the sales fulfilled by our customers using our solution. This business model is unproven, our customers have limited experience using our solution to distribute their products and we have not received significant network transaction fees under this transaction fee model. To date, we have been unable to generate significant revenues from network transaction fees. If we are unable to generate significant revenues from network transaction fees, our current revenues, consisting primarily of annual minimum network transaction fees payable upon execution and renewal of customer agreements, will be insufficient to sustain our business. If customers wish to use different business models, such as the payment of a one-time license fee instead of ongoing network transaction fees, our revenues will suffer and we may not be able to grow our business. Our existing customers may not elect to renew their agreements or they, as well as future customers, may seek more favorable terms.

Our limited operating history makes it difficult for you to evaluate our business and your investment.

We were formed in April 1998 to acquire all of the outstanding equity interests of Preview Software and Portland Software. These acquisitions closed in August 1998. Prior to August 1998, Portland Software and Preview Software had achieved only limited distribution of their respective products. For example, in 1998, 1997, and 1996, total revenues generated by both businesses combined were $809, $763, and $335, respectively. For the year ended December 31, 1999, our total revenues were $3,483. For the nine months ended September 30, 2000, our total revenues were $5,916. A majority of our significant customers entered into their agreements with us since September 1998. Accordingly, we have a limited operating history and you have little historical basis upon which to evaluate our business, products, markets and general prospects of your investment.

If our customers do not generate significant transaction fees above their minimum commitments by using our solution, our revenue growth will suffer and we may be unable to sustain or increase our business.

Unless our customers generate significant sales and transaction fees using our solution, our business will be seriously harmed. We depend on our customers to use and to facilitate the use of our solution and the failure of our customers to do so will cause our revenues to suffer. For example, one reason our revenues have not grown as anticipated is because one of our largest customers, Ingram Micro, has not sold significant amounts of digital goods using our solution and has not generated transaction fees beyond their minimum commitments. We are unable to predict if and when Ingram Micro may generate transaction fees above their minimum commitments. The failure of existing and future customers to sell significant amounts of digital goods using our solution will result in slower revenue growth and is likely to prevent us from growing or sustaining our business.

We expect operating expenses to increase significantly, we have incurred significant net losses and we expect our losses will continue in the future.

As of September 30, 2000, we had an accumulated deficit of $48,646. We experienced a net loss of $17,704 for the nine months ended September 30, 2000 and net losses of $17,054, $11,276 and $2,380 in 1999, 1998 and 1997, respectively. We have not achieved profitability and we expect significant operating losses and negative cash flow to continue through at least the end of 2001, and possibly longer. Our losses will continue to increase because we expect to continue to incur increased costs and expenses related to research and development and marketing, and, to a lesser degree, sales, services and general and administrative functions.

In addition, we are in the early stages of marketing our solution to address electronic distribution of digital music. We anticipate that this effort will entail additional significant increases in research and development costs as well as in sales and marketing. We do not expect to recognize meaningful revenues from the music business for at least the next 12 months, if ever. Because we will spend these amounts before we receive any incremental revenues from these efforts, our losses will be greater than the losses we would incur if we developed our business more slowly. In addition, we may find that these efforts are more expensive than we currently anticipate, which would further increase our losses.

If a significant number of distribution channel participants do not agree to sell digital goods through our solution, we may not be successful.

The distribution channel for digital goods is complex and multi-tiered, consisting of publishers, which sell to distributors, resellers and end customers; distributors, which sell to resellers; original equipment manufacturers, which sell to resellers and end customers; and resellers, which sell to end customers. Unless a significant number of these channel participants adopt our solution in a timely manner, we will not achieve the critical mass of participants we believe necessary for our success. Our success depends on the adoption of our solution not only by our customers, but by the distribution channel partners of our customers as well. For example, in order for a distributor to sell digital goods using our solution, the publisher of the goods must consent to distribute its goods electronically and the reseller of the goods must also agree to use our solution. We do not know whether our customers' distribution channel partners will agree to use our solution. We depend on our customers to obtain publisher consents and to facilitate the adoption of our solution by their distribution channel partners. Unless a significant number of our customers' distribution channel partners agree to sell digital goods through our solution, we may not be able to earn enough revenues from our network transaction fees to become profitable or execute our business model.

The loss of any of our current major customers would cause our revenues to decline.

Two customers combined, Sony Marketing of Japan and Ingram Micro, accounted for 22% of our total revenues in the first nine months of 2000. Sony Marketing and Ingram Micro combined accounted for approximately 38% of our revenues in 1999. Sony Marketing accounted for approximately 45% of our revenues in 1998. We expect that a small percentage of our customers will continue to account for a substantial portion of our revenues for at least the next 12 months. Contracts with these customers are generally short term in nature, varying in length from one to three years, and can be terminated by the customer on short notice without significant penalties. A failure to renew, or the termination of, or renewal on less favorable terms to us of, any of these agreements, would result in a loss of a large portion of our revenues.

If Microsoft does not consent to the electronic distribution of its products through distributors using our solution or adopt our solution for direct sales, we may be unable to increase our revenues or become profitable.

Sales of Microsoft products accounted for approximately 11% of worldwide packaged software sales in 1999 according to an International Data Corporation Bulletin titled "Packaged Software: 1999 Worldwide Performance Preliminary Results." If Microsoft does not consent to the electronic distribution of its products through distributors using our solution or adopt our solution for direct sales, we will lose a significant revenue opportunity. Additionally, Microsoft may initiate its own standard for the electronic distribution of its software over the Internet. Microsoft has initiated programs for the secure electronic distribution of music. If distribution channel participants favor Microsoft's existing or future solution for electronic distribution of digital goods, we may be unable to increase our revenues or become profitable.

Our sales cycle is lengthy and unpredictable which could cause us to fail to achieve projected results.

Our sales cycle is a long and complex process. If network transaction fees are delayed or reduced as a result of this process, our future revenue and operating results could be impaired. Our sales process requires a significant level of education regarding the use and benefits of our solution. The purchase and deployment of our solution involves a significant commitment of capital and other resources. As a result, our customers typically spend substantial time performing internal reviews and obtaining corporate approvals before making a purchasing decision. Accordingly, the period between our initial sales call and the signing of a contract with significant sales potential typically ranges from four to six months and can be significantly longer. Therefore, the timing of sales to new customers is difficult to predict. Delays in receiving signed contracts with major customers could cause us to fail to achieve our projected results, as well as those of industry analysts, which would have a severe adverse effect on the price of our stock.

Our solution has not been used under high-volume transaction conditions and it may not meet the demands of our high-volume customers.

Our solution has not yet been subjected to the volume of business and the complexity we anticipate will be required to fully support the future transactions of our largest customers. If our solution is not capable of processing the necessary volume of transactions, our business may be seriously harmed because the number of revenue generating transactions using our solution will be limited, customers may elect to use another solution and we may be exposed to adverse publicity. In addition, it is likely that production software tools, diagnostic tools and maintenance upgrades, as well as significant financial and other resources, will be required to achieve reliability and resolve technical issues related to large-scale transactions.

If our maintenance and upgrades to our solution disrupt our customers' operations, we may suffer lost revenues and harm to our reputation.

We will need to upgrade and improve our solution periodically. Upgrading or deploying a new version of our solution requires the cooperation of our existing customers and their network participants. These network participants may be reluctant to upgrade our solution since this process can be complicated and time-consuming and poses the risk of network failures. If our periodic upgrades and maintenance cause disruptions, we will lose revenue generating transactions, our customers may elect to use other solutions and we may also be the subject of negative publicity that may further adversely affect our business and reputation.

Delays caused by integrating our solution with channel participants' existing systems may cause revenue shortfalls in a particular quarter.

Our customers and their distribution channel partners must integrate our solution into their existing systems or a new system. Our business model is based on receiving network transaction fees. Thus, our success depends upon the timely and successful deployment of our solution by customers and their distribution channel partners for the distribution and licensing of digital goods.

The timing and success of commercial deployment depends upon the:

•: complexity of our customers' systems and necessary development efforts;
•: technical and engineering capabilities of our customers;
•: budget for and relative importance of electronic distribution of digital goods to our customers;
•: ability of our customers to integrate and test the implementation of our solution successfully; and
•: efforts of our consulting, training and support services staff in providing technical support to our customers. We have, in the past, experienced, and continue to experience, delays in the period between entering into a licensing arrangement and the time a customer commercially deploys our solution. We expect that this period will continue to vary widely from customer to customer.

Variations in the volume of sales of digital goods and services over the Internet will cause fluctuations in our quarterly operating results, which could cause our stock price to decline.

The amount of network transaction fees we receive in any given quarter will depend on the sales of digital goods that occur using our solution. Because sales of digital goods using our solution are outside of our control, it will be difficult for us to make accurate quarterly revenue projections, even if our solution is deployed commercially by our licensees. In addition, our revenues will depend on the number of new deployments of our solution that occur in a particular quarter. However, in the short term, our operating expenses are relatively fixed and based in part on our revenue projections. As a result, if our revenue projections are not accurate for a particular quarter, our operating results for that quarter could fall below the expectations of analysts and investors. Our failure to meet these expectations would likely cause the market price of our common stock to decline significantly and rapidly.

Security breaches to our encryption technology may harm our reputation and business and may cause us to expend significant additional resources to protect against future breaches.

Individuals, referred to as crackers, have in the past gained unlicensed access to secured digital goods distributed through our solution. While we expend significant efforts to make unauthorized access increasingly difficult, we expect that determined crackers will continue their attempts to crack our solution and may prove successful. We may have to expend significant resources to alleviate problems caused by these attempts to crack our solution.

Any breach of our security systems could harm our reputation, which could materially harm our business. A party who is able to circumvent our security measures could misappropriate digital goods without paying the required license fees, gain unauthorized access to proprietary information, erase or modify electronic audit trails, or disrupt our customers' operations. Security breaches could also harm our reputation and expose us to litigation and liability. We cannot assure you that our security measures will prevent security breaches or that a failure to prevent such security breaches will not seriously harm our business.

We do not expect to recognize any significant revenues from the use of our solution by our customers to sell digital music for at least the next 12 months, and we may not ever recognize meaningful revenues from these sales.

We have limited experience marketing our solution for electronic distribution of music and few customers are currently using our solution to distribute music. As a result, we do not believe that we will recognize any significant revenue from the use of our solution to sell music or any type of digital goods other than software for at least the next 12 months, if at all. We expect to incur significant expenses to develop and promote the use of our solution for the electronic distribution of music. If electronic distribution of music fails to develop or we are unable to penetrate this market, we will have expended a great deal of time, effort and financial resources that could have been directed to more beneficial activities. In addition, our business may be adversely impacted if our efforts are not successful.

Several factors create risk in our ability to be successful in this market, including:

•: Although EMI and Time Warner have made a public commitment to support our platform, if they fail to offer a sufficient amount and variety of digital recorded music available for distribution, our music solution may be unable to obtain sufficient market penetration to provide a return on our investment.
•: Physical CD distribution is still a significant portion of the music distribution business and until the music industry provides content in such a way as to create a barrier for consumers copying content in a digital format, digital distribution may not succeed.
•: Recent mergers and acquisitions in the music industry may slow the selection and adoption of a digital distribution platform.
•: Other companies, such as IBM and Liquid Audio, have already begun to distribute digital music using their proprietary methods. If these methods are adopted prior to our solution gaining wide spread acceptance, our plans to use our solution for the distribution of digital music may be seriously harmed.
•: The emergence and popularity of peer-to-peer technology, such as Napster and Gnutella, have made the free distribution of music easily obtainable, which may hinder our ability to obtain sufficient market penetration.
•: We rely on our ability to integrate digital rights management systems, such as Microsoft, Intel and others, into our technology. If we are unable to successfully integrate these systems into our product, we may be unable to provide a viable solution for electronic distribution of music. Although we have successfully incorporated certain digital rights management systems into our solution, we rely on our ability to do so on a continuing basis.
•: We license multiple technologies to complete our solution. If any of the technology providers change their business model or licensing structures, it may not be feasible for us to obtain the necessary technology to provide a complete solution.

•: Our music distribution solution provides for the continual protection of music, but the underlying operating systems themselves are insecure and may be breached, thus providing ways for crackers to capture the music bits as they are rendered or sent to the sound card. In addition, the personal computer is an inherently open device with multiple access points that may be insecure and digital rights management systems may be unable to protect content sufficiently.
•: Our solution has not been commercially tested at high transaction volumes.
•: We rely upon third parties to create digital music players that support the digital rights management systems we have integrated. If such third parties fail to support this technology or end customers do not purchase devices to play music distributed through our solution, our solution may not gain market acceptance.
•: Technology standards may emerge that marginalize the value of our solution.

Our intellectual property rights are difficult and costly to protect because our industry is characterized by the existence of a large number of patents and frequent litigation. This may place a significant burden on our management team and may make it difficult for us to operate our business successfully.

The digital encryption and distribution industry is characterized by the existence of a large number of patents and frequent litigation based on allegations of patent infringement and the violation of other intellectual property rights. We regard our patents, copyrights, trademarks, trade dress, trade secrets, and similar intellectual property as critical to our success. We have 9 patents issued or allowed, and an additional 21 applications pending with the United States Patent and Trademark Office and an additional 12 patent applications pending in foreign jurisdictions. Our proprietary technologies will be protected from unauthorized use by third parties only to the extent that they are covered by valid and enforceable patents or copyrights or are effectively maintained as trade secrets. These legal protections afford only limited protection and may be time consuming and expensive. In addition, litigation may be necessary in the future to enforce our intellectual property rights, to protect our trade secrets or to determine the validity and scope of the proprietary rights of others. Litigation could result in substantial costs and diversion of management and technical resources away from our business operations. Despite our efforts, we may be unable to prevent third parties from infringing upon or misappropriating our intellectual property. If we are not able to protect our intellectual property rights, our business may not succeed.

Factors outside our control may limit our expansion in international markets and may prevent us from developing international revenues.

Although we sell our solution to customers outside the United States, we might not succeed in expanding our international presence. As a result of our agreement with Sony Marketing of Japan, which provides them the exclusive right to distribute our products in Japan, our success in this market depends on their efforts and ability to sell our solution. This grant of an exclusive right to Sony Marketing may prevent widespread adoption of our solution by the Japanese market, which may prevent us from becoming a widely-used solution in Japan.

Conducting our business outside the United States subjects us to unfavorable international regulations and conditions affecting businesses that operate in our industry and could cause our international business to fail.

Conducting our business outside of the United States is subject to additional risks related to our business which are largely outside our control, including:

•: the possibility that the scarcity of high speed Internet access, the high cost of Internet access and the pace of future improvements in access to the Internet in countries outside the United States will limit the market for electronic distribution and licensing of digital goods;
•: reduced protection of our patents, copyrights and other intellectual property rights;
•: potential tax withholding of our network transaction fees;
•: U.S. and international export and use restrictions on our encryption technology; and
•: currency rate fluctuations that can impact our network transaction fees that are denominated in local currencies.

One or more of these factors may materially and adversely affect our future international operations, and consequently, our business.

If our key employees do not continue to work for us, our business will be harmed because competition for replacements is intense.

We are substantially dependent on the continued services of our officers and key personnel who are all at-will employees. These individuals have tacquired specialized knowledge and skills with respect to our business. As a result, if any of these individuals were to leave, we could face substantial difficulty in hiring qualified successors and could experience a loss in productivity while the new employee obtains the necessary training and experience. We expect that we will need to hire additional personnel in all areas. The competition for qualified personnel in our industry is intense, particularly in the San Francisco Bay Area, where our corporate headquarters are located. At times, we have experienced difficulties in hiring personnel with the right training or experience, particularly in technical areas. New employees require extensive training and typically require four to six months of training to achieve full productivity. Our success depends on attracting and retaining personnel.

We may need to raise additional funds in the future, which could result in dilution.

We require substantial working capital to fund our business. We expect our existing capital resources to be sufficient to meet our working capital and capital expenditure needs for at least the next 12 months. After that, we may need to raise additional funds, and additional financing may not be available on favorable terms, if at all. This could seriously harm our business and operating results. Furthermore, if we issue additional equity securities, stockholders may experience dilution, and the new equity securities could have rights senior to those of existing holders of our common stock. If we raise additional funds through the issuance of debt securities, holders of these securities could have rights, preferences, and privileges senior to holders of common stock, and the terms of this debt could impose restrictions on our operations. If we need to raise funds and cannot do so on acceptable terms, we may not be able to develop or enhance our solution, take advantage of future opportunities, or respond to competitive pressures or unanticipated requirements.

Our executive officers and directors will continue to have substantial ownership control over us, which could delay or prevent a merger or other change in control.

As of October 25, 2000, our executive officers, directors and entities affiliated with them and affiliates, in the aggregate, beneficially owned approximately 34% of our outstanding common stock. These stockholders, if acting together, would be able to influence significantly the election of directors and all other matters requiring approval by our stockholders. This concentration of voting control could have the effect of delaying or preventing a merger or other change in control, even if it would benefit our other stockholders.

Our charter documents have anti-takeover provisions that could discourage a change in control, even if an acquisition would be beneficial to our stockholders.

Our certificate of incorporation, our bylaws and Delaware law contain provisions that could make it more difficult for a third party to acquire us, even if doing so would be beneficial to our stockholders. These provisions include:

•: authorizing the issuance of shares of undesignated preferred stock without a vote of stockholders;
•: prohibiting stockholder action by written consent; and
•: limitations on stockholders' ability to call special stockholder meetings.

Substantial sales of our common stock could depress our stock price.

Substantial sales of our common stock could depress our stock price. If our stockholders sell substantial amounts of our common stock in the public market, the market price of our common stock could fall. Based on 17,134,070 shares outstanding as of October 25, 2000, we had 16,952,812 shares of common stock eligible for sale in the public market. The remaining shares of common stock outstanding will be eligible for sale upon the lapse of our repurchase options on various dates through July 2003.

We expect to make future acquisitions where advisable and acquisitions involve numerous risks. Our business is highly competitive, and as such, our growth is dependent upon market growth and our ability to enhance our existing solution and introduce new products and services on a timely basis.

One of the ways we anticipate addressing the need to enhance our solution and develop new products is through acquisitions of other companies or technologies where advisable.

Acquisitions involve numerous risks, including the following:

•: difficulties in integration of the operations, technologies, and products of the acquired company;
•: the risk of diverting management's attention from normal daily operations of the business;
•: potential difficulties in completing projects associated with purchased in-process research and development;
•: risks of entering markets in which we have no or limited direct prior experience and where competitors in such markets have stronger market positions; and
•: the potential loss of key employees of the acquired company.

Mergers and acquisitions of high technology companies are inherently risky, and no assurance can be given that any acquisition will be successful and will not materially adversely affect our business, operating results or financial condition. We must also maintain our ability to manage any such growth

effectively. Failure to manage growth effectively and successfully integrate acquisitions made by us could materially harm our business and operating results.

Risks Related to Our Industry

The success of our business will largely depend on the widespread acceptance of commerce in digital goods over the Internet.

The use of the Internet for distribution and licensing of digital goods may not be commercially accepted for a number of reasons, including:

•: failure to adequately develop the necessary infrastructure for the electronic distribution and licensing of digital goods, including data compression or broadband communication technology;
•: lack of adequate speed, access, or server reliability;
•: public perception of the security and confidentiality of digital information and the confidentiality of its providers and users;
•: development of competing technologies;
•: rate of adoption of electronic distribution and licensing of digital goods by the existing retail and other channels;
•: demand for digital goods that are available for purchase through electronic distribution; and
•: level of end customer comfort with the process of downloading software, music and other digital goods over the Internet, including the ease of use.

In addition, our business will be seriously harmed if publishers, distributors or resellers of digital goods are unwilling to sell their digital goods over the Internet. These factors are outside of our control. If commerce in digital goods does not achieve widespread market acceptance or grow significantly, we may be unable to generate sufficient revenue to sustain our business.

Our market is subject to rapid technological changes; we may not be able to introduce new products and enhancements on a timely basis, impairing our ability to generate future revenue.

The market for electronic distribution and licensing of digital goods is fragmented and marked by rapid technological change, frequent new product introductions and enhancements, uncertain product life cycles, and changes in customer demands. There is currently no standard for electronic distribution and licensing of digital goods. New products based on new technologies or new industry standards can quickly render existing products obsolete and unmarketable. In the past, we have experienced delays in new product releases and we may experience similar delays in the future. Any delays in our ability to develop and release enhanced or new systems could seriously impair our ability to generate future revenue.

We are in a highly competitive industry, and we expect to face increased competition in the future; increased competition may reduce our revenues and market opportunity.

The market for electronic distribution and licensing of digital goods is new, rapidly evolving and intensely competitive. We expect competition to intensify in the future. We currently compete directly with other providers of electronic commerce solutions for digital goods such as Cybersource, Digital River and InterTrust Technologies. More broadly, we compete with other providers of technology to secure digital content such as AT&T, IBM, Liquid Audio, Microsoft, Real Networks, and Xerox, as well as solutions developed in-house. In the future, operating system manufacturers may include digital rights management solutions in their operating systems.

We believe that the principal competitive factors in our markets include:

•: software publisher, music label, distributor and reseller relationships;
•: system security, scalability and reliability;
•: breadth of products and services;
•: price; and
•: speed of deployment.

Many of our current and potential competitors have longer operating histories, larger customer bases, greater brand recognition and much greater financial, marketing and other resources than we do. In addition, larger, well-established and well-financed entities may acquire, invest in or form joint ventures with competitors as the use of the Internet and other online services increases. Increased competition may result in reduced prices, and loss of market share may negatively impact our ability to obtain network transaction fees. In addition, adoption by publishers, distributors and resellers of competing systems may significantly limit the size of the potential market for our solution. We may not be able to compete successfully against current and future competitors, and any inability to do so would materially adversely affect our business.

We may be sued for violating the intellectual property rights of others.

The digital encryption and distribution industry is characterized by the existence of a large number of patents and frequent litigation based on allegations of patent infringement and the violation of other intellectual property rights. We have not completed an in-depth and exhaustive analysis of such patents or applications. Some of our competitors have extensive patent portfolios with broad claims. As the number of competitors in the market grows and the functionality of our solution increases, the possibility of an intellectual property claim against us increases. In addition, because patent applications can take many years to issue, there may be a patent application now pending, of which we are unaware, which will cause us to be infringing when it is issued in the future. Moreover, we expect to receive more patent infringement claims as companies increasingly seek to patent their software, especially in light of recent developments in the law that extend the ability to patent software. To address these patent infringement or other intellectual property claims, we may have to redesign our solution to avoid infringement or enter into royalty or licensing agreements on disadvantageous commercial terms. We may be unable to successfully redesign our solution or obtain a necessary license. A successful claim against us or our licensees, or our failure to design around the infringed technology or license it or similar technology, would harm our business. In addition, any infringement or other intellectual property claims, with or without merit, which are brought against us could be time consuming and expensive to litigate or settle and could divert management's attention from our business.

In April 1998, our predecessor and subsidiary, Portland Software, received a letter from representatives of TAU Systems Corporation informing us of two patents held by TAU Systems. In the letter, the representatives stated their opinion that Portland Software's ZipLock System software contained various elements recited in the two patents and requested that Portland Software discuss licensing the technology of these patents. Portland Software responded to the letter stating that although it had not undertaken a detailed review of the patents, it was unaware of any of its products having one of the elements required by the patent claims. In March 1999, we received correspondence from TAU Systems, essentially reiterating the above claims. In August 1999, after further investigation of the TAU Systems patents, we notified TAU Systems that we do not believe our software falls within the scope of coverage of TAU Systems' patents and, therefore, we were not interested in licensing arrangements. We have not received further correspondence from TAU Systems.

On March 30, 1999, the United States District Court for the District of Connecticut dismissed a lawsuit filed by E-Data against several defendants, including Portland Software, alleging that they infringed E-Data's U.S. Patent No. 4,528,643 ("System for Reproducing Information in Material Objects at a Point of Sale Location") issued July 9, 1985. Although the suit was dismissed, it may be reinstated depending upon the outcome of E-Data's appeal before the Federal Circuit of a New York district court's dismissal of a prior patent infringement suit on the same patent that was filed by E-Data against different defendants. In the future, we, or our licensees, could be found to infringe upon the patent rights of TAU Systems, E-Data or other companies.

We have been, and may in the future be, subject to litigation that may adversely affect us.

From time to time we have been, and may in the future be, subject to legal proceedings and claims in the ordinary course of our business, including claims of alleged infringement of third-party intellectual property rights by us and our licensees. We were subject to litigation initiated by 20/20 Software, Inc. in the United States Court for the District of Northern California. The 20/20 complaint alleged copyright infringement, unfair competition, interference with prospective economic advantage and misappropriation of trade secrets and confidential information of 20/20. On October 21, 1999, we entered a settlement agreement with 20/20 regarding these claims for an amount which was not material and with no admission of liability. On December 21, 1999, 20/20's counsel sent us a letter indicating that 20/20 continued to believe that we had misappropriated 20/20's technology and 20/20 therefore intended to assert additional claims. Our counsel responded that any such claims would be covered by the prior settlement agreement. As of now, it remains unclear whether 20/20 will in fact assert any future claims or, if so, on what basis such claims might be asserted. Claims like these, whether or not meritorious, could result in the expenditure of significant financial and managerial resources and could materially and adversely affect our business.

Legal uncertainties and potential government regulation could increase our costs and be a barrier to doing business.

To date, communications and commerce on the Internet have not been highly regulated. State and federal governments may decide to enact new laws or regulations at any time and it may take years to determine the extent to which existing laws relating to issues including property ownership, defamation, and personal privacy apply to the Internet. Any new laws or regulations or implementations of existing laws and regulations relating to the Internet could harm our business.

The European Union has adopted a privacy directive that regulates the collection and use of information that identifies an individual person. These regulations may inhibit or prohibit the collection and sharing of personal information in ways that could harm our partners or us. The globalization of Internet commerce may be harmed by these and similar regulations since the European Union privacy directive prohibits transmission of personal information outside the European Union unless the receiving country has enacted individual privacy protection laws at least as strong as those enacted by the European Union privacy directive. The United States and the European Union have not yet resolved this matter, and they may not ever do so, in a manner favorable to our customers or us.

Imposition of sales and other taxes on electronic commerce transactions may hinder electronic commerce.

The taxation of commerce activities in connection with the Internet has not been established, may change in the future and may vary from jurisdiction to jurisdiction. One or more states or other countries may seek to impose sales or other taxes on companies that engage in or facilitate electronic commerce. A number of proposals have been made at the local, state and international level that would impose additional taxes on the sale of products and services through the Internet. These proposals, if adopted, could substantially impair the growth of electronic commerce and could

significantly harm our business. Moreover, if any state or other country were to assert successfully that we should collect sales or other taxes on the exchange of products and services through the Internet, our business may be harmed.

The trading price of our Common Stock has been and is likely to continue to be highly volatile and could be subject to wide fluctuations.

The trading price of our common stock has been and is likely to continue to be highly volatile and could be subject to wide fluctuations as a result of numerous factors such as:

•: actual or anticipated variations in quarterly operating results;
•: announcements of technological innovations;
•: new products or services offered by us or our competitors;
•: changes in financial estimates by securities analysts;
•: conditions or trends in the Internet and online commerce industries;
•: changes in the economic performance and/or market valuations of other Internet, online service industries;
•: changes in the economic performance and/or market valuations of other Internet, online service or retail companies;
•: announcements by us of significant acquisitions, strategic partnerships, joint ventures or capital commitments;
•: additions or departures of key personnel;
•: sales of common stock; and
•: other events or factors, many of which are beyond our control.

In addition, the stock market in general, and the Nasdaq National Market and the market for Internet-related and technology companies in particular, has experienced extreme price and volume fluctuations that have often been unrelated or disproportionate to the operating performance of such companies. These broad market and industry factors may materially, adversely affect the market price of our common stock, regardless of our actual operating performance. In the past, following periods of volatility in the market price of a company's securities, securities class-action litigation has often been instituted against such companies. Such litigation, if instituted, could result in substantial costs and a diversion of management's attention and resources, which could materially adversely affect our business, financial condition and operating results.

Item 3. Quantitative and Qualitative Disclosures About Market Risk

We develop products in the United States and make agreements with customers in North America, Europe, and Asia. As a result, our financial results could be adversely affected by various factors, including foreign currency exchange rates or weak economic conditions in foreign markets. Network transaction fees from our European and Asian partners will be primarily denominated in foreign currencies and generally translated on a monthly basis to U.S. dollars to determine the amount of fees we are due. As a result, we could be affected adversely by fluctuations in foreign currency exchange rates.

Our exposure to market risk for changes in interest rates is limited to the exposure related to our debt instruments and credit facilities, which are tied to market rates. We do not plan to use derivative financial instruments in our investment portfolio. We plan to ensure the safety and preservation of our invested principal funds by limiting default risk, market risk, and reinvestment risk. We plan to mitigate default risk by investing in high credit quality securities.

PART II—OTHER INFORMATION

Item 1. Legal Proceedings

See "Risk Factors—We may be sued for violating the intellectual property rights of others" and "We have been, and may in the future be, subject to litigation that may adversely affect us."

Item 2. Changes in Securities and Use of Proceeds

The Company filed a registration statement on Form S-1, File No. 333-87181, for an initial public offering of Common Stock, which was declared effective by the Securities and Exchange Commission on December 8, 1999. In that offering, the Company sold an aggregate of 4,370,000 shares of its Common Stock with net offering proceeds of $82.4 million. As of September 30, 2000, the Company had used approximately $14.6 million of those proceeds as follows:


Cash loss from operations	$	11.9 million
Working capital	$	0.7 million
Purchases of property and equipment	$	2.0 million

No payments were made to directors or officers of the Company or their associates, holders of 10% or more of any class of equity securities of the Company or to affiliates of the Company.

Item 6. Exhibits and Reports on Form 8-K

(a) Exhibits

The exhibits filed as a part of this report are listed below and this list is intended to constitute the exhibit index.

Exhibit No.
10.1		Loan and Security Agreement dated August 4, 2000 between Preview Systems, Inc. and Silicon Valley Bank. Incorporated by reference to the Company's Form 10-Q for the quarter ended June 30, 2000.
10.2		Loan Agreement dated October 11, 2000 between Preview Systems, Inc. and Vincent Pluvinage.
27		Financial Data Schedule

(b) Reports on Form 8-K

The Company did not file any reports on Form 8-K during the quarter ended September 30, 2000.

SIGNATURES

Pursuant to the requirements of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned thereunto duly authorized.


Date: November 2, 2000		PREVIEW SYSTEMS, INC.
		By: /s/ G. BRADFORD SOLSO G. Bradford Solso Chief Operating Officer and Chief Financial Officer (Principal Financial and Accounting Officer)

QuickLinks

PREVIEW SYSTEMS, INC. FORM 10-Q INDEX
PREVIEW SYSTEMS, INC. AND SUBSIDIARIES CONSOLIDATED BALANCE SHEETS (In thousands, except per share amounts)
PREVIEW SYSTEMS, INC. AND SUBSIDIARIES CONSOLIDATED STATEMENTS OF OPERATIONS (In thousands, except per share data) (Unaudited)
PREVIEW SYSTEMS, INC. AND SUBSIDIARIES CONSOLIDATED STATEMENTS OF CASH FLOWS (In thousands) (Unaudited)
PREVIEW SYSTEMS, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (In thousands) (Unaudited)
PART II—OTHER INFORMATION
SIGNATURES